POLITICAL RISK INVESTMENT INSURANCE: GOVERNMENT-BACKED AND PRIVATE MARKET. Cecil Hunt*

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1 POLITICAL RISK INVESTMENT INSURANCE: GOVERNMENT-BACKED AND PRIVATE MARKET Cecil Hunt* Prepared for the American Law Institute-America Bar Association Program Going International: Fundamentals of International Business Transactions Washington, D.C., December 7-9, 2006 I. INTRODUCTION It is widely recognized that, as a general proposition, greater risk attaches to transnational investment and trade than to strictly domestic transactions. The risk differential is found in both commercial and political risk. Generalizing again, the risk differential is greater, in actuality or in common perception, with respect to transactions in developing countries. To compensate for the greater risk, firms will adjust upward the anticipated rate of return required for a decision to invest and will provide for an extra margin for profit in the pricing of goods and services in international business. Techniques for assessing these special risks, for reducing risks, and for minimizing exposure can be expected to be touched on in program materials relating to the planning, structuring, negotiation, and financing of the various types of transnational transactions. This paper presents the various forms of insurance that are specially designed to permit a company to protect itself against loss arising from political events affecting its foreign investment or operations. This material compares the investment insurance coverage available from the United States government s Overseas Private Investment Corporation with that provided by similar government-backed investment insurance programs of other countries. Political risk coverage available from the private insurance market is described and compared with that provided by government-backed agencies. The paper also deals with special political risk coverage that construction contractors and others can obtain to protect against political events or foreign government action affecting overseas contracting. The programs of export credit and finance institutions, such as the Export-Import Bank, are outside the scope of this paper as, for the most part, the coverage of political risk is not provided separately by these institutions, but is combined with coverage of commercial risk of non-payment under the export credit insurance that these institutions provide. Cecil Hunt 2006 *Harris, Wiltshire & Grannis LLP, Washington, D.C.

2 II. OVERSEAS PRIVATE INVESTMENT CORPORATION A. The Organization OPIC is a U.S. government agency that supports, finances, and insures against political risk projects in developing and transitional countries that meet statutory criteria with respect to host country and United States interests. OPIC is required to conduct its operations on a self-sustaining basis. The insurance and other obligations of OPIC are backed by the full faith and credit of the United States and by OPIC s reserves. Foreign Assistance Act of 1961, as amended, sections B, 22 U.S.C b., hereinafter OPIC Charter. B. Eligibility for Coverage 1. Eligible insureds are (a) United States citizens, (b) entities organized in the United States with majority beneficial ownership by U.S. citizens, and (c) foreign corporations at least 95% owned by persons covered by (a) or (b). 2. Eligible countries are the over 150 developing or transitional countries that have agreed to the operation of OPIC programs and to suitable arrangements for OPIC subrogation, for the use of any local currency acquired by OPIC, and for arbitration of any unresolved disputes between OPIC and the host government. 3. Investment is defined in the OPIC Charter to include any contribution or commitment of funds, commodities, services, patents, processes, or techniques, in the form of (1) a loan or loans to an approved project, (2) the purchase of a share of ownership in any such project, (3) participation in royalties, earnings, or profits of any such project, and (4) the furnishing of commodities or services pursuant to a lease or other contract. 22 U.S.C (a). 4. New investment may be insured, that is, investment not committed before seeking OPIC coverage. This investment may be in a new enterprise, or in an expansion, upgrading or privatization of an existing enterprise. 5. Project ownership and control need not be by U.S. investors. Coverage is normally not provided for investment in an enterprise majority owned and controlled by a foreign government. 6. Social and economic criteria have been added to the OPIC charter over the years. These include criteria barring coverage of investment in a runaway plant or in a project having a negative effect on U.S. employment or trade. There is no tying of procurement to U.S. 2

3 sources, but a project with procurement preponderantly from other industrialized countries will not be eligible. No coverage may be given for a project that will contribute to a violation of internationally recognized worker rights, and investors must agree to respect such rights, including rights of association, collective bargaining, and acceptable working conditions. OPIC will assess projects with regard to their development contribution and environmental impact. C. Basic Coverage 1. Currency inconvertibility coverage provides for payment if repatriation of investment or transfer of earnings is prevented by new exchange restrictions or by the failure of exchange agencies to act on a transfer application. The insurance does not cover devaluation, and it will not give an insured better transfer treatment than that existing at the time of investment. 2. Expropriation coverage indemnifies against outright nationalization or confiscation and against creeping expropriation government actions that deprive the insured of fundamental ownership rights or financial benefits. Such actions must continue for six months before a claim matures. Excluded are losses from lawful regulatory or revenue measures and actions by a government or government agency in its capacity as owner, supplier or customer of the project, but a government s failure to honor an arbitration agreement or award can be covered, as can unlawful breaches of certain specific host government obligations. 3. Political violence coverage compensates for property and income losses caused by international hostilities, civil war, revolution, insurrection, or civil strife (including politically motivated terrorism or sabotage). Losses due to labor actions are not covered. Compensation covers the insured s ratable share of loss of or damage to tangible assets. Business income coverage protects the insured s share of income losses resulting from damage to the project or to key off-site assets specified in a rider, such as a critical utility or supplier. 4. Terrorism insurance is available as stand-alone coverage for equity investments and investments of property. Terrorism coverage is for acts of individuals or groups that do not constitute national or international armed forces and that act with the primary intent of achieving a political objective. 3

4 D. Special Coverage 1. Financial institutions can obtain OPIC insurance of political risks in various types of transactions ranging from loans to capital or operating leases. The project must be in private control and the loan or lease life must be at least three years. A fairly recent development has been the use of political risk insurance to securitize debt used in capital market financing for infrastructure projects. 2. Contractors and exporters coverage is designed to protect U.S. companies performing international construction and service contracts and U.S. exporters of major capital goods, typically where the customer is a foreign government. Disputes coverage protects against customer frustration of the operation of a contractual dispute settlement process or a customer s failure to honor an award against it. Bid, performance, or advance payment guaranties in favor of a foreign government buyer can be covered against the risk of loss to the U.S. contractor or exporter from wrongful calling. With other than bid guaranties, the insured must have invoked and have been denied the benefit of the disputes provisions in its contract with the buyer before OPIC will pay compensation. The physical assets and bank accounts held abroad by U.S. contractor can be insured against loss due to inconvertibility of asset sale proceeds, confiscation, or political violence. E. Election of Coverage and Insurance Premium Rates 1. The duration ( tenor ) of committed coverage can extend for the life of a contract, loan, or equity investment, normally not exceeding 20 years, 2. The amount of coverage is 100% for institutional lenders and lessors and 90% for others. Equity investors can obtain the right to coverage of future earnings retained in the project, up to a limit of two times the insured amount of the initial investment. 3. The election of coverage for successive contract periods (mostly annual) allows for adjustment of the amount of insurance in force for the ensuing period and determines the premium payable. Equity investors have a coverage ceiling that allows for later coverage of future retained earnings, and they must maintain and pay premium for an active amount that must at least equal book value of the insured investment. Other types of insureds, such as contractors, pay a premium both for the current insured amount (the insured s election based on anticipated exposure during the period) and the standby amount (additional coverage, limited by a maximum insured amount) that can be activated in later contract periods. 4

5 4. Premium rates are set with reference to a base rate which may be adjusted up or down by not more than one-third at the outset of coverage on the basis of OPIC s assessment of project risk and which remain applicable for the life of the contract. The same base rates apply worldwide. 5. Premium base rates for current coverage for a specific risk range from $0.20 to $0.80 annually per $ of coverage, except for oil and gas project expropriation coverage during the development and production stages, which is $1.60. The base premium for current coverage for inconvertibility and expropriation would total $1.15 per annum for an equity investment in a manufacturing project. The base premium for such a project to cover against loss of both business income and assets due to political violence would be an additional $1.10 per annum. It should be noted that it may be reasonable to keep political violence coverage at a lower level than the other coverages because the physical assets and revenue flows exposed to political violence have a total value below that of the net investment. Rates for institutional loans and leases are generally lower, and the standby base rate is $0.20 per annum. F. OPIC s Record 1. The capacity and performance record of OPIC in political risk coverage is impressive. Capital, retained earnings, and reserves available at the end of fiscal 2005 for insurance payments were over $1.7 billion. OPIC earned over $30 million in insurance premium income in fiscal The ultimate backing for OPIC insurance is the full faith and credit of the United States. The size of investments insured by OPIC in fiscal 2005 ranged from less than $100 thousand to $310 million. By the end of fiscal 2004, OPIC had paid, guaranteed, or provided indemnities totaling more that $900 million in settlement of 279 insurance claims. Twentyfive claims have been denied, with the insureds invoking their contractual right to arbitration in thirteen cases. 2. Information about OPIC can be obtained from its website, and by telephone at its Infoline, III. FOREIGN GOVERNMENT-BACKED INSURANCE A. General Most capital-exporting countries have an agency issuing political risk insurance. Even more widespread are government run or backed export finance and export credit insurance facilities. Unlike the separation of OPIC and Eximbank, almost all investment 5

6 insurance programs offered or backed by other governments are available through the same agency that provides export credit insurance. A list of these agencies can be found on the website of the Berne Union, an international association of both credit and investment insurers. B. Government Role The manner and extent of government backing of these political risk insurance agencies ranges from being a unit of a cabinet ministry, through mixed ownership entities, to a wholly private company serving as agent for or being reinsured by the government. The mixture of governmental and private involvement is made even more complex by reinsurance and other risk-sharing arrangements. Government involvement in the approval of individual contracts of insurance issued by private or quasigovernmental agencies varies among country programs. C. Investment Insurance Comparisons with OPIC 1. Premium rates of other national programs are generally somewhat lower than those charged by OPIC. 2. Social and economic criteria are prescribed for some, but relatively few, programs, although most programs are focused to some extent on investment in developing or transitional countries. 3. Commercial risk is not covered by most government-backed investment insurance programs. A few may provide terms of currency inconvertibility coverage that have the effect of providing some protection against devaluation, which is normally regarded as a commercial risk. 4. Capacity figures are not readily available. The total amount of investment cover written by the major national programs has trended upward in recent years, but unevenly. The Berne Union reported that its members -- which include OPIC, other government-backed insurers, MIGA, and some private insurers did $19 billion in political risk investment insurance business in This figure does not relate to new investment flows, however, Private market insurance, with its comparatively short tenor is counted as new business each time a policy is renewed on investment already insured, whereas government-backed insurance will generally be counted only at the time of initial issuance. D. Exporter/Contractor Insurance There are broad similarities among national programs. Most have some products comparable to coverage provided by OPIC for contractors and exporters, 6

7 protecting against business interruption or the loss of assets through political violence, blockage of accounts or confiscation of equipment, or the refusal of a public sector owner to honor disputes resolution agreements. IV. MULTILATERAL INVESTMENT GUARANTEE AGENCY A. Organization The Multilateral Investment Guarantee Agency was organized in 1988 as a member of the World Bank Group. MIGA is to guarantee foreign investment in developing member countries against loss due to political risk. (MIGA uses the term guarantee rather than insure, but the latter is standard usage in the political risk coverage context and will be used in this paper s description of MIGA programs.) Twenty industrialized countries and 147 developing or transitional countries have become signatories to the MIGA Convention. The subscribed capital of MIGA is over $1.8 billion. B. MIGA Activities 1. In addition to selling political risk investment insurance, MIGA provides advisory and technical services to member countries in encouraging investment flows and provides an investment dispute mediation service. 2. Coinsurance and reinsurance arrangements, as well as direct political risk insurance, are authorized, and MIGA shares risks with the national agencies of member countries and with private insurers and participates in cooperative underwriting of political risk. 3. Host government approval is requested before MIGA issues insurance. Approval may be deemed to have been given in the absence of timely objection after notification. MIGA is not required by its charter to enter into operational agreements with countries in which investments will be insured. It has, however, concluded many such agreements. Like those for OPIC investment insurance, these agreements cover rights to use local currency received in claim settlements, MIGA s subrogation rights, and dispute resolution provisions, including international arbitration of disputes between a host government and MIGA, as subrogee. C. Differences from OPIC There are broad similarities between MIGA and OPIC investment insurance. A few of the differences will be noted. The standard maximum tenor for coverage of equity investment by MIGA is fifteen years, versus twenty years for OPIC, but MIGA will go to twenty years in special cases. Whereas OPIC limits coverage of retained earnings to a level of two times the covered initial investment, MIGA has no comparable limit.. 7

8 Perhaps the most salient difference involves claims experience. MIGA had received and paid only three claims through the end of fiscal year D. Capacity and Activity MIGA has maintained impressive levels of activity. In fiscal years 2002 through 2006, the annual number of contracts written ranged from 55 to 66, representing $1.1 to $1.4 billion of new coverage annually. This level of activity has been accompanied by an increase of the MIGA net per project ceiling. With reinsurance or other risk sharing arrangements, the per project ceiling can rise as high as $400 million. V. PRIVATE MARKET A. Introduction Although the coverage of war perils as part of marine risk coverage has been provided by insurers at Lloyd s since that market was organized in the early 1700s, the private market political risk insurance products discussed in this paper are a development of the last thirty years. Coverage of land-based war risk had been virtually nonexistent since before World War II, stifled by realization of the magnitude of losses that could result from modern warfare. Lloyd s, with its tradition of innovative underwriting and its specialists in the underwriting of unusual risks, was a natural locus for the private market s venture into political risk coverage for overseas investment and operations. OPIC pioneered reinsurance of part of its portfolio in the London market, beginning in 1971, and this spurred private market interest in political risk insurance in the 1970s. American International Group became the first American underwriter of such political risk insurance, followed by Sovereign, Chubb & Son, Zurich U.S., and others. B. Advantages 1. The eligibility provisions that can restrict the availability of political risk insurance from government-backed programs are not a factor in the private market. The investment need not be new. The nationality of insureds and the locus of projects will not be limiting factors. Coverage is theoretically available world wide, although insurers may from time to time go off cover in specific countries due to excessive concentration of exposure, loss experience, or other extraordinary circumstances. The economic and social factors that are taken into account by government agencies are irrelevant in the private market, except to the extent that they might affect risk assessment and the pricing of coverage. 2. The range and flexibility of cover offered by the private market is unmatched by government programs. All of the types of risks covered by government-backed insurance will be found available in some form in the private market. Cover of certain other political risks, however, is unique 8

9 to the private market. Examples include loss with respect to the personal property of employees, kidnap/ransom/extortion ( KRE ) coverage, and the cancellation of export licenses by authorities in project procurement source countries. Moreover, the private market has the freedom and willingness to customize coverage to deal flexibly with novel risks. 3. The speed with which private market brokers and underwriters can respond to a potential customer for political risk insurance can be a major advantage. Typically, a broker can obtain a quote from an underwriter in the London or American market in a matter of days for risks that are not extraordinary in size or character. Such speed may not be a major factor in the planning of an equity investment, but it can make a big difference to a supplier of goods or services that needs such information in order to price and pursue a contract. C. Limitations 1. Until recent years, the tenor of a private market contract of political risk insurance would not exceed three years. Now, however, ten to fifteenyear tenor may be available for some investments in some countries. Although, in theory, cover can be renewed indefinitely, the right of the insurer to reassess the risk and to adjust premium rates accordingly means that cover can effectively be denied when most needed. This need not be a serious problem for shorter duration contractor exposures, but it means that government-backed cover is decidedly advantageous for long-term investment. 2. The cost of private market insurance is generally markedly higher than that for government-backed insurance. Premium rates are not published in the private market, and helpful current rate data is difficult to obtain. Not surprisingly, the higher rates will apply to those risks as to which there is no cover competition from the government-backed programs. 3. The capacity of the private market ebbs and flows, depending upon both political risk loss experience and the general health of the insurance industry. As with premium rates, private market capacity data can be imprecise and hard to acquire, but the trend is toward capacity growth. Private market capacity declined in the wake of 9/11 and the Argentine debt crisis, but capacity now appears to be growing again. Per risk limits of the major underwriters are believed to be in the $60 to $100 million range. 9

10 VI. RISK MANAGEMENT AND THE DECISION TO INSURE Every company doing business internationally should realize that improving the systematic analysis of its political risk exposure is vital in the formulation of sound financial and operating strategies. Risk reduction can range from such fundamental strategic steps as the geographic dispersion of operations to such transaction tactics as negotiating for a favorable force majeure clause or for an ample mobilization payment. The pricing of goods and services and the rate of return supporting a decision to invest should certainly be determined with some reference to the relative degree of political risk perceived in a country. Deal evaluation should also take into account the company s ability to reduce loss exposure through the structuring of the transaction, the procurement of insurance, or both. The decision on whether to buy political risk insurance will depend primarily on the particular company s sensitivity to losses in the range involved in its overall exposure to such risks. A construction contractor heavily dependent upon credit will be concerned about the cash flow effects of an abrupt contract termination, even if prospects are believed good for eventual recovery from the owner. A manufacturer with a number of plants abroad may conclude that it can absorb the nationalization of one or more of them without serious financial dislocation, considering such factors as the early availability of tax write-offs and the likelihood that the nationalizing government will eventually pay some compensation. This paper was designed to show the diversity of the political risk investment insurance market. This diversity is both a challenge and an opportunity for the planners of foreign direct investment. The sourcing of equity and debt capital, major procurements, and other project assets (such as off-take contracts) in several countries can serve to attract the interest and support of more than one national insurer and, at the same time, make the project attractive to MIGA. There may also be some risks that can be covered only in the private market. Attempting to match the exposure pieces and the insurance pieces in a politically and economically advantageous way is a worthwhile effort. There is another phenomenon to be taken into account when deciding whether to purchase political risk insurance. It has been called the halo effect. The concept is that some governmental action that would be adverse to investors may be deterred or ameliorated when the host government realizes that the action would trigger a claim under insurance backed by a government-backed agency or by MIGA. There have been instances of overtly favorable treatment of such lenders and investors by the governments of Argentina and Russia. It is also clearly significant that MIGA has had to pay only three claims, notwithstanding the number of investments that MIGA has covered world-wide. During its payments crisis, Argentina differentiated its actions to favor foreign creditors insured by Berne Union members, thereby extending the benefit of the halo even to the one or two private insurers who were then members of the Berne Union. Of the total amount of the annual foreign direct investment flows into countries where government-backed political risk insurance is available, it has been estimated that only five to ten percent of that investment has had such coverage. The choice to self-insure appears to be 10

11 the more common choice. We can only speculate as to how informed or considered some of those choices have been. No company should ever let the availability of political risk coverage cause it to relax its efforts to obtain contracting, financing, or investment arrangements that reduce its exposure to political risk. Nor should any company proceed with an investment or contract heedless of warning signs pointing to an unusually high risk of political turmoil. Not only is there typically risk retention of at least ten per cent, but insurance rarely compensates fully for the very real losses that a company might suffer in terms of the opportunity costs of having financial resources and key people tied up in a troubled project,. VII. REFERENCE MATERIAL There has been a series of symposia on political risk insurance in recent years that were sponsored by the Multilateral Investment Insurance Agency and the Karl F. Landegger Program in International Business Diplomacy at the School of Foreign Service at Georgetown University. The symposia proceedings have been published in book form. The most recent symposium was held in November 2004, and the proceedings were published by the World Bank in International Political Risk Management: Looking to the Future, Theodore H. Moran and Gerald T. West, eds. This most recent volume lists the contents of previous volumes in the series, making it a convenient starting point for research on the subject. These publications can be ordered online at and can also be ordered from: P.O. Box 960 Herndon, VA Tel , Fax The Berne Union Yearbook is a good source for up to date data and commentary on political risk insurance. This Berne Union publication covers both investment insurance and credit insurance. 11