Political Risk Coverage: What’s New?
The October Newswire carried an article reviewing the core traditional political risk insurance coverages available from the private and public agency insurers, namely coverage against expropriation, political violence and currency inconvertibility. It concluded with a promise to discuss in the next Newswire the cutting edge innovations and other developments in the political risk insurance arena, including developments post-September 11.
The parameters of the traditional coverages have been substantially settled for the past half century. Recent years have seen growing pressure to update conventional coverages, by expanding or enhancing the scope of coverage to encompass more contemporary risks — notably breach of contract by governments and currency devaluation risk.
Breach of Contract
Expropriation cover has traditionally compensated investors for a government’s taking of a project without adequate compensation. With the nineties and the fall of the Berlin Wall came privatizations in myriad forms. These included all shades of public-private partnerships and private projects based on public undertakings, such as sovereign guarantees of the performance of state-owned entities that act as offtakers and fuel suppliers. The government became if not overtly, at least for all practical purposes, a partner in the development and success of these projects.
Traditional expropriation cover protected private investors from the government seizing their property, but such coverage was never intended to protect one partner from bad acts of another partner — including the government. Indeed, coverage often explicitly excludes from the definition of expropriation the failure of a government to provide goods, services or cash promised to a project or its investors. Breach of contract by the government may be explicitly carved out from the scope of coverage or simply be unlikely to fall within the boundaries of the more conventional definitions of expropriation.
Yet a government’s breaches of obligations upon which the project’s economics are founded are clearly a political risk and a critical risk to mitigate if the public-private partnerships that have come to dominate infrastructure development in emerging markets during the past decade are to be successfully developed and financed.
The traditional mitigation for the risk of breach of contract is a lawsuit. Perform or pay damages. As imperfect a remedy as that may be for commercial counterparties, it is scant comfort when dealing with sovereigns — who are substantively omnipotent and, if they choose, immune to suit. Consequently, subject to the relatively minimal constraints of international law, they may be quite free to treat and mistreat their business partners as the mood, or the current administration, sees fit and to do so free from any concern of being held accountable in court.
Thus arose demand for “enhanced expropriation coverage” to cover the risk that sovereign partners will walk away from their promises.
The market demand has been met, at least part way, by both commercial and agency insurers offering variations of “disputes cover.”
Under such cover, if a government breaches a contract that has an arbitration provision, the project company or, as appropriate, the project sponsors must invoke that clause. If the government loses the arbitration, including by failure to participate, but fails to pay the arbitral award, then the insurer pays that award. A common theme of these coverages is that the insurer depends upon an arbitral panel rather than its own staff or the insured to determine whether a breach has occurred.
Demand for coverage that avoids the requirement of pursuing arbitration in advance of a claim payment from the insurer has been substantial. Though a number of insurers have agreed to provide such coverage in connection with direct payment obligations of a government or one of its ministries under export sales or other contracts, it generally remains a step beyond the cutting edge for infrastructure projects. Still, some project developers are currently pressing both commercial and agency insurers to provide such cover in connection with government undertakings in support of infrastructure projects. This is an area where further evolution is likely.
Currency Devaluation Cover
The Asian economic crisis, triggered in 1997, highlighted disappointment in the marketplace with the inability to insure against the risk that a currency would not become technically inconvertible but would suffer a wholesale collapse in its market value. Although forward contracts and other currency hedges exist, in emerging market currencies such instruments are scarce and for, at best, very short terms. Project term lenders would very much appreciate a hedge against the risk of project debt defaults as a consequence of a general collapse in the value of the host country currency.
Until recently, this was generally deemed an insoluble problem. This past May, however, the AES Tiete projects in Brazil closed a $300 million project bond issue supported by a devaluation guaranty from OPIC. (See related article in the June 2001 NewsWire.) The industry has been holding its breath a bit since then to see whether this would prove a unique event or the first in a series.
The second volley sounded in late November. Sovereign Risk Insurance Ltd., a leading commercial political risk insurer, issued a press release indicating that it was prepared to issue devaluation insurance for lenders to appropriate projects. Where this will all lead is an open question, but it is likely that, while the number of transactions may be constrained by short supply of available coverage, a new product line may be taking form in the political risk marketplace.
Capital Markets Cover
One relatively recent development in the political risk market relates not to the scope of coverages but to the beneficiaries. Originally, political risk insurance was very much associated with equity investment. In the 1990s, there was great growth in demand by institutional lenders for such coverage to support their foreign project loans. More recently, such coverage has been sought for bond offerings and has been provided both by agency and private political risk insurers.
Beginning in July 1999 with the Overseas Private Investment Corporation’s currency inconvertibility coverage of bonds issued by Ford Otosan in Turkey, many of the other providers have also now issued coverage on such capital markets transactions. More than a dozen bond issues have now been successfully supported with political risk insurance.
The coverage can enable an investment grade project in a non-investment grade country to “pierce the sovereign ceiling” and achieve an investment grade rating. The benefits are greater access to the US capital markets and improved pricing.
Terrorism Cover Post-September 11
Political violence coverage, whether from formal warfare or informal terrorism or insurrection, has been solidly within the core coverages available from political risk insurers for the past half century. And it continues to be available today. Yet the headlines have correctly reported a collapse in the availability of, and escalation of the pricing for, such coverage.
Not surprisingly, the most dramatic developments have been in the arena of property (damage) and casualty (liability) insurers. Though not generally considered part of the relatively narrow fraternity of political risk insurers, property and casualty insurers have conventionally covered war and terrorism coverage as part of their basic coverage, mostly via the lack of specific exclusions, and at little to no incremental premium. The supply of such insurance for aircraft, marine vessels, and industrial and commercial facilities has been dramatically cut back. Reinsurance treaties that expire December 31 of this year pose the prospect for specific terrorism exclusions or very specific sublimits as well as price increases still to come. A number of legislative proposals that are intended to stem the unwinding of capacity for such insurance in the United States are now pending in Congress.
The situation for casualty liability insurance is more dire in emerging markets where, for the moment, some insurers are hesitating to offer coverage for any kind of casualty liability. The likelihood is that markets will soon develop new mechanisms to fill the vacuum and provide casualty coverage generally, but terrorism cover as an element of such cover is no longer automatic, much less free, and its availability post-January 1, 2002, when existing reinsurance platforms expire and remain to be renegotiated, is very much an open question in certain emerging markets.
As for property insurance, many companies with billions of dollars in assets are facing the prospect of no terrorism coverage at all or, at best, coverage with limits of $5 million in total. While some terrorism coverage is being placed in the London market and, with the announcement of a new facility this week, by AIG in the property markets, limits in both facilities remain small and the coverage is expensive.
In late November, representatives of the major multilateral development banks plus a number of US trade promotion and development agencies gathered in Washington to discuss how they might, individually or jointly, act to assure availability of adequate coverage to support infrastructure projects in emerging markets. What products or initiatives may emerge from these agency efforts remains to be seen. But organizations that in the best of times require time to navigate initiatives through a maze of policies, politics and legislative hurdles are not likely to head off entirely availability or cost problems whose severity will probably escalate effective New Year’s Day.
Notwithstanding the arsenal of political risk mitigants available in the private and public agency marketplaces, it is clear that the correspondence between risks and mitigants is far from perfect. While demand for the products readily available in the market is probably stronger today than at any time in recent memory, it is also clear that important risks spill over the boundaries of the scope of the traditional products. Those risks take careful identification and negotiation — or will quietly go unmitigated and, with some probability, arise to haunt the project and its investors. Commerce, like nature, abhors a vacuum, so it is much more likely that risk mitigants will be found. Who — that is, which companies, which agencies of which countries, and which multilateral organizations — will step in, with what products and at what price remains to be seen.