The Bulk Annuity market and how UK insurers invest to meet their annuity promises

1. The Bulk Annuity market and how UK insurers invest to meet their annuity promises Steve Robinson FIA, Head of Annuity Trading & Pricing

2. agenda Bulk annuity background Investing to meet annuity promises

3. HOW DO DEFINED BENEFIT (“DB”) PENSION SCHEMES WORK? • Assets and liabilities are market related and volatile • Employees and employer contribute but employer picks up the tab. Contributions are assessed on a prudent basis. • Deficit sits on sponsor’s balance sheet. Accounting position assessed on a best estimate basis. • An expensive legacy issue – most liabilities are in respect of ex-employees. • The key risks are market and demographic Assets Liabilities Pension scheme Over £2 trillion of DB liabilities in the UK Over 6,000 DB pension schemes in the UK £15bn per annum transferred to Insurance Sector 100-150 schemes per annum purchase Bulk Annuity policies

4. MORTALITY IMPROVEMENTS Is recent heavy mortality a blip or a new trend? • 1975 to 2000 fairly steady improvement, average 1.5% pa • 2000 to 2011 very steady improvement, average 2.5% pa • No real improvement and lots of volatility since 2011. • Common assumption is for future improvement of c1.5%. Higher for younger ages and in the initial years.

5. MORTALITY IMPROVEMENTS

6. EMERGING LONGEVITY RISKS CRISPR • Significant step forward in gene editing • Study DNA sequences and potential for treating disease • Applications trialled so far? Reverse mutations causing blindness, inhibit cancer cell growth and protect against the HIV virus. • Ecology and conservation: e.g. kill off mosquitoes that spread malaria and Zika virus; make bananas immune to panama disease • Potential to improve life expectancy of tens of thousands, though perhaps a decade from being clinically available. • Longevity re-insurance is now key to the Bulk Annuity Market

7. What is a buy-in / buy-out? • A buy-in is a bulk annuity policy insuring the benefits for a group of pension scheme members, held as an asset of the scheme. The policy is in the Trustee’s name and a premium is paid to the insurer in return for the policy. • Under a buy-out the Trustee policy is converted to an individual annuity policy in the member’s name. Typical Pensioner Liability and Asset Cash Flows Typical Pensioner Liability and Buy-in Cash Flows Nominal liability cash flows (variable with inflation & longevity) Nominal Liability Cashflows (variable with inflation & longevity) Buy-in/buy-out Cashflows matched Asset Cash Flows Many schemes have been able to exchange existing matching assets (e.g. gilts) for a pensioner buy-in at an attractive price (e.g. no strain against benchmark liability measures).

8. overview of THE UK bulk annuity market TRANSACTION VOLUMES TO END OF 2017

9. agenda Bulk annuity background Investing to meet annuity promises

10. THE KEY LINK: LONG TERM ASSET NEED TO MATCH LONG TERM LIABILITIES Long dated cashflows needed Importantly assets need to be Matching Adjustment compliant

11. What is the matching adjustment? • Flat addition to risk free interest rate used to calculate the best estimate of liabilities • Provided liabilities are matched with eligible assets. Earned spread over risk free on portfolio 35% of LTA spreads F’mental Spread (FS) Downgrade Default MA • Calculated as the total yield less FS • The FS must be at least 35% of long term average spreads Risk Free Rate Risk Free Rate

12. Asset and liabilities cash flow matched subject to 3 tests • The limits on the Test 3 offer little latitude, and prevent prudently holding excess assets. • The rationale being to promote a buy-to-hold strategy

13. What is the impact of the matching requirement? • Liabilities - Restrictions on features (or impact on pricing / structuring). • Investment - Hedging / restructuring of asset portfolios to remove optionality and make cash flows “fixed”. • Capital optimisation – Optimising the size of the MA and how it behaves under stress and over time.

14. So how about illiquid assets? • Holding illiquid assets constrains a company’s ability to rebalance the portfolio. It is not just the 1 year view which is important here, but also future rebalancing requirements (e.g. annuity basis change), a “year 2 aftershock scenario etc”. • Downgraded illiquid assets are not efficient assets for the matching adjustment. The increased fundamental spread results in small matching adjustment for those assets and gives exposure to future increased volatility. • Reduced aability to trade assets increases the fundamental spread as more sub-IG assets are held (compared to base scenario where eg Bonds are assumed to be sold once sub-investment grade).

15. Which assets ARE TYPICALLY targeted? • Indicative size of the potential annual opportunity in various loan asset classes; includes illustrative tenor and returns • Total illiquid asset lending could be £20bn to £30bn

16. MAIN PLAYERS ASSET allocation Other / Property • Asset-Backed Securities • Covered bonds • CMBS • RMBS • Secured bonds Sovereigns, Supras & Sub-Sovereigns (72% UK, 8% US) Cash and Liquidity Funds Other 2% Sovereigns, Supras & Sub-Sovereigns Lots of competition for similar assets Derivatives • Corporate Bonds • Financial services • Utilities • Consumer services • Insurance • Technology • Industrials • Telecoms • Oil & Gas c£50bn c£20bn • Corporate Bonds & Loans • Corporate bonds • Covered bonds • Infrastructure • PFI Projects • Loans • Securitisations & debentures • Utilities • PFI/Social Housing • Infrastructure 2% Cash • Residential mortgages • Equity release mortgages • Newly originated mortgage loans • Bulk purchases • Other • University loans • Charity / not-for-profit loans • CRE loans • Negative basis trades Commercial Mortgages • Infrastructure Lending • Transportation • Utilities Sovereigns, Supras & Sub-Sovereigns • Other Secured Lending • Tri-party repo • Bilateral agreements • Total return swaps • Corporate Bonds & Loans • Corporate bonds • Index-linked investments • Private placements • Infrastructure loans • Derivatives • Interest rate swaps and futures • CDS • Inflation swaps • Fixed coupon cross currency swaps c£30bn c£15bn Sovereigns, Supras & Sub-Sovereigns • Secured Residential Lending • Ground rents loans • Covered bond • Social Housing Cash Cash

17. Political Risk: Case Study of Brexit Agricultural Industry update • 2 year ‘transition period’ after expiry of Art 50 exit notice – would mean agricultural markets are far less likely to be severely disrupted after March 2019. • It is assumed that the Common Agricultural Policy would not continue to apply in the UK during the transition period.  The National Farmers Union propose support payments to be maintained through a new ‘Domestic Agricultural Policy’ to be implemented gradually and fully in place by 2023 at the earliest. • Figures from DEFRA show an increase in profitability across most farming business sectors in 2016/17 compared to 2015/16 and are forecast to see further increases in 2017/18 • For Cereals and Grazing sectors, farm losses were made in respect of actual agricultural activity but overall profit once other sources of income, including subsidies, were taken into account. • Basic payment subsidies are paid in Euros – payments are 5% higher in 2017 compared to last year’s due to depreciation of GBP against EUR and represents best figures since 2009. • (Source: The Andersons Centre, LBG AgriBrief Bulletin No.5, 01/11/2017)

18. Political Risk: Case Study of Brexit (Cont’d) UK Farmers Majority View: Lack of clarity per Brexit is considered to be the biggest business risk as it delays investments and slows down corporate activities such as land purchases/developments. On the other hand, this forces the farmers especially the ones employing large number of FTEs to improve their efficiencies. Short to medium term outlook is positive on the sector due to improved commodities prices and larger subsidy payments mostly due to weaker GBP. Fundamentally positive, forward looking mood amongst farmers consistent with majority of them having voted for Brexit Impact analysis on Agriculture Sector

19. Credit CONSIDERATIONS OVER 30+year investment horizon • According to a report published by the Bank of Korea on May 14, 2008, investigating 41 countries, there were 5,586 companies older than 200 years. Of these, 3,146 are in Japan, 837 in Germany, 222 in the Netherlands and 196 in France • Of the companies with more than 100 years of history, 89.4 percent employ fewer than 300 people • Since 2000, 52 percent of companies in the Fortune 500 have either gone bankrupt, been acquired, or ceased to exist as a result of technology disruption. The collision of the physical and digital worlds has affected every dimension of society, commerce, enterprises, and individuals • More than 88% of the companies from 1955 have either gone bankrupt, merged with (or were acquired by) another firm, or they still exist but have fallen from the top Fortune 500 companies Some hits from Google and Wikipedia when searching for corporate longevity ⇒ Investments should be secured with Real Assets such as Property or Public Utility (Infrastructure, Transport, Energy) or should have a long-standing social benefit such as Education • 2017: $869bn $721bn $560bn $510bn

20. summary huge demand for buy-ins Lots of competition for MA compliant assets Customer Value in bulks market at record highs New business vs backbook a key consideration for insurers

21. Q&A Thank you