Solvency II, the new regime for the prudential regulation of European insurers, came into force throughout the European Union (“EU”) on January 1, 2016. Solvency II will impact private funds with (or hoping to attract) investment from European insurance companies by changing (1) the way the capital impact of private fund investments is determined and (2) the way data on those investments is reflected in reports to insurance supervisors and the markets. Furthermore, by favouring investments in European funds, as well as in specified classes of assets (such as debt and infrastructure) acquired by those funds, Solvency II might also have an impact on the attractiveness to European insurers of certain types of funds over others.

Practical Impact on Fund Sponsors

As discussed in detail below, the Solvency II requirements applicable to investments made by European insurance companies are likely to lead to higher compliance burdens on fund sponsors, because insurance company investors will need help from fund sponsors to satisfy the new regulatory requirements.

  • Insurers Investing In Funds From January 1, 2016. Given the importance to European insurers of calculating the amount of their prudential capital, it is likely that a European insurer will request a private fund in which it invests from and after January 1, 2016 to provide the insurer with the very granular data that the insurer must report under Solvency II. The amount of information required, and the timing for the provision of that information, are likely to impose significant administrative burdens on fund sponsors. In addition, a European insurer may even request modification of a fund’s investment criteria, creation of special fund vehicles with investment limitations, or excuse rights (1) that enable the European insurer to qualify for the lower capital charge applicable to certain infrastructure investments or (2) so that the insurer is not otherwise overweighted in a particular asset class.
  • Insurers That Invested in Funds Before January 1, 2016. Fund managers are likely to receive similar detailed data requests from their existing European insurance company investors, since the data reporting obligations under Solvency II will apply whenever the investment was made. In the absence of specific contractual provisions that might have been negotiated previously with these existing investors, fund sponsors will need to decide whether, and to what extent, they are willing to comply with such detailed data requests.

The amount and type of information requested by new and existing European insurance company investors is likely to vary amongst insurers, requiring close ongoing interaction among fund sponsors and their European insurance company investors as the new requirements roll out.

If a fund sponsor is unwilling or unable to assist a European insurer investor in complying with the burdens imposed by Solvency II, the European insurer may be unwilling or unable to invest in funds managed by that fund sponsor.

Capital Charges

Solvency II makes fundamental changes to the regulatory mix of restrictions and incentives that affect a European insurance company’s decision to invest in particular classes of assets, including private funds. Solvency II removes most of the old rules that restricted the assets that insurers were permitted to hold, including the percentage limitations that applied to particular investments. Instead, Solvency II applies a “prudent person principle” and permits insurers to invest in whatever assets they believe are appropriate to their businesses. While this may give European insurers more freedom to invest in different asset classes, including private funds, Solvency II also adds new risk weightings (capital charges) that insurers must apply when calculating their Solvency Capital Requirement (“SCR”), i.e., the amount of prudential capital they must hold. The risk weightings effectively act as an incentive for insurers to invest in certain asset classes rather than others—applying, for instance, particularly high capital charges to investments in unlisted equity investments, with more favourable capital charges to highly-rated debt investments.

The following table sets out some of the market risk weightings that apply to the calculation of the SCR under the so-called Standard Model (the basic way European insurers are allowed to calculate the prudential capital they must hold):1


Asset class    
Capital charge

EEA/OECD listed/MTF traded equities (“type 1 equities”)


 
 
39% of market value

Other equities (“type 2 equities”)


 
 
49% of market value

Property / Real Estate


 
 
25% of market value

1-year AAA corporate debt


 
 
0.90% of market value

1-year BBB corporate debt


 
 
2.5% of market value

5-year AAA corporate debt


 
 
4.5% of market value

5-year BBB corporate debt


 
 
12.5% of market value

10-year sovereign debt


 
 
0.0% of market value

It is worth noting that the equity capital charges are subject to a seven-year transitional period for equities purchased on or before January 1, 2016. In addition, Solvency II also potentially requires other risk charges to be added with regard to the investment, for instance to account for interest rate, currency and concentration risks.

Fund Investments: The “Look-Through Approach”

Where a European insurance company invests in a fund, Solvency II generally applies a “look-through approach” that requires insurers to calculate their SCR on the basis of their proportionate share of the market value of the underlying assets of the fund. The appropriate capital charge applies to the relevant category of the underlying assets. For example, a five-year corporate debt investment held by a mezzanine or debt fund would attract a 4.5% capital charge for the fund’s European insurance company investors.

Although unlisted investments held by the fund generally would be considered “type 2 equities” and attract a 49% risk weighting, at a late stage in the Solvency II implementation process the European Commission ruled (due in part to lobbying by the European Private Equity and Venture Capital Association, now known as Invest Europe) that all equities held by certain types of closed-ended and unleveraged funds will be treated as type 1 equities, subject to a lower 39% risk weighting. Interests in closed-ended and unleveraged funds where the look-through approach is not possible (because, for example, adequate information on the fund’s underlying investments is not available) will also be treated as type 1 equities.

This was welcome news for the private equity industry, not least because it recognised the distinction (in terms of market risk) between traditional private equity funds and other (i.e., open-ended or leveraged) funds. However, the favourable capital charge only applies to a closed-ended and unleveraged fund that is established in the EU and managed by a European authorised alternative investment fund manager or marketed in the EU under the passport available under the Alternative Investment Fund Managers Directive2 (the “AIFMD passport”). The European Commission has not yet adopted legislation extending the AIFMD passport to funds and fund managers established outside the EU, which means that interests in non-EU private funds or interests in funds managed by non-European fund managers do not currently benefit from the favourable capital charge for type 1 equities.

If insurers are unable to apply a look-through approach to fund investments for the purpose of their SCR calculation and do not benefit from the type 1 equities capital charge described above, their fund interests as a whole will be treated as “type 2 equities” subject to a 49% risk weighting; and, therefore, they may have to hold higher levels of capital in respect of those fund investments. To reduce these capital requirements, some European insurance companies will want to apply the look-through approach—particularly where the fund that is invested in is a non-EU fund or is managed by a non-EU fund manager. See “Data Reporting” below.

Infrastructure Funds

Solvency II did not originally recognise infrastructure investments as a distinct asset class for the purposes of calculating capital charges. However, in order to provide an incentive to insurance companies to invest in infrastructure, on September 30, 2015 the European Commission proposed amendments to the Solvency II regulations that included introducing a new asset category: “qualifying infrastructure investments”. The risk weighting allocated to infrastructure investments (including infrastructure investments held through a fund) would be, broadly, 30% of their value, compared to 49% for unlisted equities, into which category most infrastructure project equities would otherwise fall.

Which infrastructure investments qualify for the new asset class will be decided on a broad range of criteria, in order to ensure that innovative projects are not unfairly excluded. The criteria include the requirement that infrastructure projects are able to generate predictable cash flow, withstand stressed conditions and have a contractual framework that offers a high level of protection to investors. Qualifying infrastructure investments also require enhanced due diligence on the part of investors before investment, and active performance monitoring following investment. Assuming the amendments to the regulations are approved by the European Parliament, they are due to come into force in March 2016.

It is important to note that while it is up to the European insurance company itself to confirm that the criteria for making qualifying infrastructure investments are met, infrastructure funds that have European insurance company investors may be asked by those investors to carry out much of the diligence on their behalf. It is also conceivable that European insurers may seek to participate only in infrastructure investments that meet the Solvency II criteria. If any of those obligations are assumed by a fund sponsor, the fund sponsor will need to create a framework for collecting and reporting enough information to their insurance company investors for them to confirm that the criteria have been satisfied. Under Solvency II this information must be subject to validation by the insurance companies—implying that a statement provided by the fund simply confirming compliance with the Solvency II requirements may not be enough, but that underlying data and materials will also need to be provided. As there is no specified framework for how an insurance company will reach its own conclusions on compliance with these rules, the information to be requested of an infrastructure fund manager may be differ from European insurer to European insurer.

Funds of Funds

Where a European insurer invests in a fund of funds and that insurer applies the look-through approach, information on the underlying investments of the underlying funds will be required. This will inevitably give rise to significant practical issues for insurers and their fund of fund managers, particularly in terms of agreeing and coordinating data transfers from multiple funds.

Data Reporting

Solvency II’s “prudent person principle” requires that insurers only invest in assets and instruments whose risks they can properly identify, measure, monitor, manage, control and report. As mentioned above, generally the Solvency II approach to European insurers’ investments in private funds is to apply a look-through approach to the valuation of the underlying assets of the funds, both for the purposes of calculating their SCR and for quarterly and annual reporting purposes.

Although data is only required to be reported by a European insurance company to its insurance supervisors on a quarterly basis (or an annual basis if the insurer holds less than 30% of its assets in funds), insurers are likely to require access to underlying investment data on a real-time basis in order to satisfy their ongoing risk management and governance requirements under Solvency II. In practical terms, this means that fund managers may find themselves on the receiving end of frequent requests from insurance company investors for underlying investment data to be provided to them on an automated basis.

Data reporting is a key component of Solvency II, and the information required by insurance companies is extensive. The reporting template that insurers are required to submit to their national regulators requires information on, among other things, asset category, geographical exposure and currency exposure of the underlying assets. In order to assist fund managers in the provision of accurate, consistent and good quality asset data for Solvency II reporting purposes, BVI in Germany, club AMPÈRE (sponsored by the French Asset Management Association) and The Investment Association in the UK have established a draft template, designed to be reported at the share class level. The current version of the template (version 3.0) was published on October 13, 2015.

The Solvency II regulations and associated guidance make it clear that insurers are expected to report data regarding their investments on a look-through basis, subject only to a general materiality standard; if information is not available to be reported on a look-through basis, insurers will need to discuss any exception with their insurance supervisors. In the UK, the Prudential Regulation Authority has issued guidance on what “best available data” and approximations might be acceptable, and has indicated that in some situations – such as when the fund is listed and subject to market disclosure rules limiting the information that can be disclosed to a shareholder – a failure to report on a look-through basis should not result in an insurance company breaching its reporting requirements.

Conclusion

As summarized at the beginning of this article, the Solvency II requirements applicable to investments in private funds by European insurance companies are likely to lead to higher information reporting and other compliance burdens on fund sponsors and might reduce the appeal to European insurers of investment in certain private funds.

Endnotes

1 Subject to approval by their insurance supervisors, insurers are also allowed to use either full or partial internal models to calculate SCR, which may provide for different levels of capital charges.

2 Directive 2011/61/EU of 8 June 2011.