Circular NBB_2022_08 / Management of Liquidity Risk

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NATIONAL BANK OF BELGIUM

Circular Brussels, 23 March 2022 Reference: Your correspondence Christel Beaujean tel. +32 2 221 30 59 christel.beaujean@nbb.be

NBB 2022 08 Management of Liquidity Risk

Scope Insurance and reinsurance undertakings governed by Belgian law (excluding small insurance undertakings governed by Belgian law as referred to in Articles 275 and 276 or local insurance undertakings as referred to in Article 294 of the Solvency II Act), Branches established in Belgium of insurance or reinsurance undertakings governed by the law of a third country (a state that is not a member of the European Economic Area), Entities responsible for an insurance or reinsurance group within the meaning of Articles 339, 2°, and 343, second paragraph, 1° and 2° of the Solvency II Act, to which the Bank has been appointed as group supervisor within the meaning of Articles 407 and 408 of that Act, Mutual insurance companies as defined in Article 15, 79° of the Solvency II Act. For these undertakings, "the Bank" is to be replaced by "the Control Service for the sickness funds and the national federation of sickness funds".

Objective This circular sets out the Bank's expectations regarding the framework to be established by insurance and reinsurance undertakings for the management of liquidity risk.

Legal Basis The Solvency II Act: the Act of 13 March 2016 on the status and supervision of insurance or reinsurance undertakings Regulation 2015/35: Delegated Regulation (EU) 2015/35 of the Commission of 10 October 2014 supplementing Directive 2009/138/EC of the European Parliament and of the Council on the access to and exercise of the activities of insurance and reinsurance (Solvency II) The Overarching Circular on Governance: Circular NBB_2016_31 of 5 July 2016 on the prudential expectations of the National Bank of Belgium regarding the governance system for the insurance and reinsurance sector (revised version of 5 May 2020) - Chapter 3 "Risk Management System"

Structure I. Objective................................................................................................................................................ 3 II. Entry into Force........................................................................................................................... 3 III. Management of Liquidity Risk ................................................................................................. 4

1. General Framework............................................................................................................................. 4
2. Identification of Liquidity Risk...............................................................................................4
3. Monitoring of Liquidity Risk...................................................................................................... 5
4. Prospective Assessment and Stress Tests....................................................................................... 5
5. Planning of Contingency Measures..................................................................................................... 6
6. Preparation of a Report on the Management of Liquidity Risk............................................7

Dear Madam, Dear Sir,

I. Objective Insurance and/or reinsurance undertakings must ensure that they have sufficient liquidity to meet their financial obligations to their policyholders and other counterparties when these become due, even in crisis situations. This circular covers: the development and maintenance of appropriate policies, systems, controls, and processes for the management of liquidity risk, the identification of significant liquidity risk factors, the establishment of indicators for monitoring liquidity risk, the preparation and execution of prospective scenarios and stress tests, the planning of contingency measures, and the preparation of a periodic report on the management of liquidity risk. This circular focuses on the key principles for the management of liquidity risk: since the liquidity risk of each undertaking and each group stems from a unique combination of sources, each entity must have an understanding of the liquidity risk factors it faces and must apply the principles contained in this circular according to the size, nature, and complexity of its activities. The principles below are aligned with those prescribed by ICP16 (Insurance Core Principles) of the IAIS.

II. Entry into Force This circular applies upon its publication. The first periodic report on the management of liquidity risk, referred to in Chapter 6, is expected in the first year following the publication of this circular (i.e., in 2023).

III. Management of Liquidity Risk

1. General Framework

2. The risk management system aims to identify, assess, manage, and monitor the risks to which undertakings are exposed or may be exposed. In particular, undertakings are expected to develop and implement an effective system for the governance and management of liquidity risk. This system must include, among other things, the following elements: a clearly defined risk appetite approved by the board of directors and consistent with the undertaking's overall strategy, a liquidity risk management strategy and one or more documented policies and processes, including limits, in accordance with its risk appetite, a clear division of responsibilities and a clearly defined decision-making procedure, appropriate IT systems and reporting procedures to provide timely risk management information to enable the measurement, assessment, and monitoring of all significant sources of liquidity risk, quantitative measures and instruments to measure liquidity risk factors and to serve as early warning indicators, and a prospective risk assessment based on liquidity scenarios and stress tests assuming severe but plausible hypotheses.

3. Where applicable, liquidity risks must be managed consistently at both the group level and the level of individual entities. The established governance and risk management system must therefore include clear hierarchical lines within the group, as well as effective systems ensuring the timely flow of information.

4. The governance and liquidity risk management system must be proportionate to the nature, size, and complexity of the activities, and to the extent of exposure to liquidity risk.

5. Identification of Liquidity Risk

6. The Bank expects undertakings to identify the sources of liquidity risk they face and to map the implications of these risks for their liquidity position under normal conditions and in crisis situations.

7. Liquidity risk depends on various factors, including: the occurrence of insured losses: This includes, for example, considerations regarding the nature, frequency, and severity of exposures to insurable events, including catastrophic events or significant legal decisions that may occur within a relevant time horizon. Consideration must also be given to the role of reinsurance and the possibility that part of the reinsurance recovery may not be recoverable; the behavior of policyholders: This requires assessing the potential cancellation of various types of products, taking into account features such as guarantees, surrender charges, tax consequences, maturities, interest rate sensitivity, client type, etc., as well as any declines in recurring premiums, non-renewals of policies, and declines in new policies, and their effect on net cash flows; the (decrease in) liquidity on financial markets, as well as the deterioration of the liquidity and/or solvency of counterparties, and concentration: Undertakings must ensure an adequate level of liquid, diversified assets that can be easily and immediately converted into cash, in accordance with the "prudent person" principle. The potential consequences of increased credit risk, increased market volatility in times of crisis, and greater reduction in liquidity must be assessed; exposures off-balance sheet and to derivatives: This includes the valuation of cash flows associated with derivatives - notably margin deposits and collateral requirements - arising from the passage of time, market fluctuations, the exercise of options, etc. The same applies to any transactions in repo and securities lending; the consequences of any deterioration in the financial position or rating of the insurer; the reduction, availability, and concentration of funding, as well as the correlation/dependence between funding sources.

8. Group-specific risks: since liquidity is not always freely transferable within a group, the Bank expects undertakings that are part of a group to examine how intra-group transactions may affect their liquidity position. Likewise, any dependence of an undertaking on the support of one or more other undertakings within its group must be thoroughly assessed. When liquidity is managed centrally, there must also be no legal or regulatory impediment to the availability of liquid funds, both under normal conditions and in crisis situations.

9. Monitoring of Liquidity Risk

10. Undertakings must prepare and maintain a liquidity risk management plan containing a forecast of incoming and outgoing cash flows related to their assets and liabilities, and must develop a set of liquidity risk indicators to detect, monitor, and address any liquidity crisis.

11. Undertakings must establish their own risk parameters for their activities, taking into account their own situation and risk profile, to determine whether they remain within their liquidity risk tolerance limits, both under normal conditions and in crisis situations. These parameters (which must relate to all relevant risks to which the undertaking is exposed), the underlying hypotheses, the time horizons taken into account, and the associated processes (including monitoring frequency) must be documented.

12. In the event of a significant deterioration of liquidity risk, undertakings must notify the Bank thereof without delay.

13. Prospective Assessment and Stress Tests

14. Undertakings must provide in their risk management system for the execution of stress tests and scenario analyses for all relevant risks to which they are exposed. Accordingly, undertakings are expected to also perform liquidity stress tests to identify potential sources of stress, and to ensure at all times that their liquidity profile remains consistent with their risk appetite as approved by the board of directors.

15. In stress tests, the consequences of a range of severe but plausible shocks on liquidity must be analyzed, both for incoming cash flows (sources), outgoing cash flows, and liquid funds, as well as for the undertaking's overall position. Stress tests must cover macroeconomic, sectoral, and idiosyncratic events, as well as different time horizons (both rapidly changing scenarios and more prolonged scenarios in which the undertaking's liquidity position deteriorates slowly).

16. Where applicable, separate stress scenarios must be developed at the group level to take into account group-specific risks.

17. The details and justification of the methods and hypotheses used in stress tests must be included in the undertaking's policies on liquidity risk management. The frequency of stress tests must be proportionate to the nature, size, and complexity of the undertaking's activities, as well as to the extent of its exposure to liquidity risk. Finally, the Bank expects the design of stress tests, including the shocks and scenarios tested, to be regularly reviewed and approved to ensure that their nature and severity remain appropriate.

18. Planning of Contingency Measures

19. Undertakings must maintain a clear decision-making process and contingency plan to address any liquidity crisis and to cover a cash shortfall in adverse circumstances. The planned contingency measures must enable them to respond quickly to various liquidity stresses that would disrupt their ability to finance all or part of their activities in a timely and cost-effective manner.

20. The form and detail of the plan must take into account the principle of proportionality and the results of liquidity stress tests.

21. The Bank expects groups to limit contagion risk within the group in their contingency plans in the event of a crisis. Furthermore, the liquidity contingency plan established at the group level must be consistent with that of the relevant legal entities.

22. The Bank expects undertakings to regularly test and, if necessary, update their liquidity contingency plan to ensure it remains operationally sound. The appropriate frequency for testing and updating depends on the size and complexity of the undertaking's activities, as well as the content of its contingency plan. When testing, undertakings must ensure that the division of tasks and responsibilities is appropriate and understood, test whether they are able to implement the proposed measures, and identify any implementation constraints.

23. If vulnerabilities are identified, the Bank expects undertakings, depending on the results of the stress test(s) performed, to build up and maintain a portfolio of highly liquid and unencumbered assets. When liquidity shortages occur, these highly liquid assets must be liquidated to cover these shortages.

24. Highly liquid assets must be easily and immediately convertible into cash; they typically have low credit risk and low volatility and are traded on active markets. To ensure that these assets will be available to meet liquidity needs, they must not be encumbered, i.e., they 1) are not subject to legal, regulatory, contractual, or other restrictions on the undertaking's ability to sell or transfer them quickly, and 2) are not pledged or used as collateral for another transaction. Finally, undertakings must apply an appropriate haircut to the real value of their liquid assets as part of their risk monitoring to account for increased credit risk and the increased volatility and illiquidity of financial markets in the event of a crisis. The applied haircuts must be a good reflection of the differences in credit quality and market volatility between different types of assets and of the time required to sell the asset. The haircuts must be documented, and the main underlying hypotheses must be described.

25. Preparation of a Report on the Management of Liquidity Risk

26. The report on the management of liquidity risk is primarily intended to document and demonstrate the overall adequacy of liquidity risk management, both under normal conditions and in crisis situations, as well as to highlight potential risks. This report must contain at least the following elements and follow this structure:

27. the undertaking's liquidity risk appetite,

28. the established risk limits,

29. the undertaking's liquidity position relative to its risk appetite and limits,

30. a summary of the strategies, policies, and processes established to manage liquidity risk,

31. the identification of potential vulnerabilities and ways to improve the liquidity position,

32. the design and results of liquidity stress tests. The detail of the report must be proportionate and commensurate with the risks to which the undertaking is exposed.

33. The report on the management of liquidity risk must be regularly updated and submitted to the Bank. The Bank expects significant undertakings to prepare (and submit) the report at least annually; less significant undertakings must prepare (and submit) the report at least every three years. More frequent updates are expected when the nature, size, and complexity of activities or the extent of exposure to liquidity risk change significantly.

Yours faithfully,

Pierre Wunsch Governor

See point 0.5.1 of the overarching circular on governance NBB-2016-31 (updated in May 2020) regarding the proportionality criteria to distinguish between significant and less significant undertakings