PUBLICATION - POLITICAL RISKS INSURANCE (August 2015)

POLITICAL RISKS INSURANCE

INTRODUCTION:

Political risk is the disruption of the operations of an enterprise by political forces or events, whether they occur in host countries or result from changes in the international environment. Political risk exposures relate to people, assets and contracts. In very broad terms, the risk comprises of any political event or activity which has a negative impact on a large-scale project or investment and which could lead to a financial loss of some description. Political risk is usually present where there is volatility or wide-spread instability in the governing process.


For multinational companies, political risks refers to the risk that a host country will make political decisions that will have adverse effects on the multinational’s profits and or goals. Adverse political action can range from catastrophic, such as widespread destructions due to revolution, to those of a more financial nature, such as the creation of laws that prevent the movement of capital.

In general, there are two types of political risks, macro risks and micro risks. Macro risks refers to adverse actions that will affect all foreign firms, such as expropriation or insurrection, whereas micro risks refers to adverse actions that will only affect a certain industrial sector or business, such as corruption and un favorable action against companies from foreign countries.

All in all, regardless of the type of political risk that a multinational corporation faces, companies will usually end up losing money if they are not prepared for the adverse situations.

Political risks can also arise from sudden changes in local certification rules or newly established unexpected security rules. The same applies to higher import taxes, or in provision changes regarding local contents, or regarding the number of local employees which should be suddenly hired. The risk is outside the control of the buyer or seller. These risks can be caused by changes in a country’s political structure e.g. prior to or after elections.

In summary, Political risks refer to losses caused by:-

  1. Political violence and instability, contractual breach (financial and otherwise) and the erratic actions of governments that militate against successful investment and, more significantly, the delivery of wider business strategies.
  2. The actions or inactions of a government (host or export country) a third party country, or supranational entity (e.g. UN, EU)may deprive a company of its assets, prevent or restrict performance of a contract, and have an influence on the repayment of loans, to financing banks and lenders.

Recent events in the Middle East, North Africa, Venezuela, the credit crunch, its aftermath and the Euro zone crisis, illustrate that political risk in all its forms continue to pose real risks to companies investing in both emerging and developed markets. In reality, all types of investors are likely to suffer financial losses as a result of some form of political instability.

The African continent is in a transitory phase and episodes of political instability will continue to mark this phase for some time to come. Statistically speaking, in Africa, political upheavals in some shape or form usually appear in a 3 – 5 year cycle. The issues facing Africa today and the lessons learned from the global economic crisis have made investors to think very differently about the impact of political risk on their potential returns. Consequently, the sub Saharan Africa has recently seen arise in the demand for Political risks covers.

It should also be appreciated that in mature democracies, the risks that are associated with freedom of expression such as strikes, public disorder, election violence, food riots, government policy protects are imminent. Providing insurance covers against such perils are imperative.


CHARACTERISTICS OF POLITICAL RISKS

Events of a political nature are generally infrequent and often unpredictable. However, a single event may result in particularly large insurance losses. As a result, many political perils are classified as catastrophic risks and underwriting these risks requires large amounts of capital. A common feature of political risks is clustering, where similar events may occur in different locations at the same time period.

Geographical accumulations are usually of key importance when analyzing political risks (as is the case with other catastrophic risks). As a result, major commercial centers (major shopping and entertainment centers, mines, oil refineries, etc) are usually areas of greatest interest when analyzing risk exposures.

POLITICAL RISKS INSURANCE

Multinational Companies, Enterprises and Banks that conduct business overseas face a number of risks and challenges. Some of these risks can be removed or mitigated by conducting due diligence on the parties involved and on the economic viability of the proposed business. Other risks are harder for investors or lenders to predict. These include some commercial risks and, non-commercial—or political—risks.

Political risk insurance (PRI) is a tool for businesses to mitigate and manage risks arising from the adverse actions—or inactions—of governments. As a risk-mitigation tool, PRI helps provide a more stable environment for investments into developing countries, and to unlock better access to finance.

More generally, investors should seek to understand for themselves the political environment in which they are operating or intend to operate in and the political situation on which their long term returns may be contingent.

While political instability may not be good news for investors, the ensuing change can sometimes lead to increased stability and create more favorable operating conditions. This is true of a number of countries in Africa which have made a transition to a democratic process of government.

Political Risk Insurance (PRI) is taken out by businesses, of any size, against political risk.

Whether planning to establish a direct investment abroad or as exporters, multinational enterprises use PRI to enhance their confidence in markets which are perceived to be riskier than home markets and allow the investors to concentrate on the commercial aspects of investments, with the comfort that someone else—PRI providers—will help them avoid potential losses, or reimburse them in case of a loss emanating from political causes.

The investors most of the time rely on lenders to provide the finance for investments. The lenders will in turn create provision for country risk, and PRI, in certain cases, will reduce the provisioning requirements, and generally give comfort to lenders. PRI therefore improves access to financing, including the amounts, interest, and period of loan repayment.

Historically it was the large multinational corporates that were the main buyers of PRI cover to protect them against expropriatory action, governmental breach of contract and the damage, both physical and in business interruption terms, caused by political violence.

In recent years however, financial institutions, particularly banks, are the major users of non-payment covers to enable them to do more business with more clients and in more markets. It is this “secondary” motivation which has increasingly come to the fore and which interests investors and their lender partners.


Political risk insurance cover is available for several different types of political risk, including:-

Political violence, suchrevolution, insurrection, civil unrest, terrorismwar; riots, strikes, civil commotion within the country’s borders that may not have been necessarily caused by the Government
Governmental expropriation or confiscation of assets;
Governmental frustration or repudiationcontracts;
Wrongful callingletters of credit
Business Interruption; and
Inconvertibility ofcurrency

As with any insurance, the precise scope of coverage is governed by the terms of the insurance policy. Obviously, clients will need to refer to the terms of their insurance contracts for any particular definition as no two situations are the same.

The Insurance payout is usually aimed at covering damage to property or other assets, business interruption, and sometimes legal liability. Limits (Scope) and excesses are built in the contracts.


IMPACT OF SOME OF THE POLITICAL RISKS:
Some negative effects of political risks on firm are summarized in the following table:

  

Expropriation Loss of future profits
Confiscation Loss of assets
Loss of future profits
Campaigns against foreign goods Loss of sales
Increased costs of public relations efforts to improve public image
Mandatory labor benefits legislation Increased operating costs
Kidnappings, terrorists threats, and other forms of violence

Disrupted production

Increased security costs
Increased managerial costs
Lower productivity
Civil wars Destruction of property
Lost sales
Disruption of production
Increased security costs
Lower productivity
Inflation Higher operating costs
Repatriation Inability to transfer funds freely
Currency devaluations Reduced value of repatriated earnings
Increased taxation Lower after-tax profits

Source, Ricky W. Griffin, International business, 2005.

The underwriting of political risk insurance is a dynamic, growing business. As globalization increases, there are more corporations doing more business in more places around the world with each passing year.

While political risk insurance policies are sometimes crafted for specific situations, the major political risk insurers have standard forms for the coverages that they issue. For "complex" or larger investments specifically crafted policies are the norm and there may be several insurers providing cover in the form of syndication, through co-insurance, or perhaps with the participation of a reinsurer on a facultative basis.


In measuring the possibility of likelihood of occurrence of a political risk in any given area, a combination of factors is used by the analysts:-

  1. A combination of research tools and intelligence data
  2. The macro political environment
  3. Objectives and goals of the client are trying to achieve within that environment.
  4. Indicators used to measure a variety of key factors like governance, ease of doing business and so on.

PROVIDERS OF POLITICAL INSURANCE COVERS:
Providers of political risk insurance include public agencies and private insurance companies. The use of specialized brokers is highly recommended since there is a wide range of options available, and the risk is very complex.


Private providers of PRI are profit-oriented, offer coverage for developing and developed countries and for varying periods and at varied prices.

Public providers are National Export Credit agencies (ECAs), which may cover both export credit/trade transactions, as well as longer-term investments. ECAs usually support investors and lenders from their home country going into developing countries, and may also have mandates to support development and be self-sustaining.

Coverages, pricing, tenor, and eligibility vary widely by PRI provider, host country (destination of the investment), and sector or type of investment. Investors and lenders are strongly encouraged to contact various providers to find the coverage most suited to them.

Historically private and public insurance markets did not cooperate closely. However, for example, in the infrastructure sector where project values are often large and tenors long with uncertainty of payback as regulatory and legal frameworks change with government changes, the pattern has shifted as the demands on equity investors and their lenders increase. A review of the reinsurance arrangements for Multilateral Investment Guarantee Agency (MIGA), or the membership of the Berne union whose 50 plus members provide support for export credit and foreign investment insurance demonstrates the close relationship between both markets.

The confidentiality provision in private market insurance means that the extent of cover available is often little known or understood. In reality private market solutions often mirror those in the public market – non-cancellable for their policy term, with similar heads of cover and the use of private markets by public markets for reinsurance on a follow the fortunes basis demonstrates how closely aligned the two are.


In the COMESA Region, ATIA is the major if not the sole provider of political risks.

UNDERWRITING GUIDELINES

1.The most important aspect here is to maintain a close control of accumulations area –wise. Care has to be taken to see that Company’s exposure in one street or locality does not exceed the limit proposed under the contract.

2.Types of Risks:-

The following risks are more prone to losses:-

    1. Supermarkets
    2. Electronic Shops
    3. Grocery Shops
    4. Hotels
    5. Shopping Malls.

These will carry higher rates than for example offices or residential buildings.

3.Industries:

While underwriting industrial risks, care should be taken to ensure that there is proper fencing and access control. Also, industries where there is a large amount of open air combustibles storage should be urged to put more emphasis on Risk Management techniques.

4.Politically affiliated Ownership:

An effort must be made to identify the political affiliations if any of the owners, as it has been seen that such organizations can be targeted during sensitive periods.

5.Proximity to economically backward areas:-

No underwriting as far as possible of industries or risks which are located in, or in close proximity to areas that are economically backwards, as these represents potential flash points.

BY KENNETH OBONGO OBALLA

TRAINING MANAGER,

ZEP_RE (PTA REINSURANCE COMPANY)

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