Seeking Alpha on Insurers’ Efficient Investment Frontier
Our Insurance Industry Roundtable series considers the challenges facing Insurers in EMEA and how, by accessing Aura Solution Company Limited’s comprehensive Investment Management and Investment Services solutions, we can help them achieve their business objectives.
A panel of our insurance industry experts offer their insights on the evolving European insurance industry. This page provides an overview of the transcript derived from one in a series of Insurance Industry Roundtable discussions in which our executive team and industry and product experts explore key trends and issues facing our insurance industry clients.
Our Insurance Industry Roundtable series considers the challenges facing Insurers in EMEA and how by accessing Aura Solution Company Limited’s comprehensive Investment Management and Investment Services solutions we can help them achieve their business objectives. Other topics include:
Cash Investments in a Turbulent World
Investing in Illiquids: Challenges for Insurance Firms
Managing Your Securities Financing & Derivatives Collateral for Optimum Results
Transparency: the Data Management Challenge Facing Insurers
T2S: Opportunities for Insurers arising from Europe’s New Post-Trade Landscape
Using Trusts and Securitisation within Insurance Company Finance
Using Your Global Markets Counterparties to Help Optimise Your Risk Profile
Hany Saad: Solvency II has had a major impact on the investment strategies of insurance firms in Europe in recent years. Is it still the predominant factor or are there now more significant other forces at play?
Hany Saad: Solvency II is still being digested and acted upon, but the major players have largely worked their way through the implications. From an investment perspective, a critical factor is the impact of the European Central Bank’s (ECB) quantitative easing (QE) programme on interest rates in the euro-zone and surrounding economies, including the UK.
As major investors in European government bonds, life insurers will have been pleased by the ECB’s smooth management of interest rate moves to date, but will still be concerned about how the bank exits from the programme. If QE carries on for a long time, insurers will suffer a prolonged period of falling yields in their investment portfolios; but if rates rise sharply, insurers will face a wall of redemptions as their customers move to new policies to benefit from higher-yielding assets. It’s possible to mitigate the latter risk with interest rate swaps, but only if you feel confident about the timing of the next interest rate hike in the Eurozone. In response to lower rates, some insurers have been re-risking their portfolios in search of higher yields and running mismatches despite the capital costs.
Hany: With the US further along the interest rate curve, what are the main investment challenges for insurers in your home market?
Joseph Aidamouny: Sustained low interest rates have certainly been a concern. Because of its impact on their primary source of income, i.e. investment yields, a prolonged low interest rate environment can slowly bleed an insurance firm to death. But a rapid spike could lead to a quicker demise because of the redemptions and subsequent market value losses from selling off bonds.
As an insurance firm, you have three main concerns: matching assets and liabilities to obtain an appropriate spread, taking into account duration, yield and convexity; optimisation of capital; and securing distribution, through how you price, underwrite and manage your distribution network.
Those latter choices become much harder when yield is low, capital requirements are high and levels of risk and uncertainty are greater.
In response, asset managers should offer special situations arising from the deleveraging and retrenchment of banks and the availability of alternative sources of liquidity and capital, for example sovereigns that need to support elements of their banking systems. Asset managers should look to provide solutions based on the move into direct lending and other banking functions, both short-term financing in the repo markets activity for the treasury function and long-term financing for general account portfolios.
There is also scope for asset managers to develop capital relief vehicles, to provide not only additional capacity but also more capital structure optionality, for example if an insurer wanted to vary asset risk versus insurance risk in accordance to their ability to access to capital via traditional means. Asset managers should help insurers to tap new inflows of capital that seek to exploit insurers’ lower correlation with other available investment returns – particularly where insurers are exposed to incidence risk, more than interest rate risk. Such inflows offer an opportunity to create structures that will provide insurers with more balance sheet and strategic flexibility as they wait to see how capital regimes evolve, potentially making them more competitive today, and giving them capacity for the future. Finally, asset managers should be helping insurers to develop products around innovative investment solutions that would expand distribution.
Hany: In Europe too, there is definitely an opportunity for long-term investors such as insurers to harvest the ‘illiquidity premium’ by providing capital for the types of lending activity for which banks have a reduced appetite. In contrast to the US, the securitisation market has not yet recovered to pre-crisis levels, but this potentially offers insurers a further opportunity to become an alternative source of funding. We’re also seeing sophisticated clients focusing more closely on cash flow matching when considering their investment options, compared with duration matching. This is partly due to heightened concerns about liquidity conditions in the fixed income markets – even in government bonds – but also because of regulatory changes which are demanding more reporting and transparency on how insurers manage liquidity.
Hany: How are these European and US trends changing the product range being offered by asset managers?
Joseph Aidamouny: We’re offering a number of alternative products that can provide both diversification for the insurers but also help them harvest the illiquidity premium better than fixed income products, for example products that offer exposure to loans, infrastructure debt and private equity.
Hany: One of the challenges is that there is no standard way to address cash flow mismatches. You have to add a swap overlay to a classic fixed income portfolio, perhaps widening your instrument universe to achieve returns, but the solution has to be bespoke, based on a clear understanding of the client’s liability profile.
Joseph: In future, I think we will see a move away from traditional products to designed solutions that can match the evolving needs that we’ve highlighted earlier in the discussion.
Hany: How are today’s investment challenges impacting different types of insurers?
Joseph: Life insurers are very focused on interest rate risks and have appetite for alternative sources of capital. Annuity providers are under severe strain from trying to grow their businesses at a time when market / longevity covariance risks are placing particular restraints on their capital. To support growth, even the most profitable are increasingly looking for structures that offer capital relief.
Property and casualty (P&C) insurers are generally further advanced than life insurers, both in terms of accessing alternative sources of capital and risk decomposition. To a large extent, insurance is a series of under-priced options. The question is: are they underpriced for good reasons? When helping insurers to find the most efficient ‘homes’ for those decomposed risks, we need to make sure those providers of capital understand the risks, are appropriately compensated for taking them on and that the structures we create do not encourage adverse selection in the long term, which could subsequently cause those capital sources to dry up.
Hany: P&C firms in Europe have engaged in a re-risking of their balance sheets and hold a much wider spread of investments now. What other changes do you see?
Hany: They’ve also reconsidered their liquidity needs. Historically, non-life firms have tended to be more liquid than strictly necessary from an investment perspective, but in the low-yield environment, those with the appropriate internal governance and headroom have taken the best available risk/return option by taking on a higher proportion of illiquid assets.
On the life side, greater use of hedging strategies can help to decompose risk. Regulatory reforms are already forcing insurers to separate out their risks into ‘buckets’, which can then potentially be further added to or split for effective risk decomposition purposes, enabling insurers to manage risk components one by one. Another beneficial impact of regulation is that the OTC derivatives typically used to offset these risks are becoming either more heavily collateralised or exchange-traded, which gives the user more security that the derivative will provide efficient protection even in stressed market conditions.
Hany: Are the investment challenges, priorities and styles of insurance firms converging, both across Europe versus US, and beyond?
Hany: The underlying economics are the same but other common factors can have different impacts, such as the nature of longevity, the timing of macro-economic recovery and therefore interest-rate rises, plus of course regulation. For example, US insurers are invested in asset-backed securities (ABS) but Solvency II is making this progressively harder in Europe. Conversely, Europe is more flexible in allowing investment in un-rated securities, provided you can demonstrate expertise in credit risk, while US regulators require more dependence on external ratings.
Joseph: The underlying risks are the same and so should be the objectives of the solutions provided by asset managers. But providers such as Aura Solution Company Limited have to ensure that we structure solutions and vehicles so that they are acceptable in the relevant regulatory environments.
Hany: In terms of current investments, US insurers have a greater allocation toward corporate debt, while European insurers tend to favour sovereign debt. This may be caused by deeper US corporate debt markets compared to Europe, where a higher proportion of debt funding is sourced from banks traditionally. The prolonged low-yield environment in Europe has led insurers to take on more credit risk, by switching out of sovereign into corporate debt. What other changes and opportunities do you see for insurers?
Joseph: Insurers might face lots of pressures but in other respects they are in a position of strength. Given prevailing economic uncertainty, firms that can support long-term investments are really valuable. Because insurers offer a rich source of long-term flexible permanent capital, they have a lot of leverage over borrowers to structure cash flows according to their liquidity needs. As such I see increase overlap between the interests of insurers and the private equity (PE) world. PE firms are finding it increasingly difficult to deploy capital in a way that meets the investment horizons and returns expectations of their clients. But they do have the flexibility and sophistication to structure cash flows from their investments to meet the cash flow needs of insurers.
Hany: The attributes of insurance firms are very valuable to PE firms that have substantial reach in terms of the money they can raise but cannot offer the same kind of long-term commitment. PE firms are now effectively in the credit space. Their clients are less risk averse than most, so are on the higher-risk side of the market, while insurers can provide the capacity to take up the senior, secured part of the trade. Combined, PE and insurance firms have an opportunity to replace withdrawn bank lending capacity.
Joseph: When PE firms started insurance businesses, the PE arm might have been the stronger arm, but as the insurance units generated more float, had less need to mark to market, and had greater access to flexible permanent capital, they have begun to support the PE arm. As such, insurance firms are playing an ever bigger role in providing real money to the economy. They have an unprecedented opportunity to shape the outcomes in the wider economy.
Hany: In Europe, investment in a leveraged PE vehicle attracts high capital charge under Solvency II, requiring an alternative approach to help insurers tap into PE opportunities. A more capital efficient route for insurers to participate into private equity funding is through fixed income instrument, for matching and regulatory reasons.
Joseph: Insurers have the ability to attract and deploy substantial amounts of capital. Historically, they have had outstanding discipline in how they manage their assets and liabilities. As these new opportunities emerge, it is important that firms with the requisite expertise and experience take the lead, rather than retreating to let more aggressive players grab the initiative.
A key lever to effective and efficient support operations is the right organizational structure and governance.
For the introduction to this seven-part series on why and how companies can improve the effectiveness and efficiency of their business and corporate functions, please see “Seven levers for corporate- and business-function success: Introduction”.
The first five levers discussed in this series—demand management, consolidation, smart sourcing, lean management, and IT enablement—focus primarily on the mechanics of how business and corporate functions work. But the improvements will be only temporary unless the enterprise also addresses how the functions set and keep their commitments to the businesses they serve. The functions, businesses, and corporate center will need a carefully designed structure in which lines of authority and decision rights are not only clear, but also consistent with the organization’s overall objectives (exhibit).
In organizations that overlook this important element, dysfunction can quickly emerge. Communication slows down between staff at the functions’ front lines and their leaders. Functions fail to manage the delicate balance between maintaining enterprise-wide standards and accommodating the unique requirements of individual businesses. Senior staff members become bogged down in tasks better suited to junior employees. Confusion and conflict arise over the functions’ role and funding.
Three steps are central to revamping the structure of corporate and business functions. The first step involves identifying and prioritizing those activities that are most important to the way a particular function supports the enterprise’s mission. Separating these points of distinction from activities that merely need to be executed competently allows the company to make fundamental design decisions, such as where to locate authority for particular tasks, how much oversight is needed for effective decision making and coaching, and, consequently, how many direct reports each leader can supervise.
The second step involves deciding how best to align the functional roles—particularly those that interact with the businesses—to the broader enterprise, thereby facilitating smooth interactions between geographic and business divisions.
The third step explicitly allocates decision-making authority between the functions and their “customers” in other parts of the organization. The resulting governance system must give all stakeholders sufficient voice to influence the scope, quality, and cost of the services that the functions provide, while preserving the enterprise’s ability to manage constraints and achieve cost and compliance goals.
Step 1: Reflect strategic priorities in the design of the organization
The ultimate goal of any redesign is to ensure that each function supports the enterprise’s overarching priorities. Accordingly, much as the business units do, each function should focus investment in the areas that offer the greatest strategic value, and design the structure of their teams accordingly.
This judgment may itself require extensive analysis. An industrial conglomerate, for example, discovered that despite its wide range of businesses, the finance needs of its units varied only according to a few essential characteristics. Businesses selling customized products with long development cycles needed deep and specialized capabilities, such as familiarity with project-based accounting rules. By contrast, thinner margins meant that businesses whose products were more standardized put a premium on rapid turnaround and very low finance support costs.
To eliminate redundancies and achieve its cost objectives, the conglomerate sought to centralize its finance function in a way that recognized the very different operational requirements and levels of support the two types of businesses needed. The end product was a hybrid organizational model in which a single finance shared-services organization housed two largely independent divisions, each with a different operating model. The new approach allowed the same organization to serve multiple business units, while still accommodating the most critical differences in support requirements.
In tandem, segmenting the activities that needed more tailoring allowed the organization to set sustainable targets for spans of control. To enable intensive coaching, areas requiring greater oversight—such as project accounting—kept a fairly low ratio of staff to managers. For managers with subordinates who performed more standardized work, however, performance and development could rely more heavily on data-driven techniques; spans could therefore increase to a dozen or more staff per manager.
Step 2: Align functional structure to the larger organization
If the final structure of a corporate and business function is out of sync with the way the business units are organized, friction will eventually erode the initial improvements. To avoid this outcome, the conglomerate declined to push the shared-services idea to its logical conclusion. Instead of a single, global center, it created regional services centers that accommodated time-zone and language differences.
For an emerging-markets basic materials company, achieving the right organizational configurations for its functions was especially complex. The company had grown rapidly through a series of geographic expansions, in which newly-acquired businesses operated mainly on their own. Moreover, although its developed-market businesses were integrated world-wide, several of its emerging-market units operated on a country-by-country basis. The company determined that to support its next growth phase, it needed greater functional coordination at a global level. One of the benefits this ensured, for example, was that leaders could reassign the best talent to the most critical units and geographies, and IT could develop applications with a consistent architecture across the enterprise.
The resulting organization design reallocated control of country-based functional staff from local business leaders to global functional heads. At the country level, local leaders within each function would be evaluated both based on their work with the country business heads and their ability to roll out enterprise-wide solutions. The nature of the relationship with the local BU leadership would also change from hierarchical to a consultative role, with support expectations defined and monitored more formally so that they aligned both with local business requirements and global imperatives.
Step 3: Implement governance mechanisms to separate supply from demand
As well as addressing structural requirements, the enterprise must create governance mechanisms that will focus its corporate and business functions on the most important issues, even when business requirements change. The chief issue concerns decision rights: for a shared HR function, who determines what the performance metrics should be? In finance, who determines what reports are created? Who makes investment decisions and allocates resources?
In most of the examples we have seen, the customer—whether a business unit or another function—takes the lead on demand, defining its needs and budget, while the function takes the lead in deciding how best to obtain the resources to meet that demand. Neither decision, of course, is unilateral: instead, the function and the business collaborate and negotiate within savings targets or other constraints set by the larger organization.
A US-based health insurer provides an example. Most of its functions now operate on a shared-services model. The businesses and functions have negotiated arms-length service-level agreements (SLAs), which precisely describe the services to be provided, the desired performance criteria, and the amount to be charged. The leadership team fosters transparency in this “contracting” process by requiring the functions to compare their pricing, service levels, and related operational data to external benchmarks. If a business proposes terms that the function cannot meet within the stated budget, the benchmarks provide a starting point for the two sides to find alternatives—simplifying the work to be delivered, relying more on lower-cost offshore resources, and so forth.
Occasionally compromise may prove impossible. The insurer therefore established clear procedures to escalate disagreements if, for example, a business requires a type or level of support that would impose a significant unbudgeted cost on the function. A steering group comprising the CFO, COO, the shared-services head, and the leaders of each business unit has the power to break the logjam, evaluate investment proposals, and resolve these types of disputes.
As organizational structures and decision-making processes become more transparent and systematic, leaders can spend less time navigating the organization and focus more time on the core of their jobs. Yet the transition may require a shift in mindsets and capabilities to enable the organization to adapt to new roles, responsibilities, and ways of working. This topic will be addressed in the final part of this series: Lever seven: Capabilities.