How to structure a Qualifying Infrastructure Fund

Done correctly, these new vehicles allow regulatory capital under Solvency II to be cut by up to 16 and 18 percentage points for infrastructure debt and equity respectively, Jegor Tokarevich and Jens-Eric von Duesterlho explain

Solvency II, a complex and extensive regulatory framework, regulates the majority of European insurance investors. While it aims to regulate every material area of an insurance company, the following three requirements are key for their investment activities.

Solvency Capital Requirement (SCR): Every single investment is subject to capital requirements. For example, while no capital is currently needed for European government bonds, direct investments in unlisted infrastructure may lead to a capital charge of up to 59 percent of the fair market value of the investments. Investments via funds need to be classified according to the ‘look-through approach’, where the SCR is calculated based on the underlying investments. Fund products with an optimised SCR may therefore benefit from increased marketing opportunities.

Solvency II reporting: Insurance companies have to report information regarding their investments on a quarterly basis to their national supervisory authorities. To fulfil the reporting requirement, insurance investors will require regular inputs from fund managers. In this sense, the SCR, also depends on the quality and content of the fund manager’s reporting for his product. Implementation of adequate Solvency II reporting is thus also necessary for the optimisation of the SCR at the investor level.

Investment process based on the Prudent Person Principle: Additional tasks such as independent pre-investment assessments covering risk management, internal ratings and risk indicators must be completed, especially when it comes to non-routine, complex and/or unlisted investments, such as infrastructure. A transparent and structured investment process, which is free of conflicts of interest, has to be implemented. To accelerate and facilitate the decision-making process at the investor level, certain tasks – like independent validations, for example – could be performed at the fund level.

One of the key projects currently being undertaken by the European Commission is the so-called ‘capital markets union’, aiming to enhance jobs, growth and investments in Europe. In this context, the Solvency II framework was extended in May 2017 to ‘qualifying infrastructure investments’ (QII), a new category within the regulatory capital requirements.

The general idea is simple: if an investment and the investor fulfil certain criteria – mainly laid down in Article 164a of Commission Delegated Regulation (EU) 2015/35 – the capital charge for this investment is significantly lower than the capital charge for investments not fulfilling those criteria – more specifically, equity stress factors are reduced for equity investments and spread stress factors are reduced for debt investments. This mechanism aims to make certain low-risk investments more attractive for insurance companies and thus increase their investment activities into politically prioritised areas. A reduction in SCR can total up to 16 percentage points for infrastructure debt and up to 18 percentage points for infrastructure equity.

In order to classify an investment as a QII, it is necessary to assess it based on the Solvency II criteria. In practice, a fund manager could provide the investor’s portfolio management department with a documented suggestion, while the investor could complete and sign off the final assessment based on the suggestion.

That assessment, however, needs to be independently validated. For example, the fund manager could appoint a specialised independent expert to validate his assessment according to the Solvency II requirements. This process would significantly reduce the amount of work by the investor’s risk management department, as well as methodically support the fund manager during his assessment.

The qualifying criteria mentioned above range from legal formalities incorporated in various agreements; business requirements such as liquidity reserves; complex risk management requirements, including assessment of the material risks, stress resistance and the validation of the financial model.

Before any detailed assessment, the first step should be to analyse if the intended investment falls under the Solvency II definition of “infrastructure assets” and “infrastructure project entity”. Formally speaking, the following criteria under Art. 1 (55a) and (55b) of Commission Delegated Regulation (EU) 2015/35 have to be fulfilled:
The investment needs to be structured as project finance, as opposed to corporate finance. This means the infrastructure asset has to be owned by a special purpose vehicle with a narrowly defined purpose of “owning, financing, developing or operating infrastructure assets, where the primary source of payments to debt providers and equity investors is the income generated by the assets being financed”. While this is the current status quo, it is worth mentioning that the European insurance supervisor, EIOPA, initiated a consultation process aiming to extend the category to so-called “project-like corporates” and “infrastructure corporates”.

The underlying asset has to be a “physical structure, facility, system or network”. While this assessment is rather simple for certain assets (for example, schools and hospitals), there might be some uncertainty regarding other assets, such as rolling stock (system, network or not included in the definition?).

The underlying asset has to “provide or support essential public services”. This definition would also require a case-by-case analysis of the business model. For example, the definition should be fulfilled if a power plant provides energy to a privately owned utility distributing energy to the public. However, that wouldn’t be the case if the power plant sold the energy solely to a single factory or enterprise primarily using it for its private purpose.

In short, classifying an investment as a QII will require a thorough, multidisciplinary analysis on a case-by-case basis with the involvement of at least two independent parties.

Since the final decision about whether an asset is a QII lies with the investor, how does he decide? The answer depends, to a large extent, on the regular reporting provided by the fund manager for Solvency II purposes.

The methodology for the SCR calculation for funds is laid down in the following hierarchy:The general requirement for fund investments is to calculate the SCR based on their underlying assets – ‘look-through’, as set out in the Article 84 (1) and (2) of Commission Delegated Regulation (EU) 2015/35).

If ‘look-through’ can’t be applied, the capital charge may be calculated on the basis of the target allocation, which can usually be derived from the investment guidelines.
If that’s not possible, pre-defined equity shocks are applied to the fund shares.

Provided that a fund manager selects assets fulfilling the QII criteria, what would be the most beneficial way to structure a fund? In order to answer this question we would have to look at different reporting processes. Examples could include direct reporting from a fund of funds or a single fund to a Solvency II investor; or more indirectly, reporting from a single fund to a fund of funds, which in turn would have to report the information received to the Solvency II investor.

On both levels, the recipients (Solvency II investor or fund of funds manager) may or may not be able and/or willing to process the ‘look-through’ reporting in their departments and IT systems. That is especially the case for fund of funds managers, who would have to collect and aggregate ‘look-through’ data from several single funds and sometimes feeder vehicles often located outside of the EU – a very challenging project from an operational perspective.

A pragmatic alternative to the burdensome ‘look-through’ reporting might be the design of investment guidelines from which the investor may infer the target allocation and calculate the SCR. This approach would allow the investor to still benefit from the reduced capital charges for QIIs (which would in turn increase the marketing opportunities for the investment manager) and could result in a more efficient operational implementation for a fund manager.

Based on this example, a conservative target allocation (as a percentage of the NAV) of 100 percent in a QII with 30 percent US dollar exposure and 20 percent pound exposure could be derived. This allocation could result in a SCR of 27 percent of the NAV for the equity risk and 12.5 percent of the NAV for the FX risk. In contrast, a fund not disclosing those details could be charged a significantly higher SCR of up to 45 percent equity risk and 50 percent for the FX risk.

While SCR and Solvency II reporting are only relevant for Solvency II investors, the formal assessment and the independent validation performed for an asset to classify as a QII may also be beneficial for non-Solvency II investors.

That’s because Solvency II qualification criteria can generally be fulfilled by low-risk investments only; the detailed validations performed by an independent party reduce operational risk and overreliance on fund managers usually subject to conflicts of interest; regular updates of the assessments and validations improve the ongoing monitoring of the investment quality; and documentation of the assessments and validations can be used in internal processes and external audits.

If implemented properly, the classification procedure can effectively contribute to the quality of the investment process between all parties and thus reach beyond a regulatory box ticking exercise. ?