Credit Risk Increases Across All Classes

This is the third part of a four part series exploring the impact of COVID-19 on the Financial Sector. Read Part I, II here.

Financial markets have been characterized by sell-off across asset classes, increased volatilities for bond and equity markets, increasing risk premia and flight to quality investment behaviour in March 2020. Credit risk has increased across all asset classes, in particular CDS of government bonds, financial and non-financial corporate bonds have increased sharply. Liquidity and funding risks have been raised to high level due to potential additional strains on the disposable liquidity of insurers in the medium to long-term horizon.

According to EIOPA, market perceptions remain at medium level, albeit deteriorating. The EU insurance sector underperformed the market, both life and non-life businesses lines, and the median price-to-earnings ratio of insurance groups in the sample decreased since the last assessment. Insurers’ external ratings and rating outlooks do not show sign of deterioration as of end March 2020, however credit quality is expected to deteriorate. 

On 1 April 2020, EIOPA urged continued action by insurance market participants to mitigate the impact of the Covid-19 pandemic, and in particular, called for continued access and continuity of insurance services, a COVID-19 update explains.

EIOPA issued a further statement on 2 April 2020, calling on “…(re)insurers [to] take

measures to preserve their capital position in balance with the protection of the insured, following prudent dividend and other distribution policies, including variable remuneration”. In particular, it urged (re)insurers to temporarily suspend all discretionary dividend distributions and share buy backs aimed at remunerating shareholders.

The European Securities and Markets Authority (ESMA) has issued recommendations to financial market participants relating to business continuity, market disclosure, financial reporting, and fund management, amongst other issues relating to the crisis. In its initial statement on the COVID-19 pandemic on 11th March, it made the following recommendations:

  • Business Continuity Planning – All financial market participants, including infrastructures should be ready to apply their contingency plans, including deployment of business continuity measures, to ensure operational continuity in line with regulatory obligations;
  • Market disclosure – issuers should disclose as soon as possible any relevant significant information concerning the impacts of COVID-19 on their fundamentals, prospects or financial situation in accordance with their transparency obligations under the Market Abuse Regulation;
  • Financial Reporting – issuers should provide transparency on the actual and potential impacts of COVID-19, to the extent possible based on both a qualitative and quantitative assessment on their business activities, financial situation and economic performance in their 2019 year-end financial report if these have not yet been finalised or otherwise in their interim financial reporting disclosures; and
  • Fund Management – asset managers should continue to apply the requirements on risk management, and react accordingly.
Stressed Out Markets

The PRA Rulebook defines ‘liquidity risk’ as ‘the risk that a firm is unable to realise investments and other assets in order to settle its financial obligations when they fall due.’ Liquidity risk is inherent to the business model of banks (because of the mismatch between liabilities (usually demand deposits) and assets (usually long-term loans). This risk is typically less pronounced for insurers than for banks as insurers receive premiums upfront and pay claims later, upon the occurrence of an insured event (the so-called ‘inverted production cycle’).

The regular inflow of liquidity through premiums can, however, cause insurers to consider liquidity risk a second order concern and to potentially underestimate, or fail to recognise, the risks to a positive liquidity position in times of market stress.

The PRA report Liquidity risk management for insurers says that there have also been a number of changes in the insurance sector and financial markets more broadly that have increased liquidity risk for insurers. In PRA Executive Director of Insurance Supervision David Rule’s speech in July 2017, he observed that a potential concern for the life industry is the shift towards direct investment in illiquid assets, and the potential that this might in future lead to exposure concentrations.

Non-insurance obligations may also contribute to liquidity stress at an insurer. Collateral upgrade transactions may pose risks to an insurer’s liquidity position. Insurers with material derivatives positions, even those insurers using such contracts to hedge market risk in their insurance liabilities, may face unexpected liquidity demands if the value of the derivative moves against the insurer.

While insurers benefit from the inverted production cycle, they are not immune to liquidity risk. Insurers have experienced financial distress or failed in other jurisdictions because of liquidity concerns, for example as access to wholesale funding has reduced. Insufficient liquidity in the insurance sector may impact the PRA’s general safety and soundness objective, its insurance objective and the Bank’s financial stability objective. The PRA takes the view that this is a serious risk for the sector, and one that may rise further in the future.

UK Solvency II firms and managing agents should conduct stress testing and scenario analysis for relevant risks, and have in place an effective risk-management system that covers liquidity risk. Consistent with these obligations, the PRA would expect that an insurer conduct liquidity stress tests and to have in place proper systems and data processes to enable it to carry out stress testing. An insurer’s stress tests should capture all material risk drivers, relevant to its business, and use a range of severe but plausible stress scenarios over different horizons.

With the Benefit of Hindsight

With hindsight it is very interesting to read that: “The PRA expects an insurer to understand the sources of liquidity risk it faces. To this end, an insurer should consider the relevance of the sources of liquidity risk. Liability-side risks: For a life insurer, this may include sudden, unexpected increases in lapse rates 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. A general insurer may consider the nature, frequency and severity of its exposure to insurable events, including market-turning events.”

This PRA paper was written in March 2019!

Other risks that need to be considered include: asset side risks, concentration risks, off balance sheet risks, funding risk, cross currency risk, intra day risk, and franchise risk.

The PRA expects an insurer to pay particular attention to the liquidity risks associated with material use of derivatives. While hedging programs may limit the impact of market shocks on capital, they can also lead to 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.

The asset and liability management (ALM) strategies of insurers vary depending on the company’s lines of business. Non-life insurers primarily use stochastic models such as dynamic financial analysis (DFA) to cope with their liquidity risks. Life insurers generally engage in immunisation strategies, optimisation strategies, and scenario analyses, where stochastic modelling is extensively used in economic scenario generators (ESG) for valuation and risk modelling purposes. Derivatives are considered a valuable instrument for the ALM of insurance companies and pension funds, and a liquid derivatives exchange market with a sufficiently long time horizon is important for this purpose.

Post Date: 02/07/2020

Related Articles

Credit and surety

Global Credit Risks Rise as Recession Fears Loom

Read morePost Date: 24/10/2022

Credit and surety

Half a trillion dollars wiped from high-flying FinTechs as inflation fears spook investors

Read morePost Date: 19/07/2022

Credit and surety

Fears about Omicron variant spook World Stock Markets

Read morePost Date: 24/12/2021