Political Risks: Is insurance needed?

Private sector investment in Latin America and the Caribbean has increased significantly over the last several years and this trend is expected to continue. Nevertheless, there is a considerable amount of potential investment that does not take place due to the perception of political risk. Some investors, particularly those that do not have extensive experience in international markets, are uncomfortable with the prospects for continued political and economic stability in the region or perceptions of legal system problems (delays and/or uneven enforcement of laws). Other investors indicate that they are uncomfortable regarding the ability of host governments to fulfill commitments made in support of a specific investment. These perceptions of political risk are particularly problematic for smaller countries where the size of a potential investment may not justify the commitment of resources to fully analyze the current political situation. Even where project sponsors are willing to invest, many lenders generally insist of external guarantees for what they consider the "political risks" associated with a project. The large international banks involved in project finance may know the region, but they too have a very limited capacity for additional country risk.

Political risk has traditionally been covered by official bilateral agencies (credit insurers or export-import banks), by private insurers, and by multilateral institutions. Among the later, the most active is the Multilateral Investment Guarantee Agency (MIGA), a part of the World Bank group that provides political risk insurance in those countries with which it has signed an investment treaty. Nevertheless, the World Bank, the Inter-American Development Bank, and other multilaterals are increasing being asked to insure against political risk and have developed or are developing partial guarantee programs that offer political risk coverage. Within the Inter-American Development Bank, the Private Sector Division can provide guarantees of political risk (as a stand alone partial guarantees or in connection with a loan) without a counter guarantee from a member government. Partial risk guarantees to cover political risks, other than those provided of the Private Sector Department, require counter guarantees from member governments.

Definition of "Political Risks"

There is no single definition of political risk. In general, the term refers to those risks that are subject to the political decision making process and are therefore beyond the control of the firm. Political risk must be carefully distinguished from commercial risk. As noted in the accompanying box, the former relates to specific actions (or non-actions) under the control of the central government (or under certain circumstances other political entities). Generally, a governmental entity must agree to a specific arrangement (e.g., investment law, tariff agreement, investment contract, etc.) for the risk to be considered political. Action taken by the government must likewise be specific and result in an expropriation of value without payment of fair compensation. Commercial risks, including those associated with the production process, changes in input and output prices, interest or foreign exchange rates, market demand, and/ or the competitive environment are specifically excluded.

Political risks fall into four general groupings: Confiscation, Expropriation and Nationalization; Currency Inconvertibility; Contract Frustration; and War and Civil Unrest. The following sections provide more detailed information on each coverage.

Confiscation, Expropriation or Nationalization

The most common form of political risk insurance is coverage against acts by the government which deprive an investor of ownership or use of property without fair compensation. Most often this is associated with government seizure of tangible assets, but it can also be associated with expropriation of intellectual property rights. Effective expropriation can also be associated with actions that do not allow the value of a project to be realized. (e.g., forced sale of production at below market prices, failure to connect a power producer to the distribution network, denial of import/export licenses, etc.).

Currency Inconvertibility

The second most common type of political risk insurance is associated with the inability or unwillingness of the government to provide foreign exchange for the payment of interest, dividends and principal (and occasionally for needed imports of critical inputs) when the insured has made (or stands ready to make) the appropriate payment in local currency. Inconvertibility insurance does not provide coverage against the devaluation risk or other price changes. Coverage is limited to the non-availability of foreign exchange.

Contract Frustration (Policy Risk or Creeping Expropriation)

The form of political risk insurance that is most difficult to obtain, relates to noncompliance on the part of the government (or governmental entity) with a contract signed with the investor. Such actions, while not equivalent to an outright expropriation, can result in a significant reduction in the value of an investment project. Covered acts can range from simple delays in obtaining construction permits to refusal to connect a power generation station to the national distribution system; from changes in a specific tax treaty to changes in an agreed upon tariff structure. Insurance coverage is limited to specified acts covered in a specific contract or investment treaty to which the government is signatory. Coverage may also extend to compliance with credit guarantees provided by the national government to municipal, provincial or state-owned enterprises. It is critical that the covered risks, and how the specific amounts of any loss will be calculated, are clearly defined in the insurance contract.

War and Civil Unrest

Political risk insurance is sometimes available to cover damages associated with war, revolution, terrorism or general civil unrest. While a government may not have full control over these actions, given their random nature and difficulty in determining cause or collecting damages, many investors consider these to be risks that are "political" in nature and actively seek insurance coverage for associated losses.

Provision of Political Risk Insurance

The public investment insurance and export guarantee agencies of the OECD countries provide the vast majority of political risk insurance. A significant amount of this coverage is associated with the government policies for supporting exports. Pricing and coverage limits have less to do with specific country risk than with the importance of the export, the bilateral relationship, and the perceived ability to influence the actions of a country in abiding with investment agreements. Terms are generous with coverage being available for 15 years or more; rates are often highly subsidized. The bilateral agencies provide all four types of political risk insurance listed above. MIGA, the political risk insurer of the World Bank Group, provides political risk insurance throughout the world, but does not provide coverage for contract frustration.

The private market for political risk insurance protection is limited. The largest provider of political risk insurance is Lloyds of London, followed by the American International Group. Other active private sector insurers include CITI (an insurance subsidiary of Citicorp), Unistrat, (a French speciality insurer), and Exporters Insurance (an association of manufacturers, trading companies and financial institutions that provides political risk insurance to members). A couple of financial institutions are seriously contemplating entering the political risk insurance arena.

In private markets, coverage for confiscation, expropriation or nationalization is extensively available, but coverage for other type of political risk insurance is quite limited. Private coverage is considered expensive in most countries and, although some insurers are discussing providing longer terms, is generally limited to three years or less. Coverage is even more limited and expensive, if not nonexistent, in those countries perceived as high risks. While a renewal option is sometimes available, there are no rate guarantees associated with the renewal option.

A Role for the Inter-American Development Bank

Is there a role for the Inter-American Development Bank in the provision of political risk insurance? Due to the special relationship of the Bank with member countries and its position as a preferred creditor, the Bank may have a comparative advantage in the reduction of political risk, and equally important, in the reduction of the perception of political risk. This maybe particularly important in smaller countries where there is a perception of higher political risk. Involvement in the provision of guarantees covering political risk may also be important as the Bank could play the role of an honest broker in the discussions with countries regarding a variety of contractual obligations and work with the countries in the development of appropriate legal and regulatory structures. This does not mean that the Bank does not have to be careful in the provision of such guarantees. Political risk is real and needs to be carefully evaluated and properly structured-usually on a case by case basis. When there is involvement of the private sector, appropriate pricing of the political risk insurance or partial guarantees covering political risks will be needed to assure that appropriate risk mitigation steps are in place and that the guarantees do not simply increase the propensity for risk taking. There is a potential role-indeed a very promising role-but like other development tools it must be employed properly.

 

Kim B. Staking
Infrastructure and Financial Markets Division

 

 

 

Last updated: 01/16/07