Mitigating political risk: Treaty protections versus political risk insurance
Lexology | 26 September 2016
Mitigating political risk: Treaty protections versus political risk insurance
Bernard P. Bell and Tara C. Kowalski
Jones Day
Investor-state dispute settlement (“ISDS”) provisions in trade agreements allow foreign investors the right to apply to a tribunal to claim compensation when a host government acts, or fails to act, in a way that arguably discriminates against or expropriates the foreign investment. ISDS provisions are intended to encourage foreign investment by protecting investors from discrimination or expropriation. Critics of ISDS provisions, however, including critics of the TPP, assert that ISDS protections in trade treaties are exploited by sophisticated cross-border investors to evade laws enacted to protect health, safety, the environment, and workers’ rights in the host country.
These critics argue that ISDS provisions infringe on national sovereignty, and that foreign investors should protect themselves against unfair government action through the host country’s domestic legal system with political risk insurance as a backstop. Below is an overview of political risk insurance and a discussion of some general distinctions between treaty protections and political risk insurance.
What Does Political Risk Insurance Cover?
Political risk insurance is available to protect foreign investors against different types of political risks, including the following:
Expropriation. This coverage protects investors against losses arising from government actions that reduce or eliminate ownership of, control over, or rights to the insured investment. Coverage typically includes direct outright nationalization and confiscation of tangible assets, equity shares, funds, or interest in loans and loan guarantees. Coverage is also available for “creeping” expropriation—a series of government acts that have an expropriatory effect. These may include, for example, imposition of confiscatory taxes or forced renegotiation of contract terms. For U.S. investors, arbitral award default (or “denial of justice”) coverage may be available to protect against nonpayment of an arbitral award by a host country government.
Currency Inconvertibility. This coverage protects against losses arising from an investor’s inability to legally convert local currency into hard currency, or to transfer hard currency outside the host country where that inability results from a government action or failure to act. Examples of host government actions that may trigger coverage include enactment of more restrictive foreign exchange regulations, failure to approve or act on an application for hard currency, or blocking repatriation of funds. Coverage is typically not provided for depreciation or devaluation of host country currency.
Political Violence. This coverage protects against loss from or damage to tangible assets and also for business interruption (losses arising out of the inability to conduct operations essential to a project’s financial viability) caused by politically or religiously motivated acts of war or civil disturbance in the country, which typically includes declared or undeclared war, revolution, insurrection, coups d’état, civil strife, sabotage, and terrorism. This coverage applies to loss arising from violence directed against a host country government and may also include violence directed against foreign governments or foreign investors. As with conventional business interruption insurance, this coverage may be extended to cover temporary business interruption, including evacuation expenses, unavoidable continuing expenses, and extraordinary expenses associated with the restart of operations and lost business income. It can also be extended to cover contingent business interruption losses resulting from damage to specific sites not owned by the foreign investor, such as a critical railway spur, power station, or supplier.
Breach of Contract by the Host Government. This coverage protects investors against losses arising from a host government’s breach or repudiation of a contract with the investor. Breach-of-contract coverage may be extended to the contractual obligations of state-owned enterprises in certain circumstances. Coverage may require an investor to exhaust (or at least invoke for a fixed time) the dispute resolution mechanism (e.g., arbitration) set out in the underlying contract.
Failure of Sovereign Financial Obligations. This coverage protects against losses resulting from a failure of a sovereign or state-owned enterprise to make a payment when due under an eligible unconditional financial payment obligation or guarantee. It does not require the investor to obtain an arbitral award. This coverage is applicable in situations where a financial payment obligation is unconditional and not subject to defenses.
The foregoing list of coverages is not exhaustive, and there are an increasing number of specialized coverages available that can be tailored to specific investors and investments.
Who Underwrites Political Risk Insurance?
Political risk insurance is offered by private insurers as well as public, state-backed investment guarantee firms.
The public market accounts for approximately 70 percent of the political risk insurance underwritten (by limits), which varies by year. See, e.g., World Investment and Political Risk Report, 2013. Washington, D.C.: MIGA, World Bank Group. Within the public market, national export credit agencies (“ECAs”) focus on cross-border trade and investment for constituents in their own countries. Several ECAs for countries relevant to the TPP include the Overseas Private Investment Corporation (“OPIC”) in the United States, the Export Development Corporation in Canada, Nippon Export and Investment Insurance in Japan, and the Export Finance Insurance Corporation in Australia.
ECAs often require insured investments to meet certain policy standards established by the state sponsor. For example, OPIC is required to analyze the insured investment’s effect on the U.S. economy, the host country’s environment, and workers’ rights, among other things. Investments insured by OPIC must meet detailed environmental standards, including public disclosure of environmental assessments of the project or investment. Private insurers do not impose such requirements.
In addition to the ECAs, there are multilateral providers, including most importantly the World Bank’s Multilateral Investment Guarantee Agency (“MIGA”). MIGA insures investors from World Bank member counties that invest in other developing member countries. MIGA often jointly underwrites and reinsures polices underwritten by the national ECAs. As with the ECAs, insurance through MIGA requires that investments comply with social and environmental standards established by the World Bank.
Private insurers, including Lloyd’s of London, AIG, XL Catlin, Zurich Financial Services Group, and others, account for the remaining share of the market. The private market underwriters are frequently reinsured by other private insurers, the ECAs, and MIGA.
Private insurance may be preferable for investors in high-risk environments and may be the only alternative in countries without treaty protection for foreign investors. Private insurance also may be preferable for investors who cannot meet, or do not wish to subject themselves to, public insurers’ social, economic, or environmental conditions and possible disclosures. The private market also is considered to be more responsive to the needs of individual investors, willing to tailor coverage to their specific needs and place the coverage more quickly to facilitate transactions. Finally, private insurers may be able to provide coverage that covers more territory than a single country, which may be increasingly important for investors wishing to protect against political violence on a global basis.
Is Political Risk Insurance a Suitable Substitute for ISDS Provisions?
Whether treaty obligations or political risk insurance, or some combination of both, is a better tool for mitigating political risk will depend on the specific investment, the treaty’s dispute resolution terms, and the specific insurance available. However, available data suggests certain general conclusions.
The duration and amount of protection offered by insurance may be more limited than treaty obligation protections. For example, treaty protections last as long as the treaty is in place, compared with maximum insurance policy periods of 15–20 years and sometimes far shorter. Insurance recovery amounts are also subject to the applicable policy limits, in contrast to treaty obligation protections, which typically do not limit the amount of compensation available. Also, treaty protections cost the individual investor nothing, whereas the investor pays for insurance with a premium. Protection by treaty (or private insurance) requires no public disclosure prior to investment, and claims under private insurance are likely to be handled confidentially. If an investor must rely on public insurance providers like OPIC and MIGA, insurance may require compliance with environmental and social requirements and a degree of public transparency that some investors would prefer to avoid.
Conversely, while an investor’s rights may be more comprehensive and private and less expensive under treaty protections, data suggests that compensation is speedier and more certain under insurance. Treaty protection bears the risk that a losing state will not honor an arbitration award, and insurance protection may be needed to mitigate this risk even if treaty protection exists. Finally, insurance coverage is perceived to provide a more objective standard of expropriation liability than most treaties.
These factors, as well as the terms of the treaty and the insurance available, should be considered by foreign investors when considering which mitigation tool offers greater protection.
