Buy-side Awards 2016
Rothesay Life’s agreement to buy Aegon’s UK annuity book in April was a turning point for the insurer that came at a turning point for the market.
Amid uncertainty about the effect of Solvency II on annuity firms and buy-ins, Rothesay closed the biggest insurer-to-insurer buy-in so far – a deal that boosted its book by one-third – and the first such deal under the new capital regime.
The transaction, which is structured as reinsurance to be followed by a Part VII transfer, makes Rothesay the fourth-largest annuity provider in the UK, adding 180,000 customers and providing the impetus for the insurer to boost its team from 100 to 150 in the space of 12 months. It called for the first discussions with regulators about recalculating Solvency II transitional measures, a topic of critical importance for similar deals in future.
“This moves us up the scale dramatically,” says Sammy Cooper-Smith, co-head of business development at Rothesay in London. “With that, you get more people knocking on your door with ideas because they realise the scale of the assets available is bigger.”
The deal also moves privately owned Rothesay closer to a possible initial public offering (IPO), says Cooper-Smith: “One of the things we have said is we need to be IPO-ready. To get to IPO, you need scale – and that scale comes with the amount of capital the back book throws off. The Aegon deal is a big step towards what is required.”
Aegon UK’s chief financial officer, Stephen McGee, says he planned to split the trade into a number of tranches of roughly equal size when the firm first approached buyers in September 2015: “Annuities are a capital-intensive business under Solvency II. We knew there was a competitive market, and saw an opportunity to de-risk.”
Rothesay would have taken on the full £9 billion ($11.2 billion) portfolio, he says. But Aegon wanted more than one counterparty for such a big deal. During the period from the buy-in to a Part VII transfer of liabilities – planned in 2017 – Rothesay reinsures the risk, but the liabilities remain on Aegon’s books.
Rothesay, therefore, took on £6 billion, while Legal & General subsequently reinsured the remaining £3 billion.
Rothesay was “crystal clear about what it could and couldn’t do” – the most “credible” of participants in an open tender process, McGee says.
A combination of capital requirements under Solvency II and low rates is forcing insurers to ask themselves whether annuities is a business they want to be in, with insurers such as Standard Life, LV= and Prudential scaling back their offerings.
“An annuity business sitting within a multi-line insurer can look like a drain on the rest of their business,” says Cooper-Smith. “The process and effort of managing an annuity portfolio with the matching adjustment [MA] means you may be better off finding a new home for even large back books if they are a small proportion of the balance sheet – freeing up capital and putting that capital to work in your core business.”
For specialists such as Rothesay, though, unwanted back books have particular appeal, he says: “Because it is old business, it works quite neatly under Solvency II because transitional relief can transfer from the current owner to the new owner, whereas new pensions business does not come with any transitional benefits any more.”
Our trading system allows us to perform a rapid, full recalculation of the value of all assets and liabilities under both the IFRS and Solvency II regimes. This, coupled with the ability to carefully customise risk reports to the situation at hand, means even in volatile conditions we understand how our exposures evolve
David Land, Rothesay Life
That was uncertain to be true, however, when negotiating the deal. Rothesay needed clarification from the UK’s Prudential Regulation Authority (PRA) that the transitional would apply, but had to agree exclusivity and terms with Aegon before the PRA would take the question to its policy committee.
The intricacies of the directive called for some further structuring of the deal, too.
“In the event of recapture of the business, the ceding insurer in a transaction such as this will need to apply the MA to the recaptured annuity book. One of the terms we offer our clients is that the collateral we post is capable of becoming a matching portfolio,” says Cooper-Smith.
Some of the negotiations were difficult, but we always knew why they were doing what they were doing,” says Aegon’s McGee. “It felt like they had thought everything through and showed real expertise on the risks of an insurance-to-insurance transfer under Solvency II.”
The trade improved Aegon’s solvency coverage ratio from 140% to 155%. Rothesay’s solvency coverage ratio was 162% at the end of the June 2016, slightly higher than its year-end 2015 number.
In Rothesay’s case, those two numbers are from either side of the UK’s June referendum on leaving the European Union, which caused a precipitous fall in rates and weakened the solvency position of many insurers.
After the vote to leave the EU, the PRA signalled to insurers its willingness to allow transitional recalculations. To its advantage, by that time, Rothesay had already performed such a recalculation in the context of the buy-in.
“Effectively we’d been the first to do it,” says Graham Butcher, chief underwriting officer. “It meant we had an idea how the regulator was thinking. It also meant we understood the consequences for risk and in particular what hedges are required to neutralise the Solvency II surplus to rate moves. This is important because just recalculating the transitional is nothing like enough to restore solvency in a big rates fall if you are only hedging economic risk. So there was still work to do.”
Rothesay chooses to not fully hedge the Solvency II risk margin, but instead to dynamically balance the hedging of its Solvency II surplus with its International Financial Reporting Standards (IFRS) profit and loss statement (P&L). The system worked well during the referendum aftermath, says chief investment officer David Land. The firm tracks its location on a solvency and interest rate grid and adjusts its hedging positions accordingly, using a combination of swaptions, swaps and bonds.
“Our trading system allows us to perform a rapid, full recalculation of the value of all assets and liabilities under both the IFRS and Solvency II regimes. This, coupled with the ability to carefully customise risk reports to the situation at hand, means even in volatile conditions we understand how our exposures evolve,” he says.
“As results came in during the early hours of the morning after the vote, we knew what we had to do and it was actually easier than you might have thought. Our trading team were busy managing our positions with desks across Asia.”
The firm has also had to re-examine its approach to investment, where Solvency II gives it more time to select assets. There is no flat capital requirement against a portfolio from day one, says Land, so a portfolio can be held in gilts while suitable investments are selected. But the new regime, and the MA in particular, means capital optimisation is a much bigger part of choosing the best assets to buy.
The need to match cashflows to maximise MA benefit means assets with the highest yield might not be the best buys, so Rothesay relies on tools it has developed in its trading system that allow the insurer to check the MA impact of adding any given security to the portfolio.
Rothesay is able to do the same with new liability transactions. “A month prior to the Aegon transaction, we were running a shadow portfolio, so we knew if we owned Aegon that day what our P&L and our risks would look like,” Butcher says.