To help meet the Juncker plan’s objectives, the European Commission wanted to establish a more favourable framework for infrastructure investments in the context of Solvency II, a European regulatory reform of the insurance world. Its objective is to ensure that policyholders throughout the EU enjoy the same level of protection, no matter where they buy insurance. It also adapts the amount of capital insurance and reinsurance undertakings required to hold to the risks incurred in their activities.
This reform is divided into three pillars: quantitative requirements, qualitative requirements and reporting.
The first pillar determines the calculation of the Solvency Capital Requirement of insurers’ and reinsurers’ undertakings, as well as the principles for the allocation and eligibility of capital. In short, the SCR corresponds to the economic capital required by an insurance or reinsurance undertaking to limit the probability of bankruptcy. It is in the context of Pillar 1, and more particularly in the context of the methodology for computing the SCR according to the standard formula, that the risk relating to infrastructure investments is involved. The second pillar determines the best practices in terms of governance, risk management and supervisory interaction. And the third determines the supervisory reporting and public disclosure.
In February 2015, the European Commission issued a call for advice to the European Insurance and Occupational Pensions Authority. EIOPA is an independent advisory body to the Council, Parliament and the Commission, but above all, one of the three supervisory authorities of the European System of Financial Supervisors, focused on insurance and pensions.
This call for advice concerned the identification and calibration of Solvency II risk categories in relation to infrastructure investments. The results of the consultation can be found in regulation 2015/35 as amended.
In practical terms, and with a specific focus on infrastructure investments, these regulations contain, in article 164a, the conditions allowing an infrastructure entity to qualify as a Qualifying Infrastructure Investment. Articles 164bis and 164ter introduced a similar approach, based on different conditions, to identify infrastructure entities as a Qualifying Infrastructure Corporate Investment. The difference between the two is that the criteria to be met by infrastructure companies are partially different and can be seen as less restrictive for QICI than they are for QII. The potential reduction in capital requirements is also different and less important for QICI than it is for QII.
This means that insurance and reinsurance undertakings have an incentive to invest in infrastructure entities or securities that comply with the regulation in order to profit from lower capital requirements. To do so, they have to perform a detailed analysis of these opportunities on a case-by-case basis and determine the percentage of the positions that respect the requirements.
There are two main issues around this. The first one is in the methodology used to perform this analysis. The second is that the investor is expected to perform its own analysis of the investments. It is challenging for insurers or reinsurers to perform detailed analysis on each and every investment they have, particularly for positions taken through third-party funds, as there is quite a lot of information to digest and analyse.
Let’s focus on methodology first. We can split this challenge into three distinct elements: methodology, interpretation and access to data.
Simply put, it is not straightforward to start with the information regarding an infrastructure entity on one side, three articles of a regulatory framework on the other and arrive at a report making the link between the two. The challenge, then, is to build a solid and objective methodology that is consistent between investments and over time. The starting point is to reorganise and reinterpret the regulation.
In our view, the best way to do so is to restructure the regulatory articles and reclassify them into families, criteria or categories. Depending whether we are referring to QII or QICI, the articles and corresponding elements to check will differ. In addition, depending on the type of financing considered – debt or equity – the number of criteria to check will vary.
Broadly speaking, the range of criteria to meet goes from 18 for QII financed through bonds to fewer than 10 in the case of QICI financed through equities. While some requirements will be similar, the difference is that some of the requirements under QII are more stringent and demanding to prove. One way to reclassify these criteria could be, for example, to use the following classification: definition and location, investor protection, cashflow stability and risk of default.
In parallel to defining the methodology, the second challenge is moving from a series of articles to what is practically required. How can we prove that a specific infrastructure asset provides essential public services? What level of revenues should come from owning, financing, developing or operating infrastructure? How can we assess refinancing risk?
These are some of the questions investors will need to raise. At this level, there are various sources of information to support such an analysis, ranging from publications from EIOPA, the European Commission or local regulators.
Finally, the third challenge faced when trying to perform this in-depth analysis is access to data. For QICI, the requirements or criteria can generally be assessed on the basis of public information. This means that any infrastructure-related bond or equity can be assessed for each issuer without having to perform more demanding analysis, like cashflow stress tests, that require an understanding of valuation models. For such securities there is a market price and data available.
Things become more challenging when the complete QICI analysis needs to be performed. In those cases, we are in the context of infrastructure entities investing in infrastructure assets that tend to be owned by a limited number of shareholders with very limited public information, particularly regarding valuation models or the debt structure. Specific information and documents are required. Examples include valuation models that need to be stress-tested, and financing structures that need to be sustainable in balancing short-term interests with the debt repayments that will need to be faced in the longer term.
This last element introduces another roadblock: that potential investors that want to benefit from lower capital requirements need to perform the analysis on their own or at least support the responsibility of performing this analysis. The cost of performing such analyses can rapidly become significant when one investor is considering investing in two or three infrastructure portfolios, with each of them having five to 10 positions. More and more asset managers have worked on such analyses, generally with the help of consultants, in order to be able to share their own preliminary analysis with their clients.
This does not prevent the final investor from having to perform their own analysis but can simplify the process and reduce the amount of work.
BEYOND CAPITAL REDUCTIONS
The attractiveness of the opportunity to invest with lower capital requirements for insurers and reinsurers as well as for pension funds is real, but the scale of the decrease in requirement depends on the quality of the infrastructure entity and the assets considered.
The good news is that the quantity of work to be performed is in line with the reduction in capital requirements. For example, the analysis for QICI is lighter and less demanding than the one for QII, but so is the corresponding reduction in capital requirements.
Solvency II represents a unique opportunity for infrastructure asset managers to attract more investments from insurance and reinsurance companies and, in some countries, from pension funds too. It is, however, not the only opportunity it offers.
As previously stated, Solvency II requirements aim to prove the quality of an asset in terms of investor protection, location, cashflow stability or risk of default. There has been a growing trend from other players to consider and even require infrastructure investments to meet these requirements. The best example is Norway, which has decided to adopt Solvency II-like requirements for pension funds, along the same lines as those already applying to the country’s insurers.
Finally, it is worth mentioning that some index providers have been working on Solvency II-friendly infrastructure indices, confirming this trend is here to stay. In fact, it is highly probable such indices will exist soon. Now imagine such an index would start to outperform a broader index – it is obvious this will lead to more investments in higher quality infrastructure entities, creating a virtuous circle.
A UNIQUE OPPORTUNITY
Solvency II represents a unique opportunity for infrastructure asset managers. If their investments respect the requirements stated in the regulation, select institutional investors investing in their products will benefit from lower capital requirements.
This is the first opportunity, but, as mentioned above, it is not the only one. More and more players are looking at the field not just to enjoy lower capital requirements, but as a screening tool to remain focused on higher quality infrastructure opportunities.
Early movers will profit from this interest, allowing them to distinguish themselves in the medium term. At this stage, their track record will be key. Asset managers performing these analyses now, sharing it with investors and potentially with regulators, will be able to show their methodologies work and will differentiate themselves from others, thereby attracting more investors over time.