1. Supervisory basis

Pursuant to section 2 (1) no. 4 a) of the Investment Regulation (Anlageverordnung – AnlV), the restricted assets of insurance undertakings may be invested in “loans to undertakings ..., if on the basis of the past and expected future development of the net assets and results of operations of the undertaking the contractual interest payment and repayment appear to be guaranteed [i] and if the loans are adequately secured [ii].” Accordingly, two assessments must be performed when granting a loan, a credit assessment (i) and a collateral security assessment (ii).

As set out in Circular 4/2011 (VA) and the “Principles for the Granting of Loans to Companies by Insurance Undertakings – Borrower’s Note Loans” (“Grundsätze für die Vergabe von Unternehmenskrediten durch Versicherungsgesellschaften – Schuldscheindarlehen”), formerly known as “Credit Guidelines” (“Kreditleitfaden”), issued by the German Insurance Association (GDV) in consultation with BaFin, insurance undertakings have two options to assess the credit quality of borrowers (i):

1. assessment based on the company’s ratios stated in the Credit Guidelines, which must comply with the minimum requirements set forth therein or
2. assessment based on a long-term rating by a recognised rating agency that is at least investment grade quality when the loan is granted.

The Credit Guidelines explain in their preliminary remarks that the financial ratios are based on the ratios the rating agencies consider necessary to maintain an investment grade rating so that an analogy is established to the approval of external investment grade ratings as a prerequisite for making a loan eligible to be included in the guarantee assets (Sicherungsvermögen). The aim is that criteria for assessing the credit quality should be equally strict for both assessment options.

The Credit Guidelines thus primarily apply if the borrowing company is not rated in line with the market and the insurance undertaking has to assess the credit quality itself.

In accordance with section 2 (1) no. 4 a), aa) to cc) of the AnlV, loans may be collateralised (ii) in three different manners:

aa) by first-ranking land charges,

bb) by receivables which are pledged or transferred as collateral or by securities admitted to trading on a stock exchange or admitted to another organised market pursuant to section 2 (5) of the Securities Trading Act (Wertpapierhandelsgesetz – WpHG) or included in such market, or

cc) in a similar manner ...; a formal commitment issued by the borrower to the insurance undertaking (negative pledge) may serve as collateral instead only if and for as long as the status of the borrower alone is guarantee for interest payment and repayment of the loan“.

The requirements imposed by the legislature on borrowers are particularly strict with regard to collateralisation by means of a negative pledge as set out in point cc), since this type of collateralisation is eligible and thus equivalent to collateralisation pursuant to points aa) and bb) only “if and for as long as the status of the borrower alone is guarantee for interest payment and repayment of the loan requirements”. Without the particularly strict requirement on credit quality set out in point cc), the collateralisation options under points aa) and bb) would be superfluous, since nobody would use them.

In its Circular 4/2011 (VA) part B.4.3 d) BaFin therefore stated that the borrower must be “prime rated” (see government draft in respect of section 54a of the Insurance Supervision Act (Versicherungsaufsichtsgesetz – VAG) of 4 March 1994, BT-Drucksache 12/6959, p. 76).

2. Administrative practice of the supervisory authority with regard to negative pledges

Until 1995 loans that were not collateralised by land charges but were based only on a negative pledge and compliance with the financial ratios were subject to approval by the insurance supervisory authority.

In the following years, the insurance supervisory authority issued several circulars and official bulletins based on the term “prime-rated” used in the above government draft in which it required undertakings intending to collateralise a loan by means of a negative pledge to document that the borrower is pre-eminent in its sector, that the financial ratios set out in the Credit Guidelines show a particularly good credit quality and that compliance with the financial ratios has been contractually agreed for the entire term of the loan. Assessments made on the basis of the company’s ratios must show the status of the borrower as set out in section 2 (1) no. 4 a) cc) of the AnlV. The status is in particular based on:

• more stringent requirements with regard to the ratios capital structure “risk bearing capital”(27% compared with 20% for collateralised loans) and “total debt/capital” (no more than 50% compared with up to 60% for collateralised loans),

• the exclusion of compensation among the core ratios and

• an extraordinary call right for contracts stipulating compliance with financial ratios during the entire term of the loan if there is a breach of ratio.

When long-term rating was added as a second option to assess the credit quality of borrowers (see Circular 15/2005 (VA)), BaFin examined whether a negative pledge can serve as a collateral also in this case. For this purpose, long-term ratings of e.g. AA and AAA (S&P) were applied to justify the classification of a borrower as “prime-rated”. As a consequence, BaFin considered it reasonable to ease the principles further and allow borrowers with a long-term rating of at least e.g. A- (Fitch, S&P) or A3 (Moody’s) to be classified as particularly highly rated. However, other circumstances or risks may not indicate that a differing negative assessment is more appropriate (see Circular 4/2011 (VA) part B.4.3 d)) If the borrower is split-rated, the lower rating will apply.

Taking account of both options for assessing a borrower’s credit quality, Circular 4/2011 (VA) defines “prime-rated” borrowers as particularly highly rated companies (i.e. the company’s ratios indicate a particularly high credit quality or a long-term rating of at least e.g. A- (Fitch, S&P) or A3 (Moody’s) that are pre-eminent in their sector. The insurance undertaking must document this appropriately when granting the loan.

In the case of borrowers that are not at the same time represented by listed debt instruments on the capital markets, the Supervisory Authority also continues to expect an unrestricted negative pledge under which the commitment by the borrower not to grant any other creditors better rights or collateral than the lender refers to all loan liabilities and is not limited to “capital market liabilities” or “financial liabilities” (see Circular 4/2011 (VA) part B.4.3 d)). While it is permitted to adjust the model contracts comprised in the Credit Guidelines individually, such adjustments may not result in diminishing the security of the loan. Any limitation of the commitment by the borrower to “capital market liabilities” would permit borrowers to additionally take out unlimited amounts of bank loans or to additionally take out bank loans to cover future capital market liabilities. In such a case the loan granted by the insurance undertaking would be subordinated to the bank loan, with the total indebtedness of the borrower remaining the same.

The only case where the supervisory authority does not accept collateralisation by means of an unrestricted negative pledge is when borrowers are the same time represented by listed debt instruments on the capital markets, to ensure that such borrowers are not put at a disadvantage against purchasers of listed debt instruments.

3. Addition of investments which do not meet the requirements set out above

The strictness of the above requirements with regard to collateralisation under section 54 (1) of the VAG when granting a loan pursuant to section 2 (1) no. 4 a) of the AnlV takes into account that 50% of the investments in the restricted assets may be invested in loans in accordance with section 2 (1) nos. 3, 4 a) of the AnlV and assets in accordance with section 2 (1) no. 11 of the AnlV (see Circular 4/2011 (VA) part B.3.4 d)).

In the area of investments with standard market ratings, Circular 4/2011 (VA) part B.3.1 e) permits up to 5% of the restricted assets to be invested in so-called high-yield bonds with at least a rating of e.g. B- (Fitch, S&P) or B3 (Moody’s), provided that the risk-bearing capacity is adequate.

At the same time, the Insurance Supervisor will not object if, within the 50% minimum diversification requirement for loans in accordance with section 2 (1) nos. 3, 4 a) of the AnlV and investments in accordance with section 2 (1) no. 11 of the AnlV, up to 5% of the restricted assets are invested in borrower’s note loans that do not meet in full the requirements specified in point 2 above for collateralisation by means of a negative pledge (in particular a minimum rating of the borrower of e.g. A- or A3 and/or an unrestricted negative pledge in the case of non-publicly traded borrowers). At a minimum, however, these loans must have an investment grade rating (e.g. BBB-/Baa3) for the borrower resulting from the credit assessment. As a result, this 5% loan ratio cannot be additionally subjected to the risk asset ratio, in contrast to the high yield ratio.

If the credit quality of the borrower is assessed based on the company’s ratios stated in the Credit Guidelines, compliance with the financial ratios during the entire term of the contract must be contractually agreed for loans collateralised by means of a negative pledge. The borrower has an extraordinary call right in the event of a breach of ratio (see above). This call right, however, is not or only reluctantly accepted by several prime-rated borrowers since the calling of the loan would entitle all other lenders to exercise their respective extraordinary call rights (cross default clause) and the entire business finance could collapse. For this reason, the insurance supervisory authority will in future permit borrowers to collateralise a loan by means of a negative pledge even if compliance with the financial ratios during the entire term of the contract has not been contractually agreed. Such loans must be counted towards the 5% loan ratio and reported in financial statement form 670 page 1 line 21 with reference to Collective Decree of 21 June 2011. The company’s ratios shall continue to be complied with even if compliance has not been explicitly stipulated in the contract and there is no extraordinary call right. If there is a breach of ratio, loans with adequate security can only be hold in accordance with the opening clause (see section 2 (2) of the AnlV) and must be reported by the end of the quarter in financial statement form 670 page 6 lines 12 and 16.

Overall, the requirements with regard to borrower’s note loans continue to be stricter than the requirements imposed with regard to debt instruments.