Risk Nexus
Long-term investments, risks and regulation:
an insurance perspective
November 2014
Contents
1.Introduction
1
2.
3
4
5
5
Insurers as long-term investors
2.1 Linking investments to liabilities
2.2In search of optimal long-term exposures
2.3Factors that might limit insurers’ long-term investments
3. Beyond long-term investments: the specific insurance perspective
4. The accounting and regulatory treatment of insurers’
long-term investments
4.1 Challenges associated with Solvency II
4.2Assessing the reform proposals…
4.2.1 …with respect to fair-value accounting…
4.2.2 …and with respect to capital requirements
7
9
10
12
12
14
5. Policy recommendations
5.1 Improve the stability of regulatory regimes and
limit the scope for arbitrage
5.2Further deepen and strengthen the capital market
5.3Ensure a functioning insurance market
16
17
18
6.Conclusions
19
7. Appendix: Definitions and issues related to long-term investments
7.1 Definition of long-term investments
7.2 Definition of long-term funding
7.3 What challenges do long-term investors face?
7.3.1 Availability of savings
7.3.2 Transformation of savings into investments
7.3.3 Private sector incentives to invest in long-term assets
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22
23
24
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Cover: Investment in basic infrastructure will help to stimulate
global economic growth.
About Risk Nexus
Risk Nexus is a series of reports and other communications about
risk-related topics from Zurich.
© Zurich Insurance Company Ltd. 2014.
All rights reserved. No part of this publication may be reproduced or transmitted
in any form or by any means without permission in writing from Zurich, except in
the case of brief quotations in news articles, critical articles, or reviews.
15
1. Introduction
The financial crisis that began in 2008, and the ensuing Great Recession, have
weakened the fiscal position of many countries, induced financial institutions to
deleverage their balance sheets and led to reduced bank lending. As a result,
there has been an appreciable reduction in investment funding, in particular for
long-term infrastructure investments.
According to McKinsey,1 between 2013
and 2030 infrastructure investments
of the order of USD 57 trillion or an
equivalent to an annual 2.5 percent of
global GDP will be needed – 60 percent
more than in the previous 18 years. Given
the public sector’s fiscal constraints and
the reluctance of banks to commit to
long-term investments (LTIs), it is not clear
where the funding for these investments
will come from.
That’s why policymakers are interested in
tapping new funding sources, with insurers
and pension funds appearing to be the
most likely candidates to fill the gap.
No one would dispute that insurers, with
assets of more than USD 24 trillion,2
have a significant capacity to engage
in LTI funding. But there appear to be
barriers to the contribution of insurers.
Observers have deplored a lack of suitable
funding vehicles with an acceptable risk/
return profile, and they have identified
regulatory hurdles.
Recent policy proposals aim therefore
to make funding LTIs more attractive
to insurers. They call specifically for
adjustments to the accounting treatment
of long-term assets and the risk weights
relevant for solvency requirements, and
they look for ways to overcome the
pro-cyclical nature of accounting and
regulatory rules.
McKinsey (2013), ‘Infrastructure Productivity.’
(http://www.mckinsey.com/insights/engineering_
construction/infrastructure_productivity)
1
This paper takes a different tack. While
acknowledging that insurers have been, and
will continue to be, holders of infrastructure
investments, it emphasizes the importance
of maintaining appropriate risk-reward
incentives when it comes to assessing
the prospects of LTIs. It argues that the
regulatory treatment of LTIs, as for example
proposed under Solvency II, is by and
large in line with the risks related to
these investments.
Setting low capital requirements for
certain long-term assets would distort the
economic risk-reward calculus of LTIs.
Regulatory measures alone will not make
LTI risks disappear, and they will likely
backfire if risks that were downplayed
artificially by regulatory fiat do, in fact,
materialize. Moreover, politicallymotivated preferences for one specific
class of investments over another may
crowd out other investments with the
potential to increase an economy’s
productive capacity.
This paper also emphasizes the dual role
of insurers in support of LTIs. The focus
on investment funding is only one side of
the equation. The reduction to the funding
contribution neglects the equally important
economic role of insurers. By taking risk out
of the entrepreneurial equation, insurance
contributes – in often-unacknowledged
ways – to the growth of businesses, and
thus to the long-term prosperity of society
as a whole.
Insurance not only facilitates risk transfer
by charging risk-sensitive premiums and
therefore incentivizing rational risk-taking,
it also serves as a mechanism to allocate
scarce funds efficiently to the economy.
If for no other reason than this specific
economic role, we hope this study will
foster a better understanding of how the
insurance industry contributes to economic
growth now and in the future.
Our policy recommendations follow from
the dual role of insurers. We acknowledge
the need to better promote LTIs. But rather
than focusing on the funding role of
insurers and creating artificial regulatory
incentives to promote this, policymakers
should enable the industry to add value in
a sustainable way. Measures could include
the provision of a stable and consistent
regulatory environment across the whole
Raffaele Della Croce and Juan Yermo (2013),
‘Institutional Investors and Infrastructure Financing,’
OECD Working Papers on Finance, Insurance and
Private Pensions No. 36, Paris.
2
Closing the long-term investment gap: the dual role of the insurance sector
1
financial sector, thus creating a level playing
field for all LTI investors. They should
further ensure that insurers can mitigate
the economic, political and legal risks
associated with LTIs by facilitating a fully
functioning insurance market. This requires
inter alia the acceptance of risk-based
pricing and international risk diversification
through access to reinsurance or other
forms of cross-border capital pooling.
This paper examines first in section 2
how insurers support LTIs by providing
long-term funding, which is followed in
section 3 by a discussion of the specific role
insurers play in providing protection for
these investments. Section 4 summarizes
the accounting and regulatory treatment
of long-term funding by insurers as well as
current policy proposals to promote LTIs.
In Section 5 we present policy
recommendations. Section 6 offers
concluding remarks. Readers interested
in the specific nature of LTIs and their
contribution to economic growth are
referred to the appendix in section 7.
This is a joint paper drafted by Zurich’s Government and Industry Affairs, Investment
Management, and Group Risk Management. Contributors were Jérôme Berset
(Head of Risk Governance and Reporting); Michael Christen (Strategy Development,
Investment Management); Hansjörg Germann (Head of Strategy Development,
Investment Management); Daniel M. Hofmann (Senior Advisor); Christian Hott
(Economic Advisor, Government and Industry Affairs); Benno Keller (Head Research
and Policy Development, Government and Industry Affairs); and Katja K. Müller
(Risk Governance and Reporting Specialist).
2
Closing the long-term investment gap: the dual role of the insurance sector
Section 2
Insurers as long-term investors
Closing the long-term investment gap: the dual role of the insurance sector
3
2.1 Linking investments
to liabilities
Achieving the optimal balance
between risk and return
remains the key challenge in
the insurance industry.”
Insurers hold substantial assets to back
their promises to policyholders. Globally,
insurers have investable funds in excess
of USD 24 trillion, of which roughly
USD 20 trillion are with life insurers.
Insurers hold reserves for two reasons:
(i) in many lines of business, and especially
in long-tailed liability insurance, the full
amount of losses or claim payments
becomes known only years after a loss
event has occurred. To meet their
obligations, insurers must hold assets
that generate future cash flows
sufficient to meet expected payouts
to policyholders;
(ii)in life insurance, savings product
payouts are usually made many years
after customers have paid premiums
for these products. In addition to
reserves that are needed to cover
expected payouts, insurers have to
hold sufficient equity capital and an
adequately liquid investment portfolio
to cover unexpected payouts. These
unexpected payouts result from the
fact that risk pooling is not always
perfect and in some lines of business,
losses can be large and unpredictable.
The maturity of an insurer’s liabilities varies
with its business model. The maturity may
range from a few months for some ‘non-life’
or general insurance products (liability
insurance is typically an exception) to
30 years or more for certain life insurance
products. An insurer’s investment strategy
needs to take not only the maturity
but also the liquidity of liabilities into
consideration. Due to the nature of their
liabilities, life insurers in particular have a
capacity to hold certain amounts of less
liquid, longer-term assets. They are thus
seen to be in a much better position than
banks to provide long-term funding for
infrastructure projects and other LTIs.
4
Closing the long-term investment gap: the dual role of the insurance sector
However, insurers need to be careful not
to hold an excessive amount of less-liquid
assets: in times of crisis, such assets may
need to be sold at large discounts to find
buyers. Less-liquid asset holdings on the
balance sheet of an insurer that exceed
the true amount of long-term liabilities
can therefore create ‘price discount risk’
or ‘haircut risk,’ which would require
insurers to hold additional capital.
If the amount of investments in an insurer’s
less-liquid assets does not exceed this
type of capacity constraint, the liquidity
risk is largely mitigated: The long duration
of liabilities enables the insurer to hold
investments through a cycle without facing
a forced sale at discount prices (fire sale).
This promotes stability in financial markets,
something often observed in previous
crises. For example, when the financial
crisis erupted in 2008, banks in particular
were forced to sell risky assets at large
losses to mitigate the threat of insolvency,
while other investors – especially insurers
– with sufficient capital, appropriate risk
management practices and no appreciable
asset-liability mismatches, were able to
withstand the downturn, hold on and
benefit when markets recovered.
One key point is that insurers’ investment
strategies differ in significant ways from
those pursued by asset managers. Insurers
strive to manage potential asset-liability
mismatches and ensure that mismatches
do not endanger the company or risk their
ability to make good on promises to
policyholders, while at the same time
maximizing the expected return spreads
between assets and liabilities. By contrast,
asset managers often seek to achieve
superior investment returns relative to
agreed benchmarks, such as equity or
bond market indices.
Insurers’ investment strategies must meet
two objectives: They must allow insurers
to hold a sufficient amount of assets
traded in liquid markets to cover not only
expected payouts but also unexpected
larger payouts; and they must provide
sufficient equity capital to absorb adverse
results from asset-liability mismatches.
It follows that insurers wishing to hold
riskier assets must also hold more lossabsorbing capital. That is the only way to
ensure that obligations to policyholders
will continue to be honored if these assets
lose value relative to an insurer’s liabilities.
2.2 In search of optimal
long-term exposures
Achieving the optimal balance between
risk and return remains the key challenge
in the insurance industry. Seeking higher
returns has a downside, however: capital
markets will only offer a higher expected
return when higher risks are included in
the equation.
Assets that are not traded in liquid
markets tend to benefit from a liquidity
risk premium. Liquidity risk in this context
is defined as the potential loss on assets
that have to be sold at a discount in order
to meet liability outflows (forced sales or
fire sales). The liquidity premium has a
term structure. Longer-term investments
need to offer higher returns and are
optimal assets to match long-dated
liabilities. The ability and willingness to
seek returns and tolerate the resulting
risks varies from investor to investor.
The funding provided by an insurer’s
liabilities must be understood before
investing in less-liquid assets. Assessing
the optimal exposure to these types of
assets requires a structured process.
Insurers differ from banks in that while
banks are typically funded with shortterm wholesale borrowing and deposits
that are callable on demand, insurers –
even in economic downturns – are funded
by stable premium flows. It is nevertheless
crucial that insurers diligently monitor
their capacity to invest in less-liquid assets
as an integral part of their asset-liability
management. This capacity is primarily
dependent on the ‘stickiness’ of the
liabilities, i.e., the availability of continued
access to funding in liquidity crises.
Investment and actuarial functions must
work together to determine the insurer’s
capacity to invest in less-liquid assets,
comparing the liquidity profile of assets
against the liquidity profile of liabilities
for many years into the future.
The matching principle is the defining
characteristic of the insurance sector’s
investment behavior. This liability-driven
investment approach differs in significant
ways from the conservative buy-and-hold
strategy that often – and somewhat
erroneously – is typically associated
with insurers.
2.3 Factors that might limit
insurers’ long-term investments
A number of impediments could limit
an insurer’s appetite for infrastructure
investments. Three of the more
prominent are:
• Lack of expertise. Risks associated with
infrastructure projects are varied and
may well exceed conventional expertise.
Specifically, these risks may include
failures in construction and technical
design, and lack of comprehensive
and reliable performance data about
infrastructure investments, a point
that the European Insurance and
Occupational Pensions Authority
(EIOPA) also made in its analysis of
certain long-term investments.3
• Unstable cash flows. To match their
long-term liabilities, insurers prefer
predictable and stable cash flows.
Greenfield projects, which comprise
more than two-thirds of all
infrastructure investments and carry
a considerable construction risk, may
not meet this requirement. Moreover,
project loans are typically not traded
in secondary markets, a characteristic
that may conflict with an insurer’s
liquidity preference.
See EIOPA (2013), ‘Discussion Paper on Standard Formula
Design and Calibration for Certain Long-Term Investments.’
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Closing the long-term investment gap: the dual role of the insurance sector
5
• Regulatory and legal uncertainty.
Given the long tenor of infrastructure
investments, the political environment
in which a project loan is signed off may
change repeatedly over time, adding a
considerable degree of regulatory and
legal risk. This point is illustrated by
the Norwegian government’s recent
decision to reduce gas pipeline tariffs,
a measure that is likely to have an
impact on the expected cash flows
of pipeline investments.
These reservations notwithstanding, what
counts in the end is a comprehensive view
of the investment process and how it is
embedded in the asset-liability management
process. This consideration is also reflected
in rating agencies’ commentaries. According
to a recent paper by Standard & Poor’s (S&P),
Standard & Poor’s Ratings Services (2014), ‘Investing in
Infrastructure: Are Insurers Ready to Fill the Funding Gap?’
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Closing the long-term investment gap: the dual role of the insurance sector
an insurer’s investments in infrastructure
would be assessed on how those
investments affect “its capital and
earnings and the quality, diversification
and liquidity of its investment portfolio.
We (S&P) 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.”4
In light of such a comprehensive assessment,
and in considerable contrast to what
many believe, S&P analysts conclude
that “infrastructure development can
potentially meet insurers’ appetite for
long-tenor, higher-yielding assets that
provide a good match with their longterm illiquid liabilities.”
Section 3
Beyond long-term investments:
the specific insurance perspective
Closing the long-term investment gap: the dual role of the insurance sector
7
There is considerable potential
to enhance the role of insurance
in enabling LTIs, particularly in
emerging economies.”
A central function of insurance is to
protect against the financial consequences
of adverse events. By providing such
protection, insurers make investments
more attractive to risk-averse investors
and therefore enable investments, which
in turn enhance the productive capacity
of entrepreneurs and thus the growth
potential of the entire economy.5
private sector, for which insurance is even
more important, is likely to increase its
share of total infrastructure investments.
As, on a global level, only about a third of
all losses from natural disasters are insured
(and in emerging economies only 10 to 20
percent), there is considerable potential to
enhance the role of insurance in enabling
LTIs, particularly in emerging economies.
Insurance can also be seen as a form of
contingent capital: The insured pays a
premium today to receive cash (or capital)
later in compensation for the financial
consequences of a pre-defined adverse
event. Because the risk is passed to the
insurer, the customer does not actually
have to hold capital to absorb the financial
loss caused by an adverse event.6 This
contingent capital has two interesting
features: it becomes capital only after an
idiosyncratic (or insured) event and, unlike
bank credit or access to the capital market,
it is available independent of economic and
financial cycles. This makes the availability
of contingent capital provided by an
insurance contract wholly independent
of other sources of capital.
To facilitate the beneficial role of insurance,
it is important to allow insurers to charge
risk-sensitive prices or rates. Risk-sensitive
(or risk-commensurate) rates serve a number
of purposes. They are instrumental for
reducing, if not eliminating, the problem
of adverse selection.10 By assigning a
price to risk, insurance also provides an
economic incentive to appropriately
manage the trade-off between risk and
return, and avoid or reduce excessive
risk-taking activities. In addition, riskcommensurate rates (in other words rates
that are not politically prescribed) enable
an appropriate return to be generated on
the equity capital allocated to insurance,
thus preventing economically inefficient or
wasteful allocation of capital. In meeting
these three objectives, private insurance
based on risk-commensurate rates plays
an important and often under-appreciated
economic role. Yet many countries limit
insurers’ freedom to charge risk-sensitive
rates, particularly for risks covered by
flood insurance.
In 2012, property insurance globally covered
losses in excess of USD 200 billion.7 Of this
total, USD 81 billion covered natural
catastrophes and man-made disasters.8
Thus, insurance coverage made a substantial
contribution to taking idiosyncratic risks
out of LTIs. The importance of this
contribution is likely to grow in future
as economic losses caused by natural
catastrophes are expected to increase.
See also Zurich Government and Industry Affairs (2012),
‘The Social and Economic Value of Insurance: A Primer.’ https://
www.zurich.com/internet/main/SiteCollectionDocuments/
insight/social-and-economic-value.pdf.
5
See also Shimpi, P. (2004), ‘Leverage and the Cost of Capital
in the Insurative Model.’ Mimeo.
6
7
Source: Axco Global Statistics
Source: SwissRe (2014)‚ ‘Natural catastrophes and
man-made disasters in 2013,’ sigma 1.
8
See von Peter, G., S. von Dahlen, and S. Saxena (2012‚
Unmitigated disasters? New evidence on the macroeconomic
cost of natural catastrophes,’ BIS Working Papers No 394.
See also Geneva Association (2013), ‘Insurers’ contributions
to disaster reduction – a series of case studies.’
9
10
Adverse selection may result because information (about
a pre-existing condition, for example) is known only to the
insured (asymmetric information) or because regulation
prevents the insurer from charging an appropriate,
risk-commensurate rate (regulatory adverse selection).
Insurance can significantly reduce the
long-term macroeconomic consequences
of disasters by supporting necessary
investments and financing reconstruction
in the wake of natural catastrophes.9
In a more recent development, insurers
and reinsurers have also begun to provide
catastrophe coverage for emerging
market governments. This allows these
governments to react quickly to
catastrophes. Governments that would
otherwise struggle to raise sufficient
funds can provide relief to victims and
fund reconstruction. In the future, the
Examples are Argentina and Brazil, but also the Neal Bill
in the United States.
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Closing the long-term investment gap: the dual role of the insurance sector
Insuring large-scale risks of the kind
associated with infrastructure or caused by
natural catastrophes requires international
risk diversification, access to reinsurance
and a global capital market. On a national
or regional level, losses arising from these
risks occur too infrequently to make them
suitable for pooling. To some extent, only
large and internationally-diversified insurers
and reinsurers are in a position to provide
protection for such large-scale risks that
escape pooling. However, a number of
countries have recently introduced barriers
to international re-insurance of such risks,
making protection potentially more
costly or putting it entirely out of reach
of domestic policyholders.11
Section 4
The accounting and regulatory treatment
of insurers’ long-term investments
Closing the long-term investment gap: the dual role of the insurance sector
9
Solvency II is likely to create a
number of challenges for insurers,
particularly with regard to
investments in long-term assets.”
Ever since G20 leaders stated that “long
term financing for investment, including
infrastructure, is a key contributor to
economic growth and job creation in all
countries”12, accounting and regulatory
treatment of long-term investments has
been very high on the political agenda and
has influenced discussions with accounting
standard setters and prudential regulators.
Regulations will soon be introduced in the
European Union (EU) which, according to
critics, could induce institutional investors
to at least partially retreat from long-term
investments and, in most cases, less-liquid
segments of the credit market. Implicit
in these concerns is the view that the
proposed changes do not adequately
take into account insurers’ ability to ride
out short-term market volatility.13
4.1 Challenges associated
with Solvency II
See G20 Finance Ministers’ Communique, Moscow 2013
(https://www.g20.org/sites/default/files/g20_resources/
library/Final_Communique_FM_July_ENG.pdf).
12
Representative for such views is a report by the World
Economic Forum (2011), ‘The Future of Long-term Investing,’
Geneva: World Economic Forum.
13
14
Solvency II is only one variant of risk-based insurance
regulations. In 2011, Switzerland introduced its version,
known as Swiss Solvency Test (SST), which in large parts
anticipates, and corresponds with, the solvency regime to
become effective in the EU in 2016. In the interest of brevity,
this text refers to Solvency II in a generic manner, as a proxy
for all risk-based regulatory regimes.
Solvency II will soon be at the heart of
the new European prudential regulatory
framework for insurance companies.14
In a notable departure from the current
Solvency I framework, the amount of
capital that insurers are required to hold
in the future will no longer be determined
solely by the volume of premiums, but
rather on the risks insurers assume through
their underwriting and investment activities.
The new regime has thus been accurately
described as an economic risk-based
system of financial regulation. Its salient
features are the integrated and consistent
view of risks associated not only with the
liability side of the insurance balance sheet,
but also with the asset side and the
mark-to-market valuation of the entire
balance sheet. The greater the risks
associated with assets and liabilities and
the mismatch between them, the more
capital must be available on the insurer’s
balance sheet to carry those risks. The
new regime also promises to abolish
quantitative restrictions on specific asset
classes, as is the case under Solvency I.15
Under Solvency I there are no specific capital
requirements on investments, instead the regime imposes
asset admissibility limits.
15
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Closing the long-term investment gap: the dual role of the insurance sector
Although the comprehensive risk-based
framework and an end to restrictions on
investment are significant improvements
over Solvency I, as well as other statutory
frameworks, Solvency II is likely to create
a number of challenges for insurers,
particularly with regard to investments in
long-term assets. The three main concerns
typically raised in this debate relate to (i)
the valuation of assets and liabilities
under the fair value or mark-to-market
accounting principles introduced with the
new regime; (ii) the calibration of risk
models, and specifically the risk weights
assigned to various asset classes; and (iii)
the pro-cyclicality introduced by the
capital requirements and fair value
principles. These three challenges can
be summarized as follows:
• Fair value, or mark-to-market accounting
principles, will be the basis for the
valuation of insurance balance sheets
under Solvency II. As long as there are
liquid markets that allow for transparent
and homogenous price-building, an
asset’s fair value is given by its market
price. If this does not apply – as can
be the case for long-term investments
(such as infrastructure) for which there
is no liquid market – the valuation must
build on models that include market
information deemed to be as relevant
as possible. While these principles
are readily understood, in practice
their implementation is fraught with
obstacles. Changes in risk assessment
and/or observable market information
(e.g., interest rates) may have a much
greater impact on the values of longterm assets than on short-term assets.
Additionally, given the heterogeneity
and low liquidity of many LTI markets,
valuation models must rely on very
limited data. As a result, the valuation of
long-term investments is associated with
a considerable degree of uncertainty.
Treatment of long-term assets and corresponding capital
requirements under Solvency II
In a manner similar to the framework governing banking regulation (as codified in
Basel II and Basel III), Solvency II consists of three pillars, with capital requirements
in Pillar 1. There are no specific capital requirements tailored to infrastructure
investments. Insurance companies, like banks, can choose to either calculate the
required solvency capital and minimum capital by applying a standard formula,
or by using an approved internal model. Either way, the calculations are based on
a broadly economic total balance sheet approach; fair values are the starting point
for the valuation of the balance sheet.
Only through the use of an internal model can a company capture the specific risks
of long-term investments; calibration must be backed up with appropriate statistics
and validated. Under the current version of the standard formula, investments
in long-term assets are not specifically segregated as a specific risk module.
Investments in infrastructure would be captured in different ways, depending
on the type of investment:
• Infrastructure project equity: Investments in project equity are captured by the
equity risk sub-module of the standard formula and due to their characteristics
are most likely to be classified as ‘type 2 equity.’ This implies calculating the
required capital based on a 49-percent shock, plus or minus any ‘symmetric’
adjustments. A symmetric adjustment that reduces the capital requirements
after a market crash by up to 10 percentage points is designed to mitigate
unwanted pro-cyclicality.
• Project bonds: Project bonds will be treated under the bond sub-category of
the spread risk sub-module in the standard formula. The calibration according
to the duration is not linear, resulting in incentives for investing in longer-term
project bonds.
• Project loans: Loans are subject to the same capital requirements as bonds.
Hence, the risk charge is dependent on the duration as well as the external
rating of the instrument.
• Infrastructure investment funds – listed and unlisted funds: Assuming the
relevant information is available, the look-through principle would apply when
evaluating the capital requirements for listed infrastructure investment funds.
This means that the risk charges would be the same as those that would be
applied if the insurance company had invested directly in the underlying asset.
Risk-based frameworks for determining
capital requirements make the link
between the risks on an insurer’s balance
sheet and the amount of capital it must
hold. As individual asset classes carry
different risks, capital requirements (or
risk weights) are adjusted accordingly.
In each asset class, weights increase with
increasing duration, and the question
arises whether the risk weights used in
the standard formula adequately reflect
the characteristics of LTIs. Consequently,
if not appropriately compensated with
higher returns, the capital requirements
on long-term investments are perceived
as burdensome, making the investments
less attractive relative to investments in
the same asset class that have shorter
durations. Given this line of reasoning,
capital requirements proposed under the
Solvency II standard formula would likely
deter insurers from financing LTIs. On the
other hand, Solvency II requires and rewards
sound asset-liability management, which
will motivate insurers to invest in longterm assets that match the corresponding
liability profile.
Closing the long-term investment gap: the dual role of the insurance sector
11
Fair-value accounting principles and the
capital requirements proposed under
Solvency II are perceived to lead to
‘pro-cyclical’ investment behavior. Capital
requirements that are largely independent
of market cycles could potentially trigger
such behavior, leading insurers to buy assets
in market upswings and sell assets during
downturns. Such behavior could amplify
market cycles and contribute to financial
instability. In other words, the proposed
regime could impair the insurance sector’s
ability to ride out market volatility.
4.2 Assessing the
reform proposals…
Given the economic importance
attributed to LTIs, policymakers and other
stakeholders have advanced a number
of proposals to mitigate some of the
challenges discussed in the previous
section.16 Examples include (i) matching
and volatility-adjustment mechanisms,
(ii) changes to the extrapolation
methodology used to determine the
adjustment speed to the very long-term
discount rate (the ultimate forward
rate, ‘UFR’), and (iii) counter-cyclical
premiums (CCP).
In late 2013, EU policymakers agreed on
pragmatic modifications to the proposed
Solvency II regime, including a more
detailed treatment of securitized instruments
and a 16-year transition period for the
valuation of insurance liabilities. At the
same time, the EIOPA refused to grant
specific exemptions that would favor
infrastructure investments on the grounds
that this body lacks “comprehensive, reliable
and publicly available performance data”
to justify lower capital requirements.17
16
The European Commission’s (2013) ‘Green Paper Long-Term
Financing of the European Economy,’ explicitly asks, for
example, “To what extent do you consider that the use of
fair value accounting principles has led to short-termism
in investor behaviour? What alternatives or other ways to
compensate for such effects could be suggested?”
EIOPA (2013), ‘Discussion Paper on Standard Formula
Design and Calibration for Certain Long-Term Investments’
and EIOPA’s letter to the European Commission on this issue;
available at https://eiopa.europa.eu/en/consultations/
consultation-papers/2013-closed-consultations/april-2013/
discussion-paper-on-standard-formula-design-andcalibration-for-certain-long-term-investments/index.html.
17
12
In principle, all of the proposals advanced
so far endeavor to take the bite out of fair
value accounting principles and capital
requirements that are seen by some to be
incompatible with the business model of
insurers and specifically with the long-term
nature of many insurance investments.
One could indeed argue that fair value is
not always the same as the investment
value, i.e., the subjective value an investor
may attribute to a certain asset. In particular,
Closing the long-term investment gap: the dual role of the insurance sector
investors with longer time horizons may
value an asset based on the discounted
value of cash flows through to maturity
and, for a bond, its redemption value.
Both cash flows through to maturity
and the redemption value in the distant
future may not be affected even during
times of market stress, when the fair
value of an asset can fall significantly
below its investment value as liquidity
risk premiums increase.
Even though insurers are able to hold
assets, including less-liquid assets, through
severe market dislocations, the potentially
significant discrepancies between fair
value and investment value still need to
be reconciled. One way to address the
diverging valuation metrics during crises
could be to adjust the discount rate
applied to the value of liabilities by an
appropriate liquidity premium calibrated
to the liquidity premiums observed in the
financial markets.
4.2.1 …with respect to
fair-value accounting…
Given the economic importance of LTIs,
policymakers and academics are seeking
to address these issues and to facilitate
conditions for insurers to provide longterm funding. The current low-yield
environment combined with substantial
market uncertainties can be especially
challenging for certain insurers.
A number of proposals have been made to
better deal with this situation. Examples
include matching and volatility adjustment
mechanisms to the relevant risk-free
interest rates used to value an insurer’s
liabilities. Another example is an
extrapolation mechanism for the UFR to
contain the so-called ‘artificial volatility’
embedded in the fair-value principles for
long-term liabilities. But these mechanisms
would only buy time. If the environment
does not improve in due course, economic
losses would eventually be revealed.
Such mechanisms are implicitly linked to
expectations that governments would
step in if the environment deteriorates
or losses are realized at policyholders’
expense (through reduced benefits).
Recent empirical studies have
documented the ability of fair
value to predict failure due to
poor asset and credit quality.”
CFA Institute (2013), ‘Fair Value Accounting and Longterm Investing in Europe: Investor Perspective and Policy
Implications.’ The CFA Institute represents nearly 110,000
chartered financial analysts and 138 member societies.
The study is available at: http://www.cfainstitute.org/
ethics/Documents/fair_value_and_long_term_investing_
in_europe.pdf.
18
Blankespoor, E., T. J. Linsmeier, K. R. Petroni, and C.
Shakespeare (2012), ‘Fair Value Accounting for Financial
Instruments: Does It Improve the Association Between
Bank Leverage and Credit Risk?’ The Accounting Review,
Vol. 88 (4), pp. 1143-1177.
19
20
The crisis literature is, by default, focused on the banking
sector since few insurance groups failed during the recent
financial crisis. The notable exception was, of course, one
large American insurance group, with a substantial financial
market division.
While no one claims that the fair-value
approach provides a perfect outcome when
applied to accounting and reporting, critics
tend to downplay the important arguments
in support of fair-value principles. The
following summarizes four insights published
in a recent study by the CFA Institute:18
• Fair value is an indispensable signaling
device; it provides the foundation for the
purchase, sale and holding of financial
assets, and it is an early warning indicator
of financial trouble. The financial crisis
has underscored the importance of
always having an up-to-date view of the
true value of the assets and liabilities
underlying an economic transaction.
As the CFA Institute notes, “The
absence of such information simply
leads to moral hazard by originators of
securities and sub-optimal allocation of
capital by investors.” Moreover, recent
empirical studies have documented the
ability of fair value to predict failure
due to poor asset and credit quality.
Blankespoor et al (2013) found that
“both two and three years prior to
failure, fair-value leverage dominates
the other two leverage measures in
predicting failure,” which in their view
“… demonstrates that leverage based
on fair value provides the earliest signal
of financial trouble.”19
• Fair value reduces agency conflicts.
Inherent in many investment decisions
are conflicts between principals (or
investors) and agents (management).
Under conventional cost accounting,
management has considerable leeway
in the recognition of gains and losses.
This can drive a wedge between the
reported value of assets and their fair
value, providing a short-term incentive
for management to inflate reported
gains and thus inflate its own bonuses
and incentive payments. Fair value will
reduce such information asymmetry
and take out the short-termism often
associated with cost accounting.
• The validity of fair value is independent
of the investment horizon. Both shortterm and long-term investors must
continually reassess the quality of
their holdings. This implies that the
“relevance of fair value information
does not change with the holding
period of financial instruments.”
Holding periods may be subject to
(i) changes in economic conditions or
(ii) abrupt and unforeseeable structural
breaks. In both cases, fair value will
provide relevant information when it
comes to deciding whether to either
hold or shed an investment. In light
of these considerations, policymakers
would be ill-advised to endorse the
‘business-model-based’ accounting
schemes, despite occasional demands
for such an approach among LTIs’
stakeholder groups. Long-term investors
are no different from other investors.
They, too, must continually monitor
the value of their investments, even
when they choose to hold their assets
for very long periods.
• Concerns that fair value increases
pro-cyclical investment behavior are
likely exaggerated. There appears to be
little empirical evidence to support the
fear that requiring financial institutions
to write down their assets to depressed
market values could trigger fire sales,
turning what might have been a modest
market setback into a full-fledged
implosion.20 In fact, one study found
no “clear link between fair value
accounting, regulatory capital rules,
pro-cyclicality and financial contagion”
among U.S. banks at the time of the
recent financial crisis. It concluded that
there must have been other, more
significant factors, putting stress on
bank regulatory capital.21 Moreover, as
the CFA study points out, a number of
German institutions that failed or were
bailed out at that time had not applied
fair-value accounting on financial
instruments prior to the financial crisis.
Shaffer, S. (2010), ‘Fair Value Measurement: Villain or
Innocent Victim? Exploring the Links between Fair Value
Accounting, Bank Regulatory Capital and the Recent Financial
Crisis. Federal Reserve Bank of Boston,’ Working Paper No.
QAU10-01, available at http://www.bostonfed.org/bankinfo/
qau/wp/2010/qau1001.htm.
21
Closing the long-term investment gap: the dual role of the insurance sector
13
In light of these considerations, it is fair to
conclude that mark-to-market accounting
and reporting principles are better than
their reputation would suggest, and that
it would be unwise to weaken them in
the alleged interests of long-term investor
concerns. During the recent crisis, financial
institutions did not fail because fair-value
accounting forced them to reveal
unsustainable asset positions. They failed
because they mismanaged a toxic brew
of risk, leverage and opacity.
That said, it is important to acknowledge
that fair value – although it provides a
very important set of information – will
provide only one set of information for
the valuation of assets and liabilities. In
order to provide transparency and make
sound decisions, there is scope to augment
this information using other accounting
principles as reference point. To create an
environment that is favorable to long-term
investments, policymakers’ objective should
be to promote disclosure of the valuation
models used, and the level of uncertainty
embedded in the valuations, rather than
seek to rig or skew accounting rules.
4.2.2 …and with respect to
capital requirements
Considered in isolation, the capital
adequacy requirements for different asset
classes imposed by Solvency II appear to be
considerable, particularly when compared
with the non-differentiating regime of
Solvency I. However, the conclusion that
Solvency II’s capital requirements would
be punitive with respect to long-term
investments does not necessarily follow.
22
Laas, D. and Siegel, C. (2013), ‘Basel Accords versus
Sovlency Solvency II: Regulatory Adequacy and Consistency
under the Postcrisis Capital Standards,‘ Working Paper,
Universität St. Gallen.
14
Closing the long-term investment gap: the dual role of the insurance sector
Setting the right risk weights for capital
regulation is a challenging exercise,
especially when it comes to illiquid and
heterogeneous assets, including many
long-term investments. Further research
is needed to assess and measure the
interaction between the opportunities
related to the investment in LTIs and the
corresponding risks. This is especially
important because risk weights have the
potential to have a direct impact on asset
allocation.22 Providing artificial incentives
to encourage investments in specific types
of assets, however, may lead to bubbles
that increase risk, thus threatening market
stability. Investors will only be in a position
to make sound (risk-based) investment
decisions and evaluate whether expected
yields are proportionate to the risk if
true economic and risk-based capital
requirements are used.
Besides taking the risk weights for long-term
assets into consideration, it is important to
note that (i) insurance investments are to
a large extent liability-driven, (ii) insurers
will always seek to optimize the risk-return
profile of the investment portfolio, and
that (iii) diversification may significantly
lower the capital requirements of a
well-balanced portfolio. This leaves room
for engagements in a broad portfolio of
assets, including infrastructure investments,
so long as the risks are commensurate
with expected returns, and providing the
risky assets are part of a diversified portfolio.
Section 5
Policy recommendations
Closing the long-term investment gap: the dual role of the insurance sector
15
Each new regulatory initiative
gives rise to another set of
challenges with additional
costs and potentially
unintended consequences.”
Although the EIOPA has thus far refrained
from granting regulatory relief for
infrastructure investments, it is fair to
assume that EU policymakers will continue
to look to insurers to fill the LTI funding
gap. They are likely to exert pressure on
regulators to relax regulatory requirements
for these activities. It is hardly surprising
that parts of the industry welcome these
political pressures, as evidenced by a
number of proposals for regulatory
adjustments that would make funding of
infrastructure investments more attractive.
However, any attempt to adjust current
and proposed regulation should take at
least two fundamental guiding principles
into account: Regulation should not
distort incentives and therefore should not
interfere with an efficient allocation of
financial resources; and capital adequacy
requirements must reflect a comprehensive
view of the risks on the insurance balance
sheet to promote a sustainable and stable
insurance business. With these principles
in mind, we offer our policy proposals
relating to (i) regulation and accounting;
(ii) the governance of the European capital
market; and (iii) the functioning of the
insurance market.
5.1 Improve the stability of
regulatory regimes and limit
the scope for arbitrage
• Maintain fair-value valuation, as it
provides the necessary transparency for
insurers to make appropriate decisions.
Introducing matching adjustments or
an extrapolation mechanism would
only temporarily hide losses and could
distort markets. Instead, insurers should
remain transparent about their valuation
model and the level of uncertainty
embedded in the valuation.
23
Centre for the Study of Financial Innovation (2013),
‘Insurance Banana Skins 2013 – The CSFI survey of the
risks facing insurers.’
• Capital requirements must capture
all underlying risks. In particular, they
should avoid setting artificial incentives
24
Swiss Re (2013), ‘Strengthening the role of longterm investors.’
Laas, D. and Siegel, C. (2013), ‘Basel Accords versus
Solvency II: Regulatory Adequacy and Consistency under
the Postcrisis Capital Standards,’ Working Paper, University
of St. Gallen.
25
26
Basel Committee on Banking Supervision (2010),
‘Review of the Differentiated Nature and Scope of
Financial Regulation, Key Issues and Recommendations.’
Basel: Bank for International Settlements.
16
Closing the long-term investment gap: the dual role of the insurance sector
to promote investments in specific
asset classes. Only truly risk-based
capital requirements will provide
incentives to investors to make risk-based
investment decisions that are in line with
appropriate risk-reward considerations.
• Ensure a stable regulatory environment.
The stability of regulatory and legal
frameworks has a significant impact on
the insurance industry because of its
long-term time horizon. In addition
to creating compliance burdens, each
new regulatory initiative gives rise to
another set of challenges with additional
costs and potentially unintended
consequences.23 With respect to
investment strategies, regulatory reforms
may already have resulted in unwanted
shifts in the global asset allocation of
insurance investment portfolios.24
• Establish a consistent regulatory
framework across the whole financial
sector. When investing in the same
asset classes, the same types and
amounts of risk have to be assigned
equivalent capital charges, regardless
of the type of financial institution, in
order to maintain a level playing field
within the insurance industry and
across the financial sector.25 The Basel
Committee on Banking Supervision
recommends that the banking, securities
and insurance sectors “work together
to develop common cross-sectional
standards where appropriate so that
similar rules and standards are applied
to similar activities, thereby reducing
opportunities for regulatory arbitrage
and contributing to a more stable
financial system.”26 It goes without
saying that this should also include
pension funds. Without a strong joint
effort by regulators, standard setters
and industry participants, opportunities
for regulatory arbitrage will remain,
with negative consequences for the risk
profile of the whole financial sector.
5.2 Further deepen and
strengthen the capital market
• Complete the European capital market.
While insurers are well-positioned to
provide long-term LTI funding, the
availability of appropriate funding
vehicles continues to be a hurdle.
Deepening and completing the European
capital markets would address these
challenges. One way to facilitate the
provision of long-term finance by
insurers is to increase the share of
bond issues, especially by corporates.
To improve financing for SMEs, banks
could securitize loans and sell them
on the market.27 As the financial crisis
revealed, this could result in principalagent problems, which in turn could
adversely affect the quality of the
securitized loans. Encouraging covered
bond issues, or requiring the bond
originator to hold equity tranches,
could mitigate this problem. Defining
new guidelines and structures, as well
as standards for the rating of financing
vehicles,28 are additional measures that
are worthy of consideration.
• Complete the longer end of the bond
market by issuing more long-term
government bonds. As part of
broadening the European bond market,
governments should start issuing more
long-dated bonds. This would allow
insurers to better match (‘unrewarded’)
asset-liability interest rate risk exposure
and free up capital for (‘rewarded’)
risk-taking, such as risks associated with
long-term infrastructure investments.
• Strengthen insurers’ expertise in
infrastructure investments. Historically
dominated by banks, infrastructure debt
markets are now opening to institutional
investors. They see these assets as an
opportunity to diversify away from
government and covered bonds. But
professionalism and experience are key
factors for an appropriate understanding
of infrastructure investments. As most
insurers have neither the scale nor the
skill to be professional and experienced
infrastructure investors, the use of
third-party specialist asset managers
will likely be essential for insurers.
• Further promote retirement savings.
In macroeconomic terms, the lack of
savings may constrain investments.
Since the flow of savings may be
limited in the future for a number of
reasons (see also page 25), European
governments may wish to encourage
individuals and households to increase
their savings. To meet this objective,
measures could include compulsory
auto-enrolled savings programs to
fund future retirement income.29
• Provide a stable macroeconomic,
political and regulatory environment.
All investments – long-term investments
in particular – are prone to risks arising
from changes in the macroeconomic,
regulatory and legal environment.
Inflation erodes the confidence of
savers and creditors, while rapidly
increasing government debt may call
the stability of current tax regimes into
question. These factors add considerable
uncertainty and can discourage investors.
A stable macroeconomic environment,
long-term price stability and balanced
budgets will go a long way towards
supporting a favorable environment
for investment. Economic stability is
also likely to promote a stable regulatory
and legal environment, which is
instrumental in maintaining both
investor confidence and the insurance
industry’s ability to offer long-term
risk protection.
In this context we refer to the recent joint proposal by the
Bank of England and the European Central Bank on how to
reform the impaired securitization market in Europe. The joint
paper is available at https://www.ecb.europa.eu/pub/pdf/
other/ecb-boe_impaired_eu_securitisation_marketen.pdf.
27
28
See also Group of Thirty (2013), ‘Long-term Finance and
Economic Growth.’
29
See also Group of Thirty (2013), ‘Long-term Finance and
Economic Growth.’
Closing the long-term investment gap: the dual role of the insurance sector
17
5.3 Ensure a functioning
insurance market
Risks associated with infrastructure
investments are likely to be large
scale and highly concentrated.”
To fill the long-term investment gap, it is
important to address all challenges. There is
no point in promoting long-term investment
funding if businesses continue to face
unmitigated economic, political and legal
risks because they cannot access insurance
services that would allow them to manage
these risks, or at least reduce their financial
consequences. Ensuring a functioning
insurance market requires that at least
two principles be upheld:
• Insurance must reflect risks. Risk-sensitive
prices help insurers to address the
problem of ‘adverse selection.’ They
provide an economic incentive to
reduce risk-taking activities and
promote an economically-efficient
18
Closing the long-term investment gap: the dual role of the insurance sector
allocation of capital. In meeting these
objectives, private insurance based on
prices commensurate with risk fills an
important economic role.
• Risk diversification should not be
constrained. Risks associated with
infrastructure investments are likely to
be large scale and highly concentrated.
Losses arising from them occur too
infrequently to allow for an efficient
pooling of risk; mitigation through
international risk diversification and
access to reinsurance will be essential.
Policymakers should therefore allow
for international risk diversification
and refrain from artificially constraining
access to reinsurance or other forms of
cross-border capital pooling.
Section 6
Conclusions
Closing the long-term investment gap: the dual role of the insurance sector
19
The current post-crisis environment of
sub-par growth in many corners of the
global economy provides a strong case for
the promotion of LTIs. And in light of the
huge need in particular for infrastructure
investments, stimulating LTIs is a sound
policy lever to support growth.
However, there appears to be a funding
gap, given the constrained conditions of
public finances and the banking sector’s
understandable reluctance to engage more
actively in long-term lending. Insurers are
prepared to close at least part of this LTI
funding gap. Given the stable long-term
nature of their liabilities, they have the
capacity to hold risky and less liquid
long-term assets.
However, it is important that insurers fill
this role in a prudent and sustainable way.
An exclusive focus on the funding side of
LTIs is incomplete. It neglects the reality
that insurers have a dual role to play when
it comes to supporting LTIs. Equally
important is the industry’s capacity to
absorb risks, thereby facilitating the growth
of businesses and thus the long-term
prosperity of society as a whole. For that
reason, strengthening the insurance
sector’s core function – risk transfer –
should be high on policymakers’ agendas
– also in the interest of promoting LTIs.
20
Closing the long-term investment gap: the dual role of the insurance sector
A strong risk-based regulatory framework
contributes to a stable insurance sector
and increases trust in insurance products.
It is important that regulation does not
hinder the beneficial contribution of
insurers, for example, by hampering
international risk diversification. Such
diversification is essential for insuring
large-scale risks, such as infrastructure
projects, or providing coverage to protect
against natural catastrophes. However,
regulation should also avoid using the
insurance industry to support often
parochial political objectives.
Insurers are not risk-absorbers of the last
resort and their balance sheets should not
be deployed to correct policy mistakes or
make up for regulatory inconsistencies.
Accounting rules and capital adequacy
requirements that do not properly reflect
risks can lead to serious market distortions
and possibly even sow the seeds of the
next crisis. In order to support long-term
investments, policymakers would be well
advised to promote a functioning market
for insurance services, rather than
encouraging institutional investors to take
risks by selectively changing the incentives
for holding long-term assets.
Section 7
Appendix: Definitions and issues
related to long-term investments
Closing the long-term investment gap: the dual role of the insurance sector
21
7.1 Definition of long-term investments
LTIs are commonly defined as investments in productive assets that have a long life span.30
LTIs enhance the productive capacity of individual enterprises and the entire economy over
the long term, providing a foundation for sustainable growth and employment. ‘Long-term’
in this case has no commonly-agreed definition but, as the Financial Stability Board (2013)
states, the life span of LTIs is usually assumed to be longer than a business cycle.
On a global level, LTIs fluctuate over time between 25 percent and 30 percent of gross
domestic product (GDP).31 Based on IMF global output projections, this implies that
annual LTIs should be between USD 24 trillion and USD 29 trillion by 2018. But there are
substantial differences between countries, depending on the economic growth trajectory
and the capital intensity of production. China, for example, invests more than 50 percent
of its GDP in long-term assets, in particular in real estate, equipment and infrastructure.
By contrast, in advanced economies, investments in infrastructure are comparatively
small; in these countries, equipment and software, and education account for the largest
portion of LTIs (see Chart 1).
Chart 1: Long-term investments in percent of GDP
60
Residential real estate
CRE and other structures
50
Infrastructure
Equipment and software
40
Education
R&D
30
20
10
0
USA
GBR
GER
FRA
JPN
CHN
IND
BRA
MEX
Data from 2011 and 2010. Source: Group of Thirty (2012)
LTIs are mainly carried out by corporations (e.g., equipment and R&D), governments
(e.g., infrastructure and education) and households (e.g., residential real estate).
In most countries corporations are the largest contributors (about 45 percent of all LTIs),
especially when it comes to funds for equipment and software, as well as commercial
real estate.32
30
See, for example, European Commission (2013), ‘Green
Paper – Long-Term Financing of the European Economy’
(http://eur-lex.europa.eu/resource.html?uri=cellar:9df9914f6c89-48da-9c53-d9d6be7099fb.0009.03/
DOC_1&format=PDF); Financial Stability Board (2013),
‘Financial regulatory factors affecting the availability of
long-term investment finance’ (http://www.
financialstabilityboard.org/publications/r_130216a.pdf);
and Group of Thirty (2013), ‘Long-term Finance and
Economic Growth.’ (http://www.group30.org/images/PDF/
Long-term_Finance_lo-res.pdf)
31
Source: Group of Thirty (2013), ‘Long-term Finance and
Economic Growth.’
32
Source: Group of Thirty (2013), ‘Long-term Finance and
Economic Growth.’
22
Closing the long-term investment gap: the dual role of the insurance sector
7.2 Definition of long-term funding
An individual household, company or government can fund its LTIs by using internal
sources (savings or, in the case of governments, tax revenues that are not used for other
expenses) or external sources, i.e., the excess savings of others. These excess savings are
usually channeled to investments via banks that collect deposits and provide loans, or via
the market, where companies can raise funds by issuing bonds or equity. Savers invest in
these financial assets either directly or indirectly, for example via insurers or pension funds.
On the aggregated macroeconomic level, however, investments are equal to savings,
regardless of how much of the investment is funded internally or externally (see Chart 2).
In order to avoid maturity mismatches and related refinancing risks, LTIs require long-term
funding, i.e., loans and bonds with long maturities.
Chart 2: Simplified overview of long-term investment funding in
a closed economy
Public
‘savings’
Funding by public ‘savings’
(taxes‌ – noninvestment
expenses
Public
investments
Bonds
Private
sector
investments
Insurers
Premiums
Bonds
Other
institutional
investors
«Investments»
Loans
Banks
Deposits
Private
savings
Equity
Direct holdings of equity and bonds
Funding by internal sources
Source: Zurich Insurance Company Ltd33
Governments finance their LTIs with tax revenues and by issuing bonds. They fund about
30 percent of all LTIs (see Chart 3), and are the single largest funding source for infrastructure
investments and education.
Almost half of private LTIs, or about 30 percent of total LTIs, are funded by internal
sources (i.e., household wealth and income or retained income of corporations). Loans
dominate the external funding of private LTIs and are used to finance roughly 30 percent
of all LTIs. The remaining 10 percent of total LTIs are funded through the market by equity
(8 percent) and bonds (2 percent).
33
Other institutional investors are, for example, pension funds
and investment funds.
Closing the long-term investment gap: the dual role of the insurance sector
23
Chart 3: Financing long-term investments (in percent)
Total
R&D
Education
Infrastructure
Equipment and software
Commercial real estate
Residential real estate
0
Internal financing
20
Government
40
60
Equity
80
Loans
100
Bonds
Source: Group of Thirty (2012)
7.3 What challenges do long-term investors face?
A private household may decide to build a new home, or a company might plan to make
capital expenditures, but challenges could deter them from their objective. As noted, on
the macro level, investments must equal savings. Challenges for LTIs can therefore
emanate from three different angles: sufficient savings need to be available to fund LTIs,
these savings must be transformed into investments, and investors require incentives to
engage in LTIs. These challenges are discussed in more detail here.
7.3.1 Availability of savings
• In many countries, high public indebtedness and adverse market conditions have led
governments to adopt fiscal austerity. As a result, many governments have cut back on
their LTIs. This has particularly affected investments in infrastructure and education, for
which, as mentioned already, governments are the main funding source. According to
a McKinsey report,34 between 2013 and 2030 infrastructure investments on the order
of USD 57 trillion are needed – 60 percent more than in the previous 18 years. Given
fiscal constraints, most governments will be hard-pressed to fund these investment
needs. To lessen the impact of austerity measures on long-term economic growth,
countries need to shift from entitlement spending to more discretionary long-term
spending. Limits should be imposed on cuts to education and infrastructure spending.
Where possible, cuts in these areas should be offset by measures to make the investments
more efficient or compensated through increased private-sector involvement.
McKinsey (2013), ‘Infrastructure Productivity.
’(http://www.mckinsey.com/insights/engineering_
construction/infrastructure_productivity)
34
24
Closing the long-term investment gap: the dual role of the insurance sector
Many potential investors
are holding back on LTIs
and their reluctance in this
regard may delay a more
robust economic recovery.”
• Demographic developments are likely to pose additional barriers to long-term financing.
The saving behavior of people follows a life cycle with increasing saving rates during
working age and negative saving rates in retirement. The aging population, especially
in advanced economies, leads to a decline in the proportion of the population that is
working and saving. As a result, savings rates could decline over the coming years. In
addition, since older people tend to prefer investments with less risk, the availability
of funding for risky LTIs will likely decrease as the population ages. This demographic
development will also put an increasing fiscal burden on countries that continue
to adhere to public pay-as-you-go pension systems, further limiting the ability of
governments to invest. To deal with these challenges, it will be important to promote
savings for retirement.
7.3.2 Transformation of savings into investments
Banks, as one of the main providers of funding for real estate and a significant funding
source for equipment and infrastructure, have become increasingly reluctant to lend,
especially when it comes to granting loans with a longer maturity. One reason is the
short-term nature of banks’ liabilities, which limits their ability to provide long-term
funding. Stricter regulations and enhanced risk management practices imposed in the
wake of the financial crisis appear to have further constrained lending. Tighter regulation
governing liquidity is making illiquid, long-term lending less attractive. These factors have
affected long-term lending, especially in the five- to seven-year segment. In certain countries
the impact is felt particularly by private households and small- and medium-sized enterprises
(SMEs) with limited access to capital markets.35
7.3.3 Private sector incentives to invest in long-term assets
• LTIs are attractive in part because of their long life span. Hence, LTIs become less
attractive if they are at risk due to fires, floods, accidents or other adverse events.
Economic losses caused by natural catastrophes have been rising in recent decades.
This trend is expected to continue as population density and property values increase
in catastrophe-prone coastal areas.
• The deep and entrenched financial and economic crisis has made prospects for long-term
economic growth less certain. Many potential investors are holding back on LTIs and
their reluctance in this regard may delay a more robust economic recovery. Entrepreneurs
willing to accept economic risk are needed to break this cycle. Public policy could help
by adopting prudential monetary and fiscal policies, thus providing the basis for a stable
economic environment with low inflation and reduced cyclical volatility.36
• In response to sovereign debt problems, as well as out of concern for the environment,
tax regimes and public subsidies in advanced market economies are undergoing rapid
and far-reaching changes. This is creating an additional layer of uncertainty that hampers
LTIs. To promote LTIs, policymakers should aim to secure a sound macroeconomic and
institutional framework with predictable taxes and a high degree of contract certainty.
Especially in emerging economies, weak property rights, social unrest and the risk of
severe political disruption contribute to uncertainties. These factors also constitute major
concerns for long-term investors.
According to the ‘2013 SMEs’ Access to Finance survey’
by the European Commission (2013), access to finance was
the most pressing problem mentioned by SME managers in
peripheral Europe. However, it was the least-mentioned
problem in Germany, Austria and Luxembourg.
35
See also principle one of OECD (2013), ‘G20/OECD
High-Level Principles of Long-Term Investment Financing
By Institutional Investors,’ DAF/AS/WD(2013)16.
36
Closing the long-term investment gap: the dual role of the insurance sector
25
As LTIs are subject to the major challenges outlined here, doubts are growing
as to whether there will be sufficient LTIs to achieve an economic growth
rate that is both sustainable and high enough to reduce unemployment.
Difficulty obtaining appropriate long-term funding for public infrastructure
projects and inadequate funding for LTIs carried out by SMEs in peripheral
European countries are among the main challenges. In other segments
and countries, private-sector LTIs face economic, legal and political risks
and, increasingly, the threat to property posed by natural catastrophes.
If these risks are not adequately compensated by higher returns, LTIs will
be postponed or simply not undertaken at all.
Given the long-term nature of their liabilities, many insurers and pension
funds are able to hold long-term assets that are not traded in liquid markets.
They could thus help to fill the funding gap for certain LTIs, especially for
infrastructure. In addition to providing long-term funding, insurers facilitate
LTIs; they provide insurance coverage for certain risks (mainly property risk)
and offer risk management services to mitigate those risks.
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Closing the long-term investment gap: the dual role of the insurance sector
Closing the long-term investment gap: the dual role of the insurance sector
27
Disclaimer and cautionary statement
This publication has been produced solely for informational purposes. The analysis contained and
opinions expressed herein are based on numerous assumptions. Different assumptions could result
in materially different conclusions. All information contained in this publication have been compiled
and obtained from sources believed to be reliable and credible but no representation or warranty,
express or implied, is made by Zurich Insurance Group Ltd or any of its subsidiaries (the ‘Group’) as
to their accuracy or completeness. Opinions expressed and analyses contained herein might differ
from or be contrary to those expressed by other Group functions or contained in other documents
of the Group, as a result of using different assumptions and/or criteria, and are subject to change
without notice.
This publication is not intended to be legal, underwriting, financial, investment or any other type
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disclaims any and all liability whatsoever resulting from the use of or reliance upon this publication.
Certain statements in this publication are forward-looking statements, including, but not limited to,
statements that are predictions of or indicate future events, trends, plans, developments or objectives.
Undue reliance should not be placed on such statements because, by their nature, they are subject
to known and unknown risks and uncertainties and can be affected by other factors that could cause
actual results, developments and plans and objectives to differ materially from those expressed or
implied in the forward looking statements. The subject matter of this publication is not tied to any
specific insurance product nor will adopting these policies and procedures ensure coverage under
any insurance policy.
This publication may not be reproduced either in whole, or in part, without prior written permission
of Zurich Insurance Group Ltd, Mythenquai 2, 8002 Zurich, Switzerland. Zurich Insurance Group Ltd
expressly prohibits the distribution of this publication to third parties for any reason. Neither Zurich
Insurance Group Ltd nor any of its subsidiaries accept liability for any loss arising from the use or
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an invitation for the sale or purchase of securities in any jurisdiction.
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Closing the long-term investment gap: the dual role of the insurance sector
Closing the long-term investment gap: the dual role of the insurance sector
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