SL Insurers’ Investment risks increase
Fitch Ratings believes Sri Lankan insurers’ asset risks have risen due to the sovereign’s weaker credit profile and the resultant lowering of some State-owned and private-sector institutions’ national ratings. However, the impact on the regulatory capital ratios of Fitch-rated insurers will not be material due to the limited increase in risk charges according to local risk-based capital (RBC) rules.
Weaker sovereign credit profile
Sri Lanka’s sovereign rating was downgraded twice in the last 12 months to ‘CCC’ from ‘B’ due mainly to rising public and external debt sustainability challenges. The national rating scale was recalibrated and the national ratings of some state-owned and private-sector institutions were revised down or downgraded. We estimate that around 12% of the fixed-income investment portfolios of Fitch-rated insurers, or around 28% of deposits and debt instrument portfolios, were invested in these entities at end-June 2020.
No regulatory risk charge for sovereign
Sri Lanka’s regulatory RBC rules exempt debt securities issued or guaranteed by the government from charges on credit and concentration risks in the calculation of the regulatory capital ratio. Fitch does not assign a national scale rating to the sovereign, although, under our National Scale Rating Criteria, the agency will not assign a ‘AAA (lka)' rating on the national scale to issuers rated below ‘B-’ on the international scale. (See Fitch’s recalibrated national rating correspondence table at the end of this report). The increase in asset risks will not materially affect the regulatory capital ratios of most Fitch-rated insurers as a result of the favourable regulatory treatment of sovereign assets. In addition, some of the recent negative national rating actions were within the same national rating category and therefore not subject to additional credit risk charges, according to the local RBC rules.
Sovereign-dominated investment portfolios
Sri Lankan insurers maintain sizeable allocations in debt securities issued by the government. Insurers also invest in bank deposits and debt securities issued by state-sector institutions. We estimate total investment in government securities and state-sector institutions represented around 71% of Fitch-rated insurers’ fixed-income investment portfolios. Insurers maintain high allocations to short-term government securities to meet their liquidity needs, as they generally consider these investments will provide better liquidity than corporate debt securities of similar tenure. In addition, life insurers invest heavily in long-tenure sovereign debt securities to minimise their asset-liability duration mismatches due partly to the limited availability of suitable long-tenure corporate debt securities in the domestic market.
High capital exposure to sovereign
Fitch-rated Sri Lankan insurers’ sovereign investment-to-capital ratio, a measure of their exposure to the sovereign within their investment portfolios, averaged around 100% at end -2019. The numerator of the ratio includes bonds issued by the sovereign and the securities of state-owned entities, whose default experience would be highly correlated to the government.
We estimate Fitch-rated insurers have invested around 55% of their fixed-income portfolios in direct government securities such as treasury bills, bonds, Sri Lanka Development Bonds (SLDB), repo and unit trust assets backed by government securities. The majority of these are denominated in local currency, while the exposure of Fitch-rated insurers to foreign currency-denominated sovereign debt, mainly in SLDBs, was at around 12% of government security investments.
Insurers also invest in deposits and debt securities issued by state-owned enterprises including banks, non-banking financial institutions, and corporations. We estimate investments in these assets represent around 16% of their fixed-income portfolios.
In addition to favourable risk charges in the calculation of regulatory capital ratios, insurers in Sri Lanka are also incentivised to invest in government securities over other assets by better liquidity, and in the case of life insurers, the availability of longer-tenure instruments.
Insurers’ investment options are mostly limited to securities issued by the sovereign and financial institutions because participation in the corporate debt market is quite low for Sri Lanka’s non-financial corporate, which generally have a better credit profile than the sovereign as a majority of their ratings, are not constrained by the sovereign rating relative to those of financial institutions.
Modest changes in regulatory capital
Fitch believes the impact on the regulatory capital ratios of most Fitch-rated Sri Lankan insurers will likely be modest as only limited investments are subject to incremental risk charges per local RBC rules. Investments in government securities are not subject to credit risk charges while the charges will not vary for securities rated within the same national rating category. Incremental risk charges will be applied when ratings move down to a different rating category.
The debt ratings of some financial institutions were lowered by a national rating category. Insurers’ investments in these instruments will attract incremental credit risk charges in the regulatory capital ratio calculation. An incremental risk charge of 2.4 percentage points will be applied on debt securities that were revised lower to the ‘A (lka)’ from the ‘AA (lka)’ rating category. We estimate these instruments accounted for around 5% of Fitch-rated insurers’ fixed-income investment portfolios.
The local RBC rules also consider investments in securities issued or guaranteed by the government as fully admissible in the calculation of the regulatory capital ratio, and therefore not subject to any concentration risk charges. However, any securities issued by institutions other than the government are subject to admissible limits and concentration risk charges as shown below.
Risk-based capital regime shapes investments
Fitch believes that insurers’ investment decisions are partly influenced by the risk-based capital regime, which attracts higher risk charges based on the credit quality and risk characteristics of investments.
We estimate that 55% of fixed-income investments of Fitch-rated insurers were in securities issued or guaranteed by the government at end-June 2020, while a vast majority of the remainder were in securities rated at or above the ‘A (lka)’ rating category on the national rating scale. Securities rated at or below the ‘BBB (lka)’ category on the national rating scale and unrated securities remain small.