Handling Global Political Risk

Geopolitical risk – defined as any peril that arises from geographic, historic, and societal variables related to international politics – has become an integral part of the risk management landscape in recent years. When evaluating these risks, executives must take into account many specific considerations. One of the main considerations regarding geopolitical risks is that they are typically catastrophic in nature. In many cases, severe losses can put a company in serious financial and operational difficulties; in extreme cases, they can trigger a company’s demise.

Another consideration when dealing with geopolitical risks is that indirect exposure – such as perceptions of corporate governance and possible shareholders’ lawsuits – could have a higher financial impact than direct exposure (i.e. terrorism attacks that could lead to property damage or halt production). Because executives can be deemed responsible for not clearly identifying the perils to which a company is exposed – or worse, they do identify the perils, but the mechanisms available to mitigate or transfer those perils are not used – executives should use care when assessing and reporting geopolitical exposures. Clearly this becomes a more imminent issue when a company suffers significant market value loss following a geopolitical event. For example, a company might have to stop production because a key material could not be bought due to a trade embargo or civil war. That could negatively impact the company’s quarterly profitability, which might further trigger a credit downgrade by a rating agency and/or a major stock price drop. As a result, there could be a shareholders’ lawsuit or technical default on debt. If capital allocation follows risk, then transferring risk is a consequential credit enhancement.

A recent Economist Intelligence Unit (EIU) survey¹ of global executives reveals that corporations normally identify geopolitical risks (risk assessment). However, there is a gap between identifying the risk and implementing mitigation and/or risk transfer mechanisms to deal with those perils (risk management).

Part of the challenge, according to the survey, is that geopolitical risks are on the radar screens of CEOs and CFOs, who are constantly weighing country risks against country opportunities, but not necessarily evident to risk managers and Chief Risk Officers (CROs). A link to this trend is also identified in Global Risks 2007, a World Economic Forum (WEF) report,² which suggests that CROs should embrace the idea of country risk managers – either by creating such a position (large global financial institutions have already done that, as have some truly global companies) or by establishing country risk metrics in the overall corporate risk management policies.

Another reason for further involvement of risk managers and CROs with geopolitical risks is that many of these risks can be quantified, priced and transferred into the insurance, reinsurance (e.g. with captives) or capital markets. Therefore, not only can those perils be added to the mix of risk assessment, they can further be managed for a company’s optimal allocation of (insurance) capital.

Terrorism and regional nationalism are among today’s top geopolitical risks that concern corporations, insurers, investor groups and some government bodies.

Although the severity attributed to acts of terrorism may be considered lower than other geopolitical exposures in the short term, terrorism is one of the most evident exposures that companies face. The growing number of areas prone to produce followers of extremist ideologies (e.g. Iraq, Lebanon, West Bank/Gaza), the possibility of future fissile materials acquisition (new or poorly disposed) and the real number of thwarted attempts and threats registered by different intelligence agencies underlie the seriousness of the risk of terrorism.

As indicated in the WEF report, some identified risks have a higher probability of frequency than others, making the underwriting of these risks very difficult. A high frequency of risks will limit the number of markets with technical capacity or an appetite to absorb those risks. Severity, although relatively challenging to quantify, can be limited on an individual company basis to the aggregate maximum capacity available from the different insurance markets. For example, if a company has properties valued at US$13 billion that are exposed to terrorism risk, and the total market capacity – insurance, reinsurance and capital markets – can absorb only US$2.5 billion, an event might trigger a loss above that capacity limit and the indemnity will not match the severity of the peril.

Surprisingly, after decades of global liberalization, the nationalism/populism phenomenon is making a comeback in the beginning of this century. This might prove very challenging for corporations operating across multiple countries. The extractive sector (oil and gas, mining) knows this peril quite well: as the prices of metals and energy appreciate for a prolonged period of time, so, too, does the risk that local governments will “change the rules of the game.”

Some governments, for example, might take a short-term, opportunistic view that reviewing contracts, taxation or licensing rights represents the best way to increase revenue at the expense of foreign investors. There are a number of recent cases in which countries have nationalized certain industries. But that’s not new. The “new” part of the phenomenon is that regional blocks are firming up around the same agenda, further expanding the nationalistic rhetoric around global trade.

Further trade liberalization is halted on a global basis. Now we see traditional liberal players such as the United States and the European Union backtracking and embracing nationalistic protectionism, preventing freer trade. Whether as a result of economic causes (e.g. high unemployment) or disguised under the cloak of health or security measures, countries are starting to abandon the idea of free trade; instead, they are implementing trade embargoes. Not only do individual corporations stand to lose as a result, but also societies as a whole.

Finally, another thought-provoking aspect of geopolitical risks is the interdependence of these risks with other types of risk. As graphically pointed in the WEF report’s Correlation Matrix, these perils influence one another in multiple ways. For example, a proliferation of nuclear weapons not only increases the risk of interstate wars, but it also potentially increases the possibility of fissile materials falling into the wrong hands. When you factor in some growing socioeconomic trends such as global supply chains and employee mobility, this is an example of how these risks can be exacerbated to astounding proportions (trade disruption, exposure to world diseases, war/civil war, etc.).

Geopolitical risks are unique and complicated not only because of their multiple causation effects or underwriting peculiarity, but also due to their catastrophic nature.

The risk management community has the responsibility to generate corporate discussion around the probability and implications of such risks and the available mechanisms to manage them.

1 Operating Risk in Emerging Markets, A report from the Economist Intelligence Unit sponsored by ACE, IBM and KPMG (London, New York, Hong Kong: October 2006).

2 Global Risks 2007, A World Economic Forum Report prepared by the Global Risk Network in collaboration with Citigroup, Marsh & McLennan Companies (MMC), Swiss Re and Wharton School Risk Center (Cologny/ Geneva, Switzerland: January 2007).