By Matteo Ricciarelli, Associate Director in Risk Modelling Services, PwC
The insurance industry, traditionally conservative and (fortunately!) underrepresented in the production of financial thrillers, could feature as well.
In response to the ‘Dear CEO’ letter dating back to September 2018, insurers stepped up looking for dependencies on LIBOR in their asset portfolios, derivatives to hedge interest rate exposures, reinsurance agreements, and insurance policies. To automate the execution of otherwise manual and cumbersome jobs, firms are also considering contract review technologies. The output of contract review projects will inform re-papering strategies that firms may wish to adopt when dealing with their counterparts.
However, for insurance firms, LIBOR is also deeply rooted on the liability side of the balance sheet and Solvency II calculations. The European insurance regulator, EIOPA, has not yet shed light on how the new SONIA-based risk-free-rate (RFR) will look. The recent letter from the Working Group on Sterling Risk-Free Reference Rates recently addressed to EIOPA aims at encouraging ‘[…] EIOPA to go beyond monitoring transition to now actively removing the recognised Solvency II barriers to transition’. The lack of certainty around timelines for the production of new RFR hinders the progress the insurance industry can make in terms of its preparation for transition. Secondly, it also bears the risk that the LIBOR-related financial instruments currently used to derive the EIOPA RFR may become illiquid as we approach the end of 2021 hence it may invalidate the resulting RFR for liability valuation purposes.
As we approach the end of 2021, the EIOPA term structures should be unveiled, so that the insurance industry can abandon the realm of educated guesswork around how term structures may develop.
In light of the historical spread between LIBOR and SONIA rates, we may expect that the new SONIA-based RFR will be lower than the current RFR. This will lead to higher Best Estimate Liability (BEL) and Risk Margin (RM) and, potentially, echo the Solvency Capital Requirement (SCR) by hindering the effectiveness of some hedging practices. ALM (interest rate) mismatches may thus come into play and increase the interest rate SCR. Hedging strategies will need rebalancing. On the operational side, firms using stochastic runs to estimate their liabilities may need to consider amending the vastly popular Libor Market Model (LMM) and its several variations to reflect the backward-looking mechanism adopted to convert overnight rates into term structures.
The Credit Risk Adjustment (CRA) may become the ‘illustrious victim’ of the IBOR discontinuation: the secured nature of SONIA will diminish the need for the CRA to offset the counterparty credit risks. At the same time, given the CRA is embedded within the Solvency II text, it may not disappear without a regulatory challenge.
Similarly, the new SONIA-based RFR may exhibit a liquidity profile different from the one derived from the LIBOR-based RFR. Arguments to bring forward the Last Liquid Point (LLP) may be developed, which would have a big impact on ALM, hedging, and liability valuation. Finally, the new SONIA-based RFR will have implications for the calibration of Solvency II internal models, which may be more challenging due to the limited availability of SONIA rate historical data.
The insurance industry awaits clarifications within well-defined timelines to start addressing the necessary changes to their valuation, hedging and Solvency II internal models. Until further clarity is provided, “2021: The end of (IBOR) Days” should remain the title of an intriguing thriller - hopefully one with a happy conclusion and few dramatic twists!
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