New Insurance For Capital Markets Financings
The Overseas Private Investment Corporation has introduced a new insurance policy aimed at protecting bondholders in capital markets financings from losses due to political risk. Other multilateral and private political risk insurers are expected to come to market shortly with similar products.
Political risk, or the risk that a commercial project will be adversely affected by politically-caused actions or circumstances over which an investor has little or no control, is a well-recognized risk in international project finance. To mitigate that risk, project developers and commercial bank lenders often seek political risk insurance policies from multilateral or bilateral agencies such as the Multilateral Investment Guarantee Agency (MIGA), the Overseas Private Investment Corporation (OPIC) or the US Export-Import Bank (US Exim), or from private market players such as American International Group (AIG), Zurich US or Lloyds, to name a few.
Until recently, however, political risk insurance was not available to one important and growing source of financing for emerging market projects: project bonds and bondholders.
That has now changed with OPIC’s introduction of its new product: a political risk insurance policy specifically designed for the capital markets and investors in fixed-income securities. Officials from the Inter-American Development Bank and Zurich US said at a conference in late September that their own products in this area are imminent.
Traditional political risk insurance policies for equity participants and bank lenders generally cover three main categories of risk: expropriation, political violence, and inconvertibility of local currency. The new capital markets political risk insurance policies offered to date cover only one of these risk categories, namely inconvertibility of local currency. Inconvertibility can occur as a result of newly-imposed governmental restrictions or lack of sufficient foreign currency. Typical inconvertibility insurance also covers the inability to transfer converted funds overseas. It is important to emphasize that, although often referred to as insurance against “exchange risk,” the new products do not cover devaluation risk, which continues to be borne by investors. None of the political risk insurance products — be they the traditional political risk policies or the new capital markets product — covers project credit risk. (Partial credit guarantees are available for emerging markets projects through the World Bank and other multilateral institutions, and private monoline insurers also offer credit support products.)
The most important and attractive feature of the capital markets political risk insurance policy for project bonds issuers from emerging market jurisdictions is the possibility, in the case of an otherwise investment grade credit, to pierce the so-called sovereign ceiling and to achieve a foreign currency investment grade rating. In reviewing the new OPIC product, both Moody’s Investors Service and Duff & Phelps Credit Rating Co. have indicated that the OPIC capital markets political risk insurance policy could be an effective means for certain projects to surpass the prevailing sovereign foreign currency rating and, in certain cases, may suffice to bring the foreign currency credit rating up to the level of the local currency rating.
Where this new product enables a project to achieve an investment grade foreign currency rating, the implication is clear. It opens the door for a large universe of institutional investors (such as insurance companies, pension funds, etc.) that would otherwise be prohibited from investing under their applicable investment policies and guidelines and potentially reduces the cost of borrowing significantly.
The capital markets political risk insurance product is not a risk panacea. It only covers one out of the three traditional political risks. In addition, the OPIC coverage also has specific conditions to payment and other requirements and limitations that should be carefully considered, both by developers contemplating using OPIC-insured project bonds as part of their financing plan and by potential investors considering an investment in OPIC-insured project bonds. While some of these are peculiar to OPIC as a creature of US law, it is almost certain that some of these conditions, requirements and limitations will also form part of the capital markets political risk insurance policies from other public and private providers of political risk insurance.
OPIC’s coverage is limited up to an amount of US$200 million for any single project. In addition, OPIC’s individual country exposure guidelines limit its exposure under each form of coverage to no more than 15% of its total exposure. As a result, in some cases, the amount of OPIC coverage may be less than the total amount of scheduled principal and interest payments on the project bonds. However, the possibilities for co-insurance and reinsurance arrangements should grow as additional public and private providers of political risk insurance join the market.
As with any insurance policy, there are certain exclusions to the new OPIC policy. Coverage is excluded in the case of pre-existing restrictions on convertibility, lack of due diligence by the insured to use all reasonable efforts to convert local currency into US dollars through all customary legal channels, and where the primary cause of the loss is unreasonable action attributable to the insured.
A key aspect of the OPIC capital markets insurance policy is the “eligibility” of the insured. This requirement comes directly from OPIC’s governing statute, the Foreign Assistance Act of 1961. The statute provides that OPIC can issue insurance to “eligible investors,” a term that the Act defines as US citizens, any US corporation, partnership or other association, or any foreign corporation, partnership, or association that is wholly-owned by a US entity. OPIC officials have indicated that, in order to accommodate the nature and dynamics of capital market transactions, OPIC will treat a “US trust structure” in which a trust is established in the US and in which a majority of the bondholders will be US persons as satisfying the eligibility requirement for purposes of the new OPIC policy.
Perhaps the most significant aspect of OPIC’s capital markets political risk insurance policy from the perspective of developers and project sponsors, however, is OPIC’s requirement that the project company or the issuer of the project bonds must enter into a “company support agreement” with OPIC. Under this agreement, the project company provides certain representations and warranties and undertakes certain covenants, breach of which could result in the denial of claims under the policy by OPIC or withdrawal and termination of the policy. The most important of these are the following:
1. anti-corruption representations and covenants to the effect that any project concessions, licenses, or other regulatory approvals were obtained in compliance with applicable anti-corruption legislation, specifically including the US Foreign Corrupt Practices Act, and that the project will continue to be operated in compliance with such laws,
2. environmental representations and covenants to the effect that the project is in compliance with applicable environmental laws and regulations, including applicable World Bank environmental guidelines, and that the project will continue to be operated in compliance with such laws, regulations and guidelines, and
3 a covenant that the project company will not take any action to prevent its employees from lawfully exercising their right to organize and bargain collectively.
In the event of misrepresentation or breach of any of the foregoing, OPIC may decline to pay a claim or withdraw and terminate the policy, irrespective of whether such violations brought about the loss. Consequently, “bad acts” of the borrower could result in loss of political risk insurance coverage for the bondholders.
For capital markets investors looking for a fixed income stream of payments, these potential “outs” are also a possible weakness of the OPIC capital market political risk insurance product. Both Moody’s Investors Service and Duff & Phelps Credit Rating Co. have indicated that these are factors they will take into account in rating an OPIC-insured project bond issuance. However, both rating agencies appear to be taking comfort from OPIC’s claims-paying track record to date — OPIC has denied only 26 of approximately 280 claims filed against the agency over its 28 years of operations. They also take comfort from its track record in handling the public policy aspects of its program — OPIC has only cancelled one policy for reasons relating to breach of environmental covenants.
One pioneering transaction with OPIC insurance already closed, and others are in the process of coming to market. There is no doubt that the capital markets political risk insurance policy will strengthen the nascent project bonds market as more developers, bankers and investors become familiar with the product.
by Noam Ayali, in Washington