Reclassifications by several Korean life and non-life insurers of the accounting designations for a significant part of their bond holdings are interfering with capital metrics and duration management, says Moody's Investors Service.
"The reclassification of bonds from available for sale (AFS) to held to maturity (HTM) essentially gives insurers an option to shield the reported value of their bond investments from further market changes and thus stabilise shareholders' equity and risk-based capital (RBC) ratios, even if interest rates increase," said Mr Edwin Liu, a Moody's Associate Analyst.
"As a result, the reclassification reduces the sensitivity of insurers' reported RBC ratios to interest rate changes, thus weakening the RBC's usefulness as an indicator of capital adequacy," he said.
Moody's conclusions are contained in its just-released report, "Insurers -- Korea: Investment reclassification interferes with capital metrics and duration management".
Significant reclassifications have occurred in recent years during a period of low interest rates, and the amount of bonds reclassified range from 6% to 40% of an insurer's total assets at the end of the reporting years they were reclassified. Most of these reclassifications were from AFS —which is the prevailing classification of insurers' bond investments—to HTM. Insurers have the incentive to reclassify because they face difficulties in meeting regulatory capital thresholds.
Indeed, among those major insurers that have made reclassifications, most face capital difficulties to various degrees because their reported RBC ratios are only modestly above the regulatory recommended level of 150%.
In addition, the reclassification of securities to HTM results in smoothed-out RBC ratios that are less volatile to economic change, raising the potential issue of capital overstatement if interest rates continue to rise. Furthermore, this situation imposes constraints on investment disposal and exacerbates large duration mismatches between assets and liabilities.
However, the sector's new solvency regime is likely to prompt a reversal of this trend in reclassification. The Korean Insurance Capital Standard (K-ICS), to be implemented in the next few years, will require insurers to use market value in assessing both assets and liabilities, regardless of the accounting classification in solvency capital calculations. It will also impose more stringent capital charges on duration mismatches and hence insurers may have an incentive to reclassify back to AFS to have the flexibility to reshuffle portfolios to lengthen asset duration, even at the expense of higher volatility in their RBC ratios.
Nonetheless, Moody's expects insurers that consider this type of reclassification (i.e. from HTM to AFS) as still a minority, because doing so still requires insurers to sacrifice stability in their reported capital metrics when most insurers' RBC ratios are not far above their regulatory thresholds.