NAIC Capital Markets Special Report 3/6/13

"NAIC Capital Markets Special Report 3/6/13"

U.S. Insurance Company Asset Liquidity:

"The term liquidity can have different meanings depending on context. Funding liquidity refers to “the availability of credit or ease with which institutions can borrow or take on leverage.” Market liquidity, which is more relevant for insurer investment portfolios, “is the ease with which market participants can transact, or the ability of markets to absorb large purchases or sales without much effect on prices.” The more liquid an investment, the more readily it can be sold in the marketplace; that is, the more easily it can be converted into cash and at a minimal impact to the value of the investment. The most liquid investment is cash; short-term investments are typically liquid investments in that they can be sold quickly, within a market where there is a sufficient number of willing buyers and sellers.

On the contrary, an illiquid asset (such as a residential mortgage-backed security (RMBS) collateralized by subprime mortgage loans) is not easily saleable due to uncertainty about its value or the lack of seasoning in the market in which it is regularly traded. When investors lose confidence in the value of certain securities — particularly those not traded in an active market — a liquidity crisis results, which is what happened in the RMBS market post-2007. Prior to 2008, particularly between 2005 and 2007, RMBS, including those collateralized by subprime mortgage loans (i.e., borrowers with the lowest credit scores) were highly liquid due to a boom in the housing market. With the onset of the financial crisis, many borrowers (beginning with subprime) defaulted on their mortgage loans, causing the RMBS they securitized to default. As a result, the value of these securities dropped significantly, their credit ratings were lowered or withdrawn by the rating agencies, and the market — as well as the liquidity — for RMBS (especially subprime RMBS) disappeared. Only recently has new issuance appeared in the private label RMBS market, but nowhere near pre-crisis levels. In due time, we expect liquidity will eventually return. In general, securities with complex structures — such as RMBS and other types of structured finance investments — are less liquid than other types of more simple, straightforward bond issues.

Investment portfolios should follow guidelines that include asset-liability matching rules to ensure that funds are available when claims need to be paid by matching maturity, or duration. Investing in liquid assets also ensures that funds will be available when needed, although it is not necessary for the entire portfolio to be liquid. After all, with illiquidity comes increased risk, which, in turn, is associated with higher return on investments. And, in the current low-interest-rate environment, perhaps a bit of illiquidity in a portfolio would not be harmful, if appropriately managed. Note that, while illiquidity does change an investor’s risk profile, how the risk translates depends on the investor’s liquidity needs."

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