LIBOR Transition and its Effect on Insurers

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A planned phase out of all London Interbank Offered Rate (LIBOR)-linked products will transition to new Alternative Reference Rates (ARRs) by the end of 2021. Significant impact from the transition can be mitigated if insurers plan to manage the transition intentionally.

Background

In 2014, the Financial Stability Board (FSB) recommended the transition to alternative benchmarks using a multiplerate approach instead of the LIBOR-style reference rates. Working Groups were created across the globe with both public and private sector representatives to identify ARRs that would conform with international standards. The FCA intends to stop prompting banks to report rate estimates by the end of 2021.

The Board of Governors of the Federal Reserve System (FRB) and the Federal Reserve Board of New York (FRBNY) assembled the Alternative Reference Rate Committee (ARRC) in 2014 to identify a suitable ARR for the U.S. along with practical implementation guidance to those impacted by LIBOR transition. The ARRC accomplished its first set of objectives in 2017 by identifying the Secured Overnight Financing Rate (SOFR) as the preferred rate to be used in certain new U.S. dollar derivatives and other financial contracts. For more information on the transition from LIBOR to SOFR, please reference LIBOR Transition to SOFR.

LIBOR timeline infographic
Challenges Facing Insurance Companies

The transition from LIBOR to ARRs may have a significant impact on an insurer’s business if not managed intentionally. Insurers should focus on numerous aspects of their business that could be affected.

Balance Sheet Valuation: A small change in the discount rate could have a material impact on long-dated liabilities with a floating interest rate. Insurers should measure and analyze the impact of these changes on their overall capital position.

Liquidity: With the potential impact on cash flow, insurers should revisit their asset and liability matching as it may be difficult to project the specific timing of cash flow needs.

Pricing: The shift to an ARR may complicate the pricing for some long-duration insurance products, such as legacy contracts that are tied to LIBOR.

Fallback Language: Contracts containing fallback language describing what happens if LIBOR is not produced or temporarily unavailable should be inventoried for analysis, remediation and repapering. Failing to address the fallback language may cause unintended consequences, such as floating rate products becoming fixed or interest rates for a borrower increasing substantially.

Investments: Asset backed securities, floating rate notes and money market instruments will see a direct impact of the LIBOR transition on their valuation. Insurers must be mindful of the potential negative downstream effects on surplus levels as they manage the interest rate risk of their investments.

Portfolio Hedging: LIBOR is the most used rate for interest rate swap transactions. The decommissioning of LIBOR will present issues for insurers hedging against risk. The derivative market for new ARRs will take longer to mature and develop adequate levels of liquidity for market-based pricing.

Operations and Systems: ARR adoption may cause disruption across business processes, models and applications, such as interest rate calculations, security master data updates, assessments using multiple rate curves and uncleared margin rules. Insurers should ensure systems are in place to trade and value contracts based on ARR rather than LIBOR.

How Insurers Can Prepare
  • Identify areas within the business (e.g., products, models, systems) that are most at risk and quantify the impact (e.g., basis point risk, direct and indirect exposures).
  • Understand the approach needed to address LIBOR transition, including the dependencies involved. LIBOR transition can have an effect across the organization. Many functions may be involved in the transition program, including distribution, finance, risk management, information technology and operations.
  • Develop a clear plan and governance framework for operational readiness to help prevent bottlenecks and avoidable delays during the implementation process.
  • Create processes for analyzing and assessing ARRs and the potential benefits and risks for the insurer, their customers and counterparties.
  • Inform the board of directors and senior management about the transition with regular updates. Additionally, speaking with clients and agents early will limit surprisesand disruptions in the future.
Insights & Takeaways

Regulators and rating agencies are evaluating if insurers fully understand the impacts of LIBOR decommissioning.1 Insurers are expected to develop appropriate plans to facilitate the transition to ARRs and manage the risks that may arise. Regulators and rating agencies may examine insurers’ operational readiness for the transition process and their ability to adjust their products, provisions and contracts accordingly.

For more information on how DHG can assist insurers in monitoring developments, assessing potential exposure, identifying potential risks and determining necessary actions to mitigate those risks, please reach out to our insurance advisory leaders outlined below.

Sources

  1. New York State Department of Financial Services & AM Best