Question

How does the degree of liquidity risk differ for financial institutions, insurance companies and property casualty companies? What can these types of companies do to defend themselves against liquidity risk?

Answer 1

Before moving to comparison of liquidity risk in financial institutions, insurance companies and property casualty companies,

we need to understand that about liquidity risk first.

Liquidity risk - It defines for a particular individual or organization ability to pay of its debts without suffering losses. If the specific security or asset is at lack of marketability and it can not be bought or sold quickly enough to prevent or minimize a loss, then we can say that it is under liquidity risk. In other words we can say if an individual or firm is unable to meet its short term debt by its asset conversion from marketable security to cash, it is called liquidity risk of individual or organization.

Liquidity risk differ for financial institutions, insurance companies and property casualty companies:

1) Financial institutions majorly takes loans or borrow money to a very large extent to run their business and to meet short term debt requirement, so they're commonly scrutinized to determine whether they can meet their debt obligations without realizing great losses, which could be catastrophic. Institutions therefore face strict compliance requirements and stress tests to measure their financial stability. In case of financial institutions and banks they play a middle role and get money from public by giving return to them in terms of interest and provide loan to other firms and an individual for short term and long term. This makes it susceptible to the risk that their creditors may demand a repayment or withdraw their funds at an uncertain time. In other side, insurance companies does not have major risk as they have a sufficient revenues in terms of premiums in regular interval from customers which is more certain and less liquid risk. In terms of Property insurance and casualty insurance are types of coverage that help protect the stuff a person own such as home or a car. It also provide liability coverage to help protect a person found legally responsible for an accident that causes injuries to another person or damage to another person property. It generate significant and continuous cash flows through the collection of premiums, assuring access to liquid funds at all times and irrespective of investment market or economic conditions. Moreover, insurer investments are highly liquid. So, there is very less chance to liquid risk.

2) Whenever, depositors get any news on any bank is in trouble, immediately begin to withdraw their funds without assessing the solvency he solvency position of each individual bank. Therefore, the failure of one bank may lead to a collapse in the confidence of the entire banking system. On the other side, insurance companies usually referred to as ‘risk intermediaries’ which transfer the risk of a loss arising from a contingent event, from the policyholder to the insurer, in exchange for premiums.These companies are financed by premiums which are paid in advance and the claim payments are only made on the occurrence of the pre-defined insured event. in case of Property insurance and casualty insurance companies also same thing happens and they collect premium beforehand from insured person and no chance to liquid risk.

What can these types of companies do to defend themselves against liquidity risk -

1) The company should maintain the cash flow of assets and liabilities.

2) Before providing money to borrowers, financial institutions should analyse his / her borrowing power and upto a limit amount can be provided as loan for a specific period of time.

3) If a insurance company or any financial institution invest its money further to any other financial institution, that should not be invested in one area and different portfolio can be made while investing. Proper hedge should be prepared. Should not invest more than its capacity.

4) Companies should maintain a block of unencumbered assets which can be drawn on any time to mitigate the liquid problem.