Saturday, December 31, 2011

International Investment Strategy - Professionalizing Investment and Risk Management

International Investment Strategy

Investment management is a critical pillar of the insurance business, and one that is particularly important for large incumbents who have significant assets under management. The stakes are high. If they get this right it can serve as a structural advantage; on the other hand, the risk of not getting this right can be fatal - Asian life insurers are under tremendous pressure due to the high cost of their liabilities and, thus, any mis-steps in investments can ruin the entire franchise.

Local incumbents have traditionally viewed investment management as an afterthought. For decades, in many companies, the investment function has been organized as a department under finance. This is because for a long time, in most Asian markets, investment options have been rather limited by regulation and an immature capital market. Hence, the investing of insurance assets has been rather straightforward, mostly involving fixed deposits, government bonds, and in some cases, large real-estate holdings. During long periods when interest rates were high, this investment strategy served the incumbents well. However, the situation has changed considerably in recent years.

First, many insurers have issued long-term, high-guaranteed products in periods when interest rates reached heady levels (mostly during the late 1990s). However, during that period, there were not as many long-term assets, such as 20-year government bonds, to invest in - most insurers held their assets for a significantly shorter duration, assets such as short term government bonds and bank deposits. Therefore, as interest rates declined insurers were landed with a big problem - their investments yielded less than the cost of their liabilities. International Investment Strategy

This negative spread is a very serious issue - as is well known, it has brought many Japanese life insurers to the brink of collapse. But this is not just a Japanese phenomenon. For example, the average liability of Taiwanese insurers was in the region of 6.5 percent in the late 1990s while returns on their own investments were around 4.5 percent resulting in a 2 percent gap. South Korean and Chinese insurers have similar legacy issues.

Second, regulators have loosened restrictions on insurers, allowing them to invest in a greater variety of domestic and foreign asset classes, Much of this deregulation is due to the realization of regulators that insurers needed to find ways to alleviate their negative spread problem and to generate attractive returns for policyholders in low-interest-rate periods.

For example, in Taiwan the restrictions on investments in foreign markets have been raised from 5 percent of total investments in the 1990s to 45 percent in 2007. China now allows companies to invest in domestic equities and domestic alternative asset classes, particularly infrastructure products. And in 2006, the Qualified Domestic Institutional Investor (QDII) scheme was launched allowing Chinese insurers to invest part of their assets overseas. The pressure of the negative spread and the opportunity to diversify investments into new asset classes are creating an urgent need for Asian insurers to professionalize their investment management function. The urgency is not only in investment management, but also in risk management, since investing in these new asset classes brings a lot more volatility to the insurer.

There are three ways for Asian life insurers to make their investment management function more professional in the short term.

First and foremost, they need to upgrade their investment management talent. This sounds obvious until one realizes the extent of the culture changes that need to happen in an incumbent insurer. Investment management is a very talent-intensive business, which is not something that insurers are good at managing (retail insurance is much more about size and scale). In particular, domestic insurers have a very tough time attracting the best investment talent since they are competing with local and foreign fund management houses as well as hedge funds. Part of the problem is the pay scale - many Asian life insurers have adopted a very rigid compensation structure and hierarchy over the years, and their approach to investment management falls within that construct. 

Compared with the much more flexible and professional environment that fund houses provide, it is not surprising that insurers are far behind in this war for talent. One insurance executive mentioned to us that he had to go through layers and layers of paperwork just to hire one portfolio manager, and there were so many constraints and so much bureaucracy that the new hire just gave up and went to a foreign fund-management company, The asset-management pay structure has also increased substantially in recent years, and presents a shock for most local insurers. In the past, investing was a low-cost activity, where the life insurers would find investment professionals to place their assets into long-term government bonds or they simply negotiated bank deposits. However, as the insurers venture out towards hiring professionals to manage more international asset classes, they are finding that salary expectations are often significantly more than the company's culture and bureaucracy can absorb.

Second, with the right talent in place, life insurers in Asia will need to significantly upgrade investment, asset liability management (ALM), and risk-management processes by learning from best practices. Despite all the peculiarities of the Asian markets (for example, lack of deep fixed-income markets, a legacy of high-guaranteed policies, structural mismatch of assets and liabilities), there is no excuse for not adopting some of the best practice tools that are used by many of the leading global players. 

Life insurers in many mature markets have learned the hard way that excessive risk-taking can endanger the very existence of the company. Asian life insurers are well advised to learn from those examples and build the analytical tools required to assess the economic value that is created with more risky investment strategies. The accounting-based, absolute-return number that most insurers focus on - even if required to service liabilities from high-guaranteed, interest rate products in the in-force book - is not a good measure to determine value in the investment function. International Investment Strategy

Using modern analytical tools to derive investment decisions from a rigorous strategic asset allocation is key to improving investment decisions. Many consulting firms and insurance IT vendors can provide the tools and processes that can be adapted to local Asian market situations. While localization of these tools is a significant effort, it is a necessary process that can involve quite a bit of learning for the local insurer. Controlling risks and increasing risk-adjusted returns can be facilitated in a number of ways including ALM, strategic asset allocation (the science of allocating the asset base to different asset classes), stock picking, and running a professional and systematic investment process. 

Having a proper risk management process is also critical. The combination of chasing returns to minimize losses on the negative spread and investing in unfamiliar foreign asset classes can be lethal in terms of risk management. For example, a few of the Asian life insurers invested in subprime assets, which led to significant write-offs and subsequent capital calls. Another significant risk is currency exposure - with substantial volatility in currency markets, investing in foreign asset classes can lead to a myriad of new exposures that are very complex to manage. The foreign currency exposures of many assets cannot be easily hedged, and there are also market circumstances where the hedging costs are prohibitively expensive and will take away any incremental gain from the investments. For these incumbent insurers, hiring a proper chief risk officer could be one of their most worthwhile investments at the start of their journey toward upgrading skills and practices in investment and risk management.

The risk of not getting this right is huge. From Japan to South Korea to Taiwan, the contribution of investment management to total returns is higher than it has ever been, and, subsequently, risks have also increased significantly. For example, in October 2008, Yamato Life in Japan filed for bankruptcy after significant losses from its securities holdings. Life insurers have a disproportionate value at stake due to the large sizes of their portfolios, and it is imperative that they upgrade this area as quickly as possible.

Some insurers, once they have successfully professionalized their investment management function, may consider taking the next step - separating the asset-management unit into its own profit center and expanding into third-party asset management. Many European and US insurers have made asset management an important, independent part of their business. Global insurers such as Allianz, AXA, and Prudential (UIO have sizeable asset-management businesses with assets under management (AUM) in the hundreds of billions of dollars. 

A significant part of this business comes from third-party institutions and retail investors. Some of the players in Asia have started on this trend. In China, Ping An and China Life are seeking to replicate the Western development and have started to build their own asset-management businesses. In January 2007, China Life announced a partnership with Franklin Templeton to form a joint venture in Hong Kong for its overseas asset-management business. Ping An announced a joint venture with Singapore's UOB to create a new domestic funds business in China, and paid US$154 million for a 9 percent stake in Value Partners, one of Hong Kong's leading asset managers in November 2007.

Building a brand in the third-party, asset-management business will take time and a track record. On the retail side insurers need to develop distribution channels with banks and other distributors (for example, securities brokers) in order to reach customers. In most Asian countries, banks dominate mutual fund distribution; a strong distribution team that can work closely with banks will be one of the critical factors for success. It typically takes over five years to achieve the required scale when building a third-party, asset-management business (meaning that as a percentage of total assets, third-party assets need to reach 20 percent or more), and insurers embarking on this road should ready themselves to learn quite different skills in order to compete. 

Acquisitions may be a way to accelerate this process; indeed most leading global insurers with sizeable asset-management businesses have at some point relied on acquisitions to grow. For example, Allianz bought PlMCO in the US, while AXA bought Sanford Bernstein's asset-management businesses and Rosenberg, a well-regarded, quantitative asset manager. To find out more, you can check out International Investment Strategy.

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