Nordic pension funds embrace ILS, but complexity also a deterrent

by Artemis on December 2, 2013

Making investments in insurance-linked securities (ILS), catastrophe bonds and other reinsurance-linked investments requires a certain level of sophistication, a fact that a number of Nordic pension funds have embraced but some still find a deterrent.

The decision to make an investment allocation to the ILS or reinsurance-linked investments space is not one that a pension fund takes lightly. The initial research into the sector can be lengthy and often involves gaining an appreciation for terminology and concepts which are foreign to the average pension fund manager.

Once the research phase is complete and the pension fund has decided that ILS and reinsurance is an asset class it wants to gain access to, the due diligence phase begins which can see pension funds assessing a multitude of ILS managers and reinsurance-linked funds, as they attempt to find one which matches their risk and return requirements and which also provides a good cultural fit.

Some pension funds go a step further still, preferring to manage their own investments into ILS, catastrophe bonds and even more sophisticated investments directly into collateralized reinsurance contracts or sidecars. This required dedicated resource with an understanding of risk, reinsurance and portfolio management, skill sets which the average pension fund does not have on tap.

According to this article in Nordic Region Pensions and Investments News (NRPN), a number of Nordic pension funds are embracing reinsurance as an asset class, with differing levels of sophistication. At the same time, other Nordic pension funds still find the prospects of investing in ILS or reinsurance too daunting and complex an initiative to progress.

The premise of the article is that insurance-linked securities and reinsurance-linked investments are a sophisticated asset class which as yet is not gaining a strong foothold amongst Nordic pension funds. Despite this, the article shows that for some, ILS and reinsurance is an asset class which has been thoroughly embraced.

NRPN says that there are currently few investors in the Nordic region with exposure to ILS and reinsurance and that its quarterly investor survey found little evidence that this was going to change any time soon. However two of the Nordic regions largest pension funds are truly invested in the space.

AP3 is a well-known Swedish pension fund in the ILS space, fully capable of making its own investments in assets such as catastrophe bonds, reinsurance-linked funds and even directly into collateralized reinsurance contracts.AP3 appreciates the lack of correlation that ILS displays when compared to its equity portfolio.

According to the article, Danish pension fund PKA currently invests around 3.1% of its asset base into ILS and reinsurance, which equates to 4.8 billion Danish Krona, or approximately $872m. This is a very sizeable investment for a single pension fund in the space.

PKA also appreciates the low correlation of ILS and reinsurance with other assets such as equities. Line Vestergaard, PKA’s head of absolute return strategies, told NRPN; “You might see a catastrophe that also leads to losses on the equity side, as happened briefly after the earthquake in Japan, but a crash in equities will never result in a catastrophe. I also think it’s well paid for the risk you take.”

AP3’s chief investment officer Gustaf Hagerud suggested that the reason more pension funds do not dive into ILS is largely due to the fact that there is a lack of competency in the asset class and that it is not considered a mainstream investment yet. He commented; “It’s much better for your career to lose money on equities than on cat bonds because on equities you would lose money together with everyone else. It’s also not a traditional financial market investment – but being seen that way is perhaps what makes it interesting.”

AP3 manages its ILS and reinsurance-linked assets in-house, with a team built up to include underwriting skills and leveraging relationships with scientific institutions for risk modelling. This has clearly allowed this pension fund to develop its own view of risk, making it as sophisticated an investor as many dedicated ILS managers.

PKA, on the other hand, outsources its allocations to ILS and reinsurance, preferring to let dedicated managers of capital make the investment decisions. Interestingly, its mandate for ILS has changed from one requiring diversification to a more focused mandate where it could stand to lose everything from one major event. This is interesting, as many pension funds Artemis talks to are beginning to reach this conclusion, that the allocation to ILS is small in terms of their overall assets and so pension funds gradually come around to their allocations being less diversified than you might think they would require.

Vestergaard of PKA explains this well, saying; “A manager that only works with insurance-linked securities has an interest in having a diversified portfolio because it’s very hard to sell a track record where you have lost 50 per cent from one catastrophe. But from an investor’s point of view, it’s not that big a problem because insurance risk is a minor part of the portfolio.”

PKA told NRPN that so far this year its investments in ILS and reinsurance have returned about 17%, showing that it has a higher risk strategy than AP3, who would only disclose that its ILS portfolio returned high single digits.

Both however take a long-term view with the asset class it seems and that good years will generate sufficiently attractive returns to outweigh the bad over a number of years.

Interest is certainly growing in ILS and reinsurance as an asset class among Nordic and Scandinavian investors and pension funds. These two large pension funds are clearly leaders in the space, given their large commitments and sophisticated approaches to investing in the space. This will rub off on other local pension funds and help to educate others in the region.

As we wrote recently, the Scandinavian region could soon see its first dedicated ILS fund manager, another step forwards for the region that will help to broaden the knowledge of ILS as an asset class with the local investor base.

With significant assets in pension funds in the Nordic, and Scandinavian, region it is expected that pension funds located there will become a much larger contributor to the reinsurance market in years to come.

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