Introduction

Under the Investment Act^[2] hedge funds have been authorised as added-risk investment funds managed by an investment company (InvG secs. 112 120). They are institutional investors whose managers have a free choice of investment markets, instruments and strategies and may invest largely free of statutory restrictions. Typical features under InvG sec. 112 (1) are borrowing or the use of derivatives to increase the level of investment (leverage) and the sale of assets which are not owned by the fund at the time they are sold (short selling).

The Ordinance on the Investment of the Restricted Assets of Insurance Undertakings (the Investment Ordinance^[3] ) has been amended to take account of the change in investment law requirements. Pursuant to AnlV sec. 1 (1), no. 15, investments in single hedge funds and funds of hedge funds within the meaning of InvG secs. 112 and 113 (hereinafter referred to as investment companies) and, pursuant to AnlV sec. 1 (1), no. 16, investments in units in investment companies with variable capital whose investment meets the requirements of no. 15 (hereinafter referred to as open-ended investment companies) are suitable for restricted assets under the terms set out in the present Circular. In addition, AnlV sec. 1 (1), no. 17, permits investment in foreign investment fund units as defined by InvG sec. 2 (9), provided that they are issued by an investment company having its registered office in another signatory state of the EEA which is subject to public supervision for investor protection purposes and provided that the investment funds (InvG sec. 2 (8)) are subject to requirements regarding their investment policy which are comparable to those applying to added-risk investment funds under the Investment Act and provided that investors may demand payment of that part of the fund's assets corresponding to their share (hereinafter referred to as foreign investment companies).

In addition to these direct investments, mixed funds, which also fall within the definition of AnlV sec. 1 (1), no. 15, may include among their investments hedge funds in the form of added-risk investment funds and units in open-ended investment companies up to 10% of the value of the mixed fund (InvG secs. 83 85; hereinafter referred to as mixed funds).

Furthermore, insurance undertakings can also invest in hedge funds outside the purview of investment law via structured products the debtors (issuers) of which have their registered office in the EEA and the earnings, repayment, market price or value of which are linked to hedge funds and by means of other forms of investment issued by companies having their registered office in the EEA, such as shares or profit participation rights of companies which for their part invest primarily in hedge funds (hereinafter referred to as structured products). Up to now these investments could be allocated to restricted assets only via the opening clause (AnlV sec.1 (2)), even if the asset could be allocated to any of the investments listed in AnlV sec. 1 (1) and the earnings or repayment were linked to hedge funds. For risk reasons, though, such investments should be included in the asset mix and diversification provisions of the Investment Ordinance applying to hedge funds.

For the sake of simplicity, in what follows below only the term "hedge fund" will be used. In the absence of any indication to the contrary, this should be understand to mean all the aforementioned forms of direct and indirect investment.

A) General information regarding investments in hedge funds

Investors are in particular need of protection, since hedge funds can be complex, difficult to understand and highly risky. In addition, the investor's right of redemption is often severely restricted (InvG sec. 116). For that reason, in order to safeguard policyholders' interests, insurance undertakings must thoroughly analyse before they acquire them whether and which of these products are suitable for their portfolio and provide proper documentation of the investment process. In addition, due diligence must be applied in order to satisfy the necessary duty of care requirement in the selection of products. Furthermore, particular attention needs to be paid to hedge funds in insurance undertakings' risk management.

Direct and indirect investments in hedge funds, including structured products, may be allocated to restricted assets if the following conditions are met:

1. General investment principles of VAG sec. 54 (1)

1. Investments in hedge funds must satisfy the general requirements of VAG sec. 54 (1) regarding the safety, profitability and liquidity of the investment. For this purpose, the principle of the safety of the investment should be accorded the highest priority. Especially in view of the complexity of such investments, higher standards should be set for the safety assessment, and risks should be very largely excluded. This is of particular importance, since a total loss is possible on these investments.
2. Investments in hedge funds may be made only by insurance undertakings which can demonstrate adequate risk-bearing capacity according to the terms of Circular R 29/2002 (VA), Section A, Sub section V 2b). If they no longer have the risk-bearing capacity, they should cease from allocating further resources.
3. Investments in hedge funds should be thoroughly analysed in a verifiable manner for legal and financial risks before they are acquired and repeatedly during the life of the investment. Insurance undertakings must be able at all times to quantify the effects of an investment on their portfolio and must monitor their exposure on an ongoing basis.
4. Irrespective of the method of investing in hedge funds, the only investments suitable for restricted assets are those on which the investor's loss is limited to the value of his investment. Since leverage and short sales may give rise to a total loss, steps must be taken to ensure that there is no possibility of an obligation to put up further margin arising. If an obligation to put up further margin is not already excluded because of the legal form of the investment, steps must be taken to ensure that this is included in the Terms of Contract of the investment company's investment fund or the Articles of the open-ended investment company or foreign investment company or by way of a contractual supplementary agreement. In addition, no liability of any other nature may exist on account of the investment in the event of the investment company, open-ended investment company or foreign investment company becoming insolvent.

2. Fitting into the Investment Ordinance

1. Insurance undertakings must audit compliance with the requirements governing the allocation of investments to restricted assets and provide the supervisory authority with proof that they have done so.
2. With regard to the prohibition on investing in movable property or claims to moveable property (AnlV sec. 1 (4)), an allocation to restricted assets can be made only if steps have been taken to ensure that there is no possibility of physical delivery of precious metals and goods to the insurance undertaking. To this end, insurance undertakings must obtain confirmation to that effect from the investment company, open-ended investment company or foreign investment company. This confirmation may be dispensed with if the fact that the possibility of physical delivery is ruled out is laid down in the Terms of Contract of the investment company's investment fund or the Articles of the open-ended investment company or foreign investment company.

3. Investments in hedge funds pursuant to AnlV sec. 1 (1), no. 15 17, are suitable only for cautious additions to the main portfolio. For that reason, pursuant to AnlV sec. 2 (2), letter (g), they may not amount in total to more than 5% of the guarantee assets and other restricted assets respectively. All investments that are counted towards the 5% limit are also included without restriction in the 35% limit referred to in AnlV sec. 2 (3), sentence 1. This takes account of the fact that the investments in question are risk capital investments.

   In addition, other investments of the kind referred to in AnlV sec. 1 (1), whether held directly or indirectly, are also counted towards the limit specified in AnlV sec. 2 (2), letter (g). Structured products part of which is linked to hedge funds and part to other assets of the kind referred to in AnlV sec. 1 (1) are to be applied on a pro rata basis to the limits specified in AnlV sec. 2 (2) and (3). If it is not possible to determine the relevant proportions, the structured product is not suitable for restricted assets pursuant to AnlV sec. 1 (1).

4. Mixed funds, which fall within the definition of AnlV sec. 1 (1), no. 15, and which may invest up to 10% of the fund's value in hedge funds (see p. 2, para. 2, above), are to be set against the limits on a pro rata basis. Insurance undertakings can apply the actual share accounted for by hedge funds which are held directly or indirectly by the mixed fund if the asset structure is transparent.

   Transparency means that insurance undertakings must be notified of the composition of the fund in a timely manner. The asset structure is transparent if the insurance undertaking is informed of the composition of the mixed fund by the investment company, open-ended investment company or foreign investment company within one month at the latest, so that the amount of investments in risk capital can be established within this period and compliance with the 5% and 35% limits is ensured. If the precise value cannot be ascertained, the most recently estimated net asset value may be used to calculate the actual share of hedge funds held by the mixed fund. For retail funds the notification period is three months.

   If the asset structure is not transparent, pursuant to AnlV sec. 2 (4), sentence 3, the maximum permissible proportion for investments in hedge funds is to be set against the 5% and 35% limits. If the Terms of Contract of the investment company's mixed fund or the Articles of the open-ended investment company or foreign investment company specify lower quantitative upper limits for investments in hedge funds, these may be applied.

5. With due regard to AnlV sec. 3 (1), investments in hedge funds should be suitably diversified.

   For risk reasons investment in one single hedge fund is limited to 1% of restricted assets. Insurance undertakings may not invest in more than two single hedge funds issued by the same issuer or managed by the same fund manager. Nor may they invest in single hedge funds which themselves invest more than 50% of their assets in other target funds.

   Insurance undertakings may invest in one single fund of hedge funds to an amount of up to 5% of restricted assets if such a fund is in itself diversified pursuant to InvG sec. 113 or the comparable statutory provisions of another signatory state of the EEA. The same applies mutatis mutandis for broadly diversified structured products.-

   These diversification requirements do not apply in respect of structured products linked to hedge funds which carry a capital guarantee, exclude a negative return and do not create obligations to make or take delivery. Furthermore, the conditions of Circular R 29/2002 (VA), Section A, Sub-section II 1a) applying to capital guarantees must be met (hereinafter referred to as structured products with capital guarantee).

B) Requirements applying to the structuring of the investment process and risk management in respect of investments in hedge funds

The success of any investment in hedge funds depends crucially upon whether the right strategy has been chosen and upon whether the fund manager has then also implemented the strategy he has been set in an appropriate manner. In this context it should be noted that the fund manager has only very general contractual and statutory requirements to observe in this respect and therefore has great discretion and is in general not subject to any extensive official supervision. For that reason due diligence and the choice of manager are very important for the safety and profitability of the investment.

1. General

Insurance undertakings which do not have the necessary personnel and organisational capabilities for investment in and risk management of hedge funds must not undertake such investments.

The personnel capabilities are determined by the nature and risk content of the investment. It is therefore essential that insurance undertakings have adequately qualified personnel who meet these requirements. In addition to the general professional qualifications required to carry out risk capital investments, they must have sufficient know-how of trading strategies and a sound knowledge of the special risks attaching to hedge funds. For investment in single hedge funds a sound knowledge of the risk management of derivative financial instruments is the least that is required.

The internal guidelines (see Sub-section 6 below) should specify which members of staff are entrusted with investing and in which cases, possibly depending on the amount or risk, individual approval from the member of the Management Board responsible for investment or from the Management Board itself is required for an investment.

The risk profile of the hedge fund should be integrated into the insurance undertaking's risk management system, so that the effects on its portfolio of investing in hedge funds can be quantified. During the due diligence process the business models developed by the hedge fund manager and the performance characteristics of the strategies pursued must be understood and analysed for how they perform in different market conditions. Strategies which cannot be properly understood may be unsuitable for investment, since any deviation from a strategy and the resultant change in the hedge fund's risk profile may not be able to be identified.

2. Information required

Before making any direct or indirect investment in units in single hedge funds of an investment company, open-ended investment company or foreign investment company, insurance undertakings must have before them all the information required for the investment decision, and as a bare minimum:

1. Information on the organisation, management, investment policy, risk management and custodian bank and - if available - a comparable institution
2. Details of investment restrictions and liquidity
3. Details of the scale of leverage and short-selling
4. The latest annual and six-monthly report; if the latter does not have to be produced under foreign law, information corresponding to the details required under InvG sec. 44 (1), sentence 3, no. 1 3, and
5. The Terms of Contract or Articles and sale prospectuses or equivalent documents.
   

In the case of direct and indirect investment in units in funds of hedge funds as defined in InvG sec. 113, units in open-ended investment companies whose Articles provide only for investment in accordance with InvG sec. 113 and comparable foreign investment companies, insurance undertakings must obtain the above-mentioned information in respect of the fund of hedge funds. The details referred to in no. 3 above may be omitted, since under InvG sec. 113 (1), sentence 3, leverage and short-selling are prohibited.

In the case of direct and indirect investment in units in mixed funds, the above-mentioned information must be obtained in respect of the mixed fund.

In the case of structured products held directly or indirectly, in addition to the above-mentioned information relating to the associated single hedge fund or fund of hedge funds, insurance undertakings must also be aware of the main features of the product and how it works.

Where a product is linked to a broadly-diversified hedge fund index, further details on the composition of and criteria for the selection of the hedge funds included are required. In addition, insurance undertakings must also be aware of the main features of the product and how it works.

3. Due diligence and selection of managers

In view of the complexity of the products and the possibility of a total loss, all the information required for a prudent investment decision to be made must be obtained; for investments in single hedge funds, at the very least the following areas must be covered:

1. Structural information on the fund, eg:

   1. Nature of the investments
   2. Information on the company
   3. Participating interest of the manager and/or senior employees of the fund
   4. Detailed information on the investment and decision-making process
   5. Detailed information on the legal framework and business philosophy
   6. Details of external service providers

   7. Details on the repurchase and liquidity of the units

2. Detailed information on:

   1. The strategy
   2. Risk measurement and risk management (eg details of and explanation of prevailing market risk indicators)
   3. The valuation process
   4. Performance
   5. The reporting system
   6. Fees and charges

In the case of investments in funds of hedge funds and mixed funds the above-mentioned information need be obtained only in respect of the fund of hedge funds and mixed fund.

Since in the case of investment in structured products insurance undertakings assume the hedge fund risks in whole or in part, they are obliged to carry out a due diligence process in respect of the hedge fund linked to these products. In addition, the issuer risk also has to be taken into account. In the case of structured products linked to a hedge fund index, insurance undertakings must be aware of the risks and details of the structure.

As an aid to this end, insurance undertakings can make use of the list of questions agreed with BaFin and issued by the Federal Alternative Investments Association [Bundesverband Alternative Investments e.V.].

If other lists of questions are used, they must go into comparable degree of detail. In addition, interviews to gain a deeper understanding should held with the investment company, open-ended investment company, foreign investment company and, in the case of structured products, the debtor (issuer) or arranger who are on the short-list for an investment.

Then the main reasons behind the decision to make the specific investment and, if appropriate (depending on the size of the investment), the diversification effects for the insurance undertaking's portfolio should be documented in an readily comprehensible manner.

4. Risk management for direct and indirect investments in hedge funds

Since especially high standards have to be applied in the assessment of the safety and profitability of investments in hedge fund units, if insurance undertakings are to acquire them, this of necessity presupposes - according to the nature and risk content of the investment - that they have an effective risk management system capable of handling the higher risk.

The investment must be monitored continuously, so that the insurance undertaking can react promptly to changes in the hedge fund's risk profile. Very close monitoring is required, since the quality and frequency of hedge fund reporting is sometimes lower than is the case with other funds. Furthermore, personnel changes in hedge fund management must be alerted as soon as possible, in order to be able to react to them as appropriate.

Insurance undertakings have to continuously monitor compliance with investment strategies. The risk profile of funds of hedge funds, mixed funds and structured products that are linked to several single hedge funds in a broadly diversified manner requires continuous monitoring, but there is no need to monitor their target funds. Furthermore, insurance undertakings must ensure that the single hedge fund or fund of hedge funds in question regularly provides them with generally accepted risk indicators. Insurance undertakings must be given a statement of and explanation of the methods used to calculate the risk indicators. In the case of investments in single hedge funds, insurance undertakings must ensure that the single hedge fund's custodian bank and - if available - a comparable institution regularly provide them with confirmation of the value of the hedge fund. The monitoring process must be documented in such a way that it can be verified later.

5. Outsourcing of risk management

All insurance undertakings making direct and indirect investments in hedge funds are permitted to contractually entrust the task of risk management to another company that has the necessary organisational and personnel capabilities. Any such company may not, however, exercise the function of custodian bank or comparable institution for the hedge fund in question or be a company related to the latter within the meaning of sec. 15 of the Stock Corporation Act [Aktiengesetz] and sec. 271 (2) of the Commercial Code [Handelsgesetzbuch]. Nor may there be any other hints of any restriction of its professional independence.

Irrespective of the method of investing in hedge funds, the particulars of the company entrusted with the task of risk management must be adequately integrated into the risk management of the insurance undertaking, in order for it to be able to promptly assess its sensitivity to changes in the hedge fund's risk profile.

6. Internal guidelines

In order for the business to be run properly, it is essential that the Management Board draws up internal principles and procedures for investments in hedge funds and the risk management thereof before any such investments are made and also that it ensures that these principles and procedures are adhered to and regularly reviewed. They are to be incorporated into the Internal Investment Guidelines to be submitted to BaFin (cf. Circular R 29/2002 (VA), Section A, Sub-section IX, Section B).

7. Information and reporting requirements

The full Management Board and the Supervisory Board are to be informed of the risks, content, scale and outcome of all investments in hedge funds on a regular basis, but in any event, not less than every three months.

8. Transitional arrangements

In order to avoid financial losses, investments in hedge funds that are to be regarded as not suitable for restricted assets following publication of the present Circular may be terminated as insurance undertakings see fit. They may not, however, be allocated to restricted assets as defined in AnlV sec. 1 (1).

C) Order relating to reporting and notification requirements in respect of investments in hedge funds

Pursuant to VAG sec. 81 (2), sentence 1, in conjunction with VAG sec. 7 (2), sentence 2, and VAG sec. 54d, I do hereby issue the following Order:

1. Insurance undertakings shall submit a report to BaFin once a quarter by the end of the month following the calendar quarter on each new investment in hedge funds, classified by type of investment (cash instruments), stating the key features in accordance with Annex 1, the allocation to guarantee assets, to other restricted assets in accordance with the relevant number in the list of investments set out in AnlV sec. 1 (1) or the opening clause of AnlV sec. 1 (2) or to other assets. Insurance undertakings shall also submit a report in accordance with the same reporting cycle on the amount of investments outstanding, using the form provided in Annex 2. A nil return shall not be required.

   Annexes 1 and 2 shall be submitted for the first time in respect of the third calendar quarter of 2004. For this purpose, the returns should also include investments made earlier which are already held in the portfolio.

   In other respects insurance undertakings' existing investment reporting requirements, especially those specified in Circular R 30/2002 (VA), shall remain unaffected. However, investments in structured products within the meaning of the present Circular shall be reported on the basis of Annex 1 only.

2. The internal guidelines to be drawn up pursuant to Section B, Sub section 6, shall be submitted to BaFin in duplicate within three months of receipt of the present Circular. BaFin shall be notified without undue delay of any amendments. This requirement can be ignored if the insurance undertaking does not invest in hedge funds. A nil return shall not be required.

Information regarding legal remedies

Objections to the Order contained in Section C can be lodged within one month of promulgation. Any objection should be filed with the Bundesanstalt für Finanzdienstleistungsaufsicht, Graurheindorfer Str. 108, 53117 Bonn, or Lurgiallee 12, 60439 Frankfurt am Main, in writing or for the record.

The objection should contain a specific application and state the points of complaint and the facts and evidence being cited in support.

^[1]

Versicherungsaufsichtsgesetz - hereinafter referred to as VAG

^[2]

Investmentgesetz - hereinafter referred to as InvG

^[3]

Anlageverordnung - hereinafter referred to as AnlV