IMPACT OF SAM ON PRIVATE EQUITY FUNDS
The Financial Services Board (FSB) has finally reached the implementation phase of the Solvency Assessment and Management (SAM) framework and insurers are expected to be ready to comply with their SAM obligations. So far, discussions around the implications of SAM have centred largely around insurers, with little focus on other significant industry players, such as private investment funds in which insurers may invest their capital. This article briefly considers the inevitable impact of the SAM regulatory framework on certain private funds in which insurers may look to invest.
SAM is a risk-based regulatory framework for the prudential supervision of insurers and reinsurers in South Africa. The framework is largely based on the principles of the Solvency II Directive of the European Parliament and the Council of the European Union (Solvency II) and is primarily aimed at achieving heightened protection of policyholders and maintaining the stability of the South African financial economy.
SAM establishes a new set of solvency capital requirements (SCR), minimum capital requirements (MCR), risk management, governance structures and reporting requirements. From the perspective of SCR and MCR, the SAM framework introduces a “tiered” approach to the classification and valuation of recognised or eligible assets held by insurers. The objective of these tiers is to ensure that insurers maintain adequate capital resources that can act as a buffer against adverse losses and to ensure that insurers are able to meet their obligations to policyholders.
The classification of assets into each of the three tiers depends on the quality of those assets, measured by the extent to which such assets possess the characteristics of:
- loss absorbency (this being the extent to which the assets are readily available to absorb losses, including on winding-up);
- an absence of mandatory costs attaching to them; and
- an absence of any encumbrances.
The three tiers are organized as follows:
- ‘Tier 1’ capital, comprising assets exhibiting all of the above-mentioned characteristics;
- ‘Tier 2’ capital, comprising assets which must at least be available to absorb losses on winding-up and are sufficiently subordinated; and
- ‘Tier 3’ capital, which is essentially lower quality capital not meeting the requirements for inclusion in Tier 1 or Tier 2.
The various South African Quantitative Impact Studies conducted pursuant to SAM suggest that the sophisticated and granular capital risk weighing charges adopted under Solvency II will be imposed under SAM in respect of investments by insurers in high-risk instruments. This means that insurers will be required to maintain more capital to back identified high-risk investments. More concerning for insurers is the fact that the FSB will adopt a “look-through” approach in respect of a fund’s underlying investments for the purpose of asset valuation and classification. In terms of this approach, insurers will be required to calculate their SCR and MCR on the basis of their proportionate share of the market value of the underlying assets of a fund in which they are invested.
The application of the “look-through” approach is expected to have a significant impact on insurers’ appetites to invest in certain fund structures, including private equity funds, infrastructure funds and multi-manager investment funds (better known as “Funds of Funds”), the latter presenting arguably the biggest challenge given that the underlying investments making up these funds are often not fully known. Insurers will now have to study the investment mandates of each fund in which they wish to invest and also consider firstly, whether or not it is onerous, from a structural perspective, to ascertain the underlying assets held by such fund and secondly, whether the underlying assets are prone to attracting any capital risk weighing charges. This means that the structural issues inherent in certain funds such as Funds of Funds will make these funds less attractive to insurers as it will be difficult for insurers to ascertain the concentration risk, market risk and leverage risk of the underlying assets, as they are required to do in terms of SAM. In addition, private funds that do not offer heightened protection to regulated investors so as to reduce exposure will not find prominence in the investment strategies of insurers, as an indirect consequence of SAM.
Investments by insurers in high risk instruments and volatile markets will need to be reconsidered as these will result in heavy capital charges which could impact on insurers’ compliance with the SAM requirements. Fund managers, if they have not done so already, will need to develop proactive measures in order to increase investor confidence and, in particular, the attractiveness of their investments to insurers. Insurers will need consistent and frequent data in relation to underlying investments, and it is for fund managers to ensure that they develop efficient systems for collecting and reporting this data, which will make it easier for insurers to meet their SCR and MCR obligations. While this will be particularly challenging for the managers of Funds of Funds, both from a cost and structural perspective, fund managers cannot afford to be complacent in the wake of this changing regulatory landscape.