The role of Country Risk Management and Political Risk Insurance in Emerging Market investment strategies.

Chris Hamilton Hamilton.c.chris@gmail.com

Harvard Business Summer School: Emerging Markets in the Global Economy (MGMT S-5027)

Contents:

(i) (ii) (iii) (iv) (v) (vi) (vii) (viii) (ix)

Introduction Identifying Country and Political risks Why manage Political Risk? Political Risk Insurance Alternative risk management options Managing Political Risk The future of Political Risk Insurance in Country Risk Management Conclusion Bibliography

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(i)

Introduction:

Business and Politics are integrally linked. Rarely, if ever, does an emerging market investment transaction go unnoticed by a host government. Much of the time, it exists only with the unofficial blessing and backing of that same government. In most instances, careful due diligence combined with high levels of relationship management (and positive capital flows) will ensure that the investment remains intact. But a small change in the political landscape resulting in an unforeseen event, can very quickly have detrimental consequences to an asset and an investment. These are the Country or geopolitical risks to an investment because of changes in a countrys political structure or policies. These changes can be deliberate or forced, and can be reflected in laws, tariffs, restriction or denial of rights, profits, and assets. In extreme cases companies face the serious issues of acts of expropriation, confiscation of assets, cancellation of licenses, and legal changes that render the investment dead in the water. 2

Against this investment backdrop developing countries are currently projected to have average growth rates between 7 and 9 percent this year, while the US struggles with comparatively anemic growth. The imperative for companies to trade and invest in emerging markets is strong, perhaps without fully considering the implications of doing so from a country risk perspective. Figure1, below, represents responses to the question, asked of US based corporate foreign investors: In your opinion, which of the following factors will pose the greatest constraint on investments by your company in emerging markets this year and over the next three years? (Source: MIGA-EIU Political Risk Survey 2009.) Figure 1:

Note: Percentages add up to more than 100 percent due to multiple selection 3

As is evident, the overarching concern was the Political Risk exposure over the next 3 years (20092012)

(ii) Identifying Country and Political Risks. The Backdrop: A survey of the largest global multinational corporations found that unconventional risks such as corruption, crony capitalism and political risk cost US firms $24 billion in lost revenue in 1998 alone, leading 84 percent of subsidiaries in emerging markets to fall short of their financial targets, and ultimately to a reduction of between 8% and 10% in total corporate returns. (Merchant International Group. (1999). The Intelligence Gap. London)

Country Risk is described as the collection of risk associated with investing in a foreign country (www.investopedia.com). Within this definition we include a countrys economic, political, and social patterns that might present a risk. Country risk has become a topic of major concern for any institution involved in international financial operations. As a result, a detailed assessment of country risk and its potential impact is crucial. For risk management purposes, rating agencies (such as Moodys, the Economist Intelligence Unit, International Country Risk Guide, Political Risk Services), continue to compile country risk ratings to measure the risks associated with cross border operations, which is of particular importance for emerging market countries. Country risk ratings help these countries access capital markets, and provide institutions and investors with essential tools to assess and manage such risk. One agency, International Country Risk Guide, has created a rating system comprising not less than 22 variables, representing three major components of country risk, namely economic, financial and political, which goes to prove the depth of concern that is prevalent. For the sake of this paper, and briefly, we will be looking at only the Political Risk. 4

Political risk is an analysis of the political stability of a country, and how that stability affects the countrys ability and willingness to service its financial obligations. In general, there are two types of political risk, macro and micro. Macro risk refers to adverse actions that affect all foreign firms, involving significant triggers such as expropriation. Micro risk refers to adverse actions that only impact certain industries, such as corruption within the Mining sector. Regardless of the specific type of political risk, companies can (and do) lose significant money if unprepared for these situations. To most, Political Risk is the risk of investing and operating across borders, specifically into countries with weak institutional, legal, and political frameworks. Classically, these are the

emerging markets or developing countires. To echo this point, Political Risk is more extreme in countries with weak economic fundamentals, fragile institutional structures and unstable governments. The risk exposures in conducting cross-border investment include:

counterparty risk (sovereign, sub-sovereign, banks, corporate) foreign exchange risk (devaluation) foreign exchange controls (convertibility and transferability of currency) government interference in the business conduct (various forms of expropriation) breach of contract or wrongful acts on specific transactions other changes in policies (be they discriminatory or non-discriminatory) Societal instability (terrorism, acts of war)

Figure 2, below, represents the types of risk of most concern to investors, when asked he following question: In your opinion, which types of political risk are of most concern to your company when

investing in emerging markets? (Source: MIGA-EIU Political Risk Survey 2009).

To elaborate on Exhibit 2, whilst the wide reaching Expropriation risks are less of a threat in todays globalized economy, investors continue to have concerns about Political Risk, for due reason: Breach of Contract risk, of most concern, can change an investment opportunity to such an extent that an investor can loose everything. Whilst information on Political Risk insurance claims is difficult to obtain from private insurers, (because of the confidential nature of the insurance contracts between underwriter and client) OPICs (Overseas Private Investment Corporation, an independent US government agency) insurance claims information is available and transparent. As of September 30, 2006, OPIC had paid out 284 claim settlements totaling $967.5 million. These claims settlements were either direct cash payments to investors ($611.5 million), or as OPIC guaranties of host government obligations ($365 million). Over the past twenty years, political risk 6

insurance broking company Aon, (who control perhaps 10% of the Private Insurer Political Risk Insurance business) has processed over $3 billion in claims.

(iii) Why manage Political Risk? Ultimately, risk management exists to protect the corporate balance sheet. The purchase of Political Risk insurance is no different. When companies buy coverage, they have two goals: financial indemnification (in case of an adverse event), and enhanced bargaining power. Essentially, the transfer of risk, via a premium, to an insurer is a way of quantifying and paying away that risk, removing the potential liability of adverse events (and their results) from the balance sheet. That said, the risk mitigation benefits offered by PRI go beyond cash indemnification in the event of a loss. Political Risk insurers, especially the public quasi-government insurers such as OPIC have significant positive influence with foreign governments, and have proved success in preventing adverse actions from occurring, or when events have happened, in securing preferential treatment for investors. Avoiding disputes, litigations, or outright expropriation in the first place is far more valuable than having insurance to pay for it once it has happened. Obviously enhanced bargaining can be achieved through other means, for example by joining a local partner with a better understanding of the local environment or simply better connections and lobbying capacity.

Political Risk Insurance also provides coverage for investors making direct equity investments in projects, as well as those lending to emerging market borrowers. Recently, PRI has been used as a credit enhancement when securitizing emerging market debt. A recent clean water project in Angola would never have happened without Political Risk coverage, which secured the payment obligation by the Angolan Ministry of finance to the lending US banks. 7

(iv) Political Risk Insurance

The Political Risk Insurance market exists to support emerging market investment, and specific insurance coverage is available from a number of government, public and private sector insurers. Public sector insurers, such as OPIC, provide project-specific political risk insurance, while private market insurers (Lloyds of London, Zurich, Chartis, Chubb etc) can provide cover for projects as well as a portfolio of investments. As a general rule, private market insurers are more flexible with coverage, faster to respond and fundamentally cheaper, whilst Public / quasi government insurers can bring significant political weight to bear, often preventing negative events from occurring. MIGA (Multilateral Investment Guarantee Agency) defines Political Risk Insurance as follows: Political Risk Insurance is a tool for businesses to mitigate and manage risks arising from the adverse actions - or inactions - of governments. As a risk mitigation tool, PRI helps provide a more stable environment for investments into developing countries, and to unlock better access to finance.

Coverage:

The coverage outlines specific triggers, such as expropriation or breach of contract

by a local party, and entitles the insured, after premium payment, to indemnification by the insurer. Coverage can be purchased for losses resulting from: Confiscation, Expropriation, Nationalization Contract Frustration Political Violence Currency inconvertibility and non-transfer of funds 8

Terrorism, sabotage, war, insurrection, rebellion Government act, law order or decree Trade disruption, embargo Sovereign non-performance or payment default (willingness or ability to pay) Wrongful calling of contract guarantees and bonds

The coverage can be tailored (from a menu of available options as above) to the insured's requirements for a broad range of overseas exposures, including equity investments, physical assets, cross-border loans or contracts for goods and services.

Often, investors test the PRI market as a part of their due diligence process. The availability of an insurance coverage, at a good price, often confirms the investors internal risk assessment of the project. Conversely, many buyers will not receive quotes from insurers, implying that the

investment may be too risky even to be insurable. Cost: Premiums must factor in considerable uncertainty. Similarly, the infrequency and unique nature of political risk events means there is a lack of credible statistical data on which to base estimates of future losses. Losses can be vast in their magnitude, such as an expropriation loss, which can have a ripple effect throughout a country, continent, or globally. A single sizeable political risk claim event has the potential to negate numerous years of profitable underwriting. Given this potential for catastrophic loss, as well as the difficulties in assessing the underlying risk, insurers need to bank significant premium capital in anticipation of losses. As a result, political risk insurance premiums (like other insurance premiums associated with catastrophe coverage) can be costly. The massive variances to premiums depend on the types of coverage sought, the country in 9

question, the industry sector, the size, visibility, duration and strategic importance of the investment and, perhaps most importantly the Insured. Let me use the following example of an Insured and country combination to demonstrate a cost spread: ABC Co is a US domiciled small to mid-size engineering company with exposure in the Democratic Republic of Congo. The premium rate for their Confiscation cover is 4 times higher than for the same coverage in Ghana. Their premium for Political Violence cover in Mexico is 6 times more than identical coverage for their operations in Guatemala. The identical coverage for Caterpillar Corporation, with the same involvement on the same project, is 60% of the ABC Co premium, in both instances. This is because of the leverage that Caterpillar is able to exert, the relationship that they have built over time, and the investment that they have demonstrated to both countries and governments.

Aside from close inspection of the Insured as a criteria for underwriting a deal, the following chart represents underwriting coverage and cost considerations when insurers are considering offering Political Risk Insurance.

Government Stability Socio-economic Ethnic Tensions

Corruption Investment Profile Democratic Accountability

Internal Conflict Military in Politics Bureaucracy Quality

Religious Tensions Law and Order External Conflict

Similarly, the supply and demand, and the capacity available from Insurers (the amount that they can bet based on their own internal Risk appetite and Re-Insurance arrangements) on a countryby -country basis, is also factored into every premium rate equation. At the beginning of an underwriting year, cost remains lower as fresh capacity is readily available. As that capacity is 10

purchased, rates continue to rise, until the cycle begins with a new year, and new capacity.

(v) Alternative risk management options What are the options in a risk management strategy to the purchase of insurance to mitigate, or at least, reduce your corporate exposure to Political Risks? Some companies turn to self-insurance. The largest multinationals, for example, often manage political risk internally, as they are able to exert both political and economic pressure at the highest levels of host government, whilst enjoying the support of home government.

In many developing countries, the political risk present can actively create opportunity.

In

emerging market countries particularly in Sub-Saharan Africa, the lack of central government rule, combined with the lack of infrastructure can create Institutional voids. In circumstances where an institutional void results in weak regulation, corrupt judicial systems, poor social governance, there are opportunities for a large organizations to invest strategically in filling these local voids, investing in building the non-tangible and tangible infrastructure. This in turn can hugely benefit the organization, through a more favourable legal backdrop, smoother operations, positive community branding, higher investment profile, notice by central government.

As discussed earlier, the most important factor in a Political Risk scenario, is the Insured. The size, nationality, familiarity and relationships with the local environment, partner status, knowledge leadership and network that an organization brings to the table are all directly relevant criteria for political risk exposure analysis. A multinational firm providing significant employment opportunity to the local community, and demonstrating constant and sustainable direct investment into the country will be looked on much more favourably than one that does none of the above. 11

Dan Riordan, political risk underwriter at insurance company Zurich believes that that the insured is the most crucial part of risk assessment, because the experience and capabilities of the insured that will ultimately have the largest impact on risk in the long term. Similarly, Charles Berry of Berry Palmer & Lyle, a leading Political Risk Broker at Lloyds of London suggests that There is no such thing as abstract political risk in my opinion: political risk very much depends on who you are and what you are doing in a country.

What can organizations do to lessen the risk, aside from due diligence and in advance of political risk insurance? One of the first and most powerful actions to take is the involvement of local joint venture partners, who can help organizations navigate the local political and legal environment. Those same partners might have influence within central government. A vested local JV partner with skin in the game is more likely to head-off potential negative actions, and similarly, central government is less likely to act to the detriment of enterprises if doing so would harm significant local interests. Continued relationship management within local partners eases the business environment for a foreign investor, and pays dividends if situations were to arise. Support garners support in many instances. Likewise, strong, and measurable Corporate Social Responsibility builds solid Community relationships. CSR measures include employing a sizeable local workforce, providing education to the community, promoting social welfare, investing in local infrastructure (schools, hospitals etc), being environmentally positive. Diversification, a strategy long since used by Private Equity firms particularly, ensures that an investment portfolio is largely protected from the risk of a catastrophic event in any single country. Company office locations on the ground (rather than a fly-in, fly-out) model allows collection of 12

better local intelligence, better relationship management and a deeper understanding of the actual risks on the ground, rather than the perceived risks from home office. Working only with

established businesses and brands also has positive risk avoidance benefit. Finally, operating in hard currency such as US Dollars (written into all contracts in regard to returns), helps to mitigate currency risk to a large extent. Likewise, Hedging the currency risk is a similar risk mitigant.

(vi) Managing Political Risks A huge percentage of multinational companies believe they are not doing all they could to manage political risk effectively. These same companies believe that more effective management of

political risk exposure can help protect their investments, as well as help them take advantage of new opportunities, improving business performance. Many companies cite that the complex web of information that would help them to assess political risk exposure is difficult to obtain and evaluate. As a result, CEOs and boards of directors are not getting the timely, accurate information they need to make strategic decisions about cross border exposure. Political risk is difficult to define, tough to predict, and practically impossible to

quantify. It is no wonder that corporations often fail to address political risk in a systematic way, given the complexities in its assessment.

In their report on risk management protocols, PriceWaterhouseCoopers in conjunction with Eurasia Group addressed their view of a Political Risk management process. They advise the following principles for a systematic political risk management process:

1. 2.

Political risk management starts at the top Managing political risk directly impacts performance 13

3. 4. 5. 6.

Evaluating political risk optimizes decision making Assessing risks before taking action delivers value Systematic political risk management protects investments Guidelines should be set and accepted at board level, including establishing and implementing a risk management framework for risk tolerance.

7.

Companies need a comprehensive framework for identifying and assessing all of the risks they face, understanding interdependencies, assessing the impact of risk.

8.

The formal process of gathering and assessing data on political developments should be overseen by a risk manager and disseminated at the corporate, operating unit, and regional level.

9.

A portfolio view of risk can mean looking at political risk across the globe as an investment portfolio rather than as isolated, country-by country investments.

10.

Companies must monitor political risk on an ongoing basis and use this information proactively to inform investment and operating decisions, and to make better decisions regarding global expansion, sourcing, branding, intellectual property protection, community and government relations, operational structures, and other business issues that arise in complex international markets.

As we have mentioned, Political Risk assessment relies very heavily on a number of active participants, as well as the harvesting of outsourced information. It is not enough for a company to rely on its own staff as subsidiary locations in developing countries for information alone. Nor is it acceptable to rely solely on the interpretation of prepared country reports so readily available in todays market. As I have demonstrated, each country presents different risks to different

organizations, depending on the sector, company size, relationships, activities and the investment. 14

In my opinion it is imperative to procure strategic risk management advice and due diligence based on the exact specifics of the situation. This has to involve the outsourcing of detailed reporting and analysis of the risks to a third party company, appropriately skilled in this craft. In my opinion, only the understanding of a detailed and tailored country and political risk exposure analysis report will uncover and highlight the risks associated with each investment. Within the report, mention should be paid to all risks, no matter how minor or how prominent, which can then be categorized by potential impact (High, Medium, Low), leaving managers with a clear menu of the exposures that they face, and with clarity as to which risks warrant genuine concern, and which need addressing. This report, overlaid onto an internal risk management strategy should provide a road map to the choices faced by an organization, and whether the investment makes strategic sense, needs taking off the table entirely, or where further risk management is needed.

Below is an example of the of steps that need to be taken, and the information that needs to be gathered and integrated into a Political Risk management strategy for an investment situation: (Source: How Managing Political Risk improves global business performance. PWC Advisory & Eurasia Group report (2006)).

1.

Gather political risk data from multiple sources including in-country networks, on-site management, and objective third parties.

2.

Develop a process that evaluates political risk information and translates it into meaningful, actionable, and tactical data regarding business risks and opportunities.

3.

Communicate political risk information on a proactive, timely basis throughout the organization, especially to decision makers at the corporate and operating unit levels.

4.

Provide guidance on how to use political information to assist corporate, business unit, and 15

regional managers strategic planning, operational processes, and crisis preparedness. Embed political risk management and monitoring processes in the organization.

In applying strategic investment decisions, some organizations have multiple options, while others dont. If you are a Bauxite trading company, you have access to a small number of locations, partners, supply chains in a limited number of countries. It is impractical to avoid the risks of one adverse country to do business with a safer country where there is no raw material. Your risk management choices are limited therefore to dealing with the country, government, and counterparties you trade with. Conversely, a consumer products company has more choices on locations and partners, and can move to regions which offer less risk. Foreign direct investors, especially in capital-intensive ventures with large initial sunk costs, are the most frequent buyers of Political Risk Insurance. Banks that finance Foreign Direct Investment or other cross-border transactions also purchase coverage, using the insurance to make sure that their own loans (short term trade-related or more long term investment-related) are repaid, or as a protection for their lending collateral. Banks, which have the most sophisticated risk management controls and processes, use available cover to optimize capital allocation. Within their strategy, cross border risk management is an important component. Banks have often a choice between allocating marginal capital to a new transaction and buying an insurance policy: this creates the arbitrage opportunity. If the cost of the policy is more than compensated by the return on the freed capital, banks will have an incentive to do so.

(vii)

The future of Political Risk Insurance in Country Risk Management

Overtime, the impact of the current financial crisis will move from being an economic problem to 16

being a political problem. When an economy is in a downturn, the government has less resources available to deal with issues when they arise, potentially leading to political instability. Despite globalization in economic terms, globalization in social terms has a long way to go. Because of social media and its rise in oppressed states, global political instability is rising fast and creating yet another challenge for companies doing business around the world. It's hard to predict the next flare up, as recent events in Northern Africa (Egypt, Syria) and the Middle East attest. Events move so quickly that not even the most astute insurance underwriters were able to see it coming. In January 2010, Pakistan's expropriation of one of the country's largest ever foreign investments, the Reko Diq mine in Baluchistan, sent shockwaves through the foreign investment community. The government said that the Investors originally agreed deal with the provincial government is unfair, and not in the country's long-term interests. Even when investors are comfortable investing in emerging markets or frontier economies, they frequently face constraints from lenders. Lenders often must provision for country risk, and PRI may, in certain cases, reduce the provisioning requirement, and generally give comfort to lenders. This can improve access to financing, including the amounts, interest, and tenor of loans.

(viii)

Conclusion

Investing in developing and emerging market countries is, by default, risky. The more an investor knows about the specific political risks that exists, the more informed the decision making process is, and the smoother the risk management function becomes. Some risks can be managed internally, and as we have discussed, mitigated through combinations of relationship management, corporate governance, and positive economic and social actions. A companys positive standing in a host country will usually shape a favorable outcome. Other risks need further management through market instruments, and Political Risk Insurance exists to support companies that show affirmative 17

economic, political and legal foreign investment appetite. Successful political risk management requires the knowledge and participation of country experts, risk analysts and senior executives, and the application of these onto a risk management process to qualify the business risk. By implementing a systematic approach to Political Risk management, companies can identify their exposures and, through the purchase of specific Political Risk Insurance coverage, mitigate those risks that have been identified as having the greatest potential impact on their global business operations. As a risk mitigation tool, Political Risk Insurance helps provide a more stable environment for investments into developing countries, and to unlock better access to finance, allowing investors to concentrate on the commercial aspects of investments, with the comfort that the insurance will help them avoid potential losses, or reimburse them in case of a covered loss related to political causes.

As a tool for growth, the purchase of Political Risk Insurance allows organizations to invest in Developing countries that have elements of perceived risk, whilst complying with risk management protocols, adhering to investors demands for appropriate levels of risk management, and suiting internal appetite for risk. The use of Political Risk Insurance as a tool to access high yield returns on investments (that appeared at one point to be too challenging) is increasing Foreign Direct Investment to emerging market countries, and adding to Global growth and developing market stimulation. To conclude, emerging markets and developing countries will be the driving force of global growth, even more than in the past, and whilst no substitute for a thorough due diligence and pro-active risk management, Political Risk Insurance will be a valuable tool to unlock this potential, drive growth, mitigate risk and protect investments.

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