Global M&A trends and risks
Powerful new forces shaping in the M&A landscape
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Global | Publication | October 2020
On July 27, 2017, the UK Financial Conduct Authority (FCA) announced that it would no longer compel or persuade banks to make submissions to LIBOR as from the end of 2021. In the wake of the LIBOR manipulation scandal, regulators found that there were few transactions taking place to support some of the currencies and tenors for which LIBOR was published. Submissions, it was felt, were based more on expert judgment rather than transaction data, making it subject to potential manipulation, which in turn led to a number of criminal actions around the world.
This focused the attention of global regulators on benchmark reform more generally. The IOSCO Principles of Financial Benchmarks struggled with banks reluctant to make submissions, and this prompted regulators needing to convince banks to make submissions just to keep LIBOR going. In 2014, the Financial Stability Board had already made recommendations that financial institutions transition away from LIBOR. The implementation of Regulation (EU) 2016/1011 in 2016 on indices used in benchmarks in financial instruments and contracts to measure the performance of investment funds provided further impetus for reform. Written plans were required setting out actions that will be followed, in the event that a benchmark changes or ceases to be provided. It also set out processes which could lead to a national competent authority declaring a relevant benchmark as unrepresentative.
The ICE Benchmark Administrator (IBA) which is the administrator of LIBOR has taken steps to reform LIBOR. IBA has also indicated the intention to continue to work with panel banks to see if LIBOR can continue post 2021. However they said that banks should not rely upon the continuation of LIBOR and in the United Kingdom, the FCA has warned that even if LIBOR continues, it will have changed as a rate and as such there is “a high probability that it would no longer pass regulatory tests of representativeness”. The Bank of England’s Working Group on Sterling Risk Free Reference Rates has set a target of end of Q3 2020 to cease issuance of GBP-LIBOR based cash products, with tenors past the end of 2021. This means that LIBOR will cease as a benchmark by the end of 2021.
The insurance industry is exposed to this. Insurers have huge sums invested and are counterparties to many financial instruments which will remain in force after the end of 2021, and which have LIBOR (or another benchmark which will be amended or replaced) as the benchmark for applicable interest rates, and triggers for hedging contracts and swaps. In addition, insurers may insure trade credit arrangements where the underlying financial contracts use LIBOR (or another benchmark which will be amended or replaced). They are insuring financial institutions who, as the issuers of financial instruments, may have their own exposures arising from this, the directors and officers of businesses that may also be at risk from the same issues in financial contracts that their businesses have, and the likes of pension funds and investment managers. The list goes on.
The regulators want to know what the insurance industry is doing to manage its exposure to benchmark reform, across its investment portfolios and in considering the risks that it writes. After focusing for much of the year on the issues arising from COVID-19, most regulators have resumed work on LIBOR from June 1, 2020.
What do regulators expect insurers to do with exposure to LIBOR references? In most EU member states there have been clear statements requiring market participants, including the managers of insurance companies, to address the exposure to the demise of LIBOR (and other benchmarks). This work needs to be undertaken as soon as possible if it is not already underway.
This short paper looks at the issues for insurers and explains how Norton Rose Fulbright can assist in managing the risk associated with benchmark reform by identifying where contracts need to be renegotiated and with innovative and cost efficient solutions. We can also assist in the risk management analysis of the risks written as part of the underlying business.
What do regulators expect insurers to do with exposure to LIBOR references? Most regulators have made clear statements requiring financial institutions like insurance companies to address the exposure to the demise of LIBOR (and other benchmarks). This work needs to be undertaken as soon as possible if it is not already underway.
The change from LIBOR (or other relevant benchmarks) will have implications for insurance company risk management and therefore is of concern to regulatory authorities. Insurers hold a number of long-dated instruments to cover their liabilities. Life insurers and annuity providers rely on derivatives to hedge exposure to differences in the values of assets and liabilities over long time horizons. According to the UK regulator, the Prudential Regulation Authority, insurance companies in the UK have entered into around £323bn of LIBOR-linked derivative contracts. References to LIBOR can also be found in commercial loans, company pension scheme documents, reinsurance contracts, commercial contracts, intra-group loans and discount rates used in valuations. A small change to the discount rate could significantly impact long-term liabilities. Changes to LIBOR may have a knock-on impact for reinsurance collateral arrangements.
Contracts that insurance companies have entered into may contain “fall-back” terms that specify the position should LIBOR not be available. Insurers should review contractual terms and “re-paper” these documents with an alternative risk-free rate.
Insurance companies use a number of internal tools to measure, monitor and report based on LIBOR rates or yield curves. Under Solvency II insurers are required to discount liabilities using risk-free rate curves that are derived from LIBOR. In February 2020, the European Insurance and Occupational Pensions Authority (EIOPA) launched a discussion on the impact of IBOR transition on the risk-free rate environment. Following feedback EIOPA is planning to make recommendations for suitable steps to reduce insurers’ exposure to the transition.
Some regulators are quite active and have written to insurance companies to seek assurance that managers understand the risks associated with the transition and are taking appropriate action to move over to alternative rates by the end of 2021.
The PRA in the UK, for example, has set out initial expectations for transition progress during 2020. The PRA has asked insurance companies to engage actively with the wider transition efforts in the market. Plans should include targets in project milestones to ensure that management information is available to track progress. Regulators expect to see momentum on transition and will need to see evidence of this over the course of 2020.
Findings from the UK review of firms’ preparations has revealed that although firms have looked at exposure on their balance sheet, they have not always looked beyond this towards wider risk management issues such as pricing, FX-related risks, liquidity risk and valuation.
Some firms lacked information on where their current exposures were and did not have appropriate tools to monitor exposure. Strong responses to regulatory requests for information showed a commitment to reducing the risk of a “cliff-edge” at the end of 2021. These firms were undertaking due diligence on their contracts and exposures and transferring over to alternative risk free rates in advance.
Insurance companies are expected to understand where they are exposed to dependence upon LIBOR and ensure that any such dependence is removed. They should have in place robust governance arrangements for managing and monitoring the risk to their business. Regulators will be expecting firms to make progress on preparations for the end of LIBOR over the course of the next few months
As the immediate challenges of COVID-19 subside, the regulators have renewed efforts to ensure that firms are getting ready for the changes.
Insurance companies should already be considering how to meet their obligations in the context of LIBOR transition. If they have not done so this should be addressed as a priority. Actions might include keeping appropriate records of management meetings or committees that demonstrate they have acted with due skill, care and diligence in their overall approach to LIBOR transition. Firms should also undertake a review of their existing financial instruments and reinsurance agreements for references to LIBOR and produce an assessment of the consequences of the references no longer being valid.
As the immediate challenges of COVID-19 subside, a number of regulators have renewed efforts to ensure that firms are getting ready for the changes, announcing that from June 2020 LIBOR-exposure is back on the agenda.
There are also the risks that insurers write. Consideration may also need to be given to whether certain underlying risks might be higher than perceived. If a risk has insured exposures which themselves could be increased by underlying contracts referencing LIBOR, this could lead to higher claims or a line of claims that was not expected. This may apply to say Financial Institutions or certain advisors or investment managers who are recommending or arranging investments, or advising on transactions. Directors and Officers may be exposed if their business suffers as a result of failure to manage LIBOR exposures. Perhaps some trade credit insurances have underlying financial instruments with LIBOR exposure.
At a practical level there are two activities for insurers in responding to the legal challenges raised by IBOR:
Step 1 is to understand institutional exposure
Step 2 is to implement a plan to deal with that exposure
We have developed a solution for both of these steps, which is overseen by senior lawyers, but much of the work is completed by associates and a closely supervised paralegal team. We use machine learning tools to extract the relevant information on current exposure more rapidly, efficiently and accurately than would otherwise be possible, as well as automating documents and managing negotiations through central platforms. A team of technologists, who have developed the process, adapt it for each client and provide support throughout each project. The process works as follows:
Understanding exposure to IBOR is challenging. It is likely to be incorporated across a wide range of agreements. Typically information about where IBOR is incorporated into agreements is not held centrally, or cross referenced to other pertinent information like type of contractual counterparty and risk weighting. Gathering this information therefore requires an extensive due diligence process.
Depending on an insurer’s subsequent role in initiating amendments to these agreements, due diligence may feel more or less urgent, but it is always recommended. Sometimes an insurer needs to request amendments, for example where it has made an investment on a quasi-loan basis referencing IBOR, requiring a contractual update to reference a functional interest rate. In other cases, an insurer has bought a bond referencing IBOR and another party requests the amendment.
In the former case, there is little choice but to complete a wide ranging due diligence, to decide what form of amendment agreement to propose. However, if responding to amendment requests, an insurer has a choice. It can proactively review relevant agreements and decide on a consistent position in advance. Alternatively it can wait and respond piecemeal as requests come in. The total effort required is likely to be less (and quality of decision making greater), if a proactive review is completed, before amendment requests arrive.
In other scenarios, insurers may be exposed to other parties, on whom it is incumbent to complete similar processes. Again, assessing where this situation arises can enable an insurer to consider the risk and decide what action to take.
*See annex for flow diagram.
This depends on whether the insurer is requesting contract amendments themselves, or responding to requests from others. All work is again managed and tracked through a central workflow, allowing ongoing oversight and reporting.
Flow charts setting out the steps and tools involved are attached in the Annex.
Whilst this is aimed primarily at your own contractual arrangement, in terms of underwriting we can also utilise the same capability in considering underlying contracts that may be on your underwriting files or in conjunction with your insureds as a form a risk management exercise.
*See annex for flow diagram.
If you would like to discuss any aspect of this in more detail, please feel free to approach your usual contact at Norton Rose Fulbright, or one of the individuals on the contacts page at the end of this booklet.
Nina Varumo is a freelance portrait and documentary photographer based in Stockholm. A recent project of hers Kvinnor till sjöss (‘Women at sea’) is on ongoing photo series highlighting the working life of female seafarers in order to change the stereotypical image of what and who is a seafarer.
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