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What next after property funds ?

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Patrick Kelliher

During the financial crisis from H2, 2007 – Q1, 2009, life insurers experienced a surge in property fund surrenders after experiencing strong inflows in the preceding years. In response most invoked deferral clauses, though there were issues to be addressed in terms of whether systems could cope with deferral (in many cases, system functionality for this contingency was not built); and whether deferral was consistent with TCF (arguably not deferring would not be fair on remaining investors in these funds).

Looking forward, there is a risk that non-property unit-linked funds could experience liquidity strains similar to that experienced by property funds. A particular area of concern would be funds investing in corporate bonds. During the financial crisis, some bonds such as ABSs become effectively illiquid as the market in these collapsed. Furthermore, following the financial crisis, and in response to higher capital requirements, market makers have cut inventories of corporate bonds, reducing market liquidity - according to data compiled by the Federal Reserve Bank of New York, the inventory of corporate bonds held by primary dealers plunged from a high of $235bn billion on October 17, 2007 to just $55.9bn as of March 27, 2013, a fall of over 75% [1]. Were corporate bond funds to suffer a surge in surrenders, some funds could struggle to realise bonds at a fair price even if the deferral clause was invoked [2].

Another area to be wary of is funds investing in emerging markets. These can be vulnerable to currency restrictions which prevent assets proceeds being repatriated e.g. restrictions imposed by Malaysia during the 1997 Asian financial crisis. These may last longer than any deferral period on the unit fund. Furthermore, financial markets in emerging markets are still developing and liquidity may dry up, making it difficult to sell assets even if proceeds could be repatriated. As an example of what can go wrong, in 2008 New Star had to suspend dealing in its Heart of Africa fund due to a combination of currency restrictions and illiquid markets [3].

Life insurers should check whether their systems could cope with deferrals on non-property funds. Typically the deferral period will be much shorter for non-property funds (1 month v 6 months), and functionality developed for property fund deferrals may not cope with non-property funds. There are also TCF issues regarding how well deferral clauses have been communicated to non-property fund policyholders (the property fund deferral clause is generally prominent, but it may be less so for other funds).

Note that as well as the liquidity challenge, moving from an offer to a bid basis could lead to a significant drop in unit price particularly for corporate bond funds due to large bid/ask spreads on these bonds. There may be TCF issues regarding how well the risk of such step changes in unit price have been explained to policyholders, as well as reputation damage from moving to a bid basis.





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