Luxembourg: The "Cost" Of Performance: Alternative Asset Funds Under Solvency II

The increasing appetite for alternative investment products by institutional investors is dramatically changing the asset management industry. Opportunities are on the rise, as are competition and new regulatory challenges.

In this context, asset managers in the alternatives space are asking themselves how much they "cost" in solvency capital requirement terms, and how they can make their products more appealing to potential investors under Solvency II.

What should alternative asset managers know about Solvency II?

By now, three years after the regulation went live, it is common knowledge that Solvency II requires (re)insurance companies to set aside capital for each of their investment funds, and that the capital "cost" depends on the riskiness of the target asset class. Nevertheless, there's no common wisdom yet regarding which quantitative and qualitative factors are important, or which levers must be pulled to optimise the solvency capital requirements' profile of an investment strategy—especially when alternative assets are at stake.

This lack of knowledge often translates into low self-awareness, sub-optimal allocation, poor due diligence practices, and, ultimately, potentially missed opportunities for alternative asset managers. Arguably, AIFs identical in assets, fees, and compensation can have massive differences (by margins of 100% or even higher) in their "capital-adjusted" return profiles when specific Solvency II elements are considered.

Solvency II positioning of alternative investment funds

The solvency capital requirement (SCR) profile is critical for asset managers in marketing their products to (re)insurance companies and in standing out from their competitors.

In cases where no look-through¹ is performed, investment funds may demand a solvency capital requirement of nearly 49%.² This means that, speaking generally, for every euro invested in the fund, the investor must set aside almost half the amount of capital in reserves. This penalising approach stems from the aim of the regulator to discourage institutional investors from getting into products which they cannot properly understand and monitor.

On the other hand, when the look-through is performed, the capital requirement is driven by the risks underneath the specific asset allocation and by the investment fund's strategy. The classification of the asset, under Solvency II's risk dimension, is therefore crucial for the estimation of expected SCR. Under the "standard approach", and leaving aside some debatable exceptions (e.g. "unleveraged AIFs", private loans, or equity), the SCR is proportional to the riskiness of the asset class, as estimated by the regulator when the technical specifications document is transcribed.

Counterintuitively, all of these prescriptions may lead to situations where products with attractive risk return profiles on paper are still avoided by insurance companies, who perceive high risks and therefore capital burdens under Solvency II. This can be mitigated (or even turned into an opportunity) with more sophisticated stances on product-structuring (asset selection), investment strategy, and disclosure practices.

The nuts and bolts of optimising your capital requirements

Unbeknownst to many, the calculation of a fund's SCR doesn't depend wholly on a mathematical formula or stress model. Indeed, there are several not-purely-quantitative factors to take into account.

Among the manifold possibilities of limiting a performance drag from capital requirement, the most overlooked is probably the exchange of investment-level information in order to perform the look-through. Many asset managers may be unwilling to share this information, hoping to protect their know-how and deal access, but the (likely) significantly higher capital adjusted returns may be a strong argument for doing so.

Asset class allocation naturally defines a portfolio's first-level approximation of the SCR level; from that point, asset managers can set specific strategies to lower the expected capital costs, including hedging, collateralisation, and other risk management and due diligence practices.

Furthermore, asset categorisation and qualification under specific regulatory requirements (e.g. infrastructure assets) can be pursued to achieve substantial diminishment, ceteris paribus, of the expected SCR cost.

Notably, these strategies should be rolled out under Solvency II and are therefore subject to very detailed applicability conditions and requirements. Ultimately, this encourages asset managers to intensify their disclosures so as to help their investors, personnel, and even regulators acknowledge their strategies.

Challenges and opportunities for alternative asset managers

Beyond the usual difficulties of collecting structured investment information on alternative assets, other factors also pose challenges for AIMs under Solvency II.

The heterogeneity of alternative assets and the related valuations and reporting framework represents a remarkable informational barrier. Standard reporting solutions (like the Tripartite Template) can mitigate this barrier, but are often insufficient in collecting all the information needed.

Furthermore, different (re)insurance companies may have substantially different expectations and methodologies for handling Solvency II data. For example, some methodologies don't depend solely on whether a standard or an internal model is being used.

The lack of specialised knowledge on regulatory topics (among asset managers) and alternative investments (among insurers) may hinder mutual understandings, in turn stopping (re)insurance companies from exploring more sophisticated alternative asset products.

The key takeaway is that the capability of asset managers to collect, process, and exchange specific investment information is a fundamental element in getting their investment strategies recognised under Solvency II—which ultimately is what can help them establish a mutually beneficial relationship with investors.

A New Year's resolution: get your Solvency II practices in shape!

New regulatory updates, some of which could relieve the capital requirements on alternative assets, are on the horizon. In the meantime, there is much to do for asset managers keen on reassessing their product strategies, especially for those whose natural audience includes institutional investors concerned by Solvency II.

While the deal-driven nature of the alternative investment industry is unlikely to be severely swayed by these policy considerations, other factors such as compensations, fees, and regulatory capital costs are growing in importance, becoming terms of comparison in the investment selection process of institutional investors. As national regulators continue to advocate transparency and risk management improvements, alternative asset managers must realise that future competition will not solely come from within the industry, but also from traditional asset classes.

Accordingly, an attentive stance over regulatory and reporting topics will certainly be a distinguishing trait of the alternative asset managers better positioned to ride the momentum of the alternative investment industry.

Footnote

1 The look-through practice is that of exchanging exhaustive asset-level information within collective investment undertakings, allowing (re)insurance undertakings to determine their own solvency capital requirement.

2 +/- symmetrical adjustment charge and not acknowledging other potential provisions for target allocation method or "unleveraged" AIFs.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.