Duration mismatch and liquidity pressure in a short-tail health portfolio

The portfolio is mismatched. Liabilities have a duration of 2.5 years, while assets have a duration of 8 years. That means a rise in yields reduces asset values much more than liability values. The recent 90 basis point rise has already cut the solvency ratio from 1.75 to 1.52. A further 50 basis point rise could take it below 1.40, which is the risk officer's warning.

The liquidity position is also tight. Claims are short-tail, paid on average within 45 days, and a new hospital network agreement could create a backlog. The insurer has a large claim payment next month and a bank covenant requiring a minimum liquid asset buffer of INR 500 million. Holding 70% in 10-year government bonds may look safe from a credit perspective, but those bonds are exposed to interest rate risk and may be costly to sell if cash is needed quickly. Corporate bonds add credit and liquidity risk. Equities add volatility.

The combination is dangerous: a rate rise hurts solvency, while a claims backlog forces asset sales at the wrong time. The insurer should not rely on holding bonds to maturity if cash outflows are uncertain. It needs a cash-flow match for the next 12 months and a larger liquid buffer.

The proposal would reduce equity risk, which is helpful for solvency volatility, but it would worsen the duration mismatch. The asset duration is already 8 years against a liability duration of 2.5 years. Buying longer bonds would increase asset duration further, making the solvency ratio more sensitive to rising yields. That is the opposite of what the insurer needs if it is worried about a further 50 basis point rise.

There is a case for buying long bonds if the insurer wants to lock in higher yields for long-term liabilities, but these liabilities are short-tail. The insurer does not need long-dated assets to back claims paid within 45 days. The priority is to shorten the asset duration and build a ladder of short-dated government and high-quality corporate bonds that mature when claims are expected to be paid.

Selling equities may still be sensible to reduce volatility and raise cash, but the proceeds should not go into longer bonds. They should go into short-dated bonds, a liquidity buffer or cash equivalents. The committee should also consider transaction costs and the risk of selling equities after a market fall. The decision should be based on the liability cash flows, not on a view that long bonds are cheap.

I would recommend a three-part plan. First, set a duration target for the asset portfolio that is close to the liability duration, perhaps 3 to 4 years, and reduce the long-bond exposure over time. Second, build a liquid asset buffer well above the INR 500 million covenant, using short-dated government bills and high-quality corporate deposits, so the next claim payment and any backlog can be met without forced sales. Third, stress test the portfolio for a further 50 and 100 basis point rise, a claims backlog and a equity market fall, and report the results to the board.

The investment committee should be told that selling equities to buy longer bonds would increase, not reduce, the main risk. The committee may have been focused on equity volatility, but the dominant risk is interest rate mismatch. The board should be told that the solvency ratio is sensitive to yields and that the current asset allocation is not matched to short-tail liabilities. The bank covenant adds a hard liquidity constraint.

The insurer should also review the hospital network agreement and prepare a contingency plan for the claims backlog. If the backlog is likely, the insurer should pre-fund it with liquid assets rather than wait for the payment date. Communication should be clear, quantified and tied to the risk appetite. The board should approve a rebalancing plan with limits and monitoring triggers.