Regulation brings unlevel playing field for insurers in Asia

Solvency II has prompted serious interest from the Asian insurance industry, but while regulators head down the risk-based route it is a long way behind the European model, causing problems for international groups competing with their local peers. Theodora Tsentas reports

The move to Solvency II in Europe has prompted a number of jurisdictions, both in Africa and Latin America, to adopt a similar approach to regulating their insurance industry. And with historic cultural and financial links to Europe, it would be reasonable to expect Asian regulators to follow their peers in South Africa and Mexico by instituting a similarly sophisticated approach to risk-based capital (RBC) regulation. But this has not proved to be the case.

Until the turn of the millennium, supervisors across the continent had used Solvency I to regulate the insurance sector, however, following the fallout of the Asian financial crisis there was a shift to an RBC approach. First-movers were Taiwan and Singapore in 2003 and 2004 respectively, followed in 2009 by Malaysia and South Korea, with Thailand following suit this year. While a step forward from their Solvency I predecessor, these regimes are less sophisticated than Solvency II and have given rise to claims from western insurers that they will be the unwitting victims of regulatory arbitrage as local firms can operate on less restrictive standards.

Mark Saunders, Hong Kong-based managing director and Asia Pacific risk consulting and software managing director for UK consultants Towers Watson, says a two-tier system of regulation is taking place within the various insurance sectors in Asia, as increased capital requirements are only being demanded of multinationals while domestic firms have a clear lobbying advantage over the regulator to reduce or dissolve any potential increase.

"The question to ask is, ‘is there a level playing field between the multinationals and the domestics?' Some would say that in most jurisdictions the balance is more in favour with the domestics. So if a domestic company got into trouble over this, it is assumed that the regulator would be more inclined to work things out so that it can move forward," he says.

Interest in Asia by Western insurers is clear. The failed attempt by UK-based Prudential to acquire the assets of ailing former US insurance giant AIG prompted worldwide media coverage, but at the same time its peer, Aviva, successfully re-entered the Asian insurance market five years after previously exiting it. As possibilities to growth disappear in mature markets, this trend of Western insurers taking an interest in the Asian insurance market can only increase – but questions remain over whether a disparity in local and European insurance regulation may pose a barrier to growth.

Over-regulation

A clear example of regulatory arbitrage can be found in Taiwan, where a series of multinationals exited the island as a direct consequence of a divergence in accounting and capital requirement regulations between multinational insurers and the domestic market has caused members within the former category to dismantle their operations and pull out of the country.

"One of the reasons why the Europeans have pulled out of Taiwan is that they already have to conduct business on an economic capital basis and doing that typically doesn't make their Taiwan business look good. Taiwan insurers abide by local regulation and, therefore, do not need to raise extra capital. So some European insurers came to the conclusion that their capital would be best used elsewhere," says Paul Melody, director and head of life insurance consulting for Towers Watson's Greater China office.

Prudential and Dutch insurers ING and Aegon were among the first to sell their Taiwan units, after experiencing consecutive quarter losses. The variation between international financial reporting standards (IFRS) and local Taiwan accounting policies – where high interest rate assumptions for estimating the policy reserves of domestic insurers contrast with the current valuation rate and stricter policy reserves of foreign subsidiaries – has also impacted non-European multinationals such as AIG. Unfortunately for the US insurance giant, its most recent attempt to sell its majority interest in its Taiwanese unit, Nan Shan Life, to Ruen Chen Investment Holding for $2.6 billion (£1.6 billion) has once again been obstructed – this time by union opposition representing its more than 4,000 employees.

Despite this divergence, Asian insurance regulators may have little choice but to oversee a two-tiered system favouring domestic insurers for the time being. Solvency II would have been the most natural progression from the one-size-fits-all Solvency I type regulations, previously implemented across countries in the region, but In Seok Seong, director-general for the non-life insurance department of South Korea's Financial Supervisory Services (FSS), says a Solvency II-equivalent regime would not have been an option at present as the European framework is still in its preparatory stages and the criteria for equivalence have yet to be confirmed and instead they looked to the US for inspiration in deciding their regulatory system.

Towers Watson's Saunders goes further and claims that the level of sophistication and detailed nature of Solvency II regulations far surpass the current capacity of both insurers and regulators in Asia. "A system based on the American one is quite formulaic - it's not resource-intensive, it's not IT-intensive. Candidly, if Solvency II was to be the standard, the regulators in Asia wouldn't have the resources, the capacity or capability to regulate at the current time. I think one must see RBC as a stepping stone to Solvency II and, ultimately, regulators will see it as a sensible way to go, but practical considerations outweigh that at present," says Saunders.

Saunders' views were backed in a recent survey published by UK law firm Norton Rose in February highlighting the dilemma facing multinationals and regulators within the insurance sector across the Asia Pacific region. Though 61% of respondents considered overregulation a problem in their jurisdiction, 80% wished for tighter regulation in the form of Solvency II to enable them to remain competitive within their market.

The report notes that the imbalance between the requirements asked of subsidiaries of European Union (EU) insurers operating in Asia and domestic firms "will give EU-based insurance groups and those based in equivalent countries a distinct disadvantage against their non-European peers when it comes to profitability, so it is natural for many of the respondents (who are typically from western insurance groups) to want regimes implemented that will diminish this impact".

Slim prospects

Prospects for a widespread adoption of a Solvency II-type approach appear slim. The main reason is the underdeveloped nature of capital markets in the region - principally the lack of long-dated bonds - which hamper asset and liability management (ALM). Long-dated paper is scarce across the region with South Korea, Singapore, Malaysia or Thailand having no bonds of 30-years and while Japan, Indonesia and Taiwan do have some bonds, liquidity is so low they are of little use for large-scale ALM.

This absence of long-dated instruments already poses a problem for South Korean insurers operating under its RBC regime. In the republic, the capital charge for interest rate risk is based on an insurer's duration gap, making the minimal options for long-dated debt a serious concern according to Jong-Yeal Kim, senior vice-president of insurance risk management and product development and management for Korea Life, one of the three largest firms in the domestic life market. "Every insurer is trying to grab a fixed-income security long-term bond to reach the required RBC levels. That is the biggest impact for us; but we need a 30-year or over 20-year government bond, and that's very hard to find here," he says.

Even in the exceptional cases of Taiwan and Indonesia where a 30-year bond is available, reduced market supply, credit rating benchmarks and the high yields of the bonds could be prohibitive. While the 2.07% yield on Taiwan's 30-year bond is even lower than the 30-year German bund (currently yielding 3.38%) and has an investment grading of A+, the equivalent in Indonesia is below investment grade with a rating of BB+ and has a yield of 10.14%.

Paul Mussche, Hong Kong-based director of securities for Deutsche Bank, says: "What this means is there is sometimes a discrepancy between what would be a natural solution to satisfy RBC and what is actually available or admissible in the local capital markets. And that's why some companies have reached outside the local capital markets to find solutions to their RBC."

One such insurer is Singapore's Great Eastern Life Assurance, which has S$53.4 billion of assets under management. According to its head of group risk and compliance, Ronnie Tan, the insurer uses a combination of 20-year plus government and corporate bonds and interest rate swaps, to match its assets and liabilities. "Great Eastern has a significant portfolio of US and European government and corporate bonds due to the limited Singapore dollar (SGD) bond market. To avoid the foreign exchange and yield curve mismatch risks, we predominantly hedge these bonds back to SGD using currency swaps," he says.

Resorting to foreign capital markets to solve the duration mismatch may get rid of one major risk, but it then leaves insurers more exposed to forex risk issues, according to Wilson Chan, Singapore-based director of cross-asset strategic solutions at Citigroup Asia.

"Theoretically, foreign asset swaps of this kind can help overcome a duration mismatch. However, what insurers tend to do in reality is use a foreign sovereign 40-year bond to match their 40- or 50-year liabilities with short-dated forex hedges in place. From a cost and liquidity perspective, one-year FX forwards offer the only option to hedge but still leave you heavily exposed," he says.

It may not be the most palatable solution for risk managers but in Chan's view "there's not much to do than wait for a suitable long-dated bond to be issued at the moment".

Regardless of the general relationship between RBC and ALM in other solvency frameworks, the urgency of asset-liability matching for domestic insurers in relation to the introduction of risk-based capital regimes in Asia may be questionable.

Increased requirements

Unlike the Solvency II preparations where increased capital requirements are publicly debated by European insurers at every stage, it is less clear how this process occurs in Asian states.

Taiwan, for example, saw a marked drop in the capital levels required by the regulator following strong industry lobbying. According to one person familiar with the situation when RBC measures were introduced into the country, they were originally set at twice the Solvency I levels - a figure that subsequently fell to 1.7 times following industry protests they would become insolvent otherwise.

And in any case, according to Frank Park, Seoul-based general manager of German reinsurer Hannover Re's South Korean operation, regulators in the region are not prone to making rash decisions.

"RBC has not been introduced suddenly or in the short term - the Korean regulator studied it for several years and then introduced it. The capital requirements should be developed organically and I think they will become stronger," he says.

And with this long time-frame for introduction, market players are not concerned the move to RBC will not result massive spikes in their capital requirements according to the FSS’s Seong.

“The capital requirements are not likely to increase on the whole under the RBC system and will remain at similar levels to that of the existing Solvency framework,” with the exception already “taking active steps in preparing for the new system… [and] are expected to meet the minimum RBC ratio requirement of 100%”, he says.

However, practitioners in the Korean life market say the acceptable level within the market is 150%, not the 100% stipulated in the regulations. Despite the minimal change in capital requirements, the industry view is that smaller firms may have more difficulty surviving once the new RBC framework is officially launched in April.
"A company with an RBC level under 100% will definitely need a capital requirement and that's usually small- to-medium sized companies, not big companies," says Korea Life's Kim.

What is certain, however, is that RBC changes in Korea and elsewhere have altered insurers' business model and products either for the purposes of risk reduction or, in the case of European multinationals, to adapt to an unequal regulatory landscape. Traditional annuities were hit hard in Singapore in terms of capital requirements.

"The implication of that," says Saunders, "is some insurers stopped selling annuities and many moved to a unit-linked business because that needs less guarantees and,
in turn, less capital."

So far, the introduction of RBC has not caused a drastic shift in annuity products in the Korean market. On the multinational level, Deutsche Bank's Mussche disagrees with the description of the climate across Asian insurance markets as regulatory arbitrage. After all, the true underlying economic risk is the same for all companies. He claims, though, that the dichotomy that exists between the two local and foreign regimes has created a bifurcation in terms of the type of products sold.

"I would say it creates a different incentive structure for different kinds of companies so that it will probably steer some companies towards particular types of products and others to other types of products that are better suited to whatever regulatory regime is more binding – meaning the local regime or headquarter regime," says Mussche.

The change in regulatory approach in the region is likely to have a twin impact - European groups operating in the region are likely to be at a disadvantage whereas there are clear benefits for local players – helping them establish transparency in the market and achieve better credit ratings.

"Clearly, the better the credit rating they can have, the better they can raise capital and operate, and they are all aware that, if they were to get credit-rated, they would need to have the proper risk measurements in place," says Saunders.

All in all, the introduction of risk-based capital regulations could enforce the position of Asian insurers in the global financial markets. "For Korea in particular, we think the RBC framework could raise the overall financial health of the industry," says Fitch Rating's Siew Wai Wan, senior director of CFA for Fitch Ratings Singapore. The same could be applied for the prospects of insurers across the region.