STRAPLINE

(From left) Tim Bunch, Nick Eyre and John Reizenstein, Co-Operative Group

22 Life & Pensions

 PRACTITIONER PROFILE

How does the Co-operative Group

tackle the complexities of its life and
pensions liabilities while staying true
to the ethics enshrined in its
founding principles?

ethical
The
BY NICHOLAS DUNBAR

investor
WITH ITS NORTH of England working class Victorian roots, the
Manchester-based Co-operative Group is something of a national
institution in the UK. Famously run according to ethical and fairness
principles, the Co-op is a retailer owned by its customers, who for a £1
fee enjoy voting rights and an annual dividend as a reward for trading
with the company. The banking and insurance products sold by the
group’s Co-operative Financial Services (CFS) subsidiary brought in
operating profit of £85 million in 2005. With the group itself report-
ing a profit of just £41 million in 2004 on retail turnover of £1.8
billion, the high-margin CFS business is a key asset for the Co-op.
However, for the Co-op to take full advantage of this asset, it faces
a challenge. The company has complex life and pensions liabilities,
both within CFS and at group level, which require risk and capital
management; all within the constraint of the Co-op’s unique owner-
ship structure and social focus.
A driving figure in this risk and capital management process is former
investment banker John Reizenstein, who was appointed chief finan-
cial officer of CFS early in 2006. Having been involved in the 2002
creation of CFS via the merger of stand-alone units Co-operative
Insurance Society (CIS) and the Co-operative Bank, Reizenstein was
faced with two extremes of capital fungibility.
On one side is the Co-op Bank, incorporated as a limited company
for regulatory reasons. The bank’s £10 billion of assets are mostly
retail mortgages and unsecured loans, with the remainder being loans
to small and medium-sized enterprises in the Co-op’s heartland.
“There’s quite a focus on the public sector and the voluntary sector, all
of which fit with the ethical branding, which is a very strong mark of
the Co-op Bank,” Reizenstein explains.
The bank provides a ready stream of cash to the parent group. “We
can take dividends out of the bank and the bank pays a regular dividend

www.life-pensions.com April 2006 23

PRACTITIONER PROFILE
 PRACTITIONER PROFILE

of about £20 million a year to us, CFS, then up to group,” Reizenstein our options were still well out of the money, but we could see that
says. CIS, on the other hand, is a Swedish-style hybrid mutual: an £18 potentially there was a risk there. We went into the market in 2001 and
billion with-profits insurer run on mutual lines for policyholders, bought £3.2 billion of swaptions to hedge all the liabilities that we
from which the group cannot extract a dividend. Faced with a classic reasonably could at that time, given that they were very long dated and
capital trap, Reizenstein has engaged on a thorough rationalisation of there wasn’t the capacity for such long-dated stuff. So we actually only
the CIS business. did the first 20–25 years’ worth.” Concerned about such limited
capacity, CIS did not return to the derivatives markets until 2004 and
Hedging the risks 2005 when it hedged its longer-dated and residual guarantee exposure
The first priority, which began to be addressed even before the crea- with £3.6 billion of additional swaptions.
tion of CFS, was risk management. This was a challenge because CIS Meanwhile, aside from hedging transactions, CIS improved the
has a liability profile particularly heavy in guarantees, as CFS head of matching of its assets to liabilities. The fund adopted the popular
actuarial services Tim Bunch explains. “Out of total liabilities of just hypothecation approach in order to reconcile guarantee commitments
over £15.5 billion, about £14.5 billion is with-profits and just over a with policyholder reasonable expectations, as Bunch explains. “Instead
billion is non-profit unit-linked, of which half is annuities in payment. of regarding all our assets as spread across all our liabilities, we’ve very
Just over £12 billion of the £14.5 billion is traditional with-profits much divided them up, which has reduced our capital requirements.”
with guarantees.” The cost of the guarantees is clear from the He adds: “The overall effect is that the asset shares of the with-prof-
Financial Services Authority’s realistic reporting requirements which its policies have a particular investment profile, which includes equities,
add £1.2 billion to liabilities via the with-profits insurance capital property, corporate bonds and gilts, depending on whether it’s tradi-
component (WPICC). tional with-profits with guarantees or
“We pick up a big additional cost under accumulating with-profits without guaran-
realistic solvency,” Bunch says. “There are
two types of guarantee: guaranteed annuity
“Instead of regarding all our tees. The ones with guarantees have got
lower equity-backing ratios.”
options (GAOs) on our personal pensions assets as spread across all For policyholders without guarantees this
business and the traditional sum-assured and our liabilities, we’ve very translates to an equity backing ratio of 65%
reversionary bonus guarantees on all of our much divided them up, in the asset share portion of the CIS fund.
traditional with-profits business.” “We’re looking to reward policyholders with
GAOs are notorious for having brought the
which has reduced our good, real assets,” explains Reizenstein.
UK life industry almost to its knees. Most capital requirements” Meanwhile, the guarantee reserve or WPICC
large UK with-profits companies stopped Tim Bunch, Co-op is funded partly using guarantee charges,
selling the products by 1988, only to fall and the rest is allocated to gilts and £1 bil-
victim to solvency issues in the late 1990s as lion of equity put options.
interest rates fell, triggering big swaption hedging programmes. Bunch has rejected the use of dynamic hedging advocated by
Remarkably, CIS carried on selling GAOs until 1999, but as Bunch Edinburgh-based consultants Barrie & Hibbert. “It gives you delta
points out, its products were different to the “fairly mature and shorter protection but it doesn’t give you vega protection, because the guaran-
dated” products sitting on competitors’ balance sheets. tee cost in the balance sheet is dependent on implied volatility
“We did the reverse in the sense that prior to 1988 when personal assumptions,” Bunch says. “When the market’s moving rapidly you
pensions came in, CIS did deferred annuities, so we had annuity expo- can’t rebalance sufficiently quickly. So we came to the conclusion that,
sure without the optionality bit,” he says. “Then we introduced our although it’s a nice idea, it makes more sense to just buy complete
GAOs from 1988 until 1999, so ours is a less mature book. We stopped protection through equity options, which is what we’ve done.”
selling policies with GAOs in 1999.” Being a late entrant to the GAO While CFS has had several years’ experience in controlling market risk,
market gave CIS an unexpected risk management advantage, explains the introduction of the Financial Services Authority’s Individual Capital
Bunch. “Because we were selling policies during that period rather Assessment (ICA) exposed an equally significant risk for the CIS fund:
than during the ‘80s, the effective interest rates were much lower than mortality. “More than half of the with-profits business is pensions, so
the rest of the market. The underlying basis was to have a 3.5% guar- more than half of it is exposed to annuity mortality,” says Bunch. “Some
anteed interest rate and a mortality that was relevant to the period. of that is actually deferred annuity business and some of it is personal
Mortalities have got lighter over time: 3.5% has moved up to about pensions business, which is written as cash at retirement date but with a
5.5%. That’s the underlying investment return you need.” GAO on top. When we do our ICA calculations, longevity is a big risk.”
However, the crisis suffered by other firms alerted CIS to the dangers As with market risk, CFS is exploiting hedging opportunities, recently
lurking on its balance sheet. “Although other people had a problem, entering into a £1 billion reinsurance treaty with Bermuda-based XL Re.

www.life-pensions.com April 2006 25

PRACTITIONER PROFILE
According to Reizenstein: “That’s effectively
taken out mortality risk on three-quarters of
our in-payment annuities and we’re looking to
do another one of those with someone at the
moment, and then there’ll be others. Of course,
the blossoming of all these new vehicles that
want to get into the bulk purchase annuity
business potentially means there are more
buyers of this stuff.”
Cost-cutting
Having hedged risks and matched the assets to
liabilities, Reizenstein has begun rationalising
the CIS staffi ng structure, which is dominated
by a large in-house sales network. “Since mid-
2004 we’ve had a huge change programme at
CIS, as a result of which about a quarter of the
workforce have left. For example, we had 100
local offices around the country that have been
closed and we basically centralised all the
admin and processing they were doing.”
“We have brought in new ways of managing
the sales force – the fi nancial advisors – to
ensure that we keep standards up in all
respects: compliance standards, quality of
sales, customer service and so on. That has
reduced the number of fi nancial advisors.
We’ve made a lot of change in the back offices
here to make them more efficient and as a
result of which we’ve taken out a very large
level of costs across both businesses. Almost
every customer-related process has changed
and been modernised in the last 18 months.”
The cost savings from this operation, which
flow directly to CIS policyholders, are essen-
tial in order to make up for lapses in policies.
With the legacy guarantee-rich business
effectively a “closed book” within CIS
according to Bunch, “persistency is obvi-
ously very important because we need to
keep business in force in order to have a
base over which to spread the costs.” The
reduction in staff numbers has meant that
the single-policy expense ratio has not
been forced to rise to cover lapse rates,
says Reizenstein.
Meanwhile, the remaining sales force is
focusing on cross-selling between dif-
ferent parts of CFS. “We like to develop
new things to do with the customers, not
just replace the old ones,” says Reizenstein.
“20% of our motor policyholders have a life
policy, which is quite a good cross-sale within
CIS. However, only a tiny percentage of
them have any bank products and the same
would be true the other way round. There is
a lot of potential to convert those customers
to being integrated customers, which has not
yet been exploited.”
If successful, such cross-selling will unlock
the CIS capital trap. At the beginning of
2006, CFS hived off the general insurance
part of CIS into a separate new unit – CIS
General Insurance – which will release some
of the formerly locked-up capital. “When the
GI business is making more money than it
has, we’ll be taking dividends from there,”
says Reizenstein.
Having mastered the CFS risk and capital
conundrum, Reizenstein has set his sights on
improving the way the Co-op Group rewards
its members for being Co-op customers. “The
bulk of the ownership and the voting strength
in the Co-op is individual members, some of
whom but not enough are our customers.
We’re trying to converge all this.”
“Within a couple of years, if you do a mort-
gage with the Co-op Bank and a general
insurance policy and maybe you pre-book your
funeral in advance and you go shopping in the
stores and buy your holiday with Co-op, all
these things will be added up into points.
Points mean pounds and you collect something
as well as having a vote obviously,” he adds.
Meanwhile, the Co-op Group itself is about
to apply some of Reizenstein’s thinking to its
own thorny risk management problem: what
to do with the group’s £4.7 billion of defi ned
benefit (DB) pension liabilities. The FRS17
liabilities – spread across three legacy fi nal
salary schemes for the Group, the Co-op
Bank and CIS – encompass some 80,000
members, and by the end of 2003, declining
assets forced the group to examine the issue.
Company secretary Nick Eyre, who chaired
the working party responsible, describes what
happened. “We very rapidly came to the con-
clusion that the status quo wasn’t sustainable:
PRACTITIONER PROFILE
firstly, in terms of increased longevity, but
also increased regulatory cost, increased tax
cost, increased volatility and underlying
changes in accounting treatment – the fact
that interest rates were going down.”
Fair play
According to Eyre, the Co-op ethic of fairness
meant that the company was loath to follow the
route of many large UK sponsors and close its
schemes. “We didn’t feel it was right to close a
scheme to new joiners and keep open a final
salary scheme to existing employees. That was
really for two reasons: one was that the financial
impact that you’re looking to have takes a hell of
a long time to have any effect even if you’ve got
10% staff turnover. Also, we felt it was divisive
amongst the workforce.”
Eyre is critical of approaches taken by other
UK companies. “An awful lot of companies
that have gone to defined contribution
schemes use the opportunity to massively
reduce their contribution. By sleight of hand
they’ve pretended this is all about risk and
then proceeded to put less money into the
pension scheme. We didn’t like that so we
decided we wanted to keep the DB and have a
universal scheme.”
This decision, says Eyre, was in keeping with
the Co-op’s progressive, caring image. “We
felt that as a sophisticated multi-billion pound
employer, we ought to be better able to
manage the mortality and investment risk
than the employees.” But the decision would
come at a price. “If we were going to do that
we needed to take some fairly prudent steps to
make that more effectively manageable.”
28 Life & Pensions
Scheme Active Deferred
Co-op Group 12,000 22,500
Co-op Bank 4,000 3,500
CIS 5,500 12,900
“We told the unions that this was a total pack-
age. We were prepared to offer a generous DB
scheme provided they accepted; and we said
this to the trustees too – that all three schemes
would merge. We needed to concentrate all of
this so that a small number of people could
keep control of these risks.”
The next decision faced by Eyre and his work-
ing party was the type of benefit that the
merged scheme would offer. Reducing pension
costs would be a key constraint. “The employer
contribution has differed between the three
schemes, but in the Group Scheme, the total
cost was 27% with cost to the employer of 21%.
“We didn’t feel it was right
to close a scheme to new
joiners and keep open a
final salary scheme to
existing employees”
Nick Eyre, Co-op
If we’re to maintain a defined benefit scheme,
we cannot see how we can sustain more than
16%, so that is what it will cost us going for-
ward if we merge the schemes.”
One cost-cutting possibility was to follow
the example of Barclays Bank and switch to a
cash balance hybrid scheme, but the Co-op
rejected this idea as too risky for scheme
members. “Effectively you take out the mor-
tality risk and investment risk during the
period they’re an employee, but then of course
you dump them with the annuity risk at
retirement,” says Eyre.
Again, the solution eventually chosen was in
keeping with the Co-op’s principles. “We
decided on career average, which is effectively
a progressive rather than a regressive pension
scheme,” Eyre explains. “It takes out the
Retired Assets FRS17 funding
26,000 £3.268bn 108%
1,000 £405m 82%
9,500 £1.927bn 102%
investment risk and the mortality risk for the
member of the scheme, but it doesn’t involve
the lower paid effectively cross-subsidising
the higher paid. So the people who lose are
the people like me who are higher paid.”
This argument appears to have gone down
well with the unions and trustees who, accord-
ing to Eyre, have acquiesced to the deal which
takes effect in April. Under the terms of the
deal, the company will contribute about £60
million per year to the merged scheme.
Having negotiated the new scheme struc-
ture, Eyre is now examining the investment
philosophy, but is unsure whether to follow
the de-risking strategies adopted by some defi-
cit-ridden UK corporate schemes. “In one way
we’re less vulnerable than WHSmith because
we haven’t got their funding position to start
with. In another way we’re much more vulner-
able because we have the whole financial
services business of CIS. There needs to be a
holistic view, taking account of CIS.”
Eyre is also sceptical about the recommenda-
tions of external advisors. “It is argued that the
best asset-liability matching is 20% equities,
80% bonds. I can’t quite intellectualise why,
but that feels wrong to me, and I want to
understand whether you can get around this
by using derivatives, by writing caps, collars or
floors. If you can find another way of replicat-
ing that sort of return that has to be the clever
thing to do.”
Here, Eyre is likely to deploy the expertise
of Reizenstein and his team. “The technology
that we have developed in CIS is exactly what
we want to bring into the pension analysis, so
that there is joined-up thinking. At this stage
you’d call it a laboratory, which we concluded
was a prudent approach – to get the trustees
comfortable with some of these products. We
may look to use them, anticipating the merger
and the bigger scheme, as we try and address
this over the next 12 months.” L&P