Empirical Study on Investment Strategy in the Emerging Insurance Market: A case of China Qi Wei Hao YanSu

ABSTRACT Many China insurance companies hold stock of bank, though the capital of the whole China insurance companies only equates with the capital of Industrial and Commercial Bank of China, which is contrary to the situation in developed countries. This phenomenon represents the positive investment strategy of insurance in the emerging market. The first aim of this paper is to analyze the reason why this strange phenomenon and the strategy should happen. Based on the above research, this paper evaluates the systematic risk which Chinese insurance adopt the positive investment strategy should face at present. And we will estimate the cost of capital of China insurance company, and check the rationality of riskier investment strategy. Eventually, this paper finds that the positive investment strategy shouldnt achieve its initial aim. Keywords: Insurance investment, portfolio, investment strategy

1. Introduction and Literature Review

China economy continued the strong growth in 2006, and the Real GDP growth for 2006 is estimated to be about 10.5%. The same as China financial and insurance market, the Shanghai and Shenzhen stock exchange have experienced a tremendous breakthrough in 2006, the representative index of Shanghai stock exchange: SSE composite reaches the historical height in Dec.29th, 2006. The gross assets of China insurance industry have undergone high-speed growth, 38% on average, which has reached 1973.1 billion by the end of 2006, with an increase of 29.6% than 2005.The bullish stock market impulse the China insurance companys investments yield well. Return on investment of China insurance market rose from 3.6% in 2005 to 5.8% in 2006. And as a newly emerging insurance market, China insurance companies customers age structure represent pyramid, a majority of it is relatively young people which are keen on saving. The average age of customer is 40. Furthermore, the most customers hold investment-linked life insurance products (such as Investment-Linked Insurance and Bonus Insurance). It means that China insurance companies have more desire and pressure to gain fat investment profit. Against this backdrop, China insurance companies adopt the positive investment strategy, taking explicit M&A activities with commercial banks insatiable appetite for higher yielding. But the flourish is on the basis of poor quality, China Insurance penetration and premium per capita remained small. There are many unpredictable

The author gratefully acknowledges helpful comments and suggestion from Profession Zhang Nannan. Hao Yansu is a professor of Insurance School at Central University of Finance and Economics, E-mail: haoys@cufe-ins.sina.net. Wei is a graduate student of Insurance School at Central University of Finance and Economics, E-mail: heroqi11@163.com 1

systematic risk and immature regulation in China. This research is a proof testifying that China insurance companies adopting positive investment should face some risk that have burdensome aftereffect. Firstly, this paper applies qualitative and quantitative methods to measure and calculate these risks. And this research calculates China insurance industrys cost of capital (COC), and compares the COC of insurance between develop country and China. Then we show that which investment strategy is more suitable for China insurance companies. And then, we try to provide some suitable suggestion for China insurance companies to avoid these risks. Many foreign scholars analyzed investments of insurance funds. Lambert and Hofflander (1966) used Markowitz's portfolio theory in research of the investments of the property insurers. Forst (1983) considered the structure of the insurance funds, and analyzed the feasibility of using modern portfolio model in the research of life insurers. Assets allocation is a chief step in the modern securities investment Decision-making, and it is a fundamental factor that determines the security and profit of securities investment. The assets allocation, especially strategic assets allocation, is the immune means most forcefully preventing systematic risk. In china, the study of insurance investment still stands on discussing the investment of qualitative analysis methods. Sun Qi Xiang. Wang Xu Jing(1999), suggests constructing the investment system of China insurers. Fei Guan(2001)indicate many problems of China insurance market investment. Li Xiu Fen(2002) introduce many international prevalent asset-liability management Methods. Bin Cui (2004), according to CAPM theory, constructed a minimum risk investment portfolio under a given profit. The measuring and managing the risk of investment is the core factor in the investment decision-making. The total risk of bond investment risk concludes two risks: the systematic risk and the non-systematic risks. There are many Chinese scholars use the portfolio theory and the CAPM models to study the systematic risk of China stoke market. Overall, these studies can be divided into two types: 1) they think China stock market has a high systematic risk, and has definite stability. The representative literatures conclude: Shi Dong Hui(1996), Wang Xing Jie(1999) Liang Wang Quan(2005) and He Li Jie (2006)etc. These central idea is that China stock market has a high systematic risk which amount for total risk is above 40%, even amount to 81.37%, more than 20% 40% level that the mature stock markets; 2) they think that China stock markets systematic risk is descending gradually. Zhang Ren Yi(2000) and Zeng De Jun (2005) think that the systematic risk of China stock market will decline as the maturity of China stock market, and the portfolio management could disperse the risks of investment in China stock market.

2. The investment strategy in China insurance market

China insurance companies adopt the positive investment strategy. The share of assets held in stock is increasing (Figure 2.1). The average growth in the investment
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on stock market (include the direct and the indirect way: fund) is 83 percent between 2006 and the first quarter of 2007. But Chinese insurance market is a newly emerging insurance market. There are many immature and especial behaviors appearing in China insurance market. Many China insurance companies want to purchase the stock of some Chinese commercial bank. Figure 2.1 Distributions of China Insurer Assets, 2003-2007

100% 80% 60% 40% 20% 0% 2003 2004 stock and fund 2005 bank deposit 2006 bonds other 2007Q1

Source: 2003-2006 China Insurance Annual Report The China insurance company is in the steep competition situation at present. With the insurance debt of Chinese underwriting accumulated rapidly, which investment strategy the insurance company should take will produce far-reaching effect on the developing of China insurance. Our objective is to examine what drives China insurance company in the purchasing. China banks reform is close to the end, and China bank industry has been opened to the entire foreign bank. The reform about China state-owned banks after China's WTO entry will bring a fat profit to the participant. So the China insurance companies want to participate in the listing of the state-owned commercial banks. The insurance companies have long-term shifts in investment demand. The insurance companies could achieve a stable and long-term return from the investment in taking stock of commercial bank. China insurance market has a special insurance debt structure different from the developed countries. China insurance companies new customers age configuration is relatively young. The average age of customer is 40.This means that many insured accidents in the long-term policies will happen many years later. The growing competition among China insurance companies caused the company to seek the income through the portfolio management of investment. And the investment-linked life insurance product (such as Unit-Linked Insurance and Bonus Insurance) is developing more and more quickly in China. China life insurance Companys premium of investment insurance is 91,441 million Yuan in 2006, up 6.4percent from the previous year (Figure 2.2). The first reason is that the young people have more pressure to save and make more money to prevent the
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inflation risk and longevity risk. Figure 2.2 the development of China lifes investment insurance (million Yuan) investment insurance total premium percent distribution Year's end average annual Year's end average annual percent change percent change 2006 9144 6.4% 18376 14.2% 49.8% 2005 8594 -3.2% 16088 7.4% 53.4% 2004 8873.7 74.7% 14980 26.9% 59.2% 2003 5080.7 13.5% 11802 6.2% 43.0% 2002 4474.8 N/A 11116 N/A 40.3% The second reason is the flourishing stock market in China. The SSE composite index1 increases by 130% in 2006, the SHSE-SZSE300 index 2 increases by 121% in 2006. Up to Mar.2007 the Shanghai stoke market value is 11,745 billion Yuan. The rising of stock market drives the increase of China insurance investment performance. Up to 2006 December end, the total amount of insurance company funds investment reached 95 million Yuan, and the average rate of return is 5.8%, compares to rise together 2.2 percentage points. The bull market of China stock market gives China insurance companies 93 billion Yuan, account for 97.8% of all China insurance markets income in 2006. If consider the income that did not realizes at present, the whole year rate of return will be higher, creating the historical best level of China insurance investment income ratio. Investment insurance product looked very attractive to clients during the years of booming equity markets, as they offered them direct participation in the soaring equity markets. Figure 2.3 show that stock market performance and sales volume of investment insurance are closely related. Figure 2.3 the premium of China life insurances investment insurance and stock market performance in China (million Yuan)
1000 900 800 700 600 500 400 300 200 100 0 20 02 20 03 20 04 20 05 20 06 447.48 1357.65 508.07 1497.04 1266.5 1161.06 887.37 859.4 914.4 2675.47 3000 2500 2000 1500 1000 500 0

p i u of i n rem m vestm t i n ran en su ce

S E C p te I n ex S omosi d

Source: 2003-2006 China Life Annual Report and 2004-2006 SSE Annual Report Constituents for SSE Composite Index are all listed stocks (A shares and B shares) at Shanghai Stock Exchange. The Base Day for SSE Composite Index is December 19, 1990. The Base period is the total market capitalization of all stocks of that day. The Base Value is 100. The index was launched on July 15, 1991. 2 As the first equity index launched by the two exchanges together, CSI 300 aims to reflect the price fluctuation and performance of China A share market. CSI 300 is designed for use as performance benchmarks and as basis for derivatives innovation and indexing.
1

This special debt structure and developing of investment insurance are the key factors why China insurance companies take explicit M&A activities with commercial banks. We think that the finance mixed management isnt the impetus of China insurance companies investing in bank. In other words, the investing isnt the equity investment, is financial investment. This M&A activities is the outcome of Chinese insurance companies positive investment strategy. Because of the reason mentioned above, the inner drive of income and the outer drive of customer construction impulse China insurance company holding stock of bank.

3. The comparison between China and the developed

countries market
China insurance market still is an immature market. In 2006, Chinese premium income totaled 564.1 billion Yuan, of which life insurance contributed 63.6%, or 359 billion Yuan, and non-life 36.3%, or 150.9 billion Yuan. An average of 431.3 Yuan was spent on insurance in China in 2006, and Chinese insurance penetration is 2.8%. China insurance market is at the primary stage of developing now. China has lower premiums per GDP and per capita. There are many strange phenomenon which different from the industrialized countries situation. 3.1 The comparison between developed countries We want to get a reasonable conclusion through the comparison between China insurance companys investment strategy and the developed countries strategy in early stage. China insurance markets current condition is similar with some developed countries at 20 years ago. We could estimate the performance evaluation of China insurance companys investment by comparing the common ground and differentia between China insurance market and developed countries market. We take USA and UK for the example of developed country. Even if as the two large insurance market all over the world, USA and UK have many differentias. Such as the share of assets held in stocks, which is close to 60% in UK, and nearly 30% in USA. By contraries, at year-end 2005, 54 percent of life insurer assets were held in bonds in USA, and closely 40% in UK. We estimate the reason of this differentia to three: 1) the different of insurance debt structure, the Unit-Linked insurance is well-developed in UK, its premium income accounted for more than 50% of British total premium income. And annuity products in the United States are very developed. By 2005, annuity accounted for roughly more than half of premium receipts (52%). So the American insurance company invests more funds in bonds. Bonds are publicly traded debt securities. Often referred to as fixed-income securities, bonds generally offer low risk and a greater certainty of return. And the Unit-Linked insurance return presents the policyholder and life insurer with an interesting alternative to traditional products.
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Policyholders find themselves with a transparent product and can participate in a stock market recovery. 2) The different of financial market structure. Britain is the traditional financial center; the stock market has a long history. Although the United States stock market is very developed, the bond market has more comparative advantages. American bond market, especially the corporate bonds market, has many kinds of bands (Figure2.4); multiform maturity; stable relatively high-yield and good quality. At year -end 2006, the United States bonds market scale reached 27.4 trillion U.S. dollars, 1.6 times of American stock market. Figure 2.4 US Outstanding Bond Market Debt as of Dec 31st, 2006

Money Market Asset-Backed

Corporate

Treasury MortgageRelated

Federal Municipal Agency

Source: Securities Industry and Financial Market Association 3) The different of insurance supervision institutions. There is little restriction in the share of asset hold in stock in UK. Since the early 1990s, the share of assets held in stocks has been increasing in USA. Historically, stocks had been a small percentage of total assets for reasons rooted in the laws regulating American insurance. Stocks had not been heavily used as a major investment medium for funds backing life insurance policies because of the policies contractual guarantees for specified dollar amounts. 3.2 The comparison between China and developed country We could evaluate the reason why China insurance company participating in Chinese-funded Commercial Bank by Shares on the same way of above research. We will review the three factors listed above of China. 1) The insurance debt structure, as mentioned upper, China investment insurance has a good developing performance. The growth of investment insurance premium will rise more and more quickly. So China insurance companies share of assets held in stock has been increasing. The average annual growth in equity holdings was 36.1% between 2003 and 2007Q1. 2) The different of Financial Market Structure. The finance in China, however, is still a new industry. China Bond issuance only reached 567.66 million Yuan in 2006, far smaller than US bonds market. And the term structure of China bonds is imbalance
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(Figure 2.5). From figure 2.5, we can see the shares of long-term bonds are smaller than short-term bonds. Figure 2.5 the term structure of China bonds market at end of 2006

m than 10year, ore 12.54% 7-10year, 7.21% 5-7year, 7.74% 3-5year, 13.01% 1-3year, 19.69%

less than 1 year, 39.80%

Source: www.chinabonds.com.cn 3) The different of insurance regulation institutions. There are many different rules among China and developed countries, because of China insurance still in the early stage of developing, need more protection. Such as China insurance companys share of assets hold in stock is restricted to 5% of the insurance companys total asset. The rigorous restriction causes a high share of bank deposit in China (Figure 2.1). China stock market has a blooming performance in 2006 and 2007Q1. Since the restriction on directly investment participate in stock market is canceled, the share of assets hold in stoke is rising rapidly. There are many common situations between China now and USA in 1980s. The percent of stock and bonds have the same increasing trends. The American restriction on stock market is also released in 1980s. So it seems that we could get a conclusion that the positive investment strategy is the necessary strategy in early stage. But figure 2.6 also show that there are an opposite trends between stock and bonds after 1995. It means that the effect of substitution exist between stock and bond. When the cow stock market comes out, the insurance company should increase the share of assets hold in stock and decrease the share of bonds, vice versa. This behavior could reduce risk clearly. But Chinese stock and bonds market still need more development. The risk of the stock market in China doesnt disperse easily. So the positive investment strategy should face poor risk. We will evaluate the systematic risk of China stock market in next chapter. Figure 2.6 the comparison of China and American asset allocation

Ch a in 60.00% 50.00% 40.00% 30.00% 20.00% 10.00% 0.00% 1999 2000 2001 bon ds 2002 2003 2004 2005 ban deposit k 2006 2007Q1

stock an fu d d n

USA 70.00% 60.00% 50.00% 40.00% 30.00% 20.00% 10.00% 0.00%

19 90 20 00 19 80 19 82 19 84 19 86 19 88 19 92 19 94 19 96 19 98 20 02 20 04
8

bonds

stocks

Source: American Council of life insurance, China insurance regulatory Commission

4. Systematic risk of China stock market

4.1 Methodology and literature review For measuring the risk when China insures adopting the positive investment strategy; we estimate the -coefficient to evaluate the systematic risk of stocks are hold by China insurance company. -coefficient is the measure of CAPM model to evaluate the systematic risk. Sharpe and Lintner independently developed the CAPM as a general equilibrium model for asset returns. It postulates that the expected return on a firms equity can be explained as a linear function of a single factorthe expected return on the market portfolio of assets. The ideas relate back to the seminal work by Markowitz. He developed the theoretical work, which considers an investor aiming to maximize utility derived from the returns obtained by holding individual assets. CAPM divides the risk of holding an asset into two parts, systematic or market risk and non-systematic or specific risk. The systematic or market risk is the part related to the risk of the market portfolio; the non-systematic or specific risk is the

residual part of the risk, which cannot be explained by the market and is company specific. An investor can avoid the residual, non-systematic or specific risk by holding a diversified portfolio. Accordingly, an investor should receive no added return for bearing diversifiable risk and, therefore, the expected return of an asset should only reflect the systematic or market risk. CAPM assumes that all investors have the same one-period horizon, and asset returns have multivariate normal distributions. Let Ri and MRP be the return and standard deviation of return for the market portfolio. The CAPM model is given by:
E ( Ri ) = R f + M RP i

i=1 n; t=1 T

(1)

Where E ( Ri ) and R f denote the required return on asset i and the risk-free rate, is the beta for stock i. respectively, and MRP denotes the market risk premium, i defined as MRP = E ( Rm ) R f , where E ( Rm ) denotes the required return on the market. is a measure of the stocks sensitivity to changes in the expected market return. The CAPM suggests that an average stock would have a value of one and. A stock with a greater than one carries above average systematic risk and an investor would, therefore, require a higher expected return to hold it. Conversely, a stock with a less than one carries below average systematic risk. Miller and Scholes showed that equation (1) cannot be used to accurately estimate
, because R f is not constant over the estimation period. Black solved this

problem by taking as their basic time series model (Market model):

Ri (t ) R f (t ) = i + i [ Rm (t ) R f (t )] + i (t )

i=1 n; t=1 T

(2)

Where Ri (t ) is the holding period return on the equity of company i in period t,

R f (t )

is the risk free rate, Rm (t ) is the holding period return on the market

portfolio of stocks in period t, while i (t ) is the residual left unexplainedthe nonsystematic or specific risk. The total risk of an asset i taken individually is measured by the assets standard deviation of returns ( i ), which is given by:
i = E[( Ri i ) 2 ]

(3)

Where R and represent returns and mean returns. We will use the equation (2) to estimate the stock of insurance companys systematic risk by Ordinary Least
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 Squares (OLS) to obtain estimates for i and , say i and , respectively. i i i

is given by:

i =

iM E[(Ri i )(RM M )] = 2M E[(RM M ) 2 ]

(4)

Where iM is the covariance between the asset's return and the return on the market portfolio

2M

is the variance of market returns. In other words, the implied

corresponds to the systematic risk of asset i (or its correlation with the market i
portfolio). As company-specific risks may be diversified through portfolio formation, one should consider market or systematic risks ( ), rather than total risk (standard deviation) as the metric of risk for each sector. The CAPM of equation (2) provides the tool to measure these. We can evaluate the one stocks rate of systematic risk per total risk by the correlation coefficient square of the return of the individual stock and market portfolio, which is given by:

( i ) 2 2 M

iM i M 2 2 M =[ 2 ] 2 = 2 iM M i

(5)

4.2 Data and sample For study of this paper, we collect the stock portfolio of China insurance company by the year report of the listed company of Shanghais stock market. Because the listed companies promulgate the configuration of stockholding every quarter, so we gather the portfolios from 2005 when the direct invest on stocks restriction have been released to 2006. For analysis, we use the data come from CSMAR China Stock Market Trading Database. The CSMAR Database offers accurate and comprehensive trading data from the Chinese stock market. The data range from 1990 to 2007Q1. The correct choice of market portfolio is the key factor for estimating the CAPM model. In the stock market, systematic risk for a stock refers to its correlation with the market portfolio (usually is a broad stock index). Many previous researches use the famous index to substitute the market portfolio. So the beta coefficient is estimated by regressing daily returns on stock against SSE composite. The daily return of market index is given by:
R n ,t = rn ,t rn ,t 1 1

(6)

Where: Rn ,t = return of index n in day t

rn ,t = closing price index of index n at day t rn ,t =closing price index of index n at day t-1 1

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The dataset used in the current paper involves daily China stock data, covering the sample period 2005 to 2006. We get four periods reports to estimate the model. We use the CSMAR databases daily return of Single Stock (consider the cash bonus)
rn ,t

to elucidate the daily return of stock Ri , which is given by:

rn , t = Pn ,t (1 + Fn ,t + S n ,t ) Cn ,t + Dn ,t Pn , t 1 + Cn ,t S n ,t K n ,t 1

(7)

Where: reinvestment)
P ,t n

rn ,t

= daily return of Single Stock (consider cash dividends

= the closing price of stock n at day t price of stock n at day t-1

P ,t = the closing n 1 Dn ,t Fn ,t S n ,t K n ,t C n ,t

= per shares cash bonus when day t is the ex-right day = per shares Bonus share when day t is the ex-right day = per shares share allotment when day t is the ex-right day = per shares Price of share allotment when day t is the ex-right day = per shares breaking up number when day t is the ex-right day

We can see the mount of sample include in this paper from figure 4.1. In 2006, the samples ratio is 60%, increasing the reliability of this articles calculation. The equal weighting investment is seldom used at present, and the portfolios return and risk characteristics is decided by stocks which have larger proportion to the portfolio. So we will use weighted average method to estimate the portfolios risk and return, the weight is the measure of a single stocks market value with respect to whole portfolios. The beta coefficient of portfolio is p , which is given by:

p = Wi i
i =1

(8)

Where: Wi = the proportion of the stock is market value per whole portfolios

=the beta coefficient of stock i i

time Figure 4.1 the samples market value 2005 2006Q1 2006Q2 2006

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portfolio's market value 3.64 7.09 19.79 46.826 (in billion RMB) Sample size 77 84 196 164 3 Ratio 23% N/A 49% 60.70% 4.3 Result and Conclusion We establish an OLS estimation of the CAPM market model to measure the systematic risk of a stock portfolio which China insurance companies hold. The sample period is from 2005 to 2006. Average return over the whole sample period is summarized by weighted average method daily arithmetic returns; these estimates are reported in Figure 4.2. The result of this figure analysis indicates: The average beta coefficient is 1.105, which is close to 1. It means that the stock portfolio of China insurance companies risk is approximately equal to the average risk stock (market portfolio). And the ratios of systematic risk are above the level of 60%. High rates imply that the rate of unsystematic risk is low, in other word, the Chinese insurance companies portfolio investment dispersing risk at the possible greatest extent; the purpose of portfolio to reducing the Risks of investment couldnt reach. Another signification of it is the portfolio have a high systematic risk, the annual average rate is 65.38%, higher than the mean rate of 30% in the developed market. In many previous studies about the China stock market systematic risk, such as Wang Xiao ling (2006) estimate that the whole Chinese stock markets average beta coefficient is 1.04, the ratio of systematic risks are exceed 50% in the sample period. The study shows that Chinese stock market has a larger systemic risk which couldnt be dispersed by the portfolio investment. Figure4.2 the risk characteristics of China insurances stock portfolio Total risk ratio of systematic risk p i period Min Max Mean Min Max Mean Min Max 2005 1.02 0.05 2.86 0.136 0.086 0.284 67.2 98.7 24.6 2006Q1 1.1 0.08 2.52 0.088 0.014 0.58 62.76 92.72 21.5 2006Q2 1.12 0.075 2.47 0.084 0.017 0.394 63.45 95.6 18.6 2006 1.18 0.063 2.35 0.079 0.009 0.45 68.14 90.77 43.45 Figure 4.3 describe the distribution of individual stocks systematic risk in Chinese insurance stock portfolio. This table indicates that the systematic risk of different stock doesnt differ greatly. Nearly 60% of listed companies systematic risk plane distribute over the narrow range of 60%-80% in sample period. Such as the 2006 years sample is 76.2%, which is the biggest proportion in the entire sample period. And there arent obvious increasing time trends of diversification of samples systematic risk level between the sample periods. Figure 4.3 the distribution data of single stock in portfolios ratio of systematic risk

Ratio of the samples market value per China insurance companies 12

We want to evaluate the beta coefficient of different sector, for measuring the diversity of China insurance companies portfolio. Robert Faff (2002) found that when the analysis of relationship between beta and returns is run on the resources sector and industrial sector separately, it is primarily the latter sector which is driving our overall result. That is, while the Pettengill et al prediction of a positive (negative) 0-10% 20%-30% 30%-60% 60%-80% 80%-100% ratio numbers ratio numbers ratio numbers ratio numbers ratio numbers 2005 0.0 0 7.8% 6 24.7 19 58.4 45 9.1% 7 % % % 2006Q1 0.0 0 6.0% 5 26.2 22 57.1 48 10.7 9 % % % % 2006Q2 1.0 2 5.1% 10 17.9 35 69.4 136 6.6% 13 % % % 2006 0.0 0 0.0% 0 14.0 23 76.2 125 9.8% 16 % % % relationship between up market (down market) betas and returns is found to be strongly in evidence in the industrial sector, it is only weakly evident in the resources sector. We divide the entire sample to six sectors follow the standard of Shanghai Stock Exchange. From the figure 4.4 we can see that the estimated coefficient is statistically insignificant regardless of whether we limit the analysis to the any sector or to the full set of industries (the sample period is 2006). The six sectors average ratios of systematic risk are range from 65% to 70%, and the beta coefficients of these sectors are approximately equal to each other. The necessary distinctness of distinct industry doesnt appear in investment portfolio of China underwriting. So the portfolio investment in China shouldnt obtain the same effort in developed country. It means that Chinese stock market and insurance industrys stock portfolio is difficult to achieve a real sense of decentralization of investment risk. Figure 4.4 the empirical evidence of different sectors in 2006 Industry Number of Ratio of Market beta coefficient ratio of systematic risk observations value Mean Max Min Mean Max Min real estate 7 3.2991% 1.051 1.24 0.874 67.2498 78.9589 63.8995% 4 % % industry 109 47.1424% 1.033 1.20 0.882 70.6962 78.5947 50.2651% 2 % % public 26 13.5009% 0.95 1.09 0.773 70.3142 90.7756 53.4418% service 2 % % integration 15 0.8865% 1.02 1.52 0.595 66.9437 86.6728 43.4585% 8 % % finance 5 35.1084% 1.098 1.18 0.994 68.8028 83.9142 66.6770% 4 % % business 2 0.0626% 0.981 1.26 0.471 66.4356 68.1719 64.8735% 3 % % And we could also consider the liquidity of Chinese stock market to check the risk that the China insurance companies take the positive investment strategy could face. Datar, Naik and Radcliffe (1998) use turnover rate as a measure of liquidity, and

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provide evidence for a negative correlation between liquidity and stock returns. The turnover ratio is the ratio of trading value to market capitalization. SG Jun, A Marathe, HA Shawky(2003) find that stock returns in emerging countries are positively correlated with market liquidity as measured by turnover ratio, trading value, and turnover-volatility multiple4. The turnover ratio is likely to vary with the ease of trading, hence with market liquidity. China stock market has a high turnover ratio(see figure 4.4); the average of it is approximately 5 times of the developed market. It means that there are many speculation behaviors and irrational investment decisionmarking in Chinese stock market. Figure 4.5 the turnover ratio of same stock market in the world 2000 2001 2002 2003 2004 2005 Mean standard deviation Shang Hai 504 217 208 268 308 274.36 296.6 91.529 Hong Kong 75 59 59 54 74 61 63.67 7.3614 NYSE 51 61 44 40 52 58 51 6.7612 Source: Yearbook of China Financial, 2006 and NIFV As emerging stock market, the external factors have a strong impact on Chinese stock market, such as the change of policy and institution about stock market. So the long-term investment in Chinese stock market will fall across many risks. The result of this chapter elucidate that China insurance companies should maintain the restricted proportion of stock hold for evading from the systematic risk and larger loss should happen in the future.

5. China insurers Cost of Capital

The cost of capital (COC) is a key parameter for steering a company. The COC is the return investors expect to earn on alternative projects with a comparable risk. For all enterprises, the COC is directly related to the size and type of risks assumed. Insurance is a very special industry, encompassing numerous lines of business with different risk characteristics, bearing diverse kinds of risk. It is unlikely, for example, that the COC for a firm specializing in life insurance will be the same as the COC for a firm emphasizing workers compensation or commercial liability insurance. Unfortunately, little progress and research has been made in estimating the COC for insurers in China. 5.1 Methodology and literature review Butsic (2002) think that insurers have a higher COC than other industry, because the insurance mechanism will introduce extra costs come from the illiquid nature of insurance liability and information asymmetry. Cummins and Phillips (2005)s paper is to remedy this deficiency in the existing literature by developing cost of capital models that reflect the line of business characteristics of firms in the property-liability insurance industry. The advantage of cost of capital is it can estimate the cost of capital of the pure insurance part of insurance company. We expect that there may be a higher COC of Chinese insurer than developed countries, as Chinese immature regulation, organization and institution extend insurers extra capital costs. We estimate the COC of Chinese insurance companies to

SG Jun, A Marathe, HA Shawky - Emerging Markets Review, 2003 14

reflect their exposure to both insurance and investment risks. If the COC increases, people might expect firms to find ways to use less capital or use it more efficiently. According to sigma 5, 2005, companies that take less financial market risk will have a lower investment cost of capital than companies that follow riskier investment strategies. Therefore, the extra return generated by taking financial market risk does not create shareholder value. This also means that the price/book ratio will not be affected by the investment strategy. And this reports empirical evidence presented indicates that it is difficult in practice for insurers to earn excess returns through investment strategies simply involving more market risk. But based on above research, Chinese insurance companies are adopting the positive investment strategy which involving more market risk instantly to earn more return. This activity couldnt increase indeed the shareholder value. There are many methods to estimate the COC from a variety of sources: 1) CAPM, The capital asset pricing model has been widely used in many financial applications. The CAPM cost of capital is given by the following formula:
E ( ri ) = r f + i ERP

(7)

2) The Fama-French Three-Factor (FF3F) Model, the Fama-French three-factor model retains the CAPM risk-premium for systematic market risk but adds risk premium for two additional factors to capture the effects of firm size and financial distress. The FF3F model has been tested extensively and shown to be a significant improvement over the CAPM (see Fama and French 1992, 1993, 1997, Schink and Bower 1994, Wang 2003). The FF3F model for COC is as follows:
E (ri ) = r f + mi [ E (rm ) r f ] + si s + vi v

(8)

Where i = firm is beta coefficient for the size factor, s

s = the expected market risk premium for firm size,

= firm is beta coefficient for the financial distress factor, and vi

= the expected market risk premium for financial distress. v

The risk-premium for systematic market risk ( E ( rm ) rf ) in the FF3F model is usually the same estimate that is used for the CAPM. Insurers also take insurance risks, which give rise to additional costs known as frictional capital costs. But this papers primary aim is measuring the investment risk of China insurance company, so we wouldnt use this model. 3) The Market Consistent Pricing Model (MCPM), MCPM is based upon marketconsistent valuations of an insurers assets and liabilities. The key to implementing MCPM is the adoption of replicating portfolios. The cost of capital for the insurance company can be identified by estimating the expected return on the relevant benchmark for the investment operations and then adding the additional margin that
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investors require as compensation for taking additional insurance risks. The MCPM model for COC is as follows: COC= Investment cost of capital5+insurance cost of capital6 But this method is primarily suit to internal use by insurers. Using this model to estimate COC need the disclosure of relevant information which is incomplete disclosed. Especially in replicating portfolios of the determination of the value of insurance liabilities is the most essential phase. The replicating, or hedge, portfolio for a non traded liability is defined as the portfolio of traded market instruments whose cash flows match as closely as possible the corresponding cash flows of the liability being replicated. In the case of those insurance liabilities whose cash flows do not depend on financial market risks, the best approximation is achieved by matching the expected cash flows of the liability with those from a bundle of zero coupon bonds. For example, a claim payment of USD 100 expected 3 years from now is matched with a 3-year zero coupon bond with a maturity value of USD 100. The data available also condition the methodology adopted. But there arent the compatible instruments for replicating the liability portfolio in China capital market, because the amount of financial tools category in China is still small. So we couldnt collect the information necessary for this calculating way in China insurance industry. All the study about the above models is base on the situation of developed countries, the validity of these models in the developing countries remains to be further tested. So we couldnt use the MCPM model to estimate the COC in China insurance industry. We use the CAPM model to estimate the COC of China insurance industry. Although many previous studies show that the historical average market excess return is higher than the actual market risk premium. Thus, the estimate of equity returns overstates what rational investors would have expected to earn. The poor performance of this common practice has cast doubt on the application of the CAPM. CAPM is by far the most widely used model of capital cost in insurance and other industries. It allows for a quick comparison across companies and industries and represents a good first approximation of capital costs. And the core part of this model is beta coefficient which has been calculated on the above section. 5.2 Data and sample We use the samples which are included in the portfolio of above study. We can see the detail in figure 4.1. In this paper, the risk-free rate is set equal to the three-year rate on voucher form Treasury bill in China. The government bill or bond rate is used to represent r f . The monthly returns on stock market which is given by equation (6) yield for the expected return on the market return. The equity risk premium is the extra return generated by the stock market over the risk-free rate. The risk premium is investment cost of capital = risk-free rate + compound financial risk premium (For example: equity risk premium * equity gearing + credit risk premium * bond leverage) 6 Frictional capital costs
5

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compensating investors for bearing systematic market risk. It is generally estimated through a geometric difference, as indicated in the formula:
ERP = 1 + rm 1 1 + rf

(9)

Where rm stands for market return and r f for risk-free rate. We will use equation (7) to estimate the COC of Chinese insurance company. 5.3 Empirical Result Figure 5.1 presents the summary statistics for Chinese insurance industrys COC and the other study based on the developed countries for the purpose of comparison. From figure 5.1, we can find that Chinese insurance industry COC is higher than developed country insurance industries COC. And the beta coefficient in China underwriting is bigger than the figure of mature markets. The result implies that the COC for the insurance sector in China has been increasing over the past few years, which is declining according to the study of sigma and Cummins and Phillips (2005). Sigma 5, 2005 believes that the declining trend of American insurance company has two reasons: declining risk-free rates and a shift in investment allocation out of stocks and into bonds (which reduces the compound risk spread above risk-free, since equity investments demand a higher risk premium than bonds). Risk premiums on shares and bonds have also been trending downward. We also think that the increasing trend in China is in virtue of the two factors. But there are ascending risk free rate and a shift investment allocation out of bank deposit and into stock and fund (figure 2.1). And the stock market return is rising distinctly. So the risk premium is trending upward too. The study of sigma shows that it is difficult in practice for insurers to earn excess returns through investment strategies simply involving more market risk. Riskier investment strategies are expected to generate higher investment income, and some shareholders may prefer this option, accepting the higher risk. Insurers can choose their investment portfolio based on their financial market risk appetite, which is affected, not only by the firm's own risk tolerance overall, but also by restrictions imposed by solvency, rating and financial analysts' requirements. In addition, riskier investment strategies (e.g. more stock) lead to higher capital requirement.

6. Summary and Conclusions

First section of this papers result represents that China insurance company wants to earn excess returns through investment strategies simply involving more market risk. China insurance industrys investment scale of bank deposit is decreasing and the shares of stock is increasing in the sample period. China insurance company adopts the riskier investment strategy to get more investment income for compensating the loss of insurance operation. And we estimate the beta coefficient and proportion of systematic risk in China stock market. We find that the systematic risk and Speculation of China's Stock Market are all bigger than the developed country. So the positive investment strategy could bring uncertain risk to China insurance company.
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Then we count the cost of capital of China insurance company. We compare the COC of China insurance industry and developed country. We find that the COC in China is bigger than developed country. It means that China insurance company should have big opportunity cost to absorb new equity. The result presented above indicates that it is difficult in practice for insurers to earn excess returns through investment strategies simply involving more market risk. The COC for the insurers investment arm depends on the riskiness of the investment portfolio selected. From the two kind of empirical result, we have a conclusion that the positive investment strategy doesnt only face more risk but also couldnt achieve the original project. So there arent senses for China insurance company to adopting the riskier investment strategy.

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Figure 5.1 Summary Statistics for CAPM Regressions on China insurance industry and comparison of Swiss Re sigma 3/05 and Cummins & Phillips Sample size 2005 2006Q1 2006Q2 2006 Study of sigma 5,2005 Study of Cummins and Phillips 77 84 196 164 27 117 Risk free rate 3.60% 3.81% 3.81% 4.08% 3% 4.90% Market return 7.27% 8.79% 8.21% 11.97% N/A N/A Excepted risk premium 3.54% 4.80% 4.24% 7.58% 4% 8.40% beta coefficient 1.02 1.1 1.12 1.18 1.03 0.836 Cost of capital 7.21% 9.08% 8.56% 13.02% 7.60% 11.80%

Note: The comparison data listed in above figure are the average data estimated by the results of sigma and Cummins and Phillips obtained based on CAPM. The assumptions of risk free rate of these studies are: 1) sigma, Notes that short-term t-bill rate has ranged from 1.0% in June 2003 to 16.7% in Aug 1981, with average 6.7%. 3% is chosen as close to recent one-year rate. 2) Cummins and Phillips (2005), 30-day t-bill over the period 1997 to 2000. The risk premium in excess of risk free rate: sigma assumes it to be 4.0% going forward. And Cummins and Phillips (2005) evaluate the historical value of 8.4%.

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