The London Interbank Offered Rate (LIBOR) has been a global yardstick for interest rates at which banks borrow across borders, since 1986. However, in light of the LIBOR-fixing outrage and the ensuing $10 billion in penalties, both regulators and banks have demanded reference rates founded on actual market prices. Therefore, the Financial Conduct Authority (FCA) has tasked all financial firms linked directly or remotely to LIBOR to disembark from it and prepare to embrace multiple Alternative Reference Rates (ARRs) before the end of 2021.
“The discontinuation
of LIBOR should not be considered a remote probability ‘black swan’ event.
Firms should treat it is as something that will happen and which they must be
prepared for. Ensuring that the transition from LIBOR to alternative interest
rate benchmarks is orderly will contribute to financial stability. Misplaced
confidence in LIBOR’s survival will do the opposite.”
– Andrew Bailey, Chief Executive, Financial
Conduct Authority (FCA), July 2018
LIBOR currently underpins around USD 400 trillion in financial contracts for derivatives, bonds, mortgages, commercial and retail loans. While the transition is expected to overhaul the entire financial landscape, insurance firms will be most affected.
Why should insurers be concerned?
Siloed regulatory bodies, long-dated liabilities, and dynamic risk factors within each insurance sector are some of the most significant factors influencing this transition. For instance, life, annuity, and casualty insurers hold liabilities that span beyond three decades. With the non-existence of LIBOR, these are bound to undergo liquidity limitations, pricing and hedging issues along with other transition-based uncertainties.
In order to venture into life sans LIBOR, insurers will need a clear foresight into what lies ahead. A survey gauging the LIBOR readiness of financial firms reveals that a majority claim to have a formal transition plan in place. However, these lack detailed thinking, unified planning and strategizing of investment priorities.
To ensure minimum friction, let’s look at the top challenges insurers will face en route this move:
Hedging assets and liabilities
For companies that provide long-dated insurance coverages and annuities, the limited term structure and liquidity restrictions of Secured Overnight Financing Rate (SOFR) are bound to put them in a tight corner. Firms using LIBOR for asset-liability management, discounting, and derivative structuring may find their operations coming to a standstill.
Moreover, insurers will be increasingly challenged to develop prudent hedging strategies. A proactive Alternative Reference Rates (ARR) commitment could end up in ill-timed hedging. Similarly, a last-minute switch to an ARR may hamper the firm’s liquidity potential given the race to deplane LIBOR.
Pricing products
With ARRs becoming mainstream, the market is bound to witness some amount of volatility. This could cause substantial shifts in interest rates and disrupt old pricing assumptions culminating into prepayment, repayment, duration, and extension risks.
Given such fluctuations, firms that operate on tight margins may find it difficult to thrive. For others, predicting and developing a plan B to beat such odds will be imperative.
Evaluating risks
The road ahead is speckled with all sorts of risks. From accurately identifying direct and indirect exposures to this transition, to comprehending the need for renegotiating existing contracts. According to a 2019 LIBOR survey on financial firms only 17% of the respondents claim to have allocated funds to developing advanced risk models.
To mitigate unforeseen risks, insurers will need to deep-dive into every contract linked to LIBOR and minutely assess its fallback language. Apart from this, companies will need a new game plan on how they measure and quantify risk basis varying ARRs and benchmark their own tolerance levels across their product line.
Finding competent resources, systematically transitioning from archaic technologies and ensuring active collaboration from third-party providers are some other pertinent needs that will be key in implementing this exodus from LIBOR.
How can insurers stay prepared?
While most firms broadly know what they ought to do next, many are still unsure of the level of preparedness required of them to complete this move within the given deadline. Acting with caution and vigilance while ensuring flexibility at the core of it all will be key for decision-makers. Here are some action points insurers can employ for a complete and smooth switchover:
- Determine which products, processes, contracts, systems, and models are directly or indirectly linked to LIBOR and evaluate their transitions needs.
- Assess and analyze your products to understand the profits they will garner post-LIBOR. A detailed analysis will help you leverage the ones that show promise.
- Notify your corporate and retail clients, suppliers and stakeholders about the transition and how it would affect your engagement with them. Develop custom communications to answer their apprehensions. This will also offer a platform to discuss and negotiate about the switchover, thus reducing future liabilities.
- Stay vigilant of market volatility in order to refrain from investing in illiquid assets.
- Build a global governance team to effectively navigate across rapidly fluctuating ARRs in different geographies.
Effective risk management is at the crux of it all. In order to ride on the opportunities posed by the post- LIBOR world, insurers will need to make informed planning and strategizing a priority. Netscribes conducts in-depth market research and analysis to help financial leaders take calculated steps to stay future-ready in this light. For a detailed evaluation of the issues arising from LIBOR and guidance on how your company can smoothly transition to the post- LIBOR world, contact info@netscribes.com
