The introduction of Hong Kong’s risk based capital RBC regime in July this year has seen insurers’ solvency ratios fall to roughly half the level recorded under the previous factor based supervisory approach, according to research by AM Best.
The Hong Kong Insurance Authority introduced HK RBC, its new solvency framework on 1 July 2024, replacing the legacy HKIO factor-based regime.
Pillar 1 of the framework outlines quantitative requirements, including a regulatory capital adequacy assessment and the values assets and liabilities on an economic, rather than book, basis.
The HK RBC regime is more complex and comprehensive than the HKIO regime, introducing more granular regulatory capital requirements and integrating enterprise risk management (ERM) into insurers’ daily operations.
This is in contrast to the Solvency I based HKIO, which sets minimum capital based on premiums or reserves regardless of the firm’s risk profile.
Researchers at ratings agency AM Best compared insurers’ regulatory capital levels under both systems and unsurprisingly given the more comprehensive nature of the latest regulatory standard, they found HK RBC resulted in a significant capital reduction for insurers.
“Unlike the legacy HKIO, which does not consider asset, counterparty, or underwriting risk, Pillar 1 accounts for these risk factors to make risk assessment more comprehensive.
The solvency ratio of the carriers rated by AM Best under HK RBC is generally around half of what it was under HKIO,” the ratings agency said in a report.
Capital comparison
AM Best uses its own assessment of insurers capital adequacy, known as BCAR, which evaluates the balance sheet strength of companies that do not file US or Canadian statutory statements. But it was unable to provide a meaningful comparison between BCAR and HK RBC.
“A common question is the equivalence of HK RBC level to the strongest BCAR measure. Despite the high correlation between the two measures. However, there is no one-to-one formula to translate the HK RBC and BCAR ratios due to the differences between the two models,” AM Best said.
The second pillar of HK RBC requires that insurers establish a robust risk governance framework, which includes integrating risk identification, assessment, management, and monitoring into daily operations and decision-making.
It also allows for capital add-ons for non Pillar 1 risks such as conduct, group, legal, and reputational.
HK RBCs Pillar 2 requirements are a major step-up on the previous HKIO which included minimal on-financial risk management requirements for carriers.
ERM improvement
AM Best was positive about the potential for the Hong Kong Insurance Authority’s latest capital adequacy standards to improve firm’s enterprise risk management, particularly the addition of an Own Risk Solvency Assessment (ORSA) as part of the framework.
“HK RBC could strengthen Hong Kong (re)insurers’ ERM practices and better align them with international standards. Practising sound risk management and executing strategies effectively will result in a prudent and stable level of net required capital and successful operating performance over the long term,” said AM Best.
In addition to the new risk categories under HK RBC it also includes a number of sub-risk categories, such as credit risk under the market risk umbrella. Credit risk captures the effect of credit spread changes on insurers’ assets and liabilities.
According to a research report by PineBridge Investment Managers, under the new regime, insurance fixed income portfolio managers will need to incorporate spread risk capital requirements in their portfolio construction process.
PineBridge’s researchers said that this requirement adds significant complexity to managing a fixed income portfolio.
Credit risk
Under HK RBC, the capital requirement for a debt instrument is calculated as the change in fair value under a spread stress scenario across credit rating bands and remaining term to maturity buckets.
“Thus, the capital requirement for a corporate bond investment is determined by its rating, remaining term, and spread duration, while its yield is determined by a wide range of fundamental, technical, and quantitative factors,” PineBridge said.
PineBridge looked at what HK RBC regime meant for insurers Asia dollar fixed income investments, an asset class it said was attractive to the sector for several reasons, including: stronger credit profiles among Asian investment grade issuers compared to developed market peers and a more favourable macroeconomic environment.
The asset manager assessed the impact an active management strategy would have on insurers’ Asian dollar fixed income portfolio under HK RBC and concluded the outcome was better than an index tracking approach.
The firm looked at two Asian US Dollar corporate bond investment strategies. The first is fully allocated to investment-grade bonds and the other (APAC IG+) allows allocating up to 15% to high-yield bonds.
“For both strategies, the capital efficient frontiers sit above the JP Morgan Asia Credit Index (investment Grade) and the Bloomberg US Credit Index. In other words, the combination of active security selection and capital optimisation delivers a more attractive return on capital than the index,” PineBridge said.
“APAC IG+ frontier sits above that for the investment grade-only strategy: allowing for a modest allocation to high-yield bonds enables higher portfolio spreads for the same capital budget,” the asset manager added.
