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...

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