Demand for export credit and political risk insurance

Doing business with and in other countries is vital for the growth of companies of all sizes and sectors. But in addition to business opportunities for internationally active companies through trade and foreign direct investment, exporters and investors operate in an environment characterised by heterogeneous political systems, economic conditions and cultural behaviour. When firms export their products and services or set up foreign manufacturing operations, they are exposed to several dimensions of risk: Political risk, commercial risk, currency exposure as well as cross-cultural risk. Exporters often require insurance cover for political and commercial risks linked to export transactions (Klasen, 2014). Export credit agencies are important to mitigate negative trade effects of financial constraints due to market failures (Badinger and Url, 2013). Political risk insurance is a risk mitigation tool foreign direct investors regularly use.

Recognising that risk aversion and risk mitigation as the only motive is not adequate, several authors have provided a theory following evidence that firms purchase substantial insurance amounts (see, e.g., Mayers and Smith, 1982). This theoretical framework about insurance demand in general has been extended and tested by a number of authors with empirical studies on corporate demand (see, e.g., Hoyt and Khang, 2000). However, it is still not yet well understood what drives the corporate demand for insurance due to difficulties in data availability and challenges in measuring the theoretical constructs (Krummaker and Schulenburg, 2008). There is also limited evidence on the question why exporters and foreign investors use export credit and political risk insurance as an essential risk mitigation tool.

Background and research design

Due to this research gap, the international research project Demand for Export Credit and Political Risk Insurance has been launched in 2015. The project conducted by researchers from Offenburg University, the University of Westminster and the London School of Economics and Political Science (LSE) follows an explorative qualitative approach and an explanative quantitative approach, both informing each other. Data were collected via open-ended interviews, via a survey with qualitative and quantitative questions, as well as from annual reports. Multiple rounds of qualitative data collection via interviews run simultaneously with the collection of data via questionnaires. This empirical study was conducted with more than 35 export credit and political risk insurers in both public and private forms. The selection of insurers was driven by the aim to include a variety of suppliers from different countries but also to cover both public agencies and private commercial insurers. It was the intention to cover organisations from different cultural and national backgrounds but also from more mature to young insurers. The participants of each insurer was the CEO, COO or Managing Director.

The rise of geopolitical risk

Geopolitical risk is in the core of export credit and political risk insurance. The evidence indicates that there is a strong relationship between the demand for coverage against those risks and the perceived or actual risks. These findings are supported by the results of the survey, in which 65% of the respondents expect political risk to increase. Additionally, being asked to name the top five of the most important risks to the global economy, the most often mentioned risk was the risk of geopolitical conflicts, followed by a recession in China and volatility in oil and commodity prices. It can also be seen from the data that the country rating influences the opportunities for importers. In countries with lower ratings, investment and financing is more difficult and comes usually with additional requirements. Credit export and political risk insurance can alleviate some of these issues. Companies intend to complement private credit insurance with government offerings, and government export credit agencies and political risk insurers can be regarded as insurers of last resort.

The importance of financing

In export credit and political risk insurance, the question of how the transaction is financed is often tightly associated with the requirement to transfer the export credit or investment risk to a public or private insurer. Thus, the bank which finances the transaction plays a decisive role in the demand for coverage against these risks. The role of the financial intermediaries is also emphasised in the topic of financing for SMEs. Several statements in the interviews describe that external financing for SMEs is more difficult than for larger companies, which often have long and active relationships with several banks. Some arguments also point out, that the 2007/8 financial crisis has made it even more difficult for smaller companies to obtain substantial financing via banks. Statements also emphasise that SMEs actually would benefit even more from risk transfer via export credit or investment insurance. As these companies have less expertise in dealing with these instruments, financial intermediaries could take the role in advising the companies and to connect the financing of export trade with the financing question.

Signalling and stakeholders

The interviews reveal that many exporters and foreign investors are concerned about the impact of the risks of international trade on the firm’s balance sheet. The key reason here is to avoid earnings volatility, as this is in general considered to be a feature of risky firms. This motive is closely connected with the factors of signalling to stakeholders. Insurance is assumed to be a means of signalling risk of the company to markets and stakeholders, as companies with insurance contracts will have a lower earnings volatility due to insurable unsystematic risk.

Regulation

A further trend showing is regulation with 75% expecting a high or very high impact on trade. This is also reflected in the data from the interviews. Tightened regulations and rules internationally are expected to make foreign trade for companies more difficult and therefore will have an impact on the demand for insurance. Both international and national regulatory regimes influence demand and, in particular, higher banking regulation negatively impacts the availability of small ticket loans. Preliminary results also show that global standards as well as harmonised products and policies affect demand, and national content policies play an important role for government export credit insurance.

SMEs as key customers

One of the most mentioned reasons influencing the demand for export credit and political risk insurance is the size of the company. According to the empirical data, company size impacts the demand through three main factors: Transaction cost of risk management, knowledge and diversification. Another argument was that larger companies have more weight in negotiating the terms of an insurance agreement. Nearly all of the interview participants mentioned that SMEs have a higher need than large corporations to cover risks associated with international trade via insurance agreements.

For example, the interviews show that larger companies have more professional risk management or finance functions. They also have more knowledge about markets for risk and financing products available. This factor can also be labelled as transaction cost of risk management, because the effort to build up a risk management and the related knowledge is not increasing proportional to firm size. Once a growing company has installed such a function, the benefits are that more resources and knowledge are available to manage risks efficiently. In smaller firms, the insurance portfolio is often managed in the finance, accounting or law department without a dedicated function. Thus, time and knowledge is limited and as a result, smaller firms’ often not only lack sophistication but also might let go benefits and opportunities of professionally organised export credit and political risk insurance coverage.

Trends

Besides factors driving the demand for insurance directly, some more subtle trends were explored asking if and how these trends might shape future trade and therefore the demand to cover related risks. In addition to further financial crises, the respondents are concerned about geopolitical issues, such as shifting of power towards Asia as well as fragile multilateral relationships. Another trend emerging from the survey is digitalisation. 85% of the respondents believe that this will have a high or very high impact on global trade. It emerges from the interviews that export credit and political risk insurers at the moment see changes coming up in how the internal processes and distribution of their insurance products will be made simpler and quicker. No clear picture yet emerges about the impact of digitalisation on trade directly.

Preliminary results

The project will be completed at the beginning of next year, but there are already several important initial findings emerging from this research. Preliminary results show concepts emerging from the data which enrich the current theoretical landscape on firms’ demand for export credit and political insurance. The project will also have important implications for a number of parties involved in export credit and political insurance. This includes private and public insurers, guardian authorities and policy makers. The concept of the size of the company, for example, does not seem to influence the demand of insurance directly, but rather via factors which are a consequence of size effects within companies. The context of financing and risk management for SMEs differs significantly from those in larger or even multinational companies, in particular with regard to restriction on access to finance and limitations on the sophistication of risk management and knowledge. The role of financing institutions is crucial, and regulatory issues have to be addressed in an appropriate manner. Companies seem to expect a levelplaying- field, as well as more harmonised products and policies. Furthermore, context factors such as the macroeconomic and geopolitical environment are important. As many participants expect some of these factors to be more volatile in the nearer future, this will have an impact on the demand for export credit and political risk insurance. Furthermore, digitalisation is a key challenge for the industry, and companies expect solutions for new and innovative approaches.

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Andreas Klasen is Professor of International Business at Offenburg University and Senior Honorary Fellow at Durham University. As a Partner with ATRx, he advises governments, multilateral development banks and multinational firms on strategy, innovation and process improvement. Until 2014, he served as Vice President of the Berne Union.

Simone Krummaker is Senior Lecturer at the University of Westminster in London and a Senior Research Associate at the Center for Risk and Insurance, Hannover. Before entering academia, Simone has worked more than ten years in the insurance industry where she held positions such as underwriter and HR controller.

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References

References Badinger, H. and Url, T. (2013) Export Credit Guarantees and Export Performance: Evidence from Austrian Firm- Level Data, World Economy 36, pp. 1115-1130.

Hoyt, R.E. and Khang, H. (2000). On the Demand for Corporate Property Insurance, Journal of Risk and Insurance 67, 1, pp. 91-107.

Klasen, A. (2014). Export Credit Guarantees and the Demand for Insurance, CESifo Forum 15, 3, pp. 26-33.

Krummaker, S. and Schulenburg, J.-M. von der (2008). Die Versicherungsnachfrage von Unternehmen: Eine empirische Untersuchung der Sachversicherungsnachfrage deutscher Unternehmen, Zeitschrift für die gesamte Versicherungswissenschaft 97, 1, pp. 79-97.

Mayers, D. and Smith jr., C.W. (1982). On the Corporate Demand for Insurance, Journal of Business 55, 2, pp. 281-296.