New regulations, new opportunities for Hong Kong insurers

Alastair Sewell

Liquidity Investment Strategist at Aviva Investors

The same water that floats the boat can also sink it, or so the Chinese saying goes. The same can be said of the role that liquidity plays in investment management. Hong Kong’s new insurance industry regulations – the risk-based capital regime that came into effect on July 1 – will drive meaningful change in the way that the city’s insurers manage liquidity.

This much is well understood, but many insurers are just beginning to grasp the potential opportunities the new framework presents for generating higher returns on the most liquid assets in their portfolios without consuming more capital. This rising tide could lift all boats.

Most readers will be familiar with the problems that can occur when liquidity dries up – or when it isn’t available where it’s needed, at the time it’s needed, or in the amount that’s needed. Just look at recent market shocks such as the UK gilt market dislocation of 2022, or the demise of Silicon Valley Bank in 2023, to see the potential for liquidity stress.

Those are the sort of scenarios that Hong Kong’s new risk-based capital regime aims to protect insurers against. By making the capital and funding requirement levels for different insurers more sensitive to each insurer’s risk profile, the idea is that insurers with solid risk management measures and better asset and liability management can enjoy lower capital requirements. This clearly incentivises best practice across the industry.

But under such a model, what is the right level of liquidity to target?

Enter the unknown

When thinking about liquidity from a strategic asset allocation perspective, getting the balance right is critical. An investor with a significant weighting to illiquid assets may well need a higher liquidity allocation than an investor with a higher allocation to liquid markets portfolios. Liquidity needs to be valued appropriately as part of a broader strategic asset allocation.

The starting point in determining the appropriate size for a liquidity portfolio will almost always be the “knowns”. Investors know the cash demands they have experienced in the past and they may have expected cashflows they need to fund periodically in the future.

However, as we all know, the past is not a guide to the future. A good example of how this is relevant to sizing liquidity portfolios comes from the insurance industry: consider the fact there is significant variance in weather-related claims in any given year.

Because history provides only a partial guide to potential liquidity challenges, investors must therefore build scenarios to account for the “unknowns”. In many cases this comes down to stress tests. These processes broadly follow one of two approaches.

In the first, there is some level of liquidity need; if this need can be met, the test passes. The second, or reverse, stress test estimates how much liquidity could be provided before all liquidity is exhausted. The latter can then feed into a liquidity governance process in determining the appetite for a given level of liquidity risk. These stress tests will typically form part of any scenario generation exercise. Such exercises will be increasingly common under Hong Kong’s new risk-based capital framework.

Returns on liquidity

Under Hong Kong’s new regulatory regime, asset allocation for insurers shifts from being simply a question of optimising the balance between risk and return to a triangulation of the capital an asset consumes, the yield it generates, and the absolute risk it entails. The question becomes: “How much capital do I need to have against my assets, and what is the investment return on those assets?”

That change presents new opportunities to enhance returns on highly liquid assets. The implications differ depending on the type of insurer, from general to life. Take for example general insurers, which are subject to more frequent short-term claims on the liability side, and so tend to hold a bigger share of highly liquid assets on their balance sheets, often as cash. The shift to the risk-based capital regime means assets like bank deposits will fall into the counterparty risk module. That means deposits with less creditworthy banks will in turn receive a higher risk weighting than those at banks with higher credit quality.

In this scenario, an insurer could choose to move funds out of deposits with banks that have lower credit quality and into potentially higher yielding assets with lower risk weightings. Assets like high quality government bonds or short duration bonds also tend to carry low capital charges under the new regulations as they are classified under the market risk module.

What this means, from a risk and return perspective, is that there could be a strong case for rotating out of low-yielding bank deposits into a more blended portfolio of liquid assets that adds high quality fixed income or money market funds. Such an approach could deliver both better capital treatment and potentially higher yields for insurers, optimising liquidity across their portfolio. For life insurers or hybrid insurers, the mix could include allocating to high quality sovereigns or supranational bonds, or even the more senior tranches of securitised debt.

Hong Kong’s risk-based capital regime for insurers should certainly strengthen the industry’s resilience against liquidity risks, and align regulation in the city more closely with other major insurance jurisdictions around the world. But it also creates welcome opportunities for some insurers to boost returns on their most liquid assets.