How China's life insurers can avoid Japanification

Japan's life insurance industry is in a renaissance as the economy leaves its "lost decades" behind. Yet life insurers in China now face the same "negative spread" challenge. Investment yields in China's life industry have declined by over 300 basis points since 2020 and we estimate industry net profit fell 20% yoy in 2023. Japan's insurers can offer lessons on how to manage low interest rates.

• As Japan's life insurers finally see higher interest rates, China's life sector faces the same "negative spread" challenge Japan used to.
• Life insurers in China reported investment yields of 2.16% in 1Q 2024, down by more than 300bps since 2020.
• Japanese insurers' shift into foreign securities is less of an option for Chinese insurers.
• Shifting to protection products while targeting gains in mortality and morbidity risk could give Chinese insurers a profitability buffer in a low-yield environment.
• Still, China's GDP growth should stay much higher than Japan's during its lost decades.

The Bank of Japan's interest rate rise in March 2024 was small in size (from -0.1% to a range of 0-0.1%), but large in symbolism, as the first for 17 years. Japan's "lost decades" of deflation, low growth and zero/negative interest rates caused a long-lasting "negative spread" problem for its life insurers, in which guarantees on products sold in times of higher yields exceeded the investment returns subsequently. Now, just as Japan's insurers look forward to growth in life savings and annuity products offering savers better returns,¹ Chinese insurers are experiencing a comparable fall in investment yields. Life insurers in China reported investment yields of 2.16% in 1Q 2024, down by over 300bps compared to 2020,² due to a steady fall in government bond yields and a limited market of better-return assets to invest in. We estimate the net profit of China’s life sector declined by nearly 20% y-o-y in 2023, mainly due to lower investment returns. China's life insurers can follow some of Japan's strategies in managing a low interest rate environment.

Figure 1. Japanese life insurance companies' asset allocation

To boost their average investment yields, Japan's life insurers shifted their asset portfolio towards foreign securities (see Figure 1). Depreciation of the yen, particularly against the US dollar, was also turned into a growth opportunity for FX-denominated products. However, Chinese life insurers have more limited overseas investment channels and portfolio choices, which may put further pressure on investment returns. A more applicable lesson for China would be that Japan's insurers also shifted their product mix towards protection-type policies, such as traditional life insurance and medical or long-term care insurance, to better meet the needs of an ageing population. These typically offer better margins than savings-type policies, and in Japan the shift was supported by deregulation. Endowment policies were estimated to account for 86% of policies in force in Japan in 1970, but only 8% by 2010.

Figure 2. FTSE life insurance sector equity price indices, December 2019 = 100

Carefully managing mortality and morbidity risk could be key for Chinese insurers to provide a profitability buffer to offset narrowing interest rate margins. In Japan, mortality improvements (longer lifespans) helped to mitigate the negative spread problem. In short, life insurers expected higher death rates than actual, so saw lower payouts than expected. And as contracts with high guaranteed yields matured, life insurers' interest margins continued to improve, helped by the combination of higher-yielding foreign assets, impressive longevity gains, and general cost-cutting: the operating expenses of the Japanese life industry fell nearly 20% from 1992 to 2002. The Bank of Japan estimated the net interest margin for the largest insurers to have turned positive by 2013, so high policy rates were not a necessary condition.

At macroeconomic level, we do not see China "turning Japanese". We expect GDP growth to stabilise, not Japan-style stagnation and deflation. There are some similar causes between China today and Japan in the 1990s, such as overexpansion of real estate and bank lending based on ever-rising property prices. Some of China's challenges are even more urgent: its population is already shrinking, while Japan's only started to decline in 2009, when it was already rich in per capita terms.³ However, China is an emerging market at a earlier stage of economic development than Japan in the 1980s, so has sources of growth to offset the slack in its real estate sector (e.g. green tech, digital economy). China's potential GDP growth rate has fallen post-pandemic, but should stay much higher than Japan's during its lost decades. Its life insurance penetration is much lower today than Japan in the 1980s. More robust new premium growth (offering lower guarantees) can still help insurers' toplines.

Finally, a lesson both countries are heeding is the need to prioritise reforms. The Japanese government is pushing companies to improve corporate governance.⁴ Stock investors have welcomed this, as seen in the Nikkei225's outperformance in the past year: Japan's benchmark stock index recaptured its 1989 peak earlier in 2024. For China too, continued progress on financial reforms can improve productivity and capital allocation.