Captives must start evaluating their Libor agreements: Johnson Lambert
Captives should begin evaluating agreements that refer to the London Interbank Offered Rate (Libor) as soon as possible, according to Elyssa Nagle, senior manager at Johnson Lambert, to identify which ones may need to be modified.
Current US GAAP requires companies to determine whether contract modifications result in a new contract or the continuation of an existing contract, explained Nagle. Many captives have a large volume of contracts referencing the Libor, which is set to expire by as soon as 2021, and “making this determination would be very time consuming and costly,” she warned.
Captives are likely to have contracts based on the Libor including promissory notes, surplus notes, lines of credit, loans and premium financing contracts, Nagle said.
The Libor is supposed to represent the average interest rate banks pay to borrow funds from each other and is widely used as a benchmark to set interest rates for loans and other financial products. But the reference rate has lost favour following the emergence of evidence that several major financial institutions had manipulated it to improve their profits.
The US Alternative Reference Rates Committee was charged with finding an alternative to the LIBOR that is not susceptible to manipulation, and has recommended the Secured Overnight Financing Rate (SOFR) as a replacement. The SOFR is a daily rate, based on transactions in the Treasury repurchase market.
Nagle said: “The FASB recently approved an accounting standards update (ASU) to provide temporary relief for these contract modifications.” The ASU allows companies to account for reference rate changes by prospectively adjusting the effective interest rate in the agreement for certain contracts, which effectively modifies the current contract, she explained.
The ASU pertains only to contracts that reference the LIBOR and will provide temporary relief through December 31, 2022. The final ASU is expected to be issued in early 2020.