Stewart: Every insurance asset management outsourcing involves an IMA – an Investment Management Agreement, or it’s supposed to. I’ve been in this business a long time and I’ve never spent more than a second thinking about that document. But, I had a recent conversation with our guest who told me there’s quite a bit of interesting things that happen in an IMA. And so I said, “Man, that would be a great podcast. How about coming on?” So, I’m very happy to welcome our guest Ed Toy, senior manager, investment specialist at Risk & Regulatory Consulting. Ed, welcome.
Ed: Thanks, Stewart. I’m happy to be here.
Stewart: We’re happy to have you. You are a bit of a regulatory celebrity. I mean, you are the Beyoncé of insurance regulation, in all sincerity, right? We’re very happy to have you on this topic. And I want to start this one the way we start them all. Hometown, first job of any kind, fun fact?
Ed: Hometown, New York City. Born and raised in New York City, Manhattan General Hospital. Second avenue in 17th street, lived here pretty much my whole life. First job, I worked for a catering service to pay my way through college. And at that time, I actually got to meet Bob Keeshan. For those of you who are too young, that was Captain Kangaroo.
Stewart: Yeah. That’s right. I thought that name sounded familiar. Oh, man. Listen. Most of our audience is like what? And what about the fun fact? That’s the fun fact-
Ed: Fun fact? Well, that was fun. But fun fact. Oh, I used to be a serious runner and I’ve run 35 marathons in my life.
Stewart: Good for you. Congratulations. That’s good stuff. Now, this is a topic that not everybody thinks about a whole lot. And when you and I talked very briefly, you opened my eyes wide about this issue. So let’s just go over, hit the highlights, right? Insurance companies are outsourcing more and more. Investment markets have been more complex, more volatile, and we’ve had a prolonged low level of interest rates. No news, but insurance portfolios have become much more complex than when I was managing money; my last year was 2010. So, markets have changed. Where do we start with the IMA discussion?
Ed: Well, I think what a good place to start is where it’s into the regulatory framework, so to speak. And it is something that state insurance regulators, given the growth among insurance companies, have been paying more and more attention to. There’s all guidance in the financial examination handbook, the financial analysis handbook.
And state insurance regulators, under their state investment laws, are supposed to look at insurance companies and all of their different agreements. And they require insurance companies to submit their IMAs for review so that they can determine that the agreements are fair and reasonable to the insurer. And therefore of course, indirectly fair and reasonable to the policyholders.
Stewart: Yeah. And I think it’s important to note just… I didn’t know your background, you came out of the NAIC, right? Your firm Risk & Regulatory Consulting is known in the industry as riskreg, right? And what does riskreg do? I didn’t realize that this happened. I didn’t realize this was a thing, but what is it that riskreg does?
Ed: We’re a consulting firm that primarily works with state insurance regulators doing a lot of different things that state insurance departments need to do. Our biggest revenue source, so to speak, is working on financial exams. All insurance companies in the United States go through a financial exam by the state insurance departments, at least once every five years in some cases more frequently, but at least once every five years.
And it’s a very, very comprehensive review, everything, documentation, IT, investment practices, all the different agreements that the company engages in which, of course, again, includes investment management agreements, custodial agreements, everything is reviewed by state insurance departments. And for many of the states, they outsource the significant parts of those projects or entire exams. Obviously, the states continue to coordinate and oversee the process, but they have somebody like riskreg come in and do a lot of the groundwork for them.
Stewart: And that’s the part I didn’t understand, is that there’s some outsourcing of regulation, which is why, as a senior member of riskreg, you are looking at these IMAs. So as we talked on the first little pre-call, and I’ve talked to students… every regulation is designed to protect the consumer, right? The idea of insurance regulation is that you wreck your car, your insurance company writes a check and the check clears when you get the repairs made, right?
And so the regulator is looking at these IMAs to, just exactly what you just said, which is “Is it fair to the insurer?” And that leads to good for the policyholder, right? And that’s the purpose of the review. Okay, good deal. An investment manager, just to get to the basics of it, has to be registered, right? They are required to be registered with the SEC, that’s my understanding anyway.
Ed: Well, that is my understanding as well, and we spent a lot of time researching this a few years ago at the NEIC to figure out what we wanted for the guidance in the financial exam handbook. The basic requirement is that investment managers are required to register with the SEC under the Investment Advisers Act of 1940. There are a handful of exceptions to that registration requirement to the SEC.
For example, really small investment managers are not required to register with the SEC. In fact, investment managers that work solely with insurance companies are not required to register with the SEC, but that exemption for registration with the SEC is then replaced by a requirement to register under the state laws. And it probably varies from state to state, which specific department they’re supposed to register with.
But they’re supposed to then register as an investment advisor with the New York Department of Financial Services, probably. They’re supposed to register somewhere to acknowledge that they are an investment manager. Now it’s just that there’s an exemption for certain specific circumstances to register with the SEC.
Stewart: And that registration process is a big undertaking, and the maintenance of that registration as well. But here’s the shocker for me. When you told me this, I was absolutely shocked. When I joined Merrill Lynch back when the earth was cooling, they started beating us over the head with prudent person standards, appropriateness of investments, and that we were fiduciaries.
And anybody who’s been in this business for more than about two seconds knows what that means. That means that I am required to act in the best interest of my client, right? I thought this was bedrock stuff. Does the asset manager always acknowledge that they’re acting as a fiduciary in the IMAs you’ve reviewed?
Ed: Well, let me take a step back to start to answer that question, Stewart, and that is fundamental to the Investment of Investor Advisers Act of 1940 is the acknowledgment of investment advisors and managers that they are in fact, acting as a fiduciary, that they’re treating their clients’ money, not only as an important as theirs, but more important than theirs. And so that’s fundamental to the basic concept.
And I’ll say that in our review of Investment Management Agreements for the states under their guidance, we have found, it obviously is not often, but we have found situations where the investment managers either refuse to register as an investment advisor, either with the SEC or the state, or they refuse to acknowledge that they’re a fiduciary, which as you just said, was quite shocking to me. I mean, that’s the basic bedrock of being an investment advisor or an investment manager.
Stewart: Absolutely. I mean, I can’t imagine hiring a manager that wouldn’t make a statement that says, “Yes, we are acting as a fiduciary.” I can’t even imagine how that happens. So one of the things in the IMA, and I think this is true, but the investment policy guidelines are those embedded into the IMA, is that an addendum or an exhibit? How does the agreement, or do you think it adequately provides the guidance on what the manager’s mandate is? Because this is, as if things go wrong, if there’s a dispute or whatever, we’re going to go back to those investment policy guidelines and say, “was the manager doing what the manager was hired to do?”
Ed: Exactly. And that is something in our reviews we always look for. Where are the investment guidelines? How clear are the investment guidelines? We’re obviously not going to nitpick at specific details, whether it should be 10% invest below investment grade or 15%. That’s not our job, but at the same time, our job, our charge is to make sure that there’s adequate guidance in the Investment Management Agreement. It is usually put as part of an addendum or an exhibit because fundamentally the expectation is that those guidelines will change over time. The investment guidelines of the company internally will change over time. And as that changes, quite likely, they will say to your former employer, Merrill Lynch, “Our guidelines from our board no longer allow us to invest in such and such, so we’ve got to take that out.” Or alternatively, “We’ve decided we want to add something to your mandate.” So having it as part of an exhibit, as opposed to actually parting of the document, makes it easier for companies to make amendments and to change those guidelines when it’s necessary.
Stewart: Maybe this is a goofy question, I don’t know. But as you know, very well insurance companies, investment policy guidelines are impacted by a wide range of things, the capital position lines of business, tax position, risk tolerance of the company on and on and on. It’s endless, right? And then you just said, “Hey, it’s not my job to say if 10% high yields the right amount,” if you saw something really out of bounds, let’s just say, for example, the company can invest 100% of their portfolio and equity securities. Would that something that glaring be something that you said, “Hey, we ought to have a look at this?”
Ed: Well, let me parse your question. First of all, Stewart, that not all investment managers for insurance companies manage all of the investments of the insurance company, some do, but there are lots of instances where the portfolio of the insurance company is divided up between different investment managers. So they will have investment in manager ABC managing all of the corporate bond portfolio XYZ during the structured securities portfolio. So having said that though, in our review of the investment management agreements, one of the things that we will do is take a look at those investment management agreements and be reasonably sure that they fit within the state investment laws that if the state investment laws, and I’ll give a simple example, that I’m pretty sure is always true, prohibits a company from investing in commodities. They can’t buy wheat or gold, then nothing. That will be something we will flag. If we see it in the Investment Management Agreement, that the investment manager is going to invest as permitted under the guidelines to invest in something that’s otherwise prohibited by the code.
Stewart: So that’s really helpful. And this is another topic that I had never considered. Does the IMA allow for sub-advisors? Now, that’s amazing. So you hire manager A, but it turns out that manager B is actually running the money because they’re sub-advising. And then, the follow-on to that is, does the insurer have control over who that is? I’ve never heard of that, but it’s a great point. And how can you walk me through that, please?
Ed: So that is something that I will start by saying does not happen all the time, but it’s not unusual here, because going back to your earlier question, there are situations where an insurance company will decide to hire an investment manager, but that investment manager doesn’t have the expertise to invest in commercial mortgage loans, so they will then outsource that part. So they will have still primary responsibility for making sure everything is done according to the guidelines because the guidelines are under their IMA, but they will outsource to a sub-advisor. But the key, Stewart, is the question that you touched on very quickly, and that is sub-advisor is still managing money of the insurance company.
And so, therefore, as we review Investment Management Agreements and seeing whether or not there is either sub-advisors or permission for sub-advisors, that the insurance company still has authority. They can still say, “Well, we don’t like that one that you want to outsource to.” Or we’ve decided we let you hire them to start out with, but we’ve decided that we don’t like what they’re doing. So you need to get rid of them. A second part of this discussion about sub-advisors that we look at, is who’s responsible for the fees of the sub-advisor. We would expect that it’s because they’re doing the job of the investment manager, the primary investment manager, that the primary investment manager takes whatever cut out of their fee to pay the sub-advisor so that we’re not essentially double dipping, you’re paying investment manager. And then the insurance company is also then paying the sub-advisor.
I do also want to make one additional point, as you bring up the question of sub-advisors, that it reminded me that the financial statements of insurance companies do have a disclosure requirement. And that disclosure requirement is for all investment managers. So anybody that manages money for the insurance company, whether it’s an investment man, a primary investment manager, or a sub-advisor is required to be reported under that generally interrogatory. That gives regulators the ability to see, “Oh, who we got here, what agreements do we need to review? Is there anybody we got a past experience with that we don’t like, or that we’ve had issues with?” So, that’s also part of what we need to talk about is the disclosure requirements so that the states can do what they need to do.
Stewart: And everybody’s favorite topic. This one will perk up some ears. Management fees have gotten a lot more competitive. As we talked about, the more complicated asset classes tend to have higher fees. What can you tell us about management fees?
Ed: Well, so similar to the comment that I made about investment guidelines, our job is not to quibble over management fees. I mean, if that is, as a general statement is the purview of the insurance company. To the extent that they feel a fee is appropriate, then that’s certainly their decision to make. However, we do look for reasonableness, it shouldn’t be something absurd. As you said, Stewart, investment management fees have gotten more competitive. The market has changed. And we want to be sure that in the context of any penny that’s paid out by the insurance company to somebody is a penny that’s not there, to pay on the policies and the claims. So we want to be sure that it’s not exorbitant and that it meets basic market, current market expectations. But at the end of the day, that decision is up to the company. We do want to look at how the fee is calculated, mainly from a control standpoint, to make sure that the company has adequate controls to decide what they’re paying.
We also take a very close look at a related issue and related to termination provisions. And that is what happens to the management fee when the contract, or whatever reason, either by the insurance company or the investment manager that decide to end that relationship. And going back to what you comment that I said earlier, “Where we’ve occasionally seen ridiculous things,” one of the ridiculous things, or at least in my opinion, one of the ridiculous things is where a company could decide to terminate a relationship with an investment manager, but the investment manager continues to get paid the fee for the assets they put on the books. So quite possibly the insurance company realized after the fact that wait, this was a horrible investment. “How could you invest in this from us? It just barely meets our guidelines. So we’ve decided to terminate this relationship,” but the insurance company can’t sell that investment now. And the investment manager continues to get paid the fee for that. That’s a basic absurdity. And again, in my opinion.
Stewart: And the next one is really interesting: conflicts of interest provisions. And that covers a lot of ground, right? There’s the trading between accounts, which can be advantageous to both, to get the bid asked closer together. But there’s also things like I’ve seen where a board member’s firm is managing the assets, for example. How do you deal with conflicts of interest?
Ed: Complex interest? The reality is that is a very difficult topic because we would expect that investment managers going to have more than one client. They’re going to have lots of clients. They’re going to have situations where even under the fiduciary standard, there are things that they feel they need to do, in the best interest of the insurance company by combining orders or doing certain things that are in fact in the best interest of the insurance company.
But we do want to look at the language. We do want to make sure that there is adequate guidance on how to deal with those situations, recognizing that those situations are going to happen. It is a reality, but how do they happen? And, a good example is cross trade. If the investment manager says, “Look, I’ve got another client, that’s looking to sell a bond. And rather than going through a broker-dealer and needing to pay that third party fee, I’m going to trade it directly with the insurance company,” that happens and we recognize that that is in many, many cases, very appropriate and is in fact beneficial to the insurance company. But when that happens, first of all, there should be a provision addressing cross trading, and there should be expected to be documentation to say, “Well, we’re going to do this trading without the benefit of a broker, like reviewing the pricing, but we will get bid asked prices to show and will document it, that we show that it was, in fact, a fair price and we’re not using doing something inappropriate. It’s also going to be the case with some investment managers that also have affiliated brokers, that there will be some additional documentation to show when that happens, that the prices companies either paying or receiving is a fair market price, and that will be documented in the company’s records.
Stewart: Yeah. I mean, it’s all about price in the cross, right? It’s got to be a market price to be fair to both parties.
Stewart: So what about reporting requirements? Obviously, insurance companies are required to report to regulators. They report to rating agencies. They have as transparent of investment disclosures as it could be. I mean, it’s down to the CUSIP level.
Stewart: What can you tell us about reporting requirements?
Ed: This is something that’s also very important, Stewart. And it drives to not just the relationship that the insurance company might have with an Investment Management Agreement, but what are the requirements of the insurance company that they understand what the investment manager is doing for them? What kinds of reports do they get to be able to see? What risks there are in the portfolio? That there’s adequate information about reading agency downgrades, that there’s adequate information about fair market pricing so that they can make on their end the assessments of whether or not things need to be reported in a different way, or it should enter into their watch list procedures.
In addition to that, what we also look at, Stewart, and you alluded to, this is the reporting requirements for insurance companies that while there are very extensive requirements in the investment schedules, there are also ad hoc requirements that states will decide, “Oh, such and such is happening.” We need to know what are domestic insurance companies have invested in, pick a topic, oil and gas. And so it’s important that the requirements that the IMA have a provision where the manager will help the insurance company with ad hoc requirements so that they can meet their regulatory needs. Now, recognizing that if it’s something extreme, then certainly the investment manager should get paid for their trouble. But if it’s something more normal, what is your oil and gas exposure? That should be rolled into the general fee structure for the company.
Stewart: It’s interesting you talk about those ad hoc requirements because I was working managing money during the GFC and the ad hoc requirements are at least two-thirds of the reason that I’m so gray, but the ad hoc reporting requirements around subprime and the LTVs and the loan performance of those… Some of that reporting and some of those analytics had to be built, but it was, to your point, it was a serious ad hoc request that insurers had to be able to provide, to, I think, frankly understand better, and for the regulators’ perspective, what they actually owned? So just in wrapping up, right? Can you tell me generally what would raise the eyebrows of a regulatory examination from an IMA perspective?
Ed: Before I get to that, Stewart, there’s one other thing that just came to mind, and I was thinking about it before, and then it escaped my head and it is one of the things that we also looked at that I alluded to before, and that is termination provisions. We want to make sure also when we review the IMAs that the insurance company does have the right to terminate with reasonable notice, 30 days or written notice or something like that. But within that, we also want to make sure that any kind of termination is not abrupt, that the investment manager agrees within reason, and that ‘within reason’ language is important. We understand that to help with the transfer of the assets so that everything is relatively smooth. And we’re now suddenly not seeing a situation where the insurance company is like, “Well, we just lost our investment manager for whatever reason, and we don’t know what we’ve got in the portfolio.” So, there’s got to be a reasonable termination provisions for both parties. I mean, I think that’s an expectation for both.
Stewart: Yeah. I mean, that’s a great point because making those transitions, insurance asset management, you’re operating an investment portfolio inside the operating entity, right? And you can’t do anything disruptive, if anything that’s done disrupts the investment operation, it certainly has the potential to disrupt the insurance company more broadly. But sorry, just to talk about what would raise your eyebrows just generally without any particular focus or topic, what are the red flags?
Ed: Well, I mean, we’ve obviously gone through a lot of this specific provision store and that we’ll look at and say, “Is the investment manager registered? Does it acknowledge its fiduciary responsibility? All those different things, but at the core, what we’re also looking for is to make sure that the investment manager and the insurance company really have a firm understanding between the two of them of exactly what they’re doing. That this is an insurance company. This is not a mutual fund. This is not a hedge fund. There are certain things that insurance companies and the way insurance regulators look at insurance companies that they expect to see, that is basically still a buy-and-hold investment operation at an insurance company. Yes, it’s gotten more actively managed, but it’s still basically buying world with a long-term time horizon.
So, when we see things that are not appropriate, when we see, for example, a lot of short-term trading. Insurance companies, there is some. There is always going to be some, but when we see a huge amount of short-term trading as a percentage of the trading, or see it spike, when we see, as we were talking about before, we expect to see some cross trading, but when we see a huge percentage of cross trading, it raises a lot of questions. It raises, well, what is going on here? Is the investment manager doing the right thing, recognizing also that there are also a lot of differences between investment managers and what they bring to the table?
So some are really, really great across all asset classes and some are very specific in their expertise. So we’re always looking to parse the question appropriately. We don’t expect everything from every investment manager. We’ll also know, as we look at the Investment Management Agreements and recognize that 99% of the investment managers out there are fine. I mean, that’s not to say I couldn’t quibble every single Investment Management Agreement. I could pick at almost anyone, but that’s, again, not our job. Our job is to make sure that the agreement as a whole is fair and reasonable. And therefore it’s very unique, that means that the insurance regulators and the insurance industry are also working with investment managers on a level playing field, that you don’t have the good players needing to tow the line, so to speak. And there’s somebody out there who’s not looking out for the best interest of the insurance company and is in some ways painting the broad brush of investment managers in a bad way.
Stewart: I really appreciate it. You have made insurance investment regulation interesting. I’ve learned a lot on this thing. I really appreciate you coming by, Ed.
Ed: Happy to do it, Stewart.
Stewart: My pleasure. Ed Toy, I have to say, insurance regulation celebrity, I think is well earned. I really do, but your official title, Ed Toy, senior manager, investment specialist at Risk & Regulatory Consulting. Thanks for being on. If you have ideas for podcast, you can email me at email@example.com. Thanks for listening. My name is Stewart Foley and this is The InsuranceAUM.com podcast.