Take falling interest rates, add new accounting standards. This mix of factors is shaping Korean insurers' risk management priorities. S&P Global Ratings believes that insurers with liabilities of much longer duration than assets will likely face a capital squeeze, when the discount rates used to value insurance liabilities decline.

We assume this duration mismatch will become problematic for some, as Korea's policy rates and domestic interest rates likely enter a down cycle. Rates globally are poised to fall, following the U.S. Federal Reserve's 50 basis point cut last week.

The rate dynamics are one factor; increased transparency is another.  The financial disclosures of Korean insurers better represent the economics of their business following the introduction of international financial accounting standards (IFRS) 17 and 9 in Korea, about one year ago. These standards replaced IFRS 4 and international accounting standard (IAS) 39 with revisions in local supervisory accounting rules.

At its essence, insurance liabilities under IFRS 17 reflect market-consistent interest rates and actuarial assumptions. This differs from IFRS 4, under which assets were based on the market value and liabilities were on book value . The move to IFRS 17 also means that an insurer's capital sensitivity to interest rate movements will show on its balance sheet more explicitly than before.

In our view, life insurers and non-life insurers with high exposure to long-term policies or fixed-rate guarantee policies will likely be more vulnerable to capital erosion than other non-life insurers over the next two years. While we expect most rated insurers should be able withstand moderate capital strains over this period, they will need to continue to strengthen their management of interest-rate risk.

A Capital Squeeze Looms

In the past two years, high interest rates have somewhat alleviated reserving pressures on Korean insurers, following the implementation of the new accounting rules (see "Korean Insurers And IFRS 17: Jury's Out If Increased Capital Is Here To Stay," published on RatingsDirect on Sept. 21, 2023). However, over the next two years, we expect a decline in discount rates used to value insurance liabilities, which in turn will require a costly increase in reserves.

This could lead to volatility in Korean insurers' capitalization, if reserving requirements increase more than asset valuations when domestic interest rates decline, or if there are regulatory changes in the calculation of discount rates.

We believe an insurer's capacity to manage capital volatility under IFRS 17 will serve as an important indicator of its financial strength. Korean insurers will continue to tighten asset and liability management. They will do so through investing in long-dated bonds and bond forwards, selling products that pose less interest rate sensitivity, and risk-transfer measures such as co-insurance.

At the same time, their improved profitability and internal capital generation under IFRS 17 could also support their capital buffers. These will likely help cushion pressure on capital; falling interest rates may test insurers' risk management capabilities and capital buffers.

The Discount Rate Applied Across Korean Insurers Will Likely Decline

Under IFRS 17, the value of insurance liabilities are derived by discounting future cash flows related to insurance contracts.  Uniquely, the Korean financial regulator sets the country's discount rate. The regulator guides all Korean insurers to apply this discount rates curve when valuing their liabilities. In so doing, the regulator aims to enhance comparability of financial statements among insurers.

This addresses a facet of the principles-based IFRS 17 accounting framework, which allows insurers to derive their own discount rates. For example, in the eurozone, we see a wide variety of discount rates being applied by insurers. This could potentially impede comparability between insurers that have chosen different choices under IFRS 17.

The discount rate applied across Korean insurers is composed of the market risk-free rate plus a liquidity premium until there is observable market data, or the last liquid point. Beyond the last liquid point, discount rates are extrapolated to the ultimate forward rate. The Korean regulator provides guidance on how to set the key variables, such as, liquidity premiums, the last liquid point, and the ultimate forward rate.

We expect the discount rate to gradually decline over the next two to three years.  This is mainly because we forecast a downward trend in domestic interest rates over the next two years. In addition, the regulator has ongoing plans to tighten the calculation of key variables that shape the discount rate, which will effectively lower the discount rate curve.

For example, the regulator provided guidelines to enhance the calculation of liquidity premiums and extend the last liquid point to 30 years from 2025 (from a current 20-year time frame). The regulator also provided guidance on adjusting the Korean won ultimate forward rate to closer to the 4.0% level over the next three years, from 4.55% in 2024.

Capital Pressures Will Vary Among Major Rated Korean Insurers

We believe the major rated Korean insurers can withstand moderate capital pressure stemming from lower discount rates,  over the next two years. Korean insurers have been steadily lowering interest rate sensitivity in the past several years in preparation for the adoption of IFRS 17. Nevertheless, most life insurers and non-life insurers with long-term policies still have some gap in their duration of assets and liabilities.

In our view, life insurers will likely be more vulnerable to capital pressure than non-life insurers over the next two years. This is because their liabilities are typically more sensitive to downward shift in discount rates than their assets, due to the longer duration of life liabilities and higher reliance of fixed-rate guarantee policies. Among non-life insurers, we expect duration-gap management will be a challenge for those with high exposure to long-term policies providing accident and health coverage over several decades.

Within Korean insurers we rate, Hanwha Life Insurance Co. Ltd. and Hyundai Marine & Fire Insurance Co. Ltd. could face increasing pressure on capital adequacy as interest rates decline. Their regulatory solvency ratio based on Korean Insurance Capital Standards (K-ICS) stood between 160% and 170% as of end-June 2024. The range is lower than the life and non-life combined industry average of about 210%. We estimate their K-ICS ratios could decline by five to 15 percentage points over the next two years. The estimate assumes a 100 basis point decline in the yield of 10-year Korean government bonds.

We believe Samsung Fire & Marine Insurance Co. Ltd. is best positioned among rated Korean insurers thanks to its track record of above-par asset-liability management. Samsung Fire & Marine has been managing its capital adequacy using internal models reflecting prudent actuarial and economic assumptions. This is in addition to regulatory stress test scenarios. Its efforts will continue to underpin the insurer's very strong capital and earnings over the next two years, in our view.

Table 1

Chart 1

Insurers View Capital-Adequacy Management As The Top Priority

Major Korean insurers will strengthen their interest-rate risk controls by managing risk appetite and risk limits.  They continue to prioritize the reduction in the gap in the duration between assets and liabilities by tweaking their investment and product strategies.

For example, insurers with a longer duration in liabilities will continue to increase investments in fixed-income securities and bond forwards with tenors of 10-30 years. They are also shifting focus to protection-type policies with shorter maturities, or policies with low or no fixed-rate guarantees. Major insurers are leveraging their strong market presence and extensive distribution channels to change their product mix.

Insurers with low headroom in their regulatory solvency ratios could seek co-insurance, or increase their issuance of hybrids and subordinated securities, in our view. In particular, we believe demand for co-insurance could steadily rise as it allows primary insurers with long-term insurance liabilities to transfer interest rate risk to reinsurers. While these measures can help to bolster regulatory solvency positions, insurers should also consider the cost of coinsurance and funding, which could undermine profitability.

Table 2

Increased Internal Capital Generation Will Cushion Strains

We expect the sound profitability of rated Korean insurers will help to mitigate pressure on their financial soundness over the next two years.  This follows a step improvement in profitability under IFRS 17 from 2023. The average return on average assets (ROAA) of Korea's life insurers will remain stable at about 0.5%-0.6% over the next two years, in our view. The average return for non-life insurers will likely be 2.2%-2.4% over the same period.

This is higher than the average ROAA of about 0.4% for Korea's life insurers in 2018-2022, under IFRS 4. For the non-life entities the average ROAA was 1.1% for the same period, under IFRS 4.

The improvement in profitability under IFRS 17 mainly reflects the change in accounting rules that better reflect the underlying economics of long-term insurance contracts than under IFRS 4. For example, under IFRS 17, insurance profits and costs are recognized over the contract period as insurance service is provided.

In addition, insurance liabilities are presented on a market-consistent basis on the balance sheet, reducing expenses related to reserve provisioning.

The key accounting changes under IFRS 17 that affect Korean insurers' income statements are:

• Under IFRS 4 and prior local statutory accounting rules, insurance contract acquisition costs were deferred only up to seven years; the amount in excess of a regulatory deferrable limit was expensed as incurred. Under IFRS 17, direct insurance policy acquisition costs are recognized over the insurance contract period.
• Under IFRS 4 and prior local statutory accounting rules, Korean life insurers faced high reserve provisioning expenses related to legacy policies with high fixed-rate guarantees that were sold after the Asian financial crisis (1997-1998) because these were based on book-value under IFRS 4. Under IFRS 17, such insurance liabilities with negative interest spreads have been marked to market on the balance sheet.

Chart 2

Korea's rated insurers will likely refrain from excessively increasing payouts to shareholders, at least over the next two years. This restraint is in keeping with insurers' efforts to enhance capital positions ahead of a decline in discount rates. While Samsung Fire & Marine and most other rated insurers plan to gradually increase their annual dividend payout and share buybacks over the mid-to-long-term, we expect such measures to be implemented slowly, only after the insurers can demonstrate stable capital amid falling interest rates.

Chart 3

Regulatory Developments Put The Focus On Risk Management

Regulatory oversight on discount rates, the management of interest rate risk and actuarial assumptions will continue to tighten, at least over the next three years. This follows regulatory guidelines announced in July 2023 that aim to prevent insurers from applying overly optimistic assumptions; for example, on prospective loss ratios of medical indemnity.

In our view, the financial regulator in Korea may provide additional guidelines on actuarial assumptions. Such guidelines aim to enhance the comparability of financial statements across the domestic insurance industry. However, they could raise volatility in the insurers' financial statements and capital in the coming years, adding another layer of complexity for the insurers.

Insurers Need To Reckon With Lower Rates, Regulatory Changes

IFRS 17 and 9, as well as the Korean regulator's guidance, underscore the importance of interest-rate risk management. They provide insurers the incentives and framework to address any gaps in the duration of assets and liabilities. It will shortly become clear which insurers have best prepared to reduce their capital sensitivity to interest rate movements. This is as discount rates come down from the elevated levels seen in the past few years.

The market will soon become acutely aware of extensive asset-liability mismatches, or mismanagement of duration risk. The interest rate risks are rising, and so is the visibility of that risk.

Related Research

• Assessing Europe's Global Reinsurers Under IFRS 17, July 2, 2024
• Various Rating Actions Taken On Six Korea-Based Insurers And Reinsurers On Revised Criteria; Ratings Removed From UCO, Feb. 28, 2024
• Insurance Industry And Country Risk Assessment: Korea Property/Casualty, Dec. 19, 2023
• Insurance Industry And Country Risk Assessment: Korea Life, Dec. 19, 2023
• Korean Insurers And IFRS 17: Jury's Out If Increased Capital Is Here To Stay, Sept. 22, 2023
• How Will The Move To IFRS 17 Affect S&P Global Ratings' Analysis Of Insurers And Reinsurers?, Aug. 24, 2022