COVER STORY: GAIN OR PAIN
By Paula L. Green
In their headlong rush to set up operations in the fast-growing emerging markets, many Western companies are failing to take full account of the risks involved. The consequences could be painful.
With their global companies sitting on billions of dollars that shareholders and board members eagerly want invested in emerging markets as developed economies stagnate, corporate risk executives are warily picking their way through a minefield of risks both old and new. Yet whether age-old worries, like the possibility of government takeover of assets and lax enforcement of employee safety standards, or newer hazards such as the leaking of corporate secrets over the Internet, the risks lurking in these less-developed markets are being exacerbated by political uncertainty worldwide and many countries' ongoing fiscal crises.
As the world stabilizes in the wake of the global financial crisis, global businesses—and those desperate to claim a slice of the fast-growing emerging markets pie—are navigating an environment of unprecedented uncertainty. Though the economic playing field may have leveled off over the past several decades, the absence of a clear global political leader has produced more uncertainty for business executives operating in these developing countries. "Who do you take your cues from today," asks Miles Everson, a partner and leader of PricewaterhouseCoopers' global governance, risk and compliance services practice. Mixed with the overall economic uncertainty and the speed with which news of political and economic events and decisions ricochet electronically around the world, executives need rapid response plans nailed down more than ever. The potentially lightening-quick loss of customers and market share, along with the tarnishing of a reputation and brand, are real risks that companies have to manage.
"If you have a call center operation overseas and one of your employees mistakenly swears while still on the phone with a customer, a report of that incident could be around the world in minutes," says Everson.
Chris Lajtha, a former corporate risk officer who now runs his own firm, Adageo, out of Paris, agrees that executives frequently are not mindful enough of the risks emanating from a modern technology that lets huge volumes of data move around the globe in seconds. "Anyone with access to the Internet has the ability to spread information, whether true or false, very rapidly around the world via email, blogs and social networks," says Lajtha, who went solo in 2004 after working for more than 20 years with Schlumberger, a global oilfield services company.
Lajtha also points to the new technological risks resulting from employees who can, for example, download data onto mobile phones and walk out the door with information commercially useful to a company's competitors. Risk officers and information technology executives need to work together to lay down adequate security measures as they ramp up employee training. "Employees should be recognized as great ambassadors for a company. Many leave company premises each day with commercially valuable information in their heads. They hold the company's value and reputation in their care," he says.
The proper training and retention of employees in emerging markets is another crucial piece of the puzzle facing the modern multinational, experts say. In hot markets such as China and India, the salary discrepancies between international and national employees are shrinking as national employees realize they can demand higher salaries with their top-notch educations, experience and expertise in the local market. Increasingly, if they don't get the pay they're looking for, they walk. "Companies have to focus on talent retention," says Varun Bedi, co-chief investment officer at Tenex Capital Management, an investment management firm based in New York City that focuses on operational turnarounds. He notes that the rule of thumb is that it takes one year for a manager to truly to learn his or her job. That makes losing local talent to competitors an expensive—and disruptive—prospect.
Local Talent, Global Benefits
Failing to employ or retain enough locals in senior positions can put a company at a competitive disadvantage. Local talent employed at the country manager level can help multinationals negotiate the intricacies of doing business in emerging markets and avoid discriminatory action by local authorities. "You want to be seen as being as local as possible," adds Bedi, a native of India whose work with a family import-export company included business in India and other emerging markets. One of the key benefits, he adds, is that local employees can provide a business with local insight, information and relationships.
Local managers can also help minimize the risks of indiscriminate government interference in their operations. Shifts in legislative and regulatory climates can quickly slash the value of a foreign company's investments. "Naked seizure is less of a risk than in the past. The higher risk is the change of regulations," Bedi comments.
Alfred Bergbauer, northeast zone leader for insurer Marsh's multinational client service practice, says Russia provides a perfect example of this potential setback. Late last year Russia's health and social development ministry tweaked the rules governing foreign pharmaceutical firms in a way that may prevent their engaging in phase-one clinical trials. The impact could be severe, as Russia is a top-20 global clinical training destination, and foreign firms were ill prepared to deal with the rule changes. "These legislative changes can come down the pike without a warning," Bergbauer says.
A new Brazilian insurance law, also enacted late last year, could limit foreign insurers' capacity to transact business in Brazil, one of the world's hottest emerging markets with expected annual growth of 7.5% in 2010 and 4.1% in 2011. "The law's exact intent is not yet known, and the industry is seeking clarification from the Brazilian insurance regulators," Bergbauer says, adding that Brazil appears to be departing from a trend toward insurance market liberalization.
One downside of the dependence on local partners to transact business in an emerging market is the risk of encroachment of a firm's intellectual property rights on its products. This risk has only increased as technology permeates more and more sectors, from oil-service to aerospace to manufacturing. "Too many times, companies are so attracted to an emerging market that they are ignoring some of the real risks," says Bedi. "Many executives are looking at these markets through rose-colored glasses."
Bergbauer of Marsh agrees and has even seen companies venture into sectors outside their expertise, such as an oil-services company selling consumer products, just to gain access to a hot emerging market. "Sometimes the C-suite is not grounded in reality when going into these markets," he says. "Business people in these markets are astute, urbane, educated and geared up to relieve you of your wealth."
Igor Mikhaylov, head of the risk management division at Russian telecommunications company Mobile TeleSystems in Moscow, doesn't believe investors are necessarily too bullish on emerging markets. Managers and their boards should assess their risk appetite and find the right balance between high risks and high rewards. "The board defines risk appetite," Mikhaylov says. "It is a process of standard, strategic decision-making that depends on the particular risk, its severity, the knowledge of information, the ability to influence or mitigate risk, and cost/effect ratios."
A Tangled Web
It is in the area of insurance that companies new to the international—or emerging markets—scene can get into the most trouble. The entire insurance-buying exercise for a multinational doing business in a plethora of countries with different insurance regulations and insurance tax regimes has always required fortitude and diligence. Despite the fact that globalization is hardly a new trend, no simple packaged solution exists that would enable a company to enter any market it chose. And while a global insurance program can be coordinated by a single broker and underwritten by one of the giant international insurers, an insurance company cannot underwrite a risk that does not comply with local laws. These myriad laws and regulations govern everything from taxes to compensation requirements to liability coverage to terrorism.
"Sometimes the C-suite is not grounded in reality when going into these markets"
"Business people in these markets are astute, urbane, educated and geared up to relieve you of your wealth" – Alfred Bergbauer, Marsh
The laws also apply to the tricky world of non-admitted and admitted insurance. A global insurer based in the financial district of New York City, for example, can cover the overseas auto manufacturing plant of his multinational client even though this insurer is not licensed or registered—hence the use of the term non-admitted—to do business in the emerging market country where the factory is turning out cars. Though its name may suggest otherwise, non-admitted insurance can be legally used by a multinational when its use is allowed by insurance regulators in the country where the property is located, or the risk lies.
Bergbauer: "Legislative changes can come down the pike without warning"
Unfortunately for companies looking to expand into new markets, the number of countries allowing the use of non-admitted insurance has declined over the past five years, says Clive Hassett, director of major risk operations for ACE European Group in London. "Irrespective of whether non-admitted insurance is allowed, you have to be sure how the policy will respond in a certain country," says Hassett. The property coverage in a firm's master insurance policy, for example, may have a $200 million limit and use local policies that provide a $50 million property limit for each of 50 subsidiaries around the world, with the master policy containing a difference in limit endorsement. "But if a fire destroyed a factory in an overseas market that was critical to your business, and it would cost $100 million to rebuild, you would suffer unless the endorsement correctly spelled this out and local regulations had been complied with."
If that plant was in Indonesia, for example, which does not allow the use of non-admitted insurance, the company would have to be sure to have its coverage underwritten by an Indonesian insurer.
As the emerging markets become more sophisticated, they are also getting stricter about ensuring that international entrants play by the rules, says Hassett.
As if choosing and managing insurance weren't complex enough for the fledgling multinational, it also illustrates some of the daunting pitfalls that await companies in another key area: taxation. Global insurance contracts are effectively a complex contingent-balance-sheet asset. Depending on the structure of its global insurance program, a multinational could suffer double taxation if it is taxed on the claims payments of its home country insurance policy and then taxed in the foreign jurisdiction where a subsidiary has suffered a loss. "Understanding exactly how your insurance program will operate in the event of a loss should be an integral part of an overall corporate risk management, cash flow management and balance sheet protection plan," Bergbauer says.
And it's not just tax collectors at the headquarters country who bear watching. The fiscal crisis has prompted governments in both emerging and developed markets to boost the annual premium tax slapped on corporate insurance premiums. Bulgaria, for example, just introduced a premium tax of 2%, the United Kingdom upped its premium tax from 5% to 6% in January, and the Netherlands will hike its insurance tax rate from 7.5% to 9.7% on March 1.
Fast-growing emerging markets are a magnet for Western companies, but they can present unforeseen and unfamiliar risks
Hassett adds that greater enforcement of more extensive and stringent anti-money-laundering laws could also create headaches for corporate financial officers as legitimate insurance reimbursements are transferred from headquarters to a subsidiary in an emerging market to rebuild, for example, a mining operation damaged by an earthquake.
And while most businesses have incorporated strategies to deal with the political risks posed by terrorism, they may not realize how governments' greater use of economic sanctions to thwart terrorists can impact their business.
Paul L. Davidson, chairman and chief executive officer of the financial solutions division at Willis Group in London, sees the application of economic sanctions as part of the increased regulatory burden that corporate financial and risk officers face when doing business across borders. "Fifteen to 20 years ago, economic sanctions were a blunt instrument and easier to understand. The level of complexity is higher since 9/11, and the sanctions are more sophisticated," he says. Multinationals trading goods, whether military hardware or consumer products, as well as their insurers have to sort through intricate regulations to avoid violating sanctions.
Crisis Shockwaves Reverberate
Although the world economy is past the freefall it endured in late 2008, many countries are still in the vise of a fiscal crisis, and businesses need to keep a keen eye on the public policy changes under debate on both sides of the trading and investment relationship. "A small change in economic policy of a developed country can create greater volatility around the performance of an emerging market," says Everson of Pricewaterhouse-Coopers. For example, the US government is debating the economic benefits of borrowing money to pay for the national debt. "If the dollar gets devalued, then the products produced by these developing markets may become relatively more expensive," he adds.
The growing public debt in many countries—particularly in the developed world—is another risk to watch carefully. "You need to see austerity measures, such as the slashing of pensions plans, before they happen. They can cause the value of a currency to fluctuate more."
Despite the risks, emerging markets offer an opportunity for companies ready to shape new approaches tailored individually to new consumers in new markets, says Jorge Luzzi, group risk managing director for tiremaker Pir¬elli in Milan. "It is almost impossible to do business in emerging markets just by applying a remote-control strategy," says Luzzi, who is vice president of the Federation of European Risk Management Associations.
Sim Segal, founder and president of enterprise risk management specialist SimErgy Consulting in New York, says an investment in emerging markets can bolster a firm's resistance to risks by contributing businesses that move in the opposite direction on economic growth, currencies or labor costs. When a company fully understands its current enterprise risk exposure and can accurately quantify it, emerging markets can look quite attractive. "It is not the level of risk itself that is a problem for businesses entering emerging markets," Segal says, "but more the level to which management understands the risks and how they interact with the risks generated by their other businesses."