Hong Kong Hops On The ILS Bandwagon

More uniquely, as a special administrative region (SAR) of China, Hong Kong is often considered as the gateway to China. Not only does the Chinese territory’s banking system hold assets equivalent to approximately 9.5 times its gross domestic product (GDP) and is a major profit driver of several globally systemically important banks, it also hosts one of the world’s largest stock exchanges with a market capitalisation of US$6.1 trillion. In its recent Financial System Stability Assessment Report[i], the International Monetary Fund reaffirmed Hong Kong as an international financial centre with a resilient financial system, sound macroeconomic and prudential policies, and robust regulatory and supervisory frameworks.

Apart from its well-established banking sector, the SAR also has a thriving insurance industry with an independent regulatory regime under China’s “one country, two systems” model. Hong Kong’s insurance regulator, the Insurance Authority (IA), continually engages in modernisation initiatives to enhance and raise its supervisory standards to meet those of its global peers. Given Hong Kong’s proximity and relationship with China, the IA also undertakes the responsibility of advancing the territory’s position as an international (re)insurance hub to tap the potential of the Chinese insurance market, especially in non-life insurance and reinsurance.

The Hong Kong life insurance sector is one of the most advanced markets in Asia with the highest life insurance penetration (premiums as a percentage of GDP) globally. Provisional 2020 statistics from the IA showed that the total premium revenue of in-force and new long-term businesses were US$70.4 billion and US$17.1 billion respectively, despite negative economic impact from COVID-19 related lock-downs and restrictions. Due to restrictions on cross-border passenger traffic, new premium revenue from mainland visitors contracted from US$5.6 billion in 2019 to just US$12.9 million during the first quarter of 2021. Nonetheless, this negative impact to new business is expected to be temporary; the prospects for Hong Kong’s life insurance sector remain positive, supported by the Chinese government’s initiatives in prompting the development and interconnectivity of financial services in the Greater Bay Area (which covers nine cities in Guangdong province, Hong Kong and Macau).

The non-life insurance sector is a crowded and fragmented market with approximately 100 non-life insurance companies. The IA’s 2020 provisional statistics reported that the size of the SAR’s non-life segment is about US$7.7 billion in terms of gross premium income.

Promoting Hong Kong As A Risk Management Centre And ILS Hub

Further to its push to position Hong Kong as a captive insurance centre for China’s state-owned enterprises (SOE), the IA has spared no effort to promote Hong Kong as a specialty risk consortium for businesses, including the passage of tax concessions for specialty risks. While the SAR is considerably “late” compared to international peers, the IA still aims to establish the territory as an Asian hub for insurance-linked securities (ILS).

In July 2020, the Legislative Council passed the Insurance (Amendment) Ordinance 2020 that set out the regulatory regime for the issuance of ILS in Hong Kong through the formation of special purpose insurers. The bill also empowered the IA to formulate rules to limit ILS sales to eligible institutional investors, while the minimum investment quota was US$250,000, which was aimed at achieving a balance between market facilitation and investor protection.

The Hong Kong Financial Secretary recently announced details of a two-year pilot ILS Grant Scheme, promulgated in the SAR’s 2021/2022 Budget, to attract insurance companies and organisations to issue ILS in the territory. Eligible issuances in Hong Kong may be entitled to a cost subsidy of up to 100 per cent of total upfront issuance costs, capped at HK$12 million (US$1.5 million) depending on maturity and size of issuance; however, at least 20 per cent of upfront issuance costs must be allocated to locally-based service providers. The Grant Scheme will also help channel part of the subsidy to support the local ILS development and specialist employment.

In 2018, Singapore launched a similar grant scheme which sponsors 100 per cent [up to SG$2 million (US$1.5 million)] of the upfront issuance costs of ILS domiciled in Singapore. The grant scheme, originally due in 2020, was extended to the end of 2022. Over the past two years, Singapore has successfully attracted several catastrophe bond (CAT bond) issuances, which provide coverage of perils in Australia, Japan and North America.

Competitive Edge

Apart from welcoming supranational organisations and non-Asia based issuers, the IA also plans to leverage Hong Kong’s proximity to and relationship with China and focus on promoting ILS issuances by Chinese (re)insurers. Given that the mainland is prone to natural catastrophe risks (including earthquakes, typhoons, floods and droughts), the country’s rapid economic development and urbanisation over the past two decades have only exacerbated insurers’ catastrophe risk accumulation. As such, CAT bonds may be a viable alternative to traditional reinsurance protection. More importantly, this initiative is strongly encouraged by Chinese government policy supporting Chinese insurers’ CAT bond issuances on Hong Kong’s ILS platform.

However, despite the overt support from China, there remain several challenges that Hong Kong will need to overcome in order to achieve its goal. First, the government must develop the local ecosystem and expert talent so as to facilitate efficient and effective ILS issuances. According to the IA, the first Chinese-sponsored ILS issuance from Hong Kong is a work in progress and is expected to be completed in 2021.

Next, given that investment timing is vital in ILS issuances, the ecosystem and regulatory approval process needs to be prompt. For example, Singapore has a fast-track approval framework that enables issuance approval within eight weeks from application.

Thirdly, the IA and the China Banking and Insurance Regulatory Commission (CBIRC) will need to collaborate on educating Chinese insurers about ILS and CAT bonds as alternative insurance solutions.

The last and greatest challenge is to create a meaningful supply of ILS from Asia-Pacific sponsors (i.e., (re)insurance companies) in the current relatively cheap reinsurance environment.  The use of ILS usually comes into consideration when the lack of reinsurance capacity leads to expensive reinsurance protection. Typically, this occurs after the (re)insurance industry has suffered from poor results after major catastrophe events. In recent years, due to benign catastrophe activity in Asia-Pacific (except in Japan) and the consequently cheap cost of traditional reinsurance, the demand for reinsurance protection in China and in other Asian countries (excluding Japan)  has been quite easily met. As such, the subsidy offered by Hong Kong’s ILS Grant Scheme will help to make ILS options more competitive compared with traditional reinsurance from a cost perspective.

Hong Kong’s ILS Focus On China Presents Greater Diversity For Investors

Existing CAT bond investors in the overseas markets are mainly institutional investors, pension funds, sovereign wealth funds, family offices, and foundations that view CAT bonds as an alternative investment that is lowly correlated to other financial instruments subject to financial risks. Typically, only a very small percentage of the investment portfolio is allocated to CAT bonds. Given the complex structure and prospect of losing a substantial part of the principal investment sum on occurrence of a trigger event (such as a specific natural catastrophe event in a specific country), CAT bonds are unsuitable for retail investors. In the interest of building up a track record, the IA limited investor eligibility even further to exclude sovereign wealth funds, pension funds, and family offices.

The ILS markets in Bermuda, Cayman Islands, Guernsey and Dublin are relatively mature; existing CAT bonds predominantly cover risks from US and Europe while a number of issuances cover perils in Japan and Australia. Hence, we expect that existing CAT bond investors will welcome the IA’s initiative in introducing new underlying risks (from China or Asia) that are not yet available in the market, which could allow them to further diversify their portfolio risk.

In Asia, ILS and CAT bond investments remain very new, even to institutional investors. However, if Hong Kong is able to successfully establish itself as a CAT bond hub for both Chinese and overseas risks, this will also attract other regional (especially Chinese) investors pursuing an overseas institutional investor strategy. The current investment options available to Chinese investors are very limited and concentrated to the China domestic market. Nonetheless, the Chinese government’s policy direction is to open up cross border investments, with the recent Greater Bay Wealth Management Connect policy launched as the first step to facilitate north and south bound cross-border investment in a structured manner.

Overall, while it has an edge as an established global financial centre, Hong Kong remains in a nascent stage of ILS development. The SAR still has much to accomplish in order to demonstrate its efficiency and effectiveness in ILS issuance, albeit strong policy support from the mainland is likely to catalyse ILS demand. It is expected that the first ILS issuance in Hong Kong will be a showcase to demonstrate this, while the ILS Grant Scheme is likely to accelerate the market’s development. Given that ILS capital has now gained a notable share of the international reinsurance market (i.e., replacing some forms of reinsurance protection offered by traditional reinsurers), several years from now, there is a chance we may see the same picture for Asia, especially in China.

What Is ILS? 

Insurance-linked securities (ILS) are financial instruments designed to transfer a well-defined insurance risk to third-party investors. ILS generally is considered to have low correlation with wider financial market risks as their value is linked to insurance-related and non-financial risks such as natural catastrophes, insurable specialty risks or life and health insurance risks (such as mortality and longevity risks) from insurance policies. The most common types of ILS include catastrophe bonds (CAT bond), collateralised reinsurers, and reinsurance sidecars.

What Is A CAT Bond? 

A CAT bond is a structured debt instrument that transfers risks associated with low-frequency, high-severity events (such as natural catastrophe risks) to investors. The insurance industry has utilised catastrophe bonds as an alternative solution to traditional reinsurance and retrocession (i.e., reinsurance of reinsurance) contracts. Depending on the risk appetite of investors, specific layers of catastrophe insurance risks are bundled together and transferred to the capital markets through traditional securitisation methods.

Typically, the sponsor (i.e., insurer or reinsurer that wants to obtain insurance protection) will establish a special purpose vehicle (SPV) and transfer the risk to the SPV via a reinsurance agreement. The SPV will receive premiums from the sponsor in exchange for providing the coverage via the issued securities. The SPV issues the securities to investors and receives principal amounts in return. Interest payments comprise interest that the SPV invested from the collateral, and the premiums paid by the sponsor. If a pre-defined event (e.g., an earthquake in Japan) occurs which meets the trigger conditions to activate a payment, the SPV will liquidate collateral required to make the payment and reimburse the sponsor according to the terms of the catastrophe bond transaction. If no trigger event occurs during the investment period, at the end of the CAT bond term the collateral is liquidated and repaid to investors.

The first CAT bond was issued in the mid-1990s during which the US was struck by major catastrophe events, such as Hurricane Andrew and the Northridge Earthquake, which led to capital erosion in reinsurance markets. The insurance and reinsurance industry sought alternative solutions to traditional reinsurance protection. The CAT bond was thus devised through a collaboration between the reinsurance industry, capital markets structuring firms, investment banks and investors.

According to Artemis, new CAT bond & ILS issuances in 2020 were estimated at US$16.4 billion, while outstanding risk capital as of 2021 continues to grow and has reached a record high of US$51 billion.

Footnotes:

[i] People’s Republic of China—Hong Kong Special Administrative Region: Financial System Stability Assessment-Press Release and Statement by the Executive Director for the People’s Republic of China—Hong Kong Special Administrative Region (imf.org)

Christie Lee
Christie is a senior director and head of analytics of AM Best Asia-Pacific Limited. She leads a team of rating analysts within AM Best that cover all types of rated insurance companies, including life, non-life, reinsurers and captive insurers, for Greater China, Japan and Korea. Founded in 1899, AM Best is the world’s first credit rating agency, and has grown to become the largest credit rating agency in the world specialising in the insurance industry. It is the oldest and most widely recognised provider of credit ratings, financial data and news with an exclusive insurance industry focus.