Nov 2009 Royal Berkshire Swiss Re 1bn Pensioner bespoke longevity swap

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1 UK Risk Settlement Understanding and Managing Pension Risks Risk Settlement Group Quarterly Update, July 2013 Market news After an uneven 2012, several key transactions completed in Q1 of 2013, giving a very encouraging picture for the settlement market. Funding positions have also been improving, with equity gains and some initial easing of low yields suggesting more schemes should now consider their plans for a future settlement. Longevity swaps Q1 saw two longevity swap transactions, whose overall size made the quarter the best ever for this part of the market: The biggest UK pension settlement transaction to date a 3.2bn longevity swap for BAE Systems, with Legal & General. This demonstrated the continued appetite for pension fund longevity risk in the global reinsurance market. A further 400M longevity swap deal for Bentley Motors, with Abbey Life. Both of the new deals provided a hedge based on the specific longevity experience of the pensioners covered, showing the continuing focus of the market on bespoke swaps rather than swaps based on a more general longevity index. The Bentley transaction showed that this structure is within the reach of more than just the very largest schemes, particularly now the market has developed further we believe that transactions from around 250M upwards can now secure a longevity hedge specific to their membership profile on strong terms with a robust collateral arrangement. Aon Hewitt were the lead advisor on both these transactions. The table below summarises the longevity swap business placed to date: Date Fund Provider Approx size Solution Mar 2013 Bentley Abbey Life 400m Pensioner bespoke longevity swap /Deutsche Bank Feb 2013 BAE Systems Legal & General 3.2bn Pensioner bespoke longevity swap Dec 2012 LV= Swiss Re 800m Pensioner and all members over age 55 May 2012 Akzo Nobel Swiss Re 1.4bn Pensioner bespoke longevity swap Jan 2012 Pilkington Legal & General 1bn Pensioner bespoke longevity swap Dec 2011 BA Goldman Sachs 1.3bn Pensioner bespoke longevity swap Nov 2011 Rolls-Royce Deutsche Bank 3bn Pensioner bespoke longevity swap Aug 2011 ITV Credit Suisse 1.7bn Pensioner bespoke longevity swap Feb 2011 Pall J P Morgan 70m Non-pensioners index based longevity hedge Jul 2010 British Airways Goldman Sachs 1.3bn Synthetic buy-in (longevity swap plus asset swap) Feb 2010 BMW Abbey Life 3bn Pensioner bespoke longevity swap /Deutsche Bank Nov 2009 Royal Berkshire Swiss Re 1bn Pensioner bespoke longevity swap Jul 2009 RSA Insurance group Goldman Sachs 1.9bn Synthetic buy-in (longevity swap plus asset swap) May 2009 Babcock Credit Suisse 1.5bn Pensioner bespoke longevity swap (3 schemes) 1

2 Bulk annuities For bulk annuities, placements were also up compared with the corresponding quarter in recent years. Whilst Q1 is traditionally a quieter quarter for transactions passing the finishing line, 876 million was actually placed in Q with 54 deals ranging from 1 milion to 250 million being placed. This compares with 491 million and 348 million placed in the first quarters of 2012 and 2011 respectively. This could support a material growth in the market for the year, from around 5bn pa in , reflecting the pent up demand for de-risking. The three insurance companies taking over 90% of the business placed by overall volume were Legal & General, PIC and Rothesay Life these three also ended 2012 with the majority of that year s bulk annuity sales. The majority of the deals being transacted are pensioner buy-ins traded from low risk assets, especially lowyielding Government bonds. However there are also a number of full scheme buy-outs being considered in the market, as some companies look at completely de-risking in 2013, with a 250M full risk transfer case completed in Q1 (with Legal & General), perhaps marking the start of a return towards the more complete transactions that had been anticipated widely before the Credit Crunch. L&G secures Lucida book Legal & General announced on 26 June that it is acquiring Lucida plc, subject to regulatory approval. Lucida had built up a 1.4bn book of business from large bulk annuity transactions with three schemes and from an ongoing reinsurance arrangement with the Bank of Ireland, which L&G have also taken on. Lucida started taking on liabilities in 2008 and then closed to new business in As with some other players, Lucida found it hard to price competitively on a consistent basis, and also to establish its credentials in difficult economic circumstances without an initial stepping stone of taking on smaller deals. It is currently owned by the hedge fund Cerberus. We believe that this resolution over the ownership of the Lucida book, which has been the subject of speculation for some months, is a very positive outcome for its policyholders. The reassurance of L&G s long-term market commitment, its known brand and the size of L&G s existing annuity administration services will give comfort. We also expect that the book acquired can be comfortably integrated by L&G s much larger annuity operations and should not impact existing policyholders. L&G is reported to be paying around 85M of its surplus capital for Lucida, net of initial capital savings from the efficiencies of the takeover, and this should not materially affect its solvency. As Lucida had already closed to new business, this purchase doesn t directly affect the existing competitiveness and capacity of the settlement market. While we believe there is sufficient capacity in the market to cope with existing demand, if changes in investment conditions materially improved funding levels, it is conceivable that market capacity among direct writers of bulk annuities could be found wanting for a period, because the latent demand from companies to de-risk is so substantial. However, this deal could mark the end of a period of tidying-up after some of the new settlement market entrants over the 2006 to 2008 period pulled back from the market, with the liabilities, and in some cases the operations, from the Paternoster, Synesis, ALICO and Lucida businesses finding new homes. In all these cases the stability of the insurance model has been demonstrated, with policyholders experiencing change by getting a new bigger counterparty but seeing no disruption to their benefits or to their coverage. Q1 Rank Bulk annuity providers (2012 year ranking in brackets) Cases written Q Q Value ( m) 2 Market share (%) Cases written Value ( m) Market share (%) 1 Legal & General (3) PIC (1) Rothesay Life (2) , MetLife (6) Aviva (5) Partnership (7) 2 3 <1 2 5 <1 7 Prudential (4) 8 Just Retirement 9 Abbey Life Total ,021 These figures exclude longevity hedge transactions.

3 The bulk annuity market is still proving to be competitive for deals falling into Lucida s past target market 100M+ transactions which are typically for pensioners. There are a number of deals of this size currently in the market, with several organisations competing and price pressure being demonstrated as the insurers look to maintain market share and to find investment opportunities to support a compelling price. Medical underwriting Interest is continuing to grow for medically underwritten annuities annuities using information gathered on key members health and lifestyle to price longevity risk more accurately. Trustees are starting to become more familiar with this approach to pricing, and there is considerable appetite to know more. At the time of writing, Partnership have placed six such bulk annuity transactions. They have recently successfully completed a public offering for their shares, which is encouraging both for the development of the medically underwritten market and for the other young insurance companies in the settlement market. Just Retirement, Legal & General and Aviva are actively quoting for medically underwritten annuities, and the providers are seeing growing interest as the concept becomes more established. The most typical transaction considered is for a pensioner population with substantially under 300 lives, with a concentration of liabilities towards particular members (as applies in most schemes). This can represent all of a scheme s pensioners, or just a sub-set, for example to secure the larger pensioners in a scheme. Derisking interest spreads across the pond We have seen a substantial increase in UK de-risking interest from US sponsors. This follows the US mega buy-out deals that we arranged with General Motors and Verizon last year. In some cases, the sponsor is prepared to consider a full buy-out, despite this triggering settlement accounting in its books which will affect the company s P&L, because of the positive message that de-risking can send about the sponsor, and in some cases opportune timing when other items are going through the company s books. Other sponsors are more sensitive to the impact on their books, and are then considering a pensioner buy-in, which does not trigger the same immediate P&L change. Clarification on scheme auditors view of Risk Settlement The audit profession via the Pensions Research Accountants Group have released a discussion paper on the treatment of insurance policies and other longevity risk transfer in pension scheme accounts. As this is their 2nd round of consultation, this paper is now not expected to change substantially. It is expected to become final guidance once FRS102 is finalised. This paper proposes that best practice will be to treat buy-in and longevity swaps as follows: Item Buy-in Longevity swap Asset Value Options: 1. Actuarial value consistent with technical provisions 2. Premium Cost of replacement contract If the policy is material it will no longer be acceptable to attribute it a nil value. Options: 1. Actuarial value consistent with technical provisions 2. Premium Cost of replacement contract 3. Mark to model value for example that used for collateral calculations Treatment All the payments into the scheme should be Options: of income/ treated as income with a note as to why the 1. treat as investment income cashflow capital value falls over time 2. treat as derivative payment/receipt. Collateral If applicable, consider the guidance on derivatives Consider the guidance on derivatives For a synthetic buy-in it is acceptable to consider whether it is better treated as a buy-in or the sum of its component parts. There is also additional guidance in the paper as to the level of disclosure required for best practice. The paper does leave some clarity lacking on how the valuations are updated annually, which is more material for valuing buy-ins. It also suggests that new individual annuities bought in the trustees name are expected to be valued going forward. For more information the paper can be found via 3

4 Solvency II The revised solvency standard for insurance companies remains subject to some uncertainty on its precise form and timing. A key issue remains how insurers are to reserve for long-term guarantees such as annuity commitments. EIOPS, a European advisory body, has published a paper with its proposals on this issue. This distinguishes between guarantees where the benefit cashflow payments needed are predictable, and those where for example due to longevity risks or options the policyholder has affecting the form of benefits taken they are more unpredictable. EIOPS is more supportive of insurers being allowed to continue to recognise the additional return they can expect to achieve from taking measured risk, such as from corporate bond investment, where the cashflows are more predictable. This potentially still leaves issues for risk settlement products, particularly those for non-pensioners, and will no doubt be subject to further debate and lobbying before a conclusion is reached. In the meantime, there was substantial relief for pension schemes, as a key part of the proposed Solvency II equivalent standard for pensions the use of a holistic balance sheet as a new test of funding adequacy was put on ice. This followed substantial lobbying, including our own efforts. This removes one potential source of pressure to fund and de-risk at a pace not chosen by the employer and trustees, for now. Market pricing So far 2013 has seen some positive periods for equity asset gains and some initial easing of the low yield environment, but with stutters along the way. The timeframe for a more material easing of yield levels remains very uncertain. As many bulk annuity transactions are trading from bonds to annuities, both with values increased in a low yield environment, affordability has been more stable. We have shown below the implied yield underlying typical pricing for pensioner buy-ins, relative to gilt yields, over time. As our Bulk Annuity Market Monitor (BAMM) demonstrates below, in current conditions, competitively priced annuities typically remain at a slight premium to the expected value of funding the liabilities using a matching gilt portfolio. This means there is often a relatively small cost to pay for the removal of risk, that can look very reasonable for the risks removed, in particular longevity risk. For some transactions, we are though seeing best pricing closer to gilt yields, so the specific trade of interest does need to be considered. Implied return on annuities less gilt yield Additional return (bps p.a) Annuities cheaper than gilts Annuities more expensive than gilts 4

5 It s all about being ready There is still time to obtain your free personalised Settlement Readiness Assessment that Aon Hewitt is offering to all UK defined benefit schemes. To obtain your assessment please visit com/settlementreadiness. Complete the short survey about your scheme and you will then receive your results or a member of the team will be in touch. GMP equalisation The Government announced recently that there would be no further help with finding an appropriate approach to address GMP inequalities before 2014 at best. This is not proving a barrier to transaction in practice. Where schemes are looking to discharge liabilities under a buy-out, a practical if not completely straight-forward approach to this issue is found, and discussed with the insurer and legal adviser to ensure it is workable and a reasonable reflection of best endeavours to accurately finalise the Scheme database. Contact If you would like further information on the bulk annuity market, please contact your Aon Hewitt consultant. Alternatively contact one of our members of the Aon Hewitt Risk Settlement Group: Martin Bird martin.bird@aonhewitt.com Dominic Grimley dominic.grimley@aonhewitt.com Paul Belok paul.belok@aonhewitt.com Tim Gordon tim.gordon.2@aonhewitt.com Aon Hewitt is the global leader in human resource consulting and outsourcing solutions. The company partners with organisations to solve their most complex benefits, talent and related financial challenges, and improve business performance. Aon Hewitt designs, implements, communicates and administers a wide range of human capital, retirement, investment management, health care, compensation and talent management strategies. With more than 29,000 professionals in 90 countries, Aon Hewitt makes the world a better place to work for clients and their employees. For more information on Aon Hewitt, please visit Copyright July 2013 Aon Hewitt Limited. Aon Hewitt Limited is authorised and regulated by the Financial Conduct Authority. Registered in England & Wales. Registered No: Registered Office: 8 Devonshire Square, London EC2M 4PL. Nothing in this document should be treated as an authoritative statement of the law on any particular aspect or in any specific case. It should not be taken as financial advice and action should not be taken as a result of this document alone. SB3882 5