Sources of liquidity risk


The PRA expects an insurer to understand the sources of liquidity risk it faces and to consider the relevance of the sources of liquidity risk listed in paragraph 3.2, including the implications of these risks on its liquidity position under both normal and stressed conditions. However, the mix of liquidity risk drivers is unique to each business, and hence an insurer should not consider this list to be exhaustive, nor are all of the elements necessarily relevant to all insurers.


Material sources of liquidity risk may include:

  • Liability-side risks: The PRA expects a life insurer to consider sudden, unexpected increases in lapses, withdrawals or surrenders of life insurance or investment policies within a short period or a sudden increase in the volume of claims triggered following, for example, a pandemic. It expects that a general insurer will consider liquidity needs, both relating to direct claims and regulatory funding requirements (eg trust fund requirements), following insurable events, including market turning events such as severe natural catastrophes.16 A reinsurer is expected to consider the above sources of liquidity risk, where applicable, and also where contractual terms in reinsurance contracts could cause unexpected liquidity needs, for instance, required funding of reinsurance trusts or forced commutation clauses. For providers of longer duration contracts, such as annuities, including those stemming from non-life or health insurance contracts, potential liquidity needs may arise from changes in long-term experience.
    • Where exposed to significant insured events, the PRA expects an insurer to consider the extent to which reinsurance payments could be used to satisfy liquidity needs. Consistent with paragraph 1.59(d) of EIOPA Guideline 22, this should involve an assessment of the likelihood and extent to which reinsurance claims will be adjusted  downward by the reinsurer and of claims settlement delays and whether payments will be available in a timely manner. Some of these risks may be mitigated where reinsurance claims are pre-paid, assets are placed in trust for the benefit of the cedant or the contract is conducted on a funds withheld basis.
    • The PRA expects an insurer to, in line with paragraph 1.63(e) of EIOPA Guideline 26, also consider the extent of reliance on premium receipts from business not yet written or renewal business as a source of liquidity and whether its assumptions regarding the availability of such premiums are consistent with stressed conditions.
  • Asset-side risks: The PRA expects an insurer to consider how its assets could be monetised, including as acceptable collateral, in both benign and stressed market conditions by taking into account factors such as market depth and access, the time required to monetise an asset (eg time to settlement, delays in finding a willing buyer), haircuts and the likelihood and extent of forced-sale losses. Some types of assets may only be able to be sold at a significant discount. A stress that puts pressure on multiple insurers could exacerbate these effects, to the extent that other insurers try to sell similar assets. In stressed market conditions, it may not be feasible to properly value or sell other types of assets. Operational constraints may limit an insurer’s ability to monetise even the most liquid assets in sufficiently short timeframes.
  • Concentration risks: Liability-side concentrations may include: the term structure of an insurer’s liabilities; their sensitivity to an insurer’s own credit rating; the mix of secured and unsecured funding; concentrations among funding providers and policyholders or related groups of funding providers and policyholders; reliance on particular instruments or products; and the geographical location of funding providers and policyholders. Asset concentrations may include significant concentrations in relation to: individual counterparties or groups of related counterparties; credit ratings of the assets in an insurer’s portfolio; instrument types; geographical regions; and economic sectors. In the context of liquidity risk, these asset concentrations may be relative to the insurer’s own portfolio and relative to the amount of a particular asset in the market. In the case of the former, there is a risk that a significant portion of its assets may become illiquid when they are needed most. In case of the latter, such assets may be thinly traded and thus the insurer may not be able monetise them in stress.
  • Off-balance sheet risks: Where material, the PRA expects an insurer to consider how its off-balance sheet activities affect its cash flows and liquidity risk profile under both normal and stressed conditions. For example, risks associated with holding derivatives positions are often overlooked (and are discussed further below). An insurer is also expected to consider the impact of a downgrade in its own credit rating. Downgrades may trigger the early redemption of funding instruments or collateral or margin obligations and may impact an insurer’s ability to roll over wholesale funding. The PRA expects the insurer to assess and monitor any other material contingent obligations for cash or collateral. An insurer may need to consider the impact of maintaining liquidity facilities to support securitisation or internal asset restructuring programmes.
    • Consistent with Article 260(1)(c)(iv) of the Delegated Act, insurers should pay particular attention to the liquidity risks associated with material use of derivatives. While hedging programs may limit the impact of market shocks on an insurer’s capital position, they can also create liquidity needs, thus transforming capital risk into liquidity risk. A liquidity need will arise where the value of the derivative moves against the insurer and requires extra collateral to be posted. This risk was the focus of the Bank of England’s Financial Policy Committee (FPC) assessment of the risks from leverage in the non-bank financial system.17 Stress may be amplified where derivatives are centrally cleared, as these contracts will require an insurer to post cash variation margin, as opposed to securities, against movements in their value. The PRA expects an insurer to be aware of the conditions in any credit support annexes that could restrict acceptable assets for collateralisation or initial margin.
  • Funding risk: Flows arising from secured funding sources, including collateral upgrade transactions, could incur a number of risks. For both secured and unsecured funding sources, the PRA expects stress assumptions to test an insurer’s ability to roll over funding at maturity or at the earliest possible termination date, where such a date is not within the insurer’s control.
  • Cross-currency risk: The PRA expects an insurer to consider foreign currency liquidity needs, both in each individual currency and in aggregate. It expects an insurer to also consider the risk of non-convertibility of currencies over short time periods (ie market lockout).
  • Intra-day risk: Where relevant to its activities the PRA expects an insurer to maintain systems capable of monitoring intra-day liquidity positions and cash needs (ie those arising at particular times during a single day), and to take appropriate steps to ensure it holds sufficient funds to cover intra-day risk in both cash accounts and the cash side of securities accounts. Some examples of potential sources of intra-day liquidity risk include collateral or margin calls on derivatives, stock borrowing/lending transactions or (reverse-) repurchase agreements or intra-day securities settlement, specifically where the insurer uses intra-day credit to partially or fully fund the transaction.
  • Franchise risk: Liquidity resources may be required to make payments on claims to maintain an insurer’s core business franchise and reputation, even where an insurer has the right to defer or delay such payments. The PRA expects an insurer to assess the extent to which it can, and realistically will, defer or delay payments, including claims, surrenders or dividends, without significantly damaging its core business franchise and reputation.


Collateral upgrade and other transactions


A collateral upgrade transaction is a collateralised borrowing transaction where there is a material difference in the quality of assets exchanged. This difference in quality may be a function of differences in liquidity, credit quality or another risk parameter. In such transactions, a ‘borrower’ receives higher quality assets (eg cash or gilts) from a ‘lender’, and in return, the borrower posts collateral to the lender. Examples include repo and reverse repo transactions, stock lending and borrowing, and any form of collateralised borrowing that is in substance economically similar, including synthetic transactions (eg a sale plus a collateralised and margined total return swap).


For the lender of liquidity, the value of the less liquid and/or lower quality collateral being taken may be difficult to assess, both before and in the event of a borrower default. An insurer, generally the lender in such transactions, is expected to have adequate systems and controls in place to appropriately value and manage collateral, including:

  • ensuring the collateral is individually identifiable and suitably diversified, with adequate information available about the underlying assets held through any securitisation vehicle; and
  • establishing an independent and robust challenge process in agreeing valuations with the borrower.


If the collateral received by the insurer is relatively illiquid, particularly where it has been re-used, there may be difficulties in realising its value within a reasonable timescale, for example if the borrower wishes to substitute collateral or to terminate the transaction, or in matching the insurer’s liabilities in the event of counterparty default. There may also be additional risks for the insurer resulting from any leveraging of the collateral received. The PRA expects the insurer to take into account any mismatch between the type, quality and liquidity of the assets held by the insurer following re-use of the collateral, and the collateral that would need to be returned to the borrower.


The insurer is expected to carefully consider whether the collateral may expose it to wrong-way risk (ie the risk that the collateral declines in value as the health of the counterparty deteriorates). A prudent assumption is that higher price volatility of the collateral is likely to correspond to greater correlation with other assets during stress.


The scale and concentration risk of any collateral upgrade transaction may potentially exacerbate the risks associated with such transactions. An insurer is expected to have appropriate limits in place to manage these risks, including limits on:

  • the scale of transactions;
  • the type of assets lent and collateral received;
  • the credit and liquidity correlation with the credit quality of the counterparty; and
  • other model sensitivities, eg minimum levels of haircuts by asset class.


Liquidity provided to the insurer, through these transactions, may decline in stressed times as counterparties may be less willing or able to extend new funding or roll over existing funding. Moreover, the dynamic nature of margining in these transactions means that a fall in the value of the posted collateral may result in the insurer having to encumber more assets. Triggers within transaction agreements may lead to additional margin calls, further reducing liquidity. This is likely to be exacerbated in periods of stress. The PRA expects an insurer to be particularly mindful of situations where it has pledged assets and falls in their market value are likely to be closely correlated with the insurer entering into a liquidity stress.


Whether as a borrower or lender of liquidity, depending on the scale of such transactions, an insurer may be encumbering a significant proportion of its assets. The insurer is expected to be mindful of the extent of asset encumbrance and the extent to which those assets may or may not be available to meet liquidity needs during a period of market stress. If a material part of an insurer’s liquid assets are borrowed or lent under a collateral upgrade transaction, the insurer is expected to conduct a thorough analysis of the potential liquidity risks under stressed scenarios.

Fungibility considerations


An insurer is expected to be mindful of any applicable restrictions on fungibility that may limit its ability to access or monetise assets under stress. Of particular note are matching adjustment (MA) and with-profits funds.


Although many of the sources of liquidity risks mentioned in paragraph 3.2 will still be relevant, the MA involves unique considerations with regard to liquidity risk. Conditions Governing Business 3.1(3) requires an internal liquidity condition to be satisfied for an MA portfolio, and an insurer is required to develop a specific liquidity plan for this purpose. In particular, an insurer is expected to be mindful that there can be no subsidy to the rest of the business from the MA portfolio, that is, MA assets will not be available to meet liquidity needs elsewhere in the business. The insurer is also expected to manage the liquidity implications of any change in the MA portfolio or in the underlying assumptions, such as longevity. For example, any potential liquidity strains on the business as a result of a change in the MA portfolio will need to be managed properly, and the insurer is expected to consider the need to obtain eligible assets to maintain MA approval.


With-profits funds can pose similar challenges to an insurer’s liquidity management. Like the MA portfolio, an insurer is expected to reflect the fact that assets in the with-profits fund will be unavailable to cover the risks of the rest of the firm. The PRA expects an insurer to also be mindful of the liquidity implications of any applicable support arrangements that could require it to provide support to a with-profits fund.


Further guidance on the liquidity planning required in connection with the application by an insurer of the MA can be found in SS7/18. Further guidance on with-profits funds can be found in SS14/15 and the Conduct of Business Sourcebook chapter 20 (COBS 20) in the FCA Handbook.

Unit-linked business


Unit-linked products present different risks to an insurer’s liquidity position. In general, the policyholder bears the risk, including liquidity risk, associated with the underlying investments in unit-linked funds. An insurer should refer to Financial Conduct Authority rules and guidance on the management of liquidity within unit-linked funds.


Liquidity risks may generally arise from unit-linked funds through operational costs. Some examples may include the terms, charges and processes associated with unit redemptions, with switching investments or with payments for operational errors. The insurer is expected to maintain sufficient liquidity to carry out these operations without material disruption. Where feasible, the PRA expects that liquidity for such operational purposes and for non-linked funds will be segregated from liquidity held for policyholders in unit-linked funds.


In some instances, for example where policy documentation provides for a specified time to payment, an insurer may be expected or required to provide supporting liquidity when liquidity buffers within funds are depleted. An insurer is expected to consider the possible actions it can take to meet such short term liquidity needs and to take such circumstances into account in its liquidity risk management strategy.


Where liquidity risk management is shared between functional areas such as fund managers, portfolio managers, operations, treasury, pricing and client relationship management the PRA expects that the roles and responsibilities of each are set out clearly.


The PRA expects an insurer to review its rights to apply fair value pricing adjustments, suspend fund redemptions or liquidate investments, including any contractual provisions that may limit these rights. Where these rights are not consistent between funds and the insurance product in which the fund units are held the insurer is expected to ensure it understands the liquidity implications and takes these into account in its risk management.


Invoking any of the aforementioned rights may have fairness and consumer protection implications. The insurer is expected to be aware of the effects of such actions on policyholders and whether such rights are likely to be available to be exercised where doing so could raise concerns about the equitable treatment of policyholders, both present and future.

Group-specific risks


Liquidity is not always freely transferable around a group. The PRA expects an insurer that is part of a group to consider how intra-group transactions affect its liquidity position. As discussed in SS4/18, any planned reliance by an insurer on support from other entities within its group is expected to be assessed carefully. Where liquidity is managed centrally the PRA expects that there would be no legal or regulatory impediments to liquidity being available, in both benign and stressed conditions, to the regulated entities where and when it is needed.


At the parent entity level, there may be shareholder expectations and debt obligations that require funding. Servicing these obligations may rely on cash flows from subsidiaries. For example, the parent entity may rely on up-streaming of dividends or intra-group loan repayments to meet such obligations. Hence, the PRA expects the cash flow implications of an insurer’s financial projections to be considered at group level. It expects any insurer that is part of a group to assess whether there is the ability to generate sufficient cash flows in stress to cover group liabilities as they fall due.


In line with Group Supervision 17.1(3), mechanisms should be in place to identify, monitor and manage significant risk concentrations and intra-group transactions that could threaten the group’s liquidity position.