Liquidity and Asset-Liability Management in a Rising Rate Environment 

Life insurance firms encounter considerable difficulties with respect to liquidity and asset-liability management (ALM) in an environment where interest rates are rising. ALM mismatches can result from rapid changes in interest rates, which might surprise insurers. Other industries, such as health insurance, pension plans, and property and casualty insurers, are typically less vulnerable to similar hazards. Their responsibilities are usually shorter, and they have enough cash on hand to pay for both anticipated and unforeseen claims. Pension schemes can purposefully function with mismatched assets and obligations, but higher interest rates can reduce liabilities and keep the plans reasonably well-funded even when assets are lost. But because public sector pension plans disclose liabilities using high expected-return discount rates, they can miss economic mismatches, which could expose them to unmonitored risk.

 

Insurance companies can use a variety of risk management techniques to reduce these risks. Designing products with surrender protections and constraints in place can help avert or decelerate liquidity shocks. Resilience can also be increased by accounting for falsely inflated valuations, understanding the underlying economic value of assets, and diversifying the client base. Diversification reduces the risk of reinsurance counterparty as well as specific issuer risks from assets. Furthermore, regulatory compliance and balance sheet stability can be improved by the conservative accounting treatment of assets, such as the implementation of a floor on discount rates or the recognition of smaller unrealized capital gains. When combined, these steps help insurers navigate a variable rate environment with a stronger foundation for risk management.

 

Systemic Risks and Contagion

When a great number of institutional failures occur simultaneously or in close succession, the risk of the collapse of an entire financial market arises, which is known as systemic risk. On the other hand, contagion risk is the risk that problems associated with some financial intermediaries could spread to other financial intermediaries. When a financial intermediary fails, investors and customers could lose confidence and act accordingly, which could then create a downward spiral of fear and uncertainty. 

 

The financial markets of today are highly interdependent. As a result, the effect of institutional failures could ripple through a single region or sector. Not only that, the effect of institutional failures could also ripple through national and international levels. The insurance industry is faced with political and legal risks, for example, tax law changes. Tax law changes could have  wide ranging and sometimes disruptive impacts on the financial system.  

 

Risk Management, Governance, and Regulation 

There are three common pitfalls with respect to the modeling and analysis of risks. The first pitfall is the over-reliance on models. Up to this point, statistical models are unable to capture the actual path of interest rates in simulated scenarios as well as predicting the actual interest rates. Deterministic scenarios, like sensitivity tests and stress tests are used to help companies have a better understanding of the risks which they are exposed to. These deterministic scenarios combine multiple assumption changes under distinct narrative scenarios. For instance, stress tests are useful for pensions, especially those employing significant allocations to investments, like derivative securities that can have margin and collateral requirements and illiquid investments.

 

The next pitfall is the practice of applying shocks one at a time during sensitivity analysis and ignoring the possibility of risk clusters at the same time. A straightforward way to incorporate risk clusters in risk appetite assessments is that insurers rank their top risks and consider the amount of risks that they could survive if they occurred simultaneously.  

 

The last pitfall is narrow focus on a specific view of risks. For instance, one statutory, GAAP, economic, or capital view is overly focused while the others are ignored. Alternative lenses for risks are important to provide different and deeper insights. In addition, insurers should also strike a balance between rule-based and principle-based analysis of risks by considering both qualitative and quantitative analytical techniques.  

 

Reference:

https://www.soa.org/497715/globalassets/assets/files/resources/research-report/2023/learn-from-bank-failures.pdf