Spotlight on China: C-ROSS II encourages greater stability in Chinese insurance sector

In December 2021, the China Banking and Insurance Regulatory Commission (CBIRC) announced the launch of Phase II of the China Risk-Orientated Solvency System (C-ROSS II), to be implemented in the first quarter of 2022. Phase I of C-ROSS (C-ROSS I), which was launched in 2016, introduced a risk-based capital solvency regime for insurers; C-ROSS II is a further evolution to improve and strengthen the efficiency of the C-ROSS I regulatory framework.

The Chinese insurer solvency regulatory framework is supported by three pillars:

• Quantitative Capital Requirements: These spell out capital requirements on three types of quantifiable risks- insurance risk, market risk and credit risk. Using a correlation matrix, these requirements are aggregated with pre-defined weights and an additional buffer is maintained for other systemic risks that may arise.
• Qualitative Supervisory Requirements: These include four types of risks which are challenging to quantify - operational risk, strategic risk, reputational risk, and liquidity risk.
• Market Discipline Mechanism: This aims to improve insurers' overall risk management capabilities by requiring solvency related information disclosure. This makes insurers more accountable to the media, rating agencies, auditors, and the public.

C-ROSS II ushers in new capital planning requirements for insurers, regulating market risk, investment risk, and credit risk. These new rules are ultimately aimed at strengthening insurers' capital bases, although solvency ratios may decline in the short term. Listed below are select changes under C-ROSS II aimed at improving risk related transparency and capital quality and requirements (summarised in Figure 1).

• C-ROSS II introduces morbidity trend risk to reflect the deteriorating trend of Critical Illness Insurance Products

China's commercial health insurance market has grown rapidly since its launch in 2009 to accompany a new phase of reforms to the medical care system, including the establishment of a well-funded social medical insurance scheme. In 2020, total health insurance premiums came to nearly CNY 930 billion (USD 135 billion), representing a 28% compound annual growth rate since 2009.¹ Critical illness (CI) insurance accounted for almost half (47%) of this growth, with premiums of CNY 435 billion (USD 63 billion) in 2020², making CI a core pillar of the health insurance market. With over a decade of rapid growth of CI insurance³ products, the industry has seen increasing claims deterioration. It has had to acknowledge that CI has complex risks driven by screening diagnostics, medical advancement, changes to healthcare policies, lifestyle, environment, and regulation.

• C-ROSS II promotes greater transparency by discouraging the use of funds in complex structured products.
• When insurance companies cannot accurately assess the present value of assets with low transparency, the highest available factor will be charged, resulting in a significant increase in capital requirement.

C-ROSS II has proposed a mandatory “look-through” approach to calculate the minimum capital to support investment risk. There has been high recent demand for alternative investment products - such as trust schemes, asset-backed debt schemes, and other insurance asset management products- as they offer higher yields. Under C-ROSS II revisions, these investment alternatives will no longer be listed as fundamental assets. A detailed investigation of underlying assets will now need to be undertaken to levy appropriate risk charges. Opaque investments will attract the highest capital charges. This is a positive step in the direction of stabilising and de-risking insurers' investment portfolios by reducing concentration risks and requiring companies to transparently lay out the flow of investment funds and potential counterparties.

• C-ROSS II improves the measurement method of interest rate risk, optimises the asset range and evaluation curve for hedging interest rate risk, and guides insurance companies to strengthen asset-liability matching management.
• The interest rate risk assessment under C-ROSS II will adopt the 60-day moving average yield curve of Treasury bonds.

Prior to C-ROSS II, a 750-day moving average yield curve was used to reflect interest rate movements. Changing this to a 60-day moving average treasury yield curve makes interest rate assessment more sensitive to recent market movements. This encourages insurers (particularly those with higher interest rate sensitivity) to be more vigilant and strengthen their interest rate risk management by reserving as appropriate. Improved measurements and hedging of interest rate risk will offset liability movement and drive better asset-liability management.

We have highlighted only some of the changes that C-ROSS II will usher in. Rating agencies view most of these changes as credit positive and helpful in forming an accurate assessment of insurers' investment risks. Overall, C-ROSS II should help in guiding the Chinese insurance industry to return to its core value proposition- that of protection against risks and uncertainty. By strengthening the risk control capabilities of insurers, cultivating transparent investment activities, C-ROSS II is certainly a positive step towards improving capital management strategies.