Diversification and the outsourcing conundrum

While insurers are keen to diversify their portfolios, this often requires the outsourcing of asset management – and then the question of fees arises. Investment and risk managers discuss these and other issues in part two of this Insurance Asset Risk/Royal London Asset Management roundtable

Liquidity

Chris Cundy: How do you go about considering liquidity in your investment portfolio? What constraints do you see and is it possible to optimise?

Neil Parry: You can definitely optimise it. From our point of view, a natural catastrophe is a liquidity event, so if we have a big hurricane season or there is a big earthquake on the West Coast of the US, that is what impinges our liquidity. Assessing liquidity in the credit market is one of the topics that keeps me awake at night. For me, liquidity is government bonds or cash, and we keep an amount of those.

Lucy Davies: We set our risk appetite according to high-quality liquid assets – cash and government bonds. We do not try and forecast "haircuts" and things like that on corporate bonds.

Craig Inches: Is that a set percentage of the portfolio, or do you model the liquidity you think you need and then hold a certain percentage?

Lucy Davies: We look at liquidity requirements over both near term and longer term, calculate how much liquidity we think we need, and set a buffer above that.

Craig Inches: Does the maturity of government bonds matter? Do you force yourself to own a percentage of shorter-dated governments?

Neil Parry: Because we are non-life, we do not really own anything past seven years, so almost all is at the short end, and we do not differentiate between those maturities in liquidity terms.

Lucy Davies: As a life insurer, our main aim is to match our assets and liabilities.

Diversification

Chris Cundy: How are you approaching diversification within the fixed income world? What assets are you looking at?

Lucy Davies: We are talking about it more and have considered other asset classes including private fixed income. But the problem is you need specialised asset managers, which contributes to the cost.

Craig Inches: You are probably less likely to diversify into something that offers low yield enhancement. The pay-off is not worth it, basically.

"With yields being so depressed, outsourcing is probably less beneficial than it used to be"

Neil Parry: Yes, unfortunately fees have become an overwhelmingly large consideration in a typical mandate, because they make up such a large proportion of it.

Chris Cundy: Are the fees a strong barrier to you choosing to diversify? Is there not a commensurate diversification benefit?

Lucy Davies: Fees are just something we have to take into account in weighing the benefit of the diversification.

Craig Inches: With yields being so depressed, outsourcing is probably less beneficial than it used to be because you take off quite a large proportion of that extra income.

Chris Cundy: Are you able to get a premium for investing in illiquid assets, at least?

Atanas Christev: Our experience of allocating to private placements is that it has become harder to find deals that overcome our hurdle – a 25-basis point minimum above comparable public securities. In this particular segment, it does not feel as though we are getting an illiquidity premium.

Lucy Davies: Do you think the illiquidity premium is being squeezed because everybody is trying to pile into it?

Neil Parry: It is a popular strategy.

Atanas Christev: When you have big buyers of public bonds – the central banks' liquidity programmes – that pricing pressure must trickle into other fixed income segments, such as private placements.

Chris Cundy: What does this mean for the diversification trend? Is it still worth the effort?

Neil Parry: There is less diversification available in fixed-income than there used to be and I think that the correlations between different fixed income return sources are higher than they have been. That is because of central bank activity, to some extent. So, I am slightly sceptical. I would not advocate having everything in one asset class; that is not a good idea. But I am not sure you are rewarded the way you were.

Craig Inches: Picking up on the earlier point about liquidity, if you are worried that liquidity in the corporate bond market may not be there when you need it, there is an argument that you may as well take the illiquid asset because at least it's paying you something for illiquidity.

Outsourcing

Chris Cundy: What have been the biggest considerations in the process of outsourcing asset management?

Neil Parry: We manage some assets internally and use external managers. For us, the question is: 'Can you perform the function yourselves?' And if you can, you do it. We think that we can efficiently manage core assets ourselves.

Atanas Christev: We are in a very similar position. But for high yield, commercial real estate or infrastructure, you have to live and breathe these assets to be good at managing them.

"If you want someone to generate alpha, you have to give them the leeway to do it"

Lucy Davies: As a closed book insurer, expenses are our biggest risk so we need to think about this when deciding to outsource. The key is to ensure you have the right number of fund managers, because obviously they are all charging a fee.

Chris Cundy: What is the right number of fund managers?

Lucy Davies: It is difficult, but we look at the size of the funds that they are running, the similarities between them, performance, fees etc

Chris Cundy: Are there any thoughts about using a single manager?

Lucy Davies: I do not think we could ever get to one manager. For the range of funds that we want, that would not be possible and we would not be comfortable from a risk perspective.

Neil Parry: There would not be many managers that could cope.

Chris Cundy: Is there any point in having two or more competing managers in the same asset class?

Atanas Christev: It depends on a few things. If the asset class is highly commoditised, either due to its very nature or due to us having imposed so many constraints that the asset manager has little freedom, then you are not losing much by having a single manager. But if that is not the case, then probably it is worth having two or three. That is a type of diversification, if you will, because fund managers will have different views on the market.

Craig Inches: When outsourcing, would you give the external manager a higher performance target than you would expect from the in-house team?

Neil Parry: I would feel sorry for a manager if you give them a portfolio and make the mandate so narrow that it's almost impossible to do very well. If you want someone to generate alpha, you have to give them the leeway to do it.

Servicing Solvency II

Chris Cundy: Have your outsourced managers got to grips with servicing insurance companies in a Solvency II world?

Neil Parry: You have the big players who have pulled everything together and are fine with it, and then you have more niche asset managers who are doing it maybe in a more manual way. But by and large, we are not experiencing any big problems with it.

Lucy Davies: For things like look-through, there were lots of discussions at the end of last year before Solvency II came in. We got there in the end.

Atanas Christev: I cannot complain in terms of look-through and additional reporting. In some cases, it can be a convoluted process – for example, our US dollar credit portfolios' interest rate exposure is 100% hedged with swaps, so the back office team calculating the efficiency of the hedges for hedge accounting purposes occasionally have to go back to the managers for additional information. But the added complexity has not put the process in danger.

The views expressed in this article are those of the individual, rather than necessarily of the firm.