Solvency II capital charges should be lowered
European regulators should lower the Solvency II capital charges for insurers investing into hedge funds just as they did for private equity, it has been argued.
In October 2014, the European Commission announced that private equity investments would attract a capital charge of 39 per cent, down from 49 per cent, bringing it in line with the charge for infrastructure funds and listed equities in OECD countries. Risk weightings for hedge fund investments, however, remain stuck on 49 per cent.
“It would be advantageous if insurers with hedge fund allocations were permitted a capital charge similar to that of private equity. We believe that hedge funds, which offer a strong risk-adjusted return and allow insurers to achieve diversification, do not warrant such a high capital charge,” said Peter Coates, chief executive officer at Omni Partners, a London-based alternatives investment manager.
The high capital charges have been subject to criticism. European Economic Area (EEA) sovereign debt, for example, commands a 0 per cent capital weighting. A report by Blackrock and The Economist Intelligence Unit questioned this wisdom given that five members of the EU (Portugal, Ireland, Greece, Spain and Cyprus) have effectively defaulted or been bailed out. “The risk weighting for insurers with exposure to European sovereign debt does not really stack up,” said Coates.
Academic papers have argued for a lower capital charge for hedge funds. In Solvency II: A Unique Opportunity for Hedge Fund Strategies, a paper published in 2012 by Lyxor Asset Management and the EDHEC-Risk Institute, it was proposed hedge funds be subject to a capital charge of no more than 25 per cent.
There are fears Solvency II could precipitate a decline in insurers allocating to hedge funds. More than two-thirds of insurance companies intend to scale back their exposures to alternative asset managers as a result of regulation, according to a recent survey by UBS Fund Services and PricewaterhouseCoopers (PwC).
Sixty-eight per cent of European insurers told the survey - Needs of Institutional Investors in the New Alternative World - that they planned to decrease the number of alternative asset investments in their portfolios over the coming two years. This is being driven by Solvency II, which demands improvements in insurance companies’ governance structures and requires them to collect more data on their underlying investments that must be passed onto national regulators within six weeks of every quarter end.
“There is a strong risk some insurers might be reluctant to invest into hedge funds given the added capital charges and data requirements. While some hedge fund managers might be reluctant to share position level data with insurers for fear of information leakage, I believe these fears are largely misguided. Managers should work with insurers and their consultants or fund of funds managers in order to understand the reporting requirements, reasons for transparency, purpose for providing the data and controls in place along the reporting lines. Of course, most insurers, funds of funds and consultants are not in the business of trading against hedge funds that they invest with,” said Coates.
However, there are ways insurers can lower their capital charges. One way this could be done is through managed account structures whereby the insurer is given a “look-through” into the fund manager’s positions. Another method is by obliging managers to report position-level data through the Open Protocol Enabling Risk Aggregation (the Open Protocol, or “OPERA”), the risk reporting toolkit developed by Albourne Partners.
“There has been talk that insurers can claim a lower capital charge by investing into alternatives through managed accounts or by demanding Open Protocol. I firmly believe that managed accounts and other solutions exist for insurers to gain exposure to alternative investments. However, the dialogue has thus far been minimal as hedge funds and other alternatives are currently a small allocation of insurers’ assets. We are looking to provide solutions in the form of Solvency II compliant bonds and managed accounts, both of which would enable insurers to maximise their return on regulatory capital, a key focus for insurers rather than the traditional return on volatility,” said Coates.