Corporate risk manager of the year: BMW

Rising life expectancy is a wonderful testament to giant leaps in medical science and the result of healthier lifestyles, but it’s causing havoc with company pension schemes. According to a report by consultancy firm Lane Clark & Peacock last May, FTSE 100 companies have, on average, added nearly a whole year for each of the past three years to the life expectancy estimates within their pension scheme accounting disclosures. Throw in low government bond yields and volatile equity prices, and it amounts to a toxic mix that has caused some sizeable pension deficits – in some instances, exceeding the market capitalisation of the company.

As a result, corporate pension funds are more determined than ever to de-risk their liabilities. For the UK pension scheme of German car maker BMW, the answer was to turn to the longevity market with the largest transaction to date.

BMW’s takeover of UK car manufacturer Rover in 1994 left it responsible for the Rover group pension scheme – even once the Rover brand itself had been sold on to another owner in 2000. In total, the UK pension plan has 90,000 members, including both Rover legacy workers and post-takeover BMW employees.

By the end of 2009, its UK defined-benefit obligations had hit €5.58 billion, up from €4.4 billion at the start of the year. That translated into a deficit of €1.256 billion at the end of 2009 versus €344 million the year before. As a result, hedging this risk became a high priority for BMW.

“We have been very active in hedging all the other risks involved in the scheme. We started very early on with a liability-driven investment process, and now our assets are linked to the liability structure in cashflow terms as far as possible,” says Richard Matschke, head of pension fund asset management at BMW in Munich.

Having looked to hedge interest rate and inflation risk, the firm felt the time was right at the start of 2010 to tackle the scheme’s longevity exposure. Several options are open to pension schemes: a full buyout (where all assets and liabilities are transferred to an insurance company) or a buy-in (where an insurance policy is purchased to cover current pensioners only). However, costs for these solutions had increased early last year, due to funding shortfalls at pension schemes and increasing capital requirements for insurance firms. A buy-in or buy-out would also have required the transfer of assets to the insurance company – something some pension funds are reluctant to do amid heightened awareness of counterparty risk.

The alternative was the longevity market, which had developed quickly over the previous six months, and would allow the pension scheme to retain legal ownership of assets. BMW decided on this route. “The market for longevity risk insurance has existed for some time, but I believe it has developed really fast in the past couple of years,” says Matschke.

There has been a string of deals over the past 18 months, with London-based engineering support services organisation Babcock International the first to move in May 2009 with a £500 million (discounted using AA rated bond yields, or £300 million if discounted using Libor) longevity swap on the Davenport Royal Dockyard pension scheme. Babcock was also involved in two other trades: a £350 million swap for the Rosyth Royal Dockyard in September 2009; and a £300 million trade for Babcock International Group in December of that year.

Other trades include a £1.9 billion swap between two pension schemes of RSA Insurance Group and Goldman Sachs and its insurance subsidiary Rothesay Life in July 2009, and a £750 million contract between the Royal County of Berkshire pension scheme and Swiss Re in December 2009.

The size of the BMW transaction was to dwarf all these, however, covering a whopping £3 billion in liabilities related to around 60,000 pensioners. Despite the size, Matschke says it was important to take action to mitigate this risk. “Doing nothing to hedge it would be a very high risk to run,” he says.

The number of counterparties that could manage a transaction of this size was relatively limited, Matschke adds. “It was very important for us and our trustees to look at what the counterparty looked like. We shopped around in the market and took advice from our UK consultants on the options available, but a deal of this size and with this number of people is very hard work.”

Ultimately, the group decided upon Deutsche Bank, with the deal closing in February 2010. Importantly, the hedge was structured as an insurance contract via Deutsche’s insurance subsidiary, Abbey Life. This meant the contract was covered under the Financial Services Compensation Scheme (FSCS), a UK compensation fund of last resort for customers of authorised financial services firms, so if Abbey Life ever fails to meet its obligations, the FSCS would potentially cover 90% of the claim.

A collateral agreement was also put in place to cover the remaining 10% of the exposure, says Matschke. Abbey Life calculates the margin requirement every quarter, and collateral comprising government bonds, government-guaranteed debt, high-quality corporate bonds or cash is posted with the custodian, JP Morgan.

“In this case, we made a collateral arrangement. We always hold collateral from the insurance provider of the value recognised at that date for our longevity exposure. The collateral is updated on a quarterly basis, so we are always covered 100%,” says Matschke.

The deal was notable for other reasons – there is no finite maturity, meaning the contract runs until the last premium has been paid or the last pensions payment has been made. The transaction also covered second lives – spouses and other dependents – rather than just the primary members.

Much of the analysis was conducted by London-based insurance firm Paternoster, which is partly owned by Deutsche Bank. Using a proprietary pension database and longevity modelling techniques, along with data from BMW, the firm was able to assess the various risks.

“The model is based on our own actuarial assumptions and our experience of our own pensioners. So far, our real-life experience on the scheme corresponds very well with the assumptions we have made,” says Matschke.

Much of the risk was sold on to several reinsurance companies, including Hannover Re, Pacific Life Re and Partner Re. However, Deutsche Bank retained a certain amount, most of which was sold on to a small number of capital market investors via structured notes.

Despite the size of the BMW trade, future deals along the same lines are a possibility. While the February 2010 transaction covered 60,000 pensioners, there are 30,000 more current or former Rover employees in the UK who have not yet started to draw pensions because they are still employed at Rover (active members) or elsewhere (deferred members). “If you look ahead for the next decade, this will still be an issue,” Matschke says. “We have already covered two-thirds of members, but there are still 30,000 members not covered. I’m not sure how we will deal with the risk arising from the remaining members. I wouldn’t exclude future deals, but it will be based on the market and what price we can get for insurance.”