Insurance asset management is relatively undeveloped in Europe and Asia compared to the United States, but it forms an important part of capital or enterprise risk management for insurers. Jürgen Meisch explains the opportunities for reinsurers.
Asset management undoubtedly has become one of the most vibrant areas of the financial services industry in recent years. The need for a major restructuring of global public pension systems towards much higher private savings build-up, the changes expected in corporate pension plans and the enormous financial wealth increase of the post-war and especially baby-boomer generation is driving the financial industry into preparing itself for a fund management bonanza. As numerous publications and press articles have identified, the major beneficiaries of this trend will be banks, insurance companies and professional fund managers.
So how can the reinsurance industry contribute value to this development? Is there a role for a reinsurer in managing assets other than for its own book? And if there is such a role, how is it defined and what could be a successful business model?
In principle, asset management is a relatively normal business for which only two key ingredients are needed: Distribution and factory. In that, providing asset management services is not too different from selling cars, as long as one stays in a broad retail environment.
Let us first deal with distribution. A reinsurer's natural distribution power is in the primary side of the business, which in itself is defined as an institutional client base. Even if one expands its distribution to large corporates as some reinsurers do, the counterparties are still of an institutional nature. From an asset management point of view this is a very sizeable piece of the global asset management cake, but there are a few very significant constraints which a reinsurer must consider before entering into that business:
• There is a clear trend for larger primary companies (generally beyond US$10 billion of assets under management) to increase their in-house asset management capabilities and only outsource specialty asset classes, such as emerging market equities, small cap equities or high yield bonds to name a few.• The industry leaders and other sizeable primary companies, which together account for a large part of global insurance assets under management, are investing into fully fledged asset management operations with the aim of competing directly with the large banks and fund managers.
Given that the above two factors lead to a sizeable reduction of “uncommitted” assets, i.e. insurance company assets available for third party asset managers, it becomes quite clear that the reinsurer entering into this field faces significant competition. The key competitors are the asset management subsidiaries of the global investment and money centre banks, as well as local fund managers which outside the United Kingdom and the United States are usually subsidiaries of local banks. All of these players are fighting for the same shrinking cake!
Two other forms of distribution are of course available to a reinsurer thinking about entering third party asset management. First, it could enter into a strategic alliance with a primary company or, as in the case of Munich Re /ERGO and Hannover Re/HDI, build up asset management as a group function.
Both ways, building a group asset manager or forming a strategic alliance will normally be geared towards a retail strategy, which makes a lot of sense given the attractive margins available in retail compared to institutional asset management. Depending on the distribution power in the corporate segment the target market of such a group asset manager / alliance could also be expanded into the corporate pension sector.
However, adding the traditional client base of the reinsurer to the potential target list may become very problematic as it contains a potential conflict of interest in the eyes of the primary client: Why would I have my assets managed by a firm that competes with me in my core business? Here, each client would have to assess his own market position and decide whether or not the advantages of using the professional services from the hands of a competitor justified the threat to his position in his core market.
The third form of distribution available to reinsurers is the internet. Now that sounds easy - just develop competitive retail products, invest in the necessary advertising and then pump them out through the web. Unfortunately, there is a little more to it than that. First, the cost of advertising in brand awareness and “strategic web placement” is very high. Second, the technological platform necessary to do this is usually something with which a reinsurer has no experience and is also connected with a major start-up investment. And thirdly and most importantly, pure-breed reinsurers simply have neither the experience nor the necessary in-house systems to deal with mass business coming in a very large number of low-volume transactions. Of course, most of those problems can be outsourced, but only at the expense of giving away the bulk of the front-end charges that make direct distribution so attractive. Nevertheless, internet distribution is possible and potentially successful on a long-term basis.
In summary, the essential message from the whole distribution discussion is for the reinsurance company to very clearly define its target client segment and, originating from that, its strategic business model. The key question is that of institutional or retail focus. In a retail model the major requirement is to obtain a very broad customer base that is hopefully protected to a certain extent from competitive pressures, for example through a strong and exclusive agent network. In the institutional model, a natural customer base is given- primary insurance companies. However, as we pointed out before, that target base is highly fought for, so the business model must be to offer highly specialised services on the back of a clearly superior industry knowledge. This model leads to the establishing of a so-called “insurance asset manager”, that is an asset management firm that specialises in the management of assets held by primary insurance companies.The insurance asset management market, to this date an unknown market niche in Europe and Asia, has been a viable asset management business model in the US. According to a survey by Insurance Finance & Investment, the largest US market participants are BlackRock Financial Management, Conseco Capital Management and Conning Asset Management. If widened to include asset management firms that employ a meaningful insurance unit dedicated to the same segment, one would have to also include names like Alliance Capital, Credit Suisse, Goldman Sachs, Scudder and Wellington.
There are also two large players which are fully owned by reinsurance companies - General Re New England Asset Management (GR-NEAM) and American Re Asset Management (ARAM). In the case of General Re, it was the very clear vision to broaden the service spectrum offered to the client base in a holistic fashion that led to the 1995 acquisition of New England Asset Management, and that vision has proved to be successful ever since.
To exploit successfully the distribution power a reinsurance asset manager has at its hand, it needs to very define clearly what services it wants to provide to its clientele. In a retail model this is simple - the market basically defines the products it wants by itself.
In the institutional model, and especially in the insurance asset management market, there are a few central ingredients of success:
• Understand the main business strategy, the financial targets, the capital needs and the balance sheet of the client.
• Provide the majority of asset management products the client may require to reach its goals.
• Provide administrative and service support that allows the client to minimise internal overheads.
The above ingredients have to be provided by what has earlier been termed the “factory”, which is obviously an over-simplified description. The factory in itself consists of people and systems and must be divided in three basic segments in order to fulfil the clients needs:
1. A research and development function to provide capital management services as well as product development;
2. Portfolio management to provide the necessary investment returns; and
3. Client services and administration, to provide investment reporting and investment accounting to clients.
At the core of modern insurance asset management, be it handled internally or outsourced, is what is frequently called “capital management” or “enterprise risk management”. This practice is a framework to help insurance companies understand how to deploy capital most efficiently and effectively throughout the enterprise. It is based on the belief that each component of capital (see diagram below) is related and must be considered in the context of the overall portfolio of a firm's capital management initiatives. Consequently, an effective capital management framework must take into consideration the risk, return and cost of capital on both sides of an insurance company's balance sheet.
To be successful as an insurance asset manager it is much more important to offer clients such an integrated risk tool than to bank on pure market out-performance on the portfolio management side. And quite obviously, a reinsurance company is ideally suited to provide that knowhow to its cedants as it deals with all the issues involved in its core business on a daily basis.
In addition, having capital management tools available has one further big advantage for a reinsurance company. With an increasing part of the reinsurance business coming from the non-traditional side, nowadays dubbed “new markets” or “alternative solutions”, there are high synergies when advising clients in the field of managing its balance sheet. While an optimising proposal coming out of this analysis may lead to changed asset allocation requirements, it may also lead to changed capital structure requirements or changed liability allocation. Here we are back to “two sides of the same coin” as Tillinghast's Stephen Lowe calls it in a 4/98 Emphasis article.
While offering superior portfolio management results is also important, it is not an area where a reinsurance company would have a natural competitive advantage over the other suppliers. However, it must be able to offer the major investment management competencies required in the core asset portfolio of an insurance company:
• Domestic fixed income; here the focus will more and more move away from traditional government bond investing to spread product investing, which entails the taking of credit risk (corporate bonds) and convexity risk (US mortgages, bonds with option features).
• Domestic large-cap equity investing; with increasing performance pressure from all angles (shareholders, policyholders, marketing), insurance companies have moved towards taking more investment volatility risk on their books to continue to obtain returns that are no longer achievable in traditional bond investing. Adding equity exposure has, therefore, become quite common among insurance companies, especially in Europe.
• Other, more specialised competencies such as international fixed income, high yield, emerging markets, equity sector investing, alternative investments etc. are nice to have but not essential - here specialised product providers may be used.
The term “domestic” as described above has a special meaning when looking at the European markets. Here most regulators have defined domestic as being local currency denominated investments. Subsequently, internal investment departments have been focussing solely on their home market for a very long time. With the introduction of the Euro, domestic investing has taken on a new meaning. On the one hand, previous strategies such as spread trading between European government markets is gone, while on the other hand, credit selection on a European wide basis is the place to be. The same holds true on the equity side, where it is no longer country rotation that creates performance, but much rather pan-European sector rotation or bottom-up stock picking across Europe. It is quite natural that a reinsurer, who historically had to deal with an internationally diversified portfolio of its own, has applied practical experience that a primary insurer would normally not have.
The final building block of insurance asset management is the ability to provide the full spectrum of the so-called “back-office” services, since it allows a primary company to have a true make-or-buy choice from a single supplier - something that the classic bank asset manager or fund management company has been unable to provide. This requires the ability of the insurance asset manager to:
• produce investment accounting data that can automatically be entered into the general ledger;
• provide all regulatory reporting necessary in the primary companies operating environment;
• produce top-notch investment portfolio reporting, including performance and attribution analysis.
In summary, a reinsurance company that is able to offer all of these building blocks should be almost ideally positioned to provide asset management services to primary insurance companies in a much more comprehensive and superior way than the traditional fund management service providers. The development of that market in the US, as described earlier, shows that there has been a growing need in the primary sector for that approach.
In Europe, we are just at the beginning of such a development. This is largely due to the fact that capital management considerations are just starting to appear on insurers' radar screens and that the asset management requirements have been less complex than in the US, due to lower sophistication in the European capital markets. As we are all experiencing now, change is happening at a very rapid pace. Competitive pressures from market consolidation but also from a growing convergence between insurance and banking force insurance companies to rethink completely their strategic rationale. Business models will have to be rewritten, and to that end reinsurers are moving away from pure risk taking to becoming much more of a strategic advisor to primary companies, almost in a way investment banks would behave.
Reacting to those developments, the General & Cologne Re Group has recently formed an asset management company called GCR Capital which, being modelled on its sister company General Re New England Asset Management, will be among the first pure insurance asset managers in Europe. We believe that we will, following the above mentioned strategic considerations, thus, match our existing competencies with the special needs of our primary insurance client base. Jürgen Meisch is a member of the board of executive directors of the Cologne Re. Previously, he held senior positions in the field of asset management within UBS and Munich Re, where he founded Munich Re Capital Management in the US in 1994.