Shape up or ship out
Asset consultants are helping insurance companies smarten up their investment performance. By Michael O’Brian
Isn’t it funny how quickly everything changes? In the pensions arena, pension funds are moving from peer group benchmarks to client-specific ones, from defined benefit to defined contribution. The overall industry is globalising, with labour becoming increasingly mobile. And then there’s the insurance industry.
Some players in what has historically been a fairly conservative industry are becoming increasingly aggressive and focused in the manner in which they manage their business. There is a growing recognition within the insurance industry that asset management needs to be treated with greater importance.
As investment performance in insurance products becomes more visible to consumers with the growth in unit-linked business, it is an important factor in the ability of an insurance company to attract new business. Within the UK, key distributors, such as independent financial advisers, are focusing not only on whether investment results are above average, but also on how they have been achieved and the sustainability of these results going forward. What is apparent is that investment performance that has been achieved consistently will tend to be more highly rated by independent financial advisers than a single year of exceptional performance.
There has been increased competition for investment business from ‘specialist’ investment management companies. In the UK, where this is particularly prevalent, these specialists have made significant inroads into some traditional markets of life insurers, such as pooled pension funds, based on strong historical investment performance. This has caused insurance companies to face up the crucial role of professional investment management in the successful development of the overall business. Across Europe, a number of insurance companies have been successful in improving and developing their investment management offerings.
This trend can be expected to continue. This focus on the need to have a credible investment management capability has, for example, led some insurance companies to extend their product range to include the products of third party investment management companies.
Against this background, asset consultants are assisting more insurance companies to face the challenges in the investment management arena. Areas where asset consultants are now advising insurance companies include :
q strengthening the company’s investment management function;
q selecting external investment managers and custodians, and
q assessing and managing investment risk.
Where an insurer has not been achieving satisfactory investment results, the first step is to determine whether the internal operation can be improved. Performance issues can arise due to a number of factors:
q Availability of information. Decisions are made on the basis of limited or inappropriate information.
q Clarity/completeness of decision- making processes. Problems can arise where accountability in the investment decision-making process lacks clarity. For example, decisions may not get made if all individuals involved assume that someone else is responsible for it.
q Effectiveness of research. It is important that functions are resourced effectively, with individuals who have relevant skills and are effectively motivated. Where this is not the case, it is unlikely that the function will be performed optimally.
q Effectiveness of control/review structures. There must be adequate controls in place to ensure that the investment decisions are appropriate. This can involve a number of issues. For example, there must be controls to ensure that risk targets are adhered to, and that decisions represent the view of the investment management company rather than that of the individual.
The decision by an insurance company to appoint external investment managers can arise in two broad ways. One, as mentioned above, results from a desire to extend the existing product range to include the products of third party investment managers. The second occurs when, following a review of its investment management function, an insurance company decides it would be more effective to outsource a portion of its investment management to a specialist.
Asset consultants can provide valuable expert, objective assistance in selecting external investment managers, not only in designing suitable mandates and identifying and assessing appropriate candidates, but also in monitoring the appointed investment managers.
The key to identifying potential suitable investment managers is to clarify precisely what is required from such an organisation. In particular, the level of support required by the insurance company from the investment manager might limit, to an extent, the number of organisations that may be considered appropriate.
In the short-listing process, the asset consultant can help ensure that a high level of clarity exists regarding what both parties require. This will include determining the form and frequency of information flows and that any asset reconfiguration or transfer takes place effectively and efficiently.
As part of a move towards refocusing on core competences, a number of insurance companies have decided to outsource their custody and/or investment administration functions. This has been because custody has been identified as a non-core activity within the insurance company and where the cost of remaining current and competitive has become significant. Within the range of custody-related issues to be considered, a consultant can provide assistance through a structured process. In our experience, insufficient attention is paid to:
q the specific services the insurance company requires from the custodian, and
q the additional services the insurance company could get from the custodian.
As well as being in part responsible for the security of assets, the custodian can provide, through the supply of timely information, an effective level of control over the investment manager function. This can also be beneficial in providing an early warning system against issues that may arise in the future.
For types of business where the level of return is effectively guaranteed (for example, non-profit annuity business), against a background where more and more insurance companies are demutualising, it is incumbent on senior management to understand the impact of different investment strategies on shareholder value.
These include, for example:
q Accounting risks. The insurance company will naturally be concerned about the impact that asset performance can have on its various disclosed financial measures.
q Fiscal issues. It is necessary to consider whether or not a proposed investment strategy is tax-efficient overall.
This is an area where asset consultants and actuaries traditionally have had extensive involvement with insurance companies, through the use of asset-liability modelling. Going forward, the debate has started to widen beyond the development of an appropriate asset strategy – the allocation across broad asset classes such as domestic equities and bonds – and now includes issues concerned with the actual implementation of the agreed investment policy.
The services provided by asset consultants can benefit to the insurance industry, by providing objective, focused in-depth expertise in an area that is of critical importance for competing in the marketplace. The challenge for all parties involved is to ensure that the work is undertaken and delivered within a framework that does not lose sight of the company’s wider objectives and acknowledges its strategic weaknesses and strengths.
Michael O’Brian is an asset consultant at Towers Perrin in London