Foreign investment, insurance fraud, and ETFs.

March 16, 2012 6:00 AM

The headline on the Yonhap piece was jarring: “N. Korea sets up insurance firm to attract more foreign investment.” The last time “North Korea” and “insurance” met, it was in the context of fraud, in which it was claimed that the North Korean state insurance agency insured assets (such as the contents of a warehouse), purchased re-insurance from European providers, submitted exaggerated claims, and then collected.  A suit in London against the Korea National Insurance Corporation (KNIC) collapsed because the Western firms had contractually agreed that any dispute would be settled in North Korean courts. (The scuttlebutt at the time was that the insurers had not understood the difference between North and South Korea, a trait that they would seem to share with Jeff Sachs, and some statistical agencies around the world.) Blaine Harden’s account for the Washington Post provides the background.

According to Yonhap, “North Korea has established an investment insurance firm recently in what is believed to be an effort to attract more foreign investment by reducing risks stemming from uncertainties in the communist nation…. The North's firm is expected to purchase reinsurance from an international company, the source said. The system is similar to an insurance measure that South Korea's government has been operating to compensate its businesspeople for lost investment in the North….’For foreign investors, this could ease concerns about investment loss risks stemming from uncertainties of North Korea,’ said the source familiar with economic affairs in the communist nation. The source said, however, that it is questionable how effective the measure will be in drawing outside investment.  North Korea has long sought to attract foreign investment to revive its broken economy, but with little success because investors stayed away from one of the most closed nations, which is under international sanctions over its pursuit of nuclear and weapons of mass destruction.”

South Korea provides insurance to its foreign investors (as does the US and many other countries).  So, for example, if the North Koreans did a nuclear test, and the government of South Korea responded by suspending activities at the Kaesong Industrial Complex, a South Korean firm operating at KIC that had bought insurance would be eligible for a payoff. It is sometimes claimed that liability associated with such insurance claims is one of the reasons that the South Korean government appeared loath to close down KIC in the face of North Korean provocations in the recent past.

But what the North Koreans seem to want to do is quite different.  They want to offer insurance to foreign investors against eventualities in North Korea (including presumably international reactions to future provocations) and then purchase reinsurance.  In light of past alleged insurance frauds, moral hazard would appear infinite.

But open to the possibility that I might have misconstrued the Yonhap piece, I asked someone with direct experience in the insurance market. Their response:  “This is [expletive deleted]. North Korea's attempt has nothing to do with South Korean government's insurance which works for the protection by the state of its private investments in North Korea. They are going to get foreign business buy insurance from them, reinsure it to the foreign reinsurers and then if loss occurs, the reinsurers will compensate for that….If this really happens, North Koreans get everything and foreigners lose everything.”

Institutional weakness, specifically fear of expropriation, deters investment in North Korea.  If the North Koreans were serious about attracting investment, they would be better off focusing on strengthening dispute resolution and building up some credibility in that dimension.

Another way of investing in foreign countries is through the financial markets. iShares, the world’s largest provider of exchange traded funds (EFTs), has filed the paperwork with the Security and Exchange Commission to introduce a “human rights” EFT. Burma, Iran, and Sudan would be excluded from investment, but China makes the cut.  Lacking financial markets, North Korea is beyond the universe of possibilities.

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Marcus Noland Senior Research Staff

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