Buy-out preparation: 3 practical considerations

Nearing end-game you are likely to have adopted higher levels of cash-matching and income-generating assets within your portfolio. Your return requirements from growth assets will have reduced.

Whilst investment risk will have fallen, you still need to be aware of your portfolio’s liquidity risk

The less liquidity risk that your portfolio is taking, the easier it will be to sell scheme assets. It is a key component of making any preparatory repositioning easier.

Not all cash-matching assets are the same. Be wary of investment managers who tell you that their mixture of illiquid and complex income generating assets are “attractive to insurers”. Insurers’ preferred assets vary widely from firm to firm and change over time based on their portfolios’ positioning, flow of new business and regulation.

It’s true that corporate bonds help to minimise basis risk (i.e. the difference in how the value of your assets change, relative to insurers’ buy-out pricing, as market conditions change), but that’s more of an art than a science. It’s unlikely an insurer will want the exact corporate bonds that you own and would prefer a clean slate.

So, liquidity is important: that way your assets can more easily be repositioned once you’re in discussions with an insurer.

Liquidity provides you with the flexibility to act at short notice – and without significant transaction costs – to help capture opportunities to settle.

The ‘price-locked’ portfolio eliminates market risk from the settlement transaction

As you approach buy-out, Cardano will be able to survey market conditions, research insurer preferences and fine-tune your investment portfolio. Establishing and maintaining a ‘price-locked’ portfolio is achievable; this is the portfolio of assets that is aligned with minimal basis risk to a chosen insurer’s pricing calculations.

Cardano’s approach to LDI portfolio management means that we can easily reshape a portfolio towards a precise match to an insurer’s view of your liability profile. This reshaped portfolio eliminates market risk from the settlement transaction allowing time for fine details to be negotiated.

And, this is important as it minimises the risk that that markets move against you during negotiations – market movements could lead to large, unexpected costs or even jeopardise the feasibility of the transaction.

There is great value in doing this well. Establishing and maintaining the ‘price-locked’ portfolio accurately requires segregated LDI portfolio management; your portfolio manager will be able to  select individual gilts, sell or in specie transfer at a precise time of day (coordinated with the insurer) and transfer cash promptly all with an eye towards reducing or even eliminating transaction costs and any out of market risk prior to the transfer.

Careful consideration of your credit assets (which contribute towards your overall hedged position due to their interest rate sensitivity) is important too. Having your credit assets managed holistically alongside your LDI assets with one investment manager, within one matching portfolio, helps ensure that the reshaping of the overall matching portfolio towards a price-lock portfolio can be done with ease without the scheme bearing any out of market risk in the interim (which often can be difficult to avoid when multiple parties are involved).

When transacting in the bulk purchase annuity market for your buy-out you will see a trade-off between price and the level of protection that you receive. Completing a buy-out settlement will remove the remaining investment risks that your scheme runs but you will assume insurer counterparty risk.

No two insurers offer the same risk profile to policyholders

Trustees will need to consider these trade-offs. Cheapest doesn’t mean most secure. You will need to consider which insurer will best serve your members before transferring liabilities.

You should be aware that the sustainability credentials of insurers differ too. We assess the sustainability of insurers’ investments and business profiles, making sure that you select one that is aligned with your own goals and objectives.

Although insurers operate under the same regulatory regime, the regime offers a great level of flexibility as to how they run their business. No two insurers offer the same risk profile to policyholders. Which means that no two insurers will equally offer the same transaction price, sustainability credentials, counterparty default risk and service levels to your members.

Cardano Advisory has in depth knowledge of the insurance regulatory regime and maintains regular dialogue with all insurers in the bulk purchase annuity market. We can directly compare insurers across a number of different risk factors and identify any material areas of concern prior to transacting.