31 May 2019
In Hong Kong, local stakeholders tell Vincent Huck how they are getting ready for a risk-based capital regime which will require them to put in place ALM strategies and define their investment risk appetite.
A wave of regulatory changes is sweeping through Asia, with South Korea, China, Taiwan, Japan, Singapore either upgrading, or introducing new, regulatory regimes.
Hong Kong is also moving in that direction, following on an International Monetary Fund recommendation, and is expected to introduce a risk-based capital (RBC) regime by 2021.
Unlike its regional rival Singapore which has had an RBC framework since 2004, Hong Kong doesn’t require insurers to consider risk when investing.
While the current regime requires to hold reserves, but not linked to the assets, Aviva chief investment officer for Asia Jaijit Kumar says most insurers haven’t taken that at face value and most “have asset liability management (ALM) teams and internal considerations”.
The insurance market in Hong Kong can be segmented in three distinct group: the large subsidiary of western groups, the mid-size players most of whom are affiliated to Chinese insurance companies and the small local players.
Western subsidiaries tend to be more conservative in their investments, Sally Yim, Moody’s Investors Service associate managing director for financial institutions in Asia Pacific, says. That’s because the subsidiary will have to follow the investment guidelines of the parent and if the parent is subject to a regulation such as Solvency II, it will usually have more stringent requirements on the asset risk than the local regulation.
“Some of the local players - while it is not one size fits all - have legacy high guarantees policies, like in Taiwan for example, so they need to invest in riskier assets to compensate or meet the cost of liability of the policy.”
Mi Namkung, associate partner for actuarial and insurance advisory services at EY, says: “Apart from the European [subsidiaries] and larger insurers, [Hong Kong’s insurers] don’t seem to have any asset strategy, they don’t have to think about what to do.”
This will change with RBC, Chris Howells, head of insurance solutions Asia Pacific at Schroders, says. “Firms will have to address the impact by adjusting their assets to different degrees.”
But there won’t be any wholesale shift in risk appetite, he continues. “I haven’t seen any intention to pile out of one asset class into the other.”
The same shift was predicted when Solvency II came about, Howells says, but it never happened.
“Hong Kong’s insurers will have to go through a change in mind sets,” Howells says. “There has been a bit of a pursuit of return – I wouldn’t say at all costs – but return being the number one consideration, whereas now return is a very important consideration but they have to think a great deal more about why they are pursuing that return, to what end it will be used, and how that feeds into the liability side of the balance sheet.”
Although some asset class might not be deserted in favour of others, there is a clear consensus that post RBC implementation Hong Kong insurers will be much more conservative on their investment strategy.
The current regime incentivised insurer to invest in long term bonds regardless of credit quality, according Arnaud Mounier, managing director for insurance business development at AllianceBernstein, and former CIO for Axa across Asia ex Japan.
“A lot of insurers invested in BBB bonds which means they will have to recalibrate,” Mounier added.
While he didn’t want to name which insurers would be impacted by this, Insurance Asset Risk understand in conversation with local stakeholders that this is the case for local household name AIA.
Mark Konyn CIO of AIA Group didn’t wish to comment on the level of exposure to BBB bonds.
he said the group was working through the changes brought by RBC. “We have to be conscious of the cost of investment, we want to make sure we deploy our capital effectively.”
In particular AIA is looking at ways of creating capital efficiency using balance sheet management and derivatives overlay, Konyn continued. “I would imagine over the next three to five years we are going to see insurers make greater use of derivatives in order to achieve those levels of capital efficiency.”
David Alexander, head of P&C reinsurance Hong Kong & Taiwan, also believes derivatives in hedging strategies will pick up on the back of the RBC introduction.
Alexander, who is also chairman of the Hong Kong Federation of Insurers’ (HKFI) taskforce on RBC and as such has been directly involved in liaison with the Authority, says it is about the modelling.
“It is better to have derivatives which are backed by a counter party - so you get the ALM benefits but you have to put up some capital for the counter party risk - or is it better to use a slightly less effective method with a stronger counter party?,” he asks. “All these balances will come into play and insurers need to think about them because the amount of money involved is significant.”
These choices could be very important, he continues, in terms of getting a bit of extra yield out by being able to minimise the capital an insurer needs to be able to offer more attractive products to its consumer or to make an extra return for the shareholder, or both.
As no draft rules has been published yet, the only indications so far as to what the final RBC regulation would look like comes from the interaction between the regulator, the Insurance Authority (IA), and the industry through the quantitative impact studies (QIS).
|Suggested capital charges for equities in QIS2|
|Developed market, listed||40%|
|Other equities (incl funds where look-through cannot be applied)||50%|
|Affiliates (if applying no look-through)||20%|
QIS 1 and 2 were completed in 2017 and 2018 respectively.
QIS 2 was received with particular scepticism by insurers and Insurance Asset Risk has learnt that a number of them sent a joint letter to the IA arguing the calibration for some of the investment risk capital charges might disadvantage Hong Kong versus some of its neighbouring markets like Singapore and China.
Indeed, When speaking with professionals in Hong Kong about the current regulatory changes, Singapore is the elephant in the room. Although no one would want to comment on the record, there is a clear sense that the IA is monitoring closely Singapore’s progress in updating its RBC regime. And practitioners seem prone to use Singapore as their trump card in their lobbying efforts to the IA.
|Suggested capital charges for property in QIS2|
|REITs||Classified as equities|
Areas of contention in QIS 2 according to Guy Mills, chief executive officer of Manulife Hong Kong & Macau, are real estate and alternative long duration assets.
QIS 2 proposed charges of 44% for property investments (against 25% under Solvency II) and 22% for own-used property (See box out).
|Suggested capital charges for currency in QIS2|
|USD and MOP net exposure||1%|
|RMB and TWD net exposure||10%|
|Other foreign FX net exposure||20%|
Howells and Namkung also highlight some concerns over the charges for interest rate risk calibration.
However, the main concern was for credit risk, Namkung says. “There aren’t much local sovereign bonds to invest in so the majority of assets are corporates, that can drive the credit risk quite high.”
A lot of the investment turn out to be quite onerous in QIS 2 because there isn’t enough data available which drives volatility up and consequently increases the risk, Namkung continued. “There wasn’t enough refinement of the risk charges and that’s why a lot of companies found it onerous.”
The calibration hardened between QIS 1 and QIS 2, Howells notes. He says this is a common trend across the region.
“The direction of travel seems to be stronger rather than lower capital charges,” Howells says. “That might be the result of the regulators better understanding the calibration of risk, thinking that perhaps the markets are a bit more volatile, or it might the result of them looking other regimes and thinking ours is too low.”
Suggested capital charges for credit spread risk in QIS2 - bps (Spreads to be added to underlying yield curves)
|Rating band||Up to 5 years||Between 5 to 10 years||>10 years|
Note: To calculate the credit spread risk capital requirement for investment assets, a) calculate yield to maturity of each credit risk-sensitive investment, based on current market price and expected cash flows, and b) overlay the additional credit spreads (above) to holdings split by ratings and term-to-maturity. The new yield to maturity is used to discount expected cash flow of holdings, to obtain the stressed market price.
Note 2: Sovereign bonds are exempted from credit spread shock if they are of (1) rating band of 1 or 2, or (2) the issuing jurisdiction is China or Taiwan. Debt securities issued by public sector entities and fully guaranteed by central govts / central banks follow credit rating of sovereigns.
|Rating band||S&P||Moody's||Fitch||AM Best|
|Rating band 1||AAA||Aaa||AAA||aaa|
|Rating band 2||AA+ to AA- / A-1||Aa / P-1||AA / F1||A++ to A+ / aa|
|Rating band 3||A+ to A- / A-2||A / P-2||A / F2||A to A- / a|
|Rating band 4||BBB+ to BBB- / A-3||Baa / P-3||BBB / F3||B++ to B+ / bbb|
|Rating band 5||BB+ to BB-||Ba||BB||B to B- / bb|
|Rating band 6||B+ to B- / B||B / NP||B / B||C++ to C+ / b|
|Rating band 7||Below B- / C and lower||Caa and lower||CCC / C and lower||C / ccc and lower|
Note: Participants are encouraged to consider ratings from at least 2 credit rating agencies. Where a counterparty has multiple ratings from different credit rating agencies, the lowest rating band should be used.
The implementation of RBC will be costly, Namkung says not revealing if EY has put a price on it.
“Companies are already quite busy with IFRS 17 and we haven’t thought about how to leverage between IFRS 17 and RBC,” Namkung says. “We think there will be some leverage they can achieve between these two standards adoptions but so far a lot of companies have to spend a significant among money to be able to produce these number.”
This burden could lead to some consolidation especially amongst the smaller players, Alexander notes.
“There are quite a few really small companies, around 40, with less than $25m of premiums,” he says. “Their parent companies might think it isn’t worth it and they would look to sell or close down the business.”
Namkung agrees but believes for Chinese subsidiaries the parent companies will prefer to inject the capital to operate and hope for growth in the market.
Rise of Unit Link products
With RBC and the need to put in place ALM strategies to have the right assets backing the liabilities, Howells says insurers might look at changing the products they write.
An analysis shared by Mounier who says CIOs might tell the insurance team to stop selling high guarantees liabilities as there is no assets to match those. “And that is one of the reasons you see a higher demand for unit-linked products.”
There are signals that RBC will cause insurers to write more unit-linked business, Mills confirms. “Hong Kong regulator has been quite hostile to unit- linked products for historical reasons,” he explains. “Six or seven years ago, there was a round of mis-selling that caused the banks to stop selling that type of products all together as a lot of additional burden was placed on sale process which caused the market to almost evaporate.”
Less than 10% of new businesses are unit-linked, Mills says. But with RBC products sold will change, he continues. “That is something the regulator acknowledges, so as an industry we are working at ironing some of the impediments.”
While unit-linked might be on the rise and it might solve a few problems in the future, when RBC comes into play insurers will still face some challenges to fill the duration gap between liabilities and assets.
“Changing the type of product that you are writing is fine for new businesses going forward,” Howells summarises. “But it doesn’t solve your historical problem of products written and sold prior to RBC.”
Beyond compliance requirements, when the final rules come out stakeholders will pay particular attention to similarities between Hong Kong’s RBC and China’s C-Ross. Indeed, Hong Kong having been nominated by the central government of China to be the risk management expertise hub of the whole of China, there is an argument for convergence.
But with also with a lot of cross border activities between Hong Kong and the Mainland, there is a question over which rules firms will have to follow, Namkung says. “Companies that have Chinese subsidiaries when they consolidate will they use C-Ross or the Hong Kong RBC? And similarly, for Chinese subsidiary in Hong Kong which regime will they consolidate into?”
Overtime the two might converge, she says.
Similarly Mills says in the very long term there is some logic in converging the two. “It’s not an immediate pressure but it is perhaps on the political agenda.”
Hong Kong will have its own view and will make its own rules, but it will be conscious to stay close to the IAIS standards and principles in terms of what a solvency regime should look like, Alexander believes.
“That allows them to make it easier to gain equivalence to another regime,” he continues. “Already they have got some agreement with the authorities in the mainland to have some equivalence with C-ROSS and there is a four-year program started last year, to have those discussions, move closer together or have a greater understanding and equivalence between the regimes. It doesn't mean they would be the same, but they would have cross border recognition.”
Last year, a first step was already made as it was agreed mainland insurance companies who are reinsuring to a Hong Kong reinsurer, that reinsurer is treated exactly the same as if it ceded within Mainland China in terms of the capital they have to put aside for the credit risk of that reinsurance contract.
Alexander concludes: “The expectation is that over the coming four years they will be more of these types of agreements.”
This is part II of a two-part report. Part I is available here.