The move by the CBIRC to allow insurers to invest in perpetual and Tier 2 capital bonds issued by qualified Chinese banks has been described as credit negative for insurers because it will elevate their correlation risk to the broader financial system, according to an article in the 30 January issue of "Moody's Sector Comment".
Insurers' current exposure to the banking sector is already high through their investments in debt and equity securities issued by banks, as well as holdings in deposits. These bonds will also introduce additional credit risk to their investment portfolios, note the writers of the article, Mr Frank Yuen, AVP-analyst, and Ms Sally Yim, associate managing director, both of the Financial Institutions Group at Moody's Investors Service.
Compared with the bank issued senior or subordinated debt that insurers currently hold, perpetual and Tier 2 bonds have a higher expected loss because of contractual subordination and higher loss-absorption features, such as coupon skip mechanisms for perpetuals.
Additionally, insurers would face higher liquidity risk from investing in perpetual bonds because their secondary market is still developing. This risk also suggests that non-life insurers, which have short-dated liabilities, would have a much smaller appetite for these bonds than life insurers.
Safeguards against relaxation
However, two safeguards reduce the risks posed by the regulatory relaxation.
1.The first safeguard is restricting insurers to investing in perpetual and Tier 2 bonds issued only by qualified Chinese banks. The CBIRC stipulates that insurers can only invest in perpetual and Tier 2 bonds issued by banks that have assets and net assets exceeding CNY1trn ($149bn) and CNY50bn billion, respectively, and have AAA local ratings. In addition, the banks’ core Tier 1 ratio is required to be above 8%, the Tier 1 ratio above 9% and the capital adequacy ratio above 11%.
2.The second safeguard is the high capital requirements on these securities. For example, under China's Risk-Oriented Solvency System (C-ROSS), the current solvency regime for Chinese insurers, risk charges for counterparty default risk for Tier 1 bonds are 30% for those issued by joint stock commercial banks and 40% for those issued by city commercial banks that fully meet the minimum regulatory capital requirement.
The Moody's analysts said that they expect the capital requirement for perpetual bonds to be even higher given their long-dated nature. The high capital requirement compared with other investments such as corporate bonds (risk charge of 9% with local ratings in the A range) will reduce insurers‘ appetite for these bonds issued by joint stock commercial banks and city commercial banks.
As a result, insurers are likely to invest in perpetual and Tier 2 bonds issued by policy banks, large state-owned banks or large commercial banks to reduce the capital requirements and credit risks.
Despite the credit challenges, investing in perpetual bonds could bring benefits to the insurance sector if the market liquidity of these securities eventually improves as the relaxation will provide greater diversification in insurers’ asset allocation.
At the same time as the CBIRC's announcement was made on 24 January, the People's Bank of China announced the launch of a swap facility to support these securities, which Moody's sees as a key step in improving their liquidity.