Political risk insurance (PRI) is a product designed to help mitigate the political uncertainties investors and lenders face when investing or lending into emerging markets. Typically clients are concerned about the long-term political stability of a country, and a PRI policy is designed to provide insureds with the comfort that even if the sociopolitical situation in the country implodes or a new government is elected on an anti-foreign investment platform, they can exit the country without losing the investment or debt.
The inception of political risk insurance was in the 1948 Marshall Plan – US Government promotion of US equity investments to rebuild post-war Europe in the form of political risk guarantees. This has developed over the years from government-backed schemes to promote national companies overseas investments (which still exist in the form of export credit agencies) into a burgeoning private market based largely out of the London market.
Political risk insurance will cover the parent company’s
- fixed investments
- retained profits
- intercompany loans
- dividends to be paid by foreign subsidiary
From a financial institution basis, the cover is most frequently bought to protect against a default by a borrower under a loan agreement or lease as a result of political risk events–i.e. Bank A lends $100m to an oil and gas company and 6 months later that country’s government nationalizes the company. Subsequently the borrower defaults as they no longer have the revenue to repay the loan.
The cover is also bought when financial institutions are prevented by a government from accessing security under a loan agreement and also where they are trading commodities as principal on their own balance sheet.
The groups within financial institutions that have the greatest need for the product are those operating in the following areas:
- Project & export finance
- Commodity finance
- Trade finance
- Securitisations/capital markets
- Asset-based finance
- Essentially any area where the bank’s balance sheet is exposed to a credit risk
What Risks Are Covered?
Political risk insurance for lenders cover banks against the default of borrowers under a loan agreement (includes asset leasing) as a result of the following:
Confiscation – perils insured:
- Confiscation / expropriation / nationalisation
- Forced divestiture
- Forced abandonment
- Selective discrimination
- Licence cancellation / revocation
- Currency inconvertibility / exchange transfer
Physical Damage – perils insured:
- War on land
- Strikes / riots / civil commotion
- Terrorism and malicious damage
There is also the ability to cover arbitration award default in the event that insurers will not offer cover for license cancellation / revocation.
What Risks Are Not Covered?
Political risk insurance for lenders covers default by a borrower or loss to financial institution as a result of political events only. It does not cover loss resulting from the ordinary insolvency of a borrower or general commercial defaults by third parties. Comprehensive non-payment insurance (which I’ll cover next week) covers insolvency and protracted payment default.
Exclusions under PRI policies include (but not limited to):
- Failure to maintain or secure necessary permits,
- Non-compliance with laws of the foreign country (in place at inception)
- Currency fluctuations
- Commodity price fluctuations
- Breach of the loan agreement by the insured
A PRI policy will not cover defective contracts–i.e. if the underlying investment agreement or concession agreement allows the government to take a 50% free hold at any time, then you can’t claim under a PRI policy when the government executes this right.
It is important to note that the policy is designed to cover an act by government resulting in a loss where the government had no right to take that action. If a government acts in its role as legally appointed governing authority to improve public safety or environmental safety (which of course is seen by international arbiters to be reasonable) then insurers will be unwilling to respond positively.
It is important to note that, if a financial institution is lending to a sub sovereign or sovereign entity, then only comprehensive non-payment cover is appropriate as you will find it impossible to differentiate between the political and commercial actions of a sovereign or sub-sovereign entity (any company owned >50% by the government).
Commercial/ private market insurers:
- Company markets
- Export credit agencies – for example SACE, the Italian export credit agency and COFACE, the French export credit agency
- Multilaterals – MIGA (Multilateral Investment Guarantee Agency – part of the World Bank) ATI (African Trade Insurance)
Private markets vs. export credit agencies:
- Speed of response
- Documentation risk
- Local content rules
- Down-payment /commercial loan
- Double trigger cover
As most PRI for lenders loss scenarios (apart from physical loss or damage as a result of political violence) are 100% of the policy limit, the limits need to reflect the full value of the loan or investment, unless the financial institution has the appetite to take some of the risk on their own book. If a loan, it is highly unlikely that the borrower will be able to suddenly make payments again further down the line following a government confiscation for example.
It must be made clear to financial institutions that PRI for lenders is country risk mitigation only and does not provide cover against insolvency of a borrower. Wording negotiations can be complicated as there is much interpretation into what an appropriate act of a government is and what is political and what is commercial.
PRI isn’t a cheaper version of comprehensive non-payment cover, it is only covering a portion of the risk.
There should be a cross border element to the transaction, i.e. UK bank lending to UK-listed company for the purpose of developing a project in Guinea Bissau. Insurers will not cover domestic political risk.
Instances of outright expropriation by governments are less frequent today, however assets are still expropriated but by much more subtle means. This is what is known as “creeping expropriation.” This normally takes the form of a number of small actions by the government, which individually cannot be seen to be an expropriation, but when seen as a whole they have the same effect as an outright expropriation.
Increasingly, resource-rich countries in emerging markets are flexing their muscles as they seek to take a greater share in the proceeds of strategic projects. This is known as resource nationalism – which is typically seen as when a State thinks that a foreign investor is not sharing the profits from an operation, especially when prices for the natural resource rise beyond the levels originally anticipated. In these cases, the State may seek to impose new terms or regulations on the investment or the foreign investors to improve the position of the State.