At a recent industry event, a panel about regulatory risk chaired by a former utility regulator became a 45-minute grilling by the investor-heavy audience. In a challenge to the agreed protocol, the moderator quickly found herself besieged by questions about the increasingly invasive nature of regulatory interventions, their lack of predictability and their sensitivity to political pressure. It ended on the agreement that everyone would be better off if both sides could agree to work together – but a feeling lingered that much unfinished business had to be dealt with in the first place.
That investors and regulators often see their relationship as an arduous exercise in negotiation, rather than a dialogue, only aids the common perception that their respective roles amount to a zero-sum game. This is particularly true in the case of industry regulation, where supervisors are largely portrayed as the protectors of customer welfare and taxpayer money against the profit-seeking motive of private investors and businesses.
Perhaps slightly less polarised is the debate about prudential regulation. Half a decade after the Great Financial Crisis, few strongly dispute the principle that financial institutions need more oversight, and it is generally accepted that the purpose of regulation is to make them stronger and more resilient in the long-term (which, eventually, protects customers and taxpayers). But the details of new rules and their application remain the subject of heated conversations – with investors largely convinced that, at least in their initial attempts, regulators tend to impose overly conservative constraints on institutions.
The latest version of Solvency II, the regulatory framework that governs how insurance and reinsurance companies can invest their money, brings nuance to the debate. In a report released this week, Standard & Poor’s hails the new body of rules as “far superior” not only to the existing regime but also to most other approaches currently in use worldwide: it sees it as far less of a blunt tool in terms of regulating insurance companies’ investment behaviour.
While Solvency I involved asset admissibility limits (the maximum amounts of a certain asset an investor can hold), Solvency II adopts a risk-based framework for assessing solvency. Insurers have to value their investments on a mark-to-market basis, and set a target amount of capital they will hold against them. But there is an additional consideration: investors can either choose to set these targets using the calibration provided by the regulator’s standard formula, or they can opt to develop their own model (provided it is first approved by the supervisor).
The implication for infrastructure investment is twofold. For one, as critics of the framework contend, it may limit the allocations some institutions can make to the asset class, because the regulator’s standard calibration relies on rather conservative assumptions. Small insurers, which typically don’t have the capabilities to develop their own models, may find it too costly to invest in infrastructure. On the flipside, however, institutions with sufficient in-house capabilities will be able to better tailor their investments in accordance with their risk-return profiles, such that their assets match their liabilities more closely. This may lead them to boost their allocations to infrastructure.
S&P hence sees Solvency II as a “double-edged sword” for the asset class – which at least is rather better than a Sword of Damocles hanging over insurers’ heads. And it probably has a point: large insurance companies have already shown great appetite for infrastructure and more of them are setting up dedicated programmes. They may well applaud the opportunity to devise their own models. But there are caveats. For one, it remains to be seen whether regulators will tolerate calibrations that markedly differ from their own. It is also possible, at least initially, that this tolerance may sometimes be applied by supervisors across the EU’s various jurisdictions in an inconsistent fashion.
Most importantly, the jury is still out on whether the asset class, on balance, stands to benefit from the new framework. It’s easy to see why S&P would find it a positive development: as a rating agency, anything that effectively restricts the asset class to the savviest investors is undoubtedly good for the creditworthiness of projects. But what’s needed to plug the world’s enormous infrastructure financing gap is for projects to be able to tap more of the huge pool of institutional money lying on the sidelines – and a large part of it is still in the hands of smaller, less sophisticated investors.
Of course, gaining access to this capital is not bound up solely with regulation: the right investment structures, climate and opportunities have to exist to channel it to the right places. It’s also worth noting that, under amendments to the draft rules announced last year, pension funds are so far shielded from Solvency II. But given that, according to S&P, insurers continue to represent more than 40 percent of institutional investors' assets under management worldwide, it clearly remains a matter worth arguing about.