China's life insurance companies have adopted asset-liability matching, but as a result find themselves short of instruments to invest in that reflect the long-term nature of their obligations.

"Our problem is lack of supply in the bond market," says Raymond Tam, a member of Taiping Life Insurance's investment committee in Shanghai.

The situation is less acute for Taiping, which is a newer company and did not write policies with guaranteed payouts reflecting the high interest rates of the early 1990s. It is also small, with only Rmb16 billion ($2 billion) of assets under management, compared with $45 billion at market giant China Life Insurance, or the $22 billion at Ping An Group. Duration mismatch is a huge problem for these big names.

As a result, Taiping's average liability is only 8.5 years while its average asset tenor is seven years, leaving only a modest duration mismatch. But for the big players, saddled with legacy promises, the negative spread is significant.

Nonetheless investment returns have been on the decline for the past two years, says Ping Yi, senior investment manager at the Rmb120 billion ($15 billion) China Pacific Insurance in Shanghai. Government five-year bond yields have fallen from 4.9% to 2.8% since early 2004, and there is no high-yield market.

Yields have slumped partly for macroeconomic reasons such as domestic deflation, but also because demand among insurance companies has increased dramatically.

"There's been a change in mentality," says Tam. "Insurers are increasing their bond portfolios, which means prices are rising and yields are falling."

A third difficulty is hot money from offshore speculators (many of whom may be Chinese entities using offshore vehicles for non-renminbi holdings) keen to play the renminbi's appreciation story. Many qualified foreign institutional investors have used their quotas to park money in the bond market.

Despite falling yields, insurance companies are ratcheting up their bond exposures, mainly by reducing their bank deposits or cash holdings. That's in part to deal with better match assets to liabilities and smooth total volatility, but also because bank deposit rates have fallen even further than bond yields.

For example, over the past year China Pacific has cut its allocation to deposits from 50% to 40%, and boosted bond holdings (including money market instruments) from 45% to over 50%. Insurers are also keen to find corporate bonds, says Ping Yi, but the supply is small: only Rmb30-40 billion is issued each year, versus Rmb600 billion of annual government issuance.

Four years of bear equity markets have so far put insurance companies off, despite their need to boost returns. The government this year allowed insurance companies to directly invest in stocks but the industry consensus puts most holdings at no more than 5% of assets under management.

The lack of supply in the bond market means, therefore, that excess assets go to money market funds, say insurance executives - a big reason why these have been virtually the only type of mutual fund product that fund companies have had success selling in the past year.

The biggest insurers, although saddled with the worst negative spreads, are able to use their connections and relationships to lobby companies to issue bonds. "The market is not liquid and you have to use your connections," says one insurance executive.

But this seems to be a temporary problem. The government is encouraging more companies to issue bonds, and this year has seen the first companies issue CDs instead of raising money by borrowing from banks. "This is a good move because it reduces banks' risks and lets companies get better financing terms," says Tam, although he adds that these instruments are still very short term.

In the meantime, insurance companies are casting about for alternatives. They are eager to see the first mortgage-backed securities emerge, the first of which is expected from China Construction Bank by the end of the year. China Development Bank, a policy bank, is also expected to securitize infrastructure loans. Ping Yi believes these securities could yield 5% or more, and will be in high demand.