11/01/2012 Author: Will Wainewright

Impact assessment: Getting to grips with Solvency II

While the AIFM Directive dominated the Alfi conference agenda in Luxembourg last November, another regulatory issue, perhaps surprisingly, was proving an equally hot topic among delegates networking outside the venue – Solvency II. It was a sign that an item of regulation which had previously received limited attention was moving onto people’s radars.

Given the combination of Solvency II’s insurance focus and far-off introduction date – it was pushed back to January 2014 last October – it is unsurprising the industry has been slow to focus on its potential impact. That is changing now, says Theo Brennand, a senior manager at Deloitte who is advising funds on how its introduction could affect them.

“It has taken a while, but funds we talk to are really starting to take this seriously,” Brennand told HFMWeek. “The details have developed over time – contributing to the lack of clarity – but it now looks as if the impact on the industry really could be quite profound.”

Hedge funds will be impacted by Solvency II in two main ways. The most significant effect, which could dissuade insurance firms from investing in the sector, comes through the high capital charges the new regulation will apply to hedge funds. Upon its implementation, insurance firms will have to maintain underlying capital equivalent to 49% of their total hedge fund investments, which analysts say could lead to redemptions.

“The capital charges element will have the biggest short-term impact on the hedge fund industry,” says Dean Brown, who leads Ernst & Young’s Solvency II work. “Hedge funds have been placed into the highest equity risk category, which is why they need to develop much more awareness of Solvency II and how to handle it.”

Hedge funds can avoid these capital charges if the insurance firm which invests builds an internal model to demonstrate that the risks present do not necessitate a 49% capital holding. There is a dichotomy in the European
market when it comes to internal models, with around 80 issued in the UK compared to a single-figure tally in Germany.

Internal models are likely to be the preserve of larger insurance companies, but Brennand of Deloitte thinks hedge funds should be taking the opportunity to communicate with their insurance clients and “make clear how they can co-operate in the process.” Some are doing so. One sizeable systematic hedge fund in London is currently looking to fill two insurance analyst positions, with Solvency II knowledge the key requirement. Experts say the regulation could lead to a surge in such hires by hedge funds.

The second major impact of Solvency II comes through its requirement for greater data reporting, particularly if insurance companies take the internal model route. “Insurance companies now need more knowledge of specific underlying positions taken by hedge funds,” says Brennand. It will no longer be enough to issue investors with general information about trades and investment themes, and a more systematic breakdown will be required to allow insurance firms to make their risk calculations. This is a nightmarish prospect for a lot of hedge funds keen to protect their commercial advantage.

Offering funds in a managed account format would seem the obvious solution, and experts say there could be growth in the sector, which offers complete visibility over underlying positions. Service providers are already developing Solvency II solutions. Mick Murphy, managing director within BNY Mellon’s Global Client Management group, has spoken to more than 100 insurers about the demands of the legislation and ran an event on the issue attended by more than 50 hedge funds last month.

“Through our affiliate HedgeMark, BNY Mellon is offering a hedge fund managed account solution, which includes a service where we collect and aggregate data for insurance companies without revealing specific positions of any particular hedge fund manager,” says Murphy. This could be an option funds had not considered before. “Even 12 months ago hedge funds were saying that they would not provide the information required,” according to Brennand. “But some are now working out how they can provide the data without having to disclose potentially commercially sensitive information.”

 This is an issue for both hedge funds and funds of hedge funds (FoHFs). “We have been involved with a number of funds of funds who have been looking at their underlying funds and examining how they can provide the necessary data,” says Ernst & Young’s Brown.

Some, however, will choose not to. Jeff Holland, co-founder at Liongate, a $3bn FoHF, told HFMWeek that the company would not pursue managed account or data aggregation solutions, as “delivering that level of transparency would limit the investable universe and therefore impact performance.” Around 5% of Liongate’s assets are held by insurance firms, meaning company assets would take a noteworthy dent if they decide to redeem.

A source at one global FoHF with over $10bn under management said it was not a pressing concern at present but was being worked on by the firm’s lawyers and accountants. “Once there is increased clarity on it then I am sure the back office will start communicating with the front office and tell us what to do.” There is some concern at the prospect of redemptions.

It is hard to get an overall figure for how much insurance companies have invested in the hedge fund industry, but if Solvency II puts them off the sector to the extent some fear, the effect could be significant. Average allocations tend to be low but a lot of insurance firms have them, according to Craig Stevenson, a senior investment consultant at Towers Watson. “Insurance houses with hedge fund investments tend to allocate quite a small amount to the sector – around 5% would be a common allocation,” he told HFMWeek. “It was higher until 2008 but the drawdown put off a lot of cautious investors and insurance firms were no exception.”

A further burden for the insurance industry which could impact hedge funds concerns governance and oversight. “The insurer will have to demonstrate that in using an external hedge fund manager as opposed to managing positions internally, they are not exposed to additional risk,” says Brennand. There has been some talk of extending the SAE 3402 – the new standard focused on operational controls – to cover controls pertinent to Solvency II, but this is another area of potential concern for funds.

Some hedge funds, however, are viewing it as an opportunity – and it is not just European funds who are thinking about how developing their knowledge of Solvency II could give them first-mover advantage. “We have seen a number of US hedge funds contact us, seeing it as an opportunity to move into the European market,” says Brown. “More generally, funds seem to be realising that speaking to insurance clients and getting a handle on the demands of Solvency II will put them in the driving seat upon its introduction. Insurance companies will obviously be keen to work with funds that are fluent in the legislation’s requirements.”