Impact On Investments
Most insurance companies are likely to observe various degrees of decline immediately in solvency ratios depending on their product mix, capital structure, and aggressiveness of investment strategy. Under the updated solvency regime, capital recognition has been tightened and the industry is expected to see a drop in admitted capital in solvency calculations. Specifically, the regulator has changed the recognition of real estate held for investment purposes from fair value to value at cost, while insurers are required to make adequate provisions for impairment and apply timely and appropriate reductions to their capital.
Another key update is the mandatory application of a “look-through” approach in calculating minimum capital to support investment risk. For example, alternative investments, including trust schemes, insurance asset management products, and asset-backed debt schemes, have received strong demand over the past few years due to their higher yields amid the current low interest rate environment. Under the new rules, these will be classified as nonfundamental assets and examined to reveal the underlying assets in order to apply appropriate risk charges accordingly. Investment instruments that are opaque and cannot be broken down into more fundamental asset components will receive more prudent, higher capital charges.
Insurers will also face higher capital requirements arising from long-term equity investments, particularly for investments in non-insurance subsidiaries that give the insurer controllership, which will be 100 per cent fully risk charged. Further, insurers should evaluate their investments in joint ventures and associates to assess any potential impairment and make adequate provisions in a timely manner. We view these changes to be credit positive as they drive a more thorough understanding and accurate assessment of investment risk and seek to improve insurers’ capital management strategies.
Impact On Non-life Insurers
The implementation of C-ROSS Phase II will extend greater support to small- and medium-sized non-life companies in the form of relatively smaller increases in the motor insurance risk charge amid the challenges from the motor comprehensive reform. Motor insurance currently accounts for over half of the non-life segment’s gross premium written. Following the reform that was rolled out in September 2020, motor insurers have recorded dampened revenues and higher-than-expected average combined ratios, while many small- and medium-sized insurers have reported underwriting losses due to continued market competition and a lack of economies of scale.
As such, the regulator has abolished favourable treatment for large insurers based on the premium size on the motor insurance risk base factor; this allows for fairer competition between large and smaller insurers in terms of the capital requirement to support business growth. A growth factor has also been included to better reflect the additional insurance risk from rapid business expansion.
Credit and surety insurance is a segment that has expanded quickly over the past few years before an economic slowdown amid the COVID-19 pandemic brought on a segment-wide contraction in the top-line and deterioration in claims experience. The revised rules under C-ROSS Phase II differentiate between financial and non-financial credit insurance. Calculation details are set out for financial credit insurance based on the outstanding balance on loans as risk exposure instead of balances of premium and reserves when calculating the minimum required capital on insurance risk. This better reflects the actual risk exposure underwritten by the insurance companies.
The CBIRC also seeks to promote sustainable growth in the agricultural insurance segment which plays a strategic role in the country’s agricultural policy. The updated regulatory framework includes discounts on the minimum capital requirement on insurance risks for insurers for whom more than 80 per cent of their agriculture book is policy-oriented business. This is in line with China’s previously announced plans for more agricultural insurance subsidies in additional pilot areas which are expected to continue driving the expansion of the agricultural insurance market.
The revisions from C-ROSS Phase II include lower capital charges of counterparty risk for offshore reinsurance. For instance, reinsurance recoverables due from qualified reinsurers domiciled in Hong Kong or special purpose insurers backing catastrophe bond issuances will receive lower capital charges. This will help to boost Hong Kong’s positioning as a reinsurance hub to offer a wider spectrum of reinsurance experience and services to meet the demands of mainland cedants.
Since the implementation of C-ROSS in 2016, financial reinsurance has been one of the tools that insurers use to alleviate solvency pressure amid fast business expansion. However, the revised regime tightens the requirements on contract terms with an aim to strengthen capital quality. In particular, for reinsurance contracts that can be terminated within three years, the reinsured will not be able to benefit from the capital relief.
Impact On Life Insurers
For life insurers, C-ROSS Phase II will lead to more stringent admitted capital recognition from long-term policies’ expected future profits, as it will be recognised based on different capital tiers according to the remaining terms of the policies. This standardised approach could prevent insurance companies from overstating their capital with more aggressive assumptions in future profit estimation. Asset-liability management is likely to become more important in solvency management as insurers can enjoy reduced capital charges on interest rate risk with an expanded scope of assets that can be used to net interest rate risk exposure. A standardised yield curve derived from a 60-day moving average of government bond yields will also be used for interest rate risk valuation.
In terms of life product risks, the revised regulatory framework will introduce a morbidity development risk factor on critical illness products in view of the deteriorating morbidity trend to guide insurers more accurately in the design and pricing of such types of product.
Updates To Qualitative Requirements
With C-ROSS Phase II, the regulator has revised qualitative requirements under Pillar II of the framework. For example, the integrated risk rating (IRR) assessment has been revised to allow finer gradation for better differentiation and supervision. The revised rules continue to link the Solvency Aligned Risk Management Requirements and Assessment (SARMRA) score with minimal capital calculations to allow top scoring companies to enjoy benefits in their solvency calculation. Further, a new set of rules has been introduced to enhance capital management by requiring insurers to prepare a three-year rolling capital plan annually.
C-ROSS Phase II comprises Solvency Regulatory Rules No. 1–20, with three new rules added from its predecessor in the areas of market and credit risk, capital planning, as well as regulations for Lloyd’s China specifically. The revised rules are effective from 1 January 2022. While most insurers should prepare their 2022 first quarter solvency disclosure according to the new rules, CBIRC is allowing a transitional period for companies that are under pressure to establish transition plans and implement the new rules in phases, with full compliance no later than 2025.
The industry should be able to mitigate the solvency pressure given its current strong solvency. Under C-ROSS Phase I, as of the third quarter of 2021, the comprehensive solvency ratios for life, non-life and reinsurance companies were 231.6 per cent, 285.6 per cent and 307.3 per cent respectively. These are significantly above the minimum requirement of 100 per cent for the comprehensive ratio.
Nonetheless, with the implementation of the revised solvency regime, it will be incumbent upon insurance companies to revisit their business and capital strategies as they seek to better deliver on shareholders’ expected return on capital.
Christie Lee is Senior Director of Analytics at AM Best Asia-Pacific Limited in Hong Kong. AM Best reports on the financial stability of insurers and the insurance industry. It is the oldest and most widely recognised provider of ratings, financial data and news with an exclusive insurance industry focus.
Associate Director, Analytics