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June 2016 Asset Strategy for Matching Adjustment Business Challenges 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.

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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.

Standard Life Investments

Investment Context and Trends for Insurers

Economic context for long-term liability owners

Long-term trend in global 10-year Government Bond Yields

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12

14

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1980

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2012

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2014

2015

Lo

ng

-Term

In

tere

st

Rate

(%

)

US

Germany

Japan

Canada

UK

Australia

Source: OECD

1000 bps

3

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.

4

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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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.

7

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

9

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

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

12

Standard Life Investments

Private Credit

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

16

• 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

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150

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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

20

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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100

125

150

175

200

225

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300

325

350

2010 2011 2012 2013 2014 2015

Spre

ad t

o B

enchm

ark

(bp)

GBP Infrastructure Spreads vs Corporates

BBB 15yr+

A 15yr+

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

22

Cashflow Matching with Physical Assets

23Source: Standard Life Investments 31 December 2015

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

Standard Life Investments

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

29

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

The information shown relates to the past. Past performance is not a guide to the future. The value of investment can go down as well as up.

Any data contained herein which is attributed to a third party ("Third Party Data") is the property of (a) third party supplier(s) (the “Owner”) and is licensed for use by Standard Life**. Third Party Data may not be copied or distributed. Third Party Data is provided “as is” and is not warranted to be accurate, complete or timely. To the extent permitted by applicable law, none of the Owner Standard Life** or any other third party (including any third party involved in providing and/or compiling Third Party Data) shall have any liability for Third Party Data or for any use made of Third Party Data. Past performance is no guarantee of future results. Neither the Owner nor any other third party sponsors, endorses or promotes the fund or product to which Third Party Data relates.

**Standard Life means the relevant member of the Standard Life group, being Standard Life plc together with its subsidiaries, subsidiary undertakings and associated companies (whether direct or indirect) from time to time."

Standard Life Investments Limited is registered in Scotland (SC123321) at 1 George Street, Edinburgh EH2 2LL.

Standard Life Investments Limited is authorised and regulated in the UK by the Financial Conduct Authority.

Calls may be monitored and/or recorded to protect both you and us and help with our training.

www.standardlifeinvestments.com

© 2016 Standard Life, images reproduced under licence

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