Background and issues
The Cambridge dictionary defines ‘infrastructure’ as ‘the basic systems and services that a country or organisation uses to work effectively’. This rather broad definition covers a wide range of assets at the heart of economic activity: they do not just provide a service to an individual or enterprise, but to economic agents in general. The main sectors in this category are transport (bridges, motorways), energy (electrical and wind power stations), distribution (water, gas) and communication (telephone networks, fibre optics). To these we can add social infrastructures (hospitals, schools, and administrative buildings), leisure infrastructures (stadiums, sports facilities) and industrial infrastructures, such as plants in the sectors they serve (chemical production, manufacturing).
Nevertheless, sector of activity is not the only way to classify infrastructures. They can also be distinguished by their pricing (free to use or paid for by the user, regulated or open pricing) or by their stage of maturity (“brownfield” if the construction is completed and information is available about its revenue, “greenfield” otherwise).
While the picture seems heterogeneous at first sight, these assets do share a number of characteristics:
– Long lifespan;
– Significant barriers (which may be economic, financial, legal or regulatory) to entry;
– Low sensitivity to economic cycles;
– Potential for inflation-indexing revenues;
– Significant leverage effect;
– Contractual undertakings protecting lenders.
The European Commission believes that Europe faces very significant infrastructure investment needs: somewhere between €1500 and €2000 billion are needed in order to meet the objectives of the flagship initiatives under the Europe 2020 strategy for smart, sustainable and inclusive growth. This amount can be broken down into €1000 billion for the energy sector, €500 billion for transport (rising to €1500 billion by 2030), and €270 billion for broadband networks. The Commission’s analyses have shown that the banking sector and national budgets must make a significant contribution to these infrastructure investments, but that without action by the EU some of these needs will not be met, or will not be met in time. One of the main factors explaining the gulf between financing needs and investments by governments and the banking sector is the tightening of regulatory constraints. The Basel III agreements discourage banks from holding assets with long maturity or illiquid assets, and this risks reducing their involvement in infrastructure finance.“Insurers are faced with a need to review their asset management policies”
In parallel, and at a time of historically low interest rates accompanied by the introduction of the new Solvency II prudential regulation, insurers are faced with a need to review their asset management policies. These last relied on the near-certain and relatively high yields on bond debt: insurers could then offer contracts with very attractive rates, whereas they now struggle to find this level of yields. Investment in infrastructure debt, therefore, looks like a sound compromise: it offers long maturities corresponding to the liabilities of life insurers and pension funds, low default rates and higher yields than government bonds.
A brief review of the market reveals the growing appetite of institutional investors for infrastructure. Australian and Canadian pension funds have led the way in this area. In 2011 they respectively allocated 5-7% and 7-8% of their funds on average, though this figure could be as high as 14.8%. In the European market, interest is also growing. In June 2013 the Axa group announced that it was targeting investment of €10 billion (1.7% of assets under management) in infrastructure debt in five years, while CNP Assurances was aiming for €2 billion in two years; Allianz, where infrastructure represents about 2% of the allocation, was also a forerunner on the French market, with the introduction of two project bonds for financing the Ile Seguin “Music City” project and the road designed to join the A7 and A50 motorways. In August 2016, the Meridiam Transition investment fund, dedicated to long-term investments in energy transition, received €425 million, with support from several insurers (Allianz, Aviva, BNP Paribas Cardif, CIC, CNP Assurances, ProBTP, Société Générale Insurance) and from institutional investors such as the pension reserve fund. What is more, in December 2016 the Caisse des Dépôts and CNP Assurances signed an agreement to acquire a 49.9% stake in the electricity transmission network RTE, whose equity capital is valued at €8.2 billion.
Treatment under Solvency II
In order to encourage institutional investors to turn towards infrastructure, the European Union has used a number of levers, including the creation of European project bonds (which can be compared with the discussions in France over the creation of a mutual securitisation fund for financing Public-Private Partnerships) and an adaptation of the prudential regulation. Until 30 September 2015, the Directive treated debts and equities issued to fund infrastructure projects as standard corporate debts and standard equities respectively. Now, generally speaking, such debts have long maturity and these equities are not listed, which makes investment in infrastructure costly in terms of regulatory capital. The only exception concerned the securitisation funds used for financing infrastructure, the Directive stipulating that where a fund is used to finance the construction or maintenance of physical assets, it must not be treated as a securitisation position (more costly than treatment as equities or bonds).
This cost, in terms of the Solvency Capital Requirement (SCR), reduces the incentive for institutional investors to put their capital into infrastructure assets. After receiving feedback to this effect, between March and August 2015 EIOPA examined the question of whether investment in infrastructure should be consider as an asset class of its own and how to treat it under Solvency II. The study used a combination of two approaches, liquidity risk and credit risk. The first approach assumes that the exposure to price changes is only due to variations in liquidity conditions when the insurer is forced to sell the instrument before its maturity. The second depends on the calculation of a factor for the reduction of the risk premium demanded by investors, obtained by comparing the basic credit risk of an infrastructure project debt portfolio with that of a corporate debt portfolio. This study resulted in the creation of a new class of assets known as ‘eligible infrastructure investments’. These assets benefit from appropriate risk calibration, reflecting their greater security as compared with traditional corporate investments. This results in a reduction in the capital charge of 30% on average for eligible bonds and 39% (excluding the impact on the symmetric adjustment) for eligible unlisted equities. In return, institutional investors must show that they are able to hold the bonds until maturity and obtain confirmation that the financial models used in the projects have been validated by an independent party.
The new asset class created requires a clear definition of the terms ‘infrastructure’ and ‘eligible’. The term “infrastructure assets” is defined as “physical structures or facilities, systems and networks that provide or support essential public services”, while an “infrastructure project entity” means “an entity which is not permitted to perform any other function than 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.” This last definition is important, because it targets Special Purpose Entities (SPE), entities devoted to the construction, management, maintenance and operation of an infrastructure project, excluding more indirect exposure such as investment in the equities of listed entities which manage infrastructure projects but whose activity is not limited to this area (e.g. Vinci, Bouygues, etc.). Eligibility depends on a number of criteria set out in article 164a of the Delegated Regulation (EU) 20-15/35, guaranteeing the stability of the project.
These criteria include:
– The existence of contractual arrangements giving lenders a substantial degree of control over the assets and the income they generate;
– Resilience to sustained stresses that are relevant for the risk of the project;
– A credit quality rating of between 0 and 3 for bonds;
– Conditions for the contractual framework applying to revenues.
These definitions are not devoid of ambiguities. Returning to the definition of an infrastructure asset provided by Solvency II, we find the expression “essential public services”. The question is therefore “What services can be considered essential?” While there can be no doubt that sectors such as energy or distribution are essential, should the same be said of broadband networks, which are a Commission target? What about sports facilities? An evaluation of the criteria also reveals some ambiguities. In particular the “sustained stresses” which a project must be capable of resisting are not described in detail, and for good reason: they will be different for every project.
How can insurers show that the stresses they have studied are relevant and sufficient? What is more, the evaluation of eligibility criteria is frequently conducted by infrastructure fund managers. These are not necessarily able to step back and grasp the spirit of the criteria required for eligibility. These aspects show that insurers need to develop expertise, whether in critically assessing the analyses provided by managers or in ensuring greater control of the risks to which they are exposed. Further, for users of an internal model, significant research and development will be required, since there is limited scientific literature on modelling the cash flows generated by an infrastructure asset.
For more information:
1. Delegated Regulation (EU) 2016/467 of the European Commission of 30 September 2015 amending Commission Delegated Regulation (EU) 2015/35 concerning the calculation of regulatory capital requirements for several categories of assets held by insurance and reinsurance undertakings.
2. TAHRI HASSANI, I. (2015), Financement des infrastructures sous Solvabilité II
Article written by Ismaël Tahri Hassani, junior actuary at Mazars France.