The European capital adequacy regime for insurance companies puts fund managers under pressure to deliver detailed and accurate information about investments to their insurance company clients on a frequent basis. But if they get it right, they should get higher allocations from insurers, and help to head off a threat to their more important pension find allocations.

Six years have elapsed since the second iteration of the Solvency Directive (Solvency II) capital adequacy regime for insurance companies was first announced by the European Commission. The latest delay in October 2013 moved the implementation date forward by two years from January 2014 to January 2016, though the Directive will be transposed into the national laws of European Union (EU) member-states in January 2015.

Regulators are almost as anxious about the systemic risks posed by insurance companies as they are by those alleged to be created by fund managers (see “What happens when fund managers become SIFIs,” page [TK]). The collapse of American Insurance Group (AIG) in 2008, after a subsidiary of the insurance company wrote too many credit default swaps (CDS) against structured credit instruments and had to be rescued with $182 billion of taxpayers’ money, is raised whenever a sceptic dare to ask if insurers are systemically important financial institutions (SIFIs).

The purpose of Solvency II is to ensure that no European insurer puts taxpayers’ money at similar risk – ironically, the United States government has actually made a profit on re-privatising its stake in AG – or fails to meet claims made by policyholders (who double as voters). So, despite the delays, there is no doubt that Solvency II will happen. When it does, it will have a profound effect on how insurers invest the capital they hold against the risks they assume.

The value of that capital should not be under-estimated. Insurers are thought to be the second largest investor in alternative investment strategies after public and private pension funds. A study by PricewaterhouseCoopers (PwC) estimated global assets under management (AuM) by insurance companies at $24.1 trillion in 2012. If the AuM continues to grow at current rates, insurers will have $35.1 trillion to invest by 2020.

But nor should the value of insurance capital to alternative investment managers be over-estimated. According to the 2014 Towers Watson Global Alternatives Survey, only about one dollar in a hundred of the capital controlled by insurers finds its way into portfolios run by the top 25 alternatives managers ($247.9 billion) and the overwhelming majority (63 per cent) goes into directly held real estate. The balance is scattered across private equity funds of funds (12 per cent), illiquid credit (11 per cent), funds of hedge funds (6 per cent), direct hedge funds (4 per cent), direct infrastructure funds (2 per cent) and direct private equity funds (2 per cent).

In Europe, insurers are not as keen as their North American counterparts when it comes to investing in alternatives. In 2012, BlackRock estimated European insurance assets stood at approximately €7.5 trillion. This made them worth more than European pensions managed of roughly €5 trillion, but just one euro in a hundred (€75 billion) is invested in hedge funds. That is well below the 3 per cent allocated to hedge funds by pension funds.

That said, €75 billion is still a lot of money, and fund managers would like to run it. The first obstacle to doing that is the fact that “pillar one” of Solvency II, which sets out minimum capital requirements for insurers, imposes a higher risk-weighted capital allocation to more volatile asset classes, into which hedge funds (rightly or wrongly) are judged to fall. The greater the volatility in an insurance investment portfolio, the higher the capital weighting. Solvency II demands insurers allocate capital equivalent to 49 per cent of the value of any hedge fund or private equity investment that they make, 25 per cent higher than the 39 per cent weighting of straightforward equities.

Predictably, European Economic Area (EEA) sovereign debt bears a 0 per cent capital risk weighting. This has caused some amusement, given that five members of the European Union (Portugal, Ireland, Greece, Spain and Cyprus) have effectively defaulted or had to be bailed out. As a report published in the aftermath of the euro-zone debt crisis by BlackRock in conjunction with The Economist Intelligence Unit put it: “The recent euro-zone debt crisis has thrown the very inclusion of a risk-free asset (sovereign debt) in the standard capital model into doubt.”

But there are less predictable reasons why some find the logic of Solvency II hard to follow. In Solvency II: A Unique Opportunity for Hedge Fund Strategies, a paper he published in 2012 in conjunction with the EDHEC Risk Institute, Mathieu Vaissie, a senior portfolio manager at Lyxor Asset Management, warned that the Solvency II capital charges might be counter-productive.

It is certainly obvious that forcing insurers to abandon diverse alternative strategies and narrow their assets down to equities, fixed income bonds and infrastructural assets could put their long term capacity to keep their assets and liabilities in alignment and their funding ratios under control. A drop of, say, 25 per cent in capital-favoured equities could prompt a 20 per cent fall in the capital ratio of an insurance company, leading to increased rather than reduced volatility in insurance company capital ratios. After all, there is a reason why insurers like investing in alternatives.

Whatever happens, any fund managers looing after asset classes that can survive the capital risk-weighting criteria of Solvency II will then find that they have furnish their insurance company clients with reams of detailed information, and on a quarterly basis. The “third pillar” of Solvency II obliges insurers to supply national regulators with information about their assets within six weeks of every quarter-end, which effectively mean that insurers will be asking their fund managers for data on a monthly basis.

At one level, this is a straightforward request. “Insurers must supply position level data to regulators, which will be obtained from their asset managers, vendors or custodians,” explains Andrew Melville, head of insurance product and strategy for Europe, the Middle East and Africa (EMEA) at Northern Trust. “It is a data collection exercise. Insurers gather the data, ensure it is complete and accurate and then they report it to the relevant regulators.”

However, the detail is far from straightforward. A report prepared by KPMG on behalf of the European Fund and Asset Management Association (EFAMA) and Aviva Investors, Solvency II: Data Impacts on Asset Management, points out that insurers have to prove to regulators that the data they source from fund managers is accurate, complete and appropriate, and any shortcomings remedied before submission. In fact, fund managers are obliged to meet the same data standards as their insurance clients. Solvency II sets a range of previously unseen data fields and ambiguous data coding conventions – such as the “complementary identification code” for each asset - which adds complexity even before the different capital charge for each asset class are added to the mix, forcing data to be provided on a security by security basis.

Other challenges identified in the KPMH paper include an insistence that insurers “look through” their funds of funds managers to the ultimate assets held by the underlying managers; the absence of a common standard for the transmission of the data between fund managers and insurance companies; the possibility of conflicting asset valuation methodologies; the need to obtain the appropriate licences from all third party data vendors; the difficulty of ensuring custodian banks and fund administrators deliver data of the right kind in timely fashion; and, in echo of the chaos that followed the launch of derivative reporting in Europe, the fact that the Quarterly Reporting Templates (QRTs) to be submitted to regulators by insurers have yet to be finalised by the European Insurance and Occupational Pensions Authority (EIOPA), forcing insurers to come up with freelance solutions of their own.

It follows that data collection, testing and submission is a far from straightforward exercise for insurers. “Some insurance firms are building their own reporting model in-house,” says made by Stephen Oxley, managing director at Pacific Alternative Asset Management Company (PAAMCO), the $9.5 billion emerging manager-focused fund of hedge funds based in Irvine, California. “The difficulty with that is insurers need to report all of the aggregate positions of their individual hedge funds, and insurers tend to invest with more than one manager. Therefore it can be very difficult to create models. Some insurance firms prefer to create a simple, massive master spread-sheet outlining all of their positions, be they in bonds, or equities. The problem with alternatives such as hedge funds is that they may have exotic positions in their portfolios or short positions, which could complicate matters.”

The potential upside of getting reporting right is that regulators may eventually agree to moderate the capital charges set out in Solvency II. There were reports recently that the European Commission was already amenable to lowering the risk-weighting for private equity investments to 39 per cent, putting it on a par with equities. The 49 per cent capital weighting for hedge funds has received a predictable stream of criticism as excessive for an asset class whose primary goal is to preserve capital.

There is plenty of respectable evidence that alternative fund managers have delivered decent risk-adjusted returns even in exceptionally volatile markets, which is something which cannot be said of equities or European sovereign debt. In his EDHEC paper, Mathieu Vaissie ventured that a capital charge of 25 per cent would be more appropriate for hedge funds. “Our experience as a hedge fund investor indicates that a diversified portfolio of hedge funds carries less risk than a long-only portfolio of equities,” adds Stephen Oxley. “One could argue the capital charges do not take into account for the risk-adjusted returns hedge funds have delivered.”

Insurers with a high level of investment management skills will be able to blunt the impact of Solvency II, especially if they can persuade regulators they have hedge the risk out of their portfolios. That prospect may tempt less sophisticated insurers to upgrade their internal risk management models and calculations in an attempt to impress regulators. But greater sophistication can only increase the burden on fund managers to supply more accurate and detailed and up-to-date information on underlying positions. Certainly, her greater the granularity of reporting, the more the opportunity to cut capital charges – which implies increased disclosure by fund managers.

A hedge fund portfolio, for example, might contain United States Treasuries and equities, whose lower risk-weighting could offset the higher charges of more exotic asset classes. Provided the positions were reported by the manager individually, the insurers could cut the capital cost of working with that manager. “Hedge fund managers would need to provide insurance companies with position-level data and transparency,” says Mario Mantrisi, chief strategy and research officer at KNEIP, a Luxembourg-based legal and regulatory information provider. “The insurer could calculate the risk exposures accordingly, and this would substantially reduce the capital charge. This would make life more palatable for insurers with significant exposures to alternative asset classes.”

However, greater transparency by some managers to some insurers for the purposes of Solvency II could prompt regulators to argue managers were offering preferential treatment to some investors. This is an issue of particular concern to the Securities and Exchange Commission (SEC) in the United States. Managed accounts might be the answer. “If an insurer was invested in a commingled fund, then, yes, disclosing position-level data may fall foul of the rules surrounding preferential treatment,” says Stephen Oxley. “However, if an insurer created a managed account with a manager, then that could satisfy the regulators.”

Managed accounts provide investors with the “look-through” to underlying exposures which Solvency II demands as part of the price of lowering capital charges. “If you establish a managed account with a manager whereby you have control of the operational aspects of the business and the manager just has a trading mandate, then it would be possible for the insurer to reduce its capital charge,” explains John Godden, chief executive officer at IGS Advisors, a UK-based consultancy. “Segregated managed accounts will offer insurers the level of granularity of data and portfolio positions, which is essential to lowering their capital charge.”

However, Godden tempers this observation with some cautionary remarks. “The term ‘managed account’ is a label used to describe a variety of different structures,” he says. “Will some types of managed accounts give an insurance company better capital treatment under Solvency II? Yes. However, if you are an investor holding a hedge fund via a managed account that is commingled and run by an entity other than the hedge fund – say, a platform – then insurers could still be subject to the 49 per cent capital charge.”

This refinement of the managed account solution to Solvency II is disputed by managed account platforms. “An insurer using a managed account platform can obtain full transparency and look-through to its underlying investments,” says Akshaya Bhargava, chief executive officer at InfraHedge, a managed account platform owned by State Street. “This permits the investment to be classified in a category that attracts a lower capital charge. The ownership of the fund platform should not weigh into the debate but rather the look-through to underlying positions.”

Another method by which insurers could substantially lower their capital charge is by obliging managers they appoint to report position-level data through Open Protocol Enabling Risk Aggregation (Open Protocol, formerly known as OPERA), the risk reporting toolkit developed by Albourne Partners. Open Protocol is of course a voluntary initiative but, given the allocation power of Albourne Partners, a number of managers are overcoming the reluctance to fill in yet another form.

The data disclosed via Open Protocol includes firm, fund and investor details, and exposures by asset class, which sis germane to Solvency II. In addition, managers must report the techniques, such as Value at Risk (VaR), stress tests, sensitivity analyses and counterparty risk management processes by which they keep abreast of the risks posed by these asset classes. Gaurav Amin, head of risk at Albourne Partners in London, is confident that insurers which receive Open Protocol reports from their managers will be subject to less onerous capital charges. Others are not so sure. One industry expert questions whether the level of information supplied to insurers through Open Protocol would be sufficient to impress regulators.

The answer to that question matters to fund managers, since they have to decide whether it is worthwhile to supply granular data on exposures to anyone in return for being open to investment from insurance companies. Disclosure is not without risks, in terms of short-squeezes and copycat trades. “Some hedge funds might be concerned with the security of the data they are supplying investors,” says Stephen Oxley. “Many managers feel their portfolios represent their proprietary ideas. It is their secret sauce and they do not want to give away the ingredients, and they fear it might leak.”

Andrew Melville of Northern Trust agrees challenges could arise. “If we look at funds of equity funds or funds of bond funds, there are multiple layers, which could be difficult for insurers to fully look-through,” he says. “In addition, some hedge funds might not be that transparent. Obtaining data is going to be difficult for insurers and asset managers may be nervous about disclosing position level data.”

If they can overcome their misgivings, managers will then face the considerable operational challenge of getting data to insurers in a timely and accurate fashion. The BlackRock study found 90 per cent of managers were very or somewhat concerned about meeting the Solvency II data requirements, and 96 per cent fretting they would struggle to get the appropriate data to clients in a timely fashion.

Andrew Melville acknowledges it is an issue. “Initially, insurers will need to report on an annual basis 20 weeks after the year end and this will transition to quarterly reporting eight weeks after the quarter end,” he explains. “The issue will be how quickly managers disclose this data. Will it be in real-time or near real-time? Some insurers may ask for the data to be supplied more quickly or with a time-lag depending on the ability of their internal infrastructure to consolidate all of the information.”

Predictably, given the sheer volume of reporting that has to be done, the level of preparedness for Solvency II at hedge fund managers does vary widely. “Hedge fund managers have not fully got to grips with Solvency II’s reporting standards,” says Stephen Oxley. “This is mainly because insurers are not the largest institutional investors in hedge funds. If the capital requirements had been extended to pension schemes, then there would have been a different story.”

As it happens, there were plans to extend the Solvency II capital adequacy regime to pension funds in Europe via the Institutions for Occupational Retirement Provision (IORP) Directive. In May 2013, the European Commission announced it would shelve the Pillar 1 capital requirements under IORP amid fears (voiced by pension fund associations, plan sponsors and trade unions) it would have added ruinous amounts to the already excessive liabilities of European pension funds. One estimate of the increase in the liabilities of pension funds in the United Kingdom alone stood at $150 billion.

Despite the retreat by the European Commission, Stephen Oxley warns that IORP is not dead, but only sleeping. “A reintroduction of the IORP Directive capital requirements on pension schemes is always a possibility,” he says. “Such a proposal would certainly face stiff resistance from the United Kingdom pension fund industry, which makes up a substantial percentage of overall European pension fund assets. However, European regulators tend to bucket pension plans and insurers together, so it is possible.”

Andrew Melville concurs. “I think regulators will assess how Solvency II implementation is going and then determine the extent of the impact that this may have on pension funds and their asset managers in the context of the IORP rules,” he predicts. “Asset managers and asset owners should not be complacent and look to work closely together on these regulations.”

Which puts an unusually high premium on the outcome of Solvency II in terms of its effect on the appetite of insurers for certain asset classes. At this point, nobody knows whether the Solvency II capital weightings will or will not deter insurers from allocating assets to alternatives. Industry surveys indicate that insurance company CIOs are gradually getting more bullish on the question of investing in alternatives.

A 2012 study prepared by the Economist Intelligence Unit for BNY Mellon, Insurers and Society: How regulation affects the insurance industry’s ability to fulfil its role, found 45 per cent of insurers anticipating a decreased risk appetite among their peers for hedge funds, with just 8 per cent predicting an increase. 37 per cent predicted a drop in private equity investment, compared with 14 per cent who expected an increase.

A year later, a 2013 study by the asset management arm of Goldman Sachs of 189 CIOs at insurance companies placed private equity third behind United States domestic and emerging market equities as likely to attract increased allocations. This year, a 2014 survey of 206 chief investment officers (CIOs) at insurers conducted by BlackRock in conjunction with The Economist Intelligence Unit found 54 per cent of respondents were “moderately likely” or “highly likely” to increase their allocations to private equity.

At KNEIP, Mario Mantrisi is certainly bullish. “If fund managers in the hedge and private equity space adhere to the transparency requirements outlined in Solvency II, insurers will invest more with them,” he says. “Insurers are growing their allocations into alternatives and I believe that will only increase.”