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Political Risk

Political Risk Insurance in Asia: Who Purchases It, Where, and Why

Daniel Wagner | July 1, 2002

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Daniel Wagner examines how in Asia it is the banks and their lending requirements that are the real driving force behind the majority of political risk insurance (PRI) purchases.

The question of what motivates companies to purchase political risk insurance (PRI) has long been a subject of debate in the PRI industry. Some practitioners believe that purchasing PRI is purely a risk management function—that a company's risk management philosophy drives the decision. Under this view, companies purchase PRI when they have concerns about the political risks associated with specific transactions in accordance with their corporate guidelines governing political risk management.

Others maintain that banks drive the purchase of PRI. Many banks will not lend money to projects without PRI, either because of their own internal risk management concerns or because they have reached their lending limits for a given country. Still others believe that purchasing PRI is a reaction to specific country or regional events, making it a reactive rather than proactive response.

Having compiled detailed statistics on PRI submissions in Asia for 2 years, I believe that a combination of factors ultimately motivate companies to purchase PRI. While the perceived political risks associated with country-specific events are unquestionably a motivating factor in the decision to purchase PRI, and while individual corporate risk management philosophies clearly impact the decision, in Asia it is the banks and their lending requirements that are the real driving force behind the majority of PRI purchases.

Host Countries with Highest Demand

Let us first examine where organizations have been most concerned about political risk in Asia over the past 2 years. During the last 6 months of 2000, 40 percent of all submissions for coverage that I received were for Indonesia. This may come as no surprise, particularly given Indonesia's political and economic situation, the fact that Indonesia is the largest economy in Southeast Asia, and that I am physically based in Singapore. However, 40 percent is statistically a very significant number, particularly when one considers that of the dozen countries in Southeast Asia, many are rarely the subject of PRI coverage requests. The Philippines took second place with 10 percent, followed by Vietnam and Thailand with 7 percent each, and China with 5 percent. As we will see, it is no accident that the Philippines assumed second place during this period.

The China figure is at first glance surprising. Given that 80 percent of Asia's Foreign Direct Investment is soaked up by China, and given the omnipresence of China economically and politically in the region, one would think, logically, that China would account for a significant percentage of the total number of submissions.

Graph #1

Political Risk Insurance Submissions Graph #1

I believe that there are two reasons why China accounts for such a relatively small percentage: first, investors' perceived risk of doing business in China appears to be lower than in other countries in the region; second, there are vast indigenous sources of financing available in China which do not require cross-border capital flows.

By the first 6 months of 2001, things began to change. Only 27 percent of submissions received were for Indonesia, a drop of one-third. Meanwhile, in the Philippines, submission levels rose from 10 percent, to 13 percent; also a one-third rise. There was a point, between June and August 2001, when Indonesia and the Philippines were virtually equally weighted, with the Philippines at 22 percent and Indonesia at 25 percent.

Graph #2

Political Risk Insurance Submissions Graph #2

This is interesting because the numbers indicate that investors and traders responded favorably to the ouster of President Wahid and ascension of Megawati Sukarnoputri in Indonesia. At the same time, investors and traders did not appear to respond with confidence to the ouster of President Estrada and ascension of Gloria Macapagal-Arroyo.

My interpretation is that few investors and traders had confidence in President Wahid, while in the Philippines it wasn't so much that they lacked confidence in President Arroyo, but that they were uncertain about how events would play out. Since the summer of 2001, the international investment community has by and large given the Arroyo Government a vote of confidence.

Regarding the other countries listed for the period, I don't attribute much importance to the appearance of a substantial number of submissions for Sri Lanka and Pakistan, as they did not appear as countries of top demand during any other semi-annual period in the 2-year time frame, and it is quite common for countries to appear in one statistical period but not another.

Graph #3

Political Risk Insurance Submissions Graph #3

As the statistics for the last half of 2001 show, the Philippine situation stabilized, with submission levels settling at 14 percent, with Indonesia hovering around the 25 percent level. China picked up some steam, rising to 12 percent, followed by Vietnam and South Korea. Statistics for the first half of 2002 show that the Indonesia/Philippines submission levels stabilized with Indonesia at around 30 percent, and the Philippines in the mid-teens. China and Vietnam remained in the third spot. What was notable for this period was that Singapore was tied for fourth place with South Korea. I attribute this to the attention Singapore received after it arrested 13 suspected terrorists in January. That Singapore can go from virtually no previous political risk submissions to assume one of the top spots so quickly appears to support the notion that investors/traders react to news events when deciding to purchase PRI. Interestingly, Singapore disappeared from the radar screens just as quickly as it appeared.

Graph #4

Political Risk Insurance Submissions Graph #4

The conclusions to be drawn from these statistics are two: (1) Indonesia and the Philippines are likely to remain number one and two in terms of investor/trader demand for PRI in the region for the foreseeable future; (2) China and Vietnam are likely to remain third or fourth, and any number of other Asian countries will fill the secondary ranks. Since political risks exist in every country in the world, my view is, the fact that traders and investors seek PRI in a given country is more of an indication that they are eager or willing to do business in a country than that they are overly concerned about the existence of political risks. If investors and traders are overly concerned about the political risks in a specific host country, I do not believe they will be doing business there in the first place.

Trade and Investment Flows

Statistics regarding trade and investment flows are worth discussing because I believe they are a fairly accurate gauge of investor/trader sentiment. During the last 6 months of 2000, requests for trade-related PRI coverage (such as contract frustration, wrongful calling of on-demand guarantees, and non-honoring of letter of credit coverage) were roughly 2:1 over investment-related coverage (such as expropriation, currency inconvertibility/non-transfer, political violence and breach of contract). However, the situation changed dramatically during the first half of 2001. Requests for investment coverage outpaced trade coverage by a 3:1 ratio.

I believe that this change is attributable to the initial optimism that investors felt for the prospect of an improved investment climate in the region in 2001. In the 12 months between June 2001 and May 2002, requests for investment coverage continued to outstrip requests for trade coverage by roughly a 2:1 margin. By the middle of last year, it was evident that the economic gains and relative political stability that had characterized 2000 were not going to persist. I therefore believe that the statistics for this past 12-month period are indicative of a general trend toward caution about investing in Asia, even before the terrorist attacks of September 11 occurred.

Indeed, the project finance business in Asia has been slow since 1997—a result of the Asian financial crisis, of banks having generally reduced their lending levels in Asia, and of many infrastructure-related problems materializing in the 5-year period since the crisis began. This remains fresh in the minds of lenders and equity investors. As a result, relatively few projects are reaching the financial close stage, margins remain tight for banks, and many banks are chasing the same transactions. In fact, it is not uncommon for me to see requests for coverage for the same transaction from five or six different sources.

Conclusion: What Motivates Companies to Purchase PRI in Asia?

The conclusion to be reached is that investors and their partners are the driving force behind the majority of PRI submissions. Most of these submissions have been generated because of banks' desire to satisfy internal credit committee lending requirements. This, in turn, is linked to the banks' own risk management guidelines as well as a desire to reduce capital allocation costs and/or satisfy home office central bank lending guidelines. The pursuit of risk management techniques that remove the need to provision for cross-border exposure while simultaneously reducing capital allocation costs will continue to be a prime motivating factor behind bank lending guidelines.

Although it is less common for equity investors to pursue PRI without the involvement of a bank, investors' own risk management guidelines often require that PRI be utilized to remove political risk from their balance sheets. Investors' risk management guidelines generally fall into three categories: (1) purchase PRI for each overseas exposure; (2) do not purchase PRI for any such exposure; or (3) purchase it only for those transactions that exceed the company's tolerance for political risk exposure. The most common approach appears to be the last one, with most investors pursuing coverage only for those exposures that are of particular concern. This creates a tendency for PRI providers to receive only adversely selected transactions from equity investors.

There can be little doubt that investor/trader/lender reaction to individual political events in host countries is a prime motivating factor in the purchase of PRI for transactions in Asia. The example of the dramatic jump in submissions for Singapore earlier this year is a good indication of this. I have seen similar rises in submission levels following other political events in the region, and indeed, globally. However, the interest levels tend to dissipate as quickly as they arose once the event in question subsides.

It is quite common for PRI purchasers to pursue PRI only after a political or economic event has occurred. PRI is ultimately a commodity that is sensitive to supply and demand. It would therefore be wise for purchasers of PRI to pursue coverage either well in advance or well after such events occur because, not only is it less likely that coverage will then be available, but the cost of coverage will undoubtedly be higher during the storm.

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