Reinsurance, like many aspects of finance in China, is a work in progress. The leadership transition is raising hopes among professionals that this field will also be liberalised.
New premier Li Keqiang talks about boosting household incomes. One way to do this is to expand the availability and range of insurance products, which are limited in China.
Insurance companies need third parties to assume some of their risk in order to expand their product offering. That is the role of reinsurers, massively capitalised firms that provide cover to insurance companies and trade those exposures among themselves and, in the West, in capital markets.
London is the epicentre of this activity, thanks to Lloyd’s historic presence. Lloyd’s is the fifth largest reinsurance group in the world, with Munich Re, Swiss Re, Hannover Re and Berkshire Hathaway the leaders.
However even these leviathans don’t want to handle the riskiest aspects of the market, which has led to the development over the past 30 years of insurance-linked securities (ILSs), primarily catastrophe bonds and catastrophe swaps. The $15 billion-plus cat bond market is mainly originated in the United States, but the $200 billion cat swaps market is traded in London.
Capital markets not only help insurers to de-risk, but also protect taxpayers against bailing out insurers or policyholders in the wake of natural disasters.
Cat bond proceeds generate money-market returns plus an insurance company’s premium. The risk is that the event insured against – a storm, an earthquake, a flood – occurs, which results in a total loss for bondholders. But as such risks are rare (typical cat bond durations extend only three years), investors usually enjoy steady returns.
According to Otello Padovani, founder of Eskatos Capital Management, a Luxembourg-based ILS specialist investor, only one cat bond has ever defaulted in the history of the industry, in 2011, due to exposure to flooding from the Fukushima earthquake. A diversified portfolio of ILS is therefore a low-risk bet. (Although climate change could affect that, if extreme storms become more frequent.)
Cat bonds also bring collateral account risks: as these instruments are traded in the derivatives market, they are exposed to counterparty risks, and the Lehman Brothers collapse created losses.
Despite these concerns, cat bond risk is totally uncorrelated to financial markets, which has made it popular with some investors. They have also benefited from low interest rates. In addition to specialist ILS funds, cat bonds are bought by US, European and Japanese pension funds and institutional money managers.
For Chinese insurance companies, the ability to offset risk is limited, but there are signs that the government will broaden the options. China Reinsurance was only founded in 1996, and remained the sole provider even as the number of insurance companies grew.
In 2003, a number of foreign reinsurers were allowed to establish local branch offices, as did reinsurance brokers. But China Re became an arm of Central Huijin Investment, the holding company of China Investment Corporation, and continues to dominate the local market.
That quasi-monopoly has made China Re the eighth largest reinsurer in the world, by gross premiums written to third-party clients, according to AM Best. But it also limits the ability of local insurance companies to diversify their risk – and therefore their ability to offer product. For example, the property and casualty side of the industry is very underdeveloped, with only PICC and, to an extent, China Pacific Insurance offering basic, single-payer P&C contracts.
For example, farmers in China do not have access to crop insurance, because local insurers won’t offer it, partly because they can’t spread the risk. This is one example of how the government could score political points by liberalising financial markets.
Several Chinese insurance companies, including Ping An and PICC, have gone to London to participate in the swaps market. (Insurers have a bit more leeway to operate overseas than banks.) This allows them to trade the riskiest aspects of their portfolios, with foreign reinsurers and ILS investors as counterparties.
Chinese regulators are just starting to wake up to this activity, and wondering whether China should develop an internal market that mirrors US issuance of cat bonds and swaps trading in London. This looks like a long-term trend, given the lack of swaps of any type in China, let alone for the more obscure end of the market.
For ILS managers, this is a long-term opportunity to create a new market. “Senior people in China are starting to ask questions about how to develop cat bonds and how to copy the technology and know-how of the leading reinsurance companies,” says Padovani.
One sign of change is the founding in January of Peak Reinsurance in Hong Kong, a new reinsurer majority owned by Chinese conglomerate Fosun International, with the World Bank’s International Finance Corporation a minority owner. China Pacific Insurance has already signed as a client for P&C contracts.
China Re remains the only state-banked reinsurer.