Draft Solvency II directive could mean European insurance companies (and possibly other institutional investors) will not be able to invest in hedge funds because of excessive capital requirements.

Proposed European Union Solvency II capital requirements could mean insurance companies might not be able to invest in hedge funds. At present the draft directive allocates a 49% capital requirement for investment into hedge funds. New research, however, argues the weighting does not reflect the real risks inherent in hedge fund strategies.

Instead a capital charge of no more than 25% is more appropriate for a diversified hedge fund allocation, concludes a research paper* by Mathieu Vaissié, a senior portfolio manager at Lyxor Asset Management. The findings were presented at a research conference in Paris sponsored by Lyxor and NYSE Euronext.

Vaissié believes the premise of the Solvency II directive is flawed and that “apples, oranges and bananas” are being compared using the same criteria. If the paper’s findings, handed to the regulator, the European Insurance and Occupational Pensions Authority, earlier this week are taken into account and a new way to calculate the capital requirement against hedge fund investment is used, Vaissié believes it could offer an opportunity for hedge fund strategies to be used much more in the core investment portfolios of insurance companies.

However, if the directive, out for consultation, keeps the same accounting rules, insurance companies will need to rethink their overall investment policy. The directive was originally expected to come into force in 2013 but has been delayed until 2015.

Using data collected from the Lyxor Managed Account Platform, Vaissié was able to use 365 ‘observations’. This is because the platform offers a wide range of strategies and data, collected weekly, covering 2008-11. Not only does the information give details of performance during a severe market dislocation and crisis, it is able to bring together data that would otherwise take around 30 years to collect if normal individual hedge fund statistics were used.

Using the most “conservative as possible” method to calculate the capital requirements, the correct number is almost half that of the one proposed under Solvency II, says Vaissié.

He hopes the detailed analysis and research will push the European regulator to amend the analysis and assumptions contained in the present draft of the directive.

Vaissié fears that if the 49% capital requirement for hedge funds together with a 39% requirement for equities remains, insurance companies will be forced into fixed income instruments as the only alternative for portfolio investment. This, he believes, could not only lead to a long-term mismatch between assets and liabilities but could also present a dangerous systemic risk equal to that seen in the Lehman collapse in 2008.

It remains to be seen whether the regulator will reconsider the method of calculation for capital requirements. Vaissié is hopefully that a dialogue will open and a more objective and appropriate method of calculation will eventually be adopted under the directive.

* Solvency II: a unique opportunity for hedge fund strategies, January 2012. Mathieu Vaissié, research associate at Edhec-Risk Institute and a senior portfolio manager at Lyxor Asset Management.