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On regulation .. Solvency II

This is taken from a series of blogs on various regulation themes that are occupying the minds of asset managers and fund administrators globally.

While Solvency II is of European origin, it has global implications, and while it’s primarily targeted at the insurance industry, it has ramifications that reverberate deeply into the global asset management community.

The Solvency II directive seeks to harmonise the capital adequacy requirements for insurance firms operating in the European Union - think of it as the Basel II of the insurance world.

What pray tell does this have to do with the asset management industry? Well, on closer inspection, the third of the three pillars of the directive requires each insurer to disclose and make transparent the risky assets they have on their balance sheets, and in turn they must ensure they have the correct amount of capital to hand to deal with any investment risk.

Since insurers are quite open to outsourcing the management of assets, this directive has knock-on implications for any asset manager currently managing investments owned or mandated by insurer clients.

European insurers do not limit their mandate outsourcing to just European asset managers – so this is a problem for the global asset management community and with a €7 trillion investment portfolio at stake, this is a very significant slice of pie.

Pillar III of the directive requires each insurer to complete annual and quarterly QRT (Quantitative Reporting Template) reports, which in turn translates to a requirement for the asset manager to facilitate this report build in a timely and efficient manner for their insurer clients on an investment by investment basis.

What is in the QRT reports that asset managers need be concerned with? Quick answer – holdings!

The asset manager will have to facilitate a timely report of line level holdings for any collective investment scheme they are managing (funds, structured products, separate accounts etc) i.e. they must provide a full look-through to the Nth level until the report has just ‘leaf’ level holdings.

This is not as simple as it sounds, and it’s a major concern for fund-of-fund managers, since if they want to maintain the management mandates from their insurer clients, they need to report their own holdings, as well as the holdings of the investments they hold, and the holdings of those holdings, and so on, until all the leaf-level holdings are found.

Now it would be unusual to see a look-through go beyond a level of N=2, since a fund-of-fund does not typically invest in other fund-of-funds, but you do have many single fund wraps out there so there is scope for a very small number of look-throughs to go to a level of worst case N=4 (my own personal opinion!).

In addition to working through the investment portfolio to the individual security lines, the insurer also needs to codify each line with a CIC (Complementary Identification Code) which combines each security’s risk profile and asset characteristics. Many insurers and asset managers are struggling to understand how they implement a codification schema in their security master to handle CIC coding, although the codes were defined to work with existing ISO classification schemes and thus could be mapped from current implementations.

Naturally, the asset manager is going to be uncomfortable with demands to disclose share holdings, after all the holdings for an active manager is their “special sauce”, not something to be shared readily!

So, if an asset manager is going to be reluctant to share holdings with a direct investor (the insurer), how do you think they will feel about sharing them with another asset manager when they request holdings to facilitate look-through from an indirect client? For example,

  • Insurer A invests in Asset Manager AM1’s fund-of-fund AM1F1
  • AM1F1 invests in Asset Manager AM2’s fund AM2F2
  • Insurer A needs AM1 to report to leaf-level all holdings in their investment
  • This means AM1 needs AM2 to report to them the holdings for AM2F2....

So you can see how this is going to cause a few headaches and long nights as the deadline of January 1st 2013 starts looming for the year long run into the full force directive.

Naturally the asset manager is going to look to their Fund Administrator or Custodian to take on the pain – after all, that’s what they do!  All of the major TPA players are working feverishly to prepare themselves to meet the avalanche of requests to support QRT generation, and the look-through and CIC codification issues that goes with it.

But the TPA will still suffer when it comes to solving look-through, since for the same reason asset managers have issues sharing holdings with each other, means they will not be open to willingly share with a TPA they are not in contract with.

So what is going to happen? How will this pan out?

First of all you need to see it from the eyes of the asset manager:

-          Firstly, they cannot accurately assess how much of their existing AuM is held indirectly by European insurers, so they are unsure at this point in time of how much of their revenues are at stake. This in turn is making it difficult to understand relative trade-offs and cost-benefit analysis of inaction versus full compliance.

-          The asset manager wants to market themselves as being ‘Solvency II’ friendly -  just like RDR introduced clean RDR share classes, expect the asset managers to market themselves as Solvency II friendly, and to build and market specific products targeted at the insurer.

-          Fund-of-Fund managers in particular will be screening their target investments more carefully to ensure the funds they invest in are Solvency II friendly i.e. their target investments must be willing to share and provide holding reports as early as T+1 at quarter end.

-          Insurer-owned asset managers, or asset managers which have originated from an insurer, will all be taking direct action to put themselves in control of their destiny and will not be relying on their TPA to pick up the slack, although they will (and are) putting their service providers under serious pressure to support their own internal efforts.

-          Non-insurer related asset managers will (in the main) be relying on their Administrator or Custodian – where they have one – to play the leading role.

So where does this leave the asset service providers and third party administrators? What are their concerns and what actions are they taking?

-          The TPAs know that many of their asset managers clients will push the pain downstream, so they are currently bolstering their product/service lines to reassure their clients that they can assist them in maintaining their insurer AuM.

-          The TPA’s biggest concern is the look-through requirement. TPAs (in particular the European operations) might be able to find a way to agree to work together for common good and efficiency – but they are not presented with the infrastructure required to meet customer demands with the most cost-effective approach. While there are working groups exploring the opportunity for working together to solve look-through, what remains to be seen is can the industry for once align itself to working toward a common shared goal of market efficiency, a single entity to manage the industries look-through requirements, or will each house go down the more costly approach of a solo run?

What we can say definitively is that the realisation has dropped that if asset managers want to retain their direct and indirect insurer mandates, they MUST share their holdings, otherwise the top level asset manager will just move their investment to an asset manager that is Solvency II friendly. Remember the figure of €7 Trillion (~€9.2 Trillion USD) – that generates a heck of a lot of management fees!


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