What Is Current Liquidity?
Current liquidity is the total amount of cash and unaffiliated holdings compared with net liabilities and ceded reinsurance balances payable. Current liquidity is expressed as a percentage and is used to determine the amount of an insurance company’s liabilities that can be covered with liquid assets. A high ratio indicates that the insurer is not dependent on new premiums to cover existing liabilities.
- Current liquidity is the total amount of cash and unaffiliated holdings compared with net liabilities and ceded reinsurance balances payable.
- Current liquidity is used to determine the amount of an insurance company’s liabilities that can be covered with liquid assets, such as cash and cash equivalents.
- A high current liquidity ratio indicates that the insurer is not dependent on new premiums to cover existing liabilities, indicating a strong financial footing.
- Rating agencies examine an insurer’s liquidity in order to establish a credit rating. These agencies will publish the liquidity ratio as well as a quick ratio, which compares cash and cash equivalents to liabilities.
- Consumers can find the ratios for insurers from the NAIC Insurance Regulatory Information System (IRIS).
Understanding Current Liquidity
Insurance companies generate their revenues primarily from underwriting insurance premiums. When an individual buys an insurance policy, they pay the premium to the insurance company. Insurance companies also generate money through investing activities. The primary liabilities of insurance companies are the claims they have to pay out on insurance policies, for example, when a customer gets into an automobile accident.
Understanding the types of liabilities that an insurance company has taken on by underwriting policies and ceding reinsurance is an important step in determining whether an insurer is at risk of insolvency. Insurers that are able to cover their liabilities with cash and other readily available financial sources are better able to weather increases in claims (more money out the door) and are thus less reliant on underwriting new policies or increasing premiums in order to cover liabilities. This sort of analysis is called liquidity analysis.
"Current liquidity" references an insurance company's current assets: cash and cash equivalents. If an insurance company's current assets are enough to cover its liabilities, it is in strong financial standing. It is not in a position where it has to generate more cash by doing more business to cover its liabilities because it has enough liquid assets on hand to do so.
Measures of Solvency
Insurance companies balance profit-maximizing investment activities with the risks associated with the policies that they underwrite. Investments with higher yields may also have longer durations, thus locking up assets for a longer period of time. These types of assets, such as real estate, may also be more difficult to sell quickly. Thus, insurers hold a mix of cash, cash equivalents, government securities, corporate bonds, stocks, and mortgages, creating a mix of high yield and high liquidity in varying amounts.
Rating agencies examine an insurer’s liquidity in order to establish a credit rating. These agencies will publish the liquidity ratio as well as a quick ratio, which compares cash and cash equivalents to liabilities. Similar to the stress tests that banks are put through when determining capitalization, insurance companies are also put through various scenarios in order to determine if the amount of liquidity that an insurer has will cover liabilities. The results of these stress tests for a single insurer are compared to the results of other insurers offering similar policies.
Consumers can find this and other ratios for insurers from the NAIC Insurance Regulatory Information System (IRIS), a collection of analytical solvency tools and databases designed to provide state insurance departments with an integrated approach to screening and analyzing the financial condition of insurers operating within their respective states. IRIS, developed by state insurance regulators participating in NAIC committees, is intended to assist state insurance departments in targeting resources to those insurers in greatest need of regulatory attention. IRIS is not intended to replace each state insurance department’s own in-depth solvency monitoring efforts, such as financial analyses or examinations.
Example of Current Liquidity
Assume Insurance Company A has $100 million in cash and cash equivalents, and over the next three months, it has to pay out insurance claims worth $40 million. The company's current liquidity is strong as its cash reserves are able to cover the amount it has to pay out to customers: $40 million. Insurance Company A is financially sound.
Now, Insurance Company B also has to pay out $40 million in insurance claims over the next three months, however, it has cash and cash equivalents valued at only $25 million. Insurance Company B is short $15 million in what it owes its customers. To meet this shortfall, Insurance Company B will have to bring in more business by writing new insurance policies to new customers, which will bring in insurance premiums, which will hopefully be enough to cover its shortfall.