Managing Financial Market Risk Has Become Increasingly Difficult
Effective management and optimization of an insurer's asset portfolio directly drives profitability. The price carriers must charge for their products, their ability to offer competitive returns on their products and their ability to meet the obligations of their insurance contracts all are impacted by the performance of their own investments. That performance relies heavily on the selection and evaluation of investment risk, which is becoming increasingly complex as managers oversee with alternative risk mechanisms, merger-and-acquisition activity, and regulatory changes.
As portfolio managers pursue higher yields, the investments they manage span a broader scope of vehicles and countries. Further complicating the picture, companies are expanding their product mix and are being forced by market conditions to distribute through multiple channels. And in each of those channels, they must demonstrate they are pricing competitively and offering solid rates of return. As a result, there is a need to manage a high degree of instrument coverage and valuation in order to foster a better understanding of both financial markets risk and insurance-related risks.
Regulators, shareholders and board directors want guarantees that investments are suitable, and they increasingly find ways to instill accountability around investment vehicles -- whether those sold to individuals or those managed as part of insurers' overall investment portfolios. Pressure is particularly intense where variable products are involved. More and more, variable annuities mean insurers must be able to perform unit-value calculations to help federal and state regulatory agencies better understand the value of underlying products.
"As we support our company's specific growth and profitability goals, we see an increased need for data transparency," says Jim Landis, SVP of operations and accounting for AEGON USA Investment Management, the investment management unit in the U.S. for AEGON (The Hague, Netherlands), a provider of life insurance and pensions as well as investment products. "Our ability to manage transaction, market, accounting and operations data is an essential part of our decision-making," he stresses.
"With more than $100 billion under management, our goal is to increase the return on the portfolio and boost the earnings of our operating units by taking the appropriate amount of risk," adds Landis. "There is a need for transparency into how assets match liabilities, and our investment professionals and operating divisions need answers to specific questions, such as, 'What drove the quarterly change in yield and income?'"
This dynamic interrelationship between assets and liabilities adds another level of complexity and has placed financial modeling systems on the list of insurers' mission-critical applications. "Insurance products are becoming more complex, with guarantees that are essentially embedded options that put significant risk back on the insurance company," observes Van Beach, an Atlanta-based senior consultant with Towers Perrin, which provides financial modeling solutions through its MoSeS software. "These risks require sophisticated modeling tools to assess the investment strategies used to hedge the underlying liabilities." This emerging state of affairs has pushed software that traditionally has resided on an actuary's desktop into the corporate IT infrastructure, Beach notes. "Financial modeling software is rapidly evolving to require more enterprise-level functionality and is becoming a differentiator in risk and asset management," he says.
In addition to asset-liability management, technology solutions around data management, transaction processing, operations and accounting are more important than ever for offering visibility into compliance and performance across all asset classes, notes AEGON's Landis. According to Celent, that need will grow and lead to aggressive spending in the portfolio system market in North America. The Boston-based research firm, in its report, "Portfolio Systems 2006: Full Suite With Risk & Derivatives," predicts that approximately $973 million will be spent on portfolio systems by 2008.
"Those responsible for managing the options within variable life or annuities products consider performance to be the main competitive differentiator," says Donald Light, a senior analyst with Celent. "Just straight portfolio management and trade execution are going to become table stakes, as carriers need sophisticated tools that dig down into data so they can see how different components perform, as well as determine which investment managers are adding value and which are not."
It Starts With Good Data
The ability of analytics engines to answer those questions will depend on data integrity and the ability to gather and disseminate data effectively, which requires strong systems integration. Further, in order to reap the benefits of automated decisioning via rules engines, carriers will need to identify the business processes and causal factors that result in effective management of volatile liability mixes and shifting investment options. Only when this intimate knowledge of investing is combined with good data will carriers be able to take advantage of sophisticated business-rules engines and real-time functionality.
"Business users want customizable views and dashboarding so they can see trends through graphical representations of data," relates Brian Buchinski, managing director of product management for Princeton Financial Systems, a Princeton, N.J.-based provider of portfolio management and accounting systems for institutional investors. He says service-oriented architecture (SOA) and Web services will help insurance companies achieve a more holistic approach to data. "Today's SOA and Web services-based strategies will call for data flows coming in on a transaction-by-transaction basis," Buchinski explains. "That will enable more real-time integration and processing."
But with all the hype around real-time functionality, most insurers still are in the process of building Web services-based interfaces to external partners and messaging structures capable of handling data feeds. As a result, carriers need to pay particular attention to those portfolio management solutions that are focused on building Web services to expose the systems to partners and clients. Such openness fosters an agnostic environment in which integration is less of a challenge, Buchinski notes.
Of course, integration is a huge area of focus for those building systems for traders and money managers who want to integrate investment data with other financial information. "Clients increasingly want us to create extracts from our accounting software to tie into their data warehouses and OLAP [On Line Analytical Processing] tools used for achieving deeper financial reporting and risk management capabilities," says John Veralino, strategic accountant manager for SunGard (Wayne, Pa.). "Ultimately, they want to quickly see how their assets manage up to their liabilities."
Veralino contends that the real-time component of portfolio management is an increasing focus within GMI, the company's back-office clearing and trade processing solution that is designed to trade many types of exchange-listed derivatives, accommodating currencies, languages and margin requirements across 65 exchanges worldwide. "We've built in regional regulatory reports and integrated accounting ledger capabilities as well," he notes.
That type of open connectivity and integration is necessary to perceive weaknesses in both risk and investment strategies, as well as to ensure regulatory compliance. "Risk never sleeps, so you have to be able to do more than just pick up data in a reactive manner," says Peter Teuten, president and CEO of government risk and compliance (GRC) solutions provider Keane Business Risk Management (a division of The Keane Organization; Wayne, Pa.). "You have to understand how something may affect you on a given date so that you can make sure you are in compliance and will remain in compliance through time."
To conform to government risk and compliance guidelines around the quality of capital and the ability to pay liabilities (e.g., individual capital adequacy standards [ICAS], risk-based capital [RBC]), carriers again look to financial models to understand dynamic interaction, according to Towers Perrin's Beach. "Regulators and rating agencies are requiring carriers to demonstrate that they understand their risks and have adequate capital," he says. "Financial models of an insurer's assets and liabilities are necessary to evaluate the financial impact across thousands of economic scenarios. To effectively manage this volume of analysis, the models must be automated and integrated with the carrier's data."
Supporting this level of risk analysis means carriers have to aggregate data about risk and compliance coming from disparate sources and involving myriad processes across the enterprise. "To make information intelligible, you have to measure, manage and monitor data across many different applications -- each with its own formats and definitions and fields," notes Keane's Teuten.
To handle the tremendous amount of data created by systems critical in investment, compliance and risk management issues, carriers can either use data warehousing approaches for consolidation or they can work right from their accounting engine databases. According to industry observers, most insurers are moving to data warehousing to enable more-robust reporting, which can flourish once there is open integration among software that feeds the data warehouse.
"Accounting data is meaningless if you can't access it, so architecture has to focus on integration and openness to enable carriers to get to the data in their data warehouses," says Princeton Financial Systems' Buchinski. He adds that the vendor has focused on integrating with investment and asset management software providers Charles River Development (Boston) and Bloomberg (New York) so as to merge the capabilities of trading systems with its accounting requirements.
The Center of the Universe
AEGON is one example of how a data warehouse becomes the "center of the universe" for applications germane to investment and portfolio management. AEGON USA worked over the past several years to construct an aggregated data warehouse around which best-of-breed applications for transaction processing, analytics and accounting would sit. "Transparency" was the holy grail that power users in many functional areas wanted, according to the firm's Landis.
To achieve that goal for the risk management and asset management groups within AEGON USA, data marts housing risk analytics and performance data were layered with core asset, transaction and accounting data to create its investment data warehouse (IDW), Landis explains. IDW is an Oracle (Redwood Shores, Calif.) platform on top of which a robust family of products and applications sits, including the Aladdin package from BlackRock Solutions (New York) that it used for front-office trading and analytics; SS&C's (Windsor, Conn.) LMS system for commercial loan processing; Princeton Financial Systems' PAM for securities management; and limited partnership processing through SunGard's Investran.
Essential to the project was an Informatica (Redwood City, Calif.) ETL (extract, transform, load) solution for extracting data from different parts of the company. The tool enabled data from disparate systems to be synthesized for use in analysis. "We needed to see detail across all asset classes so users could perform the appropriate amount of analysis on returns -- for example, on guaranteed products, which often have thin margins," says Landis.
Units within AEGON connect directly to IDW, and portfolio managers can utilize IDW and related analytical data as they make asset allocation decisions, according to Landis. "Some of our operating divisions go even further and link asset data from IDW with liability information from their own systems into data warehouses," he adds. "That enables them to do further analysis to help manage their businesses."
A "business unit support team" evaluates business users' needs and business processes to help customize information in reports and analytics, Landis continues. "Our customers either receive the information directly in the form of a management information packet, or they access IDW directly to perform analyses on risk and returns," he explains.
"Our customers often want to analyze yield and income roll-forwards of yields, or get deep into the reason codes that help explain why yields changed for bonds or mortgages," Landis adds. "They often want to understand why certain assets were traded, and what the impact was on book yield, for example."
Setting the Stage for BPO
As part of building such sophisticated and complex environments to enhance their core competencies, carriers seek out software and tools that expedite processing and reduce the points of contact. If they can automate the data feeds from reporting systems into investment products, general ledger and regulatory products, they can concentrate more on proactively taking action based on the information that comes out of reporting and analytics systems.
"As they get more automated, traders and money managers increasingly want to offload processing and reconciliation of data to a trusted third party," asserts Lindy Hartley, EVP of enterprise solutions for Sungard, which handles back-office order management, trade registration, settlement, expiration, delivery and reporting through its iWorks EPS product. "Reducing the amount of internal processes necessary to incorporate new service releases and patches helps them to mitigate risk."
SS&C also has noticed a significant rise in the number of clients who want to move toward an application-service-provider (ASP) model rather than relying on licenses, according to Eric Rocks, the vendor's VP of software development. "Clients want to come in through a Web connection," he says. "More and more, they want us to integrate things under the hood to enable more-consolidated reporting." As a result, CAMRA 5.2, SS&C's portfolio management and investment accounting and reporting system, now has an integrated module for debt and derivatives. "We integrated it because carriers wanted a middle- and back-office system for processing swaps, credit default swaps and equity options," Rocks explains.
Rock adds that there is more focus now on enterprisewide reconciliation capabilities, through which the characteristics of a security from an external source are compared to what resides in the insurer's accounting database. "Carriers want feeds taken in daily to pick up on trends around external asset management and internal asset management," he says.
Whereas reconciling positions daily was rare a few years ago, it's the rule today for both custodians and insurers. "We see insurers reconciling to asset managers every day now that the technology exists to reconcile on both sides, and now that custodians can provide data in formats readable to the end user," Rock continues. "Today, if you wait too long, it gets out of hand," he says, noting that CAMRA compares feeds from inventory about invested assets -- usually separated out by security, custodian or asset manager.
Looking ahead, there are certain characteristics that all portfolio management, investment operations and accounting systems should possess, according to AEGON's Landis. One, he asserts, is the ability to adapt quickly to international issues, regulatory requirements and accounting developments.
"It puts stress on the software when your business units operate in multiple countries. There has to be recognition and action by vendors when there is convergence of legislation or changes. We need our software vendors and solutions partners to adapt, adopt and comply long before we have to," recommends Landis. "We don't want a lot of workarounds and one-offs."
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