The transition to SOFR is rapidly approaching

The process of replacing the London Interbank Offered Rate (LIBOR), owing to concerns about manipulation, is nearing its conclusion. In July 2017, the UK Financial Conduct Authority announced that it no longer planned to persuade or compel banks to make LIBOR submissions beyond the end of 2021.

The ICE Benchmark Administration, the authorised administrator of LIBOR, ceased the publication of LIBOR denominated in euros, Swiss francs, Japanese yen, or British pounds for all tenors after December 31, 2021. The US dollar-denominated one-week and two-month LIBOR tenors were no longer published after the same date. The remaining US dollar-denominated LIBOR tenors will be phased out on June 30, 2023.

Contracts that do not provide for the use of a replacement benchmark rate pose operational risks for the LIBOR transition. A large volume of US dollar-denominated LIBOR contracts mature after June 30, 2023, and lack adequate fallback provisions. Some states, including New York, adopted legislation to establish defaults in the absence of fallback language, but national legislation was needed to consistently address these legacy contracts.

The Consolidated Appropriations Act, which was signed into law by President Joe Biden as 2022 drew to a close, included the LIBOR Act, the provisions of which address legacy US dollar LIBOR contracts. The law allows the Federal Reserve to choose the benchmark rate for LIBOR contracts lacking a fallback provision or whose fallback provisions do not adequately determine a benchmark replacement.

The Fed’s Alternative Reference Rates Committee (ARRC) released a paper with recommended replacements in line with the new law. The LIBOR Act provides a backstop: if a new benchmark rate is not selected by the deadline, the rate selected by the Federal Reserve will apply. The LIBOR Act also includes continuity of contract and safe harbour provisions to protect firms from legal claims arising from the selection or use of a Fed-selected benchmark replacement rate and the implementation of conforming changes.

LIBOR exposures appear on both the asset and liability sides of balance sheets. LIBOR’s benchmark rates are widely incorporated into contracts and financial instruments such as corporate bonds, structured bonds, mortgages, loans, and derivatives. Liabilities may feature LIBOR provisions for credited rates, and reserve valuation rates may also be based on LIBOR. LIBOR liability exposure is more of an issue in the UK, where insurers’ reserve liabilities are based on it; the US has less exposure to LIBOR liability.

Insurers’ debt structures may also be impacted, especially those that have either floating rate obligations currently tied to LIBOR or fixed rates that will become floating rates based on LIBOR—including floating rate surplus notes that are part of many insurers’ capital structures.

What comes next

As the June 30, 2023, transition deadline approaches, insurers should be aware of their exposure and assess their operational capabilities in anticipation of the number of contracts that may be changing after that date.

Remaining liquidity in LIBOR markets will diminish. The ARRC encourages market participants to transition from LIBOR to the Secured Overnight Financing Rate (SOFR) ahead of the June 30, 2023, deadline. To facilitate the transition, the Depository Trust & Clearing Corporation (DTCC) launched a LIBOR Replacement Index Communication Tool on March 13, 2023. In the US, changes made to the interest rate methodology of a fixed-income security are not serviced by the DTCC, and change information is typically communicated narrowly, leaving many market participants unaware, including those responsible for calculating and receiving interest payments. The new tool is intended to simplify the process to effectively communicate rate changes, to minimise the operational risk of the transition to SOFR.

The ARRC has identified SOFR as the replacement for US dollar-based LIBOR rates. SOFR is a measure of the cost of overnight borrowing collateralised by US Treasuries. In late July 2021, US regulators began requiring that interest rate swap desks execute derivative transactions tied to SOFR instead of LIBOR, adding much-needed liquidity with SOFR derivatives and promoting SOFR lending.

SOFR has since become the dominant benchmark for derivatives. The ARRC also recommends the use of SOFR term rates in a limited scope. SOFR term rates are determined by compounding the daily rates, making it difficult to know what the rates will be.

SOFR is the alternative officially recommended by the ARRC, but there are non-LIBOR alternatives. Companies need to determine which alternative best fits their needs. In the US, Ameribor and Bloomberg Short Term Bank Yield Index (BSBY) are the most popular non-SOFR rates. Ameribor is similar to SOFR in that it is based on overnight rates, but it is generated from unsecured transactions, which may result in rates that more accurately reflect the cost of funds.

BSBY is a proprietary index calculated with rates posted daily. The BSBY index addresses the needs of the market by providing a series of credit-sensitive reference rates that incorporate bank credit spreads and defines a forward term structure. BSBY measures the average yields at which large global banks access US dollar senior unsecured marginal wholesale funding.

Ameribor and BSBY spreads over similar SOFR rates will reflect the unsecured nature of transactions on which they are based, but all three will be based on actual transactions, unlike LIBOR.

According to the Financial Accounting Standards Board, a reference rate change does not require contract remeasurement because the change is outside the control of the entity holding the hedging instrument. A reference rate change will also not result in the de-designation of a hedging relationship, meaning that it will remain a qualified hedge.

The National Association of Insurance Commissioners agreed to this framework for statutory accounting purposes, which minimises volatility when reference rates are changed for existing debt, leases, and derivative contracts. These standards should facilitate the transition from LIBOR to SOFR or other approved reference rates.

Helen Andersen is an industry analyst at AM Best. She can be contacted at: helen.andersen@ambest.com

Jason Hopper is an associate director, industry research & analytics, at AM Best. He can be contacted at: jason.hopper@ambest.com