Investing In Infrastructure: Are Insurers Ready To Fill ... · Investing In Infrastructure: Are Insurers Ready To Fill The Funding Gap? representing 75% of global project finance

Investing In Infrastructure: AreInsurers Ready To Fill The FundingGap?

Primary Credit Analyst:

Marco Sindaco, London (44) 20-7176-7095; [email protected]

Secondary Contacts:

Lotfi Elbarhdadi, Paris (33) 1-4420-6730; [email protected]

Mark Button, London (44) 20-7176-7045; [email protected]

Michael Wilkins, London (44) 20-7176-3528; [email protected]

Table Of Contents

Investments That Make A Good Match

Industrywide Commitment Shows The Way Forward

Fulfilling The Need For Attractive Yields In A Low Interest Rate

Environment

Infrastructure Assets Have A Strong Default And Recovery Record,

Although Based On Limited Data

A Source Of Diversification, Although A Complex And Still-Underdeveloped

Asset Class

Solvency II Clamps Down On Capital Charges

How Infrastructure Investments Affect Our Financial Strength Ratings

Infrastructure Investments And Our View Of Risk Position

Infrastructure Investments And The Impact On Capital Adequacy

A Tempting, But Not Necessarily Straightforward Purchase

WWW.STANDARDANDPOORS.COM/RATINGSDIRECT JULY 7, 2014 1

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Table Of Contents (cont.)

Related Criteria And Research


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Investing In Infrastructure: Are Insurers Ready ToFill The Funding Gap?

Infrastructure and insurance are key elements of global economic and human development. Investing in infrastructure

creates jobs, generates demand, and enhances efficiency, which lowers costs for businesses and governments,

generating a multiplier effect on GDP growth (see "U.S. Infrastructure Investment: A Chance to Reap More Than We

Sow," published May 5, 2014). Economic and human development is also correlated with the protection provided by

insurers for individuals, their livelihoods, dependents, and assets. At the same time, insurers' role as investors is as

important as their protection role, given their key activity of investing the premiums received, particularly for their

savings and investment products, which benefits the economy even more directly (see "Underwriting The Recovery:

Insurers' Role As Investors Expected To Be Preserved," published Jan. 14, 2014).

Recent developments indicate the two sectors may be strengthening their ties, helping each other to fully accomplish

their roles. On one side, Standard & Poor's Ratings Services estimates infrastructure financing needs worldwide could

total $3.4 trillion annually through to 2030. While we expect governments and banks will remain the dominant

investors in infrastructure programs, we also estimate $500 billion in additional funding will be needed each year to

make up the shortfall (see "Global Infrastructure: How to Fill A $500 Billion Hole," Jan. 16, 2014). On the other side,

life insurers are struggling to find suitable investments to match their long-term and stable liabilities in the current low

interest rate environment (see "Why Some European Life Markets Are More Sensitive To Interest Rate Movements

Than Others," May 14, 2014).

The opportunities for insurers to play a greater role in filling the funding gap are apparent. However, as insurers'

interest in, and exposure to, infrastructure investments rise, so could the risks and consequent impact on credit quality.

To help issuers and investors understand these risks, we have examined how infrastructure investments can affect

insurers' operating performance, portfolio quality and diversification, and capital adequacy--and hence their financial

strength ratings.

Overview

• We believe insurers are well-placed to help plug the $500 billion per year gap in infrastructure funding between

now and 2030.

• Infrastructure investments can be a good match for life insurers' liabilities, owing to their long-term maturity

and attractive yields.

• That said, regulation, together with project complexity, illiquidity, and a lack of suitable projects, may thwart

insurers' progress in making such investments.

• When assessing the effect of infrastructure investments on an insurer's financial strength, we look at capital

and earnings, risk position, and liquidity, among other factors.


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Investments That Make A Good Match

Long tenors, attractive yields, high recovery rates, and low correlation with other asset classes make infrastructure

investments a good match for life insurers' predictable, long-term liabilities. That said, an expansion in infrastructure

assets will increase insurers' credit, valuation, and liquidity risks. Infrastructure is a complex asset class, embodying

risks that in our view insurers might not be willing to accept, including construction, regulation, and political

intervention risks.

We note that insurers have in the past had difficulties finding suitable and sizable infrastructure investments, an issue

that will likely persist as they increasingly look to alternative investments to diversify from low-yielding government

bonds and/or property. Insurers' appetite for infrastructure investments will also be influenced by the regulatory

capital requirements they will be subject to under Solvency II regulation. Consequently, we believe many insurers will

need to develop in-house skills to manage infrastructure risks, which could slow their diversification into this asset

class.

We estimate insurance companies worldwide are targeting an allocation of about 3% of their assets under

management (AuM) to infrastructure investments over the next 20 years, from 2% at present (see chart 1). Assuming

assets managed by insurers continue to represent more than 40% of institutional investors' total AuM (see chart 2), the

worldwide allocation by insurers could be about $80 billion per year (for more details, see "Global Infrastructure: How

To Fill A $500 Billion Hole," published Jan. 16, 2014).


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Investing In Infrastructure: Are Insurers Ready To Fill The Funding Gap?

Chart 1


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Chart 2

Industrywide Commitment Shows The Way Forward

Insurers' interest in infrastructure investments is evident in the December 2013 announcement by six U.K. insurers of a

collective commitment of £25 billion over five years. AXA Group has announced a €10 billion commitment over a

similar period, while Allianz SE and Munich Re Group have also announced material commitments in the asset class.

(See "Out Of The Shadows: The Rise Of Alternative Financing In Infrastructure," published Jan. 31, 2013.) In addition,

Belgian insurer AG Insurance says it will allocate €3 billion, or 5% of its AuM, to infrastructure projects, while CNP

Assurances has already committed in 2013 to increase its loan infrastructure debt portfolio up to €2 billion over three

years. Furthermore, Assured Guaranty (Europe) Ltd., a bond insurer, has wrapped £77 million of U.K. infrastructure

bonds so far in 2014 after wrapping £238 million of similar bonds in 2013. Outside of Europe, Australia-based global

multiline insurer QBE Insurance Group has also announced that it is diversifying its investment portfolio to include

infrastructure debt.

Life insurers are long-term investors able to hold assets for long periods, and typically face less short-term liquidity

strains than banks. Annuities, pensions, and long-term saving products are very long-term liabilities for insurers. And

long-dated government, mostly domestic, bonds have historically been insurers' favored investments to match their


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relatively illiquid, and predictable, life insurance liabilities, supported also by regulation. However, with government

bond yields at low levels in developed markets, the search for yield to mitigate declining investment spreads and

deliver competitive policyholders' returns has caused insurers worldwide to seek alternative investments.

Fulfilling The Need For Attractive Yields In A Low Interest Rate Environment

Investments in infrastructure generally offer higher yields than those available on highly rated government and

corporate bonds. This is largely due to their illiquidity premium and the risks associated with infrastructure projects.

Over recent months, rated long-dated project finance bonds have typically attracted yields of between 4% and 5% (see

chart 3), which is a considerable improvement on the 3% or lower yields available on sovereign debt with equivalent

ratings, implying credit spreads between 100 basis points (bps) and 200 bps depending on the rating and tenor (see

chart 4).

Nevertheless, the attraction of infrastructure investments could decline if interest rates were to increase, enabling

traditional asset classes to recover their attractive yields.

Chart 3


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Chart 4

Infrastructure Assets Have A Strong Default And Recovery Record, AlthoughBased On Limited Data

Out of more than 510 rated project finance debt issues globally from 462 issuers since Standard & Poor's issued its first

project finance rating in 1991, we've seen 34 defaults. (see "Project Finance Default And Recovery: Shale Gas Fuels

Rise In U.S. Defaults," published Aug. 9, 2013). And since the first rated project default in 1998, the annual default rate

for rated project finance debt has averaged 1.5% (see table 1). This is slightly below the default rate for corporate

issuers of 1.8% over the same period. We also note that while corporate default rates spiked upward to more than 4%

at the height of the global financial crisis of 2007-2009, rated project finance transactions remained relatively resilient

(see chart 5).

Table 1

Cumulative Rated Project Finance Default Rates 1992-2012*

--Time horizon (years)--

RatingYear

1

Year

2

Year

3

Year

4

Year

5

Year

6

Year

7

Year

8

Year

9

Year

10

Year

11

Year

12

Year

13

Year

14

Year

15

AAA 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0


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Table 1

Cumulative Rated Project Finance Default Rates 1992-2012* (cont.)

AA 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0

A 0 0 0.4 0.8 1.2 1.7 2.3 2.9 2.9 2.9 2.9 2.9 2.9 2.9 2.9

BBB 0.3 0.6 0.8 1.2 1.6 1.7 2 2.3 2.7 3.4 4.3 5.4 6.8 6.8 6.8

BB 0.9 2.4 5.8 8.6 10.6 11.6 12.4 13.3 14.2 14.2 14.2 14.2 14.2 14.2 14.2

B 3.6 9.3 12.5 16 18.7 19.6 20.7 22.3 24.9 29.3 29.3 29.3 29.3 29.3 29.3

CCC/C 17.6 22.6 25.4 27.1 29 29 29 29 29 29 29 29 29 29 N/A

Investment

grade

0.2 0.5 0.8 1.1 1.5 1.7 2 2.4 2.7 3.3 3.9 4.8 5.9 5.9 5.9

Speculative

grade

3.3 6.3 9.6 12.5 14.7 15.5 16.3 17.2 18.3 18.7 18.7 18.7 18.7 18.7 18.7

All rated 1.2 2.4 3.6 4.8 5.7 6.1 6.6 7.1 7.6 8.1 8.6 9.2 10 10 10

Source: S&P 2013. *Calculated By multiplying non-default marginal rates and then subtracting from 1 to get cumulative default rate. N/A--Not

applicable.

Chart 5

The total number of rated project finance issues is statistically small, however, implying that small numbers of outliers

can materially affect our results. Data compiled by the S&P Capital IQ Project Finance Bank Consortium broadly

confirms the trends in rated project finance default statistics: In 2012, the database comprised 34 lending institutions


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representing 75% of global project finance syndicated loans (6,862 loans in total).

Compared with corporates, project finance debt has also delivered a stronger rate of recovery post default. The

average level of recovery across our rated project finance universe is about 75%. However, we would caution that our

sample is not large enough to be statistically relevant. Furthermore, these rates form a barbell distribution, with some

lenders receiving recoveries close to 100% and others minimal amounts.

Also, the recovery patterns of defaulted projects are in part confirmed from data collected by S&P Capital IQ Project

Finance Bank Consortium. Data for unrated loans show that defaulted loans have achieved almost full recovery (that

is, between 91% and 100%). Either way, this post-default performance is considerably stronger than for corporate

bonds, for which recoveries average about 45%. We believe this reflects the specific characteristics of project debt,

which typically benefits from a strong collateral package with first-ranking priority security given to lenders. On the

downside, it takes longer to resolve infrastructure bond defaults than their corporate counterparts, which could offset

some of the benefit of the higher relative recoveries of infrastructure bonds.

A Source Of Diversification, Although A Complex And Still-UnderdevelopedAsset Class

Insurers might use project finance as a means to diversify their asset portfolios because of the low sector correlation to

other asset classes. In particular, investments via unlisted investment funds, albeit illiquid, have little correlation with

the broad range of assets in which insurers would traditionally invest, including their stock portfolios.

However, insurers might not be willing to invest in an infrastructure project, because the asset would not fit their risk

tolerance considerations. For example, most insurers remain reluctant to invest in greenfield projects (that is, those

projects that incorporate construction risk), which comprise about 70% of the infrastructure project pipeline

worldwide, because such projects lack a track record of stable cash flows. Furthermore, project finance loans are rarely

traded in the secondary market and lack critical size to be included in public indices. This could prevent insurers from

benchmarking and valuing their exposures, which could in turn temper their appetite to increase their project loan

portfolios.

Diversifying into infrastructure investments requires specialist knowledge, of which insurers have relatively little

experience, in our opinion. The risks involved in infrastructure projects include construction and technical and design

failures, which are unfamiliar to the majority of insurers. Meanwhile, potential investors cite a lack of industry data as a

deterrent to funding infrastructure projects. We therefore believe larger insurers with specialist teams of investment

professionals may be more inclined to invest in infrastructure directly through private equity and loan structures,

compared with smaller insurers that are more likely to participate through bonds and shares in investment funds.

Regulatory and political risks add uncertainty, however, because unpredictable and frequent changes in policies, tax

regimes, and tariff-setting can significantly affect infrastructure investments. The Norwegian government's recent gas

pipeline tariff reductions, for instance, have raised criticism in the market regarding the potential harm to insurers'

investments in infrastructure.


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Solvency II Clamps Down On Capital Charges

Regulatory requirements--particularly those of the standard formula under the proposed EU Solvency II

Directive--could challenge insurers' commitment to infrastructure investment, in our opinion. In September 2012, the

European Commission (EC) publicly wrote to the European Insurance and Occupational Pensions Authority (EIOPA)

explicitly mentioning infrastructure financing, asking the authority to examine "whether the calibration and design of

capital requirements for investments in certain assets under the envisaged Solvency II regime necessitates any

adjustment or reduction under the current economic conditions, without jeopardizing the prudential nature of the

regime." In December 2013, EIOPA announced that it does not believe that modifications should be made for

infrastructure investments, given that it lacks "comprehensive, reliable, and publicly available performance data" on

which to base lower requirements.

In our view, the question remains as to what extent infrastructure investment will be able to compete with less

capital-intensive long-term government bonds under Solvency II. As of today, EIOPA has not introduced specific

charges for infrastructure investments. Nevertheless, we believe the EC is likely to keep up the pressure on EIOPA to

modify its proposals.

Notwithstanding the standard formula calibration, we believe the effects of Solvency II on infrastructure investments

may not only be negative (See "Solvency II Could Be A Double-Edged Sword For Infrastructure Investment," published

on RatingsDirect.) We expect the larger insurers to make more investments in infrastructure than their smaller peers.

Larger companies are more likely to leverage their diversification and internal modelling abilities to minimize the

potentially onerous capital requirements of the standard formula under Solvency II. However, we believe it likely that

internal models will be subject to stringent regulatory approval, and it remains to be seen whether regulators will

accept models yielding capital charges that are significantly below those resulting from the standard formula.

How Infrastructure Investments Affect Our Financial Strength Ratings

As part of our analysis of an insurer, we assess how its investments in infrastructure affect its capital and earnings and

the quality, diversification, and liquidity of its investment portfolio. We also assess how these investments affect the

insurer's asset and liability management, investment and overall risk tolerances, and ability to operate within clear

limits, supported by effective control systems.

The risks arising from an infrastructure investment and their associated impact on an insurer's financial strength rating

will largely depend on the nature of the insurer's exposure. This is because an insurer can invest in infrastructure

projects through:

• Unlisted or listed equities in the infrastructure company, including private equity;

• Shares in investment funds;

• Rated or unrated bonds issued by the infrastructure company; and

• Privately placed loans and other direct investments.

The following paragraphs outline the specific elements that we consider when evaluating an insurer's risk position, and


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capital adequacy.

Infrastructure Investments And Our View Of Risk Position

To capture the potential volatility of an insurer's capital base, among other factors, we review the proportion of high

risk assets in its investment portfolio relative to capital. Our assumption is that infrastructure investments are high-risk

assets if effected through bonds and loans that are unrated or rated 'BB+' or lower; or through equity, partnerships, or

alternative investments such as private equity. We regard the investment leverage as positive if an insurer is exposed

to risky assets for less than 10% of its TAC (total adjusted capital) and negative if more than 100%. We apply different

limits to insurers with significant profit-sharing liabilities that are able to transfer the risk to policyholders.

When analyzing the risk position of an insurer, we also look at the insurer's exposure to a given asset sector or obligor.

As per our global industry classification standard, we do not regard infrastructure investments as a separate category.

Rating committees will therefore decide on a case-by-case basis whether a company's concentration should refer to

infrastructure as an individual sector or whether it's more appropriate to classify the concentration according to the

underlying sector of the project bond (construction or energy, for example). We regard sector concentration as

positive when no more than 15% of the portfolio is held within any one sector, neutral (that is, moderately diversified)

if between 15% and 30%, and negative if more than 30%.

Independent of the type of asset, we also look at the exposure of the insurer to a given issuer. This takes into account

the amount of equity, debt, and loan obligations issued by the same obligor. And when assessing the concentration to

a single issuer, we consider any exposure to a given infrastructure project via different asset classes as one single

obligor. We view the obligor diversification as positive if less than 5% of the assets are invested in one obligor, neutral

if between 5% and 10%, and negative if more than 10%.

Infrastructure Investments And The Impact On Capital Adequacy

Standard & Poor's bases its overall opinion of an insurer's level of capital adequacy on insights drawn from its

quantitative, risk-based capital model, in conjunction with more qualitative factors. The model determines the amount

of capital in excess of reserves that an insurer needs to cover losses from disparate risks related to both assets and

liabilities. Our capital model criteria do not define specific charges for infrastructure assets. Rather, we apply capital

charges to those investments that reflect the underlying risk (market, credit, and/or asset-liability management (ALM))

of the instrument into which the insurer is investing. This means the charge we apply to infrastructure investments will

depend on the specific asset class into which the insurer is investing.

Consequently, the asset charges that we apply to infrastructure investments held by an insurer will depend on the

position the insurer is taking in the infrastructure project (either directly or via a fund), on its credit quality, on the

tenor of the investment if it has maturity, and on the effect of the ALM.

Fixed-income securities

The credit risk factor that we would apply to an infrastructure bond will depend on the specific rating level of the


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instrument and the term to maturity. We determine these factors using our default studies. This means that the risk

charges we apply to the nominal value of a project bond rated 'BBB' with a maturity of 15 years will be the same as

those we apply to a bond issued by a financial institution or a government with same rating and maturity.

For fixed-income securities, we also apply an ALM charge, which is regional and may be refined depending on our

analysis of the insurer's enterprise risk management. The charge consists of two elements. First, our estimate of the

divergence between asset and liability values, assuming they are mismatched by one year, for interest rate and spread

movements associated with each confidence level. Second, our assumption of a duration mismatch between the

insurer's assets and liabilities. For life insurers, this ranges between one and 10 years, depending on the market.

Table 3 shows the charge we would apply at different confidence levels in our capital model to an investment in an

infrastructure bond rated 'A' and in one not rated, with 10-20 years maturity and assuming two years duration

mismatch.

Table 3

Charges For Credit Risk--Bonds; 10-20 Years To Maturity; 2 Years Assumed Duration Mismatch

(%) AAA AA A BBB

1. Rating: 'A'

Credit risk charge 2.3 2.2 2.0 1.8

ALM charge 4.9 4.4 4.0 3.0

Total charge 7.2 6.5 6.0 4.9

2. Rating: Not rated

Credit risk charge 25.8 24.6 23.3 21.2

ALM charge 4.9 4.4 4.0 3.0

Total charge 30.7 29.0 27.3 24.2

ALM--Asset liability mismatch. Source: Standard & Poor's.

Equities and private equities

We capture the risks associated with holdings in equity investments by applying volatility risk factors in our capital

model that we derive for each geographic market. We charge investments in the equity capital of infrastructure

projects, either direct or via funds, as we would any other equity investment.

Table 4 shows the charge we would apply at different confidence levels in our capital model to an investment in the

equity capital of an infrastructure project in the U.S., U.K., Australia, and Switzerland as per our criteria on the capital

model.

Table 4

Charges For Market Risk--Equities (U.S. U.K., Australia, And Switzerland)

(%) AAA AA A BBB

Volatility charge 47.0 42.0 38.0 27.0

Source: Standard & Poor's.

For insurers investing in infrastructure projects via private equity, the charge applied is the regional equity market risk

charge (the same as listed equities; see table 4), plus an incremental valuation and liquidity risk charge (see table 5).


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Table 5

Charges For Market Risk--Private Equities (U.S., U.K., Australia, And Switzerland)

(%) AAA AA A BBB

Volatility charge 47.0 42.0 38.0 27.0

Incremental valuation and liquidity charge 16.0 14.0 13.0 10.0

Total charge 63.0 56.0 51.0 37.0


Unsecured loans

Like fixed-income securities, we apply a default charge to unsecured loans (see table 6), which we determine through

our cumulative default and recovery statistics. As with any other loan, we would assume in our capital model that

one-half of the insurer's infrastructure loans are rated in the 'B' category and the remainder in the 'BB' category, with

an outstanding duration of five years. In addition, we would offset the insurer's provision for bad debts or recovery

against loans.

Table 6

Charges For Credit Risk--Unrated Loans

(%) AAA AA A BBB

Loans 27.8 26.1 25 22


As per our criteria for our Risk-Based Insurance Capital Model (see "Refined Methodology And Assumptions For

Analyzing Insurer Capital Adequacy Using The Risk-Based Insurance Capital Model," published June 7, 2010), when

unsecured loans represent a material asset on the balance sheet, we can conduct additional analysis to refine the credit

risk charge. The applicable risk charge is supported by our in-depth review of the insurer's portfolio, including the

concentration per issuer/project/sector, duration, liquidity, and historical performance of the portfolio against other

benchmark portfolios. We can also use our historical default and recovery statistics, subject to sufficient data. For

example, we apply lower capital charges to U.S. commercial mortgage loans compared with unsecured loans because

we've tracked and studied default rates on more than 30,000 U.S. commercial mortgage loans since 1993. The charge

computation can also take into account data from the insurer's internal models, through our assessment of economic

capital models.

A Tempting, But Not Necessarily Straightforward Purchase

Infrastructure development can potentially meet insurers' appetite for long-tenor, higher-yielding assets that provide a

good match with their long-term illiquid liabilities. In our view, the projected infrastructure funding gap of €500 billion

a year is likely to find increasing interest from insurers seeking better returns in the current low interest rate

environment. However, these investments may not prove straightforward, and we believe regulation, difficulties in

assessing risk, and the availability of suitable projects could dull insurers' enthusiasm for these assets.


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Related Criteria And Research

Related criteria:

• Insurers: Rating Methodology, May 7, 2013

• Enterprise Risk Management, May 7, 2013

• Management And Governance Credit Factors For Corporate Entities And Insurers, Nov. 13, 2012

• Refined Methodology And Assumptions For Analyzing Insurer Capital Adequacy Using The Risk-Based Insurance

Capital Model, June 7, 2010

Related research:

• U.S. Infrastructure Investment: A Chance to Reap More Than We Sow, May 5, 2014

• Global Infrastructure: How to Fill A $500 Billion Hole, Jan. 16, 2014

• Underwriting The Recovery: Insurers' Role As Investors Expected To Be Preserved, Jan. 14, 2014

• How To Unlock Long-Term Investment In EMEA Infrastructure, Oct. 4, 2013

• Project Finance Default And Recovery: Shale Gas Fuels Rise In U.S. Defaults, Aug. 9, 2013

• Out of The Shadows: The Rise Of Alternative Financing in Infrastructure, Jan. 31, 2013

Under Standard & Poor's policies, only a Rating Committee can determine a Credit Rating Action (including a Credit

Rating change, affirmation or withdrawal, Rating Outlook change, or CreditWatch action). This commentary and its

subject matter have not been the subject of Rating Committee action and should not be interpreted as a change to, or

affirmation of, a Credit Rating or Rating Outlook.

Additional Contacts:

Karin Clemens, Frankfurt (49) 69-33-999-193; [email protected]

Michael J Vine, Melbourne (61) 3-9631-2102; [email protected]

Farooq Omer, CFA, Hightstown (1) 212-438-1129; [email protected]

Insurance Ratings Europe; [email protected]

Infrastructure Finance Ratings Europe; [email protected]


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Investing In Infrastructure: Are Insurers Ready To Fill ... · Investing In Infrastructure: Are Insurers Ready To Fill The Funding Gap? representing 75% of global project finance