Infrastructure as an asset class is hardly a new idea. Retirement funds are attracted to the promise of higher turns, long-dated cash flows, and consistency with increasingly important ESG factors.
Insurers, unlikely retirement funds, have to hold risk-based capital against the risks inherent in their investments. This makes it more difficult to underestimate the risks and services as a deterrent to large allocations.
Infrastructure assets can play a part in linked funds for life insurers, where the investment risk is passed straight back to the policyholders and no market risk capital is held by the insurer.
Under this policy construction, the risks can be similar to a defined benefit retirement fund. These include the practical challenges of pricing and valuation, and conduct and fairness issues of managing investment and divestment prices, liquidity with large withdrawals and transparency of pricing.
These liquidity constraints also make this a poor investment for non-life insurers or smaller life insurers, especially where they primarily write risk business.
Where are alternative assets used in insurance?
The three areas where infrastructure assets have a meaningful place to play in insurance are:
1. As a part of a portfolio of assets for long-dated, predictable and illiquid annuity liabilities.
2. Part of a with-profits portfolio, whether this is accumulation phase or with profit annuities in payment.
3. Part of large, well-capitalised insurer’s shareholder portfolio, subject to risk appetite constraints.
How are infrastructure assets treated for insurers for regulatory purposes
In 2014, EIOPA started to consider whether the Solvency II regulations would discourage insurers to invest in infrastructure assets. It was carefully phrased as “removing disincentives” but the line between that and deliberate incentives for insurers to invest in infrastructure assets is invisible.
Right towards the end of the development of South Africa’s Solvency Assessment and Management (SAM) regulatory overhaul, Task Groups of the SAM project were asked whether any adjustments were recommended.
Technical Provisions adjustments for infrastructure assets
The answer from the Technical Provisions Task Group was “no”. Technical Provisions were intended to be market consistent and, with possible exceptions for illiquidity premium / matching adjustments (already a part of the regulations) returns on assets should not, in general, affect the measurement of liabilities.
The illiquidity premium is still very much relevant. Up to 50bps can be added to the risk-free yield curve for discounting life annuity cash flows, provided the backing assets are a good cash flow match and are managed separately from the rest of the portfolio. The illiquidity premium is calculated as 50% of the spread achieved on the matching assets.
In South Africa, most of the available corporate paper available to generate spreads has a term of five years or less. This greatly reduces the effective average spread that can be applied. Longer-term (20 or 40 year) infrastructure debt-based investments are very welcome in this scenario.
This allowance is not specific to infrastructure assets, but is important as part of the overall capital assessment of infrastructure assets.
It’s worth mentioning that the European Solvency II “matching adjustment” is far more generous. I regularly experience actuaries or consultants from the UK talking up great plans for assets in a SAM environment, assuming that the rules are the same in South Africa as they are across Europe.
(The volatility adjustment in theory also has a place in this discussion, but that’s a bigger topic and typically a smaller impact in any case.)
Solvency Capital Requirement (SCR) adjustment for infrastructure assets
The Capital Requirements Task Group followed the European lead and allowed reductions in the equity shock and spread shock that would be applied to qualifying, high quality, infrastructure investments.
- 33% shock for equity (which is 77% of the “SA equity” shock, or about 70% of “Other Equities” shock, which I’d argue would be the most typical classification in the absence of an infrastructure asset class)
- Symmetric adjustment = 77% of SA equity
- 70% of spread shock for debt
- 65% illiquidity premium shock
The 65% shock to the illiquidity premium is not specific to infrastructure. It’s also complete irrational and greatly reduces the benefit of the very limited illiquidity premium in the first place.
- The stated risk here is a narrowing of the illiquidity premium, but this could only be realized through an increase in the relevant asset prices, matched with an increase in liabilities with no net impact. Since the shock is defined as “A 65% fall in the value of the illiquidity premium used in the valuation of technical Provisions” there is no offset for the asset of this calculation.
- The actual risk, if there were one, would be an increase in illiquidity premiums in the market, resulting in a decrease in asset values, only partially offset by a decrease in liability values due to the 50bps cap.)
Impact of SCR relief
The impact of lower SCR on after cost-of-capital investment returns needs to be calculated for the specific portfolio and how it interacts with other risks within the business. One might expect a 1% to 2% increase in penalized returns.
To qualify as an “infrastructure asset” and benefit from the lower capital charges, a fairly lengthy set of criteria must be met. For insurers already intended to invest in only high quality (and therefore lower return) infrastructure assets, these criteria may overlap with existing due diligence and investment analysis processes.
Non risk-based criteria
- The investment must be in South Africa
- The investment must be considered in the interests of the South African public
The Infrastructure project entity can meet its financial obligations under sustained stresses that are relevant to the risk of the project.
- Must be externally rated (in theory it doesn’t have to be, but in practice it really should be and questions would be asked by the Prudential Authority if it weren’t.)
- The off-taker must be either the South African government, or there must be a large number of, ideally independent, diversified customers.
- The Infrastructure assets and Infrastructure project entity are governed by a contractual framework that provides debt providers and equity investors with a high degree of protection
- For bond investments, significant additional covenants are required
- The cash flows that the Infrastructure project entity generates for debt providers and equity investors are predictable. This must be demonstrated through one of the following:
- Availability based revenues
- Rate of return regulation covering revenues
- Take or pay contract
- Output or usage and price imply low risk
Should insurers invest in infrastructure?
It’s unhelpful to say “it depends”, but of course it does. However, with appropriate due diligence and consideration of the financial and capital implications, life insurers with large with profits or annuity books can benefit shareholders and policyholders, as well as potentially the country as a whole, by investing judiciously in infrastructure assets.
The risk is that they are outbid by retirement funds with less risk sensitivity to the investments.