idity riskLiquidity risk can best be described as the risk of a funding crisis. While some would include the need to plan for growth, the risk here is more correctly seen as the potential for a funding crisis. Such a situation would inevitably be associated with an unexpected event, such as a large claim or a write down of assets, a loss of confidence, or a legal crisis. Because insurers operate in markets where they may receive clustered claims due to natural catastrophes, or massive requests for policy withdrawals and surrenders due to changing interest rates, their liabilities can be said to be somewhat liquid. Their assets, however, are sometimes less liquid, particularly where they invest in private placements and real estate. Given this situation, it is important for an insurer to maintain sufficient liquidity to handle easily any demands for cash. Otherwise, an insurer that would be solvent without a sudden demand for cash may have to sell off illiquid assets at concessionary prices, leading to large losses, further demands for cash, and potential insolvency. Credit riskCredit risk is the risk that a borrower will not perform in accordance with its obligations. Credit risk may arise from either an inability or an unwillingness on the part of the borrower to perform in the precommitted contracted manner. This can affect the investor holding the bond or lender of a loan contract, as well as other investors and lenders to the creditor. Therefore, the financial condition of the borrower, as well as the current value of any underlying collateral, are of considerable interest to an insurer who has invested in the bonds or participated in a direct loan. The real risk from credit is the deviation of portfolio performance from its expected value. Accordingly, credit risk is diversifiable but difficult to eliminate completely, as general default rates themselves exhibit much fluctuation. This is because a portion of the default risk may, i...
