5 minute read 2 Jul 2019
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How insurers can understand, plan and prepare for the IBOR phase-out

5 minute read 2 Jul 2019

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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.

A “no regrets” response

In the insurance industry, front office and board awareness of the big picture implications of IBOR transition is strong or growing. Where time could be now well spent – on a no regrets basis – is in looking in more detail at the repercussions – identifying where exactly value is at most risk and quantifying the impact. Such a financial impact assessment can expand on what IBOR transition could really mean for the specific insurance business.

With this greater insight, a useful next step is to understand the likely approach needed to address the IBOR transition challenge and the time it could take. This includes considering the dependencies involved – the details that will need to be clarified by other parties, and when that could happen. What aspects of the business will need to be involved? What’s the likely lead time for addressing all issues properly before the use of new ARRs becomes standard?

IBOR transition affects insurance entities from front to back. Many different functions will be involved in the IBOR transition program, including front office, finance, treasury, risk, IT and operations, governance and legal teams. Bottlenecks in the program could easily arise, given that IT and finance resources could be in high demand. Implementing the program may not be necessary yet, but developing a clear plan in terms of actions required, by whom and when, should help to avoid bottlenecks and unnecessary delays. The year 2021 may feel comfortably in the future, but programs could ultimately come under tight time pressure if not clearly mapped out and managed properly.

The greater insight enabled by the previous two steps – understanding the impact and developing a clear plan of action – can inform a potential third step in the run-up to IBOR transition. Insurers and the insurance industry need to keep an eye on developments and consider whether at any stage they should be setting the agenda themselves – perhaps to mitigate emerging risks or capitalize on business opportunities. Although it’s sensible that banks and buy-side organizations take the lead in IBOR transition, greater understanding of the insurance ramifications may inspire proactive involvement in developments at future stages.

Interaction with IFRS 17

IBOR migration isn’t the only issue on many insurers’ minds. For European firms, implementing new accounting standard IFRS 17 is a far bigger current priority than preparing for IBOR transition. Many insurance players have major programs in progress to ensure proper IFRS 17 adoption, absorbing substantial finance and actuarial resources.

Given these programs are live now, one priority action could be to understand the extent of any commonality between IFRS 17 and IBOR transition. For example, valuing the balance sheet on a market-consistent basis sits at the core of IFRS 17 – this has a similar range of balance sheet and P&L impacts as those identified from IBOR transition, but particularly on liabilities. Insurers could therefore consider how their IFRS 17 and IBOR programs could co-exist in a productive way. There may be useful synergies to be obtained from taking a coordinated approach to the two transition challenges.

IFRS 17 programs are already active – whereas IBOR transition planning is generally yet to start. This is another reason why effort spent now in clarifying IBOR transition impact and drawing up an action plan would be worthwhile. Such insights could be considered in IFRS 17 work, helping to reduce the risk of re-visiting and repeating work in a few years’ time when the need to switch to ARRs becomes a real priority.

Looking ahead

Although some value creation opportunities for insurers exist, IBOR transition is more a matter of change management. It’s important that insurers move from high-level hypothesis to quantified impact assessments and documented plans to prepare for and achieve a smooth transition to new ARRs.

Summary

As we move away from interbank offered rates (IBORs), insurers may justifiably await clarity from sell-side institutions which appear to be taking the lead. While the timeframe for phasing out IBOR isn’t fixed, it’s still important to begin understanding the scale of the challenge – and start taking action with a “no regrets” response.