Under the current Chinese solvency regulation, which was established in 2003 by the China Insurance Regulatory Commission (CIRC), solvency capital is calculated using a fixed formula. Following the worldwide trend toward a risk-oriented solvency regulation such as the European Solvency II, a new risk-oriented solvency system named “China Risk Oriented Solvency System” (“C-ROSS“) has been introduced by the CIRC from 2012. The calculation method under C-ROSS is far more complicated than the current Chinese solvency regulation.

How C-ROSS Works – Three-Pillar Framework

The CIRC adopts a “three-pillar” approach to the structure of C-ROSS, which is very similar to the European Solvency II.

Pillar I – Quantitative Capital Requirements

Quantitative capital requirements deal with the risks which are quantifiable in measuring the minimum capital requirement. Specifically, it links these requirements to three types of risks: insurance risk, market risk and credit risk.

• Insurance risk refers to the unanticipated losses arising from the deviation of actual insurance loss ratio from insurer’s anticipated loss ratio. Unlike the current solvency system which has a unified capital requirement, capital requirements for different lines of property insurance vary significantly under C-ROSS. For example, the minimum capital requirement for automobile insurance is much lower than for enterprise property insurance.
• Market risk refers to unanticipated losses arising from the variation of interest rate, equity price (public or private equity), real estate price, and exchange rate in the operation of an insurance company.
• Credit risk means the unanticipated losses arising from the late performance or non-performance or a decrease of level of credit of the counterparty of the insurance company. Under C-ROSS, the risk factors to be used as a basis of default ratio of offshore reinsurers are significantly higher than those applicable to onshore reinsurers. Consequently, the domestic cedants would be required of a higher capital requirement if they reinsure risks to offshore reinsurers.

Pillar II – Qualitative Supervisory Requirements

Pillar II includes four types of unquantifiable risks, namely operational risk, strategic risk, reputational risk and liquidity risk. Operational risk means losses arising from defect internal operation process, human error, defect system or external incidents (including legal and compliance risks). Strategic risk means risks arising from an ineffective strategy or its implementation or a change of business operation environment. Reputational risk refers to an adverse reputation due to the insurer’s business operation or external incidents. Liquidity risk means the risk of insurer’s default in paying its debts due to a short of capital.

CIRC places its supervisory actions based on the integrated risk rating (IRR): insurer’s overall solvency is evaluated based on both quantitative results in pillar I and qualitative risk assessments in pillar II. The insurance companies are categorised into level A, B, C and D, among which, A and B types of insurers are considered having both a good solvency ratio and sound risk control of operation, strategic, reputational, or liquidity risks, while C and D types of insurers either fail to meet minimum solvency ratio or have a high operational, strategic, reputational or liquidity risks even if the minimum solvency ratio is met.

CIRC also places another level of supervision under C-ROSS: solvency aligned risk management requirements and assessment (SARMRA) (i.e. companies’ own solvency management (known as COSM under European Solvency II)). CIRC sets up the minimum standards of risk management for insurers and will evaluate their practices such as governance structure, internal controls, management structure and processes and etc.

Pillar III – Market Discipline Mechanism

Pillar III of C-ROSS enforces oversight of insurance companies by the media, rating agencies, financial analysts and the general public by requiring information disclosure from these companies. It intends to use the self-regulation power of market to supervise the insurers and also to optimise the market environment.

Summary

C-ROSS reflects the CIRC’s intention to shift their focus from compliance monitoring and capital to evaluation of the risk profiles of insurers as well as the quality of their risk management and governance systems and to move apace with reforming the insurance industry in China. We anticipate the implementation of C-ROSS will profoundly change the operations of the Chinese insurance industry in due course.

For further information, please contact:

Carrie Yang, Partner, Clyde & Co

[email protected]

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