Posted on Nov 28, 2011 by Sergio Ulloa
The further expansion of insurance and pensions sectors in populous Asian countries like China and India will be both integral to the development of their own capital markets as well as offering huge potential for rapid growth for overseas investment, according to a new report published this month by the City of London Corporation.
In 'Insurance companies and pension funds as institutional investors: global investment patterns
,' Trusted Sources, a top emerging markets research group, study how pension funds and insurance companies have historically helped to shape the financial systems of developed countries, gradually increasing liquidity in their established capital markets through the introduction of long-term and stable funding mechanisms to market. By contrast, the contribution of such institutions towards China and India's development has been limited so far due to the evolving nature of their insurance and pension sectors as well as tighter government restrictions placed on their investments and business decisions. If these two emerging Asian superpowers want to increase the depth and diversity of their respective financial markets, greater liberalization of investment mandates for insurance companies and pension funds may be needed going forward to match their rapid growth potential.
The report first observes the role insurance companies and pension funds have played in developed markets and what experiences can be garnered for emerging economies now. Generally speaking, as a country grows richer, they develop more active insurance sectors and the markets benefit overall. This has been especially true in the United Kingdom and United States, where the pension and insurance industries have grown rapidly in tow with their more sophisticated financial systems and with more people demanding protection and retirement planning services as they grew richer. The report cites that in the past 30 years, insurance company assets in the UK have increased from 20 percent of GDP in 1980 to 100 percent in 2009, with pension assets growing four-fold as well. In the US meanwhile similar growth was occurring, with pension funds and insurance companies investing more in equities and corporate bonds.
As a result of these developments, huge sums of stable, long-term funds have been pumped into the UK and US's respective capital markets over the past three decades. This deep and stable pool of capital provided by the insurance companies and pension funds has worked to reduce market volatility and fund other ventures. In the UK, this influx of capital has been behind the development of the country's stock market, helping it turn into one of the most efficient and sophisticated financial centres in the world. Before foreign investors became major shareholders on the FTSE, UK pension funds and insurance companies held the majority of issued shares. Insurance company and pension fund investors in the US meanwhile have contributed both significantly to equity markets as well as the growth of the corporate bond market, which is now the world's largest at 140 percent of GDP.
Trusted Sources' report also examined the approach other Western markets have taken. Continental Europe has used a more bank-based financial system, where the role insurance companies and pension funds have played in the markets has historically been much smaller. Furthermore, investments remained much more focused on government bonds, partly due to regulations that are stricter than in the UK and the US. As a result, the financial system remained centred on bank lending and growth has been more limited. However more recently these same European institutional investors have grown and have diversified their investments into equities and corporate bonds considerably. This has facilitated a move towards market-based financing through stocks and bonds, following the likes of the US and UK. While in the US, the insurance sector has stabilised at around 40 per cent of GDP, in Germany it is at 60 percent, and France near 100.
Insurance companies and pension funds in Asia have much to do to match the overall contribution made by their Western counterparts toward their respective economies but time is on their side. The report notes that while the insurance and pension sectors in India are underdeveloped now, with assets at 7 percent and 16 percent of GDP respectively and limited investment activity in equities and bonds, there is considerable potential for growth going forward.
The county's insurance sector in particular has progressed rapidly over the past decade, driven by an expansion of life products, which dominate the market. Since the insurance sector in India was first opened up to the private sector with the passage of the Insurance Regulatory and Development Authority Act in 1999, total insurance penetration has doubled with the domestic protection industry overtaking several developed markets in output. According to the report, the market share of state-run firms has decreased to 65 percent for life insurance and 60 percent for non-life insurance during this period. Foreign multinational insurers have been integral to the sector's overall development so far. Despite a 26 percent cap on foreign ownership, 20 out of the 22 life and 16 of the 18 general insurance firms that have been set up since 2000 have been joint venture operations with foreign partners. One of the first recommendations Trusted Sources makes is to of course lift these restrictions to increase overseas stimulus.
India's pension funds and insurance companies are expected to grow as the overall economy matures, as has happened of course in the UK, US and other developed markets. Regulation permitting, there is of course considerable room for insurers and pension funds to shift their assets from government bonds into equities and corporate bonds. The country's expansive, high-inflation market environments make equity investment attractive and this, according to Trusted Sources, will drive the popularity of index-linked insurance products (ULIPs) for the foreseeable future. Despite this considerable potential however there are several restrictions holding India back. Insurance companies are, in general, barred from investing more in equities, and have been blocked moving into corporate bonds and derivatives as well. Pension funds face even more obstruction. Trusted Sources notes that the Employees' Provident Fund Organisation (EPFO), which accounts for around two-thirds of India's pension fund market, is prevented from investing its sizeable reserves into equities at all.
These restrictions are obviously limiting the overall contribution pension funds and insurance companies could make towards growing India's capital markets. To improve upon this situation, Trusted Sources made several policy recommendations including: lifting restrictions on equity investments, corporate debt and derivatives, allowing the EPFO to invest in equities and removing burdensome tax and regulatory constraints which would increasing incentives for institutional investors to buy Indian corporate bonds.
In China, like India, the insurance and pension sectors have traditionally had a small presence in the domestic stock market, each holding only around 2 percent of issued shares at present. According to Trusted Sources however, that will soon change with both institutions likely to start playing a larger role in both equity and corporate bonds in the near future. China's insurance industry has grown dramatically over the past few years and currently ranks as the sixth largest protection market in the world with assets under management now worth CNY4.6 trillion (US$720 billion) at the end of 2010, up from CNY1.4 trillion (US$171 billion) in 2005. Despite increased competition as of late, the Chinese insurance market is dominated by four state-backed insurers, China Life, Ping An, China Pacific Insurance Corporation (CPIC) and People's Insurance Corporation of China (PICC). The market share for foreign insurance companies (who operate principally through joint ventures) remains at around 5 percent. More than 70 per cent of total premium income of China's insurance industry currently comes from life insurance companies. As the country grows richer, demand for more sophisticated savings products will likely rise in tow, driving further expansion.
In spite of this pronounced industrial growth, institutional investment in China's capital markets from insurance companies has been perhaps overly risk averse. Chinese Insurance companies invest only around 11 percent of their holdings into equities, with the rest held in bank deposits and bonds. According to Trusted Sources, this is occurring due to several factors. The first is that most insurance activity in China still involves conventional insurance products, which offer returns of only around 4 and 2.5 percent respectively. These returns are backed by government bonds and negotiated-term deposits with limited downside risk, and provide little incentive for insurers to diversify their investment portfolios at present. Trusted Sources inferred however that this could soon change "ULIPs occupy only a marginal position. If they increase in popularity, as happened in the UK and the US when competition increased, a shift into equities is expected."
Chinese insurance companies, in general, are finding the stock market too volatile to invest in at the moment, with dividend guarantees effusive. The report claims furthermore that strict regulatory control over corporate bond issuance is affecting supply, and is thus restricting overall investment growth. To encourage greater participation from Chinese pension funds and insurers in capital markets, Trusted Sources listed several policy recommendations including increasing competition amongst local insurance companies, tax incentives for ULIPs, clearer dividend-payout rules for listed companies, and the relaxation of qualification rules for private companies allowed to issue bonds.
Overall, the report believes that, in China and India, increased liberalization of local insurance and pension markets could foster greater liquidity and depth in their domestic capital markets, which will of course be needed to support the effective growth of businesses in each country going forward.