Risk Management, Insurance and Guarantees: Overcoming the Challenges of Infrastructure Financing in Latin America and Caribbean

Vinicio Alberto da Fonseca

PIN 001 028 625 B

Dissertation for The Felowship Program

September 2004

Abstract

This report attempts to identify how insurance and risk management can be used to facilitate the financing of infrastructure projects in Latin America and Caribbean. It pointed out that infrastructure demand currently is not being meet and main negative impacts for the region. Traditional and new sources of funding and contingent capital providers are identified and recommendations are made on how insurance and risk management techniques can be applied as to further promote the development of the sector.

Contents

Abstract

Introduction

Chapter 1-Infrastructure Demand

1.1-The demand for investment

1.2- Economic and Social Impacts

Chapter 2-Risks and Insurances

2..1- Public Works

2.2- Project Finance

Chapter 3 – Alternative Sources of Funding and Guarantees

Chapter 4- Conclusion

References

List of Figures

Figure 1- Infrastructure Stock Index 7

Figure 2- Water Sanitation 7

Figure 3- Transport 9

Figure 4- Subway Network 9

Figure 5- Risk Management diagram 10

Figure 6- Different Ownership Struture 11

Figure 7- Public Work Model 12

Figure 8- Depletion of Capital in the Insurance Industry 14

Figure 9- Institutional Investor Assets for Larger LAC Markets 1999 21

Figure 10-Perceived Value of Political Risk Insurannce 23

Figure 11-Mezzanine Guarantee 24

Annexes

Annex 1 – Consensus Forecast

Annex 2 – Construction Insurance Market Trend

Annex 3 – International Surety Capacity 2001 - 2003

Annex 4 – Risk Matrix for Project Finance Model

Annex 5 – List of Multilaterals and main instruments available

“Clearly to achieve any meaningful improvement in the living standards of the poor, the Latin American and Caribbean countries will have to achieve far higher rates of growth than those realized so far. Among the key lessons I have drawn from the East Asian experience is the crucial role that the provision of infrastructure can play in facilitating competitiveness and economic growth”.

Klas Ringskog 1995, Meeting The Infrastructure Challenges in Latin America and Caribean

Introduction

The benefits of Infrastructure for the development of emerging countries appears to be undoubtly high. It varies from direct effects, such as the raise in the employment rates generated by the construction of the facilities, to indirect, as a greater penetration of education levels through the existence of transportation in rural areas. In his original paper known as ‘Washington Consensus’, Williamson (1990) identified investment in infrastructure as a key developmental factor for Latin America and Caribbean (LAC) and Peter Woicke (2001) suggested that a greater efficiency and productivity in the provision of public services are essential to fostering growth and closing inequality. These arguments are supported by several studies executed by multilateral institutions. A survey of over 40,000 poor men and women in 50 countries on their view of development indicates that they consider infrastructure as important as health and education[1].

Qureshi (2004) highlights that straightening infrastructure is paramount for the countries to meet the targets of the Millennium Development Goals[2]. An adequate and functioning physical infrastructure (water, power and transport) is essential to a country’s economic growth but reduction in public spending and a volatile political and economic environment limit the amount of capital available for infrastructure projects. And here is where risk management and insurance may play an underpinning role. Risk management contributes to prevent that adverse events causes negative impact on projects and insurance, as a contingent capital provider, operates as a second layer of protection, thus supporting the viability for both public and private sectors projects that otherwise would be not be feasible.

However, the complexity of the risks involved in infrastructure finance shall not be underestimate. The combination of limited fiscal resources (for public investment) and incipient regulations (for private investment), limit the ability of LAC economies to develop infrastructure projects in general. In addition to the region’s own factors, external global chocks contributes to the reduction of capital available in the international markets for investment in LAC and defers infrastructure finance.

This report address how risk management and insurance can be structured in order to tackle the challenges related with the above risks. Rather than the underlying regulatory and structural reforms and other governmental related issues, the report will focus only on the insurance instruments available that helps to mitigate the financial market’s gaps.

The report is structure as follows:

Chapter 1: Addresses the demand for the services and the main developmental impacts for the region

Chapter 2: Discuss the classes of risks and insurances associated with the main types of structures.

Chapter 3: Analysis of alternative sources of funding and guarantess

Chapter 4: Conclusion and recommendations

Chapter 1-Infrastructure Demand

1.1-The demand for investment

To catch up with investment needs and rehabilitation backlog created during the 1980s and to raise services levels and so spur growth, funding levels must rise sharply.

The Inter-American Development Bank (IADB) estimates that the needs for new investments for physical infrastructure in the LAC exceed US$45 billion[3] annually as follows:

–$28 billion in energy

–$10 billion in transportation

–$7 billion in water and sanitation

These figures appear to be consistent with the 2004 Consensus Forecast (Annex 1) published by Latin Finance. Considering a 4 percent average growth forecast in a sample representing the 8 largest Latin America countries and assuming a investment in infrastructure at 4 percent of Gross Domestic Product (GDP) the result is a total investment amount of US$ 62 billion. When telecommunication is excluded (estimated at US$ 20 billion), the outcome is US$ 42 billion, close to IADB’s figures[4].

However, investment in the region has suffering from a steady decline. Figure 1 shows that in the 1980’s LAC countries had more roads, power and telephones per worker than the East Asian Countries (EAC), but by 2000 the situation was reversed and the gap with the EAC and the member countries of the Organisation for Economic Cooperation and Development (OECD) has now widened. On the other hand, LAC has made progress in water and sanitation but it continues to lag behind EAC and the OCDE (Figure 2).

Figure 1- Infrastructure Stock Index

Source: World Bank Data

Figure 2-Water Sanitation

Source: World Bank Data

Klas Ringskog (1995) noted that there was a close link between the growth of infrastructure and that of GDP per capita. Historically, for each percentage point of growth in the GDP per capita, the infrastructure stock has grown by 1 percent. With the resumption of economic growth in the region, a combination of insufficient infrastructure capacity and poor management will limit possibilities for sustained growth and closing inequalitiy. Brazil assumes an especial role for the region. The Brazilian PPA (Plano Plurianual) 2004-2007 contemplates investments of US$ 100 billion therefore more than 50 percent of the needs of the entire region. But Brazil faces important issues. The 09/2003 IMF reports that in recent years GDP growth have been below expectations due to mainly to a reduced level of savings and investments and high levels of both, external and internal public debt. These factors, that make the country more vulnerable to financial crises, are commun to the majority of the LAC countries and contributes to the weak investment climate in the region.

1.2- Economic and Social Impacts

Physical infrastructure services (water, sanitation, energy and transport) are key imputs for:

grow and competitiviness

porverty reduction

improved equity

education and health improvements

The World Bank development report pointed that roughly half of all paved roads in LAC are under poor conditions (see Figure 3), which limits the region’s export capacity. Investment in public transportion is also critical for large cities. The Figure 4 compares the subway network extensions of the two largest Brazilian cities with major cities in developed world and shows that there is an enormous gap between the two groups. The situation is aggravated by the highly density of these two cities.

Additionally, considering that in these cities only a minor portion of the population uses vehicles, the expansion of more efficient methods of transport will benefit a largest percentage of the population,with positive impacts in safety, productivity, enviroment pollution and more and human urbam facilities with parks, footwalks and biketracks.

Source: Adapted from World Development Report 1994 database.

Source: Exame magazine, November 2003

The situation in the energy sector is not different. In the last five years several countries suffered from power shortfalls. Finally, in human terms, the statistics are devastating. According to the World Bank (2001), in developing countries, water related infections are the primary cause of the high incidence of diarrhoeal diseases, which kill about two million children and cause 900 millions episodes of illness each year. In rural areas there are several troubling aspects. One of them, specially for its long term consequences for educational attainment, are the large number of children who cannot adequately prepare for school due to lack to access or proper illumination. These children are further incapacitated[5] by brain damage and lung diseases, brought by indoor air pollution, as their households are reliant on traditional fuel.

Chapter 2-Risks and Insurances

This section will briefly apply principles of risk management to infrastructure finance. Gordon (1992) states that the process of risk management is divided into three stages, namely analysis, control and finance. Once a risk has been identified and its significance measured, it must be decided the most effective manner of handling it. The range of options are summarised in Figure 5 below.

Source: Risk Finance (1992)

The decision to retain, transfer, reduce or a mix of these options, is generally defined as risk finance and usually involves the following variables:

Features of the losses associated with different exposures: frequency and severity of potential individual losses. (i.e. lower severity and high predicable losses are more adequate to retain than rare catastrophic losses).

The cash-flows (their size, direction and time delay between inflows and outflows)

The rate-of-return required by the investors from its resources

Turning to infrastructure finance, considering that the risks and exposures depends on the different structures, it would be interesting to analyse the varios risk models according to future ownership structure and the extend of private participation.

Figure 6: Different Ownership Stuctures

Source: Adapted from IFC 1996 PFI Investment.

Figure 6 shows the different ownership structure, raging from very limited private participation, herewith defined as public works, to full private responsibility for long term investment and operation, defined as Divestiture. Other models involve the operation of the infrastructure asset by a private entity (Management and Leasing). As a starting point, it shall be clear that the appetite for risk retention from public owners is generally higher than those of the private investors. This means that projects with public ownership and funding have a lower demand for insurances than the private ones. Finnerty (1995) and IFC (1996) classifies the risks in three main groups as follows:

Project risks (related with the construction activities).

 Market risks (commercial risks linked with the specific segment of operation, such as price of tariffs)

 Non-commercial risks (of political nature).

For the seek of simplicity, instead of exploring in the full spectrum of risks that affects the parties involved in the project, this report will examine briefly how these main groups of risks can be mitigated by the party better equiped to handled it. Since risk allocation depends on each individual structure, the assesement will be made on the two most used models of structure, namely public works and project finance.

2..1- Public Works

Considering the multiple forms of finance, it shall be clarified that the public works model being discussed here is where obligations of private sector is limited to the execution of the construction contract only. Thus the owner, a public entity, assumes full responsibility for the repayment of the finance and operation of the asset. Financiers can be private lenders, export and regional credit agencies. The main limitation of this model is the reduced financial capacity and the lack of operation efficiency of public entities, which can make the provision of the service costly. The advantages are related to the fact that the government is not only depended on the private initiative to make the service available to the population. Furthermore, since the majority of international tenders there is an option for the bidders to provide a finance proposal, in order to be competitive, they shall obtain the more efficient form of finance. This result in a cheaper cost of finance for the public sector. The figure 7 belowshows a typical financial structure for the public model followed by comments on the man risks faced by the various contracting parties. [6]

The mains risks associated with the above contractual relationships are:

1 and 2) Loan Agreement: Political risks are always seen as one of the main obstacles for foreign direct investment and the main exposure faced by lenders. Defaults can be triggered by general moratoriums, restrictions on remittances and war. Repayments are backed by sovereign, sub-sovereign or state-owned companies. Generally federal government guarantees offers more comfortable levels of security.

3) Construction Contract: Owners and contractors face with a wide range of risks, such as natural hazards and technical risks (i.e design error).

4) Performance Guarantees: It can take form of a stand-by letter of credit or surety bonds. Is generally issued by financial institution (bank or insurance company) for a percentage of the primary contract amount. The objective is protect owners against contractor’s default.

As noted from the above, there are two main sources of risks in this structure, namely construction and political risks. Finnerty (1996) refers to construction risks as technical feasibility and describes it as the follows:

(i)that the project facilities can be constructed within the time schedule proposed

(ii) that the construction cost estimates together with the appropiate contingencies for cost escalation, will prove adequate for completion of the project; and

(iii) that upom the completion of the construction, the facilities will be capable of operating as planned.

These risks can be reduced in several ways (i.e using a experient contractor/designer for detail engineering), retained (i.e contractual budget provisions for contigencies) and tranfered throught the purchase of insurance and the provision of surety bonds or guarantees by the contractor. IFC (1996) provides a brief description of the insurances designed to cover construction risks:

a)Construction All Risks (CAR): Cover the replacement of the work damaged caused by accidents of technical nature (such as design error or workmanship) and natural hazards

b)Marine Transport and Cargo, similar to the above but ocurring during the transportation of the raw materials supplies

c)Public Third Liability: Cover personal or material damage caused by the construction activities to third parties

Until late 90’s the market was very competitive for these insurances, however several shocks, including the attacks of September 11, affected the global capacity. As Molavi (Impact 2002) observed, infrastructure financiers will have to face new insurance market realities; higher premiums, negociation of existing cover, substantially higher deductibles, new restrictions in coverage, lower appetites for risk and the rise in importance of political risk insurance.

Figure 8 estimates that total impact of the attacks on the insurance industry.

Source: Swiss Re 2003

Therefore in the last three years this global shock, combined with a negative loss experience, affected the availibility of these insurances (Annex 2), in special the CAR. This means that, unless there is a more pro-active approach of designers and contractors regarding loss prevention, insurers are unwilling to provide these covers under reasonable terms for certain projects such as subways and hydroplants. An evidence of this is The Joint Code of Practice for the Procurement, Design and Construction of Tunnels and Associeted undergroung structures in The United Kingdown, now being adopted internationally. The Code establish guidelines whereby insurers are transfering to contractors the formal responsibility for monitoring critical risks, obvioulsy with cost implications. At this instance, owners will have to decide about the uninsured contingent costs related with these perils, which again may affect the project feasibility.

On the other hand, surety bonds are usually required by the owners to warranty contractors performance. The main types of bonds are the following:

(a)Performance Bonds; which guarantee the owner that the contractor will duly execute general obligations established in the contract works

(b)Advance payment bonds; which guarantee the owner that the contractor will duly use any money advanced to him in the execution of the works

(c)Mantainance bonds; guarantee the repair of any construction defects by the contractor after the project completion but within ots warranty period.

This market has also suffered a dramatic reduction in the amount of capacity available (Annex 3) mainly as a direct consequence of fraud losses caused by the collapse of Enron (2002). The outcome was that large contractors, usually the same involved in the heavy infrastructure sector, had their capacity shortened because of new limits imposed to them by the surety market, which reduced their ability to bid for jobs. Bank guarantees are not an adequate alternative because draw the liquidity from the system, having also a negative impact over the contractor’s working capital facility.

Surprisingly, despite the above, the World Bank make a clear distinction between surety and bank guarantees. Its guidelines states that public projects backed by the bank shall require 30% of contract value for surety or alternatively 10% bank guarantees, which imposes obstacles even for major contractors[7]. The justification is that bank guarantees are a more liquid instrument. However banks only assess the financial standing of a firm whereas sureties, in addition to credit, also underwrite technical and moral capability of the contractor, which appears to be a more comprehensive approach towards performance risk. Furthermore, a bank’s obligation is to pay money only, which sometimes can be of little help to finish complex projects, whereas sureties provide technical and financial support to the contractor, until the contract is completed, thus a more reasonable solution.