In this section we elaborate on the following:
- Global risk exposures in the international competitive landscape
- Risk control measures for reducing common global risks
- Insurance options for global risk exposures
As with the Internet, global exposure is rapidly growing for many companies. This forces management to think about the unique problems that arise when companies cross national borders, also known as global risk. Political Risk Services (http://www.prsonline.com/), an organization that ranks countries for their instability, attaches a major cost to each country. This highlights the importance of understanding the countries that businesses decide to enter. In a survey conducted by the insurance broker AonMark E. Ruquet, “Big Firms Worry About Coverage for Political Risks Abroad,” National Underwriter Online News Service, August 9, 2001. The Aon survey asked 122 risk managers, chief financial officers, and others in similar positions of responsibility to assess various aspects of their overseas risks. The surveys were done by telephone and in some cases over the Internet. of Fortune 1,000 companies in the United States, 26 percent of the respondents felt comfortable with their political risk exposure and 29 percent felt comfortable with their global financial or economic risk exposure. While most respondents felt comfortable with their property/casualty coverages, only a small percentage felt comfortable with their political risk protection. The survey was conducted during May 2001, before the September 11 attack. In 2005, Aon provided a map of the political and economic risk around the world. The climate around the world has changed with the war in Iraq, a part of the world surrounded by major economic and political hot spots.
Political risk can be defined as unanticipated political events that disrupt the earning or profit-making ability of an enterprise. In “The Risk Report: Managing Political Risks,” insurance expert Kevin M. Quinley describes some of the perils that can affect a global organization: nationalization, privatization, expropriation (property taken away by the host nation according to its laws), civil unrest, revolution, foreign exchange restrictions, labor regulations, kidnapping, terrorism, seizure, and forfeiture. Some of the risks are considered political risks, others are economic risks. Table 11.2 explains some of these risks. In summary, the main categories of global risk exposure are as follows:
- Destabilized international political environment
- Heightened terrorism risk
- Legal risk due to changes in local laws
- Lack-of-data risk
- Currency inconvertibility risk
- Cultural barriers risks
According to the Risk Report, the nature of the risks has changed. Twenty years ago, the major risk was in the area of nationalization of capital assets, while the perils of today are more related to economic integration and the power of international financial markets. Experts agree that political risk looms larger after September 11, the war in Iraq, and the instability in the Middle East. Following the September 11 attack, Marsh and all large brokerage firms began providing political risk assessment services to clients worldwide.“Marsh to Begin Crisis Consulting Led by Anti-Terror Expert,” National Underwriter Online News Service, October 12, 2001; see Aon services at www.aon.com/risk_management/political_risk.jsp; see Willis services at http://www.willis.com/Services/Political%20Risk.aspx. The consulting includes formulating and reviewing crisis management plans for events such as natural disasters, product recalls, and terrorism. The plans are comprehensive, and they are integrated throughout the enterprise.
Reproduced with permission of the publisher, International Risk Management Institute, Inc., Dallas, Texas, from the Risk Report, copyright International Risk Management Institute, Inc., author Kevin Quinley CPCU, ARM. Further reproduction prohibited. For subscription information, phone 800-827-4242. Visit http://www.IRMI.com for practical and reliable risk and insurance information.
Often, the decision to undertake operations in a particular country is made apart from any risk management considerations. Although the legal environment may have been carefully reviewed from the standpoint of firm operations, little information may have been obtained about insurance requirements and regulations. For example, in many countries, social insurance is much broader than in the United States and there are few, if any, alternatives available to the risk manager. The risk manager may be forced by regulations to purchase local coverage that is inadequate in covered perils or limits of liability. Particularly in less-developed countries, there simply may not be adequate insurance capacity to provide desirable amounts and types of coverage. The risk manager then must decide whether or not to ignore the regulations and use nonadmitted coverage.
Nonadmitted coverage involves contracts issued by a company not authorized to write insurance in the country where a risk exposure is located. Admitted insurance is written by companies authorized to write insurance in the country where a risk exposure is located. Nonadmitted contracts have advantages to some U.S. policyholders: they are written in English; use U.S. dollars for premiums and claims, thus avoiding exchange rate risk; utilize terms and conditions familiar to U.S. risk managers; and provide flexibility in underwriting. However, such contracts may be illegal in some countries, and the local subsidiary may be subject to penalties if the contracts’ existence becomes known. Further, premium payment may not be tax deductible, even in countries where nonadmitted coverage is permitted. If nonadmitted insurance is purchased where it is prohibited, claim payments must be made to the parent corporation, which then has to find a way to transfer the funds to the local subsidiary.
Coverage is also affected by the codification of the legal system in the other countries. The Napoleonic code, for example, is used in France, Belgium, Egypt, Greece, Italy, Spain, and several other countries. Under this legal system, liability for negligence is not treated in the same way as liability is treated under the United States system of common law; any negligence not specifically mentioned in the code is dismissed. The common law system is based on legal precedence, and the judges play a much more significant role.
Another problem facing the international risk manager is the collection of adequate statistical information. Economic and statistical data commonly available in the United States may simply be nonexistent in other parts of the world. For example, census data providing an accurate reflection of mortality rates may not be available. Even in industrialized countries, statistics may need careful scrutiny because the method used to produce them may be vastly different from that typical to the risk manager’s experience. This is particularly true of rate-making data. Data may also be grossly distorted for political reasons. Officially stated inflation rates, for instance, are notoriously suspect in many countries.
Faced with this lack of reliable information, the risk manager has little choice but to proceed with caution until experience and internal data collection can supplement or confirm other data sources. Contacts with other firms in the same industry and with other foreign subsidiaries can provide invaluable sources of information.
Data collection and analysis are a problem not only in this broad sense. Communication between the corporate headquarters and foreign operations becomes difficult due to language barriers, cultural differences, and often a sense of antagonism about a noncitizen’s authority to make decisions. Particularly difficult under these circumstances are the identification and evaluation of exposures and the implementation of risk management tools. Loss control, for instance, is much more advanced and accepted in the United States than in most other countries. Encouraging foreign operations to install sprinklers, implement safety programs, and undertake other loss-control steps is generally quite difficult. Further, risk managers of U.S.-based multinational firms may have difficulty persuading foreign operations to accept retention levels as high as those used in the United States. Retention simply is not well accepted elsewhere.
Any multinational transaction, where payments are transferred from one currency to another, is subject to exchange rate risk. Under the current system of floating exchange rates, the rate of currency exchange between any two countries is not fixed and may vary substantially over time. Currency exchange risk is in the area of liquidity and convertibility between currencies. The risk exposure is the inability of the global firm to exchange the currency and transfer out of hostile countries. How this kind of risk can be mitigated is explained in "5: The Evolution of Risk Management - Enterprise Risk Management".
Cultural Differences Risk
As we are very acutely aware after the September 11, 2001, attacks, cultural differences are at the root of much of the trouble around the world. But this is not only in hostile events. When a business expands abroad, one of the first actions is the study of the local culture of doing business. If you ever were in the market in old Jerusalem, you may have experienced the differences in shopping. You learn very quickly that a merchant never expects you to buy the item for the quoted price. The haggling may take a long time. You may leave and come back before you buy the item you liked for less than half the originally quoted price. This is the culture. You are expected to bargain and negotiate. Another cultural difference is the “connection” or “protection.” Many business moves will never happen without the right connection with the right people in power.
Labor laws reflect another interesting cultural difference. In some countries, it is common to employ very young children—an act that is against the law in the United States. The families in these countries depend heavily on the income of their children. But an American business in such a country may be faced with an ethical dilemma: should it employ children or adhere to U.S. practices and labor laws?Etti G. Baranoff and Phyllis S. Myers, “Ethics in Insurance,” Academy of Insurance Education, Washington, D.C., instructional video with supplemental study guide (video produced by the Center for Video Education, 1997.) Islamic finance is very different from finance in the Western world; for example, in Islam, interest payments are not permitted. With the expanded involvement of many businesses in the Middle East and Islamic countries, many academics, as well as businesspeople, are learning about the special ways to conduct business there.
Global Risk Management
The steps in global risk management include processes to reduce risk and develop loss-control policies, along with obtaining the appropriate insurance. Table 11.2 lists ways to manage political risks. The steps include learning the culture of the country and becoming a good corporate citizen, learning about the reality of the country, and finding ways to avoid political and legal traps. In the area of insurance, the global firm first looks for public insurance policies. The U.S. government established an insurance program administered through the Overseas Private Investment Corporation (OPIC) in 1948. The types of coverage available include expropriation, confiscation, war risks, civil strife, unfair calling of guarantees, contract repudiation, and currency inconvertibility. These are shown in Table 11.2. OPIC insurance is available only in limited amounts and only in certain developing countries that have signed bilateral trade agreements with the United States for projects intended to aid development. Some private insurers, however, also provide political risk insurance. Private insurers do not have the same restrictions as OPIC, but country limits do exist to avoid catastrophe (dependent exposure units). Additional types of coverage, such as kidnap, ransom, and export license cancellation, are also provided by private insurers. Poor experience in this line of insurance has made coverage more difficult and costly to obtain.
After September 11, some insurers pulled out of the political risk market, while others took the opportunity to expand their global coverage offerings. A Canadian insurer reported that the demand for insurance for employee political risk and kidnap and ransom for a dozen global companies increased by 100 percent.Daniel Hays, “Insurer Finds Good Market in Political Risk,” National Underwriter Online News Service, November 28, 2001. Zurich North America and Chubb expanded their political risk insurance offerings to the Asian market.“Zurich North America Expands Political Risk Insurance to Asian Market,” National Underwriter Online News Service, April 6, 2002; John Jennings, “Political Risk Cover Demand Surges: Insurers,” National Underwriter, Property & Casualty/Risk & Benefits Management Edition, April 27, 1998. The private insurance market’s ability to meet the demand has been strengthening each year because customers require broader coverage with longer terms, up to ten years. Other companies expanding into the market are Bermuda’s Sovereign Risk, AIG, and Reliance, among others.
Until recently, long-term political risk insurance was available mostly from international government agencies such as the Washington-based Multilateral Investment Guarantee Corporation (MIGA), a member of the World Bank Group; OPIC; the United Kingdom’s Export Credit Guarantee Department; and the French government’s export credit agency, Coface. But now the private market has been competing in the longer-term coverages and has opened coverage to losses caused by war and currency inconvertibility. Capacity and limits increased as reinsurance became more readily available in this area of global risks. Lloyd’s of London, for example, offered about $100 million in limits in 2002, a huge increase from the $10 million it could provide in 1992, according to Investment Insurance International, the specialist political risk division of Aon Group. AIG has increased its limits to $30 million per risk, while the rest of the private market had about $55 million to work with.
Coverage is even available in Israel, where major concerns about security made investors and businesspeople nervous. A political risk team at Lloyd’s (MAP Underwriting) developed a policy to address those concerns.“Armed-Conflict Risks Covered,” National Underwriter, Property & Casualty/Risk & Benefits Management Edition, June 11, 2001. Many Internet sites deal with global risk. For example, Global Risk International at http://www.globalrisk.uk.com/ offers counterterrorist training, kidnap and ransom management, close protection, and surveillance. The policy gives peace of mind to businesses that believe in the economic future of Israel by protecting the effects of “war and other political violence on their investments, property and personnel.” This specific coverage includes acts of war.
As noted in Table 11.2, some global firms use captives for this exposure. Captives were discussed in"6: The Insurance Solution and Institutions".
In this section you studied global risk exposures that arise from the increasingly international nature of business operations:
- Political risk results from unanticipated governmental destabilization that disrupts an enterprise’s profit-making ability
- Legal attitudes with respect to insurance can be very different in other parts of the world, leading many international companies to turn to nonadmitted coverage
- International data-gathering may be limited, suspect, or inconsistent with domestic techniques, so internal collection efforts and collaboration among businesses is often required
- Volatile currencies can create unfavorable exchange rates
- Cultural differences, especially as reflected in labor laws, pose ethical dilemmas for companies with opposing views in conducting business
- Public insurance policies available through groups like the Overseas Private Investment Corporation (OPIC) and the Multilateral Investment Guarantee Corporation (MIGA) provide options for mitigating global risks such as expropriation, confiscation, war risks, civil strife, and currency inconvertibility
- Private insurers have increased political risk insurance offerings such as coverage for kidnap, ransom, and export license cancellation in response to greater demand
- What is different about international property exposures compared with U.S. property exposures?
- Why might an American company operating in a foreign country choose to purchase nonadmitted coverage?
- Describe the steps of political risk management.