Fall 2008 Version

1. Fall 2008 Version Professor Dan C. Jones FINA 4355

2. Risk Management and Insurance: Perspectives in a Global Economy17. Political Risk Management Professor Dan C. Jones FINA 4355

3. Study Points • Modes of foreign market entry • Nature of political risk • Risk analysis • Risk control • Financing the political risk exposure • The importance of monitoring • Political considerations in emerging markets

4. Modes of Foreign Market Entry • Exporting • Use of a domestic intermediary • Foreign direct investment (FDI) • Joint venture • Wholly-owned subsidiary • Branch • Differences in the level of political risk

5. Political Risk • Any governmental action that diminishes the value of a firm operating within the political boundaries or influence of that government • Elements (selected) • Nationalization (taking of property with compensation) • Confiscation (taking of property without compensation for criminal activity) • Expropriation (taking of property without compensation in eminent domain) • Contract repudiation • Currency inconvertibility Note on “Expropriation” Depending on the country and jurisdiction, the property owner may receive some compensation but the amount is likely below the market value of the property.

6. Political Risk Management • Identification/measurement of loss exposure • Political/legal environment • Socio/ethnical environment • Economic/financial environment • Regional/international environment • Use of external data/analysis • Internal analysis • Frequency and severity of an adverse event • Changes in firm value • Benefit-cost analysis

7. Public Information Sources (Table 17.1)

8. The World at Risk – August 2008 • China • The Olympic Games begins and a massive security operation is mounted in Beijing. Earlier, 16 policemen in Kashgar were killed in an attack by separatist Muslim militants. • Venezuela • President, Hugo Chávez, issues 26 decree laws, the provisions of which could lead to a big increase in the role of state. • Rwanda • A commission accuses French officials – including the late president, François Mitterrand, and two former prime ministers – of actively supporting the Hutu génocidaires who massacred 800,000 ethnic Tutsis and moderate Hutus in 1994. The Economist.com

9. Coface @Rating (Selected Countries, August 2008) Source: http://www.trading-safely.com

10. Sudan Sovereign CC Currency CCC Banking sector CCC Political C Econ structure CC Iran Sovereign B Currency BB Banking sector CCC Political CC Econ structure BB Risk Ratings by Economic Intelligence Unit Economic Intelligence Unit (Feb 2007)

11. Political Risk Control Techniques • Integrative strategies • Discourage the host government from interfering with the operation of the firm • Managerial approaches • Increase in communication and tighter relationships (e.g., use of local resources including personnel) • Financial approaches • FDI through joint venture • Fair, accurate and open financial reporting

12. Political Risk Control Techniques • Defensive strategies • The cost of interference > the cost of letting the firm stay • Managerial approaches • Joint venture partner from outside the host country • Minimum use of host country nationals • Use and enforcement of intellectual property rights • Financial approaches • Source equity/debt financing from within the host country • Minimize retained earnings locally

13. Financing the Political Risk Exposure

14. Financing the Political Risk Exposure • Retention • Insurance • Intergovernmental agencies • Governmental agencies • Private companies

15. Multilateral Export Credit Agencies (Table 17.2) The correct name for the Arab is “Inter-Arab Investment Guarantee Corporation.”

16. The Multilateral Investment Guarantee Agency • Created in 1988 as a World Bank Group member • Promote FDI in emerging economies • Offer political risk insurance (guarantees) • Over $2 billion in capital paid by 163 World Bank member countries Click Here to Go to the Webpage

17. The Inter-Arab Investment Guarantee Corporation • Established in 1975 to foster inter-Arab investment flows • Provide coverage for inter-Arab investments and export credits against non-commercial risks • $83 million capital in 2002 Click Here to Go to the Webpage

18. Overseas Private Investment Corporation (U.S.) • Established in 1971 to help US business investments overseas, foster economic development in emerging markets, and complement the private sector in managing the risks associated with FDI • Up to $250 million per project against: • Currency inconvertibility, expropriation or political violence • Protection of up to 20 years of equity life or maturity Click Here to Go to the Webpage Previously “Overseas Private Insurance Corporation”

19. The Export-Import Bank of the U.S. • Finance the export of U.S. goods and services • Does not compete with private sector lenders • Pre-export financing • Commonly one-year transaction-specific or revolving loan • Small Business Multi-Buyer Export Credit Insurance • Commercial losses due to insolvency, bankruptcy and default (up to 95% coverage) • Political losses due to war, revolution, cancellation of an import or export license, currency inconvertibility (up to 100% coverage) Click Here to Go to the Webpage

20. Export-Import banks around the world African Export-Import Bank Export Import Bank of Japan the Export Import Bank of India… Private insurance firms American International Group The Chubb Group Zurich (North America) Lloyd’s… Other Risk Insurance Providers

21. In Your Countries?

22. Differences between Public and Private Insurance • Public insurers must consider their governments’ policy objectives • Private insurers are in the business to make a profit while avoiding undue risk. • These providers are perceived as being more flexible. • Their coverages can be more expensive.

23. Differences between Public and Private Insurance • In general, public-sector insurers rely more on published rate schedules than do private insurers • Government policy toward a particular country or region heavily influences pricing and coverage availability. • Traditional actuarial methods based on probabilities are less applicable. Hence, private insurers use portfolio management and diversification to assure spread of risks, both in terms of coverage provided and geographic area.

24. The Importance of Monitoring • MNCs should carefully monitor the effectiveness of their political risk management programs, including the environment in the country of operation. • Circumstances that create political risk in one country may create it in another. • Marketing practices that are effective in a developed country may provoke suspicion and controversy in a developing country. • Managerial practices that are effective in the home country may precipitate labor unrest in a host country.

25. Political Considerations in Emerging Markets • Eastern Europe • Asia • Latin America • Middle East • Africa

26. Case Study: Iran Not in the Text.

27. Background • Persia until 1935 • Became an Islamic republic in 1979 • Religious scholars as political leaders • 1980-1988 war with Iraq • Designated as a state sponsor of terrorism • Nuclear development

28. Population of 65.6 million Median age 26.4 15~64 72.3% Life expectancy Infant mortality of 36.94 per 1,000 lives at birth Life expectancy 69.39 (male) 72.4 (female) Ethnicity Persian (51%), Azeri (24), … Religion Muslin (98%)  Shi’a (89%) and Sunni (9%) People Source: CIA World Factbook (August 2008)

29. Central planning with large enterprises 47% services and 42% industry Per capital GDP (purchasing power parity) of $8,900 GDP real growth of 5% Exports – gas, carpets Imports – raw materials, capital goods, technical services 15.8% inflation (2003*) 15% unemployment (2002*) 40% below poverty line Single exchange rate system since 2002 Economy

30. Iran – International Disputes • Fitch Credit Rating (December 2003) B+ (long-term rating) B (short-term rating) Outlook – stable • S&P Do not rate • Moody’s • Withdrew rating action in June 2002 • US government concerns that the rating was “inconsistent” with U.S. sanctions

31. Insurance in Iran • The history • Initially serviced by foreign insurers • 1935 – First, state-owned insurance firm established • 1979 – The industry (with 12 foreign firms) nationalized, leaving only state insurers: Iran Insurance Company, Asia Insurance Company, and Alborz Insurance Company • The regulator • Bimeh Markazi (Central Insurance, www.centinsur.ir) of Iran established in 1971

32. Insurance in Iran • The market • The market is closed to the private sector and foreign firms • Third party motor liability insurance is compulsory • Related activities • Social Security Organization (SSO) for workers’ compensation type of coverage • Medical Service Organization (MSO) for medical insurance to anyone who selects not to be insured by Iranian commercial insurer or SSO • Export Guaranty Fund of Iran (ECGD)

33. Insurance Data – Premium Source: http://www.centinsur.ir/frmHome_en-IR.aspx

34. Insurance Data – Claims Source: http://www.centinsur.ir/frmHome_en-IR.aspx

35. Discussion Questions

36. Discussion Question 1 • With increasing internationalization of national economies, would you expect political risk exposures to grow or diminish in importance? Justify your answer.

37. Discussion Question 2 • Could political risk exposures of MNCs might be hedged in the capital market? Speculate as to how this might be accomplished.

38. Discussion Question 3 • An entire national economy can be exposed to political risks in the sense that the actions of other governments can diminish its collective “value.” How should governments apply sound risk management principles to such exposures? Do government considerations in this respect differ fundamentally from those of firms?

39. Discussion Question 4 • Can governmental political risk exposures justify the creation, maintenance and protection of a domestically owned insurance industry? Justify your response.

40. Discussion Question 5 • We discussed two strategies for political risk management: an integrative strategy and a defensive strategy. Pick a country (or a political environment) for which an MNC might use an integrative strategy. Pick another country (or an environment) for which an MNC might use an integrative strategy. Support your choice for each with logical explanation. Would your choices of countries, tactics or both change depending on the nature of business?