Martin Stone discusses the current trends in political risk insurance and what this means for clients, brokers and underwriters in the political risk market

Along with terrorism risk insurance, political risk is one of the fastest-growing lines in today's insurance market. Our US political risk team recently estimated(1) that political and terrorism risks cost the global economy more than $800bn last year in terms of curtailed spending and lost investment. But even that hefty price tag doesn't tell the whole story, since companies will be more reluctant to invest in the future if they perceive that there are serious risks to doing business in high-return markets in the developing world.

There have been plenty of instances of political events affecting business: in May 2004, for example, the Indonesian government declared a bond issue by Tri Polyta illegal, announcing that the company would no longer be liable for its debts to various creditors. Elsewhere in Asia, Coca-Cola was forced to suspend production at its Indian plant by the government of the state of Kerala as part of a drought order, meaning that 1.5m litres of production was lost.

In the past 18 months, political risk events have reached a peak not seen since the Latin American debt crisis in the early 1980s, when mounting international debt on the part of Latin American economies was exacerbated by terrorist activity in Peru and the Falklands war.

At the current point in the economic cycle, when the demand for return from shareholders is particularly acute, companies will seek to invest in high-return developing markets. But investing in these markets inevitably brings risks as well as rewards - and investors must be aware of these risks, and how they can affect business plans.

There are a number of factors investors should take into consideration before committing to an overseas investment. Principally, these risks can originate in four areas: their home government, supranational bodies such as the EU or UN, the host government, and local elements such as political or religious extremists and terrorists.

Governments, whether foreign or domestic, may force investors to abandon business interests for political reasons, either through embargo or legislation.

In the 'host' nation in which the investment is planned, political risks may take the form of political violence, non-issue or delayed issue of permits, licences or other vital documentation by the host government, non-payment on the part of creditors, currency convertibility risk, contract risk, or war with a third state that directly affects the investment under consideration.

There are also specific risks associated with being a contractor in developing economies, and for importing or exporting from these markets. Considering all of these factors as part of the investment process can be made easier if investors develop a risk assessment grid as follows:

In developing the risk profile for a particular investment destination, investors and traders should consider all factors that pertain to each of these areas to develop a full picture of the risks they face. In the case of China, for instance, the EU has been expressing concerns about human rights abuses on the part of the Chinese government. Furthermore, the Chinese government is concerned about devaluation and widespread corruption in the public sector. At the same time, foreign firms are being accused of tax evasion, and the entire legal and judicial system is seen as unreliable and unpredictable.

On the positive side, there is little threat to business in China from supranational bodies, as the market is now perceived to be too big to jeopardise for the UN and US, notwithstanding tensions with the US over Taiwan. Inside China, there is little political or terrorist activity outside Xinjiang province, but there are concerns about political unrest in the public sector, and, of course, the threat of war with Taiwan.

Taking all of these factors into consideration, our risk profile for an investment in China might look like the table above.

Once the risks profile of an investment destination has been developed, investors can begin working with their advisors on a risk management strategy, part of which will no doubt include political risk insurance. Currently, the political risk insurance market is divided between London, France and Bermuda.

Effectively, investors face a choice between private contract insurance and the Export Credit Agencies (ECAs). The private insurance market has grown rapidly, with available capacity per investment growing from $350m per investment in 1995 to $800m per investment in 2004. Typically, private insurance policies have no national content requirement, and are more flexible than ECAs.

Unlike ECA cover, private insurance cover is not systematic and risks are treated on a case-by-case basis. Investors seeking private insurance should be aware that underwriters are independent and have their own underwriting criteria, and that they should expect a potentially inconsistent range of outcomes.

Typically, underwriters will request analysis of the project being proposed for insurance, including any security arrangements that have been made for the project, the profile and track record of the partners involved and how sustainable the relationships have been. The quality of the firm seeking insurance will also be assessed, and criteria applied in this regard will include a firm's reliability, experience, its business development strategy, the size of firm and its record in handling unforeseen situations and/or events.

In addition to information that relates directly to the risks being presented, underwriters will also consider macro-economic factors which could impact on your investment, recent political events and government decisions taken in either the home or host countries which could affect the outcome of the planned investment.

The political risk insurance market is still growing rapidly and there are opportunities for investors with the right risks to find the cover they are looking for at a good price. But, as Aon's 2004 political risk map and political risk rating guide indicate, the world is becoming an increasingly risky place to do business as the certainties of the Cold War recede to be replaced by the threat of fundamentalist terrorism and unbalanced growth in emerging economies.

References

1. Source: Aon Political Risk, '2004 Global Political Risk Map', February 2004.