GLOBAL - Pension funds could achieve greater investment diversification by incorporating insurance-linked instruments in their portfolios, Watson Wyatt said.
The consultant said most investors lacked genuine diversity and relied mainly on equity exposure. But, this could be remedied through greater allocations to other forms of rewarded risk, such as credit or insurance.
Watson Wyatt global investment committee chairman Robert Brown said: "We recommend that institutional funds with sufficient governance seriously consider the merits of certain insurance-linked instruments as they offer attractive risk-adjusted returns, while at the same time genuinely diversifying the portfolio."
The firm identified three main categories of insurance-based strategies. Firstly, price assurance strategies, which provide an extra return to the investor in exchange for price certainty - such as commodity futures.
Secondly, price insurance strategies which compensate investors for providing protection against extreme price movements, but provide a highly asymmetric payoff profile - such as selling puts on equities or bonds.
And thirdly, event insurance strategies which compensate investors for providing protection against extreme events - such as catastrophe reinsurance.
Brown said: "They [insurance-linked instruments] also appear attractive now, based on elevated premium levels due in part to a reduction of available capital in the market. This approach is more a direct play than investing in insurance company shares, which also have undesirable general equity exposure."
According to the firm, an appropriately diversified portfolio of insurance instruments can return around 4% to 6% above LIBOR.
In addition to the insurance risk premium, the firm said schemes could benefit also from diversity across strategies that exploit other risk premiums such as equity, credit, time/ illiquidity and skill.
Brown added: "Given the complexity, this is for investors with high governance. With a typical allocation of 2% to 5% of their return-seeking allocation, investors need to acknowledge that this will involve specialist management, a diversity of non-traditional instruments and deployment that matches liquidity conditions. All of these require the application of significant resources."
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