Managing Director & Partner
Life insurers are feeling the squeeze. The industry’s overall business growth has stalled, and investment income has become a critical mainstay. Yet that income stream is weakening, as low-risk investment yields dip toward 0% and central banks continue to drain the bond markets.
In their efforts to adapt to this upside-down world, life insurers are focusing on optimizing their investment strategies and operations. And they are asking challenging questions: How can we shift investments to compensate for the evaporation of low-risk returns? Can we cut costs to boost overall profit? How do we manage capital consumption and the volatility of our assets?
Many internal asset managers have become caught in the headlights of this rising scrutiny. Increasingly, managers find themselves in sometimes heated debate, pitted against their companies’ actuaries, product managers, risk and finance executives, and boards of directors.
As each side of the business jockeys to promote its own agenda, a life insurer can quickly lose sight of its long-term goals. The result: investments are managed opportunistically as each faction seeks to optimize its own favored KPI quarter by quarter—whether it is cash flow, earnings, solvency, market risk exposure, rating requirements, or investment performance. Corporate life becomes a series of zero-sum battles in a war with no winners.
To escape this trap and prevail in today’s environment, life insurers and asset managers must close ranks. In our experience, a structured process is necessary to bridge divisions and map a collaborative path forward. This will require greater transparency on both sides and a shared understanding on a number of issues—including how the asset manager creates value, relative to costs, for shareholders and policyholders alike. Cooperation and even radical reteaming across siloed interests will be needed to create powerful, integrated management of both sides of the balance sheet.
Asset management has become a crucial activity for life insurers. It offers a steady flow of customers’ captive assets and—for the best insurers—significant revenues from managing the assets of third parties. Moreover, as return on equity becomes an increasingly critical performance benchmark for insurers, asset management has the advantage of consuming negligible amounts of risk capital.
Yet with ultra-low yields beginning to sting, life insurers and asset managers fight to overcome formidable challenges that can drive a wedge between them, such as the following:
As yields fall across fixed-income maturities and ratings, there is less room for error in the cash flow generated by asset managers. It is therefore crucial to fine-tune the strategic asset allocation (SAA) of investments to prevent wrong bets that can’t be corrected or offset through tactical moves. Both insurers and asset managers need to revisit questions regarding SAA, especially those related to participating business that is written on the general account:
How adept is your assessment and management of low-correlation, alternative assets—particularly those that are illiquid, including infrastructure, venture capital, private equity, and non-capital-market correlated classes, such as insurance-linked, parametric securities? Is your team skilled in managing overlays and efficiently making controlled SAA or market-driven bets? We expect insurers with significant third-party business to retain an advantage in alternative assets over peers that manage only captive assets. But to do so, they will need to develop asset management capabilities that are more specialized than ever.
Many insurers entered the European Union’s Solvency II era with significant excess capital on their books. That surplus will be short-lived. Capital will increasingly constrain asset strategies as back-book reserve requirements rise, capital gains are realized, investors hunger for cash, and new money is encumbered by low yields. In this environment, diligent life insurers are tightening the management of their balance sheets. They are bringing together actuaries and internal model experts, as well as capital-steering and investment strategists, to form more integrated, strategically focused teams that oversee their asset and liability management (ALM).
Simulating the likely outcomes of liabilities against current assets reveals management questions and options, such as the following, that can transform an insurer’s fortunes:
Asset management costs are increasingly important—and a source of growing disagreement between insurers and asset managers. Historically, when portfolio yields exceeded 6%, those costs had negligible commercial impact. That is no longer the case. Under Solvency II, and with new-money yields dipping below 3% in the UK and below 2% in Germany and Switzerland, many insurers are still saddled with sales and administrative costs exceeding 100 basis points. Meanwhile, capital charges can easily add another 100 basis points, as new money is invested in ever-riskier assets. Suddenly, a cost differential of 20 to 40 basis points is no longer academic. This is especially pertinent for asset managers that have built a significant third-party business and now face increasing scrutiny from regulators and nonexecutive directors alike.
Simply arguing over fee levels, however, adds little shareholder value and is unlikely to lead to a resolution or to change the underlying economics. Instead, insurers and their in-house asset managers should cooperate closely to identify the solutions that will allow them to prosper jointly. They should consider, for example, the following questions:
Captive asset management can be rewarding for all parties. Benefits for the insurer include the ability to define and execute long-term strategies, to create business transparency at the base fund level, and to build its retail business on in-house capabilities. Benefits for the asset manager include access to attractive funds—such as those of endowments, pension funds, and smaller insurers—and investment opportunities, all under the brand of the life insurer. Captive management also allows the insurer to commit funds to long-term investments (such as in private equity, senior debt, and private placements) and to bring scale to product innovation.
To prosper together, both insurers and asset managers must review options jointly, transparently, and in a spirit of cooperation—an approach that differs radically from that of traditional, siloed interactions:
The life insurance industry’s evolution over the coming decade is not yet charted. Global markets, central banks, regulators, technological innovation, and the needs of customers will all play roles in creating the opportunities and challenges ahead. But insurers and their asset managers don’t have the luxury of waiting to see what the future holds. They must make decisions now that will either improve their institutions or leave them weaker in the years to come.
Assessing these choices in a spirit of radical cooperation, and capturing the new opportunities collectively, can make the task a lot more agreeable and, ultimately, more profitable.