Sophisticated use of political risk insurance
By making more sophisticated country risk analyses, lenders and equity investors in emerging market projects can insure selected risks in a manner that increases the internal rates of return on projects.
The increased return more than covers the insurance premium.
A recent study by IHS Markit and Marsh Specialty, called "A New Perspective on the Cost and Benefits of Political Risk Insurance for Foreign Direct Investments," suggests that many equity investors systematically underestimate the benefits of political risk insurance (PRI) relative to its cost.
Such insurance brings the obvious benefit of at least a partial recovery if a covered loss occurs.
It also can affect the determination of an appropriate country risk premium when projecting the internal rate of return of a proposed investment. The country risk premium is added to the weighted average cost of capital when estimating an overall cost of capital. A lower country risk premium yields a higher IRR.
The study concludes that, although the magnitude of the effect depends on the country and the nature of the project, there is necessarily a non-zero, and more typically a substantial, reduction of the appropriate country risk premium when the investment is covered by conventional political risk coverages.
That reduction alone can more than justify the cost of PRI, without even taking in to account the benefits of claim payments if an insured event happens.
New Risk Analyses
IHS Markit has developed over 20 years a country risk investment model — called CRIM — that estimates the adverse impact of country risks on the cash flow projected for an investment. The CRIM offers a far more nuanced approach to measuring country risk than the common simple adoption of the premium for sovereign debt as a proxy for country risk.
The model identifies 21 distinct country risks, each of which is scored in their review of a given country and project.
The study mapped conventional political risk coverages to the CRIM and applied the enhanced model to an illustrative power generation project with a long-term power purchase agreement with a government offtaker in three emerging markets: Ghana, Brazil and Indonesia.
PRI does not mitigate all of the scored risks (for example, natural disasters). However, conventional PRI coverages are relevant to a number of key risks scored in the IHS Markit model. PRI thus invariably reduces the country risk premium that comes out of the model. The only questions are by how much and what is the benefit of that reduction relative to the cost of the insurance.
Applying the CRIM to the sample power generation project proposed to be developed in Ghana (which has an S&P sovereign rating of B-), yielded a country risk premium of 6.30% without PRI.
The country risk premium fell to 2.23% if the project purchased conventional political risk coverage.
The effect of incorporating PRI into the financing plan improved the simulated S&P rating from B- to BBB. (While the initial country rating is based on actual S&P ratings, IHS Markit calculates a revised, simulated rating for purposes of comparison.)
Thus, the PRI substantially improves the project economics without any direct weighting of the benefit of ultimate claim payments.
The study then transported the same project to both Brazil (with an S&P sovereign rating of BB) and Indonesia (with an S&P sovereign rating of BBB). Because the IHS Markit estimates of the relevant risks in those two countries are different from Ghana and from each other, the financial impact of mitigating those risks also varies.
The reduction of the country risk premium in Brazil was from 2.91% to 1.41%, with a corresponding increase in the project's simulated S&P rating from BB to A -, leaving a narrower margin, but still possibly feasible for PRI to be worth its cost.
In Indonesia, the impact of PRI was to reduce the country risk premium from 1.84% to 1.05% and to improve the S&P rating from BBB to A-.
In both cases, the margin for PRI pricing is narrower than in Ghana, although it may still make sense for an investor to obtain PRI if it is available at a price point that avoids depressing the project's returns. Then, without giving up any upside, the insured still benefits from the "safety belt" that PRI provides for a class of risks that are inherently difficult to forecast, especially over longer investment horizons. Additional benefits can include comfort to prospective lenders and enhancing the options for exit.
This sample suggests that a more compelling case for PRI may arise in certain countries with lower sovereign risk ratings.
That depends on the PRI premium. PRI pricing on its own is an interesting topic, in which institutional factors and intuition have historically dominated analytics. The determination of the premium required for PRI coverage of a given project in a given country at a given time is more a function of tradition, on one hand, and recent anecdotal experience on the other, with some reflection of competitive pressures on prospective insurers.
A general impression in the market is that the risk elasticity of the price of PRI is lower for agency insurers than for commercial insurance companies. That is, coverage costs more in higher risk countries, regardless of whether that coverage is sought from the public or private sector providers, but the price is likely to rise more quickly with perceived risk with the commercial insurers. Thus, as an opening bid, a commercial insurer may be the best bet for lower risk countries, while the agencies may be the better bet in more challenging environments – assuming coverage is available at all.
However, what has traditionally been the case is no longer necessarily so, with the continued growth of the private market.
Offered rates in the private market tend to vary widely. For example, in a recent large 2021 placement for an infrastructure project in a Latin American country that, like Indonesia, is a BBB rated country, the quoted insurance pricing sourced by Marsh ranged from 150 to 50 basis points per year, and a policy limit of $800 million was secured at a market-clearing price very near the bottom end of the range. Marsh's view is that PRI would typically be available at a cost that is exceeded by the benefits implied by the CRIM as applied to the sample project in Ghana and Brazil and perhaps also in Indonesia.
CRIM country risk events:
- Corporate taxes
- State contract alteration
- Contract enforcement*
- Environmental regulations
- Business regulations
- Capital transfer*
- Currency depreciation
- Construction material shortages
- Energy shortages
- Labor costs
- Skilled labor shortages
- Export disruption
- Import disruption
- Infrastructure disruption
- Strikes and protests*
- Manmade disaster*
- Natural disaster
- Criminal violence
*Risks mitigated in whole or substantial part by PRI.
Conventional PRI coverages:
- Selective discrimination
- Forced divestiture
- Forced abandonment
- Political violence
- Business interruption (following political violence)
- Non-repossession, deprivation
- Arbitration award default/breach of contract
- Currency inconvertibility/non-transfer
- Deprivation of creditor's rights (for debt investments)
The CRIM analysis provides a basis for going deeper than just a go or no-go decision with respect to the full basket of PRI coverages. The costs and benefits of PRI can be broken down coverage by coverage.
Scores for particular risks can vary widely within a single country. For example, a country can have low fiscal risk, but a high risk of political violence. For that reason, political risk insurance underwriters shy away from a single risk score, like a sovereign rating.
Different insurers have different views about unbundling coverages and their corresponding premium amounts, but the CRIM provides a basis for negotiating optimal coverage from the perspective of maximizing investment value.
Some PRI coverages correlate only imperfectly to the risks measured in the CRIM. An example is expropriation. A PRI claim will typically require total expropriation, where the government action is so adverse that the investor prefers to abandon the project in exchange for the insurance claim payment. Partial expropriation, in which government actions reduce the value of an investment without wiping it out, tend not to be covered. To address this difference, the CRIM assumes that a host government will, on average, provide compensation for 50% of the loss, so it considers expropriation risk to be only partially mitigated by expropriation coverage.
The CRIM model focuses on cash flows. So do some PRI coverages, such as business income coverage, which replaces income lost for up to one year as a result of political violence. On the other hand, political violence coverage of the cost of repairing or replacing damaged assets provides assets-based, not income-based, compensation. The impact on cash flow will depend on the impact of the damage on operations and the time required for such repair or replacement. That could vary from hours to years.
Thus, the impact of some coverages on the risks measured by IHS Markit is speculative, although IHS Markit says it has been conservative in projecting benefits in such cases.
IHS Markit may have been too conservative in the credit given to PRI. The joint report notes that "the Marsh co-authors felt that IHS Markit did not give enough credit to the presence of the element of PRI cover commonly called 'breach of contract' or 'arbitration award default,' which would further improve the predicted financial benefits of PRI."
Such coverage is relevant to the sample projects assessed by CRIM since the expected revenues are derived under a power purchase agreement with a government offtaker that has a termination payment that could be subject to arbitration and thus benefit from arbitral award default coverage. Breach coverage is only relevant to projects that depend importantly on contracts with host governments, but that would include most substantial energy and infrastructure projects.
A key consequence of the PRI-enhanced CRIM is that potential investment projects with IRRs that otherwise would not have qualified for pursuit by an investor may, with PRI, clear the required hurdle.
Using a single discount rate for country risk rather than digging deeper and adding insurance for particular risks can inadvertently inflate the discount rate used to value cash flows. Applying PRI through the lens of the CRIM tool can improve the return.
Of course, the math only works if the lenders or equity investors agree with the CRIM's weighting of the benefits of PRI. But the CRIM model has a broad following in the market, so its approach is likely to have some influence.
The CRIM model methodology is not the final word in evaluating the relevancy of PRI to investment decisions. Work will continue on how best to reflect the impact of PRI in calculating country risk premiums, IRRs and the net present value to assign to a project. However, the work to date appears sufficient both to improve the project economics available to current emerging market investors and to expand the universe of investors who might take seriously investment opportunities in emerging markets.