10 July 2012

Risk.net: Insurers urged to be cautious of long-term liquidity swaps

The lack of clarity on Solvency II, in addition to continuing volatility within the financial markets, makes large and long-term liquidity swaps between insurers and banks a potentially risky undertaking, rating agency Fitch has warned.

In a liquidity swap, a bank exchanges illiquid assets, such as asset-backed securities, with liquid assets held by an insurer, such as gilts. The bank increases its liquidity, while the insurer earns a fee.

"Companies don't really know where Solvency II is going to land so they don't know whether or not they are going to be better off holding onto those sorts of [liquid] assets and how they would be treated under Solvency II", says Clara Hughes, insurance group director at Fitch Ratings in London. "They could enter into these deals, but if their regulator takes the view that they are quite risky and not that desirable the amount of capital that needs to be held would be more than what would be considered economically viable by an insurer", she says.

Following the publication of guidance from the Financial Services Authority (FSA) on the governance of the trades earlier in the year, bankers report growing interest from insurers in undertaking liquidity swaps. There has been considerable interest in sub one-year transactions and longer-term transactions are expected later in the year.

Insurers should remain wary of engaging in deals beyond five years in length, warns Hughes. "It is a case of looking at each one individually because some of them are reasonably safe and don't cause the insurer a lot of problems. The liabilities and assets are tied up anyway and there is flexibility and they are not too long-term", she says. "But if you are looking at a longer-term transaction – between five to 10 years – where insurers are tying up a lot of their gilts, that is probably a little bit more on the negative end of the spectrum", Hughes adds.

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