Liquidity and Capital Management
IN ThE YEARS LEADING uP to the recent financial recession, many
insurance companies designed incentive compensation arrangements
that encouraged senior management to give earnings, sales, and expense management top billing. These arrangements implicitly demoted
long-term liquidity and capital management. The incentive structure
pushed modeling teams to spend their time designing products with
increasingly aggressive pricing and guarantees.
Many companies allowed the capital
and liquidity components of their pricing
and projection models to become underdeveloped relative to the complexity of
their new products. Numerous models
simply assumed capital and liquidity
to be available as needed, in unlimited
amounts and at a fixed cost.
The crisis in the financial markets
in 2008 temporarily reversed priorities,
with several high-profile companies
struggling to maintain sufficient capi-
tal and liquidity. As traditional methods
of raising capital and liquidity became
less available, insurers learned that the
cost of capital and liquidity can increase
rapidly when needed most—even for
companies with relatively strong bal-
ance sheets. Insurers scrambled on the
fly to come up with more robust capital
and liquidity management strategies.
Each alternative was expensive, and
several companies considered writing
new insurance liabilities with gener-
ous crediting rates as the least onerous
In reaction to the crisis, regulatory
bodies and ratings agencies are moving
to develop new regulations and finan-
cial reporting metrics that encourage
companies to adopt more robust and
better-documented capital and liquidity
risk management practices. Provisions
included in the Dodd-Frank Wall Street
Reform and Consumer Protection Act
will force companies to hold larger
amounts of liquid assets. The Financial
Accounting Standards Board (FASB)
and International Accounting Standards
Board (IASB) have proposed changes
to insurance contract accounting rules
that will encourage asset-liability man-
agement (ALM). And Standard & Poor’s
(S&P) has refined its framework for
evaluating companies’ internal risk meas-
urement and management processes.
Table 1 shows a collection of tools companies traditionally have used to raise
capital and manage liquidity. Many of
these tools became prohibitively expensive during the crisis and remain so
today. Others may become less effective
under proposed changes to accounting,
legal, and ratings agency frameworks.
While few of these tools remain as attractive as they were four to five years
ago, creative minds have started to develop new and effective alternatives.
■ ■ surplus notes and other hybrid capital methodologies are available today,
but surplus relief from these strategies is under attack in insurance and
banking. Some ratings agencies have
discussed changing their treatment of
these securities, and trust-preferred
securities (a banking industry variant
of surplus notes) have been removed
from Tier 1 capital calculations.
■ ■ Letters of credit (LOCs) traditionally have been used in conjunction with
other strategies to gain surplus relief.
LOCs are available, but costs have increased tenfold to twentyfold from
pre-crisis levels. Mortality-contingent
LOCs can be used to reduce the cost
of some forms of surplus relief.
■ ■ debt issuance and commercial paper have returned as viable options