A life insurance policy for China

After 20 years of breathtaking growth and massive industrialization, China is now facing economic and social challenges to its sustained development.

On the one hand, it must find 12 trillion renminbi ($1.5 trillion) over the next five years¹ to finance the construction of a staggering amount of physical infrastructure if it is to keep its growth on track and extend economic development to smaller cities and rural areas. On the other, it must address increasingly pressing issues of social harmony and stability, in part by tackling shortfalls in its pension and social-welfare systems. Both of these efforts will be crucial for narrowing the potentially explosive gap between the wealthier coastal and urban regions and the poorer countryside.

Since either undertaking—let alone both—will almost certainly cost more than the government can afford, China must mobilize a market-oriented source of finance to expand its investment capacity without compromising fiscal discipline. It could do so, at least in part, by further reforming the Chinese life insurance market.

A vibrant life insurance² industry is uniquely suited to address infrastructure and social needs alike. By redirecting China's enormous household savings, now held largely in short-term bank accounts, into life insurance products, insurers could help to raise the long-term financing that the state needs for big infrastructure projects. On the social-welfare side of the equation, life insurance protects ordinary people, giving them peace of mind and securing long-term savings for their retirement. Moreover, it helps to reduce the burden on government by supplementing the social-pension and -welfare system. Thus a thriving life insurance industry, once further reforms are implemented, would allow China to address its infrastructure and social issues simultaneously.

Competing economic and social needs

Sustaining China's amazing growth won't be easy. In road construction alone, the government must build 16,000 kilometers (about 9,950 miles) of highways over the next five years, at an estimated cost of $200 billion. Railways, airports, water-treatment facilities, power plants, ports, telecommunications facilities, hospitals—the country needs all of them urgently. Infrastructure investments are already stretching the resources of China's government: for example, commercial loans finance 60 to 70 percent of current spending on road construction—a problem that will probably get worse. According to the Asian Development Bank, the government will need to borrow about $12 billion a year to complete its road construction program.³

Social needs are equally important. One effect of China's meteoric growth has been a widening income gap between the wealthy and the poor. To tackle this social problem, the government is building a pension and social-welfare system, but critical gaps remain. Disparities in coverage are one major issue . Currently, only some urban areas have the full system of protection: a pension plan; medical, workplace injury, and unemployment insurance; and maternity leave. Even then, only 44 percent of the eligible urban population participates in the statutory pension plan.

Rural regions receive less protection, with even lower participation in their basic pension plan and health care scheme, which is called rural cooperative "medicare."⁴ In fact, only 10 percent of the eligible rural Chinese population participated in the pension plan in 2004. Moreover, whereas the government finances urban programs, the participants themselves pay for the basic pension plans in rural areas. Another problem is that the system offers only a meager income: in 2003 the average monthly pension paid to urban retirees came to less than 700 renminbi.⁵ Finally, the system has difficulty addressing the problems of some 300 million people: the urban poor, "landless" peasants, and those who no longer farm (for instance, the 100 million or so peasants who have moved to cities in search of work).

Today, just 3 percent of government spending in China supports social welfare. According to the China Ministry of Labor and Social Security, the government will need an additional 740 billion renminbi to cover future pension expenses.⁶ The situation will likely get worse because the population is aging rapidly—a result of the country's one-child policy combined with rising average life expectancy, which under current trends will reach 79 years in 2020.

A recent survey reveals that urban Chinese are increasingly concerned about illnesses, accidents, retirement, unemployment, housing, and the education of children.⁷ One product of this anxiety is that people resist changing jobs or locations or taking other actions that could benefit them economically. This immobility contributes to the widening income gap between rich and poor, a potential cause of social instability.

Fears about an uncertain future have also generated China's stratospheric household savings rate, which at 20 percent is much higher than it is in other Asian countries. From a macroeconomic perspective, some of this private capital would be better deployed in public investments or freed up for other needs, such as private domestic consumption, which dropped in China (as a share of GDP) from 50 percent in 1990 to 41 percent in 2003⁸ With early signs of overcapacity in many Chinese industries, consumer confidence needs boosting in both urban and rural areas to stimulate domestic consumption.

Why life insurance?

Life insurers can help to raise long-term financing for infrastructure by investing their premium income (at least partially) in government bonds. They can also invest directly in long-term debt instruments dedicated to specific projects and guaranteed by the state but with potentially higher returns than general government bonds (a natural fit given the insurers' need for stable long-term returns). Social harmony and stability would be enhanced as well. Life insurance not only offers protection in the event of accidents, illnesses, and the death of family members but also helps people to save for retirement—an equally important consideration for a government seeking ways to reduce its financial burden. To this end, China has introduced a "three-pillar" system: government, employers, and individuals together contribute to a comprehensive solution. Since it is unrealistic for the government, as the first pillar, to provide protections to everyone, it should encourage second-pillar (employer) and third-pillar (individual) contributions. If commercial insurance covers people who can afford it, the government will be in a better position to tackle the huge task of helping the very poorest.

China's government recognizes this opportunity. It has implemented regulations to promote legal certainty, so that customers can have confidence in their insurers' ability to pay them over a long period. It allows private insurers to experiment with tax-deductible corporate-pension plans and encourages commercial insurers to participate in special pension programs for landless rural groups. The government has restructured the shareholding of some key state-owned life insurance enterprises, thus freeing them to expand their operations. And it now permits private and foreign life insurers to set up shop in China. As a result, the industry has posted a compound annual growth rate of 27 percent since 1997

Yet even by Asian standards, life insurance—at 2.2 percent of GDP, as measured by the volume of premiums—has barely penetrated China. In addition, many of the insurance products sold in the country today have strong short-term investment and savings components and provide little long-term protection.⁹ The barrier to faster growth isn't a lack of funds: Chinese citizens, as we have seen, actually save at an extraordinary rate. What's more, vast numbers of them earn enough to buy insurance. But few of them do

Beyond the teething problems of what, in China, is still a new industry, we see two main reasons for its underdevelopment. The first is that many Chinese either don't know about life insurance or don't understand it at all well: a recent survey found that only 6 percent of the population had even a modest knowledge of its benefits.¹⁰ Moreover, aggressive and sometimes misleading sales practices have created mistrust among consumers. China's lapse (or "surrender") rate for life policies reflects these problems; in 2004 it rose to 10 percent, from 6.8 percent the year before. (In the United States, by contrast, the surrender rate is just 2 percent.) The second reason is that life insurers neglect the rural population because its average income is lower, it is less educated about life insurance, and it is more costly to reach.

Promoting life insurance in China

China should set several goals for the life insurance industry during the next 10 to 15 years. These goals should include promoting the income protection benefit of insurance as a supplement to government-funded social-welfare programs, achieving the life insurance penetration rates of more developed countries, and stimulating greater diversity in the structure of the financial system.

After defining such high-level aspirations, the government should consider launching an integrated program to drive the industry's healthy development. The impressive results achieved in South Korea, where the Department of Treasury deemed 1977 the "year of insurance," show the potential. Both the government and the industry promoted insurance through television and newspaper ads, and the government reorganized the regulator and provided tax breaks for insurance consumers and corporate-insurance plans. As a result, the life insurance market grew by 51 percent annually over the next ten years, with life insurance premiums increasing to 6 percent of GDP, from 1 percent.

China's government should consider five initiatives.

Educate the market

To begin with, China should educate its citizens about the value of life insurance. The mass media will play a central role, and the government has an advantage in its ability to direct these outlets. But China's size and the vastly different needs of different consumer segments mean that education must also be tailored to specific groups.

In urban areas, efforts should focus on the mass-affluent segment of consumers, who can afford these products. The government might also reach targeted people through an annual letter that summarizes the recipient's social-security benefits and possible shortfalls in protection and that provides clear, detailed information on how insurance can help to eliminate them.

In rural areas, the basic functions of life insurance are poorly understood, so the problems of communication are much greater. Efforts should start with the consumers most likely to purchase life insurance: villagers in thriving areas, landless peasants, and people who work for township enterprises. The government can also consider teaching the basics of life insurance in middle and primary schools.

Strengthen the regulator

An understanding of the benefits of life insurance won't be enough. Experience from more developed markets shows that a strong and wise regulator is vital to ensure a healthy environment, so that the best-run insurers can expand and the industry can win the popular trust it needs to thrive. The primary task of the China Insurance Regulatory Commission (CIRC) will still be to monitor the financial health and risk-management systems of life insurers, but it should take on other tasks as well.

For one thing, it should better regulate the product design of insurance and outlaw unsustainable pricing, impossible promises of future returns, and contracts that are incomprehensible or disadvantageous to consumers. Second, CIRC should improve the quality of distribution, perhaps by raising licensing requirements to boost the professionalism of insurance sales agents. Third, it should promote industry best practices by allowing more foreign players to compete for business; at present, such companies still hold only a few percentage points of the national market. Fourth, it should reduce red tape, to encourage growth and innovation. Finally, as its regulatory abilities improve, it should design more flexible rules for highly skilled insurers while keeping a close eye on less skilled ones.

As the insurance regulator becomes stronger, China will want to establish a formal mechanism to coordinate CIRC's activities with those of the banking and securities regulators. Cross-sector regulations for converging markets and for financial-services firms that continue to expand their scope will also be required. Bancassurance is the leading example of a product that falls within the purview of two regulators.

China may not yet need a "super regulator" that combines all regulatory offices for the different financial sectors. Nonetheless, better cooperation among insurance regulators and other government departments (such as the ministries of finance, health, and civil affairs) will be important. Commercial insurers, for example, are not allowed to participate in the provision of social benefits. Only when the relevant government bodies agree on the role of commercial insurance will it be possible to improve the laws and regulations that govern it and to build a coherent legal framework for the commercial-insurance industry.

Create new investment opportunities

An attractive and thriving life insurance industry will also require more flexible investment options so that insurers can achieve stronger returns. That in turn will let them offer higher returns to their policyholders and thus help to close the gaps in the government's social-welfare programs.

China can begin by opening its state-run pension scheme to fund-based annuity products. In Singapore, for instance, members of the Central Provident Fund (CPF), a compulsory pension scheme for private-sector employees, can choose to invest in not only fixed-deposit but also unit-linked products¹¹ from insurance companies chosen by CPF.

To stimulate other forms of domestic investment, the government must relax rules about what insurers can invest in, and where. Above all, it should encourage life insurers to invest in the long-term infrastructure projects that the country needs most urgently. It should also issue more long-term bonds, which the industry sees as attractive investments, since they help companies to manage asset and liability risk.

China could do even more by allowing insurers to invest overseas—a move that would encourage more insurance companies to enter the market. Chinese insurers recently got permission to invest their capital in foreign currencies in order to purchase shares of Chinese companies listed abroad. The government could consider a two-step approach: first allowing more kinds of share purchases and more ways to purchase them and then permitting unrestricted offshore investment. But before going further, the government should be certain that insurers' investment and risk-management skills are up to par.

Provide tax incentives

Life insurance plays a special role in boosting economic growth and social stability. Many countries therefore use preferential taxation policies to encourage greater participation and to influence the behavior of insurers, employers, and customers. China should do the same.

At present, companies in the Chinese insurance industry pay a 5 percent business tax, while those in industries such as telecommunications and construction pay only 3 percent. The difference obviously puts life insurers at a disadvantage. This isn't the only form of tax inequality: domestic companies pay more than their foreign counterparts and companies based in China's special economic zones. India, by contrast, grants domestic insurers a lower income tax rate than foreign ones. Meanwhile, individuals in China owe other taxes: insurance agents, for example, must pay not only a business tax (5.5 percent of their commissions) but also income taxes, whereas agents in Hong Kong pay only the latter. China should think about equalizing the rules. In addition, the government could consider granting special tax relief to insurers that operate desired but particularly challenging businesses—for example, life and health insurance in rural areas.

In many countries, tax incentives for employers have proved their effectiveness. China is already using them in a supplementary medical-insurance deductible from corporate taxes, as well as in pilot programs for tax-deductible pensions in certain areas. The rollout of a tax-advantaged corporate-pension scheme in the rest of the country will be a critical next step.

Tax relief for individuals will have only a limited impact on the industry's short-term growth, however: only 6 percent of the Chinese now pay individual income taxes, though in some urban areas, such as parts of Beijing, close to 40 percent of the population does. As China's economy develops and income taxes become more widely accepted and enforced, tax relief schemes could give a substantial lift to life insurance.

Extend coverage to rural areas

Even if all these measures were implemented, both government and industry might have to devise creative initiatives to assure broad life insurance coverage in rural and remote areas, where a direct sales force is costly to field.

Other countries have successfully used a range of approaches that provide food for thought. India, for instance, requires insurers to sell a small but escalating percentage of policies in rural areas—starting with 7 percent in the first year and rising to 14 percent in the fifth. This rule poses formidable difficulties because perhaps 80 percent of the rural population earns less than the equivalent of $138 a month and can't afford to pay conventional premiums. Vast distances, poor roads, and unreliable transport make distribution difficult. Carriers must be creative: they design customized products and develop efficient infrastructure and distribution systems.

Some insurers have developed new policies with low premiums and commensurately low payouts for this market. Their rural-distribution model involves traditional channels such as agents and brokers, as well as arrangements for referring customers to them from rural-development agencies and other nongovernmental organizations (NGOs), microfinance institutions, local governments, and corporations. Insurers have built a presence in all 15 Indian states through various partnerships, and sales in rural areas have grown significantly.

In the Philippines, a few entrepreneurs have pursued another creative business model by persuading telecom companies to bundle sales of mobile phones with special life insurance policies that are easy to understand and have low monthly premium payments. The partnership gives the insurers access to the telecom companies' distribution networks, while the telcos gain detailed information on customers and a chance to increase their loyalty.

Time and again, experience has shown the many benefits of life insurance in the developed world. China's life insurance industry could play a key role in tackling the country's economic and social challenges if the government helps the industry to realize its vast potential.

About the Authors

Stephan Binder is a principal in McKinsey's Shanghai office; Heidi Hu is an associate principal and Peter Walker is a director in the New York office.

Notes

¹The State Development and Reforming Commission (SDRC) made this rough estimate of the cost of the investments the country will have to make from 2006 to 2010.

²We define life insurance in this article as policies that combine the accumulation of assets with a benefit in the event of the holder's death. Such policies may include annuities and pension plans and accident insurance but not health and medical insurance.

³China Hand, Economist Intelligence Unit, December 2004.

⁴A medical scheme cofunded by the central government, local governments, and rural residents.

⁵Ministry of Labor and Social Security Statistics Yearbook, 2004.

⁶Xie Xuezhi (Vice chairman of the National Council for Social Security Fund, China) in Lan Xinzhen, "Plugging the gap," Beijing Review, 2006, Volume 49, Number 2.

⁷Lu Renbo, "China 50 cities insurance market survey: Good market, bad sales," Xinhua News Agency, July 3, 2002.

⁸Global services database, Global Insight, August 2005.

⁹Under the US generally accepted accounting principles (GAAP), sales of these products are not even counted as premium income but instead are recorded as a deposit or liability on the balance sheets of most foreign insurers operating in other developed countries. If such products were excluded, the penetration of life insurance in China would be at least 30 percent lower.

¹⁰Lu Renbo, "Forty-six cities: Sixty percent of insurance customers unsatisfied with local insurers," Xinhua News Agency, July 5, 2002.

¹¹Life insurance savings plans connected to mutual funds.

Rural finance Challenges

A large proportion of the population of developing and transition economy countries and three-quarters of the developing world's poor people live in rural areas. Sustainable livelihood development in rural communities is, thus, an important process and requires efforts to help people improve their social and financial assets.

Financial assets enable households to make better use of other assets, such as their land, labour and skills. Financial services help people to build their financial assets and can also help to facilitate their transactions, solve cash flow problems and manage risk.

Rural finance is, therefore, about the development of financial services in rural areas. The rural environment does have a number of particular problems, e.g.

A lower spatial density of clients, compared with urban areas, and therefore higher transaction costs; A mix of economic activities in which agriculture (including livestock and fisheries) is often very important, with consequent higher levels of risk from uncontrollable factors and irregular cash flows from seasonal production; A tendency towards lower levels of human capital, especially literacy and numeracy, with women often being disadvantaged; A history of poorly conceived, sometimes politically-driven, rural lending that has left a residue of bad debts, weak portfolios and borrowers unaccustomed to strict interest and repayment practices; Poor infrastructure and long distances from markets, which limits economic opportunities and debt capacity.

These issues require close attention to policies, to the operations of financial institutions, to improving the design of projects and to finding ways of improving capacity building so that best practices are followed wherever possible. Interesting Article .... Examining Design and Innovations in Rural Finance For Addressing Current and Future Challenges By Calvin Miller FAO Rural Finance Workshop: SEEP Pre-Event October 26, 2004 Twelve Key Challenges in Rural Finance Rural finance has been recognized as an important element and catalyst to rural development. Millions of dollars have poured into rural finance, especially agricultural credit, in the past and yet rural communities have little to show for it. Donors, governments and bankers became disillusioned with the results. Today there is renewed interest to learn from the past and experiment for the future to meet the seemingly illusive goal of increasing rural farm and non-farm investment and assets through the ready access of appropriate and sustainable financial services to all households. In addition, rural finance has begun to be seen in a broader spectrum than agricultural and farm credit but is rightly now being defined as farm credit and non-farm credit, savings, insurance, transfers, clearing, equity finance, etc. and is not restricted to institutional lines of finance. Twelve key challenges for achieving this goal are laid out below. Even so, these are challenges as seen by rural finance specialists. While these are recognized obstacles to overcome, are they the most important questions? What are the root causes and with which ones can we have the most impact? What is missing? What is not important? Should we focus more on adapting products to fit the constraints or on addressing the constraints? How must the responses to the key issues fit together in order to be effective. Key challenges for rural financial service provision Vulnerability Constraints Systemic Risk – rural incomes, especially among the agriculturalists, are highly susceptible to similar risks at the same time. Weather is the most uncontrollable and often devastating risk but disease and plagues are similarly important. Failures in agriculture affect not only the farmer households and the production and marketing linkages but also the rural non-farm economies that revolve around and depend upon those income flows. Even so, the most problematic is farm credit because of higher risk. Market Risk – especially in developing countries, there both cyclical and seasonal price fluctuations of agricultural commodities, not only due to local production variation but also affected by “outside forces” such as political price and exchange controls, subsidies and globalization. Credit Risk – collateral, especially mortgage, is a missing element in most rural finance hence increasing the risk of the lender. Similarly collateral substitutes may be costly in both financial terms as well as social stigma risk terms as can be the case with peer lending. Other support services and information networks such as credit bureaus are often not available to help lower the risk. For term lending, a financial gap risk between sources and uses of funds poses another risk constraint. Operational Constraints Investment Returns – rural capital revolves slowly, with often one or less frequently two crops per year. For investment capital the returns are even slower and in spite of that are often faced with very low profit margins. Hence the margins for error are much less than for example in commerce or most microfinance which tend to have high returns per unit of funds invested and higher profit levels. Low Investment and Assets – the relative poverty in rural areas causes common crises to become major crises due to the lack of asset “cushion.” Any loss of expected income through sickness or production losses cause significant impact. In compensation, traditional networks and production risk minimization become more important than profit maximization. The small asset base also reduces savings and borrowing capacity, thus constraining economies of scale in the use or provision of services. Geographical Dispersion – rural areas are characterized by low density of population and high dispersion, which is coupled with a relatively low market potential. with a relatively low market potential make access and communication difficult and hence high costs of operation for both production and marketing and for access and delivery of services. Capacity Constraints Infrastructural Capacity – poor communication, pitiful roads, unequipped schools and missing social and health services decrease efficiency of operations, discourage new services and increase the outflow of the most talented and resourceful persons and a reluctance of educated families to live in rural communities. Technical Capacity and Training – a relatively unskilled rural population reduces opportunity for ready access and adaptation to new technologies and employment. The lack of capacity affects not only the productivity and competitiveness in the changing marketplace but also the ability to find trained staff for service provision. Social Exclusion – cultural, linguistic, gender, racial, religious and educational constraints affect market and financial integration. Such barriers reduce production and marketing efficiencies. These are required in order to compete effectively in the marketplace and thereby generate income and levels of assets needed to reduce poverty and vulnerability. HIV/AIDS makes this even worse in many countries. Institutional Capacity – while there is an abundance of organizations in rural areas, the relative capacity is lacking. This includes management and technical capacity, size/economies of scale competitive viability, economic integration and often risk-bearing capacity. Even when urban based institutions have the capacity to reach into rural areas, there is little incentive to do so. An exception to the capacity constraint is at the micro level where the social fabric is able strong and is sufficient for the level of operations undertaken and may also form linkages with intermediaries of higher institutional capacity. Political and Regulatory Constraints Political and Social Interference – loans can be forgiven, savings can be withheld, interest rates can be capped, mortgages can be rendered useless and payments can be suspended due to decree. Even danger is not uncommon; hence uncertainty can become an insurmountable hurdle. Regulatory – regulations and/or a lack of enforcement of them hinder rural as well as urban environments. Land tenure regulations, banking laws, exchange rate manipulation and tax considerations are examples of such constraints that destabilize and/or hinder viability of business and financial operations in rural areas. Examples of responses to these challenges are being discussed, researched and/or tested throughout the world. Today we will learn about progress being made on some of these development fronts. Development is a collaborative effort and each one of our contributions is important. What steps can we take toward that end? Key Challenges Affecting Rural Finance Category of Challenge Constraints and Issues Response Approaches for Rural Development (What are priority issues to address?) Vulnerability Systemic risk Market risk Credit/financial risk Weather Plagues, diseases Prices Production Useable collateral Demand preferences Health and family needs Operations · Profitability/ investment returns · Poverty/lack of assets · Low-density dispersion Low growth potential Low velocity of capital Non-competitive technologies Lack of market integration · Lack or quality of roads and communication · Low efficiencies of business operations · High operating costs Capacity · Infrastructural capacity · Technical skills and training · Social exclusion · Institutional competency · Lack of business investment · Lack of competitive technologies · Lack of roads · Lack of communications · Lack of education · Lack of technical and management skills · Lack of institutional capacity · Lack of social representation(civil society) Political and Regulatory · Political and social interference · Regulations, policies and their application · Political interference · NGO “donation” interference · Cultural and gender constraints · Land tenure laws · Financial regulations · Tax policy Key Challenges Affecting Rural Finance Category of Challenge Constraints and Issues Designing to Fit (What is appropriate for addressing given constraints) Rural Finance Delivery Approaches and Methodologies Appropriate Products and Services Vulnerability · Systemic risk · Market risk · Credit/financial risk · Weather · Plagues, diseases · Prices · Production · Useable collateral · Demand preferences · Health and family needs Key Challenges Affecting Rural Finance Category of Challenge Constraints and Issues Designing to Fit (What is appropriate for addressing given constraints) Rural Finance Delivery Approaches and Methodologies Appropriate Products and Services Operations · Profitability/ investment returns · Poverty/lack of assets · Low-density dispersion · Low growth potential · Low velocity of capital · Non-competitive technologies · Lack of market integration · Lack or quality of roads and communication · Low efficiencies of business operations · High operating costs Key Challenges Affecting Rural Finance Category of Challenge Constraints and Issues Designing to Fit (What is appropriate for addressing given constraints) Rural Finance Delivery Approaches and Methodologies Appropriate Products and Services Capacity · Infrastructural capacity · Technical skills and training · Social exclusion · Institutional competency · Lack of business investment · Lack of competitive technologies · Lack of roads · Lack of communications · Lack of education · Lack of technical and management skills · Lack of institutional capacity · Lack of social representation(civil society) Key Challenges Affecting Rural Finance Category of Challenge Constraints and Issues Designing to Fit (What is appropriate for addressing given constraints) Rural Finance Delivery Approaches and Methodologies Appropriate Products and Services Political and Regulatory · Political and social interference · Regulations, policies and their application · Political interference · NGO “donation” competition · Cultural and gender constraints · Land tenure laws · Financial regulations · Tax policy