Liquidity of Standard and Non-Standard P&C Contracts
I was reviewing the IFRS sample questions and Question 6 part c and Question 2 part b refer to page 21 of the Discount Rate paper when determining liquidity of insurance contract. In a nutshell:
- LRC is liquid because Policyholder can cancel contract before expiry date and get a refund on unearned premium without incurring significant exit costs
- LIC is illiquid because Policyholder cannot obtain the exit value in advance of normal payment date if they cancel their contract
My question is why are we only looking at it from the lens of the policyholder? Would we get marks if we argued it from the perspective of the insurer?
1. LRC is liquid because insurer can exit contract without significant exit costs (because paying unearned premiums is immaterial compared to paying out existing claims)
2. LIC is illiquid because insurer must continue to pay its claim obligations even if they have exit the contract. You could argue there is no real way to "exit" from obligations to pay outstanding claims hence the illiquidity
Also while I completely understand that anything in the syllabus is fair game, in your opinion what is the likelihood they could ask us about the liquidity of the non-standard P&C contract LRC (Mortgage Insurance, Surety, etc.)?
Comments
This is well explained in section 4.6 of the discounting paper. In short, no as liquidity should be viewed based on the contract features. Remember the option to cancel or prematurely exit a contract lies only with the policyholder, not the insurer. The insurer has no option to exit a contract prematurely. An insurer cannot arbitrarily cancel a contract if there is no misdemeanor on the policyholder's end.