Case Studies: Stability through diversity
• Assets: €189bn
• Location: Zeist, The Netherlands
• Invested in ILS since: 2006
The Dutch pension provider PGGM invests in a large portfolio of insurance-linked securities (ILS) on behalf of its main client, the healthcare and social work sector pension fund PFZW. While the portfolio has grown to €3bn it still makes up only a relatively small proportion of PFZW’s overall assets which stand at about €161bn.
PGGM was a relatively early entrant into the ILS market, and has been an investor in the sector for 10 years. It first bought exposure to the asset type in 2006, with catastrophe (cat) bonds as an initial step. PGGM’s next step came with investment in collateralised reinsurance in 2009. The main reasons for adding these investments to the PFZW portfolio were diversification combined with attractive returns. PFZW considers ILS to be a separate investment category and has a strategic allocation to the instruments of 1.5-2%.
Although the ILS market has broadened in terms of the types of insurance risk it provides exposure to, PFZW’s allocation only covers natural catastrophe risks. The pension provider sees the advantages of ILS as good investment diversifiers within a portfolio and they also offer attractive returns, although PFZW notes that these returns have reduced in the last few years.
“PGGM was a relatively early entrant into the ILS market, and has been an investor in the sector for 10 years”
Disadvantages of ILS are the small size of the market is and their relatively high fees. The small size of the reinsurance market means that as a large investor it is hard to build up a sizeable ILS allocation.
Rather than getting involved directly in the buying and selling of ILS, PGGM undertakes this type of investment through external managers. Using these managers, it has set up customised investment funds on behalf of PFZW. This allows it full control over many aspects of these funds, including their objectives, risk limits and collateral investment
PGGM has a five-person team to manage and monitor the €3bn ILS portfolio, and it licenses a catastrophe risk model for monitoring purposes.
The process of investment in ILS begins with work to determine the allocation to the peril regions, PGGM says. The second step is deciding how PGGM will implement that allocation. Each of the underlying funds it invests in serves a specific role in the overall ILS portfolio. It tries to avoid having too much overlap between these funds.
As a seasoned investor in ILS, PGGM has some advice to pass on to other investors considering the asset type. Investors considering ILS should first determine their objective, the pension provider says. For example, are they aiming for diversification or high returns?
“Investors considering ILS should first determine their objective”
Next, investors should ask themselves what kind of losses they are willing to accept. PGGM says there is a trade-off between – on the one hand, suffering no losses at all, attritional losses (small losses that reduce returns), tail losses and extreme tail losses – and return on the other.
Next a potential investor should consider risk tolerance, says PGGM. Specifically, investors should determine how much they can afford to lose in an extreme tail year with multiple losses.
Before deciding whether to invest in ILS, investors should also consider whether they require liquidity or not. Experience within the field is also key, according to PGGM, and investors should think about which managers they are willing to work with.
• Assets: SEK304bn (€45bn)
• Location: Stockholm, Sweden
• Invested in ILS since: 2008
Sweden’s AP3 buffer fund holds a diversified, internally managed insurance-linked securities portfolio. The fund has a strategic long-term allocation to ILS, and describes that allocation as part of its ongoing work to diversify its total portfolio and stabilise the return stream. The SEK304bn (€45bn) state buffer fund first added the asset class to the overall investment mix in 2008, although the allocation has varied since then.
In its approach to ILS, AP3 focuses on risks related to weather and natural catastrophes such as hurricanes and earthquakes. “The bulk of the return and risk in many – or even most – institutional portfolios stems from the selected market exposure,” says Dan Bergman, AP3’s head of investment research and ILS, adding that AP3 is no exception. This means that in bull markets these portfolios perform well, he points out, but in bear markets, less so.
Including assets classes that are only correlated to traditional markets to a low degree is one strategy to improve this situation and stabilise returns, he adds. “This is where ILS comes into play in our portfolio,” Bergman says. “Starting in 2006 we began assessing ILS as an asset class to see if it met our requirements.”
The investment type looked promising on the drawing board and now, 10 years later, the fund says returns have been well above expectations. Every year in that period, returns have been positive, having averaged 9%, and with zero correlation to the global equity market.
AP3 says its ILS investments are strategic and long-term. It systematically, year after year, takes on different insurance risk, such as weather and climate-related risks.
“During years when few or no major disasters happen we expect to earn good returns, but when a disaster happens we expect to pay back part of the profit we have made during the other years,” Bergman says. During a bad year, the loss can be substantial and cannot be avoided, he says, adding that this is a central part of the strategy. “However, over time, on a net basis the fund expects to earn a good return.”
Unlike most other pension funds investing in this space, AP3 has opted to focus on direct investments. Another key feature of its investment process in ILS, Bergman says, is the pension fund’s focus on analysis and a smaller number of investments and strategic relationships. This selective approach has paid off.
AP3 has built up a small internal team to manage its direct ILS investments. Bergman says this approach has been right for the fund because it has the size and long investment horizon necessary to overcome the barriers of entry associated with some of the more exotic asset classes.
But a smaller institution wanting to invest in ILS might be forced to rely more on external managers, Bergman warns. “Some of these managers are highly skilled and have good market access but, of course, you need to find them and structure the mandate correctly,” he says.
“Over time, on a net basis, the fund expects to earn a good return”
For AP3, one advantage of having invested in weather and catastrophe-related risks has been the build-up of knowledge that is relevant when managing climate change.
Apart from the fact that well-managed insurance-related investments can give good risk-adjusted returns and fundamental diversification, another advantage is the lack of correlation — hurricanes and earthquakes do not follow the business cycle, and a global equity market downturn or crash will not cause a hurricane or an earthquake.
“Fundamentally, the risk doesn’t change, in contrast to, for example, a portfolio of credit bonds where equity market turbulence often coincides with increased concerns about default rates,” Bergman says. On the other hand, ILS investments are quite specialised and it may be hard for a new investor in the space to find the right point of entry.