18 February 2013

Risk.net: Hedge funds grapple with Solvency II look-through test

This is a mixed blessing for hedge funds. Solvency II could force insurers to take potentially punitive capital charges against their hedge fund holdings. Although the delay gives the industry more time to adjust to the rules, it also prolongs the uncertainty in the marketplace and may encourage insurers to defer hedge fund allocations in the interim.

Solvency II sets out tougher risk management and capital requirements for European insurers, an attempt to avoid an AIG-type fiasco in Europe. Pillar I requires insurers to hold sufficient capital to ensure a 99.5 per cent probability of meeting obligations to policyholders over a one-year period. The amount of capital an insurer needs to set aside depends on the nature of their liabilities and the market risk of invested assets.

The standard formula proposed in the Directive provides for a sliding scale of capital charges. Government bonds retain their risk-free weighting, while capital charges for corporate bonds range from 4.9 per cent to 16.9 per cent, depending on their credit rating and duration. There is a 25 per cent charge for property investments and 39% for equities.

The most punitive capital treatment is reserved for private equity and hedge funds, which are classified as ‘other equities’ in the standard formula and subjected to a whopping 49 per cent capital charge.

The harsh treatment of hedge funds stems from Solvency II’s emphasis on transparency. The rules specifically penalise portfolios that do not have a clear ‘look through’ to the underlying assets. In the absence of detailed information about portfolio holdings and risk exposures, these investments are classified as ‘other equities’ in the standard formula.

“The ‘look through’ requirement is quite a challenge for hedge funds”, says Scott Robertson, head of investment risk and asset liability management strategy at the Phoenix Group, the UK’s largest manager of closed life insurance funds. “It’s clear the regulators want insurance companies to stay away from black boxes.”

The sanctions for holding opaque assets are serious. In the worst-case scenario, regulators can impose a 100 per cent capital charge for ‘black box’ investments where the insurer is deemed to have insufficient visibility into the underlying risks. Hedge funds that provide a basic level of transparency and standard monthly or quarterly performance and risk reports would qualify as ‘other equity’ with a 49 per cent capital charge.

“Solvency II makes it very difficult to invest in hedge funds that do not provide full transparency”, says Robertson. “It’s ultimately a decision about expected return versus capital constraints and what we could earn elsewhere. But hedge funds that don’t provide ‘look through’ transparency will start at a disadvantage.”

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