The end of the road for LIBOR but a new way ahead for ALM?

David Roseburgh, Investment Director, Liability-Aware Insurance

In July 2017, Andrew Bailey, head of the UK Financial Conduct Authority, made a monumental announcement. He stated that at the end of 2021, banks would no longer need to submit fixings for the London Interbank Offered Rate (LIBOR). That statement put global financial market practitioners on notice – to begin preparing for a world without LIBOR.

As the deadline draws closer, we examine the impact of this momentous event on UK insurers and what the road ahead might look like. More specifically, how will LIBOR’s retirement affect asset liability management (ALM)? 

A well-trodden path

Before the announcement, LIBOR was very much viewed as ubiquitous, pervasive, and vital to the ongoing function of almost all participants in financial markets. While the challenge associated with LIBOR’s cessation are global, the UK has been at the forefront of the change. The government, central bank, and regulators have been proactive, visible and absolutely clear that market participants should prepare to thrive in a post-LIBOR world.

The government, central bank, and regulators have been absolutely clear that market participants should prepare to thrive in a post-LIBOR world.

In parallel, industry working groups acted decisively to anoint SONIA (Sterling Overnight Index Average), as a replacement risk-free rate (RFR). SONIA is an interest rate benchmark based on actual overnight unsecured lending transactions. All this activity allowed liquidity and confidence to quickly build in LIBOR-alternative instruments.

The journey so far

After Mr Bailey’s speech, liability-focused institutional investors like life insurance companies and defined benefit (DB) pensions focused on the embedded exposure in derivative back-books. UK life companies and pension funds are among the world’s largest users of interest rate derivatives. They faced the prospect of hundreds of billions of pounds worth of exposure to a benchmark that soon wouldn’t exist. The burning question asked by (and of) them, was ‘what do we do with this?’.

The liability-driven investment (LDI) managers of large DB schemes were among the first to move quickly. They traded out of LIBOR interest swaps and into strategies based on gilts or OISs (overnight index swaps) referenced to SONIA rather than LIBOR.

Insurers, meanwhile, largely acted more conservatively. They likely engaged in a more involved decision-making process and governance framework. In addition, uncertainty around several key factors meant that a mass exodus from LIBOR didn’t instantly materialise.

Insurers were particularly keen to understand how a shift in interest rate benchmarks would impact the liability discount rate prescribed by the European Insurance and Occupations Pensions Authority (EIOPA) under Solvency II. They also wanted to consider the regulatory perspective on the various options open to them.

For example, would stakeholders look favourably on a transition strategy that depended on the so-called fall-back mechanism? That is to say, existing LIBOR referencing derivatives would simply default to referencing SONIA plus a pre-agreed spread. Or would insurers need to pro-actively transition their exposures in the market? And would those insurers who pro-actively transitioned to a SONIA-based derivatives hedging strategy have to hold basis risk capital indefinitely if their liabilities were still discounted on an adjusted LIBOR basis?

So many questions. However, various regulatory consultations and communications meant clarity soon emerged around these key issues. Several large insurers reduced LIBOR exposure across their ALM hedging books through late 2019 and 2020.

It’s worth noting that this reduction didn’t necessarily mean a direct transition to OISs. In some cases, it just meant collapsing offsetting LIBOR exposures. Elsewhere, the correct transition strategy might vary according to a number of factors:

  • what is the nature of the liability?
  • how much liquidity is available?
  • is the existing exposure centrally cleared?
  • is the existing book deep in the money?
  • what are the decision makers’ views on the relative value of the hedging strategies available?

The answers to these questions can and should drive materially different strategies. This may include moving into funded or unfunded gilt exposures, exchange traded derivatives (ETDs), cleared or bilateral OISs, or indeed, not to transition at all.

The road ahead

As of today, almost all new institutional GBP linear interest rate derivative exposure references SONIA and not LIBOR. Meanwhile, UK insurers have already removed LIBOR exposure from great swathes of their hedging back books.

Nonetheless, there is still progress to be made in advance of LIBOR’s cessation by the end of this year. Deep and liquid markets still do not exist in key non-linear interest rate derivatives. In particular, UK insurers commonly use swaptions to hedge guarantee costs, the risk margin, and their overall solvency requirement. However, we might politely describe markets in non-LIBOR swaptions as embryonic. So, an obvious next step for the market is to shift its focus to these exposures.

We also await an expected switch from LIBOR to SONIA-based liability valuation. A recent Prudential Regulation Authority consultation paper suggests we may see a “big bang” style switch in the third quarter of this year. The detailed taxonomy of the impact of this switch is worthy of an article in its own right. However, there are a few anticipated effects that we can touch on here.

Quantitatively, we might expect this switch to reduce liability discount rates by around 15 basis points. An insurance company shareholder may view this negatively, expecting increased technical provisions, reduced own funds and an adverse impact on solvency ratio.

In practice, the picture is more nuanced. The transitional measure on technical provisions (TMTP) will limit the impact on business written before 2016 (including most outstanding with profits liabilities). New annuity business, meanwhile, will see the shift in liability discount rate largely absorbed by the Matching Adjustment. While we may expect an increase in this business’s required risk margin, the longevity risk that primarily drives that margin is largely re-insured.

So, the impending discounting change may encourage laggards to switch to a SONIA-based hedging strategy to mitigate basis risk. However, it remains to be seen if it will have a material impact on balance sheets.

Final thoughts ...

In the last three challenging years, the UK insurance industry has addressed a range of issues as it prepares for the post-LIBOR epoch.

There’s still work ahead. However, the big-ticket ALM items – transition of derivatives back books, new-business hedging strategies, the treatment of liabilities – have or are being addressed.

Questions remain around non-linear derivative markets, but we believe ALM teams across the UK can look ahead with confidence rather than trepidation.

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