By staff reporters Chen Huiyin and Yu Ning

Insurers’ scramble for solvency has become a controversial topic this year. The China Insurance Regulatory Commission (CIRC) chairman Wu Dingfu said on July 15 at the National Insurance Regulatory Conference that 12 insurance companies are struggling to maintain solvency. In their first-half 2008 financial reports, several large insurers reported lower solvency ratios on a year-on-year basis.

The solvency ratio is used to gauge an insurer’s capital adequacy against risk. If the solvency ratio, or margin, is below 100 percent, it suggests that the company does not have a solid operational foundation. In such cases, insurance companies should either add to their capital or reduce their operations.

Chinese insurers will have to abandon years of chasing “fast-track” growth to focus on shoring up their solvency. The CIRC has yet to disclose details to individual insurers, but regulators have made it plain that they plan to shake up the oversight system without delay.

For years, Chinese insurers have focused on building up their premium incomes and assets. Although a solvency-based regulatory system was discussed as early as 2002, in reality, getting “big and strong” has been the favored strategy for insurers.

“At different levels of development, it is natural to have a different focus. As the market reaches a certain scale, the tendency is for more segmentation and sophistication,” said an insurance analyst with a joint consultancy firm.

As of the end of 2007, the insurance sector’s assets exceeded 2.9 trillion, five times the figure at the end of 2001. In 2007, premium income topped 700 billion yuan, triple the 2001 figure.

During the last few years, insurers moved into the securities and investment industries and became highly competitive with banks and securities firms. Yet, insurers have also assumed an increasingly important role in supplementing the social security system and promoting societal management.

“The insurance industry is at a new starting point and a new phase,” said the CIRC’s Wu. In his view, the Chinese insurance industry has assumed its basic shape but is not fully formed; institutions have developed swiftly but in an imbalanced way; services have improved but not enough; the regulatory system has taken shape but is not fully fledged.

Speaking with Caijing, Wu did not shy away from challenging questions. Among his unequivocal answers: “The major hurdle for the use of capital is risk” “We should tighten our grip on solvency” and “More energy should be invested in corporate governance to deepen reforms.”

For industry insiders, his comments have a sharp edge. As corporate governance and the market framework remain in their infancy, cost competition without risk assessment and illegal use of capital has occasionally occurred. Along with those issues are the larger questions of the business cycle and systemic problems. Thus, enforcing regulations and deepening reform go to the roots of the challenge.

However, corporate governance cannot emerge overnight. With the establishment of solvency as a core principle of the insurance business, adjustments are necessary. It is early days yet for rendering a verdict on the success of enforcement.

Macro Adjustments Near

“Bull market hangover”

Declining investment returns, excessive reliance on investment-type insurance products, and solvency problems are combining to give Chinese insurers a hangover from the bull market.

Premium income and investment return both soared in 2007, but since 2008 began, the insurance industry’s outlook has been complicated by changing conditions.

On the one hand, premium income continued to rise. In the first half, aggregate premium income topped 561.8 billion yuan, up 51 percent year-on-year. Property & casualty (P&C) insurance premiums hit 129.9 billion yuan, up 19.9 percent year-on-year. Life insurance premium income soared more than 64 percent to top 386 billion yuan, the fastest growth in the past ten years.

On the other hand, investment income probably plummeted. As of June 30, the amount of insurance capital invested was 2.7 trillion yuan, up a mere 1.3 percent from the beginning of the year. Realized investment income was 64.9 billion yuan. With the nearly 60 percent first-half decline in the Shanghai stock market, investment income fell sharply.

Solvency is under severe pressure. The insurers’ situation reflects both the tumbling markets and the macroeconomic cycle, which might be turning down in China.

Investment-type insurance products prevailed in 2007 during the equity bull market. In the life insurance market, short-term investment products with convenient payment methods have sold remarkably well. In particular, unit-linked products, universal products, and participating products accounted for more than 70 percent of premium growth.

Several factors supported growth in investment-type insurance products in 2007, compared with traditional life insurance. China’s central bank raised one-year deposit interest rate six times in 2007, while traditional life insurance was still fixed at 2.5 percent, which was not attractive to consumers.

As a sales channel for insurers, banks aggressively promoted investment-type insurance products to earn commissions.

Universal insurance products offer interest rates of 5 percent or more, according to information released by insurance companies. However, Liu Peng, an analyst with Huatai Securities, warned that these rates might not be the actual investment income rates.

Liu said if the investment return rate cannot be raised substantially, expensive competition cannot be sustained. The dilemma is, however, that if insurers lower settled interest rates, consumers might shun or withdraw these products and sales will be hurt.

Increasing competition has insurers under pressure. The market share for China Life dropped to less than 40 percent in 2007 from more than 47 percent in 2006. In an attempt to halt the decline, China Life started to actively promote universal insurance products. Between January and April, the insurer’s premium income grew 43 percent, driven by a favorable consumer response to its universal insurance products and dividend insurance products.

But China Life can’t yet breathe easy. Zhou Guang, an analyst with China Investment Corporation, noted that shrinking investment income, soaring capital costs and compressed profit margins are combining to create a difficult environment for life insurers.

Property & Casualty Insurance

Smaller P&C companies have to find new ways to make a profit. Over the past few years, the CIRC has ordered several P&C companies to suspend some of their business.

China United Property Insurance Company Limited is a good case study. It is widely known that the Xinjiang-based company has operational problems. China United managed to establish a nationwide footprint within its first three years, from 2002 to 2005. Its insurance income soared from 628 million yuan in 2002 to 10 billion yuan in 2005, making it the fourth-biggest P&C company in China. In June 2006, China United completed joint stock incorporation and increased its capital base to 1.5 billion yuan from the original 200 million yuan.

China United’s losses resulted from chasing growth without considering costs. For example, when the auto insurance sector was extremely competitive in 2006 and 2007, 90 percent of the company’s business was auto insurance. And China United expanded through price cuts that, on a large scale, hurt its solvency.

But China United proactively sought a solution, by lowering its reliance on auto insurance and clamping down on branches’ operating costs. It also slowed its overall growth in 2007 to 20 percent year-on-year from 50 percent in 2006. The company even started looking for foreign investors in October 2007, although it hasn’t found any yet.

“The P&C sector is experiencing an industry risk, in that insurers win premium income via price competitiveness and expect relatively high investment income,” said an industry insider who asked to remain unidentified.

Many insurers have realized the importance of restructuring their business to ensure profits from underwriting premiums. The chairman of PICC, Wu Yan, said in the company’s interim report that PICC will boost its operating profits from two sources: underwriting profits and investment income. Wu said that the company will strengthen its business model by improving underwriting quality and compensation.

The CIRC released a working plan on regulating the P&C sector on August 29. The authority stressed accurate accounting, including in such areas as indemnities and provisions. Also, regulators said that senior management should be held fully responsible for the accuracy and authenticity of all information.

The 11^th National Congress Standing Committee reviewed a revised draft of the Insurance Law on August 25, 2008. In particular, the draft widened the use of insurance capital, which had previously been limited to government and financial bonds, to all kinds of securities, including stocks and mutual funds, and to real estate.

Actually, this revision would simply codify industry practice regarding investment portfolios over the past few years. Since 2006, when the State Council promulgated opinions on reforms of the insurance industry, insurance companies have played a role in the equity market, private equity funds, and infrastructure projects.

For example, China Life invested in CITIC Securities and Guangdong Development Bank, as well as China Southern Power Grid. China Ping An led a syndicate to invest 16 billion yuan in the Beijing-Shanghai high-speed railway. Subsequently, Ping An invested nearly 4 billion euro in Fortis Group and Fortis Asset Management.

Fixing Root Causes

Incorporation reform: halfway home

In his interview with Caijing, CIRC chairman Wu repeatedly stressed the importance of improving corporate governance and solvency supervision. China has more than 100 insurance companies. Except for policy insurer Sinosure, all of the insurers have completed joint stock incorporation reform.

But Wu is still not satisfied. “Some have changed a great deal through better corporate governance, but some are lagging behind.”

“When we first assisted China Life in pursuing an initial public offering (IPO), my first impression was that the company would never be qualified to list overseas,” an investment banker told Caijing.

China Life did pull it off, achieving the world's biggest IPO in 2003 in which it raised US$ 3.46 billion, helped by an impressive presentation to overseas investors by then chairman Wang Xianzhang. Subsequent to the listing, however, its financial disclosures were questioned by overseas investors.

Four months after China Life’s shares were listed in Hong Kong and New York, the insurer was hit with allegations of accounting fraud, amounting to US$ 652 million, by investors in the United States. This turned out later to result largely from the discrepancy between the Chinese and international auditing standards.

PICC fared little better than China Life. It was listed on the Hong Kong Exchange prior to China Life, but shortly thereafter, the exchange said it had received allegations of “fraudulent accounting practices” at PICC. The insurer changed its auditor from KPMG to Ernst & Young because the first auditing team members were not able to reach a consensus opinion.

Although corporate governance among China's insurers has improved significantly, some fundamental issues have never been resolved.

The issue of shareholders’ qualifications “has always been on our mind,” Wu told Caijing, “We favor strategic investors as shareholders.”

In the past few years, there's been a wave of insurance start-ups. In 2006, buying shares in insurance companies was highly popular, as their shares might quickly rise five- or six-fold, allowing for rapid profits.  

But many shareholders did not understand the insurance industry and did not want to wait seven to eight years before yields could be generated, as is common for the industry.

As a general director at a small insurance company has said, small and medium-sized investors cannot provide continuous capital injections. But while state-owned enterprises have sufficient capital, their frequent personnel changes mean that they can't really be committed, long-term strategic investors.

“We hope primary shareholders will be strategic investors, as insurance contracts have long durations. Therefore, investors should commit to capital injections and also help with corporate governance,” Wu told Caijing.

Since 2007, CIRC has restricted those who can qualify as shareholders in insurance companies and groups. The list of approved shareholders was subsequently broadened to include specially approved financial institutions.

“Solvency” has replaced “investment income” as the catchphrase for insurers. As an industry insider told Caijing, solvency supervision has been around for a long time in theory, just not in practice. The same source said that people feared an emphasis on solvency in the past, as it would have put constraints on their expansion.

Wu stressed in his interview with Caijing years ago, insurance businesses in China could operate indefinitely, even if the companies were technically insolvent. Today, financial weakness will impair their ability to expand and open new outlets. And, he said, this shift in policy has been welcomed by the markets.