A tale of two cities

The early adopters in Hong Kong – primarily the largest insurers – tell us they are already at an advanced stage in applying the new regulations. Others have begun to adapt, after the new rules were implemented in July 2024. While we can see progress, we do not believe all insurers have fully embraced the opportunities the new RBC framework brings.

The fact that capital issuance is up year-to-date tells us that while some may be in an advanced position it terms of adapting their asset allocations, for many the blunt approach of issuing more capital to ensure compliance has been the primary tool.

In our view, the next phase for many Hong Kong insurers will be balance sheet optimisation. On the one hand this may well mean adjustments to liabilities, including potential reductions in more capital-intensive activities. On the other, insurers may begin to optimise their assets. Those insurers who thrive will be adept at triangulating between risk, return and capital to achieve an optimal asset allocation.

The changes brought by new regulation can have profound implications for asset allocation. In Europe for example, insurer demand for securitisations following the advent of Solvency II decreased sharply, although there are some signs that may be starting to reverse.¹ On the other hand, demand for low capital weighted assets, such as covered bonds, increased.

Closer to home, the experience of Singapore, which introduced its RBC2 framework in March 2020, may be of more relevance from the perspective of Hong Kong insurers.

A preliminary observation: RBC2 was a success. Singapore life insurer total assets increased 15 per cent between the end of 2019 and the end of 2022 (the most recent for which full market statistics are available). General insurers, albeit a substantially smaller part of the market, grew over 30 per cent in the same period. Looking at a sample of large life insurers, solvency ratios have steadily risen year-on-year following a post-implementation dip.

Singaporean insurers actively adapted their asset exposures in response to the RBC2 framework. Based on a sample of the five largest life insurers (representing over 80 per cent of total industry assets) in the four years to the end of 2023 there was:

• A modest increase in core government bond holdings. This reflected the relative capital efficiency of sovereign, quasi-sovereign, supranational and agency bonds, along with the availability of long-duration bonds for liability-matching purposes. Exposure to other debt types decreased. Indeed, when considering (undiversified) credit spread risk levels, risk declined over the sample period.
• A more major increase in exposure to unlisted collective investment schemes, indicating increasing appetite for real and private assets. These assets will typically feature in non-liability matching – or surplus – allocations. We believe much of the increase in equity risk requirements (again, undiversified) have been driven by this allocation.
• A modest increase in cash and deposit exposure. On the one hand this indicates life insurers are maintaining prudent liquidity buffers as part of their surplus allocation and to service ongoing cashflow needs. On the other, it highlights the risk of operating with a “liquidity barbell” with a mix of the most liquid assets and exposure to illiquid private assets. This liquid-illiquid relationship is arguably a key risk factor for insurers to manage. Regulators appear to agree.

We expect Hong Kong insurers, like their Singaporean counterparts, to increase core government bond holdings for liability-matching purposes, and to become more selective in their surplus asset allocation, which typically includes exposure to return-seeking assets like equities. However, differences in the two regimes’ capital charging structures mean there will be differences in asset allocation.

While the largest Singaporean insurers modified their asset allocation in broadly similar ways, a closer look at the allocations of individual insurers reveals they were far from identical. Other insurers have charted materially different courses to the largest. This reflects the fact that adaptation is always anchored in the business mix and focus of each individual insurer. General insurers, for example, tend to hold significant amounts of liquidity as a function of their business profile. 

Three recurring considerations crop up in our discussions with insurance clients in the region as they have navigated regulatory change.

The first of these is where to buy-in capability, and where to manage in-house. There are material benefits to be gained from outsourcing certain asset allocation capabilities. Equally, retaining some capabilities in-house can deliver good results and keep costs down.

The combination of allocation shifts and changes in risk requirement levels show us that the Singaporean insurers in our sample were precise in the changes they made. We infer from this combination that much of this change has been at the selection level. i.e. the selection of a given asset – or collective investment scheme – within an allocation bucket.

We believe some Singaporean insurers chose to in-source specific componentry following the implementation of RBC2. This approach can work well when the in-sourced capability combines demonstrable asset class (or risk management) expertise with insurance awareness, i.e. capital efficiency. Additional benefit can also be gained where an in-sourced solution or asset exposure is bundled with specialist skill sets, such as net-zero transition capabilities.

The second issue concerns the path insurers choose to follow to achieve an optimal asset allocation. This will not necessarily happen overnight. It took the Singaporean insurers in our sample up to three years to adjust their allocations, although that process was probably influenced by the market volatility experienced during the onset of Covid-19.

This experience shows the value of “enabling” allocations. Capital efficient liquid asset strategies can help when moving to a longer-term capital optimised strategic asset allocation. Suitable liquid assets should be easy to access, with short settlement times and of a sufficiently high-quality to minimise the risk of price instability. Assets meeting these criteria can mitigate periods of market volatility while providing “dry powder” to deploy as and when market opportunities arise. Of course, they also need to generate sufficient yield to pay their way both in absolute and risk capital-adjusted terms.

While attention will inevitably focus on the two “poles” of insurance asset management - liability matching and surplus assets, respectively, liquidity cannot be overlooked. Some insurers – generals, property and casualty – will naturally hold high liquid asset allocations.

On the other hand, life insurers may hold liquidity buffers to reduce the likelihood they will need to try to liquidate illiquid surplus asset holdings, such as private asset fund holdings. In this sense, increased liquidity allocations play a dual role: first as “normal” liquidity – to meet expected and unexpected cashflow needs; and, second, to mitigate the risk of needing to liquidate private asset exposures in a stress scenario.

In all three cases, we see great opportunities in reconsidering liquidity allocations. Bank deposit counterparty capital charges can be material, while short-term government bond yields can be low. Other options, such as money market funds and our ReturnPlus strategy can provide high levels of liquidity along with attractive yields and in capital efficient formats.

The fact that the RBC framework in Hong Kong does not differentiate between fixed income asset types, means that strategies like ReturnPlus, which can access high-quality covered bonds and securitised assets, can potentially benefit from higher yields than comparably rated bank or corporate bond exposures.

Liquidity risk is rising up the agenda for insurance supervisors and is appearing with increasing frequency in insurance regulations. The UK’s Prudential Regulatory Authority dedicates an entire supplement (SS519) to liquidity risk. The Bermudan Monetary Authority’s new rules in 2024 introduced prescriptive liquidity risk management requirements, with further guidance in its August 2024 report: “Liquidity Risk in the Bermuda Long-term Insurance Market”. The Monetary Authority of Singapore’s recent Notice FHC-N126 of April 2024, introduced more specific and binding liquidity risk requirements on insurers.

Hong Kong currently embeds liquidity risk management in the operational risk self-assessment. Given the amount of focus on liquidity risk from insurance regulators, we suspect there may be more to come from the Hong Kong Insurance Authority on this topic. Of course, regulatory requirements often codify existing good practice. Prudent liquidity risk management is an obligation of any insurer, irrespective of the regulatory requirements involved.

All that being said, many of our clients across regulatory regimes, have a narrow view of liquidity. They may limit themselves to a combination of bank deposits and government bonds only for core liquidity, potentially with a limited allocation to short-term corporate credit for yield enhancement.

We believe there are better options available. Liquidity optimisation is the process of sizing and best matching liquid asset exposures to business needs, while factoring in regulatory capital requirements, by combining the characteristics of high credit quality, high liquidity, attractive yields and, most importantly, capital efficiency. 

Introducing ReturnPlus

Our ReturnPlus strategy is designed to help investors enhance returns on excess cash by investing in short-maturity, highly rated fixed-income securities. We invest in liquid sovereign, corporate and securitised debt, taking modest credit spread risk, mitigating other risks and maintaining liquidity. We hedge interest rate and currency exposures back to the base currency, resulting in a highly capital efficient overall portfolio.

Our clients use ReturnPlus primarily as a surplus asset allocation, and/or as a core liquid asset allocation. The strategy targets the Sterling Overnight Index Average benchmark (SONIA) + 75bps. The strategy composite has been active since 2014.

Figure 4: Performance of ReturnPlus GBP Composite versus its benchmark (per cent)

Past performance is not a reliable indicator of future returns

Note: Inception date is October 31, 2014. Performance is expressed gross of fees and fund expenses, in GBP.
Performance net of indicative investment management fees of 15 bps. Benchmark is SONIA: Sterling Overnight Index Average. Fees will reduce the performance shown.

Source: Source: Aviva Investors. Data as of August 31, 2024.

We see an opportunity for both Hong Kong and Singaporean insurers to optimise their liquidity. While the recent change to regulation in Hong Kong makes this topic front-of-mind for these insurers, the key concepts resonate across markets.

A well-structured, capital efficient liquidity pool provides multiple benefits. From acting as a mitigant to liquidity risk, to generating yield as a core allocation, to serving as a tactical “war chest” for deployment into markets or a wider balance sheet optimised portfolio when conditions are opportune.

We have solutions which can help, either as end destinations for liquidity or as capital efficient and yield generative interim measures pending a wider allocation shift.