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Transparency is critical to monitor and manage the risks associated with pooled fund investments, from money markets to hedge funds. Beyond the economic benefits of risk transparency, insurers can employ fund look-through to better manage regulatory capital and satisfy the reporting requirements of Solvency II. GSAM Insurance Asset Management illustrates this principle with an investment in a hypothetical portfolio of hedge funds and demonstrates the potential benefits of a look-through approach under the three pillar requirements of Solvency II.

The 2008 financial crisis highlighted the need for accurate and timely risk information across the whole balance sheet of an insurance company. Any subscription to a pooled vehicle should not rely on the stated investment policy or external ratings alone. Examples of unexpected risk exposures revealed by the crisis abound. What looked like ‘money market’ funds took on risky or insufficiently liquid positions, while the Madoff debacle highlighted the potential dangers associated with the lack of transparency of certain funds and investment processes.

A decision to subscribe to fund vehicles depends on numerous factors. These include the performance record, quality of the management, the rigour of the investment process and the full disclosure of the risks assumed by the fund. An appropriate level of fund transparency, best realised with a look-through approach (if this can be achieved), may improve risk management. At the same time, insurers may achieve capital efficiency under Solvency II. Of course, successful transparency depends upon the ability to obtain the information, as well as its quality and timeliness.

Transparency and the Solvency II framework
Facing the complex demands of Solvency II and Basel III, financial institutions may view the new regulatory standards as an onerous burden. Alternatively, one may view risk-based capital and reporting standards as an opportunity to build a best-in-class risk management process and as a compelling incentive to adapt investment and capital management strategy.

Transparency is a great illustration of the latter view. The requirement for detailed holdings information can be viewed as a proactive strategy for the management of risk and capital based on high-quality and timely information about asset portfolios, impacting all three regulatory pillars.

In the absence of detailed information about holdings and risk exposures, Solvency II imposes uniform, ‘risk blind’ capital charges on fund investments, potentially making the return on capital of low-risk funds unattractive.

An appropriate level of risk look-through can help realign capital requirements with economic risk, and insurance companies should actively seek to optimise capital-adjusted return while improving risk transparency.

Worked example – investment in a hypothetical diversified portfolio of hedge funds
What information is available about the risk exposures of a fund investment, and how can this be turned into a capital advantage? GSAM Insurance demonstrates the application of a look-through approach with an example of a diversified portfolio of hedge funds.

Pillar I and the potential to lower capital charges
The Solvency II standard formula would apply a large pre-diversification capital charge of 49%, corresponding to the Quantitative Impact Study 5 (QIS5) ‘other equity’ category. This blanket capital charge may appear excessively onerous in light of the returns history of the portfolio – one-year 99.5% value-at-risk (VaR) estimates for diversified hedge fund portfolios range from 12% to 30% for the more directional, high-beta strategies.

In order to better align capital requirements with the true economic risks of a hedge fund portfolio, an insurance company would ideally apply a look-through approach and assess the sensitivity of the positions assumed by the hedge funds to all relevant risk factors, and calculate the corresponding capital requirements. This example employs three approaches: a standard formula applied without a look-through; an internal formula with a look-through; and a hypothetical formula with a look-through.

The look-through approach would give rise to similar solvency capital requirement (SCR) estimates under the standard formula and the internal model, broadly in line with VaR estimates of the hedge fund portfolio risk but in sharp contrast to the 49% standard formula capital charge applicable to non-transparent fund investments.
A closer examination of the look-through exposures4 of the hedge fund portfolio provides important information about the nature of the risks and the potential for diversification at a company level.

Pillar II and Pillar III: A look-through to emerging risks
Granular risk information informs Pillar I calculations such as the SCR, as illustrated above, as well as Pillar II and Pillar III. Information about the risk positions assumed by a hedge fund can help an insurer identify and measure emerging risks, such as yield curve basis risks, currency correlation risks or differential behaviours of equity indexes across markets. Such information may be made available by the risk look-through process. Other important elements include scenario analysis and stress tests to complement Pillar I.

Taking this dynamic approach one step further, fund investors may assess changes in risk exposures and the resulting Solvency II capital over time.

In this example, the standard formula SCR of the hedge fund portfolio remained broadly stable over time, despite risk reallocations between interest rate, foreign exchange, spread and equity positions.

Line-by-line information about assets and liabilities may need to be provided in Quantitative Reporting Templates (QRTs). Transparency has a critical role in aligning investment strategy with new regulation.

In summary – making transparency work
Insurance companies are demanding transparency within their fund holdings for their capital and risk management processes.

Transparency is key to the management of fund investments, from money-market funds to hedge funds. The benefits of such a look-through approach range from enhanced risk management to a better alignment of capital requirements with economic risk.

<sub>Goldman Sachs does not provide compliance, legal or regulatory advice relating to Solvency regulations. The analysis and views expressed herein should not be construed as advice on fulfilling regulatory capital or other requirements of Solvency regulations. Investors are strongly urged to consult with their own advisors regarding Solvency regulations and its implications.
Views and opinions expressed are for informational purposes only and do not constitute a recommendation by GSAM to buy, sell, or hold any security. Views and opinions are current as of the date of this presentation and may be subject to change, they should not be construed as investment advice.
This material has been prepared by GSAM and is not a product of Goldman Sachs Global Investment Research. The views and opinions expressed may differ from those of Goldman Sachs Global Investment Research or other departments or divisions of Goldman Sachs and its affiliates. Investors are urged to consult with their financial advisors before buying or selling any securities. This information may not be current and GSAM has no obligation to provide any updates or changes.

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© 2012 Goldman Sachs. All rights reserved. 73681.OTHER.MED.OTU.</sub>

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