Solvency 2 is about the regulatory capital Insurance companies have to put against their investments portfolio that back up their potential liabilities.

Hedge Funds are classified as “Equities” as far as riskiness is concerned. The bad news is they are included in the “Other Equities” bucket, initially calling for 55% capital allocation against 45% for “Global Equities”. Up there with Commodities, Private Equity and Emerging Markets.

This clearly does not recognise the fact hedge funds, using the HFRX Global Hedge Funds Index, shows a regulatory stress of 23% (source AIMA).  So far the only concequence of that has been a lowering of the capital charge to 49%, still higher than “Global Equities” and still failing to recognise Hedge funds’ low stress level.

The alternative for Insurance companies would be to develop and in house model that would them to better qualify the hedge funds they invest in. This requires willingness of the Insurance companies to do so … and willingness from the hedge funds to provide them with the information they will need to achieve that.

By no means an easy feast…