Solvency II – The Impact on Private Equity Fund Managers (and administrators)

August 24, 2016

Alex Di Santo - Version 2

The Solvency II Directive (Directive) came into force on 1 January 2016, introducing a new, harmonised EU-wide regulatory regime for EU Insurance companies which helps increase protection for policyholders. The Directive provides a risk framework covering the amount of capital that EU insurance companies must hold to reduce the risk of insolvency, and also sets out governance, supervision, reporting and disclosure requirements.

The Directive is divided into three areas:

  1. Financial Requirements (quantitative) – insurance firms must show they have adequate financial resources to satisfy solvency and minimum capital requirements.
  2. Governance and Supervision (qualitative) – firms must demonstrate they have sufficient systems in place to manage risk. Good governance is equally important as the allocation of additional capital when managing risk.
  3. Reporting and Disclosure (transparency) – firms must publish details of risks/risk management and provide supervisors with the information they need for effective supervision.

Two key considerations for Fund Managers are:

  1. The potential impact on Funds seeking to attract investment from European Insurance companies as those insurers must set aside additional capital to address the risks they face for investing in private equity.
  2. A significant increase in information requests from existing and prospective insurance investors,particularly around portfolio assets,to enable said investors to meet their governance and reporting obligations under the Directive.

With insurers reportedly representing 10% of investment into European private equity an impact on the private equity industry is certain.

Key Implications for Private Equity Fund Managers

Allocations to Private Equity

Legacy asset holding restrictions have been replaced with the “prudent person principle” which provides insurers with more freedom to invest, but only in assets where risk can be adequately managed.

The Directive adds specific capital charges which dictate the capital that must be reserved to mitigate the risk of investing in certain asset classes. This enables the insurer to cover significant losses and protects the policyholders. Under the standard risk capital weighting model (set out in the Directive), closed ended private equity funds that are unleveraged or EuVECA venture capital funds will suffer a high 39% charge (Type 1 Equities). This meansthey may have to hold higher levels of capital in respect of those fund investments. Consequently, allocations to private equity suffer significantly higher capital charges than allocations to, for example, highly-rated debt instruments, for example,1-year AAA corporate debt with a 0.90% charge.

It is worth noting that the 39% charge applies to funds that are established in the EU or marketed in the EU using the AIFMD third country passport. Offshore funds will be classified as Type 2 equities and suffer a significantly higher 49% charge.

Those larger insurers using “internal” risk measurement models rather than the standard model set out in the Directive must have their internal model approved by their regulator.

So what does this mean for Private Equity fund managers?

  1. Although private equity investment suffers a relatively high capital charge the appeal of potentially higher returns should mean that insurer allocations to private equity do not decrease.
  2. Prior to investing, prospective investors (post 1 January 2016) will seek a significant amount of data from the Fund Manager to enable them to satisfy their own risk reporting requirements and support their obligations under Solvency II. We will likely see enhanced due diligence demands from investors and perhaps even an increase in side letter requests covering, for example, excuse rights and the provision of additional reporting templates.
  3. Existing investors may require increasingly granular information on portfolio assets.

Reporting

Insurance companies will be required to collate and analyse huge amounts of data to meet their reporting obligations under the Directive. The requirements are substantial and will most likely impact Fund Managers where fund portfolio asset data is required as insurers will be required to collate “look through” data to identify underlying assets and their resulting exposures. Short turnaround times for reporting and an increased need for granularity of data will impose on Fund Manager resources as investors seek timely, transparent and accurate reporting encompassed by a robust control framework.

So what specific challenges will Fund Managers and Investors face?

  1. Relentless global regulation and the ability to deliver operational efficiency have been key challenges for Fund Managers. As Fund Managers seek to meet the demands of increased risk analysis and reporting for insurance investors the resource and cost implications will become very real. The key challenge is data: collating and analysing data.
  2. From the investor perspective, as we have seen over the past years, value creation is no longer the only driver for investment. The contemporary investor will turn to Fund Managers who can demonstrate operational excellence through slick reporting and more sophisticated value-added investor services. The transparency, timeliness and accuracy of financial information driven by investment in technology is critical but many organisations will not have the infrastructure to adequately meet demands. With transparency and timeliness of reporting being so critical to investors there is an increasing demand for reporting through digital portals.
  3. Insurers need to demonstrate to their supervisor that the information they are providing is complete and accurate and there is therefore an onus on the Fund Manager to get it right. Investors will likely seek some comfort around the control framework the Fund Manger has in place, particularly around financial reporting and data governance. Where fund administration and reporting services have been outsourced, Fund Managers may seek the same assurance from the fund administrator.

How can Elian Fund Services assist?

At Elian the combination of a robust control framework and market-leading technology ensures we are well placed to assist our clients and their investors with the reporting requirements of the Directive as far as possible:

  1. Our ISAE3402 Type 2 accreditation demonstrates a robust control framework governing the production of financial reports and information.
  2. Market-leading fund administration technology (FIS Investran) provides accurate and timely reporting for Fund Managers/Insurance Investors and tailored reports driven through FIS Reporting Services.
  3. Dynamic portal technology (DX Portal) provides Fund Managers/Insurance Investors with seamless access to key reporting metrics at any time of day, enhancing the sought after transparency and timeliness of information.

Conclusion

It is unlikely that the Directive will have a significant impact on insurer allocations to private equity but the increased reporting obligations for insurance investors will certainly impinge on Fund Managers. Heightened due diligence and reporting requests may emerge and it will be important for Fund Managers to demonstrate strong data management (using technology) governed by a robust control framework. The impact on resource and cost-effect is something that will need to be considered.

Fund managers should consider outsourced service providers who have the infrastructure in place to deal with the ever increasing requests from investors. The infrastructure in place at Elian provides a platform whereby Fund Managers (and their insurance investors) can meet their obligations under the Directive in a timely and cost-effective way.