A new asset class for insurers and reinsurers
On 1 January 2016, the ‘Solvency II’ regulatory regime became fully applicable to insurance and reinsurance companies with a ‘prudent person principle’ requiring insurers to invest their assets so as to ensure the security, quality, liquidity and profitability of their asset portfolios. This includes an obligation for their investment portfolio to be adequately diversified. However, the European Commission also seeks to encourage investment by insurers in longer term infrastructure projects, in order to overcome what it perceives as an ‘investment gap’ in infrastructure in the EU.
One of the first steps taken under the Capital Markets Union (CMU) initiative was to amend the Solvency II Delegated Regulation to provide insurers and reinsurers with better capital treatment for a new distinct asset category of “Qualified Infrastructure Investments”. The amendment took effect on 2 April 2016. The recalibration was intended to better reflect the true risk of infrastructure investment and to incentivise insurers to invest in longer term infrastructure projects.
The recalibration is also meant to breathe life into the European Long Term Investment Fund (ELTIF) Regulation, which has been developed in parallel to channel funds into the infrastructure sector. It is expected that investments in ELTIFs will benefit from the same capital charges as investments in European Venture Capital Funds and European Social Entrepreneurship Funds, which benefit from the same lower equity capital charge as equities traded on regulated markets.
Qualified Infrastructure Investments
In order to be designated a Qualified Infrastructure Investment, an investment project must satisfy the following criteria:
- the project entity must be able to meet its financial obligations under sustained stresses that are relevant for the risk of the project;
- the infrastructure assets and infrastructure project entity must be governed by a contractual framework that provides investors with a high degree of protection including reserve funds or protection against losses resulting from the termination of the project by the purchaser of the goods and services;
- the cash flows must be predictable, and there must be restrictions on the use of net operating cash flows for purposes other than debt servicing;
- equity must be pledged to the investors so that they can take control of the project prior to the project entity’s default; and
- there must be contractual restrictions on the project entity performing activities that are detrimental to the investors’ interests
In addition, the investing insurer/reinsurer must be able demonstrate to its regulator that it is able to hold the investment to maturity. The investor must meet a required minimum level of due diligence, and have procedures in place to monitor performance of the project on an on-going basis.
If there are limited numbers of end purchasers of the project’s goods or services, then the end purchaser must be either of a prescribed type (e.g. a regional government), have a minimum credit rating or be easily replaceable. Unhelpfully, it is left open in the legislation as to how large the number of purchasers should be.
The criteria appear to favour rated projects. If the project bonds are unrated, then the eligibility requirements become more prescriptive. The following additional set of criteria must also be satisfied for unrated project bonds:
- the unrated project bonds must be repaid senior to all claims other than statutory claims and hedge providers;
- the infrastructure assets and project entity will need to be located in the EEA or the OECD;
- there must be safeguards to ensure completion of the project according to specification, on budget and on time;
- the project entity must use ‘tested’ technology and design, and properly manage material operating risks;
- the capital structure must enable the project entity to service its debt, and the refinancing risk for the infrastructure project must be low; and
- the project can only use derivatives to hedge risk.
Going forward, the European Insurance and Occupational Pensions Authority (EIOPA) is advising the Commission on the possibility of extending the preferential regulatory capital treatment to infrastructure companies at the operational stage (rather than limiting it to the development stage). There also remains the possibility that EIOPA and the Commission will consider recalibrating the Solvency II capital requirements for the new simple, transparent and standardized class of securitizations as part of the Commission’s broader CMU project.