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What is political risk insurance?

The insurance part is easy to understand, but where do the politics come in? Here’s a closer examination of political risk insurance that exporters may have overlooked when profiling export risk.

After the devastation of World War II came the Marshall Plan, also know as the European Recovery Program, which was the USA’s investment in post-war Europe to rebuild the continent. However, US investors were sceptical about the security of their investments. With the threat of communism on the doorstep-where a government could potentially take assets on behalf of the state with no compensation-what guarantee of asset retention would there be for an investor? What if investors couldn’t repatriate their profits back to the USA? And with World War II following on the heels of World War I, what was to say World War III wouldn’t break out and destroy the new investments?

The US government stepped in to mitigate these risks and said they would cover investors’ operations, thus providing the first known type of political risk insurance (PRI).

SMEs and political risk
“With the proliferation of the FTAs of late, we’re seeing more and more SMEs go overseas,” says Chang Foo, head of product management and risk transfer at the Export Finance and Insurance Corporation (EFIC). “SMEs are internationalising their operations for a number of reasons: to capitalise on the benefits of the supply chain; establishing offshore manufacturing and distribution services; to capture lower cost base operations and cheaper labour costs.”

Other businesses use international bases to assess the local market, or as a base for the region, taking advantage of preferential market access like trading blocs. Other benefits include finding talent, taking advantage of research and development incentives and having access to raw materials. “We’re seeing a lot of the manufacturing sector in particular relocating their operations outside Australia,” remarks Foo.

More often than not, countries that provide lower cost operations are emerging economies, that is, countries that are still developing in terms of their government and legal system. Uncertainty and perceived instability is one reason why SMEs should consider PRI. “With emerging countries, it comes as a package: you have weaker governments, weaker law and judiciary systems that are not as transparent as you’d expect in OECD countries,” says Foo. “You have the risk of an unstable regime in which governments come and go.”

When businesses, particularly SMEs, decide to invest internationally, political risk is one of the factors they should examine in their assessment of a location alongside other forms of due diligence such as commercial risk. While the presence of political risk shouldn’t dissuade investments, businesses should understand how political intervention could affect their investment and consider methods of reducing the impact of those risks.

“While businesses are able to accept economic risks, there are risks inherent in their investment out of their control, especially what we call government intervention. This is where they have the ability to mitigate those risks by PRI,” says Foo.

Defining political risk
According to Foo, a broad definition of political risk is “government intervention in your investments”. Types of political risk vary and intervention can take many forms. A government could:
* Confiscate, nationalise or expropriate privately owned assets;
* Make currency inconvertible, such that an investor cannot transfer money out of the country, which occurred in the 1997 Asian financial crisis;
* Directly or indirectly cause political violence such as civil war, riots, insurrection, and coup d’etat, which causes forced abandonment of property and may include damage to property;
* Cancel your export licence. “This could be your inability to export or inability to import things that are instrumental to your operations,” says Foo. “Originally when you made the investment it was available, but could not be renewed”;
* Unfairly discriminate against foreign entities, which may include imposing higher taxes on you or giving preferential treatment to local competitors;
* Breach obligations on a public private partnership. “For example, an investor could buy into a power plant and agree to sell electricity to the government at a set rate. PRI covers a business if the government reneges on the agreed concession,” says Foo.

All governments make unpopular decisions from time to time, so it is equally important to understand that not every government action that negatively affects your business is considered under a political risk policy. Foo says the key is to look at whether they maintain a level playing field for you, the foreign entity, and if they follow international law. “If the government undertakes action for the public good, such as raising taxes uniformly, that is not discrimination,” he says. “Everyone thinks if a government expropriates your assets, that’s where PRI kicks in.

Governments have the right to do this, so long as they follow international law and you are adequately compensated in a prompt manner.”

PRI is a type of insurance designed to compensate a commercial organisation if government intervention prevents the normal course of business. This applies mainly to exporters with investments or operations in a country.

There are three main types of coverage.
For investors: if you put your equity into establishing a business overseas such as a warehouse, distribution outlet, factory or joint venture, then PRI will cover the risk of you outlaying that equity into that investment.
For lenders: PRI also covers lenders who lend money for a risky project if the non-payment of a loan is due to a political event, as distinct from commercial reasons for non-payment.
For equipment: You may also insure against political interference in valuable or specialised equipment. “For example, if you imported a drilling rig into a country for exploration, but the government did not allow you to export it back out, then you would be compensated for the loss of that piece of equipment,” says Foo.

Conditions of coverage
The business has obligations to disclose all the known facts for the insurer to underwrite the deal. An insurer would look at the risks most probable for that business and make them aware which ones can be covered. This would depend on the asset you are looking to insure and the country where it is located.

Foo says EFIC would provide insurance for the majority of countries except a notable few: “Venezuela because of Chavez’s rhetoric in nationalising a lot of foreign investments, Cuba, Korea, and Zimbabwe. We would not provide coverage where there are UN sanctions such as in Iran.” However, these tend not to be popular markets for Australian companies, which are more likely to take out policies in South East Asia and the Pacific Islands.

“We would also be cautious about post-conflict countries,” he notes. “It’s not that we wouldn’t do it, but we’d analyse the risk more thoroughly; places like Afghanistan and Iraq. Sometimes we may need to do it because of national interests, for example if there’s a project in Iraq and a company wishes to do business there, and it’s deemed to be a big market for Australian exporters, we may have to protect it and assume those risks.”

Coverage only applies to new investments because businesses would have already chosen to take the risk on any existing investments. “We are trying to promote outward investments. If you have existing investments and you want to expand we can cover the expansion part, the provision of new equity,” says Foo.
For EFIC in particular, a government-related organisation, other criteria relate to whether Australia will benefit from the investment. “We’ll need to assess the benefits. One criteria is that they must be doing business in Australia, legitimately set up to do business here rather than a shell company to take advantage of our policy,” states Foo. “What we would not cover are projects related to speculative positions, buying property, for example: there have to benefits flowing back. We wouldn’t touch industries such as gambling and arms.”

Buying PRI
Public PRI providers include export credit agencies such as EFIC but also multilateral agencies like the World Bank and similar region-based banks. On the private side, the major companies like Lloyd’s of London, Zurich and AIG also provide coverage. There isn’t much difference in coverage and price between public and private agencies, but the advantage of buying with a public agency is having what Foo calls the “halo effect”.

“The difference is we have the ability to mitigate potential problems because of our G2G [government-to-government] relationship. We can be proactive and engage appropriate channels to make sure things don’t deteriorate,” he explains.
“Agencies like the World Bank have a larger halo effect: they have preferential creditor status.”

Not everyone will need PRI but it is something that businesses should certainly consider, especially when making investments in emerging economies. Like any insurance policy, you probably don’t want to have something happen to make a claim, but you’ll derive plenty of value from peace of mind.

– Case scenarios and summary provided by Chang Foo

Case Scenario: Contractors
A mid-sized contractor with oil rig equipment wins a tender to drill for soil samples in an emerging country. The company needs to deploy expensive equipment to the drill site and faces the potential risk of political violence, which could result in equipment damage. The company also worries about its ability to transfer its equipment, upon contract completion, to another overseas location, or have it returned to Australia: there is a potential that the host government could cancel its export licence. Oil rig equipment is in demand around the world, hence the risk is perceived to be high.

EFIC could help mitigate these risks by issuing a Plant and Equipment Political Risk Insurance policy. The policy can be tailored to cover not only all of the company’s equipment in the emerging country, but could also respond to cover the equipment as it is relocated to another overseas destination.

Case Scenario: Joint Venture
A small fresh fruit juice company looks to establish a joint venture company with an overseas local partner as a strategic move to increase market share by serving the market from local output, thus supplementing exports from Australia. The company faces unpredictable changes in the host country due to government policies that can disrupt its operations and place physical assets at risk. It is also at risk with respect to its ability to repatriate profits or pay intra-company dividends since all outbound remittances require the prior approval of the host country’s central bank.

Through the Investor’s Political Risk Insurance Policy, these political risks could be transferred to EFIC. EFIC’s policies can be tailored to meet exactly meet the company’s needs and exposures.

Case Scenario: Public Private Partnership
A high-technology information company could be in joint partnership with a government agency. The partnership arrangement entitles the entity to win government concessions with a first right of refusal to provide the information technology to all other government agencies.

Because of its propriety technology, the company worries that the host government could expropriate its overseas partnership arrangement or that future governments could breach its concession undertakings. These risks can be specifically mitigated by EFIC’s Political Risk Insurance Policy.

Summary of coverage
EFIC’s coverage includes the following:
Confiscation, expropriation and nationalisation: Actions by the host government that result in partial or total loss of investments or assets;
Currency inconvertibility and transfer blockage: Government controls that prevent the purchase or transfer of hard currency for dividend payments, loan repayment or other remittances;
Politically-motivated acts of violence, including war and civil war, which results in physical damage to property;
Deprivation: Cancellation of a valid export or operating licence by the host government;
Forced abandonment: Complete abandonment of a foreign investment as a direct consequence of political violence at the directives of the Australian government to evacuate the host country;
Breach of contract or arbitral award default: Following a contract breach, the matter is brought to arbitration with the award in favour of the insured where the host government defaults or simply refuses to pay.

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Adeline Teoh

Adeline Teoh

Adeline Teoh is a journalist with more than a decade of publishing experience in the fields of business, education, travel, health, and project management. She has specialised in business since 2003.

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