How to avoid concentration risk in times of political uncertainty

Alan Sheppard, Head of Insurance Policy at the Bank of England examines how insurers can evaluate and manage risks against the backdrop of political unpredictability

Insurance Investor Editorposted on Wednesday, September 11, 2019

This excerpt is taken from a roundtable: ‘Political and Socio-Economic modelling – setting an investment plan on a scenario basis and developing a liquidity plan”.

You can read the full roundtable in the research report Insurance Asset Management – Europe 2019, which can be downloaded here.

In this environment of heightened political uncertainty there is even greater importance for risk management to understand and avoid concentration risks, thus diversifying your asset base and your exposures to political risks.

You should also carry out stress and scenario testing as an adjunct to traditional quantitative risk measures.

There is less value to historical data than there would be in a stable political and economic environment. The only way through this is to stress test under some very extreme scenarios.

We have been talking in terms of solvency risks so far rather than liquidity risks. There was a lot of nervousness within the insurance community when insurance regulation and supervision passed to the merged Bank of England and Financial Conduct Authority that insurance regulation would be dominated by banking supervisors despite the very different business models of the two sectors.

"The only way through this is to stress test under some very extreme scenarios"

We do understand that liquidity risk isn’t inherent to the insurance business model in the way that it clearly is to banks and indeed that maturity transformation generally works the other way around in an insurance company.

Nevertheless, it can become a major risk to insurers and particularly in an environment of political uncertainty, the behaviour of investors and policy holders becomes less predictable.

There are examples of insurers who have failed due to excessive holdings of illiquid assets coupled with poor asset liability management, such as Confederation Life in Canada.

As well as the uncertainties, we have discussed there are some large structural developments in the past few years that mean that although liquidity risk remains structurally lower for insurers than banks, it has increased.

"There are insurers who have failed due to excessive holdings of illiquid assets coupled with poor asset liability management"

On the liability side pension reform, and changes to consumer expectations of liquidity available to them from products offered by insurers; not meeting those expectations creates franchise risk regardless of the letter of contracts.

Asset markets have generally become less liquid, perhaps in part as a result of regulatory reforms on the banking side since 2007 (although those reforms should have had the beneficial effect of reducing the instability of asset market liquidity).

The other trends on the asset side are the technical challenges posed by the matching adjustment for those firms who use it and the pretty impermeable barrier that places between the matching portfolio and the rest of the balance sheet.

Also, the big trend that is being driven partly by the regulations and rates environment that we find ourselves in to increase holdings of illiquid assets on the balance sheets, primarily of life insurers.

"You also need to look at reliability of sources of liquidity resilience which is a big part of what we learnt in 2007/08"

Before going ahead with a strategy of increasing allocation to illiquid assets and given the uncertainties I have mentioned, firms need to ensure that they have this rigorous understanding of their liquidity needs in normal times and in stress.

Many less sophisticated firms may have taken the view that because they are not inherently exposed to liquidity risk, they have plenty of cash and gilts, so there is no problem.

But, with a strategy of increasing investments to illiquids you need to quantify what plenty means. You also need to look at reliability of sources of liquidity resilience which is a big part of what we learnt in 2007/08 – that what were previously considered to be totally liquid assets and safe sources of liquidity within the banking sector are not necessarily reliable.

This is often an overlooked aspect of concentration - concentration to particular sources of resilience.

This excerpt is taken from a roundtable: ‘Political and Socio-Economic modelling – setting an investment plan on a scenario basis and developing a liquidity plan”.

You can read the full roundtable in the research report Insurance Asset Management – Europe 2019, which can be downloaded here.