Financial Benchmarks
On the Way Out

• Dr. Richard L. Sandor
• June 2020
• 

Key Points

• What’s Happening: The rate-setting mechanism insurers use to support their investments, the London Interbank Offered Rate, is being phased out.
• The Alternative: The multiple rates emerging might better serve specific segments of the market. The replacements are based on actual trades and are better suited to different segments of the marketplace.
• Next Steps: To mitigate the risks of transition, insurers must understand their current risk profiles, including how much is tied to Libor, how much expires before and beyond 2021 and what alternatives can be considered?

Before the recent financial turmoil from the coronavirus, regulators were stepping up efforts to require financial services companies to prepare for the sunsetting of the London Interbank Offered Rate, or Libor, interest rate benchmark in 2021. U.S. life insurers write many products that are designed for the long-term, such as annuities and long-term care insurance. Insurers support those obligations with long-duration assets, such as mortgages, mortgage-backed securities and high-grade corporate bonds. They can benefit from understanding the various alternatives to Libor, both secured and unsecured interest rate benchmarks, to meet their specific needs.

Concerns about Libor came to a head in 2012 when a series of investigations revealed collusion among banks to manipulate rates to their benefit. Libor came under U.K. regulatory oversight soon after.

There may be short-term pain as insurers prepare for the transition but it is high time for Libor to go. It was an accident of financial history, based on a poll of banks with a very small cash market to price hundreds of trillions of dollars. Its demise presents opportunities for change and innovation that will benefit financial-market participants. There are multiple rates emerging right now to better serve specific segments of the market. The replacements are based on actual trades and are better suited to different segments of the marketplace.

Already a number of alternative benchmark rates have emerged, including:

• The Federal Reserve's SOFR (Secured Overnight Financing Rate), a secured rate derived from borrowing and lending activity in Treasuries.
• The British government's Sonia (Sterling Overnight Interest Average rate).
• The Japanese Tonar (Tokyo Overnight Average Rate).
• The Swiss Saron (Swiss Average Rate Overnight).
• U.S. Ameribor (American Interbank Offered Rate), a benchmark rate that reflects the actual market-determined cost of borrowing for U.S. financial institutions.

The Advantages of Alternative Rates

Economics teaches us that choice is good. Since insurers are heavy users of derivatives, including interest rate swaps, to hedge risks, it is a critical choice. Libor is the most frequently used reference rate in swap transactions. It also serves as the basis for corporate loans, floating rate mortgages and notes and other securitized products.

For large insurers, there is the Federal Reserve's SOFR, which is a broad measure of the cost of borrowing cash overnight collateralized by U.S. Treasury securities. The Intercontinental Exchange Benchmark Administration, which took over the administration of Libor at the request of the U.K. government in 2014, has introduced another benchmark for large institutions that revamps Libor to mitigate credit risk.

Some insurers have chosen other solutions, including using the Ameribor benchmark for their lending transactions. Ameribor is a benchmark developed to meet the specific lending needs of insurance companies, regional banks and credit unions from the American Financial Exchange (AFX). During the current pandemic, Ameribor performed faultlessly, with an all-time record in volumes (over $3 billion a day) and low volatility. Members of the AFX had access to a reliable source of liquidity that demonstrated great stability.

The world after Libor will provide many options to insurers. It's not that any of these benchmarks are better than the alternatives, just that they work better in some situations than other benchmarks. That's one of the positive things about the transition away from Libor—that it will create multiple alternatives, each with their own distinct features and applications. It will make the lending market more like equities, with its multiple benchmarks from the S&P 500, Dow Jones Industrial Average, NASDAQ to the Russell 2000, EAFE (Europe, Australasia and Far East) and beyond.

With contracts tied to Libor that are valued at hundreds of trillions of dollars, practitioners need to become familiar with which of the alternative new benchmarks out there best conform to their needs. Of particular concern are the trillions in Libor-linked loans whose contractual language enables lenders to renegotiate their terms if the base rate changes or disappears.

We are six years into the transition process. That means there's still time for bankers and other financial institutions involved in financial markets to prepare. There is also much work to be done on loan transition documentation. It is critical that financial players start to pay very close attention and start reviewing their documents. The number of conferences, workshops and white papers concerned with the transition away from Libor is increasing. Interest in them is likely to grow as we move closer to the transition date. Banking, insurance and mortgage trade associations and others who depend on floating rates can play an important role in educating market participants and resolving common problems and challenges the industry faces.

Steps for Insurers

What else can insurers do to prepare for the transition? To mitigate the risks of transition, insurers must understand their current risk profiles. How much is tied to Libor, and how much expires before and beyond 2021? What alternatives can be considered? From an asset-liability point of view what can be done to prevent imbalances? The use of new benchmarks will also require education.

Along with record keeping, education and transitioning to a new rate or rates, an insurer needs to select the right rate. Does it accurately represent the cost of borrowing? If the chosen rate creates asset-liability mismatches, it obviously increases operational and financial risks for insurers. Boards and asset liability professionals must be prepared to address these issues.

The transition to new benchmarks, and the creation of new markets that comes with it, will require building institutional infrastructure. That means that insurers, and regulators who support this change, need to be joined by accountants, lawyers and academics who can help provide the skills and knowledge required to help everyone understand the changes and new options.

We have every reason to believe that the U.S. financial sector, the most developed, flexible and innovative in the world, will maintain an orderly and smooth transition to new interest rate benchmarks. Industry groups are organizing to educate stakeholders. There are contracts currently being traded on organized exchanges, which will provide greater transparency and price discovery and speed up adoption.

When it comes to alternative rates, choice is critical. It enables insurers and other participants to pick the appropriate rate for their circumstances and it helps lower systemic risk. In times of volatility, it is better to have a choice of rates than a single benchmark. A rate like SOFR caters to bigger players, while Ameribor, an unsecured rate derived from transactions on the AFX, is better suited for certain types of financial institutions and client segments. There's still time for insurers to prepare and benefit from better choices available now. Insurers that welcome the transition will enjoy a competitive edge.

Best’s Review contributor Dr. Richard Sandor is the Aaron Director Lecturer in Law and Economics at the University of Chicago Law School. He is also chair and CEO of the American Financial Exchange. He can be reached at bestreviewcomment@ambest.com.