DEFINITION OF ‘CURRENT LIQUIDITY’
The total amount of cash and unaffiliated holdings compared to 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.
INVESTOPEDIA EXPLAINS ‘CURRENT LIQUIDITY’
Understanding the type 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. Insurers that are able to cover their liabilities with cash and other readily-available financial sources are better able to weather increases in claims, 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.
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.
Ratings 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.