Following the publication of the latest Solvency II amending regulation, the time is now ripe for (re)insurance companies to seize new opportunities in private equity and debt assets.
After several months of preparation, the European Commission has recently published its amending regulation on Solvency II, the CDR (EU) 2019/981, effective as of early July 2019. Amongst its numerous provisions are some that pursue directly the EC's mission to establish a more favorable environment for (re)insurance companies investing in qualified alternative assets.
The amending regulation hopes to crystallize the European Union's long-term sustainable growth objective of facilitating access to funding for European SMEs, by sponsoring private equity and debt investments that are high-quality, long-term, and strategic.
Opportunities for AIFs
Under the rationale that some of the barriers to accessing unlisted equity and unrated debt assets are unjustified, the new regime aims to bolster (re)insurers' allocations of alternative investments by eliminating those barriers—lowering otherwise unfavorable capital requirements.
Such provisions are relevant not only in cases of direct investments (or co-investments): the same guiding principles will apply for (re)insurance company accessing these assets through funds whose managers are authorized in the EEA. This is expected to foster a renewed interest by (re)insurance companies in this flourishing asset class and ultimately to boost opportunities for AIF managers seeking new investors.
The new rules align with former lawmaking activity on asset classes such as infrastructure, property, and venture capital, reinforcing a regulatory ecosystem that fosters quality private investments for the benefit of the greater economy. Though the EC's goals are about enabling long-term employment and economic growth, they will probably alter the whole alternative investments sector in a much more immediate way as well.
What's new in CDR (EU) 2019/981?
Prior to the introduction of the amending regulation, (re)insurance companies investing in private assets faced higher regulatory capital charges compared to their listed corresponding; a similar situation would apply between alternative and traditional funds in virtue of application of the look-through principle. For private equity shares, the capital charge (re)insures were required to set aside would tally to roughly half of the investment value, detrimentally damaging the attractiveness of the asset class for potential investors.
Under the new framework, different categories of private assets can benefit from reduced capital requirements, down to a lower level ranging from 20–56% of the original capital charge. The correspondent savings then become available to the (re)insurer, unleashing more capital to be potentially used to increase the size of investment allocations.
Clarification has also come on the definition of "unleveraged" in relation to categorizing closed-ended alternative investment funds as equity type 1: the update addresses the prescription about the commitment calculation method for AIFs.
Furthermore, other capital deducting provisions (e.g. risk mitigation techniques) have also been re-touched, moving in a direction of broader applicability and therefore increased ability to abate the ultimate SCR from investments.
A complex set of requirements
While these new provisions grant a distinctively eased treatment for certain asset classes, the leeway is certainly not wide: merely stamping an asset as a qualified unlisted equity isn't enough for it to benefit from the lower capital requirement. In the context of AIFs, there are in fact different aspects to be considered such as the availability of detailed portfolio allocation information (look-through) and the fulfillment of specific qualitative requirements for each asset in the portfolio.
The level of information and technical knowledge required for organizations to assess the qualification of assets under the new regulatory provision is arguably extensive. For unlisted equity, the requirements span the collection of detailed corporate information, determination of diverse financial ration, correlation measures with broad equity index, and more. On the debt side, (re)insurance companies directly investing in unlisted debt would need to have in place an internal rating model that is compliant with the extensive regulatory prescriptions.
It is perceivable that these requirements will add to the already time-consuming investment due diligence efforts of alternative asset investing, but the ultimate benefits are likely to outweigh the costs. This is especially true for those managers who will be able to scale operational costs and reach a broader audience of investors.
Addressing the classification of investments under pre-defined categories and characteristics is nevertheless only one dimension that can be pursued to improve the capital consumption profile of a fund. Other solutions, from investment allocation to implementation of specific portfolio and risk management strategies, can be used to optimize capital consumption and so improve the fund's competitiveness.
Risk transparency implications
Similarly to other provisions within the Solvency II framework, the qualification of assets and practices under the new prescriptions requires a significant amount of information to be collected and verified. This is aligned with a prudential approach that ultimately aims to ensure that (re)insurance companies have the proper capability to understand and monitor their risks.
However, the market standard for the exchange of look-though information between asset managers and (re)insurance companies—the so-called Tripartite Template—has not yet been amended to reflect potential disclosure requirements stemming from the amending regulation. A review process is undergoing, but there is not yet clarity on the expected changes or the timeline for the promulgation of a new template version.
In consideration of the degree of granularity and complexity of the information required, these aspects will likely continue to be tackled by (re)insurance companies and asset managers as part of a more general investment due diligence practice.
While it is true that the solvency capital requirement of investment funds has become a critical selection element within institutional investors' fund selection process, other general manager characteristics (including disclosure and investment due diligence practices) can make a difference in the definition of the fund's competitive profile.
Finding your way through the jungle of applicable regulations, amendments, technical specifications, and recommendations surrounding Solvency II is not a straightforward job. Given the complex nature of Solvency II prescriptions, it is advised to navigate with the help of expert regulatory and insurance guidance.
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.