Introduction

In its 2015 Action Plan on building a Capital Markets Union, the European Commission (Commission) announced its desire to “unlock more investments and to mobilise capital in Europe” focusing in particular on small and medium sized enterprises (SMEs).¹ The Commission's aim is to facilitate the channelling of funding into non-financial companies and thereby to give greater access to debt and equity finance for EU SMEs. This, it is hoped, will boost growth, innovation and competitiveness in the EU and generate benefits for the wider economy.

In particular, with trillions of assets under management, the Commission has identified the insurance sector as being well positioned to assist in the achievement of these objectives. On 8 March 2019, the Commission published draft legislation (the Draft Delegated Act) proposing various detailed amendments to the regulatory regime applicable to EU insurers designed, amongst other things, to unlock any “unjustified impediments” to an insurer’s investment in the capital and debt instruments of SMEs.

This article focuses on the changes proposed in the Draft Delegated Act in respect of unlisted equity portfolios and long term equity investments. In particular, the Draft Delegated Act includes various proposed tweaks to the existing regulatory capital rules contained in Commission Delegated Regulation (EU) 2015/35 (the Delegated Regulation).

Before discussing the proposed changes in any detail, first this article provides a high level overview of the Solvency Capital Requirement (SCR) under Solvency II as it relates to the standard equity risk sub-module under the standard formula.

Solvency Capital Requirement

An insurer subject to Solvency II is required to maintain a portfolio of assets to meet its insurance liabilities and also additional capital (SCR) to cover the risks of adverse events occurring.

The standard formula under Solvency II for calculating SCR is divided into a number of risk modules, including the "market" risk module.This module is designed to ensure insurers have sufficient capital to withstand adverse movements in the market value of the investments held to cover their insurance liabilities. Insurers are required to hold capital equal to the loss that would result from an instantaneous decrease in the value of the relevant assets by a percentage specified in the rules for each relevant asset class (often referred to as applying "capital charge" to the value of those assets).

The market risk module is divided into different sub-modules applicable to different asset classes, including the "equity risk" sub-module. Under the equity risk sub-module (starting at Article 168 of the Delegated Regulation) equities are divided into categories, the main two being:

1.  “type 1” equities - broadly, those listed on regulated markets in the EEA or OECD; and
2.  “type 2” equities - broadly, all other listed or unlisted equities;

Article 169 of the Delegated Regulation sets out the capital charges which apply to the different categories of equities: 

1. for type 1 equities, the capital charge is, in most cases, 39%, plus a "symmetric adjustment"² (being a "dampener" to take account of market movements over the previous 36 months, up to a maximum of + or - 10%). So the percentage will be between 29% and 49%; and
2. for type 2 equities, the capital charge is, in most cases, 49% (subject again to a symmetric adjustment of up to + or - 10%) - so the percentage will be between 39% and 59%.

As a result, under the current rules, capital charges for equities – and particularly unlisted equities are relatively high. This may be one reason why, as noted by the Commission in its Staff Working Document accompanying the Draft Delegated Act, that in the first quarter of 2018, investments in equity represented only approximately 16.5% of insurers’ total investments.

There are a number of special cases where these general rules are modified. As an incentive for insurers to invest in EU infrastructure, the existing rules provide for more favourable capital charges for qualifying infrastructure equities (in most cases, 30% subject to 77% of a dampener of up to + or – 10%) and qualifying infrastructure corporate equities (in most cases 36% subject to 92% of the same dampener).

Equities held within (i) social enterprise funds; (ii) qualifying venture capital funds; and (iii) closed-ended unleveraged EEA AIFs, or third-country AIFs marketed in the EU qualify as type 1 equities, regardless of whether they satisfy the normal criteria enable these particular equities to benefit from a 10% reduction in the capital charge applied.³

It should also be noted that equity investments “of a strategic nature” in related undertakings (broadly speaking, where the insurer owns at least 20% of the voting rights) will attract the lowest possible equity capital charge (being a flat 22%). This will only apply where the insurer can demonstrate a stable relationship with the related undertaking including a close economic bond and the sharing of risks and benefits.⁴ 

Changes proposed by the Draft Delegated Act

As noted above, a number of amendments to the standard equity risk sub-module were proposed by the Commission in March 2019 which, if enacted, would provide for a more favourable capital charge for certain investments. The Draft Delegated Act introduces two main changes for equities.

Unlisted equity portfolios

First, an additional relaxation has been proposed for “qualifying unlisted equity portfolios” which meet certain criteria set out in the Draft Delegated Act. The intention is that investments by insurers in portfolios of high-quality unlisted equities should be able to benefit from the same treatment as equities listed on regulated markets. An unlisted equity portfolio will qualify under the proposed new rules if it satisfies the following requirements:

1. the set of investments consists solely of investments in the ordinary shares of companies;
2. the ordinary shares of each of the companies concerned are not listed in any regulated market;
3. each company has its head office in a country which is a member of the EEA;
4. more than 50% of the annual revenue of each company is denominated in currencies of countries which are members of the EEA or the OECD;
5. more than 50% of the staff employed by each company have their principal place of work in countries which are members of the EEA;
6. each company fulfils at least one of the following conditions for each of the last three financial years ending prior to the date on which the Solvency Capital Requirement is being calculated:
   
   a. the annual turnover of the company exceeds EUR 10m;
   b. the balance sheet total of the company exceeds EUR 10m;
   c. the number of staff employed by the company exceeds 50;
   
   
7. the value of the investment in each company represents no more than 10% of the total value of the set of investments;
8. none of the companies is an insurance or reinsurance undertaking, a credit institution, an investment firm, a financial institution, an alternative investment fund manager, a UCITS management company, an institution for occupational retirement provision or a non-regulated undertaking carrying out financial activities; and
9. the “beta” of the set of investments does not exceed 0,796.⁵

If a portfolio of equities qualifies under the proposed rules, the type 1 equity treatment would apply, resulting in a reduction by 10% of the capital charge.

Long-term equity investments

The second change proposed under the Draft Delegated Act is in respect of “long-term equity investments”. Similar to equity investments of a “strategic nature”, those equities which meet certain proposed criteria will benefit from a flat 22% capital charge (regardless of which of the four categories of equities the investment would fall in).

The proposed new Article 171a, set out in the Draft Delegated Act, provides that a sub-set of equity investments may be treated as long-term equity investments if the following conditions are met (subject to the satisfaction of the relevant supervisory authority):

(a) the sub-set of equity investments as well as the holding period of each equity investment within the sub-set are clearly identified;

(b) the sub-set of equity investments is included within a portfolio of assets which is assigned to cover the best estimate of a portfolio of insurance or reinsurance obligations corresponding to one or several clearly identified businesses, and the undertaking maintains that assignment over the lifetime of the obligations;

(c) the portfolio of insurance or reinsurance obligations and the assigned portfolio of assets referred to in point (b) are identified, managed and organised separately from the other activities of the undertaking, and the assigned portfolio of assets cannot be used to cover losses arising from other activities of the undertaking;

(d) the technical provisions within the portfolio of insurance or reinsurance obligations referred to in point (b) only represent a part of the total technical provisions of the insurance or reinsurance undertaking;

(e) the average holding period of equity investments in the sub-set exceeds 5 years, or where the average holding period of the sub-set is lower than 5 years, the insurance or reinsurance undertaking does not sell any equity investments within the sub-set until the average holding period exceeds 5 years;

(f) the sub-set of equity investments consists only of equities that are listed in the EEA or of unlisted equities of companies that have their head offices in countries that are members of the EEA;

(g) the solvency and liquidity position of the insurance or reinsurance undertaking, as well as its strategies, processes and reporting procedures with respect to asset-liability management, are such as to ensure, on an ongoing basis and under stressed conditions, that it is able to avoid forced sales of each equity investments within the sub-set for at least 10 years;

(h) the risk management, asset-liability management and investment policies of the insurance or reinsurance undertaking reflects the undertaking's intention to hold the sub-set of equity investments for a period that is compatible with the requirement of point (e) and its ability to meet the requirement of point (g).

For type 1 equities that meet the long-term equity investment criteria, insurers would see a reduction in the capital charge applied from the current range (between 29% to 49%, depending on the applicable dampener) to a flat 22%. In the case of type 2 equities the reduction would be from between 39% and 59% to 22%.

Certain of the criteria for long-term equity investments may be familiar to insurers given that they resemble the existing requirements under Solvency II for the so-called “matching adjustment” to apply. For certain life insurance risks (e.g. annuities), the matching adjustment allows an insurer to use a more favourable discount rate in determining the present value of its liabilities arising under an identified book of insurance obligations where those obligations are matched over their lifetime by the cash flows of a separately identified and managed portfolio of assets held to cover them.

The rationale is similar. Insurers holding assets to cover separately identified and predictable long-term liabilities are not exposed to illiquidity risk to the same degree as other investors in those assets (given they should be able to avoid a “fire-sale” of the assets under stressed market conditions). The matching adjustment allows an insurer holding a matched asset portfolio to take advantage (through a more generous liability discount rate) of the portion of the yield on illiquid assets compensating investors for risks to which the insurer is not actually exposed. Similarly, the proposal is to reduce the capital charge for long-term equity investments to reflect reduction in the risk the capital charge is intended to protect against (i.e. the impact of adverse market movements on assets).

Brexit

Depending on the outcome of Brexit, the proposed rules on equities may make investments in UK equities relatively less attractive to EU insurer investors. This would be the case if the outcome of Brexit resulted in the UK no longer being part of the EEA, as the new rules require equity investments in the EEA, whether they are listed or unlisted.

^{1 European Commission Action Plan on Building a Capital Markets Union (30 September 2015), p.3.}

^{2 See Article 172 of the Delegated Regulation. 3 Article 168(6) of the Delegated Regulation} 

^{4 For further detail on the criteria for equity investments to be considered “strategic” see Article 171 of the Delegated Regulation and EIOPA’s Guidelines on treatment of related undertakings, including participations (2 February 2015), p.5.}

^{5 In its Staff Working Document, the Commission describes “beta” as “a measure for the systematic or non-diversifiable risk of equity investments”. It is calculated based on several financial indicators, such as gross margin, debt-to-net cash-flow from operations ratio and return on common equity}