IBOR transition effects for the insurance industry
The end of the IBOR era is near and IBOR transitions are a big challenge for both the regulators and the insurance industry. Survey results have revealed that most of the insurance firms already have a formal transition plan in place. However, these often lack details, unified planning, and strategizing investment priorities. Nevertheless, we need to anticipate for the transition before the end of 2021.
Some of the most significant factors influencing the IBOR transition within the insurance sector are diverting regulatory guidance, long-term liabilities, asset valuation and other dynamic risk factors. In this article we summarize the top issues that need to be addressed.
The overall complexity and impact of the transition will vary across currencies and across asset types. For example, your derivatives may transition to an overnight rate plus a spread based on 5 year historically observed average spreads, while your loan portfolio may transition based on current market conditions. Therefore, portfolios with several affected asset types (such as loans, bonds, derivatives, etc.) may see different levels of impact. There will be some guidance and market practice, but also many parties involved and contract legal language that is not prepared for this transition.
Capital requirement and liabilities
In terms of liabilities, the biggest unknown is the future regulatory discount rate (also called EIOPA Risk-free interest rate or EIOPA RFR) that will apply – which could have a material impact on available capital and required capital. The ‘mystery’ around the new discount rates stems from the uncertainties about how the differences between the old and new curve will impact the different components of EIOPA RFR curve: Ultimate Forward Rate (UFR), Credit Risk Adjustment (CRA) and Volatility adjustment/Matching adjustment (VA/MA).
With regards to liabilities covered by the matching adjustment, there would be less impact as the spread above the risk-free would be expected to adjust accordingly. However, for liabilities where the volatility adjustment is applied, the value is likely to rise if the new rates are lower than the current. Finally, a lower discount rate would also lead to an increase in the risk margin via lower forward rates. Note that the risk margin is valued using a hybrid curve of market and prescribed forward rates. Summarizing, the foreseen decrease in the EIOPA RFR curve will increase Best estimate of liabilities (BEL), the Risk Margin and also the Solvency Capital Requirement. Some of the impacts may be dampened by the elements of long-term guarantee measures such as VA/MA.
Insurance companies seeking to hedge interest rate risk face direct exposures to the coming discontinuation of IBOR rates. The switch to alternative rates may differ per derivative depending on the fallback language, negotiation with counterparties and whether your derivative is centrally cleared or not. Transition will have impact on market value, which will be compensated, which may be fair value neutral but not risk neutral.
The differences in transition timing across currencies may cause additional challenges in cross currency risk. Problems may arise, for example, in cross currency swaps. Companies should be aware of their exposure to cross currency products and how they want to minimize basis risks between currencies.
The structure of numerous (existing and new) financial and insurance products may be impacted as well. The shift to an alternative rate may complicate the pricing for some long-term insurance products and change the business case for marginally profitable businesses.
Insurance companies with international businesses may face a more complicated LIBOR transition than their purely domestic counterparts. Because each of the alternative rates may be at different developmental stage and may follow different adoption schedules.
Insurers with investment products will require a clear decision-making process to determine when the investment products transition from IBORs to alternative reference rates (ARR) in order to ensure that the change will take place at a reasonable time for all parties in the contract. This will raise a challenge around conduct risk, making customer communication vital.
Preparation is key
In addition to the operational challenges, it is undisputable that solvency ratios could be materially impacted by LIBOR transition if insurance companies do not act timely and appropriately. Particularly for life insurers with long-term liabilities, a small difference in the transition in either liabilities, assets or hedge could have an impact on the capital position. From an asset liability management perspective, the IBOR transition will be complex for firms to hedge their interest rate exposures – exacerbated by the fact that transition of the Solvency II curve and the new ARRs for assets and derivatives will differ in timing and per balance sheet item. In order to make the switch from the current LIBOR based curve to the new ARRs based curve, firms are required to revisit their hedging programs and rebalancing policies.
Overall, there’s a lack of legislative underpinning related to the IBOR transition ahead of us, it is left to the markets. The consequence is that different market players could take different approaches to what actions to take and when. Although EIOPA has not provided specific transition plans yet, we expect the regulator to produce a consultation in the second half of 2020, which will include specific policy recommendations regarding the transition of the EIOPA curve. EIOPA is currently seeking responses to the proposals set out in its discussion paper and firms will have the opportunity to do so until 30 June 2020.
Contact and Whitepaper on IBOR Reform & Solvency II
More details on the impact of the IBOR reform for insurance companies is available in an in-depth whitepaper, written by Hanh Minh Hoang: ‘IBOR Reform & Solvency II’. You can request a free copy of this whitepaper. If you have any questions, please contact her co-authors Martijn de Groot or Lennard Beijering.