The London Inter-Bank Offered Rate (LIBOR) change will affect all Insurers – regardless of size, sector, specialism or locality. What seems minor for insurers – a switch from LIBOR to Sterling Overnight Index Average (SONIA) in the UK – could, in fact, result in a sizeable challenge. It’s a change that, due to the Senior Managers and Certification Regime (SMCR), requires C-Suite oversight, forcing its way into an already crowded change landscape.
Below, we have laid out a handful of the considerations which the LIBOR change could exact on Insurers. Acting fast will ensure organisations are well-placed to accept change across customer, internal and regulatory lenses.
- Existing contract re-papering
If a contract references LIBOR or another currency’s Alternative Reference Rate (ARR) this will require to be changed for all contracts ahead of the 2021 deadline. This is a substantial undertaking for firms and we are working with our clients to reduce the manual effort required to support this exercise through implementing electronic document searching tools.
Aside from the sheer volume of contracts, insurers must also be mindful that when contract negotiations occur it is possible counter-parties could see this as an opportunity to include additional terms. The costs for lawyers to oversee and update these changes will be considerable and the potential risk around required availability of lawyer resource to fulfil all required contract changes by the end of 2021 is a key consideration.
Type of contracts where LIBOR could be found:
- Inter-company loans
- Investment products
- Commercial bank loans
- (Non UK) 3rd party distribution contracts (interest on missed commission payments)
- The yield curve impact - Internal Modelling, Solvency II, Pricing
The European Insurance and Occupational Pensions Authority (EIOPA) designate the yield curve used for internal modelling by UK insurers under the Solvency II regime. This curve is currently based on LIBOR with a new ARR yet to be confirmed (@28/11/2019) by EIOPA. This curve is used to support the financials underpinning required core capital scenarios, therefore firms will need to understand the impact of this change on their internal modelling processes, systems on economic output.
Crucially, modelling teams may need a period of dual-running both LIBOR and (the anticipated) SONIA yield curves regardless of potential wider changes required. Comparing both scenarios will be an essential but time-consuming activity with potential performance and infrastructure challenges.
Changes to the core yield curve will also impact any pricing and underwriting projections (process, systems and economic) supporting core Life and Pension products.
- Insurer’s treasury function – Financial product exposure
Products regularly used by UK treasury functions are regularly linked to LIBOR. As a result, how this function manages risks and the products they use will change. From our initial findings it is clear that all treasuries are facing the same challenge but the size of the challenge is dependent on the complexity of the organisation (including currency exposures). A key factor is that bank lending is currently linked to LIBOR and so the treasury function will need to work through all the required changes as a result. Internal loans, for example, depending on the legal entity structure, may have multiple LIBOR references.
- Conduct Risk – Risks of customer detriment need to be mediated, rectified and communicated
Due to the market changes with LIBOR the financial institution will be required (dependent on contract type) to make investment decisions on the customer’s behalf. The insurer will need understand the impact, communicate and mitigate any impacts for customers accordingly. Customer messaging is going to be key – timely, clear and explicit.
A significant number of retail investment products sold in the UK have a reference to LIBOR in their contracts. If these contracts continue post December 2021, they will need to be re-issued as per point 1 above.
How should insurers approach LIBOR?
In order for an Insurer to understand the scale of their exposure to LIBOR, and thereby formulate strategies to reduce and manage the business impact and residual risk, Baringa recommend the following six step approach.
- It is critical to assign a Senior Sponsor and set-up a Programme team to govern, co-ordinate and drive your LIBOR transition activities. The role of this team will be to:
- Set up relevant workstreams and assign leads to support the programme on a global, business line and functional level
- Ensure sufficient plans, budget and resources are allocated and that this is a board level agenda.
- In order to understand where LIBOR exposures exists, we recommend creating a catalogue of “LIBOR exposures” right across the breadth of your business:
- Analysis across the product inventory and business to catalog use of LIBORs (e.g. products, risk models, documentation, valuations etc.
- Review and agree which areas need to be considered and define the scope and approach for completing impact assessments
- After identifying where your LIBOR exposures exist, you need to quantify the impact of this exposure:
- Current capital model and impact scenarios, including Reinsurance contracts
- Current positions and evolution of investment products
- Customer outcomes and the impact of fallback rates in investment products
- Having assessed and quantified the impact of your LIBOR exposure, it is necessary to formulate a transitional plan and product strategy, which focuses on the following:
- Solvency II model formulae
- Asset management strategy
- Investment product approval processes
- Risk appetite
- Development of products referencing alternate RFRs
- Once this initial plan and strategy has been developed, it will then be possible to develop a detailed transition plan which will need to cover the following areas:
- Contracts and Terms (e.g. new contract design and old amendments)
- Derivative, Cash products, hedging strategies, and managing existing book and future trading strategy (if applicable)
- Insurer infrastructure (e.g. Risk, IT, Finance, Operations, Treasury etc.)
- The final step in this approach transcends each point of the journey, and pertains to communication. It is absolutely critical to the success of Insurers IBOR Transition programmes that they communicate with their staff and with their clients the impact of this change. In addition, taking part in industry wide discussions of this will be hugely important, and will allow Insurers to learn and understand from each other the best way to tackle this imminent change.
What are we doing on IBOR?
Baringa know that LIBOR transition activities are highly complex and far reaching in their impact. Based on conversations held across the market we understand that there is a nervousness about the extent, scale and business impact of the changes required.
As such, Baringa is working with clients to help them understand the scope, scale and impact of their LIBOR transition activities, bringing with us three key differentiators which make us the partner of choice.
- Proven Approach – Baringa is already working with clients to help them articulate and calculate their IBOR exposure across a range of business functions, including; Treasury, Actuarial, Reinsurance and Compliance
- Deep Specialism – Baringa is uniquely structured to help Insurance clients approach their IBOR transition, being able to pull on a wealth of industry and regulatory experience from across the Financial Service sector
- Unique Experience – In order to deliver a successful LIBOR Transition, Baringa knows we need to partner closely with each impacted team and work with them to help shape and deliver the activities required.