‘Insurance contract’ will help combat Solvency II

A form of insurance contract to hedge private equity risk could also prevent pension funds halving their allocation in hedge funds and infrastructure under the European regulations, which currently require them to hold the same collateral as insurance companies – up to 59%.

Using a contract for difference (CFD), an investor in private equity funds will effectively separate and hedge the risk of their holdings with an institutional counterparty.

Should Solvency II be extended to pension funds – as per European regulatory intention – these institutions would also be able to offset a similar portion of the new capital requirements.

The same principle could also reduce reallocation away from real estate by about a third.

The UK pensions industry has warned Solvency II regulations could be ruinous for sponsors if they demand the same capital requirements from pension funds as they do insurance companies, and is currently consulting with the European Commission on how Solvency II should be implemented.

Kishore Kansal, managing partner at PEFOX, the company that designed the CFD, said some larger institutional investors are “starting to dip into this market”.

Capital requirements for bonds and equities are around 3% and 22% respectively for insurance companies under Solvency II, indicating they will be significantly less affected than alternative assets.