In Part 1 of this series, BBH highlighted the growing appetite for ETFs by insurance general accounts and the benefits the product provides to that group of institutional investors. In Part 2, we highlighted similar efforts by variable annuity providers to leverage ETFs as low-cost investment vehicles for their investors. Now, here’s an outline of critical steps insurers should consider when launching their own ETF.
In recent years, insurance firms have been some of the fastest-growing institutional buyers of exchange-traded funds (ETFs). And more recently, as these firms have become more familiar with the ETF product structure, they have also sought to become ETF manufacturers themselves. Insurance firms bring institutional-caliber asset management, product and sales talent, a large pool of assets, and perhaps most importantly: customers. This combination may allow insurers to scale quickly and efficiently — a pronounced leg up in the highly competitive ETF market.
Because the use of ETFs by insurers is growing rapidly, both in their own general accounts and their variable annuity offerings, some insurers have found product synergies and captive distribution channels by launching their own ETF lines. Additionally, the broker-dealer business lines affiliated with insurers are developing ETF models as a service to their clients, providing another captive asset allocation channel for the affiliated asset manager to distribute ETFs. However, having a built-in customer base, significant assets, and easier access to outside investment doesn’t mean that insurers are launching vanilla products. Quite the opposite — with more than 8,000 ETFs available today,1 insurers must go to market with differentiated products in order to gain traction in a crowded playing field. For this reason, many new ETFs from insurers employ nuanced strategies like multi-factor and managed volatility methodologies.
Insurers are still in the early innings of ETF adoption and issuance. Before attempting to enter this market, insurance affiliated asset managers need to understand the lay of the land.
Cross Your Verticals
The investment management arm of an insurer is often just one business vertical in a complex organization. While not every vertical will need a seat at the table when it comes to launching an ETF business, it’s important that those associated with building and managing client portfolios, models, annuity products, and managing the investments associated with the firm’s liabilities be brought in during the ETF assessment phase. These internal partners may present opportunities for seed capital, product ideation, and on-going investment if the investment manager launches ETFs. Often times, these verticals already have integration into the asset management business. However, for more siloed firms, holding a series of ETF roundtable discussions with these internal partners may help the asset manager better understand if and how ETFs are used by the other channels today, and that feedback could be instrumental in assembling an ETF line-up.
Key considerations for these discussions may include:
- Impact to distribution relationships with third party managers
- Revenue impact when using an affiliated vs. a third party product
- Potential cannibalization of existing investment products and revenue
- Familiarity with ETFs and ability to trade over primary and secondary markets
- Sensitivity to product expense ratios
- Oversight and due diligence of investment managers selected for client portfolios, general accounts, etc.
Custom Product Development
Given that insurers increasingly deploy ETFs in their general accounts and through their annuity offerings, product managers within insurance firms may be able to customize ETFs that fill the specific technical needs of their general accounts. It’s common practice for ETF issuers to work with Authorized Participants (APs) and market makers during the product development process to assess the fund’s strategy, liquidity of the underlying holdings, and potential trading and hedging costs. In a similar light, insurance affiliated asset managers can work across their organization to ascertain product gaps, desired exposure, and fee sensitivity so that any products launched can be used by a general account or annuity immediately. While this may pose added work to the product development teams in designing the ETFs, this cross-organizational feedback can be a valuable tool and may help promote early assets under management (AUM) in newly launched products.
The second benefit of working with the general account is seed capital. In the past, most ETF managers sought out seed capital from their lead market makers. However, this amount was traditionally less than $5 million and many ETFs experience low volume in the early days, lengthening the time the market makers had capital tied up in the products. In recent years, many global asset managers have entered the ETF market and used their own capital in seeding new products, often launching with $10-50 million per fund. For insurance affiliated managers, a product built in partnership with an affiliated business line may provide a larger pool of assets to seed the fund and extend the investment timeline on that initial capital infusion. Not only does a larger seed investment benefit the fund, it also helps to underscore the firm’s commitment to the ETF market.
Selling investment products into an insurance business can be a very different conversation than targeting RIAs or retail broker-dealers. Managing volatility, risk-based capital charges, hedging, IRS tax treatment, and state insurance regulations are but a few of the themes and topics that distribution teams focusing on insurers may be expected to navigate. Firms that have been successful in distributing into these channels have spent years building out sales expertise and establishing their credibility for these investors.
For the asset management arm of insurers, this may present an opportunity when compared to stand-alone managers. Access to the needs and input from affiliated business lines like the general account, annuity business, or affiliated broker-dealer can provide product feedback and input. Stand-alone managers, on the other hand, would need to create dedicated sales personnel to achieve similar insights.
Additionally, insurance-based investors may have certain requirements from their regulators that need to be met by the ETF. One example is the approval provided by the National Association of Insurance Commissioners (NAIC) of securities available for investment by general accounts, including fixed income and preferred stock ETFs. ETF managers seeking to sell products to the general account need to apply for a Regulatory Treatment Analysis Service (RTAS) through the NAIC, which will provide a Preliminary Designation to the funds and make them eligible for investment by the general accounts. This process includes fees per ETF, though the costs can be reduced if the ETF manager works through an insurer (see graphic below for more information regarding NAIC designations). Ultimately, these designations will drive the risk-based capital charge incurred by the general account.
Other considerations for effectively distributing into the insurance channels include the use of systematic valuation for fixed income ETFs. While this account treatment is elected by the insurer, the asset manager must understand the nuances in the calculation and be able to field questions from the insurers regarding methodology and differences in this treatment versus original cost. Additionally, the ETF manager may be asked to provide aggregate cash flows for the underlying ETF investments to support this valuation process.
Lastly, cross-selling ETFs through an affiliated insurance broker-dealer should be top of mind. Many of these platforms are offering ETF models to their investors, which strike a resemblance to robo-advisory platforms that have emerged in recent years across the retail market. The typical low cost of ETF ownership has been well covered and the benefit exists for insurance-based broker-dealers as it does for other channels. Building out an ETF offering for use by these models is low hanging fruit that insurance affiliated managers should consider.
For managers yet to enter the ETF market, competition is only increasing. With the entry of many insurance-based managers and other global institutional asset managers, the focus on distributing ETFs to institutional clients is growing. Cerulli reports that 68% of ETF managers view insurance general accounts as a primary or secondary focus from a sales perspective, placing this channel ahead of hedge funds and pension plans in terms of focus.2 Competition for these assets is only going to get harder.
In the US, for now, ETFs are covered by the Investment Company Act of 1940, a rule that was primarily designed for mutual funds. Because of this, whenever an ETF sponsor wants to launch a new fund, they must get a special exemption (known as “exemptive relief”) from the Securities and Exchange Commission (SEC) regarding certain provision of the ‘40 Act not applicable to ETFs. Most ETF managers can receive SEC approval in three-six months, however more complex strategies may take closer to a year.
However, in June 2018, the SEC proposed new ETF rules that would allow asset managers to bring certain types of ETFs to market without first obtaining explicit SEC approval — a change long sought by the industry. The proposed rule would effectively end the need to obtain exemptive relief. It would also would rescind all existing exemptive relief that had been granted to certain existing ETFs, requiring them to comply with the new rules as well. This may make entering the ETF market a quicker and less costly process.
Additionally, in another win for the ETF market, the SEC included provisions that would permit qualified ETFs to use custom baskets with a fund’s authorized participants, which may help in easing the ability of APs to create and redeem ETF shares as well as maintaining tax efficiency in the product. [Note: Most ETF issuers who received exemptive relief after 2012 are not permitted to use custom baskets, creating inconsistencies in how managers can interact with APs, and manage funds’ tax efficiency and liquidity.] Overall, the proposed rules have been well received by the market.
It’s also worth mentioning that globally, ETF regulations are shifting, resulting in changes as to how products are traded. For asset managers with global reach, a proper ETF assessment should include the aspect of launching products in multiple domiciles. For example, while some European investors had sought out US listed ETFs, since the inception of PRIIPs on Jan. 1, 2018 US ETFs no longer comply with EU regulations, resulting in some EU assets moving back to locally domiciled UCITS ETFs. As the global regulatory market evolves, managers should monitor how changes in cross-border regulations will impact their ETF distribution efforts.
Brown Brothers Harriman has proven expertise in assisting insurers from the development of their ETF business case to supporting their ETF operations. We’d be pleased to provide pre-launch consultation, guidance, and strategic insight to help guide your firm through the ETF launch process. Please contact Ryan Sullivan if you’d like to discuss your options further.
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1 Thomson Reuters (represents global ETFs)
2 The Cerulli Report: U.S. Exchange-Traded Fund Markets 2017