How Finalyse can help
Designed to meet regulatory and strategic requirements of the Actuarial and Risk department.
Helping you comply with the Solvency II regulations as well as optimising your Solvency II balance sheet
Helping you comply with the regulations as well as optimising your Economic Balance Sheet (EBS)
Written by Francis Furey (Principal Consultant)
Background
In the complex world of insurance, effective liquidity risk management is crucial to ensuring that a company can meet its financial obligations as they come due, even in adverse conditions. For (re)insurance companies, maintaining a robust liquidity risk management framework is fundamental to operational stability and long-term success.
The amendments to the Solvency II Directive[1], which were finalised in January 2024, establish comprehensive requirements for managing and monitoring liquidity risk, and ensuring the fulfilment of obligations to policyholders. (Re)insurers will be required to develop and maintain a current liquidity risk management plan that includes short-term liquidity analysis and projecting cash inflows and outflows relative to their assets and liabilities. This liquidity risk management plan will need to be submitted to the local regulator at least yearly. The Bermudian regulator has also published similar high-level guidance on liquidity planning following the release of two consultation papers.
This blog post delves into the intricacies of liquidity risk management planning, offering insights into key principles, methodologies, and governance structures that underpin a resilient liquidity strategy.
What is Liquidity Risk?
Liquidity risk is the uncertainty surrounding a company’s ability to meet its payment obligations in a full and timely manner. For a (re)insurance company, this encompasses the interplay between its assets and liabilities. Effective liquidity management ensures that cash outflows over the next 12 months can be met under both normal and stressed conditions, thereby safeguarding the company from potential liquidity crises.
Key Principles of Liquidity Risk Management
Principle | Description |
Alignment with Group Standards | Align liquidity risk management policies with broader group standards such as a parent group’s ERM Framework. |
Regulatory Compliance | Align policies with regulatory frameworks, including EU directives and EIOPA guidelines. |
Stakeholder Notification | Ensure effective communication of the liquidity risk management policy to all relevant stakeholders. |
Liquidity Risk Governance
A structured governance framework is essential for effective liquidity risk management. This involves multiple levels of oversight and responsibility:
Liquidity Risk Management Process
The liquidity risk management process involves several critical steps:
- Risk Identification: This step involves identifying the sources and needs of liquidity within the company. Sources include cash, credit lines, and liquid assets, while needs arise from operating activities, investments, and financing activities.
- Risk Assessment/Measurement: The Risk Management Function conducts cash flow analysis over specific time horizons to project the company's liquidity position and verify that liquidity resources cover liquidity needs under both normal and stressed scenarios.
- Monitoring & Reporting: Continuous monitoring and regular reporting to the Investment & ALM Committee ensure that any potential issues are identified and addressed promptly.
Liquidity Risk Assessment Methodology - Example
To project the liquidity position, the Risk Management Function could use the following approach, using these time buckets: 1 week, 1 month, 3 months, and 12 months. For each period, they calculate:
Time Buckets | Liquidity Resources (LR) | Liquidity Needs (LN) | Excess Liquidity (EL) |
1 Week | Cash, Money Market Instruments | Net Outflows (Outflows - Inflows) | LR - LN |
1 Month | Liquid Assets | Net Outflows | LR - LN |
3 Months | Government Bonds, High-Quality Bonds | Net Outflows | LR - LN |
12 Months | Listed Equities | Net Outflows | LR - LN |
In stressed scenarios, the Risk Management Function applies various shocks to simulate extreme market conditions, such as distressed financial markets, natural catastrophes, and confidence crises. The worst-case scenario helps the company prepare for potential liquidity crises.
Defining Liquidity Resources
Eligible liquidity resources include:
Defining Liquidity Needs
Liquidity needs are determined by summing the outflows and subtracting inflows over the projection period. These needs arise from various sources:
Stress Scenarios
Stress scenarios help (re)insurance companies prepare for extreme conditions by applying shocks to liquidity resources and needs. These scenarios include:
Scenario Type | Example |
Market Shocks | Changes in asset prices, liquidity, and funding access. |
FX Shocks | Currency fluctuations affecting liquidity positions. |
CAT Scenarios | Catastrophic events like earthquakes impacting cash flows and insurance claims. |
Liquidity Crisis Management
A well-defined liquidity contingency plan is crucial for managing potential liquidity crises. This plan involves:
Corporate Governance and Policy Review
The Chief Risk Officer (CRO) is responsible for developing and reviewing the liquidity risk management policy annually or following any major changes. The policy must be approved by the Board and communicated to relevant internal functions, ensuring everyone is aligned with the company’s liquidity management strategy.
Conclusion
Liquidity risk management is a critical aspect of a(n) (re)insurance company's overall risk management strategy. By implementing a robust framework, aligning with group and regulatory standards, and preparing for potential crises, companies can ensure they remain financially stable and capable of meeting their obligations under any conditions. Through diligent governance, regular assessment, and comprehensive planning, (re)insurance companies can navigate the complexities of liquidity risk and safeguard their operations for the future.
(Re)insurers should anticipate that liquidity risk management will be a significant topic in the coming months. The new Solvency II requirement to produce a liquidity risk management plan for submission to the local regulator will become clearer once the Technical Standards are released by EIOPA. In the meantime, clients can enhance their current processes and begin documentation if they have not already done so.
How can Finalyse help you?
Navigating the evolving landscape of liquidity risk management, Finalyse offers tailored support for insurance and reinsurance undertakings:
- Assessment and Gap Analysis
We assess your current framework to identify gaps and ensure alignment with regulatory expectations and provide benchmarking to best practice. - Liquidity Risk Management Plans
Our experts help create comprehensive plans, including short-term liquidity analysis and cash flow projections. - Stress Testing
We design stress testing frameworks to simulate extreme market conditions, preparing you for potential crises. - Governance and Reporting
Finalyse establishes effective governance structures and reporting mechanisms for continuous oversight. - Training and Workshops
We provide training sessions to keep your team informed on the latest developments and best practices. - Regulatory Compliance
While awaiting EIOPA's Technical Standards, we offer interim solutions to keep your practices compliant and adaptable. - Technology Implementation
We assist in implementing advanced tools for cash flow analysis and real-time monitoring. - Ongoing Support
Finalyse offers continuous advisory services to keep your framework effective and up-to-date.
Partner with Finalyse to enhance your liquidity risk management, ensuring resilience and compliance.
[1] The proposal issued by the Council of the European Union on 19 January 2024 -https://data.consilium.europa.eu/doc/document/ST-5481-2024-INIT/en/pdf