China: a candidate for provisional equivalency under Solvency II?
Karel Van Hulle,
10 Dec 2014
China has one of the fastest growing insurance markets in the world. Ping An Insurance (Group) Company of China, Ltd., one of China’s largest insurance operations, was recognised in 2013 as a Global Systemically Important Insurer. It is obvious that such an important insurance market needs high quality insurance supervision.
As is the case in many other countries in the world, the present supervisory regime in China is based on Solvency I1. The lack of risk sensitivity and the absence of an incentive for insurance undertakings to improve their risk management under Solvency I were important reasons for the China Insurance Regulatory Commission (CIRC) to plan a reform to its existing regulatory scheme first introduced in 2003. This reform also aims at liberating capital presently blocked in the insurance industry, so as to provide new impetus for further growth.
CIRC has been following closely developments in other parts of the world for a number of years, with a view to modernise its regulatory regime and to adapt it to the latest developments. During that period, CIRC also joined the Executive Committee and the Technical Committee of the International Association of Insurance Supervisors (IAIS), where it consistently supported the efforts of the IAIS to develop a modern risk-based solvency capital standard.
Before launching its new scheme, CIRC examined carefully the development of solvency regimes at the international level in accordance with the IAIS Insurance Core Principles2, as well as the reforms carried out in the European Union with Solvency II3, the United States of America with the National Association of Insurance Commissioners' (NAIC) Solvency Modernisation Initiative4, Singapore's Risk-Based Capital 25 and Australia's Life and General Insurance Capital Standards6.
CIRC officially launched the China Risk Oriented Solvency System (C-ROSS) in March 2012. A conceptual framework was published in May 2013 and technical standards were developed in several working groups, followed by a quantitative impact study during the course of 2014. The objective is to have the new system enter into force in 2015 subject to a number of transitional arrangements.
Although the texts are not yet final, it is obvious from a reading of the available material that the planned reform is very substantial and that CIRC has looked carefully at similar projects elsewhere in the world. The texts are very detailed and provide for further implementing measures to be issued by CIRC7.
This article describes the main characteristics of C-ROSS, with reference to similar requirements under Solvency II.
CIRC prepared its new solvency regime based on a conceptual framework that describes the overall objectives of the new regime as well as its components. A similar approach was followed in the EU when developing Solvency II.
The objectives of the new regime are very similar to those which form the basis of Solvency II, ie creating a linkage between capital requirements and the risk profile of the undertaking, providing incentives for improved risk management and strengthening the competitiveness of the Chinese insurance industry. Further objectives are to mitigate undesirable or unintended risk exposures and to develop an appropriate model for solvency supervision in an emerging market. Policyholder protection is not specifically addressed, although one can presume that this is included in the objective to mitigate undesirable or unintended risk exposures.
The new solvency regime takes account of the particularities of the Chinese market with much emphasis on an efficient allocation of capital because of the presence of many small and medium-sized operators in China, and on the qualitative aspects of supervision. The latter is in the form of more detailed rules which put the quantitative rules into their proper context.
Three pillar approach
The conceptual framework adopts the three pillar approach also present under Solvency II and in the Insurance Core Principles of the IAIS, although the content of the pillars is not exactly the same.
The first pillar contains the quantitative requirements. Five quantitative requirements are established. They include capital requirements for 1) insurance risk, 2) market risk, 3) credit risk, and 4) macro-prudential risk (described as pro-cyclical risk and systemic risk). There are also provisions for further capital requirement adjustments which might be imposed by CIRC. These are probably similar to a "capital add-on" under Solvency II.
Pillar 1 contains detailed rules on capital and the valuation of assets and liabilities. It also provides for dynamic solvency testing, ie the projection and evaluation of the company’s solvency position for a given period of time under a base scenario and various adverse scenarios. Supervisory action in the case of non-compliance with the quantitative capital requirements is also part of Pillar 1.
Pillar 2 contains the qualitative requirements. It deals extensively with those risks that are difficult to quantify - operational risk, strategic risk, reputational risk and liquidity risk. It includes rules on an integrated risk rating arrived at through a comprehensive evaluation by CIRC of an insurance company's overall solvency position, including both quantifiable and non-quantifiable risks, on risk management, on supervisory inspection and analysis and on supervisory action in the case of non-compliance with the qualitative requirements..
Much attention is paid under Pillar 2 to liquidity risk, for which detailed risk management rules are prescribed in the technical standards. Liquidity risk should be mitigated mainly through qualitative supervisory methods. Current and future liquidity risks are to be monitored both at the solo and group levels under both base and adverse scenarios.
In terms of risk management, Pillar 2's conceptual framework expects insurance companies to regularly self-assess and report to CIRC details of their own risk management capabilities, specific risks and the overall risk profiles of the undertaking. This self-assessment, which appears to be very similar to Solvency II's Own Risk and Solvency Requirement will be an important element in the determination of the integrated risk rating carried out by CIRC.
Pillar 3 deals with market discipline through public disclosure in an annual, as well as quarterly solvency reports. Public disclosure should operate to restrain the risk taking behaviour of insurance companies, complement the supervisory action of CIRC through the disciplinary power of the market, and improve market conditions in terms of competition. Public disclosure should follow the principles of adequacy, timeliness, faithfulness and fairness, as well take into consideration the cost-benefit ratio. There is however, no specific reference in the conceptual framework to supervisory reporting as part of Pillar 3, as is the case under Solvency II.
The conceptual framework points out that the three pillars are interrelated and that the new requirements also apply to groups. Group supervision is important for two reasons. In the first instance, insurance groups can potentially benefit from risk diversification. Furthermore insurance groups have some specific risks - double gearing, opaque organisational structures, conflicts of interest and internal systemic risks - that can be detected by group-level supervision.
In terms of solvency adequacy, the new regime distinguishes between two indicators. One reflects the capital adequacy position of the insurance undertaking and the other is an integrated risk rating which reflects the profile of all risks. The former, looks at quantifiable risks, ie the core solvency adequacy ratio (core capital/minimum capital) and the aggregated solvency adequacy ratio (core capital and supplementary capital/minimum capital). The integrated risk rating also includes the non-quantifiable risks associated with the solvency of the undertaking and which will be used by CIRC to define the degree of supervisory intervention.
The conceptual framework provides definitions for available capital8 and minimum capital9 . Assets and liabilities must in principle be valued on a market consistent basis. Furthermore, the valuation rules should be consistent, objectively reflect the actual situation in China, and fully consider the impact of the valuation on the entire insurance industry.
For the calculation of the quantitative capital requirements, the conceptual framework adopts the Value at Risk (VAR) approach, also followed under Solvency II. The confidence level is not yet defined, although 99.5% is referenced as an example. Companies will have to apply a standard formula. Internal models are not yet allowed, although C-ROSS does indicate that they could be gradually introduced in the future when appropriate. Risk diversification is recognised in the standard formula using a correlation matrix approach. For the standard formula, the approach seems similar to that applied under Solvency II, with separate risk modules that are aggregated using correlation matrices. For each risk module the capital requirement is calculated using either a scenario method or a risk factor method.
A number of technical standards, called Regulatory Rules Governing Solvency of Insurance Companies have been developed which describe in more detail the approach set out in the conceptual framework.
Actual capital, equivalent to Solvency II's "basic own funds”, is defined as the excess of admissible assets10 over admissible liabilities11. The capital is divided between tier 1 and tier 2 core capital and tier 1 and tier 2 supplementary, also referred to as ancillary capital. Supplementary capital cannot exceed 100% of core capital. Tier 2 core capital may not exceed 30% of core capital and tier 2 supplementary capital may not exceed 25% of core capital.
Minimum capital12 is the amount of capital which an insurance undertaking must have in order to meet the adverse impact of various risks, such as market risk, credit risk, insurance risk and control risk, on the undertaking’s solvency position. Specific standards deal with the calculation of the minimum capital for: 1) market risk; 2) credit risk; 3) insurance risk for life insurance and non-life insurance undertakings; 4) non-life insurance business of reinsurance companies; and, 5) control risk. The quantifiable risks are calibrated and assessed under a VAR approach.
Risk management requirements and assessment
In order to assess the solvency risk and capital adequacy of an insurance company, a distinction is made between inherent risk, comprising both the quantifiable and non-quantifiable risks mentioned above, and control risk, which is defined in the conceptual framework as the risk that inherent risk cannot be timely identified and controlled due to defective or ineffective internal management and control of an insurance undertaking.
Quantitative inherent risk is measured according to capital requirements and control risk is identified through an assessment of solvency risk management. CIRC will assess the management of solvency risk on a regular basis, verify the control risk level, and then determine the minimum control risk capital based upon an assessment of the quality of solvency risk management. The assessment results for solvency risk management are an important element of the comprehensive risk rating applied to a concern by CIRC.
In order to assess solvency risk management, a distinction is made between two classes of insurance companies based upon their development stage, size and risk features13. This approach is similar to the application of the proportionality principle under Solvency II. The rules describe in detail how risk management must be organised and carried out. Each insurance company is expected to appoint a senior manager as the chief risk officer in charge of risk management.
Under the conceptual framework, Class I companies must establish an independent risk management department with at least ten experts in risk management, whilst Class II companies must establish a risk management department according to the company’s actual needs. The risk management department is in the lead to manage solvency risk, however the internal audit department must periodically assess and inspect the operation of the risk management department. The rules include a list of risk management indicators and impose the development of a risk management training plan.
By way of example, a Class I life insurance company must establish an economic capital model for the measurement of economic capital. A Class II life insurance company however may choose whether to measure economic capital or not according to its actual needs.
Specific rules describe how the risk management function should deal with the various types of risks. They include insurance risk (including risks related to product development), market risk, credit risk, operational risk, strategic risk and reputational risk. The latter specifically refers to "the risk of losses caused by the negative comments of stakeholders of an insurance company towards the company due to the latter’s operation, management or external events”.
A 100-point system will be adopted for the assessment of solvency risk management which will be used by CIRC to score insurance undertakings based on assessment criteria. The assessment may be entrusted by CIRC to an independent third party agency, which could be either an accounting or a consulting firm. The resulting assessment report on solvency risk management must be signed by an expert, who could be a Chinese certified public accountant, a Chinese actuary, a generally recognised international actuary or another professional as recognised by CIRC.
The rules include a formula for the assessment of control risk. If the assessment result is below 80 points, CIRC might require the company to upgrade its solvency risk management system. The assessment results are valid for 12 months from the reporting date of the assessment results.
Classified regulation (comprehensive risk rating)
Based upon an assessment of quantifiable and non-quantifiable risks, CIRC classifies insurance companies into four specific classes for the purpose of regulation and the application of different regulatory policies and measures. For the comprehensive risk rating, the technical standards set specific factors for the assessment of the non-quantifiable risks which are operational risk, strategic risk, reputational risk and liquidity risk. Based on the assessment of these risks, CIRC will rate the solvency risk of insurance companies taking into account their solvency adequacy ratio reflecting the quantifiable risks.
For the classified regulation, ie comprehensive risk rating, a 100-point system will be adopted, whereby 40 points are allocated to the assessment of quantifiable risks and 60 points to the assessment of non-quantifiable risks. The assessment of quantifiable risks is based upon the situation of the core solvency adequacy ratio and the overall solvency adequacy ratio as well as on daily regulatory information. A number of points are allocated to companies based upon whether their core solvency adequacy ratio and/or their overall solvency adequacy ratio meets or has met over a number of quarters regulatory requirements.
The assessment of non-quantifiable risks is based upon the weighted average of the assessment results for various risks and branch risks as well as on daily regulatory information. The rules set out specific risk weights for the various risks, for instance 50% for operational risk with a total score of 30 points, as well as assessment criteria. Different regulatory measures will be taken depending on the classification of the companies following the classified regulatory assessment results.
Liquitdity risk management
C-ROSS contains detailed provisions on liquidity risk management15 and insurance companies are required to prepare an effective liquidity emergency plan. As part of their liquidity risk management, insurance companies must conduct at least on an annual basis a cash flow stress test in order to assess liquidity risk to strengthen cash flow management and prevent liquidity risk under a basic scenario as well as under various stress scenarios. The results of these tests must be disclosed in the annual solvency report.
The technical standards define regulatory indicators for liquidity risk which include:
- The liquidity coverage ratio to monitor the liquidity level of an insurance company under stress scenarios in the next 30 days;
- The liquidity ratio to monitor the liquidity level of an insurance company in the next year;
- The liquidity ratio of investment assets to monitor the liquidity of investment assets of an insurance company; and
- The consolidated liquidity ratio to monitor an insurance company's liquidity risk in the next 30 days and next year, based on a consideration of the liquidity of all assets and liabilities of the company.
CIRC will, through a combination of off-site supervision and on-site inspection, assess the effectiveness of an insurance company’s liquidity risk profile and liquidity risk management.
Liquidity information must be disclosed in the annual solvency report, as well in the quarterly solvency report. Furthermore insurance companies must, upon discovering a liquidity risk, report it within two working days after the date of discovery to CIRC. CIRC might impose regulatory measures on companies whose risk indicators do not meet the requirements.
With the implementation of C-ROSS, China will become part of the increasing number of countries in the world that have opted in favour of the introduction of a risk-based solvency capital regime. Considerable attention is paid to the supervision and monitoring of unquantifiable risks, which are referred to as "risks that are hard to quantify" and to risk management. Rather than making an outright distinction between a Minimum Capital Requirement and a Solvency Capital Requirement, as is the case under Solvency II, the Chinese regime is more granular making a distinction between different classes of insurance undertakings based upon the quality of their risk management.
It is interesting to note the absence of detailed rules on governance and on supervisory reporting. Governance is mainly dealt with in terms of risk management. Not much is said about other key functions, such as the actuarial, internal control and internal audit. The conceptual framework however makes clear that the board of directors of the undertaking is in charge of the governance of the business. Supervisory reporting is for the moment dealt with on a piecemeal basis. Further detailed rules to be issued by CIRC will probably address this in a more coherent manner.
It is obvious that the new regime will have a profound impact on the insurance industry. It will also have a large effect on CIRC. C-ROSS attempts to formalise as much as possible the actions that can be undertaken under different circumstances. However, the greater emphasis under C-ROSS on qualitative aspects will require considerable investment on behalf of CIRC in high quality staff in order to make the regime operational and effective.
It is still unclear when the new regime will become mandatory. Further measures must still be issued by CIRC, which include sections on the supervision of groups and financial conglomerates. Although 2015 has been mentioned as the first year of application, there still is some work to do before the regime be implemented. However, with the introduction of its new solvency regime, China is clearly a candidate for provisional equivalency under Solvency II.
1. Solvency I is the name given to 2002 changes to the European Union's insurer solvency regime, originally put in place in the 1970s.
2. The IAIS set out principles that are fundamental to effective insurance supervision. Principles identify areas in which the insurance supervisor should have authority or control and that form the basis on which standards are developed. http://www.iaisweb.org/Principles-39
3. See https://eiopa.europa.eu/en/activities/insurance/solvency-ii/index.html
4. See http://www.naic.org/index_smi.htm
5. See http://www.mas.gov.sg/~/media/resource/publications/consult_papers/2014/Consultation%20Paper_RBC%202_2014.pdf
6. See http://www.apra.gov.au/mediareleases/pages/12_25.aspx
7. All references and quotations in this paper are to the second draft of the China Risk Oriented Solvency System Conceptual Framework, September 2014.
8. Available capital is defined as admitted assets minus admitted liabilities.
9. Minimum capital is defined as the amount of capital required to cover the adverse impact on the company’s solvency arising from insurance risk, market risk, credit risk, as well as market risk, credit risk, insurance risk, operational risk, strategic risk, reputational risk, liquidity risk and off-balance sheet risk.
10. Admissible assets are defined as assets which can be disposed of without restriction so that they can be used to pay policyholders, such as cash and cash equivalent instruments as well as investment assets, fixed assets, receivables and contingent capital. Non-admissible assets include intangibles, goodwill and deferred tax assets.
11. Admissible liabilities are defined as those liabilities which must be paid under either going-concern or gone-concern circumstances. They include technical provisions and other financial liabilities. Non-admissible liabilities are those liabilities that are specified by the CIRC. Special rules apply to the recognition of subordinated liabilities.
12. The minimum capital is comprised of the minimum capital required for quantitative and control risks, the supplementary capital required as a countercyclical buffer, additional capital requirements for domestic systemically important insurers, additional capital requirements for international systemically important insurers, and other supplementary capital.
13. Article 6 of the Regulatory Rules governing Solvency of Insurance Companies No. 7: Solvency Risk Management Requirements and Assessment (Exposure Draft) provides that insurance companies which meet any two conditions as shown below shall be classified into Class I insurance companies, and other insurance companies shall be classified into Class II:
i. The companies have been incorporated for more than 5 years;
ii. Actual premium of property insurance companies and reinsurance companies has exceeded CNY 5 billion and their total assets have reached more than CNY 20 billion; and actual premium of life insurance companies has exceeded CNY 20 billion and their total assets have reached more than CNY 30 million. Actual premium means the premium collected by an insurance company from policy holders according to relevant insurance contract;
iii. The number of provincial branches has exceeded 15.
14. For branches a similar classification is made based upon operational risk and reputational risk.
15. Liquidity risk is defined as the risk that an insurance company is unable to obtain sufficient funds on a timely basis or at a reasonable cost to pay due debts or perform other payment obligations.