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Special report

Insurers increasingly sending assets outside

James Gillard
James Gillard attributed a drop in insurers’ returns to low-yielding core bonds.

The amount of U.S. insurance company assets invested by external money management firms has grown at a steady clip since 2011, as insurers look for managers that can offer specialized investment strategies to boost their returns.

General account assets outsourced by U.S. insurers totaled $1.3 trillion in 2014, up 18.2% from a year earlier and up 30% from the end of 2011, according to a survey by Patpatia & Associates, Berkeley, Calif., a consultant that tracks insurance outsourcing.

The survey covered 60 managers that control about 90% of the U.S. market for outsourced insurance assets. The survey was based on 2013 numbers from insurers, and were projected to 2014 by firm officials. The firm found more than 40% of the outsourced assets came from firms with $5 billion or less in general account assets.

The $1.3 trillion in outsourced assets represents around 23% of general account insurance assets, according to a Patpatia & Associates estimate.

Another survey by the Insurance Outsourcing Asset Exchange, run by consulting firm Eager, Davis & Holmes LLC in Louisville, Ky., used a smaller sample of 34 large U.S. external money managers but found a larger number of outsourced assets, $1.381 trillion.

That survey, based on actual 2014 numbers provided by the insurance industry, found outsourced assets were up 8.6% from 2013. The Outsourcing Asset Exchange has done its survey for only two years.

Looking for better returns

Regardless of the percentage increase, consultants who help insurers find external managers contacted for this story are unanimous in their view that the search for extra yield is pushing more insurance companies to outsource part of their assets.

“The low-yield environment is one of the key drivers for increased outsourcing,” said Sunny Patpatia, president and CEO of Patpatia & Associates.

Mr. Patpatia said insurers are hiring external managers to add investment strategies beyond traditional core fixed income — a staple investment that can account for more than 90% of an insurer's general account — as they attempt to make up for the low interest rates.

Mr. Patpatia said the search for yield has been a boon to firms offering alternatives as well as those with specialty offerings, like emerging markets equity or high-yield fixed income. Large firms with multiasset capabilities also have been in a good position to benefit as insurers look to diversify their portfolios, he said.

Traditional external insurance money managers that mainly specialize in core fixed income strategies have been hurt by the trend, Mr. Patpatia said.

He said insurers are choosing to outsource assets because building in-house specialized investing capabilities from scratch doesn't often make sense economically, never mind the difficulty of finding the right talent.

“Why bother at that point? It's more logical to hire an experienced manager with specialty expertise,” Mr. Patpatia said.

James Gillard, vice president-credit rating criteria, research and analytics at rating firm A.M. Best Co., Oldwick, N.J., said the overall net investment gain for the insurance portfolio for life insurers dropped to 4.92% at the end of 2014 from 5.37% at the end of 2010 because of low-yielding core fixed-income assets.

“As the bonds mature, they are rolling off the books and insurers have to replace them with lower-yielding assets,” Mr. Gillard said. “It's a slow decline. It's going down and down and not likely to reverse itself anytime in the near future.”

Mr. Gillard said a 10-year Treasury note that would have yielded 4.8% in 2006 now yields 2.5%.

He said property and casualty insurers also have seen declines in net yield returns to 3.6% at the end of 2014 from 3.8% at the end of 2010.

Alternative assets produced a yield for life insurers of 7.1% in 2013 and 7.3% for property and casualty insurers, according to a Patpatia & Associates analysis. In comparison, life insurers in the same year saw a 5.2% yield from their fixed-income portfolios, while property and casualty insurers saw a 2.8% yield.

Mr. Patpatia said because life insurers can estimate their payouts from mortality calculations, they are able to invest in longer-duration assets with better yields than property and casualty insurers.

Life insurance firms are able to invest to a greater extent in private placements and below-investment-grade securities, which generate a yield premium over investment-grade public bonds, he said.

Property and casualty insurers have greater needs for liquidity to pay out claims in a disaster, so they can't take big bets on riskier fixed-income securities because they might have to sell in a down market, Mr. Patpatia said.

Still, much of the outsourcing occurs at the margins because insurers often manage core fixed-income assets — mandated by insurance regulators to be their dominant asset class — internally.

Prudential Financial

One of the largest life insurers in the world, Prudential Financial Inc., Newark, N.J., manages most of its $400 billion general account internally, but the firm has $8 billion invested in more than 100 external private equity funds and about 75 hedge funds, said Scott Sleyster, senior vice president and chief investment officer, in an interview.

“I have a lot of capabilities in-house that I would never think of going externally for,” Mr. Sleyster said. “For the really big asset classes for an insurance company — public fixed income, private placement, mortgages — we have terrific, world-class internal capabilities. There is no reason why I would go anywhere else.”

Mr. Sleyster said Prudential outsources investments in those areas for which the company doesn't have sufficient expertise, and where it would be difficult to build internal capabilities with a “sustainable competitive advantage.”

“Prudential runs one or two sleeves of various hedge funds within its asset management businesses, but if you want to construct a well-diversified hedge fund or private equity fund, we can't do that, that's not the business we are in,” Mr. Sleyster said.

But other major insurers are building in-house investment staffs for alternatives.

Nicholas Liolis, chief investment officer-general account at TIAA-CREF, said in an e-mail that the company's insurance general account has increased its overall allocation to alternative assets over the past few years, gaining exposure to natural resources, infrastructure and real estate “at a good time in the cycle.”

“Though we do employ outside managers for private equity investments, there has been a general shift in management of our (non-traditional) assets to TIAA-CREF asset management and its subsidiaries, as our percentage of unaffiliated (non-traditional) assets has declined over the same period,” Mr. Liolis said. “This is because as our alternative platform grows we have the ability to manage investments directly rather than through third-party funds, reducing the cost of accessing these returns for our portfolio.”

Change in thinking

Prior to the 2008 financial crisis, insurers outsourced mainly because they thought it was more cost-efficient than internal management, said Robert Goodman, managing director and global head of insurance relationships at Goldman Sachs Asset Management in New York.

But he said the rationale changed after the crisis.

“What we have seen more recently in the low-rate environment is a much greater focus by most insurers on turning to external advisers for ideas, and in some cases mandates, regarding yield enhancement,” Mr. Goodman said.

An April survey by Goldman Sachs of 267 chief financial officers and chief investment officers of insurers around the world, representing $6 trillion in assets, found 26% of respondents are looking to outsource hedge fund investing in the next 12 months; 22%, private equity; 23%, emerging markets equity; 23%, U.S. investment-grade corporate bonds; and 20% middle-market loans.

The survey also found 22% of global insurers planned to outsource more of their portfolio in the next 12 months, while 58% planned to outsource the same amount.

A reduction in fees by external managers of insurance assets is also leading to more outsourcing, said George Caffrey, head of the insurance investment advisory group at consultant Towers Watson & Co. in New York.

“The cost of managing these assets has dropped significantly,” he said.

As external money managers garner more insurance assets, they have been able to reduce fees because of increased scale, Mr. Caffrey said. Increased competition among external managers for insurance assets also is driving fees lower, he said.

“Insurers are finding that external managers can manage their assets cheaper than if they managed it themselves,” Mr. Caffrey said.

He would not offer specifics on the amount of the reductions but other consultants, talking on background, said the fee for managing core fixed-income mandates has dropped to less than 15 basis points in some cases, half of what it would have been 10 years ago.

The Insurance Outsourcing Asset Exchange survey found that as of Dec. 31, BlackRock (BLK) Inc. (BLK) was the largest manager of global insurance assets with $239.95 billion; followed by Deutsche Asset & Wealth Management, $194.71 billion; Goldman Sachs Asset Management, $111.63 billion; Guggenheim Investments, $101.42 billion; Wellington Management Co. LLP, $96.51 billion; Conning Inc., $89.88 billion; Delaware Investments, $87.5 billion; Pacific Investment Management Co. LLC, $79.3 billion; J.P. Morgan Asset Management (JPM), $77.84 billion; and General Re-New England Asset Management Inc., $67.98 billion.

Large insurance companies

While some big insurers don't outsource insurance assets or only do so on a limited basis, a February report from J.P. Morgan Prime Brokerage said hedge fund managers seeking to deepen their relationships with insurers should seek out larger insurance companies instead of middle-market and smaller insurers.

“Companies in the latter group tend to be unfamiliar with alternative assets and lack the in-house capability to analyze them,” said the report, “Barriers to Entry: Permeating the Insurance Company Investor Segment.”

“Accordingly, any dialogue with such firms likely would entail a lengthy, high-touch education process with only modest prospects for any actual allocations,” the report said.

Major insurers already have allocations to hedge funds and are better prospects, the report said.

Often, smaller insurers don't have the capabilities to outsource because their financial reporting and compliance systems don't have the ability to track and report outsourcing, said Steve Case, a senior investment consultant with Mercer in New York.

“Their pipes don't link with external managers,” Mr. Case said.

This article originally appeared in the August 24, 2015 print issue as, "Insurers increasingly sending assets outside".