The Insurance Authority in Hong Kong is developing a capital framework for a new risk-based capital regime for Hong Kong. EY Asia-Pacific insurance leader Jonathan Zhao elaborates.
The Insurance Authority (IA) in Hong Kong is developing its capital framework toward a risk-based capital regime that is tailored for the Hong Kong insurance industry (HK RBC) and is consistent with relevant insurance core principles issued by the International Association of Insurance Supervisors (IAIS). Once in effect, it will significantly overhaul the current capital framework as set forth in the Hong Kong Insurance Ordinance (HKIO).
Similar to the RBC requirements in other jurisdictions (eg, Solvency II, Bermuda solvency capital requirement, IAIS Insurance Capital Standards (ICS), China Risk Oriented Solvency System (C-ROSS), Singapore RBC), HK RBC is a three-pillar approach, covering quantitative aspects, qualitative aspects on enterprise risk management (ERM) and own-risk and solvency assessment (ORSA) and disclosure.
To understand the likely impact of Pillar 1 on the insurance industry, quantitative and qualitative data were collected through the first quantitative impact study (QIS 1) by the IA, which was completed on 1 December 2017.1
QIS 2 and QIS 3 are expected in mid-2018 and 2019 respectively, with the aim to implement HK RBC fully in 2022.
While QIS 1 did not cover all balance sheet components,2 the results are important inputs to the risk and capital management agenda. After supporting different insurers on QIS 1 implementation, we conducted an industry benchmarking3 on the assets, liabilities,4 the PCR and, more importantly, the solvency ratio (estimated using Solvency II correlation matrix) under HK RBC.
We noted that while the average solvency ratio among the participants under the current capital regime was high, the estimated solvency ratio based on QIS 1 results dropped by more than 300%, mainly because of a significant increase in required capital.
Under HK RBC, both assets and liabilities are valued on a consistent and economic basis. The liabilities tended to increase for participating and universal life business because of the explicit consideration of the future discretionary benefits, and time value of options and guarantees (TVOG). Insurers who have allowed for future discretionary benefits implicitly or explicitly under current basis would have smaller impact when moving to HK RBC.
The biggest capital drivers are:
1. Credit spread risk
Credit-spread risk contributed to the highest PCR on average, as the credit-spread shock impacted the assets,
but the yield curves for liabilities were not adjusted accordingly.
Insurers with more fixed income securities in banding 45 and below investment grade had significant higher credit spread risk PCR, as the respective shocks are much more severe.
Apart from the amount and credit ratings of the fixed income securities held, the credit spread risk PCR was also highly driven by asset hypothecation. In particular, allocating a higher proportion of fixed income securities to the participating and universal life business would result in lower credit spread risk PCR, as the adverse impact could be absorbed by reducing future discretionary benefits.
If dynamic volatility adjustment is considered, further analysis might be needed for credit spread narrowing since only widening was considered in QIS 1.
2. Interest rate risk
For most insurers, downward interest rate shock was biting. Insurers with lower interest rate risk PCR tended to have larger proportion of assets in the shareholder fund invested in fixed income securities. They benefited from the full increase in asset value without a corresponding liability increase.
Insurers with higher interest rate risk PCR had larger asset and liability duration mismatch. Such mismatch is allowed in resilience testing under the current capital regime instead of the required capital under HK RBC.
3. Equity risk
Similar to credit spread PCR, apart from the amount and types of equities held, the asset hypothecation also drove the equity risk PCR.
Furthermore, insurers with higher equity risk PCR did not apply full look-through of their collective investment scheme (CIS) holdings, resulting in a more severe equity shock of 48%. Some companies invested more aggressively and hypothecated equities to back lines of business (LOBs) other than participating and universal life business. This severely impacted them under HK RBC.
4. Lapse risk
The lapse risk PCR was mainly driven by the product designs and the (additional) management actions. Insurers with lower lapse risk PCR tended to have products with high surrender charges and applied management actions to reduce the future discretionary benefits.
Practical lessons learnt for QIS 2 and beyond
On the basis of our experience supporting insurers on QIS 1, there are a number of moving parts in HK RBC:
- International Financial Reporting Standards (IFRS) and Hong Kong Financial Reporting Standards (HKFRS) 17: The definition of contract boundary is to be used for HK RBC. For companies that have not yet decided on the IFRS or HKFRS 17 accounting policy on contract boundary, they will have to consider this in parallel.
- Volatility adjustment, matching adjustment, own assets with guardrails (OAG): While a fixed volatility adjustment was considered in QIS 1, given the severe credit spread risk PCR, dynamic volatility adjustment and matching adjustment should be further analysed. The OAG approach for liability discount rate would continue to be tested on a voluntary basis, according to the IA, and insurers subject to ICS field testing should monitor the development of the OAG approach.
- Funds on deposit: Insurers typically earn a spread on dividends and coupons on deposit. It could be a significant future income for insurers who have accumulated significant deposits. While QIS 1 required these to be reported at the current balance, there were different views on their treatment under HK RBC.
- QIS 2 and beyond: The components not tested in QIS 1 would be covered in QIS 2. In particular, more guidance is expected on TVOG, MOCE and risk correlation, which would impact insurers’ balance sheets directly. Insurers should also plan for Pillar 2 on ERM (risk culture, risk statement, risk tolerance and risk limits) and ORSA, as well as Pillar 3 on disclosure to shareholders, regulators and policyholders.
Wider business implications for insurers
The QIS 1 results provided an early indication of the key risks in managing the balance sheet under HK RBC. As we are currently supporting the IA to develop a set of calibrated stresses relevant to the Hong Kong insurance market for QIS 2, insurers would be able to have a more realistic view of the balance sheet impact from HK RBC. Yet, they would need to tackle different challenges brought by HK RBC:
- The collaboration among actuarial, finance, investment and risk functions is essential for a holistic view of the impact. More importantly, when HK RBC comes into force, the coordination among these functions should continue to be strengthened for better risk and capital management.
- Another challenge is that insurers could be subject to different capital regimes. The CIRC and IA have said they will assess equivalence between C-ROSS and HK RBC. This would have implications especially for Chinese insurers. Insurers should also compare the capital requirements with other international capital regimes that they are subject to.
With QIS 2 and QIS 3 coming along the way and the capital rules being finalised, insurers should continue to analyse the causes of capital charge drivers and explore potential optimisation options. Examples include more thorough look-through, product redesign, a shift in product mix and strategic asset allocation. Some of these take time for the effect to emerge, so insurers need to plan ahead. A
1 The valuation date for QIS 1 was 31 December 2016.
2 Margins over current estimate, operational risk, diversification benefits and capital tiering were not required in
QIS 1. Also, the stress parameters used in QIS 1 have not been calibrated to the Hong Kong insurance market.
3 Participants in our benchmarking represented 60% of the market share in terms of 2017 September Year to Date (YTD) Individual Business annualised premium.
4 Liabilities would be determined on the basis of discounting future cash flows with risk free rates plus volatility adjustments under HK RBC.
Disclaimer: This article contains information in summary form and is therefore intended for general guidance only. It is not intended to be a substitute for detailed research or the exercise of professional judgment. Member firms of the global EY organisation cannot accept responsibility for loss to any person relying on this article.
This feature is part of a series developed for the Asian Insurance CFO Summit, jointly organised by AIR and EY.