The Importance of Political Risk Insurance in the Era of Disruption

01/12/2017 09:13 am ET Updated Jan 13, 2018

Political risk exists everywhere, as does uncertainty about how, when, or whether it will manifest itself in ways detrimental to international traders, investors, and lenders. For decades, conventional wisdom dictated that developing and emerging countries were the greatest sources of such risk, due to the absence of meaningful and enforceable laws, the prevalence of corruption, lack of financial resources, and security concerns. That of course remains the case, but as has been proven as a result of the Great Recession, the global war on terror, corruption scandals and growing income disparity, developed countries contribute every bit as much as those 'other' countries to the rising risks associated with cross-border transactions.

This has become a source of great concern to many global businesses, which are scrambling to stay ahead of the headlines. Some of the things that used to be taken for granted - such as that Europe will always be a source of stability and growth, or that China is an investment destination that must be included in an investment portfolio - simply are no longer the case. Europe's rolling recession -- complete with anemic growth and security concerns - will mean the continent will be a source of instability for many years to come. China's incessant bubble economy, declining long-term growth rates, and increasingly unfriendly policies toward foreign investors have given many companies pause for many years now. There are plenty of other examples of how conventional wisdom has been turned upside down.

As the U.S. enters a period of unprecedented post-war political instability, many businesses are wondering how to plan for the near and medium-term future. Decision makers in business sometimes have short memories; a preoccupation with making profit will continue to cloud the judgement of some of them. Recent headlines have stated how optimistic some business leaders are about America's future, believing that the pro-business platform about to be implemented is a stairway to heaven. It may well be. A significant reduction in corporate tax rates combined with an orientation toward "America First" could indeed propel the U.S. economy to heights unseen in decades -- at least, in the short-term.

The alternative argument is that the U.S. is about to lead the world into a wave of destructive economic nationalism that threatens to undermine the core of the post-war global trade and investment regime. In a zero-sum world where my gain must come at your loss, everyone stands to lose, of course. Imposing unilateral tariffs simply results in more of the same. Protectionism implies less competition, higher prices, rising inflation, and higher interest rates. Some of those foreign companies that previously couldn't wait to earn tax breaks by investing in the U.S. and hiring American workers are about to become a thing of the past.

While global businesses have become accustomed to finding new markets and identifying ways to hedge risk, they are less adept at fundamentally altering their business models. Some U.S. businesses are already canceling plans to build foreign production facilities abroad. Some foreign businesses are already purchasing insurance in the event their U.S. investment proposals are not approved in the coming months. There is great unease about what the trade and investment regime will turn out to be 6 or 12 months from now, and with good reason. The paradigm shift that voters in the U.S., UK, the Philippines and elsewhere have ushered in is about to start sending shock waves around the world.

In 1990 I published an article entitled "Why Political Risk Insurance Will Grow in the 1990s". At that time, the former Soviet Union had recently disintegrated, the Gulf War was about to commence, and there was general uncertainty about where the world was headed. I predicted at that time that political risk insurance (PRI) would grow dramatically because of enhanced demand. Indeed, it did. The PRI industry stands at a similar precipice today. With the looming possibility of trade wars, a deterioration in investment climates, and ever tightening lending standards, there is every reason to believe that, as much as the industry has grown - and that growth has been dramatic over the past 25 years - it also stands to grow dramatically in the coming 5-10 years.

This is both an opportunity and a challenge for the PRI industry, as well as those traders, investors and lenders who will utilize PRI to reduce their cost of capital and expand their business operations around the world. For the PRI industry, the challenge will be how to delicately balance a desire to underwrite more transactions with the need to impose even tighter underwriting standards. The temptation will be to incorporate a variety of long-term investment transactions and short-term credit transactions into underwriting portfolios, based on the many lessons learned as a result of previous claims. That temptation will be tempered, however, by the realization that history is no longer the teacher it once was. When paradigms shift, meaningfully predicting the future will become an even greater challenge.

For businesses, the desire to rely on PRI to strip out non-commercial risk from transactions will become greater than ever, for the same reason - to grow and generate ever greater revenue, deals must be done, even when the ground shifts beneath them. There will be ever greater competition for the product, but only those transactions with the best story to tell, and having the right combination of quality, tenor, size, and location, will receive coverage. Revenue in coming years will become increasingly associated with thought leadership and bravado, combined with deployment of the right risk management tools.

In ordinary times, PRI has proven to be an indispensable tool for many businesses that operate internationally in order to maintain growth and profitability. But this is no ordinary time; The winds of change are about to hit us like a hurricane. As the global trade and investment climate deteriorates, and becomes more unpredictable, demand for PRI should soar. The ability to manage cross-border risk through PRI -- and other insurance products -- will ultimately make the difference between those businesses that find a way to thrive in this era of disruption, or merely survive.

*Daniel Wagner is Managing Director of Risk Cooperative and co-author of the new book "Global Risk Agility and Decision Making".