ILS & cat bond portfolio “strategically important” to AP3

AP3, also known as The Third Swedish National Pension Fund and one of the five managing Swedish state pension system assets, manages approximately 2.7bn Krona ($335m) of insurance-linked securities (ILS) and catastrophe bond investments, which it calls “a strategically important” piece of its portfolio.

AP3 managed a huge 303 billion SEK ($37.2bn) at the end of 2015, with 55.5 billion SEK in alternative investments, including the insurance-linked securities (ILS) mandates and portfolio. The ILS component amounts to around 2.7bn Krona, approximately $335m or just under 1% of the total pension fund capital.

This ILS assets managed figure is up around 50% from 1.8bn SEK at the end of 2014, but still below the much larger allocation that AP3 had in ILS a few years ago. The downsizing of the allocation was a response to rates, but 2015 has clearly provided more opportunities for the pension fund, enabling it to increase its assets in ILS again.

Seen as strategically important by AP3, these alternatives, such as ILS, enable the pension fund to target absolute return while also benefiting from diversification and low-correlation, versus the equity components of its portfolio.

Bengt Hellström, AP3 Head of Alternative Investments, explained; “They are investments that generate stable returns over time – returns that are not dependent on the same factors that determine the performance of our other important asset classes like equities and bonds. Alternative investments are about diversifying portfolio risk and generating the best possible returns for the pension system.”

Insurance-linked investments, such as ILS fund allocations, catastrophe bonds and other vehicles such as reinsurance sidecars, as well as being a return driver these provide AP3 with a mechanism to “achieve low correlation with total risk.”

For major pension funds of the world, this is becoming an increasingly important goal, especially since the volatile financial and equity market conditions of late 2015. There is a growing interest in increasing the size of absolute return and alternative portfolio allocations among major institutional investors, something the ILS and reinsurance market would be wise to keep an eye on.

AP3 has been investing in insurance, climate and weather related securities, as it terms them, since 2008, seeing them as a way to help make the pension fund’s returns more stable over time, as well as benefiting from the low correlation.

The investments include both catastrophe bonds and weather derivatives and AP3 was the first investor in Sweden to target those instruments, since which it has built a team and developed relationships with universities and research institutions.

AP3 has clearly become quite sophisticated in its allocation to ILS, saying that it continuously monitors climate factors such as El Nino “because it affects hurricane activity in the Pacific and Atlantic oceans and has a bearing on our risk and returns.”

AP3 considers ILS both “strategic and long-term” as an asset class, recognising that it will benefit in years where losses are light but also that there are risks of major losses when large catastrophe events occur.

“These losses are unavoidable and part of the underlying investment strategy. The key point is that, over time, the investments are expected to deliver positive returns,” AP3’s annual report explains. A sensible approach to the ILS asset class.

Insurance and reinsurance linked investments are part of AP3’s strategy to invest in assets that can provide a buffer against financial market volatility. ILS is seen as one way to help stabilise the returns of the pension fund, particularly in the event of volatility in equity markets.

“This strategy looked attractive on the drawing board 10 years ago. And looking back, we can see that the returns have exceeded our expectations,” commented Mårten Lindeborg, AP3 CIO.

And AP3 has seen its ILS investments perform as expected, providing a very attractive return while the low correlation and diversification has been as expected.

“Fundamentally we know that natural disasters are not caused by political decisions or changing economic cycles. If we look back historically, this portfolio has demonstrated a very low correlation with the equity market and still generated a positive return every year at an annual average of 9.7%,” explained Dan Bergman, AP3 portfolio manager.