The transition from the long-standing London Interbank Offered Rate (LIBOR) reference rate, used to help set other interest rates, to the Secured Overnight Financing Rate (SOFR), will likely be challenging for the insurance industry.
The Bests Special Report, titled, Transition From LIBOR: A Known Unknown for Insurers, states that the differences between SOFR and LIBOR may make the transition problematic, as SOFR currently is only available based on overnight transactions. There is plenty of work still needed to be done with the replacement reference rate and many of the basis risk are still being worked out with regards to SOFR such as the basis risk, the development of an options market, a term structure, and use of SOFR as a fall-back provision in existing contracts. Early results show SOFR to be more volatile than LIBOR, given that it is tied to U.S. Treasury bill issuances, which can fluctuate, especially at month and quarterly end dates when supply issues may drive auction results.
Insurers are heavy users of derivatives to hedge risks, particularly interest rate swaps. LIBOR is the most frequently used reference rate in swap transactions. LIBOR also serves as the basis for corporate loans, floating rate mortgages and notes and other securitized products. As of year-end 2017, U.S. insurers held 259 surplus notes with floating rate coupon provisions, totaling $5.6 billion, or 11% of the $49.5 billion industry total. Insurers also may be exposed to basis risk and changes to the accounting treatment of cash flow/fair-value hedges as the discount rates used to value liabilities and the hedges backing the liabilities may transition at different rates.
AM Best will continue to monitor developments with the LIBOR-to-SOFR transition. AM Best currently does not anticipate any rating changes, but will examine insurers operational readiness for the transition process, as well as their ability to adjust their products, provisions and contracts, as well as other expenses, accordingly.
To access the full copy of this special report, please visit http://www3.ambest.com/bestweek/purchase.asp?record_code=283394.
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