asset strategy for matching adjustment business · asset strategy for matching adjustment business...
TRANSCRIPT
June 2016
Asset Strategy for
Matching Adjustment BusinessChallenges and Choices
This document is intended for institutional investors only and must not be relied on by anyone else.
This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any strategy.
Economic context for long-term liability owners
Long-term trend in global 10-year Government Bond Yields
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8
10
12
14
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1980
1981
1982
1983
1984
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2012
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2015
Lo
ng
-Term
In
tere
st
Rate
(%
)
US
Germany
Japan
Canada
UK
Australia
Source: OECD
1000 bps
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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.
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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
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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.
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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.
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Quality of Matching
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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.
Example Matching Adjustment Bond Portfolio
0
50
100
150
200
250
2016 2026 2036 2046 2056 2066
Millio
ns
Annual Cashflows
Assets
Liabilities
0
500
1,000
1,500
2,000
2,500
3,000
3,500
4,000
4,500
2016 2026 2036 2046 2056 2066
Millio
ns
Cumulative Cashflows
Cumulative assets
Cumulative liabilities
Key Rate Duration Exposure
Cashflow
MaturityPortfolio 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. 11
Example MA Portfolio – Asset Characteristics
Source: Standard Life Investments, model portfolio for illustration only.
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%
S&P (A-rated) Capital Requirement 2.5%
Volatility 6.22%
18%
11%
15%
5%13%
9%
14%
15%
Financials
Property
Utilities
Sovereign / Supra / Regional
Industrials
Telecoms / Media / Advertising
Private credit (Commercial RealEstate Lending)Private credit (Infrastructure debtand private placements)
Sector AllocationsQuality Distribution
4.80%
21.30%
41.30%
32.60%
0
13.20%
57.90%
28.90%
0.00%
10.00%
20.00%
30.00%
40.00%
50.00%
60.00%
70.00%
AAA AA A BBB
Public Portfolio
Private Portfolio
• 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
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Credit Opportunity Set
14
G7 Treasuries
UK Investment Grade Credit
Non G7 Sovereign Debt
Global Investment Grade Credit
Real Asset Private Debt
Direct Lending
Syndicated Corporate Loans
High Yield Debt
Emerging Market Debt
Secondary Bank Loans/Pools
Distressed Debt
Specialised Finance
Return
Low Loss Severity
Capital Preservation
Real Estate LoansRegulated and Social Infrastructure
Real Estate Subordinated LendingJunior Debt/Mezzanine
Aviation Shipping
Leasing Niche Bank Financing
Asset Backed Securities
Cash
Traditional Alternative Niche
Commercial Real Estate (CMBS)Residential Real Estate (RMBS)
Collateralised Loan Obligations (CLOs)Asset-backed Consumer Loan Pools (ABS)
SME LoansConsumer Loans
Real Estate Loans
Higher Loss Severity
Alpha Seeking Credit
MA-eligible Not so MA-eligible
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 risk-adjusted returns
� Illiquidity premium estimate can be incorporated into discount rate for reserves
• And provide credit diversification
15Source: Standard Life Investments
Internal credit ratings and Solvency II
Investment Process and
Internal Rating
Methodology
Calibration
Back-testing
Governance
Management Information
Triggers for Review
Asset Manager Insurer
Internal Model SCR
MA Fundamental
Spread
Due diligence and on-going
oversight
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• 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.
CREL in an Matching Adjustment Portfolio
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Risks of the asset
class
Identify
Measure
Monitor
Manage
Control
Report
Diversify asset
holdings
Prudent limit for off-
market assets
Restricted use of
derivatives
Invest with regard to liabilities
Prepayment Protection
Oversight of Inv. Manager
Internal Rating Framework
Management Information
CRE Debt: Loan example – South East office
Secured, transparent yield 18
Key Features Summary
Security of assets and low probability of default
• 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
Transparent
• Full transparency on cash flow position, physical asset management and valuation
• Borrowers required to provide specific regular reporting
• Internal covenant analysis and management processes
Asset Characteristics
Interest coverage
Tenant
Weighted average lease
Income
Principal Amount
Term structure
Interest
Number of tenants
Covenants
Type
Value
360% (income : interest)
Robust
15 years
Circa GBP 4.6m
GBP 50m
4 years
1.95% over 4 year Gilt
Single tenant
Loan to valueInterest coverageCash sweep
HQ Office
GBP 78m
Overall Loan Rating – A
Loan to Value 65%
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Relative Value of Commercial Real Estate DebtIlliquidity Premium of 125 - 200 bps
19Commercial Real Estate Debt Fund still offers attractive illiquidity premium
Spread bps
* 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
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50
100
150
200
250
300
350
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* SLI Commerical Real Estate Debt Fund**
Illiquidity premium
Infrastructure Debt Pricing and illiquidity premium
• 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
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Opportunity still to capture illiquidity premium vs. public comparables
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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125
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200
225
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350
2010 2011 2012 2013 2014 2015
Spre
ad t
o B
enchm
ark
(bp)
GBP Infrastructure Spreads vs Corporates
BBB 15yr+
A 15yr+
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
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Cashflow Matching With Interest Rate Derivatives
Cashflow matching using bonds and interest rate swaps
Source: Standard Life Investments, December 2015 24
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
25Source: 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)
• 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
Change in Yield (bps)
Collateral Requirement (%)
100 15
200 26
300 36
Change in Yield (bps)
Collateral Requirement (%)
100 3.1
200 5.3
300 6.8
26Source: Standard Life Investments, December 2015
Liability Hedging: Optimal Instrument Selection
0.0
0.5
1.0
1.5
2.0
2.5
0 5 10 15 20 25 30 35 40 45 50
Nominal UK Swaps Curve 31 Jan 2016 Nominal UK Sovereign Curve 31 Jan 2016
Long-end gilts yield
more than swaps
Short-end swaps
yield more than gilts
-1.0
-0.5
0.0
0.5
1.0
0 5 10 15 20 25 30 35 40 45 50
27Source: Standard Life Investments, January 2016
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
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Managing FX Risk in an MA Portfolio
30
-60%
-50%
-40%
-30%
-20%
-10%
0%
10%
1.3
1.4
1.5
1.6
1.7
1.8
1.9
2
2.1
2.2
Jun-2008 Nov-2009 Mar-2011 Aug-2012 Dec-2013 May-2015 Sep-2016
Sw
ap
MtM
(%
of
no
tio
nal)
GB
PU
SD
GBPUSD Swap MtM (% of Notional)
• 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 30
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