Mitigating political risk in an uncertain world through insurance

November 2024 | SPOTLIGHT | RISK MANAGEMENT

Financier Worldwide Magazine

November 2024 Issue

There is no escaping that in the current geopolitical climate, political risk is on the rise. We are seeing a rise in income inequality within countries, a rise in natural disasters, a rise in tensions among various countries and regions, and, coupled with all of this, 2024 is the ‘year of the election’. Changes in government are a particular flashpoint for political risk, with new administrations entering the fold and looking to shake things up.

When governments feel the need to provide answers or solutions to populations in times of uncertainty, that can mean looking at, among other things, foreign direct investment in the country and capital flows out of the country – analysing how the fruits of investment are distributed. This can result in political risk for investors in the country, i.e., the risk of negative consequences for their investment as a result of government action.

One way of mitigating political risk is through purchasing political risk insurance. Types of cover include: (i) confiscation, expropriation or nationalisation; (ii) forced abandonment (which will typically kick in after a waiting period); (iii) deprivation (i.e., loss of use and possession caused by prevention of export of assets, which also typically applies after a waiting period); (iv) currency inconvertibility; and (v) political violence. There are many others that are offered by insurers but these are some of the most common.

Political or credit risk insurance is also sometimes a requirement to access lending from banks. However, it should not simply be seen as a finance-enabling tool – it can have real value for insureds and it is important that it is procured in a way so as to maximise its potential assistance in times of need.

This article explores some of the key points to be aware of when considering political risk insurance.

Scope of cover. There are various elements of political risk cover that can be purchased depending on the investment or project in question and the needs of the insured. Insureds should review the proposed cover carefully to understand whether it includes the key risks envisaged and should also review draft wordings to ensure that the risks are appropriately defined. Note that it is likely that political risk insurers will exclude known risks. If the main driver for seeking political risk insurance is because, for example, a host government has threatened to not grant (or withdraw) a particular licence that is necessary for a project, cover will likely not be provided for the same. In these circumstances, an insured could seek a contingency cover instead (although, of course, it is likely that the pricing will be higher).

Fair presentation of risk. For policies subject to English law, under the Insurance Act 2015, before a contract of insurance is entered into, the insured is under an obligation to make a fair presentation of the risk to the insurer. A ‘fair presentation’ is defined as a disclosure of every material circumstances which the insured knows or ought to know, or failing that, disclosure which gives sufficient information to put a prudent insurer on notice that it needs to make further enquiries for the purpose of revealing those material circumstances. The disclosure must also be made in a manner which would be reasonably clear and accessible to a prudent insurer. Where the insured fails to meet its duty to make a fair presentation, the Act provides for remedies for the insurer which depend on whether the failure was deliberate and/or reckless and what the insurer would have done if it had known the true position. In the most severe circumstances, an insurer can avoid the policy from inception and retain all premium paid. Note that it is possible to amend these obligations and remedies in any contract of insurance, so insureds should seek to negotiate the same, where desirable.

In the context of political risk insurance, it can be difficult to know what information is ‘material’ (and which therefore requires disclosure to the insurer), particularly during the early stages of a project or investment (which is typically when political risk insurance will be purchased). Courts have held that materiality is to be tested at the time of placement and not by reference to subsequent events.

However, when events unfold in a detrimental manner (which will always be the case in the event of a claim ultimately made on a political risks policy) it is likely that underwriters will re-review the placement file to assess the information presented to the insurer against the insured’s duty of fair presentation and hence the basis on which the risk was originally bound. We would therefore always advise to err on the side of caution when considering whether to disclose a particular matter during the placement process.

One particular point of note is that it is common among political risk insurers to review press articles associated with the country in the context of the type of project or investment in question to assess the political risk environment in which insurance is required. As part of the underwriting process, political risk insurers often also have access to subscription political risk analytics providers which can supply country or industry-specific reports.

In preparing for a political risk underwriting process (and as part of normal risk management processes surrounding their investment risk), insureds could therefore specifically consider any press articles pertinent to the risk in question, reflect on how these may impact on an assessment of political risk associated with the project or investment in question, measures or strategies that they may deploy to mitigate this risk, and how it would respond if asked to comment on the same.

Exclusions. There are certain exclusions that are typical in political risk insurance policies. In particular, political risk insurance is not intended to cover economic or commercial risk (e.g., the risk that the market deteriorates) so exclusions will be included which are geared toward this. War exclusions are also typically included – if political violence cover is being obtained, the interaction between these clauses should be considered carefully.

Confidentiality. For policies purchased in the insurance market (as opposed to from government-sponsored or multilateral insurance agencies) there will be a strict confidentiality provision within the policy which provides that the insured is not permitted to disclose the existence of the policy at any time to any third party (subject to limited exceptions) without the prior consent of the insurers. The rationale behind this is that if a host state becomes aware that the insured has a political risk insurance policy in place, it may be encouraged to carry out the activities insured against as the insured will have recourse against its insurers in any event. These obligations should therefore be carefully adhered to, not only for the reasons articulated, but also because breaching the same could lead to insurers seeking to deny or reduce payment in respect of a claim. There will need to be exceptions in the relevant policy provisions in the event that the insured asset is financed, to enable details and evidence of the cover to be made known to finance parties.

Mitigation. Not only will there be a general duty to mitigate in the event of a loss included within the policy terms, but some of the individual covers will also require reasonable efforts to have been made to, for example, remove assets out of the country. In the context of political risk, there are often differing mitigation strategies that need careful consideration. In the event of a potential loss, it is therefore important to be aware of the precise requirements that are included in any policy and adhere to the same.

Subrogation. Upon payment of a claim under a policy, as a matter of English law, insurers are subrogated to the rights of the insured (i.e., insurers have the right to step into the shoes of an insured to pursue any claims that it may have against third parties). This is an important right for insurers (particularly in political risk insurance given that losses (where they occur) tend to be large) as it allows them to pursue recoveries and seek to recoup amounts paid out. Insureds should therefore ensure that they do not inadvertently waive any such rights since this may affect any claims payment.

This is particularly so in relation to the right to pursue recoveries against host states under a bilateral investment treaty (BIT). Certain political risk insurers may have an internal policy that they will only provide insurance where the project or investment falls within the scope of protection of a BIT because this is one of the key avenues for potential recoveries in the event of a loss.

The interplay between BIT claims and political risk insurance is an interesting topic. Under English law, where an insurer exercises its subrogation rights, it will sue other parties in the name of the insured and, in the event it obtains recoveries from third parties, the standard position is that first the insured will be compensated for the full amount of its loss, then the insurer shall be compensated for the amount it has paid out and, finally, any amount left over shall be retained by the insured. This means that there is no double-recovery by any party.

However, this position has been challenged in certain BIT claims. For example, in Hochtief AG vs. the Argentine Republic (2014), Argentina asserted that as the German government had agreed to pay the claimant’s claim under a political risk insurance policy, by virtue of article 6 of the relevant BIT, Germany was subrogated to the rights of the claimant so that the claimant could no longer pursue its claim. This assertion was dismissed on the basis that the provision of the BIT in question did not require the insuring state to succeed to and extinguish the rights of the insured investor once payment was made on the insurance policy.

Ultimately, the protection of subrogation rights in the event of payment under a policy is a matter primarily for insurers rather than the insured. However, parties may want to set out in the policy the intended manner and consequences of the exercise of subrogation rights, including the order of payment of any recoveries to strengthen the position.

Jamie Rogers is a partner and Ellie Rees is a senior associate at Hogan Lovells International LLP. Mr Rogers can be contacted on +44 (0)20 7296 5795 or by email: jamie.rogers@hoganlovells.com. Ms Rees can be contacted on +44 (0)20 7296 5929 or by email: ellie.rees@hoganlovells.com.

Jamie Rogers and Ellie Rees

Hogan Lovells International LLP