The insurance industry has finally welcomed the “Second Generation of Solvency” extension amid the dual dilemma of counter-cyclical and regulatory switching

Zheng Jiayi

As the deadline for the second phase of the solvency regulatory rules approaches, the long-awaited delay policy has finally been implemented.

On December 20, the National Financial Regulatory Administration issued the “Notice on Extending the Transition Period for the Implementation of Solvency Regulatory Rules for Insurance Companies (II)” (hereinafter referred to as the “Notice”), extending the deadline for the second phase transition from one year to the end of 2025, and clarifying that the “one company, one policy” model will continue to determine the transition period policies.

This is seen by the industry as a typical action under the counter-cyclical regulatory approach.

When the second phase of the solvency project was launched in 2017, the insurance industry was still in a phase of “barbaric growth” with high growth rates, and the rules-driven risk orientation also had certain “restrictive” factors.

In the actual implementation of the second phase, the insurance industry has faced numerous challenges, including the impact of the pandemic, declining interest rates, a decrease in new business value, and a significant drop in agents, with the previously high premium growth rate showing signs of fatigue.

Especially in the nearly three years of being trapped in a transformation cycle, the difficulty for insurance companies to supplement capital has further increased.

First, insurance companies under pressure from net profits find it difficult to supplement endogenous capital through retained earnings;

Second, the difficulties faced by real enterprises combined with “refund” requirements have led to a decline in the once-booming external capital influx into insurance company equity, making external capital supplementation extremely challenging.

Li Yunze, director of the National Financial Regulatory Administration, stated in a public speech in June this year that it will strengthen counter-cyclical regulation in the insurance industry, improve solvency and reserve regulations, and broaden capital supplementation channels.

Zhou Jin, a partner in financial management consulting at PwC China, pointed out that “many insurance companies are currently facing urgent solvency adequacy ratios, and problematic companies are still struggling to find suitable investors for restructuring.”

Zhou Jin stated that considering interest rate trends and the risks of interest spread losses, if the second phase of solvency is fully implemented as originally planned, the development of the industry and even sustainable operations may be affected.

Providing more buffer space through a temporary extension of the transition period seems to be the most appropriate choice at present.

“Anemic” insurance companies, extending for another year

The transitional measures at the time of the implementation of the second phase of the “Notice” are consistent.

In 2021, regulators clearly stated that for insurance companies “whose core solvency adequacy ratio or comprehensive solvency adequacy ratio significantly declines due to the switch from old to new rules, or falls below the critical point with regulatory action significance,” a transition period policy would be formulated on a “one company, one policy” basis.

At that time, the deadline for the full implementation of the second phase was set for the end of 2024.

This round of policy also targets insurance companies “significantly affected by the switch from old to new rules on solvency adequacy ratios,” but the deadline has been postponed to the end of 2025.

In comparison to the first phase of solvency, which was launched in 2012, the second phase shifted from scale orientation to risk orientation, establishing a “three-pillar framework of quantitative regulation, qualitative regulation, and market constraints” based on the Basel Capital Accord III;

In the second phase construction that began in 2017, prudence and risk orientation became more prominent, not only refining the minimum capital requirements for investment real estate and long-term equity investments, increasing concentration risk factors, but also implementing a penetration principle for complex financial instruments
This has led to a general decline in the solvency of insurance companies after the implementation of the second phase project.

In the first quarter of 2022, over 90% of life insurance companies and over 60% of property insurance companies saw a month-on-month decline in their comprehensive solvency adequacy ratio data;

By the end of that year, the comprehensive and core solvency capabilities of the insurance industry had decreased by 36.1 and 91.3 percentage points year-on-year to 196% and 128.4%, respectively.

Under the strict second phase rules, several insurance companies, represented by Bohai Property Insurance and Dubang Property Insurance, applied to enter the transition period at the first opportunity.

Wang Guojun, a professor at the School of Insurance at the University of International Business and Economics, pointed out that despite three years having passed, the insurance industry has still not digested the impact of the rule switch.

Insurance companies suffering from “capital hunger” are making every effort to seek external capital supplementation.

As of December 25, 14 insurance companies issued new bonds totaling 117.5 billion yuan this year, setting a new historical high after first breaking the 100 billion yuan mark in 2023.

In the previous three peaks of bond issuance, the insurance industry issued 73.28 billion yuan in 2012, over 60 billion yuan in 2015, and 78 billion yuan in 2020, all of which were far lower than in 2023 and 2024.

At the same time as issuing bonds, another 19 insurance companies were approved for capital increases of nearly 20 billion yuan this year; several insurance companies have proposed capital increase plans, awaiting regulatory approval.

However, the results show that intensive “blood replenishment” is still a temporary solution rather than addressing the root cause.

As of the end of the third quarter of this year, the comprehensive and core solvency adequacy ratios of the insurance industry remained at 197.4% and 135.1%, not much different from the end of 2022; another 16 insurance companies have not disclosed data, leaving their solvency status a mystery.

Zhou Jin assessed the current situation and stated that the insurance industry will still face significant capital supplementation pressure next year.

“First, the overall profitability level of the industry is not high, and the operating conditions of small and medium-sized companies are showing further signs of deterioration, with insufficient endogenous capital supplementation capability.” Zhou Jin stated, “Second, under performance pressure, real enterprises do not have strong capacity and willingness to invest in insurance companies, and external channels remain unblocked.”

Wang Guojun also stated, “In the context of uncertain economic prospects, insurance companies need more time to adjust their capital structure and optimize risk management. Extending the transition period helps avoid operational difficulties for insurance companies and maintain the stable operation of the entire insurance industry.”

The Inevitability of Cycle Mismatch

Many industry insiders pointed out that extending the transition period of the second phase aims to provide the industry with a buffer space under the counter-cyclical regulatory approach.

Zhou Jin analyzed that compared to the initial issuance of the second phase rules, both the macroeconomic and market environments have undergone significant changes.

These include but are not limited to the operational difficulties following the outbreak of the pandemic in 2020, the “asset shortage” under a weak equity market, and the adjustment of the upper limit of the life insurance premium rate due to the decline in government bond yields.

Taking changes in premiums and the number of agents as an example.

From 2013 to 2019, China’s premium compound annual growth rate reached 16.07%, but from 2019 to 2023, it was only 4.7%.

The number of agents registered in the regulatory system peaked at 9.12 million in 2019; however, according to the latest industry communication data, this number has now shrunk to around 2 million.

After entering a deep adjustment period, the restrictive rules from the expansion phase seem to have become “out of date.”
A leader of a small to medium-sized insurance company pointed out that there is a significant mismatch between solvency rules and the industry cycle.

“Undoubtedly, the second generation of solvency regulations is an advanced rule globally, and it was correct at the time of chaotic capital expansion,” the leader stated. “However, the second generation of solvency regulations encountered certain resistance from design to implementation, resulting in a delayed rollout and a changed industry environment.”

Another industry expert indicated that the current regulatory trend in the insurance industry is overall strict, “from liabilities, investments to shareholders, everything is tightly controlled, which prevents major failures but also leaves almost no room for self-rescue.”

Especially under the restrictions of the second phase of the second generation of solvency regulations, small to medium-sized insurance companies that are “anemic” often find it difficult to break free from a vicious cycle.

Currently, the solvency requirements include three “passing lines”: “the core solvency adequacy ratio must not be less than 50%, the comprehensive solvency adequacy ratio must not be less than 100%, and the risk comprehensive rating must be B class or above.”

If these conditions are breached, insurance companies will not only face measures such as dividend restrictions but may also be required to suspend new business and limit the establishment of new branches. In severe cases, they may be taken over or apply for bankruptcy.

Under this requirement, high-risk insurance companies with low solvency and many operational restrictions find it difficult to expand and lack profitable breakthroughs, ultimately leading to a continuous decline in solvency.

Accounting Adjustments Exacerbate the Situation

The overall industry is facing a “transition between old and new standards,” which exacerbates internal contradictions.

The new standards consist of financial instrument-related accounting standards aligned with IFRS 9 (hereinafter referred to as “new instrument standards”) and “Enterprise Accounting Standards No. 25 – Insurance Contracts” aligned with IFRS 17 (hereinafter referred to as “new contract standards”).

Listed insurance companies have switched to the new standards starting in 2023, while non-listed insurance companies will implement them starting in 2026; currently, some non-listed insurance companies have already adopted the new standards in advance.

As early as 2019, before the second phase of the second generation of solvency regulations was implemented, scholars had pointed out that the new standards would directly impact the calculation of solvency adequacy ratios through changes in actual capital and minimum capital measurements.

For example, after Ping An Life adopted the new instrument standards in 2018, actual capital grew slowly and showed significant fluctuations.

“The fluctuations in Ping An Life’s actual capital are influenced by the implementation of the new standards,” the scholar stated in the research. “Equity assets measured at fair value will cause fluctuations in the book value of increased assets when market values change dramatically, leading to changes in actual capital. It is recommended to consider counter-cyclical adjustments for the pro-cyclical effects of fair value measurements.”

Another significant change is reflected in the new contract standards.

Under the old standards, the discount rate used for liability assessment was based on a 750-day moving average of government bond yield curves;

The new standards use the spot government bond yield curve but allow insurance companies to use the OCI option to smooth fluctuations, incorporating some impacts into other comprehensive income rather than current profits.

After the changes in reserves are recorded in other comprehensive income, the most direct manifestation is the inverse change in profits and assets.

For example, in the third quarter of 2024, Xinhua Insurance’s net profit attributable to shareholders increased by 116.7% year-on-year, while net assets declined by 13.4%; Zhongyou Life turned a profit with a net profit of 10.8 billion yuan, but net assets decreased by 5.44 billion yuan.

Zhou Jin summarized that the new standards require financial reports to capture market fluctuations and changes in the value of company assets and liabilities more timely, which will lead to increased volatility in financial reports; however, the OCI option can limit the impact of fluctuations to equity items, not affecting current profits
The combination of both factors, along with the introduction of new standards in a declining interest rate environment, may significantly reduce the net assets of insurance companies, thereby affecting actual capital.

“For a few companies with severe asset-liability duration mismatches, net assets may even turn negative,” Zhou Jin revealed. “Therefore, for the insurance industry facing tight solvency, this is akin to adding insult to injury.”

Granting the industry another year of buffer space is certainly beneficial for insurance capital to “recover,” but fundamental issues still persist.

Zhou Jin pointed out that regulatory agencies still need to reassess the second phase of the solvency II rules and consider appropriately relaxing certain standards from a counter-cyclical adjustment perspective.

For example, last year’s relaxation of the future surplus recognition of policies as the upper limit standard for minimum capital had an immediate effect in alleviating the solvency pressure on the industry.

In September 2023, the Financial Regulatory Administration issued a notice on optimizing the solvency regulatory standards for insurance companies, clearly differentiating the adjustment of minimum capital requirements for insurance companies, by lowering capital requirements to ease solvency while enhancing the investment space for insurance capital.

At that time, Zhang Qingsong, the financial officer and chief investment officer of Anhua Insurance, stated that the solvency adequacy ratio of small and medium-sized property insurance companies is expected to increase by 13-18 percentage points under the relaxed policies.

Looking to the future of counter-cyclical regulation, Wang Guojun stated, “The key lies in the judgment of the macroeconomic situation and the grasp of the timeliness and appropriateness of policy adjustments, avoiding directional errors and delays or excessive adjustments in policies.”

Zhou Jin also suggested revising the actual capital and minimum capital standards in the solvency criteria.

“It is possible to appropriately relax the recognition standards for actual capital, for example, the upper limit for recognizing future surplus of policies as actual capital can be further raised,” Zhou Jin said. “At the minimum capital level, the risk factors for corresponding asset minimum capital can be lowered according to the idea of real estate bottoming out and insurance capital entering the market; at the same time, the counter-cyclical adjustment factors reserved in the rules can be activated.”

In addition, Zhou Jin also suggested adjusting the equity management regulations for insurance companies, appropriately relaxing the investor access standards; broadening the capital replenishment channels for small and medium-sized insurance companies, and appropriately relaxing the bond issuance access thresholds; at the same time, considering the introduction of “counter-cyclical adjustment factors” in the aspects of expected credit losses on assets and the provision for liability reserves to reduce the impact of pro-cyclical factors