Insurance firms in Hong Kong with substantial holdings of low-grade bonds are facing a greater risk of insolvency, given that the cost of owning such assets is set to rise sharply under the city’s incoming risk-based capital (RBC) regime.

That’s the view of industry experts, who argue that insurers should thus take a close look at their fixed income portfolios after many have allocated more to lower-quality, higher-yielding debt in recent years.

Hong Kong’s proposed RBC rules – modelled on Europe’s Solvency II framework – will come into force in 2022 and are set to heavily impact insurance firms' asset allocations. A series of quantitative impact studies (QIS) are under way, testing the effect of the planned regime on insurers’ investment portfolios. The third study was launched last Friday (August 9).

Thibaut Ferret

The new framework will make it particularly expensive for insurers to hold certain assets, such as listed equities and real estate. The proposed risk capital charges for such investments are as high as 50% and 44%, respectively.

Yet fixed income accounts for the biggest chunk of insurance company portfolios in the city. And, as bond yields have remained low since the 2008 financial crisis, many firms have upped their exposure to lower-rated debt in their hunt for returns.

A report by consultancy Milliman in March 2018 showed that Hong Kong insurers held 57% of their portfolios in fixed income, with 28% of their bond exposure rated between BBB+ and BBB-, only just above junk level (see chart below).

HK INSURERS' DISTRIBUTION OF FIXED INCOME ASSETS
(Click for full view; Source: Milliman)

Such assets could prove more costly to hold than many anticipate. The risk charge for triple-B-rated 15-year bonds could be as high as 25%, an insurance specialist at a big US fund house told AsianInvestor.

CREDIT SPREAD CONCERNS

That’s because the new rules will take into account factors including credit-spread risk, interest rate risk and currency risk when calculating RBC charges and consequent solvency ratios.

Credit-spread risk – which is inversely proportional to the credit quality of bond holdings – has been assigned the biggest weighting (26%) of any of the stress parameters used to calculate risk charges under QIS 2. The weighting reflects the regulator’s view of the underlying risk of different factors, which also include interest rate risk, equity risk and currency risk. 

Hence insurers that invest in a lot of lower-grade bonds are more likely to hit problems, as they will have to fork out more to cover the risk charges, which might render them insolvent.

The investment head at a Hong Kong-based insurance company agreed: “If you have long-dated credit in your portfolio, it might give rise to a credit charge and basis charge in the new regime, and therefore reduce your solvency ratio, which would have looked fine before.”

When the proposed RBC figures were applied in the QIS 2 study done in late 2018, the average solvency ratio for Hong Kong life insurers dropped to 112% from 293%, according to a March report from Milliman. Close to one-half (44%) of the 43 firms tested would be insolvent under the new regime, and only 31% would achieve a solvency ratio considered healthy, at 150%-plus, it said (see chart below).

DISTRIBUTION OF INSURERS' SOLVENCY RATIOS UNDER QIS 2
(Click for full view; Source: Milliman)

With all this in mind, Hong Kong insurance firms might naturally start their capital optimisation review by restructuring their fixed income portfolios, said Thibaut Ferret, Hong Kong-based senior solutions director for Asia Pacific at Aberdeen Standard Investments.

They will be looking to reduce both the credit spread and interest rate mismatch charges while generating a competitive yield, added Ferret, who has overseen asset-and-liability management and investment functions at insurers such as Axa and Sun Life.

In response to the rule changes, he expects the fixed income portfolio construction process to become more sophisticated, incorporating consideration of yield, capital charge and liability matching.

Insurers are most likely to start preparing for the upcoming regime after the QIS 3 findings come out, said Bruce Porteous, Edinburgh-based global insurance investment director at Aberdeen Standard. At that point, he added, companies will start to hedge some of their risks or re-allocate assets and potentially change their product distribution.

It seems they should be paying at least as much attention to their corporate bond exposure as to their supposedly higher-risk asset holdings.

 

*This story was updated on Monday 12 August to reflect the launch of the third QIS study. The publication date of the results are not yet known.