THE CROSS-BORDER TRANSPLANTATION OF VARIABLE UNIVERSAL LIFE INSURANCE: THE EVOLUTION AND THE REGULATORY CHALLENGES.

• Author: Li, Xingxing

1. INTRODUCTION 282 II. THE WAVE OF INSURERS' EQUITY INVESTMENTS AND THE REGULATORY FRAMEWORK BEHIND THE BOOM 286 A. The Taking Off of Variable Insurance 286 B. The Investment Mania 290 C. The Sharp Turn 291 D. Improvised Regulatory Responses and the Asset Management Rules on the Horizon 293 III. CHARACTERISTICS OF VARIABLE PRODUCTS MADE IN CHINA 296 A. "Separate Account" in the U.S. versus "Separate Investment Account" in China 296 B. The Distinctions 299 IV. ARE THE SYSTEMIC RISKS OPTIMALLY TAMED? 303 A. Net Capital Requirements & the Cost of Capital 303 B. Guaranteed Minimum Income Benefit 308 C. Mismatch of Long-Term Investment and Short-Term Liability 311 D. Investment Restrictions and Possible Fiduciary Duty Constraints 314 V. THE MORE DEEP-ROOTED PROBLEM: THE MUDDY WATER OF FINANCIAL PRODUCTS IN AN INSTITUTION-BASED REGULATORY STRUCTURE 320 A. Separate Account as a Transplanted Instrument 320 B. Regulation of Financial Institutions, or of Financial Products? 322 C. Tensions between the Imported Financial Product and the Regulatory Status Quo 327 D. The Securities Registration System for Variable Insurance 328 E. The Information Disclosure Dilemma 334 F. Is the Time Ripe For the Functional Regulation of Variable Insurance? 336 VI. CONCLUSION 343 I. INTRODUCTION

   A few years ago, variable universal life insurance ("variable insurance") was a novel concept in the eyes of many Chinese insurance practitioners. Few would envision the almost overnight proliferation of variable insurance in China. However, as of today, variable insurance has surged to take up a significant market share in the Chinese financial market, analogous to its counterpart in the United States.

   Variable insurance was initially developed and matured in the U.S. market. When transplanted to China by insurers, it seemed to overwhelm the Chinese regulators. As in other markets, financial innovation has outpaced the ability of regulators to deal with it. (1) As Doreen McBamet puts it, the scholarship would not be surprised to see "the failure of the whole cumbersome apparatus of law itself, destined always to lag behind dynamic business." (2) This article analyzes the serious regulatory challenges that variable insurance brings to the surface of China's financial regulatory framework. This is attributable in part to the fast speed at which variable insurance gained its popularity. It is also in part due to the different regulatory infrastructure that variable insurance faces in China than its counterpart in the United States.

   This article reviews the economic driver and regulatory shift behind the booming (and subsequent stagnation) of the variable insurance business in China. A comparative analysis reveals that the Chinese variable insurance products, albeit patterned on their counterparts in the United States, present certain features that distance themselves from their U.S. counterparts. It argues that in response to the financial risks associated with this novel financial product, China's regulators merely treat the symptoms and not the root causes. Despite regulators' rhetoric to the contrary, China's institution-based regulatory structure is unlikely to be overhauled in the short run. Among other issues, it would be difficult, if not impossible, for the regulators to recognize variable insurance as a securities product as the U.S. regulatory structure does.

   Above all, the Chinese regulators seem to have underestimated the impact of insurers' investments as a conduit for asset management activities. The Asset Management Rules, which bring about sweeping changes to the landscape of the entire asset management industry, do not include variable insurance as one of the asset management businesses under its coverage. Such an approach leaves room for regulatory arbitrage relative to other asset management businesses such as mutual funds, asset management subsidiaries of securities companies, and banks' wealth management business.

   Second, the institution-based regulatory approach exacerbates this problem. Financial regulators oversee the financial institutions, together with the financial products they issue, on an institutional basis. The separation of regulatory function renders variable insurance, notwithstanding its substantial similarity to a securities product, subject to the China Insurance Regulatory Commission's ("CIRC's") sole regulation (3) and not that of the China Securities Regulatory Commission ("CSRC"), China's securities regulator. Not deemed as a securities product in China, variable insurance is exempt from the registration requirements of the CSRC, (4) and thereby gets around the mandatory disclosure requirements that are otherwise applicable to securities. Variable insurance policyholders' right to make informed decisions, similar to securities investors, are therefore in jeopardy.

   Third, to the regulators' credit, they are aware of the systemic risks associated with variable insurers' practice of borrowing short-term while investing long-term. Nevertheless, the Asset Management Rules, aimed at addressing such risk mismatching, leave variable insurance out of its coverage. The liquidity risk of the variable insurance industry remains.

   Fourth, in an arbitrary fashion, the Chinese regulators devoted tremendous regulatory resources to restrict the insurers' ability to issue variable insurance on a case-by-case basis. In particular, the regulators tightened their grip on variable insurance following Baoneng's takeover campaign of Vanke, one of China's largest real estate developers, for fear of the raider's use of variable insurance as a financial instrument for a leveraged buyout. (5) These swinging regulatory responses in effect undermine the viability of the variable insurance business.

   This article proceeds as follows. Part I addresses the questions of why variable insurance was transplanted into China and why it did not prosper until recent years. It finds that regulatory changes in the framework for the insurance industry catalyzed the blossom of variable insurance. Similarly, it was the subsequent policy shift that accounted for the withering of the same product.

   Part II compares variable insurance in China and in the United States. It finds that while variable insurance made in China resembles a securities product more so than its U.S. counterpart, it is not regulated as such.

   Part III forays into the systemic risks embedded in the Chinese version of variable insurance. It criticizes the regulators' arbitrary suppression of variable insurance as a business model, which is not tailored to the inherent risks of the financial product, while disproportionately biasing small- to medium-sized insurers on the market. The negative consequence of such regulatory suppression may be leaving a hidden time bomb while sacrificing the business viability of variable insurance.

   Parts IV delves into more deeply rooted structural issues in variable insurance regulation. It argues that despite the worthwhile attempt of the new Asset Management Rules to unify the regulation of wealth management products, it is premature to claim it as a breakthrough to the status quo since Chinese financial regulators still divide their regulatory authorities on an institutional basis. In this sense, to regulate variable insurance as an investment company and a security product, as is the approach in the United States, has a much longer way to go than scholars would expect. Part V draws conclusions.

2. THE WAVE OF INSURERS' EQUITY INVESTMENTS AND THE REGULATORY FRAMEWORK BEHIND THE BOOM

   1. The Taking Off of Variable Insurance

      Variable insurance is a hybrid of insurance and investment. It provides life insurance to policyholders, but the death benefits and cash value of the policy are based on the performance of investments, which are made through a separate account maintained by the insurance company. A few years ago, Chinese insurance practitioners could not have foreseen the boom in variable insurance. To them, while variable products may be popular in developed markets like the U.S., they do not have many competitive edges compared to wealth management products offered by banks.

      Chinese insurers began to spot a huge business opportunity in 2015 when the CIRC, the Chinese insurance regulator (which was later merged into the banking regulator), published a regulation liberalizing the minimum return rate that an insurer can guarantee its policyholders. (6) As a series of efforts aimed at liberalizing interest rates of life insurance products, the CIRC promulgated the "Circular on Certain Matters Concerning the Reform of the Fee Rate Policy in Relation to Variable Life Insurance"("Variable Insurance Fee Rate Circular") (7) as well as the "Rules on the Actuarial Calculations of Life Variable Insurances" ("Actuarial Rules"). (8) The Variable Insurance Fee Rate Circular and the Actuarial Rules lifted the cap on the minimum interest rate, previously set at 2.5 percent per annum, (9) that an insurer may commit to its policyholders.'" Like bank interest rates, fees that insurers charge on their insurance products are tightly regulated in China. The deregulation initiatives marked a milestone in the CIRC's proposal to liberalize the fee rates charged by insurance products."

      Liberalizing rates was the legal catalyst for variable insurance products' popularity in the Chinese insurance market as there was already a strong business case for variable insurance. Following the global wave of quantitative easing in the aftermath of the 2008 financial meltdown, first by the U.S. Federal Reserve, then by the European Central Bank and the Bank of Japan, China adopted a loose monetary policy and has maintained a low interest rate since 2014. (12) With the flooding of easy credit, there was a "safe asset shortage" on the Chinese market, meaning it was hard for the financial institutions to find quality assets to invest in. (13) Good assets quickly drained out when...