2018 marks the 10th anniversary of a massive earthquake in China's Sichuan province that caused disastrous losses of life and property. More than 70,000 people died and millions were left homeless as buildings collapsed. Less than 1% of losses were covered by insurance claims. In the decade since that disaster, authorities have invested in systems to improve everything from construction standards to insurance. S&P Global Ratings believes reinsurers will be at the forefront of China's efforts to mitigate risk from natural disasters and other types of catastrophes.

Over the past few years, premiums have accelerated for nonmotor property/casualty (P/C) reinsurance, especially agriculture. This comes at a time when we expect demand in China's dominant auto-reinsurance segment to shift to a lower gear over the next two years.

In our view, the potential for growth is a given in China's reinsurance markets. Profitability, however, is another matter. Insufficient underwriting expertise, unmodeled catastrophe risks due to continued urbanization, and an evolving risk management framework, are among the factors that can lead to volatility in returns.

How The Market Can Help Mitigate Risk From Natural Disasters

China's reinsurance market has the mission of enhancing domestic primary insurers' capacity to offer coverage for risks such as liability, agriculture failure, and extreme weather events. While the premium contribution to the overall P/C market remains small, we expect liability and agriculture to grow faster than other nonauto business in the domestic primary insurance market.

Given that the Sichuan 2008 reconstruction bill may have been the world's costliest for a quake, it is no surprise China is committed to developing a catastrophe-insurance system. According to government figures, economic losses from the Sichuan quake reached Chinese renminbi (RMB) 845 billion (US$124 billion at today's conversion rates). The insured loss amount was RMB1.6 billion, indicating only around 0.2% of economic losses were ultimately insured. In more developed markets, by comparison, often around 20%-30% of economic losses from large natural catastrophes are insured.

China's P/C insurance penetration have deepened since 2008, but remain low (see charts 1 and 2) by both regional and global standards.

Chart 1

Chart 2

Until 2015, China had only one dedicated domestic reinsurer, China Reinsurance (Group) Corp. (China Re Group; A/Stable/--). Since then three domestic reinsurers have been issued licenses to operate. As of July 31, 2018, there are seven global reinsurers with branches in China.

A major step toward increased coverage came with the establishment of a domestic earthquake insurance pool in 2015, after years of study and negotiation. The China Residential Earthquake Insurance Pool (CREIP) is comprised of 45 P/C insurance participants. China Property & Casualty Reinsurance Co. Ltd. (China Re P&C--the P/C reinsurance arm of China Re Group; local currency A/Stable/--) is the sole reinsurer and plays a lead role in setting pricing at CREIP.

As agricultural price controls lift, insurance coverage demands rise

Policymakers are also very focused on developing protection in agriculture markets. Since the government introduced premium subsidies to support the growth of agriculture insurance in 2007, sector premiums have grown 55x, to RMB47.9 billion at end 2017, compared with less than RMB1.0 billion in 2006. In the first five months of 2018, agricultural premiums rose by 33.9% year-on-year.

China already has the world's second-largest agricultural insurance market; however, the system is heavily subsidized. We expect further strong growth in agriculture insurance. With support for the segment provided from reinsurers, we also anticipate that primary insurers will expand their product suite to provide more innovative agriculture insurance products to underpin demand. Besides the conventional crop insurance, index-based insurance products are also offered by market participants.

This sector has benefited from insurance pools to extend coverage and improve risk assessment. China's agricultural reinsurance pool (CARP) was established in 2014, with China Re P&C and 23 licensed insurance companies initially providing reinsurance (later increased to 32).

Chart 3

With new markets come new investments in technology

Given the industry's growing catastrophe exposures, we anticipate that domestic reinsurers will increase investments in catastrophe modeling to counter uncertainties. The country's first earthquake catastrophe model was established by China Re Group in May 2018. In December 2017, PICC Reinsurance Co. Ltd. (PICC Re) announced a partnership with AIR Worldwide (AIR) to manage their growing catastrophe exposures.

We also expect domestic reinsurers to utilize technology, such as drones or remote sensing, for better risk assessment. China is a big country with much geographic diversification. Some areas are prone to floods and typhoons, other to earthquakes. The concentration of risks underwritten in urban areas remain largely untested amid continuous urbanization.

Reinsurance Is A Favored Sector

We anticipate the reinsurance sector in China will play an increasingly important role in the government initiative of promoting the insurance sector's growth over the next five years. By our estimates, the reinsurance cession rates for China's P/C sector will stabilize at around 9% by 2020. As of year-end 2017, the industry's reinsurance cession rates was 8.7%.

Chart 4

Individuals and business interests are also more aware of losses that can come from natural or even man-made disasters, for example the August 2015 explosion at a storage container in Tianjin. That caused RMB70 billion in economic losses, of which RMB10 billion was insured. The unexpected event imposed underwriting pressure on a long list of domestic P/C insurers, as well as reinsurers.

Some growth will also come from overseas expansion: but this is marginal

Chinese reinsurers are likely to remain domestically focused, given their knowledge and established relationships in the market. We expect them to only cautiously grow their international presence. In 2017, overseas premiums for Chine Re Group jumped by 23% from a low base. We also expect more partnerships between Chinese reinsurers and global reinsurance companies to come. China Re Group's stand-alone reinsurance entity, Syndicate 2088, continues the strategic partnership with XL Catlin from 2011. Taiping Re has established a cooperative relationship with Lloyd's of London since October 2015.

Profitability: A Different Kind Of Challenge

Domestic reinsurers' returns mirror that of the underlying insurance industry. This is because most reinsurance contracts are proportional-treaty in nature. For the China Re P&C, proportional treaty contracts account for more than 95% of the total premium income, with nonproportional business equating to less than 5%.

Consequently, domestic reinsurers' underwriting performance is closely linked to the primary market—where underwriting margins are volatile and have been on a weakening trend in recent years. Among the recent pressures: continuous motor pricing reforms, soft premium rates environment amid frenetic competition, and rising regulatory costs. We expect the reinsurance industry to take more time to balance its growth and profitability aspirations, also due to insufficient underwriting expertise, rising uncertainties associated with catastrophe exposures, and evolving risk management frameworks.

Given low penetration rates in China, we feel confident that long-term growth fundamentals are solid. Profitability will always be more volatile, however. We believe market participants will undertake increased investment risk offset pressure on underwriting margins. Take China Re P&C as an example. Its investments in equity and alternative assets (such as debt schemes, trust plans and wealth management products that are considered part of China's "shadow banking" sector), more than doubled from 2015 to end 2017. We foresee a further expansion in these investments, exposing reinsurers to greater liquidity and asset risks.

Chart 5

Despite constraints, the potential for China's reinsurance markets remains promising. Nor is the growth or interest just domestic. Already there are more global reinsurers than domestic ones in the country, and we expect more international peers to set up operations.