The second generation of European prudential regulation for insurance companies has received a rare industry accolade, through a report by Standard & Poor’s (S&P) underlining how some of the new features could entice large institutional investors to invest more in infrastructure.
Solvency II, as the revamped framework is known, has so far received mixed reviews from insurers as many think the higher capital requirements it requires for infrastructure investments will limit their ability to deploy money in the asset class. Yet the rating agency notes that Solvency II will allow investors to use two different models to assess the risk, and thus the capital charges, associated with a given set of infrastructure assets.
S&P recognises that the standard formula, which takes a more conservative approach and thus imposes more stringent restrictions on insurers than Solvency I, could indeed detract smaller institutions from investing in infrastructure.
But insurance companies, typically larger ones, will also have the option to develop and use internal models to evaluate risk – provided they’re first approved by the regulator. As such, institutions with in-house capabilities will be able to better tailor their investments in accordance with their risk-return profiles, so as to more closely match assets with liabilities.
This, S&P notes, was not possible under previous regulation: instead of relying on capital requirements, Solvency I only involves asset admissibility limits (maximum amounts of a certain asset an investor can hold).
“We anticipate that the majority of sophisticated insurers will prefer to have their internal model approved because this will help them align their risk management and regulatory capital management processes,” the report said.
A side effect of the regulation, in addition to improving the creditworthiness of insurers and bringing about more stable regulation, will be to avoid an investor gold rush towards the asset class – which would put it in a vulnerable situation should institutions suddenly realise there are investments with better risk/return characteristics, for example if interest rates start to rise.
The rating agency sees a couple of caveats, at least in the short term: it’s not yet clear regulators will tolerate internal models that offer markedly different calibrations than the standard formula; it also remains to be seen whether such tolerance will be consistently applied by supervisors across the EU’s various jurisdictions.
But S&P thinks insurers can play a significant part in plugging what it sees as a $500 billion annual need in private infrastructure investment up to 2030. The rating agency estimates that insurance companies worldwide will increase their allocations to infrastructure from 2 percent to 3 percent by 2035, enough to inject an annual $80 billion of new money in the asset class over the next two decades.