Academy - Report of Life Liquidity

Question 1

What is liquidity risk

Answer 1

The risk that at some time an entity will not have enough cash or liquid asset to meet its cash obligations.

Question 2

Possible sources of liquidity Risk

Answer 2

1. A credit rating downgrade, which results in either more demands for collateral from lenders, or an early withdrawl of funds from customers/policyhoders.
2. Negative publicity: which causes customers to lose confidence in the company and make early withdrawls.
3. Deterioration of the economy
4. Reports of problems at similar companies, raising fears that such problems exist at the company.

Question 3

Three levels of liquidity management

Answer 3

1. day-to-day cash management
2. intermediate term cash flow management

typical strategy for 1&2 will be to conserve cash and access credit lines

3.stress liquidity risk management:

response for 3 will typically involve forced liquidation of assets

Question 4

Examples of company-specific characteristics that can contribute to liquidity risk exposure include:

Answer 4

1. A single or a few contract holders control large sums of money.
2. The sized of the company may limit access to capital markets.

• too small => may not have the funding choices available to large companies
• if large company is forced to liquidate billions of $s of assets at once, the marketplace may not be able to absorb the volume without a discount from fair value

3. Immediate demands on cash

• Any immediate demand for a cash payment can be a risk if cash is in short supply
• A predictable cash demand is less of a risk. A well-managed company can structure its assets to cover the known obligation.

4. Unpredictable deferred or deferrable demands on cash.
5. Insufficient ability to borrow short-term through bank line of credit, commercial paper, etc.
6. Lack of diversity in either the liability or the asset portfolio

Question 5

Liquidity sources that are common

Answer 5

• Asset Sales (of the most liquid assets, size of haircut should be eveluated)
• Asset Securitizations (to monetize future cash flows without selling the assets in the open market, consider cost of securitization)
• Borrowing (preferably at pre-agreed terms on an existing credit facility)
• Increase Premiums Written

Question 6

Haircut

Answer 6

Haircut: the difference between the fair value and the estimated amount of cash that can be raised by a sale

Question 7

Risk Reduction Techniques

Answer 7

1. Cash flow match: ladder asset maturities to closely match liability maturities
2. Diversify assets: less susceptible to a stress situation
3. Diversify liability: diversification by market, product, channel, etc
4. Ladder liability maturities not forced to flood market with new sales
5. Back Surplus/capital with liquid assets: available for extreme events. But there is a price tag involved
6. Establish a durable line of credit
7. Issue commercial paper: can used to access short-term markets under normal operation
8. Use repurchase agreements: use repos to mitigate ST cash needs. Disadvantage is that repos typically tie up assets that are relatively liquid, so it is usually not a viable long-term solution
9. Purchase liquidity options