William Dadzie, founder of Pharos Inter­na­tional Risk Advi­sors, Inc., was kind enough to respond to some ques­tions I posed for him.  It makes for inter­est­ing read­ing about the cur­rent  state of the polit­i­cal risk industry.

1. When invest­ing in emerg­ing mar­kets, what do risk man­agers most over­look when pass­ing on polit­i­cal risk insur­ance (PRI)?

PRI: Lip­stick on a Pig Vs. Icing on the Cake?

Most peo­ple are famil­iar with the expres­sion “A hog in a silk waist­coat is still a hog”, or its more con­tem­po­rary ver­sion “Put lip­stick on a pig, it is still a pig”.  The same goes for polit­i­cal risk insur­ance, PRI in indus­try jar­gon. When applied to a poorly struc­tured project, the project remains poorly struc­tured, and both lenders and PRI providers would tend to shy away from it.

Con­versely, PRI may sig­nif­i­cantly enhance the risk pro­file of a good project, by trans­fer­ring a por­tion of the risk to a qual­i­fied third party. It is impor­tant, how­ever, to sell PRI for what it is: An instru­ment, among many, to enhance the attrac­tive­ness of a trade or invest­ment transaction.

PRI: More than just a risk man­age­ment tool, a trea­sury man­age­ment tool

PRI being only one option avail­able to a risk man­ager to mit­i­gate polit­i­cal risks asso­ci­ated with a trade or invest­ment project, pass­ing on it could mean that the risk man­ager avails him/herself of some other risk man­age­ment tools, or decides to retain the risk or self-insure to use indus­try jar­gon. In either case, the risk man­ager know­ingly or unknow­ingly over­looks two key attrib­utes of PRI. One is related to the use of PRI as an instru­ment to facil­i­tate financ­ing, and the other, to the use of PRI as an instru­ment to mit­i­gate the cur­rent height­ened volatil­ity and the poten­tial for con­ta­gion of risk events that some­times reaches well beyond the epi­cen­ter of a crisis.

The use of PRI to enhance bor­row­ing terms:

Con­di­tions for financ­ing, includ­ing the tenor of a loan and the inter­est rate, are mostly a com­bined func­tion of the com­mer­cial risk and the polit­i­cal risk asso­ci­ated with a spe­cific trans­ac­tion. An effec­tive trans­fer of the polit­i­cal risk to a third party, when that party enjoys a strong credit rat­ing or cred­it­wor­thi­ness, may often result in improved bor­row­ing terms, includ­ing longer tenors and lower inter­est rates.

A case in point is PRI pro­vided by the World Bank Group’s MIGA (Mul­ti­lat­eral Invest­ment Guar­an­tee agency). The Bank for Inter­na­tional Set­tle­ment (BIS), the “cen­tral bank of cen­tral banks” based in Basel, Switzer­land, has clas­si­fied MIGA as a “Highly-Rated Mul­ti­lat­eral”. As a con­se­quence, BIS, under the rules of its Com­mit­tee on Bank­ing Super­vi­sion, has agreed that national reg­u­la­tors may allow banks to apply a zero per­cent risk weight to claims on MIGA due to its sta­tus of “Highly-Rated Mul­ti­lat­eral”. This con­sti­tutes a con­sid­er­able advan­tage for banks that no longer have to pro­vi­sion dol­lar for dol­lar (or more) on the facil­i­ties extended to the cross-border invest­ment projects under discussion.

Given that lend­ing insti­tu­tions are the main dri­vers for the use of PRI, con­tract­ing PRI to pro­tect the equity and/or debt por­tion of the fund­ing of the project cost, may result in con­sid­er­able advan­tages for an investor. The cost is cer­tainly less for a bank to con­tract PRI, and pass on part of the cost to the bor­rower, than it is to pro­vi­sion. A bank that is able to apply a zero per­cent risk weight, or sim­ply a lower risk weight, on its claim on a PRI provider will be open to pass on some of that con­sid­er­able advan­tage to its bor­rower. This remains, how­ever, a mat­ter of nego­ti­a­tion between the lender and the borrower.

The use of PRI as part of an inte­grated risk man­age­ment strat­egy in a con­text of increased volatil­ity and high poten­tial for contagion:

In many instances, pass­ing on PRI is ignor­ing the nature of the cur­rent global envi­ron­ment for invest­ment. The strug­gle for global dom­i­na­tion in the twen­ti­eth cen­tury has given way to an era char­ac­ter­ized by the absence of any dom­i­nant power capa­ble of uni­lat­er­ally impos­ing its rule or influ­ence on oth­ers. In turn, the absence of a global hege­mon has cre­ated a sit­u­a­tion of flux and fueled both a polit­i­cal awak­en­ing amongst and claims from new con­tenders who have lever­aged their emerg­ing eco­nomic power to chal­lenge the old polit­i­cal and eco­nomic order. This sit­u­a­tion of flu­id­ity is one of the main causes for higher volatility.

Cross-border investors and lenders oper­ate in a brave new world char­ac­ter­ized by height­ened finan­cial volatil­ity that will per­sist until ade­quate reg­u­la­tions are adopted, a stronger inter­de­pen­dency between nations and events, and new threats that are not fully under­stood, includ­ing cli­mate change, cyber-terrorism, pan­demics, and media-propagated pan­ics. All of these fac­tors pose an unprece­dented chal­lenge to risk man­age­ment teams over­see­ing trade and cross-border invest­ment projects.

The nov­elty of these threats, as well as their volatile and/or con­ta­gious nature, require that the respon­si­bil­ity for risk man­age­ment in a cor­po­ra­tion not be left to indi­vid­ual, ad hoc, or acci­den­tal risk man­agers, but be assumed by capa­ble multi-disciplinary teams oper­at­ing within the frame­work of an inte­grated risk man­age­ment func­tion. Such a ded­i­cated func­tion entails a sound under­stand­ing of most major threats faced by the com­pany, the prospec­tive inter­re­la­tion between these risks, and an inte­grated map­ping of these risks and of the pro­posed responses. It requires an inte­grated under­stand­ing of geopol­i­tics, inter­na­tional finance, the rel­e­vant indus­try sec­tors, and social and envi­ron­men­tal issues, for the least. The required strate­gies are com­plex. They can­not antic­i­pate each and every risk, but they must go beyond the threats imme­di­ately spe­cific to the investor. This is because an investor is also poten­tially vul­ner­a­ble to threats fac­ing project part­ners, or fac­ing the coun­tries or regions of their investment.

Pass­ing on PRI in that con­text is often ignor­ing the unpre­dictabil­ity of the cur­rent invest­ment con­text. It is also, in many cases, over­look­ing the dif­fi­culty of struc­tur­ing a holis­tic and inte­grated risk man­age­ment strat­egy that pro­motes a rapid and effec­tive response. An effec­tive response is not one that elim­i­nate risks alto­gether, as there is no such thing as a zero-risk envi­ron­ment in inter­na­tional trade and invest­ment. It is a response that reduces risks to a rea­son­able level of prob­a­bil­ity. And if the sys­tem fails and the risk events mate­ri­al­ize, PRI may con­tribute to the avoid­ance of a dead loss.

2.  In the past year what has changed most in the industry?

The past year has been marked by the con­cur­rence of events that have cre­ated a rare degree of global uncer­tainty in finan­cial mar­kets. Here, we are not refer­ring just to events in the Mid­dle East, where a sit­u­a­tion of flux con­tin­ues to pre­vail after the so-called Arab Spring, but also in Cen­tral Asia where insta­bil­ity in Afghanistan has the poten­tial of spilling over well beyond the imme­di­ate neigh­bor­ing region all the way to the Mid­dle East. We may add to that, the finan­cial cri­sis in Europe, the flar­ing up of eco­nomic nation­al­ism in South Amer­ica and the resur­gence of resource nation­al­ism all around the globe. Stronger volatil­ity has height­ened aware­ness of polit­i­cal risks in the con­texts of inter­na­tional trade and cross-border investment.

The greater aware­ness of polit­i­cal risk has in part trans­lated not only into sig­nif­i­cantly higher demand for PRI, but also into a change in the nature of the demand. An increased num­ber of investors are seek­ing PRI for exist­ing invest­ments, and not just new investments.

The mar­ket has scram­bled to respond to the higher demand in a num­ber of ways, includ­ing through the entry mar­ket by a num­ber of insur­ers who have added PRI to their lines of prod­ucts. Also, some under­writ­ers have expanded the scope of their busi­ness. Fol­low­ing the exam­ple of MIGA, who has changed its Con­ven­tion to expand its busi­ness, the Kuwait-based Arab Invest­ment and Export Credit Guar­an­tee Cor­po­ra­tion (AIECGC or Dhaman) has recently amended its Arti­cle of Asso­ci­a­tion to be able to under­write the risk of exist­ing busi­ness, which not all PRI providers do.

Mar­ket response, how­ever, has not resulted in a suf­fi­cient increase in capac­ity to match the increased demand. This gap has placed an unavoid­able pres­sure on the lev­els of pre­mium and the cost of sourc­ing PRI in general.

In terms of regional trends, there have been a num­ber of note­wor­thy devel­op­ments. Demand has appeared where it did not exist or was rather rare before. To cite exam­ples, there has been a surge in demand for PRI for some Euro­pean coun­tries, includ­ing Roma­nia and Greece. This is remark­able. In the case of Greece, PRI demand cen­tered on the prospect of Greece leav­ing the Euro­pean Union (EU) and the drachma, the national cur­rency, becom­ing incon­vert­ible. With­out engag­ing in any doom pre­dic­tion, the Greek exam­ple may well be the canary in the mine that may pave the way for greater demand for PRI from investors with projects in Europe. This trend is truly note­wor­thy when a country’s mem­ber­ship in the EU had been viewed tra­di­tion­ally as suf­fi­cient risk mit­i­ga­tion for investors to pass on PRI.

In Latin Amer­ica a num­ber of events in the past year have made it more dif­fi­cult to con­tract PRI for invest­ments in some coun­tries, have increased the cost of PRI where avail­able, and have con­se­quently tight­ened lend­ing terms for projects in these coun­tries. These events include:

  • Argentina’s expro­pri­a­tion of Repsol;
  • Bolivia’s seiz­ing of power-grid com­pany Trans­porta­dora de Elec­t­ri­ci­dad in May and the nation­al­iza­tion of Glencore’s Colquiri mine in June, which con­firmed the coun­try as a ser­ial ‘nationalizer’;
  • Paraguay’s impeach­ment of Pres­i­dent Lugo by the country’s Par­lia­ment, which has been read as noth­ing short of a par­lia­men­tary coup; and,
  • Venezuela’s con­tin­u­a­tion of its vast expro­pri­a­tion pro­gram, with Siderur­gica de Tur­bio, the lat­est victim.

Those are a few trends observed lately in the PRI markets.

3.  What about Pharos helps sep­a­rate it from its competitors?

I would cite two specificities:

  •  Our spe­cific under­stand­ing of the PRI mar­ket and past expe­ri­ence in under­writ­ing gives us a par­tic­u­lar edge, in as much as we under­stand the think­ing of PRI providers and what may make them shy away from a trans­ac­tion. We lever­age that expe­ri­ence to help our clients improve the struc­ture of their trans­ac­tions and approach the PRI provider effi­ciently; and,
  • Our part­ner­ship with MIGA, a mem­ber of the World Bank Group, as Pharos is an Offi­cial MIGA Agent. Again, the fact that MIGA is clas­si­fied as a ‘Highly Rated Mul­ti­lat­eral’ is a con­sid­er­able advan­tage for banks that oth­er­wise may have to pro­vi­sion up to 150 cents per each dol­lar of financ­ing extended to projects in emerg­ing mar­kets. In addi­tion to that trea­sury man­age­ment tool avail­able to lenders, the MIGA policy-holders enjoy strong pro­tec­tion due to the qual­ity of the MIGA poli­cies, the low credit risk asso­ci­ated to the MIGA lia­bil­ity, the agency’s medi­a­tion capac­ity, as well as its know-how when it comes to man­ag­ing envi­ron­men­tal and social issues.

For more infor­ma­tion about Pharos please con­tact William at [email protected].