04 March 2010
Published in: Capital - models, Insurance risk, ALM, Regulation - supervision
Task force report details liquidity premium choices
Here's a summary of the conclusions and recommendations released earlier this week by the task force set up by the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS).
Initial reaction was reported yesterday (IERM, Regulation/supervision, 3 March 2010, "Liquidity premium report is "positive", says ABI").
Definition of liquidity of an insurance liability
Conclusions
- The illiquidity of an insurance liability measures the extent up to which its cash flows are certain in amount and in timing, due consideration being given to the resilience to forced sales.
- Most life insurance liabilities can be considered to be at least partially illiquid.
- A prerequisite for the application of a liquidity premium to illiquid liabilities is the existence of objective and reliable methods allowing the degree of illiquidity to be measured.
Industry's business case: why a liquidity premium
As a conclusion of its work on decomposition of spreads of corporate bonds versus government bonds and swap rates, the insurance industry concludes that:
- In normal circumstances the liquidity premium on assets is small and thus has no significant influence on the valuation of insurance liabilities.
- During periods of stressed liquidity, the liquidity premium on assets has a positive value, but its application to insurance liabilities aims only to eliminate any valuation mismatch between the valuation of assets and liabilities.
- Although it is not its main objective, the liquidity premium has an anti-cyclical
effect and allows a harmonized treatment of distressed market conditions.
Principles underlying the use of liquidity premiums
It is proposed that the following nine principles should apply to the use of liquidity
premiums:
- The risk-free reference rate applicable to the valuation of a liability should be the sum of a basic risk-free reference rate and a liquidity premium depending on the nature of the liability.
- The liquidity premium should be independent of the investment strategy adopted by the company.
- The liquidity premium applicable to a liability should not exceed the extra return which can be earned by the insurer by holding illiquid assets free of credit risk, available in the financial markets and matching the cash flows of the liability.
- The liquidity premium applicable to a liability should depend on the nature of the liabilities having regard to the currency, the predictability of their cash flows (e.g. the ability to cash back/withdraw/surrender) and the resilience to forced sales of illiquid assets covering technical liabilities (e.g. where any loss of liquidity premium can be transferred to policyholders).
- The liquidity premium should be calculated and published by a central EU institution with the same frequency and according to the same procedures as the basic risk-free interest rate.
- The liquidity premium should be assessed and quantified by reliable methods based on objective market data from the relevant financial markets and consistent with solvency valuation methods.
- No liquidity premium should be applied to liabilities in the absence of a corresponding liquidity premium evidenced in the valuation of assets.
- The design and calibration of the SCR standard formula should ensure that its calculation is consistent with a recognition of a liquidity premium in the valuation of liabilities and compatible with the set Solvency II target criteria for solvency assessment. The calculation of the SCR with internal models should also include an appropriate recognition of the risk arising from the liquidity premium in order to guarantee the targeted confidence level.
- The undertaking should have in place risk management systems and investment policy provisions specifically oriented to the risks inherent to the application of a liquidity premium, including liquidity risks.
Choice of the basic risk-free interest-rate term structure
In a submission produced late in the process and thus not further discussed by the task force, the CRO/CFO Forum proposed the following principles:
- The basis risk-free interest rate should be based on a swap curve appropriately adjusted to remove credit risk.
- The adjustment for credit risk should refer to overnight swap rates where these are available and the market is sufficiently liquid.
- Where this is not the case, other market swap rates adjusted for long-term through-the-cycle credit risk should be used.