Liquidity risk cannot easily be hedged or diversified away
August 24, 2015 — OLDWICK, N.J.–(BUSINESS WIRE)–With the continuation of low interest rates and narrowing credit spreads, A.M. Best is seeing evidence that some life insurers are reaching for yield via the assumption of liquidity risk in their fixed income portfolios.
According to a new Best’s Briefing, titled, “A Reach for Yield: Fixed Indexed Annuity Writers Turn to Less Liquid Bonds,” fixed income securities may be affected by several risk factors, including, but not limited to: interest rate risk, credit risk, prepayment risk and liquidity risk. Unlike other risk factors, liquidity risk cannot easily be hedged or diversified away and when markets become stressed, it’s the bid-price rather than the mid-price that matters.
From an insurance investment perspective, asset liquidity can be defined generally as the ease of trading that asset. Measuring asset liquidity or illiquidity is not straightforward. Liquidity risk is a multifaceted, time-varying concept with complex relationships that make it difficult to quantify in a single statistic. Assessing the fixed income liquidity risk of an insurer’s investment portfolio is as much a qualitative process as a quantitative one.
An investment portfolio with increased liquidity risk characteristics that appears to match well against the liquidity characteristics of the insurance products in a benign or even moderately adverse macroeconomic environment may not match well in more extreme economic scenarios (as some securities lending programs demonstrated during the 2008-2009 financial crisis, duration matched does not always equate to liquidity matched).
The move to increase yield via the liquidity risk premium in some instances appears to be efficient from the standpoint of the current Best’s Capital Adequacy Ratio (BCAR) and The National Association of Insurance Commissioners’ risk-based capital frameworks. By allocating to illiquid bonds, the company can minimize the required capital/surplus needed for a given yield. A.M. Best’s BCAR score is just one of the quantitative subcategories that analysts use to assess balance sheet strength. The interpretation of quantitative measurements, such as BCAR, involves the incorporation of qualitative considerations into the assessment of an insurer’s overall balance sheet strength.
For the full copy of this briefing, please visit here.