The changing of the guard (LIBOR to SOFR) and how both insurers and regulators are responding

Abstract

The London Inter-bank Offered Rate (LIBOR), the rate for which banks can borrow short-term from each other, and perhaps the most common floating interest rate benchmark, is going away, and may become obsolete by end of year (EOY) 2021. LIBOR is being replaced by the Secured Overnight Financing Rate (SOFR) in the U.S. and by other country-specific alternative risk-free rates abroad. However, SOFR differs in several key respects from LIBOR; for example, LIBOR includes credit risk, is unsecured, is based on expert judgment, and has a full-term structure, whereas SOFR is a risk-free rate, is collateralized, is based on market transactions, and has no term structure. We examine the credit risk and maturity risk adjustments needed to ease the transition, along with fallback provisions for legacy contracts tied to LIBOR. We discuss the ramifications of rate transition to insurance companies, as it relates to their assets, liabilities, and internal processes. We then consider the perspective of both U.S. and global insurance regulators while highlighting specific areas of inquiry. We conclude with an overview of general recommendations for insurers to manage these risks, along with a detailed discussion about whether interest rate swaps tied to LIBOR will continue to be deemed as an effective hedge for accounting and valuation purposes.