This post discusses political risk and political risk management. In this post, you will understand the meaning of political risk and the management of political risks.

WHAT IS A POLITICAL RISK?

Political risk, also known as geopolitical risk, is the risk that an investment’s returns could suffer because of political changes or instability in a country. Political risk indicates the commencement of risk arises due to a change in the governing body of a nation and therefore poses a risk to the investors who have investments in financial instruments, including debt funds, mutual funds, and equity. Instability affecting investment returns could stem from changes in government, legislative bodies, other foreign policy makers or military control. 

Political risk faced by investors, corporations, and governments affect the profitability of businesses actors and the expected value of a given economic action. Political risks are associated with changes within a country’s policies, business laws, or investment regulations. Specific terms like corruption and terrorism are related to the politics of a country due to changes in a political scenario, which might further result in a change in the nation’s regulations. Other influential factors include international relationships and any situation that may influence a country’s economy. 

The term political risk has had many different meanings over time. Political risk refers to the complications businesses and governments may face due to political decisions. The implication is that political change can alter a given economic activity’s expected outcome and value by changing the probability of achieving business objectives. Political risk can be understood and managed with reasoned foresight and investment. Political risk is among the most critical factors facing international investors.

In many emerging and frontier markets, the political situation is affected by more than the country’s influences. Conflicts in the Middle East, Chinese debt problems, American policies, and disputes over global resources directly affect international investment opportunities. Political risk is an essential factor as the investment time horizon increases. Hence, the importance of a sound political risk management within business organisations.

CATEGORIES OF POLITICAL RISKS

To ensure an effective political risk management, two levels of political risks should be addressed: macro and micro political risks. Macro-level political risks have similar impacts across all foreign actors in a location. While these should be included in country risk analysis, it would be incorrect to equate macro-level political risk analysis with country risk as it only looks at national-level risks and has financial and economic risks. 

Micro-level risks focus on sector, firm, or project-specific risk. Macro-political risks affect all participants in a country. A common misconception is that macro-level political risk only looks at country-level political risk. The macro-level political risk looks at non-project-specific risks. However, the combination of local, national, and regional political events often means that events at the local level may have spiral effects on stakeholders at the macro level. 

Other indirect political risks include government currency actions, regulatory changes, sovereign credit defaults, endemic corruption, war declarations and government composition changes. These events pose portfolio and foreign direct investment risks that can change investment suitability.

TYPES OF POLITICAL RISKS

In the context of political risk management, there are several types of political risks including:

1. Expropriation and Government Interference: For no apparent reason or with no justification, foreign governments can seize, confiscate, or otherwise expropriate a company’s investment. 

2. Transfer and Conversion: During an economic crisis, foreign governments or central banks may impose restrictions or prohibitions on converting the local currency to hard currency or preventing the currency from leaving the country. 

3. Political Violence: Political terrorism, war, civil strife, or other forms of political violence can damage or destroy a company’s assets and prevent it from conducting operations essential to doing business.

CLASSIFICATION OF POLITICAL RISKS

Political uncertainty arises from the marketplace of the country. Several businesses surround the economy’s marketplace. Change in government leads to a change in regulations and changes in business scenarios. For example, any change in the corporate tax rate by the ruling government can change corporate profits. Certain legal aspects also may challenge the way of doing business, lower profitability, and enhance risks for the investors. 

Political risk can arise at a different level at the national level, federal level, and state levels. Thus, based on the scenarios, political risks can be classified into macro and micro. The macro risk relates to the multinational companies with businesses in the country and the adverse effects those companies face. In contrast, micro risk arises from internal conflicts such as corruption, poverty, and cynical manipulations.

POLITICAL BUSINESS RISKS

The political risk faced by firms are associated with strategic risk, financial risk and personnel loss for a firm due to non-market factors such as macroeconomic and social policies (fiscal, monetary, trade, investment, industrial, income, labour, and developmental), and events related to political instability (terrorism, riots, coups, civil war, and insurrection). Portfolio investors may face similar financial losses.

POLITICAL RISK MANAGEMENT PROCESS

Steps involved in managing political risks include: understanding, analysing, mitigating, and responding to political risks.

1. Understand: It relates to the spread of a “risk culture” to all organisation levels thanks to the construction of efficient communication channels. This stage could be supported by insights offered by the organisational behaviour field to facilitate the comprehension of external perspectives.

2. Analyse: It means collecting political information based on a firm’s specific needs and plans and fully integrating them into the decision-making process.

3. Mitigate: It is synonymous with identifying vulnerabilities to reduce their exposition, even establishing fundamental relations with stakeholders.

4. Respond: It is related to developing a strategy that responds to failures and whose main pillars are represented by cross-functional cooperation and employers’ training.

STRATEGIES TO MINIMISE BUSINESS POLITICAL RISK

The impact of political associated risks on a business is unlikely to be isolated or short-lived and may ripple across the entire company and aggravate other types of risk. So how can a business prepare for sudden and unexpected political risks?

Strategies for protecting a business against political risks include due diligence, appropriate diversification of local and international investments, involving critical external stakeholders in political risk mitigation, developing a recovery response plan, sound credit risk management, embracing sound supply chain management, proper human resources management, and engage suitable risk management tools.

BUSINESS STRATEGIES FOR DEALING WITH POLITICAL RISKS

Here are practical actions for businesses to deal with political risk (i.e., a sound political risk management) based on business-related critical questions. 

1. Identify the issue: Political issues affecting a business should be identified. 
2. Define the political and other aspects of the issue: The identified political problem and associated risks should be clearly defined. 
3. Was there any past upheaval like this? What was the outcome then? What would the political fallout be if the government sided with other firms? 
4. Assess the potential political action by other firms and the special-interest groups: whom are all different parties like us affected? What are their reactions? Will they apt for a coalition of all to mount pressure? How strong are the special interest groups putting a united face to tone down the issue?
5.  Identify influential individuals or institutions: Who are the individuals (Public Leaders, Politicians, Elected Representatives, Regulatory Institutional Heads)? What are the institutions involved, and what are their bargaining powers?
6. Formulate strategies: What are the firm’s key and minor objectives in responding to the issue? What are the procedures to cede, supersede or recede? How to break the ice? How to establish contact? How to make the offers of conciliation and reconciliation? Evolve alternative strategies for dealing with affected and aggrieved. Evolve alternative strategies for dealing with those on the front line of confrontation.
7. Determine the impact of implementation: What will be the outcome of ceding? What will be the outcome of superseding? What will be the outcome of receding? Financial, corporate image and relational impacts should be addressed.
8. Select the most promising strategy: A precise evaluation of strategies’ overall costs and benefits should be established in financial terms, corporate image, and relational impacts. Choose a suitable plan and prioritise the expected actions.

PHASES OF POLITICAL RISK MANAGEMENT

Political risk management should address three core stages:

1. The pre-investment planning phase,
2. Post-investment operating phase and
3. Post expropriation phase.

POLITICAL RISK INSURANCE

Political risk insurance is a tool for businesses to mitigate and manage risks arising from governments’ adverse actions or inactions. Political risk insurance is a major political risk management tool. Unlike commercial insurance, political risk insurance protects companies and business ventures against perils that conventional insurance policies would not typically cover. Political risk insurance helps provide a more stable environment for investments in developing countries and unlocks better access to finance as a risk mitigation tool. 

Political risk insurance provides financial protection to investors, financial institutions, and businesses that may lose money because of political events. It protects against the possibility that a government will take action that causes the insured to experience a significant financial loss. Due to the unpredictability of many political events, political risk insurance allows companies to cushion the impact and increase long-term durability, mainly when operating in emerging economies. The volatile geopolitical environment can threaten global businesses’ operations, assets, and people. Companies can purchase political risk insurance to manage their geopolitical risks. 

Political risk insurance can cover many possibilities, such as expropriation (e.g., government confiscation of property), political violence (e.g., acts of civil unrest and insurrection), the inability to convert local currency and repatriate it, sovereign debt default, and even acts of terrorism and war. Political risk insurance aimed to mitigate against the loss of commercial assets, income, or property due to a political risk event. The policies can cover many risks, including political violence, expropriation, currency inconvertibility, non-payment, and contract frustration. Political risks are often complicated and sometimes impossible to predict, and the loss of assets and income arising therefrom may be catastrophic.

BUYERS OF POLITICAL RISK INSURANCE

While emerging markets can present an excellent opportunity for business growth, they also offer more significant risks than developed markets. Political turbulence can cause assets to decline severely in value or to be destroyed or confiscated and lose value altogether. With political risk insurance, businesses would be more willing to operate in developing countries with above-average levels of political instability that threaten their assets and ability to work smoothly. 

Political risk insurance is often purchased by multinational corporations, importers and exporters, project lenders, financial institutions and capital markets, foreign investors, and contractors in industries like construction and engineering. Based on the findings of a World Bank survey, investors in financial services are the highest users of political risk insurance. 

Political insurance policies are customised to each client’s needs. Companies that might purchase political risk insurance include multinational corporations, exporters, banks, and infrastructure developers. They can cover one or multiple countries with longer terms and multimillion-dollar coverage amounts. 

Many business opportunities require years to achieve, and political conditions can change dramatically quickly. The ability to purchase an insurance policy for many years, e.g. for 15 years, an insurance company, is a crucial feature of political risk insurance. Suppose a business knows it will be insured against political risks for years regardless of what happens. In that case, it can confidently proceed with activities that might otherwise be too risky to pursue.

WHAT MOTIVATES COMPANIES TO BUY POLITICAL RISK INSURANCE?

It is common for buyers of political risk insurance to pursue political risk insurance only after a political or economic event. It is often purchased to satisfy the banks, which desire to meet internal credit committee lending requirements. According to the International Risk Management Institution (IRMI), investors and their partners drive most political risk submissions. 

Political risk insurance is ultimately a commodity sensitive to supply and demand. Therefore, companies should purchase political risk insurance before losing commercial assets, income, and property due to a political risk event. Insuring an investment against political risk requires a proper and precise specification of those political events that are to be covered under an insurance policy. The event in question must have been triggered by political action to receive payment for loss, although the precise meaning of “political action” is often equivocal. Once a political event occurs, coverage and the exact amount of insurance recovery should be clear. 

Political risk insurance can be purchased from private and public providers. Private providers typically offer coverage related to developing and developed countries and the coinciding risk events while conducting business in these places. Political risk insurers offer various products tailored to any investor’s needs and can cover the entire range of politically induced risks.

THE STRUCTURE OF THE POLITICAL RISK INSURANCE MARKET

Global Risk Insights states that two types of political risk insurance providers have two agendas. The first is the private market, dominated primarily by the London-based Lloyd’s market. Other large insurers that offer political risk insurance services include AIG, XL Catlin, Euler Hermes, Starr Insurance, and Atradius. Public, state-backed investment-guarantee firms are motivated by the government’s foreign policy and international development goals.

DIFFERENCE BETWEEN ‘POLITICAL RISK INSURANCE’  & ‘POLITICAL VIOLENCE AND TERRORISM INSURANCE’

There is often a grey area between “terrorism” and what is considered “political violence”. How insurers and governments distinguish between the two should inform whether companies opt for political risk insurance, political violence insurance, terrorism insurance, or some form of combo. Because rates for political violence and standalone property terrorism insurance are typically lower than those for political risk insurance, some multinational companies manage the risk of political instability and violence through a combination of the two rather than through political risk insurance. 

It is, however, important to emphasise that standalone terrorism insurance policies do not cover all forms of political risk. A political risk insurance policy will only cover expropriation, forced abandonment or divesture, currency inconvertibility, non-payment, and contract frustration. Furthermore, there may be some interpretation about whether a politically motivated act of violence would be covered by political risk, political violence insurance, or standalone terrorism insurance.

See video on Political Risk and Political Risk Management: https://youtu.be/oU6asYaLrwQ