There are a host of reasons why insurers should consider investing in infrastructure. Not only are there benefits for the industry, there are benefits for wider society too, as we report.
The upgrading and delivery of high-quality infrastructure is near the top of government agendas all around the globe.
Both the short- and longer-term benefits for societies are clear. Short term benefits come through a boost in aggregate demand in areas such as construction, materials and engineering services; the importance of which is amplified in the aftermath of the economic contraction driven by COVID-19.
Over the longer term, maintenance and delivery of public services such as schools, hospitals and rail networks are essential parts of living.
In addition, infrastructure focused on ‘mainstreaming’ recently-developed technology helps ensure countries can enhance productivity, for example rural access to fibre broadband. Lastly, infrastructure projects focused on supporting innovative technologies, such as low carbon hydrogen as a fuel source, are hugely important in ensuring more significant steps can be taken in delivering a sustainable future for all.
A general recognition that a funding gap exists
However, within the EU1, public spending on infrastructure remains well below pre-financial crisis levels. There’s a general recognition that a funding gap exists. And globally, more funding is needed to meet infrastructure needs. Estimating the funding gap is challenging because of the number of assumptions that need to be made. However five years ago, for the period to 20202, the European Investment Bank estimated the gap was around 435 billion euros per annum.
Governments are looking to do more. For example, the UK’s National Infrastructure Strategy (NIS) estimates that UK public spending on economic infrastructure between 2021-22 will be £27bn. The EU’s Recovery Plan for Europe meanwhile has set aside 750 billion euros as a COVID-19 recovery package for 2021-27, of which 390 billion euros will be awarded in grants to member states with the remainder provided as loans.
Given the size of the funding gap, governments are acutely aware of the need for private sector investment. Public finances alone are not sufficient to deliver the infrastructure development requirements needed. The UK’s NIS says ‘private investment … will be critical over the coming decades as the UK moves towards meeting net zero in 2050’. The UK government has therefore created a UK Infrastructure Bank to co-invest alongside the private sector and support the government’s ambitions on ‘levelling up and net zero’ and to encourage further private sector investment. The EU’s 2017 European Investment Plan is another example of encouraging private sector investment, specifically focusing on sustainable development projects.
The need for infrastructure development and the associated benefits are clear. The need for both public and private sector investment to support development are also clear.
The need for infrastructure development and the associated benefits are clear. The need for both public and private sector investment to support development are also clear. Insurance companies are the largest institutional investors in Europe, holding approximately 10 trillion euros in assets3. From their perspective, there are a number of reasons why investing in infrastructure is attractive. We take a closer look at those reasons below.
The continuing importance of ESG factors
Environmental, social and governance (ESG) considerations are paramount in many insurers investment portfolios. The importance placed on ESG has been on a steep upward trajectory in recent years, particularly with regards to climate change.
We recently interviewed 60 Chief Investment Officers and Heads of Sustainable Development from insurance companies across Europe covering 4.5 trillion euros of assets (42% of the European Insurance market). We found that 50% of firms have measurable ESG objectives, of which a staggering 96% relate to climate change. There are good reasons for this:
- The urgency and scale of the climate change challenge. The consequences of inaction are huge.
- Greater advancements have been made in measuring potential exposure to climate change than have been made in other areas, such as measuring biodiversity or wellbeing.
- Regulators are increasingly requiring insurers to consider climate change risk across their firms, including their investments.
Insurers are considering how resilient their investment portfolios are to the effects of a transition to a low carbon economy. Having made their own commitments to a net zero investment portfolio by 2050, many need to go further to ensure their portfolio supports the transition through the investments they make – often with a view to incrementally increase allocations to ‘climate solutions’ over time. There’s perhaps no more obvious an asset class candidate than infrastructure which funds many of the projects that are key enablers to achieving a low carbon economy. We estimate around 40% of infrastructure projects by value in Europe are in the renewable energy space.
The commitment of and momentum behind insurers action in the space cannot be underestimated. The enormity of the actions required will need multi-year focus, innovation and change. For insurers to achieve these ambitions, they will need to consider action across all asset classes. However, such is the alignment of infrastructure to a green economy, it’s an obvious consideration for increased insurer allocations.
From our experience, conversations with insurers about this asset class have often focused on the ESG angle ahead of discussing more traditional investment characteristics and solvency requirements.
Infrastructure and its investment characteristics
Infrastructure is a private market asset class and insurers can choose to access it in either equity or debt format.
In debt format, the long-dated nature of loans creates interest from life insurers, with maturities typically in the range of 8 to 15 years. Additionally, being a private market asset class, insurers can expect to benefit from an illiquidity premium. This has been a major driver of insurers’ access to private market assets in recent years, driven by the low yield environment and an acceptance that insurers’ liability profiles often allow them to accommodate a good degree of illiquidity on the asset side.
Such premium is transaction specific and can vary as a function of supply and demand. However, from our experience, a typical range for senior investment-grade quality debt would be 20-80 basis points over equivalent (rating and duration) public corporate credit. Another attraction of infrastructure debt is the lower expected loss relative to public corporate debt of equivalent quality. This is driven both by a lower occurrence of default and higher recovery rates in the event of default. Additionally, the default cycle for infrastructure has a low correlation to the default cycle of public corporate debt providing diversification benefits; the former often being driven by political and regulatory risks, the latter driven by economic risks.
As well as having a need to invest in interest rate-sensitive asset classes such as debt for ALM purposes, the quantum of insurers excess assets over liabilities is significant. It stood at around 1 trillion euros at the end of 20193. As a result, there’s also great interest in infrastructure in equity format. Internal rates of return can be in the region of 8-10%, with an income yield of 4-5% assuming core and core+ European infrastructure assets. This compares attractively to public market equity with our long-term expected returns focus in the region of 6-7% for European equities.
Whether accessed through debt or equity, infrastructure shows low levels of correlation relative to other asset classes meaning insurers can achieve diversification benefits for their investment portfolio.
Public versus private
Infrastructure has a number of advantages over public corporate debt and equity however it would be remiss not to mention areas where public markets may have an advantage.
Firstly, as infrastructure is a private market asset class which many are looking to access, deployment of capital requires more patience and experience. This dynamic goes hand in hand with investing in illiquid assets.
Secondly, allocations to individual infrastructure deals have been much larger than allocations to a single public corporate credit within a broad bond portfolio. In other words, one can expect an infrastructure portfolio to contain fewer individual investments than a public corporate credit portfolio of the same value. There’s good reason for this; infrastructure deals are private in nature meaning they are time and resource intensive to source. Each deal is typically funded by a smaller pool of investors than those buying a public corporate bond. This dynamic has been fairly easy to overcome for larger insurers who are able to allocate many millions to the asset class. It has been more difficult however for those looking to take smaller allocations to achieve diversification within the asset class.
This hurdle is being remedied as infrastructure equity and debt pooled vehicles are being developed, allowing insurers and other investors to take a smaller allocation and still achieve the same diversification benefits as a larger allocation would.
The investment characteristics of infrastructure are therefore supporting insurers’ increasing allocations in this space.
Regulatory capital requirements
Insurers investment considerations are not complete without an assessment of insurance regulations and capital requirements. For European insurers those requirements are set out within the Solvency II directive.
Solvency II prescribes optionality for insurers to develop their own internal models to assess the risk of investments and the associated capital charges. The considerations specific to infrastructure for insurers running internal models will be unique to their model. However, we’re increasingly seeing those insurers most committed to infrastructure investment going down the internal model route, with the model usually showing reduced capital requirements as compared to similar public markets investments.
Insurers who have chosen not to develop their own internal model will follow the standard formula as laid out in the directive. Post its inception in 2016, two amendments have been made with the aim of supporting the goals of the Investment Plan for Europe – i.e. facilitating private investment in infrastructure to help close the investment gap.
Firstly, an amendment was made to recognise infrastructure investment projects as distinct assets with their own capital treatment, provided they met certain qualifying criteria which would give comfort that such investments exhibit lower risk. For projects that did, the capital treatment for debt would be some 30% lower relative to equivalent rating and duration public corporate credit. For equities, the reduced capital charge was of a similar magnitude – with a 30% capital charge as opposed to 39% for Type 1 equities (or 49% for Type 2).
Secondly, a further amendment was made to recognise that those undertaking infrastructure development may also structure themselves as broader corporate entities, capable of undertaking a number of infrastructure projects - as opposed to project-specific entities set up with the sole purpose of developing a single infrastructure project. Again, capital treatment was beneficial relative to public equivalents, although not quite as generous as for infrastructure projects. This reflects a view of slightly higher risk given the entity would be undertaking a potentially broader range of activities.
While not specific to infrastructure equity alone, it’s also worth noting that Solvency II provides for Long Term Equity (LTE) investment to receive beneficial capital treatment. This time at 22% relative to 39% for Type 1 equities (or 49% for Type 2). The insurer will however need to meet strict requirements in order to classify equity investments as LTE, including holding the equities within a ringfenced portfolio assigned to cover a specific set of liabilities. We have witnessed extremely limited take-up of insurers utilising the LTE criteria, which may indicate that such requirements are too onerous to meet. EIOPA has recognised the limited take up, and this area has been highlighted within the 2020 review to the Solvency II directive as one where further amendments will be considered.
While the requirements are prescriptive and often onerous, they demonstrate that regulatory authorities have clearly recognised both the benefits from encouraging private investors, such as insurers, to invest in infrastructure as well as the reduced risk that such investments can bring.
Ensuring we live in a sustainable world
The rationale for insurers to consider infrastructure investments is clear. Many have done so already and we believe many more will.
Governments and regulatory authorities recognise the need for private sector investment to supplement the public finances governments are able to commit – and encourage it. In turn, insurers recognise the opportunity to benefit from an illiquidity premium while accessing assets that support their ALM activities and supporting socially worthwhile projects, which insurers’ stakeholders are increasingly demanding.
Potentially most significant is the alignment of infrastructure as an asset class to insurers commitments to support the climate transition – increasing the potential for them to play a meaningful role in ensuring we live in a sustainable world.
1 European Parliament briefing October 2018: Ioannis Zachariadis)
2 (European Investment Bank: Restoring EU Competitiveness: 2016 Update Version)
3 (EIOPA Insurance Statistics: Balance Sheet 2016-2019)
Aberdeen Standard Investments manages assets on behalf of 168 insurance clients with strategies spanning the whole range of investing from ALM and capital aware solutions through to private markets and global asset allocation portfolios.
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