China's insurance industry is set for a long drawn-out battle between industry giants and midsize players. Competition is intensifying at a time of tighter regulation and more pervasive technology disruption. And volatility in investment markets is adding to the strain. S&P Global Ratings believes all this will ratchet up the need for insurers to craft smart strategies to outfox competitors and sustain profitability. But growth prospects remain bright. We believe insurance demand should remain strong, given China's growing affluence, greater risk awareness, and continued urbanization.

The sector reached a regulatory milestone in 2018. The banking and insurance regulatory authorities merged to form China Banking and Insurance Regulatory Commission (CBIRC), following years of discussion. While the move signals President Xi's resolve to prioritize financial system stability and reduce regulatory loopholes, it may seem to relegate the insurance sector to a secondary role given its smaller scale relative to banks. Nevertheless, we believe the insurance industry plays a very important role to supporting the needs of China's aging population, particularly in areas of social welfare and healthcare.

Product diversification, multidistribution strategies, and effective expense and risk controls will set insurers apart in one of the world's largest insurance marketplace. For China's midsize insurers, identifying target customers and providing specialized products will be key to competing against the sheer size of insurance group giants.

Our study of China's leading 30 insurers reveals the continued widening divergence in credit quality between the insurance majors and midsize players, particularly for the property and casualty (P&C) sector. The worsening competitive landscape, exacerbated by excessive commissions paid to distributors, will further chip away at insurers' thin profitability. For life insurers, capitalization remains the key constraint on credit profiles as companies hunt for long-duration investments to keep pace with their focus on protection products. We examined the financial data of 30 leading Chinese insurers over the past several years: the top 15 life companies and top 15 P&C companies. Our survey covered their premiums, investment assets, key profitability metrics, and solvency ratios.

Table 1

The regulatory merger may slow down the former China Insurance Regulatory Commission's (CIRC) earlier efforts to establish China Risk Oriented Solvency System (C-ROSS) as one of the leading regulatory solvency regimes for emerging markets globally. In our view, the ongoing phase 2 initiatives (started in May 2018) seek to consolidate the learnings over the past two years since the implementation of C-ROSS in 2016. C-ROSS' rapid pace of formation and implementation is unprecedented, especially for a large market like China. We consider that the inherent differences between banks and insurance companies in areas such as actuarial reserving, investment philosophy, and capital funding, will warrant a varied supervisory approach regarding capital assessment.

Life Insurance: Journey To Reform Is Costly For Late-Comers

Protection policies are at center stage for life insurers in 2018, given a regulatory clampdown on short-term savings products. Chinese insurers seek to speed up a revamp of their product mix to dilute their previous reliance on short-term savings policies, particularly for bancassurance life insurers. However, the switch to protection and regular premium policies will take time because insurers will need to establish and acquire distribution channels to sell these policies (see chart 1). Underpinning this push for protection policies is China's enormous agency force, which comprised over 8 million agents as of December 2017.

Chart 1

Indeed, net expense ratios of life insurers could increase to around 50% for China's leading 15 life insurers over the next two years (2017: 35.5%). This leap would occur as insurers compete to build bancassurance channels to cross sell more regular premium policies and improve the productivity of captive agents. Soaring acquisition expenses will further squeeze the profitability of China's leading insurers, particularly midsize insurers as they adjust the business in response to lower topline revenue (see chart 2).

Chart 2

Growth, therefore, should continue to be subdued in 2019, compared with the heady days in 2016 and 2017. The slowdown would reflect a consolidation of product reform initiatives from China's leading insurers. The top insurers had regained their market presence with the retreat of midsize insurers due to a pullback in their short-term savings policies. For example, the regulator took control of, and nationalized, Anbang Life Insurance Co. Ltd. (not rated), a key provider of short-term savings policies. Compared with banks' wealth management products that have higher investment returns, these savings policies had since lost their luster for bank customers, further dampening insurers' topline revenue.

Multidistribution channel strategies and a strong understanding of customers will be critical for life insurers to weather the growth trough. While size had given China's top-five life insurers a headway, greater differentiation in products and services will be needed amid intensified competition stemming from a narrower product suite.

What's more, distribution via captive agents will become an increasingly important, though costly, channel to sell protection products. However, scale alone isn't the solution to distribute these policies efficiently. The increasing complexity of these products versus savings policies will require more interaction with policyholders. Indeed, improving agents' product and customer knowledge and retaining top talent will be the first priorities of China's leading life insurers. With urbanization, the hunt for qualified sales agents had increasingly strained life insurance companies.

Technology, in our view, would facilitate this knowledge transfer. IT platforms would enable insurers to centrally manage the training and management of sales tactics. In addition, technology may assist in containing expenses.

We expect insurers' strong management teams to help steer the companies through the difficult times. Still, the regulatory and industry changes may call for a restructure of their business models, testing the companies' management.

Rising Investment Risk If Debt-Equity Swaps Increase

Slower deleveraging by the Chinese government could result in life insurers shouldering greater responsibility to assist the economy. The insurers would have to invest more in distressed assets and provide funds to highly leveraged institutions. These alternative investments (including debt schemes, wealth management products, trust plans, and real estate) account for nearly 40% of life insurers' investments as of December 2017 (2016: 36%).

Should these trends continue, we anticipate a rise in the investment risk exposure of life insurers (see chart 3). That's because the risk-adjusted investment yields from alternative investments are low and expose the insurers to higher credit risks. Liquidity concerns are less paramount for life insurers than P&C insurers given the long duration of the former group's liabilities.

Chart 3

Still, the removal of guarantees on these alternative investments (previously provided by local governments, banks, and large corporates) will require insurers to deepen their understanding of the underlying risk exposures of these assets. What's more, the increasing number of defaults in China's growing capital market for domestic debt calls for rigorous credit risk management.

Compared with the past two years, the pressure for investment yield has eased with the maturity of guaranteed short-duration savings policies and tighter regulatory governance regarding product features. We anticipate a marginal reduction in the cost of liabilities for China's leading life insurance companies to around 3.2%.

While reinvestment yields are lower than before, we expect the capital positions of Chinese life insurers to remain stable. Amid steady and still-low domestic interest rates, the reserving needs of China's leading life insurers should remain adequate, in our view. Depending on the evolving C-ROSS phase 2 initiatives, we anticipate a decline in the prospective regulatory solvency of Chinese life insurers. That said, the narrowing gap between insurers' core and comprehensive solvency ratios indicates lower leverage (i.e. reduced subordinated debt issuance) and improved quality of capital (see chart 4).

Chart 4

P&C Insurance: Auto Insurance Revamp Is Paramount For Profitability

Topline revenue pressures are cranking up for China's leading P&C insurers amid declining new car sales and escalating uncertainty over the U.S.-China trade war. Insurers would need to conserve expenses and reduce claim costs to maintain profitability.

We estimate that the P&C sector's return on equity (ROE) will stay at around 10.0% and the combined ratio at slightly above 100% in 2018 and 2019 (a ratio above 100% indicates an underwriting loss). The auto sector represents 76% of the P&C sector's gross premiums written in 2017 and declined to below 70% in August 2018 for the first time in history (see chart 5). A restructure in the auto insurance sector, therefore, will be high on insurers' agenda, with technology likely to play an important role.

Chart 5

Auto insurance is struggling to make ends meet as acquisition costs increased substantially over the past year. While the loss experience had improved (i.e. reduced claim frequency) and cushioned some of the hike in expenses, the aggressive commission payouts to distributors have eroded underwriting profits.

As a result, we consider auto insurance's existing business model to be unsustainable. The model often includes a refund of acquisition commission to policyholders, and faces heightening demands from distributors. To control ballooning expense ratios, CBIRC introduced measures to control the amount of commission that domestic P&C insurers can offer to their distributors from August 2018. While the curtailed commission rates will benefit China's P&C insurers and improve the sector's overall underwriting profitability, midsize insurers continue to face an uphill battle to wrestle market share from dominant players.

Meanwhile, technology disruption would be widespread for the auto insurance sector. The country's strong adoption of technology and still-limited data protection laws would support an ecosystem for insurers to deepen usage of big data. These substantial data can assist insurers and underwriters to assess risk with greater granularity than before.

Nevertheless, many insurers still lack a strategy to deploy big data into pricing decisions to provide individual-sensitive rates, despite their awareness of its importance. Advanced analytics and its greater use in decision-making could be a game changer for the auto insurance landscape. Indeed, even midsize players can leapfrog industry giants through smart use of technology and focused product offerings to target customers.

Chart 6

Non-Auto Insurance Sector: Growth Or Risk Engine?

The P&C sector has turned to the non-auto insurance sector in 2018, following the downturn in the auto insurance sector. In particular, the agriculture and liability insurance segments have boomed this year.

However, the expansion and diversification into these new lines of businesses is not without risk. The increasing frequency of natural catastrophes generated losses for agriculture insurance. Furthermore, the underwriting of liability lines requires specialized knowledge that is lacking in China. To cushion against this higher risk, the required capital from insurers when underwriting such risks is also the among the highest under C-ROSS.

In addition, increasing defaults among retail peer-to-peer lending platforms had raised issues about the profitability of credit guarantee insurance underwritten by Chinese P&C insurers. We continue to perceive this line of business as risky, given its high correlation with economic trends.

Capitalization has weakened as Chinese P&C insurers venture into non-auto segments that are more capital intensive than other sectors. At the same time, the insurers have invested aggressively to boost investment yield and maintained returns to shareholders and dividend payouts. As a result, Chinese P&C insurers had increased leverage through issuance of subordinated debt/tier 2 instruments.

In our view, these instruments are pure debt with limited equity content. The widening gap between the core and comprehensive solvency ratio signifies the increasing reliance on debt financing and insurers' sensitivity to funding costs.

What's more, the unprecedented strength of this year's typhoons brings a timely reminder about catastrophe losses and unmodeled risk exposures for Chinese P&C insurers as they diversify to non-auto commercial lines. We expect the losses (mostly related to property damage, business interruption, and motor losses) to prompt greater pricing discipline and risk awareness about natural catastrophes. In addition, the rapid urbanization of coastal cities could mean historical data are obsolete, pushing insurers to increase usage of technology to obtain real-time information on their cedants.

Depreciating Renminbi Weighs Down Overseas Investments Aspirations

We believe the tight regulatory leash over insurers will stabilize the credit quality of Chinese insurers. Growth should slow down as insurers shift to fundamentals of providing protection products, after a boom in volumes over the past decade. However, the fast-evolving operating landscape will intensify competition, diluting underwriting profits.

Insurers' ability to balance growth and profitability will determine their success. China Reinsurance (Group) Corp.'s recent acquisition of Lloyd's reinsurance syndicate, Chaucer Insurance Co. DAC, signals a reopening of the door to overseas expansion, though at a slower pace than before. While the depreciating renminbi will reduce the attractiveness of these assets, we believe Chinese insurers' interest in global investments hasn't wavered. However, volatile conditions in global investment markets will prompt insurers to tread carefully.

Table 2a

Table 2b

Research contributor: Li Jiaxin