A Big Step Forward for China's Insurance Industry: Building Broader and Safer Avenues for the Utilization of Insurance Funds

There are a total of 68 articles in the Tentative Measures, which are divided into seven chapters. In addition to the General Provisions (Chapter 1) and the Supplementary Provisions (Chapter 7), the main body of the regulations are provisions regarding investments in various kinds of bonds (Chapter 2: Investments in Government Bonds; Chapter 3: Investments in Financial Bonds; and Chapter 4: Investments in Enterprise/Corporate Bonds), risk control (Chapter 5), and supervision and administration (Chapter 6).

Characteristics

As early as in the 1995 version of the PRC Insurance Law (中华人民共和国保险法)- before its first and so far only amendment in 2002 - insurance funds could be used for the purchase of government or financial bonds. And in recent years, the CIRC has enacted several regulations regarding insurance funds' investment in various kinds of bonds. These include the Tentative Measures for the Administration of Investments in Corporate Bonds by Insurance Companies on May 30, 2003; the Circular Concerning Matters Relevant to Investments in Bank Subordinated Debt with Fixed Term by Insurance Companies on March 29, 2004; the Circular Concerning the Adjustment to the Proportion of Investments by Insurance Companies in Bank Subordinated Bonds, Bank Subordinated Debt with Fixed Term and Corporate Bonds on June 25, 2004, as well as others (collectively, 'the prior regulations').

Undoubtedly, the Tentative Measures have been enacted with an eye on the prior regulations. However, it must be pointed out that the Tentative Measures are not merely a summary of the prior regulations. Indeed, there are some breakthroughs in the Tentative Measures that mean the prior regulations shall only continue to be effective where their stipulations are consistent to those provided in the latest legislation (Article 67). Compared with the prior regulations, the Tentative Measures are characterized by their encouragement of market-oriented, independent and active investments, as well as effective risk-control mechanisms.

More Diversified and Independent Bond Investment Choices for Insurance Institutions

In addition to the bond products included in the prior regulations, the Tentative Measures also provide specific stipulations regarding the investment policy for some new bond products, such as commercial bank financial bonds (Articles 15-19), international development organization renminbi bonds (Articles 26 and 27), and short term financing bonds (Articles 36-39). These new products allow insurance institutions' portfolios access to all the bond varieties presently available in the domestic capital market. Different insurance institutions may, according to their actual circumstances and at their own discretion, select different bond products to make up diversified bond portfolios. Moreover, by authorizing the CIRC to enact separate regulations for insurance institutions' investments in corporate bonds without guarantee (Article 32), in asset-based securities, financial bonds issued by non-bank financial institutions, short-term financing bonds issued by financial institutions and other financial products (Article 62) - as well as in securities forwards and other derivative products (Article 63) - the Tentative Measures have left enough room for the development of future bond investments of insurance funds.

Compared with the prior regulations, the investment ratios in some bond products, such as corporate bonds, commercial bank subordinate bonds and fixed term subordinate debts, have been increased. What is more important about the administration of investment ratios, however, is that the Tentative Measures adopt a more flexible differential investment ratio control method instead of the previous single ratio for different kinds of bonds. Under this new control method, an insurance institution may independently determine the total ratio and the individual item ratio of its investment in state credit bonds, including government bonds, central bank bills, and policy bank financial bonds and subordinate bonds (Articles 8, 10, 13 and 14). The same applies to international development organization renminbi bonds (Article 27), while the investment ratios in other bond products are still subject to different maximum investment ratios. However, investment ratios in the same kind of bond, or even in the same bond, may vary if the credit rating or other conditions of such a bond, such as its issuing party and/or guarantor, change or vary (Articles 18, 19, 31, 33 and 48). In general, the better the quality of a bond, the higher the permitted investment ratio and vice versa. Correspondingly, insurance institutions enjoy greater autonomy in their investments in high quality bonds and in their allocation of bond assets according to their capacity for risk tolerance.

Multiple Risk Prevention Mechanisms

According to international experience, the quality and performance of different bonds are directly related to their issuing parties. Therefore, the Tentative Measures clearly divide all the bond varieties that may be invested in by insurance funds into four categories: government bonds, financial bonds, corporate bonds and other bonds approved for issuance by the relevant departments (Article 4). These divisions are made according to different bond issuing parties for the convenience of insurance institutions' risk management and the regulatory authority's effective regulation. The Tentative Measures further set down strict and detailed qualifications and conditions based on various aspects of each kind of bond (with the exception of government bonds and central bank bills), the issuing parties and the guarantors (details as per Articles 11, 12, 14, 15-17, 20, 22, 23, 25, 26, 29, 30, 33, 36-38). Priority is given to the credit rating of various kinds of bonds, the issuing parties and the guarantors. Only those bonds that fulfil all the qualifications and conditions, i.e. bonds with high credit ratings, can be invested in by insurance funds. The rationale is perhaps to minimize, even avoid credit risks as much as possible right from the very beginning.

In addition, an insurance institution is required under the Tentative Measures to establish a sound bond investment risk control system and formulate a precise, scientific and effective business operation flow (Article 40). Insurance institutions must also establish a credit risk evaluation system for bond issuing parties and bonds, and continuously track and evaluate the credit circumstances of the bond issuing parties and the bonds (Article 44). Investment ratios for certain bonds must be adjusted periodically, moreover, when the credit circumstances of such bond and/or its issuing party change (Article 45 and 48). All of these measures will surely improve the risk management capability of insurance institutions and play an important role in the effective prevention, control and minimization of credit risks in bond investments of insurance institutions.

Also in the Tentative Measures, an independent third-party custody system has been introduced for insurance institutions' bond investments (Article 6) for the first time. Custodians are accordingly responsible for the custody of bond assets, liquidation and settlement, asset valuation, investment supervision and other matters (Article 42). Therefore, investment managers will not directly handle bonds and funds, so as to avoid the risks of misappropriation and embezzlement of bond assets. The third-party independent custody system will also help the CIRC in obtaining timely and accurate information regarding insurance institutions' bond investments, thereby improving its regulatory capabilities over such investments.

Impact on the Insurance Industry and the Capital Market

In March 2005, about 48.6% of insurance funds were invested in bonds. This marked the first time that bonds replaced bank deposits as the largest investment product of insurance funds. By June 2005, insurance institutions as a whole became the second largest institutional investor in bonds, behind banks. As such, bond investments of insurance funds are of great importance not only to the insurance industry, but also to the domestic capital market.

The Tentative Measures, on the one hand, encourage insurance institutions to make investments in bonds by permitting all bond products to be included in the investment portfolios of insurance funds, whilst also providing a more flexible differential investment ratio control method. On the other hand, the Tentative Measures pay great attention to the financial security of insurance funds and, as discussed above, take various measures to prevent bond investment risks. As a result, the implementation of the Tentative Measures has opened a door to a freer yet safer bond investment market for the huge quantity of insurance funds accumulated in the insurance industry. This will help insurance institutions optimize their insurance asset structure and obtain greater returns from their bond investments. It could be said that the 'weak wing' of insurance funds utilization has been made stronger. This is imperative for the healthy development of the insurance industry in the future.

As for the capital market, the implementation of the Tentative Measures means, first of all, a stable inflow of large amounts of funds that can be expected to continue into the future. Greater investment is crucial in the continuous and healthy development of the capital market. Moreover, the Tentative Measures, by prescribing more demanding investment criteria for riskier bonds, will urge the relevant parties to act more prudently. This is further encouraged by subjecting insurance institutions to self-disciplinary action and requiring them to maintain bonds with high credit ratings in their portfolios. In so doing, the Tentative Measures promote a standardization of operations for credit rating and guaranteeing activities in the capital market. All these factors are essential in the construction of a mature and standardized capital market.

THE IMPLEMENTING RULES

Summary of Legislative Framework

There are a total of 56 articles in the Implementing Rules, which are also divided into seven chapters. In addition to the General Provisions (Chapter 1) and the Supplementary Provisions (Chapter 7), the main body of the rules are provisions regarding the requirements for, and documentation and materials to be submitted by, the entrusting party, the entrusted party and the custodian for conducting overseas utilization of foreign exchange insurance funds (Chapter 2: Administration of Application and Submission). The Implementing Rules also provide currency portfolio, scope and ratio of investment (Chapter 3: Administration of Categories); the requirements for the investment management agreement between an entrusting party and the entrusted party, as well as the custody agreement between the entrusting party and the domestic custodian (Chapter 4: Administration of Agreement); administration of investments (Chapter 5); and supervision and administration (Chapter 6).

Characteristics

Although called the Implementing Rules, these rules are not merely detailed interpretations about the provisions of the Tentative Measures for the Administration of Overseas Utilization of Foreign Exchange Insurance Funds (the 'Foreign Exchange Measures'); rather they enhance the enforceability of the Foreign Exchange Measures. The Implementing Rules have also contributed some new developments and progress by providing further clarification regarding the Foreign Exchange Measures and prescribing certain additional stipulations.

Establishment of Basic Management Mechanism

The Implementing Rules, on the basis of the Foreign Exchange Measures, further establish the basic management structure for entrusting parties, entrusted parties and custodians, where the insurance company is the entrusting party, the investment management institution is the entrusted party and the commercial bank is the custodian (Articles 2 and 3). They also set down clear stipulations regarding the duties and responsibilities of various parties (Articles 19 and 20) and prescribe the operations and management procedures for foreign exchange insurance fund utilization (Articles 21-42). The Implementing Rules dictate, furthermore, that the selection of the entrusted party, the custodian and the entrusting party shall follow market-oriented principles (Articles 2, 4, 23, 45 and 46). Such a management structure will therefore ensure the standardized and efficient utilization of foreign exchange insurance funds.

Addition of New Investment Products

By providing definitions for the investment products or instruments prescribed in Article 9 of the Foreign Exchange Measures, the Implementing Rules add some new overseas products such as structured deposits, mortgaged-backed securities (MBS) and money market funds that can be invested in using insurance institutions' foreign exchange funds (Article 14). Articles 15 and 16 of the Implementing Rules also allow foreign exchange insurance funds of insurance companies to be invested in shares of Chinese enterprises listed on the New York, London, Frankfurt, Tokyo, Singapore and Hong Kong Stock Exchanges. Such purchases may be made in the primary and secondary markets. The CIRC, moreover, is authorized to modify the various investment ratios in accordance with market conditions and the circumstances of specific overseas investments by foreign exchange insurance funds. It is also able to gradually modify the investment category, the investment currency and the investment market in accordance with the management capability of the entrusting party. The investment channels for the overseas utilization of foreign exchange insurance funds have, nonetheless, been expanded under the Implementing Rules and are certain to be further expanded.

Construction of a New Regulatory System

The construction of a new regulatory system has been encouraged under the Implementing Rules by, firstly, introducing independent third parties, including the custodian, internationally recognized rating agencies and accounting firms (Articles 3, 11, 12, 17, 19 and 55 etc.) to assist the CIRC in supervising funds flow, evaluating internal control mechanisms, performing accounting functions, and providing credit ratings and assets evaluation. This not only enhances the transparency of foreign exchange funds utilization, but increases regulatory efficiency and protects the safety of assets.

Secondly, an evaluation benchmark has been set down for the selection of entrusted parties and custodians (details as per Articles 8-12). The entrusted party, being the actual operator of the overseas investment of foreign exchange insurance funds, and the custodian, being the actual custodian of the foreign exchange insurance assets, are vital to the safety of the overseas utilization of foreign exchange insurance funds. This evaluation benchmark will help insurance companies in selecting experienced and capable financial institutions to act as the entrusted parties and the custodians, to ensure the safe, steady and efficient utilization of foreign exchange insurance funds. And thirdly, special prescriptions regarding affiliated investments and affiliated parties (Articles 18, 45 and 46 etc.) have been enacted to ensure the independence of the custodian, in order to avoid moral risks and to guarantee the open, fair and equitable utilization of foreign exchange insurance funds.

Development of New International Markets

The currency portfolio of overseas investments by foreign exchange insurance funds of insurance companies may include US dollar, euro, Japanese yen, pound sterling, Canadian dollar, Swiss franc, Australian dollar, Singapore dollar, Hong Kong dollar and other currencies approved by the CIRC (Article 13). These basically mirror the basket of currencies used since July 2005 as a reference in determining the exchange rate of the renminbi. This makes it possible for insurance institutions to invest in the major mature financial markets around the world, as well as establish multiple currency investment portfolios and disperse investment risks, especially interest rate risks and foreign exchange risks.

Impact on for the Insurance Industry and the Capital Market

To date, the total foreign exchange assets of China's insurance industry amounts to more than US$10 billion, mainly coming from the funds raised from the overseas initial public offerings of three Chinese insurance companies. A significant proportion has also come from foreign exchange capital funds and operating funds of foreign-invested insurance companies and foreign exchange insurance business income. With the further opening of China's insurance market, the foreign exchange insurance assets are expected to increase more rapidly in the future.

Although the Foreign Exchange Measures were promulgated on August 9, 2004, no Chinese insurance company was approved to conduct overseas utilization of foreign exchange insurance funds until January this year. At this time, Ping An Insurance received approval from the State Administration of Foreign Exchange (SAFE) for a US$1.75 billion quota for overseas foreign exchange investments. To this day, Ping An remains as the only insurance company that is approved to utilize foreign exchange insurance funds overseas for investments.

With the People's Bank of China's reform of the renminbi exchange rate regime to a managed floating exchange rate regime based on market forces with reference to a basket of currencies from July 21, 2005, intense pressure has been placed on the proper utilization of foreign exchange insurance funds. Indeed, China Life Insurance, which holds foreign exchange insurance assets of approximately US$3.1 billion, has suffered a foreign exchange loss of about Rmb500 million (US$61.8 million) from the appreciation of the renminbi against the US dollar by 2% following the reform.

The promulgation of the Implementing Rules, by providing more enforceable provisions, will undoubtedly accelerate Chinese insurance institutions' utilization of foreign exchange insurance funds overseas. This will enable insurance institutions to participate in international competition on a wider scope and at a higher level; allocating assets worldwide, dispersing risks and increasing investment returns.

The promulgation of the Implementing Rules also has great impact on China's domestic capital market. The investment of foreign exchange overseas by insurance institutions is not included under the qualified domestic institutional investor scheme (QDII). The latter includes overseas investments of renminbi funds in the domestic capital market by certain qualified institutional investors. Yet the funds utilized overseas by insurance institutions represent self-retained foreign exchange insurance funds of such institutions, which have no relation whatsoever with the renminbi funds in the domestic capital market. Indeed, the investment overseas of foreign exchange by insurance institutions has no negative effect on the quantity of renminbi funds in the domestic market. Still, the overseas utilization of foreign exchange insurance funds by insurance institutions will provide opportunities for domestic insurance institutions to learn from the international financial market, gain investment management experience and perfect their risk control mechanisms. This will in turn benefit domestic institutions investments' in the domestic capital market. With the appearance of mature insurance institutional investors, the domestic capital market can expect to become more standardized and predictable in the future.

CONCLUSION

The Tentative Measures and the Implementing Rules, seen from the analysis above, have both paved broader and safer avenues for the utilization of insurance funds. This has been achieved through the provision of more investment choices for insurance institutions, with greater autonomy, and superior regulatory framework and risk control mechanisms. As such, the previously 'weak wing' of funds utilization of the insurance industry can be expected to become stronger in the future under the new regulations. This is of great importance to the continuous, rapid and healthy development of the insurance industry. Greater investment in the domestic capital market on behalf of insurance institutional investors will, furthermore, expand liquidity in the market and encourage sound investment practices.

In closing, China's insurance industry is marching forward as never before, with the Tentative Measures and the Implementing Rules but the beginning of a big step forward.

* Lü Guoming, Juris Master, is also a lecturer of law at Jining Medical College