Practical application of Liquidity Premium

|Practical application of Liquidity Premium

Practical application of Liquidity Premium

The CRO Forum believes that the liquidity premium is a fundamental part of the economic valuation of insurance contracts. We support the underlying principles agreed by the Task Force, and the formulaic approach for deriving the liquidity premium adopted in QIS5.

Importantly, there must be certainty on the application of liquidity premium, in order to fulfil its counter-cyclical function. A formulaic approach is necessary, within the Level 2 text, to ensure the impact of the liquidity premium adjustment is known under any given market conditions. EIOPA must not have the power to determine arbitrarily when the illiquidity premium can apply without specifying in advance the formula-based approach used for doing so, due to the potential pro-cyclical impact on capital markets.

Further, the CRO Forum reiterates that liquidity premium should be applied to the risk-free forward curve and not to the spot curve, to ensure the resulting curve is arbitrage-free. The liquidity premium should be applied up until the point that extrapolation of the basic risk-free curve begins, to ensure a smooth risk-free forward curve.

The recently introduced Matching Premium concept, depending on final methodology, may be complimentary to the liquidity premium formula adopted in QIS5 for fully illiquid liabilities.

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