For insurers, time could now be well spent – on a no regrets basis – quantifying IBOR’s impact and identifying where value is at most risk.
Interbank offered rates (IBORs) impact trillions of dollars’ worth of financial instruments worldwide. Although the timeframe for phasing out IBOR isn’t fixed, IBOR could cease to exist for both legacy and new contracts, across derivative and cash markets, by the end of 2021.
Recognizing the scale of the change, IBOR transition work is now getting under way across the financial services industry. The issue appears more urgent for some specific sectors. It’s natural, for example, that buy-side businesses should be allowing sell-side entities and institutions to take the lead – in clarifying uncertainties, developing standards and devising new products.
But, it’s still important for insurers to monitor developments and engage as necessary, being prepared to influence the agenda to prevent being disadvantaged. The value at risk is potentially large, so insurers need to make sure they don’t end up on the wrong side of any value transfer, particularly shifts in market liquidity.
Understanding insurance impacts
IBOR transition is clearly a huge issue for the banking sector, and becoming an important board agenda item. The magnitude and complexity of the IBOR transition challenge facing insurers may not be as great, but there are potential impacts to consider. Value is at risk from an asset, liability and derivative perspective.
For example, although insurers will typically own fixed-rate assets, there are increasing amounts of floating-rate assets particularly in illiquid loan format. In terms of liabilities, the biggest unknown is the future regulatory discount rate that will apply – which could have a material impact on balance sheet valuations and solvency positions. Particularly for life insurers with long-dated liabilities, a small change in the discount rate could have a material impact on the capital position. Thirdly, most insurers are exposed to potential impact through the extensive derivative programs they maintain to manage their interest rate risk, and to match assets and liabilities.
As valuations are affected, so are regulatory capital positions and models. Just as banks need to monitor these, so do insurers. Models could be affected, not just by the migration away from IBOR itself, but also by the limited availability of historical data on the new alternative reference rates (ARRs).
Insurers also need to understand the operational impact of IBOR transition. Perhaps most obviously, contracts, products and investments that reference IBOR will need to be transitioned. Any policyholder contract or product that depends on IBOR as part of the benefits, or where there is second order reliance, such as through rolling up payments, benchmarks in third-party funds or cash accounts, will need to be addressed. From a reinsurance perspective, contracts will need to be renegotiated or otherwise restruck if IBOR is used in the mechanics of the collateral arrangements.