Prudential Regulation Authority Rulebook

5.1

Under Investments 2.1, a UK Solvency II firm, the Society and managing agents are required to invest in assets that ensure the liquidity of their investment portfolio and, under Article 260(1)(d)(ii) of the Delegated Act, to consider the appropriateness of their assets in order to meet obligations as they fall due. Under paragraphs 1.63(b) and (c) of EIOPA Guideline 26 an insurer should consider its total liquidity needs, including an appropriate liquidity buffer and consider the level and monitoring of liquid assets, as well as potential haircuts that could be imposed on their sale. A non-Directive insurer, under Insurance Company – Overall Resources and Valuation 2.3 or Friendly Society – Financial Prudence 4.1 must maintain adequate liquidity to ensure there is no significant risk that its liabilities cannot be met as they fall due. An insurer must therefore maintain an adequate stock of liquid assets, hereafter called a ‘liquidity buffer’, sufficient to meet liabilities as they fall due, and is expected to do so under both benign and stressed conditions.

5.2

The liquidity buffer is intended to fill any shortfall of cash in-flows relative to cash out-flows (in line with paragraph 1.63(a) of EIOPA Guideline 26) arising over the chosen time horizon, in both benign and stressed circumstances. The insurer may, for example, use cash flow estimates from its business as usual projections (as mentioned in paragraph 2.17) and its stress testing (as mentioned in paragraph 4.2), respectively, to determine the appropriate size of the liquidity buffer in line with its liquidity risk appetite.

5.3

Through Group Supervision 17.1(1)(b) and Conditions Governing Business 3.4, an insurer that is part of a group must ensure sufficient liquidity on a group basis to meet group liabilities as they fall due and is expected to do so under both benign and stressed conditions.

5.4

An insurer may consider it appropriate to have in place multiple buffers, composed of different assets, depending on the nature and duration of the stresses to which it may be exposed.

5.5

The PRA expects that an insurer should be able to monetise the assets in its liquidity buffer to meet its excess cash flow needs in the chosen time horizon without directly conflicting with any existing business or risk management strategies. Hence, an insurer is expected to avoid counting funds committed for future payments or investments used for regular income generation, such as fees, dividends or interest, as part of its liquidity buffer.

5.6

An insurer is expected to tailor its liquidity buffer to the needs of its business and the drivers of liquidity risk that it faces, taking into account a number of factors, including:

• assets of primary and secondary liquidity (discussed in paragraphs 5.9 and 5.10);
• the ability of the insurer to monetise the assets in its buffer to meet liquidity needs within the relevant time horizon;
• the need to have a well-diversified range of assets in the liquidity buffer;
• whether the assets in the liquidity buffer can be accessed and controlled by the insurer’s liquidity management function at all times;
• the appropriateness of haircuts applied to assets held in the liquidity buffer, informed by an insurer’s own stress tests. This is expected to include the potential costs and financial losses arising from their sale (as discussed in paragraph 1.63(c) of EIOPA Guideline 26), noting that these may be exacerbated when the insurer is a forced seller; and
• the consistency of the currency denomination of its liquid assets and net liquidity out-flows.

5.7

Where applicable, to avoid double counting, intra-group transactions are expected to be excluded from analysis of the insurer’s liquidity position on a group basis.

5.8

The PRA considers that assets included in the liquidity buffer should be unencumbered,^[19] of a high credit quality, readily marketable, and have a proven record as a reliable source of liquidity during stressed market conditions. Such assets should be easy to value with a high degree of certainty (ie low likelihood of material disagreement between transacting parties in a sale) and will either be listed on recognised exchanges or tradable on large, deep and active cash or repurchase markets with a large number of participants, low concentration, high trading volume and timely and observable market prices. Even assets of ‘high credit quality’ may have differences in the speed at which they may be realisable, particularly during stressed market conditions. The PRA considers two classifications for assets in the liquidity buffer to emphasise this distinction: assets of primary liquidity and assets of secondary liquidity.

5.9

Assets of primary liquidity are generally those that are realisable over a very short time horizon, even under stressed conditions. Examples of assets of primary liquidity include:

• cash held at highly rated financial institutions;
• highly rated securities issued or unconditionally guaranteed by sovereigns or central banks; and
• certain money market funds which hold high levels of cash or liquid assets and have an objective to provide liquidity on demand.

5.10

Assets of secondary liquidity are generally those that are realisable over a short to medium time horizon as finding a willing buyer in a short amount of time may not be feasible in stressed conditions. Examples of assets of secondary liquidity include:

• other (ie those not included in paragraph 5.9) investment-grade securities issued or guaranteed by sovereigns;
• highly rated and publicly issued covered bonds;
• investment-grade, vanilla corporate debt securities;
• common equity shares traded within a major stock index;^[20] and
• any other assets that an insurer deems to be sufficiently liquid that demonstrably meet the criteria set out in paragraph 5.8.

5.11

Assets of secondary liquidity are not generally usable for very short duration stress periods, for example 7 days or less, as an insurer may be unable to monetise these assets soon enough. For short to medium term stresses, for example between 7 and 90 days, it is good practice for an insurer to rely only on assets of primary and secondary liquidity. For longer-term stresses, an insurer may wish to include a broader spectrum of assets in its liquidity buffer, although it may incur substantial losses in the process of monetising these. An insurer should consider the potential losses arising from asset sales to meet its liquidity requirements under stressed conditions and may wish to explicitly define its appetite for capital erosion in such situations.

5.12

To ensure that assets in the insurer’s liquidity buffer remain suitable, the PRA expects an insurer to review and regularly test its access to the markets for its liquid assets. The appropriate frequency of testing will depend on the mix of assets included in the liquidity buffer. Buffers comprised largely of assets of primary liquidity are likely to need less frequent testing than buffers with more assets of secondary liquidity.

5.13

The PRA expects insurers to assess market access under both normal and stressed conditions. In particular, an insurer is expected to consider carefully the extent of its reliance on repo and other secured funding transactions, as the availability of liquidity in these markets may not be guaranteed, particularly in the event of short duration severe stresses.

5.14

The PRA expects an insurer to consider whether assets it has borrowed or received as collateral or margin are appropriate to include in its liquidity buffer; any liquid assets that have been lent or posted as collateral to secure a transaction are encumbered and will not be available to meet liquidity needs. An insurer is expected to be mindful of circumstances where it has borrowed or received liquid assets that could be withdrawn or recalled. It is prudent to assume that counterparties will withdraw such assets at the first opportunity in stress.

5.15

An insurer is also expected to consider the extent to which access to liquidity in money market funds may be limited in stress. As a collective investment undertaking, the money market fund structure creates a layer between the insurer and the underlying asset, which could create additional risk. When investing in money market funds, an insurer is expected to look through to the fund’s underlying assets to establish its liquidity during stress. This includes assessing the extent to which money market fund holdings may increase concentration risk, particularly with the banks in which the insurer maintains deposits. An insurer is also expected to consider whether the fund’s own risk management strategies or liquidity management tools, as described in the fund’s prospectus, may limit their realisability, particularly during times of stress. Of particular note are a fund’s ability to apply liquidity fees on redemptions or to apply ‘swing pricing’,^[21] which may increase the haircut imposed on their sale, to impose gates or withdrawal limits or other characteristics which may limit their realisability, particularly in stress.

5.16

In evaluating whether other collective investment undertakings or pooled vehicles are considered to meet the criteria in paragraph 5.8, the PRA expects an insurer to consider the same aspects as for money market funds, though noting that the additional complexity of the structure around less liquid assets may reduce their liquidity in stress.

5.17

The PRA also expects an insurer to be mindful of the use of securities issued by financial institutions in its liquidity buffer as these assets are more likely to become illiquid during stress events.