For multinational companies, political risk refers to the risk that a host country will make political decisions that prove to have adverse effects on corporate profits and/or goals. Adverse political actions can range from very detrimental, such as widespread destruction due to revolution, to those of a more financial nature, such as the creation of laws that prevent the movement of capital.
Instability affecting investment returns could stem from a change in government, legislative bodies, other foreign policy makers or military control.
The Two Types of Political Risk
In general, there are two types of political risk, macro risk and micro risk. Macro risk refers to adverse actions that will affect all foreign firms, such as expropriation or insurrection, whereas micro risk refers to adverse actions that will only affect a certain industrial sector or business, such as corruption and prejudicial actions against companies from foreign countries. All in all, regardless of the type of political risk that a multinational corporation faces, companies usually will end up losing a lot of money if they are unprepared for these adverse situations.
For example, after Fidel Castro's government took control of Cuba in 1959, hundreds of millions of dollars worth of American-owned assets and companies were expropriated. Unfortunately, most, if not all, of these American companies had no recourse for getting any of that money back.
How to Minimize Exposure to Political Risk
So how can multinational companies minimize political risk? There are a couple of measures that can be taken even before an investment is made. The simplest solution is to conduct a little research on the riskiness of a country, either by paying for reports from consultants that specialize in making these assessments or doing a little bit of research yourself, using the many free sources available on the internet (such as the U.S. Department of State's background notes). Then you will have the informed option to not set up operations in countries that are considered to be political risk hot spots.
While that strategy can be effective for some companies, sometimes the prospect of entering a riskier country is so lucrative that it is worth taking a calculated risk. In those cases, companies can sometimes negotiate terms of compensation with the host country, so that there would be a legal basis for recourse in the event that something happens to disrupt the company's operations. However, the problem with this solution is that the legal system in the host country may not be as developed and foreigners rarely win cases against a host country. Even worse, a revolution could spawn a new government that does not honor the actions of the previous government.
Buying Political Risk Insurance
If you do go ahead and enter a country that is considered at risk, one of the better solutions is to purchase political risk insurance. Multinational companies can go to one of the many organizations that specialize in selling political risk insurance and purchase a policy that would compensate them if an adverse event occurred. Because premium rates depend on the country, the industry, the number of risks insured and other factors, the cost of doing business in one country may vary considerably compared to another.
However, be warned that buying political risk insurance does not guarantee that a company will receive compensation immediately after an adverse event. Certain conditions, such as trying other channels for recourse and the degree to which the business was affected, must be met. Ultimately, a company may have to wait months before any compensation is received.