Insurers are involved in the business of accepting risks in exchange for premiums. While insurers provide protection for clients, they are not completely insulated from business risks. As a result, insurers may face liquidity problems or illiquidity at certain times in their operations. Illiquidity for an insurer suggests that no cash is available to finance daily operations and commitments. It also suggests that the insurer cannot convert existing assets to cash.

Insurers are highly regulated and supervised; making it less likely for them to become illiquid strictly though bad business practices. Even though this is the case, the 2008 economic crises aptly demonstrated how the liquidity crunch affected some firms in the insurance sector. One insurance giant from the Caribbean faced a liquidity crisis towards the end of 2008. That case provided a fair insight into some of the prerequisites for illiquidity.

1) Over-reliance on short-term funding

Insurance is as a long-term business. Insurers deal with annuities and life insurance contracts that span lifetimes. However, if an insurer develops a business model that is heavily reliant on products (like annuities) that mature every few years, the exposure to risk is greater. A business model that places more emphasis on short-term business than long-term business can put an insurer in financial difficulty.

2) Weak surrender charges or penalties annuities

The insurer who faced illiquidity had a particular product that offered no loss of capital if the annuitant decided to surrender the policy. The result was that there was no steep disincentive for withdrawal. Any withdrawal request would have put significant strain on an insurer who operate more like an investment bank.

3) Aggressive investing

In the same way that an individual must manage risk in a diversified portfolio, so must an insurer. An insurer can become illiquid if aggressive investments (in an unregulated or weakly regulated environment) collapse. After all, growth options pose a high degree of liquidity risk.

4) Over-emphasis on credit and leveraging

If an insurer were allowed to leverage assets, those assets would become illiquid since they are pledged. Should there exist an economic downturn, pledged assets become even more problematic. This means that the insurer can maintain a healthy balance sheet but have serious cash flow problems. The emphasis on borrowing to finance aggressive investment strategies could also lead to illiquidity if the investments fail.

5) Low liquidity levels that force withdrawals

The economic recession of 2008 lead to a liquidity crunch in other sectors. This eventually led to a contraction of aggregate demand. The insurer who faced a liquidity crisis had two problems. Credit lines started to contract and large investors demanded their short-term funds because of low liquidity in external markets.

6) Weak regulatory context

Even though insurers fail, there are regulatory bodies in place to protect policyholders. However, in a weak regulatory framework (or where regulators have limited power), oversight is often compromised. As a result, insurers may engage in activities that could compromise their promise to policyholders.

Given that there is some oversight into insurance operations across the globe, it is unlikely that only one of the aforementioned factors could precipitate a liquidity crisis. Two or more factors can wreak havoc on an insurer’s cash flow.

A liquidity crisis- even if the insurer has assets- can decrease the financial strength of an institution. Then some assistance may be required from regulators or the government to restore operations. That intervention- though necessary- can be embarrassing to an insurance company accustomed to bending rules.