Insurance and the Outsourcing of Asset Management

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1 4 Insurance and Finance Research on Finance Issues in Insurance Outsourcing of Asset Management in Insurance: Challenges and Opportunities by Cecilia Reyes This article was published in Insurance and Finance No. 4, February 2009 Managing investments for an insurance company is quite distinct from managing investments for pension funds, retail and institutional mutual funds. The investments are on the asset side of the insurer s balance sheet and their returns directly impact its profits and losses and balance sheet. It requires strong focus on managing the assets relative to insurance liabilities, meeting solvency targets, managing realised gains and losses, generating investment income, meeting other financial and accounting targets and complying with insurance regulation on investments while meeting the primary objective of generating economic value for the insurance company. Maximising risk-adjusted total return under these insurance specific constraints makes insurance investment management a specialised capability in investment management. Investment management is estimated to be a US$85 trillion industry at the end of 2007 and of this, close to a fifth, or US$19 trillion, is insurance assets. Over 95 per cent of these assets are managed by insurance companies within their own in-house asset management operations. Although the size insurance assets managed by third party asset managers is expected to grow from $800 billion at end of 2007 to $1 trillion by end of 2011, it remains a small proportion of total insurance assets. Large insurers even those with no third party asset management business predominantly manage their assets in-house. For example, of the top 10 insurers by market capitalisation all, with one exception, have large in-house asset managers that manage their own insurance assets. 1 Zurich Financial Services engages third party asset managers to manage the majority of its insurance assets. Is this strategy unique to this large insurer or is it a trend that other insurers, large or small, will follow to gain operational efficiency or even competitive advantage? Several factors that could drive a strategy of in-house asset management are strategic, operational and industry specific: strategic retain full control of the investment process and investment results operational difficulties in incorporating important insurance specific constraints in outsourced asset management managing assets in-house is cost-effective lack of internal competence to manage and oversee an outsourced strategy execution risk of moving from insourced to outsourced strategy * Cecilia Reyes heads the Investment Strategy Implementation team in the Investment Management department at Zurich Financial Services. In this role she leads the implementation of centrally driven investment strategies across Zurich s global insurance balance sheets. cecilia.reyes@zurich.com. 1 As of 29 October 2008, the top 10 insurance companies by market capitalisation in descending order are: 1. AXA; 2. Assicurazioni Generali; 3. Allianz; 4. Manulife Financial Corp; 5. Zurich Financial Services; 6. Munich Re; 7. Metlife Inc.; 8. AIG; 9. Travellers Inc.; and 10. Tokyo Marine Holdings Inc.

2 industry specific lack of sufficient diversity in the investment industry of third party asset managers with scale and insurance-focused capabilities Outsourcing within the insurer s investment management value chain Large insurers with no third party asset management business and who are contemplating to outsource asset management either fully or partially as a strategy must think carefully how such outsourcing fits in the insurance investment management value chain. The key is to add value through outsourcing all or parts of this value chain while retaining full control of the chain of activities itself. Once the strategic fit of any outsourcing in this value chain is analysed and decided upon, the internal capabilities and structure must be put in place to implement that strategy effectively. The insurance investment management value chain An insurer can adopt a three-step approach that follows the three sources of return: risk-free rate, beta and alpha. 2 This is shown in Chart 1 below: An insurer s three-step investment approach Portfolio Systematic risk Determine risk-free construction to taking to Investment position generate extra enhance returns skill-based returns (risk-free ree return) (ϑ) (Ι ) The first step involves determining the insurer s minimum risk position relative to its shareholders capital. The minimum risk portfolio consists of assets that match the insurance liabilities to the extent possible. This portfolio is called liability replicating portfolio. Investing in this portfolio enables the insurer to allocate the smallest amount of capital to cover ALM risk. For general insurance liabilities, it is sufficient to build this replicating portfolio with government bonds, whereas for life insurance liabilities where many policies have embedded guarantees, the replicating portfolio is more complex to build and will normally include derivatives positions to hedge the embedded options. Investing in this liability replicating portfolio will earn enough return to pay the insurance claim in the future with a high degree of certainty. The second step involves optimising the utilisation of the insurer s investment risk bearing capacity. Insurers must hold capital and a large part of it is trapped by regulation in local operating companies. There is an optimum level of this capital that should be allocated to investment risk due to diversification benefits from combining investment and insurance risks. This risk-based capital allocated to investments enables insurers to bear risks and earn returns, i.e. the market risk premium or beta, in excess of the risk free rate. The output in this second step is the insurer s strategic asset allocation its long term investment strategy. The third and last step is the actual portfolio construction itself, implementing the investment strategy derived in the second step. The objective in this stage is to implement effectively the long-term investment strategy and generate additional return, or alpha, from skills in managing these portfolios. The portfolios are held by operating companies and must meet insurance specific requirements, including compliance with local investment regulations. For a large global insurer, the number of locally regulated insurance companies can be large which makes portfolio construction challenging. The combined portfolios earn the risk free return, excess return for bearing capital market risk (beta) and excess return from skills in managing individual portfolios (alpha). 2 This is based on a discussion of insurance investment management, Investment Management a creator of value in an insurance company, Zurich Financial Services, November

3 The investment management value chain is a series of value adding activities that implement this threestep approach. This is shown in Chart 2 below: Investment management value chain Asset Liability Analysis Earn risk-free investment return by understanding the risk-free investment position St rategic Asset Allocation Define the long-term Strategic Asset Allocation based on allocated risk capital Earn market risk premium (Beta) Tact ical Asset Allocation Manager Selection Local Adaptation and Portfolio Construction Security Select ion and Trade Execution Cent ral Asset Manager Oversight & Inv. Reporting Operations Generate skill-based returns based on market strategies Select high-performing asset managers at right price Systematically monitor manager performance and act on underperformance Ensure efficient implementation of investment strategies Alpha generation by internal and external specialist asset managers Provide timely, high quality information for decision making in the investment process Create effective and efficient governance structure for investments through: - effective and documented investment governance process - mitigation of operational risks and conflicts of interests within the group - execution of projects to improve effectiveness and efficiency of the investment function - effective investment planning and management of investment budgets The ALM process within investment management involves clear understanding of the insurer s liabilities that must be backed by the investments. This is the process that builds the liability replicating portfolio. The strategic asset allocation (SAA) process formulates the strategic portfolio that maximise expected excess returns relative to liabilities per unit of risk-based capital allocated to support the investment risk. The value chains for earning alpha include the Tactical Asset Allocation, Manager Selection, Security Selection and Trade Execution processes. Finally, the last components of the value chain are operational: investment performance measurement, monitoring, analysis and reporting. These activities are necessary to monitor all the steps in the value chain. It is very important to note that this value chain must be supported by a state-of-the-art investment technology platform allowing for centralised measurement and monitoring of ALM and investment risks, monitoring of investment positions in each portfolio, and tracking portfolio structures and investment guidelines agreed with the asset managers. Where outsourcing fits the value chain When an insurer contemplates and analyses the benefits of outsourcing, it must look into this value chain and decide which parts are insourced and which ones can be outsourced to third party service providers. Small insurers could outsource the entire investment value chain to asset managers with full service capabilities. Large insurers with resources to build the infrastructure to support all or parts of the value chain would selectively outsource parts of the value chain. The best approach to the question of outsourcing is to outsource unless there are compelling reasons not to do so. The larger and more complex the insurer s organisation, the more difficulties it will face in effectively outsourcing parts of its investment management value chain. Upon detailed and in-depth analysis, the most compelling part of the value chain to be outsourced is the Security Selection and Trade Execution process. The ALM and SAA processes are most difficult to 3

4 outsource. Operational complexity and confidentiality of information required in these processes have led Zurich to conclude that these activities should continue to be insourced. The TAA, Manager Selection and performance measurement processes can be outsourced; however, cost benefits analyses favour these activities to be insourced. Outsourcing security selection and trade execution Security Selection and Trade Execution involves selecting sectors and individual securities that comply with the portfolio mandate (which includes the relevant constraints) with the goal of generating returns that meet or exceed agreed market benchmarks. An insurer requires active management of a large part of its investment portfolios. In risky assets such as equities and credit portfolios, the opportunities for asset managers to generate alpha from active management are tremendous and to harness this, it must build solid infrastructure for research and analysis of the macro- and microeconomic factors and trading capabilities covering a vast investment universe. Such capabilities are expensive for an insurer to build in-house. For an insurer that has no third party asset management as a line of business, engaging third party asset managers with solid research and trading infrastructure is the optimal strategy. Other compelling reasons for an insurer s decision to outsource this part of the value chain are as follows: (a) unfettered ability to tap top asset management talent in the industry, (b) flexibility to enter and exit asset classes in an efficient way without frictions arising from consequent Human Resources decisions, (c) access to other market information and services useful in managing the rest of the value chain, (d) reduce operational risks, (e) leverage the size of its assets and long term investment horizon to negotiate low fees. Large insurers can give large mandates to asset managers. With its ability to be invested in an asset class for the long term as well as capacity to form long-term stable relationships, the insurer has a lot of leeway to negotiate attractive fees. Cost benchmarking analysis performed by Zurich revealed that costs paid to external asset managers in basis points of assets under management is competitive relative to costs of internal asset managers. The challenges in outsourcing asset management Once the outsourcing strategy is decided upon, implementation and execution become the drivers to making it a success. In the case of Zurich, it outsources only the sector and security selection and trade execution for securities portfolios to external asset managers. Close to 70 per cent of its general account insurance assets is managed by a selection of external asset managers. This 70 per cent represents over 80 per cent of its securities portfolios which is close to US$130 billion of its investments. To meet its strategic goal of retaining direct and full control of the investment process while adopting an outsourcing strategy for important parts of the process, it is important for an insurer s investment management department to have a clear focus on the investment value chain and build internal core competencies and capabilities to deliver value in each part of the chain. The key challenges to outsourcing and how an insurer can overcome them successfully are as follows: Manager Selection Selecting the right insurance asset manager is very important because the cost of underperformance. Going through the process to understand what is giving rise to the underperformance, terminating a mandate and going through another selection process is very costly. The insurer must get the right manager in the first place to avoid and mitigate the significant costs of replacing the wrong manager. Diversification of asset managers is also important. The third party investment management industry has to meet the challenge of supplying capacity to manage insurance assets at scale that makes it costeffective for the insurers and sufficient diversity of managers to enable insurers to diversify asset manager risk. 4

5 Portfolio construction to meet ALM, SAA and TAA requirements Communicating effectively with external asset managers the ALM requirements is necessary. Such requirements can be simple, such as duration targets of fixed income mandates, or complex which may require separate derivatives mandates. Implementing derivatives strategies with outsourced asset managers is a key challenge. Strong derivatives capability is an important requirement in selecting asset managers. Risk management Risk management and control are best implemented through investment guidelines. Each portfolio mandate with an external asset manager is governed by a legally binding set of investment guidelines that specify the objectives, investment universe, constraints and risk limits that in aggregate reflect the insurer s investment goals and risk tolerance. The formulation of investment guidelines for each portfolio mandate is a core competence of the investment team in an insurer that has adopted an outsourced asset management strategy. The investment guidelines must balance well the risk and return trade-off in any given mandate. Both external asset manager and the insurer s investment teams must obviously focus on the investment guidelines. Agreeing on the investment guidelines is a serious activity and often follows intensive discussions with the asset manager. Breaches of investment guidelines by asset managers that result in a loss to the insurer will result in compensation payments to the insurer. Clearly, it is also challenging to a large and complex insurer to manage the risks in the outsourced relationship. Monitoring systematically the compliance of its asset managers to agreed investment guidelines is difficult to put in place. Where individual security positions and number of portfolio mandates are large, the insurer must develop such a compliance monitoring system centrally. The insurer will also rely on compliance attestations of its asset managers and external audit certifications of the systems and controls of the external asset managers. The insurer may find it useful to allow its own internal audit teams to conduct site audits from time to time to get first hand evidence of the adequacy of the asset manager s systems and controls. Investment operations Engaging third party asset managers to manage investment portfolios require that infrastructure must be in place to feed transaction information from asset managers to the insurer s investment operations staff. Each single trade an external asset manager conducts for the insurer s general account portfolios must be booked and accounted for. The more the asset managers, the more complex the investment operations can become. It is important for the insurer to implement operations infrastructure that allows external asset managers to communicate within agreed time the transaction and price information to its back office operations. Investment information solutions To manage investment management centrally where major investment activities are outsourced, the key to success is the ability to have access to information on investments held in numerous insurance company balance sheets globally and managed by a team of internal and external asset managers. Furthermore, a technology platform to store and monitor all portfolio mandates is critical. Implementing a technology platform is perhaps one of the biggest challenges for any large insurer contemplating on outsourcing its investment management activities. In volatile markets, speedy access to information on risk exposures, in which insurance company balance sheet, in which portfolios and which asset managers, is very important and it allows the insurer to communicate effectively with internal and external stakeholders. Communication Last but not least, efficient and effective communication between the insurer as client and its external asset managers is of critical importance. The level of communication usually spans a wide range of staff and activities, starting with back office operations staff, the insurer s custodians and the investment teams. In any relationships of strategic importance to the insurer, regular high level communication between the senior management of the insurer (e.g. its Chief Investment Officer) and the external asset manager is always helpful. 5

6 Quite understandably, communication between the insurer with outsourced asset management and its team of external asset managers will have intensified tremendously during the financial crisis. It is important for an insurer to have designated points of communication with its external asset managers. Establishing these points of contact between the insurer and their counterpart Relationship Managers mitigates frictions in communication. The insurer should also develop internal performance monitoring systems to store, analyse and report on performance of all its asset managers. This should include a performance rating scorecard for all its external asset managers covering all relevant aspects of the relationship and ratings should be done regularly. The outsourced strategy and a disciplined and systematic implementation and execution of this strategy are two of many factors that can contribute to the success of an insurer in weathering the financial storm. Investment guidelines that dictate its risk management requirements with a good balance between risk and return and strict diversification criteria play an important role in avoiding the worst of the toxic assets at the centre of the crisis. Furthermore, the skills in selecting the right sectors and individual securities by its asset managers are important factors that will allow the insurer to mitigate large losses in its investment portfolios. Conclusion Selective outsourcing of the investment management value chain is a strategy that an insurer can and should pursue. Now in the midst of the worst financial and economic crisis since 1929, this strategy if implemented and executed effectively will pay off very well for the insurer. Outsourcing sector, security and trade execution to best of breed asset managers allows the insurer s investment management to focus in a disciplined and systematic way on its investment strategy and the value drivers in insurance investment management. Giving mandates to external asset managers to perform the security selection activity within predefined investment guidelines removes costly and potentially fatal distractions away from its investment strategy and the other value drivers that matter most: managing risk, focusing on the long-term investment strategy, and analysing market conditions and their impact on the strategy. For large complex insurers, outsourcing selectively parts of the investment value chain has great benefits. But there are challenges to implement and execute the outsourcing strategy. But when challenges are overcome successfully the benefits are very evident and compelling, especially in today s turbulent conditions in the financial markets. About the author: Cecilia Reyes heads the Investment Strategy Implementation team in the Investment Management department at Zurich Financial Services. In this role she leads the implementation of centrally driven investment strategies across Zurich s global insurance balance sheets. cecilia.reyes@zurich.com. This article was published by The International Association for the Study of Insurance Economics (The Geneva Association). Articles, documents and recent publications of the Association can be found on its website, at 6