Pandemic Response, Asset Allocation, ESG and Solvency II

The pandemic not only introduced a new market regime forcing Nordic insurance industry allocators to review portfolio risk levels on the back of heightened market volatility but also introduced organizational challenges to cope with the work from home environment.

Naturally, large insurance companies had enough internet bandwidth, remote working and collaboration tools, including digital platforms, to function more or less normally while working from home, but this brought both benefits and costs.

The benefits of remote working in terms of saving on travelling time, flexible working hours, and team collaboration across locations, are well understood, since it was not entirely a new phenomenon for some firms anyway. Staff remained highly motivated, and formal meeting schedules continued, sometimes even more frequently. They also continued to remotely participate in industry conferences, which gathered some intelligence, but did miss out on informal networking and gossip.

Working from home challenges

Yet there were also business efficiency drawbacks as a result of the work from home environment such as lack of spontaneous and creative communication and thinking, exchanging ideas over coffee machines and water coolers, and team integration. This might in some cases have slowed down some longer-term projects, according to the respondents

“The biggest disadvantage is that it has been harder to integrate new team members, and get a team working feeling in terms of wider group dynamics,” – Pontus Bergekrans, Group Chief Investment Officer, SEB Life and Pensions.

There were also social and human drawbacks in some cases given the need for humans, as social animals, to interact physically. Most people are looking forward to returning to the office, for at least part of the week, and travelling for on-site meetings and due diligence.

“Equally, we do not underestimate the personal costs for employees and their families. Many may experience some sense of isolation and several employees do not have enough space for their family and children at home,” – Jan Erik Saugestad, CEO, Storebrand Asset Management.

Managing volatility

Though the March 2020 equity market crash was the fastest for decades, governance frameworks were able to handle the volatility.

Sometimes asset owners introduced more frequent meetings, and small changes to allow for remote decision making. Some operational frameworks have also been enhanced: including Value at Risk (VAR) models for collateral and liquidity management, routines for shifting collateral and margin between counterparties, and valuation of illiquids.

“Market volatility stress tested our valuation models on unlisted investments, which led to some changes in the model and sharpened up our governance procedures. We have started making monthly price adjustments to our unlisted portfolio, based on historical data and back-testing, using indicators from listed markets,” – Anders Schelde, Chief Investment Officer, AkademikerPension.

Due diligence and new managers

Due diligence in general, and the amount of engagement with new managers in particular, often suffered as allocators could not see the full picture and found it harder to form a qualitative assessment of some softer criteria, such as managers’ personal and social qualities.

“Remote due diligence does miss out on the face to face human contact of meeting managers, which is important to develop understanding of elements beyond quantitative numbers, such as whether they are good custodians of capital,” – Thor Abrahamsen, Senior Investment Risk Analyst, Gard.

Some firms, such as Gjensidige and AFA Forsakring, have a hard requirement to make physical visits before investing while others, such as PRI Pensionsgaranti, were able to make use of outsourced due diligence, which was itself carried out remotely in many cases.

A world of very low, zero and negative interest is not a new phenomenon – in Europe it has been the case for 10 years. What has changed recently is above average valuations across all asset classes, which leads insurers to fear that future returns will be lower. There are also concerns about how to maintain portfolio diversification, and specifically whether government bonds will act as diversifiers for risk assets.

The most common multi-year trend among Nordic institutions was identified within the liquid credit universe with shifts from lower yielding government and investment grade debt to higher yielding corporate bonds and emerging market debt, both sovereign and corporate.

“The fact that we are in a broad recovery, with low levels of default risk, makes it reasonable to have a tilt towards corporate bonds. In other words, aiming for the higher yielding part of the fixed income space,” – Stefan Klohammar, Investment Director, Movestic

Many insurers have also moved assets from liquid fixed income, into equities, and various illiquid and alternative asset classes, including private debt, infrastructure debt, infrastructure equity, private equity and real estate. These are designed partly to pick up illiquidity premia. Percentage allocations to alternatives range from about 12% to 40%, and can vary between portfolios within the same company. Some firms have doubled their alternatives allocation over the past few years.

“We believe that private equity will perform better than listed equities. We also think that this is the area where the most exciting investments are being done in terms of funding companies that are doing new things,” – Lars-Göran Orrevall, Chief Investment Officer, Skandia Life

Interest Rate Exposure remains high
The shift into alternatives and illiquids should not be exaggerated however. Most insurers still own fixed income and many insurers still have the majority of their assets in fixed income, and some cash, for regulatory liquidity and solvency reasons.

Some investors are now contemplating higher interest rates, prompting shifts to shorter duration exposures.

“As interest rates have continued to decline over many years we have shortened the duration of our fixed income portfolio, from about 4 to 2 years, as we do not see interest rates falling any further from here. Hence with a longer duration on our liabilities than our fixed income portfolio we are positioned for increasing interest rates,” – Johan Held, Chief Investment Officer, AFA Försäkring.

Inflation not deemed critical for most
Inflation is also a possible concern, at least in the short-term, for some, but it is far from translating into widespread inflation protection strategies being implemented:

“The main change in 2020 was adding commodities as an extra hedge for inflation risk” – Erik Ranberg, Chief Investment Officer, Gjensidige.

A handful of other allocators are not concerned about inflation.

Mixed Opinions on Equities
In 2020, some investors took advantage of the sell-off. Akademiker Pension made just two tactical trades in the first quarter of 2020, reducing exposure before the March 2020 crash and adding it afterwards. In May 2021, opinions were more mixed. Some asset owners are still increasing equities while a few other investors are starting to become concerned about equity valuations.

“We also see increased risk to current equity valuations in the rising yield environment and have started to buy out-of-money equity put option cover for the Q4,” – Timo Salminen, Head of Capital Management, Fennia.

In contrast, some investors await less friendly monetary policy before reducing risk:

Credit quality being prioritized
The outlook for credit risk is generally sanguine, but some insurers are sensitive to rising defaults, which they were actually expecting before the Coronavirus crisis simply because the cycle had gone on for a long time. Some of them are reducing allocations to lower yielding papers; many are more defensively emphasizing higher quality credit, or avoiding companies without a credit rating, while others, such as SEB Life and Pensions, are more offensively seeking opportunities in distressed debt.

“We do not believe corporate credit with very low yields is paying us for default risk,” – Thor Abrahamsen, Senior Investment Risk Analyst, Gard.

Most asset owners use a mix of active and passive management, but several asset owners we interviewed, such as PRI Pensionsgaranti, are 100% active. Some may use 100% active management for strategic asset allocation – but still use passive instruments such as ETFs for tactical asset allocation.

In strategic asset allocation, there is usually some mix between active and passive management. Alternatives are always actively managed and so is the great majority of fixed income. Only two insurers mentioned using indices for part of their fixed income exposures.

Equities are where there is most likely to be passive management. It is most often seen in large cap or all cap or large cap US or European equities, with active management more often used for Nordic equities, small caps, Asia and emerging markets. AFA Försäkring seems to be relatively unusual in running Asia and Japanese equities passively. The mix can of course change over time: AFA has recently increased its proportion of active management in emerging market equities.

“In our listed strategies we are active through the selection of our benchmark. For instance, our equity benchmark is now MSCI Climate Change index. Part of the portfolio has a tracking error around 1% to seek some alpha,” – Claus Jørgensen, Chief Investment Officer, Pensam

Fennia has a flexible approach to the active versus passive split, monitoring information ratios to measure the benefit of active management.

Some asset owners are using various sustainable/ESG equity indices, both from major global asset managers and from Nordic asset managers. For instance, Denmark’s PENSAM uses MSCI Climate Change index as its equity benchmark.

In House versus External Management
Strategic asset allocation and manager selection is nearly always done in house, as is tactical asset allocation, and asset/liability management, including interest rate derivatives and overlays. This is not being outsourced to investment consultants or other consultants (though they may assist with some aspects of Solvency II modelling).

Local bond or equity portfolios or both are most likely to be managed in house, including local government, municipal, covered and mortgage bonds, and local real estate is often managed internally, usually in a dedicated corporate structure.

Passive equity management is generally external, but Storebrand Asset Management and Skandia Life are two examples of asset owners that have developed their own sustainable equity indices (Skandia also uses an external provider for ESG indices in emerging markets equities).

Alternatives are nearly always managed externally, though there are some joint ventures in the infrastructure space such as that amongst Pensam and PKA, which Storebrand Asset Management has recently joined.

Only one asset owner we interviewed – Akademiker Pension – is potentially insourcing more asset management.

“Sustainability could be the new lower for longer trend. Sustainability is one of our biggest challenges, both in terms of fulfilling new regulations and investing in the right places to connect to the trends,” – Pontus Bergekrans, Group Chief Investment Officer, SEB Life and Pensions.

The Nordics were some of the earliest movers on ESG but they still face some challenges in meeting new EU regulations, which many highlighted amongst their top three challenges. The most common short-term ambition is simply preparing for new EU regulations such as the SFDR (Sustainable Finance Disclosure Requirement) and the EU taxonomy. (Some firms, such as pension insurers and providers of workplace insurance which do not distribute products as such, are not actually sure if these rules apply to them, or are awaiting guidance, but they still want to keep abreast of these developments and sometimes be aligned with them).

Both the SFDR and the taxonomy are still at an early stage with many areas remaining to be clarified. Some asset owners are expecting to allocate mainly to ‘article 8’ (“light green”) or ‘article 9’ (“dark green”) funds under SFDR, while others keep an open mind about also being invested in ‘article 6’. Some are not yet sure how all of their external funds will be classified. The first versions of the EU taxonomy are often seen as rather narrow in sector coverage, but of course the taxonomy is expected to be broadened out over the coming years, so in many cases it is probably too early to be confident about determining which strategies will fit into it.

Asset class and mandate coverage

The aspiration is nearly always to apply ESG across all asset classes, but in practice it is not always seen as immediately practical for all of them. ESG might not apply to some historical or “legacy” private equity investments.

The general consensus is that ESG is most developed for equities and corporate bonds. On the illiquid and impact investing side, asset owners have most confidence about their ESG policies in relation to real estate, where they have direct ownership and control.

ESG has sometimes ruled out entire asset classes. Skandia Life is winding down its commodities program because the commodities with the greatest diversification benefit – fossil fuels – are at odds with the ParisAgreement.

Sovereign Debt
The general perception is that ESG could apply to emerging market sovereign debt, where some sovereigns have low ESG scores, but not developed market sovereign debt – or interest rate derivatives.

The largest number of excluded countries we identified was 45:

“In sovereign debt we also exclude 45 countries, and exclude state-controlled companies in those countries. We mainly look a number of quantitative indicators of human rights, and we look both at the level and direction of these indicators as well as a host of more qualitative inputs. Exclusions include Saudi Arabia, China and Belarus, and we have now started using our own benchmarks in the EMD space because with have excluded several of the large issuers in the mainstream benchmark,” – Anders Schelde, Chief Investment Officer, Akademiker Pension.

External Managers
Some asset owners such as PKA provide their external managers with a quarterly exclusion list, but of course exclusions or negative screening is nowadays only a small part of ESG policies. Most asset owners expect their external managers’ ESG policies to be broadly aligned with their own, but recognise that it is not realistic to expect other firms to have exactly the same policies or apply them in precisely the same way.

Benchmarking
Benchmarking is an area where practices vary. Some insurers, such as Topdanmark, currently use standard equity benchmarks such as MSCI Developed world. Others, such as AP, have already developed ESG benchmarks, and others, such as AFA, are considering introducing ESG or sustainability adjusted benchmarks.

ESG Data and Reporting

ESG policies are not applied uniformly across asset classes partly due to gaps in data, such as carbon data. Carbon and other data reporting is generally best for equities, though one asset owner, Handeslbaken, identified weaknesses with smaller companies’ data because they do not have dedicated people working on ESG reporting.

Real Estate
Real estate is not only ideally suited to precise measurement of carbon but also to improvements in its efficiency. Asset owners with direct ownership have much more control.

“ESG has most impact in real estate, where we can have an immediate and tangible effect on energy efficiency. Our biggest investment is an office in Helsinki used by Danske Bank. It has a LEED (Leadership in Energy and Environmental Design) GOLD certification and was awarded the highest score for any property on sustainability in Finland,” – Timo Salminen, Head of Capital Management, Fennia.

Improving carbon and climate reporting and targeting
Carbon reporting itself is being developed, particularly in relation to improving the quality of scope 3 data. Many asset owners are introducing TCFD reporting this year – or enhancing their existing TCFD Reporting. For instance:

“We made some additions in our TCFD reporting this year – for example we started to report the contribution of our equity and corporate bond investments to the weighted average carbon intensity, the assessment of the readiness for transition of our equity investments and the weight of equity and corporate bond investments that produce clean technology solutions”, – Katja Einesalo, Director, Responsible Investments, ELO

Carbon reporting also feeds into forward looking targets for reducing emissions, with 2025 marking key milestones along the road to expected neutrality in 2050, based on the science-based climate scenarios such as the IPCC 1.5 degree scenario for future temperature rises. For example Academiker Pension has set a target for reducing our 2019 emissions by 27% by 2025, and Storebrand has set a target for carbon emissions in 2025 to be 32% lower than in 2018.

“We have reported Scope 1 and 2 emissions, and will start TCFD reporting this year. We are starting to model forward-looking climate risk and Climate VAR,” – Mikael Bek, Head of ESG, Pensam

Allocators are exploring approaches to calculating climate Value at Risk (VaR) in most cases initially for internal reporting purposes. They are not always ready to start reporting it externally, partly because they need to get comfortable with multiple assumptions underlying the calculations.

Some asset owners want to go beyond reporting on carbon and start trading it:

UN SDG Reporting
Some asset owners are also prioritising certain UN Sustainable Development Goals. For instance, PRI Pensionsgaranti’s inaugural Sustainailty report highlights 6 of the 17 UN Sustainable Development Goals (3,4,5,8,9 and 12) as areas of focus. Gjensidige has chosen some of the same SDGs, but also some different ones. They are: 3 – Good Health and Well-being; 8 – Decent Work and Economic Growth; 11 – Sustainable Cities and Communities; 12 – Responsible Consumption and Production, and 13 – Climate Action.

ESG Impact Investing

The SDGs are one framework for measuring impact investing. Some asset owners group impact under the general heading of sustainability while others have created a segment for it. Many insurers are exposed to “green bonds” but they do not always have a specific target for these and other impact allocations.

“In general terms we will increase investments even more in areas that is attributing to the SDGs and mitigating climate change. Long term we see that investments in areas that are addressed in the SDGs have a fundamental support that will benefit the returns.” – Johann Guggi, CIO Asset Allocation, Handelsbanken Asset Management

The chart below is a snapshot at a point in time and may quickly become out of date since many firms are reviewing their ESG policies and might soon introduce targets.

Some allocators have no real opinion on Solvency II or are reasonably happy with the framework. For instance,

“As with any framework of rules you can always have opinions but I think that the Solvency 2 framework, as a whole, is actually quite well thought out” – Michael Kjeller, Chief Investment Officer, Folksam

Solvency II reforms are often seen as a slow moving process, but the sense of urgency is heightened by both ESG concerns and the search for yield and return in alternatives. Here we highlight the views of some of those who expressed a strong opinion.

Solvency II and ESG
A number of asset owners have expressed concern that Solvency II framework could conflict with and hold back their ESG ambitions. There is no suggestion that regulators want to hamper ESG, but the unintended consequences of reporting requirements could be one example of how regulations pose obstacles to ESG.

One concern is simply cumbersome reporting requirements that create a bureaucratic obstacle.

Another concern is the risk weightings applying to alternatives. Positive incentives could be one way to make Solvency II more ESG friendly through preferential treatment for sustainable investments.

Solvency II Reforms
Apart from ESG, there are many other hopes for changes to Solvency II as part of the 2020 Review, mainly to allow more flexibility and freedom to invest in asset classes and strategies with higher expected returns

Standardisation versus customization
The great majority of insurers in the Nordics use the standard Solvency II model. In Finland, all insurers use the standard model. In Denmark only one non-life insurer has a full internal model while three have partial internal models. Amongst life insurers, four have partial internal models for longevity modelling. In Sweden, five insurance companies use a partial internal model. In Norway only two – Gard and Gjensidige – have developed internal models and both of them still find that the rules are not flexible enough.

“Solvency II may also be too standardised in applying to insurers with very different balance sheets,” – Thor Abrahamsen, Senior Investment Risk Analyst, Gard.

“We are disappointed that the regulator requires extra capital buffers for our model beyond what we think are necessary,” – Erik Ranberg, Chief Investment Officer, Gjensidige.

Gard’s internal model often result in higher capital requirements than the standard model, but this is not actually a concern.

Short term versus long term
Several insurers argue that the Solvency II rules are too short term, which also encourages more fixed income and discourages equities and alternatives.

“Solvency II capital charges are disproportionate and too short term. They are too low on low risk fixed income (basically zero for government bonds) and too high on higher returning assets, such as equities, or alternatives, such as infrastructure and private equity. These assets are more sensible for a long term investor over 5 years, and the charges should be lower for longer holding periods,” says Mikael Nyberg, Head of Fixed Income, SEB Life and Pensions.

Equities and alternatives

Many asset owners would welcome more flexibility on alternatives or equities or both.

“Private equity and hedge fund allocations have gone down, due to Solvency II capital requirements. Luckily coming changes in Solvency II will make it less capital intensive on the long term investing in Equities,” – Tomi Viia, Chief Investment Officer, OP Financial Group.

“We do not understand why equities have such a high capital charge and automatic allocation mechanism,” – Erik Ranberg, Chief Investment Officer, Gjensidige.

Interest rate and credit risk
Solvency II has made changes to recognise negative interest rates, but there are still concerns that it pushes insurers into larger bond and credit allocations than they would otherwise choose.

“Solvency II rules on interest rate and credit risk were written years ago in a totally different environment when interest rates were 4-5%. Now the regulations are pushing us to take more credit risk. We would prefer to take more equity risk,” – Jani Partanen, Chief Investment Officer & CFO, Pohjantähti Keskinäinen Vakuutusyhtiö.

“Solvency II encourages us to take on more interest rate duration risk, but at very low interest rates, Solvency II does not capture the tail risks of holding government bonds,” – Thor Abrahamsen, Senior Investment Risk Analyst, Gard.

IFRS and Valuations
Changes to IFRS are not relevant to many insurers using local accounting standards, and even those using IFRS do not seem to be worried about them: “We do not expect that IFRS 9 and 17 from 2023 will have much practical impact on our investment strategies. We will have to move from holding at amortised cost, to mark to market, which will change the value of assets but we already record the market values for our ALM (asset liability matching) so it is really just moving some line items around. We already use mark to market accounting in our Danish and Swedish companies” – Erik Ranberg, Chief Investment Officer, Gjensidige.

If you have questions about this report please contact:

Jonas Wäingelin, Editor in Chief, NordicInvestor

jonas@nordic-am.com

Hamlin Lovell, Contributing Editor, NordicInvestor

hamlin@nordic-am.com

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