Author: Wang Jihong Gao Lei
At the end of 2010, the total assets of the Chinese insurance industry topped RMB5 trillion, and the insurance funds available for use amounted to RMB4.6 trillion.
The ways in which insurance funds can be used have been broadened under the new PRC Insurance Law and the Investment of Insurance Funds in Debt Investment Schemes for Infrastructure Notice. In addition, the Investment of Insurance Funds In Immovable Property Interim Measures issued in 2010 even allows insurance funds to invest in immovable property, including government land reserve projects, whether by means of debt, property or equity. Debt investment in government land reserve projects offers low risk, a long cycle, and guaranteed returns. These characteristics satisfy the regulatory requirements of the China Insurance Regulatory Commission (CIRC), spreading risk and offering the potential to preserve and increase the value of insurance funds.
The main participants in debt investment in government land reserve projects are the principal, agent, beneficiary, user of funds, guarantor, custodian and the independent supervisor of the investment scheme. Typically, a principal engages an agent to establish a debt investment scheme and enters into an “debt investment scheme investment contract” with a user of funds; a guarantor guarantees the scheduled repayment of the principal and interest; and the principal releases funds to the user of funds through a custodian.
After the debt investment scheme expires, the user of funds pays the principal and interest to the custodian who distributes this to beneficiaries; and the beneficiaries appoint an independent supervisor to monitor the agent and the user of funds.
· Principal: the principal may be an insurance company, an insurance group company or an insurance holding company which is approved by the CIRC. It engages an agent with funds to set up the investment scheme. After an investment scheme is established, the insurance company, insurance group company or insurance holding company will pay the trust funds into a custody account.
· Agent: the agent may be a trust and investment company, an insurance asset management company, an industry investment fund management company or another specialized management institution which invests in infrastructure projects in its own name as agreed under an investment scheme, according to the intentions of a principal and in the interests of a beneficiary.
· Beneficiary: a beneficiary may be a person who lawfully holds a share of the beneficial interest in an investment scheme and is recorded in its register of beneficiaries, including the beneficiaries designated by a principal at the time of establishment of the investment scheme, and persons who hold a share of the beneficial interest in the future through transfer, inheritance or other legal means. A beneficiary may be a principal, agent or a third party designated by a principal (such as a subsidiary of a principal).
· User of funds: user of funds means a project manager under an investment scheme. In land reserve projects, it usually refers to a developer with first-grade qualifications for land development.
· Guarantor: a guarantor is a third party which provides a guarantee on behalf of a user of funds for the performance of an “investment contract for a debt investment scheme”. It is usually a financially strong enterprise such as a central enterprise or a financial institution with good ratings.
· Custodian: a custodian is a commercial bank or other specialized financial institution engaged by a principal as stipulated under an investment scheme to be an agent of property.
· Independent supervisor: an independent supervisor is a specialized management institution engaged by a beneficiary as stipulated under an investment scheme to supervise the operations of the party that manages the investment scheme and the agent to safeguard the interests of the beneficiary.
Mode of operation
According to current Chinese law and practice, we believe insurance funds may invest in government land reserve projects through a debt investment scheme in four ways. In this article, wewill briefly look at two of those ways.
Agent not involved in the development
In this structure, an agent sets up a debt investment scheme and is engaged by a principal to inject insurance funds through the scheme directly into a company with first-grade qualifications for land development. A guarantor provides the developer with a guarantee for the scheduled repayment of the principal and the interest; a custodian releases the insurance funds to the developer which uses part of the funds, under the supervision of an independent supervisor, to carry out development and construction works in accordance with the debt investment scheme signed with the agent. After the debt investment scheme expires, the developer pays the principal and the interest to a custodian who distributes it to beneficiaries.
This structure involves relatively simple legal relationships, is easy to operate and relatively low-risk, and generates relatively fixed income levels and relatively narrow profit margins. A key requirement is to ensure the guarantor has the capability to provide a guarantee. Therefore, adequate due diligence on the user of funds and on the guarantor must be carried out.
Agent involved in the development
An agent establishes a debt investment scheme as engaged by a principal to inject insurance funds through the scheme directly into a company qualified for development. The agent and the developer form a joint entity to develop the land and share profits. Under this structure, as the agent may share the profit from the development of the land, the profit margins the insurance fund may enjoy are higher than under the first structure, however, the agent will also take more risk during the development process. The agent should control these risks through negotiations between the joint entity and other parties or local governments and the appropriate drafting of contractual terms.
Insurance funds can invest in government land reserve projects through a debt investment scheme in four ways.
Under this arrangement, a trustee is instructed by a principal to establish a debt investment scheme, through which insurance funds are channelled into a project company jointly funded by the trustee and a developer. The project company will take charge of the development of land reserve projects. The trustee and the developer will be the shareholders of the project company and will share any profits from the development. In this model the trustee, as a shareholder of the project company, has limited exposure to liability during the initial phase of preparing land for development.
With respect to the apportionment of liability between entities, the trustee is exposed to lower risk than in the second model discussed in the previous issue. However, difficulties may arise if the project company is unable to obtain the permissions required for the development in a short period of time.
In the build-transfer (BT) model, the government enters into a franchise agreement with an investor (which may be a state-owned enterprise, private company or foreign investment enterprise). Under this agreement, an infrastructure project is franchised to the investor (the franchisee) for financing and construction. Upon completion of the project, the franchisee will transfer the project to the government or its authorized agencies, and the government will pay the franchisee a buy-back price within an agreed period.
Where investment is made in preparatory land development projects using a BT structure, a trustee and a developer will acquire a BT franchise and jointly set up a project company. The trustee will channel insurance funds into the project company via a debt investment scheme, and the project company will conclude a BT franchise contract withthe government under which the development costs and profits of the project company will be stated. The project company will be responsible for raising and investing the funds required for development and construction, and for carrying out the construction.
The project company will deliver the completed project to the government, which will pay a buy-back price accordingly to the project company. The buy-back price will be paid in stages, generally over a period of three to five years.
After the government pays the buy-back price to the project company, the project company will pay the principal and interest to a custodian in accordance with the debt investment scheme, and the custodian will then distribute this to beneficiaries.
Compared with the other three investment models, BT franchising offers more security for insurance funds and more scope for an increase in value, for a number of reasons.
First, when a local government enters into a BT franchise contract, it must already have secured the buy-back funding for the project. This means the buy-back funding will be incorporated into that local government’s expenditure and investment plans, and will be issued with approval documents from the People’s Congress at the same level, as well as a written undertaking by the government’s finance department. In practice, some local governments have set up a financial account exclusively for buy-back funding. After proceeds from land transfers, local tax revenues and other local revenues are submitted to the local treasury, they will be transferred directly to the buy-back fund account. Details of the balance of the account should be made available to investors every quarter. The extra security therefore inherent in the BT franchising model complies with the regulatory requirements of the China Insurance Regulatory Commission for the security of insurance funds.
Second, the government is usually required to guarantee a buy-back project. Guarantees may be provided by means of a letter of guarantee from a bank, or a joint-and-several-liability guarantee by a local state-owned enterprise. In addition to these legally binding, “hard” guarantees, thereare also some “soft” guarantees, i.e. under takings by governments which do not have strict legal effect. For example, some local governments may undertake that an investor can carry out the preparation and full-scale development of land, while others may undertake that the land grant fee for a designated piece of “undeveloped land” in a certain area will first be used to pay the buy-back price to an investor. This kind of double guarantee from the government will serve to ensure a project company can receive buy-back money as scheduled, and will be able to distribute the principal of insurance funds and the interest thereon to beneficiaries through a custodian as agreed under its debt investment scheme.
Third, when entering into a BT franchise contract, a project company can often negotiate with the government over investment profits and tax concessions. Given that there is currently no national legislation in China governing infrastructure franchising, and the approach to infrastructure franchising varies among local governments, there is plenty of scope for negotiation over the cost structure, return on investment and tax concessions in a development project. This can offer insurance funds a promising outlook for the preservation and creation of value.
Know local regulations
All of the above suggests that in comparison with other models, the BT franchising model is advantageous in terms of security as well as the preservation and creation of value for insurance funds. However, this model involves more complex legal relations. Familiarity with local regulations in the place where a project is located, as well as the concerns and practices of local governments, are essential factors which determine whether a trustee is able to secure the maximum return on investment.