Political risk in emerging markets

ACE Global Markets aces the challenges of insuring investment risk in developing economies

By Elisabeth Boone, CPCU

As barriers to international trade fall, the dynamic global marketplace continues to attract investors who are eager to capitalize on the opportunities they see in emerging markets around the world. Compared to a quarter century ago, these markets enjoy greater stability and are experiencing steady growth.

However, these emerging markets remain vulnerable to a host of forces known as political risk that are largely beyond the control of investors. Among these risk factors are currency instability, corruption, weak government institutions, unreformed financial systems, patchy legal and regulatory regimes, and restrictive labor markets.

These are among the key findings of a study conducted last October by The Economist Intelligence Unit and sponsored by IBM, KPMG, and the ACE Group of Companies. Titled Operating Risk in Emerging Markets, the study surveyed 177 executives around the world about their attitudes toward operating risk management in the context of emerging market investments. As a leading international insurer and reinsurer, ACE was ideally positioned not only to sponsor the survey but also to benefit from its findings.

A major player in the political risk market, ACE Group member ACE Global Markets (AGM) is licensed to do business in 150 countries. AGMs underwriters write business through both a Lloyds syndicate and a company market, ACE European Group Limited. In addition to political risk and credit, AGM specializes in aviation, property, marine, energy, financial lines, and accident and health.

Managing political risk

Fredrik Mrer, ACE Global Markets manager of political risk and credit for North America, helps brokers and clients navigate the complex maze of exposures that embody political risk. His career spans 14 years in political risk underwriting and underwriting management with leading underwriters in both North America and Europe. Mrer joined AGM in January 2004 in London, where he underwrote risks for European and worldwide clients. A year later he moved to the New York office to head up AGMs political risk and credit unit and bring AGMs full complement of products to clients in North America.

Commenting on the findings of the survey, Mrer says, What was most noteworthy to me was that so few companies actually had a formal approach to risk management when it comes to emerging markets.

In fact, the survey shows that although 96% of respondents are aware that political risk management is important to their operations, just 49% integrate it formally into their investment process, while 41% take an informal approach to considering political risk as part of their investment process. This gap between awareness of political risk and formal action to manage it, Mrer believes, is serious cause for concern given the fact that 79% of survey respondents reported that their investment in emerging markets had increased over the past three years.

As part of the due diligence process, the survey shows, 80% of respondents said they conducted political and operating risk management before making an investment in an emerging market. Mrer notes, however, that despite the volatility of such markets, after making the investment, fewer than half actually have a monitoring process in place. Only 44% of respondents said they conduct ongoing risk assessment, and just 30% do so on a regular basis.

If you look at those two trends together and then consider the fact that a quarter of the companies surveyed also indicated theyve withdrawn their investments due to political risks and threats, that proves to be very costly, Mrer observes.

Taking all three points together, the way I sum up the most interesting parts of the survey findings is that theres some sort of complacency among companies that dont see the need to monitor, measure, and manage political risk and the social factors theyre faced with when they go into emerging markets, Mrer continues. Thats been our key message for a long time, so its interesting to have it backed up.

Perhaps not surprising in the post-9/11 world is another survey finding that Mrer deems noteworthy. Theres a perception that terrorism is a greater or at least an equal risk to U.S. assets as political risk, he comments. But if you look at the severity of what a confiscation would do to your balance sheet, I believe youd want to consider political risk as an equal or greater threat in terms of lost investments.

In some emerging markets, Mrer notes, governments seize foreign assets wholesale. In some areas they go after entire sectors, he says. Were seeing that in mining, oil and gas, and telecommunications. So its not that they get one of your facilities; they take the whole thing. If you couple that risk with the fact that you dont have an actual risk management process in place, the question becomes: What do you do if youre hit?

Volatility rules

With emerging markets in every corner of the globe, some challenges for investors are bound to be specific to a particular country or political system. Theres also, Mrer remarks, a degree of commonality.

To answer the question of how to manage emerging market risk, we first have to define what is emerging market risk, he says. Essentially, its volatility and uncertainty. If youre in a place where there are unstable political, social, and economic conditions, are you able to clearly identify the risks? And if you have identified them, do you have a backup plan for how to respond to a crisis when it happens? Once youve made that investment, Mrer says, we keep emphasizing that you have to continue to monitor and manage the risk.

The survey pointed to concern about unstable and less predictable governments, he continues. You may be facing an uncertain legal environment, environmental and health care issues, volatile employment and labor relations, and the involvement of NGOs (non-governmental organizations). You have a reputational risk as well, just being targeted by companies or countries that go after you for whatever reason. This all goes back to the question: Do you have a plan in place, and do you know how to monitor these risks? Mrer says.

ACE in action

How does ACE Global Markets North American political risk unit approach the challenges of providing coverage for firms that invest overseas?

We cover emerging market risks, and in doing that we focus on three areas, Mrer responds. First is political risk insurance, where we cover investments and trade. We address confiscation of assets as well as interruption of trade in emerging markets due to political events. We do structured trade credit, short and medium term, and offer trade credit insurance. We operate from our underwriting offices in New York, where we deal with the marketplace of the Americas.

Our headquarters office is in London, where we work with clients located throughout the European Union. Our team also underwrites at Lloyds of London, so we have true Lloyds access to world markets through reciprocal licenses. We have an office in Singapore that deals with clients located in Asia. Through these offices, we can reach almost every corner of the world, Mrer says.

A generation ago, foreign investment was almost exclusively the province of large, asset-rich corporations, and relatively few smaller firms ventured into the uncharted waters of developing economies. Today, thanks to quantum leaps in technology, the erosion of cultural barriers, and the expansion of free trade agreements, smaller companies increasingly see emerging markets as offering an attractive profit potential.

We work primarily through U.S. brokers, Mrer explains, and in that regard we are a broker-driven market. We cover all areas of emerging market risk for U.S. clients, and youll find that most of these clients are served by specialty brokers or brokers who have picked up on these trends that weve highlighted. Political risk exposures are dealt with primarily by specialty political risk brokers, trade credit through trade credit brokers, and structured trade credit through a mix of the two.

These brokers source business to us from U.S. companies of all sizes, Mrer says. We dont target only large companies, but we do target companies in our underwriting process that know how to manage their risk. Theyre multinational companies with exposures around the world, and we want to be part of their risk management process. We dont want to be there to improve a bad situation.

Changing needs

Just as investors must monitor their exposures in emerging markets, so must ACE Global Markets political risk unit remain alert to changing needs and have sufficient flexibility to respond with creative solutions.

We continue to evolve with the needs of our customers, Mrer says. That manifests itself in the breadth of cover that is now available, the longer tenures, the increasing capacities, and the innovations in the applications of cover. For example, we brought structured trade credit to market as a continuation of the political risk side of the business. We took it from dealing only with government frustrations of a contract to also include other areas of emerging market risk where a private company might default due to political events or other events, Mrer explains.

The broadening and the lengthening of covers are in response to what our customers have told us they need, he continues. We cover investment agreements, operating licenses, import and export licenses, trade contracts, and all of that is within the context of how the insureds business evolves over time.

In our group, we analyze and review and monitor country risks in over 130 countries, Mrer says. We update our key contacts with daily bulletins and key market developments, both political and economic, and we now have pre-approved counterparting in over 90 countries. We offer this to our bank clients and our corporate clients. We provide risk-specific analysis, and we also do industry sector analysis.

Based on the trends identified by AGMs ongoing analysis and monitoring, Mrer says, If you look at the business today compared with where it was five or ten years ago, theres been a strong evolution.

Emerging market trends

Given the robust growth in overseas investment, its tempting to view the entire developing world as an emerging market. Clearly, though, some markets are growing faster than others, and for different reasons.

If you look at emerging markets in terms of where flows of capital are going, the major ones are China, Russia, Ukraine, Turkey, Brazil, India, and Mexico, Mrer says, and thats where were seeing growth on the political risk side.

As to where capital flows are going with respect to industries, he says, It varies by country. As we follow the trade flows and investment flows, we see funds going into natural resources like mining, oil and gas. A big part of what we do is manufacturing, and were also involved in general trading; we continue to support that wherever its going.

Because volatility and uncertainty are the hallmarks of emerging markets, the challenges in such markets are in constant flux. At any given time, however, some countries are on the hot list with respect to political risk.

If you read the general press, youll see that theres some concern right now about whats going on in certain countries in Latin America, like Bolivia and Venezuela, Mrer says. Also, countries like Russia and Ukraine continually appear in the headlines. If were reading about developments in the headlines, investors are probably feeling it on the ground in those countries.

As more developing countries come onto the vast stage of the global marketplace, they bring with them the promise of untapped opportunities, which inexorably draw profit-hungry investors. As the survey co-sponsored by the ACE Group of Companies clearly shows, however, it is essential for investors to understand, manage, and monitor the array of political risk exposures they face. *

For more information:

ACE Global Markets

Web site: www.aceglobalmarkets.com