Clarence Wong looks at the prospects for reinsurers in the midst of regulatory and market change in China.
Global insurance companies have high hopes for the opening-up of China's insurance industry, and they have every right to be optimistic, with the consistent strength of premium growth since the beginning of this year. During the first seven months of 2003, property/casualty (p/c) and life premiums increased by 13% and 39% respectively, compared with the same period last year. The strong growth in the primary market has also fuelled expectations that China will develop into a major reinsurance market. While this enthusiasm is wholly justified, China's reinsurance market, non-life and life combined, has historically been small. Total reinsurance premiums collected amount to around $2.3bn in 2002, roughly 5% of Asia's total. Cession rates are also low by the region's standards, estimated at 25% for p/c insurers and 1.5% for the life sector in 2002.
State of the market
The relatively small size of China's reinsurance market speaks volumes about its short history. Insurance business was suspended altogether in China between 1959 and 1980, with the obvious knock-on effect of zero opportunity for reinsurance. Only when insurance business resumed in 1980 did reinsurance start to be transacted again. A major turning point came in 1988, when the government imposed a 30% mandatory reinsurance, to be reinsured with the then Peoples' Insurance Company of China (PICC). This statutory requirement has helped significantly to bolster the volume of reinsurance business in China. Since then, more insurers have joined the Chinese market and premium growth has shown fast expansion. Reinsurance business as a whole has largely managed to keep pace with growth of the direct market, reflecting the statutory reinsurance requirement, which was reduced from 30% to 20% in 1995. In 1996, China Re was established as a spin-off from the PICC, and assumed the role of a national reinsurer and recipient of all statutory cessions.
In the p/c market, total ceded premiums amounted to an estimated Rmb19bn ($2.3bn) in 2002, sustaining an average real growth rate of 12% over a five-year period. The bulk of reinsurance premiums are ceded in accordance with the national regulation on statutory cessions. The composition of the reinsured business is broadly in line with the underlying portfolio, and consists mainly of motor reinsurance, followed by property and cargo businesses. Commercial cessions are estimated to account for only a small part of total business, at about 15%. Of these, China Re has received its automatic 20% share.
Since 1993, Chinese direct insurers have been allowed to take inward reinsurance. Collectively, they accepted Rmb0.54bn ($65m) of commercial cessions in 2001, representing 17% of the total. The biggest underwriters of commercial reinsurance, however, are overseas reinsurers who are estimated to have about 60% of the market.1 Most international reinsurers operate their China business through offices in Hong Kong and Singapore. Lloyd's has traditionally remained a strong player in marine, aviation and transport (MAT) and accounts for around 10% of China's overseas cessions.2 A major barrier to overseas reinsurance is the restricted availability of the foreign currency required to purchase it. In order to ease the strain on direct insurers, and in recognition of the importance of proper reinsurance protection, the Chinese regulatory authority has recently relaxed the rules which govern insurers' access to foreign exchange for the purpose of purchasing reinsurance overseas.
Despite the small size of China's reinsurance market today, there are tremendous opportunities for future development. Major changes are in store which will reshape the competitive landscape of the market. Regulatory reform will be a prime driver, and changes in the mix and structure of cedants will also be important. While it is unrealistic to expect an explosion in demand in the short term, there is no doubt that the long-term potential is enormous.
As deregulation gradually sinks in, the requirement that obliges p/c insurers to cede 20% of their business to China Re is being phased out. As per China's accession commitments to the Wolrd Trade Organisation (WTO), the statutory reinsurance requirement has been lowered to 15% in 2003. This will be further reduced by 5% each year towards its ultimate abolition in 2006. The end of statutory reinsurance will allow domestic insurers to cede to other reinsurers, based entirely on their individual risk appetite and capital strength. While the portfolio mix of China's direct market implies that a high percentage of the original cessions will be retained, the removal of the mandatory obligation will nonetheless stimulate the growth of commercial cessions and, more importantly, encourage the adoption of proper risk management practices by direct insurers.
Other regulatory changes are also paving the way for commercial reinsurers to play a more important role in the development of China's reinsurance market. Among these changes, the decision to allow foreign reinsurance companies to establish branches in China will help enormously in promoting a balanced development of the insurance sector. It will encourage the capital and expertise necessary to benefit China's overall economic growth. Further, the ability of foreign reinsurers to expand into covering business transacted in renminbi will make it easier for domestic companies to purchase reinsurance covers. Equally important is the likely introduction of the first ever national reinsurance regulations, which will help inspire greater confidence in standards of prudential supervision and eliminate regulatory risks concerning the conduct of reinsurance business.
Growth of the direct market
Another major reason for optimism is the robust growth outlook of the primary market. After years of rapid expansion, the growth of China's p/c market still shows no signs of losing steam. The primary market is expected to maintain growth of around 10% in real terms over the coming decade. Insurance penetration is still very low in China, at 0.8%, compared with some neighbouring markets such as Hong Kong's 1.5%, Malaysia's 2.1% or South Korea's 3.5%. Despite the expected strong growth momentum, the penetration rate is projected to lift to only 0.9% by 2013. Against the backdrop of such fast relative growth in the primary market, reinsurance business likewise will see significant expansion. The ongoing restructuring of state-owned enterprises is likely to create more business opportunities. Nevertheless, the transition from compulsory reinsurance, essentially quota-share in nature, to commercial reinsurance, more likely using excess of loss and surplus treaties, will probably hinder the cession rate. Furthermore, significant growth in the primary market will come from the motor sector, where retention is typically high.
To a certain extent, the oligopolistic structure of the China insurance market explains the lower-than-average cession rate, as large insurers are better able to retain and diversify risks. All large domestic companies are licensed to operate throughout the whole of China and this allows them to diversify geographically and minimise reinsurance requirements. In comparison, foreign insurers can only operate in selected coastal cities, at least until the restriction governing their operations is phased out in the coming years as part of China's pledge to treat overseas insurers in the same way as nationals. Their current concentration of business into particular parts of the country has prompted foreign insurers to seek higher levels of reinsurance protection.
Impending changes to the insurance corporate landscape, however, will have important bearings on cedants' behaviour going forward. The influx of foreign players into China is likely to continue bolstering reinsurance demand, as foreign companies have consistently shown higher cession rates. However, liberalisation brought on by the removal of mandatory reinsurance is encouraging higher retention among domestic insurers, as competitive pressures on profit growth have intensified: the mentality that reinsurance is a costly drain on the business operation is still entrenched in the minds of some domestic players.
Harder to fathom, perhaps, is the impact associated with the gradual decline in state ownership in domestic insurers. Most large p/c insurers are contemplating listing to encourage foreign equity stakes. It is likely that such companies will seek more reinsurance cover for their risk exposures in order to satisfy the scrutiny of analysts and institutional investors. Current practice largely fails to differentiate sufficiently between large and small risk exposures, where, for example, major industrial risks are reinsured on proportional base and managed similarly to small risks. Furthermore, without the state acting as the lender of last resort, these companies will have higher incentives to properly assess their corporate risk landscape and take appropriate measures to manage risk. Hopefully, a better understanding of how reinsurance can be used as a capital management tool as well as a means to transfer risk will emerge in China.
Nat cat exposures and ART
The relatively low cession rate in China indicates clearly that insurers do not typically have sufficient reinsurance protection. Certainly, the cession rate does not correspond with the risk exposure of the direct insurance market. China risks being struck by major natural catastrophes, in particular earthquake and flooding. Historically, the high frequency of severe nat cat events has claimed huge economic and human costs, yet with minimal insurance and reinsurance recoverables. For example, flooding in 1998 claimed 3,656 victims and cost more than Rmb200bn ($24.2bn). Insurance losses, by contrast, were small. With further economic growth and wealth accumulation, the need to protect against adverse nat cat events will become more important. This suggests that Chinese insurers will need to seek more capacity from domestic and foreign reinsurers to help to cover these exposures. The lack of public risk awareness and slow product development are two of the major influences that currently hinder the proliferation of nat cat covers in China.
As China's reinsurance market continues to expand, inevitably there will be more interest in non-traditional reinsurance channels and products. Alternative risk transfer (ART) is relatively underdeveloped in China but there is no reason why it should not take off. Insurers pursuing a listing will look to ART to streamline their restructuring processes. Large domestic corporations, likewise, can take advantage of ART to better meet their insurance and reinsurance requirements. So far, few domestic companies in China have taken the step to establish overseas captives to rationalise their reinsurance needs. Hong Kong, by contrast, is poised to provide the necessary infrastructure to develop into a major captive centre for Chinese enterprises. Only one Chinese company has until recently established a captive in Hong Kong, but more interest in this alternative is almost certain to arise in the near future.
The opportunities for commercial cessions in China remain promising and further strong growth is expected. To operate profitably the China market requires long-term commitment and extensive local knowledge. Given that major discontinuities in the business landscape are rapidly emerging, it is imperative to take these developments into consideration when devising a strategy to operate in this diverse and challenging market.
1 Source: Developments of China's insurance industry 2003, Risk Management and Insurance Department, Nankai University, 2003.
2 Lloyd's only underwrites reinsurance business in China. MAT is estimated to account for around 90% of Lloyd's business in China. It has a full-time office in China and is seeking to establish an onshore reinsurance branch to conduct Rmb business.
Clarence Wong is Head of Economic Research & Consulting (Asia) at Swiss Re