Two years on from signalling that LIBOR was on the way out, the Bank of England (BoE) and Financial Conduct Authority (FCA) have shared the thematic feedback from their Dear CEO letters. These letters were sent to the CEOs of major UK banks and insurers in September 2018, and so the feedback gives great insight into the level of preparedness (or lack thereof) across the markets.
The overarching message, delivered by the BoE and FCA in a conference address on 5th June 2019, was not to leave preparations to the last minute. If not already started, firms need to quickly understand their exposures and plan for how, and when, they will address them in advance of end-2021. Dave Ramsden, Director for Markets and Banking (BoE), referenced the surprise at the varying states of readiness identified by responders, and called for firms to “invest in the necessary changes now”^1. This chimes with the FCA’s Executive Director of Supervision’s message that “inertia remains the biggest obstacle to a smooth transition”^2.
A full run-down of the key messages coming from the Dear CEO feedback can be found in this blog post. This post will focus on the considerations and exposures particular to insurers.
Many insurers will face the same considerations that any financial services firm will have; that they hold debt and hedging instruments which currently reference LIBOR. As noted above, firms need to accelerate efforts to understand the full suite of these in force; and particularly to identify those with terms ending after December 2021. For any such contracts, firms need to carefully consider how they plan to manage these, particularly in scenarios where LIBOR markets become less liquid. The potential implications on hedge accounting treatments and on income statement volatility have been raised in a letter to the IASB^3, with a full list of accounting treatment dependencies to be submitted in Q3 2019^4. The hope is that the IASB will offer relief from January 2020 for such exposures^5.
Concern around liquidity of markets in the alternative Risk Free Rate (RFR), the Sterling Overnight Index Average-based (SONIA), have been cited as potential reasons for firms delaying plans to transition away from LIBOR, along with uncertainty around term rates. The BoE advised that there is great momentum in issuance of SONIA-referenced Floating Rate Notes (FRNs), Bonds and across other markets, so liquidity is becoming less of a concern. However, there is yet to be a SONIA-based loan, which the BoE notes is an area progress needs to accelerate. The question of term rates has been set as a priority of the Sterling Risk Free Rate Working Group.
Insurers will need to give consideration to the availability of SONIA-based products, or timelines for availability, when planning their own strategy.
In addition to the above, insurers who fall under the scope of Solvency II (which is most) will have further considerations arising from the potential impact of the LIBOR change on the European Insurance and Occupational Pensions Authority (EIOPA) RFR. These rates are calculated by EIOPA, based on LIBOR swap data with a credit risk adjustment applied, and are published monthly for use in Solvency II calculations by insurers.
This additional consideration is well understood by the BoE and FCA, and this was called out in the Dear CEO letter sent to insurers, noting that monitoring of the LIBOR transition is on EIOPA’s agenda . The onus, however, is very much on firms to understand and manage their own exposure.
Assuming EIOPA moves to base its reference curve on SONIA, in the same way as it currently bases it on LIBOR, then there is potential that the new EIOPA curve will be lower, as the SONIA term structure has historically been lower than LIBOR. This is something EIOPA may try to adjust for, but firms should test alternative outcomes. For most lines of business a lower EIOPA curve will drive higher Solvency II Technical Provisions (Best Estimate Liability (BEL) and Risk Margin (RM)), but the effect on any Transitional Measure on Technical Provisions (TMTP) is less clear and will need investigating. For firms with long dated liabilities there are further questions about the future shape of the reference curve.
For companies that benefit from the long term guarantee package, the Matching Adjustment (MA), Volatility Adjustment (VA) or TMTP may at least partially offset increases in the BEL and RM. For MA it seems likely that the spread above the risk free rate will be adjusted as well as the risk free rate, to allow minimal impact of the change, however firms will be waiting to see whether transitioning assets alters the closeness of cash-flow matching enough to require re-approval of the MA. Firms should ensure to factor in the potential time and effort it will take to apply for and obtain approval from supervisory authorities. Any announcement by EIOPA will cause volatility in financial markets as changes in insurers’ hedging strategy are anticipated.
Those firms with an approved Internal Model will need to consider recalibrating their model to allow for this change and if they are more mis-matched because assets and liabilities transition at different times the Solvency Capital Requirement (SCR) may increase.
One of the key themes in the Dear CEO feedback was around the identification and management of conduct risks. Specifically for insurers, the FCA identified that some have failed to consider the potential customer impacts of changes to Solvency II surplus, reinsurance treaties and the potential changes in investment strategy or cost allocation on with-profit policyholders.
Insurers should also give consideration to any references to LIBOR tucked away within client contracts or product definitions, and factor in time and effort to change these and communicate with customers. For those insurers currently undergoing a change programme for IFRS 17 this transition could also impact those preparations if firms are using LIBOR or EIOPA rates as a basis for discounting. There should hopefully be an opportunity here to leverage the work being done in reviewing contracts for LIBOR references.
The Road to 2021
Looking ahead, there is still time for those who are behind in preparations to catch up, but action needs to be taken now. Further clarity around accounting treatments, term rates and other concerns is scheduled to come out over the next 18 months, giving an evolving picture of exposures. The BoE have advised that engagement with supervisory authorities should increase as 2021 draws closer, firms should actively seek this and enter into open discussions as early as possible.