24 April 2012

Risk.net: Insurers stress liquidity and lapse risk, amid concern over interest rate spike

For banks, liquidity risk is one of the hottest topics in town. However, insurers – and insurance regulators – are often quick to point out that liquidity risk is less of an issue for their industry than it is for their financial services cousins. Yet, insurance firms have failed due to liquidity risk issues and, in particular, weak surrender and lapse risk management.

During the financial crisis, insurers have also seen heightened levels of surrenders and lapses, sometimes outside the parameters of their initial assumptions. With interest rates dropping and fund values taking large hits, the incentive to lapse was strong, and some insurers experienced large outflows, due to variable annuity guarantees being deeply in-the-money. As a result, some insurers were forced to sell all of their government debt and equities, so that they were left holding an unbalanced, less liquid portfolio.

Now regulators and the insurance industry have an eye on the next big crisis – with a sudden spike in interest rates and the potential for increased surrender rates being a concern. “A significant rise in interest rates… is one of the big risks the industry recognises”, says Simon Hotchin, managing director, head of strategic solutions at HSBC in London. “The big question mark is what will be the impact on [policy] surrenders.”

When interest rates rise, some policyholders may choose to terminate policies to seek better returns elsewhere or to alleviate pressures on their household budgets arising from higher debt repayments. This is a scenario that US regulators are watching carefully, says Larry Bruning, international life actuary at the NAIC, based in Kansas City, Missouri, even though there are substantial surrender fees in most US cash value life insurance policies and annuities. “Should we enter into another interest rate cycle, where interest rates start spiking up, there will be that incentive for policyholders to move again”, says Bruning.

In Europe, the forthcoming Solvency II regime will also require insurers to consider liquidity risk. Firms must have proper liquidity risk management and a liquidity contingency plan, as part of their Own Risk and Solvency Assessment (ORSA). Surrender and lapse risk must be considered as part of the Pillar I solvency capital requirements.

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