Outsourcing of General Account Investment
Outsourcing of General Account Investments
Changes in the insurance market have lead to rethinking financial strategy and searching for new ways to ensure profitability.
By William Limburg
Outsourcing of insurance assets to third party money managers has grown steadily as insurers face increasing market challenges. Increased global competition and changing products with aggressive pricing and guarantees have forced many insurance company executives to reevaluate their traditional business operations and profit drivers. Superior underwriting and distribution alone are no longer sufficient to ensure profitability. This is driving insurers to seek improved returns from their portfolios. Firms are seeking to deploy strategies that best align their investments with product requirements and maximize risk–adjusted economic value.
Insurers are finding that a strategic approach to outsourcing investments is critical to enhancing value within both liability reserves and surplus portfolios. Third party managers are increasingly being employed to harness the economies of scale and focused expertise of organizations whose sole business is asset management. Firms are also outsourcing to diversify asset classes as they search for new sources of yield.
According to a study conducted by Patpatia & Associates, the scale of outsourcing has experienced strong growth across all geographic markets (see Table 1), and, importantly, it is also anticipated to continue to grow dramatically from the current $804 billion to $1.9 trillion over the next five years. While the highly competitive North American market has had strong incentives to employ external managers, European, and to a lesser extent Asian, insurers have only recently begun to explore third party asset management.
The rise of offshore domiciles, including the Bermuda reinsurance market, is further directing this rapid growth. These venture funded entities are bringing a disciplined approach to business management, outsourcing non–core functions to concentrate on underwriting and capital management. Additionally, as insurance becomes more global in nature, the need to support general accounts outside of companies' home markets is leading firms to explore third party management. Diversifying investment portfolios and hedging risks at local and global levels through third party money managers is becoming a regular practice today for many insurers with international operations. Many insurers are being led to a new breed of insurance asset manager with extensive cross–border and multi–currency capabilities.
Despite the widely prevalent view that only the smallest insurers typically employ third party management, the Patpatia & Associates market survey indicates that insurance companies of all sizes (see Table 2) have found that outsourcing select general account investments has improved their investment programs. However, having differing resources, risk tolerances and capacity constraints, the optimal role of outsourcing varies according to size and investment requirements.
Small insurers, those with general accounts below $1 billion, for example, have historically had the strongest propensity to engage third party investment managers and, not surprisingly, make up the largest proportion of asset managers' insurance clientele. Economies of scale present challenges for smaller insurers, often inhibiting their ability to internally build out competitive investment resources for their general accounts. To harness the full breadth of investments, these insurers frequently rely on third party investment managers, not just for investment management, but also for back office, strategy and risk management services.
Several managers have assembled targeted investment programs specifically to meet the needs of smaller insurers with turnkey programs. Out of 52 managers targeting the insurance marketplace, nearly one–third offer comprehensive insurance consulting services, including cash flow modeling and DFA, insurance capital forecasting, asset allocation/portfolio optimization and risk management assistance (see Table 3).
In the mid–market of insurers ranging from $1– to $5–billion, firms continue to embrace outsourcing. Some have chosen to outsource their entire investment portfolios, while others reclaim select assets in–house, while continuing to employ the third party investment firms for their resource–intensive fixed–income classes, such as high yield and emerging markets. However, as firms grow, the majority find it important to narrow the manager relationship to separate core portfolio management duties. Separating investment strategy (e.g., term structuring, asset allocation) and business infrastructure (e.g., accounting) enables insurers to effectively replace managers as necessary, independent from concerns over broader operational impacts. Further, this allows insurers to diversify investment relationships, optimizing the allocation of assets across managers to best leverage their unique strengths.
While the majority of larger insurers, with assets greater than $5 billion, have extensive internal investment capabilities, they are finding outsourcing as an ideal tool to complement their in–house investment strategies. Although these larger insurers represent only 10 percent of all outsourcing relationships, their investments now represent more than 30 percent of actual outsourced assets in the market. Typically, they outsource in order to diversify assets either into focused specialties (e.g., CDO management, non–local currency mandates) or to alternative investments, such as hedge funds and private equity holdings, where building internal capabilities would be impractical.
A recent departure is the increasing propensity of larger insurers to employ third parties for core fixed income portfolios. Historically, large insurers have been less likely to outsource these functions, having built–out extensive bond management capabilities. However, with many firms finding themselves undergoing rapid growth, the capacity of internal investment departments cannot always keep pace with the volumes of new asset flows. Deploying external managers has allowed insurers to reduce "underinvested" assets. Several insurers have also elected to outsource focused core mandates to access complementary investment viewpoints and to serve as a tangible benchmark for the performance and costs of their internal investment operations.
The different types of insurers have markedly disparate demands for and requirements of third party managers. However, all insurance companies have been aggressively increasing their outsourcing of general account investments, with an aggregate compound annual growth rate of 35 percent across all types of insurers over the past two years (see Table 4).
Although property and casualty assets represent only one–fifth of the U.S. general account marketplace, P&C firms have been aggressive adopters of outsourcing. Today, direct P&C insurers and reinsurers account for nearly 60 percent of third party managers' insurance business. Because of the limited interest rate sensitivity to their liabilities, P&C companies have greater freedom to manage investments on a total return basis. Having less predictable payouts and a comparatively higher need for liquidity, P&C insurers frequently find that active management on a market value versus book income approach is suitable. Money managers' standard, actively managed, total return institutional offerings have been attractive to property and casualty insurers. However, even with P&C firms, these strategies require a degree of customization and constraints due to the taxable nature of all insurance investors.
Life insurers have been comparatively slow to take up third party asset management. Although life, annuity and health insurers share a five–to–one (5:1) dominance in total U.S. general account assets, a much smaller share of their portfolios have been outsourced. The industry–specific book income, buy–and–hold investment style of life companies has inhibited their attraction to money managers' offerings.
The nature of their actuarially–dependent liabilities, regulations and accounting favor the use of book income strategies. Historically, few managers possessed the specialized expertise or wished to depart from their taxable, high turnover pension management strategies. However, over the last few years more managers have assembled book income investment programs, providing life insurers a greater choice of leading institutional managers (see Table 5).
Finding managers willing to accept insurance–specific restrictions has become key. Most insurance liabilities may be best serviced through custom liability–based separate accounts where insurers may dictate key criteria, like term structure, rather than investing in "off the shelf" products (see Table 6).
Portfolio turnover must also often be a focus due to the taxability of insurers' investments. Finding a manager that will allow insurers to place specific targets for maximum turnover or require managers to achieve specific levels of realized capital gains and losses is of paramount importance. Many managers are also willing to collaborate with their insurance company clients on new asset inflows and anticipate liquidity events to tailor investments to their anticipated cash flows.
Insurers' today have a stronger position when dealing with investment managers' portfolios because they represent a sizeable portion of the investment managers' business. The outsourcing of insurance general accounts has become a vibrant institutional market for investment advisors, with 9 percent of the assets of managers participating in the 2006 survey derived from insurers' general accounts. This is allowing insurers to dictate the nature of the outsourcing relationship for a more effective business solution (see Table 7).
The increasing importance of the insurance market has led investment managers to tailor their investment products to meet the specific needs of insurance companies. Today most outsourcing insurance mandates are managed differently than for pension or other institutional clients. For example, specialized book income strategies are increasingly available to insurers seeking enhanced levels of steady income as opposed to total return investments to meet the liability requirements of certain insurance portfolios, such as life and annuities. Insurers are becoming increasingly comfortable placing significant portfolios in those strategies, as reflected in their comprising 64 percent of outsourced assets, despite making up only 39 percent of outsourcing relationships (see Table 8).
Overall, insurers are showing a strong ability to adapt to the maturing insurance outsourcing marketplace. Executives should be open to engaging third parties as another viable approach to diversifying portfolios and adding value through their investments. Of course, insurers need to select the appropriate investment manager, or managers, to allocate their mandates according to each company's needs. Several factors should determine an insurance company's choice of an investment manager, such as the management style and specialist expertise of the investment manager, fee structures and the manager's ability to meet the insurer's tax and regulatory structures. Insurance companies should also maintain direct involvement in the process through ongoing oversight of their outsourced activities to ensure appropriate liability–driven, risk–adjusted performance. Investment managers are better prepared today to service insurers' customized needs. However, every insurance company has a unique set of needs and preferences. There is still an art to the process of selecting the appropriate investment manager for insurers and building the right relationships. The advantages to insurance companies, however, are evident.
William Limburg is senior associate for Patpatia & Associates, Inc. He can be contacted at 510.559.7140 or firstname.lastname@example.org.
For a copy of the full study or more information on outsourcing insurance asset management, please contact Patpatia & Associates, Inc. at 510.559.7140 or email@example.com. You are also invited to visit the Patpatia & Associates Web site.