Chinese insurance firms have been steadily raising their exposure to risk assets, from equities to alternative investments, sparking concerns among industry analysts and regulators alike. Following stellar premium growth, mainland insurers are increasingly relying on long-term, illiquid investments to achieve the returns they need to meet what are much shorter-term liabilities.

Rating agency Moody’s has just added its voice to the growing chorus by flagging the problems posed by so-called ‘universal life’ products.

The growth of these short-term savings products in China has likely peaked, as regulators have introduced measures to curb their issuance. But mainland insurers will likely continue the risky allocation strategies they use to manage these instruments for a while yet, said Moody’s in a report released yesterday.

The high-return, high-liquidity characteristics of these universal life products make them very popular among Chinese policyholders, noted the rating agency. However, the investment strategy used to deal with them raises credit and duration mismatch risk, said Moody’s.

Many insurance firms have adopted a so-called ‘barbell’ asset allocation, the company explained. This means they maintain (short-term) high cash holdings to meet potential high surrender rates on the one hand, and invest their (long-term) non-cash holdings in high-risk assets to achieve the targeted returns on the other.

China’s universal life products are essentially mass-market savings-type products that offer high crediting rates, short premium terms, low fees and minimal protection elements for the insurer, said Moody's. This contrasts with certain universal life policies in developed markets that carry comprehensive fee structures, offer material protection elements and target high-net-worth clients.

Moody’s noted that five key universal life insurers in China reported a Rmb144 billion ($20.8 billion) increase in cash-equivalent assets in 2015, which is roughly equal to 40% of the universal life premiums they collected in the period (see chart below).

Click on figure for full view

“These high cash holdings partly mitigate the liquidity risk associated with universal life products,” said the report, “but also highlight the significant lapse risk and associated potential losses.

“At the same time, long-dated and/or riskier asset allocations among insurers – such as asset-backed securities, equities and bonds funds – in pursuit of high yields, are raising credit and duration mismatch risk.”

What’s more, some insurers with high sales of universal life products have also invested large lump sums in single-name equity investments, thereby raising concentration risk, added Moody’s.

In addition, there are also material pricing risks embedded in these products. Policyholders receive relatively high minimum guaranteed rates, and have the option to surrender the policy at any time at a low penalty. Moody’s said its analysis shows that the combination of these two features is disadvantageous for insurers in both a rising and falling interest rate scenario.

Rising interest rates could trigger product lapses as customers pursue higher yields, thereby pressuring insurers’ product margins, noted the report. Falling interest rates, in turn, could result in negative spreads and thus trigger losses.

While Beijing's policy tightening should stall further growth of universal life products, some insurers – in particular small and medium-sized firms – have already sold sizeable books of these policies, which will continue to present challenges, noted Moody's.

The China Insurance Regulatory Commission sought to curb some of this risk by measures such as lowering the maximum guaranteed rate of universal life products to 3.0% from 3.5%,

But competitive pressure may push insurers to target investment returns well above the guaranteed level, said Moody’s. It is common for insurers to use yields above 5% in marketing materials to illustrate the potential returns, added the report.

Still, if all this ends badly, no one can say they haven't been warned.