Because of the amount of investment required, insurance companies are asking themselves if it's worth keeping their asset management arms. John Foster reports.
In Through The Looking Glass, Alice, the heroine of the story, finds herself trapped in a race with the Red Queen. Both are sprinting as hard as they can, but remain rooted to the spot. The Red Queen turns to Alice and says: “Here it takes all the running you can do, to keep in the same place. If you want to get somewhere else, you must run at least twice as fast as that!” The European insurance industry is finding itself trapped in the same scenario, in a conundrum over whether to stick or exit from the asset management game.
An onerous increase in the regulatory hurdles that insurance companies have to negotiate under new pan-European legislation, changes in accountancy standards, changes in risk management practices, and on the other side of the divide, the increased sophistication of investment management techniques, has meant that insurance companies will have to massively invest in their in-house asset management facilities just to stand still.
Many life companies are concluding that they are better at underwriting policies than managing money and the asset management industry is more than glad to assist. While many insurers looked after their own investments for decades, lately many have looked for help, after finding themselves caught off guard by the weakness, or complexity, of their own portfolios.
In the US last year, insurers outsourced management of more than $1.1 trillion (€868bn), according to industry estimates, up from about $980bn in 2008. Europe is fast following this trend.
Key to the survival of many life companies is concentrating on their core competence – providing and distributing insurance products – as opposed to trying to compete toe to toe with specialised boutique investment houses.
The big question is well posed by Dirk Popielas, the newly installed head of insurance Emea for JP Morgan Asset Management. He asks: “Do insurance companies still want to be in asset management?”
He believes that in the post-Millennium, pre-crash world, insurers were able to diversify their business and offer not just traditional insurance products, but compete with the asset management community for pension fund mandates and distribute retail investment products. In the UK many traditional insurers span out asset management businesses from their life companies, and these asset managers constructed a suite of products from their captive assets that they then leveraged to offer investment management services to external clients.
Soon organisations like Standard life Investments, Royal London Asset Management, born from life companies, or Pimco, acquired by life insurer Allianz, were regularly pitching for and in many cases winning mandates from the traditional investment management providers.
However, when the financial crisis hit the global investment markets, many of the new entrants to the asset management field found that they had opened Pandora’s box, and their core business assets came under pressure. One of the biggest victims of the credit crunch was US insurance group AIG.
In September 2008 it had its credit rating downgraded and as a result was forced to deposit more collateral with its counterparties to balance its swaps exposure. It didn’t have the ‘ready money’ and this spelled disaster. Although AIG fell foul of its credit default swap exposure on structured debt securities backed by sub-prime loans, the insurer had systematically moved away from its core competence into more speculative transactions.
AIG just did not have the level of sophistication needed to manage its exposures and as a result suffered catastrophically. The same scenario was replayed across the sector, which led to record losses for insurers across the board.
This is why Popielas, who joined JP Morgan in July, claims that his company can help out the insurance industry. He said: “The new insurance paradigm is all about risk management and creating an economic balance between assets and liabilities.”
He argues that specialist investment management organisations have the tools, sophistication and experience to work out the market value of an insurer’s liabilities and ‘look-through’ the company’s asset book to establish what real exposures the company has and how to mitigate its risk.
In the aftermath of the credit crunch, regulators have heaped legislation on the financial services industry. Insurers are now required to provide mark-to-market valuations of their portfolios on a daily basis. This is a revolutionary change from the book valuation system that had been the traditional accounting standard used by the insurance industry. AIG was caught out by mark-to-market reporting as the true valuations of its assets wildly fluctuated at the height of the credit crunch and stressed its liquidity – a vital component of balancing an insurance book.
Standard Life has heavily invested in its asset management arm, Standard Life Investments (SLI), and has had some success. Phil Barker, SLI’s head of pan-European sales and account management, explains that 40% of SLI’s assets under management are third-party mandates. He said: “We have credibility as an asset manager and can compete in terms of performance, people and processes.”
However, Barker is a becoming something of a dying breed, as since the Millennium crash, many European insurance companies have exited third-party asset management entirely. Zurich led the way, selling Zurich Scudder to Deutsche Asset Management in 2002. SwissRe exited the market last year, selling its third-party asset manager, Conning Asset Management, reducing its exposure to credit and securitised products and outsourcing the remaining CHF22bn (€16.7bn) portfolio to BlackRock.
In July BlackRock also won a £5.7bn (€7bn) mandate from Equitable Life to maximise returns on its assets under management and satisfy its regulatory solvency ratios, so David Lomas, managing director of BlackRock’s financial institutions group, is at the vanguard of this development.
He sees Solvency II – the EC’s new regulatory regime for a pan-European insurance market – as one of the main challenges for the industry in the march towards 2012 and an accelerant of the process of asset management outsourcing that is already underway in the European insurance industry.
“Solvency II is challenging the way that insurance companies manage their assets. They need to understand what they hold, what they are buying and what returns they can expect from their assets – all in a tricky low-yield environment.”
With yields from traditional assets such as gilts, the mainstay of a life company’s assets, depreciating and at the same time the risk from government bonds increasing, as seen by the Greek government debt crisis, insurance companies are having to hunt for yield in unfamiliar areas, while at the same time balance the risk in their portfolios. This scenario leaves a yawning trapdoor for insurance companies to contend with. They need to speculate to accumulate, and seek returns that can match their liabilities, but the pursuit of higher yields quite recently led investors into the honey-trap of collateralised debt obligations, sub-prime debt and financial ruin.
With the need for greater investment sophistication and to cast the net for increased yield further afield, matched with a growth in the regulatory and accounting environment, insurance companies need to upgrade their asset management capabilities just to have enough capital to match their incumbent liabilities.
However, with premiums diminishing and demographic pressures forcing up liabilities the economic case for further investment in asset management capability is a hard one to sell at board level. A more intelligent use of money might be the expansion of the company’s distribution network and development of product lines in order to sell more policies and achieve a greater inward cashflow.
Jaime Ramos-Martin, manager of SLI’s £246m (€300.4m) European Growth Fund and specialist on the European insurance sector, says: “The insurance companies are asking themselves, if only 3-4% of my assets are in equities, why do I need 10-20 people to manage them?” And it is this thought process that is leading insurers to outsource their asset management functions.
“They need to optimise their capital. What value does an insurance company have in managing the investment of a closed book of life assets?” said Wade McDonald, senior vice president at State Street. “Axa recently sold its closed book insurance assets to Resolution and as the need for everyone in the industry to get meaner and leaner grows, insurers will drill down and focus on what assets and what liabilities they need to manage most effectively,” he said.
Out with admin too
McDonald also sees insurance companies not only outsourcing their asset management requirements, but their administration too. He believes if insurers pool their closed-book assets, given the potential size of these insurance assets, administrators can effectively manage the back office functions of the insurance industry in a highly cost-effective manner.
“The insurance companies need to concentrate on developing products for distribution to you and me, as well as to internal clients and outsource the specialist asset management and administration functions to third parties to cut their cost basis and focus on driving their revenues,” says McDonald.
Popielas agrees: “In order to manage liabilities in a low-yield environment,
asset managers are having to consider exotic markets like Latin American credit, and understand complex investment tools like derivatives to hedge risk and create alpha. Insurance companies have to decide what their strategy is – do they want to invest heavily in beefing up their investment teams, just to stand still? Or do they want to concentrate their resources on expanding the distribution of their product, be that through platforms or by developing new hybrid insurance products?”
Insurance companies need to have an active internal dialogue about risk and strategy. Already in Europe the rise of the Bancassurance model has seen many smaller insurance companies step out of the asset management business altogether and seek strategic partners to manage their investments and administration. In the UK, insurance companies with third-party asset management arms, or just plain vanilla internal asset managers, will have to make a cost analysis on continuing under their existing model.
However, the asset manger spin-offs from the insurers with a traditional strength in understanding credit markets might also find the call for their services managing core assets to be in demand, so before 2012 and the implementation of Solvency II there will be many tricky conversations over the wisdom of investing in asset management or graciously withdrawing from the field of conflict.
As the trend intensifies, the battered traditional asset management industry could well be about to receive a fillip as new markets open at a time when the general savings and investment climate looks bleak. But insurers have to ask whether the circling flock can effectively asset manage and administer their insurance assets. After all, the entire financial industry was caught out by the credit crunch, and can these ‘strategic partners’ guarantee that they are ahead of the game this time around?
©2010 funds europe