Politically Speaking

One of the basic principles of finance is that with greater risk comes the possibility of greater returns. This often leads companies to seek opportunities in new and fast-growing regions. Unfortunately, the downside to this strategy is the need to manage the uncertainty and potentially disastrous consequences of political risk.

WHAT IS POLITICAL RISK?

Political risk refers to the negative repercussions that result from the action or inaction of governments. It is usually highest in developing countries where the economy and politics are unstable, with agitated social groups.

A recent example is the political unrest and violence that occurred during the “Arab Spring” movement in Northern Africa. However, political risk can also materialize in more developed countries, as seen by the continued financial trouble and social unrest in Europe.

Because political risk is difficult to predict and is beyond the control of an individual company, specialized insurance, called political risk insurance (PRI), can be purchased to mitigate the negative impact of political risks. PRI can be purchased from either public agencies or private insurers. Public agencies may be national, such as Canada’s Export Development Canada (EDC), or international, such as the Multilateral Investment Guarantee Agency (MIGA), a member of the World Bank Group. 

GROWTH OF PRI

The most recent annual reports of MIGA and EDC show that both agencies have experienced an increased demand for PRI in recent years. Since 2008, EDC’s average PRI exposure has increased from $1.4 billion to $1.6 billion in 2012, with an average annual increase in premiums from 0.86% in 2008 to 1.35% in 2012.

In terms of geographic concentration of risk, in 2012, 47% of EDC’s PRI exposure was related to the Middle East and Africa, 27% to Asia/Pacific, 12% to South and Central America, 12% to North America and the Caribbean, and 2% to Europe.

Regarding what type of companies use PRI, it is not surprising that in 2012, more than 44% of EDC’s PRI exposure was connected to the extractive industry (which includes oil and gas, and mining). The infrastructure and environment industry was a close second at nearly 40%. The remaining industries, ranked in order of EDC’s total PRI exposure, were surface transportation, light manufacturing, information and communication technology, and resources.

INSURABLE POLITICAL RISKS

PRI policies vary and in each case should be carefully considered and negotiated. That said, the following political risks are often insured:

• expropriation and nationalization of assets by the host country’s government;

• regulatory changes that discriminate against the foreign company;

• foreign company’s inability to convert or transfer local currency into another currency or out of the host country;

• breach or repudiation of contract by the host country’s government;

• failure by the host country’s government to honour sovereign obligations;

• refusal or frustration of the host country’s government to co-operate with arbitration, or the occurrence of new conditions in the host country that prevent arbitration altogether;

• imposition of trade embargoes; and

• the occurrence of political violence.

WHAT PRI DOES NOT COVER

Unfortunately, PRI does not offer blanket protection against all political risks, which is another reason why companies should read their PRI policies carefully. Typically, the following political risks are not covered under such policies:

• currency devaluation or inflation (note that derivatives can be used to hedge against this risk);

• actions that were illegal in the host country to begin with, or the failure of a company to comply with an existing law or regulation;

• legitimate government actions and laws, such as revised tax rates or regulations, that are non-discriminatory and apply to all companies generally; and

• for a lender using PRI, the policy will typically only compensate for the basic principal and interest amounts (as they are originally scheduled), and not extra payments, such as default interest, prepayments, accelerated principal, yield protections, indemnities, tax gross-ups or increased costs. 

BENEFITS AND DRAWBACKS OF PRI

Chris Zavos, an experienced PRI lawyer and partner in Norton Rose Fulbright’s London, U. K. office, notes that “one of the obvious benefits of political risk insurance is to facilitate foreign investment by allowing insureds to mitigate their cross-border risk. The political risk market has been around for some time and the market is experienced in assisting to resolve situations that may be entirely unfamiliar to insureds. It also continues to evolve to meet the needs of insureds – most notably over recent years with the development of political violence cover, post 9/11, and more recently, the Thai riots by way of example.”

On the other hand, the main drawback of PRI is that the insurance can be prohibitively expensive. Also, it will not cure fundamental defects or risks to a transaction.

PRI AS A RISK MANAGEMENT TOOL

Given the benefits and drawbacks of PRI, when should a company use it? Randy Bushey, a veteran insurance industry consultant, recommends that decision should come after a thorough analysis of the economic, political, contractual and business issues involved.

“For Canadian companies (particularly manufacturers and contractors) exploring opportunities with foreign government and quasi-government players, the result of their enterprise risk management initiatives lead to assessing their own confidence of their ability to complete the contract and receive final payment. Inevitably, that objective assessment involves a review of local economic and political stability issues in the jurisdiction. The result in many cases sees Canadian entities shifting the risk to a PRI insurer, thereby reducing expectations of reward in exchange for obtaining a heightened degree of financial certainty,” Bushey reports.

As part of a company’s enterprise risk management process, it should do the following:

• Thoroughly assess risk and conduct due diligence: Before investing abroad, a company, with the help of its advisors, should carefully consider what risks it will be most vulnerable to in the new host country. Every effort should be made to understand the new host country, particularly its politics, economy, history, foreign investment track record, what interest groups hold the most power and influence, and whether any cultural, social, ethnic or religious tensions exist.

• Develop a comprehensive risk management plan: This should include specific plans and procedures to deal with business disruptions, supply chain failures, crisis management and communications, and credit risk/control.

• Use multiple risk management tools: Besides PRI, political risk can be reduced by reliance on bilateral investment treaties or free trade agreements and the use of negotiated stabilization clauses in contracts with host governments. However, even if these options are available, they may not cover all political risks and the possibility exists that a host government will default on its commitments. PRI offers protection against this.

• Develop a long-term view: In addition to staying current regarding new developments and political risks, a company should develop a sustainable and long-term position in the host country. Community relationships should be valued and built on trust and respect, with local stakeholders and partners receiving a fair portion of benefits. Lobbying can also be considered, but care must be taken to comply with all lobbying, anti-corruption and anti-bribery laws in place in the company’s original and new host country.