“And then I woke up!” - Spotlight On Political Risk Insurance
Among the likely reverberations of the US declaration of war on terrorism may be a decline in the volume of foreign investment into emerging markets. Those investments that go forward are more likely than ever to welcome some mitigation of political risk. This article reviews the basic elements of what is available in the market for political risk insurance, and from whom, on what terms, and with what associated issues. Another article will follow in the next NewsWire on hidden or otherwise unexpected issues to watch out for in seeking and structuring political risk coverage and on new developments in the market.
What Does it Cover?
The classic coverages generally available in the market insure against losses because of expropriation, political violence or currency inconvertibility.
A claim payment for expropriation typically requires total expropriation of the insured investment. Total expropriation may be the result of a “creeping” process. Partial expropriation of a portion of the project will typically not support a claim absent specific terms fine tuning the policy. One test of whether an expropriation is “total” is whether the investor is willing to turn all of its interests over to the insurer in exchange for the claim payment. Consequently, expropriation coverage is effective against complete seizure or other blockage of the operations of a project, but not against government measures that simply reduce the rate of return from an investment.
Political violence coverage is typically asset-based. That means it provides compensation adequate to repair or replace project assets damaged by politically-motivated violence.
Insurance against political violence typically covers losses whether caused by “official” wars — that is military actions by nations — or unofficial, private violence ranging from terrorism to revolution, riots, and, in some coverages, general civil unrest. There may be important carveouts. Insurance purchased from the US government through the Overseas Private Investment Corporation, or “OPIC,” excludes — for statutory reasons — losses from violence that is primarily motivated by student or labor objectives. Insurance purchased from the World Bank through the Multilateral Investment Guarantee Agency, or “MIGA,” — for non-statutory reasons — has the same carveout.
Coverage for currency inconvertibility offers investors hard currency offshore in exchange for local currency whose conversion and transfer has been blocked by foreign exchange regulations imposed since the original investment was made.
This coverage lost a bit of luster during the Asian economic crisis. It was first conceived in connection with the Marshall Pan to protect US investors in war-torn Europe against the imposition of foreign exchange control regimes that might prevent the repatriation of dividends or return of the original investment. Although over the years currency inconvertibility has certainly proven to be a risk worth mitigating, in the past decade claims have been few and far between. The dominant international monetary risk for emerging market infrastructure projects has been instability in currency values, such as the devaluations that occurred in Thailand and Indonesia in 1997. Throughout the Asian economic crisis, and its reverberations in Latin America and Eastern Europe, actual currency inconvertibility was a nonissue. This has given rise to great demand in the political risk insurance market for currency devaluation cover, but, at least until very recently, there was no supply of such cover.
Gaps in Coverage
Several variations on these core themes are available in the marketplace. For instance, coverage for losses due to business interruption as a result of political violence — as opposed to physical damage to assets — is available.
An area of current tension in the marketplace has been between the demand for effective cover against contract frustration by governments and limits on the scope of available policies. Most such coverage focuses on the government’s compliance with just one contractual provision — the arbitration clause. If a dispute arises, the investor must invoke the arbitration clause in order to trigger the coverage. If the government refuses to participate in the arbitration, or somehow frustrates the proceedings, or fails to pay an arbitral award, then the insurer will be obligated to pay a claim in the amount of the award. (A recent example is the efforts by the Indonesian government to frustrate the CalEnergy arbitration which resulted in, at $237 million, the largest single claim payment in OPIC’s history.) Some versions of this coverage also require that the government’s breach giving rise to the arbitration constitute a violation of international law. This has introduced some uncertainty into the effectiveness of the coverage — the risk that a government breaches a contract and defaults on its arbitration obligations, but without clearly violating the often fuzzy parameters of international law. Some insurers have been willing to drop the requirement of a breach that violates international law. Project developers have eagerly sought coverage that also avoids the necessity of first prosecuting an arbitration. Although such coverage has not typically been available, some such coverage has recently appeared in the commercial market.
Who Offers It?
Political risk insurance is available from both private companies and public agencies.
Public sources of political risk insurance fall into two categories: the investment-promotion agencies — notably OPIC and MIGA — and the export credit agencies of which there are a multitude around the world, including the Export-Import Bank of the United States. Although each program has its own statutory constraints and policy goals — typically third world development in the case of the investment promotion agencies and export promotion in the case of the export credit agencies — there is substantial overlap among the terms and even the language of the coverages available from the various programs.
Given the insuperable challenges of undertaking useful statistical analysis of the probabilities of future adverse political events in particular host countries, newly arrived insurers, both public and private sector, have taken great comfort from trying to mirror the OPIC products to the extent possible in the hope of reproducing its profitable history. In particular, notwithstanding their different legal constraints, the project political risk coverages offered by both MIGA and Ex-Im Bank were substantially fashioned after the coverages provided by OPIC. For instance, MIGA excludes student and labor-based claims from its political violence coverage notwithstanding — unlike OPIC — any legal requirement to do so.
Private cover has been available from, and for generations dominated by, the venerable Lloyds of London. In the 1970’s AIG arose as an important force in the market. However, the mid-1990’s saw a minor eruption in the availability of political risk insurance from an assortment of private insurance companies. Today, roughly a half-dozen major companies compete to offer coverages that are substantially similar to those described above.
Advantages of the commercial insurers are that they purport to be faster in making coverage available. In Chadbourne’s experience, many deliver on that claim. Pricing can be higher than that of the public agencies, especially in the riskiest countries (like Russia) and in high-demand countries where capacity constraints may be binding (like Brazil) and for inconvertibility coverage (in which public providers have certain advantages in salvage arrangements that are reflected in lower pricing). On the other hand, in some countries, particularly those perceived to be less risky, the commercial insurers may be favorably competitive with the public agencies.
Another advantage is that the commercial insurers are not hampered by the network of statutory and policy constraints that are imposed on the availability and terms of the public sector programs. Thus, there is some truth to the claim by the commercial insurers that they can tailor the terms of coverage to the particular needs of a project or its investors. On the other hand, because of the absence of reliable statistical tables for political risks, commercial insurers take great comfort from the profitable history of OPIC and it’s predecessor programs going back to the Marshall Plan. Consequently, they hesitate to cover risks that are too far from those that have been subjected to OPIC’s 50-year test run.
To date, some of the most innovative political risk insurance products to arrive on the market have come from the public agencies who appear to be maintaining their primacy as a proving ground. This has been the case for the development of both capital market and devaluation risk products. However, in other areas marginal (but important) adjustments to mainstream political risk coverage terms have been available from commercial insurers well in advance of the public providers. Examples are waiving the requirement under contract frustration coverage of finding a violation of international law or the requirement, in filing an expropriation claim, that the related assignment of ownership interests be free and clear of any liens from project lenders.
At What Price?
Pricing depends on the country, the nature of the project, the nature of the investment, the insurer and the details of the coverage sought. Consequently, it is impossible to provide specific guidance regarding what to expect. Very broadly, rates for a basket of the traditional coverages as described above (expropriation, political violence and currency inconvertibility) is very likely to come at a per annum rate between 1.0% and 2.5% of the maximum amount insured.
Equity Versus Debt
Political risk insurance purchased to protect the equity investors in a project compensates for the loss in value of an investment as a result of a covered political event, but only to a limited extent.
Expropriation cover yields the book value of the insured investment. Political violence provides compensation adequate, if reinvested in the project company, to repair damaged assets. Currency inconvertibility coverage will support both dividend payments and the return of the original investment. However, coverage is effectively limited to out-of-pocket losses versus expectations. That is, for instance, expropriation cover reimburses out-of-pocket investment but will not typically cover lost profits, although commercial insurers have been known to provide this.
Political risk insurance purchased to protect project lenders covers defaults in scheduled payments of principal and interest as a result — typically a “direct and immediate” result — of a covered political event. Loans to a project that is failing for commercial reasons are unlikely to be bailed out by political risk insurance. If a failing enterprise is expropriated, the insurers will see the commercial deterioration rather than the expropriation as the cause of the defaults.
Public agencies offer insurance to promote something — either trade or investment. If a project already exists, their provision of new support of prior investment lacks “additionality.” In other words, it contributes nothing to their trade or investment promotion mission. Consequently, OPIC, MIGA and Ex-Im Bank insurance is available only in connection with new investment transactions. However, commercial insurers are typically open to offering coverage to existing projects as long as they are comfortable with the underwriting environment.
The availability of coverage from public agencies will depend critically in some fashion on the nationality of the investor or, in the case of the export credit agencies, the site where loan proceeds are to be expended. In the case of the only multilateral insurer, MIGA, the requirement is that the insured investment originate in a member country other than the prospective host country. So, well-to-do expatriates of an emerging market that would like to invest in the homeland will not be able to do so with MIGA support. Unless they have established US citizenship, they also will not qualify — unless they establish a joint venture majority-owned by friends with US passports — for OPIC insurance. OPIC insurance is, by law, only available to “eligible investors” which includes US citizens, US businesses majority-owned by US citizens, and foreign businesses at least 95%-owned by US citizens or such US businesses.
Export credit agencies will typically insure loans from lenders of any nationality, but only if the loan proceeds are expended on goods or services from the export credit agency’s home country. One relatively recent development has been the willingness of export credit agencies to develop joint underwriting arrangements in which they agree to provide joint coverage of loans the proceeds of which may be expended in any of their respective home countries, allocating their respective exposures according to the distribution of procurement that ultimately develops. Ex-Im Bank, constrained by US labor interests, has been slow to cooperate with its fellow export credit agencies in this regard, but recently entered into such an arrangement with the Export Credit Guarantee Department, or “ECGD,” in the United Kingdom.
Holes in the Market
Not all political risks are insurable, at least not in today’s market, at any price.
As an example drawn from today’s headlines, if the prospect of political violence in a country were to force an evacuation of key personnel whose departure were to result in a suspension of the operation of a project thus interrupting its revenue flows, but without any physical damage to the property of the project, conventional political violence coverage would be of no assistance. Business interruption coverage is available in the market, but typically only for revenues lost as a consequence of actual physical damage to the project as a result of politically-motivated violence. A perception of danger in the region is unlikely to support a claim — though it is perhaps a far greater, and more widespread, risk than the physical destruction of any particular facility.