The main engine of China's economic growth is export-led manufacturing. This has been largely led by foreign joint ventures attracted by high quality infrastructure and a limitless pool of cheap labor. Foreign direct investment is running at over USD 1 billion a week, much of it concentrated in the Pearl River Delta, which has been called the "workshop of the world.” The central government's main economic objective is to keep the economy growing at a minimum rate of 7% a year as a means of absorbing the army of rural unemployed, which currently numbers around 200 million. This involves moving from a system dominated by inefficient state-owned enterprises to a flexible mixed economy able to compete in world markets.
General Information About China
People’s Republic of China was established on October 1, 1949, with Beijing as its capital city. With well over 1.3 billion citizens, China is the world's most populous country and the fourth-largest country in the world in terms of territory. China is undergoing rapid, profound economic and social change and development. Political power remains centralized in the Chinese Communist Party. Modern tourist facilities are available in major cities, but many facilities in smaller provincial cities and rural areas are frequently below international standards.
Because of China's enormous size, climate variations range from Siberian in the north to sub-tropical in the south. The western regions endure desert conditions, the central and coastal lowlands suffer catastrophic flooding because of torrential summer rainfall. The coastal provinces are vulnerable to typhoons, which are most frequent between June and September.
China Insurance Marketplace
The Chinese market comprises 25 domestic non-life companies and 14 foreign subsidiaries and branches. The market continues to be dominated by the state-owned People's Insurance Company of China (PICC), though its market share fell from 77% to 42.5% between 2000 and 2007 as a result of challenges from new competitors. Foreign insurers had a market share of only 1.2% in 2007, but were hopeful of growing in 2008-09 as conversion from branch to subsidiary status allows them to expand outside their original cities of authorization.
The non-life market is expanding at remarkable speed, growing by 23.2% in 2006, 26.4% in 2007, and 25% in the first quarter of 2008. Almost all of this growth is the result of two factors: an increase in the number of motor vehicles and an increase in the number of state-sponsored or compulsory insurance lines. Because of intense rating competition, the property market is shrinking in real terms and is expected to produce an underwriting loss in 2008.
Topics of Discussion
This document highlights the most common operational scenarios that expose portfolio companies and private equity firms to loss in China, and how they should be addressed from an insurance and risk management standpoint. The scenarios are as follows:
- Your product is manufactured in China at a facility that is owned and/or managed by your company
- A China based contract manufacturer is responsible for all aspects of the manufacturing process of your product, but they can’t or won’t prove they purchase valid insurance
- Your employees travel to China for business reasons
- You have full-time employees based in China that require health insurance and/or Workers’ Compensation coverage
- An acquisition is based in China
- Directors and/or officers permanently reside in China
- Your product is manufactured in the U.S. and sold in China
- Your product is manufactured, sold, and intended for use in the U.S., but somehow ends up involved in a lawsuit in a China court
Your Product is Manufactured in China at a Facility That is Owned and/or Managed by Your Company
Non-admitted insurance is not allowed in China. The law provides that insurance must be purchased from companies licensed to operate in mainland China, excluding the Special Administrative Regions of Hong Kong, Macao, and Taiwan each of which has its own regulations. The only exception to this rule is international marine cargo.
To ensure that coverage is in place to respond to claims or suits in any jurisdiction permitted by U.S. law, based upon an occurrence in China, it is necessary to coordinate locally issued Chinese insurance with coverage issued in the U.S. Typical Chinese policies contain a jurisdictional restriction and will only respond to claims brought in China. Further, any coverage dispute must be adjudicated in China. The coverage should mirror the objectives and risk tolerance of the overall organization, so it is important for the U.S. based decision maker to control the coverage placed in China. Potentially disastrous inconsistencies in coverage can occur if the decision is left to local management, not to mention the potential cost savings associated with coordinating the coverages appropriately.
The policies available in China respond to the statutory, political, and cultural norms of the country. Therefore, a U.S. based insurance buyer should not expect a Chinese insurance policy to respond in the same manner as one issued in the U.S.
A China Based Contract Manufacturer is Responsible for All Aspects of the Manufacturing Process of Your Product, but They Can’t or Won’t Prove That They Purchase Valid Insurance
This exposure creates challenges even if the contract manufacturer evidences cover. The sophistication of coverage in China is problematic. It is also impossible to know if the buyer kept the coverage in force after the evidence is provided. China still does not recognize the importance of insurance the way that businesses in the U.S. do. In addition, determining whether the coverage would respond appropriately can be challenging because the policy will not be issued in English. Your broker must understand how the insurance system and language works in China.
The most important thing to keep in mind is that it is your brand that is at risk when a claim occurs. Ultimately, the contract manufacturer’s policy might pay a claim, but their insurer will concentrate on making the contractor whole. There are insurance products that allow you to extend your insurance program to your international contract manufacturers. This allows you to control how the program is designed, negotiate the premium, and control the claims process. The expense associated with obtaining coverage, and/or the expense that you incur under your deductibles/self-insured retentions when a claim occurs, can be passed through to the contract manufacturer. This approach is typically followed when your business model has a heavy reliance on a China based contract manufacturer.
Your Employees Travel to China for Business Reasons
Americans visiting or residing in China are advised to take routine safety precautions. In particular, travelers should remain aware of their surroundings and of ongoing events. Travelers should respect local police requirements to avoid travel in some areas.
Security personnel may place foreign visitors under surveillance. Hotel rooms, telephones, and fax machines may be monitored, and personal possessions in hotel rooms, including computers, may be searched without the consent or knowledge of the traveler. Taking photographs of anything that could be perceived as being of military or security interest may result in problems with authorities. Those most susceptible to surveillance are foreign government officials, journalists, and business people with access to advanced technology are particularly likely to be under surveillance.
Terrorism is rare in China, although a small number of bombings have occurred. Recent bombings have generally been criminally motivated, frequently the result of commercial disputes and large-scale job layoffs. The vast majority of these local incidents related to disputes over land seizures, social issues or environmental problems. A few instances have been reported of local employees setting off explosives at their places of business after being terminated by Western expatriate employers. American employers conducting layoff negotiations should do so at a neutral site and always notify the local law enforcement authorities in advance.
There has been a recent increase of incidents with American citizens being kidnapped or detained by workers or hired gangs for the specific purpose of extorting money, sometimes millions of dollars. In the latter cases, the American is typically threatened with violence and detained at a factory, hotel, or private residence until payment is negotiated and delivered. Sometimes the hostage is physically assaulted.
Anyone entering into a contract in China should have it thoroughly examined, both in the United States and in China. Contracts entered into in the United States are not enforced by Chinese courts. Care should also be taken when entering into a lease for an apartment or house. There have been instances of foreigners, involved in lease disputes, being evicted from their apartments and prevented from re-entering to retrieve their belongings.
Americans doing business in China should be aware that if they become involved in a business and/or civil dispute, the Chinese government might prohibit them from leaving China until the matter is resolved. There are many cases of American citizens being prevented from leaving China for months and even years while their civil cases are pending. Civil cases may sometimes be regarded as criminal cases and the defendant may be placed in custody.
Expatriates are not covered by Chinese social security. Traveling expatriates should be covered for their home Workers' Compensation benefits, including Emergency Repatriation Expense and with a carrier that provides additional services, e.g. pre-screened medical referrals, medical case management, medical charges payment guarantees.
You Have Full-time Employees Based in China that Require Health Insurance and/or Workers’ Compensation Coverage
Most healthcare facilities are in the public sector. The general principle in China is that all medical treatment must be paid for by the patient even if the provider is a state hospital or clinic. There is no national health service and no entitlement to free medical treatment except for life-saving emergencies. Following the introduction of a national social medical insurance scheme in 1998, around 223 million urban employees have enrolled in municipal health funds that reimburse the majority of inpatient treatment costs.
Although contribution and benefit levels vary across the country, the basic principle of social medical insurance is that employers contribute 6% of salary and employees 2% of salary to local social medical funds. All employee contributions, and 30% of employer contributions, are diverted to individual employee accounts. The remaining 70% of employer contributions go into collective funds. Outpatient costs are borne by employees out of their individual accounts, inpatient costs are reimbursed by the collective fund subject to a deductible. Reimbursement from the collective fund is subject to a ceiling of approximately four times the local average wage and a 15% to 20% contribution from the patient. Deductibles, contributions and expenses that exceed the reimbursement ceiling may be paid by the employee's individual account, the employee personally, the employer or a private medical insurance policy arranged on either an individual or a group basis.
There is a growing private healthcare sector, encouraged by the government's willingness to sell off redundant state hospitals. Private healthcare facilities cannot be used as the basis for private medical insurance, partly because their numbers are too small, and partly because their reputation is inferior to the best state hospitals.
China introduced a new system of workers' compensation insurance on January 1, 2004 when the Regulations on Insurance for Work-Related Injuries came into effect. The regulations require cities at the prefectural level and above to establish social pools funded by employers' payroll based contributions. The new system only applies to the urban workforce and was providing coverage for 122 million workers by December 2007.
It is common practice to purchase employers' liability policies, either to provide front-line work injury compensation in regions that are not covered by the new workers' compensation system, or as a supplement to state benefits.
Cover under the new mandatory Workers' Compensation system is provided on a "no-fault" basis and applies to work-related injuries and occupational diseases contracted within the workplace during working hours. Benefits include medical expenses, disability allowance, funeral benefit, survivors' benefit and a lump-sum death benefit. Voluntary employers' liability policies are written on a "no-fault" basis and provide specified personal accident-style benefits as well as legal liability insurance.
An Acquisition is Based in China
An acquisition of a China company presents multiple insurance and risk management challenges.
In addition to premium projections and a plan to integrate their exposures into the U.S. directed program, your broker should focus on the following coverages and services:
- Earthquake: Although not situated near any plate boundaries, China is crisscrossed by faults that have given rise to some of the most destructive earthquakes ever recorded. According to the Chinese government's official earthquake hazard map, more than half the country's large cities, including Beijing and Tianjin, are located in intensity zones of MMI VIII or higher. Despite the widespread faulting, however, large areas of China, including Shanghai and the prosperous coastal regions, are considered non-exposed. An earthquake of magnitude 7.9, the most powerful to hit China for 30 years, struck eastern Sichuan province on May 12, 2008 killing up to 75,000 people. One reinsurer has suggested that the total insured loss could be as high as USD 1.55 billion.
- Windstorm: The southeastern coastal provinces are exposed to Pacific typhoons, which occur between April and November but are most frequent between June and October. The most vulnerable provinces are Guangdong, Fujian and Zhejiang, though typhoons can penetrate as far north as Harbin in Heilongjiang province and as far inland as Wuhan in Hubei province. Shanghai and Tianjin are both vulnerable, though not Beijing. Two of the main centers of foreign investment, Guangzhou and Shenzhen, are both in the main typhoon zone. Windstorm is included in all property policies.
- Flood: The most regular and natural catastrophe is flood. Although this is mainly confined to the basins of the Pearl, Yellow and Yangtze rivers, almost any low-lying part of the country is vulnerable. The flooding of the three great rivers is the result of normal precipitation, which reaches its annual peak in the months from June to September. Flooding in the southeastern coastal regions is mainly occasioned by typhoon.
- Other: An unusual wind-related hazard in northern China is dust, which can be blown down from the deserts of the far west. The exposed areas stretch from Urumqi in the west to Shenyang in the east and from Hohhot in the north to Shanghai in the south. Beijing is in the highest risk zone. Hail is a rare but potentially destructive phenomenon that can occur throughout central China from Beijing to Guangzhou. In January and February 2008 central and southern China were crippled by the worst snowfalls for 50 years. Reported paid snow losses amounted to CNY 3.7 billion (USD $541 million). Total economic losses were estimated at CNY 151.7 billion (U.S. $22 billion)
- Travel Risk Assessment: Your people will no doubt visit a facility one or more times prior to closing the deal. Your Equity Risk Partners professional is able to alert you to weather patterns that will affect your trip and the probability of violence in the region whether political, social or criminal in nature.
It might be necessary to focus on other areas depending on the target’s specific operations and location.
Directors, and/or Officers That Permanently Reside in China
A local Director’s and Officer’s Liability policy must be placed if you have a director or officer residing in China. Failure to do so will leave that individual(s) exposed to an uninsured claim. There is no other legal or suitable way to insure a China based director or officer, even if your U.S. based D&O policy is issued on a worldwide basis.
Your Product is Manufactured in the U.S. and Sold in China
Product Liability coverage is affordable and easy to obtain for a U.S. based company that manufactures a product in the U.S. and sells it in China. This exposure can be addressed for as little as $2,500 annually.
Unfortunately, at this moment a product liability suit involving your product could be transpiring somewhere around the world and you could be unaware that it is happening. Some international courts are not required to notify the defendant of the pending suit. Most insurance policies purchased in the U.S. provide coverage on a worldwide basis; however, most insurers will only tender a defense if the suit on its merits is brought in the U.S. Therefore, without a Foreign Liability policy your company could be uninsured for suits that are brought outside of the U.S., and for Federal enforcement orders recognizing the judgment of a foreign court.
Your Product is Manufactured, Sold, and Intended for Use in the U.S., but Somehow Ends Up in a Lawsuit in a China Court
Coverage to address this exposure is easy to obtain and relatively affordable. However, it is a difficult claim scenario to foresee and the expense is equally difficult to justify. Coverage for this exposure can be secured for as little as $2,500 annually. It will provide coverage as illustrated in the prior section.
Addressing the aforementioned exposures requires the coordination of brokers and underwriters in both China and the U.S. At Equity Risk Partners, we have China partner brokers that we work with on a regular basis. Our partner brokers in China are Raymond T.F. Chow, Houlder Insurance Brokers Far East Ltd, and Ricky So, Pacific World. You can learn more about them at
www.cmfhk.com/en/home05.htm and
www.pacific-world.com, respectively.
Please let your Equity Risk Partners professional know when you are travelling to China (for business or pleasure), considering selling your product/service, and/or operating a facility in China. It would be our pleasure to assist you in assessing the risks associated with doing so.
Our White Papers on Mexico, India and China complete the first three parts of our four part series. Our series on emerging markets will continue next week with a similar analysis on Brazil.
