The Assistant Treasurers of two multinational companies, Powerco and Manuco meet at a conference and compare notes on their political risk programs. Powerco, which has invested in an investment grade rated emerging market is surprised to learn that its rates are almost twice as high as those of Manuco with investments in several large below investment grade rated countries. The Assistant Treasurer of Powerco returns home and wants an explanation. This is what I would tell her…
Pricing political risk insurance—particularly investment insurance—is unlike pricing for most “traditional” forms of coverage. Lack of an actuarial foundation, typically multi-year commitments, and vulnerability to aggregation risk and adverse selection by purchasers, make PRI pricing challenging and unique: more an art than a science. And each underwriter’s approach may be a little different. But PRI pricing isn’t just random or illogical: Here’s why.
Broad Factors Affecting Pricing: Country Risk, Capacity, and Sector Risks
Country risk is the distinctive element in PRI pricing. But it is only a starting point. Two risks in the same country may have very different profiles, and will be priced accordingly.
Underwriters initiate country risk assessments not just as a means of setting rates, but to decide if they want to offer coverage at all. Very high rates send a simple message to the buyer: GO AWAY! Private market insurers’ rates tend to go higher than those available in the public market, with private insurers offering lower pricing in low risk countries than the public market can muster but higher pricing in riskier countries. Some underwriters will go completely off-cover in a country where they have had to pay an expropriation claim and not yet recovered it from the host government. Such outstanding claims often prompt other underwriters to raise their pricing for exposures in that country, if not shun it altogether.
Underwriters carefully monitor their country aggregates—the sum of their per-country exposures—and may limit their country exposures based on risk perception. In any case, when there’s high demand for coverage in any particular country, the law of supply and demand kick in and rates trend up. A few years ago, when demand was high in one large Latin American country, one underwriter actually held an auction for its remaining capacity. In another country, rates fell by almost 50% for similar projects due primarily to an easing in capacity.
Some underwriters, such as OPIC, start with “base rates,” for each coverage or a range or rates applied to a specific industry sector or type of exposure, based on their notions about which sectors pose a higher risk. While most insurers tend to start their rating process with country assessment, all take the industry sector and type of exposure into consideration at some point.
Projects generally believed to carry higher risks include natural resource projects, those involving concessions or special licenses from the host government, those that sell to or purchase from the government or its parastatals, and those that provide essential goods and services to the public, such as power and water.
Case Specifics Matter: The Project, the Insured, and the Policy Wording.
Political risk underwriters consider factors specific to the insured, the project, and the policy terms in pricing their coverage. The insured investor’s staying power in the country, its conformity to local law and policy, its sophistication in dealing with foreign governments, and its approach to security are among the factors that help determine the likelihood of loss. So do the investor’s relations with the local community, its approach to environmental concerns, and the project’s developmental benefits. The investor’s nationality may also affect the underwriter’s perception of risk. In some countries, for example, US companies may be perceived as higher-risk than others.
The underwriter also considers the potential for salvage or recovery should a loss occur. Its pricing may take a favorable turn if it is coinsuring or reinsuring with a public agency and expects to share in that agency’s superior recovery prospects. If insured equity shares are pledged to lenders, and the underwriter is willing to accept that impairment, then that too will affect price.
Since political risk policies are typically manuscripted, meaning that the insurer tailors terms and conditions to the project and its risks, pricing may vary according to how “deluxe” the wording is. The more risk the underwriter perceives it is taking by offering broader or explicit language as a result of manuscripting, the higher the rate.
Other Pricing Ingredients
The period for which coverage is committed at a fixed price also affects pricing. Shorter term commitments are generally cheaper. In a recent case where expropriation coverage was required, we saw the price increase by about 10 basis points for each two- to three-year period beyond the initial three-year tenor. Underwriters may offer some form of “standby” coverage at, for example, half the normal premium for exposure amounts that are expected to materialize only over a given period. Or they may not offer this break, and if country capacity is scarce, decline to cover more than the initial investment.
Just as the scarcity or abundance of capacity can have a profound effect on offered pricing, so can the availability of competing interest in the insured’s business. Of course, the better risks are the ones that attract the most competition. Risk distribution is also important to underwriters: They may discount prices for an investor that offers them a well-spread book of business.
In large transactions, the investor can obtain some benefit from layering the insurance, so that underwriters in excess positions earn less than the primary (first loss) layers. Layering makes most sense for risks vulnerable to partial losses, like political violence, and less for catastrophic risks like expropriation.
PRI is affected by market cycles: Pricing broadly responds to the ebb and flow of capital into the insurance marketplace. While PRI pricing does not move in lockstep with general property and casualty pricing, shifts in these areas do affect it.
One such external force is the lending business. Bank loans and capital issues have become an important area of coverage for investment insurers. As bank liquidity has grown in the last couple of years, spreads, out of which PRI coverage costs must come, have diminished. Underwriters, eager to retain this business, have lowered their pricing accordingly.
Cost Versus Price and the Role of Intermediaries
Policy pricing is not the whole story. The total cost of supplying the policy is affected by such additional elements as deductibles, minimum coverage periods, no-claims bonuses, cancellation fees, and fee reopener provisions. These non-premium costs can sometimes be considerable. Involvement by public agencies may impose additional expenses to satisfy public concerns related to the environment, workers’ and human rights. In one recent and extreme case, the involvement of a multilateral agency cost the investor $1 million in addition to the premium.
Many companies use brokers to place cover, or may engage other advisors. Expert assistance in this very specialized insurance line can be the key to obtaining the best coverage at the lowest cost, and in many cases will spare the investor—and the underwriter—much time and effort.
PRI pricing is not formulaic or static, and varies with the underwriter. In some transactions, we have seen rates vary by more than 100% between two underwriters. Once the investor has obtained quotes from many sources, it can make a business and risk case to underwriters. The investor and its broker or advisor may find that presenting the risk in a different way or providing additional information will yield a better rate. Other things being equal, well presented and documented projects that address important issues get the best reception from the marketplace. ■