MSc in Finance & International Business Interest Rate Risk Management Of Life Insurance Companies In The Emerging Chinese Market Author: Xiao Deng Qiang Li Advisor: Anders Grosen Aarhus School of Business August 2006
ABSTRACT... 4 1. INTRODUCTION... 5 1.1 BACKGROUND... 5 1.2 PROBLEM FORMULATION... 6 2. HISTORY AND LIFE INSURANCE PRODUCTS... 9 2.1 HISTORY... 9 2.1.1 Brief Review... 9 2.1.2 Four Stages of Chinese Insurance Industry... 10 2.1.3 Reforms after China s Entry of the WTO... 12 2.2 THE DEVELOPMENT OF PREMIUM PAYMENT AND PRODUCTS... 14 2.2.1 The Regulation of Premium Payment... 14 2.2.2 THE REGULATION OF INVESTMENTS... 15 2.3 LIFE INSURANCE CONTRACTS... 18 2.3.1 Traditional insurance contract... 18 2.3.2 Participating policy... 20 2.3.3 Universal life policy... 21 2.4 OPTION ELEMENTS... 22 3. MODELS AND HYPOTHESIS... 24 3.1 REVIEW OF THE MODELS... 24 3.2 ADOPTING MODELS AND HYPOTHESIS... 28 3.3 THE SHORTAGES OF THE DURATION MODELS... 31 3.4 THE LIFE INSURANCE CONTRACTS AS AN OPTIONS PACKAGE... 36 4. EMERGING CHINESE LIFE INSURANCE MARKET... 38 4.1 THE OVERVIEW OF THE CHINESE MARKET... 38 4.2 FAVORABLE FACTORS... 41 4.2.1 Robust growth driven by continuous economic development... 41 4.2.2 High level savings ratio underpins demands... 42 4.3 RECENT ACHIEVEMENTS... 43 4.4 THE FAST GROWING OF INTERMEDIARIES AND AGENTS... 47 4.5 CHALLENGES WITH THE RAPID GROWTH OF THE INDUSTRY... 48 4.5.1 The fragility of the capital market... 48 4.5.2 Stringent regulations and limits... 49 4.5.3 Needs for experienced personnel... 49 4.6 THE OUTLOOK OF THE EMERGING CHINESE MARKET... 49 5. THE REGULATORY ENVIRONMENT OF THE LIFE INSURANCE INDUSTRY... 53 5.1 ACCOUNTING STANDARDS/REGULATIONS AND THE EVOLUTION... 53 5.1.1 The path within the past two decades... 53 5.1.2 The 2006 basic Standards for business enterprises... 56 5.1.3 Solvency... 58 5.2 THE LEGAL REGULATIONS ON THE INSURANCE COMPANIES... 59 5.2.1 The regulations about the establishment... 60 1
5.2.2 Legal constraints on investment instruments... 61 5.3 NEW MOVEMENTS... 63 5.3.1 The amendment of the PRC s Company Law... 63 5.3.2 The amendment of the Securities Law... 64 5.3.3 The new provisions on trust and investment companies... 65 5.3.4 Legislation on governing foreign financial institutions... 65 5.3.5 Insurance funds investing on stocks... 65 5.3.6 The issue related to the management debenture... 65 5.3.7 The usage of foreign exchange funds... 66 5.3.8 The rules on reinsurance... 66 6 RISKS AND DATA OBSERVATION... 66 6.1 RISKS IN THE ASSET SIDE OF THE BALANCE SHEET... 66 6.1.1 Credit risk and default risk... 67 6.1.2 Interest rate risk... 67 6.1.3 Inflation... 67 6.1.4 Performance of projects... 68 6.1.5 Mismatch... 68 6.2 BONUS MECHANISM AND SURRENDER OPTIONS... 68 6.3 INTEREST RATE S INFLUENCE ON THE LIFE INSURANCE COMPANIES... 71 6.3.1 Effects of the increase of interest rates... 71 6.3.2 Effects of the decrease of interest rate... 73 6.4 DATA OBSERVATION... 74 6.5 THE ORIGINS OF INTEREST RATE RISK... 77 6.5.1 Ratemaking of policy premium... 78 6.5.2 The mismatch of interest elasticity on the asset and liability... 83 6.5.3 Policy Embedded Options... 86 6.5.4 The change of policy demands... 87 7 INSTRUMENT OF INTEREST RATE RISK MANAGEMENT... 88 7.1 IMMUNIZATION USED IN THE DESIGN OF LIFE INSURANCE PRODUCTS... 88 7.2 ADOPTING ASSET AND LIABILITY MANAGEMENT... 91 7.2.1 Active interest rate risk management... 91 7.2.2 The passive interest rate risk management... 92 7.2.3 The mode of asset and liability management... 95 7.2.4 Use of financial derivatives... 99 8. SHORTCOMINGS AND CONTRIBUTIONS... 105 9 CONCLUSIONS... 106 ACKNOWLEDGEMENT... 107 REFERENCE... 109 ANNUAL REPORTS AND YEARBOOKS...119 TABLE LIST... 120 2
FIGURE LIST... 121 3
Abstract Since the initiation of Open and Reform policy in 1979, there is a lasting high speed development in the economic of China. Such fast increase of GDP and the development absorb many concentrations on China. In this paper, we will introduce the evolvements of Chinese life insurance industry and focus on the interest rate risk that the life insurance companies tolerance. The boost of insurance businesses starts from 1990s. Since then the Chinese insurance is one of the most fast growing markets in the whole world. The Chinese Life industry seems to jump into a leading global insurance market considering the premium growth and the establishments of new operators within a short period, especially from the birth of the Insurance Law to 2005. It is true that the Chinese insurance industry is by far a mature one compared to the American, the European and its neighboring markets. For the life insurance companies, because their products have long-term maturities that lead the mismatch of duration of asset and liability, which make the companies exposure more interest rate risk than the property insurance companies. Furthermore, the management system in the life insurance companies is far more lagging of the products the life insurance companies issued. In our paper, we aim at measure and manage the interest rate risk of the life insurance companies. We plan to use the duration and immunization models as the major tools, and then combine with the asset and liability management method try to give an instrument that suits for China. Also we recommend the derivatives as the management tools although the financial market in China is still immature. From the experience of developed countries, the derivative is an efficient and low cost way to manage risk. Key words: life insurance, interest rate risk, emerging Chinese market, duration, immunization, asset and liability management 4
1. Introduction 1.1 Background The insurance industry in China can be traced back to early 1800s but the insurance industry emerged as a business in China from late 1970s. The lack of domestic insurance operations lasted for almost 21 years until Deng Xiaoping initiated the Open and Reform policy in 1979 and launched a series of reforms aimed at stimulating economic growth (Arcy and Hui 2003). Similarly, other financial institutions in China had a rapid development since then, meanwhile the financial market also established and grew fast. Financial markets have experienced increased growing uncertainty about inflation rate, exchange rate, interest rate and commodity prices (Smithson 1998). Thus insurance firms face more and more risks and the effects come from financial market is more significant. Unpredictable movements in exchange rates, interest rates and commodity prices covey risks that no longer can be ignored (Chew 1999). So the risk now requires increased attention and consideration due to the very volatile nature of interest and exchange rate movement (Hudson, Robert et al 2000). The primary function of insurance companies is to protect individuals and corporations (policyholders) from adverse events. The industry is classified into two major groups: life insurance and property-casualty (Saunders and Cornett 2006). Traditional life insurance involves a commitment to pay the policyholder (or its beneficiaries) a given sum at a given date, triggered by either a specific event relating to the life of the policyholder or by the latter death, or a commitment to pay the policyholder installments (annuities) (Fleuriet and Lubochinsky 2005). But along with the change of environment, the life insurance companies activities also diversify. The risk stemming from the uncertain development of the interest rate can, under certain ideal market conditions, be eliminated by letting the contractual payment depend on the returns on the company s investment (Norberg 2001). In Europe, two types of life 5
insurance contracts are generally offered: unit-linked policies and traditional policies (Fleuriet and Lubochinsky 2005). In 1979, thanks to the Open and Reform Policy, Chinese insurance industry started resurgence. The People s Insurance Company of China (PICP) was re-run. In the first several years, the Company was a subsidiary of Chinese Central Bank, and it was administrated by the People s Bank of China. The PICP was separated from the Central Bank, followed by the establishments of the Pacific Insurance and Ping An Insurance, in the early 1980s. Before the birth of Insurance Law in 1995, there had been none business separation in the field. All companies run both life insurance and other non-life business at the same time. Because of the boost of insurance businesses in the 1990s, a new administration, the China Insurance Regulatory Commission was founded on 18 November 1998. From then on the Chinese Central Bank stopped its role of regulation in the insurance sector. Due to the undeveloped financial market and the regulation of insurance law, the unit-linked policies spread limitedly in China. The insurance law of China regulates that the assets of insurance companies just can be invested in the following four assets: bank deposits, trade of government bond or financial bond, and other use forms prescribed by State Department 1. So traditional contracts, participating policies (most are with-profits policies) and universal life insurance are the major types of contracts in China. 1.2 Problem formulation According to Chance (2005), the financial risks are the risks deal with the uncertainty of such factors as interest rates, exchange rates, stock prices, and commodity prices. 1 Insurance law of China, 28/10/2002, Article 105, Chapter 4 Regulation of insurance company management 6
Financial risks are a different matter from business risks, which the paralyzing uncertainty of volatile interest rates can triple the ability of a firm to acquire financing at a reasonable cost. A major objective of financial institution management is to increase the FI s returns for its owners. This often comes, however, at the cost of increase risks (Saunders and Cornett 2006). Thus there are a lot of risk control instruments come forth from practice and academy perspectives. A risk model normally has two major functions: measuring risk and controlling risk relying on the measurement. From Saunders and Cornett (2006), in mismatching the maturities of assets and liabilities as part of their asset transformation function, financial institution potentially expose themselves to interest rate risk. The life insurance companies also suffer all kinds of financial risks mentioned above, but base on the large maturity gap and the significant effects from floating interest rate, we concentrate on the interest rate risk of life insurance. Here we introduce two risk models: the duration and asset and liability management. The duration model has a long history; it was first brought forward by Macaulay in 1938. In Macaulay s work in 1956, the duration formula calculates a weighted average of time at which a fixed income security throws off cash flows. The economic meaning of duration is that it measures the interest sensitivity of an asset or liability or a portfolio. The interest elasticity was developed by Hicks (1939) first, he pointed out the price elasticity of a bond in response to a small change I its yield to maturity is proportional to duration. Based on the duration measurement, derives a management method which called immunization. The immunization is a theory that can cope with all the fluctuation of interest rate on the asset or liability side. Several researchers had contribution to the development of it, e.g.: Paul Samuelson (1945), F.M. Redington (1952), D. Durand (1957), Fisher and Weil (1971) who summarized the all preceding researches on immunization. To reduce the risk from interest rate, the financial institutions can insulate their 7
balance sheets from liquidity risk by efficiently managing their liquid asset positions or managing the liability structure of the portfolio (Saunders and Cornett 2006). The asset and liability management (ALM) deals with this problem. In ALM, the assumption of long-term expected returns are the key factors. According to Gill et al (2003), the assumption influences the asset side by asset allocation, portfolio management and trading, and the liability side by discounting the future cash flows as well as business decisions related to the fight for market share. According to the existing Accounting Standard for Business Enterprises-Basic Standard, companies adopt historical cost accounting principle for the book-keeping which is an accounting principle requiring all financial statement items to be based on original cost 2. But in 2006, the Ministry of Finance (MOF) of P.R.C issued a series of new and revised Accounting Standard for Business Enterprises (New Accounting Standards) which represent convergence with International Financial Report Standards (IFRS) 3 and to be effective from 1 January 2007. The New Accounting Standards require resetting and establishing the book-keeping systems for determining fair value. However such process just can evolve gradually in China, because the finance and accounting personnel lack of the knowledge about the requirement of New Accounting Standards and the companies, investors and market analysts need time to suit for the impacts of new standards. Thus in our paper, we use the data from the annual report of life insurance companies which are recorded followed historical cost. As the insurance contract works up day by day, the contract is no longer the traditional one which fixes the premium and the return no matter the change of interest rate or other factors that have effects on the value of contract. The new contract normally embeds options that contain surrender options, bonus options, option of premium payment and the option of mortgage loan. So we also consider the embedded option in our analysis. 2 http://www.investorwords.com/2316/historical_cost.html 3 http://www.ey.com/global/download.nsf/china_e/270306_press_release/$file/pressrelease_eng_hk.pdf 8
The paper is organized as follows. Section 2 gives a recommendation about the history and type of life insurance contracts in China. Especially the characters of the contracts issued. In section 3, we review the former researches on the duration and immunization then give out our analysis model. To comprehensively understand the life insurance industry in China, it is necessary to aware the whole insurance market. Thus we describe the Chinese life insurance emerging market in Section 4. We will give the regulatory environment of Chinese life insurance in Section 5 because the regulation directly affects the style of operation and management in life insurance companies. In Section 6, we first analysis the characteristics of risks faced by the life insurance companies. Then we give the data observation to illustrate that the life insurance companies exposure in interest rate risk and analysis the origins. The instruments of interest rate risk management are presented in Section 7. The last two sections are the shortcomings and contributions and the conclusion. 2. History and life insurance products 2.1 History 2.1.1 Brief Review China s insurance market can be tracked back to the early days in the last century. The industry had experienced an extended period over which insurance business was monopoly by national insurers. The first state-own insurance company in the People s Republic of China can be traced back to October 1949, which was named the People s Insurance Company of China (PICP). The provincial branches were established in the same period and served in the domestic market. In 1951, other twenty-eight private insurance companies emerged into two new firms, the Pacific Insurance and Xinfeng Insurance, in both of which the People s Insurance Company of China had shares. The PICP emerged Xinfeng Insurance into the Pacific Insurance Company in the mid-1950s. The new Pacific Insurance worked only for overseas customers. From 1949 to 1958, Chinese insurance industry was not prosperous, however, keeping on growing. But it was in a frozen period in the following twenty years until 1980 9
because of well-known political reasons. In 1980s, thanks to the Open and Reform Policy, Chinese insurance industry started resurgence. The People s Insurance Company of China was re-run. In the first several years, the Company was a subsidiary of Chinese Central Bank, and it was administrated by the People s Bank of China. Competition was not known in the financial market because of the Company s monopoly. The PICP was separated from the Central Bank, followed by the establishments of the Xinjiang Corps Insurance Company, the Pacific Insurance and Ping An Insurance, in the 1980s. They are all state-own enterprises. Both domestic private and (or) foreign entries do not exist until the first foreign entry of AIG in Shanghai 1992. Before the birth of Insurance Law in 1995, there had been now business separation in the field. All companies run both life insurance and other non-life business at the same time. Because of the boost of insurance businesses in the 1990s, a new administration, the China Insurance Regulatory Commission was founded on 18 November 1998. From then on the Chinese Central Bank stopped its role of regulation in the insurance sector. Besides the above two regulatory events, another milestone is China s accession to the World Trade Organization (WTO) in December 2001. As part of its pledge to enter the WTO, China promised to open its financial markets and to remove the entry barriers by the following ways: removing local protectionism, de-regulating the restrictions on the insurance, accelerating the reform of financial sectors 2.1.2 Four Stages of Chinese Insurance Industry 2.1.2.1 1949 1952 This period is the infancy of insurance industry of the People s Republic of China. Insurance companies had existed for dozens of years before the end of Chinese Civil War. In order to change private business into state-owns, the State Council accepted the bill to establish a national insurance company in August 1949. Sooner after the carry-out of the Draft of Regulations on the People s Insurance Company of China and the Draft of Charter of the PICC, the national insurance firm was established and acquired the China Insurance Co. Ltd. Founded in 1931. The national insurance 10
company had been a subsidiary of the People s Bank of China until 1984. The PICC grew fast during 1949 to 1952, which had five region subsidiaries and thirty-one provincial branches, and had more than two thousand employees. Contracts covered the most common ones, including property, marine, travel, automobile, stock and plant insurance. The prosperity mainly resulted from the compulsory rules on transportation. Re-insurance also had progress in that period. 2.1.2.2 1953 1977 Chinese insurance industry went into a frozen period. The Chinese government started the institutional revolution from 1953, which aimed to abolishing all private businesses. The State would get all benefits and any loss, which caused to freeze the insurance businesses and reached the end of the compulsory provisions in the transportation contracts. In December 1956, the People s Insurance Company of China stopped running. 2.1.2.3 1978 1996 After China decided to end its close-door policy and open to the world, the Chinese Insurance industry welcomes a renascence. The Central Bank started re-organization of the People s Insurance Company of China in February 1979 and the newly-established insurance company re-run in 1980. In this period, the state-own insurance companies had monopoly positions. They run in both the life insurance and non-life insurance business. 2.1.2.4 1996 Present The Insurance Law of the People s Republic of China was carried out in 1995. The Law regulates that insurance companies can not run both life insurance and non-life business. The state-own insurance companies were re-structured into (holding) groups and life insurance businesses were separated from. The first Sino-foreign joint life 11
insurance company was founded in Shanghai 1996. It gave a period to the local monopoly in the Chinese insurance sector. There are five insurance (holding) groups, forty-four life insurance companies, thirty-six property insurance companies and six re-insurance companies until March 2006. There is a rapid development in the insurance business of China. Witnessed from the table, the premium income increases dramatically. The average annual growth rate of life insurance is 35.24% which is much higher than other country. 2.1.3 Reforms after China s Entry of the WTO The People's Republic of China (PRC) becomes the 143 rd member of the World Trade Organization (WTO) on December 11 2001. It takes the P. R. China fifteen years to negotiate with the United States and the European Union about the bilateral market access agreements. The parties finally reached agreements respectively in 1999 and 2000. According to the agreements, the bilateral market access will be taken into the PRC s Protocol of Accession after one and a half year. Table 1: Growth of Premium Income (unit: billion RMB) 2000 change 2001 change 2002 change Total Premium 143.03 ** 210.94 47.5% 303.31 43.8% Property Insurance 55.28 ** 68.54 24.0% 77.83 13.6% Life Insurance 87.75 ** 142.40 62.3% 227.48 59.8% 2003 change 2004 change 2005 change Total Premium 338.04 11.5% 431.81 27.7% 492.73 14.1% Property Insurance 86.94 11.7% 108.99 25.4% 122.99 12.8% Life insurance 301.10 32.4% 322.82 7.2% 369.75 14.5% Source.: the website of China Insurance Regulation Commission, Statistics 12
There are several different requirements and commitments about China s insurance industry in the China s WTO agreements. Those commitments differ from each other regarding to: (1) the type of the insurance company, life insurance or non-life insurance, (2) the business fields, insurance underwriting, insurance brokerage or reinsurance, (3) geographic areas where certain business are allowed, (4) other requirements for reinsurance of risks an qualifications for oversea investors In the insurance field, China steps very fast to publicize new regulations and provisions to fulfill its WTO commitments. The recent steps are prior to the required deadline which is set in the WTO. Those important regulations include: PRC Administration of Foreign-funded Insurance Companies Regulations 4 (the Foreign Insurance Companies Regulations), Insurance Brokerages Provisions, Insurance Agencies Provisions, and Insurance Assessors Provisions. The above regulations and provisions are released in the end of 2001, which aim to governing administration about the foreign-invested insurance companies and have been in effect in some early time of 2002 Besides the regulations issued in 2001 regarding governing foreign-invested companies, the China Insurance Regulatory Commission and other adminstrations also make efforts in other fields. The CIRC issued the Questions Relevant to Large-scale Commercial Insurance Business and Master Policy Business Circular in February 2002, which clarifies the so-called "large scale commercial risks". 5 There are also other new and amended laws. In September 2002, the CIRC publicized the Establishment of Reinsurance Companies Provisions (the Reinsurance Provisions). 6 4 See China Law & Practice, February 2002, 16(1), pp. 39-47 5 Pursuant to the Circular, "insurance of large scale commercial risk" means insurance with premium over RMB 800,000 for investment over RMB 200 million upon China's accession to the WTO; within one year after China's accession, insurance with premium over RMB 600,000 for investment over RMB 180 million; and within two years after China's accession, insurance with premium over RMB 400,000 for investment over RMB 150 million 6 See China Law & Practice, November 2002, 16(9), pp. 61-62. 13
And in October 2002, the China s People Congress passed the amendment of the PRC s Insurance Law which integrates the China's WTO commitments and obligations into China s domestic laws. 7 Before October 2002, insurance companies, including foreign-invested insurance institutions are not allowed to get premiums and to settle claims in foreign currencies. The new provisions jointly released by the China Insurance Regulatory Commission and the State Administration of Foreign Exchanges (SAFE) turn on green light for insurance companies in this field. 2.2 The Development of Premium Payment and Products 2.2.1 The Regulation of Premium Payment The regulation of premium payment can be divided into two stages; 2.2.1.1 Official guide in the 1980s. In the early period of economic transition of China, the state-own People s Insurance Company of China had a monopoly position in the market. The administration gave an official guide about premium. But the provincial companies were allowed to adjust by +/- 30%. 2.2.1.2 Strict Control in the 1990s 7 The major amendments made to the PRC Insurance Law include: (i) deletion of a clause requiring insurance companies to reinsure 20% of their policies with China Reinsurance Co. Ltd. (China Re); (ii) confirmation of the CIRC's authority as the regulator of the insurance market by replacing "financial supervising and administrative department", originally referring to the People's Bank of China, with "insurance regulatory and supervising authority"; (iii) including an explicit authority for insurance companies to set their own rates and terms of insurance policies for their insurance services except for (a) insurance services that may affect public interest, (b) statutory insurance, and (c) new life insurance services; (iv) permitting property insurance companies to provide short-term health insurance and casualty insurance, subject to approval by the CIRC; and (v) replacing the prohibition on investment of insurance funds in any enterprise with a relatively less severe restriction, which prohibits insurance companies to invest insurance funds in a securities business, or to establish an entity not engaging in insurance businesses. A clause was also inserted that permits the State Council to designate appropriate investments for insurance funds in addition to bank deposits and government bonds. 14
More and more companies entered into the insurance sector, which caused competitions, especially on the premium payment. In order to take larger market shares, companies kept on the premium. The unhealthy competition resulted losses in the whole industry. The administration started a strict control of the premium payment from early 1990s. And the control is reinforced by the Insurance Law in 1995. The Regulations on Administration of Insurance Companies stipulate that clauses and insurance premium rates of,1) products for compulsory insurance, 2) newly developed life insurance products, 3) insurance products related to the public interests, should be approved by China Insurance Regulatory Committee. Others should be filed with the CIRC. 2.2.2 The Regulation of Investments The Insurance Law is a milestone in the development of regulation of Chinese life insurance industry. 2.2.2.1 Before the Law In the period from 1979 to 1985, as a state-own enterprise administrated by the Chinese Central Bank, the People s Insurance Company of China was regulated and supervised directly by the Bank. The chief officials of the Company had governmental positions at the same time. The State Council passed the Rules on Administration of Insurance Enterprises, which is the first legal paper after China restored its insurance industry. The Rules aimed to clarify the administration organization and to speculate the insurance companies investment activities. The Rules require that investment capitals of insurance companies come from deposits. All companies must have investment departments which are responsible for both investments and risk management. Though far from detailed and complete, the Rules is the framework and draft of the Insurance Law of 15
1995. 2.2.2.2 After the Insurance Law The 1995 Insurance Law came into birth after seventeen years of the restarting of Chinese insurance businesses. Both the Chinese financial markets and the insurance industry were not mature, however, new financial instruments, insurance products and theories were introduced into China gradually. The Law clearly defines the investment activities of insurance companies and the source of capital. The Regulations on Administration of Insurance (Temporary) 1996 and the Accounting Standards of Insurance Companies detail the implementation of the related provisions in the Law. Chinese insurance industry have grown fast from the middle 1990s until know. Most mature products, investments and risk management theories in the developed markets were taken into Chinese market. In 1998 the Chinese Insurance Regulatory Commission replaced the Chinese Central Bank s position on administration of insurance companies. The Commission announced a new legal profile speculating the solvency, implementations and so on. 2.2.2.3 Recent Development In the growth of Chinese insurance industry, both life insurance companies and non-life ones have experienced a period of stringent restrictions in which the ways how insurance funds are used and the fields where the investment can be done are strictly limited. Before the 1995 Insurance Law, there are few other investment activities besides governmental bonds. During the implementation of the PRC Insurance Law (Insurance Law) in 1995 until the Insurance Law amended in 2002, there are almost no obvious changes regarding to this issue. The China's insurance industry grows disproportionately. When comparing the insurance funds utilization to 16
the insurance business, the former is apparently smaller and weaker than the later. The tables and figures in the following sections shows a strong and continuous growth of premiums and the yearly average rate growth is above 30% in recent years. But if looking the counterpart side, the performance of funds on investments is far from sufficient and good in that the fields and ways of insurance funds are strictly limited to interest-earning products with low returns such as governmental bonds. The insurance companies have been pledging for more investment channels and loose restrictions so as to diversify risks and enhance returns on assets. It has taken the China Insurance Regulatory Commission (CIRC) and the State Council long time to find solution on use more smooth and safer ways for utilizing insurance funds. In order to enhance the profitability and returns of insurance companies and to relieve the anxious mood from shareholders, the CIRC publicized the Measures for the Administration of Pilot Program for Indirect Investment in Infrastructure Projects with Insurance Funds (Measures), which takes effects in the mid-march 2006. In the same period, besides the calls for more flexible and profitable channels of investments, there are certain other issues which have significant effects on the healthy growth of both the industry and individual companies. The rapid growth for Chinese life insurance industry and the further opening of financial markets lead the industry to face many joint challenges, such efficient corporate governance, de-regulation on investment, effective and professional risk management, effective financial markets, better accounting standards and so on. Recent steps 8 by the Chinese Insurance Regulatory Commission (CIRC), the Ministry of Finance P. R. China and the Chinese Central Bank demonstrate a strong trendy to follow international practice such as introducing IFRSs into new accounting 8 including the Measures for the Administration of Pilot Program for Indirect Investment in Infrastructure Projects with Insurance Funds (Measures) by the CRIC March 2006 17
standards 9, loosening limits on investments and series of announcements related to policyholder interests, financial derivatives, and transparency and so on. We will discuss those issues separately in the following sections. 2.3 Life insurance contracts Due to the character of Chinese pension system, the major business of life insurance fastens on the individual life contract. As we know there is a rapid development in the insurance business of China. Witnessed from the table, the premium income increases dramatically. The growth rate of life insurance slowed obviously in 2004. The reason for this phenomenon is that the sales of products boosted in 2003 since many life insurance companies issued the single-premium endowment products which absorbed the purchase. But such products could not keep the strong sales in 2004 because of their poor profitability performance. 10 Aiming at this problem, the insurance corrected their policy soon which leaded the premium income increased fleetly again. Even go through the fluctuation, the average annual growth rate of life insurance from 2000 to 2005 is 35.24% (see Table 1). Accompanying the fast development, the transformation of product in life insurance also has been accordingly. In spite of the short term development of Chinese life insurance, the emergence of insurance contracts is as other developed countries. The types of contracts are term insurance, whole life insurance, annuity contract and variable life contract, etc. The period of their emergence depends on the transfer of the financial market. Nowadays there are four kinds of products prevail in the insurance market. 2.3.1 Traditional insurance contract 9 Accounting System for Business Enterprises issued by the MOF 2006, a ground Standards including basic principles such as prudential principle and fair value on which the Accounting Standards for Financial Enterprises are based on. The new System will be adopted January 1 2007 onwards. 10 Swiss Re, Sigma, World insurance of 2004: growing premium and stronger balance sheets, No 2/2005, page 25 18
In our view, the term insurance, whole life insurance and annuity contract are fallen under the traditional insurance contract. The form of term insurance normally is level term. Generally speaking, the term of coverage is often 5, 10, 15 or 20 years and the term of age is 16 to 65. The policyholder can choose single premium or installment each year. For most company, the premium of term insurance is the lowest of all kinds of contracts. But now the term insurances in China most are designed as addictive contracts which are the subsidiaries of the parent contracts. The term designing of whole life insurance is almost the same as term insurance contract. The premium also is low and fixed which is not affected by the fluctuation of interest rate and price level. But it is not saying this kind of contract is inanimate since it allows the policyholder adds 20% of the sum insured every 5 years. From the beginning of insurance reform to 2001, the traditional insurance holds the dominant position in insurance market. The premium income of traditional non-participating insurance is 100.56 billion RMB, meanwhile the income of participating, universal and variable are 27.16, 4.03 and 10.66 separately in 2001 11. Even the traditional insurance is the mainstream but the premium growth rate and the market share are slowdown since the investment types of contracts appeared in 1999. The character of traditional insurance determines the decay. Because in a traditional insurance contract, the predetermined interest rate, the premium and the sum insured are low and most of them are fixed which can not suit to the change of guarantee. Further more, more and more policyholders not only regard the insurance contract as a protection but also consider it as an investment tool. So the investment type of contracts which can give the chance to the policyholder to get more than guarantee is popular. The aftereffect shows directly, in 2005, the premium income of traditional insurance is 2.63 billion which just occupies 7.4% of the total premium of life insurance in Beijing 12. 11 Yearbook of China insurance 2002 12 http://61.135.237.5/portal3/infomodule_626/21143.htm 19
2.3.2 Participating policy As we mentioned above, the participating policy was introduced since 1999. The participating contracts mainly include with-profit policy and unit-linked policy in China which holds large share of the life insurance market today. The participating policy is an insurance policy under which the insurer shares with the policy-holders some proportion of any profits it generates in a period. An insurer generates a profit if it has spent less paying claims and on expenses than it received in premium income in a period. The profit sharing may take several forms (e.g. a cash bonus to the policy-holder, or a reduction in future premiums). 13 a. With-profits policy A with-profits policy is an insurance contract that participates in the profits of a life insurance company. The insurance company aims to distribute part of their profit to the with-profits policy holders in the form of a bonus attached to their policy. The bonus rate is determined by complex actuarial calculations with reference to the return on the underlying assets, the level of bonuses declared in previous years and other actuarial assumptions. 14 The regulation issued by China Insurance Regulatory Commission (CIRS) prescribes the with-profit product adopts fixed expense rate and death rate and the ratio of distributive profit to the total profit is not less than 70%. 15 The policyholder can choose the way to get bonus such as reversionary bonus, terminal bonus and counteracting the premium of next year. When the participating contract came into the market, it attracted many policyholders because of its higher profitability. In 2003, the premium income of with-profit policy is 167 billion RMB, takes the 55.5% of the total premium income of life insurance. 13 http://www.superannuation.asn.au/dictionary/p/participating%20policy.htm 14 http://en.wikipedia.org/wiki/with-profits_policy 15 With-profit products temporary management project, China Insurance Regulatory Commission, No. 26 (2000), article 11 and 12 20
b. Unit-linked policy A life assurance policy in which a portion of the premium is used to purchase life cover (the sum assured) with the balance invested in an authorized unit trust/trusts. The return on the policy is thus linked to the performance of the units in the unit trust. Unit linked policies include single premium bonds or investment bonds, unit linked endowment assurance and unit linked whole life assurance. 16 This product first is issued by Ping An life insurance in 2000. The premium income of unit-linked policy is 10.662 billion; the growth rate reached 542.26%. 17 But this uptrend did not consist for a long time because the consumer aware that such product gave the policyholder the profitability and risk at the same time. In our opinion, the unit-linked policy is an advanced product which has the function on the mismatch of asset and liability and promotes the management in life insurance. But the spread of it still has some obstacles. First is that the developed financial market is a necessary condition for the unit-linked policy which proves various investment channels to it. But actually the use of asset is limited by the regulation of China Insurance Regulatory Commission then the kinds of trusts can be invested are also limited. Second, the management system of insurance investment is not formed, meanwhile the lack of investment manager and tools give much difficulty to the spread of unit-linked policy in China. But as the improvement of financial market and the consummation of the insurance system, the unit-linked policy will become the dominant product in the insurance market in the future. 2.3.3 Universal life policy Universal Life Insurance which also called interest sensitive life insurance is a flexible-premium, adjustable benefits life insurance policy that accumulates account 16 http://www.finance-glossary.com/terms/unit-linked-policy.htm?id=1490&ginptrcode=00000&popupmode= 17 http://www.cmbchina.com/cmb+info/publication/2005/terma/sunflower/1056.htm 21
value. The flexibility of this policy allows you to change the amount of insurance as your needs for insurance change. 18 In this contract, the premium is deposited into a fund named saving element. Normally each month the fund is charged with mortality costs and expenses, and the interest rate called universal interest rate is announced by the actuarial department of each company in China. There are two patterns of death benefit are offered on universal life. Option A death benefits were originally level until the fund exceeded the face, and then were equal to the fund. Option B provides for a constant net amount at risk, since the amount of insurance under Option B is defined as the ace amount plus the fund. 19 Because the universal interest rate has the direct relationship to the deposit interest rate, it can reduce some inflation and interest rate risk of the policyholder. As the deeper aware of the advantages of universal life insurance, the sales raise rapidly in 2005. Here we just list the major type of insurance business in China which also includes the annuity contract, variable life insurance etc. The form of contract is not the just the single but multiplex contract, such as the variable universal life insurance. Also two types of contract can be combined together, one plays host contract the other plays as the accidental contract. Totally speaking, nowadays the business of insurance is diversified in order to meet the change of policyholders demand. 2.4 Option elements As the insurance contract works up day by day, the contract is no longer the traditional one which fixes the premium and the return no matter the change of interest rate or other factors that have effects on the value of contract. The new contract normally embeds options that contain surrender options, bonus options, option of premium payment and the option of mortgage loan. This kind of option we call embedded option which is an option that is an inseparable part of another 18 http://www.statefarm.com/insuranc/life/universal.htm 19 Albert E. Easton and Timothy F. Harris, Actuarial aspects of individual life insurance and annuity contracts, ACTEX Publications, ISBN 1-56998-346-0, Page 16 22
instrument. Compare this to a normal (or bare) option, which trades separately from the underlying security. The surrender option in the contract gives the right to the policyholder can terminate the contract early and get the surrender value. If a policyholder surrender, the insurance company just deducts the express of operation and returns the total premium to him. In the bonus option, the policyholder can choose the way to get the bonus. Generally the ways can be separated by three: first is getting the bonus as cash in the end of each year; second is counteracting part of the premium should be paid next year; third is depositing it at a compound interest rate and getting it at maturity day. The option of premium payment usually is single-premium payment or installment payment. But in a universal life insurance the period and the amount of premium payment is not restricted, it just has a base line that at least 1000 RMB each time and the sum insured not less than 10000 RMB. The policyholder can apply the credit when he pays the premium on time for 2 years. The maximum amount he can get is the 70% of the total premium in his account and the loan rate is at most 2% higher than the 1 year loan rate which regulated by central bank at the same term. The embedded option partly benefits the policyholder based on some profit loss of insurer. For example, the mortgage loan is designed for reducing the surrender when the policyholder is short of money. But some policyholder regards this option as an arbitrage by taking advantage of the floating of interest rate. If the bank interest rate goes up and the change of predetermined interest rate lags of it, the policyholder has the opportunity to get the mortgage loan and reinvest in the higher interest rate project. Based on China adopts floating interest rate for a short time, the life insurance does not take the relevant defend system. The evidence is that the most contracts contain the embedded option but the devising of the contract and the premium does not take account of the option value. In a word, the actualization of the embedded option exceeds the contribution of relevant system. 23
(The calculation of the contract price, premium and reserve we plan to put it in part 5, combining with the model analysis) 3. Models and hypothesis This section we will demonstrate the financial market that the life insurance companies face by using the term structure of interest rate. Then we will introduce the interest rate risk and the models of measuring it. Meanwhile we also list the hypothesis of the model. 3.1 Review of the models In 1938, Macaulay suggested that to use an alternative way to measure the bond s longness but not maturity which he considered is a date and final payment of a loan only. He used the word duration to signify the essence of the time element in a loan (Macaulay 1938). The Macaulay s duration 20 calculates a weighted average of time at which fixed income security throws off cash flows, the weights used are the present value of each payment relative to the bond s price. Macaulay s duration is computed using the bond s yield to maturity. Hence, each one of the future payments a bond is expected to produce is discounted at the same rate, the yield to maturity. Thus Macaulay s duration given in equation (1) implicitly assumes a horizontal yield curve as well as unexpected changes in interest rates that shift the yield curve only in a parallel fashion. 21 This condition is only a special one. Actually, the duration of a bond is effected by the floating interest rate of each period and the different shape of 20 Macaulay defined duration as: D m n n= 1 ( 1+ ) ( 1+ i) C A + ( ) n ( 1+ i ) = m n= 1 Cn i 1+ i + Where C = coupon payment, A = maturity value, n = number of periods to the coupon payment, m = number of periods to maturity, and I = yield to maturity. 21 Hawawini, G.A (1982), Bond duration and immunization: early developments and recent contributions, Garlamd publishing, Inc 24 Am m m
yield curve. In his paper, Macaulay gets the result that the concept of duration throws a flood of light on the fluctuations of bond yields in the actual market. The development of concept of duration is also attributed by Hicks. In his 1939 book Value and capital, he presented a formula analogous to that of Macaulay which he called the average period of a stream of payments (Hawawini 1982). Further more, he pointed out the price elasticity of a bond in response to a small change in its yield to maturity is proportional to duration. He used a discount ratio which equals i / (1+i) where i is the interest rate of a period, to measure the elasticity of capital value (Hicks 1939). Based on the duration measurement, derives a management method which called immunization. In a paper published in 1952, Redington derived a measure similar to duration which he called mean term and proved that the existing business is immune to a change in the rate of interest when the mean term of the firm s assets is set equal to the mean term of the firm s liabilities. The immunization is a theory that can cope with all the fluctuation of interest rate on the asset or liability side. In Redington s paper he gets a conclusion that the essence of the immunization theory is contained in two definitions, two rules and a rider. They are listed in the following: Definition 1: liability-outgo (Lt), the expected net outgo of the existing business in calendar year t, viz. claims and expenses less premiums. Definition 2: asset-proceeds (At), the expected proceeds from the existing assets in year t, viz. interest plus maturing investments. Rule 1: the mean term of the value of the asset-proceeds must equal the mean term of the value of the liability-outgo. Rule 2: the spread about the mean of the value of the asset-proceeds should be greater than the spread of the value of liability-outgo. Rider: the mean term of the asset-maturity dates is considerably greater than that of the value of the asset-proceeds. 25
But Redington s immunization theory has some common ground as the Macaulay s research which is based on certain number of restrictive assumptions. He assumed that not only interest rate but also the mortality, expenses and taxation are at a continuous series of probability distribution in the future period. All the assumptions can be not meet in the real world. Fisher and Weil absorbed the former researches, and then published their classical paper 22 about the immunization strategy. In their paper, they assume that: (1) There is only a one-time change in interest rates of equal magnitude for all maturities, that is, the yield curve shifts in a parallel fashion (2) There are no taxes (3) There are no transaction costs (4) Returns are compounded continuously 23 But not like the assumptions of Macaulay, they do not suppose a flat yield curve. Further, they define the duration 24 also a little different from Macaulay and Hicks. In their formula, the forward instantaneous rate of interest compounded continuously for future times t. Almost the precious duration researches focus on the default-free bonds. As a result, the interactive effects of the stochastic process of interest rates and default risk on duration are not well documented. It would seem unlikely that default-free duration 22 Fisher and Weil (1971), Coping with the risk of interest-rate fluctuations: returns to bondholders from naïve and optimal strategies, The journal of business of the university of Chicago, Vol. 44, No. 4 23 Hawawini, G.A (1982), Bond duration and immunization: early developments and recent contributions, Garlamd publishing, Inc 24 Fisher and Weil define duration as: m D n n= 1 t= 1 = m Cn + ( 1+ r ) ( 1+ r ) C t + m t= 1 Am A t n m n= 1 (1 + rt ) (1 + rt ) t= 1 t= 1 Where C, A, n, m are defined as Macaulay and Hicks s, r t = one period discount rate (forward rate) in period t. 26