Risk-oriented solvency system signals a new chapter in China's insurance industry
10 Dec 2014
China's insurance industry is on the verge of making a great leap. The country's insurance regulator is likely to finalize its China Risk-Oriented Solvency System within a month. Following that is likely to be a final round of testing. Standard & Poor's Ratings Services expects the solvency framework to become more sophisticated and comprehensive, as well as aligned with global regulatory standards after the regulator has fully implemented the system in 2016.
China's insurance market has grown exponentially over the past two decades (about 12 xs since 2000). The last significant wave of reform came via the overseas listing of state-owned companies (eg China Life Insurance Co. Ltd. in 2003), which underpinned the government's willingness to make the sector more commercially oriented with a focus on shareholders' value. The industry's strong growth has created a few Chinese insurers that are among the largest globally, in terms of premiums in the life, nonlife and reinsurance sectors, such as China Life Insurance Co. Ltd., China Reinsurance Corporate Group, and People of Insurance Company of China. China's Ping An group is Asia's only "global systematically important insurer" and one of nine around the world.
- The implementation of the China Risk Oriented Solvency System is positive for the insurance industry and individual insurers' credit profile.
- The new system's requirements on enhanced risk management, risk-based assessment of solvency, and increasing transparency should help improve rating factors.
- The proposed change is likely to polarize the sector between strong and weak companies through increasing transparency standard and market scrutiny, but that is likely to be beneficial.
Although the insurance industry and its regulator are moving forward in regulatory and market sophistication by strengthening its solvency regime, China faces some challenges ahead still. We believe the transition from a market focused on volume growth to one that values more technical and risk-based underwriting will take time. The reasons for this include intense competition, increasing operation risks and catastrophe exposure, as well as uncertainties from volatile investment markets, economic slowdown, and an aging population. The industry will also need more experienced and qualified personnel and managers, and China has a shortage of them. Nevertheless, Standard & Poor's believes the long-term implications are positive for the credit profile of insurers, especially for the major players.
Risk-based solvency framework will be beneficial - at least for the larger ones
China's new solvency regime will be comparable to the global proposed regulatory systems such as Europe's Solvency II1 and the Insurance Core Principle (ICP)2 by the International Association of Insurance Supervisors (IAIS). The China Insurance Regulatory Commission (CIRC) has been in extensive discussions with industry participants globally in recent years, indicating its openness and willingness to align its regulatory standards with those internationally. Although this move is unprecedented, we believe CIRC will have some China-specific qualities in C-ROSS.
C-ROSS will emphasize risk management control, transparency, and oversight in addition to the quantitative risk assessment. The industry expects implementation to begin in 2015 with completion in 2016 - the same timetable as the European Solvency II's implementation. However, its promulgation period is much shorter than the European Solvency II process. In our view, that reflects the efficiency in a country with a single regulator, in contrast to various European countries and multi-states in the US involved in the process there.
CIRC has released the consultation papers for C-ROSS, covering topics such as the minimum capital requirement, risk management, disclosure, and the details for quantifying market, credit, counterparty risks. The requests also covered qualitative elements such as operational, strategic, reputational, and liquidity risks.
Standard & Poor's believes C-ROSS will strengthen Chinese insurers and help the industry to grow sustainably with less emphasis on volume growth. With stronger risk management oversight, clearly articulated risk appetite and tolerance, and the tools for assessing risk management capability, insurers' earnings are likely to be less volatile as the industry continues to grow firmly over the next decade.
The proposed solvency framework is considered comprehensive, embracing the spectrum of an insurer's risk profile. The framework is also more aligned with the factors we consider in our credit assessments on insurers. The Chinese insurers we rate have been improving their governance and risk management control over the past decade, especially in the past four or five years, but their risk culture, appetite, and tolerance have yet to develop to international standards.
The three pillars in the framework
China's new solvency framework has three core aspects:
- Capital measurement through a quantitative assessment on risks, required capital, assets, and liabilities.
- A qualitative assessment on unquantifiable risks, such as operational, strategic, reputational, and liquidity, as well as enterprise risk management (ERM).
- A market discipline mechanism encouraging transparency and better disclosure through the involvement of rating agencies, analysts, investors, and the media.
In addition, CIRC aims to strengthen its monitoring by requiring insurers to have their own risk management assessments. Using that assessment, the regulator would assign a score for its Solvency Aligned Risk Management Requirement and Assessment (SARMRA) to the insurer to identify the areas for improvement.
Table: C-ROSS Framework
Enhanced transparency will improve market discipline
The requirement for stronger disclosure and transparency, combined with market scrutiny from rating agencies, analysts, and intermediaries, is likely to help shape market discipline. The change will also contribute positively to a few factors in our credit profile assessment for insurers in China, including lower industry risks via a stronger regulatory framework and oversight, potentially better and less volatile performance in insurers, holistic ERM implementation, and more risk-based capital management.
Another important change would be the company's attitude toward its business and operations; we believe insurers will view themselves through a risk management lens. They are therefore likely to become more economically viable and profit oriented instead of focusing on price competition and volume. Insurers will also have to appoint a chief risk officer reporting directly to the board and submitting regulatory reports, which should support implementation of the risk management framework.
Capital management could become more efficient and sound
Insurers with stronger risk management capability are likely to have stronger capital efficiency and performance as well as lower volatility in operating performance and hence capitalization. We expect the capital efficiency for Chinese insurers will increase. In addition to local regulatory requirements, the industry will be subjected to global requirements because of its linkage to the group of global systemically important insurers and the Internationally Active Insurance Group. We believe capital management in the industry will strengthen, given the local requirements on risk management and capital buffer for the proposed domestic systemically important insurers and the insurers' better understanding of their own risk profiles. However, the sector came from a relatively low sophistication, especially for the newer and smaller players. We therefore believe these players have more catching up in enhancing their capital efficiency.
For the pillar on capital measurement, an insurer's minimum capital needs to match its risk profile, which is based on the risk factors stemming from its assets and liabilities. The recognized capital types for the solvency assessment under the new system have been defined. We observed that the proposed risk charges framework is aligned with the global risk-based framework. However, the individual risks factors or charges are largely China-specific and, hence, the level of charges are not comparable with those in other countries.
The inconsistent charges stem from differences in legal systems, products risks, investment assets, etc. For example, China's motor risk charge is proposed at 8.19%-9.3%, which is lower than the proposed property insurance risk charges between 29.1% and 40.2%. We expect the risk charges proposed to change the behaviour of insurers on how they will retain and manage their risks. They may retain more motor risks but cede out more property insurance risks to the reinsurers. Similarly, some of the risk charges on invested assets, such as trust fund programs, are likely to be low enough to encourage more investments.
According to media reports, market observers believe a significant amount of capital could be released when the new solvency regime is implemented. If that scenario materializes, Standard & Poor's expects capital adequacy for some insurers to decline for a few years post implementation because we expect the market's capital shortfall to remain significant at a 'BBB' confidence level, according to our own risk-based assessment (estimated at about CNY 200 billion in a 2013 assessment for 2014 and 2015).
While ERM implementation in China would improve significantly over the next few years, as required in the new regime, we don't think the stronger ERM capability would offset the capital reduced. However, we are still uncertain if capital will be released after C-ROSS is implemented because the details have not been finalized.
The path won't be a hop, skip, and jump
China's tighter risk management controls aren't without possible setbacks. Larger insurers (in Category I) are required to make the changes under the regulations, and that could affect their performance. Smaller players (in Category II) may have faster growth than the larger players because risk oversight and the mechanism required by the proposed regulations may be lower or optional. Under C-ROSS, Category I insurers are the bigger players (non-life and life insurers with more than CNY 5 billion and CNY 20 billion of premiums, respectively), while the others are grouped in Category II.
CIRC will allow more time for the weaker players to adjust to the onerous regulatory requirements. For example, the proposed paper suggests an exemption for smaller insurers from having a chief risk officer. In our view, this selective application of requirements could polarize the strong and weak or the large and small players, possibly leading to consolidation or exit of weaker or less competitive companies, especially if they could not achieve an adequate solvency requirement.
On the other hand, we expect the larger insurers to significantly boost their risk management capability and awareness over the next two to three years. We also believe they would be better equipped to adapt to the changes. However, China's insurance industry faces a shortage of experienced and qualified professionals. The industry has to urgently find those with the necessary skills to ensure the quality of the implementation.
Brighter future for the industry long term
The unprecedented and significant change in China's insurance regulations to be more aligned with international standards has set the industry on the right path. The industry is likely to have stronger fundamentals for sustainable and profitable growth. However, the path is not straightforward. The industry came from a low degree of sophistication, and it will face challenges before full implementation of C-ROSS. Data infrastructure, the country's availability of data, the shortage of experienced senior managers and qualified technical staff in overseeing risks and operations are some of the immediate issues standing in the way of implementation. If industry players can clear these obstacles along the runway, making that great leap will be easier.
Under Standard & Poor's policies, only a Rating Committee can determine a Credit Rating Action (including a Credit Rating change, affirmation or withdrawal, Rating Outlook change, or CreditWatch action). This commentary and its subject matter have not been the subject of Rating Committee action and should not be interpreted as a change to, or affirmation of, a Credit Rating or Rating Outlook.
1. See https://eiopa.europa.eu/en/activities/insurance/solvency-ii/index.html
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
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