17 April 2013

Risk.net: Libor/OIS spread challenges insurers' risk management programmes

Traditionally, insurers value liabilities that are sensitive to interest rates with reference to a Libor curve – the benchmark interest rate curve for inter-bank lending. This made sense and kept things relatively simple when hedge assets and associated collateral were also discounted using Libor. But this is no longer always the case. Since the financial crisis, the market has moved to using an overnight index swap (OIS) curve to discount the cash collateral attached to derivatives. At the same time, the European Market Infrastructure Regulation (EMIR) and the Dodd-Frank Act in the US are cementing this practice in place by requiring that most swaps be cleared through central counterparties (CCPs), and these CCPs are generally opting to use OIS to calculate margin.

This presents insurers with a number of challenges: the first is understanding the implications of having two different discount rates for their valuations and hedging calculations, and the second is figuring out how they should manage the Libor-OIS spread risk inherent in their asset and liability portfolios. The situation is made even more complicated by the fact that the European Insurance and Occupational Pensions Authority (EIOPA) is proposing that the risk-free rate for valuing liabilities under Solvency II is a construct that is somewhere between the two rates.

The shift to an OIS-based discount rate originated in the derivatives market after the financial crisis of 2007–08 when spreads between short-term Libor and OIS rates sharpened widely. Now, with the derivatives markets moving to OIS discounting to price hedge assets, insurers that traditionally use Libor for both asset and liability valuations are facing the question of whether they should follow suit.

So how should insurers respond? The first question for insurers is whether to adopt OIS discounting for their hedge asset calculations. One advantage of doing so is that it will align asset valuations with the daily margining on cleared interest rate swaps when EMIR comes into effect, because CCPs will generally use an overnight curve to calculate variation margin.

This presents a potential difficulty for companies as OIS swaps are not traded in any depth beyond two to three years. “Until market liquidity significantly improves it could be argued that they do not provide a sound and robust theoretical basis for market-consistent valuations at the longer end of the curve”, says says Neil Dissanayake, senior risk manager and trader in the financial risk management practice of consultancy Milliman, based in London.

Unwelcome as it may be for insurers, many of which may feel they already have more than enough on their plates with preparing for Solvency II and other matters, the dual discount rate regime that is emerging brings with it considerable additional complexity to the management of risk for affected products. For a start, many insurers will have hedge assets that have pay-offs still referenced to Libor that will require more complex valuation models than many companies currently have in place. Furthermore, the level and volatility of the spread between Libor and OIS will also impact performance attribution, risk monitoring and capital modelling.

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