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Political Risk Insurance and Foreign Direct Investments

Author

Listed:
  • 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)

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.

Suggested Citation

  • Brockett Patrick L. & Leng Chao-Chun & Wen Min-Ming & Yang Charles C., 2012. "Political Risk Insurance and Foreign Direct Investments," Asia-Pacific Journal of Risk and Insurance, De Gruyter, vol. 6(1), pages 1-18, February.
    • Handle: RePEc:bpj:apjrin:v:6:y:2012:i:1:n:1
    DOI: 10.1515/2153-3792.1108
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    References listed on IDEAS

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    5. Virginia Young, 2003. "Equity-Indexed Life Insurance: Pricing and Reserving Using the Principle of Equivalent Utility," North American Actuarial Journal, Taylor & Francis Journals, vol. 7(1), pages 68-86.
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