There seems to be a general belief that, because of central bank actions in keeping interest rates at or close to the “zero bound”; practicing various forms of “quantitative easing” (including monetizing government debt); and stuffing banks with cash via deposits maintained at the central bank, the financial world is awash in liquidity.
Certainly, with the burgeoning “credit bubble” being generated by desperate return-seeking “investors” and the influx of “alternative capital” into traditional insurance markets, such as NatCAT, many might argue that this has become a truism. However, capital is not liquidity. In theory any investment that carries risk and has an element of maturity transformation (banks being the locus classicus), should include assessment of liquidity risk in how the return or spread is determined.
However, financial history demonstrates time and again that liquidity risk is ignored and mis-priced. Banks are “ticking bombs” in terms of liquidity risk, because, when confidence in their solvency vanishes, they are never able to meet a sustained run by depositors demanding cash or the equivalent in a deposit transfer; yet they are now the main creators of what amounts to private money beyond the Note Issue supported by the “full faith and credit” of a central bank or other monetary authority. One only has to look at what happened during the Great Recession in various jurisdictions to understand how vulnerable banks are.
Similarly, in capital markets, liquidity risk is often ignored in reality, because investment managers have the repeatedly demonstrated tendency to crowd, herd and panic together, often making a mockery of supposedly “liquid” markets, so one always needs to consider who is the “market-maker of last resort” and can provide liquidity in all conceivable circumstances.
Conversely, diversified (re)insurance companies, such as Awbury and its partners, are not really vulnerable to liquidity risk, provided they have managed their exposure correlations and concentrations proactively; and their Invested Assets on General Account are of appropriate quality, diversity and maturity. A key point is that policies of insurance, such as Awbury’s, focus on payment of realized losses, which is intended to avoid the liquidity risks inherent in transactions or products which are subject to market prices or forced liquidation at market. With a bank, a depositor has the right to demand cash; with a (re)insurance company there has to be an Event covered by a policy of Insurance: the risks are not the same.
At Awbury, we are somewhat paranoid about ensuring that there can never be any shadow of doubt that one of our policies will answer in a timely manner and in accordance with its terms whenever there may be a valid claim.
-The Awbury Team