Posted on Jul 18, 2012 by Sergio Ulloa
As the London Interbank Overnight Rate, or Libor, scandal continues to boil into a deep and ugly stew, insurers around the world are left with an ominous premonition that the industry could be hit by billions in losses. In order to fully understand the situation, and the potential hit to the insurance industry's bottom line, it is important to know more about the background of Libor and the situation at hand prior, to looking at how and the scope of potential damage to insurance companies.
The London Interbank Overnight Rate, or Libor, is the primary lending rate which is set in London every day. The rate is calculated by Thomson Reuters representing the British Bankers' Association. This rate determines how much it would cost a bank to borrow from another bank. The Libor fluctuates day-to-day and is set by amalgamating the offered deposit rates from the largest of banks. The top rate and the bottom 25 percent of rates are both discounted and the rest are averaged to determine the Libor rate daily.
As a rate that is publicly and widely used, the Libor holds a lot of significance in the financial world and affects many real world prices. The Libor is used as a benchmark rate for many variables, including currencies, variable mortgages, and futures. The Libor plays a role in liquid asset markets and has a large influence in these areas.
With such a high dependency on the Libor, it would be assumed that a high scrutiny be placed on the calculation and the validity of its calculation.
However, big banks, including leading UK institution, Barclays, and traders have an incentive to manipulate the rate, and even slight movements by a few basis points could have a significant financial effect.
One case in which the Libor could be manipulated is by the way which big banks report their rates to Thompson Reuters. A bank indicating that it charged higher rates could signal the fact that the bank is not as healthy relative to its competitors. This could, in turn, impact that specific bank's own borrowing rates, causing it to borrow at higher costs. The big bank, therefore, has a high incentive in some cases to understate their rates in order to keep the cost of borrowing low.
Another case in which it is being manipulated is direct collusion and price fixing between traders and bankers. As the Libor rate is set on a daily basis, there stands a lot of opportunity for malpractice by knowing the direction in which the Libor is going to change in. Mentioned earlier, each basis point change could represent a significant amount of profits or losses for those who are caught on the right side of it. Advanced knowledge of the Libor rate change puts a trader at a considerable advantage. Traders lobbied rate submitters and banks in order to achieve a favourable rate.
Information about this kind of price setting broke in 2008 due to a Wall Street Journal
article. Slowly, information became more available after investigations were put in place. Finally, significant fines were levied upon those responsible for the rate manipulation.
At this point in time, the damage that is done publicly is difficult to predict. However, many have begun to speculate the amount of damage in which insurers will have to face. As insurance companies insure the banks and financial institutions, these organizations are in turn responsible for their actions. They could be facing the brunt of the cluster of storms heading their way from regulators, shareholders, investors, and more. Insurers may have to honour policies and provide the collateral for this disaster.
The real worry for insurers is the proof of Libor fixing and evidence of its negative effects. If an investor was adversely affected by the manipulation of the Libor rates, the investor must prove its case. If successful, then insurers may be on the hook for the financial institutions' transgressions under the Directors and Officers (D&O) cover.
With each passing minute of the Libor scandal comes more revelations and evidence towards Libor manipulation by financial institutions. From email conversations to testimonies, it is becoming more apparent with proof that the Libor was manipulated. Insurers could be looking at billions of pounds in damages.
Currently, most of the litigation filed establishes the institutions as defendants, rather than directors and officers themselves. The scope of the damage could also bring forth a class action suit on the purchasers' of Barclays-sponsored American depository receipts behalf. Naming institutions as the defendants is the more strategic move as the institutions have the means to pay off any settlements that might result from the litigations. As litigation is filed, more D&O implications can arise as stock prices will be affected negatively. When stock prices are reduced, shareholders' value decreases, instigating incentives for litigation against directors and officers to recoup losses. The overall effect on insurance companies backing the financial institutions at hand is significant and is still growing as many financial instruments are pegged directly to the Libor.
In addition to D&O claims from investors, more litigation surrounding errors and omissions claims are coming to light as the scandal progresses. A class action suit against banks could arise if customers of the banks believe they were adversely affected as a direct result of interest rate-related losses.
Despite the possible negative effects for insurers in the Libor scandal, some salvation is available. Policies include a long list of terms and conditions, as well as exclusions, surrounding the coverage available to corporations in light of possible claims. As each new lawsuit surface, every case is scrutinized to ensure that it falls within the coverage of the policy. Experts are recommending a complete analysis of each situation in order to avoid or to minimize the effects of the scandal. In addition, policies are often restricted to a maximum payout amount in the event of a payout, protecting insurance companies from massive compensation to policy holders.
Analysts agree that regulatory fines and penalties which arise from the Libor scandal are unlikely to be covered. In addition, costs incurred by investigations are also unlikely to be covered. Insurance companies sometimes offer themselves a veil of security by naming the investigative agencies for which the investigation originates from. Any investigations from agencies outside of those listed will likely not be covered.
Libor rate manipulation could also affect insurance companies themselves. As the Libor is a widely used rate, insurance companies and their investments as well as funds under management represent a significant amount of assets which could be negatively affected. Insurance companies themselves could be on the plaintiffs themselves in some of the litigation. However, the burden of proof again lies with the plaintiff to indicate they were adversely affected by the manipulation of the Libor.
As revelations continue to surface surrounding the Libor manipulation and the parties involved, a complex situation is at hand for insurance companies as they could stand on both sides of possible litigation. Insurance companies may be hit hard with liability claims while they potentially realize they were adversely affected by falsely reported rates.