03 December 2012

Risk.net: Enhancing investment efficiencies via tax-transparent funds

Solvency II

The Solvency II requirements for capital strength, balance-sheet consistency, risk-based capital, risk and solvency assessment, senior management accountability, and supervisory assessment comprise the biggest regulatory challenges facing the industry in Europe. In particular, the requirement to reserve additional regulatory capital to what is currently required on balance sheets commensurate with the insurers’ risk profiles of their investments, means sharp increases in the costs of holding equities and other asset classes considered to carry the most risk. High-quality government debt, other bonds with strong credit ratings and instruments with short maturity will, by contrast, be treated more favourably under Solvency II. This is likely to have an impact on asset allocation choices and the structures used by insurers.

The investment environment

Insurers must hold more capital as per the requirements of Solvency II to guard against the risk of insolvency.  However, in a period of low economic growth and uncertainty, a need exists to balance the requirements of the capital regime with that of delivering income – in particular, insurers face the requirement to deliver income for support of the legacy book of business, which can include policyholder income guarantees. Finding and maintaining this balance between income generation and safeguarding against risk may be challenging.

Insurers, tax-transparent funds and asset pooling

The use of asset pooling through the operation of tax-transparent funds offers potential solutions to many of the challenges posed by this landscape, as well as an extremely versatile product solution for insurers. By holding investments including cross-border assets through a tax-transparent vehicle, insurers can pool together different investment assets for investors of multiple domiciles within a single vehicle. Suitable vehicles include: the Irish Common Contractual Fund; the Luxembourg Fonds Commun de Placement; the Dutch Fonds voor Gemene Rekening; and the UK Tax-Transparent Fund (shortly coming into effect).

Advantages of utilising tax-transparent funds in this way can include the following:

• Tax transparency: Due to their scale, many insurance sector funds are already operating on a cross-border basis but are potentially tax-inefficient, with withholding tax applied at the fund level without regard to the underlying investor type or domicile. This may result in investors incurring higher effective tax rates than if they had invested directly in the market.
• Cost-efficiencies: The expense of the Solvency II capital requirements will accelerate the need for insurers to become more cost-efficient. Northern Trust expects European Union life and pensions insurers to assess changing from policyholder to unit-holder models to help mitigate this capital adequacy requirement. In this environment, the consolidation of fund assets from multiple funds into a single tax-transparent vehicle offers obvious advantages of scale.
• Legacy issues: As insurers look to impose tighter cost and risk management on their businesses, legacy issues are increasingly likely to come to the fore. It is expected to see life companies, in particular, take the view that their ageing fund structures – many of which will have been constructed for purposes such as individual stamp duties or capital gains tax – are now unwieldy, difficult to administer and no longer fit for purpose.

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