This document is intended for use at the Insurance Investment Exchange event only. Not for onward distribution. Asset Strategy for Matching Adjustment Business Challenges and Choices June 2016
Agenda Background to Matching Adjustment and vanilla MA asset strategy Beyond vanilla MA asset strategy: 1. Private credit for MA business 2. Using interest rate derivatives in an MA portfolio 3. Overseas credit investing in an MA portfolio
Managing a Matching Adjustment Portfolio
Matching Adjustment (MA) What is the Matching Adjustment? The MA is an adjustment to the regulatory discount rate, allowing insurers to incorporate an allowance for the illiquidity of their assets into the valuation of certain liabilities e.g. their annuity business. The rationale is that where insurers can hold these assets to maturity, they can earn an illiquidity premium on those assets. They are also no longer being exposed to the risk of changes in credit spreads on those assets - they are only exposed to changes in the risk of credit loss on the assets. What are the benefits of MA? The capital benefits of a successful MA application are significant, through reduced technical provisions (a 10% relative reduction in an insurer s annuity liabilities could be achieved). Further capital benefit could be achieved through reduced capital requirements in respect of spread risk which could be reduced by 25-55% for insurers using the Standard Formula.
Matching Adjustment Investment Process Matching Adjustment portfolios have client-specific mandate constraints on eligible assets and trading, reflecting the client-specific approvals that have been granted by the regulator. In respect of constraints on trading: Buy-and-maintain. MA credit mandates will usually specify that bonds can only be replaced for one of a specific set of reasons (improve cashflow matching; credit risk management, etc.). The reason for replacing a bond must be identified by the fund manager at the point of trade and communicated to the client as part of regular client reporting. The mandate may or may not include a quantitative turnover target or limit for the portfolio or for turnover that is attributed to specific reasons.
Quality of Matching Within an MA portfolio, the expected asset cashflows (after allowing for the probability of default) and liabilities should be matched. There is also a requirement that any residual mismatch (rates, inflation, and currency) does not give rise to material risk on the balance sheet. Within the UK, the PRA have set out three tests they expect insurers to pass in respect of their MA portfolios or, if not, explain the rationale for non-compliance: 1. The forced seller test - the maximum net cashflow shortfall must not exceed a defined threshold. 2. The VaR test the risk arising from any rates, inflation and currency mismatches must not exceed defined thresholds. 3. The notional swap test a validation check that firms are not using an MA calculated from too few assets, which could result in firms overstating the benefit of the MA. The PRA tests are not the only measures that may be appropriate and, indeed, passing the PRA tests would not automatically result in what the insurer may consider to be a well matched position.
Private Credit for MA
Credit Opportunity Set Return Traditional Alternative Niche MA-eligible Not so MA-eligible Secondary Bank Loans/Pools Distressed Debt Real Estate Loans Regulated and Social Infrastructure Syndicated Corporate Loans Emerging Market Debt High Yield Debt Specialised Finance Aviation Shipping Leasing Niche Bank Financing SME Loans Consumer Loans Real Estate Loans Real Asset Private Debt Asset Backed Securities Direct Lending G7 Treasuries UK Investment Grade Credit Non G7 Sovereign Debt Global Investment Grade Credit Commercial Real Estate (CMBS) Residential Real Estate (RMBS) Collateralised Loan Obligations (CLOs) Asset-backed Consumer Loan Pools (ABS) Real Estate Subordinated Lending Junior Debt/Mezzanine Cash Low Loss Severity Capital Preservation Higher Loss Severity Alpha Seeking Credit
Private Markets Illiquid Credit Insurers are increasingly making significant allocations to private credit asset classes Commercial Real Estate Debt (usually senior, c. A-rated) Private placements, mortgage debentures Infrastructure debt Expectation these assets will yield an illiquidity premium and superior riskadjusted returns Illiquidity premium estimate can be incorporated into discount rate for reserves And provide credit diversification Source: Standard Life Investments
Internal credit ratings and Solvency II Private credit assets will often not be rated by an external credit rating agency Insurer, possibly with assistance of their asset manager, may use internal credit rating processes in their Solvency II Matching Adjustment calculation and capital modelling. Asset Manager Insurer Triggers for Review Methodology Calibration Due diligence and ongoing oversight Investment Process and Internal Rating MA Fundamenta l Spread Management Information Back-testing Governance Internal Model SCR
Relative Value of Commercial Real Estate Debt Illiquidity Premium of 125-200 bps Spread bps 350 300 250 200 150 Illiquidity premium 100 50 0 Dec-14 Jan-15 Feb-15 Mar-15 Apr-15 May-15 Jun-15 Jul-15 Aug-15 Sep-15 Oct-15 Nov-15 Dec-15 Merrill Lynch 3-5 Year A Rated Corporate Index* * Option Adjusted Spread over LIBOR **Spread over 3 month LIBOR for floating loans / gilts in the case of one fixed loan Source: Standard Life Investments, 31 December 2015 SLI Commerical Real Estate Debt Fund** Commercial Real Estate Debt Fund still offers attractive illiquidity premium
Using Interest Rate Derivatives As Part of MA Cashflow Matching Portfolio
Interest rate derivatives in MA portfolios: Providing flexibility to credit investment strategy The inclusion of interest rate derivatives in the MA portfolio can allow greater freedom in construction of the credit portfolio: Credit duration can be chosen to optimises return on credit capital, independent of liability cashflow profile A bond-only matching strategy may have a very limited number of names available at particular maturity dates
Cashflow Matching With Interest Rate Derivatives Cashflow matching using bonds and interest rate swaps Source: Standard Life Investments, December 2015
Liquidity and Collateral Management An insurer must have a liquidity plan in place for their MA portfolio The use of derivatives introduces additional liquidity considerations, notably in the area of collateral (and margin) management The following tables give an indication of the scale of the potential collateral requirements for a 20-year receiver swap (Table 1) and the swap portfolio (Table 2) Change in Yield (bps) Collateral Requirement (%) Change in Yield (bps) Collateral Requirement (%) 100 15 200 26 300 36 100 3.1 200 5.3 300 6.8 The insurer will need to ensure that they have, or have committed access to, sufficient collateral from within their MA portfolio to meet their potential requirements. This must be achieved without being forced to sell assets prior to maturity. The insurer may be able to put in place committed agreements with banks that would allow them to source eligible collateral when (and if) required Source: Standard Life Investments, December 2015
Overseas Credit and MA portfolios
Overseas credit and MA investment strategy Large UK credit investors have some incentives to consider investing part of credit portfolio in overseas markets: UK credit market is limited in size Overseas markets, especially US, can offer credit name diversification and liquidity But MA-eligible assets for MA liabilities must deliver fixed cashflows Traditional currency hedging approach of rolling short-term FX forwards is not MA-eligible Must use a static FX hedge such as cross-currency swap But can be collateral-intensive if it moves out-the-money
GBPUSD Swap MtM (% of notional) Managing FX Risk in an MA Portfolio 2.2 2.1 2 1.9 1.8 1.7 1.6 1.5 1.4 GBPUSD 10% 0% -10% -20% -30% -40% -50% 1.3-60% Jun-2008 Nov-2009 Mar-2011 Aug-2012 Dec-2013 May-2015 Sep-2016 Portfolio must be carefully structured and collateralised to minimise collateral drag while remaining MA compliant and optimal Ring fenced cash within MA portfolio likely to be suboptimal, but numerous structures available in the market to structure portfolio if required Contingent liquidity facilities Special Purpose Vehicles Source: Standard Life Investments 31 March 2016
Appendices
Investment Context and Trends for Insurers
1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 Long-Term Interest Rate (%) Economic context for long-term liability owners Long-term trend in global 10-year Government Bond Yields 16 14 12 US Germany Japan Canada UK Australia 10 8 6 1000 bps 4 2 0 Source: OECD
Insurance Trends European Insurance Survey Standard Life Investments has undertaken one of the most comprehensive surveys of its type to date to understand and assess the longer-term impact of the low-return environment on European insurers. 56 interviews were carried out with senior insurance investment executives representing over 2.4trn, or around 30%, of pan-european insurance assets under management. Many European insurers are undertaking significant strategic and tactical asset allocation changes, expanding their traditional investment horizons as they seek to maximise returns Source: Standard Life Investments European Insurance survey 2015
Driving change in insurance asset strategy Most European insurers are pursuing at least one of the following three routes to improving expected investment returns: a) Increasing investment risk appetite b) Reducing asset liquidity c) Seeking diversified risk return through investment in new asset classes
Example MA Bond Portfolio
Millions Millions Example Matching Adjustment Bond Portfolio 250 200 150 Annual Cashflows Assets Liabilities 100 50 0 2016 2026 2036 2046 2056 2066 4,500 4,000 3,500 3,000 2,500 2,000 Cumulative Cashflows Cumulative assets Cumulative liabilities 1,500 1,000 500 0 2016 2026 2036 2046 2056 2066 Key Rate Duration Exposure Cashflow Maturity Portfolio Liabilities 1 101,321 95,219 5 393,883 380,761 10 643,719 623,071 15 677,211 670,530 20 688,660 771,380 30 383,267 440,307 40 94,172 76,611 50 11,971 12,107 Source: Standard Life Investments, model portfolio for illustration only.
Example MA Portfolio Asset Characteristics Summary portfolio characteristics Duration (bp duration, years) 10.05 Yield-to-Worst 3.68% Number of holdings 257 Spread 2.29% Average Quality A Expected Return 3.03% Matching Adjustment Compliant Portfolio Sterling-denominated assets, reflecting current market levels and potential collateral costs SLI s internal credit ratings have been used for the private credit portfolio S&P (A-rated) Capital Requirement 2.5% Volatility 6.22% Quality Distribution Sector Allocations 70.00% 60.00% 50.00% 40.00% 30.00% 20.00% 10.00% 0.00% Public Portfolio 57.90% 41.30% 32.60% 28.90% 21.30% 13.20% 4.80% 0 AAA AA A BBB 14% 9% 15% 13% 18% 11% 15% 5% Financials Property Utilities Sovereign / Supra / Regional Industrials Telecoms / Media / Advertising Private credit (Commercial Real Estate Lending) Private credit (Infrastructure debt and private placements) Source: Standard Life Investments, model portfolio for illustration only.
More on Interest Rate Derivatives and MA
Assessing Eligibility of Paired Assets For an asset to be eligible for an MA portfolio, it must have fixed cashflows Under a receiver interest rate swap, the insurer would be obligated to make future payments linked to the floating rate underlying the swap (for example, LIBOR) For this swap to be eligible, it must be paired with an asset that generates LIBOR The required floating rate payments could be provided by: cash or other money market instruments a payer interest rate swap, under which the insurer receives the floating leg surplus cashflows from fixed interest assets (that is, cash that will be held in the future) To assess asset eligibility, the insurer could model the portfolio floating rate assets and ensure that these were sufficient to meet the floating rate obligations in all future years Source: Standard Life Investments as of December 2015
Liability Hedging: Optimal Instrument Selection Short-end swaps yield more than gilts Long-end gilts yield more than swaps 2.5 Nominal UK Swaps Curve 31 Jan 2016 Nominal UK Sovereign Curve 31 Jan 2016 2.0 1.5 1.0 0.5 0.0 0 5 10 15 20 25 30 35 40 45 50 1.0 0.5 0.0-0.5-1.0 0 5 10 15 20 25 30 35 40 45 50 Source: Standard Life Investments as of January 2016
More on Private Credit and MA
CRE Debt: Loan example South East office Key Features Summary Security of assets and low probability of default Transparent Security over real assets (including cash) Control over assets following event of default. All equity/subordinated debt is junior. Provides for minimal loss given default Sensible underwriting is key to low annualised loss rate Full transparency on cash flow position, physical asset management and valuation Borrowers required to provide specific regular reporting Internal covenant analysis and management processes Value Income Asset Characteristics Loan to Value 65% Type Interest coverage Tenant GBP 78m HQ Office Circa GBP 4.6m 360% (income : interest) Robust Weighted average lease Number of tenants Principal Amount Term structure Interest 15 years Single tenant GBP 50m 4 years 1.95% over 4 year Gilt Covenants Loan to value Interest coverage Cash sweep Secured, transparent yield Overall Loan Rating A
CREL in an Matching Adjustment Portfolio Report Identify Internal Rating Framework Measure Diversify asset holdings Restricted use of derivatives Risks of the asset class Control Manage Monitor Prudent limit for offmarket assets Invest with regard to liabilities Oversight of Inv. Manager Management Information Prepayment Protection
Spread to Benchmark (bp) Infrastructure Debt Pricing and illiquidity premium Opportunity still to capture illiquidity premium vs public comparables General market tightening in recent years has also affected infrastructure. Spreads, especially for vanilla availability-based assets, fell below 150bp, but are now increasing again 350 GBP Infrastructure Spreads vs Corporates 325 300 A 15yr+ 275 250 225 200 175 150 125 100 BBB 15yr+ 75 2010 2011 2012 2013 2014 2015 Source: Standard Life Investments, Bank of America Merrill Lynch, Barclays Capital, InfraNews. Data points include selected infrastructure primary market spreads with duration estimated by Standard Life Investments, including some public bonds and bank loans, most being transactions either pre-placed or privately placed with institutional investors. Duration curves as of 04 January 2016.
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