Pension funds allocating capital to insurance-linked securities (ILS) and reinsurance-linked investment strategies, as a way to find sources of yield with low-correlation to broader financial markets, is becoming a mainstream topic. However the numbers show that this trend has a long way to go and right now it is still early days for pension funds in insurance and reinsurance-linked investing.
The influx of pension fund capital is often cited as one of the factors stimulating the growth of the ILS and reinsurance third-party capital sector. While this is certainly a true statement, pension funds are increasingly involved in the sector and some deploy meaningful quantities of their capital into ILS vehicles which in turn use the capital as reinsurance capacity, the actual amount is still just a drop in the water.
In recent weeks this trend has been getting an increasing amount of main-stream media coverage, with recent articles in the Financial Times, Reuters, the Chicago Sun Times and other publishing outlets, which is great for the sectors profile. These articles discuss the main trend of the day, that third-party backed reinsurance capacity is increasingly competing with traditional reinsurance capacity, and usually cite pension funds as the main source of this capital.
While pension funds are one of the fastest growing sources of capacity in the reinsurance sector right now, with funds becoming more familiar and comfortable with the asset class, this trend has only just begun. The global pension fund sector has somewhere between $20 trillion and $30 trillion of assets under management right now, depending on who you ask (Towers Watson said $30 trillion in a recent report), and its involvement in the collateralized reinsurance and ILS space is likely only in the low tens of billions of dollars so far.
If the alternative reinsurance capital space is $45 billion (roughly) in size, pension funds may make up a third or so, we’d estimate. Reinsurance broker Guy Carpenter recently said that pension funds may hold 15% of all outstanding catastrophe bonds, that’s only a couple of billion dollars, or so, at best, although next to zero cat bond notes were held by pension funds five years ago. Nephila Capital, which has somewhere over $8 billion of reinsurance-linked assets under management, has said in the past that perhaps 80% of its AuM came from pension funds. So we feel $15 billion to $20 billion is likely a fair number to estimate as a ceiling for pension funds current involvement in ILS and reinsurance-linked investments.
Given the estimates of pension funds having $20 trillion to $30 trillion of assets globally, the amount invested in ILS and reinsurance is really very small. It’s often cited that if a pension fund finds an alternative asset class that it really appreciates the risk/return profile of, then it may allocate 1% or 2% of its capital to that asset class.
Were the global pension fund market to decide to put just 0.5% of its assets into ILS and reinsurance that would be a very large amount of capacity. If we take the lower end estimate for the amount of assets under management at pension funds globally of $20 trillion, half a percent of that would be $100 billion. Imagine if the pension fund market put 1% or even 2% of its assets into reinsurance and ILS, how would the market react to alternative reinsurance capital accounting for 50% or more of the total market?
So, while pension funds are increasingly allocating capital into the global reinsurance markets, via collateralized reinsurers, ILS funds, directly into catastrophe bonds and through other reinsurance vehicles, at this point in time this is still a drop in the pension fund assets under management ocean.
Pension funds are notoriously conservative investors. Charged with looking after current and future retirees capital, generating a return to help retirees enjoy their post-work years, pension funds have long hunted for safe, reasonable growth, types of investment return. Increasingly though, pension funds are now looking to alternative asset classes to boost sluggish returns caused by low-interest rates and also to access different kinds of return as well as low or negative correlated returns.
Insurance-linked securities seem to fit neatly into the alternative asset areas that pension funds are increasingly turning to in this time of record low yields. While there is plenty of evidence that pension funds enjoy the low-correlation, relatively stable and very attractive returns that ILS, catastrophe bonds and reinsurance-linked investments can generate, the amount of pension funds actually allocating to ILS is still relatively low
To some pension funds ILS can prove extremely attractive and, there are pension funds out there who directly invest in catastrophe bond and collateralized reinsurance transactions, for them ILS is a meaningful alternative investment asset. Funds such as the Ontario Teachers’ Pension Plan fall squarely in this bracket of actively participating in the sector. Other pension funds are allocating capital to ILS investment specialists hoping to get managers with experience in the space to generate returns from a new, and still considered exotic in the pension world, asset class.
The fact that insurance-linked securities is not your typical asset class explains the long lead-time that some pension funds have, from beginning to research the asset class to actually deploying capital. In some cases this could be five or even ten years, from the moment a pension fund first gets interested to the asset class to the point where it actually invests in it, either directly or via a specialist manager. In some countries the lead time is much longer than others, Japanese pension funds for example are among the most conservative and can assess new asset classes for many years before finding comfort in a particular strategy which matches their return ambitions.
Bearing all of this in mind, it is no surprise that we are still really in the early days of pension fund investments in insurance-linked securities and catastrophe or reinsurance-linked investments. It’s this that leads us to think that the discussion of capital exiting the space is a bit of a moot point right now, as there is so much capital either tentatively looking at reinsurance and ILS or perhaps not even yet aware of it.
A recent survey undertaken by Mercer, part of the Marsh & McLennan Companies, discusses asset allocations among European institutional investing pension funds. The report finds that European pension plans are increasingly allocating into various alternative asset classes so as to tap into a much more diverse range of return drivers.
Mercer’s survey found that these pension plans are increasingly becoming comfortable with a wider variety of hedge fund strategies, one of which involves having exposure to natural disasters, so insurance-linked securities and reinsurance-linked investments of course.
Mercer surveyed 1,200 pension plans in Europe, which between them represent assets of more than €750 billion. Alternative investments are a small, but steadily getting larger, slice of this pot of investment assets and more of the pension funds surveyed said they would increase alternative allocation rather than decrease it. Pension funds are increasingly looking at alternative investments as buy and hold strategies rather than tactical too.
Mercer specifically surveyed pension funds allocations to insurance-linked securities as part of this survey. It found that just 0.3% of the 1,200 surveyed European pension plans actually had an allocation to ILS, a very low number. The average allocation to the ILS asset class, by those few funds which have accessed the space, was 4%.
So, and it has to be noted again that this is from a survey of just 1,200 pension funds in Europe, just 0.3% of funds had allocated to ILS but the average allocation was high at 4%. Imagine how this could grow if pension funds continue to grow their appreciation for ILS, catastrophe risk and reinsurance as an asset class? 4% of the $20 trillion of global pension fund money would be a massive $800 billion, bigger than the reinsurance market is right now.
It is interesting that Mercer’s survey showed pension funds as allocating 4% on average, as it has always been mooted that 2% was a reasonable allocation to an alternative and emerging asset class like ILS and reinsurance. However, others in the pension fund world would say that 2% is not enough to fully appreciate the diversification that ILS, catastrophe bonds and reinsurance-linked investments can offer.
In a recent report from Clear Path Analysis, Tarik Nbigui, an investment strategist with Blue Sky Group, agreed that 2% could be too low; “On the whole, we believe in the diversification effect of insurance-linked securities. If you want to invest in such a category of asset class, 1-2% is too low to see an impact on the portfolio, so you need a marginal weight, say 5%.”
However, Nbigui agreed that there are challenges with adopting a new, emerging and alternative asset class like ILS; “One of the main challenges in this area is to educate the board as well as explain the working of such instruments to the investment committees.”
This is the challenge that all investment managers at pensions funds are facing when selling ILS and reinsurance as an asset class to their board. Hence allocations take time and there is much more to come.
Nbigui also commented on when is a good time to allocate to the space, and his perspective also perhaps answers a question about whether capital would exit after a major trigger event. He said; “From a timing perspective in the cat bond market, if there is a big trigger event where you see the prices falling and the yields rising that is when you want to enter the market.”
In the same report, on the topic of whether pension fund money would exit the market after a major event, Philippe Trahan, Director of Insurance-Linked Securities at the Ontario Teachers’ Pension Plan, a pension fund which manages its own allocations to ILS, commented; “No one has talked about what happens if there is a massive loss, but only then will we know whether the products behave as they are expected to behave. It will be interesting to see how the markets react after a very large event but by and large, the value position will remain the same and you may just have different faces and market participants.”
Finally from the Clear Path report, Line Vestergaard, Head of Absolute Return Strategies, at Danish pension fund administrator PKA, commented on how the increasing interest from pension funds in ILS could impact the market. She said; “Unfortunately, I feel that many pension funds think like us and will invest more into ILS, so I expect ILS to become a more crowded market which could lead to falling rates. If that happens, we will decrease our investments. We intend to be proactive, and will of course keep an eye on further developments within this area.”
In a recent article on Artemis, we referenced Raymond Barrette, Chairman and CEO of White Mountains Group, who said that the capital currently coming into the reinsurance space from pension funds was a drop in the ocean as it’s such a small percentage of their total assets. He said it could become a tsunami of capital through the property catastrophe reinsurance business.
In a recent mid-year reinsurance renewals report, Willis Re estimated that by the end of this year the amount of in-force cover from collateralized and ILS markets will be approximately $42 billion, around 15% of total global reinsurance capital. The report notes that this is a drop in the ocean considering that if global pension funds decided to allocate as little as 0.5% of their capital into reinsurance we could see as much as $150 billion of new ILS capacity come into the marketplace.
Further evidence of the increasing allocations being made by pension funds came last week as it emerged that Swiss investment manager LGT Insurance-Linked Strategies had added $400m from three pension fund mandates this year alone. Imagine if even a quarter of large pension funds made similar allocations of over $100m each?
Pension funds globally are becoming more and more interested in alternative asset classes right now and ILS and reinsurance is becoming sufficiently main-stream that it is mentioned to these funds in the conversations they have about investment strategy and new asset classes. This trend is going to continue, as we’re still in the early days of alternative reinsurance capacity provided by third-party capital, so we can expect the profile of ILS and reinsurance among the pension funds of the world to grow significantly over the coming years.
Of course, we’re not suggesting that we’ll see a $100 billion influx of capital into the ILS space in a hurry. Neither are we suggesting that the reinsurance market will be funded by pension assets in the next few years. What we are saying is that this really is still early days for pension funds in ILS and reinsurance, their interest in ILS and reinsurance will continue to grow and we will definitely see more pension funds allocating to the asset class and increasing inflows of capital.
Of course now we just need the opportunities to exist for these assets to be invested in and that is where the opportunity lies for both traditional reinsurance players and dedicated ILS and collateralized managers to be innovative. By adapting business models to attract and accommodate this huge pool of potential reinsurance capital and being innovative in creating new products and structures suitable to pension funds investment needs the sector (traditional and alternative) will benefit from this burgeoning interest from pension assets.
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