Insurers Scrambling to Switch Benchmarks Used for Setting Short-Term Interest Rates of Investments and Debt
The impending LIBOR cessation has forced a major shift for entities used to the London Interbank Offered Rate, which has been the standard since 1986.
- Terrence Dopp
- June 2021
- Issue: By June 2023—and for many, the end of this year—the London Interbank Offered Rate will no longer be published as a reference interest rate for financial transactions.
- Replacement: In steps the Secured Overnight Financing Rate, which boosters contend is a more transparent figure based upon U.S. Treasury lending.
- Volume: The Alternative Reference Rates Committee helping to guide the movement estimates more than $200 trillion in U.S. dollar-denominated contracts are outstanding. While most mature before the deadline, some don’t, and switching them over will be key.
As the London Interbank Offered Rate (LIBOR) is slowly phased out as a benchmark for short-term interest rates, insurers and other financial institutions are quickly pivoting to using an alternative reference rate.
The rationale behind the 2017 decision to end the benchmark—which is based on short-term rates that major banks charge one another—was that LIBOR is not entirely related to wider financial markets, and there is a potential for manipulation.
According to a March decision by the U.K. Financial Conduct Authority, which is overseeing the transition, LIBOR will be prohibited after Dec. 31, 2021, in the case of all sterling, euro, Swiss franc and Japanese yen tenors, and the one-week and two-month U.S. dollar tenors. The deadline for remaining U.S. dollar settings is June 30, 2023.
“It takes some pressure off,” said George Hansen, senior industry research analyst, AM Best, about the deadline extensions. “But companies can't really stop getting things switched over to a fallback rate.”
For many insurers, making the switch means combing through multibillion-dollar portfolios and replacing LIBOR with SOFR, the Secured Overnight Financing Rate. SOFR measures the cost of overnight borrowing of money collateralized by U.S. Treasury instruments.
The LIBOR benchmark can be found throughout the derivatives insurers use as hedges to protect balance sheets, and across any investment such as collateralized loans that involve floating rates. All of those references need to be switched to a replacement, or fallback, rate.
“With lots of insurance products, there are often long-term financial instruments used to underpin them,” said David Hetling, marketing director for regulated industries at SDL, a worldwide firm that has seen a brisk business in translating complex international contracts. “In a long period of time, even a very small difference to the rate LIBOR's been set at that underpins those could make a very big difference. So it's a big deal for insurance. Quite a big deal.”
At the same time, insurers could see their own debt issuances affected, primarily by floating rate transactions, according to an October Best's Commentary LIBOR Transition Poses Operational and Legal Challenges for Insurers.
“Key issues for insurers include the nature of fallback provisions, term structures for new reference rates, market liquidity, capital requirements and consistent supervisory guidance to eliminate cross border issues,” the report said.
“It's the longer term structures that are concerning,” said Hansen, an author of the commentary.
With lots of insurance products, there are often long-term financial instruments used to underpin them.
End of a Run
LIBOR, which was started in 1986, is essentially a composite of what banks are charging to lend. It came to be the leading reference rate used for adjustable-rate securities.
There is at least $200 trillion in U.S. dollar-denominated LIBOR contracts in the financial system, according to estimates released by the Alternative Reference Rates Committee (ARRC), the New York-based panel guiding the change. The ARRC is composed of private-market participants convened by the Federal Reserve Board and Federal Reserve Bank of New York to develop best practices and try to ensure the changeover goes off without hitches, according to its website.
In 2012, a series of investigations found some instances of banks manipulating LIBOR rates to benefit from movements. Soon after, LIBOR came under U.K. regulatory oversight. And in 2017 the decision was made to ultimately stop publishing the benchmark.
One of the elements about LIBOR, and one of the criticisms of it, is that it’s a rate that is largely based on subjective judgment. And there’s not a lot of transactions supporting it.
MetLife Investment Management
There are key differences between the two rates in play for U.S. dollar-denominated contracts, explained Chris McAlister, managing director and global head of derivatives at Prudential Financial. McAlister is in charge of global trading in the instruments, as well as one of Prudential's representatives on the ARRC. He made it clear that he isn't a spokesman for the panel.
While LIBOR is a forward-looking term rate, he said, SOFR is an average of the actual daily rates for a period, set in arrears. The three-month LIBOR rate is a snapshot of where the market predicts rates will go, whereas with SOFR for a three-month contract you get a snapshot of the actual daily rates for the previous period. Finding a way to set term rates—along with the operational mechanics of the shift—is the largest open-ended debate.
In addition, SOFR comes packaged with about $1 trillion in daily activity associated with it, while LIBOR never had anything approaching that quantity of transactions to back it up, McAlister said. Also, the new rate isn't based on a credit spread. In both cases, he said insurance companies and lenders with generations of experience working with interest rates are finding ways to address those issues.
“The interesting thing is that if you were to go back and talk about the things people were concerned about from a friction standpoint with moving from LIBOR to SOFR, the market has already evolved,” McAlister said. “The market has already moved from this idea of a credit spread to no credit spread involved in the rate.”
He said a large insurer such as Prudential has the resources—and after regulators' guidance, the time—to manage the transition in-house. Understandably, this may be more difficult for firms with fewer resources, when trying to rebuild all of the transactions on their own, which he said is one of the reasons why the ARRC's guidance is critical for the LIBOR cessation.
The ARRC estimates about 67% of current dollar-denominated LIBOR exposures are set to mature prior to the June 2023 deadline, but about $74 trillion will remain outstanding. That figure includes legacy contracts without an effective or easy means of replacement, ARRC said.
Like so much of 2021, the benchmark swap has been a bit of a catch-up game.
“LIBOR's not unique in the respect that it's been derailed a little by the pandemic,” said Hetling of SDL.
In a report earlier this year SDL, part of RWS Holdings plc, found that the COVID-19 pandemic disrupted business operations and overshadowed efforts to transition away from LIBOR, which the firm estimates underpins about $400 trillion of contracts globally.
SDL's report looked at so-called tier-one financial institutions across North America, Europe, Middle East and Africa, and the Asia-Pacific regions. Among the findings: More than half, 54%, had experienced disruption by the pandemic and were either behind schedule or requiring assistance to meet deadlines.
And while the change requires 88% of respondents to update reports in multiple languages, 40% had only started doing so in the past year, and there was a need for delaying the switch. It surveyed 60 respondents and found 36 had experienced disruption as a direct result of COVID impact to LIBOR plans.
Joe Demetrick, managing director, public fixed income and derivatives, MetLife Investment Management, takes a different view of the pandemic's impact on banks and others in the process of shedding financial contracts with LIBOR benchmarks.
March and April of 2020—the early days of COVID-19 lockdowns—just showed the extent of LIBOR's shortcomings as a reference rate, Demetrick said. In that respect, the pandemic actually highlighted the rationale behind the shift, he added.
MetLife is also a member of the ARRC helping to steer the process. Like McAlister, Demetrick made it clear that he doesn't speak for the panel as an entity.
“I don't think it complicated it,” he said. “The industry, bottom line, was able to continue to make progress despite COVID. One of the elements about LIBOR, and one of the criticisms of it, is that it's a rate that is largely based on subjective judgment. And there's not a lot of transactions supporting it.”
Key to how the process plays out for smaller participants in the market will be clear standards and benchmarks, McAlister said. The industry needs to know how to deploy its resources to proceed, he said.
“Uncertainty doesn't sit well with market participants, especially if they don't feel like they have the resources to deal with the problem,” McAlister said. “If you don't know what the spread is going to be, if you don't know what date it's going to end, how do you decide what resources you need and when to get them? More certainty on a lot of these things is helpful.”