The LIBOR (London Interbank Offered Rate) was, and still is one of the most important benchmark interest rates on the global financial markets. It states the rate for which banks with outstanding credit ratings can lend money to each other on an unsecured basis. Also, the LIBOR is published daily in USD and other currencies by the ICE Benchmark Administration (IBA). Benchmark interest rates like the LIBOR, the EURIBOR (Euro Interbank Offered Rate) or the TIBOR (Tokyo Interbank Offered Rate) are used worldwide for a variety of financial products like derivatives, bonds, credits, or securitisations with volumes up to trillions of euros.
New benchmark interest rates based on real transactions
After the LIBOR scandal in 2011, where manipulation of the LIBOR rates and other benchmark interest rates by involved bank traders had been unveiled, the international organisation of securities published several guidelines for the calculation of the benchmark interest rates in 2013. These amendments have been extended in 2014 due to an article of the Financial Stability Board in which reformations of the guidelines were proposed. As a result, out of these initiatives, the European Union adopted the so-called benchmark regulation (BMR) in 2016 which stipulates that benchmark interest rates must be based on on real transactions. Benchmarks that do not comply with these regulations need to be replaced. The interest rates of the LIBOR are also affected by the EU benchmark regulation. This caused the British Financial Conduct Authority (FCA) to stop publishing LIBOR inters rates in GBP, CHF and JPY in the beginning of 2021.
Furthermore, the USD-LIBOR is also prohibited to be used for new financial products as of the beginning of 2022 and is planned to be abandoned completely on the 30th of June 2023. As replacement regulatory agencies advise to refer to the Secured Overnight Financing Rate (SOFR). This rate is based on the interest rates of credit facilities that mature on the respective day and is published by the U.S. federal reserve bank. The facilities used are secured with U.S. government bonds.
Diverse impacts on insurance companies
The insurance industry is affected by these changes in a diverse manner. Insurance companies administrate tremendous amounts of customer capital and are counterparties for various financial instruments that have maturity dates past June 2023. At the same time, they insure retirement fonds, investment manager and financial institutions which aim to secure their risk as the issuer of financial instruments. Many of these instruments used the USD-LIBOR as a benchmark interest rate in the past, as well as basis for hedging and swaps.
The changes also impact the market for credit- and political risk insurance (CPRI), which is worth well over 300 billion US-dollar. Trade credit insurance allows companies to hedge bad debts arising from deliveries of goods, work, or services, while financial institutions hedge credit default risks with the help of CPRI. Many insurance contracts are dependent on the USD-LIBOR, as the underlying financial contracts use it as a reference.
Insurers hold several instruments with long maturities to cover their own liabilities. Life- and pension insurers use derivatives to hedge against differences in value between assets and liabilities over long periods. References to the LIBOR can also be found in company pension documents, reinsurance contracts, intercompany loans, and discount rates.
Implications for contract terms
Insurance companies should therefore act promptly, review and adjust their contract terms and engage in dialogue with their customers. In many cases, contracts contain so-called "fall-back" clauses that regulate the procedure for the event that the LIBOR is not available. Corresponding contracts must now be modified and equipped with an alternative reference interest rate.
Especially for credit insurance, insurance companies rely on the cooperation with financial institutions. ING must convert all existing financial contracts and instruments, such as credit facilities that use the LIBOR, to a new benchmark rate as well. New loans are also obligated to use an alternative benchmark rate since the beginning of the year. However, many of these facilities are secured by insurance policies or risk sub-participation agreements.
For existing USD LIBOR facilities, financial institutions will need to amend the facility agreements to replace the LIBOR with a substitute benchmark. In addition to the change of the reference rate within the interest calculation clause, other changes to the facility agreement are required, including, amongst others, changes to definitions and the description of the Secured Overnight Financing Rate (SOFR) calculation methodology.
However, financial institutions may rely on consent by the corresponding insurance company for such adjustments. Since no economic value is transferred with an affected credit agreement, it should be considered that insurance companies waive the condition precedent for the liability or other consent or consultation requirements relating to the LIBOR changes under the relevant insurance agreement. Such a waiver greatly simplifies the transition for the financial institutions and reduces the administrative burden for all parties involved.
The master agreements also need to be adjusted regarding to the clause establishing a claim. The clause states that insurers are entitled to interest payments in the event of outstanding compensation money, which are also calculated using the LIBOR up until now.
Contracts that have been issued in 2022 need to adopt the SOFR as the reference interest rate from the beginning on. Since the SOFR is an overnight rate and therefore does not contain a credit, maturity or liquidity component, SOFR fixings are generally lower than the LIBOR. To achieve economic parity, a small number of basis points, known as the credit adjustment spread (CAS), must be added to the SOFR. This can be implemented in two ways: Either the CAS can be shown separately as a component of the interest rate, or it is included in the margin. In this case, only the SOFR and the margin would show as interest costs. In the first case, the renegotiated margin is comparable to the old margin under a LIBOR transaction (other conditions remaining as they were). In the second case, the new margin includes an additional CAS component. This is no longer explicitly shown in the credit facility agreement documentation. Only the definition of the margin is included, which is consequently higher by the amount of the CAS as if it would have been calculated for a LIBOR credit line.
In the midterm, the master agreements must be adjusted for both new and old credit insurance contracts. From an organizational point of view, it makes sense to adjust all existing master agreements at once. Until then, new insurance policies should be extended by a clause that a claim must refer to the SOFR.
This reformation of the benchmark interest rates entails many changes for the entire insurance industry. On an operational level the effects are enormous and present institutions face significant challenges: In the worst-case scenario transactions, customer interactions, control processes, IT systems or risk management must be adapted to the new regulations. Also, the transition phase is only going on for another year and changes are usually done on a contract-by-contract basis. To speed up the transition insurance companies should start, if not done already, to determine their individual USD LIBOR exposure within their portfolios and start engaging into dialog with customers and partners in order to be able to develop and implement measures as soon as possible.
ING actively approached its insurance partners on this topic during this year's Insurance Day. Additionally, we are in close dialog with our clients to make the transition as efficient as possible for both sides. The new implementations are also an integral part of discussions for new business.