Circular NBB_2018_29: Infrastructure Investments under the Solvency II Regime

NBB_2018_29 – 06 December 2018 Circular – Page 1/23 boulevard de Berlaimont 14 – BE-1000 Brussels tel. +32 2 221 37 40 – fax + 32 2 221 31 04 company number: 0203.201.340 RPM Brussels www.bnb.be

Circular
Brussels, 6 December 2018
Reference: NBB_2018_29 your correspondent:
Nicolas Colpaert tel. +32 2 221 35 02 – fax +32 2 221 31 04 nicolas.colpaert@nbb.be

Infrastructure Investments under the Solvency II Regime

Scope
Belgian insurance or reinsurance undertakings.
Belgian insurance or reinsurance groups.

Summary/Objectives
By this circular, the National Bank of Belgium provides supplementary clarifications on the definition and eligibility criteria for an investment in infrastructure entities and infrastructure companies under the Solvency II regime.

Structure

1. Definitions
2. Criteria
3. Risk Management
4. Delegated Regulation 'Solvency II': possible amendments

Circular – Page 2/23 NBB_2018_29 – 06 December 2018

Madam,
Sir,

On 8 June 2017, the European Commission published Delegated Regulation 2017/1542 amending the 'Solvency II' delegated regulation regarding the calculation of regulatory capital requirements for several categories of assets held by insurance and reinsurance undertakings. This delegated regulation aims to remove unjustified barriers to long-term investments within the Solvency II regime. One of these asset categories concerns the infrastructure asset category, which is the subject of this circular.

The infrastructure asset category is governed in the delegated regulation by definitions and criteria ensuring that infrastructure investments present a good risk profile in terms of stress resistance, cash flow predictability, and protection provided by the contractual framework. Compliance with these criteria should guarantee the establishment of a sound prudential policy regarding infrastructure investments. The assessment of these criteria does not require the submission of an approval file to the supervisory authority.

By this circular, the National Bank of Belgium (the Bank) provides supplementary clarifications on the definition and eligibility criteria for an investment in infrastructure entities under the Solvency II regime. Furthermore, it proposes a more detailed version of the EIOPA assessment criteria. Undertakings may, if they wish and where applicable, use these supplementary clarifications and the EIOPA assessment criteria to assess the risks associated with infrastructure investments. These assessment criteria contribute to the overall assessment; no rule imposes obtaining a specific average score. The continued development of the delegated regulation's criteria aims to facilitate infrastructure investments. The objective is not to impose additional requirements.

1. Definitions

Article 1, paragraph 55a:
'infrastructure assets': physical assets or structures, or equipment, systems, and networks that provide or support essential public services.

Article 1, paragraph 55b:
'infrastructure entity': an entity or group of companies that, during the most recent financial year of this entity or group for which figures are available, or based on a financing proposal, derives the majority of its revenue from owning, financing, developing, or operating infrastructure assets.

1.1. Infrastructure Assets

Infrastructure services are considered those ensuring the maintenance of functions performed by public authorities and contributing to the well-being of the population. This may include services falling under all of the following areas: health, security, economy, and social. The proposed definition also includes infrastructure assets that support essential public services. Examples could include buildings housing fire services, or a renewable energy production plant selling electricity to a public service. The term 'essential' aims to take into account the fact that the definition should not encompass any service or activity that promotes the well-being of the population.

The reference to public services in the definition is not intended to exclude services that are not provided directly by the State or another public body. However, it would allow, for example, the exclusion of a plant that supplies electricity to a single factory and therefore does not serve the public interest.

The conformity of an infrastructure asset to the definition must be judged on a case-by-case basis. Among other examples of sectors where infrastructure assets are typically found, we cite public services, social housing, utility services such as energy, healthcare, transport, telecommunications, and waste treatment.

1.2. Infrastructure Entity

The infrastructure entity may be active in project finance, or it may be an infrastructure company.

The project entity should not carry out activities unrelated to the infrastructure project. The project should also be safeguarded in the event that the project promoter encounters financial difficulties. Contrary to 'corporate finance', the term 'project finance' implies that the importance of activities unrelated to the project should be negligible and that there should be a true segregation from other entities (achieved generally by creating an SPV1).

It is considered that one of the reasons why recovery rates observed in project finance are higher than those of most corporate claims is that lenders are in a strong position.

The investment should concern an entity created solely for the purpose of financing or operating physical assets, or should constitute an economically comparable risk, following the principle of substance over form. To ensure that the entity does not make substantial investments in activities other than infrastructure, only cash flows directly linked to infrastructure should be taken into account when assessing the extent to which the resilience criterion is met.

Contractual provisions should give the lender a high degree of control over the assets and the revenues they generate, and the first source of loan repayment should reside in the revenues generated by the financed assets, rather than in the independent repayment capacity of a commercial company considered as a whole.

2. Criteria – Eligible Investments in an Infrastructure Entity Active in Project Finance

An eligible infrastructure investment is defined as an investment in an infrastructure entity that meets the criteria set out in Article 164 bis. Given the complexity of infrastructure investments, insurance companies may call upon the expertise of technical, legal, and tax advisors.

1 A Special Purpose Vehicle (SPV) is a legal entity created to fulfill restricted, specific, or temporary objectives, traditionally used to isolate financial risks (the asset/liability structure and the legal status of the SPV secure its commitments, even in the event of its parent company's bankruptcy, for example).

Circular – Page 4/23 NBB_2018_29 – 06 December 2018

2.1. Resilience Test

Criterion stated in Article 164 bis, paragraph 1, point a):
the cash flows generated by the infrastructure assets allow for the fulfillment of all financial commitments in the event of a lasting shock affecting the risk inherent in the project.

The cash flows generated by the project are the first source of payments to creditors (cf. the definition of 'infrastructure entity'). The project should therefore be able to honor its commitments during periods of stress. It is therefore very important to conduct thorough stress tests. The additional workload this entails should be reduced since stress tests are customary in project finance. These simulations aim to force insurers to examine project risks in depth and help them better identify its points of vulnerability.

The crisis simulation analysis also complements the other eligibility criteria. Some of them reduce the probability of a negative event occurring (the obligation for the construction company to be financially sound, for example, reduces the probability that it becomes insolvent). However, the financial impact of a potential negative event can vary considerably depending on the project structure and must also be taken into account.

Drawing the highly idiosyncratic risk profile of a project using a limited number of necessarily general criteria has its limits. The development and implementation of crisis scenarios specifically adapted to this project should counterbalance this disadvantage.

All lasting 'shocks' affecting the risk inherent in the project should be simulated. The list of scenarios presented below is therefore not exhaustive. Depending on the nature of the project, other scenarios may also apply. The crisis scenarios used to demonstrate that the project is able to honor its financial commitments should include the following situations, insofar as they apply to the risks inherent in the project (non-exhaustive list):
a) unfavorable refinancing conditions; b) severe economic shock; c) delays in design or construction; d) insolvency of the construction company; e) unfavorable weather conditions; f) operational shutdowns; g) insolvency of the operator; h) decrease in production or usage levels; i) decrease in prices per unit of production or usage; j) increase in operating costs; k) increase in inflation.

Generally speaking, the development of crisis scenarios should also take into account relevant empirical experiences.

Circular – Page 5/23 NBB_2018_29 – 06 December 2018

2.2. Predictability of Cash Flows

Criterion stated in Article 164 bis, paragraph 1, point b):
the cash flows generated by the infrastructure entity for debt providers and equity investors are predictable.

Article 164 bis, paragraph 2: for the purposes of paragraph 1, point b), the cash flows generated for debt providers and equity investors are considered predictable only if all revenue, except for a negligible portion, meets the following conditions:
(a) one of the following criteria is met:
(i) revenue is based on availability;
(ii) revenue is subject to rate-of-return regulation; (iii) revenue is subject to a take-or-pay contract; (iv) the production level, or usage, and the price each meet at least one of the following criteria:
– they are regulated;
– they are contractually fixed;
– they are sufficiently predictable due to low demand risk; (b) when the revenue of the infrastructure entity does not come from payments made by a large number of users, the party committing to purchase the goods or services provided by the infrastructure entity is one of the following entities:
(i) an entity referred to in Article 180, paragraph 2, of this regulation; (ii) a regional or local authority referred to in the regulation adopted pursuant to Article 109 bis, paragraph 2, point a), of Directive 2009/138/EC; (iii) an entity to which an ECAI has assigned a credit quality step of at least 3; (iv) a replaceable entity without significant modification to the level or schedule of revenues.

Infrastructure assets are generally extremely specific. It will likely be impossible to redeploy these assets for other purposes, such as in the case of a bridge, except by significantly reducing their value. Furthermore, infrastructure projects frequently use higher financial leverage than companies and present high operating leverage, given that their marginal costs are low compared to their fixed costs. Consequently, projects must generate predictable revenues to generate predictable cash flows for investors.

Predictable revenue may result from an availability contract2 or take-or-pay3 contract or rate-of-return regulation. In other situations, revenue might be predictable because both the production or usage level and the price per production or usage level are predictable. This could be because production, usage, or price is regulated or contractually fixed, or because the risk related to demand is low. Generally speaking, it would not be sufficient for only one of these factors to be predictable. In a renewable energy production project, the predictability of production can be evaluated using technical studies, such as statistical estimation of the minimum quantity of sunshine, wind, etc.

Entities that could be assimilated to those listed in Article 164 bis, paragraph 2, point b), i) and ii), are the following:

1. public companies or authorities with legal personality, public institutions, and associations of public law, or any other public service with legal personality;
2. administrative authorities performing public service missions within the competence of regions, communities, provinces, or municipalities;
3. non-commercial public companies owned by the State or by a public service of the State with legal personality, a region, or a community, and whose commitments are formally guaranteed by the State (legally or contractually), a region, or a community.

In its criteria for assessing demand risk, EIOPA defines the following sub-factors and establishes four risk categories (category 1 reflects the lowest risk):

• market conditions
• Category 1: few competing suppliers or substantial and lasting advantage in terms of location, costs, or technology. Strong and growing demand.
• Category 2: few competing suppliers or above-average advantage but possibly not lasting in terms of location, costs, or technology. Strong and stable demand.
• Category 3: no advantage in terms of location, costs, or technology. Sufficient and stable demand.
• Category 4: location, costs, or technology worse than average. Weak and declining demand.

When revenue does not come from a large number of users, a purchaser's failure could result in heavy losses. Furthermore, infrastructure projects can span several decades. The financial strength of the purchaser should therefore be sufficient. In its assessment criteria

2 In availability-based public-private partnerships (PPPs), the public sector acquires basic supplies or services. Payments are linked to the availability of the asset rather than its level of usage (schools, hospitals, and public buildings are typical examples). Most projects integrate a high level of delivery specifications and are also likely to take into account the quality management of the relevant equipment. Provided that the prescribed delivery standards are met, the concession company receives annual revenue payments. 3 A take-or-pay contract is a contract by which it is agreed that a customer purchases the production or service from the supplier, or, failing that, pays them compensation. Both the price and the compensation are fixed in the contract.

Circular – Page 6/23 NBB_2018_29 – 06 December 2018

for revenue, including off-take contract risk4, EIOPA defines the following sub-factors and establishes four risk categories (category 1 reflects the lowest risk):

• what is the strength of revenue contracts (e.g., off-take contracts5, concession agreements, revenue flows in a public-private partnership, and other revenue contracts)? What is the quality of termination clauses6?
• Category 1: excellent revenue strength.
• Category 2: good revenue strength.
• Category 3: acceptable revenue strength.
• Category 4: project revenue is not secured, and indicators suggest that some revenue might not be received.
• if there is a take-or-pay contract or a fixed-price purchase contract
• Category 1: excellent purchaser solvency; firm termination clauses; contract duration significantly exceeds the debt maturity date.
• Category 2: good purchaser solvency, firm termination clauses; contract duration exceeds the debt maturity date.
• Category 3: acceptable purchaser financial capacity; normal termination clauses; contract duration generally equal to the debt maturity date.
• Category 4: weak purchaser financial capacity; flexible termination clauses; contract duration does not exceed the debt maturity date.
• in the absence of a take-or-pay contract or a fixed-price purchase contract
• Category 1: the project provides essential services or a raw material sold on a large scale on a global market; production can be easily absorbed at the expected prices even in case of market growth rates lower than historical levels.
• Category 2: the project provides essential services or a raw material sold on a large scale on a regional market that will absorb it at the expected price and historical growth rates.
• Category 3: the raw material is sold on a restricted market that can only absorb it at prices lower than expected.
• Category 4: the project's production interests only one or a few buyers and is most often not sold on an organized market.

4 The off-take contract risk corresponds to the risk that there is no demand for the production or service at the price at which it is supplied, or that the purchaser is unable or refuses to honor its commitment to purchase the production or service.
5 An off-take contract is a contract between the producer of a resource, product, or service and the purchaser (off-taker) of a resource, by which the latter commits to buy or sell a percentage of the producer's future production. An off-take contract is usually concluded before the construction of a facility to guarantee a market for the facility's future production. The objective is to provide the producer with stable and sufficient revenue to repay its debt, cover operating costs, and ensure the desired return. 6 A termination clause is a provision in a contract that provides for its termination under specific circumstances.

Circular – Page 7/23 NBB_2018_29 – 06 December 2018

2.3. Contractual Framework

Criterion stated in Article 164 bis, paragraph 1, point c):
infrastructure assets and the infrastructure entity are governed by a regulatory or contractual framework that ensures debt providers and equity investors a high level of protection, and in particular:
(a) the contractual framework contains provisions that effectively protect debt providers and equity investors against losses that could result from the termination of the project by the party committing to purchase the goods or services provided by the infrastructure project, unless one of the following conditions is met:
i. the revenue of the infrastructure entity comes from payments made by a large number of users;
ii. revenue is subject to rate-of-return regulation;
(b) the infrastructure entity has sufficient reserves or other financial resources to deal with unforeseen events and the project's working capital needs; when investments are in bonds or loans, the contractual framework also provides for the following:
(i) to the extent permitted by law, debt providers enjoy security over all assets and contracts that are critical for the execution of the project; (ii) the use, for purposes other than debt service, of the project's net operating cash flows after mandatory payments is subject to restrictions; (iii) restrictions are imposed on activities that could be detrimental to debt providers, including the fact that the issuance of new debt cannot take place without the consent of existing debt providers in a form agreed with them, unless such debt issuances are authorized by the existing debt documentation.

Notwithstanding the second paragraph, point i), for investments in bonds or loans, when companies can demonstrate that security over all assets and contracts is not essential for debt providers to effectively protect or recover the majority of their investment, other guarantee mechanisms may be used. In this case, other guarantee mechanisms include at least one of the following mechanisms:
i) share pledge; ii) intervention rights; iii) lien on bank accounts; iv) cash flow control; v) provisions for contract allocation.

To mitigate many risks associated with the project, it is crucial that contractual provisions are appropriate and clearly define the obligations of the different parties to the project. The adequacy of contractual provisions will determine compliance with many criteria related to unrated debt and shares, such as the transfer of construction or operational risk.

Circular – Page 8/23 NBB_2018_29 – 06 December 2018

NBB_2018_29 – 06 December 2018 Circular – Page 9/23

For coverage against losses due to project cessation caused by the party committed to purchasing the goods or services of the infrastructure entity to be real, it is necessary that creditors and shareholders benefit from effective, if not necessarily complete, protection.

In the case of placements in the form of bonds or loans, the contractual framework should provide for limiting the infrastructure entity's capacity to carry out activities that could be detrimental to creditors. The issuance of new debt cannot take place without the consent of existing creditors. Creditors may establish certain contractual clauses ex ante setting out the conditions under which the issuance of new debt is permitted.

The World Bank's PPP Resource Centre in the infrastructure sector7 describes an example of a common (simplified for the sake of this document) project financing structure. This is a so-called "build, operate and transfer" (BOT) project:

As shown in the graph above, the number of contracts and provisions can form a complex system. Moreover, not all types of agreements, such as the interlender agreement between credit providers or the interface agreement between the operator and the construction company, promoters and/or upstream suppliers, are included therein. The agreements must carefully define the interrelationships between the different parties.

Through security interests, the activities of the infrastructure entity are framed throughout its existence in order to reduce the risk incurred by lenders. Generally, restrictions relate to authorized investments, issued debt, dividends paid to equity investors, additional privileges or other charges, project expansion, as well as sales and asset sale-and-leaseback contracts. Through security interests, creditors should be better protected than equity investors. This criterion therefore only applies to debt investments.

In its security assessment criteria, the EBA defines the following sub-factors and establishes four risk categories (category 1 reflects the lowest risk):

7 Cf. https://ppp.worldbank.org/public-private-partnership/financing/project-finance-concepts.

Circular – Page 10/23 NBB_2018_29 – 06 December 2018

(a) assignment of contracts and accounts

• Category 1: entirely complete
• Category 2: complete
• Category 3: acceptable
• Category 4: weak

(b) pledge on assets, taking into account the quality, value and liquidity of the assets

• Category 1: perfect first-ranking security on project assets, contracts, permits and accounts necessary for the operation of the project8.
• Category 2: perfect security on project assets, contracts, permits and accounts necessary for the operation of the project.
• Category 3: acceptable security on project assets, contracts, permits and accounts necessary for the operation of the project.
• Category 4: Few securities or guarantees for lenders, weak negative pledge clause9.

(c) lenders' control over cash flows (e.g., cash sweeps10, separate escrow account11)

• Category 1: strong
• Category 2: satisfactory
• Category 3: adequate
• Category 4: weak

(d) robustness of the entire contractual payment provisions (mandatory prepayments12, payment deferrals13, waterfall payments14, dividend limitations15, etc.)

• Category 1: strong clauses for this type of project. The project cannot issue additional debt.
• Category 2: satisfactory clauses for this type of project. The project can only issue a very limited amount of additional debt.

8 A perfect first-ranking security (first perfected security) is a security on an asset (mortgaged as collateral) protected from other creditors. A security is perfected by registering it with the appropriate legal institution so that it is legally enforceable and any subsequent claim regarding that asset is declared subordinate.

9 A negative pledge clause is a clause stating that the institution will not pledge any of its assets if lenders are thereby less protected.

10 By cash sweep, one means the obligation to allocate excess available cash flows to the reduction of the debt balance rather than distributing them to shareholders.

11 A separate escrow account is an escrow account in the name of the promoter held by a bank under an escrow agreement between the lender and the borrower, providing for irrevocable instructions from the borrower to ensure that all operating revenues or proceeds from the sale of project assets are paid into this account, and authorizing the bank to make payments from available funds only in accordance with the project financing documents.

12 A mandatory prepayment is a clause by which the borrower is required to prepay part of the debt using certain revenues it would receive before the maturity date.

13 A payment deferral is a clause by which the borrower is authorized to begin making payments at a specified date in the future.

14 The waterfall payment system is a clause by which the project's cash flows are modeled using a cascade of cash flows indicating the priority of any incoming and outgoing flow.

15 A dividend limitation is a clause that defines the circumstances under which the lender is able to prevent distributions on shares.

NBB_2018_29 – 06 December 2018 Circular – Page 11/23

• Category 3: adequate clauses for this type of project. The project can issue a limited amount of additional debt.
• Category 4: insufficient clauses for this type of project. The project can issue unlimited additional debt.

(e) reserve funds (debt service, operation and maintenance, renewal and replacement, unforeseen events, etc.)

• Category 1: coverage period exceeding the average, reserve funds are all funded in cash or through letters of credit issued by a top-tier bank.
• Categories 2 and 3: coverage period equal to the average, all reserve funds are funded.
• Category 4: coverage period shorter than the average, operating cash flows fund the reserve funds.

2.4. Hold to Maturity
Criterion set out in Article 164 bis, paragraph 1, point d):
when investments are in bonds or loans, the insurance or reinsurance undertaking may demonstrate to its supervisory authority that it is able to hold them to maturity.

Given the often illiquid nature of an infrastructure investment, the insurer should be able to hold it to its maturity if the project entity does not prepay the debts. The following elements should help assess whether the undertaking is able to hold its investment to its maturity. It is not required to satisfy all these elements simultaneously.

• Relative importance of infrastructure placement in the portfolio
• Ratio between liquid and illiquid placements in the portfolio
• Degree of solvency of the undertaking (solvency ratio)
• Degree of asset-liability congruence (duration mismatch, cash flow insufficiency)
• Number of risk mitigation mechanisms (derivatives, guarantees, reinsurance)
• Number of options attached to liabilities covered by the investment (maturity ratios, redemption value)

In the assessment of the aforementioned elements, the undertaking should be sufficiently forward-looking. Sensitivity tests should help it quantify and anticipate the impact of future events on its ability to hold the investment to its maturity.

The criteria described in paragraphs 2.5 and 2.6 relate to investments in unrated infrastructure assets16.

16 The Bank wishes to emphasize in this regard that these criteria are not binding but can be useful for assessing the risk posed by rated infrastructure investments as well.

Circular – Page 12/23 NBB_2018_29 – 06 December 2018

2.5. Seniority of Unrated Debt
Criterion set out in Article 164 bis, paragraph 1, point e):
when investments are in bonds or loans for which there is no credit assessment established by a designated CRA, the investment instrument and other instruments of the same seniority are senior to any claim other than statutory claims and claims of liquidity providers, trustees and derivative counterparties.

2.6. Other Conditions Required for Unrated Debt and Shares
Criterion set out in Article 164 bis, paragraph 1, point f):
investments are in shares, or in bonds or loans for which there is no credit assessment established by a designated CRA, the following criteria are met:

[Political Risk]
(i) infrastructure assets and the infrastructure entity are located in the EEA or OECD;

[Construction Risk]
(ii) if the infrastructure entity is in the construction phase, the following criteria are met by the equity investor or, if there is more than one equity investor, they are met by a group of equity investors taken as a whole:

• equity investors have a track record of successful supervision of infrastructure projects and possess the necessary expertise;
• equity investors present a low default risk, or the risk that their default leads to significant losses for the infrastructure entity is low;
• equity investors are incentivized to protect the interests of investors;

(iii) in case of construction risk, safeguard measures ensuring the proper completion of the project according to the specifications, budget and agreed completion date are taken;

[Operational Risk]
(iv) when significant, operational risks are properly managed;

[Design and Technology Risk]
(v) the infrastructure entity uses tested technologies and designs;

[Financial Risk]
(vi) the capital structure of the infrastructure entity allows it to ensure the service of its debts; (vii) the refinancing risk of the infrastructure entity is low; (viii) the infrastructure entity uses derivatives only for risk mitigation purposes.

NBB_2018_29 – 06 December 2018 Circular – Page 13/23

Political Risk
Investments are confined to EEA or OECD countries in order to ensure that political risks are limited. Infrastructure assets generally constitute long-term specific investments. Their flexibility to adapt to legislative and regulatory changes is therefore very low, which can substantially harm investors. This point is particularly important because, while many other risks are idiosyncratic (construction risks, for example), changes of this nature can affect many projects and diversification opportunities are limited.

In its criteria for assessing the political and legal environment, the EBA identifies the following sub-factors and establishes four risk categories (category 1 reflects the lowest risk):

(a) sub-factor: political risk, including transfer risk, taking into account the type of project and mitigation mechanisms

• Category 1: very low exposure; if necessary, strong mitigation devices.
• Category 2: low exposure; if necessary, satisfactory mitigation devices.
• Category 3: moderate exposure; adequate mitigation devices.
• Category 4: high exposure; weak or non-existent mitigation devices.

(b) sub-factor: force majeure risk (war, civil unrest, etc.)

• Category 1: zero or very low exposure to force majeure risk.
• Category 2: limited exposure to force majeure risk.
• Category 3: significant exposure to force majeure risk that is not sufficiently mitigated.
• Category 4: significant exposure to force majeure risk that is not mitigated

(c) sub-factor: public support and importance of the project for the country in the long term

• Category 1: project of strategic importance for the country (preferably export-oriented). Strong public support.
• Category 2: project considered important for the country. Good level of public support.
• Category 3: the project is not truly strategic but undoubtedly brings benefits to the country. Public support is not always explicit.
• Category 4: project not indispensable to the country. Weak or non-existent public support.

(d) sub-factor: stability of the legal and regulatory environment (risk of legislative changes)

• Category 1: favorable and stable long-term regulatory environment.
• Category 2: favorable and stable medium-term regulatory environment.
• Category 3: regulatory changes can be predicted with reasonable certainty.
• Category 4: current or future regulatory issues may have an impact on the project.

(e) sub-factor: obtaining all supports and agreements concerning local content laws

• Category 1: strong
• Category 2: satisfactory

Circular – Page 14/23 NBB_2018_29 – 06 December 2018

• Category 3: adequate
• Category 4: weak

(f) sub-factor: applicability of contracts, guarantees and securities

• Categories 1 and 2: contracts, guarantees and securities are enforceable.
• Category 3: contracts, guarantees and securities are deemed enforceable even if some non-essential aspects may pose problems.
• Category 4: essential issues remain pending regarding the effective enforceability of contracts, guarantees and securities.

Construction Risk
During the construction phase, marginal default rates are higher and recovery rates lower than in the operational phase. A total inability to construct the asset in accordance with the purchaser's specifications, as well as delays and cost overruns during the construction phase, can cause heavy losses to investors. The transfer of construction risk to an appropriate construction company could constitute an important instrument for mitigating this risk. The construction company could commit to delivering the project at a fixed price and agreed date. The construction company should have the necessary capabilities to design and construct the asset in accordance with the specifications.

Construction risk could be considered transferred to an appropriate construction company if the following criteria are met:
a) the infrastructure entity concludes a fixed-price, agreed-date Engineering, Procurement, Construction (EPC) turnkey contract accompanied by realistic delays and cost estimates; b) the contract provides for the payment of substantial damages backed financially, or there is a solid completion guarantee issued by promoters in excellent financial health; c) the construction company possesses the necessary know-how and capabilities, is financially solid and can boast a solid track record in the construction of projects of the same type.

In its criteria for assessing construction risk, the EBA identifies the following sub-factor components and establishes four risk categories (category 1 reflects the lowest risk):

• permits and siting
• Category 1: all permits have been obtained.
• Category 2: some permits have not yet been obtained, but their obtaining is considered very probable.
• Category 3: some permits have not yet been obtained, but the granting process is well defined and they are considered routine.
• Category 4: some essential permits remain to be obtained and they are not considered routine. They may be subject to significant conditions.

NBB_2018_29 – 06 December 2018 Circular – Page 15/23

• type of construction contract

• Categories 1 and 2: fixed-price, agreed-date EPC turnkey contract17.

• Category 3: fixed-price, agreed-date turnkey contract with one or more contractors.

• Category 4: no fixed-price turnkey contract or partial contract, and/or interface problems with multiple contractors.

• probability of project completion at the agreed price and within the agreed time

• Category 1: it is almost certain that the project will be completed on time and at the agreed price.

• Category 2: it is very probable that the project will be completed on time and at the agreed price.

• Category 3: it is not certain that the project will be completed on time and at the agreed price.

• Category 4: indications show that the project will not be completed on time and at the agreed price.

• completion guarantees18 or damages19

• Category 1: substantial damages covered by financial means and/or by a solid completion guarantee by promoters in excellent financial condition.

• Category 2: significant damages covered by financial means and/or by a completion guarantee by promoters in good financial condition.

• Category 3: sufficient damages covered by financial means and/or by a completion guarantee by promoters in good financial condition.

• Category 4: insufficient damages, or not covered by financial means or by weak completion guarantees.

• track record and financial solidity of the contractor in the context of other projects of this type

• Category 1: strong

• Category 2: good

• Category 3: satisfactory

• Category 4: weak

The insolvency of the promoter could disrupt construction works and the infrastructure entity might not be able to obtain redress (damages, for example). This is why it is appropriate to be financially solid. If the promoter does not pay the capital upfront, it is advisable to work based on bank guarantees. Damages offer protection in case of losses resulting from deviations from the specifications agreed in the contract and provide appropriate incentives to the construction company. The probability that the infrastructure entity has to rely on the effectiveness of these agreements is considerably reduced if the agreed delays and prices are realistic. It is therefore preferable that substantial damages be covered by financial means

17 By Engineering, Procurement, Construction (EPC) contract, or "turnkey contract", one means an agreement between a contractor specialized in engineering, procurement and construction (EPC contractor) and the project promoter, by which the EPC contractor agrees to carry out the detailed technical design of the project, provide all necessary equipment and materials, construct and deliver to the promoter a facility or asset in working condition, generally within a specified timeframe and according to a budget.

18 A completion guarantee is a guarantee by which the contractor commits to the project lenders to deliver the project within the scheduled time and, if necessary, to bear cost overruns.

19 By damages, one means financial compensation in case of loss, prejudice or harm caused to the rights or property of an individual, granted by court decision or by a contractual clause relating to a breach of contract.

Circulaire – Page 16/23 NBB_2018_29 – 06 December 2018

intended and/or strong completion guarantees issued by promoters with excellent financial health.
The promoter sets up the project and can genuinely influence its characteristics. Consequently, the promoter is likely to hold an information advantage over other investors. They also manage the project on a day-to-day basis. To do so, they must possess the necessary know-how and financial strength, and be properly incentivized to protect other investors.

In its criteria for assessing construction-related risk, the EBA identifies the following sub-factor components and establishes four risk categories (category 1 reflects the lowest risk):

(a) promoter’s financial strength

• Category 1: promoter with solid financial health.
• Category 2: good promoter with good financial health.
• Category 3: promoter with adequate financial health.
• Category 4: weak promoter with proven financial weaknesses.

(b) promoter’s track record and knowledge of the country/sector

• Category 1: promoter with excellent track record and knowledge of the country/sector.
• Category 2: promoter with satisfactory track record and knowledge of the country/sector.
• Category 3: promoter with adequate track record and knowledge of the country/sector.
• Category 4: promoter with non-existent or doubtful track record and knowledge of the country/sector.

(c) promoter’s commitment, evidenced by equity, the ownership clause20, and motivation to inject additional funds if necessary

• Category 1: strong. Project highly strategic for the promoter (core business – long-term strategy).
• Category 2: good. Project strategic for the promoter (core business – long-term strategy).
• Category 3: acceptable. Project important for the promoter (core business).
• Category 4: limited. Project foreign to the promoter’s long-term strategy and core business.

Operational Risks
In its criteria for assessing operational risk, the EBA identifies the following sub-factor components and establishes four risk categories (category 1 reflects the lowest risk). It should be noted that these criteria apply where the operation and/or maintenance of the asset are outsourced, which is not necessarily the case for every project.

• Scope, nature, and complexity of operation and maintenance (O&M) contracts21

20 An ownership clause stipulates that a project cannot be held by any entity other than the actual owner (the promoter).
21 An operation and maintenance (O&M) contract is a contract concluded between the designer and the operator. The designer delegates the operation, maintenance, and often the performance management of the project to an operator with specific know-how, according to the terms of the contract (scope, duration, operator’s liability, fees, and damages).

NBB_2018_29 – 06 December 2018 Circulaire – Page 17/23

• Category 1: solid long-term operation and maintenance contract, preferably with performance clauses22 and/or reserve accounts23, although such a contract is not strictly necessary to perform the required maintenance, given that the works are simple and transparent.

• Category 2: operation and maintenance works are relatively simple and transparent, and there is a long-term contract and/or reserve accounts.

• Category 3: operation and maintenance works are complex and a contract is necessary. The contract and/or reserve accounts are limited.

• Category 4: operation and maintenance works are complex and a contract is strictly necessary. There is no contract, leading to a risk of significant operational cost overruns exceeding mitigation mechanisms.

• Operator’s know-how, track record, and financial strength

• Category 1: very strong, with promoters’ commitment to provide technical assistance

• Category 2: strong

• Category 3: acceptable

• Category 4: limited/weak, or local operator dependent on local authorities

Design and Technology Risk
Technological or design problems may prevent the infrastructure entity from providing the services stipulated in the contract. Less severely, they could lead to delays or higher costs than expected. Studies indicate that problems related to technology or design during the construction or operational start-up phase, as well as operational underperformance, often linked to technology or design problems, are one of the main causes of payment default. To ensure that innovative projects are risk-free, insurers should exercise due diligence to verify if the technology is proven, preferably based on a technical analysis. Prototype tests, pilot tests, or other types of tests can provide proof that the project’s technology and design are of quality.

In its criteria for assessing design and technology risk, the EBA identifies the following sub-factor and establishes four risk categories (category 1 reflects the lowest risk):

• design and technology risk
• Categories 1 and 2: technology and design have been fully proven.
• Category 3: technology and design have been proven – start-up problems compensated by strong completion guarantees.
• Category 4: technology and design have not been proven; there are technical difficulties and/or the design is complex.

Financial Risk
A project’s ability to service its debt depends on the risk associated with the cash flows generated for investors as well as the capital structure. The higher the leverage, the more vulnerable the project becomes to lower-than-expected cash flows. The level of indebtedness should therefore be proportional to the risks associated with the project.

The infrastructure entity’s capital structure allows it to service all its debt based on very robust assumptions, provided the following conditions are met:
(a) compared to market practices, the relevant financial ratios regarding the level of risk and based on very robust assumptions are solid; (b) where applicable, the ratios take into account post-maturity cash flows for all debts.

In the event of necessary debt refinancing, the project relies on the willingness of new lenders to provide funds. Depending on the project’s financial situation and conditions on financial markets, this refinancing might only be possible at the price of unfavorable terms (which would have detrimental effects on existing debt and equity investors) or, in the worst case, not be feasible at all. The refinancing risk should therefore be low.

Derivatives should only be used to mitigate risks related to operation and its financing. “Speculative” derivatives should not be authorized.

In its criteria for assessing financial risk, the EBA identifies the following sub-factor components and establishes four risk categories (category 1 reflects the lowest risk):

(a) financial ratios such as, for example, debt service coverage ratio [DSCR24], interest coverage ratio (ICR25), loan life coverage ratio [LLCR26], project life coverage ratio, and debt-to-equity ratio

• Category 1: solid financial ratios given the project’s risk level; very strict underlying economic assumptions.
• Category 2: solid to acceptable financial ratios given the project’s risk level; strict underlying economic assumptions.
• Category 3: standard financial ratios given the project’s risk level.
• Category 4: inadequate financial ratios given the project’s risk level.

(b) financial structure

• Repayment plan (sub-factor component)
• Category 1: scheduled repayments without bullet repayment.

24 The debt service coverage ratio (“DSCR”) is equal to the ratio between the available cash flow for debt service that the asset can generate and the required repayment of principal and interest over the loan term, where available cash flow is calculated by subtracting from the revenues generated by the project the operating expenses, investment expenditures, debt or equity financing, taxes, and working capital adjustments. 25 The interest coverage ratio (“ICR”) is equal to the ratio between the available cash flow for debt service that the asset can generate and the required repayment of interest over the loan term, where available cash flow is calculated by subtracting from the revenues generated by the project the operating expenses, investment expenditures, debt or equity financing, taxes, and working capital adjustments. 26 The loan life coverage ratio (“LLCR”) is equal to the ratio between the net present value of the available cash flow for debt service and the outstanding balance, and reflects the number of times the available cash flow for debt service allows repaying the outstanding balance over the loan term, where available cash flow is calculated by subtracting from the revenues generated by the project the operating expenses, investment expenditures, debt or equity financing, taxes, and working capital adjustments.

NBB_2018_29 – 06 December 2018 Circulaire – Page 19/23

• Category 2: scheduled repayments without bullet repayment or with insignificant bullet repayment.

• Category 3: scheduled repayments with limited bullet repayment.

• Category 4: bullet repayment or scheduled repayments with significant bullet repayment.

• Market/cycle risk and refinancing risk (sub-factor component)

• Category 1: little or very little exposure to market or cycle risk because expected cash flows cover all future loan repayments over its entire duration27 and there are no significant delays between cash flows and repayments. Refinancing risk is null or very low.

• Category 2: limited exposure to market or cycle risk because expected cash flows cover the majority of future loan repayments over its entire duration and there are no significant delays between cash flows and repayments. Refinancing risk is low.

• Category 3: moderate exposure to market or cycle risk because expected cash flows cover only part of the future loan repayments over its entire duration or there are some significant delays between cash flows and repayments. Refinancing risk is medium.

• Category 4: high exposure to market or cycle risk because expected cash flows cover only a small part of the future loan repayments over its entire duration or there are significant delays between cash flows and repayments. Refinancing risk is high.

3. Criteria – Investments in Eligible Infrastructure Companies
As stated in Article 164ter, for the purposes of this Regulation, investments in eligible infrastructure companies are investments made in an infrastructure entity that meets the following criteria:

1. the majority of the infrastructure entity’s revenues arise from owning, financing, developing, or operating infrastructure assets located in the EEA or OECD;
2. the revenues generated by the infrastructure assets meet one of the criteria set out in Article 164bis, paragraph 2, point a);
3. when the infrastructure entity’s revenues do not come from payments made by a large number of users, the party committing to purchase the goods or services provided by the infrastructure entity is one of the entities referred to in Article 164bis, paragraph 2, point b);
4. revenues are diversified in terms of activities, location, or payers, unless they are subject to rate-of-return regulation under Article 164bis, paragraph 1, point c) a) ii), are subject to a take-or-pay contract, or are based on availability;

27 The loan term corresponds to the remaining repayment period of that loan.

Circulaire – Page 20/23 NBB_2018_29 – 06 December 2018

5. when investments are in bonds or loans, the insurance or reinsurance undertaking can demonstrate to its supervisory authority that it is able to hold the investment until maturity;
6. when there is no credit rating established by a designated ECAI for the infrastructure entity: a) the infrastructure company’s capital structure allows it to service all its debts under prudent assumptions based on an analysis of relevant financial ratios; b) the infrastructure entity has been active for at least three years or, in the case of an acquired company, it has been operating for at least three years;
7. when a credit rating established by a designated ECAI is available for the infrastructure entity, it shows a credit quality scale between 0 and 3.

4. Risk Management for Eligible Infrastructure Investments or Investments in Eligible Infrastructure Companies
Article 261a: risk management for eligible infrastructure investments or investments in eligible infrastructure companies

1. Before making an eligible infrastructure investment or an investment in an eligible infrastructure company, insurance and reinsurance undertakings exercise due diligence, which includes in particular the following measures:
(a) a documented assessment of the infrastructure entity’s compliance with the criteria set out in Article 164bis or Article 164ter, which has undergone a validation process, conducted by persons who are not subject to the influence of the persons responsible for assessing compliance with the criteria and have no potential conflict of interest with them; (b) confirmation that any financial modeling of the infrastructure entity’s cash flows has undergone a validation process, conducted by persons who are not subject to the influence of the persons responsible for developing the financial modeling and have no potential conflict of interest with them.

2. Insurance and reinsurance undertakings holding an eligible infrastructure investment or an investment in an eligible infrastructure company exercise regular monitoring and conduct regular stress tests on the cash flows and the value of the security benefits enjoyed by the infrastructure entity. The stress tests are proportional to the nature, scale, and complexity of the risk inherent in the infrastructure project.

3. The stress test takes into account risks arising from activities other than infrastructure, but revenues generated by such activities are not taken into account to determine whether the infrastructure entity is able to honor its financial commitments.

4. When establishing the written policies referred to in Article 41, paragraph 3, of Directive 2009/138/EC, insurance or reinsurance undertakings holding significant eligible infrastructure investments, or investments in eligible infrastructure companies, include in these written policies provisions providing for active monitoring of these investments during the construction phase and maximization of recoverable amounts for these investments in a liquidation scenario.

NBB_2018_29 – 06 December 2018 Circulaire – Page 21/23

5. Insurance or reinsurance undertakings holding an eligible infrastructure investment or an eligible infrastructure company investment in the form of bonds or loans structure their asset-liability management so as to be permanently able to hold this investment until maturity.

All risks related to infrastructure, whether they meet the eligibility criteria or not, must be managed in accordance with the “prudent person” principle (Articles 190 to 193 of the Insurance Control Law) and in accordance with the effective risk management system (Articles 42 and 84 to 90 of the Insurance Control Law).

Infrastructure investments can involve complex risks, which can vary considerably from one type of infrastructure project to another. These risks will often differ from those that insurance undertakings are accustomed to managing, whether they relate to the technical feasibility of the project, construction-related or political risks, or the extent to which contractual clauses compensate for contingencies throughout the project’s duration.

Therefore, some clarifications should be provided to ensure that undertakings are fully aware of the risks associated with their participation in infrastructure projects, and are able to monitor and manage them over time. Most of the requirements proposed in the draft opinion are related to the points or risks covered by the eligibility criteria.

Within their risk management system, undertakings must establish written policies covering all significant risks to which they are exposed. When undertakings invest in infrastructure projects, these policies should address the management of associated risks, and in particular investment risk management, asset-liability management, liquidity risk management, and concentration risk management. Regarding investment risk management, measures to be taken to comply with the prudent person principle must be included.

Given the specific risks presented by infrastructure projects, and in particular their illiquid nature, the NBB considers that undertakings investing in infrastructure projects should pay special and full attention to how such investments would comply with the prudent person principle. The Bank is of the opinion that its guidelines on unusual investment activities constitute a relevant reference in this matter. It could be expected that these requirements would be in compliance with Articles 190 to 193 of the Insurance Control Law.

Nevertheless, given the principles-based approach, the Bank believes it is important to ensure that undertakings are able to demonstrate that they understand the risks associated with each investment in an infrastructure project, as well as its appropriateness relative to their activity.

Regarding the understanding of the project, it is considered good practice to document the following subjects:

• the project context
• the project’s scale
• operational responsibility
• the schedule
• resources and uses of funds
• the parties involved
• the contractual structure
• the main financing terms and conditions

The Bank has presented its expectations in this regard in its guidelines on corporate governance systems, notably for the following points: appropriate assessment and verification;

Care, competence, and delegation; monitoring obligation; obligation to protect the interests of policyholders and beneficiaries; principle of diversification. Regarding diversification, it is considered good practice to diversify both the infrastructure investment portfolio and the overall investment portfolio.

Regarding the requirement for care, competence, and delegation, the Bank is aware that many insurance companies may need time to establish their know-how. In accordance with Article 42, paragraph 1, point 3, of the Insurance Control Act, companies must assess whether the persons performing tasks related to infrastructure projects within the risk management function are able to carry them out. They may also need to engage third parties; the intervention of experts in various fields will likely be necessary and is very common in project finance. When relying on external experts or asset managers, companies must be aware of their responsibilities regarding subcontracting in accordance with Article 92 of the Insurance Control Act and proceed on the assumption that their investments in infrastructure projects may constitute a critical or important activity.

Financial Model
The financial model used to forecast the future results of infrastructure assets is one of the essential tools for assessing project-related risks before investing. A conflict of interest may arise when such a model is provided by the project promoter, who has every interest in minimizing risks to obtain project financing. Independent validation should mitigate the risk that the model gives an inaccurate picture of project-related risks. When the model is provided by the project promoter, this validation can be carried out by the company itself, if it has the necessary know-how, or by another third party. If it is an internal model of the company, it should be subject to an independent internal review, for example by the risk management function or the actuarial function, or by an independent third party. Companies should be able to demonstrate that they understand and can challenge the assumptions on which the model is based.

Monitoring
Throughout the duration of the project, investors may need to take proactive measures to resolve problems that arise, such as the failure of the construction or operating company. In the event of financial difficulties at the level of the project as a whole, it is important that investors are able to recover their investment as best as possible. It is proven that recovery rates for infrastructure projects are significantly lower in the case of a fire sale than in the case of restructuring, which highlights the need for debt recovery capabilities. The risk of such an event occurring is normally higher during the construction phase. Consequently, the Bank considers that, as part of the implementation of adequate monitoring procedures, it is important that companies actively monitor their significant exposures, particularly during the construction phase, and, if the project encounters financial difficulties, maximize the recovery value. The Bank expects these procedures to define when a "restructuring" situation will be declared, what measures are envisaged, and which parties would be contacted. This does not necessarily mean that companies should engage specialized "restructuring" experts; in some cases, they may benefit from the services of a "lead" party, which could be a bank.

Hold to Maturity
Although investments in infrastructure projects are illiquid and it is intended to hold them to maturity, it is important that these assets be managed actively. As with all investments they normally make, companies must, when an infrastructure project does not yield the expected results, assess whether the investment still meets the prudent person principle and meets their investment objectives. Depending on the importance of their infrastructure project risks and although it may not be possible to sell these assets, companies may need to make investment or divestment decisions within their portfolio to ensure that they can continue to honor their commitments to policyholders when they come due. As part of their monitoring and as provided for in Article 269, paragraph 1, point d), of the Delegated Regulation for any material risk, companies must also ensure that the level of reporting internal to their administrative, management, or supervisory body28 is adequate.

A copy of this circular is sent to the auditor(s), approved auditor(s) of your establishment.

Please accept, Madam, Sir, our distinguished salutations.

Jan Smets
Governor

Annexes: 2

28 Both at the management committee and the board of directors.