There are a number of reasons for any financial institution managing assets to consider implementing fund look-through. Probably the most common case today is if you are an European insurance company operating under the recently introduced Solvency II regulation. In this case you do not have a choice. You have to perform look-through for any collective investment scheme on your balance sheet.
Other reasons of course include a want or need to be able to better understand the investment risks taken on as part of the investment in such a vehicle.
In any larger financial institution including an insurance company there are, from a look-through perspective, typically three categories of funds to consider:
- Internal funds
- External funds
- Alternative investments vehicles
Let us have a closer look at them, one at a time.
If the financial institution includes a fund management company (FMC), and other group companies required to use the look-through approach have invested some of their funds in these funds, there may be an opportunity to achieve a “perfect” look-though of these funds. Chances are that the assets of the funds may even be kept in the same portfolio system as is being used to keep the main portfolio(s) of the institution, substantially lowering the bar when it comes to the technical implementation.
The main advantages are:
Perfect knowledge of instrument types and relevant instrument attributes
Speedy delivery and up-to-date information available
Algorithms for theoretical valuation may already be in place, at least for more vanilla instrument types
This category is made up of funds managed by external FMC:s investing in common or standardised assets such as listed equities, government or corporate bonds, and listed derivatives (e.g. futures or options). Here, near-perfect look-through should be possible via one of two alternatives:
Using a third-party data vendor supplying the look-through data
Bilateral agreements with each external FMC enabling delivery of look-through data from each FMC separately
As usual these two approaches come with different pros and cons.
Using a third-party data vendor means a single integration and a common data format, thus potentially lowering the implementation cost. However, it may be difficult to capture all relevant instrument attributes due to limitations in the standardised format. Communication with the FMC:s is usually done via the third-party vendor increasing the risk for misunderstandings and delays.
Bilateral agreements are obviously more laborious to set up in the first place since negotiations and system integrations have to be performed in each and every case. For a large insurance company with investments in many hundreds of funds this may not even be a feasible alternative. However, the main benefit with this approach is that it allows greater control over the data format and what attributes that goes into it. The specification may even be tailored to each type of fund, thus improving the quality and coverage of the look-through data.
Alternative Investments Vehicles
We use the word vehicle here rather than fund since alternative investments (AI) may be structured in a number of different ways. Funds in this category offer a number of challenges to an ambitious look-through implementation:
- Less likely (or even unlikely) to be willing to part with any detailed information regarding the nature of their investments
Less likely to be set up for information sharing via a third party data vendor
Lack of in-house IT-resources increasing the risk of non-standard format for information sharing, and less flexibility when it comes to data formats etc.
Even if you succeed in getting detailed enough information delivered in a timely manner from all your AI counterparts, there still exists hurdles when it comes to theoretical valuation of the contents of the fund. Not many insurance companies are set up to perform accurate theoretical re-valuations under stress scenarios for assets typically found in many hedge funds. Examples of such assets include corporate bonds with embedded optionality and more or less complicated OTC derivatives.
In this post we have discussed three categories of funds to consider when implementing the look-through approach under Solvency II. As often is the case, one of the main challenges in getting it right is to make sure that the quality of the collected input data is good enough (i.e. in Solvency II-speak appropriate, complete and accurate). Having a well thought out framework for the look-through process, including appropriate treatment of each category of funds discussed herein, will make this a lot easier.