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News: OIS Discounting Still Causing Headaches

12 July 2013 | Ben Larah

A recent article in Risk Magazine states that insurance companies are struggling to move to OIS discounting for their books and records for the following reasons:

  1. There's too much variability in the discounting methodologies being used across different counterparties and different asset classes to switch to OIS.
  2. Switching to a new discounting methodology will cause P&Ls to jump, thereby prompting questions, so some insurers prefer to stick with the pre-2008/9 status quo methodology.
  3. Switching  to a new discounting methodology will require major changes to back-office processing systems, which will come at a significant cost.

Deconstructing these reasons one by one: (1) The insurers have a valid point. Multi-currency CSAs, and some general market inertia to switch to OIS discounting for anything other than IR derivatives, do cause valuations discrepancies between counterparties. However, as the mandatory central clearing of vanilla IR derivatives continues, and CSA currency silos gain wider adoption for the remaining bilateral derivatives portfolios, many of these valuations discrepancies will be ironed out. (2) The impact of a sudden P&L jump can be considerably softened by running historical back tests of one's portfolio NPV to compare LIBOR discounting with OIS discounting. The results of these back-tests can then be used to reasonably estimate the impact of switching to a new discounting methodology. This information can be used to diffuse any questions around a sudden jump in portfolio MV before-the-fact. (3) If today's knotty valuation problems are resolved in the manner explained in point (1), then firms will have no choice but to update their back-office systems and processes to reflect the prevailing market reality. Ben L.

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Comments

Ben, Thanks for useful summary and I agree with your points.The particular point that probably drives banks to push this is that OIS are lower rates and banks derivs portfolios usually benefit in higher PVs from lower discounting rates. It follows that in aggregate the buy side is on the other side of this and may explain their reluctance. i.e. it's not just that there is an awkward change in the PVs but that this is more likely to be adverse in aggregate from their perspective.... Did the artcile cover that point?J

John- thanks for your feedback and comment.In the article itself, the insurer interviewed stated that their P&L would **increase** as a result of switching over to OIS discounting. So the issue is more the abrupt change in PV than the fact that the portfolios will be adversely affected.(It's also worth noting that bank portfolios **don't always benefit** from the higher discount factors produced by OIS. Credit Agricole posted a 120-million Euro loss, attributed to their switch to OIS discounting).