Insurance on the FDI frontier

Jelmer writes*

If one were to ask a group of economists, policymakers, and other public intellectuals how to solve The Great Issue™ of stark global inequalities in wealth and development, they may very well yell “Foreign Direct Investment!” This is exactly what the World Bank has been preaching for the past thirty or so years. After all, neoclassical economics dictate that the private market should find these massive stocks of human capital, natural resources, and an untapped market to boot too good to pass up on. Considering the globalization of the economy at large it would be suboptimal at best and un-capitalist at worst not to jump on the opportunity these resources offer. Of course, it never was this easy. Resource allocation is a game we play, and when the rules and outcomes are unclear costs potentially outweigh benefits. This is often the case in poor countries; therefore, private parties keen on profits get cold feet and back out. They are wary of expropriations and (government) parties defaulting on payments. In other cases, social unrest, terrorism or even war may destroy a company’s operations abroad. Political Risk Insurance (PRI) encompasses a range of products designed to ameliorate the costs associated with these risks.

As stated by Iftinchi and Hurduzeu [pdf], PRI is offered by two main groups; public and private insurers. Public insurers are often linked to, or are an immediate part of, a development bank or government initiative. They tend to be in the market for relatively long-term investments and are less flexible due to their alignment with governments’ foreign policy or sustainability goals. Private parties, on the other hand, insure short- and medium-term projects at highly variable premiums and often with little regard for the (socio-economic) environment. As can be seen in the graph, the main public player is the World Bank’s Multilateral Investment Guarantee Agency (MIGA), with significant market share in countries with the highest risk rating (BB and worse). Zurich Group is the largest private party, insuring PRI across the board and outperforming MIGA in the, quite relevant from an international development standpoint, ‘CCC and lower’ rated market.

Source: miga.org

At its very core, the public provision of PRI is supposed to improve global resource allocation. It allows firms to engage in markets which they previously may not have considered. This very idea was central to the initiation of MIGA by the World Bank [pdf]: “sustainable economic growth in many developing and transitional countries would require stimulation of private enterprise and foreign direct investment.” Albeit easy to get behind, there are definite questions to be raised about the World Bank’s interference in this market. As market shares show, private insurers do not necessarily have a problem with fulfilling the demand in place. This issue was already being raised at the very establishment of MIGA; Stefan Sinn dealt with it extensively in his 1986 “Second Thoughts on MIGA” [pdf] paper. Furthermore, he raises fundamental concerns about the role of insurance provision in resource allocation. As with any type of insurance, risks such as moral hazard may, in fact, worsen allocation. Yes, there are obvious benefits to FDI; its size potential in comparison to other forms of development aid [pdf] says as much. And yes, its flow may very well be improved by PRI products. However, the fundamental questions raised by Sinn remain unanswered some 30 years later.

Over the next few weeks, I will further research the growing market of PRI, and the role of public provision specifically. To stay updated and receive the final report, please contact me by e-mail.


* Please help my Growth & Development Economics students by commenting on unclear analysis, alternative perspectives, better data sources, etc. (Or you can just say something nice 🙂

Author: David Zetland

I'm a political-economist from California who now lives in Amsterdam.

2 thoughts on “Insurance on the FDI frontier”

  1. Hi Jelmer,

    I had never really heard about the topic of PRI (except for one conversation we had). This post explains the scope of and possible benefits of PRI well. You shortly mentioned one possible downside at the end and pointed us at a critique by Sinn. I’m sure you’ll delve into the shortcoming more in your report and I am curious to read them. I found this (https://www.theglobeandmail.com/canada/article-federal-government-insured-suncors-middle-east-misadventures/) article about the Canadian government’s PRI arm called Export Development Canada (EDC). I am wondering to what extent this agency (and other government or development bank backed PRI firms) is able to sustain itself if it hadn’t been supported by the government. After the Libyan and Syrian civil wars, EDC had to pay $600 million to a Canadian oil company. For context, EDC had paid $900 million in insurance claims since 1971 and only earns $10 to $20 million a year of premium which means it will take decades to earn the $600 million claim back. What do you think about this?

    1. Hi Floris!

      Thank you for your comment.

      This is, in fact, a question highly relevant to my research proposition. One of the main arguments in favour of the public provision of PRI is the inability of the private market to do so either profitably or in an affordable way. EDC’s case is one in which the private market probably would be considered a failure, as a 600 million dollar claim would destroy the company in question and the potential for further PRI.

      An argument in favour of public provision concerns the overall functioning of development banks and is linked to the fact that PRI is only a very small part of EDC’s portfolio. A much larger share is made up of other ways of promoting FDI, such as direct loans and investments. It would then be reasonable to argue that PRI, as an FDI-promotion tool, has a place in the overarching toolset of publicly funded development banks. As the case in question then shows, PRI is a high-risk product which private parties would not be able to offer profitably.

      On the other hand, EDC’s case does not necessarily disprove that private provision is possible. Due to the small size of the EDC PRI portfolio risk spread was minimal, leading to the large relative loss incurred in this scenario. If a private solution were to scale and consider their spread responsibly, such a loss would be highly unlikely. The potential for private parties to do this is clearly shown by the size and performance of Zurich insurance.

      This is further supported by the possibility that the EDC may have just been a ‘wrong place at the wrong time’ kind of deal. It is quite probable that Libya had a relatively low-risk rating at the time the guarantees were issued (2006). This would place it in a sector of the market where private providers are having little issues providing PRI, leading to large portfolio size and significantly better risk-spread than EDC could achieve.

      So, to answer your question, no, in this case, with low risk-spread and a small portfolio, a private party would not have sustained itself. However, a private party with better risk management and a more significant portfolio size may very well have; as would have a private party with similar income source diversification as EDC. This then implies more questions: Are privately managed PRI portfolios managed in a less risky way? Does the public provision of PRI motivate excessive risk taking? Or are political risks just too unsure to be insured, such as what appears to have been the case with Libya?

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