Global insurer outsourcing to grow with EU rule

Solvency II is reaching far beyond its European Union origin, placing capital constraints on insurance asset allocation globally just as the low-yielding environment is pushing the boundaries of portfolio diversification.

“There's real momentum built around solvency modernization taking place in multiple countries (outside of the European Union) right now, and the genesis of that is Solvency II,” said David Lomas, managing director an head of the global financial institutions group at BlackRock Inc., New York.

The European Union directive, which will be implemented in 2016, promises to transform the way insurance portfolios are externally managed in two ways, sources say:

• Some insurers are likely to outsource a larger proportion of their assets.


• More outsourced assets likely will be invested in higher-margin strategies such as hedge funds, real estate and infrastructure to seek better risk-adjusted returns.

More than a decade in the making, Solvency II integrates the EU's 14 existing insurance and reinsurance directives under a three-pillar system: measurement of assets, liabilities and capital requirements; governance and supervision; and reporting standards. As key components of Solvency II are being exported around the world, life and non-life insurance companies in those jurisdictions likely will follow suit in the way they approach asset allocation, according to consultants and money managers.

Paul Forshaw, head of insurance asset management at Schroders Investment Management Ltd. in London, said Solvency II rules present “a useful testing bed, because they have been developed through intensive consultation with insurance companies.” Other countries can benefit from “the technical insights and practical experiences gained of fitting Solvency II EU-wide to an insurance industry with significant local differences,” he said.

At one extreme are Switzerland and Australia, both of which already enacted new capital requirements similar to Solvency II — beating the EU to the task. In Switzerland, insurance reforms that began in 2006 take on a similar three-pillar system of Solvency II, while Australia's Life and General Insurance Capital Standards, introduced last year, share some of Solvency II's main characteristics, such as capital penalties for investments deemed more volatile on a total portfolio risk-adjusted basis.

Bermuda, one of the largest international insurance markets, is moving toward Solvency II equivalency. Japan and Mexico are preparing to enact requirements that shadow Solvency II, while Singapore and China are monitoring developments with the aim of potentially adopting some key aspects of the EU directive.

“It's a patchwork quilt,” said Robert Goodman, managing director and global head of insurance relationships at Goldman Sachs Asset Management in New York.

Mr. Goodman said GSAM's expertise in Solvency II has been “very useful in advising clients in other jurisdictions, most notably in Australia and Switzerland.” (GSAM managed $160 billion in insurance assets worldwide as of March 31.)

New regulations combined with some of the lowest returns in developed market sovereign bonds mean insurers need to be cautious in how they diversify their investment portfolios in the current environment, said Peter Hughes, partner at Mercer Investment Consulting based in Sydney.

As a result, some Australian insurers are “reviewing their appetite for illiquid assets for the first time,” moving away from a portfolio that was nearly 100% invested in liquid assets prior to the 2008-2009 financial crisis, Mr. Hughes said. New allocations in strategies including real estate and infrastructure debt and equity are being introduced, albeit at a gradual pace.

In Europe, the largest insurance market worldwide, the average life insurance company earned about 3.2% from its investment portfolio in 2009, according to estimates by J.P. Morgan Asset Management using Bloomberg data. In 2013, that figure had fallen to 2.5%.

“Insurance companies can't simply look at what are the best asset classes and strategies, they have to consider the capital costs” under the relevant regulatory regimes, Mr. Goodman said. “It's comparable to a kid in a candy store,” he added. “First, you have to consider what kind of candy you want, then you need to figure out how much money you've got in your pocket.”

About 10% of the $25 trillion in global insurance assets is externally managed, according to estimates by JPMAM. “The growth rate with third-party management has been fairly dramatic,” said Matthew Malloy, managing director and global head of insurance solutions at JPMAM in New York.

In Asia, regulatory changes are not necessarily a burden but an opportunity, as they're seen as best practices to be considered for such a diverse and dynamic region, said Madhu Gayer, Singapore-based head of investment reporting and performance in Asia-Pacific at BNP Paribas Securities Services.

Asia's insurance sector is going through “a sea change,” with double-digit growth fueling a larger insurance asset base, Mr. Gayer said. The need to outsource assets is increasing in certain markets such as China, driven by the changes to Chinese insurance companies' ability to invest overseas, he said.

But he also sees “a greater movement to build in-house expertise in more established markets.” Some of the large institutions have the ability to more efficiently access the markets by building internal capabilities, which better aligns their interests as principal-agent, Mr. Gayer said.

Others “prefer deeper, broader relationships with asset managers to exploit alpha opportunities,” Mr. Gayer said. “That's where we see the evolution in Asia.”

Ultimately the challenge still boils down to being able to match revenues with liabilities, said Mr. Lomas of BlackRock, which manages more than $330 billion in global insurance assets. For an insurer in China, for example, the asset-liability matching problem is very different from a company in Japan. In China, an insurer “simply can't go and buy 10-year (U.S.) Treasuries” if liabilities track 10-year China government bonds that are currently yielding an average of about 4.3%. In comparison, the 10-year U.S. Treasury bond is returning about 2.5%.

Meanwhile Japan's 10-year government bonds are trading at less than 1%, so there are obviously more “opportunities to go overseas” for Japan's insurers compared to those in China, Mr. Lomas said.

“Asia has been the fastest-growing insurance market for us in terms of AUM in the past three years,” Mr. Lomas said. Initially, insurers in Asia moved from domestic bonds to U.S. investment-grade fixed-income assets, and “the next phase is equity-risk mandates followed by alternatives,” he added.

Regulations have also been “a big catalyst” for the growth of J.P. Morgan's insurance asset management business, although the primary driver is still the macro-environment, in which low yields are hurting investment returns. In the past three years, insurance AUM has more than doubled to about $70 billion at J.P. Morgan Asset Management globally.

“Insurance companies have needed to diversify their portfolios for a long time,” JPMAM's Mr. Malloy said. “In the last six to 12 months, there has been a lot more action toward this goal. A couple of things have happened. Markets have become more stable, and as a result, investors are more confident. Secondly, there is greater certainty surrounding what the new regulations look like.”