LGT Capital Partners has published a working paper that shows private equity is getting a raw deal from the Solvency II directive.
The directive requires insurers to hold varying levels of capital based on the riskiness of an asset. For private equity holdings, insurers are required to set aside €49 for every €100 invested, which many believe will cause insurers to cut down on their commitment to private equity. But LGT’s paper has revealed that this amount – calculated using the directive’s standard risk model – is too much.
“The standard model must be very simple as it is the default solution and needs to be applicable for everyone. It is for this reason than it is usually very crude,” said LGT’s Jürg Burkhard, author of the working paper. “The danger is that everybody gets focused on this standard model and in general certain areas – especially alternative investment strategies – get treated in ways they don’t deserve.”
The paper challenges the standard model’s effectiveness by calling into question its one year time horizon in interpreting private equity's risk and diversification attributes. Private equity commitments are typically locked in ten year closed-ended investment vehicles.
Commenting on private equity's €49 “shock buffer”, Burkhard said: “I would see the value at risk percentage to be 20-30 percent realistically because it is all a question of how you treat the length of your risk or investment horizon and how you treat illiquidity and diversification effects. So if you either have a longer term, say something more than three years as a horizon, or if you apply a realistic approach to diversification and illiquidity, the value at risk percentage should not be higher.”
This should heighten the interest of many insurers who have the option of adopting their own internal risk models to comply with the directive, which is yet to be finalised as the European Commission is still engaged in “trilogue” discussions alongside the European Parliament and EIOPA to assess its potential long-term impact.