Insurance companies generally recognize the importance of delineating their business functions across product and investment management. This includes separating the responsibilities for managing their insurance business lines from the oversight of the investments backing their reserves and capital.
The management of these assets has become increasingly strategic because of the growing scale and complexity of investments on an insurance company’s balance sheet; and the impact of performance results on profitability.
The decision by an insurer to use an unaffiliated investment manager can be driven by many factors.
Here are some of the considerations insurance companies should make when considering the outsourcing of their investment management responsibilities:
- Enhanced investment capabilities
- In many cases, insurers seek out the help of a third-party manager in order to access certain “non-core” markets. By partnering with external asset managers, insurers can also receive additional resources and insights, which can help enhance their in-house management. Third-party managers can act as an extension of the insurer’s overall capabilities.
- Resources and technology
- Technology is at the forefront of future transformation in the insurance industry. Beyond artificial intelligence, machine learning and big data, there are other technological implementations that can significantly impact day-to-day operations and risk management. Partnering with a large third-party manager can give small- to mid-sized insurers access to insight and resources they would be challenged to acquire on their own due to a lack of scale. Even for larger insurers with significant in-house resources and technology exposure, partnering with a global firm allows for a differentiated lens into how to use certain aspects of systems, services and innovation. Having alternative perspectives from outside the firm is often a valuable resource that can be used within investment divisions and beyond.
- Risk management
- A multi-layered risk management approach tends to add significant downside protection for certain aspects of portfolio management, as well as for systems and facilities. Asset managers with proprietary risk systems and analytics can add considerable value to insurers as they can help with portfolio optimization, factor sensitivities and global impacts that may require a robust application. Also, having additional human resources focused on addressing these areas of concern for insurers can aid in speed to delivery and resolution.
- Cost reduction
- Cost and economies of scale have played a significant role in the proliferation of third-party insurance asset management, particularly in the U.S. The ability to offer broad-based investment capabilities across sectors and asset classes at a reasonable bundled or à la carte pricing structure has afforded insurers added flexibility. Carrying significant personnel and fixed costs to support the platform can be daunting and inefficient. Having third-party investment managers can allow insurance companies to re-focus efforts on core aspects of their businesses to better realize potential growth opportunities.
- In many instances, this is most relevant for small- to mid-sized insurers that don’t have the scale of larger insurers to cost-effectively build out in-house management. Therefore, magnitude and investment acumen often times are the primary driver in making this decision. This segment of the market tends to have a greater percentage of their core assets outsourced to third-party managers with established reputations in the insurance asset management space.
- However, large insurers are increasingly taking advantage of the trend with more of a satellite approach. Many of the larger firms who can cost effectively manage core assets (such as U.S. investment-grade fixed income) in-house will still employ third-party managers to handle the 10%-20% of assets that are non-core. From a cost measurement standpoint, they simply do not have the volume of deal flow or need to warrant building the capabilities and team in-house. The asset classes typically contain niche/idiosyncratic strategies that insurers would not replicate, such as private markets, hedge funds and absolute return, among others.
- Specialized skill sets, idiosyncratic opportunities
- The evolution of alternative asset classes, strategies and markets has led to teams and capabilities either migrating to standalone operations or being housed in diversified investment organizations that have substantial distribution competence. This transfer of talent makes the decision quite easy to look outside the company for resources and cost-intensive strategies that are not easily replicable. It makes more sense to seek out the best talent and proficiency, which has gradually become more relevant within the insurance realm regardless of size. The strategies tend to include various direct origination private credit, emerging-markets debt, high-alpha hedge funds and absolute return strategies.
- Capabilities in optimizing asset-liability matching goals
- Optimization and modeling analytics lend themselves to generating a multitude of heuristics, which require substantial interpretation to arrive at specific results and more importantly create the execution roadmap necessary to achieve different objectives. Expanding the solution toolset can offer benefits on the micro/entity liability level as well as the macro/strategic asset allocation level. Asset managers with proprietary risk and optimization systems can help with many issues and identify opportunities regarding insurance company balance sheets and separate account portfolios.
The business and operating environment is evolving rapidly in response to changes in regulation.
- Business, operations and regulatory requirements
- The business and operating environment is evolving rapidly in response to changes in regulation. One example is that of the Bermuda Monetary Authority (BMA) and Solvency II. The BMA requires Bermuda-domiciled re-insurers to outsource a portion of assets to unaffiliated third-party managers. BMA is also a regime similar to Solvency II, which requires specialized reporting as it pertains to how assets are managed. This typically results in insurers soliciting the services of asset managers to help with these requirements. While this is just one example, foreign insurers buying other insurers or assets in a region outside their home country typically fall subject to outsourcing requirements. These foreign companies usually need assistance with reporting and regulatory requirements, as they are operating in largely unfamiliar markets.
While the motivations and goals tend to be multi-faceted in nature, the cost benefit is typically a major driver of engaging established asset managers. In doing so, insurers can access the talent and resources necessary to achieve optimal results. The size, complexity and objectives of each company will tend to be bespoke in nature. Therefore, each insurer must assess its specific needs and requirements that to determine the custom solution it requires.
Insurers have multiple implementation options when considering outsourcing investment management. Large global investment firms offer broader access to investment and risk management solutions, while smaller firms or individuals may offer niche or very specific investment offerings. Asset-liability and surplus investing tend to be specific to a certain company, entity, sector and business line. There are no one-size-fits-all solutions. Therefore, a single partner solution may suffice in a few cases, while in most cases multiple external managers may offer better optionality.
The insurance industry is a complex organism. Insurers should be diligent when selecting an investment manager or managers. Investments are subject to regulatory requirements, rating-agency evaluations, duration targets, cash-flow demands, statutory accounting and risk tolerance limitations, among others.
Therefore, managing an insurance liability-driven portfolio requires an understanding of the insurer’s business model, objectives, risk tolerances and investment goals. While total return may be important in many market and interest-rate environments, insurers should be wary of firms that promise high returns without getting a detailed representation of asset exposure, risk assessment and strategic allocation based on investment guidelines agreed upon by all parties.
Above all, insurance asset managers should consider, recommend and implement appropriate investment strategies and allocations that are suitable relative to the specific line of business and pool of assets of the insurance company. They need to be comfortable with managing portfolios with various constraints and cash management requirements.
As such, insurers should select managers based on their insurance knowledge base, reputation, and access to their insurance team, and on their operational and reporting standards. Managers should have all the requisite capabilities and value-added services to deliver comprehensive investment solutions to their insurance clients.
Alternative investments involve specific risks that may be greater than those associated with traditional investments; are not suitable for all clients; and intended for experienced and sophisticated investors who meet specific suitability requirements and are willing to bear the high economic risks of the investment. Investments of this type may engage in speculative investment practices; carry additional risk of loss, including possibility of partial or total loss of invested capital, due to the nature and volatility of the underlying investments; and are generally considered to be illiquid due to restrictive repurchase procedures. These investments may also involve different regulatory and reporting requirements, complex tax structures, and delays in distributing important tax information.
Fixed income securities are subject to certain risks including, but not limited to: interest rate (changes in interest rates may cause a decline in the market value of an investment), credit (changes in the financial condition of the issuer, borrower, counterparty, or underlying collateral), prepayment (debt issuers may repay or refinance their loans or obligations earlier than anticipated), call (some bonds allow the issuer to call a bond for redemption before it matures), and extension (principal repayments may not occur as quickly as anticipated, causing the expected maturity of a security to increase).