Liquidity – Feature


But Mick McAteer, co-director at the Financial Inclusion Cen- tre and a former board member of the FCA, warns that this could leave insurance investors exposed to higher risks at the worst possible time. “The Bank of England and the Prudential Regulation Authority (PRA) originally recommended that in return for relaxing the risk margin, the PRA should tighten up the use of the matching adjustment so that it had an offsetting effect.


“What was worrying is that the government has gone ahead with the reduction of the risk margin but they have ignored the PRA and the Bank of England on the matching adjustment, so it is even worse,” he adds. But simply removing these thresholds is no guarantee that insurers will invest in infrastructure. “I don’t know if the gov- ernment believes this story that insurers will stomp up money for social housing, levelling up and the green transition or if they are being disingenuous,” he says. “There is nothing in the rules that prevents insurers from investing in infrastructure anyway, they simply find higher returns elsewhere.” McAteer is not alone in his concerns about liquidity risks in insurance portfolios. In its insurance supervision priorities for 2023, the Bank of England and the PRA disclosed that they were keeping a close eye on the matter. “Recent events such as the liability-driven investment shock has highlighted gaps in insurers’ liquidity risk frameworks, further reinforcing the importance of sound risk management practices.


“We expect insurers to test the resilience of liquidity sources to market dysfunction and to


re-evaluate


potential liquidity


demands created by use of derivatives for risk management,” the regulators say.


Sharper awareness


Liquidity is something pension schemes have always thought about to some degree but what happened in September has sharpened the focus.


Dan Mikulskis, Lane Clark & Peacock


The question of liquidity management is even more pressing for pension funds. In practical terms, one challenge they face in the wake of the LDI crisis is to assess how much liquidity they need and what the probability of another crisis is. “Liquidity is something pension schemes have always thought about to some degree but what happened in September has sharpened the focus,” says Dan Mikulskis, a partner at consul- tancy Lane Clark & Peacock. “Liquidity risk is by definition a tail risk which is impactful, but a rare kind of risk that doesn’t fit into the standard mean variance modelling. “If you are going to address this, you have to handle it outside that framework using different risk scenarios,” he adds. “But you can’t eliminate every single tail risk out there, because then you would just be left in cash.” Mikulskis argues that pension funds should identify the specific areas in their portfolio that could represent a liquidity risk if markets deteriorate, with derivatives a key concern. “Another factor is when you have regular cashflows coming out of your portfolio. So, depending on how much LDI lever- age you have, and how cashflow negative your scheme is, there will be quite a lot of variation in how urgent the question of li- quidity is. “The key issue is what will happen to the illiquid assets they are already invested in,” he adds. “Schemes will certainly think twice about putting more money into infrastructure, but they can’t suddenly disinvest. A lot of schemes will look at running those down over time,” he says.


A slow leak September’s LDI crisis demonstrated that insufficient capital buffers in the context of a liquidity crunch could be a costly mistake. Schemes that held insufficient collateral to meet mar- gin calls turned into forced sellers of assets and had to report billions of losses. With global liquidity provision being fundamentally altered by the impact of quantitative tightening, last year’s LDI crash may only be a canary in a coal mine. But there are also reasons to believe that these liquidity challenges could play out differently from the hysteria of the Mississippi bubble, where investors stampeded to sell their shares. In contrast, institutional inves- tors seem unlikely to withdraw from private markets entirely. Investors are looking at reducing their exposure to illiquid assets, but this could turn out to be a slow leak, rather than the sudden burst of a bubble.


Issue 120 | February 2023 | portfolio institutional | 37


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