QFIP - 123 Liquidity Risk Management - Best Practices

Question 1

Liquidity Risk

Answer 1

• The risk that cash sources are insufficient to meet cash needs under current market conditions or possible future environments.
• Liquidity risk is separate from profitability. A company can be profitable, but still face signficant liquidity risk if it does not anticipate its cashoutflows properly.

Question 2

Eight Principles of Liquidity Risk Management

Answer 2

1. Liquidity Risk Should be Managed in an ALM Perspective
2. Use Qualitative and Quantitative Tools for Assessing Liquidity
   Risk
3. Consider Liquidity Costs when Designing Products
4. Incorporate Liquidity in Strategic Allocation
5. Maintain Liquidity Sources in Times of Stress
6. Write a Liquidity Risk Policy
7. Write a Liquidity Stress Management Plan
8. Liquidity Risk Should Not Increase Capital Requirements

Question 3

Liquidity Risk Should be Managed in an ALM Perspective

Answer 3

• Liquidity risk is an asset/liability concern, not solely an asset risk or liability risk

Question 4

Liquidity Risk and Cashflow Sources for Insurance Companies

Answer 4

• If an insurance company invested in assets without considerations for its liabilities, then there can be substantial duration/cashflow mismatch that will cause extra volatility in earnings results.
• Cash sources for insurance companies include:
  
  • Cash inflows from products (premiums, deposits)
  • Asset cash flows
  • Sales of assets
  • Contigent liquidity sources
• Cash needs driven by cash outflows for insurance companies include:
  
  • Cash outflows from products (benefit payments, withdrawals from surrender)
  • Operating cash outflows
  • Contingent cash needs arising from environmentally-driven factors

Question 5

Use Qualitative and Quantitative Tools for Assessing Liquidity
Risk

Answer 5

Management should set a tolerance for liquidity risk using both qualitative and quantitative tools

Question 6

Consider Liquidity Costs when Designing Products

Answer 6

Management should reflect the cost of securing adequate liquidity when designing a product

Question 7

Sources of Necessary Liquidity in Product Design

Answer 7

Necessary liquidity can be provided through:

1. Liability product design
2. The investment portfolio backing the product
3. External/contingent cashflow lines

Question 8

Example of using product design to take into consideration potential for cash outflows is the use of surrender charges for early withdrawals

Answer 8

• The product can be designed so that a surrender charge is applied to early withdrawals, thus transferring some of the liquidity cost to the consumer.
• Also can model dynamic lapse in determining the price of the product
• Impose a min time the company can hold on to the funds before withdrawals are allowed

Question 9

Incorporate Liquidity in Strategic Allocation

Answer 9

A company’s strategic asset allocation and contingent liquidity planning should directly reflect expected and contingent liquidity needs of its liabilities, as well as sudden shifts of liquidity in the market.

Question 10

Maintain Liquidity Sources in Times of Stress

Answer 10

A company should manage its access to the financial markets to get alternative sources of liquidity during times of stress.

Question 11

Contingent Liquidity Sources

Answer 11

• During times of stress when the company needs to generate large amounts of cash, the liquidity embedded in its asset portfolio may be insufficient.
• Thus, it is often necessary to obtain funding through additional guaranteed lines of liquidity in the case of an emergency.

Such contingent liquidity sources include:

1. Repo market
2. Uncommitted bank lines of credit
3. Other standby/back-up liquidity lines
4. Ability to issue new product on a guaranteed basis

Question 12

Liquidty Risk in Times of Stress

Answer 12

• It is critical to ensure these contingent liquidity sources are always available, especially in times of stress
• If a company tries to sell an excessive amount of its assets to generate large amounts of cash, market makers and dealers will notice the “desperation” of the company and charge large bid/ask spreads, thus forcing the company to sells assets at well below fair value

Question 13

Write a Liquidity Risk Policy

Answer 13

Management should have a written liquidity risk policy that is regularly reviewed

Question 14

Liquidity Risk Policy Components

Answer 14

Liquidity risk policy will cover:

• The extent of a company’s liquidity risk tolerance
• How frequently liquidity adequacy will be measured
• The degree to which the company will expect to rely on external cash sources for liquidity (i.e. lines of credit with a bank)
• Define the requirements, roles, and responsibilities for liquidity crisis planning

Question 15

Write a Liquidity Stress Management Plan

Answer 15

• A company should have a liquidity stress management plan
• A crisis management team will administer this plan, and determines how assets will be sold and cash will be generated during a stress scenario

Question 16

Liquidity Risk Should not Increase Capital Requirements

Answer 16

Liquidity risk should not lead to an additional capital requirement; it is a risk that should be managed at all times

Question 17

Liquidity Stress Sources

Answer 17

1. Disintermidiation Risk
2. Downgrade Risk
3. Catastrophic Risk
4. Capital Markets Liquidty Impairment

Question 18

Disintermediation Risk as a Source of Liquidity Risk

Answer 18

• This occurs when interest rates rise, and alternative investments become increasingly attractive to inforce annuity and insurance policyholders.
• The company can be then experiencing increasing withdrawal rates as policyholders lapse their policies to seek products that yield higher returns.
• In order to generate the cash for these withdrawals, the company is forced to sell current assets in its investment portfolio (which mainly consists of bonds) at a loss, since the market value of a bond decreases as interest rates increase

Question 19

Downgrade Risk as a Source of Liquidity Risk

Answer 19

• This occurs when a rating agencies downgrades the credit of a company’s bond.
• This can result in reduced product sales, and higher customer withdrawals as policyholders become worried about the company’s solvency

Question 20

Catastrophic claims as a Source of Liqudity Risk

Answer 20

• This is the risk that the insurance company has to pay large claims over a short period of time
• Can be caused by a natural disaster (i.e. earthquake destroys homes, triggering payouts for home insurance), or persistent higher-than-expected claims (i.e. more deaths than expected for a life insurance block)
• This risk can be mitigated somewhat by having diversified businesses with interdependency between risks (i.e. annuities and life insurance), and through reinsurance

Question 21

Capital Markets Liquidity Impairment as a Source of Liquidity Risk

Answer 21

• Occurs when previously liquid asset classes become temporarily illiquid for a period of time
• This makes it difficult for the insurance company to raise cash
• This occurred during the 2008 financial crises, as many mortgage-backed securities became illiquid.

Question 22

Developing Stress Tests

Answer 22

A company can develop stress tests on the different liquidity stress sources

• For each stress test scenario, the company would project future liability and asset cashflows.
• The company passes the stress test if its projected Cash Sources will be greater than or equal to its projected Cash Needs over various time horizons (i.e. 7 days, 1 month, 3 months, 6 months, 1 year, etc).