Pension funds eye illiquid catastrophe bonds

(updated with correction)

Significant demand for insurance-linked securities, in particular catastrophe bonds, has driven down yields and taken some of the luster off the once-shining beacons of uncorrelated assets in a pension fund's investment portfolio.

But all is not lost.

Now comfortable with the ILS sector, investors are looking beyond the more liquid, but arguably more expensive, parts of the market such as windstorm- and earthquake-related bonds, and seeking uncorrelated yield in securities that insure against firestorms and more esoteric calamities. They are also becoming more comfortable with ILS investments that are less liquid.

“There are newer products coming to market to sate some of the demand ... we will see more and more esoteric risk that goes beyond earthquake and wind — it could be a type of firestorm, or something else,” said Joe Higgins, New York-based managing director and fixed-income portfolio manager at TIAA-CREF, which manages between $300 million and $500 million of ILS assets. The firm has a total $569 billion under management.

Other managers have noticed pension funds playing in the less-liquid pools of assets.

“We have seen some investment mandates moving toward more private ILS — those pension funds without liquidity constraints,” said Christoph Buerer, CEO at Twelve Capital in Zurich. Twelve Capital is also looking to bridge the gap between the liquid catastrophe bonds market and the broader ILS sector. “We are trying to combine those two worlds with a private cat bond structure,” said Mr. Buerer. “(This type of structure) is cheaper to place and manufacture than cat bonds, and more liquid than private ILS.” Twelve Capital has $3 billion of assets under management across ILS funds.

GC Securities, a division of MMC Securities Corp., a U.S.-registered broker-dealer, has also seen pension funds cast their nets wider in a search for yield. “We are seeing investors that typically chase the liquid catastrophe bonds instead looking at more linkages with existing reinsurance or insurance companies,” said Chi Hum, New York-based global head of distribution at GC Securities.

“They're looking at private deals or managed-account type situations, with investors looking to sit alongside underwriters and allocating pools of capital to property catastrophe, for example.”

Mr. Hum said this broader investment range is starting to make up for those investors sitting on the sidelines in the tighter, liquid parts of the market. “Overall, dollars invested in the sector continues to go up — but rather than just investing in catastrophe bonds, there is now more opportunity to partner up with insurers, looking at things like collateralized reinsurance contracts.” This brave new world for investors “points to a level of comfort that (they) have gotten to with the underlying risk.”

“The catastrophe bonds market looks very unattractive right now,” said Alasdair Macdonald, Reigate, England-based head of investment strategy at Towers Watson & Co. “Even in a broader ILS market we would be watching for the moment it gets too expensive.”

Pension funds investing in catastrophe bonds were once well-rewarded. “Going back five years, catastrophe bond rates were around 5% to 10%,” said Mr. Hum. “These days they are starting around 2%, going up to maybe 6% or 7%.”

The return profile has changed, he said, “in large part due to the inflows coming from the capital markets, (from) pension funds and other money filling the coffers of these insurance flows.” Sources cited Swiss Re Group data showing that pension funds have become an increased share of the catastrophe bonds investor base, accounting for 14% by end-2012, from near-zero in 2007.

Higher pricing and lower returns are stemming inflows. “New interest from investors, particularly pension funds, has slowed a little bit in 2014, compared with last year,” said Rob Procter, London-based CEO of Securis Investment Partners LLP, which manages $2.5 billion of ILS assets, of which about 70% is from pension funds. “I think that is related to pricing — there is a perception that it is less well priced than it was, which to some extent is true.”

Pension executives “know that the market is weaker or softer in terms of pricing, and spreads are tighter by about 200 (basis points), but it hasn't deterred them from making allocations,” said Dirk Lohmann, chairman and managing partner based in Zurich, at Secquaero Advisors Ltd. “The investment case remains compelling, and adding this asset to your overall strategic allocation still gives improvements to the efficient frontier.” Secquaero runs close to $1.5 billion in ILS strategies, said Mr. Lohmann.

Some pension fund executives are increasing or decreasing their exposure depending on conditions.

The £25.7 billion ($43 billion) Royal Bank of Scotland Group Pension Fund, Croydon, England, had over £450 million invested in ILS as of March 31, 2013, according to its 2013 annual report. Since then, “we have reduced our exposure as return expectations have fallen,” Robert Waugh, Edinburgh-based chief investment officer for the fund, said in an e-mailed comment.

The 194.8 billion Danish kroner ($35.6 billion) pension administration firm PKA, Hellerup, Denmark, has increased its ILS investment to about $200 million, said Line Vestergaard, Copenhagen-based head of absolute-return strategies at PKA. The firm is owned by, and acts on behalf of, five Danish pension funds. PKA's exposure to catastrophe bonds “are very limited” for now, she said.

The NZ$25.5 billion (US$21.6 billion) New Zealand Superannuation Fund, Auckland, which increased allocations to ILS in early 2013, has lowered exposure. It has a US$200 million allocation through Elementum Advisors, and further allocated up to US$275 million to Leadenhall Capital Management LLP, focusing on natural catastrophe reinsurance-linked investments, including direct reinsurance-linked assets and catastrophe bonds.

“Spreads in the sector have tightened over the last year and, as a result, we have reduced our current exposure,” said a spokeswoman for the New Zealand fund. Both allocations, she said, give the fund the flexibility to “dial up or down our investment over time.”

At the inaugural Securis ILS investor meeting last month, pension fund executives acknowledged rates were low, but said they remained committed to the asset class.

Stacy Apter, director of global benefits, financing and asset management at The Coca-Cola Co., Atlanta, said officials allocate 5% of the assets in the $6 billion U.S. pension plan to ILS, citing the “uncorrelated risk” and equity-like returns. However, she said pension officials recognize there are times when investments should be pulled back, and so allocations are flexible.

Yoshisuke Kiguchi, CIO of the $450 million Okayama Metal & Machinery Pension Fund, Okayama, Japan, reinforced his long-term commitment to the “important asset class.” The fund has 9% of its fund allocated to ILS.