Solvency II and the calibration of infrastructure risk

The recovery of global economies depends as much on stimulating growth through investment as it does on fiscal policies.

It is natural therefore that policy-makers have been looking at possible inhibitors to private sector investment and challenging those responsible for regulation to find prudentially sound ways to facilitate such investment, with the European Commission launching its Investment Plan (also known as the Juncker plan) in November 2014. In order to help stimulate longterm investment in European infrastructure projects, the European Commission has adopted measures to introduce a new infrastructure asset class under Solvency II.

Insurance companies (which for the purposes of this article includes reinsurance companies), alongside pension funds and investment funds, are the largest institutional investors, with one estimate putting the total size of the investment portfolios of the European industry at $9.3 trillion. As with any investor, insurers are looking for the greatest return for the lowest risk, but there are certain specificities which affect their investment appetite. Insurers, particularly life companies, take a long-term view of their investments as the liabilities which are being covered can extend 40 or more years into the future so insurers often hold longterm instruments to maturity. As such, stable cash flows are typically more attractive than the ability to make short term gains. Diversification is also important, both against other investment risks and against the underwriting risks taken by the insurers. However, the downside to long-term investments is often the higher capital charges they attract, particularly under the new regulatory regime that will apply from 1 January 2016. Before considering the Commission’s new policy on infrastructure investment, it is worth recapping briefly on what Solvency II aims to do and how it goes about it.

Solvency II amounts to a complete re-write of the regulatory regime for the European insurance industry. It repeals 14 existing European directives and introduces for the first time a risk-sensitive holistic approach to the regulation of insurers. Despite the column inches that have been devoted to the impact that Solvency II will have on capital, the most revolutionary aspect of Solvency II is actually its focus on risk management. The aim of Solvency II is to put risk management at the heart of an insurer’s operations, so that it can properly articulate to itself, its senior management, regulators and ultimately its customers which risks it is prepared to run, its tolerance of those risks and the processes it has in place to identify, manage and mitigate its risks. Capital is important, as “the main objective of insurance and reinsurance supervision is the adequate protection of policy holders and beneficiaries” (per the recitals to the Solvency II directive), but it acts as the reward for good risk management and the punishment for poor risk management – those insurers with clear risk appetites and controls will benefit from lower capital requirements.

This is in sharp contrast to the current system of insurance regulation across Europe which measures capital essentially against the size of its business, taking no or very little account of the particular risks faced by an individual insurer and ignoring entirely non-underwriting risks such as market risk. The standard formula (which most insurers will use to determine their capital requirements under Solvency II) is broken down into modules, which cover not only underwriting risk but also market risk, counterparty default risk, intangible asset risk and operational risk. Insurers will therefore be required to hold capital against the risk that their investments lose value.

Not all insurers will use the standard formula. The largest and most sophisticated insurers will use their own internal models to calculate their capital requirements (or in some cases a hybrid such as a partial internal model). Before an internal model can be used, it must be approved by the appropriate national regulator. This is no small decision for a regulator to take as it effectively hands the ability to an insurer to determine its own capital level and quite correctly internal models are subject to very high standards. In the UK, 18 insurance groups and the Society of Lloyd’s have been granted approval to use their own internal model from 1 January 2016. Internal models will need to consider the same set of risks as the standard formula, but the structure and calibrations of internal models will differ from insurer to insurer, meaning that the treatment of particular risks under the standard formula is perhaps only relevant as a form of benchmark.

The calculation of the capital requirement for market risk under the standard formula is prescribed by a delegated regulation which came into force in January 2015. The regulation focuses less on the form of the particular investment and more on the actual risk to which it exposes the insurer. The module is therefore broken down into interest rate risk, equity risk, property risk, spread risk and currency risk. Within those broad descriptions the Commission, based on technical advice received from EIOPA, has sought to calibrate each risk based on empirical evidence of actual fluctuations in value. Each module works by asking how much “own funds” (i.e. capital) would be lost if a particular event or set of circumstances were to occur instantaneously. For example, the capital charge for real estate equates to loss that would result from an instantaneous decrease of 25% in the value of immovable property. Unlisted equities, by way of contrast, are subject to a shock of a 49% reduction in value.

In February 2015, the European Commission requested that EIOPA provide it with advice on the viability and calibration of a new infrastructure asset class to be recognised under Solvency II. EIOPA wrestled with how best to fit infrastructure within the Solvency II framework. The formal advice provided by EIOPA to the European Commission suggested creating a new asset class under the standard formula for infrastructure project investments so as to reduce the risk charges for qualifying project investments in both debt and equity.

The European Commission swiftly adopted EIOPA’s recommendations as part of the measures introduced under the Capital Markets Union. The amendments to the Solvency II delegated regulation introduce the concept of “qualifying infrastructure investments” which are investments that present preferable risk characteristics. The own funds that insurers need to hold against such qualifying investments should therefore be lower than for non qualifying infrastructure investment or other similar investments. Where qualifying infrastructure investments are held in a matching portfolio (e.g. to cover annuities) the spread stress applicable should be the lower of the matching adjustment stress or the qualifying infrastructure stress.

For qualifying infrastructure investments which are debts, the spread risk charge will be calculated using a modified approach based on the rating of the issuer (or an assumed minimum rating of BBB) and the duration of the debt. This would for example lead to a reduction of around 30% in the risk factor stress applied to a BBB rated infrastructure project with a duration of 3 years Risk charges for equity investments will be based on an assumed 30% reduction in value (which is lower than the 39% reduction specified for listed equities).

For qualifying infrastructure investments which are debts, the spread risk charge will be calculated using a modified approach based on the rating of the issuer (or an assumed minimum rating of BBB) and the duration of the debt. This would for example lead to a reduction of around 30% in the risk factor stress applied to a BBB rated infrastructure project with a duration of 3 years Risk charges for equity investments will be based on an assumed 30% reduction in value (which is lower than the 39% reduction specified for listed equities).

For qualifying infrastructure investments which are debts, the spread risk charge will be calculated using a modified approach based on the rating of the issuer (or an assumed minimum rating of BBB) and the duration of the debt. This would for example lead to a reduction of around 30% in the risk factor stress applied to a BBB rated infrastructure project with a duration of 3 years Risk charges for equity investments will be based on an assumed 30% reduction in value (which is lower than the 39% reduction specified for listed equities).

The contractual framework governing qualifying infrastructure investment must provide a high degree of protection in relation to the funding of the project and any losses that would flow from termination of the goods or services to be provided by the project. For bonds and loans this will mean that debt providers should have security to the maximum extent permitted by law in the assets of the project and that equity is pledged to them, so that they can take control of the project prior to default. A requirement that new debt cannot be issued without the consent of the debt providers must also be included along with control over specified cash flows. Another important requirement applicable to bonds or loans is that the insurance company needs to be able to demonstrate to its supervisor that it is able to hold the investment to maturity.

External credit rating is also helpful for items to be classified as qualifying infrastructure investments as it is expected that debt should be at least investment grade. However, if no appropriate rating is available, a number of additional conditions will apply - including that the project and its assets are located in the EEA or the OECD and that the infrastructure debt is senior to all other claims (other than statutory claims and claims from derivatives counterparties). These additional conditions appear to be designed to ensure that the risk of the project not delivering are mitigated. Where the project uses innovative technology there is a requirement that this be subject to due diligence to verify that the technology is tested.

As already stated, risk management needs to be at the heart of an insurance company’s business. The Solvency II requirements relating to both the initial investment and ongoing monitoring are also fairly onerous. They include appropriate due diligence and a documented assessment of how the project meets the relevant criteria to qualify as a qualifying infrastructure investment. Ongoing monitoring should include performing stress tests on the cash flows and collateral values supporting the project. Where the investment in the infrastructure project is material, the insurance company’s risk management should include active monitoring during the construction phase. The insurance company’s asset liability management policy should also reflect the need for bonds and loans to be held to maturity.

This recalibration of Solvency II also seeks to breathe life into the European Long Term Investment Fund (ELTIF) Regulation, which has been developed in order 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 (i.e. based on a 39% assumed reduction in value).

Although the original 3 month review period was extended at the initiative of the European Parliament, the Commission’s proposals entered into force unamended on April 2, 2016. Whether that will unlock much-needed investment from the insurance industry or whether the hurdles have been set too high for most practical purposes remains to be seen.