A whole new world: as U.S. companies increase international investing, political risk insurers take advantage of new coverages and new markets.

After a couple of lackluster years, the demand for political risk insurance is heating up again, and capacity is starting to expand.

The handful of companies that dominate the marketplace--Ace Group, American International Group, Chubb Group of Insurance Cos., Zurich North America and Lloyd's--say political risk insurance is expected to grow in 2004, through both new business and new products.

From U.S. contractors building bridges, water treatment plants, oil refineries and infrastructure projects in such emerging markets as Brazil, China, Russia and Mexico, to middle-market companies selling or buying goods and services through developing countries, political risk insurance compensates insureds when their foreign investment is lost due to the act of a foreign government, or war or terrorism in that foreign country.

In the wake of Sept. 11, the demand for political risk insurance dropped sharply as companies pulled back overseas investments.

"This past year, 2003, was probably the most difficult year that most underwriters that have been in the market for 15 to 20 years can remember," said Keith Dunford, vice president and manager of political risk for Chubb & Son's commercial insurance business. "Foreign direct investments came to a screeching halt after Sept. 11, and the money flowing across international borders simply slowed down. As a result of that, there was less demand for political risk insurance."

Although Sept. 11 itself didn't trigger any political risk insurance claims, it slowed down international investing and tightened the reinsurance market, which political risk insurers rely on for capacity. Sept. 11 was one of three major market disruptors--the Enron debacle and the Argentine financial crisis also hit the market hard, said Julian Edwards, head of political risk business for Ace European Group, which includes a Lloyd's syndicate.

After Sept. 11, the Enron situation and the Argentine financial crisis bit in quick succession, reducing the worldwide capacity for political risk insurance by 50%, Edwards said.

Edwards estimated the capacity for political risk insurance fell from $1.7 billion before Sept. 11 to $800 million three or four months later. He said he expects it to increase by 10% to 15% in 2004.

"The market is a lot more confident. We're seeing a lot more activity," Edwards said.

As the world and U.S. economies recover," we will certainly see more business," Dunford said.

Harry Palumbo, vice president of American International Group's Global Trade and Political Risk Co., said he's also seen an increase in business in the past six months. "We've started to see a pickup in the market and in international investing, as the economy has started to improve. We're working through some of the problems in the international market. There's been new growth in China, and the market is getting comfortable with Brazil again. Oil prices being up has increased investment in the energy sector, all of which led to a pick up, but we're still not at the level of business that we saw leading up to 1999, 2000, 2001, which were the peak years,' Palumbo said.

He estimated capacity in the political-risk insurance market dropped off 40% from the peak years, but has started to rebuild. Palumbo said he expected the volume of business to grow by about 10% in 2004.

Typical clients for political risk insurance include mostly U.S. or European manufacturers who have invested in plants in foreign countries or companies that export goods to a foreign buyer. In both cases, the actions of a foreign government or unrest in a foreign country could impact the companies' contracts and business.

Political risk insurance can be tailored to cover many different risks (see "Political Risk Insurance Defined," page 56), but can be boiled down into two basic types: confiscation coverage, which protects an insured in case a foreign country confiscates its goods of equipment, and contract frustration coverage, which protects an insured in case a foreign government refuses to pay a contract or interferes with a contract's being completed. Because both kinds of policies include coverage for war and terrorism, they can be seen as filling in coverage from a company's standard property/casualty insurance program.

"Every deal is custom written. We're constantly writing new spins on existing products on every deal," said Price Lowenstein, president of Sovereign Risk Insurance, a Bermuda-based company that specializes in writing political risk insurance. The company was formed in 1997 as a joint venture between XL Insurance Ltd. and Ace Bermuda Insurance.

The insurance contracts are limited to very specific events of actions, said John Minor, national director of political risk for Aon Trade Credit, a unit of the broker Aon.

Big Losses

"It's a severity line of business," Dunford said. "One year you'll do great; the next year you'll have big pops."

Unlike many other lines of business, when political risk insurers pay a claim, they then take over the insureds' stake in trying to recoup the loss from the foreign government.

For instance, in Argentina, the government essentially converted dollar-denominated contracts into peso-denominated contracts and changed the maturity on some instruments so investors couldn't collect their money. insurers paid the claims related to the conversion, and are seeking payment from the Argentina government, Minor said.

"In almost every case, the insurer will try to sue the government to get the claim payment back," Minor said.

In another case dating back to the mid-1980s, AIG paid a claim after the government of Peru expropriated Belco petroleum. After an eight-year dispute, the Peruvian government agreed to pay AIG a settlement of $184.7 million, according to the U.S. Department of State.

The key to success in political risk is the recovery potential, said Dunford. "The long-term profitability of a political risk book depends on the recoverable that we subrogate once we pay the claim. We may have a bad year where we pay out a lot of claims, but over a five- or 10-year period, we would recover the majority of the money that we have paid out," he said.

Political risk insurers don't pay immediately on a claim, but usually have a waiting period, often of 180 days. A high risk jurisdiction may have a waiting period of 360 to 540 days, Dunford said.

Insurers don't necessarily wait for a claim to be filed to take action.

Zurich Emerging Market Solutions engages the government before a claim is filed, acting as a direct advocate for the insured, said Daniel Riordan, executive vice president and managing director of ZEMS, the emerging markets unit of Zurich North America.

"We explain our business and activities and how we assist with infrastructure development and lending. We were successful in Venezuela recently, with the government providing support for payment of some loans that were insured by us," Riordan said. "We don't wait for a claim to be filed. If we can work with them to try to alleviate or mitigate the situation, we see that as a benefit."

Often, corporate borrowers are able to get more favorable rates on bonds in emerging countries if the issue is covered with political risk insurance.

ZEMS recently structured a 10-year bond deal for Brazil's third-largest private bank, Unibanco. The bond was rated higher than the sovereign country's currency rating.

"It enhances the bond issue by allowing them to be rated above the sovereign's rating. If a country is rated below investment grade, it strips out an element of risk and raises the investment issue to investment-grade level. That attracts a significant amount of new investors," Riordan said.

Small World

The handful of companies that write political risk know each other well, and are often called to participate in the same large projects.

"The larger deals are almost always coinsured with more than one player," said Lowenstein, who said Sovereign Risk offers a limit per risk of $125 million for up to 15 years. "There's a great deal of cooperation between private and public."

In addition to the private market, several governmental agencies offer political risk insurance, including the Overseas Private Investment Corp. and the U.S. Export-Import Bank, both in the United States. The Export and Credit Guarantee Department, part of the Department of Trade and Industry, provides similar protection for the United Kingdom. The Multilateral Investment Guarantee Agency, an affiliate of World Bank, provides similar coverage for World Bank customers.

OPIC encourages U.S. investments overseas by offering up to $250 million in political risk insurance for any one project in 135 developing nations. In the past, the government-backed agencies often had higher limits, both in dollars and years. The private market has responded by lengthening the term of its policies.

"The table is a little larger these days. Years ago, you had only governments involved," said Riordan. "But it's shifted to the point where a majority of business that was once in the public sector is now in the private sector, or in private/public partnerships."

Zurich Emerging Markets Solutions offers coverage of up to $80 million per risk for up to 15 years. AIG will insure on a single risk up to $80 million and $100 million, depending on market, also for 15 years. Ace European Group has expanded its coverage to $55 million per risk this year, up from $45 million per risk last year.

The private companies' "great advantage over the government programs is speed and flexibility," said Aon's Minor. "The private market still goes through due diligence, but it's nowhere near as cumbersome as public programs"

While it might take four months to get political risk insurance coverage through OPIC or MIGA, in the private market the project could gain insurance within a month, and in some cases, in as little as two days, Minor said. The governmental agencies sometimes need to get board approval, and since their boards usually meet once a quarter, it can lengthen the process.

Until about two years ago, there was fairly strong competition between the private market and government entities such as OPIC and MIGA, but with the reduction in capacity that occurred after Sept. 11, some companies have forged a close relationship with the public market, said Palumbo.

"It was no longer possible to put together a large deal, say $400 million in political risk coverage, without bringing together both the major player in the private sector along with one or two governmental agencies" Palumbo said. "It's a much more collegial relationship than it was two years ago."

Plus, insurers like having a governmental agency on their side should a claim be filed, said Edwards of Ace European Group.

"It gives us a lot of confidence if we know we can mitigate a loss with someone like OPIC or MIGA. Sitting alongside the U.S. government or the World Bank has a positive effect on the risk," Edwards said.

Riordan of ZEMS agreed. "Public agencies are not out. They're a bit smaller than they used to be, but we see them as very good partners. We like to insure and reinsure with them on large projects because they are who they are. They carry significant weight and clout in many markets."

Challenges of Accumulation

Political risk insurers are still most active in the same five countries where they've been active for the past 10 years: Brazil, Russia, China, Turkey and Mexico, said Edwards of Acc.

"The biggest problem we face--following the demand for our products--is the challenge of accumulation. We almost grow by adding more capacity in the same five countries. Our challenge is to broaden our base," Edwards said.

One potential growth spot, the Middle East, is still too uncertain, Edwards said.

"People are very optimistic about the end of major [war-related] activity in Iraq, but until there is some sort of certainty over the government and how Iraq is going to pan out in the short and medium term, it's very difficult for us to have a solid hold on the situation and to write risks there," Edwards said. "There's too much going on. But if you look at countries like Iraq, Iran and Libya ... I'm sure if the countries stabilize, there will be plenty of activity there."

Potential for Growth

One area where AIG's Palumbo sees potential for growth in political risk insurance is the burgeoning outsourcing market. With the United States and other countries looking to save labor costs by establishing call centers in cheaper locales, such as India and the Philippines, political risk insurers are beginning to craft policies to protect them in case of political interruptions.

"It's not an actual investment by a U.S. company or an actual asset, but to outsource to a third party.... If a political event happens that prevents them from operating, it's not only business interruption but the cost to move it from one location to another," Palumbo said.

Minor of Aon said the broker has seen an increased demand for such insurance.

"It's a unique risk. You don't have an asset overseas, but you have a pretty significant exposure to political instability," Minor said.

Also, Minor said terrorism remains a serious risk, which trade disruption insurance can protect against.

"The vulnerability of companies' supply chains to geopolitical and social and security threats and disruptions, originating from the terrorism threat is great," Minor said. "We've responded by developing insurance products."

Instead of products designed to protect against the loss of an asset or contract, trade disruption insurance protects against not being able to transport a product where it needs to go because a disruption has occurred along a trade route.

"A lot of experts have said the next Sept. 11-type of event will happen on the open seas, at a bottleneck port, or even an oil tanker used as a bomb," said Minor. "The impact of this t3'pe of event on a company's supply chain could be quite substantial."

While political risk remains a relatively small line compared to the entire insurance market, the players in it say they will continue to grow.

"It's a specialized business. We are pretty friendly [with competitors], but the competition can be fierce," said AIG's Palumbo.

Riordan agreed, adding: "It's not a business for everyone. The most important thing in this line of business is that you have expertise. Twenty years ago, we didn't have infrastructure investments by private companies. It was all by governments and multilaterals such as the World Bank. Now the governments, in order to develop and significantly enhance infrastructure, recognize they have to attract private investment and financing. To do that in countries that aren't fully developed, there will continue to be a strong demand for political risk coverage."

Political Risk

Investors and companies doing business in emerging markets face political risk--the risk that actions taken by a foreign government, or an unstable situation in a foreign country, could hurt their bottom line.

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Political Risk Insurance Defined

Political risk insurance protects companies' investments in foreign countries from such perils as terrorism, war and governmental actions that interfere with the companies' business or investment. Many policies are individually tailored to meet the needs of a particular insured, but political risk coverage includes the following types:

Confiscation, Expropriation, Nationalization Insurance: Protects companies from losing their foreign investments in plant, property and equipment due to acts of a foreign government.

Contract Frustration Insurance: Protects companies who cannot complete a contract due to acts of a foreign government, such as trade embargoes, import/export license cancellations, nontransfer of currency, unilateral termination of contracts by governmental agencies, and nonpayments by government buyer or by a private company when caused by a political event.

Wrongful Calling of Guarantee Insurance: Protects a company from a foreign government arbitrarily or wrongfully calling its performance bonds or letters of credit, which the insured company must put up to do business in the foreign country. It also protects a company in the event that a political event, such as a war, stops it from fulfilling its contract and the government rightfully calls its bonds.

Currency Inconvertibility: Protects investors if local currency cannot be converted into hard currency of if investors are prevented from transferring funds from the host country.

Deprivation: Protects a company in the event that a foreign country refuses or revokes an exporting license.

Forced Abandonment: Protects a company with investments in a foreign country in the event that the foreign country makes it abandon its investments.

Forced Divestiture: Protects a U.S. company with a foreign investment in the event the U.S. government orders it to divest itself from the foreign country.

Third-Patty Blockade: Protects a company with international investments from any third-party sovereign nation threatening military force that prevents the insured from removing insured assets from the host company.

Source: Chubb Group of Insurance Cos.