Political Risk Insurance and Foreign Direct Investments

Brockett Patrick L., Leng Chao-Chun, Wen Min-Ming and Yang Charles C.
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Brockett Patrick L.: University of Texas. Austin
Leng Chao-Chun: Towers Perrin
Wen Min-Ming: California State University, Los Angeles
Yang Charles C.: Department of Finance, Florida Atlantic University

Asia-Pacific Journal of Risk and Insurance, 2012, vol. 6, issue 1, 18

Abstract: Political risk is an important consideration in the capital budgeting process for firms contemplating foreign direct investment (FDI) in emerging markets or in volatile political environments. Unfortunately, the unique characteristics of political risk make the application of familiar actuarially-based pricing models almost infeasible for valuating political risk insurance. In this article we employ utility theory instead to derive an equilibrium price (premium). This price maximizes an insurer’s expected profit and the insured’s expected utility, while taking into account the effects of risk control (self-protection) and risk financing (self-insurance). In addition, within this equilibrium framework, we derive the boundary level for the amount of foreign investment, the amount of political risk insurance coverage, and the minimum required rate of return of foreign investment. Finally, we employ a constant relative risk aversion (CRRA) utility function to illustrate the theoretical equilibrium model.

Keywords: political risks; insurance pricing; foreign investments (search for similar items in EconPapers)
Date: 2012
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DOI: 10.1515/2153-3792.1108

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