Insurance firms in Hong Kong will probably have to make major changes to their investment portfolios if they are to maintain solid solvency ratios under looming risk-based capital (RBC) rules.

And the territory's insurers could face an even bigger challenge to do so than their European peers faced under the Solvency II regime.

Hong Kong's Insurance Authority is testing the impact of its proposed RBC regime – modelled initially on Europe's Solvency II regime and slated to go live in 2022 – via proposals on insurers through quantitative impact studies (QIS). The third and final study (QIS 3) is expected to be finalised next month. 

The city's proposed RBC regime would greatly reduce insurers’ solvency levels, according to analysis by actuarial consultancy Milliman. Only 30% would have solid solvency ratios of over 150% under the current proposals, according to the latest study by the regulator.

“It will not be possible for insurance companies in Hong Kong to continue with their current investment strategies under the new rules because about half of them would become insolvent,” an insurance specialist at a big US fund house told AsianInvestor. “There’s quite a big shift to be done in terms of allocations.”

Hong Kong insurance firms are likely to slash relatively high equity allocations. But may not be able to turn to physical real estate as an alternative investment – as many of their European peers have done – because that asset class will also have prohibitively high risk charges, the fund executive said. An Asia-based insurance executive supported this viewpoint, on condition of anonymity.

ALLOCATION CHANGES

The regulator, which could not immediately comment for this article, is consulting with local insurance firms to develop its RBC framework, which is modelled on Europe’s Solvency II regime. 

However, the Insurance Authority appears to be taking a particularly tough approach to its risk based capital rules. Solvency II has been called considered “harsh” and “punitive” in its treatment of equity investments, but Hong Kong's QIS 2 proposals could be even more stringent in some areas.

The higher the RBC charges are for particular investments, the more corresponding capital insurers must hold on their balance sheets. For instance, the proposed charges for equity holdings range from 40% for developed-market stocks to 50% for private equity, in line with the European charges that some see as too high.

More punitive still is the proposed Hong Kong risk charge for real estate of 44%, the unnamed insurance specialist told AsianInvestor. It had originally been mooted at 25% – the same level as in Europe, he said.

The changes would have a big effect on Hong Kong's insurers, as they stand today. In the QIS 2 consultation paper, nearly half (44%) of insurers' solvency ratios fell below 100% under the proposed charges, said the asset management executive. Indeed, Milliman's analysis found that the average solvency ratio would fall from 293% to 112% under the proposed RBC framework.

OVER-OPTIMISTIC ON EQUITIES?

If introduced as stated, the new rules would particularly impact Hong Kong insurers that hold sizeable amounts of higher-risk assets under the new regime. That's a lot of them. 

Hong Kong-based insurers hold larger equity allocations than many of their peers in Asia. The city’s insurers hold around a quarter of their portfolio in equities, found a survey by Standard Life Investments (now Aberdeen Standard Investments) in 2017.

Another issue is that Hong Kong life insurance product illustrations for clients have typically been based on very optimistic forecasts for equity returns. The products’ expected performance for equities are in the range of 7% to 9% annually for the next 20 to 30 years, but these are “overestimated” predictions, argued the asset management executive.

He suggested that it may make more sense to increase exposure to private equity than keep a big allocation to listed equities, given the fairly similar risk charges for each type of assets: 44% for listed equities and 50% for private equity. The expected returns for private equity typically in the double-digits, he noted – although the asset class comes with greater liquidity challenges.

Alternative credit, such as infrastructure and real estate debt, is also likely to become more popular given its relatively lower proposed risk charges, as was the case in Europe, the fund executive said.

He said that he expects to see a push to develop Hong Kong's unit-linked product market – again, as has occurred in Europe – to allow insurers to reduce some of the risk on their balance sheets.

RISK REDUCTION
 
The upshot is that the proposed RBC charges would make a big dent in returns from higher risk asset classes like equity and real estate. Hence insurers would likely reduce allocations to these assets in favour of assets attracting lower risk charges, such as corporate bonds or private infrastructure or real estate debt, argued the specialist.

That is what happened when similar solvency regimes took effect in Europe and the US. But in Europe, insurance firms also moved substantial amounts into property investments. Hong Kong insurers are unlikely to do the same if the charge stays at 44% for such holdings.

Ultimately, the rules around capital charges are unlikely to greatly differ much from the current proposals, although some further calibrations to the RBC framework are likely, said the Asia-based insurance executive.  

To top it all off, Hong Kong insurers also need to prepare for new accounting rules – International Financial Reporting Standards 9 and 17. These have their own implications for investment strategies, such as potentially encouraging them to shift assets out of commingled funds and into separate accounts and hastening consolidation of investment mandates.

It looks as if Hong Kong's insurer investment teams face a busy few years as they work out how to best recalibrate their portfolios. They will likely await the final outcome of QIS 3 on tenterhooks.

Joe Marsh also contributed to this article.