Liquidity Risk and Solvency II

In this paper we discuss the importance of liquidity risk when evaluating the risk of portfolios of financial assets that insurance companies hold. Until very recently and within the scope of Solvency II, liquidity risk was only considered under Pillar II, i.e. the proposal was that insurance companies should perform a mere qualitative evaluation of it. Nowadays the possible quantitative evaluation of liquidity risk is under debate but it is still unclear if it will apply only to liabilities or to portfolio holdings as well.Here we argue that liquidity is an important source of market risk that it should be measured quantitatively when accessing the overall market risk of portfolio holdings. Based upon the financial liquidity literature, we propose a way to measure liquidity risk quantitatively. The proposed method is simple, relies on publicly available data, and is consistent with the VaR approach underlying Solvency II.We implement the proposed method on the Portuguese insurance sector, using actual portfolio holdings. The main empirical findings confirm liquidity risk is an important risk representing, on average, more than 10% of the overall market risk insurance companies are exposed to