Fall 2008 VersionFall 2008 Version

Professor Dan C. Jones

FINA 4355

Risk Management and Insurance: Perspectives in a Global EconomyRisk Management and Insurance: Perspectives in a Global Economy

17. Political Risk Management17. Political Risk Management

Professor Dan C. Jones

FINA 4355

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Study PointsStudy Points

Modes of foreign market entry

Nature of political risk

Risk analysis

Risk control

Financing the political risk exposure

The importance of monitoring

Political considerations in emerging markets

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Modes of Foreign Market EntryModes of Foreign Market Entry

ExportingUse of a domestic intermediary

Foreign direct investment (FDI)Joint venture

Wholly-owned subsidiary

Branch

Differences in the level of political risk

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Political RiskPolitical Risk

Any governmental action that diminishes the value of a firm operating within the political boundaries or influence of that government

Elements (selected)Nationalization (taking of property with compensation)Confiscation (taking of property without compensation for criminal activity)Expropriation (taking of property without compensation in eminent domain)Contract repudiationCurrency inconvertibility

Note on “Expropriation”Depending on the country and

jurisdiction, the property owner may receive some compensation but the

amount is likely below the market value of the property.

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Political Risk ManagementPolitical Risk Management

Identification/measurement of loss exposurePolitical/legal environmentSocio/ethnical environmentEconomic/financial environmentRegional/international environment

Use of external data/analysis

Internal analysisFrequency and severity of an adverse eventChanges in firm valueBenefit-cost analysis

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Public Information Sources Public Information Sources (Table 17.1)(Table 17.1)

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The World at Risk – August 2008The World at Risk – August 2008

ChinaThe Olympic Games begins and a massive security operation is mounted in Beijing. Earlier, 16 policemen in Kashgar were killed in an attack by separatist Muslim militants.

Venezuela President, Hugo Chávez, issues 26 decree laws, the provisions of which could lead to a big increase in the role of state.

RwandaA commission accuses French officials – including the late president, François Mitterrand, and two former prime ministers – of actively supporting the Hutu génocidaires who massacred 800,000 ethnic Tutsis and moderate Hutus in 1994.

The Economist.com

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Coface @Rating Coface @Rating (Selected Countries, August 2008)(Selected Countries, August 2008)

Business Climate Rating Country @Rating

Afghanistan D D

Bahrain A3 A3

Brazil A4 A4

China B A3

France A1 A1

Georgia C C

India A4 A3

North Korea D D

Pakistan C C

Russia B B

Rwanda D D

United Kingdom A1 A1

United States A1 A2

Source: http://www.trading-safely.com

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Risk Ratings by Economic Intelligence UnitRisk Ratings by Economic Intelligence Unit

Sudan

Sovereign CC

Currency CCC

Banking sector CCC

Political C

Econ structure CC

Economic Intelligence Unit (Feb 2007)

Iran

Sovereign B

Currency BB

Banking sector CCC

Political CC

Econ structure BB

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Political Risk Control TechniquesPolitical Risk Control Techniques

Integrative strategiesDiscourage the host government from interfering with the operation of the firm

Managerial approaches

Increase in communication and tighter relationships (e.g., use of local resources including personnel)

Financial approaches

FDI through joint venture

Fair, accurate and open financial reporting

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Political Risk Control TechniquesPolitical Risk Control Techniques

Defensive strategiesThe cost of interference > the cost of letting the firm stay

Managerial approaches

Joint venture partner from outside the host country

Minimum use of host country nationals

Use and enforcement of intellectual property rights

Financial approaches

Source equity/debt financing from within the host country

Minimize retained earnings locally

Financing the Political Risk Exposure

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Financing the Political Risk ExposureFinancing the Political Risk Exposure

Retention

InsuranceIntergovernmental agencies

Governmental agencies

Private companies

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Multilateral Export Credit Agencies Multilateral Export Credit Agencies (Table 17.2)(Table 17.2)

The correct name for the Arab is “Inter-Arab Investment Guarantee

Corporation.”

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The Multilateral Investment Guarantee AgencyThe Multilateral Investment Guarantee Agency

Created in 1988 as a World Bank Group member

Promote FDI in emerging economies

Offer political risk insurance (guarantees)

Over $2 billion in capital paid by 163 World Bank member countries

Click Here to Go to the Webpage

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The Inter-Arab Investment Guarantee CorporationThe Inter-Arab Investment Guarantee Corporation

Established in 1975 to foster inter-Arab investment flows

Provide coverage for inter-Arab investments and export credits against non-commercial risks

$83 million capital in 2002

Click Here to Go to the Webpage

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Overseas Private Investment Corporation (U.S.)Overseas Private Investment Corporation (U.S.)

Established in 1971 to help US business investments overseas, foster economic development in emerging markets, and complement the private sector in managing the risks associated with FDI

Up to $250 million per project against:Currency inconvertibility, expropriation or political violence

Protection of up to 20 years of equity life or maturity

Click Here to Go to the Webpage

Previously “Overseas Private Insurance

Corporation”

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The Export-Import Bank of the U.S.The Export-Import Bank of the U.S.

Finance the export of U.S. goods and servicesDoes not compete with private sector lenders

Pre-export financing Commonly one-year transaction-specific or revolving loan

Small Business Multi-Buyer Export Credit Insurance Commercial losses due to insolvency, bankruptcy and default (up to 95% coverage)

Political losses due to war, revolution, cancellation of an import or export license, currency inconvertibility (up to 100% coverage)

Click Here to Go to the Webpage

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Other Risk Insurance ProvidersOther Risk Insurance Providers

Export-Import banks around the world

African Export-Import Bank

Export Import Bank of Japan

the Export Import Bank of India…

Private insurance firms

American International Group

The Chubb Group

Zurich (North America)

Lloyd’s…

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In Your Countries?In Your Countries?

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Differences between Public and Private InsuranceDifferences between Public and Private Insurance

Public insurers must consider their governments’ policy objectives

Private insurers are in the business to make a profit while avoiding undue risk.

These providers are perceived as being more flexible.

Their coverages can be more expensive.

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Differences between Public and Private InsuranceDifferences between Public and Private Insurance

In general, public-sector insurers rely more on published rate schedules than do private insurers

Government policy toward a particular country or region heavily influences pricing and coverage availability.

Traditional actuarial methods based on probabilities are less applicable. Hence, private insurers use portfolio management and diversification to assure spread of risks, both in terms of coverage provided and geographic area.

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The Importance of MonitoringThe Importance of Monitoring

MNCs should carefully monitor the effectiveness of their political risk management programs, including the environment in the country of operation.

Circumstances that create political risk in one country may create it in another.

Marketing practices that are effective in a developed country may provoke suspicion and controversy in a developing country.

Managerial practices that are effective in the home country may precipitate labor unrest in a host country.

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Political Considerations in Emerging MarketsPolitical Considerations in Emerging Markets

Eastern Europe

Asia

Latin America

Middle East

Africa

Case Study: Iran

Not in the Text.

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BackgroundBackground

Persia until 1935

Became an Islamic republic in 1979

Religious scholars as political leaders

1980-1988 war with Iraq

Designated as a state sponsor of terrorism

Nuclear development

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PeoplePeople

Population of 65.6 millionMedian age 26.415~64 72.3%

Life expectancyInfant mortality of 36.94 per 1,000 lives at birthLife expectancy

69.39 (male)72.4 (female)

EthnicityPersian (51%), Azeri (24), …

ReligionMuslin (98%) Shi’a (89%) and Sunni (9%)

Source: CIA World Factbook (August 2008)

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EconomyEconomy

Central planning with large enterprises

47% services and 42% industry Per capital GDP (purchasing power parity) of $8,900GDP real growth of 5%Exports – gas, carpetsImports – raw materials, capital goods, technical services15.8% inflation (2003*)

15% unemployment (2002*)

40% below poverty line

Single exchange rate system since 2002

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Iran – International Disputes Iran – International Disputes

Fitch Credit Rating (December 2003) B+ (long-term rating) B (short-term rating) Outlook – stable

S&P Do not rate

Moody’sWithdrew rating action in June 2002

US government concerns that the rating was “inconsistent” with U.S. sanctions

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Insurance in IranInsurance in Iran

The historyInitially serviced by foreign insurers

1935 – First, state-owned insurance firm established

1979 – The industry (with 12 foreign firms) nationalized, leaving only state insurers: Iran Insurance Company, Asia Insurance Company, and Alborz Insurance Company

The regulatorBimeh Markazi (Central Insurance, www.centinsur.ir) of Iran established in 1971

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Insurance in IranInsurance in Iran

The marketThe market is closed to the private sector and foreign firmsThird party motor liability insurance is compulsory

Related activitiesSocial Security Organization (SSO) for workers’ compensation type of coverageMedical Service Organization (MSO) for medical insurance to anyone who selects not to be insured by Iranian commercial insurer or SSOExport Guaranty Fund of Iran (ECGD)

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Insurance Data – PremiumInsurance Data – Premium

Source: http://www.centinsur.ir/frmHome_en-IR.aspx

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Insurance Data – ClaimsInsurance Data – Claims

Source: http://www.centinsur.ir/frmHome_en-IR.aspx

Discussion Questions

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Discussion Question 1Discussion Question 1

With increasing internationalization of national economies, would you expect political risk exposures to grow or diminish in importance? Justify your answer.

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Discussion Question 2Discussion Question 2

Could political risk exposures of MNCs might be hedged in the capital market? Speculate as to how this might be accomplished.

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Discussion Question 3Discussion Question 3

An entire national economy can be exposed to political risks in the sense that the actions of other governments can diminish its collective “value.” How should governments apply sound risk management principles to such exposures? Do government considerations in this respect differ fundamentally from those of firms?

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Discussion Question 4Discussion Question 4

Can governmental political risk exposures justify the creation, maintenance and protection of a domestically owned insurance industry? Justify your response.

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Discussion Question 5Discussion Question 5

We discussed two strategies for political risk management: an integrative strategy and a defensive strategy. Pick a country (or a political environment) for which an MNC might use an integrative strategy. Pick another country (or an environment) for which an MNC might use an integrative strategy. Support your choice for each with logical explanation. Would your choices of countries, tactics or both change depending on the nature of business?