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Three months into its implementation, the impact of Solvency II is being felt across the capital markets as insurance companies adjust their asset allocations to maximise their solvency capital requirement (SCR) efficiency.
Trying to balance their SCR requirements with the ever-present hunt for yield is a challenge. Sub-investment grade loans and private credit are SCR efficient (20% to 25%) while private equity is not (49%). The treatment of infrastructure equity has improved (30%) while direct investment in real estate is hampered by penalties for prepayment risk.
Solvency II will change European insurance company behaviour and thus the European capital markets. Under Solvency II, European insurers are looking at their bond allocations and asking if they deserve the 49% SCR charge that they now attract.
SCR considerations will drive allocation away from fixed income and into alternatives. This is most apparent in the stampede by insurance companies towards infrastructure. In Europe infrastructure debt spreads have come down from 350 basis points to 100bp because of a shortage of assets and the wall of money trying to get into them.
Exploiting the surge
But this money wants infrastructure assets structured to look like a bond with an equity kicker – something that can be very hard to find. The sell side needs to find better ways of structuring infrastructure assets to appeal to insurance company and pension fund investors if it wants to exploit their surge in demand for the asset class. Many disappointed European buyers are now heading to the US municipal bond market instead.
Some experts also warn that infrastructure is not necessarily the panacea that many long-term investors believe it to be. It tracks GDP and is an inflation hedge but is also one of the most opaque sectors for investment that there is.
Atif Ansar, programme director at Oxford University’s Saïd Business School, warns that infrastructure investors often don’t have a salvageable asset, just a stream of investment, so once the asset is no longer operational it can turn into a liability. Ansar points out that Duke Energy, the largest electric power holding company in the US, faces a coal plant decommissioning programme that could cost more than its total market capitalisation.
For this reason, he argues that investors need to be very careful how they approach the asset class. “It is hundreds of industries, all with different income streams bundled into one word,” he says. “It is fine to build real asset teams but the skill sets are very diverse. Someone who has worked on real estate deals for their whole career cannot suddenly start doing aircraft financings.”