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China Risk Oriented Solvency System*:

China Risk Oriented Solvency System*: A Comparative Assessment and a Study of its Impacts on the Life Insurance Industry (based on two forthcoming papers published in The Geneva Papers on Risk and Insurance ) Derrick W. H. FUNG, Hang Seng managem ent College

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China Risk Oriented Solvency System*:

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  1. China Risk Oriented Solvency System*: A Comparative Assessment and a Study of its Impacts on the Life Insurance Industry (based on two forthcoming papers published in The Geneva Papers on Risk and Insurance) Derrick W. H. FUNG, Hang Seng management College David G. D. JOU, Taikang Life Insurance Company Ai Ju SHAO, Ming Chuan University Jason J. H. YEH, The Chinese University of Hong Kong http://rdcu.be/rcCp（C-ROSS: A Comparative Assessment with Other Risk-Based Supervisory Frameworks） http://rdcu.be/vYMr（The Implications of the China Risk-Oriented Solvency System on the Life Insurance Market） * C-ROSS Introductionby Blanca Qin (FCAS) of Guy Carpenter

  2. Insurance Industry in China • In 2016, insurance companies in China wrote USD466 billion in premiums, with life insurance accounting for 56.2% and non-life for 43.8%. Life insurance recorded a 24.6% increase and non-life insurance increased by 15.8%. • On average 4.15% of GDP or US$337 per capita was spent on insurance in China. This is much lower than the average of 8.00% of GDP or US$3,505 per capital in the advanced markets. Source: Swiss Re, Sigma, No.3/2017

  3. Total premium volume in USD in 2016 Premium volume Change (in %)Share of world (in millions of USD) nominal market 2016 Ranking Economy 2016(in USD) (in %) 1 United States $1,352,385 2.6% 28.58% 2 Japan 471,295 5.1 9.96 3 PR China 466,131 20.6 9.85 4 United Kingdom 304,208 -7.5 6.43 5 France 237,644 -0.2 5.02 6 Germany 215,021 0.2 4.54 7 South Korea 170,862 3.6 3.61 8 Italy 162,383 -3.2 3.43 9 Canada 114,523 0.1 2.42 10 Taiwan 101,445 5.7 2.14 18 Hong Kong 56,448 23.4 1.19 24-3

  4. Life insurance premium volume in USDin 2016 Premium volume Change (in %)Share of world (in millions of USD) nominal market 2016 Ranking Economy 2016 (in USD) (in %) 1 United States $558,847 0.7% 21.35% 2 Japan 354,053 3.9 13.53 3 PR China 262,616 24.6 10.03 4 United Kingdom 199,369 -8.7 7.62 5 France152,817 -0.9 5.84 6 Italy 122,438 -4.0 4.68 7 South Korea 104,169 2.8 3.98 8 Germany 94,661 -1.8 3.62 9 Taiwan 84,493 6.1 3.23 10 India 61,817 10.3 2.36 14 Hong Kong 51,940 25.9 1.98 24-4

  5. Non-life insurance premium volume in USD in 2016 Premium volume Change (in %) Share of world (in millions of USD) nominal market 2016 Ranking Economy 2016 (in USD) (in %) 1 United States $793,538 3.9% 37.52% 2 PR China 203,515 15.8 9.62 3 Germany 120,360 1.9 5.69 4 Japan 117,243 8.8 5.54 5 United Kingdom 104,839 -5.1 4.96 6France 84,826 1.2 4.01 7 South Korea66,694 4.8 3.15 8 Canada 64,547 -0.4 3.05 9 Netherlands 63,746 0.5 3.01 10 Australia 44,467 2.6 2.10 16 Taiwan16,952 3.7 0.80 41 Hong Kong 4,508 0.3 0.21 24-5

  6. Macroeconomic indicators in 2016 Ranking EconomyPopulation GDPGDP per capita (millions) (billion USD) (thousand USD) 1 United States 324.0 $18,503 $57.1 2 PR China 1,382.9 11,234 8.1 3 Japan 126.3 4,954 39.2 4 Germany 82.6 3,460 41.9 5 United Kingdom 65.7 2,629 40.0 6 France 66.9 2,461 36.8 7 India 1,328.8 2,272 1.7 8 Italy61.0 1,852 30.4 9 Brazil 209.8 1,798 8.6 10Canada 36.2 1,529 42.2 23 Taiwan 23.5 507 21.6 33 Hong Kong 7.4 320 43.2 24-6

  7. Insurance density: premiums per capita in USD in 2016 Ranking EconomyTotal Life Non-life business business business 1 Cayman Islands $12,160 $596 $11,565 2 Hong Kong 7,679 7,066 613 3 Switzerland 6,934 3,700 3,233 4 Denmark 5,159 3,742 1,416 5 Finland 5,061 4,106 955 6 Netherlands 4,717 965 3,752 7 Luxembourg 4,589 2,631 1,958 8 Ireland 4,408 3,640 769 9 Taiwan 4,321 3,599 722 10 United States 4,174 1,725 2,449 47 PR China 337 190 147 24-7

  8. Insurance penetration: premiums in % of GDP in 2016 Ranking EconomyTotal Life Non-life business business business 1 Cayman Islands 22.6% 1.1% 21.5% 2 Taiwan 20.0 16.7 3.3 3 Hong Kong 17.6 16.2 1.4 4 South Africa 14.3 11.5 2.7 5 South Korea 12.1 7.4 4.7 6 Finland 11.8 9.5 2.2 7 Netherlands 10.4 2.1 8.3 8 United Kingdom 10.2 7.6 2.6 9 Denmark 9.6 7.0 2.6 10 Japan 9.5 7.2 2.4 39 PR China4.2 2.3 1.8 24-8

  9. C-ROSS: An Overview • Comparative Assessment of C-ROSS with RBC, Solvency II and SST • Impact of C-ROSS on the Life Insurance Industry

  10. C-ROSS: An Overview

  11. C-ROSS: An Overview No. 16: Solvency Assessment Report No. 17: Insurance Group

  12. Solvency Ratio = x 100% Credit Risk Market Risk Risk Diversification Loss Absorption Insurance Risk Pillar I quantifies capital requirements for insurance risk, market risk and credit risk, with allowance for diversification effect and loss sharing with policyholders. Control Risk (Refer to SARMRA in Pillar II) Actual Capital Life Insurance Risk Mortality Risk Interest Rate Risk Spread Risk Minimum Required Capital Catastrophic Risk Equity Risk Default Risk Loss Risk Lapse Risk Longevity Risk Real Estate Risk Risk Diversification Risk Diversification Expense Risk Morbidity Risk Foreign Investment Risk Non-Life Insurance Risk Risk Diversification Medical and Health Claim Risk Exchange Rate Risk • Risk Diversification

  13. Pillar I classifies admissible capital into four categories.

  14. Pillar I defines admissible assets and method of liability valuation

  15. Comparison of changes in assets, liabilities and capital between C-ROSS and the former factor-based solvency system

  16. Solvency Ratio = x 100% • Pillar II • Qualitative Supervisory Requirements Market Risk Risk Diversification Credit Risk Loss Absorption Insurance Risk • No. 10: Integrated Risk Rating (Classified Supervision) • No. 11: Solvency Aligned RIsk Management Requirements and Assessment • No. 12: Liquidity Risk Pillar II: Solvency aligned risk management requirements and assessment (SARMRA) CIRC assesses the quality of an insurer’s risk management on insurance risk, market risk, credit risk, operational risk, strategic risk, reputational risk, liquidity risk, and solvency risk. A rating is assigned to each insurer after assessment. Control Risk Actual Capital Minimum Required Capital Quantifiable Risk • Capital for control risk = Capital for quantifiable risk x Risk factor • (Risk factor ranges from -0.1 to 0.4, depending on assessment results of SARMRA)

  17. Pillar II • Qualitative Supervisory Requirements • No. 10: Integrated Risk Rating (Classified Supervision) • No. 11: Solvency Aligned RIsk Management Requirements and Assessment • No. 12: Liquidity Risk • Pillar II: Integrated Risk Rating (IRR) • Operational risk, strategic risk, reputational risk and liquidity risk are difficult to quantify • CIRC assesses these four types of risk qualitatively • The assessment results for non-quantifiable risks (i.e. operational risk, strategic risk, reputational risk and liquidity risk) together with quantifiable risks and control risks form the basis of IRR

  18. Pillar III • Market Discipline Mechanism • No. 13: Public Disclosure of Solvency Information • No. 14: Exchange of Solvency Information • No. 15: Credit Rating of Insurance Company • Pillar III: Disclosure and Exchange of Information • Transparency of insurers’ solvency position is enhanced under C-ROSS • Insurers have to disclose their financial position by uploading the extract of solvency assessment reports on their websites on a quarterly basis • The reports contain information about insurers’ solvency ratio, net profit, net asset, minimum required capital, IRR result, CIRC’s assessment result on risk management, liquidity risk, and any interventionary actions imposed by CIRC • Information about insurers’ solvency ratio and IRR result have to be disclosed in documents to policyholders, such as application notice, annual statements, etc. • Exchange of information with stakeholders is also enhanced by regular seminars, press conference and interviews held by CIRC with credit rating agencies, industry analysts, and research institutions.

  19. Pillar III • Market Discipline Mechanism • No. 13: Public Disclosure of Solvency Information • No. 14: Exchange of Solvency Information • No. 15: Credit Rating of Insurance Company • Information disclosed by insurers are centralized in the following website maintained by the Insurance Association of China: http://icid.iachina.cn/ICID/

  20. C-ROSS: An Overview • Comparative Assessment of C-ROSS with RBC, Solvency II and SST • Impact of C-ROSS on the Life Insurance Industry

  21. Highlights • Internal and stochastic models, which generally have greater predictive power and risk-sensitivity, are not operated under C-ROSS due to the limited availability of resources in the industry. • The centralized political power at CIRC facilitates active qualitative supervision on insurers and enhances flexible adjustments to the framework for the fast changing financial market. • The exclusion of residual margin as liability results in the possibility of negative reserve because all the future profits are recognized at policy inception.

  22. C-ROSS: An Overview • Comparative Assessment of C-ROSS with RBC, Solvency II and SST • Impact of C-ROSS on the Life Insurance Industry

  23. On an aggregate basis, life insurers’ solvency ratio does not change materially under C-ROSS. Life insurers focusing on writing long-term traditional life policies have improved solvency ratio under C-ROSS Life insurers focusing on writing short-term high cash value products have deteriorated solvency ratio under C-ROSS

  24. Writing short-term high cash value products is capital consuming. • Writing long-term traditional life products with heavy protection elements can contribute excess capital. • After C-ROSS implementation, the percentage of investment-related premiums written by bancassurance-oriented life insurers drops from 76.63% in 2015 to 66.84% in 2016.

  25. Required capital for market risk is more than 3 times the required capital for insurance risk and more than 6 times the required capital for credit risk. • Life insurers focusing on issuing short term endowments and high cash value products enjoy less diversification benefits and loss absorption when calculating the minimum required capital.

  26. HTM Assets (reported at amortized cost) Capital Liabilities Minimum required capital for interest rate risk = Surplus in base scenario – Surplus in adverse scenario • In adverse scenario, a decrease in interest rate only increases liabilities as well as assets classified as AFS, but not assets classified as HTM. • This gives life insurers incentive to re-classify their HTM assets to AFS so as to lower the minimum required capital for interest rate risk. • The solvency ratio for our sub-sample increases from 257% to 289% if the proportion of AFS investments doubles from 17.9% to 35.8%. AFS Assets (reported at fair value)

  27. Shortening asset-liability duration gap also reduces minimum required capital for interest rate risk. • However, life insurers in China face many practical difficulties in matching asset and liability duration because: • it is difficult to find corporate bonds in China that have maturity over 10 years to match the duration of liabilities • foreign exchange control and exchange rate risk pose extra difficulties for insurers to trade long term bond overseas • as China’s financial market is still developing, use of interest rate swap to manage duration gap is also extremely expensive • decreasing liability duration by selling short term products may be inconsistent with insurer’s strategic plan

  28. Additional to considering the expected returns and volatilities of equities, life insurers under C-ROSS also have to consider the effect of equity investments on their solvency ratios.

  29. Effects of low interest rate environment • We use 30 September 2015 as the base date and assume that the yields of China government bonds with maturity less than 20 years decrease to 2%, and then gradually increase to the ultimate yield of 4.5% for maturity between 20 years and 40 years.

  30. Effects of stock market boom • During stock market boom, the surplus increases at a slower rate than that of minimum required capital for market risk due to the pro-cyclical components embedded. MC: minimum capital for equity risk EX: exposure in equity rf: risk factor depending on stock market k1: risk factor depending on the square of unrealized gain An example: 100 * 0.41 * (1+1) = 82

  31. Conclusion • C-ROSS is more sophisticated than RBC, and not inferior to Solvency II and SST. • Life insurers specialized in writing long term traditional life products have improved solvency ratio under C-ROSS, but are also more vulnerable to decreases in interest rates. • Capital requirements for interest rate risk and equity risk motivate life insurers to take into account duration matching, accounting classification of fixed-income assets, and the underlying risks of equity investment when formulating their investment strategies. • Stock market boom has a slightly negative effect on insurers’ solvency ratio due to the pro-cyclical component embedded in the minimum required capital

  32. Thank You for Your Attention Q&A

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