Solvency II an opportunity for hedge funds?
25 January 2012 Nice
Image: Shutterstock
Solvency II could be a unique opportunity for hedge fund strategies to find their way into insurers’ core portfolios according to recent research from EDHEC Risk Institute.
Upon implementation of the regulation, insurance firms will have to maintain underlying capital equivalent to 49 per cent of their total hedge fund investments, which analysts cited by HFMWeek said could lead to redemptions. However, 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 per cent capital holding.
According to the EDHEC Risk Institute, that is a distinct possibility. Applying a pragmatic and robust internal model approach to a series of investable hedge fund indices over an observation period covering the recent crisis, the researchers found that a stress test of no more than 25 per cent is appropriate for a well-diversified hedge fund allocation.
Mathieu Vaissié, senior portfolio manager at Lyxor Asset Management and author of the report, explains that he uses the term "hedge fund strategies" to make clear that understanding the hedge fund industry requires drilling down to that level as opposed to taking a composite view. And which strategy might be suitable for any given insurance company can vary.
"The strategies insurance companies are interested in depends on their risk/return preferences and as a result their current asset mix, their funding ratio, and the way they intend to use hedge fund strategies (i.e., risk reducers, return enhancers, etc.). They definitely are keen on investing in short risk strategies, although short selling might not be their preferred route," said Vaissié.
In the report, he argues that there is no reason why hedge fund strategies should be placed in the “other equities” category, next to “emerging equities”, “private equity” or “commodities”, and suffer such poor treatment as in the standard approach. At the same time, insurance companies face significant challenges.
"There is indeed little chance in the current environment that insurance companies will favour hedge
fund strategies over traditional performance-seeking assets knowing that the capital charge is
currently materially higher (49 per cent versus 39 per cent for equities). In its current form, the Solvency II framework is thus preventing insurance companies from leveraging alternative diversification and implicitly directing them towards fixed income instruments, which may not be as safe an investment as one would have assumed. Paradoxically, the directive could put insurers’ long-term capacity to control their funding ratios at risk."
Upon implementation of the regulation, insurance firms will have to maintain underlying capital equivalent to 49 per cent of their total hedge fund investments, which analysts cited by HFMWeek said could lead to redemptions. However, 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 per cent capital holding.
According to the EDHEC Risk Institute, that is a distinct possibility. Applying a pragmatic and robust internal model approach to a series of investable hedge fund indices over an observation period covering the recent crisis, the researchers found that a stress test of no more than 25 per cent is appropriate for a well-diversified hedge fund allocation.
Mathieu Vaissié, senior portfolio manager at Lyxor Asset Management and author of the report, explains that he uses the term "hedge fund strategies" to make clear that understanding the hedge fund industry requires drilling down to that level as opposed to taking a composite view. And which strategy might be suitable for any given insurance company can vary.
"The strategies insurance companies are interested in depends on their risk/return preferences and as a result their current asset mix, their funding ratio, and the way they intend to use hedge fund strategies (i.e., risk reducers, return enhancers, etc.). They definitely are keen on investing in short risk strategies, although short selling might not be their preferred route," said Vaissié.
In the report, he argues that there is no reason why hedge fund strategies should be placed in the “other equities” category, next to “emerging equities”, “private equity” or “commodities”, and suffer such poor treatment as in the standard approach. At the same time, insurance companies face significant challenges.
"There is indeed little chance in the current environment that insurance companies will favour hedge
fund strategies over traditional performance-seeking assets knowing that the capital charge is
currently materially higher (49 per cent versus 39 per cent for equities). In its current form, the Solvency II framework is thus preventing insurance companies from leveraging alternative diversification and implicitly directing them towards fixed income instruments, which may not be as safe an investment as one would have assumed. Paradoxically, the directive could put insurers’ long-term capacity to control their funding ratios at risk."
NO FEE, NO RISK
100% ON RETURNS If you invest in only one securities finance news source this year, make sure it is your free subscription to Securities Finance Times
100% ON RETURNS If you invest in only one securities finance news source this year, make sure it is your free subscription to Securities Finance Times
