Do you need political risk insurance?

Even as the focus on the Arab Spring recedes, the issue of companies insuring against political concerns in foreign lands has become a corporate governance issue of weighing risk versus cost.

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“The interest in political risk insurance is definitely rising, but the question is whether risk managers, C-suite execs, CFOs and the like, are willing to spend the money to hedge against it,” says Roger Schwartz, senior vice-president of political risk for AON Risk Solutions.

While some organizations, like Lloyd’s of London, have been discussing rising premiums as headlines highlight violent outbreaks in places like Syria, Egypt and Libya, the bigger issue facing political risk insurance is determining its value. For some projects in politically unstable areas, the costs can run as high as 5% of the asset’s value. That’s a big amount for a company to swallow if the value of that asset is in the tens of millions.

The issue has become driven by financing and corporate governance, says Daniel Galvao, senior vice-president with Marsh Inc., a corporate insurance company and risk advisor. Though insuring against risk in stable countries can still cost 1% of the asset’s value, banks and other lenders, as well as company boards are increasingly insisting on hedging against problems through the use of insurance, Galvao says.

“We are seeing decisions made less because of the risk involved and more by a company’s corporate governance policies,” he says.

That’s not always been the case, and political risk insurance likely generates less attention than other forms of insurance because claims are rarely made public. Offered by both private insurance companies and through various government export and development agencies, political risk insurance is a means of allowing a company to hedge against circumstances – from expropriation to terrorism – that are outside of its control but could have dramatic repercussions on its assets.

“Political risk is a constant and ever present in a lot of places in the world,” says Albert van Eeden, director of political risk insurance at Economic Development Canada. “Some countries are perfectly good to do business in, and then there’s a sudden change and they’re not. Political stability is not a given.”

And while political violence and terrorism captures headlines, it is often less noticeable political risks that are actually more of a concern for many businesses doing international trade. For example, transfer risk, or the ability to get money out of a country, is a prime concern for many organizations.  Expropriation risk, while relatively rare, can have dire consequences for natural resources and infrastructure businesses.

Nathan Jensen, an associate professor in political science at Washington University in St. Louis, has studied and written on the issue of political risk insurance. His take follows that of the Organisation for Economic Co-operation and Development, which suggests that protectionism in the wake of the economic crisis of 2008 is one of the biggest concerns for foreign trade. Jensen says that while terrorism or political upheavals get the most attention, it is “old” forms of risk – expropriation, breach of contract and transfer risk — that are the real incidents to be insured against.

“Most of the work I read is that there has been an increased focus on terror and violence, but that the vast majority of dollar claims are for expropriation and transfer risk,” he says, adding, “terror risk went from something that wasn’t much of a concern, with the exception of some countries and regions, to being a more central part of firm’s risk concerns.”

That said, Jensen says expropriation rarely occurs – in his studies of the U.S. Overseas Private Investment Corporation, an independent U.S. government organization, there were around 20 expropriations out of 2,600 coverages.

“Again, this can mean catastrophic losses for a firm, but they are rare events that are difficult to predict,” he says.

As for costs, though there has been discussion of rising prices, this has not actually been the case, according to the experts who spoke for this story. Most say costs have been relatively stable over the last decade, although the actual price of a policy depends on the geography it covers. Some geographies appear stable, and circumstances change, leading to price increases for coverage.

Jensen says pricing is complicated by the lack of data insurance companies have to work with. Predicting car or life insurance is relatively straightforward given the multitudes of statistics, but determining expropriation rates or the possibility of a country limiting financial transfer is much more challenging.

“Increases in risks can be written into premiums and firms can do the cost-benefit analysis of buying PRI,” Jensen says. “But uncertainty is different — where we simply don’t know what is in store in the future.”

EDC’s van Eeden says companies are increasingly making a decision on whether to use political risk insurance based on the price. “There’s definitely a cost/benefit analysis going on,” he says, noting that only about 10% of companies insure against political risk.

What’s the next hotspot? China is an area of concern where significant investments are being made, but questions abound about the role of the government in the country and its economy. “I think people are concerned,” says John Middleton, president of Millennium Credit Insurance. “Companies don’t have full control there, and I think that raises questions.”