What manager selection criteria yields success for ILS? Part of the Insurance Linked Securities for Institutional Investors 2017 Report.

Interviewer: David Grana, Head of North American Media, Clear Path Analysis

Interviewee: Brock Stephens, Senior Investment Analyst, Utah Retirement Systems

David Grana: When did you learn about ILS and develop an interest in the asset class?

Brock Stephens: My introduction to ILS came prior to my role here at Utah Retirement Systems, where I have been since 2010. While I was in business school, I did an internship working with a portfolio manager running an internal cat bond portfolio at a sizeable foundation. Admittedly, I had no clue what a “cat” bond was when I showed up that first day. Google led me to a Michael Lewis article written about John Seo for the NY Times, which I found interesting. But more importantly, this was early 2009. Seeing how ILS had performed in the months prior helped me quickly recognize the diversifying value the asset class can provide.

David: What is the appeal of ILS? What are the factors that make it an interesting asset class?

Brock: On the surface, there are two major factors that make ILS appealing to investors like us: (1) the relatively uncorrelated exposure and (2) the reasonable yield it provides. Having exposure to an asset class that is largely indifferent to traditional market movements is interesting. There is always a search and need in a large portfolio to have exposures that aren’t correlated to one another, and this asset class fits that category. Most pension funds need to return roughly 7 – 8% annually to meet their long-term obligations. Historically, ILS has provided returns near that target level when considering that the uncorrelated nature of the returns make it attractive from an absolute, as well as relative, perspective. In recent years, that attraction has brought in more and more “third-party” capital, however, that weighs on yields. This increase in the supply of capital has caused a considerable reduction in the future expected returns for the asset class.

David: What is the manager selection process that you take when evaluating an asset class strategy?

Brock: I’ve had the opportunity to research a number of esoteric asset classes, and the approach I take involves three basic steps. First, I to simply determine whether the asset class is a potential fit within our overall portfolio. This is assessed primarily by reading relevant material and through speaking with industry participants.

If it’s determined that an asset class is a potential fit, then I’ll begin looking closer at the various strategies within it. A couple considerations relevant to ILS could include identifying the differences in instruments traded. Liquid cat bonds versus collateralized or retrocessional reinsurance contracts, for example. Or noting potential advantages and disadvantages between pure ILS asset managers and traditional reinsurance companies that also manage outside capital. Once thorough understanding is established, then it shouldn’t be difficult to determine which strategy or approach might fit best with our internal risk constraints and return expectations. Once the proper strategy is identified, then I want to find the right partner. The right partner means comes down to finding thoughtful investors we can trust. This last step is often the most difficult. Identifying the right partner requires talking with a lot of people. Narrowing down which ILS groups to speak with was relatively easy compared to more traditional asset classes, where the universe is much larger. It’s a space where people know each other. Reputations and relationships here are important, and I found people to be quite open in sharing their knowledge, experience and opinions.

As more members of the URS team were introduced to and educatedon the space, our conviction increased and we ultimately allocated capital to a partner with a strong reputation, disciplined investment approach, and a history of showing strong alignment with their LPs.

David: How long was the process of evaluating whether this was a strategy that you wanted to allocate capital towards? How long did it take to find that manager who had synergies and common goals with the retirement system?

Brock: When I first joined the Retirement System, I was placed on our equity team, so felt that I should hold back before trying to convince people to take bets on the weather - at least maybe until I had established myself. I thought maybe I’d wait until after a large weather event, when industry prices might move before I’d bring this to their attention. The Tohoku earthquake hit Japan not long afterward, so I started bringing up ILS around that time. It wasn’t until January of 2014 that we placed actual capital into the space.

We did take our time and I wasn’t solely focused on this space, but over these three years, there were a number of conversations internally. Along the way, I became more educated and tried to educate others. I took a number of due diligence trips both in the States, to the U.K, Switzerland, and Bermuda. Many managers came by our office for meetings as well.

It doesn’t always take 3 years, but we do tend to take our time on the allocating to a new strategy.

David: Presumably after the Japan earthquake, the rates of return went up significantly and it would have been an attractive time to invest. Because of the long evaluation period did you feel that you might have missed out on potentially good returns?

Brock: Yes we did. Though returns didn’t necessarily spike due to the Japanese earthquake, these were good years for ILS performance generally. I knew there was more third-party capital coming into this space with every month that passed. And as I alluded to earlier, we saw a definitive drop off in yields just about the time that we invested. That said, I am glad that we took our time. As a pension plan, we have a long time horizon. The extra time allowed our investment committee to better understand and appreciate the space. They’re fully aware that one day, an event will cause our ILS investment to lose a lot of money, and will be prepared to respond quickly with an increased allocation to the space. The extra time also allowed us to find the right partner. In the long-run, the extra time spent up-front will lead to better aligned expectations and a longer partnership.

David: What could managers have done better throughout the evaluation process to make things more beneficial for you for the sake of educating you on the asset class as well as their strategy?

Brock: Most of the managers I met with in this space were quite helpful and willing to offer education and guidance with no strings attached. Part of my job is to set proper expectations with firms and managers. Urgency tends to always come from the other side of the table and I hope they can understand why the process may sometimes seem long. While we may have a longer dating period upfront, my experience says that this typically leads to a more lasting partnership in the future.

At the end of the day, we are fiduciaries to 160,000+ public employees across our state, including my own mother and sister who are both teachers. They work very hard and provide inestimable value to our communities. They’re paid relatively little for these efforts, but they have been promised a pension for when they retire. It is important to keep this in mind when we talk about alignments of interest and fees. This is where we’re coming from, so recognizing and understanding this should only be better for our conversations in the future.

This interview is from the Insurance Linked Securities for Institutional Investors 2017 Report. Download you free copy.