The broadcaster's scheme said its 1% allocation to ILSs provided “genuine diversification” to equities last year but the market remains limited
The BBC pension scheme benefited from a "marginal" return investing in insurance-linked securities (ILSs) last year but gained more from the asset's diversification properties.
What are insurance-linked securities?
The main type of insurance-linked securities is catastrophe bonds.
Insurance companies issue these bonds to cover the potential cost of insuring catastrophic events, such as an earthquake.
Pension fund investors will receive a regular payment, or coupon, from the insurer.
If a catastrophic event occurs, the fund loses out on their initial investment.
The fund has 1% of its more than £8bn in assets invested in ILSs but has said it is limited from greater allocation by the current immaturity of the market.
ILSs are a way for pension schemes to take on the risk exposure of insurance companies, which is attractive as there is little correlation between these securities and equity movements.
This means the scheme's investments are better protected from recent equity market volatility and its impact on their funding levels.
But these structures present a challenge to schemes that do not have the size and resources of the BBC to make sure they understand the complexities of the investment.
James Duberly, pensions investment manager at the scheme, said: "This asset class can provide interesting returns and genuine diversification if you can get your head around its complexity and access it at a sensible fee level with a structure you are comfortable with.”
The Beeb's approach to ILSs
The BBC scheme has one investment in an ILS fund, attracted by by the investment's risk premium. But it found the asset class more complicated than its other allocations.
The understanding of what the premium levels are and whether that is justified is a bit harder to get a grip on
James Duberly, BBC
"We spent a large amount of time working with our external advisers and lawyers to make sure we understood the structure we were going into, including the hierarchy of the fund vehicle that we were investing in, collateral and fees," said Duberly in an upcoming report on ILSs for Clear Path Analysis.
"Quite a lot of resources went into getting comfortable with the structures and this may prove to be more difficult for organisations that have less resources than we do."
One challenge is pricing. It is not as easy for schemes to compare bond prices as it is comparing yield in the mainstream bond market.
Duberly added: "The understanding of what the premium levels are and whether that is justified is a bit harder to get a grip on from an end investor’s point of view, without a lot of ongoing dialogue with whoever is running the money on your behalf."
The scheme's reward was an asset that had less correlation to equities last year than other alternatives including commodities, emerging market debt and hedge funds.
But the current bias of the catastrophe bond market towards the US – on top of this pricing issue – is limiting further investment, Duberly added.
Global fund perspectives
The £57.5bn Ontario Teachers' Pension Plan (OTPP) also has about 1% of its fund invested in ILS bonds.
We feel that some of that money needs to be managed more directly
Phillippe Trahan, OTPP
Phillippe Trahan, portfolio director in charge of ILSs at the Canadian fund, agreed there was a bias towards the US but said there were different opportunities within that market.
He said: "There are diversifications that exist anyway within US risks, whether through single-state versus multi-state, as well as by investing at different loss-return periods for the same peril."
The OTTP decided to manage its catastrophe bond investment in-house due to an unhealthy concentration of these bonds in a few large funds.
"We feel some of that money needs to be managed more directly, that you have a broader diversity of end investors that will notably be able to tolerate the very low expected loss levels and very low rate spread," Trahan added.
Dan Bergman, head of investment research and ILSs at the £19.8bn Swedish national pension fund AP3, said a 1% allocation for most pension funds would make sense.
But he added that pension schemes should bear in mind the illiquidity of these bonds and other overlaps with the rest of their portfolio.
"If your equity book is heavily loaded with insurance and reinsurance companies, these are of course not likely to fare well in the event of a series of catastrophes," he said.
