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Jul 2020

The longer term investment implications of the C-ROSS regime

Source: Asia Insurance Review | Jun 2015

The introduction of China’s Risk Orientated Solvency System (C-ROSS) focusses insurance companies on linking assets and liabilities to improve capital efficiency. This will require sophisticated risk management tools set in improved decision making frameworks. This innovation occurs as the insurance industry is growing quickly, positioning China as the third largest insurance market globally. In this article Mr Paul Sandhu of Cathay Conning Asset Management takes a look at some of the requirements practitioners will need to consider as they implement a framework for managing the long term implications of C-ROSS while pursuing their capital efficiency agenda.
The Asian insurance industry continues to see unprecedented growth, even as the overall economic growth in the Asian market is slowing. 
   Developing markets in Asia such as China, India and Indonesia, while very different in their application of insurance and their regulations, are experiencing an expanding middle class and changing demographics, pushing growth to double digit rates. 
   China’s forecasted 7% economic growth in 2015 is the lowest in two decades, while its insurance industry continues its growth at more than double this rate. Along with this unrivalled growth, China’s ability to adapt and incorporate global best practices and innovations, be it new investment classes, risk management processes or insurance products, continues at pace.
Major reforms implemented
Most recently, China’s insurance and market regulators have implemented major reforms that have been the catalyst for a significant paradigm shift for insurance companies. 
   Two of the policy changes that carry the most fundamental implications to the insurance company investment operations are: (1) Easing of restrictions for investment into alternatives and overseas asset classes; and (2) Growth of domestic markets through creation of new asset classes and expansion of existing asset classes, such as derivatives. 
   This acceleration of market liberalisation is allowing Chinese insurance companies to build globally diversified balance sheets with the added benefit of enhanced return via global alternatives and reduced duration gap through access to longer duration debt instruments.
   An integrated framework for risk management and strategic asset allocation allows insurers to make decisions to optimise their projected capital under the C-ROSS regime.
Companies are enhancing ERM and SAA frameworks
In the midst of this new frontier of investment, C-ROSS introduced an expansive solvency framework that will require insurance companies to calculate their capital positions using a holistic methodology covering both sides of the balance sheet.
   At the cross between market liberalisation and heightened capital guidelines, companies are enhancing their Enterprise Risk Management (ERM) and Strategic Asset Allocation (SAA) frameworks that allow them to take advantage of growing opportunities in the market while managing enterprise risks. 
   Using sophisticated stochastic modelling techniques, companies can explore the impact of C-ROSS projected forward in time, in order to determine how to make investment decisions today to maximise their expected benefit tomorrow. 
Modelling the “tail” is an essential requirement for today’s risk management 
As seen in other markets as recently as in the 2008 Financial Crisis, during tail events, asset classes tend to “influence” one another through stronger correlations and ultimately causing a domino effect across the balance sheet. The ability for the modelling framework to produce this dynamic stress analysis is essential.
   In developing markets, the lack of historical data on investment classes tends to make it difficult to model future tail behaviour. However, the fact that these markets exhibit more volatility than developed markets, makes these models even more essential. 
   As such, it is important to incorporate the expertise of market practitioners and asset managers in order to supplement the historical data available. Equally important is the ability to conduct stress tests on the tail in order to understand the sensitivities to the portfolio and ultimately to the overall capital position.
   Stochastic projection of the capital into the future allows companies to make decisions today for a higher level of capital efficiency tomorrow.
Advanced modelling framework to support in-depth analysis
Modelling C-ROSS into future time periods stochastically involves building a sophisticated model capable of incorporating both sides of the balance sheet, connecting the assets to the liabilities and being able to factorize the C-ROSS specifications for application in future states of the market and still be consistent with the principles of C-ROSS. 
   Another fundamental aspect of the model is having a robust Economic Scenario Generator (ESG) that has enough flexibility to incorporate the specific market variables in China and which has the market dynamics calibrated properly and validated through actual market practitioners.
Projecting solvency ratios
Figure 1 below shows the projections of C-ROSS over a five-year horizon using such a model. The mean shows the expected reported solvency position over five years. An important issue being outlined in the projection is that the tail (bottom 5th percentile) moves very close to 120% (down from 170%).
   Analysing the multiple scenarios and their projected asset/liability interactions which caused this level of capital deficiency would lead to the basis of a risk appetite statement and a market-based trigger system used in our monitoring of market risks.
Optimise C-ROSS using the Efficient Frontier
In order to analyse multiple investment strategies applied within the C-ROSS projected framework we utilise an advanced genetic search algorithm which seeks to maximise the effective area of the convex hull in order to draw the Efficient Frontier (EF). 
   Figure 2 shows how various investment strategies plot in terms of their risk/reward trade-off under the C-ROSS regime. 
   Figure 3 goes deeper into the analysis and plots the mean of the solvency ratio over time for three investment strategies. 
In the figure, strategies B and C are both subject to a lower solvency ratio starting positions than strategy A because of the increasingly higher exposure to foreign assets and the higher initial equity hedging cost. 
   However, strategy B has a higher solvency ratio than strategy A in three years as it is utilising the benefits of the foreign investment strategy being applied to the portfolio. This illustrates that the incremental risk taken at the initial time period is eventually overcome later in the projection. The same cannot be said for strategy C which cannot overcome the higher costs for hedging and the increased foreign currency risk. 
A strategic framework that connects and enhances the decision making framework
The advent of C-ROSS will have fundamental long-term implications as to how insurance companies manage their businesses on both sides of the balance sheet. 
   As in developed markets, the ability to make decisions today to enhance the available capital of the insurance company in the future will form the basis for success and growth in an already rapidly growing and competitive market. 
   The incorporation of advanced modelling techniques and sophisticated frameworks that model both sides of the balance sheet in a holistic and connected way is increasingly necessary and will allow senior management to make the critical decisions to achieve success in this dynamic and innovative market.
Mr Paul Sandhu is Head of Risk and Capital Management Solutions, Asia Pacific, at Cathay Conning Asset Management.


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