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Title:Insuring foreign direct investment against political risk
Author(s):McDonald, Curtis T.
Doctoral Committee Chair(s):Baer, Werner W.
Department / Program:Economics
Degree Granting Institution:University of Illinois at Urbana-Champaign
Subject(s):Economics, General
Economics, Finance
Abstract:New foreign direct investment in the former eastern-block countries, SE Asia and Latin America is essential for continued growth. Historically, the absence of credible host-country guarantees to protect foreign investment has represented a substantial barrier to the inflow of capital. Political (or non-commercial) risks, such as the possibility of expropriation or war, or the inability to remit profits, still actively impede foreign investment. In response, many industrialized nations, the World Bank, and several large private insurers have established political risk insurance (also known as investment insurance) programs which indemnify overseas investors for losses resulting from the political risks mentioned above.
This work employs techniques from the economics of insurance to carry out a formal theoretical and empirical analysis of the political risk insurance (PRI). The first of three essays examines the institution of political risk insurance, defining what political risk is, and outlining the political risks addressed by PRI in the various facets of international business operations. The market for PRI is also discussed, and a comparison is made between the public and private providers of PRI. Considerable time is spent in describing the various PRI coverages and the idiosyncracies which exist in the public and private versions of these coverages. The official political risk insurance programs of Germany and Japan are also discussed, and a case history demonstrating the use of PRI is provided.
The second essay uses the concept of loss prevention, as originally introduced by Erlich and Becker (1972), to redefine the nature of PRI. Anecdotal evidence is presented which highlights the dominant position of public insurers in the market for PRI. The large market share and favorable underwriting results of public insurers is explained as a consequence of loss prevention activities which are unavailable to private insurers. An insurance relationship (insurer-insured) and a sanction relationship (insurer-host country) are modeled, demonstrating why public and private insurers provide different types of insurance for similar risks. It is shown that for certain classes of political risk insurers, in particular large government insurers, PRI is in actuality an insurance product bundled with a loss-prevention good. Salvage, an important element of government PRI programs, alters the level of loss-prevention necessary.
The third essay is an empirical work which uses data on expropriation claims and recoveries by the US government political risk insurer to evaluate the ideas set out in the second essay. Logit and probit analysis are carried out to test the relationship between the amount recovered on each expropriation claim (the dependent variable), and various explanatory variables, among which are several instruments representing possible sanctions which could be employed by a government insurer. Initial results confirm that recoveries are higher in the presence of possible sanction tools, whether or not such tools are actually used.
Issue Date:1994
Rights Information:Copyright 1994 McDonald, Curtis T.
Date Available in IDEALS:2011-05-07
Identifier in Online Catalog:AAI9512481
OCLC Identifier:(UMI)AAI9512481

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