Ladies and gentlemen, good afternoon. I am delighted to be here.
It is very good to be back to an IAIS Annual Meeting and in particular to Asuncion. Since those days during your meeting in Budapest, I have been following your impressive work closely. Today, I would like to share with you a few thoughts on how I see your and the World Bank agenda converge on a key issue that it very dear to me- infrastructure finance in a time when the prospect of climate change is becoming a reality to most insurers.
We are living in difficult times and we need a bold and strategic response to help improve global welfare and share prosperity. The global economic recovery is still sluggish. Lower oil prices and monetary easing in advanced economies have supported private spending, but investment has yet to recover. Policy uncertainty remains high, due to rising geopolitical risk and political polarization. These economic and policy challenges, including the impact of lower commodity prices on some exporting emerging-market and developing countries, are evolving against the background of pressing global problems, such as climate change and forced displacement. Thus, it is crucial that we foster new global sources of inclusive growth, adding to trade, while strengthening the resilience of emerging markets to adverse shocks.
Low interest rates make the current situation particularly precarious for insurance companies. A large fraction of government bonds are earning negative interest rates, even over significant maturities, altering the whole logic of insurers investment policies. The time horizon over which these circumstances will persist is uncertain. According to some theories, rates may be so low because there is not enough aggregate demand, mostly due to ageing populations causing high savings and new, more efficient technologies requiring less capital. This imbalance is not easily addressed by higher public spending, even if countries had enough fiscal space. People would likely just save any additional money they were to get today, if they do not have enough confidence about future income, and that would not spark economic activity.
The downside risk of low rates for insurers is aggravated by the adverse impact of climate change. Higher global temperature can disrupt economic activities in many places, further lowering returns and possibly increasing liabilities to insurers.
In these circumstances, private investment in countries with younger demographics and greater upside to potential output-especially in infrastructure-could help bring benefits to many constituencies. These cross-border investments could trigger high productivity gains if channeled to projects responding to well-identified demand. They would create new sources of growth in developing countries, and cater to the search for investment yield by insurance companies. Directing excess long-term private savings from advanced economies towards climate-friendly infrastructure could provide sustained flows with higher returns and help reduce the carbon footprint of progress around the globe. After all, infrastructure accounts, directly or indirectly, for more than half of all emissions.
Infrastructure is a natural match to insurers’ long-term liabilities. These assets tend to yield predictable cash flows, with low correlation to other assets. Credit risk is most often mitigated by the relatively high recovery in case of repayment arrears. Of course, for insurers, liquidity is not a big concern. Actually, the “illiquidity premium” of infrastructure investment is well-recognized and has found its way into recent regulatory reforms, such as Europe’s Solvency II framework. Here, the so-called “matching adjustment” allows insurers to benefit from holding assets to maturity by increasing the discount rate used in the calculation of their best estimate liabilities.
Surprisingly, direct financing of infrastructure projects remains a small constituent of insurers’ investment portfolios. The (re)insurance sector in OECD countries has about $23 trillion of assets under management (that’s about a quarter of global GDP). However, insurance companies allocate only about 2.5 percent of assets under management to infrastructure investment – which may appear low considering the natural match between long-term liabilities and corresponding cash flows.
Several factors undermine the successful deployment of funding to infrastructure projects, but the World Bank and other institutions are working very hard to address them.
Firstly, infrastructure investments can be highly complex to manage. Infrastructure projects focusing on the construction (or “greenfield”) phase pose a greater risk in terms of cash flow uncertainty. Fully operational underlying assets provide greater stability of returns and potentially simpler operational management, but their supply is somewhat limited. We at the World Bank are addressing the project phase issue by supporting our member countries in developing and bringing to the market good infrastructure programs anchored in a positive business environment. We are also established the Global Infrastructure Facility (GIF), which is focused on helping countries in project preparation. We are also reviewing ways for countries to recycle their existing assets (in the operational or “brownfield” phase), for example by leasing them to private operators. The money raised from private investors in these assets can then be used by the government to finance new projects.
Secondly, investors might face information constraints and lack instruments to bring opportunities to risk levels that they can absorb. Risk varies depending on the sector and geography of individual projects, as well as in the way their finance is structured. Many investors do not have confidence they can understand the details of the opportunities they face and whether the risk is appropriate to the profile of their portfolio. The World Bank is working with many partners to expand data platforms, establish clear PPP procurement rules, and make available risk guarantee products more understood by a broader audience. The World Bank arm that lends to the private sector, the International Finance Corporation (IFC), has also developed co-investment vehicles that allow investors to benefit from the 60 years of experience of the Corporation in developing countries.
Finally, financial regulation had often not focused on infrastructure investments until recently. Although most infrastructure investment can be less risky than traditional asset classes and present a favorable correlation with these classes, including in emerging markets, this is still not fully recognized in most regulatory systems. For instance, infrastructure debt, which is generally unrated, has a lower default probability (3.8 percent vs. 7.4 percent), and its ultimate recovery rate is quite higher than that of “BBB”-rated corporate bonds (80 percent vs. 49 percent) according to a 2015 study by Moody’s Investor Ratings.
- European regulators have been the first to formally acknowledge the particular risk properties of infrastructure finance. Following the advice from the European Insurance and Occupational Pension Authority (EIOPA) in September last year, the European Commission has revised downward the standard formula charges for infrastructure debt and equity investments, subject to a number of qualifying criteria (such as investment grade credit quality based on external ratings or self-certification, predictability of cash flows, and a robust contractual framework, including a strong termination clauses, to name just a few). The re-calibration resulted in a significant capital relief relative to similarly-rated corporate bond and loans.
- The impact of even modest reductions in capital charges on capital efficiency can be significant, representing an important enhancement in the return-on-equity of infrastructure investments. This is clear when one looks at the trade-off European insurers would need to make if they are faced with a choice of investing in either plain vanilla corporate bonds or infrastructure bonds. For a “A/BBB”-rated infrastructure bond, earning for instance 2.9 percent a year, the reduction of the capital charge from the standard value applied to corporate bonds of slightly above 10 percent (the light horizontal dotted line) to just below 10 percent (the heavy black dotted line) raises the return on equity by approximately 2 percentage points (to 13 percent), and close to 8 percentage point vis-s-vis the return provided by a standard “A”-rated corporate bond yielding 2.2 percent (Exhibit 1). If one applies a lower capital charge of 5 percent when this infrastructure bond is, for example, wrapped in a guarantee from a multilateral development bank, the rate of return would jump to beyond 28 percent if the bond kept the same yield, and to close to 20 percent if its yield adjusted downward to, e.g., 2.2 percent.
- Of course, this is a highly stylized illustration of regulatory capital efficiency, any many insurers would apply internal models for their calibration of capital charges, but this gives us comparative perspective on different asset classes. Also, even if the fair price of a guarantee were to nullify its regulatory benefits, it is not necessarily a wash if it widens the scope of eligible investments.
Exhibit 1. Market-implied Trade-off between Regulatory Cost and Return on Equity for Corporate Bonds and Infrastructure Bonds under Solvency II
- However, more work remains to be done. While Solvency II has made progress in installing a more favorable regulatory treatment of eligible debt and equity investments in infrastructure, it remains restricted to investments in countries of the European Economic Area (EEA). So infrastructure projects in emerging markets do not benefit. There are also some other aspects, such as the correlation of these assets with the market portfolio, which warrants further review. Moreover, the current calibration capital charges recognizes sovereign guarantees but does not take into account guarantees at the sub-national level, which are quite important in some countries.
- Outside Europe, the regulatory treatment of infrastructure investments is less advanced. In the United States, the regulatory capital treatment under the risk-based capital (RBC) framework is based on standard NAIC ratings, which do not recognize the superior loss experience of infrastructure debt. Moreover, the application of similar regulatory capital treatment does not capture lower return volatility (especially in private markets) of infrastructure projects.
Indeed, although regulatory restrictions on portfolio allocations in infrastructure are probably not the main impediment to growing exposure to this asset class, the evolution of these regulations may help insurers to accelerate the rebalancing of their assets in ways that will help protect their business. In addition to providing long-term income streams, infrastructure is an effective way to address risks brought by climate change. The same way insurers often address the risk of their health liabilities by investing in health providers, insurers exposure to climate change may be mitigated by investing in climate-friendly infrastructure, given its power to help limit global warming. Decisions about energy and transportation in developing countries will have a strong impact on global warming in the next decades. Helping reducing this impact will help reduce the risk of sudden depreciation of many existing assets that support insurers’ current liabilities, further increasing the potential attractiveness of investing in these assets.
This is why I believe the insurance industry is in a special position to lead a new wave of private sector capital mobilization to support higher growth and shared prosperity worldwide, in particular if multilateral development banks can provide adequate risk mitigation tools to investors, and financial regulations, including in destination countries, evolve to recognize the diversification benefits the risk profile of infrastructure can bring to investment portfolios.
Let me stop here, as will have the opportunity to discuss all this in more detail. I am keen to hear your reactions to the issues I raised in relation to infrastructure finance.
I thank you for your attention.