What are the primary methods that insurance companies can use to reduce their exposure to liquidity risk?
Liquidity risk happens when a financial institution, a business, or an investor fails to meet their obligation for short-term debts. They may not be able to change an asset into money without letting go of income or capital because of the absence of buyers or inefficiencies in the market. Liquidity risk has high chances of occurring when there is high property investment since there is the involvement of massive cash outflow for one transaction.
Answer and Explanation:
- Exposure to liquidity risk can be reduced through diversification of risk distribution in the insurance contracts. This is applicable since the risks would be shared among different types of insurance policies.
- Holding of assets that are relatively marketable to use them for coverage of the payment claims. The insurance company would gain returns from the assets leading to increased liquidity that would prepare them for the payment of the claims.
- Use of alternative risk transfer methods like cat bonds.
- Use of reinsurance which would enable the insurer to share the risk with another insurance company such that the other company would provide a percentage of the payment, leading to reduced risk.
- Failing to pay the full amount for a certain period after the occurrence of an event until the losses experienced are completely adjusted, offers the insurer extra time for asset liquidation.
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from Finance 305: Risk ManagementChapter 3 / Lesson 8