Nordea Life & Pensions was one of the earliest to invest in illiquid assets, which has helped steel it against the low interest rate environment since 2008. But with risks like Brexit threatening European stability, the insurer has turned away from the asset class. Sarfraz Thind talks to CIO Jesper Nørgaard
The financial uncertainty resulting from last month's Brexit referendum is only too familiar to Jesper Nørgaard, chief investment officer (CIO) at Nordea Life & Pensions. It is something that impacts all of Europe. But the situation may have been tempered with a little forward planning.
"If David Cameron had given the Danish PM a call before the referendum he would have learnt how difficult it is to manage a no vote," says Copenhagen-based Nørgaard. "We have voted similarly numerous times, with the Maastricht treaty and so on. The lesson is that the interpretation of this kind of vote is very difficult and can lead to a messy situation."
Prepare for turbulence
Post-Brexit, and with other major headwinds like low rates faced by the insurance asset management industry, things are likely to be grim for some time. Nordea has, however, been preparing itself for turbulence.
Nørgaard joined Nordea Life in 2004 as head of fixed income and liquid assets before his appointment as CIO in 2009 to manage the company's €60bn ($66bn) asset portfolio. At that time, 75% of Nordea's insurance products had nominal guarantees of 3.5% to 4.5%. But in 2010 it initiated a strategy to steer clients towards a new set of market return products — non-guaranteed, unit-linked investments in comingled funds to fit in with individual investor profiles.
Flows have flipped entirely since then with 90% to 95% of new business going into market return products, making the current split between guaranteed and non-guaranteed products a more manageable 50/50 ratio.
"We could see that in the future the capital requirements vis-a-vis guaranteed products would be far too large," explains Nørgaard. "The capital set aside and the return on equity would not work with the book of products 75% in guarantees that we had some years ago. Today, we are moving towards much less guaranteed products, so we can meet it. Over a short span of years, we are now down to a 50% guarantee book."
"Brexit and the future of the EU is a tail risk that is evolving into a base case risk"
While Nordea has stopped offering new guaranteed investment products, the portfolio still has a long tail of existing products with 50 to 60 years left to run. In the current zero yielding environment, the challenges to meet these guarantees are obvious. The insurer is, however, fully funded with a solvency capital ratio above 160%, says Nørgaard.
In part, its strong capital position is built on the diversity of its portfolio construction from 2007 onwards. Taking as its inspiration the US endowment model, Nordea sought to use a dynamic, multi-asset class portfolio, in many ways more progressive than its insurance peers. It currently invests 10% in equities, 5% in high yield debt, 15% in illiquid assets with the rest in fixed income and other credit, including some 2% in distressed debt.
The insurer also has a strong geographical diversity with a 50/50 split in European to US assets in its credit and equity portfolios. The US credit market is broader and deeper than the one in Europe and the insurer currency hedges everything.
Going against the grain
Having moved fairly early into illiquid assets Nordea has begun looking to tweak the portfolio. While geographical diversity still applies, Nørgaard says the company has been going against the grain in cutting its exposure to illiquid assets. When Nørgaard joined Nordea it had a 20% exposure to investments, including real estate, private equity, distressed debt, private credit and hedge funds — this is now 15%.
"We are the odd man out when it comes to illiquid assets," says Nørgaard. "We have been early movers but now we are moving in the other direction. Our European peers are building exposure to illiquid assets but we think we have seen the peak of allocation to illiquid and alternative assets."
There are two reasons for this. Firstly, cost. Quite simply put, with increased competition for private equity, real estate and private credit, illiquid assets have become more expensive during the past few years. Others may be willing to pay the price for the opportunities but with its already large existing illiquid asset portfolio, Nordea is not. On top of this is the issue of lapse risk. There is the potential of customers migrating out of Nordea's traditional products leaving a big slug of illiquid assets on the book, which are not so easily shifted.
"If I say a prudent level of illiquidity is 'X' and 10% to 20% of policyholders leave – what do I do?" says Nørgaard. "The proportion of illiquid assets increases for the remaining policyholders. It is all-round prudency. We think not just for existing policyholders but for the future also."
No shield to low yield
Nordea also has a large allocation to government bonds — specifically Northern European government debt — to match the local regulatory requirements of benchmarking liabilities against the euro swap curve. This has obliged the insurer to use Scandinavian, German or Dutch government bonds. With yields near zero in many of the government bond investments, returns are an issue.
"These are yielding zero so it is difficult but we are solvent," says Nørgaard. "We considered the trend of ever-decreasing rates and managed to build solvency buffers in that period, so we have reserves."
Fortunately for Nordea, the Scandinavian markets — in particular Sweden and Denmark — have had very proactive regulators, giving it a head start with a "Solvency 1.5" regime, says Nørgaard.
"The mark-to-market that has been implemented in Solvency II has been in place in the Nordics for 10 to 15 years so we were well prepared for Solvency II," he says. "It is a reason why we are solvent today."
A bad time to Brexit
There are risky times ahead though. Quantitative easing (QE) cannot last forever, especially when bond yields have already turned negative in many countries. At the same time, central bank rates appear to be as low as they can go.
In light of this, the potential threat to the EU's existence from Brexit is hardly welcome and investors should expect markedly lower risk-adjusted returns from now on, says Nørgaard. While he believes the financial system is better prepared than it was in 2007 and 2008, which will stave off the threat of a deep recession as back then, there will be no pick-up in growth.
"Brexit and the future of the EU is a tail risk that is evolving into a base case risk. There are no buying opportunities."
While the Brexit vote was a surprise, pre-referendum Nordea inspected its portfolios to understand its exposures. It went into the referendum underweight in equities, had a very small open dollar position and traded curve flatteners in fixed income — receiving in 30 years and paying five to 10 years — to anticipate the increased demand for safe assets in case of a Brexit.
Treading deep waters
In the medium to long-term the threat of political instability remains a deep risk for the industry. But Nordea is still looking to pick up yield where it can — distressed debt, for example, which can be a good opportunistic investment and one where market timing comes into play.
It could be said that risks are as high as they have ever been. Nørgaard is no fool in expecting the next few years to be anything but sanguine. But the CIO has experience and a progressive approach to managing the insurer's assets, which has stood it in good stead so far.