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].