S&P Global’s independent study, commissioned by Marsh Specialty, shows political risk insurance curbs country risk premium, improves valuation of investments in emerging markets, and enhances internal rate of return of projects.
Executive Summary
The mitigation of country risk using political risk insurance (PRI) has long been undervalued by foreign direct investors. While the market intuitively understands the benefits of PRI, it is often perceived as “expensive”, because the financial benefits of coverage have not been adequately quantified. Customarily, when evaluating PRI as part of an investment, lenders and investors have assigned little to no value to the existence of a PRI policy in the valuation process. The result has been to impede broader use of PRI as a risk mitigation tool.
The lack of a robust analytical framework to guide decisions around whether to insure political risk has denied financial decision makers of the means to make informed and well-supported assessments. Conversely, we assumed that using a nuanced country risk premium (CRP), developed by dissecting the elements of country risk, and methodically integrating the potential benefit of PRI into valuations, could be of great value to investment professionals.
To help companies and investors better evaluate PRI, Marsh’s Credit Specialties practice worked with S&P Global, an independent third party, to use its Country Risk Investment Model (CRIM) to evaluate the benefits of PRI. The study’s initial hypothesis was that a well-crafted PRI policy should result in a non-zero improvement in the CRP, and that this should be captured for the benefit of investors when undertaking a valuations exercise. A more robust and granular approach to quantifying the benefits of PRI should enable companies to justify investing in one or more projects with a CRP that might fall outside their traditional internal risk tolerances. The new approach examined in this study demonstrates that PRI typically improves the CRP and credit rating equivalent of an emerging market investment, and improves the project’s internal rate of return (IRR).
The key conclusions of the S&P Global study Proof of Concept, Using Country Risk Investment Model to Analyse Benefits of Political Risk Insurance (August 2021) are as follows:
- PRI can compensate companies for a significant percentage of potential cash flow losses associated with key areas of country risk — deprivation of ownership and operating rights, damage to assets, blocks on dividend repatriation, and state failure to honor contracts.
- Potential investors in a company or project need to be adequately compensated for taking on country risk, which is reflected in an increase in the hurdle rate of return achieved by adding a country risk premium to the discount rate applied to forecast cash flows.
- PRI cover is designed to indemnify companies against a proportion of potential losses, thus justifying a reduction in the CRP incorporated in the discount rate representing investors’ required rate of return.
- Models developed by S&P Global quantify the expected cash flow losses associated with all sources of country risk, including those events that would be covered by PRI and can, therefore, be used to justify a reduction in the CRP and an associated improvement in the credit rating equivalent for the project and operating company.
- Annual premium payments for PRI protection paid by the investor negatively affect the insured project’s future cash flows, although the negative impact on the expected net present value (NPV) of the project is materially mitigated where such premium expense is tax deductible.
- Historically, many companies purchasing or considering using PRI have carried the negative cash flow “expense” of the premium payments without also properly reflecting the positive impact of PRI in reducing the CRP (thus lowering the overall discount rate applied by investors). PRI raises the project’s valuation (NPV) and internal rate of return (IRR) while providing other benefits arising from a de-risked project.
- Conventional wisdom has viewed political risk insurance as a cost to the project that inevitably results in a decrease in the project’s internal rate of return, but the results of this analysis in fact show the opposite: investment insurance can enhance the IRR of an insured project, despite the PRI insurance cost paid by the investor.
- PRI thus does more for a company than cover insured losses, as a lower CRP confers higher asset valuation, enables investment finance on more favorable terms, and other benefits.
About S&P Global
S&P Global (Nasdaq: INFO) is a world leader in critical information, analytics and solutions for the major industries and markets that drive economies worldwide. The company delivers next-generation information, analytics and solutions to customers in business, finance and government, improving their operational efficiency and providing deep insights that lead to well-informed, confident decisions.S&P Global has more than 50,000 key business and government customers, including 80 percent of the Fortune Global 500 and the world’s leading financial institutions. Headquartered in London, S&P Global is committed to sustainable, profitable growth.
The S&P Global economics and country risk team takes an intelligence-led approach to forecasting the full spectrum of commercially relevant political, economic, legal, tax, operational, and security risks, in 211 countries. They provide risk solutions that are data-driven, leverage data science and geospatial analytic tools, and are informed by the largest team of country, banking, and sector risk analysts in the market. The country risk team has more than 110 dedicated analysts and data scientists.
About Marsh
Marsh is the world’s leading insurance broker and risk adviser. With over 40,000 colleagues operating in more than 130 countries, Marsh serves commercial and individual clients with data driven risk solutions and advisory services.
Marsh is a business of Marsh McLennan Companies (NYSE: MMC), the leading global professional services firm in the areas of risk, strategy and people. With annual revenue over US$18 billion and 76,000 colleagues worldwide, MMC helps clients navigate an increasingly dynamic and complex environment through four market-leading businesses: Marsh, Guy Carpenter, Mercer, and Oliver Wyman.
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