asset class spring collection 2010

Asset Class Spring Collection 2010

www.redington.co.uk 1



Table of Contents

1. Executive Summary ......................................................................................................................... 5

2. Background ...................................................................................................................................... 6

2.a. Credit Crisis ............................................................................................................................................................. 6

2.b. Impact on Pension Schemes and Insurance Companies ....................................................................................... 6

2.c. Preparing for the end game ................................................................................................................................... 7

2.d. Looking ahead: Opportunities in 2010 .................................................................................................................. 9

2.e. Spring Collection 2010 – An Overview ................................................................................................................... 9

2.f. Constraints on the Governance Budget ............................................................................................................... 11

3. LDI 2.0 ............................................................................................................................................ 13

3.a. Strategy Description ............................................................................................................................................. 13

3.b. Relative value between inflation swaps and index-linked gilts .......................................................................... 13

3.c. Funding index-linked gilt purchases .................................................................................................................... 14

3.d. Important Considerations .................................................................................................................................... 17

3.e. Summary .............................................................................................................................................................. 17

4. Secured Leases .............................................................................................................................. 18


4.b. How does a lease work? ...................................................................................................................................... 18

4.c. Key benefits of investing in Secured Leases ........................................................................................................ 19

4.d. Potential drawbacks ............................................................................................................................................. 20

4.e. Accessibility .......................................................................................................................................................... 20

4.f. Summary .............................................................................................................................................................. 22

5. Ground Rents................................................................................................................................. 23

5.a. What are Ground Rents? ..................................................................................................................................... 23

5.b. Key benefits of investing in Ground Rents .......................................................................................................... 23

5.c. Potential drawbacks ............................................................................................................................................. 24

5.d. Accessibility .......................................................................................................................................................... 25

5.e. Summary .............................................................................................................................................................. 25

6. Social Housing ............................................................................................................................... 26

6.a. Overview of Social Housing sector ...................................................................................................................... 26

6.b. Key features of Social Housing ............................................................................................................................. 27

6.c. Investing in Social Housing................................................................................................................................... 28

6.d. Key benefits of investing in Social Housing ......................................................................................................... 29

6.e. Potential drawbacks ............................................................................................................................................. 30

6.f. Accessibility .......................................................................................................................................................... 30

6.g. Summary .............................................................................................................................................................. 30

7. Infrastructure ................................................................................................................................ 31

7.a. What is Private Finance Initiative? ...................................................................................................................... 31



7.b. Investing in PFI ..................................................................................................................................................... 31

7.c. Key benefits of investing in PFI ............................................................................................................................ 32

7.d. Potential drawbacks ............................................................................................................................................. 33

7.e. Accessibility .......................................................................................................................................................... 34

7.f. Summary .............................................................................................................................................................. 34

8. Equity release mortgages (ERM) .................................................................................................. 35


8.b. Key benefits of investing in ERMs ........................................................................................................................ 35


8.d. Accessibility .......................................................................................................................................................... 38

8.e. Summary .............................................................................................................................................................. 38

9. Insurance linked securities (ILS) ................................................................................................... 39


9.b. Key benefits of investing in structured ILS notes ................................................................................................ 40


9.d. Accessibility .......................................................................................................................................................... 41

9.e. Summary .............................................................................................................................................................. 41

10. Bibliography .............................................................................................................................. 42

11. Contacts – Investment Consulting ............................................................................................ 43



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.



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



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.



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

Change benefit format, e.g. ETVs

2. Hold risk on balance sheet

Matching assets (e.g. LDI, buy-in, longevity

swaps)

3. Transfer to external entity

Buyout



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.



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.



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,



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



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.



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.



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



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




LIBOR

TRS Fund Fund FTSE 100 futures contracts




Cash from selling FTSE100 physical stocks to buy index-linked gilts

Fund


FTSE 100 futures contracts*/TRS

Higher yield from Gilts (versus swaps)



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


LDI 2.0



4. Secured Leases


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.



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 HedgeLease payments are RPI linked and so the pension fund receives a constant stream of [annual] real cashflows to match inflation linked liabilities

Interest Rate HedgeLong dated nature of the lease may offset the duration mismatch that exists between a pension fund’s assets and liabilities

The majority of pension fund liabilities are index-linked

Long dated leases often contain RPI-linked or fixed indexation cashflows

By entering into a long-term lease, the pension fund receives long dated index-linked cash flows 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)



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



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



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


Secured Leases



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.



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



typically exchanged hands between residential property developers and specialized ground

rent acquirers.


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


Ground Rents

Leased Property

Mortgage Provider on Property

Contract between both parties for the remainder of

ground rent lease

Tenant(Leaseholder)

Pension Fund (Freeholder)

12

Freeholder regains vacant property at end of lease and can resell

the term leasehold

Regular ground rent payments either indexed to RPI, LPI or HPI or fixed with

fixed periodic uplifts

Freeholder may revert to mortgage provider if

tenant unable to honour ground rent agreement



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.



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



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

Registered Social Landlords (RSLs)

Interest payments

Capital

Rent Payments (linked to inflation)

Capital used to fund and

maintain social houses

Investor

Property let to low income tenant (mostly on state subsidy)



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



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


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


Social Housing



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



PPP/PFI Projects

Pension Fund

Financing

0

5000

10000

15000

20000

25000

30000

1 4 7 10 13 16 19 22 25

An

nu

al C

ash

flo

w (£

mill

ion

)

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



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


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



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


Infrastructure



8. Equity release mortgages (ERM)


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.



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

Tho

usa

nd

s

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.



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.



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


Equity release mortgages

(ERM)



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



- 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.



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


Insurance linked securities

(ILS)



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.



11. Contacts – Investment Consulting

Direct Line:+44 (0) 20 3326 7147

Telephone: +44 (0) 20 7250 3331Redington13-15 Mallow Street

London EC1Y 8RD

David BennettDirector | Investment Consulting

[email protected]

www.redington.co.uk

Direct Line:+44 (0) 20 7250 3416

Telephone: +44 (0) 20 7250 3331

Redington13-15 Mallow Street

London EC1Y 8RD

Robert GardnerFounder & Co-CEO

[email protected]

www.redington.co.uk

Direct Line:+44 (0) 20 7250 3415


London EC1Y 8RD

Dawid Konotey-AhuluFounder & Co-CEO

[email protected]

www.redington.co.uk

Direct Line:+44 (0) 20 3326 7107


London EC1Y 8RD

Mark HerneDirector | Investment Consulting

[email protected]

www.redington.co.uk

Direct Line:+44 (0) 20 3326 7129


London EC1Y 8RD

Ian MayburyManaging Director | Senior Actuary & Co-Head ALM &

Investment Strategy

[email protected]

www.redington.co.uk



Direct Line:+44 (0) 20 3326 7137

Telephone: +44 (0) 20 7250 3331


London EC1Y 8RD

Jeremy RostenDirector| Investment Consulting

[email protected]

www.redington.co.uk

Direct Line:+44 (0) 20 3326 7111


London EC1Y 8RD

Jeremy Lee FIA

Vice President | Investment Consulting

[email protected]

www.redington.co.uk

Direct Line:+44 (0) 20 3326 7134

Telephone: +44 (0) 20 7250 3331


London EC1Y 8RD

Felicity YeohAssociate | Investment Consulting

[email protected]

www.redington.co.uk

Direct Line:+44 (0) 20 3326 7115


London EC1Y 8RD

Rodrigo Leon-Morales ASA

Vice President | Investment Consulting

[email protected]

www.redington.co.uk

Direct Line:+44 (0) 20 3326 7102

Telephone: +44 (0) 20 7250 3331


London EC1Y 8RD

David ThompsonDirector | Investment Consulting

[email protected]

www.redington.co.uk



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.

asset class spring collection 2010

Economy & Finance

asset class spring collection

secured leases

strategy description

indexlinked gilts

funding index

executive summary

pension schemes

insurance companies