The biggest implications for insurance firms surround capital requirements, which like Basel III apply a risk-based weighting. Exposure to hedge funds and “other equity”, deemed to be a risky asset class by national competent authorities, subjects insurance companies to a 49% capital charge of that investment. Private equity and Organization of Economic Cooperation and Development (OECD) listed equities carries a 39% capital charge. This lowers to 25% for real estate, while European Economic Area (EEA) sovereign debt has a 0% risk-weighted capital charge. The bail-outs of a handful of Eurozone economies have led some risk professionals to question the capital charges for EEA sovereign debt versus other asset classes.

Compromises have been made though on capital charges. Qualifying Infrastructure debt and equity investments will carry a lower capital charge for insurers as part of the European regulatory effort to encourage greater investment by insurers in European public infrastructure projects. European Long Term Investment Funds (ELTIFs), which are regulated, retail infrastructure funds subject to the Alternative Investment Fund Managers Directive (AIFMD) will carry similar capital charges to equities transacted on regulated markets and European Venture Capital Funds and European Social Entrepreneurship Funds.

“The low interest rate environment has resulted in some insurance companies exploring alternative asset classes. We have seen insurers enter into swap agreements with banks, producing liquidity for the banks and higher returns for the insurers, while there has been a renewed interest in real estate and infrastructure and other longer term, yield-creating investments. Regulators have also been assessing capital charges for Qualifying Infrastructure investments, to help make them more attractive for insurers,” said Victoria Sander, partner at Linklaters in London.

The asset class most at risk from dis-investment because of Solvency II is probably hedge funds. A handful of Nordic insurers including Storebrand have curtailed their exposures to hedge funds because of Solvency II. Insurers can benefit from lower capital charges though if their hedge funds supply position level data on their underlying investments. This enables insurers to utilize their own internal risk modelling systems to calculate their capital charges. This information must of course be provided by insurers to their national competent authorities in a timely fashion, and the risk models must also be approved by regulators. The Bank of England has already approved the internal risk models being used by a number of high-profile names such as Aviva, Prudential and Legal & General.

However, the level of preparedness among asset managers more broadly has been found wanting, “In general – with some notable exceptions – there has been a surprising lack of discussion initiated by insurers with asset managers about how Solvency II will impact their current asset management arrangements. At the moment, to the extent that there is activity, this mostly centres around the provision of asset data to insurers. We therefore anticipate that there will be a spurt of activity in this area when insurers face regulatory pressure to comply with their new Solvency II asset management obligations,” said Jennifer Yao, supervising associate at Simmons & Simmons.

Some hedge funds baulk at the idea of supplying proprietary data to insurance clients lest it finds itself in the public domain, while others point out that offering preferential treatment to insurers could lead to awkward conversations with regulators such as the Securities and Exchange Commission (SEC), which has adopted a tough stance on the issue. Funds of hedge funds and funds of private equity funds could also struggle to obtain the necessary data from underlying managers in a timely fashion to supply to their own insurance clients.

A mechanism around the reporting challenges for the alternatives industry more broadly could be to open up bespoke separately managed accounts for big ticket insurance companies although this in itself can be prohibitively expensive, especially for smaller managers. Despite this, insurance exposure to hedge funds remains low. A J.P. Morgan analysis in February 2015 said insurers had lower exposure to alternative asset classes, particularly hedge funds, relative to other institutional investor segments due to their stringent risk and concentration criteria.

The Solvency II capital requirements can, however, be implemented relatively seamlessly by larger insurance groups although smaller, bespoke providers could struggle, a point made by Sander. “We have certainly seen an increase in merger & acquisition (M&A) activity in the UK and across Europe in the last 24 months. There have been a number of providers disposing of their annuity books and specialist providers which are consolidating such businesses, and we expect this trend to continue. The capital requirements that apply, including the risk margin for annuity businesses can be relatively material and depending on how firms structure these and their reinsurance coverage, we could see more providers seeking to offload their annuity books. We are also seeing a growing number of private equity funds participate in M&A transactions,” commented Sander.

Others agree that M&A could proliferate among insurers. “Solvency II has already led to some insurers consolidating their businesses. We would anticipate this trend will continue for those who are unable or unwilling to adapt to the risk-based regulatory approach that Solvency II implements, particularly where an insurer’s business profitability is significantly tied to investment in assets which now bear capital requirements and governance costs, which no longer make it worth investing in,” said Yao.

There was speculation similar capital charges could be extended to pension schemes across the EU through the proposed second iteration of the Occupational Retirement Provision Directive (IORP). A draft report is expected at some point in 2016 although it is believed that prudential capital rules will not apply to pension schemes in what will be a much welcome reprieve for stakeholders. However, this compromise is not guaranteed as regulators could yet change course. “While I can understand the rationale for extending prudential capital requirements to pension schemes, there are challenges. Pension schemes are structured and run in a fundamentally different way to annuity insurance companies. The legal structures across the EU are varied and implementing a “one size fits all” approach would be very difficult,” said Sander.

However, there are reports that some pension schemes are demanding Solvency II-type transparency reports from asset managers in advance of IORP II. “While the revisions have not yet been finalised to say with certainty the extent to which Solvency II-type asset reporting will apply to pension providers, we are aware that some pension trustees are already requesting Solvency II-type reports from their asset managers although they do not have any regulatory obligations to require such reports,” said Yao.

The post Buy-siders ready themselves for Solvency II appeared first on The TRADE.

Solvency II, which will be implemented from January 1, 2016, subjects EU insurers to risk-weighted capital charges and additional reporting obligations.  Insurers into hedge funds must hold 49% in capital of their investment. Those insurance companies with exposure to private equity and OECD listed equities must hold 39% in capital, while real estate commands a 25% capital charge. However, the capital charge for exposure to European Economic Area (EEA) sovereign debt stands at 0%. Given the recent bail-outs of several Eurozone members, the capital weighting for EEA sovereign debt has prompted much scorn from the industry.  

The Solvency II capital requirements have already caused a handful of insurers to dis-invest from hedge funds, most notably Storebrand in Norway. However, hedge funds offering separately managed accounts can enable insurers to lower their capital charges. Nonetheless, separately managed accounts are expensive to operate so the investment mandate from the underlying insurance client would need to be sizeable for it to be justified. Those managers providing a complete look-thru on their investments could also help insurers lower their capital charges. It is these managers demonstrating complete transparency, which could see insurance capital inflows.

Some speculate funds of hedge funds (FOHFs) could struggle to maintain insurance clients if their own underlying hedge funds refuse to provide them with look-thru on their investments. “We obtain position-level data from our managers, and therefore we can supply more granular data to insurers.  As such, we believe insurance companies will invest with FOHFs that can supply them with timely data and help them understand the inherent risks in the portfolio. This should provide the diversification they are looking for without necessarily increasing their capital charges,” said Melanie Rijkenberg, Associate Director at Pacific Alternative Asset Management Company (PAAMCO), a FOHF.

Several industry associations across the EU including the UK’s Investment Association (IA) have developed a standardized template for data reporting by managers to insurers as part of their Solvency Capital Requirement (SCR). Insurers, in turn, are obliged to report this data to national competent authorities. Some managers have expressed alarm that proprietary data could inadvertently be leaked, while others are worried they may struggle to deliver the data within the tight-frames.

A paper by J.P. Morgan in February 2015 highlighted that “relative to other institutional investor segments, insurance companies historically have had lower allocations to alternatives in general and to hedge funds in particular.” Insurers have traditionally been biased towards fixed income and credit, mainly due to the stringent risk based capital frameworks they must adhere to. However, the J.P. Morgan paper added that the low interest rates and depressed bond yields was leading to income problems for insurers. As such, many will be obliged to attain diversification by exposing themselves to other asset classes, including hedge funds. 

The post Solvency II data could be key to win insurance business appeared first on The TRADE.