Crack squads to take care of ALM business

The Solvency II regime, which is set to be completed in 2010, is the insurance industry’s equivalent of Basel II – and it has had much less time to acclimatise to the change.

Whether the banks feel sorry for insurance companies or not, they have certainly identified a lucrative opportunity: the asset and liability management (ALM) business is an increasingly important area for banks’ capital markets and derivative franchises.

Several banks have even set up dedicated teams to cover the insurance and pensions industry sectors, while others have focused their efforts on corporate pension schemes with a keen eye on the new accounting standards and how treatment of pension liabilities will impact on their balance sheets.

Team efforts

Barclays Capital has a 10-person team based in London that focuses on the UK market, which is split between the insurance and pensions industry. The group was set up five years ago to provide complete solutions for the two industries, and works closely with the bank’s derivatives and cash structuring and trading teams.

At SG CIB, a group of ALM and corporate pension fund specialists have sat within the bank’s financial engineering team for several years, while rival BNP Paribas (BNPP) established a five-strong global risk solutions group four years ago to service insurance and pension funds.

Deutsche Bank’s European insurance and pensions group, meanwhile, was brought together only last year; the 17-person team had previously been dispersed within the bank. In all cases the groups are made up of a mix of actuaries, ex-pensions industry staff, accountants and derivatives specialists. JPMorgan was probably the first to move in on this area, having established an asset and liability advisory group back in 1995. This is now run alongside an insurance and pension group that was put into place in early 2000.

It is not a business for every bank to break into, however – while the stakes are high, the costs of entry are equally demanding. Rashid Zuberi, managing director, in the European insurance and pensions group at Deutsche Bank in London, says: “It is a very complex [area]. At a staffing level you need actuarial, accounting, regulatory, risk management and derivatives professionals that all have a good understanding of the risks these groups face, the changing regulatory and reporting landscapes and how these will affect their businesses.”

That is not all. Serkan Bektas, head of UK pension ALM at Barclays Capital, points out that good relationships, a strong balance sheet and a top-notch credit rating are equally important. Denis Autier, head of the global risk solutions group at BNPP, meanwhile, says the convoluted process by which business is won is a slow and often laborious route that might put off all but the more dedicated.

Denis Autier, head of the global risk solutions group at BNP Paribas

“We have to deal with and consider everyone from the consultants, to the beneficiaries, the trustees, the companies themselves and the asset managers, so it is a complex relationship process to manage,” he says.

According to Mr Zuberi, the main catalyst behind the growth of ALM activity has been the change in regulation. “This has driven the insurance companies, corporates and pension funds to gain a better understanding of their risks, particularly the gaps between their assets and liabilities,” he says. “Having gone through the risk measurement process, and being able now to monitor and model those risks, they are also looking to hedge them far more exactly than they ever were before.”

Though the changes are coming in slowly, Mr Autier says momentum is now gathering pace, because it is increasingly clear that the old actuarial models on which the savings industry were based have become increasingly difficult to sustain. “These groups are thus moving to banking-type risk models in which assets and liabilities are more closely matched,” he says.

Longevity question

Matching assets to liabilities sounds a common sense idea, but it is not easy, particularly where pension funds are concerned. Their liabilities are dependent on such factors as longevity – a growing problem given the considerable increase in expected lifespan experienced in the past century.

Ines de Dinechin, head of corporate sales in Europe for fixed income and derivatives at SG CIB in Paris, says: “There are a lot of uncertainties within pension schemes and, in the new environment, pension scheme managers will have to make assumptions on longevity, asset performance risk, probability of employment tenures – all of which are very difficult to judge.”

Even when dealing with the less esoteric interest rate and inflation risks there are difficulties: pension fund’s risks are not based on the traditional five or 10-year horizon that corporates work to, nor are they limited to the most liquid and transparent area of the swap markets.

Long-dated derivatives growth

But Bob Thorne, head of UK insurance ALM at Barclays Capital, says that the long-dated derivatives market has now taken off and is growing faster than the equivalent cash markets. He believes it is now sufficiently liquid and transparent for these entities to trade in easily and with a good degree of comfort. If that is just as well, given the relative scarcity of long-dated assets, it means there is good business to be had for the banks that are providing the hedges.

But national and corporate treasuries have neither ignored the issue nor the growing appetite for longer-term securities and some are trying to move in on the derivatives specialists space: issuing inflation-linked securities is becoming fashionable in Europe and the US. The French Treasury recently issued its first-ever 50-year bond.

Welcome as such developments may be, bankers do not believe these initiatives will replace their own services any time soon. Mr Thorne argues that bonds are not an exact fit. For funds to use bonds as hedges, they would have to be happy with their cash flows, the interest rates they are locking into and the credit profile of the issuer – and that is not always the case.

“With a derivative they are able to decide on each separately – tailoring the hedge to match their exact requirements,” he says. “And though futures are efficient and liquid hedges over the maturity ranges they cover, pension and insurance clients need close matching hedges that work over long time horizons and are tuned to their specific requirements. This can be much more reliably achieved using over-the-counter derivatives.”

Mr Zuberi says every firm and fund’s liabilities are different. Even if the UK’s Debt Management Office (DMO) were to issue 50-year index-linked paper, he says, the assets would still not provide perfect offsets for their risks. “Corporate and other pensions funds typically don’t want to carry the basis risks on the mismatches, not least because the regulators will penalise them for that risk, making them reserve against it.”

That said, he admits that, were longer-term index-linked paper to become more abundant, “it would certainly be a positive development for the market as a whole”.

In trying to answer the longevity risk problem – in the UK there is at least £1000bn-worth of assets in defined benefit pension plans that is subject to longevity risk – the DMO recently toyed with the idea of mortality-linked funding. The idea has been shelved for the time being.

Private sector moves

Where the UK Treasury has so far feared to tread, the private sector has gone. Swiss Re faces the opposite risk to the pension funds – while they are worried about longer-than expected lifespans, the reinsurer is concerned about high mortality rates. In April it closed its second life catastrophe bond, raising $362m of mortality risk coverage through its so-called Vita Capital II programme.

Serkan Bektas: good relationships, a strong balance sheet and a top-notch credit rating are important

The structure of the bond is based on a combined mortality index, which applies predetermined weights to the annual general population mortality in the US, UK, Germany, Japan and Canada. The principal of the notes begins to be at risk if, during a period of any two consecutive years within the risk coverage period, the combined mortality index exceeds predefined percentages of the expected mortality level so that, in effect, Swiss Re could receive up to $362m in payments in the event of severe population mortality, thereby protecting itself against the payouts it would have to make.

BNPP has been trying to get a mortality-linked issue off the ground on behalf of the European Investment Bank since November, but the 550 issue has yet to find sufficient takers. Mr Autier is still hopeful, though. “Longevity is clearly one of the biggest risks facing the pension funds industry, so logically, a market in longevity should be a desirable development; but it is complex and like any other product, it will take some time to take off,” he says.

Whether that is a good thing for those pension funds left carrying the risk is another question. Insurance companies will – or should – be able to hedge out the risk by broadening their demographic and product portfolios, but the only recourse for corporate schemes will be to keep the risk on or to offload it directly with the reinsurance industry. These reinsurance deals are private, and the market for longevity risk thus notoriously opaque. But given that the deals are brokered by bankers, those with the expertise should at least stand to benefit – whether or not a capital-market based longevity solutions takes off.