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Fitch Ratings : internal model key to insurers’ infrastructure investment

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The future ability of insurance firms to invest in infrastructure projects is likely to depend heavily on whether they use internal models to determine their Solvency II capital requirements and can persuade regulators that infrastructure investment merits lower capital reserves, Fitch Ratings says.

Insurers operating under Solvency II will be able to use either a standard formula or, if they have more sophisticated risk modelling, an advanced approach that would need to be approved by their regulator. Infrastructure investments can be suited to insurers because their cash flow features and long duration are a good match for the long-term liabilities that insurers have. However, these investments are treated penally under current proposals for the standard formula and the high capital charges mean that the risk-adjusted returns would be relatively low.

Every infrastructure project is different and risk can vary significantly between projects. We believe insurers operating under the internal model may be able to persuade regulators that they should attract a significantly smaller capital charge, although this will require them to show that the investment can be modelled adequately. This would put infrastructure investments among only a relatively small number of asset classes where internal models will offer capital relief.

We believe other assets in this category are likely to include continental European property, where the stress under the standard formula is 25%. This is in line with UK property volatility, but the continental European market is historically less volatile and implies a stress of 12-15%. Certain structured products, such as asset-backed securities and mortgage-backed securities may also benefit under the internal model if sufficient data is available and the risk profile of the underlying investments justifies a lower capital charge.

For equities and bonds, we believe charges are calibrated in line with the market average volatility. An insurer’s internal model could still provide relief if the insurer were holding assets that were not in line with the index used to set the charge. However, we believe the main benefit from internal models in terms of capital reduction will be where there are complicated risk reduction strategies or group structures, complex risk-sharing with policyholders or above-average geographical diversification.