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1. Executive Summary
Despite the damage caused by the turmoil in financial markets to pension schemes’ funding levels
and insurance companies’ balance sheets over the last couple of years, we can begin 2010 with some
optimism.
As the markets settle, there are several areas which offer investment opportunities. For example,
long term investors such as pension schemes and insurance companies can benefit from the re-
emergence of an illiquidity premium across various asset classes. Furthermore, the dearth of
funding from traditional sources, primarily banks, has led to a wide range of new opportunities for
long term investors.
The difficulty is that these opportunities come from a disparate set of sources, some of whom have
not traditionally worked with long term investors, and therefore they have not always been
developed to take account of the governance and operational constraints that apply to investors
such as pension schemes.
In the Spring Collection 2010, we outline the following:
The background that has led to these opportunities arising;
A framework for assessing the various opportunities that allows Trustees and investment
committees to make the most of their limited governance time;
An illustrative subset of the opportunities that in our view are worthy of consideration and
represent the spectrum of products available (see sections 3-9):
o LDI 2.0 – takes advantage of the current anomaly between the index-linked gilts and swap
curves by using gilts and equity futures or total return swaps (TRS) rather than cash equities
and swaps;
o Secured Leases – provide corporate bond-like yields with enhanced security on long-term
and inflation linked property leases;
o Ground Rents – a high credit quality asset offering long-dated and inflation-linked cashflows
linked to property freeholds;
o Social Housing – offers long-dated inflation-linked cashflows from a secured borrower with a
quasi-government backing;
o Infrastructure – explores opportunities for investments in public sector projects through
Private Finance Initiatives (PFIs) that offer long term and inflation linked cashflows;
o Equity Release Mortgages – offer attractive returns whilst also mitigating some of a pension
scheme’s interest rate (and potentially longevity) risks;
o Insurance Linked Securities – present attractive returns and potentially, a degree of
diversification.
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2. Background
2.a. Credit Crisis
The global economy went through a period of unprecedented financial instability in 2008-09, as the
credit crisis that originated in the United States spread to other parts of the world. The global crisis
followed a period when availability of cheap credit led to financial institutions using high levels of
leverage to fund their balance sheets. “Leverage” is the process in which an institution uses a small
amount of its own assets to invest in a much larger asset. Large parts of these leveraged balance
sheets consisted of highly rated but poorly understood and complex instruments. Spreads on these
instruments began to increase (and their value fell) due to the higher perceived risk of these
instruments and concerns regarding their credit rating.
The fall in asset values and lowering of credit ratings led to mark to market losses. The lack of
transparency in the value of these assets and degree of exposure of various financial institutions to
these losses resulted in an environment of widespread distrust, which in turn led to a reduction in
the amount of lending across the financial system and some companies quickly encountered
difficulties in raising capital.
The impact of the credit crunch quickly passed through banking systems to sectors and countries
across the global economy. In a vicious cycle, the financial turmoil further increased investor risk
aversion as liquidity dried up in all major asset classes and ultimately affected the ability of firms and
households to raise finance for consumption and investment (see Figure 1).
Figure 1: Credit crisis meant unavailability of credit
Source: Lloyds TSB, Economics Weekly 29-Sep-08
The developments in the financial markets forced governments and central banks to work together,
developing new tools in both fiscal and monetary policy to stimulate economies at both a national
and global level. The massive unprecedented liquidity injections and other co-ordinated actions
began to take effect as the credit crisis showed signs of abating in the second half of 2009.
2.b. Impact on Pension Schemes and Insurance Companies
The turmoil in the financial markets had a major impact on the funding levels of pension schemes
and balance sheets of insurers. The sharp falls across almost all asset classes led to a substantial drop
in asset values. At the same time, falling long term yields led to a rise in liability values, resulting in a
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large net funding deficit for pension schemes and reduction in capital coverage for insurers. Figure 2
shows the rise in funding deficit from Jun-08 to Mar-09 for schemes included in PPF 7800 index.
Figure 2: Aggregate Funding Position of Pension Scheme (data from PPF 7800 Index)
Source: PPF, Redington
The Insurance industry underwent similar stresses and strains. In 2008, Fitch moved its rating
outlooks for all segments and regions of the global insurance industry to Negative. According to a
Sep-09 press release by Fitch, while the sector had seen some signs of stabilization, further
improvements in capital access, financial flexibility and greater certainty regarding investment
valuations will need to occur before the agency improves its outlook for insurance companies.
2.c. Preparing for the end game
The fall in scheme funding levels and recognition of the significant risk defined benefit schemes bear
has led corporate sponsors to try and reduce this burden. Increasingly, companies have been closing
their DB schemes to new employees and even closing to future accrual for existing members. With
shrinking memberships, constrained sponsors, decreasing investment horizons and maturing liability
profiles, there is an urgent need and demand for defined benefit pension schemes to look at de-
risking options.
As shown in figure 3, there are three broad ways in which pension schemes can manage risk. Low
funding levels of schemes and the restrictions of the buy-out market have made full de-risking via
buy-out prohibitively expensive for most sponsors. Schemes are increasingly exploring alternative
solutions such as buy-ins, ETVs and LDI solutions as a means to partially de-risk.
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Figure 3: Mechanism for managing risk
Source: Redington Education Event 25-Nov-09 – “Preparing for the End Game”
As we see the first sign of economic recovery, now is an ideal time for pension schemes to review
their long-term risk management strategies. A flight plan approach enables schemes to use metrics
such as required rate of return, expected time to full-funding and expected contributions to build a
long-term strategy. This approach can then be used to identify traditional investments and new
opportunities to develop a solution to match the strategy.
Figure 4: Flight Plan – Long term risk management strategy
Source: Redington
*The blue dotted line represents possible variation in future asset path and incorporating risk mitigation actions as funding
levels improve.
Managing pension risk
1. Transfer to
members
Changebenefit format,
e.g. ETVs
2. Hold risk on
balance sheet
Matchingassets (e.g.
LDI, buy-in, longevity
swaps)
3. Transfer to external
entity
Buyout
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2.d. Looking ahead: Opportunities in 2010
2010 has started on a note of cautious optimism on the state of the global economy. However, with
interest rates effectively at zero (after fees) investors are searching for yield – as evident from the
net inflow of money back into financial markets.
Although the crisis has caused a great deal of difficulty for real money investors, particularly pension
schemes, an ongoing lack of funding for a wide range of market participants has led to opportunities
for investors who can provide long-term liquidity. This has been demonstrated by the wide range of
new assets that have been brought to market, many of which offer an attractive illiquidity premium.
For pension schemes and insurance companies looking at ways to improve their funding level or
strengthen their balance sheet, the key is to take advantage of their long term investment horizon.
This long-term outlook translates into an ability to invest in less liquid assets which are not
appropriate for investors with short-term liabilities. Thus, they can take advantage of their position
to capture the illiquidity premium available on such investments to achieve more attractive yields,
meet their long-term cashflow needs and offset the duration mismatch that exists between assets
and liabilities.
2.e. Spring Collection 2010 – An Overview
In the Spring Collection 2010, we have identified some such areas that we believe currently offer a
value proposition for pension schemes and insurance companies.
A brief description of the strategies explored is given below:
1) LDI 2.0
This strategy takes advantage of the current pricing
anomaly between index-linked gilts and swaps. The
strategy proposes to raise funds to buy appropriate
index-linked gilts by selling the scheme’s equity
portfolio and replacing the equity exposure with
futures contracts or a total return swap.
2) Secured Leases
Take advantage of the attractive yields on long-term secured
property leases. These yields, in some cases, are in excess of
the yields offered on corporate bonds issued by the same
borrower. In addition to the yields, the secured leases are
long dated (up to 25 years) and provide index-linked
cashflows which help offset some inflation risks of the
pension scheme liabilities. Furthermore, the investor is also
able to gain long-term exposure to the property market.
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3) Ground Rents
On a relative basis, the ground rents payable by the freehold property offers
attractive returns, limited credit risk with a high level of security, and is
increasingly available in an investible form that maintains efficiency.
4) Social Housing
Refers to rental housing supplied at low costs to people in need of
accommodation. It is generally provided by local councils and housing
associations and offers long-dated inflation linked cashflows from a secured
borrower (i.e. the housing associations) with a quasi-government guarantee.
5) Infrastructure
Investing in public sector projects through Private Finance Initiatives
(PFIs). PFIs enable government to fund new infrastructure projects
while private investors benefit from a long-term, usually inflation-linked
revenue stream.
6) Equity Release Mortgages (“ERM”)
Many pensioners and annuitants have much of their
wealth tied-up in their homes (“asset rich, cash poor”).
ERMs allow homeowners to borrow cash against the
value of their property without requiring them to
immediately service the debt. The lender obtains long-
dated fixed payments potentially with characteristics
that help manage exposure.
7) Insurance linked securities (“ILS”)
European and US insurers have been addressing their regulatory
capital and reserving requirements with capital market techniques
since the 1990s. In the Spring Collection, we consider the case of
the so-called “Regulation XXX”. Traditionally, insurers used a
reinsurance backed contract allowing them to free up capital.
However, a reduction in appetite from reinsurers to back this type
of business, created an opportunity for other investors who can
receive an attractive premium to bear US mortality risk creating an
asset that, though risky, could be uncorrelated with other parts of
the portfolio.
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2.f. Constraints on the Governance Budget
While the crisis has created a number of opportunities, the challenge is also about how to assess the
wide range available.
As a high-level guide, we set out below a simplified summary of the new opportunities to be
categorised. Please note that this summary is provided as a framework for schemes to decide how to
focus limited governance time on those areas of most interest and application to them.
We classify all investment ideas on a broad scale according to the following criteria:
Yield Enhancement: this metric refers to the extra return generated by each strategy;
Risk Mitigation: the propensity to reduce risk versus a liability benchmark;
Additional Risks: arising from the underlying assets, counterparty exposure or operational
matters;
Complexity: the nature of the investment or its structure, as it affects governance and time;
Accessibility: the ability to access off-the-shelf solutions versus solutions which require
specific structuring.
Table 1: Summary of all Investment Ideas
Investment Ideas
Yield
Enhancement
Risk
Mitigation
Additional
Risks
Complexity Accessibility
LDI 2.0
Secured Leases
Ground Rents
Social Housing
Infrastructure
Equity release mortgages
(ERM)
Insurance linked securities
(ILS)
Source: Redington
LDI 2.0 involves investing in index-linked gilts and generates the least yield enhancement, but
provides the highest risk mitigation with low complexity and high accessibility. While LDI 2.0 does not
in itself provide high returns, it provides the opportunity to increase the investment in other growth
assets to generate additional return, e.g. corporate bonds.
Secured Leases, Ground Rents, Social Housing and Infrastructure have similar characteristics and
offer relatively higher margins due to the embedded credit and illiquidity risk premium. However,
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they are currently available only in segregated accounts with the exception of Infrastructure and
Secured Leases. All of them are more complex and have lower risk mitigation properties than LDI 2.0.
ERMs and ILSs are the most attractive strategies in terms of yield enhancement, but offer the least
risk-mitigating characteristics. These are generally complex instruments available only in segregated
formats and often requiring a substantial amount of structuring; they are thus likely to be
appropriate for investors with a larger governance budget.
Figure 5: Growth and Matching Assets
Source: Redington
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3. LDI 2.0
3.a. Strategy Description
The strategy takes advantage of the current anomaly in the index-linked gilt and swaps curves by
capturing better real yields available from the index-linked gilt market compared to traditional
inflation swaps. The strategy proposes to raise funds to buy these index-linked gilts by selling the
scheme’s equity portfolio and replacing them with equity futures or total return swaps (TRS) to retain
economic exposure to equity markets.
3.b. Relative value between inflation swaps and index-linked gilts
The second half of 2008 saw a reversal in the relationship between real swap and gilt yields. Usually
swap yields are higher than gilt yields, reflecting primarily the higher counterparty credit risk.
However, over Q2 2008, gilt real yields rose above swap real yields (see Figure 6). The reasons behind
this recent upheaval include a reduction in the inflation swap supply due to the ending of long dated
issuance programs by monoline insurance companies and unwinding of positions by inflation swap
supply players such as hedge funds.
Figure 6: 30y real swap yield Vs 30y real gilt yield
Source: Bloomberg, Redington
While the spread between swap real yields and gilt real yields has narrowed significantly over the last
few months, it still remains high relative to its normal levels at certain previous points in the curve
(see Figure 7).
This demonstrates that by investing in gilts, pension schemes can still earn a better yield than
equivalent swaps with minimal counterparty risk whilst providing interest rate and inflation hedging
as well. However, the potential gain has reduced, due to pension fund demand and the Bank of
England’s Quantitative Easing programme.
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Figure 7: Current Index linked gilt yields Vs Swap real yields
Source: Bloomberg, Redington
Table 2: Hedge using swaps or bonds
HEDGING USING SWAPS HEDGING USING BONDS
Upfront Payment None Purchase Price
Counterparty Risk Yes, mostly mitigated with
collateral agreement
UK Sovereign Risk
Separate out interest rate and
inflation risk
Yes No
Real Yield Historically higher than real
yield on gilts for most
maturities, at present this
relationship has inverted
Historically lower than real rate
swaps for most maturities, at
present this relationship has
inverted
Basis Risk Versus a Swap
Benchmark
No Yes
Basis Risk Versus a Gilt Based
Liability Valuation
Yes No
Adding in Risk/Return
Exposure
Assets of fund can be invested
in risky assets
Synthetic overlay such as equity
futures or total return swaps
Position size limited by Need to post collateral against
potential negative mark to
market
Need to finance purchase price
of gilt
Documentation ISDA/CSA N/A
Source: Redington
3.c. Funding index-linked gilt purchases
To realise the cash required to purchase index-linked gilts, the strategy proposes to sell the schemes’
equity investment and replicate the position with equity futures or TRS to retain economic exposure
to equity markets.
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0
50
100
150
200
250
300
350
400
450
-6.8%
-6.3%
-5.8%
-5.3%
-4.8%
-4.3%
-3.8%
-3.3%
-2.8%
-2.3%
-1.8%
-1.3%
-0.8%
-0.3%
0.2%
0.7%
1.2%
1.7%
2.2%
2.7%
3.2%
3.7%
4.2%
4.7%
5.2%
5.7%
6.2%
6.7%
7.2%
Funding with Equity Futures
An equity portfolio which tracks an index can be replicated by entering into futures contracts on the
same index and holding cash equal in amount to the value of the cash equity portfolio (as shown in
figure 8 below).
Figure 8: Cash Equity Vs Equity Futures
Physical Holding FTSE100 Futures
*The price of the FTSE100 futures contract takes into account the current level of the FTSE100
adjusted to reflect (a) the risk free rate (which we take to be LIBOR for illustration purposes) and (b)
the expected dividend yield of the FTSE 100.
As a result, the two portfolios have similar risk-return profile. However, note there will be some
tracking error between the two portfolios. Figure 9 shows the distribution of tracking error between
the two portfolios since Dec-96. The average tracking error over the last 13 years is about 9 bps.
Figure 9: Historical Distribution of Tracking Error*
(Dec-1996 to Jan-2010)
Source: Redington
*Calculated as the average difference between yearly cumulative total return of FTSE100 futures + cash portfolio & FTSE100 index
Cash from selling
FTSE100 physical
stocks, put on
deposit
Cash put on
deposit pays
LIBOR
Fund
Cash from selling
FTSE100 physical stocks
Fund
FTSE 100
futures
contracts*
Pays out cash to
buy FTSE100
physical stocks
Buys FTSE 100
physical stocks
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Funding with Equity TRS
In a total return swap, one party makes payments based on a set rate, either fixed or floating, while
the other party makes payments based on the return of an underlying asset, which includes both the
income it generates and any capital gains. Figure 10 compares the TRS with a futures contract. As
mentioned above, it is important to recognize that the price of the FTSE100 futures contract takes
account of LIBOR and dividend yield. Hence, all things being equal, investors should be indifferent to
either the futures or TRS alternatives. However, while futures contracts are traded on an exchange,
TRS is an over-the-counter derivative – just like interest rate and inflation swap and is traded with an
investment bank counterparty. Therefore, there can be pricing differences between the two – which
can lead to either extra yield pick-up or underperformance of TRS relative to futures.
Figure 10: Equity Futures versus TRS
FTSE100 Futures FTSE100 TRS
Thus a cash equity exposure can be replicated effectively by equity futures/TRS, with the cash
released used for further risk reduction i.e. purchasing index-linked gilts to match liabilities.
Figure 11: Synthetic equity exposure + Real hedging assets
FTSE 100 TRS
Cash from selling
FTSE100 physical
stocks
Cash from selling
FTSE100 physical
stocks, put on
deposit
Cash put on
deposit pays
LIBOR
LIBOR
TRSFund Fund
FTSE 100
futures
contracts
Cash from selling
FTSE100 physical
stocks
Cash from selling
FTSE100 physical
stocks, put on
deposit
Cash put on
deposit pays
LIBOR
Cash from selling
FTSE100 physical
stocks to buy
index-linked gilts
Fund
Cash from selling
FTSE100 physical
stocks
FTSE 100
futures
contracts*/TRS
Higher yield
from Gilts
(versus swaps)
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3.d. Important Considerations
Investment Management Agreement (IMA) and Statement of Investment Principles (SIP) - Equity
index futures should be included within the definition of “derivatives” and the fund should seek
advice confirming that the use of derivatives may be for the purposes of efficient portfolio
management (rather than solely for hedging).
Collateral - Equity index futures are unfunded investments which require collateral to be posted.
Costs - Some of the costs associated with the strategy include:
i. Liquidation cost for cash equities and replacing with equity futures
ii. Rolling cost for equity futures – Quarterly exchange where you can pay or get paid to roll the
contract at a level generally close to fair value.
iii. Tracking error cost –The difference between the cash equities and equity futures which can
arise due to changes in the funding rate and dividend yields or technical factors such as
different trading hours and price limits.
Unwinding Futures - Transaction costs are similar to the initial dealing costs plus the associated
stamp duty for repurchasing the underlying FTSE 100 equities.
3.e. Summary
This strategy takes advantage of the current dislocation in the index-linked gilts and inflation swaps
market. Investing in index-linked gilts generates some yield enhancement (20 to 50 bps) but provides
high risk mitigation with low complexity and high accessibility. While LDI 2.0 does not in itself provide
high returns, it provides the opportunity to increase the investment in other growth assets to
generate additional return, e.g. corporate bonds.
Yield
Enhancement
Risk
Mitigation
Additional
Risks
Complexity Accessibility
LDI 2.0
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4. Secured Leases
4.a. Strategy Description
As an asset class, Secured Leases are of interest to pension schemes because they provide access to
long dated inflation linked cashflows which can match a scheme’s liability profile. The asset class has
similarities with corporate credit, index-linked bonds and property. Figure 12 briefly summarises the
similarities.
Figure 12: Similarities with other asset classes
4.b. How does a lease work?
Source: Redington
A long term property lease consists of the following components:
1) Rental Income Stream: This refers to the periodic payments made by the tenant to the owner.
These are typically linked to RPI and reviewed on an upward only basis.
2) Capital Value: This refers to the actual value of the underlying property which can change over
time.
3) Credit Risk of the tenant: Investors in secured leases take on the credit risk of the tenant.
Fixed
Income
• Provide long-dated index-linked cashflows throughout the duration of the lease.
Credit
• Rental cashflows are typically guaranteed by a senior investment grade borrower.
• Unlike corporate bonds, leases are secured by the underlying property. In the event
of default, the property provides security, mitigating against the default risk.
Property
• The investor has exposure to rising or falling property prices.
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4.c. Key benefits of investing in Secured Leases
LDI Hedging
Secured leases typically provide long dated cashflows indexed to RPI or LPI (LPI is capped and
floored RPI) which extend to over 20 years.
The long-dated nature of the leases provides some nominal and inflation duration which helps
offset the duration mismatch that exists between the assets and liabilities.
Figure 13: LDI characteristics of the lease component
Source: Redington
Leases vs. Corporate Bonds
At present there are some relative value opportunities available between yields on property
leases compared to those on corporate bonds.
The table below seeks to highlight this point.
Table 3: Implied spread over LIBOR
Inflation Hedge
Lease payments are
RPI linked and so the
pension fund receives
a constant stream of
[annual] real
cashflows to match
inflation linked
liabilities
Interest Rate
Hedge
Long dated nature
of the lease may
offset the duration
mismatch that
exists between a
pension fund’s
assets and
liabilities
Themajority of pension
fund liabilities are index-
linked
Long dated leases often
contain RPI-linked or fixed
indexation cashflows
By entering into a long-
termlease, the pension
fund receiveslong dated
index-linkedcashflows to
help meet the liabilities
Example: Lease Rental Income Streams received for 25 years
assuming no lessee default with annual RPI Indexation
The table shows the implied spread on an
example lease under stress scenarios of various
losses on the underlying property.
Even if the property is worth nothing at the end
of 24 years, the spread over LIBOR on the lease
(1.22%) is comparable to that of the corporate
bond (1.25%).
If the property rises in line with RPI, the investor
receives 4.71% i.e. 3.46% above the yield of the
equivalent corporate bond.
Assumed 24 year lease; no default (Source: Redington, October 2009)
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Property Exposure
Secured leases enable the investor to participate in the long-term capital appreciation of the
property.
In addition, the asset class provides a useful source of diversification. Thus an allocation to
property may help increase risk-adjusted returns.
Table 4: Diversification benefits of Property Exposure
Source: Schroders
4.d. Potential drawbacks
LDI Perspective
Long term leases are not a direct hedge for movements in the gilt/swap curve.
When investing in a fund, it is important to note that these are distribution funds without
fixed coupons. The coupons from the funds may vary each quarter depending on the
distribution of underlying leases.
Liquidity Perspective
Secured property leases are traditional buy and hold investments with lower liquidity than
other asset classes (e.g. corporate bonds).
Credit Perspective
Investment in secured leases means taking on the credit risk of the tenant. This is worth
noting as some pooled funds have exposure to BBB tenants/guarantors.
However, this risk can be mitigated when investing in leases let to high quality tenants such as
government agencies such as NHS etc.
Property Perspective
Property deals have high transaction costs (e.g. stamp duty, tax) and potential initial costs
(e.g. refurbishments) which can lead to upfront fees of 2% to 5%.
The final value of a property is unknown and the investor may receive less than the initial
investment upon sale of the asset.
4.e. Accessibility
There are 2 ways in which investors can obtain exposure to long leases. One can hold the property
directly or use a pooled fund:
Allocation
(Equity/Gilts/Property)
20 Year Return
(% pa)
Volatility
(% pa)
70%/30%/0% 8.9 13.6
60%/30%/10% 8.8 12.4
50%/30%/20% 8.8 11.2
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Direct holding
Involves purchasing the property directly from the market and subsequently leasing the
building to a tenant.
The investor has a high level of control in the investment process and is able to create his
own tailored lease portfolio.
However as mentioned earlier, property is an illiquid asset. Furthermore, the owner will be
subject to administration fees associated with repairs etc and due to the large upfront costs
involved, this is only suitable for large pension schemes with a high governance budget.
Pooled fund
The investor buys units in a fund which contains a pool of properties and leases.
This is a cheaper solution which is more suitable for smaller schemes.
However, there is still administration fees associated and this is not a tailored solution.
Major advantages of investing in pooled funds are that they provide access to higher liquidity
and diversification of holdings
Table 6: Direct Holding vs. Pooled Fund Solutions
Source: Redington
Example funds
Funds typically comprise of a portfolio of assets let on long leases to strong covenants split between
regular real estate investments, such as offices, industry and retail, and that of social infrastructure
projects, such as libraries and schools.
Library Retail – Banks Offices
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4.f. Summary
This strategy takes advantage of the high yields on long-term secured property leases. In addition to
the high yields, secured leases are long-dated and provide index-linked cashflows which offset some
risks of the pension fund liabilities. Investors can obtain exposure through both pooled and
segregated format. However, the strategy also generates some extra property risk for the investor.
Yield
Enhancement
Risk
Mitigation
Additional
Risks
Complexity Accessibility
Secured Leases
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5. Ground Rents
5.a. What are Ground Rents?
Ground rents constitute regular payments required under a lease from a Tenant (the leaseholder),
payable to the Freeholder of the property. This gives the Tenant the right to occupy with “quiet
enjoyment” and/or improve the piece of land for the duration of the lease. A ground rent is created
when a freehold piece of land or building is sold on a long lease. It is typically a pepper-corn rent
charged in respect of the land only and not in respect of the buildings placed thereon. Ground rent
payments are thus usually much lower than the rent that would be charged between a Landlord and
Tenant for a building on the open market, and for a much longer term (up to 999 years, but more
typically 99 or 125 years from the date the lease is issued). Ground rents are usually indexed to RPI,
various forms of LPI, HPI, or a fixed monetary amount (or percentage) uplift. Normally the uplift is
upwards only and the terms (including the frequency of review and the nature of the uplift) are
dictated by the contractual nature of the lease between the Freeholder and the Tenant.
5.b. Key benefits of investing in Ground Rents
Secured Lending
Due to the legal structure of ground rents, they are extremely senior (with no “financial
engineering” to create some notion of subordination) and can be viewed as very secure
investments.
Ground rents are a series of small, regular, and contractual payments that are ultimately
secured by the value of the underlying property which means they are “over collateralized”.
Furthermore, there are various points of recourse available to the Freeholder. Assuming the
Tenant has a mortgage on the leased property, the mortgage provider will be asked to pay
any arrears on the ground rent in the unlikely event that the Tenant has not paid them. The
mortgage provider has a significant motivation to make up arrears otherwise it risks losing its
security in the underlying property.
If arrears are not paid, the Leaseholder is in breach of the lease which is then forfeited.
Reversion of the property back to the Freeholder is accelerated (i.e. the title of the property
reverts back to the Freeholder) at which point the Freeholder is able to reissue the leasehold
of the property to a new Tenant with, if necessary, new terms including the ground rent
payable. A reissue of the lease would represent a substantial windfall gain for the Freeholder
i.e. equivalent to selling the property at its full market value. The Freeholder then receives
ground rents from the new tenant as dictated in the new lease.
The windfall gain from reissuing a lease means all outstanding rental and service charges
owed can be recovered, all expenses incurred can be recouped, and any residual amount is
the sole property of the Freeholder, not the original leaseholder.
The Freeholder has no outstanding obligation to pay any creditors on the leasehold and as
such they lose their security.
Upon forfeit and reissue/resale of the leasehold, the Freeholder makes an instantaneous
windfall gain due to the accelerated reversion of the title of the property back to the
Freeholder. Somewhat paradoxically, therefore, a default under the ground rent may
ultimately result in a gain.
24. Asset Class Spring Collection 2010
www.redington.co.uk 24
Figure 14: Senior ranking of Ground Rents
Source: Redington
LDI Hedging
The long-dated, fixed income natures of the cashflows from ground rents provide a good
offset against a pension scheme’s long-dated and illiquid liabilities.
The long-dated nature of the cashflows means ground rents possess attractive properties
including long duration and high convexity to help mitigate the mark to market sensitivity of
liabilities. As noted, the ground rents are often linked to inflation providing further significant
liability matching properties.
While being long-dated contracts, the structural seniority and security of ground rents means
they are robust from a credit perspective. In the event that ground rent obligations are not
paid to the Freeholder, the Freeholder may recognize a significant gain (rather than a loss)
through forfeiting the lease and reissuing a new one to new tenant).
Typically the yield on ground rents is greater than that for equivalent rating and maturity
index-linked bonds and swaps.
Ground rents therefore represent a yield-enhanced liability matching asset while retaining
robust credit characteristics.
5.c. Potential drawbacks
LDI Perspective
Typically ground rents do not provide a direct cash flow matching hedge; rather they provide
a mark-to-market hedge against liabilities. Note that very few assets by themselves provide a
direct cash flow hedge.
In order to be meaningful, investors need to invest in a portfolio of ground rents to achieve
scale and diversity.
Ground rents payments need to be administered and serviced i.e. payment demands need to
be issued by the Freeholder and payments processed. This administration costs around
ground rents can be extensive and owners of small numbers of ground rents will not benefit
from the economies of scale afforded to large owners.
Historically ground rents have not been readily available to institutional investors as large,
diverse portfolios (with the necessary infrastructure to service and administer them) have
Ground
Rent
Mortgage
Leasehold Equity
Ground rents rank higher than any claim
on the leasehold including any mortgage
obtained by the leaseholder
25. Asset Class Spring Collection 2010
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typically exchanged hands between residential property developers and specialized ground
rent acquirers.
Liquidity Perspective
An investment in ground rents should be seen as illiquid. The benefit of this is that an
illiquidity premium is available; it is this premium that represents the yield enhancement
given that the credit risk is remote. An investment in ground rents should therefore be
undertaken on the basis of a long-term buy and hold basis only.
Mark-to-market: given that ground rents are illiquid and not widely traded it can be difficult
to ascertain their fair value. Appropriate measures need to be taken to ensure price visibility
and transparency, including the use of comparative assets and “mark-to-model” if required.
5.d. Accessibility
While individual ground rents are readily available for purchase (they can be searched on Google), in
order to be meaningful they must be acquired in some volume and with the necessary level of
diversity (across regional and residential property types). This would then raise the challenge of
efficiently administering and servicing the ground rent estate. Historically this has been an
impediment to institutional investors in an otherwise attractive asset. Fortunately instruments (such
as bonds and loans) and vehicles (such as unitised funds) are increasingly available in the market
which now makes an efficient allocation to this asset class a real possibility for institutional investors.
Figure 15: Investing in Ground Rents
Source: Redington
5.e. Summary
Investing in Ground Rents offers attractive returns with limited credit risk and high level of security. It
is increasingly available in an investible form that maintains efficiency.
Yield
Enhancement
Risk
Mitigation
Additional
Risks
Complexity Accessibility
Ground Rents
Leased
Property
MortgageProvider
on Property
Contract between both
partiesfor the remainder of
ground rent lease
Tenant
(Leaseholder)
PensionFund
(Freeholder)
12
Freeholder regains
vacant property at end
of lease and can resell
the term leasehold
Regular ground rent
payments either indexed to
RPI, LPIor HPI or fixed with
fixed periodic uplifts
Freeholder may revert to
mortgage provider if
tenant unable to honour
ground rent agreement
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6. Social Housing
6.a. Overview of Social Housing sector
Social housing refers to rental housing at low costs to people in need of housing. It is generally
provided by local councils and not-for-profit organisations such as housing associations (also known
as Registered Social Landlords or RSLs). Government grants and state support in the form of housing
allowance help RSLs to build new homes and subsidise rents charged to people with low income.
RSLs can also seek finance from other sources such as capital markets to supplement government
support.
In England, the RSLs are regulated by two agencies:
Homes and Communities Agency (HCA) which deals with funding and regeneration
work and
Tenant Services Authority (TSA) which is responsible for regulation of all social
housing providers.
These agencies were established in November 2008 and replaced the Housing Corporation.
RSLs are now the United Kingdom’s major providers of new social housing for rent. According to the
2008 Regulatory and Statistical Return Factsheet (published by TSA), there are about 1700 RSLs in
England; and 90% of the stock i.e. social rented units are owned by 18% of RSLs. The type of homes
owned by RSLs is detailed in the table below.
Table 7: Type of homes owned by RSLs
Stock type 2008 (‘000)
General needs 1,713.1
Supported housing 99.0
Housing for older people 316.6
Social leased 126.1
Non-social rented 40.8
Non-social leased 0.8
Total 2,296.4
Source: Regulatory and Statistical Return Factsheet 2008, Tenant Services Authority
RSLs are also involved in a wide range of activities such as contributing to regeneration activities,
provision of community centers, training facilities and other services in the community. Their regular
activities are financed by the rent and service charges payments made by, or on behalf of those living
in its properties. In this sense, RSLs are run as commercial entities. Any surplus, however, is used to
maintain existing homes and to help finance new ones.
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6.b. Key features of Social Housing
Affordable housing – The main aim of social housing is to provide affordable accommodation to
people on low incomes. Often, the tenants have no income and therefore receive housing benefit
which is paid directly to the RSL from the relevant government department.
Owned and managed by tightly regulated RSLs - RSLs are highly regulated and continuously
monitored by the newly formed TSA. They are also under the purview of the department of
Communities and Local Government (CLG).
Guideline rent level set by the government – Each year, the government publishes formal guideline
rents. Authorities are then free to make their own decisions on the actual rent level to set in their
particular circumstances. Many authorities set actual rents below the guideline figure. However, it is
a regulatory requirement that RSLs should keep their annual rent changes to no more than the set
guideline limit specified by the TSA.
The usual guideline limit is RPI + 0.5% with maximum increase of RPI + 0.5% plus £2 per week in any
one year. However, due to an expectation of negative RPI this year, CLG advised permiting a floor of -
2% on increase to rent levels in 2010-11 in a July 2009 consultation paper. (Source: Rent setting for
social housing tenancies)
Table 8: Main differences between private sector and social sector tenants
Indicator Private Renters Social Renters
Proportion of household
reference persons (HRP) < 35
yrs old
50% 20%
Size of sector (number of
households)
2.5 mm 4.0 mm
Mean weekly gross incomes
(HRP + partner)
£493 £247
Mean weekly rent £136 £72
Median length of time in
current residence
1.5 yrs 7.8 yrs
Proportion of tenants receiving
housing benefit
21% 62%
Proportion of HRPs working full
time
61% 22%
Source: Housing in England 2007-08 Report published in Sep-2009 by Communities and Local Government
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Building New Homes
6.c. Investing in Social Housing
The traditional private lenders, mainly banks, provide short term funding to the sector. However, as a
result of the credit crunch affecting the main lending banks to this sector and a significant reduction
in income from the sale of property that housing associations were expecting to make, the sector is
currently suffering from the effects of a shortage of private finance.
This has presented new opportunities for pension schemes which can provide long-term funding to
RSLs for social housing projects and in turn, earn attractive long-dated inflation linked interest
payments on their capital.
Figure 16: Investing in Social Housing
Source: Redington
RegisteredSocial
Landlords(RSLs)
Interest payments
Capital
Rent Payments
(linked to inflation)
Capital used to
fund and
maintain social
houses
Investor
Property let to lowincome
tenant (mostly on statesubsidy)
29. Asset Class Spring Collection 2010
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6.d. Key benefits of investing in Social Housing
Secured lending
The 2008 Global Accounts of Housing Associations imply that the sector is in sound financial
health, growing in a balanced way. Sector turnover exceeded £10 billion in 2008 and the
Gross Book Value of housing properties was £85.2 billion, up 10% on 2007. (Source: 2008
global accounts of housing associations by TSA)
Ultimately, the housing assets provide the fundamental security for investors, and are
typically valued higher than the value of the loan. In the event of poor performance, the RSLs
are required to provide more assets as security collateral or can be replaced as managers of
the secured assets.
LDI Hedging
The interest payments from social housing are long-dated and typically covered by the rental
income stream received by RSL’s.
o The rental stream is generally regarded as robust given the need for people for
housing and as demonstrated by the long waiting lists for social housing.
o Relative low levels of voids and bad debts at 2.1% and 1% respectively, suggest a
continued strong demand for the properties and good performance on rent
collection. (Source: 2008 global accounts of housing associations by TSA)
In addition, the sector generates strong RPI linked cash-flows and therefore can provide
inflation linked interest payments for debts taken.
Thus, cashflows from investment in social housing can help pension schemes offset the
duration mismatch that exists between assets and liabilities of a pension fund (due to their
long-dated nature) and reduce their inflation risk (due to their linkage to inflation).
UK government and regulatory support
The UK social housing sector benefits from strong government support, notably in the form
of government-funded housing benefits, which account for a large part of UK social housing
rental income and tight regulations by TSA.
In addition, the government sets levels of annual rent increases, allocates grants to the
sector, and sets qualitative targets for housing standards. It also has powers of intervention
and can appoint board members to poorly performing RSLs.
Socially Responsible Investment (SRI)
SRI refers to an investment strategy which seeks to adopt social/ethical goals in addition to
maximizing financial returns from investment.
Investing in Social Housing is one of the ways in which pension schemes can participate in
the growing Socially Responsible Investment market. SRIs can better enable both the
pension fund beneficiaries and the broader community to create wealth in the long-term.
Further, an amendment to the UK Pensions Act in 2000 requires trustees of occupational
pension schemes to disclose their policy on socially responsible investment in their
Statement of Investment Principles (SIP). While the Trustees still have the option to not take
30. Asset Class Spring Collection 2010
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social and ethical impacts of their investments into consideration, the fact that they are
required to disclose their policy has put pressure on schemes to consider SRIs.
The global credit crisis has resulted in soaring fiscal deficit and thus constraints on spending
for the UK government. This has further highlighted the need for SRIs. According to the
National Housing Federation, “the figures set out in the Pre-Budget Report imply spending
cuts to the housing budget of 17.98%, which if implemented over the next decade, would
slash the planned number of new affordable homes by 556,000 and add another 1.25 million
people to the waiting lists”.
6.e. Potential drawbacks
Liquidity Perspective
As compared to other asset classes, investments in social housing are relatively illiquid.
However, typically, these investments therefore include an attractive illiquidity premium.
6.f. Accessibility
Access to social housing investments is currently limited, with only segregated solutions available in
this space. However, as there is more interest in this sector, funds could offer more products and
solutions to investors.
6.g. Summary
This strategy offers long-dated inflation linked cashflows from a secured borrower with a quasi-
government guarantee. However, access to social housing is currently limited with only segregated
solutions available in this space.
Yield
Enhancement
Risk
Mitigation
Additional
Risks
Complexity Accessibility
Social Housing
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7. Infrastructure
7.a. What is Private Finance Initiative?
The PFI is a form of Public Private Partnership (PPP) where private firms provide some funding and
are contracted to build and manage public sector projects (such as hospitals and schools). These
contracts are typically long-dated, often 20 years or more. The cashflows generated from the project
are used to pay the financing costs to PFI investors and servicing costs to the PFI contractors. At the
end of the contract period, the final ownership of the asset depends on the terms of the original
contract and either remains with the private sector contractor, or is returned to the public sector.
The basic underlying theory is that the government has its new infrastructure investments funded,
and to some extent managed, by the more skilled private sector. It also helps the government not to
increase its public sector borrowing requirement in some cases and transfer the risks associated with
the construction, management and servicing of the project to the private partner. On the other side,
the private sector benefits from a long-term, usually inflation-linked revenue stream, backed by a
quasi-government guarantee.
PFIs were launched by the UK government in 1992. As of September 2009, there are over 500
operational PFI projects in England with a capital value in excess of £28 billion. PFI projects typically
use around 90% of debt finance and 10% equity funding1
. While the debt finance has usually been in
the form of bank loans, bond finance or long term leases, the equity is provided by contractors or
financial institutions.
Example: PFI Projects in the UK
Health: Queen Elizabeth
Hospital, London
Defence: Future Strategic
Tanker Aircraft
Transport: Skye Bridge,
Scotland
7.b. Investing in PFI
Typically, in a PFI transaction, the public authority will contract with one, single entity, usually a
private limited company formed solely for the purpose of the project, known as the “special purpose
vehicle” (SPV). The investors (e.g. pension schemes) interested in the project lend capital to the SPV
and receive typically long-dated, inflation-linked interest payments backed by the cashflows
generated from the project.
1
Source: Private Finance Projects – October 2009, National Audit Office
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PPP/PFI
Projects
Pension Fund
Financing
0
5000
10000
15000
20000
25000
30000
1 4 7 10 13 16 19 22 25
AnnualCashflow(£million)
Lease
Cashflow Structure for PPP/PFI
Inflation
Nominal
Figure 17: Investing in PFI
Source: Redington
7.c. Key benefits of investing in PFI
Secured Lending
Typically, the cashflows generated from the project are used to pay the financing costs to PFI
investors. These cashflows are usually based on long term, public sector backed contracts,
which substantially reduces risk compared to purely private sector contracts.
Risk is further reduced as the investors can take control of the project or the asset in the
event of its failure or poor performance.
LDI Hedging
The interest payments from PFIs are typically long-dated and offset the duration mismatch
that exists between assets and liabilities of a pension fund.
In addition, in most cases, these interest payments are also inflation linked.
Thus, these investments are particularly attractive to the pension scheme, providing a
stream of long-term fixed cashflows with sensitivity to inflation that matches the scheme
liabilities.
Figure 18: LDI hedging benefits of PFI investments
Source: Redington
33. Asset Class Spring Collection 2010
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Attractive margins
The current credit crisis has led the banks, the traditional source of funding for PFIs, to scale
back. With the banks still facing balance sheet constraints, the total capacity for PFI lending
has been substantially reduced.
At the same time, the demand for public sector projects has grown, driven by demographics
and rising expectation. Together with decrease in supply, this has led to an increase in the
cost of finance for PFI investments, and hence returns for investors.
According to a paper by the National Audit Office1
, the cost of private finance has increased
to between around 140-250 bps above the government’s cost of borrowing (25y rate) for
deals closed in 2009, compared to between 100 to 160 bps above the government’s cost of
borrowing before 2008.
Socially Responsible Investment (SRI)
SRI refers to an investment strategy which seeks to of adopt social/ethical goals in addition
to maximize financial returns from investment.
PFI investments are one of the ways in which pension schemes can participate in the
growing Socially Responsible Investment market. SRIs can better enable both the pension
fund beneficiaries and the broader community to create wealth in the long-term.
Further, an amendment to the UK Pensions Act in 2000 requires trustees of occupational
pension schemes to disclose their policy on socially responsible investment in their
Statement of Investment Principles (SIP). While the Trustees still have the option to not take
social and ethical impacts of their investments into consideration, the fact that they are
required to disclose their policies have put pressure on schemes to consider SRIs.
7.d. Potential drawbacks
Liquidity Perspective
As compared to other asset classes, investments in PFI are relatively illiquid. However,
typically, these investments therefore include an attractive illiquidity premium.
“Between now and 2020, somewhere between £400bn and £500bn needs to be raised,
for energy security, low carbon investment, broadband, transport and other
infrastructure projects. Since the government needs to reduce the deficit and pay down
debt, much of that money is not going to come out of government finances. The higher
capital ratios being demanded of banks which have traditionally been a big source of
infrastructure capital, means they will find it increasingly difficult to put long term
money in to project finance. The big prize would be to set aside part of the long-term
pension industry and get them to invest.”
- Lord Davies, Trade and Investment Minister at a conference on Infrastructure,
Jan-2010
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Credit Perspective
The funding for a PFI is linked to the project, in that the investor bears the risk of
completion, delays or any other losses on the project. This risk is reflected in the cost of the
funding for these projects.
While, in theory, the inherent risk of the project is carried by the PFI partner, in practice, the
government has never yet asked a PFI partner to accept the liability when things go wrong.
It is advisable however, to conduct a thorough credit and cash flow analysis of the project
before investing.
The investors can also take control of the project or the asset in the event of its failure.
According to statistics1
, most private finance projects are built close to the agreed time,
price and specification. In a sample collected by the National Audit Office, 69% of PFI
construction projects between 2003 and 2008 were delivered on time and 65% were
delivered at the contracted price. Out of those delivered late, 42% were delivered within 6
months of the agreed time, and under half experienced price increases.
Asset/Project Value
The investors are subject to pricing risk of the final project/asset as they constitute the
ultimate security against the investment. The pricing of projects is difficult and is usually
done through appraisal and on a less regular basis.
Further, changes in inflation, costs, cash flow and economic activity over the long term can
also result in the change in value of the asset.
Nonetheless, this is a secondary consideration because the driver behind the investment
should be the nature and maturity of the cashflows in the first place, and not the asset
value.
7.e. Accessibility
Access to PFI investments is only through a few investment funds/managers offering suitable
opportunities. However, it is available in both segregated and pooled format. As demand for these
investments grow, we expect funds to offer more products and solutions to investors.
7.f. Summary
Investors in PFIs get access to long-dated, usually inflation-linked revenue stream. PFIs are available
in both segregated and pooled formats and currently offer attractive returns due to the embedded
illiquidity premium.
Yield
Enhancement
Risk
Mitigation
Additional
Risks
Complexity Accessibility
Infrastructure
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8. Equity release mortgages (ERM)
8.a. Strategy Description
Many pensioners and annuitants face a dilemma between receiving a small cash income and having
much of their wealth tied-up in their homes (“asset rich, cash poor”). Equity Release Mortgages
(ERM) were designed to increase the cash supply available to borrowers by allowing them to borrow
against the value of their property without requiring them to immediately service the cost of the
debt taken on and hence increasing their immediate liquidity. The loan is secured against the
property and repayable only upon leaving the house (e.g. long term care) or death of the borrower.
One key characteristic of ERMs is the explicit cap set on the value of the loan (plus accrued interest)
by the value of the property which implies that if the market value of the property falls below that of
loan, the lender cannot claim any additional security. This is often referred to as a “no negative
equity guarantee”. ERM’s are also known as “reverse mortgages” (particularly in the USA) but are
somewhat different from so-called “reversion mortgages” in which the lender takes far more direct
property exposure, including a share of the possible upside.
ERMs are attractive to the borrower because:
- There are no regular payments to service or amortise (i.e. re-pay) the loan
- The borrower can live in the property until they die
- No additional security is required if the property falls in value
ERM lenders include banks and some sophisticated insurance companies and annuity providers
because the long-dated nature of the cashflows and the fact that most ERMs are based on fixed
annual rates makes them a good candidate to offset the interest rate and longevity risks in their
pension or annuity books of business.
8.b. Key benefits of investing in ERMs
ERMs provide a single long-dated payment comprised of both principal and the interest accrued until
the pensioner’s death or the ERM is prepaid (either in part or in full). The charts below show a typical
ERM payoff profile for one individual using a 60% Loan-to-Value (LTV) ratio on a property worth
£100,000 at origination. From the chart we observe the following properties:
(1) ERMs increase in value the longer the individual lives and therefore provide an offset to
longevity
(2) The blue and red lines show the rates at which the loan is accruing and the property is
appreciating respectively. Clearly, as long as the accrued loan remains below the value of the
property, the “no negative equity” guarantee is not breached and the lender recovers all the
loan principal and accrued interest. However, if the property appreciates at a substantially
lower rate or the loan accrues too rapidly, the property can be worth less than the loan and
the lender’s payoff is capped, shown by the blue line in years 18th
onwards in our example.
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Figure 19: ERM payoff profile: Property Value greater than Outstanding Loan
Source: Redington
Case Studies from Just Retirement, a specialist company that helps people who
are approaching retirement.
0
20
40
60
80
100
120
140
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Thousands
Years Since Origination
Accrued Loan Market Value of Property
• With the money that is now available to them under a
flexible equity release plan, Harry and Eunice have control
over their finances and are able to continue living in their
home, in an area where they are happy and comfortable.
• Jean has been widowed for 5 years and wanted the
freedom to enjoy her retirement. She has used the money
tied up in her home to enable her to do some of things she
wanted to in retirement such as join a gym and spend
more time on holiday with her daughter and
grandchildren
• The couple’s decision to take out an equity release plan
has allowed them to increased their available monthly
income by removing the repayments on their mortgage
and credit cards and they now have more money
available to use to enjoy their retirement to the full. Sylvia
is happy that the children should still stand to gain some
inheritance whilst seeing their parents enjoy their
retirement.
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ERMs are potentially desirable assets for long-term investors that offer a significant illiquidity
premium. This can be captured if the underlying population (i.e. borrowers), LTV, and interest rate
charge are set appropriately and the following risks managed effectively:
1) Property Risk – The loan amount and accrued interest is capped by the value of the property,
therefore if the property value falls below the initial LTV (and accrued interest) the full loan
will not be fully recovered. During the pricing stage, House Price Index (HPI) growth
assumptions are crucial as well as the LTV advanced.
2) Mortality Risk – This represents the main cash flow timing risks and the reason why ERMs
are good to offset longevity-linked liabilities. A well-constructed ERM portfolio can be
structured to broadly mirror the mortality experience of the liabilities and provide long-dated
cashflows as longevity increases. Again, because of the “no negative equity” guarantee the
lender is likely to limit the LTV. Note that ERMs are typically restricted to borrowers of c.55+
years of age and older with higher LTV’s generally available to older borrowers.
3) Morbidity and Pre-Payment Risk – These cash flow timing risks will reduce the expected loan
term. It has been observed that some borrowers are forced by age or sickness to sell their
property and move into long-term care homes which results in a prepayment of the ERM.
Equally, more competitive ERM fixed rates may result in re-mortgaging and therefore pre-
payment of the original ERM.
4) Interest Rate Risk – Typically ERMs have a fixed interest charge which offers the potential
to provide fixed cashflows with a duration and longevity profile that matches the liability
base. Additionally, because the interest on the loan is not paid in the same way as a
conventional mortgage, it “rolls up” and is compounded at the same fixed rate.
However, due consideration should always be given to the “no negative equity” guarantee,
the extent to which this may bite, and the scope for prepayment. Normally this is best
managed via the LTV amounts.
5) Other Risks – The lender is exposed to potential deterioration of the asset as a consequence
of poor maintenance and to the unknown time and cost between receiving the property and
selling it.
8.c. Potential drawbacks
Reputational Issues
In the 1980s reputational issues arose mainly due to perceptions around unfair interest
charges on pensioners and annuitants. The reason was that some ERMs had an interest
component comprised of a fixed amount regardless of the elapsed time until death. This
meant that, in some cases, when people died soon after taking the ERM, the total interest
charge looked disproportionate relative to the prevailing market rates. Later ERMs had
similar problems when setting up the interest component as a participation in any property
appreciation (‘forward house sale’). In this case, if the property appreciates substantially, the
interest received seemed elevated compared to prevailing mortgage rates at the time.
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To address these perceived inequalities, the industry came up with what is known as the
accrued interest model. Under the new approach the absolute loan amount and a fixed
annual interest rate are set up front with the interest accruing annually and the total value
of the loan and accrued interests capped by the market value of the property. The model is
widely accepted because the pensioner/annuitant pays a lower interest amount (in absolute
terms) for shorter borrowing periods (as compared to a fixed amount set upfront) and a
substantial appreciation in the property does not result in a windfall gain for the lender (as
compared to the fixed participation model).
This reputational risk or moral hazard is an important factor that should be appreciated by
any potential investor.
Sophisticated Investors
ERMs are complex in nature with a number of inter-dependent risks which requires expertise
across multiple disciplines. Typically this means they are most likely to appeal to more
sophisticated investors with liabilities that possess many of the same characteristics.
8.d. Accessibility
Very commonly ERMs portfolios are kept by the original lender unless a particular distressed scenario
materialises forcing them to sell and protect their capital position (e.g. Northern Rock and B&B).
Nonetheless, we believe some other portfolios will be available and more so if bank funding
pressures return. On the demand side, despite the risks, many ERM lenders like the headline rates of
interest and the forecast internal rates of return (IRRs) making them an attractive opportunity. One
approach to access the market would be where a mortgage or retail bank or life assure originates the
ERM, funds it via the pension scheme investor, and deducts a fee for the service.
8.e. Summary
ERMs are potentially desirable assets for long-term investors that offer a significant illiquidity
premium. They are only available in segregated format and are more suitable for sophisticated
investors.
Yield
Enhancement
Risk
Mitigation
Additional
Risks
Complexity Accessibility
Equity release mortgages
(ERM)
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9. Insurance linked securities (ILS)
9.a. Strategy Description
US and European insurers have been addressing some of their regulatory capital and reserving
requirements with capital market techniques since the 1990s. There are a wide array of risks that are
passed to investors via Catastrophe (CAT) bonds and other instruments including flood, hurricane,
earthquake, household, motor and mortality.
Here we look at just one example the case of the Regulation XXX which sets out the reserving
requirements in relation to extreme mortality movements for US insurers. Traditionally, insurers
used a reinsurance contract backed by a Letter of Credit (LOC) to comply with the regulation; this, in
turn, allowed them to free up capital in exchange of a premium. However, the onset of the credit
crunch saw a reduction in appetite from reinsurers to back this type of business and created an
opportunity for other institutional investors to enter the market.
In 1995 the National Association of Insurance Commissioners (NAIC) in the US adopted what is now
known as Regulation XXX. Traditionally US insurers had to hold statutory reserves to support their
level premium term life insurance business; Regulation XXX is one component of these reserves and
stipulates that insurers need to hold additional reserves against stressed mortality scenarios which,
according to many experts are too prudent. From the insurer’s perspective, Regulation XXX is
onerous because it reduces the capital that can be deployed into business generating activities.
Figure 20: Statutory Vs Economic Reserves and Excess Capital Requirement
Source: Redington
The chart above depicts a typical reserving profile for a 20 year term insurance. The red line refers to
the economic reserve and the green line refers to the statutory reserve required to be held by the
insurer under Regulation XXX – the difference between the two is the more conservative mortality
experience under the latter. Further, the insurer has to hold additional capital to reflect the
increased reserving requirements and therefore has an incentive to reduce the capital by addressing
the structure of the reserves. Some of the ways to deal with the issue include:
- Raising Additional Capital
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- Setting up a Reinsurance Contract backed by a Letter of Credit
- Structuring an ILS Note and issuing it to the capital markets
The first option is not particularly attractive to insurers whose objective is to avoid locking up capital
for long-term reserving requirements. The second option has been the preferred choice until now;
however it also poses challenges such as:
- Long dated nature of the reserve with Letters of Credit issued for a maximum of 5 years
- Large notional exposure and limited supply of such Letters
- Reinsurance premium can vary throughout the life of the block of business
- Reinsurers having to hold similar reserves under some jurisdictions and mirror regulations
therefore defeating the original purpose of the arrangement
It is important to emphasize here that the capacity in the Letter of Credit market was adversely
affected by the credit crunch which, in the absence of alternative solutions, pushed up insurer’s
capital requirements just when they were under strain by the performance of their asset portfolios.
The net effect was a significant widening in the spreads for alternative solutions (e.g. securitisation)
that would allow insurers to ease the pain.
9.b. Key benefits of investing in structured ILS notes
As a consequence of the above, securitisation has become the preferred approach with over $20
billion of liabilities covered to-date and another $150 billion in the pipeline for the next 10 years.
From a Pension Scheme perspective, these are attractive asset-backed securities providing a one-off
or regular premium in exchange for covering the risk of the actual mortality experience of a defined
block of business reaching a particular distressed scenario. Potential investors would be those
looking for uncorrelated returns with both fixed-income and equity investments.
The chart below depicts a simplified version of the cash flow exchange between market participants:
Figure 21: Investing in structured ILS notes
Source: Redington
There are, however, many types of securitisation arrangements both in terms of structure and
counterparty and institutional investors need to consider the efficiency of accessing the market
directly, through ILS funds or possibly via derivative contracts. Investors need to know that these
assets are often marketed as hedges against the actual longevity experience of pension schemes
liabilities, but they are at best a mitigating offset as the experience is of US lives versus the schemes
exposure to UK lives and this is a key distinction.
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9.c. Potential drawbacks
Catastrophic Mortality Events
Potential investors need to carefully review the types of extreme mortality events they
would like to cover. In particular, we favour taking on secular mortality risk and avoid
catastrophic events such as hurricane risk in Florida or earthquake risk in California. The
reason for this is that we do not want events that can trigger a significant payment to the US
insurer and are completely uncorrelated to the local mortality trends and experience.
9.d. Accessibility
ILS are complex instruments requiring specialist structuring. We believe that the easiest way to
access the market is via ILS funds or notes but this might mean some compromise around the exact
exposures that the investor can control. Alternatively, full control of risks underwritten can be
achieved by engaging an investment bank to setup the structure or to develop adequate over-the-
counter insurance derivatives in exchange for a fee.
9.e. Summary
ILSs may offer attractive premium to bear mortality risks and diversification benefits due to its low
correlation with other asset classes. However, they are complex instruments requiring specialist
structuring and more suitable for sophisticated investors.
Yield
Enhancement
Risk
Mitigation
Additional
Risks
Complexity Accessibility
Insurance linked securities
(ILS)
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10. Bibliography
Tenant Services Authority - Regulatory and Statistical Return Factsheet 2008, Tenant Services.
Communities and Local Government - Housing in England 2007-08 Report published in Sep-2009.
Tenant Services Authority - 2008 global accounts of housing associations.
National Audit Office - Paper on Private Finance Projects (for the Lords Economic Affairs Committee) –
October 2009.
House of Commons Library – Note on rent setting for social housing tenancies – Jan 2010.
Financial Services Authority (FSA) – Moneymadeclear guides – Facts about equity release schemes.
The Actuarial Profession – Report on Equity Release Mechanisms – Jan 2001.
G Hosty, G Craske, S Groves, C Murray and M Shah (March 2009) – Impact of the Credit Crunch on the
Equity Release Market.
Journal of Taxation and Regulation of Financial Institution (July/Aguust 2007) – Insurance
Securitizations: Coping With Excess Reserve Requirements under Regulation XXX.
Society of Actuaries (March 2002) – Report on Regulations XXX (Survey Subcommittee).
American Academy of Actuaries (Academy) - XXX Practise Note Work Group of the Committee on Life
Insurance Financial Reporting.
Alex Cowley (Lehman Brothers), J.David Cummins (The Wharton School) (Jan-2005) - Securitization
of Life Insurance Assets and Liabilities.
43. Asset Class Spring Collection 2010
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11. Contacts – Investment Consulting
Direct Line:+44 (0) 20 3326 7147
Telephone: +44 (0) 20 7250 3331
Redington
13-15 Mallow Street
London EC1Y 8RD
David Bennett
Director | Investment Consulting
david.bennett@redington.co.uk
www.redington.co.uk
Direct Line:+44 (0) 20 7250 3416
Telephone: +44 (0) 20 7250 3331
Redington
13-15 Mallow Street
London EC1Y 8RD
Robert Gardner
Founder & Co-CEO
robert.gardner@redington.co.uk
www.redington.co.uk
Direct Line:+44 (0) 20 7250 3415
Telephone: +44 (0) 20 7250 3331
Redington
13-15 Mallow Street
London EC1Y 8RD
Dawid Konotey-Ahulu
Founder & Co-CEO
dawid@redington.co.uk
www.redington.co.uk
Direct Line:+44 (0) 20 3326 7107
Telephone: +44 (0) 20 7250 3331
Redington
13-15 Mallow Street
London EC1Y 8RD
Mark Herne
Director | Investment Consulting
mark.herne@redington.co.uk
www.redington.co.uk
Direct Line:+44 (0) 20 3326 7129
Telephone: +44 (0) 20 7250 3331
Redington
13-15 Mallow Street
London EC1Y 8RD
Ian Maybury
Managing Director | Senior Actuary & Co-Head ALM &
Investment Strategy
ian.maybury@redington.co.uk
www.redington.co.uk
44. Asset Class Spring Collection 2010
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Direct Line:+44 (0) 20 3326 7137
Telephone: +44 (0) 20 7250 3331
Redington
13-15 Mallow Street
London EC1Y8RD
Jeremy Rosten
Director|Investment Consulting
jeremy.rosten@redington.co.uk
www.redington.co.uk
Direct Line:+44 (0) 20 3326 7111
Telephone: +44 (0) 20 7250 3331
Redington
13-15 Mallow Street
London EC1Y 8RD
Jeremy Lee FIA
Vice President | Investment Consulting
jeremy.lee@redington.co.uk
www.redington.co.uk
Direct Line:+44 (0) 20 3326 7134
Telephone: +44 (0) 20 7250 3331
Redington
13-15 Mallow Street
London EC1Y 8RD
Felicity Yeoh
Associate | Investment Consulting
felicity.yeoh@redington.co.uk
www.redington.co.uk
Direct Line:+44 (0) 20 3326 7115
Telephone: +44 (0) 20 7250 3331
Redington
13-15 Mallow Street
London EC1Y8RD
Rodrigo Leon-Morales ASA
Vice President | Investment Consulting
rodrigo.leon@redington.co.uk
www.redington.co.uk
Direct Line:+44 (0) 20 3326 7102
Telephone: +44 (0) 20 7250 3331
Redington
13-15 Mallow Street
London EC1Y8RD
David Thompson
Director | Investment Consulting
david.thompson@redington.co.uk
www.redington.co.uk
45. Asset Class Spring Collection 2010
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Disclaimer
In preparing this report we have relied upon data supplied by third parties. While reasonable care
has been taken to gauge the reliability of this data, this report therefore carries no guarantee of
accuracy or completeness and Redington Limited cannot be held accountable for the
misrepresentation of data by third parties involved. Redington is not responsible for the content of
external websites.
The investments described in this paper are all complex and require greater analysis before any
decision is made as to their suitability. Nothing in our observations or comments should be relied
upon without further qualification. The safety or otherwise of any investment is dependent upon the
precise structure and form of the asset in question.
This report is provided to the Recipients solely for their use, for the purpose indicated. This report is
based on data/information available to Redington Limited at the date of the report and takes no
account of subsequent developments after that date. It may not be modified or provided by the
Recipients to any other party without Redington Limited’s prior written permission. It may also not
be disclosed by the Recipients to any other party without Redington Limited’s prior written
permission except as may be required by law. In the absence of our express written agreement to
the contrary, Redington Limited accept no responsibility for any consequences arising from any third
party relying on this report or the opinions we have expressed. This report is not intended by
Redington Limited to form a basis of any decision by a third party to do or omit to do anything.
