QFIP - 105 AAA Liquidity Work Group Report

Question 1

Types of Liquidity Management

Answer 1

1. Day-to-day cash management
   
   • Keep on top of short-term liquidty need through the combination of cash position and credit line
2. Ongoing/intermediate term cash flow management
   
   • Ongoing liquidity need over 6-24 months
   • Analyze and monitor the liquidity ratio (cash inflows vs outflows)
   • Involve management plan or tools to restore liquidity profile if needed
3. Stress liquidity risk
   
   • Ensure company has ability to meet obligation under adverse scenarios
   • Be able to stay in business and remain solvent on a statutory basis

​​​All 3 levels should be monitored, but this report will focus on the 3rd risk

Question 2

New Liabilities Issues and Demands for Insurance Companies

Answer 2

Increasing client sophistication is placing new demands on insurance companies:

• Some funding agreements can be surrendered at book value on short notice
• GICs that back defined contribution pension plans can be paid off early at book value
• Some individual and group contracts have general account guarantees on separate account products
• Off-balance sheet guarantees

Question 3

New Assets Issues and Demands for Insurance Companies

Answer 3

Life insurers are starting to buy new types of assets that may increase stress liquidity risk:

• Highly rated but illiquid commercial investment pools
• Company-specific swaps and derivatives that have low liquidity
• Letters of credit that may require cash payments on short notice

Question 4

Possible Causes of Stress Liquidity Risk

Answer 4

A run-on-the-bank scenario may be triggered by credit rating downgrades, negative publicity, or industry events
Key contributors to stress liquidity risks:

1. Amount of money controlled per contractholder (larger is riskier)
2. Company size
   
   • Small companies may lack funding resources
   • Large companies may not being able to liquidate large volumes at fair value
3. Cash flow predictability (sudden large surrenders are bad)
4. Products that allow surrenders on short notice

Question 5

Institutional Products with Embedded Liquidity Options

Answer 5

• Funding Agreements and GICs with Put Options
  
  • Often sold to money market funds, which have high liquidity requirements
  • May be putable with only 7, 30, or 90 days notice
• Standard GIC Contracts
  
  • Many do not have options
  • GICs sold to defined contribution plans may allow benefit responsive withdrawals (e.g. large payments during a layoff)
• Corporate-Owned Life Insurance (COLI)
  
  • Entire groups of individual policies may surrender at once

Question 6

Retail Products with Embedded Liquidity Options

Answer 6

• Individual Contracts
  
  • Surrender charges may decline to zero over time
  • Policyholders may borrow against their policy during times of stress
• Market Value Adjusted (MVA) Contracts
  
  • Full MVAs lessen risk, but those with fixed adjustments may not be effective in a stress scenario
  • usually attached to annuities to protect against surrenders in rising interest rate environment for when insurer might be forced to sell depressed assets below market value MVA is a type of implicit surrender charge
• Separate Account Products
  
  • CARVM allowances are treated as balance sheet assets, but they can’t be sold for cash
• Reinsurance Treaties
  
  • The ceding company may be able to cancel the treaty penalty-free if the reinsurer is downgraded
  • (may cause the reinsurer to need cash)

Question 7

Assets with Embedded Options

Answer 7

• Derivatives
  
  • Some swaps and derivatives allow a counterparty to unwind the contract if the other is downgraded
• Liquidity Back-Stops
  
  • Some insurers insure against asset default or provide letters of credit to other companies
  • Risky if other companies experience a liquidity crisis

Question 8

Other Asset Concerns Regarding Liquidity Risk

Answer 8

• Custom assets like limited partnerships may not be readily marketable
• Assets that are normally liquid may be illiquid if trying to sell large volumes
  
  • If interest rates rise and/or credit ratings fall, assets may have to be sold below book value

Question 9

Stress Liquidity Risk Management Process

Answer 9

• Stress liquidity risk can be reduced through product design, portfolio strategy, and preparednes to act
• Multi-line companies should have good communication and coordination
• May be useful to build a grid that compares demand funds with asset categories by timeframe
  
  • Assess time to liquidation for each category
• Can be useful to evaluate business units (BUs) on a standalone basis
  
  • Easier to spot the source of problems
• BU results can be rolled up and viewed at an enterprise level to evaluate run-on-the-bank scenarios

Question 10

Ways to Manage Stress Liquidity Risk

Answer 10

1. Ladder liability maturities
2. Ladder asset maturities to match liabilities
3. Avoid having a large percentage of securitized assets that mature at the same time
4. Use repos to manage short-term cash needs (but don’t tie up too many longer-term liquid assets in the process)
5. Have reliable back-stop liquidity lines from unaffiliated companies
6. Purchase credit derivatives, equity puts, and liquidity options
7. Diversify asset holdings
8. Back a portion of capital/surplus with liquid assets that can be sold in <3 months
9. Assume policyholder deposits will decrease or cease
10. Consider asset extension risk

Question 11

Considerations for Projecting Demand Liabilities

Answer 11

Demand liab is a liab where the contract holder has the right to demand return of that liab in the future or surrender it:

1. On-going, known liability interest payments and maturities
2. Possible withdrawals under stress liquidity risk scenarios
3. Consider contracts that do not penalize the policyholder for withdrawal (e.g. zero surrender charge, weak MVAs, puts, borrowing)
4. Letters of credit
5. Cash flow strain from index-based options sold by the company

Should weight the above results depending on the severity of the scenario (base case would get a lower factor than stress scenarios)

Question 12

Approaches to Quantify Asset Liquidity

Answer 12

1. Project future expected principal and interest payments
2. Project unexpected principal and interest (e.g. prepayments)
3. Determine bid/ask spreads (higher means lower liquidity)
4. Consider how volatility might lower fair value if the asset can’t be sold for a while
   
   • Adjust asset value by an appropriate “haircut”

Securitization is an alternative to selling assets
Should consider the time and cost to securitize

Question 13

Sample Best Practices

Answer 13

See notes page 11 for three examples