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Treasury Secretary Fears the Attack of the Bad Interest Rate Benchmarks

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What You Need to Know

  • Many companies, including insurers, have built Libor-linked rate calculation formulas into a wide range of contracts.
  • The United Kingdom says it's killing Libor, because the index is backed by what's now a small, easy-to-manipulate pool of transactions.
  • Top federal regulators want U.S. players to shift to using a new index, SOFR, in 2022, when the United Kingdom plans to start shutting down the Libor system.

Treasury Secretary Janet Yellen wants to see banks, life insurers and other organizations preparing now to shift away from the Libor interest rate benchmark Jan. 1, 2022.

Yellen and other top federal regulators are calling for U.S. companies to tie the rates in variable-rate contracts to the new Secure Overnight Financing Rate benchmark.

“We have reached a critical juncture and more must be done to facilitate an orderly transition,” Yellen said last week, at a Financial Stability Oversight Council videoconference meeting.

Although many market players are starting to prepare for the Libor-to-SOFR transition, “many segments, including business loans, are well behind where they should be at this stage in the transition,” Yellen said.

The world’s financial services regulators have been working to kill Libor because of concerns that the system used to create the Libor benchmark is too easy to manipulate.

Yellen said she worries that companies could adopt SOFR alternatives that have the same kinds of problems Libor has.

Randal Quarles, the Federal Reserve vice chairman for supervision, blasted companies that are resisting the shift to SOFR.

“Some market participants seem to believe that the remorseless evolution of the universe will somehow not involve them,” Quarles said. “Others have adopted a posture of strategic procrastination, watching as others take the steps to prepare for the imminent end of Libor. The deniers and the laggards are engaging in magical thinking. Libor is over.”

What’s FSOC?

FSOC is an organization that’s supposed to help federal agencies monitor and manage trends and events that could cripple the U.S. financial system.

Yellen is the council chairperson.

Thomas Workman, the former president of the Life Insurance Council of New York, serves as FSOC’s independent voting member with insurance expertise.

Eric Cioppa, the Maine insurance superintendent, serves as a non-voting member on the council on behalf of the National Association of Insurance Commissioners.

Steven Seitz, the director of the Treasury Department’s Federal Insurance Officer, also serves as a non-voting member.

Libor and SOFR

Large banks in London developed Libor — the London Interbank Offered Rate — in the 1980s, to serve as an anchor for variable interest rate provisions and variable discount rate provisions in loan contracts, derivatives contracts, annuity contracts, variable life insurance contracts and other contracts.

Libor is based on financial transactions involving a small number of big banks in London.

About 10 years ago, officials determined that Libor was based on information about transactions in a small, thinly traded market, and that Libor was easy to manipulate.

Roughly $200 trillion in outstanding U.S. contract value depends on Libor rates that are based on a market with only about $100 million in daily trading volume, according to Rostin Benham, acting chairman of the Commodity Futures Trading Commission.

The Federal Reserve Board set up the Alternative Reference Rate Committee to choose a U.S. Libor alternative. ARRC and the Federal Reserve Bank of New York have been working to establish SOFR as an alternative to Libor.

The U.K. organization that administers Libor says it will stop posting public Libor information after Dec. 31. The organization plans to calculate Libor rates for in-force products for two years, and then shut down the Libor system at the end of 2023.

“There is no path forward for Libor after the end of this year,” Quarles said.

Quarles said he would have concerns of about the safety and soundness of organizations that continue to use Libor in 2022.

Insurance Regulators’ View

Cioppa, the NAIC’s representative at FSOC, said the NAIC has supported the shift to SOFR by updating insurance regulators’ Statutory Accounting Principles and the NAIC’s Valuation Manual.

The Valuation Manual sets minimum reserve requirements for jurisdictions that base their reserving requirements on the NAIC’s Standard Valuation Law model.

“State insurance regulators believe that it’s critically important that insurance companies transition to Libor alternatives as expeditiously as possible, given the upcoming deadline,” Cioppa said.

Treasury Secretary Janet Yellen. (Photo: Bloomberg)