LIBOR’s end for insurers: finding opportunity during the switch to new reference rates

Ready or not, the end of the London Interbank Offered Rate (LIBOR) is coming, and it’s a very big deal. Roughly US$350 trillion in financial contracts have interest rates that are tied to LIBOR benchmarks—for now. But the LIBOR benchmark is scheduled to go away at the end of 2021, and its impending end has set in motion an overhaul in the world’s financial infrastructure. It’s a very big deal, with implications for your business, processes, and technology.

For insurers, there are some particular risks ahead:

  • Long-dated liabilities that can extend 30 years or more, making flexibility essential in pricing products and hedging with long-dated derivatives or other financial products.
  • Decentralized regulation under which they answer to multiple state regulators in the US and different national and regional supervisors around the world.
  • Sub-sector level vulnerabilities: stemming from their different roles depending on whether they are providers of life insurance and annuities, primary insurers, reinsurers, property and casualty insurers, or specialty firms.
LIBOR transition challenges for the insurance industry

In the US, many financial instruments now tied to USD LIBOR will be pegged instead to the Secured Overnight Financing Rate (SOFR), an alternative reference rate (ARR) calculated using US treasury repo transactions. In the UK, they’ll be linked to a different ARR: the Sterling Overnight Index Average (SONIA). Other countries and markets have recommended their own replacement benchmarks for use once LIBOR has been phased out.

Some insurers hope for a LIBOR transition delay. Don’t count on it.

Given the pandemic’s economic effects and how much work many insurers still have to do to move away from LIBOR, some companies seem to still be gambling that LIBOR’s cessation will be delayed. But COVID-19 can no longer be seen as a novel; rather, it has to be viewed as a sad-but-lasting feature of our economy that we all must adapt to. In that spirit, regulators and industry working groups are sending clear messages that COVID-19 will not delay LIBOR’s retirement. If anything, they’re actively sharing best practices and coalescing around approaches to accelerate the transition. They’re also setting timelines for transition milestones, such as those published by the Alternative Reference Rates Committee (ARRC) for moving to SOFR.

The pace of progress remains uneven across the insurance industry. We’ve seen that insurers with in-house asset management units tend to be more likely to be taking proactive steps given their responsibility for transitioning out of LIBOR-based instruments. But virtually all insurers face operational and economic risks if they don’t have a solid plan in place for adopting ARRs. Firms that use third-party asset managers, for example, are responsible for customer communications around those assets and must coordinate the transition with their vendors as deadlines begin to compress.

We expect the ARRC’s guidance will help senior management take a closer look at the LIBOR transition and give a boost to internal collaboration. The coming transition is fundamentally about risk management—which is the defining purpose of the insurance industry. By making it a strategic priority and continuing to recalibrate efforts as necessary, insurance companies can turn the risks of moving away from LIBOR into opportunities for growth.

Insurers could face challenges across multiple aspects of their business

Hedging assets, liabilities

  • Term structure: Insurers that use volatility hedges and interest rate swaps to offset timing between their assets and liabilities may have some major changes ahead. SOFR currently has a limited term structure. This may prove particularly problematic for firms that offer annuities, life, long-term care, disability insurance, and long-dated casualty coverages.
  • Declining liquidity: As ARRs gain popularity, LIBOR-based markets will likely see liquidity drying up for some asset classes. This could drive volatility and push up hedging costs, especially for longer-dated liabilities without adequate transition plans in place. A liquidity slump may also disrupt hedging and risk measurement by altering asset valuations. Many property and casualty insurers favor shorter-dated assets and so are especially vulnerable to losses from volatility or a slump of liquidity at the short end of the yield curve.
  • Valuation: In a move designed to build liquidity in SOFR, this fall, the major central counterparty clearing houses (CCPs) will change the way they value cleared derivatives by switching the discount rate they apply when calculating present value. In mid-October 2020, LCH Group and CME Group will take a coordinated step to switch from discounting cash flows with the US Effective Fed Funds Rate to SOFR. Some market participants could receive basis swaps and/or cash compensation as part of an attempt to keep the transition value neutral, and there may be operational considerations for insurers as they book these basis swaps or cash payments. The National Association of Insurance Commissioners’ (NAIC) Statutory Accounting Principles Working Group has determined that these basis swaps should be classified and reported as derivatives used for hedging and therefore are considered admitted assets under SSAP 86.
     

Pricing products

  • Profitability: The shift to an ARR may complicate the pricing for some long-dated insurance products and change the business case for marginally profitable businesses:
    • The limited liquidity and comparatively short-term structures in ARR-linked markets could increase the cost of hedging, especially in over-the-counter (OTC) derivatives.
    • The shift to new reference rates may upend the original pricing assumptions regarding prepayment risk, extension risk, repricing risk, and duration risk.
    • The adoption of ARRs may disrupt pricing.
  • Predicting future rates: When pricing products, insurers calculate the present value of estimated future cash flows based on projected changes in interest rates and other factors. The coming transition, and its interest rate shifts, could change cash flow projections and prompt pricing changes. That said, global finance has never navigated a large-scale transition from a benchmark rate, and insurers may have a hard time buffering against such interest rate fluctuations.

Gauging risks

  • Changing strategies: Portfolio managers at insurance firms will likely confront some of the same issues as asset managers across their activities. Investment teams—like their colleagues handling asset-liability management—will experience the impact of the LIBOR transition on their valuation and risk processes. We expect to see more focus on investment strategy throughout the transition.
  • Predicting problems: Some potential post-LIBOR losses may be hard to anticipate—and head off. For example, many insurers have extensive holdings of corporate bonds and loans, many of which currently have ambiguous fallback language. For example, some older vintage deals will revert to the last available LIBOR once LIBOR becomes unavailable, effectively converting a floating rate bond to one fixed at LIBOR’s final published rate. As a fixed-rate bond, the security may be especially appealing to either the borrower or lender given the then-current rate environment, and they may not want to renegotiate the terms. Most insurers have not yet begun to reach out to counterparties to renegotiate fallback language and avert potentially costly deadlocks involving floating-rate debt and other securities.
  • Tough legacy contracts: Similarly, regulators have coined the term “tough legacy contracts” to describe contracts without robust fallbacks that may not be amended before LIBOR goes away. Despite task forces and proposed legislation, counterparties to these agreements still face many open questions. Another consideration: some solutions may be deemed appropriate in one geography but may be rejected by regulators in another.
     

Operational challenges

  • Updating systems: ARR adoption may cause disruption across internal operations and systems, from interest rate accrual calculations and updating security master data to assessing value using multiple rate curves and margining collateral.
  • Finding competent talent: The LIBOR transition is unlikely to be as simple as replacing a rate table—and as the transition date nears, it could become increasingly difficult to find skilled programmers to address a problem of this scale involving software that is often very old. Insurers may need to make extensive changes, and these may not currently be built into their core technology plans.
  • Third party risks: The operational issues extend far beyond the company walls. Insurance firms rely on an army of external providers, including administrators, custodians, brokers, and other third party system, model and pricing vendors. These providers may not grasp the magnitude of the change or currently be able to switch to ARRs. (ARRC’s vendor readiness survey offers some insights into the operational challenges and transition progress made by vendors moving past LIBOR.)
  • Manual workarounds: If vendor systems or internal operations have not been updated in time for the 2021 deadline (or to address any of the interim requirements), companies may need to put manual workarounds in place. This would lead to increased cost and new training needs; it could also introduce related risks and control implications.

Additional challenges

  • Operating globally: Insurance companies with international businesses or global investments may face a more complicated LIBOR transition than their purely domestic counterparts. ARRs have considerable variability: Like SOFR, the Swiss ARR (SARON) is a secured rate. In contrast, the Bank of England’s SONIA, the European Central Bank’s €STER, and the Bank of Japan’s TONAR rates are unsecured. Each alternative—and there are others—is at a different developmental stage and will follow different adoption schedules.
  • Juggling rates: Few companies will be able to rely on just one benchmark rate. It’s far more likely that insurers will have to simultaneously handle multiple ARRs across asset classes and geographies, with different fallback approaches and adoption pacing. An insurer trying to manage a portfolio across regional jurisdictions and global headquarters could struggle to limit risk and assess liquidity, valuation, and depth of markets.
  • Juggling priorities: The LIBOR transition joins an already crowded list of accounting and regulatory items on insurers’ “change agenda.” Insurance firms have been overhauling accounting models, systems, and infrastructure to meet other new standards, including Long Duration Targeted Improvement (LDTI) and IFRS 17 for recording and reporting long-duration contracts. Unlike the other developments, though, the benchmark change explicitly changes market behavior, and the economic effects may be felt far sooner.

Building an action plan: best practices for financial firms

There are certain activities that virtually all financial firms will want to pursue during the coming LIBOR transition, from strategy through execution. While some of this work can be done in parallel, it can be highly interdependent. Many early movers have used a test-and-learn approach to refine their plans, as they’ve frequently found that the steps are more involved than they’d expected.

  • Mobilize the team: create a governance structure that spans geographies where you operate and all your business units
  • Analyze your exposure: look at direct and indirect impacts to understand what remediation might be needed
  • Define the strategy: evaluate how your products may need to change, and the downstream effects of any changes
  • Update the contracts: find, digitize, and address vulnerable terms and fallback provisions on your terms
  • Educate your stakeholders: create an outreach plan for clients, counterparties, vendors, and regulators
  • Prepare your systems: identify and manage the updates you’ll need to process ARR trades across internal/external systems and business processes
  • Adjust your models: change your risk and valuation models to reflect the new ARR(s)
  • Manage for reporting and tax: understand how the change will affect accounting and tax practices, such as hedging rules and funds transfer pricing

Some particular considerations for insurers

While all financial entities will have work to do as they prepare for the benchmark shift, insurance companies will want to focus on these specific areas:

Consider “stack and roll”

  • Given the expected changes in liquidity pools and the fluid timing of the shift to different ARRs, you’ll want to reexamine your firm’s hedging models quickly, if you haven’t done so already. For global investors using cross-currency swaps to manage exposure, liability-driven investment may begin to look like a game of four-dimensional chess. This will be particularly important for life and annuity companies, casualty insurers, and reinsurers with a comparatively large proportion of long-duration liabilities.
  • You may consider a “stack-and-roll” strategy when hedging longer-dated liabilities in ARR-linked markets. By stacking up hedges at the latest liquid hedge maturity available to cover later years, and then updating the hedges when the latest liquid hedge maturity available changes, one may implement an effective hedge. This strategy will help you match overall duration, but still leaves exposure to “key-rate” duration mismatches.

Review your contracts

  • Use fallback language: The International Swaps and Derivatives Association (ISDA) is attempting to smooth the transition and avert market disruption by announcing protocols around new rate conventions and fallback mechanisms for the derivatives market. The ARRC’s recommended fallback language will affect insurers’ cash product positions such as floating rate notes, syndicated loans and securitizations. The ARRC’s best practices guidance as of May 2020 says new LIBOR cash products should include its recommended (or similar) hardwired fallback language as soon as possible to ease the transition.
  • ...But don’t rely only on fallback language: While the inclusion of fallbacks serve a valuable purpose, much as a seatbelt can prevent injuries from a crash, ISDA itself notes that fallbacks are intended to be used as a backup plan. It recommends that market participants renegotiate or close out contracts according to their own strategies rather than relying on a fallback mechanism to affect the transition. After all, nobody has ever experienced such a fallback conversion for contracts worth many trillions of dollars of notional value. Even with preparation, there could be unexpected challenges.
  • Prepare to negotiate: Insurers will want to review all their legacy contracts to prepare for what could be months of active negotiation ahead. In some cases, insurance companies will lead, control, or have a great deal of influence on amendment or remediation efforts. Often, they could have less overt influence on the outcome. Still, they’ll want to gather intelligence on these contracts to be better prepared. This will allow them to make proactive decisions on the language they deem to be suitable when consent requests come in.

Assess product profitability

  • When pricing products during the LIBOR transition, make sure to fully explain any changes to clients and alert them in advance. Such efforts are essential for limiting conduct risk.
  • Stay as flexible as possible, given how quickly liquidity could change for some products. If you commit too quickly to a model, you could be forced to raise prices unexpectedly and risk antagonizing clients or hold prices that reduce expected profits. These considerations could be particularly important for long-dated businesses such as pension risk transfer in which you price transactions today while forecasting your ability to offset asset-liability mismatches over time.

Build a pilot program

  • You’ll face decisions on the timing and phase-in of the LIBOR transition based on your immediate needs and developments with liquidity and term structures among the various markets. By tracking markets closely, you can help mitigate the risk that you’ll be left holding illiquid securities.
  • Consider building a pilot program for trading and negotiation to prepare for the switch to SOFR and other ARRs. This can help you develop the hands-on experience essential for learning the nuances of SOFR-linked markets, and can help build relationships with counterparties to SOFR contracts. This specialized knowledge is particularly important given that the industry lacks guideposts for negotiating terms. In the process, you’ll also gain the know-how needed to update fallbacks or close out contracts at scale.

Contact us

Jessica Pufahl

Financial Services, Partner, PwC US

Tel: +1 (646) 574 2159

Prakash Mahtani

Director, PwC US

Paul Moran

Financial Markets, Partner, PwC US

Tel: +1 (973) 462 0701

Michelle Krupa

Partner, PwC Deals, PwC US

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