What is political risk insurance?

The insurance part is easy to understand, but where do the politics come in? Here’s a closer examination of political risk insurance that exporters may have overlooked when profiling export risk.

After the devastation of World War II came the Marshall Plan, also know as the European Recovery Program, which was the USA’s investment in post-war Europe to rebuild the continent. However, US investors were sceptical about the security of their investments. With the threat of communism on the doorstep-where a government could potentially take assets on behalf of the state with no compensation-what guarantee of asset retention would there be for an investor? What if investors couldn’t repatriate their profits back to the USA? And with World War II following on the heels of World War I, what was to say World War III wouldn’t break out and destroy the new investments?

The US government stepped in to mitigate these risks and said they would cover investors’ operations, thus providing the first known type of political risk insurance (PRI).

SMEs and political risk
“With the proliferation of the FTAs of late, we’re seeing more and more SMEs go overseas,” says Chang Foo, head of product management and risk transfer at the Export Finance and Insurance Corporation (EFIC). “SMEs are internationalising their operations for a number of reasons: to capitalise on the benefits of the supply chain; establishing offshore manufacturing and distribution services; to capture lower cost base operations and cheaper labour costs.”

Other businesses use international bases to assess the local market, or as a base for the region, taking advantage of preferential market access like trading blocs. Other benefits include finding talent, taking advantage of research and development incentives and having access to raw materials. “We’re seeing a lot of the manufacturing sector in particular relocating their operations outside Australia,” remarks Foo.

More often than not, countries that provide lower cost operations are emerging economies, that is, countries that are still developing in terms of their government and legal system. Uncertainty and perceived instability is one reason why SMEs should consider PRI. “With emerging countries, it comes as a package: you have weaker governments, weaker law and judiciary systems that are not as transparent as you’d expect in OECD countries,” says Foo. “You have the risk of an unstable regime in which governments come and go.”

When businesses, particularly SMEs, decide to invest internationally, political risk is one of the factors they should examine in their assessment of a location alongside other forms of due diligence such as commercial risk. While the presence of political risk shouldn’t dissuade investments, businesses should understand how political intervention could affect their investment and consider methods of reducing the impact of those risks.

“While businesses are able to accept economic risks, there are risks inherent in their investment out of their control, especially what we call government intervention. This is where they have the ability to mitigate those risks by PRI,” says Foo.

Defining political risk
According to Foo, a broad definition of political risk is “government intervention in your investments”. Types of political risk vary and intervention can take many forms. A government could:
* Confiscate, nationalise or expropriate privately owned assets;
* Make currency inconvertible, such that an investor cannot transfer money out of the country, which occurred in the 1997 Asian financial crisis;
* Directly or indirectly cause political violence such as civil war, riots, insurrection, and coup d’etat, which causes forced abandonment of property and may include damage to property;
* Cancel your export licence. “This could be your inability to export or inability to import things that are instrumental to your operations,” says Foo. “Originally when you made the investment it was available, but could not be renewed”;
* Unfairly discriminate against foreign entities, which may include imposing higher taxes on you or giving preferential treatment to local competitors;
* Breach obligations on a public private partnership. “For example, an investor could buy into a power plant and agree to sell electricity to the government at a set rate. PRI covers a business if the government reneges on the agreed concession,” says Foo.

All governments make unpopular decisions from time to time, so it is equally important to understand that not every government action that negatively affects your business is considered under a political risk policy. Foo says the key is to look at whether they maintain a level playing field for you, the foreign entity, and if they follow international law. “If the government undertakes action for the public good, such as raising taxes uniformly, that is not discrimination,” he says. “Everyone thinks if a government expropriates your assets, that’s where PRI kicks in.

Governments have the right to do this, so long as they follow international law and you are adequately compensated in a prompt manner.”

PRI is a type of insurance designed to compensate a commercial organisation if government intervention prevents the normal course of business. This applies mainly to exporters with investments or operations in a country.

There are three main types of coverage.
For investors: if you put your equity into establishing a business overseas such as a warehouse, distribution outlet, factory or joint venture, then PRI will cover the risk of you outlaying that equity into that investment.
For lenders: PRI also covers lenders who lend money for a risky project if the non-payment of a loan is due to a political event, as distinct from commercial reasons for non-payment.
For equipment: You may also insure against political interference in valuable or specialised equipment. “For example, if you imported a drilling rig into a country for exploration, but the government did not allow you to export it back out, then you would be compensated for the loss of that piece of equipment,” says Foo.

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