Sustainable underwriting for surety insurance in China
As the surety bond market in China becomes more mature, stringent underwriting discipline is needed
The premium size of the global surety bond market is estimated at around USD15-20 billion in 2022, with the US being the largest market, with around 40% share. China is estimated to represent only 2% of the market or USD320 million in surety bond premiums in 2022. However, the concept of surety bonds issued by insurance companies was only introduced to the Chinese market in 2015 and is still in an early stage of development.Surety insurance comes in different forms in China, from traditional risk protection common to the other markets to more unique protection forms addressing specific social needs in the country. Currently, there are over 20 insurers offering surety bonds in China and the market is very competitive with historical low loss ratio. The top players are PICC, Ping An Insurance, China Taiping Insurance, Sunshine Insurance and China Continent Insurance. Insurers that have risen fast recently include Tian An Property Insurance, Guoren Property and Casualty Insurance, and Asia-Pacific Property and Casualty Insurance.
Surety bonds in China were introduced to relieve property developers’ financial burden
Following the adoption of the Guarantee Law in 1995, construction guarantees were offered by banks and guarantee companies in China. Surety bond insurance first made its appearance in China after the amendment to the Insurance Law in April 2015. In 2017, the Ministry of Housing and Urban-Rural Development issued new regulations to encourage the development of surety bond insurance. The aim was to relieve the financial burden of property developers. Before the introduction of surety bond insurance, banks and guarantee companies provided construction guarantees in exchange for collaterals, which weakened the liquidity position of property developers. In comparison, insurers providing coverage against a premium would have less negative impact on the cash flow and liquidity position of the developers. Early in 2011, S&P Global Ratings had already mentioned the potential liquidity pressure on developers.Since the amendment to the Insurance Law in 2015, primary insurers have developed new types of surety bond insurance to address various social needs in China. These include the Construction Workers Salary Payment Bond, Project Owner/Principal Payment Bond, and Prepaid Card Bond. To date, the Construction Workers Salary Payment Bond is a mandatory requirement in some Chinese provinces. This product was introduced to address non-payment of salaries, particularly to migrant workers. The bond guarantees a construction company will pay its employees throughout a project. Otherwise, the insurer will indemnify the local Human Resources and Social Security Bureau once the latter becomes liable for unpaid salary. The Project Owner/Principal Payment Bond guarantees a project owner will pay bills for labour and materials to subcontractors and/or suppliers. The Prepaid Cards Bond works like a prepaid stored value card issued by a retailer.
The surety bond market is highly competitive, as reflected in aggressive pricing by market players
Property construction activities and public infrastructure, including those generated by the Belt-and-Road Initiative, are the main drivers representing almost 90% of the 2022 surety bond insurance premium in China[1]. In addition to favorable government support and a proliferation construction activity, the development of the surety bonds also benefited from historical loss ratio and technology as most tenders are done online nowadays. While the online process is more efficient, the acquisition cost can be as high as between 50% and 60% of premiums for the insurers leaving a thin underwriting margin for insurers.To understand the reasons behind the historical low loss ratio of this line of business, it is helpful to look first at the business model of the Chinese property market. Around 30% of real estate development projects are funded with debts, and one-third with deposits and advance payments (see Figure 1). Developers would raise debts from onshore and offshore bond markets to finance land acquisition and construction. Proceeds from residences sold, around 80% of which are unfinished presold units, are used to pay back debts. Suppose property prices continue to go up, and developers can quickly sell most of the units under construction. In that case, they can minimise the capital cost of each project and deliver finished properties on time.
Figure 1: Sources of funds for real estate development projects from developers (in CNY trillion)
Source: Investment in Real Estate Development from January to November 2023 and prior years, National Bureau of Statistics of China
However, the latest market developments have rendered this business model untenable (see Figure 2). With slower sales and lower prices, real estate developers are recording negative cash flows and increasingly running into liquidity strains[2]. In fact, 66% of distressed Chinese entities between 2020 and October 2023 came from the real estate sector (see Figure 3). The negative cash flow and liquidity strains experienced by real estate developers could cascade into slower cash collection by project owners and contractors. This could deteriorate into impairments of receivables and in turn affect the earning, liquidity and financial leverage of project owners and contractors[3]. It is under such market conditions that Peak Re expects the profit margin of surety bond insurance in China to deteriorate.
Figure 2: Yearly growth of floor space sold and for sale (in %)
Source: Investment in Real Estate Development from January to November 2023 and prior years, National Bureau of Statistics of China
Figure 3: Defaulted onshore and offshore bonds issued by Chinese entities between 2020 and 10 October 2023
Source: China Bond Recovery Review 2023, S&P Global Ratings, November 2023
Notes: “SOE” means state-owned enterprise. “POE” means private-owned enterprise.
Financial profile of developers expected to deteriorate, but not at the same magnitude for all
With the lockdown from early 2020 to January 2023 resulting in lower property sales, the financial profile of real estate developers has weakened, leading to a slowdown of investment in the real estate sector from 2022 onwards (see Figure 4). Having said that, we should distinguish between state-owned and private property developers.Traditionally, surety bond insurers in China have greater risk appetite for public projects undertaken by state-owned enterprises (SOEs). This is because these state-owned contractors typically have a stronger incentive to complete the projects on time, thus resulting in low loss ratios. As they are government-backed, SOEs are more resilience to external shocks and have better access to funding compared to the private property developers. They tend to focus on the upper- and first-tier market where sales are less depressing (see Figure 5). In addition, SOEs support the government’s policies such as building 8.7 million units in social housing under the 14th five-year plan from 2021 to 2025, and investing in public projects like railways, highways, education, and health infrastructures (see Figure 4).
Figure 4: Yearly growth of investment in selective fixed assets and real estate (in %)
Source: Investment in Real Estate Development from January to November 2023 and prior years, National Bureau of Statistics of China
Figure 5: Property sale by city tier (in CNY trillion)
Source: Investment in Real Estate Development from January to November 2023 and prior years, National Bureau of Statistics of China; China Property Watch: a slow, sequential recovery in 2024, S&P Global Ratings, 2023
While insurers generally prefer state-owned developers over private ones, it might also be worth distinguishing between central SOEs and local SOEs as their shareholders’ ability to support them would differ. According to S&P Global Ratings, central state-owned construction and engineering entities contribute to less than 5% of total SOEs’ debts while local state-owned construction and engineering entities’ contribution is almost 30% in 2021[4]. A weakened credit profile of the property developers means that they have and will slowdown land acquisition. Simultaneously, less property sales could have an adverse impact on property tax (Figure 6). Land sales and property tax are the two main sources of revenue for regional and local governments.
Figure 6: Land acquisition by real estate developers and total transaction value (in CNY trillion)
Source: Investment in Real Estate Development from January to November 2023 and prior years, National Bureau of Statistics of China
Hope is still there for government interventions to restore market confidence
Not all is gloomy for the real estate development and construction industry in China. It was reported in late November 2023 that the People’s Bank of China, the National Administration of Financial Regulation, and the China Securities Regulatory Commission are drafting a list of eligible developers for a range of financing (unsecured short-term loans, debt and equity from state-backed financial institutions). This rescue plan is an effort to address the swathe of unfinished housing and to minimize debt defaults from the developers.In January, the Ministry of Housing and Urban-Rural Development joined the National Administration of Financial Regulation to issue a high-level guideline on lending criteria to real estate developers to banks, which include the borrowers’ ability to provide adequate collaterals and demonstrate a good cash flow[5]. Loans thus granted will be used to complete pre-sold units, and not for new land acquisitions. Other support to the property sector includes extension of the debt maturity and restructuring.
The success of the rescue plan will hinge heavily on the implementation of the program by the financial institutions, the scale of the support mobilized and an eventual recovery in property sales. The Chinese authorities will likely continue to focus on completing stalled projects and disposing any unsold units. Previously, this was done mostly through lowering of the mortgage rates and relaxing of purchasing criteria. The authorities have also advised developers to improve their cash flow through property sales, disposal of existing assets and capital injection. These government actions aim to restore market confidence, to give developers, especially private ones, additional time to adjust to new market dynamics.
Meanwhile, banks remain reluctant to providing new credits to projects without adequate collateral unless public guarantees are offered, as in the case of China Vanke which has secured a strong pledge of support from the Shenzhen municipal government. Fitch Ratings expects non-defaulted private developers to continue to either postpone principal repayments by restructuring their debts or default in 2024, as banks remain highly selective in issuing new loans to developers, despite recent central government guidance to accelerate lending to the sector[6]. Given banks lingering concern about the negatively impact on their intrinsic credit profile[7], the efficiency of the rescue plan remains to be seen.
Further discipline is a must for sustainable underwriting
Surety bonds have been profitable in the past, resulting in fierce competition and rising acquisition costs. The market has turned, and default risks have risen, though there will be increasing differentiation between central SOEs, local SOEs and POEs. The weak financial strength of the private property developers and of the local SOEs are expected to lead to fewer number of projects in the short term. Surety underwriters will need to take note of this trend. Despite increasing government support, it remains to be seen whether this will be sufficient to stabilize the property market and improve consumer confidence. Peak Re estimates the average premium achievement against plan to be in a range of 50%-60% for the China surety market, and maybe 20% to 30% achievement only for smaller size insurers.Given this challenging market outlook in the property market, it is imperative that insurers stick to stringent risk underwriting and lower the acquisition and operation costs. The underwriting decision should adhere, for example, to the historical loss experience of the contractor, terms and conditions in the underlying construction agreement and security provided, etc… Reinsurers can share their expertise such as on pricing adequacy, wording, risk selection, control and tracking to support a sustainable development of the surety bond insurance in China.
[1] Credit and surety in the age of economic uncertainty, Swiss Re Institute, 2023
[2] China Property Watch: a slow, sequential recovery in 2024, S&P Global Ratings, 2023
[3] China growth could fall below 3% if the property crisis worsens, S&P Global Ratings, 2023
[4] China’s SOEs are stuck in a debt trap, S&P Global Ratings, 2022
[5] Notice of the Ministry of Housing and Urban-Rural Development and the National Administration of Financial Regulation on the Establishment of an Urban Real Estate Financing Coordination Mechanism, National Administration of Financial Regulation, 2024
[6] Chinese Non-Defaulted Private Developers Still Face Bond Repayment Pressure in 2024, Fitch Rating, 2023
[7] Latest Financing Support to Chinese Developers Not Yet a Game Changer, Fitch Rating, 2023
