With less than a year and a half to go before the London Interbank Offered Rate (LIBOR) will no longer be available, analysts at AM Best have highlighted several operational and legal challenges that the transition poses for re/insurers.
Based on a review of insurer debt, AM Best 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, meaning any changes in coupon rates as a result of reference rate changes will need approval.
AM Best believes a significant portion of 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) is expected to 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.
But given the sheer volume of transactions and the limited time remaining before LIBOR disappears, AM Best argues that insurers will face numerous challenges during the transition period.
One of the most significant risks when transitioning from LIBOR to other reference rates is the potential for litigation, analysts noted.
Some fallback provisions require the use of alternative bank reference rates in the event LIBOR is no longer available, and 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.
A 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.
