Solvency II criticised for 'inappropriate' stress test

John Bakie
17 August 2010

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European regulators have come under fire for choosing an тinappropriateт way to measure the stress caused by private equity investments on insurance companies. Research from Partners Group suggests the regulatorтs favoured method of calculating private equity risks, as part of Solvency II, is not representative of the asset class as a whole.

The Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS), a cross-border regulator for the insurance industry, has chosen the LPX 50 index to calibrate its stress factor testing for private equity investments. While this is just one small part of the broader Solvency II regulations, it could have a significant impact on the private equity industry.

Partners Group argues the index, which tracks listed private equity investments, is not the best way of measuring the stress caused by private equity holdings. It says the index is lacking because its composition does not match typical private equity portfolios and has significant and unrepresentative volatility.

Using the LPX 50, CEIOPS has given private equity a stress factor of nearly 70%, whereas Partners Group estimates the real stress factor lies between 25-35%.

Partners argues the LPX 50 is heavily weighted towards European private equity investments, specifically the UK, and does not represent global portfolios. Furthermore, 20% of the index is comprised of asset managers, which have fundamentally different return drivers to their portfolios.

Secondly, the index displays significant volatility from premiums/discounts of NAV, which are highly dependent on market sentiment. Partners Group said this "does not reflect the development of the underlying portfolios nor does it reflect the movements of NAVs of an insurer's portfolio. The LPX 50 shows a very high correlation to financial sector equities, which again does not reflect the nature of an (unlisted) private equity portfolio."

However, Partners believes asset managers will be able to take steps to minimise the impact of Solvency II, both for themselves and their investors. But, with the regulations due to come into force in 2012, private equity groups have only limited time to adapt their business to deal with the coming change.