Higher interest rates, a rising yuan and stock market volatility pose stiff challenges for Chinese insurance companies, the industry regulator said on Friday.

Chinese insurers enjoyed investment returns last year totalling 279.2 billion yuan ($38.67 billion) -- more than in the previous five years combined, said Wu Dingfu, chairman of the China Insurance Regulatory Commission.

But he told senior insurance executives at their annual conference that these returns, largely driven by a booming stock market, were abnormal.

Once risks crop up in the stock market, it's too horrifying even to think about it, Wu said.

He told the executives to sharpen their risk awareness and to think twice before blindly launching new equity-linked policies.

Wu said insurance premiums in China increased 25 percent in 2007 to 704 billion yuan ($97 billion), easily outpacing the 14.4 percent rise in 2006.

With fewer than 4 percent of China's 1.3 billion people covered by life insurance, the industry is expanding fast.

Insurers' investments reached 2.7 trillion yuan at the end of 2007, of which 43 percent was in bonds, 24 percent in bank deposits and 18 percent in equities, Wu said. He did not account for the remaining 15 percent.

The insurers' $21.5 billion worth of assets held in U.S. and Hong Kong dollars were shrinking in value as the yuan rose against those two currencies, Wu warned.

What's more, insurers faced serious challenges in their overseas investments because of the rising yuan and the increased risks that come with globalisation, he said.

Still, he said his agency would continue to encourage insurers to venture abroad.

Market speculation is rife that Ping An, which is planning to raise $20 billion through the sale of shares and convertible bonds, will use the funds to buy into British insurer Prudential (PRU.L: Quote, Profile, Research).

Ping An last year paid $2.7 billion for a 4.2 percent stake in Dutch-Belgian financial services firm Fortis.

Wu said the CIRC would also help insurers to diversify their investments. We will expand trials allowing insurers to invest in infrastructure and to take equity stakes, he said.

Beijing would push ahead with the opening of the insurance sector to foreign competitors, he said without elaborating.

Turning to an inter-agency agreement last week permitting Chinese banks to buy into insurers, the CIRC's spokesman, Yuan Li, said regulators had not yet decided on a maximum ownership cap. Non-financial firms may buy no more than 20 percent of an insurer, he added. ($1=7.208 Yuan) (Reporting by Langi Chiang; Editing by Alan Wheatley)