Report

Risky Business

Amid political uncertainty in Russia, insurance companies are finding a niche.

Stephen Kay's phone has been ringing off the hook. American companies with investments in Russia have been calling him incessantly over the past couple months to ask about insuring against political instability, including the possibility that the Russian government might confiscate their assets.

Kay, the head of political risk insurance in the U.S. for Marsh, a unit of the world's largest insurance broker Marsh & McLennan, sells a specialized type of insurance to companies that want to do business in other countries, but that are worried war or political strife could endanger their investments. Kay's company sells policies that protect against everything from cyber-attacks to hurricanes. But it's political risk insurance that's in demand since Russia invaded Ukraine and annexed Crimea, sparking a tense standoff between Moscow and the West.

The ongoing standoff has put U.S. companies that operate in Russia in a particularly tricky position, as the two sides trade threats of economic warfare and American companies look to cover their Russian assets. Secretary of State John Kerry warned Tuesday that the U.S. could roll out more sanctions for Russia's meddling in Ukrainian politics. After Washington froze the assets of businessmen, politicians, and a bank close to Putin last month, members of Russia's parliament fired back by considering legislation that would allow them to take over American and European companies in Russia. 

That's why so many people are calling Kay -- investing in Russia suddenly looks a lot more perilous. It's already the country with the highest level of political risk insurance. Insurers had at least $27 billion worth of exposure at the end of 2013, according to information collected by the Berne Union, a group of trade and investment insurance companies.

Foreign direct investment in Russia jumped in 2013 to $94 billion according a United Nations report, but has been falling since the beginning of this year. Investors have already moved $50 billion out of Russia in the first three months of 2014, which Fitch Ratings said Wednesday puts Russia's already struggling economy at risk.

"We believe the Ukraine crisis is exacerbating a longer-term slowdown in the Russian economy," the ratings firm said.

Unfortunately for Kay, instead of a sales boon, he has a lot of what he calls "uncomfortable conversations." That's because he no longer has any insurance to offer. Once a country is already in the midst of a political crisis, insurers consider it too risky to sell new policies.  

"When you're looking for homeowners insurance, it's a little too late to buy the insurance when the house is already burning, right?" Kay said. "The events going on right now in Russia are like a burning fire."

Political risk insurance can cover physical damage, such as to buildings from riots or terrorism, as well as financial damage like a foreign government refusing to pay out a contract or let people move money out of the country because of an economic crisis. If civil war breaks out and a factory is destroyed or new political leaders come to power and decide to nationalize foreign-owned companies, the insurer would compensate the policyholder.

Businesses that want to insure new ventures or assets that are already on the wrong side of what threatens to become a new Iron Curtain have little recourse but to wait for the volatile situation to settle down. It's unclear what proportion of foreign direct investment is insured worldwide. The contracts are private and many companies don't disclose the details. Big multinational companies often buy policies to cover their operations in multiple countries over several years, according to people in the insurance business.

American corporate giants, including General Motors, PepsiCo, Coca-Cola, Boeing, and Exxon Mobil, have substantial investments in Russia. General Motors, which produces SUVs in two Russian factories, declined to comment on the company's use of political risk insurance. "We don't disclose this information for competitive reasons," a spokesman said in an email. Boeing also declined to comment. Coca-Cola, PepsiCo, and Exxon did not immediately respond to requests for comment.

Russian lawmakers haven't moved forward with the idea of taking over parts of Western companies, but numerous countries have seized the assets of foreign firms, usually as part of a domestic economic program rooted in socialism or communism. Russia itself nationalized swathes of foreign industry in the wake of the 1917 revolution. More recently, Venezuela, Bolivia, and Argentina have incurred the wrath of foreign investors by expropriating businesses, especially in the energy sector.

Political risk insurance was created to encourage investment in Europe as part of the Marshall plan to rebuild the continent after World War II. The Overseas Private Investment Corporation (OPIC), a U.S. government agency, still provides insurance to companies that want to invest in projects that aim to achieve development goals, as does an arm of the World Bank.

But much of the political risk market is now private. It's backed by some of the world's largest insurance underwriters like American International Group (AIG), Zurich Insurance Group, and ACE Group, for whom it is a small part of their business. Because they also underwrite insurance policies on everything from life insurance to workers compensation, the giant companies generally aren't threatened by any one political event.

Curtis Ingram, another broker who sells political risk insurance at Aon, said it's much harder to quantify political risk than other types of insurance that can rely on historical statistics to gauge the future. 

"It's just not life insurance or auto insurance or even windstorms," said Ingram, vice president of Aon Risk Solutions' political risk practice. "It's profoundly unpredictable."

The underwriters can also end up owning parts of companies that they insure, which can help them recover some of the costs of paying claims. If a government decides to take over part of a foreign-owned business, the insurance company would compensate the original owner and then take over ownership of the factory or oil field that was expropriated. The insurance company can then continue to press the country's leaders to return the asset or give them compensation. In 2012, insurers reported recovering $51 million from holding onto expropriated assets, according to the Berne Union data, but in 2013 they reported zero. It all depends on whether the government that took the assets will agree to settle the dispute.

The giant insurance companies are often in a better position than investors to play the long game and wait to see if the political winds change. But the odds of that happening in Russia are still unknown.

"Nobody's got a crystal ball; nobody can really foresee one year out," Kay said. "The Russian crisis confirms that. Nobody really saw that coming."

AFP/Getty Images

Report

Putin Aims His Energy Weapon at Ukraine

Moscow is jacking up gas prices to cow Kiev and scare Europe. It may not work this time.

Secretary of State John Kerry has accused Moscow of using ham-handed covert operations to destabilize eastern Ukraine. Russia is making no attempt to hide its latest assault on Ukraine: a sharp spike in natural gas prices designed to bring the cash-strapped country to its knees.

Russian President Vladimir Putin raised the prospect Wednesday of making Ukraine pay in advance for the natural gas that it buys from Russia, a potentially ruinous move for the credit-challenged Ukrainian government. Ukraine's total gas debt to Russia now totals more than $16 billion, Russian officials said.

While Putin reportedly ordered Gazprom, the big energy giant, to wait until another round of talks with Ukraine before implementing the move, the threat of making Ukraine pay upfront for its gas will become Moscow's default stance if the talks fail. Some U.S. lawmakers, such as Rep. Michael Turner (R.-Ohio.) seized on Russia's latest saber rattling to reiterate calls for the United States to expedite the export of natural gas to countries such as Ukraine.

Kiev, meanwhile, took the pre-emptive move of halting its imports of Russian natural gas until the two countries can resolve a contentious dispute over prices. Moscow has jacked up the price it charges Ukraine twice in recent days by a total of more than 80 percent, making gas sold to Ukraine among the priciest in Europe.

In a brazen display of chutzpah, Moscow justified the second price hike after abrogating a 2010 treaty between the two countries. Under the terms of that so-called Kharkiv accord, Moscow offered price discounts to Ukraine as a lease payment for the Russian naval base in Sevastopol, on the Crimean Peninsula. Now that Russia has forcibly annexed Crimea and taken over the naval base, it argues that discount no longer applies.

Ukraine's prime minister called the price hikes "economic aggression," and the government is considering taking the dispute to international arbitration. One senior Russian state energy analyst suggested Wednesday that the price hike is meant to pressure the European Union into approving South Stream, a Russian-led pipeline that would ship gas from Russia to Europe, bypassing Ukraine entirely. The European Union has said it will halt talks on the pipeline until the Ukrainian crisis is resolved.

For now, Ukrainian Energy Minister Yuriy Prodan and other top officials say that they consider the old, fully-discounted price for gas of about $268 per thousand cubic meters to still be valid, and have offered to make their payments based on that formula. Moscow says the new price is $485.50 per thousand meters. That works out to $15.18 per million British Thermal Units, far higher than what is paid by other European countries. Russia charges Germany, for instance, $10.69 per MMBTU. The German spot market price for natural gas is $8.47, while the U.S. spot price for gas is just $4.56, according to calculations made by Mikhail Korchemkin, founder of East European Gas Analysis, an energy consultancy based in the U.S.

Russia's energy relations with Ukraine matter, because Russia remains the largest supplier of Europe's natural gas and Ukraine remains the main transit point for that gas to get to customer countries such as Germany. Russian media stressed remarks by Ukrainian energy officials that gas shipments to the rest of Europe could be affected by the dispute, underscoring longstanding Russian arguments that they need a way of bypassing Ukraine so Europe isn't dependent on its pipelines.

But while worries about another energy crisis do rattle European diplomats, especially those in central and eastern Europe most dependent on Russian supplies, times have changed.

"This is not 2009," said Carlos Pascual, the head of energy diplomacy at the U.S. State Department, in a speech last week.

Previous gas crises between Russia, Ukraine and Europe came in the dead of winter, when gas demand was at its highest; today's crisis is unfolding after an unseasonably warm winter and with spring already here. That means that Europe has natural gas in storage, and natural gas demand will remain low for the next six months.

What's more, Pascual noted, the last crisis prodded Europe to take steps to make its energy markets more resilient to sudden supply shocks. "After 2009, the European Union went into hyperdrive" to reform its natural gas markets, he said. That includes making it easier for European countries to ship gas to each other in times of need, an issue that has come to the forefront in the current showdown between Moscow and Kiev.

Countries such as Hungary and Poland can already ship small amounts of natural gas to Ukraine, or about enough to meet seven percent of Ukraine's annual demand, or about 25 percent of its lower summertime demand. Reversing pipeline flows from Slovakia to Ukraine would add twice that amount -- but would also require the construction of a new pipeline, because Gazprom has bought transit rights on the main Slovak pipeline for years to come.

Given seasonally low demand for gas, relatively healthy gas storage levels, and the possibility of importing some additional gas from alternative suppliers such as Norway and Algeria, some believe Europe is actually well placed to turn the energy weapon around on Russia by halting its purchases of Russian gas. That would put severe pressure on Moscow, which is reliant on gas and oil exports for more than half of its federal budget.

"If Russia moves into eastern Ukraine now, Brussels should impose an embargo right away," Korchemkin said. "The closer it gets to the winter, the more painful the gas embargo would be for the EU," he said, estimating that Gazprom and the Russian government could wind up losing $100 million a day.

To be sure, Europe's ability to shake off reliance on Russian gas supplies is limited in the short term, and by next winter Russian energy will be important for meeting European power and heating needs. Making pipelines reverse their flow of gas would cost millions of dollars and take months to build. U.S. supplies of natural gas won't materialize until nearly the end of the decade, and Europe would likely have to pay more for imported gas by tankers than it currently pays Russia.

"I find European optimism misplaced and foolish, because it potentially jeopardizes stable and long lasting trade relations," said Tim Boersma, an energy expert at the Brookings Institute. "Joining the American calls to isolate Russia may sound like an attractive idea, but it comes at a high cost, and Europe will pay it--not the U.S."

Sergei Karpukhin - AFP - Getty