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Regulation - May 21, 2010

On the Suitability of the Calibration of Private Equity Risk in the Solvency II Standard Formula

The drawing-up of the Solvency II prudential rules has become a major concern for the private equity industry. The capital requirements for private equity risk could turn out to be, from 2012, sufficiently binding to lead many European insurers to reduce appreciably their asset allocation to non-listed stocks. As an example, in the French market, in 2007, the total investments in private equity represented €22bn in the balance sheet of insurance companies (FFSA 2008). Insurance companies finance 21% of the funds raised (AFIC); thus becoming the leading national investors in non-listed stocks.

The new European regulatory framework Solvency II constitutes a true break with current Solvency I practices since it evolves from an “off-the-rack” system built on minimalist rules to a “custom-made” system adapted to the specificities of each company. To achieve this, the scope of the risks has been expanded and their assessment refined (distribution, correlation, diversification, extreme risks, etc.).

After the European Parliament vote of 22 April 2009 and the adoption of European Directive Solvency II (level 1) by ECOFIN, the European Commission is expected to adopt in November 2011 the so-called level-two implementing measures, which are currently being drawn up. These measures will be first tested from August to October 2010 through the impact study QIS 5. The Directive is now expected to come into force by November 2012.

The calibration of the Solvency II models, which are meant to determine the capital requirements of those in the insurance industry, affects asset management, liability management, asset/liability management, hedging management, the products offered to policyholders (guarantees and options), shareholders’ equity, and equity equivalents (junior debt), governance (capital add-ons), and so on. Indirectly, these new prudential rules will also have effects on the financing of the economy – due to their pressure on investments in listed and non-listed stocks – of health, of retirement, of real estate, and also on policyholders and, through liability, on many sectors of activity (construction, medicine), as well as on private equity.

This publication studies the calibration of private equity risk in the Solvency II standard formula by analysing the correlation of listed share performance, measured through an MSCI index (Europe or the United States, depending on the region we consider in our study) and private equity performance. The point, in other words, is to ascertain whether the coefficient of correlation of 0.75 taken by CEIOPS in QIS 4 (CEIOPS 2008), in consultation paper 69 (CEIOPS 2009a), and in the final advice of 29 January 2010 (CEIOPS 2010a) is or is not suitable.

To estimate the correlation of these two asset types, this publication proposes an alternative approach to the one proposed by the CEIOPS: the benchmark index LPX50 chosen by the CEIOPS is replaced by a benchmark that is more representative of insurance portfolios invested in private equity, incorporating the different classes and geographic regions of private equity. In fact, the LPX50, an index of listed private equity firms, by design, is distorted by the idiosyncratic risk of the firms that make up the index.

To do this, as there is no private equity benchmark and it is impossible to determine the annual return on private equity to compare it with an index of listed shares and thus to determine the performance of a fund, we have turned to academic work done on this subject and studied the practices of private equity managers. We will likewise determine the aggregated and annualised internal rates of return for different vintage years of the private equity funds. This index and the equivalent investment in an MSCI index (representative of the investment zone under consideration) associated with the same portfolio structure (different vintage years, cash flows) as that taken in the private equity benchmark are compared. The correlation of the two benchmarks is then measured.

The first part of the publication is devoted to analysing the regulators’ choice of the private equity measure (Value at Risk ) since it generated the use of controversial correlation matrices which are at the heart of our debate. The second part shows the drawbacks of choosing the LPX50 index as a reference for private equity and proposes another solution, which is more representative of the non-listed stock investments of European insurers. The correlation of the listed stocks’ performance and that of non-listed stocks is then determined based on this new solution.