China’s insurers face significant opportunities and challenges as the economy undergoes a grand transition, yet strategies deployed by other Asian insurance companies can inform investment decisions in China over the secular horizon.

On the business side, pricing liberalization has inspired insurers to differentiate their products. On the investment side, a falling interest rate environment and a solvency regulation framework that now more closely resembles mark-to-market than book-value accounting have forced insurers to be cognizant of both sides of the balance sheet and to develop investment strategies that not only exceed the cost of liabilities but also hedge the liabilities.

Solutions from other low interest rate economies in Asia have included business and product innovation, countercyclical duration management, and broader investment diversification. Also, we see potential investment opportunities in public investment grade credit and opportunistic private credit that China’s insurance companies may utilize as they embrace broader investment diversification and overseas asset allocation.

Background

China’s economy underwent significant changes over the past two decades. The insurance industry is no different. The first decade of the 21st century saw the increasing popularity of participating products (see Figure 1), largely as a result of the pricing rate cap set by the China Insurance Regulatory Commission (CIRC) in the mid-1990s that deterred consumers from purchasing traditional products because of the artificially lower guarantees. However, as a result of CIRC’s pricing rate liberalization that started in August 2013 and volatility in the equity markets, the share of traditional products increased significantly. Many prominent insurers started introducing more competitive guarantees to increase market share. While tightening regulation, lower interest rates, and a slowdown of aggressive competition have caused a number of insurers to lower the crediting rate available on their insurance policies in 2017, the tone of China’s insurance industry has definitely shifted to one that places more emphasis on product differentiation and competition.

Challenges amid low interest rates

Low and falling interest rates affect insurers both on the balance sheet and income statement. Lower rates reduce investment income, increase insurance policy reserves on the balance sheet, and may potentially lead to reserve charges on the income statement. Because of the complexities faced by China’s insurers, we looked at what other insurers have done to combat low rates.

Drawing on the experience of Japan and Taiwan offers three strategies: 1) reduce the cost of liabilities by shifting the product mix toward those offering more protection features and lower guaranteed rates; 2) manage duration countercyclically, locking in higher rates during periods of market volatility; 3) adjust asset allocation to profit from a broader set of risk premia. Let’s look closer at each strategy:

Reduce cost of liabilities. Declining interest rates increase existing liabilities while decreasing both profits and solvency. While, theoretically, new insurance products can be created at a lower cost to dilute the overall liability profile, in practice insurance buyers may be slow to adjust return expectations. McKinsey’s strategic industry research shows that as insurance markets mature, a key differentiator for company performance gradually shifts from asset management to liability management. Flexibility in product design and pricing is critical for controlling liability cost in a low rate environment.

Manage duration counter-cyclically. It is not always optimal to perfectly match asset duration to liability. In a period of falling interest rates, that means locking into lower yield when liability costs are more rigid. Alternatively, an investment approach pursuing absolute rate of return is subject to a complete mismatch of assets and liabilities. In practice, the optimal approach is somewhere in between – extend the asset duration (and lock in returns) and reduce liability duration in periods of declining interest rates, and shorten asset duration in exchange for greater flexibility in expectation of rising rates. This was evident in Japan in the low interest rate environment after 1990: Life insurers increased the allocation to government bonds from 4% in 1990 to 44% in 2014 and significantly extended maturity (see Figure 2).

Adjust asset allocation. When interest rates and risk premiums are persistently low across all asset classes, it’s harder to generate return without undertaking additional liquidity or credit risk. Adjusting the asset allocation to profit from the liquidity premium or other risk premia, as well as increasing the amount of overseas asset allocation, can, to varying degrees, decrease the impact of a changing interest rate environment at home. Asian insurers diversified their domestic investments, and took a step further by expanding into overseas markets – Japan insurers increased overseas allocation from 13% in 1990 to 20% in 2014, while Taiwan increased allocations from 5% in 2000 to 58% in 2015. Even in Korea, where domestic interest rates are relatively higher, many insurers have been pursuing overseas diversification, reaching allocations of 10%–20% in recent years.

Current opportunities in overseas markets

China’s insurers have made progress in diversifying their portfolios to include more domestic asset classes, including credit, equity and private investment. However, overseas allocations have been minimal, although CIRC allows up to 15% overseas investment. As China’s capital market continues to liberalize, we expect overseas investment will gradually increase in the future. We suggest two overseas asset classes for China’s insurers to consider:

Public investment grade credit. Part of the duration mismatch issue between Chinese insurers’ assets and liabilities is due to a structural shortage of long-dated fixed income assets in the domestic market. Based on estimates from Wind, a financial data provider, bonds with maturities of 10+ years account for just 6% of bonds outstanding.

The global market may provide a potential solution to the duration mismatch. In the U.S., for example, long-dated credit bonds with maturities of 10+ years total more than $1.8 trillion and represent 30% of the U.S. credit market. In addition, the top 10 largest issuers account for less than 14% of overall market size, providing investors with a wide and diverse base of issuers.

We believe the U.S. economic expansion should continue to support low default rates for the investment grade credit market in the country. U.S. long credit appears attractive as fundamental and technical factors remain strong. While valuations tightened significantly in 2016, current levels still offer attractive yield for long-term investors. In addition, while short-term interest rates are influenced by monetary policy divergence between the U.S. and China, long-term structural forces should act as a further tailwind for the relative attractiveness of U.S. long credit bonds when considering yield and income.

Private credit. Since 2013, China’s insurers have embraced private markets and higher-risk asset classes in the search for yield. The insurance industry’s allocation to private credit and other investments has risen to nearly 20% (see Figure 3). Lack of transparency may be luring insurers to overlook the hidden risks in private investments. Although in private form, such investments tend to share similar risk exposures as public credit and equities, though usually with leverage. Concentrated risk in domestic credit or equity markets could be detrimental to the insurers’ investment returns during market downturns.

For insurers looking for higher yield than public credit in developed markets, diversifying to global private credit can be another solution. In the aftermath of the global financial crisis, which led to changes in traditional bank lending practices, opportunities have arisen for non-bank lenders, such as institutional investors, to step up as providers of credit. As shown in Figure 4, private credit outside of China is a broad opportunity set that encompasses a wide range of asset types, including corporate, real estate, infrastructure, real assets and other niches. Prudently selecting and scaling exposure across the risk spectrum with different return and income profiles can potentially help insurance investment portfolios earn additional liquidity and complexity premium relative to public credit investments.

Depending on the asset types and investment strategies, private credit may vary in risk exposures. For example, one distressed debt strategy may be more sensitive to fixed income risk factors, such as high yield spread, than another private real estate strategy that may have exposure to equity risks. Understanding the underlying risks of the selected private credit investment, and comparing them with risks in public market investments in a common framework, is critical in sizing the allocation in the insurance portfolio.

Portfolio analysis: Integrating public and private, domestic and global investments

Consider a typical Chinese life insurance portfolio. For simplicity, we map all the sectors to three index proxies – term deposits/cash, domestic equities (MSCI China Index) and domestic bonds (JPM GBI-EM Broad China Index). We can then illustrate the average allocation of the top five life insurance companies’ portfolios, as shown in Figure 5. Analyzing the portfolio using PIMCO’s risk factor model, we identify two key factors as the underlying drivers of return and risk: domestic equity beta and interest rate duration. Although equities only represent 20% of the assets, equity risk drives 89% of portfolio volatility as domestic equity volatility is more than seven times that of domestic bond volatility.

Figure 6 shows the risk profiles of the representative insurance portfolio, the Bloomberg Barclays U.S. Long Credit Index and a sample private credit model. By disaggregating assets into risk factors, we can better estimate the return, risk and the correlation of assets in the portfolio.

We modeled a reallocation of 10% of the portfolio to U.S. long credit or private credit. In all the three scenarios (Figure 7), we expect the portfolio returns to increase based on PIMCO’s 10-year capital market assumptions. Although U.S. long credit and private credit have higher volatility than the insurance portfolio on a stand-alone basis, the risks of the new portfolios decrease because of the diversification benefit between the new risk factor exposures introduced by the global assets and China equity risk. As a result, we expect Sharpe ratios to increase after adding global assets.

Conclusion

Looking ahead, while interest rates in China may continue to exhibit periods of volatility like investors experienced around the beginning of 2017, long-term structural forces of slowing growth, aging demographics, high domestic savings and financial leverage are likely to weigh on the levels of interest rates. For life insurers in China, a structurally lower interest rate environment coupled with bouts of rising rates presents both challenges and opportunities.

We see opportunities in diversifying the investment portfolio by increasing overseas investments including public investment grade credit and opportunistic private credit. We believe insurance companies that can spend the resources to understand the global opportunity set and carefully select overseas investments may significantly improve their portfolio efficiency and differentiate themselves from competitors when dealing with evolving macro and regulatory dynamics.