As an insurance broker dealing in trade credit insurance (TCI), you will at some point in your career be required to understand risk associated with doing business in certain countries. Risk, of course, could greatly determine premiums for the insurance products you are offering to clients.
So how does one determine country risk?
Country risk assessment is the process of determining a nation's ability to transfer payments.
What is country risk assessment?
Country risk assessment, also known as country risk analysis, is the process of determining a nation's ability to transfer payments. It takes into account political, economic and social factors, and is used to help organisations make strategic decisions when conducting business in a country with excessive risk.
Different types of country risk
Country risk assessments are generally segregated into different categories, which take a closer look at some of the factors we mentioned prior. Let's discuss some of the most common and what they mean, so you can determine how they might impact your clients' transactions and, thus, premiums on TCI products.
1. Political risk
Political risk determines a country's political stability, either internally or externally. For instance, a recent military coup would increase a nation's internal political risk for businesses as rules and regulations suddenly shift. Other risks in this category could include war, terrorism, corruption and excessive bureaucracy (i.e. host government red tape is preventing certain fund transfers or other transactions).
Political risk can affect a country's attitude to meeting its debt obligations and may cause sudden changes in the foreign exchange market.
2. Sovereign risk
There is some crossover between political and sovereign risk, although the latter – also known as sovereign default risk – primarily examines debt. Specifically, this risk category measures the build up of debt that is the obligation of a government or its agencies (or that is guaranteed by the government), and how much said government is anticipated to fulfil these obligations.
For example, if a government agency refuses to carry out debt refunding, this could impact local lenders and lead to losses. This would of course have roll-on effects to local businesses and anyone undertaking trade with them.
3. Neighbourhood risk
Neighbourhood risk, also known as location risk, may not be the direct fault of the country with which your clients are dealing, but instead is caused by trouble elsewhere. This can have spillover effects on other sovereign nations, creating turmoil in the foreign market or putting pressure on local lenders and businesses.
Neighbourhood risk can be caused by:
- Geographic neighbours.
- Trading partners.
- Co-members of certain institutions or organisations.
- Strategic allies.
- Nations with similar perceived characteristics.
4. Subjective risk
Subjective risk is not a term that is used everywhere, but it measures factors that are common to most risk assessments – and could greatly impact foreign business owners trading with a host nation. Subjective risk is about attitudes, and can include social pressures and consumer opinions – whether to certain types of goods or certain types of enterprise.
5. Economic risk
Economic risk encompasses a wide range of potential issues that could lead a country to renege on its external debts or that may cause other types of currency crisis (i.e. recession). A major factor here is economic growth – the health of a nation's GDP and the outlook for its future. For instance, if a country relies on a few key exports and the prices for these are dropping, this creates a negative outlook and may increase the economic risk for foreign trading partners.
Acts of government may also impact economic risk, such as intervention in the money market or policy changes that cause tax instability. One other factor is issues with foreign currency exchange, for instance a shortage in certain currencies or a devaluation of the exchange rate.
Predicted loss created by sudden changes in exchange rate are generally covered under the exchange risk factor.
6. Exchange risk
Any predicted loss created by sudden changes in exchange rate are generally covered under the exchange risk factor. This is another all-encompassing term as fluctuations in the foreign exchange can be caused by a wide variety of factors. Economic and political factors such as those mentioned above can be significant drivers of exchange risk, although currency reserves, interest rates and inflation are also potential factors.
One example of political change that can harm economic risk is a change in currency regime, for example from fixed regime to floating.
7. Transfer risk
The final country risk assessment factor we'll discuss today is transfer risk. This is where the host government becomes unwilling or unable to permit foreign currency transfers out of the nation. Sweeping controls such as these may be a side effect of a nation in crisis attempting to prevent creditor panic turning into significant capital outflow. A major example of this occurring is the Malaysia credit controls after the 1997-98 Asian currency crisis.
Regardless of cause, capital control can prevent foreign traders from retrieving profits or dividends from the host country.
How COFACE measures country risk
At COFACE, we make 160 regularly updated country evaluations – based on macroeconomic, financial and political data – freely available. These will give you an estimate of a country's credit risk, based on an eight-point scale of risk ranging from Very Low (an A1 rating) down to Extreme (an E rating).