New York state regulators want insurers and other financial services companies to explain what they’ll do if and when a major interest rate benchmark — the London Interbank Offered Rate (Libor) — goes away.
New York State Financial Superintendent Linda Lacewell has told the companies to send her detailed life-after-Libor plans by Feb. 7.
The same London banks that created Libor could kill the benchmark at the end of 2021.
The death of the Libor benchmark may not have much effect on short-term investments, but it could have a major effect on long-term investments, Lacewell says.
- A copy of the New York Libor announcement, and a link to the industry letter, are available here.
- A SOFR comment letter that Carl Wilkerson, an ACLI vice president, sent the Fed in 2017 is available here.
- An ACLI slidedeck giving an analysis of the looming Libor-to-SOFR shift is available here
- An NAIC Capital Markets Bureau Libor presentation slidedeck is available here.
- A report by Oliver Wyman and Davis Polk on the Libor transition is available here.
U.S. health insurers and U.S. property and casualty insurers tend to have relatively modest investment portfolios, and they tend to invest in a mix of short-term and long-term arrangements.
U.S. life insurers write many products that are designed to stay in place for many years, such as long insurance, annuities, long-term disability insurance and long-term care insurance. U.S. life insurers try to support those long-term obligations with long-duration assets, such as mortgages, mortgage-backed securities, and high-grade corporate bonds.
Life insurers also use futures and swaps to manage investment risk, and the performance of many of those derivatives arrangements is linked to Libor.
Libor serves as a key parameter for about $200 trillion in financial contract value in the United States, and about $150 trillion in financial contract value outside the United States.
Officials at the New York State Department of Financial Services said they want to make sure the directors and managers of regulated institutions understand the possible risks associated with the death of Libor.
“Our financial institutions with Libor exposure need to prepare to manage the significant risks associated with its likely cessation, and be ready to transition to alternative reference rates,” Lacewell said in the New York department’s call for life-after-Libor plans.
Libor is a rough measure of the rates big banks in London might have to pay to take out unsecured loans from other big London banks for periods of up to a year.
London banks began developing the benchmark in the 1970s.
The British Bankers Association and British financial services regulators developed the current version of Libor in the mid-1980s. The Libor data series officially goes back to Jan. 1, 1986.
A few dozen banks now contribute the rate data behind the Libor benchmark.
But reports that the banks were manipulating the rate data surfaced around the time of the 2007-2009 Great Recession.
The United Kingdom’s Financial Conduct Authority said in 2017 that it would stop requiring banks to furnish Libor data after 2021.
“As a result, Libor is unlikely to continue past the end of 2021,” Lacewell writes in the letter to insurers. “Efforts in the US to create reference rate alternatives are under way, as discussed below. Your institution should be carefully following these developments.”
The Federal Reserve Board and the Federal Reserve Bank of New York have tried to create a Libor alternative by setting up an Alternative Reference Rates Committee. The committee decided to recommend a new Secured Overnight Financial Rate (SOFR) benchmark to replace Libor.
SOFR is based on the interest rates for “repurchase agreements,” or short-term secured loans. In a repo arrangement, one part sells a security to another, and agrees to buy the security back later at a predetermined date and price.
The SOFR benchmark includes only “overnight, Treasury-backed repo transactions that take place in the Bank of New York Mellon’s triparty repo system or are cleared through one of two Fixed Income Clearing Corp. platforms: (1) the Delivery-Versus-Payment Repo Service and (2) the General Collateral Finance (GCF) Repo Service,” according to the federal Office of Financial Research, an arm of the U.S. Treasury Department.
Lacewell writes in her letter to financial services companies that what happens to Libor-related provisions in existing financial instruments may be complicated.
Typical Libor-based residential mortgage loans give the lenders the option to choose a comparable bechmark if Libor goes away, Lacewell writes.
But “there are also a significant number of notes, securitization products, and other instruments that are linked to Libor,” Lacewell writes. “Many of these instruments may have no successor rate provisions or may convert to fixed-rate instruments, which may also present valuation, portfolio matching concerns and monitoring issues.”
The Insurance Community Perspective
The American Council of Life Insurers (ACLI) and the National Association of Insurance Commissioners (NAIC) are two of the insurance community organizations that have paid close attention to the looming death of Libor.
Speakers who addressed an ACLI senior investment management seminar in November told attendees that they believe the market for the kinds of transactions included in the Libor benchmark is simply too small to create good benchmark data.
The kinds of repos included in the SOFR benchmark generate an average of $754 billion in daily transaction volume, compared with an average of just $500 million in daily transaction volume for the kinds of loans included in the 3-month Libor benchmark, according to the seminar slidedeck.
The speakers note that the SOFR-based benchmark is quite a bit different from the Libor benchmark.
One difference is that the Libor benchmarks are based on rates for unsecured, short-term loans made by one big bank to another big bank, with some credit risk involved, while the SOFR benchmark is based on secured, overnight transactions, with no credit risk involved, according to the slidedeck.
One result of that difference is the SOFR averages tend to be more stable than the Libor benchmarks, according to the slidedeck.
Carl Wilkerson, an ACLI vice president, wrote in October that the ACLI is supportive of the likely shift to the SOFR benchmark, and away from Libor.
“With the transition to SOFR, life insurers will experience a more reliable and fair system,” Wilkerson writes. “This process will replace Libor’s instability with trustworthy financial benchmarks.”
Michele Wong, an analyst with the NAIC’s Capital Markets Bureau, created a slidedeck in May 2018 to explain why Libor was rising in early 2018.
She said, in a slidedeck, that the increase was due to technical factors, not to stress in the financial markets.
Wong predicted that the shift to SOFR will be “gradual and complicated,” because of the need to revise financial instrument agreements that include no provisions for the death of Libor.
Analysts from Oliver Wyman, an insurance industry consulting firm, and Davis Polk, a law firm, have argued, in a 2018 analysis, that, in the real world, life insurers may have to put up with many variable-rate securities turning into fixed-rate securities, because trying to change the built-in interest rate benchmark will be too expensive and too complicated.
Even if a contract includes “legacy fallback language” that explains what will happen when Libor goes away, “litigation regarding the interpretation and enforceability of legacy fallback cannot be ruled out,” the Oliver Wyman and Davis Polk authors write. “Counterparties may try to argue that the language was drafted to address the temporary unavailability of Libor, not its permanent unavailability, and that some other approach to calculating the interest rate should be adopted outside what is provided for in the contract… The potential merits of such claims will be highly fact specific and depend on, among other things, the governing law of the contract.”
Under New York state law, “to the extent that the contract does provide a clear and complete framework governing how to determine the interest rate if Libor is unavailable, such claims may be difficult to sustain,” the Oliver Wyman and Davis Polk authors write.
The New York Life-After-Libor Plans
Lacewell says a regulated institution’s plan for life after Libor should describe its programs for tracking and managing risk related to the death of Libor, and for analyzing potential Libor alternatives, such as the SOFR benchmark.
Lacewell also wants to know how institutions will communicate about the shift with consumers and transaction counterparties.
— Read Start Preparing Now for the End of Libor-Linked Loans, Securities, on ThinkAdvisor.