Invest in Infrastructure under Solvency II
Infrastructure investing has become more and more attractive to investors in recent years. Their long-term nature, appealing returns, and the fact that these investments are real assets, are just some of the elements behind its success.
Xavier Zaegel - [Sponsoring] Partner - Capital Markets & Financial Risk - Deloitte
Daniel Capocci - Director - Strategy & Regulatory Consulting - Deloitte
Published on 6 August 2019
Share this article
To help meet objectives outlined in the Juncker Plan, the European Commission wanted to establish a more favorable 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 retain the risks incurred in their activities. This reform is divided into three pillars; our focus here will be on the first.
The first pillar determines the calculation of the Solvency Capital Requirement (SCR) 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. This article aims to describe the context, how this process works, and the opportunity it presents.
Regulations contain the conditions allowing an infrastructure entity to qualify as a Qualifying Infrastructure Investment (QII) or as a Qualifying Infrastructure Corporate Investment (QICI). The difference between the two is the criteria that needs to be met by infrastructure companies 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.
We can split the challenges surrounding this regulation into three distinct elements: methodology, interpretation, and access to data. It is not straightforward to start with the information regarding an infrastructure entity on one side, a couple of articles of a regulatory framework on the other, and arrive at a report making the link between the two. In our view, the best way to do so is to restructure the regulatory articles and reclassify them into criteria or categories. Depending on 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. For example, one way to reclassify these criteria could be to use the following classifications: definition and location, investor protection, cash-flow 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 just some of the questions investors will need to raise. At this level, there are various sources of information to support such an analysis, including publications from EIOPA, the European Commission, and local regulators.
The third challenge faced is access to data. For QICI, the requirements or criteria can generally be assessed on the availability of public information. Things become more challenging when a QII analysis needs to be performed. In those cases, investments are typically private and therefore public information is very limited. Specific information and documents such as valuation models or financing structures are required.
Possible criteria classification
Source: 2019 Deloitte
This last element introduces another roadblock: that investors need to perform the analysis on their own and incur the corresponding cost. To attract assets, more and more asset managers have worked on such analyses in order t 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.
The three pillars
Source: 2019 Deloitte
As previously stated, Solvency II requirements aim to prove the quality of an asset in terms of investor protection, location, cash-flow stability, or risk of default. There has been a growing trend from other players to consider and even necessitate 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 how such an index would start to outperform a broader index–it is obvious this will lead to further investments in higher quality infrastructure entities, thus creating a virtuous circle.
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.
Infrastructure Investment Eligibility check under Solvency II
Assistance to insurance undertakings and asset managers in determining eligibility to lighter capital requirements for their infrastructure investments
Deloitte refers to one or more of Deloitte Touche Tohmatsu Limited, a UK private company limited by guarantee (“DTTL”), its network of member firms, and their related entities. DTTL and each of its member firms are legally separate and independent entities. DTTL (also referred to as “Deloitte Global”) does not provide services to clients. Please see www.deloitte.com/about to learn more about our global network of member firms.