This article originally appeared in Outsource Magazine Issue #28 Summer 2012
The triple threat of Solvency II, the reduced yields from “traditional” asset classes that mean new classes need to be examined, and the ever-present need to reduce internal fixed costs are causing insurers to look at outsourcing the management of their investment portfolio.
Investment management outsourcing (IMO) will need to deal with many, if not all, of the various issues as with any large-scale outsourcing. So, whilst it will be important to cover all bases with regards to scoping, transition, change management, and exit, some issues become magnified and other new considerations arise.
What then are the top five IMO-specific issues that need to be considered?
- Regulatory Overlay
This type of outsourcing will inevitably be subject to the various FSA, Solvency II and other insurance sector-specific rules on outsourcing, so it will of course be essential to ensure that the contract covers these issues. This has two impacts. First, the SYSC rules applicable to insurers tend to relate to the manner in which the arrangement is selected and managed and so the overall procurement and the terms will need to be thought through carefully to ensure that the contractual “triggers” allow for the required level of management.Secondly, if there is any suggestion that the outsourcing is taking place on the investment manager’s terms, they will need to be carefully considered not just from the usual risk and legal issues but also to ensure that the regulatory requirements are covered, since the investment manager’s terms might not be set up properly to take account of those factors. Rules applicable to the carrying on of business outside of the “home” jurisdiction of the insurer client might also need to be considered if the assets relate to insurance business written in other countries.
Likewise, the broader regulatory permissions and licensing regime will need to be considered not just in relation to the terms of the contract but also in respect of the procurement and appointment to make sure that these are performed within the requirements (for example any appointment requirements under the Pensions Acts), so that the contract itself is valid.
Typical outsourcing pricing models such as fixed price, FTE-related pricing or some form of unit pricing probably do not work on this kind of deal. More likely, the fees will take the form of a fee linked to assets under management, plus specific transaction fees. It is key to be clear on the nature of the services that the management fee covers, and what the transaction pricing relates to, if the insurer is to be able to maintain control over the charges payable under the agreement, and therefore, the inevitable impact on the business case of entering into the agreement in the first instance.Likewise, the circumstances in which the additional fees are chargeable – and the amount of those additional fees – will need to be carefully specified and administered, particularly as the nature of the relationship is likely to be a de facto exclusive one (at least in respect of the funds under management) such that the insurer cannot take its business elsewhere very easily if it needs the additional tasks performed.
- Control over Investment Decisions
Leaving aside the regulatory nuances of the degree of discretion involved and the impact that has on carrying on FSMA-regulated activities, one of the principal drivers, from a sourcing perspective, behind investment portfolio outsourcing is to gain access to a different skill-set, particularly in relation to the potential investment in different kinds of assets.The insurer needs to balance its potentially inherent desire to control the investment classes, against the investment manager’s ability to invest in the classes in which it considers appropriate (which is after all part of the skill-set that the insurer is buying).
However, loading significant restrictions on the investment manager’s ability to invest where it thinks appropriate may well lead the investment manager to seek to limit any liability and to move away from any outcome-based approach, on the basis that the more limited its degree of control, the less it can be expected to be able to influence the success of the portfolio.
- Outcomes-Based Approach
More and more, clients are looking to measure the success of the service provider by reference to the outcomes they achieve, and to tie their “reward” (i.e. their profit margin) to these outcomes. IMO is, on the face of it, an outsourcing arrangement that is perfectly set up to create that link by reference to an increase in the portfolio value at certain points in time.The difficulty with this approach, at least from an investment manager’s perspective, is that it puts them at risk to the potential vagaries of the macro-economic climate. Putting aside the argument that the investment manager might be able to overcome this issue through the use of skill and dextrous asset selection, it could be possible to assess performance by reference to comparable asset classes so as to perform some form of more immediate and quicker benchmarking of fund performance, and link relative performance against this benchmark to the investment manager’s revenue under the deal.
As the saying goes: “investments can go up and down”, and investment managers are at pains to ensure that they are not responsible for the prevailing economic climate. Liability is then generally limited to the losses that are caused by the negligence or wilful default of the investment manager, but this can be difficult to prove given it would, essentially, require an analysis of the actual steps and decisions made by the manager, as against those that ought reasonably to have been taken. Contrast this with what can be achieved from a liability perspective on other outsourcings that involve handling of money (e.g. payroll or portfolio administration) and it seems to be a less than perfect position.By the same token, a liability cap structured in the “usual” way by reference to a percentage of annual fees is not likely to be appropriate.
So, the usual approach to liability caps in outsourcing contracts needs to be reconsidered and structured so as to generate a fair balance of the expectations of responsibility the investment manager “should” take, from the investment manager’s and the insurer’s perspective.
There is no doubt that investment management outsourcing brings with it an entirely different perspective to control and risk, and the link between these two is more inextricable on this nature of outsourcing than on many others. This means that there needs to be a fresh look at the manner in which outcomes are assessed and measured, and the way in which liability is controlled if the deal is to deliver the benefits the insurer hopes it will.
About the Author
Duncan Pithouse is a Partner with DLA Piper, specialising in non-contentious technology and sourcing matters, and focussing on complex international outsourcing contracts. He advises on a wide range of outsourcing transactions and all aspects of a client’s sourcing requirements.