The trend in favour of size in financial services is changing both the buyers and sellers in the area of global custody for insurers. Fewer and larger insurance companies are now looking for global custody services from fewer and larger custodians. The trend in favour of size in financial services is changing both the buyers and sellers in an important sector of the securities market – global custody for insurers – and in particular life insurers. About one-third of all assets held by the major custody banks arise in the insurance market.
Insurance companies, traditionally seen as slower on the uptake than more aggressive independent fund managers, have different constraints and requirements in their business which result in a particular set of needs for custodian banks to fulfil.
For most insurance companies the choice of custodian for their managed assets has become more important. The key criteria for that choice, security, competence and service, are unchanged but the levels of expectation are rising and global custodians are running hard to meet them.
The overriding requirement for any insurer, particularly a life insurance company, is to choose a custodian who can ensure that policyholders’ assets will be safeguarded and have all their components dealt with accurately. The credit rating of the custodian is a prime component of choice, and any bank unable to show an AA credit rating is at a major disadvantage. Competence in settlement, income collection and corporate actions need to be a given in order to compete.
For UK insurers, who have greater overseas investments than their European or US counterparts, a global custodian has the benefit of providing a single point of entry into custody in dozens of overseas markets. This also provides common reporting and an infrastructure for service enquiries and solving problems relating to the portfolio in custody. The multiple relationships, contacts and proprietary communications systems that a regional custody or direct custody structure brings are a deterrent to using these. The prime benefit of this structure – proximity to market information – is increasingly marginal in an internet-based information age, whilst the cost savings are likely to be eaten up in inefficiencies in the insurer’s back office.
European insurers’ more domestically-oriented asset portfolios have allowed them to include in their choice of potential custodian those domestic banks with which they may already have a strong cash management or product distribution arrangement. However, as insurers invest across the Euro-zone, domestic custodians will find it increasingly difficult to compete. For the principal global custodians providing the single point of entry, the European market has great potential.
Cost control within insurance companies has been a major management goal for a number of years, but the recent publicity given to the price limits on stakeholder pensions has raised its profile. The need to cut the unit cost of production passes through to price pressures on custodians. They in turn come up against the conflicting pressures of decreasing unit cost whilst simultaneously providing a more responsive customer service.
The cost of global custody services is falling and the response to this has been further investment in technology: pushing up the number of transactions which have no manual intervention (the straight through processing rate), internet communications and smarter systems for client service functions.
Against this background, it is unsurprising that several smaller global custodians, when faced with the decision to ‘get big or get out’, have decided to do the latter. The business continues to consolidate around the major US houses: Bank of New York, Chase Manhattan, Citibank, Mellon Bank and State Street – with HSBC and Deutsche as significant European-based providers.
A common challenge facing all of these major custodians is lack of differentiation. A common complaint from insurance companies when they are reviewing custodians is that there is little separating them. The major custodians are striving for differentiation on three fronts: standardising the product; improving service levels; and adding new product features. Standardising the product may appear to be setting off in an opposite direction from differentiation, but ensuring a standard level of product incorporating common features and functionality is a starting point for the other two.
Product changes within the life insurance market are causing custodians to change. The favouring of unit-linked business over with-profits contacts by policyholders has caused the proportion of unit-linked assets held by custodians to rise. In the UK, this has gone up from 30% to 35% over the past five years. Fund manager activity on the unit-linked funds is usually greater than on the with-profits fund, putting more pressure on investment management back offices and increasing the volume of transactions passed to the custodian.
There is a growing tendency for life insurers to seek investment products from external sources, typically asset managers outside the insurance sector, as well as their own investment management operation. Current impact on the insurance sector is limited but the marketing attractions of multi-manager products are high and could push some small insurers to stop their own investment management.
With regard to outsourcing, many predicted a few years ago that most back-office functions would be provided by a third party. Custody excluded, the volume of outsourcing deals has been much lower than predicted. Few insurers have moved from a make decision to a buy decision for critical parts of their back office. Concerns about potential loss of control of key aspects of the business, together with a limited number of product providers, have delayed this trend. In addition, over the past couple of years there have been the more pressing requirements to meet euro and year 2000 needs.
The development of offshore funds has been more noticeable within the independent fund management sector than with insurers, but establishing these vehicles has given the insurers the opportunity to test out third-party administrators without committing to major changes in the core business.
Whilst outsourcing has not decreased the number of independent back offices, consolidation within the insurance industry has. Over the past five years about 60% of the UK’s then 50 largest life insurers have been or are involved in significant consolidation activity through merger, sale or purchase. The result has been to reduce the number of investment management businesses by about 30%, but dramatically increasing the size of those surviving.
As the importance of choosing the right custodian has grown, so has the role of the consultant. Initially the consultants were treated by custodians with the suspicion that they were getting in the way of principal-to-principal contact. For the larger custodians, however, the consultants bring rigour, experience and manpower to the process of choosing a custodian that the insurer may not have, which will probably result in a more favourable outcome to one of the larger providers.
Alan Chalmers is managing director and group head of UK insurance at Citibank in London