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Contracting with a third-party to assist with a company's operating objectives comes with benefits and risks. Using the example of Root Insurance and its initial need for outside investment asset management services while raising equity, some prominent benefits and risks of outsourcing are identified.
Companies need to work diligently to quickly execute the increasing demands of their stakeholders. Simultaneously, they must find ways to increase operational efficiency, stay compliant with the law, remain good employers, keep on top of macro and micro-economics trends, and be good stewards of funding dollars raised.
When making these important business decisions, management must have the insight and courage to recognize their strengths, but more importantly what needs improved or further supported. When a required capability is identified as lacking, the decision to build, buy, or outsource is often discussed. Many companies outsource business activities, functions, and processes for a variety of reasons; some include to capitalize on technological innovation, stand up a function quickly, increase specialization, or improve cost control—or as a stopgap measure to build or buy.
"Materiality of outsourcing arrangements depends on the extent to which it has the potential of influence, whether quantitative or qualitative, on a significant business line or consolidated operations of the company"
Materiality of outsourcing arrangements depends on the extent to which it has the potential of influence—whether quantitative or qualitative—on a significant business line or consolidated operations of the company. In essence, can the outsourced arrangement, if executed poorly, negatively impact the financial viability of the company or damage its reputation?
Factors to consider include:
• Impact of arrangement on finances, reputation, and operations of the company or significant business line, particularly if outsourced provider should fail to perform over a given period of time.
• Ability of the company to maintain appropriate internal controls and meet key stakeholder requirements, particularly if outsourced provider were to experience problems.
• Cost of the outsourcing arrangement.
• Degree of difficulty and time required to find an alternative provider or bring the business activity “in-house.”
The outsourced arrangement does not diminish the company’s ultimate responsibility for effectively overseeing and supervising the activities outsourced.
Root Insurance Story
In late 2017, as Root contemplated a third equity raise— what turned out to be a $51 million Series C funding in March 2018 and a $100 million Series D funding seven months later—internal discussions had begun to identify an external investment asset manager. Our overall investment philosophy was twofold: to support the development of Root’s insurance program and to support day-to-day operations. Funding dollars raised needed to be managed strategically to preserve principal, provide a reasonable return to support the business, and ensure our execution was compliant with regulatory investment guidelines.
With the assistance of a third-party investment advisor, we quickly put in place the investment building blocks—investment policy, guidelines, and benchmarks or performance metrics—and narrowed the field of asset managers to the top three who would then propose a multiyear investment strategy. Due to the significance of dollars managed, our internal review team included two board members and members of executive management.
When developing our business requirements, we pulled from a broad category of third-party risks:
Using this list as an input, our business requirements for contracted asset management included:
• Team experience with a startup property and casualty insurance asset portfolio
• Cultural fit
• Performance benchmarks, including reporting and data delivery timelines
• Client service reputations
• Ability to provide ancillary data analytics and technology and data integration services(investment accounting and regulatory reporting, impairment analysis, income forecasting)
• Management fee competitiveness
While narrowing options for outsourcing, we saw the macro trends in response to Root’s insurance product and recognized the need to identify an internal role who would have day-to-day oversight and supervisory responsibility for the asset manager. It was critically important this candidate had investment experience, would stay in tune with macro economic trends, and proactively be the eyes and ears between Root and the asset manager. Today, this individual maintains responsibility for reporting to executive management and the board on asset manager performance, including assessment against our business requirements.
As Root continues to grow, opportunities to diversify our investment portfolio are emerging. Once again, we’ll need to assess internal and external capabilities, leveraging and building on a proven third-party risk management framework, before deciding how to move forward.