What Impact will the New Solvency II Rules have on ELTIFs?

On 19 January 2024, the Council of the European Union published the final compromise containing amendments to Directive 2009/138/EC (Solvency II). The text contains details of the modified “Long-term equity investments” (“LTE”) sub-model (with a favourable 22% capital charge) and a specific treatment for European long-term investment funds (“ELTIFs”) and other “low risk” alternative investment funds (“AIFs”). This contribution sheds some light on the implications of these amendments for insurers in the (low-risk AIF and) ELTIF context.

1.?????? Long-Term Investments & AIFs under Solvency II

The issue of long-term equity investments has been on the radar of the European Commission for several years. Despite the policymakers’ objective to support these, over the past few years, insurers’ investments in equities have been modest.

Giving long-term equity exposures a separate treatment from daily traded equities was the very objective of the creation of a LTE category upon the introduction of Solvency II in 2016. The category essentially acts as a “safe-haven” within the Solvency II framework for long-term investments, i.e. for any equities where it has been established that insurers can avoid being forced sellers of their equity holdings.

The relevance of such “safe-haven” cannot be overstated. Without the LTE category, Solvency II simply makes long-term illiquid equities less attractive for insurers. The LTE category is particularly relevant for exposures to private equity and venture capital funds. As Solvency II only looks at the equity risk from a volatility angle, the category is an essential element of the framework to ensure characteristics of insurers’ long-term investments are taken into consideration in the solvency risk assessment.

Despite the regulatory efforts to make long-term equity investments attractive by the European regulator, statistics published by EIOPA show that less than 1% of insurers’ investments are made in private equity funds.[1] Furthermore, insurers make up less than 10% of the total investor base in all private equity – 3 times less than pension funds - despite insurers’ investment portfolio assets representing 58% of the EU GDP.[2]

The reason for this is that the current requirements have been perceived by insurers as overly prescriptive and difficult to apply in practice. A capital charge of 39% or even 49% is too much for insurance undertakings aiming to optimize their overall Solvency Capital Requirement (SCR). This is especially true for those insurers that struggled to keep their solvency ratio in place during the last decade of low interest rates. Furthermore, insurers investing in funds are required to adopt the “look-through approach” in calculating their SCR. This means that the SCR will, generally, need to be calculated on the basis of the underlying assets in a fund structure and this approach will need to be applied a sufficient number of times to capture all material risk. This also means that where an insurer invests in a fund-of-funds or a feeder/ master fund structure, it will need to “look-through” each (target/master) fund so that the SCR is calculated on the ultimate underlying assets in so far as possible.

From its adoption, it was obvious that the short-term focus on market risk under Solvency II is in conflict with the European Union’s objective to facilitate long-term sustainable growth. Insurers are a major investor group in Europe. Therefore, over the past few years amendments to Solvency II, without compromising capital requirements have been introduced, first with a more favourable regime for infrastructure investments and, second, for qualifying unlisted equity portfolios (QUEP) and LTE.

2.?????? The Amended Solvency II Regime: New Capital, Eligible Investments and “Look-through” Requirements

The LTE was introduced by Commission Delegated Regulation (EU) 2019/981 (Solvency II DR) in 2019. An extensive set of eligibility criteria was designed out of fear of regulatory arbitrage by insurance undertakings. As a result, the LTE has had so far limited success of facilitating further equity investments and financing of long-term sustainable growth.

The amended Solvency II regime, therefore, seeks to enlarge the LTE category and ease the conditions for applications of the regime, so as to help to achieve Europe’s sustainability goals by (i) easing capital requirements, (ii) more flexible eligible investment rules and (iii) the ease of the “look-through requirements” for certain types of low-risk AIFs and, in particular, ELTIFs.

2.1.??? Reduced Capital Charge

To encourage investments in long-term investments that recognizes the need for insurance companies to invest more robustly and strategically in long-term projects, the amended LTE regime reduces the capital requirements for specific long-term equity investments from 39% to 22%. This adjustment aims to facilitate greater participation of insurers in long-term investments, contributing to insurers’ capacity to allocate more capital to long-term equity investments, such as (low-risk) AIFs and ELTIFs.

2.2.??? Eligible Investment Rules – A more Flexible Regime

The amended Solvency II regime sets out clear eligibility criteria for (long-term) investments to qualify for the reduced capital requirements. To qualify, an insurance undertaking has to demonstrate, to the satisfaction of the supervisory authority, that all of the following conditions are met:

1.?????? the sub-set of equity investments is clearly identified and managed separately from the other activities;

2.?????? a policy for long-term investment management is set up for each long-term equity portfolio and reflects the undertaking’s commitment to hold the global exposure to equity in the sub-set of equity investment for a period that exceeds five years on average;

3.?????? the sub-set of equity investment must consist of equities listed in EEA or OECD countries, or unlisted equities from companies headquartered in these regions;

4.?????? the insurance undertaking is able to demonstrate to the satisfaction of the supervisory authority that on an ongoing basis and under stressed conditions, it is able to avoid forced selling of equity investments within the sub-set for five years;

5.?????? the risk management, asset-liability management and investment policies of the insurance undertaking reflect the insurance undertaking's intention to hold the sub-set of equity investments for a period that is compatible with the requirement laid down in Nr. 2 and Nr. 4;

6.?????? the sub-set of equity investment is appropriately diversified in such a way as to avoid excessive reliance on any particular issuer or group of undertakings and excessive accumulation of risk in the portfolio of long-term equity investments as a whole with the same risk profile; and

7.?????? the sub-set of equity investment does not include participations.

The mentioned eligibility requirements with respect to the LTE regime are based upon the Solvency II DR, but have been made considerably more flexible.

2.3.??? Low-risk AIFs, ELTIFs & Look-through Requirements

Important in the fund context, is that the amended Solvency II allows ELTIFs to assess the eligibility requirements at the fund-level only and thereby does away with the current “look-through approach”. The amended Solvency II only grants a similar benefit to specific low risk-profile AIFs, the criteria defining these funds as lower risk-profile still have to be identified in the delegated acts to be adopted pursuant to the amended Solvency II. Currently, there is not yet a draft published that suggests any criteria to be adopted. Based upon the discussions during the legislative process, the “low-risk AIF” category is expected to be made available for certain types of closed-ended private equity funds with no redemption rights.

3.?????? Outlook: What Impact is to be expected for ELTIFs?

With the amended Solvency II LTE the European regulator recognizes that private markets are here to stay and that a larger allocation of investments in this domain from insurance companies are needed to stimulate and support the growth in the real economy. In particular, with view to the financing of the green transition as part of sustainability initiatives in Europe.

Insurers are an interesting type of target investor for the European AIF industry, as they have constantly premiums to invest that are being paid in advance. They are, thus, able to invest for the long term, and able to hold these investments throughout different business and economic cycles. Furthermore, a larger allocation of investments towards alternative investments also presents an interesting opportunity for insurers, as it allows for more diversification of asset classes for them to invest in.

The elephant in the room is whether the regulator will achieve its goal to enlarge the scope of LTE and the LTE eligible investment rules are eased enough to help achieve the European sustainability goals. Albeit the to be contemplated amendments are going in the right direction, as the absence of a “look-through assessment”, as well as the relaxation of the eligibility criteria are helpful, compliance with the requirements may still be perceived as to remain a complex exercise and it will remain to be seen whether the new LTE regime and the application of the criteria thereof on a “no look-through basis” to “low-risk AIFs” and ELTIFs will make the use of this category more economic and attractive.

[1] EIOPA European Insurance Overview, 2018.

[2] Invest Europe, Supporting long-term growth through long-term investments – Position paper on the Solvency II review, January 2021.