Solvency II will facilitate retreat from alternatives by insurers, says UBS/PwC study
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 survey by UBS Fund Services and PricewaterhouseCoopers (PwC).
Seventy per-cent of insurers told the survey – “Needs of Institutional Investors in the New Alternative World” – that they planned to decrease the number of alternative asset managers in their investment portfolios over the coming two years. This is mainly being driven by Solvency II, which demands improvements in insurance companies’ governance structures, and requires them to collect more data from their underlying investments, which must be passed onto national regulators within six weeks of every quarter end.
Most significantly, Solvency II requires insurers allocate capital equivalent to 49 per cent of the value of any hedge fund investment that they make, and 39 per-cent for any private equity or equity investment. Nonetheless, these capital charges can be lowered if insurers obtain granular data from underlying managers on their portfolio holdings as they can offset lower risk-weighted assets against more esoteric instruments.
"Fund managers would need to provide insurance companies with position-level data and transparency. 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,” said Mario Mantrisi, chief strategy and research officer at KNEIP, a Luxembourg-based legal and regulatory information provider.
One way this could be done is through a managed account structure whereby the insurer is given a look-thru into the fund manager’s positions. Another method by which insurers could substantially lower their capital charge is by obliging managers 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.
“Some insurance companies are dealing with the regulation by changing the way they gain exposure to alternative strategies. For instance, in order to continue investing in real estate and lower their capital charge, they replace their “fund” structures with “direct investments” as part of a joint venture with real estate funds,” read the UBS/PwC study.
However, there are challenges. Managers must supply substantial amounts of data to their insurers if the latter are to obtain more generous capital requirements. A BlackRock study found 90 per cent of managers were very or somewhat concerned about meeting the Solvency II data requirements, and 96 per cent were fretting they would struggle to get the appropriate data to clients in a timely fashion.
Conversely, an absence of detailed information about portfolio holdings could result in a 100 per-cent capital charge being applied to insurers, warned the UBS/PwC study. Such a charge could arise if an insurer was invested in a hedge fund that uses a proprietary algorithmic trading model or “black box.” Funds of funds could also be adversely impacted by Solvency II as many of their underlying managers might be reluctant to share proprietary data with them, fearing short-squeezes or copycat trades.
Previous studies have concurred regulation is going to have a detrimental impact on alternative investing. 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. However, in 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.
The chief fear is if these capital adequacy regimes are extended to pension funds, which are increasingly allocating into alternative asset classes. There had been plans to introduce the Solvency II capital adequacy regime to pension plans in Europe via the Institutions for Occupational Retirement Provision (IORP) Directive although this was shelved in May 2013 by the European Commission following vocal opposition from pension fund associations, plan sponsors and trade unions who complained that it would have added further costs to the already excessive liabilities at pension plans. Nonetheless, this does not mean pensions will be exempt from the rules. “A reintroduction of the IORP Directive capital requirements on pension schemes is always a possibility,” said 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 UBS/PwC survey also found investors are looking for more “predictable and uncorrelated returns in this evolving regulatory environment.” It said recent investor entrants into alternative asset classes had become increasingly sophisticated and experienced in the space. “As a consequence, the quantitative process initially used for the selection of alternative asset managers will be steadily replaced by a more qualitative approach,” said the study. It added these institutions would therefore narrow down the number of managers they work with.
UBS and PwC surveyed investors with $1.9 trillion in Assets under Management (AuM) globally.