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Transition from Libor to SONIA

14 January 2021
Jennifer Osoata

This is a brief summary of Consultation Paper (CP) 1/21 covering the transition of Solvency II technical information (TI) from the London Interbank Offered Rate (Libor) to the Sterling Overnight Index Average (SONIA).  The expectation is that GBP Libor rates will not be published after 2021.

The Solvency II TI for GBP, USD and JPY currently references the Libor rates but the intention is for GBP, JPY and some USD Libor panels to stop at the end of 2021 and for the remainder of the USD panels to stop at the end of June 2023.  SONIA is recommended as the preferred replacement for Libor for sterling markets by the Working Group on Sterling Risk-Free Reference Rates (RFRWG).  Therefore the PRA is expected to transition the GBP Solvency II TI to reference SONIA before the end of 2021.  In particular, the PRA has proposed calculating the GBP RFR using SONIA for TI published with a reference date of Saturday 31 July 2021 onwards.  The PRA is expected to confirm the transition date in a Policy Statement following consideration of responses to this CP.

The PRA is also expected to transition the JPY and USD TI references from Libor to an Overnight Indexed Swap (OIS) rate.  The date and approach to these transitions depend on the liquidity of swaps referencing the Tokyo Overnight Average Rate (TONA) and the Secured Overnight Financing Rate (SOFR).

The GBP Libor-based rates are currently higher than the equivalent SONIA-based rates.  If this continues at the time of transition from Libor to SONIA, it will lead to higher technical provisions.  Therefore the PRA has proposed the following:

  • Credit risk adjustment (CRA): Amendments to the determination of the risk-free interest rate term structure (DR) in respect of the CRA currently applied for Libor-based RFRs, may be necessary as residual credit risk may be negligible given that SONIA and OIS rates are based on overnight deposits. The implication is that the CRA could reduce to zero.
  • Long-term average spread (LTAS): The LTAS calculation should reflect the change in spreads as a result of transitioning from Libor-based RFR to SONIA from the transition date onwards but historic spreads should not be adjusted as sufficiently reliable information to adjust the historic spreads is not available. These are used only in the Matching Adjustment and Volatility Adjustment.

The PRA expects the transition from Libor-based RFR to SONIA to lead to a reduction in most firms’ Solvency Coverage ratio of less than 5 percentage points.  Therefore although firms are eligible to apply for transitional relief as a result of the move from Libor-based RFR to SONIA, the PRA generally does not expect this to be the main reason for any firm to apply for transitional relief.

Matching Adjustments and internal models will also need to reflect the move from Libor to SONIA.  Although a new Matching Adjustment approval application will not necessarily be needed, benchmark references in matching adjustment will need to reflect the transition to SONIA.  Firms with approval to use internal models (and partial internal models) should consider updates needed to reflect the transition to SONIA.

Although the effect on most firms of the change in the basis of the risk-free rates is expected to be low, it is important that every insurer considers whether the effect on its liabilities will be significant. For example, the effect will generally be greater the longer the liabilities.  In addition, insurers must ensure that they have considered any wider effects of the loss of Libor, such as supplier contracts or investments that reference Libor.