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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 penalty under current proposals for the standard formula, and the high capital charges mean that the risk-adjusted returns would be relatively low.
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, Fitch believes charges are calibrated in line with the market average volatility.
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.