March 1, 2004 by Sean van Zyl, Editor
Suicide bombings in Baghdad continue to see a rising toll in deaths of “reconstruction” foreign workers and military personnel…Ongoing conflict between Palestinians and Israelis continues to produce reprisal acts of violence…A coup de tat in Haiti results in mass civil unrest…A previously unheard of terrorist organization in France plants bombs on the country’s major railway network and makes ransom demands…The territorial conflict between nuclear-capable India and Pakistan over the Kashmir heats up…North Korea’s demands for economic concessions over its nuclear program become more aggressive…Financial system meltdown among Latin American countries results in heightened crime and guerrilla insurgence activity. All the above have been featured in news reports since the beginning of the year – a clear indication that the insured political risk market is subject to greater volatility and a rise in claims incidence. Yet, insurers and brokers maintain that comprehensive coverage remains relatively cheap and available in light of the impact of the hard market on other commercial lines of business. As corporations become increasingly global, the jury is still out to whether companies are making effective use of the coverage tools available or baulking at the risk of expanding offshore.
A report recently released by Aon Corp.’s “Trade Credit and Political Risk Practice Group” – in conjunction with the publication of its annual “Political and Economic Risk Map” – suggests that uncertainty surrounding political risk during 2003 cost about US$800 billion in reduced global economic expansion – equivalent to a 0.25% “geo-political tax” on overall gross domestic product (GDP) growth. The report points out that this cost has risen more than four-fold from the estimated annual US$200 billion GDP cost attributed to “political risk” prior to 9/11. The report also predicts that the cost of global political risk could exceed US$1 trillion by the end of 2004.
Of particular note is that 2003 saw the return of “traditional geo-political risks” on the global stage such as strikes, insurgency, and war, observes Aon Trade Credit’s chief economist Michel Leonard. The immediate prior years saw terrorism as the greatest threat – a factor which is still very much a concern for international companies engaged in reconstruction projects in the Middle East, Central Asia, Eastern Europe and Africa. And, while kidnap for ransom and extortion (K&R) tends to fall under a separate insured category to political risk, many corporate risk specialists report an unprecedented rise in kidnap incidences (as well as value of ransom demands) in the post-9/11 era. All of which sums up to be a significant “loss of appetite” for companies to expand into what otherwise could be lucrative markets.
The impact of political risk has been particularly severe on emerging markets, says Leonard. Latin America and the Caribbean (which are the top K&R hotspots globally) are still suffering from the aftershocks of Argentina’s economic crisis, which has resulted in foreign direct investment (FDI) in the region dropping for the fourth consecutive year. The region’s plight has also not been helped by a new economic crisis in the Dominican Republic caused by a massive US$2.2 billion bank fraud, he observes.
The overall reduction in foreign corporate investment over recent years has much to do with the fact that companies are more aware of the negative repercussions of political risk in operational areas such as supply-chain, market access, and ability to anticipate market growth and consumer behavior, Leonard says. However, from a positive perspective, this “awareness” has resulted in a better understanding of the mechanics of geo-political risk by international corporations, and how terrorism, war and civil unrest can impact operational efficiency and ultimately, balance-sheets, he notes. Risk managers and senior management of corporations are now using “systematic political risk” auditing tools to identify risk profiles, he adds – from civil unrest in Pakistan to disruption caused by increased security at U.S. ports of entry. “Geo-politics is no longer a vague concept but a concrete, increasingly manageable set of variables with clear business implications.”
Aon’s political risk map for 2004 (see page 18 for detail) identifies heightened volatility due to war, civil unrest and general strikes in Venezuela, Bolivia, Nigeria and the Dominican Republic. “[These factors] led us to downgrade the political and economic ratings of those countries, indicating a substantial increase in the risks posed to individuals, assets and operations. 2003 is the first year since the late 1990s that traditional forms of political risk, rather than terrorism or financial crises, are responsible for the top political and economic downgrades,” the report notes.
International security consultants Control Risks Group states in its recently released “RiskMap 2004” risk survey, “the number of countries that have risen from a low to a medium political risk rating has increased by 23% from 2003-2004. The majority of these countries are home to substantial foreign business activity and investment. Without preparation to properly manage these increased risks, the security of their people, assets and intellectual property will be seriously undermined.”
Global commercial brokerage group Willis also recently issued a global political risk overview report – in its “Marketplace Realities and Risk Management Solutions 2004” – which suggests that coverage will likely remain generally available to corporations during this year, although claims incidence will likely result in tighter technical policy wordings. The Willis report notes that political risk insurance (PRI) encompasses a broad array of “named perils”. The standard perils under this class of cover include “expropriation”, “currency inconvertibility or non-transfer”, and “political violence” (inclusive of terrorism coverage). Most coverage plans tend to be highly tailored due to the unique requirements of each client, the report observes.
Willis expects that 2004 renewals for PRI will remain “stable” with premiums mostly dependent on the specifics of each transaction. However, the brokerage believes that recent claims will see new coverage restrictions introduced by insurers. “For example, we expect some markets [insurers] will attempt to exclude what is being called ‘denial of justice’ coverage from the expropriation peril.”
Furthermore, the Willis report notes that many corporations with international exposures tend to only seek PRI once a problem has already arisen in an emerging market. This short-term perspective often results in insureds paying a higher price for coverage, or simply finding no availability, as insurers operating in the PRI field are generally quick to react to adverse events. Notably, PRI supply has been withdrawn in several recent cases due to a change in the risk profile, the report points out:
Material adverse change of country risk (most recently the Dominican Republic and Venezuela);
Limited remaining, highly selective country capacity (Brazil and Turkey); and
Ongoing PRI claims activity (Argentina and Venezuela).
Udo Nixdorf, senior vice president at Chubb Insurance Co. of Canada, confirms that PRI is presently much in demand from Canadian companies with operations abroad. Availability of cover within the PRI marketplace has fallen over the past year, he adds. “We’re [Chubb] ‘maxed out’ in the various places of the world where it [PRI] is needed.”
Aon highlights two specific areas of vulnerability where political risk could seriously cripple a corporation operating in today’s globally competitive environment:
Business process outsourcing (BPO) has experienced “explosive growth” over recent years as companies have sought to relocate certain back-office functions to countries offering cheaper labor. The most popular countries offering BPO services also tend to offer greater instability, Aon observes. The brokerage refers to a market survey conducted by
the Meta Group which shows that about 20% of the “Global 2000” companies had expressed an interest in offshore BPO by 2000. This figure had risen to 40% of companies by 2001. Another survey conducted by The Gartner Group suggests that 75% of European companies will have expressed an interest in offshore BPO by the end of 2003. The lead BPO countries are India, Brazil, the Philippines and Russia – all of which are known for instability, Aon says (also see BPO article on page 46 of this issue of CU).
Supply chains and the potential disruption thereof can prove to be the weak belly of many companies. Aon points to South Korea as an example of a country that, facing mounting political tensions, is also the main supplier to the rest of the world of many computer electronic circuitry items and components. South Korea accounts for about 44% of total worldwide production of Dynamic RAM chips (computer memory chips). “A war in Korea would cause a major disruption in the high-tech industry, because so many goods rely on those basic components.” International companies also face potential exposure through disruption of “just-in-time” (JIT) supply chain processing.
Reports issued by international security consultants suggest that the incidence and cost of kidnap and ransom has risen steeply over recent years. However, establishing exact numbers in terms of incidence is near impossible as many cases go unreported, observes JLT Risk Solutions Ltd. Similarly, determining the real demand for K&R and extortion cover is clouded by the fact that most companies and/or individuals purchasing such coverage do not want that information made public. As Bob Fellows, president of St. Paul Insurance Co. of Canada, remarks “K&R is one of those coverages that you don’t talk about who is buying it”.
The ransom demands made by kidnappers has risen substantially over the last three years, notes security consultants IIG Associates. “Demands can be huge, more than 14 countries recorded cases of US$30 million or more in the last three years…Many of the largest settlements paid in the last three years were made in Europe.” JLT Risk Solutions points out that the highest ransoms paid since 1990 range from US$19.5 million to US$77.5 million. “…it cannot be stressed enough that these are only payments about which we have reasonably reliable information.”
The 9/11 terrorist attacks and subsequent increased attention on security has heightened awareness of K&R risk, says Roger Hacala, manager of financial & professional services at St. Paul (the insurer began marketing K&R policies in Canada from April of last year). Interest by Canadian companies in K&R coverage is reasonably strong due to the country’s large oil & gas and mining exploration sectors. “The oil & gas and mining sectors are the highest risk industries [in terms of exposure to K&R in offshore markets].”
Nixdorf says Chubb has experienced low double-digit growth in new K&R policies. He notes that, “whenever you have a global event, there is a burst of interest”. The K&R “hotspot” region is Latin America – specifically Colombia, Mexico, and Brazil – where many Canadian energy and natural resource companies have operations, he adds.
Sophie Stregos-Egnatis, manager of sales development & marketing at William J. Sutton & Co. (a Lloyd’s of London underwriter in Canada), agrees that there is growing demand from Canadian companies and individuals in K&R insurance. She adds that the insurer has increased its premium in this line by approximately 100% over the past five years with much of this growth resulting from new business rather than pricing adjustments.
Notably, the buyers of K&R insurance include a growing number of smaller companies and individuals, Stregos-Egnatis points out. And, she observes, recent years have seen a change in mindset of companies from insuring only their top personnel and directors to include lower level field staff and families. “Naming specific individuals on a policy was the old mindset.” But, despite the greater awareness of the K&R threat, currently less than 1% of persons kidnapped are insured, she adds.
Hacala believes part of the reason for the increased demand for K&R cover and reaction handling programs comes down to employees being more aware of the potential risk they may face, and are therefore demanding their employers provide coverage. Hacala concedes that determining the loss risk potential in the K&R line is extremely difficult due to the lack of public reporting of cases. Pricing of coverage is therefore more influenced by where the employee will be located, he explains. “But, this is definitely a more risky global environment [as a result of political risk].”