Change to SOFR will affect both sides of the balance sheetNew commentary from AM Best suggests there could be challenging transition. Access the full report here.
OLDWICK, N.J., October 13, 2020—With less than a year and a half to go before the London Interbank Offered Rate (LIBOR) will no longer be available, several areas of concern remain, according to a new AM Best commentary.
A review of AM Best-rated insurer debt, as detailed in a Best’s Commentary, titled, “LIBOR Transition Poses Operational and Legal Challenges for Insurers,” found that nearly 80% of USD debt with LIBOR provisions will mature after year-end 2021, when LIBOR is no longer in use. Included in the USD debt are floating rate surplus notes with LIBOR provisions, which are heavily regulated by state insurance departments; therefore, any changes in coupon rates as a result of reference rate changes will need approval.
A significant portion of AM Best-rated debt with LIBOR provisions will need to be modified using fallback provisions agreeable to all parties involved, which may have implications for capital management. Other issues include term structures for new reference rates, market liquidity, capital requirements and consistent supervisory guidance to eliminate cross-border issues.
The transition from LIBOR to the Secured Overnight Financing Rate (SOFR) will affect both sides of insurers’ balance sheets, as it affects assets and liabilities. LIBOR is used to set interest rates on a plethora of financial assets, including mortgages, loans, corporate bonds and derivatives, with the volume of assets using this rate estimated in the hundreds of trillions of dollars. Given the sheer volume of transactions and the limited time remaining before LIBOR disappears, insurers will face numerous challenges during the transition period.
A Potential For Litigation?
One of the most significant risks when transitioning from LIBOR to other reference rates is the potential for litigation. Some fallback provisions require the use of alternative bank reference rates in the event LIBOR is no longer available. Issues may arise if the parties involved have not agreed to replacement reference rates. In addition, reference banks may be unwilling to provide quotes for the benefit of third parties, resulting in no backstop, which could lead to legal arguments to be settled by courts.
The Federal Reserve has been keeping interest rates very low through the COVID-19 pandemic. Effective June 30, 2020, the Federal Housing Finance Authority (FHFA) ended issuance of LIBOR-linked transactions extending beyond 2021. Another key part of the transition from LIBOR to SOFR will take place in October 2020, when central clearing parties plan to switch the discounting rate from the Fed Funds rate to SOFR. This may have a significant impact on the life insurers’ hedges cleared on these exchanges.
The change is intended to increase liquidity across the SOFR term structure, as well as point new transactions away from LIBOR. Companies trading with central clearing parties will receive basis swaps representing the difference in value as a result of using the new discount rates.
AM Best is a global credit rating agency, news publisher and data analytics provider specializing in the insurance industry. Headquartered in the United States, the company does business in over 100 countries with regional offices in New York, London, Amsterdam, Dubai, Hong Kong, Singapore and Mexico City. For more information, visit www.ambest.com.