Liquidity transformation: an examination of US life insurers

Abstract

Purpose – The purpose of this paper is twofold: first, this paper measures how much liquidity is transformed by the US life insurance industry for the sample period; and Second, this study tests the “risk absorption” hypothesis and “financial fragility-crowding out” hypothesis to identify the impact of capital on liquidity creation in the US life insurance industry. In addition, a regression model is conducted to explore the relationship between liquidity creation and other firm characteristics. Design/methodology/approach – In order to construct the liquidity creation measures, all assets and liabilities are classified as liquid, semi-liquid, or illiquid with appropriate weights to these classifications, which will then be combined to measure the amount of liquidity creation. In addition, a regression model is analyzed. The level of insurers’ liquidity creation is regressed on the capital ratio (surplus over total assets) and other financial and organizational variables to test two prevailing hypotheses. Findings – This paper finds that the US life insurers de-create liquidity. The authors provide that the amount of liquidity de-creation is related to the size of insurers such that liquidity de-creation has increased as assets grow and that large insurers de-create most of liquidity. The US life insurance industry de-created $2.1 trillion in liquidity, i.e., 43 percent of total industry assets, in 2008. The empirical results support the “financial fragility-crowding out” hypothesis. Life insurers’ liquidity de-creation is mainly caused by the large portion of liquid assets, which is required by regulation and capital is not a main factor of liquidity de-creation. Originality/value – There is no known study on the issue of liquidity creation by life insurers. Thus, the extent of liquidity creation by the life insurance industry, if any, is an empirical matter to investigate, but also an important matter to regulators and the academia since the products and business operations (e.g. asset portfolio and asset and liability management) of life insurers are different from those of property and liability insurers.

Why Do Property‐Liability Insurers Destroy Liquidity? Evidence from South Africa

“…Unlike Shiu (), Chang and Tsai () and Liu et al (), Choi et al () and () employed a broad‐based measure of insurance liquidity using a comprehensive financial data and the approach of Berger and Bouwman (). The first paper by Choi et al () examines liquidity creation among property‐liability insurers in US from 1998 to 2007 by adopting the Berger and Bouwman () liquidity creation measure for insurance markets.…”

“…In this paper, we follow the three‐step categorisation of Choi et al () and () which is based on the liquidity creation approach of Berger and Bouwman (). First, we follow the categorisation of balance sheet items in Schedule B2 of the returns submitted by the insurance companies to the regulator.…”

“…Based on the classification of assets, liabilities and surplus into liquid, illiquid and semi‐liquid, we assign weights to each of the three categories. Following Choi et al () and (), both illiquid assets and liquid liabilities are assigned weights of 0.5. This is because insurers are assumed to create liquidity of R1 if they transform R1 of illiquid assets into R1 of liquid liabilities and de‐create liquidity if they transform R1 of liquid assets into R1 of illiquid liabilities.…”

“…The second contribution relates to the examination of liquidity determinants, which are important in highlighting areas of concern for regulatory actions. Unlike the US where the insurance liquidity creation behaviour has been analysed by Choi et al (), the regulatory framework of the South African insurance market in the Solvency and Assessment Management (SAM) is “principle‐based” which is consistent with the Solvency II regulatory framework for insurance companies in the EU (Vaughan, ). As argued by Lindberg and Seifert (), insurers operating under principles‐based framework like those in SA are more likely to use greater discretion in the computation of risk‐based capital compared to the US insurers which operates under rule‐based regulations (Lindberg and Seifert, ).…”

“…Property‐liability (P&L) insurers underwrite policies with shorter durations and unpredictable loss development; therefore, they are constrained by investments in long‐term projects and illiquid assets as they seek to promptly settle claim demands by policyholders (Lambert and Hofflander, in Choi et al , ). Unlike banks and other depository financial institutions, insurers have relatively more liquid assets in cash and bank deposits and illiquid liabilities in technical reserves (Colombini and Ceccarelli, ; Choi et al , ). This reflects the differences in the production cycle of insurers and banks.…”