Volume 1 Number 29
July 19, 2004









 

 

 

 


SO YOU THOUGHT INSURANCE WAS BORING? POLITICAL RISK INSURANCE

More than 160 years ago, British merchants made a gigantic fortune selling opium to the Chinese. The Chinese government tried to put a stop to the trade. In 1839, it burned 2.5 million pounds of English opium in Canton harbor. The British government reacted by declaring war on China. By 1842, it had so badly defeated China that not only did China have to accept the British opium—it was forced to let Great Britain have free run of its ports--so-called “extraterritoriality rights.”

Nations generally no longer resort to warfare when their commerce is disrupted. Instead, the insurance industry has come up with a solution, which is usually called political risk insurance. “Political risk” comes in a variety of shapes and sizes, and the number of solutions is matched only by the types of problems that can occur.

In 1991, a large manufacturer of cardboard boxes in Western Europe received an incredibly large order from a foreign buyer. The buyer insisted on extraordinary credit terms, which the company was reluctant to accept, but the volume of the order was so large it was hard to resist. The buyer was a trade organization in the Soviet Union. Six months later, the Soviet Union no longer existed, and neither did the trade organization that ordered the boxes. The manufacturer was left with a gigantic hole in its annual statement. But fortunately for the company, it had purchased insolvency risk insurance, which pays for any credit losses over 10 percent of what is expected in the course of normal business.

You don’t have to operate overseas to need this kind of insurance. For example, there were several companies, mostly suppliers of clothing or house wares, who relied primarily or totally on sales through Kmart. When Kmart declared insolvency, these companies were faced with bankruptcy themselves – except for the fortunate ones that insured against it. However, it is primarily companies operating in developing countries that need this type of insurance.

Currency issues are a major source of problems. Some governments put restrictions on how much of the hard currency reserves in their national banks can be paid to foreign creditors. “Hard currency reserves” are held in a country’s banks in dollars, euros, pounds or other easily convertible currency. A customer in Kenya may owe an American company $1 million for services, but the Kenyan government may only allow the local customer to exchange $20,000 a month into U.S. dollars. The American company will show an outstanding account receivable on its books for years, as well as lost investment income, unless it has credit risk insurance.

A country’s currency may face a sudden devaluation. To illustrate, in 1997, Thailand’s currency dropped by 54 percent practically overnight, and all at once, many Thai customers did not have enough money to pay for services they had already contracted in U.S. dollars. If the U.S. companies had credit risk insurance, they would be protected.

Many times, American companies deal directly with foreign governments, rather than with foreign companies. These situations create their own sort of difficulties because governments have much greater discretionary powers than companies. A government can unilaterally decide to terminate a contract, default on payment, cancel export or import licenses, increase shipping charges or import duties, or take any number of other undesirable actions for which an American supplier would have no recourse. Sometimes a government (or maybe a rebel army) will confiscate a company’s entire operation. Contract repudiation insurance would cover any and all of these contingencies in dealing with governments.

One example of this sort of problem occurred in Somalia, when the government nationalized the oil industry in 1975. The Somali government confiscated the equipment and products of the oil companies operating in the country, did their own unilateral assessment of what they thought it was all worth, paid the companies whatever they assessed--in Somali currency--and then refused to let the companies take the money out of the country. The funds sat in Somali banks, then the Somali government charged the foreign companies income tax on the investment income generated by the funds – even though the Somali currency kept dropping in value to the dollar and the funds in the banks were actually getting smaller in U.S. dollars.

Policies can be purchased for individual contracts or for all operations within a specific time frame, usually up to 20 years. A handful of companies operate in this market, most notably AIG and Lloyd’s of London. However, it is interesting to note that perhaps the biggest entity selling political risk insurance is the U.S. government, through the government-owned Overseas Private Investment Corporation, or OPIC (not to be confused with OPEC).

Surprised? You shouldn’t be. Foreign countries, particularly developing countries, get a lot of foreign aid from the United States. These foreign countries often use this foreign aid to purchase products and services from overseas, particularly from American companies, and of course the U.S. government is interested in encouraging them to do just that. In fact, aid program contracts between the American government and foreign governments usually stipulate that American suppliers or local subsidiaries of U.S. companies will be given priority.

What’s more, the American government wants to encourage U.S. companies to operate overseas. In order to get American companies to take the risk, Uncle Sam is willing to back them with government-sponsored insurance. Logical, isn’t it? The next time you complain about how much foreign aid the United States gives away, think about all this.

So you thought insurance was boring?