The past decade or so has been a hard one if you are a chief financial officer or a chief investment officer of an insurance company. The reason for this is a simple: investment income has proved to be problematic.
Twelve years ago, times were different. Government bonds, which were nice, safe investments that almost always resulted in a healthy yield, were the staple of an insurance company’s investment portfolio. Not exactly exciting, but that was the point: they were a safe investment.
All of that changed after the great financial crisis that rocked the world in 2008. As central banks slashed interest rates in an attempt to spark a recovery, government bond yields fell as a result. And as the recovery slowly ground its way through the years and rates stayed low, insurance companies watched as what had been a safe source of funds dried up.
As a result, CFOs and CIOs had to decide where to invest elsewhere – and where not to. Higher yielding investments might get you a great return, but might be a bit too risky for some of the more cautious and conservative insurance investment asset managers.
According to the latest report by Mercer, Marsh & McLennan Companies’ health and employee benefits-focussed arm, as insurance companies look for other areas of income and invest in a wider spectrum of assets than they were used to, their investment portfolios grew more complex – which had the knock-on effect of making it vital that they aligned with regulatory and operational guidelines.
The growing third-party option
As a result, Mercer’s report says, “Often even the largest insurance company in-house teams don’t have the required infrastructure to maintain the growing complexity of their asset portfolio. We have seen increased interest in the benefits and opportunities of implementation through third-party platforms as clients seek to release internal bandwidth to focus on investment decision-making.”
According to Richard Bruyère, Managing Partner at Paris-based asset management strategy adviser INDEFI, the use of external fund managers for insurance companies is a fast-growing market. He points out that the European insurance market is as big as the pension market, something that people very often tend to forget or underestimate. Traditionally, pension outsourcing rates are around 30% to 40% of assets, i.e., invested with third-party managers, or even higher in some markets. In the insurance industry, however it’s historically been less than 10%, because a lot of that work is done in-house or with unaffiliated managers – like AXA giving money to AXA Investment Managers, for example.
“This traditional pattern has shifted very clearly throughout the past decade since 2010, especially in Europe,” Bruyère says. “First and foremost this is a reflection of the decrease in interest rates and the decrease in yields that insurance companies have had to face over that time. This has been the first source of the growth in external asset outsourcing, as insurance companies have had to look for alternative sources of yield, that their traditional way of operating in capital markets, such as direct investments or what their investment manager was in a position to offer, was no longer sufficient – which meant going to external asset managers.”
The tip of the iceberg
Bruyère adds that that’s just the tip of the iceberg. He claims that the rest of the insurance industry has fundamentally changed as well, especially the Life insurers, where manufacturing financial returns is critical because of liabilities. He points out that insurance companies in Europe are no longer willing to offer guaranteed products and are doing everything they can to move their clients on to unit-linked products. Unit-linked products are interesting in that their use of third-party managers is traditionally much higher: it’s about 35% across Europe. He estimates that 35% of assets distributed in unit-linked products are managed by asset managers that are independent from a capital standpoint from the parent insurance company.
Second, this shift to unit-linked products is ongoing, and a process that takes time, Bruyère says. “I don’t think that we have seen the full extent of the impact of this. So, very strong growth proportionality for third-party managers. Looking at outsourcing rates – it was 9% in 2010 for the European insurance market, excluding the UK, because the UK market is different, and it’s now 14%. That rise of 5% might not seem like a huge increase, but when you apply it to the overall asset base that these institutions are managing it’s a huge move, because we’re talking about €8tn – 5% of that is €400bn that’s headed the way of third-party managers.”
Randy Brown, Chief Investment Officer, Sun Life Financial & Head of Insurance Asset Management, stresses that this is an increasingly widespread phenomenon. He says that Sun Life has seen insurance companies globally diversifying away from core fixed income into non-fixed income, as well as alternatives to fixed income, as they seek to enhance yields and returns.
As a result, Brown says, “What we’ve seen is that even if they run their money internally, if they don’t have the in-house expertise, they have turned to outside managers that specialise in those capabilities. You’ve always seen that to a certain degree in asset classes like private equity and hedge funds, but now we’re seeing it across other asset classes. Things like private debt, infrastructure equity, real estate debt, areas like that where they may not have in-house expertise, so they are increasingly turning to third-party providers. That shift has been building because rates have been low and have stayed low.”
Colin Tipping, Head of Insurance Investment Management – International Region at Mercer, adds that insurers have also started to get concerned about a number of areas when it comes to how they were allocating assets. Mercer also identifies concerns in the credit space. According to Tipping, Mercer has some concerns about credit quality and insurers still stretching for yields – perhaps overreaching, in some cases – and Tipping thinks that this showed in the numbers that Mercer identified in terms of the proportion of credit of lower quality.
“A lot of the debt out there is probably not of the quality that in normal circumstances would be on insurers’ balance sheets, particularly the reinvestment risk,” Tipping warns.
He adds that Mercer was advising clients to be aware of the quality of the credit risk that they are taking on and not to push the investment-asset envelope too far and create too complex an investment portfolio.
Choices, choices
Another issue is where these assets and third-party managers are based, as insurers need to keep one eye on the local regulator. According to Brown, in some cases it depends on the jurisdiction involved. He points out that some jurisdictions have a lot of minimum guarantees that some third-party asset managers looking to invest in assets are unable to meet because of persistent low rates. Other jurisdictions might have negative rates, resulting in these third-party managers leaving to find other sources of return. And as Brown stresses, this is happening on a global scale.
When it comes to determining what insurance companies should invest in, he adds, there are two considerations. The first is: is this a risk exposure that I think can enhance the yield or return for my company? The second is, what is the form of that investment and does that fit my regulatory, accounting and capital regime?
“So you might pick something that is a really good asset class that diversifies your balance sheet, has good return characteristics, adds yield enhancement, but transforms – as an example, a fixed-income investment which would draw low capital into a fund that may draw private equity type of capital,” says Brown. “So you automatically want to do it from a risk perspective you have to be cognizant of what is the capital effect in the various different regimes – how will it be accounted for, how will the earnings flow through my different statements?
As a result, he says that it’s necessary but not sufficient to just have a return stream that looks attractive; you have to deliver it in a solution that meets the need of the particular insurer, and that’s where the regulatory piece of the puzzle comes in.
Back to the good old days?
Of course, for many insurance companies there is a solution to avoid these difficult and time-consuming choices: go back to the good old days of simple investments like government bonds.
However, when asked what could reverse the move to third-party asset managers and mark a return to those halcyon days, Bruyère is very clear – only a rise in interest rates, something that does not appear to be on the economic horizon anytime soon.
According to the Mercer report, many expected 2019 to be a year that had a “more normal investment environment,” with the potential at least for higher interest rates. However, the year instead saw more of the same.
“We expected the cycle to move a little quicker in 2019 than it actually did,” says Tipping. “We were talking a lot about surfing the white waters of the late stage of the cycle and I think that the cycle has extended longer and further and deeper than anyone had really anticipated. We were asking if there was going to be any return to normality – and that debate’s going to go on for quite some time. We got a bit of a run on the markets that we didn’t anticipate and the cycle did extend further than we thought, from a strategic point of view.”
It might be fair to say that “normal” is not on the horizon. So – is this the new normal? The market will have to wait and see – and hope not.
This story originally appeared in Reactions.