Norway solves its solvency problems
The State Petroleum Fund may have readied billions of krone for investment in niches such as US core small cap equity, but local insurers of a similar size to the fund are playing a far safer game.
Slow to react to the long-lasting fall in equity prices from 2000, Norway’s insurers of pension promises are now in possession of fairly slim risk budgets and resting on the stability of hold-to-maturity bonds, which account for 50% of some portfolios.
Unlike the Petroleum Fund, whose inflows continue apace without any consequent liabilities appearing, the insurers have to find promised increases of up to 4% for existing pension customers. The expected cut in that requirement to 3% from next year will provide some relief. Nevertheless, it is arguable that some solvency ratios have been eaten away so much that firms are in no position to capture any of the renewed growth in equities. The Oslo Bourse alone has climbed 50% in value since a lowpoint this year in late February. But the insurers which dominate pension provision are mostly watching from the sidelines. A fresh survey of the Nordic region for IPM and AIMA reveals that Norwegian institutions have on average 17% in equities; the lowest proportion in the region.
“We have used constant proportion portfolio insurance as one way to manage risk,” notes Frederic Ottesen, finance director of Storebrand Liv. “But some of our competitors are below their natural allocation to equities because their risk capital has been eroded.”
As evidence of the erosion, Ottesen points to the Additional Statutory Reserves (ASRs) which insurers are supposed to keep. These reserves should be worth about one year’s worth of promised returns, ie 4%, as an obvious buffer or “storage”. Storebrand’s are about 3%, according to Ottesen; at the end of 2002, the mutual KLP’s were just 1.1%. It has NKr3bn (E365m) booked profit to play with, however, thanks to asset price rises this year. Benedicte Bakke Agerup, KLP’s finance director, notes that if that profit was allocated to the ASR, it would stand at 3.9%, although that has not been decided and some of the NKr3bn may be used to strengthen the company in other ways.
Hold-to-maturity bonds, which as the name suggests cannot legally be sold on, have been the necessary solution to solvency problems. An observation of big insurers’ portfolios reveals that hold-to-maturity bonds have been acquired at the expense of nearly every other asset class. At the end of 2000, shares accounted for about 30% of KLP’s portfolio. By July this year that percentage had been cut radically to 5% while over the same period hold-to-maturity bonds rose from 15% to nearly 50%.
Storebrand halved its holding in ordinary bonds from NKr29.3bn to NKr14.5bn between July last year and June of this. Over the same period it almost doubled its portfolio of hold-to-maturity bonds to NKr44bn, or almost 30% of total assets. The reason for the switch is clear. The locked-in value of the commitment is worth over NKr3.1bn as unrealised gains to Storebrand and shareholders. Third quarter results should show that that figure of 30% has climbed to 40%.
Norway’s investment folk joke that they are in the worst of both worlds: the asset side is as in the UK because investments are marked-to-market. But the liabilities side is like Germany where they remain fixed under law with no corresponding flexibility in either good times or bad. Norway also imposes some of the most draconian capital adequacy requirements in the world on financial institutions.
Given these conditions, hold-to-maturity paper promise returns without those gains having to be booked and thus subject to the vagaries of marking to market.
But what is their provenance? The Norwegian state has traditionally issued debt at fairly generous rates compared with its sovereign peers in the West: a 10-year in 2000 with a 6% coupon and another last year at 6.5%. There was also a very generous one-year bond marketed last year which was so attractive that even foreign investors were drawn to Oslo, until the krone began to rise again and dissuade visitors (although in local terms, 12-month lending is still more lucrative here than any other European nation bar the UK).
But in general, the Norwegian state is rich because of oil. It does not need to borrow much money and so the government bonds get snapped up and subsequently become hard to trade. That benchmark 10-year is now trading at just 4.9%.
Hans Aasnaes, chief investment officer of Storebrand’s NKr153bn assets, says that Storebrand persuaded government-guaranteed bodies to borrow to finance infrastructure projects. That was one innovation. Otherwise, municipalities, banks and insurers themselves all raise money, and tend to so locally. Aasnaes notes that Storebrand only has government-guaranteed debt in its hold-to-maturity portfolio. It has not been prepared to take any credit risk.
Which brings us onto two moot points. The first is the problem of accessing capital when lenders are unwilling. This is the current dilemma for KLP, mutual insurer for most public sector pensions. Having over committed to equities in 2000, KLP now finds some of its owner-customers such as the municipalities reluctant to support it with more capital – hardly surprising when for 2001 and 2002 they saw little back in the way of profits or returns.
The board wants to convert the entity into a private company in order to allow it to access capital markets in future, and break the link of owner with client. The question is whether this triggers more departures by public bodies as they take their employees’ pension savings to other insurers, or whether KLP will be made stronger. Agerup reckons that assets will grow because the public sector workforce has been growing at three times the rate of the private sector. But she declined to make public estimated asset growth for KLP, which currently has around NKr120bn under management.
The second point in such an insular market is that of currency risk on overseas investments. The policy of the Petroleum Fund is to benchmark its assets’ performance against an international basket of currencies, although it is in a blissful position of being free from any actual liabilities. And so the fluctuations of the krone in international markets are irrelevant in as much as the investments are not going to be liquidated and the returns brought back to Norway for the foreseeable future.
Aasnaes, in a company with ongoing liability concerns on the other hand, believes in hedging foreign investments back into krone: “We have one of the most open economies in the world: Norway imports 70% of its goods. So why not hedge?”
It is significant that several of the biggest insurers outsource or have outsourced the management of their portfolios there to third parties such as Schroders. Bearing in mind the severe paring back of overseas equity investments, diversification is not a popular theme among insurers.
For Sverre Hope, first vice president for business development at GN Asset Management in Lysaker, however, Norwegian pension funds ought to be looking at alternatives as a solution to the problem of volatile returns. “Let’s be modest; no one cast forecast perfectly; no one runs the world. So let’s instead look for decent performance no matter what the circumstances.”
GN hired RMF to create a fund of hedge funds strategy that would offer 8-10% annual return in dollars net of fees but with standard deviation of not more than 4%. Since November 2002 the return has been 11% and GN has gathered $173m (E147m) into the fund. GN also has its own hedge funds, including a nascent long/short technology strategy and a macro fund which seeks to satisfy Hope’s claim of decent performance in all conditions. The macro fund was born out of GN’s competence in global fixed income. It looks to exploit developments in up to 50
different index derivatives, including commodities and equities.
Performance has not been great although a long-only version is slightly positive.
According to the IPM/AIMA survey on the Nordic region, Norwegian insurers and pension funds are going to increase their allocation to funds of hedge funds, which is currently less than 1% of total assets.
Certainly all are aware that the locked-in value of hold-to-maturity bonds may not cover all eventualities.
Roar Hatling, head of asset allocation and risk management at KLP, is content to note that its portfolio’s interest rate level at 5.8% leaves a comfortable margin over the mutual’s average guarantee of 3.3%. But the portfolio’s maturity till redemption is just over five years, which will mean searching for new sources of steady income. The state proposed cut in required returns to 3% from 4% should help, but on the other hand that benchmark 10 year government bond is already down to 4.9%. Hatling, like many others, is aware of reinvestment risk.