insurance sector of india

7/29/2019 Insurance Sector of India

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PROJECT ON

insurance sector in India

Bachelor of Commerce-

Banking & Insurance

Semester VI

(2012-2013)

Submitted By

GEETA MEDI

Roll no- 19

GURU NANAK COLLEGE OFARTS,SCIENCE, AND

COMMERCE

G.T.B nagar sion (E), Mumbai -400037


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Insurance sector of India.

PROJECT ON

insurance sector in India

Bachelor of Commerce-

Banking & Insurance

Semester VI

(2012-2013)

Submitted By

GEETA MEDI

Roll no- 19

GURU NANAK COLLEGE OFARTS,SCIENCE, AND

COMMERCE

G.T.B nagar sion (E), Mumbai -400037

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C E R T I F I C A T E

This is to certify that Miss. GEETA MEDI of B.Com -

Banking & Insurance Semester VI (2012-2013) has

successfully completed the project on INSURANCE

SECTOR IN INDIA

under the guidance of SUDHA MAM

Project guide

Principal

Course Co-ordinator:

Internal Examiner:

External Examiner:

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Declaration

I GEETA MEDI student of B.Com Banking & Insurance Semester

VI (2012-2013) hereby declare that I have completed the Project on

INSURANCE SECTOR IN INDIA The information submitted

is true and original to the best if my knowledge.

Signature of the student

Name of the student

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ACKNOWLEDGEMENT

I would like to thank a lot of people without whom this

project would not have been complete. First prof. SUDHA

MAM she was of utmost help in guiding me structures this

project. She helped me throughout and was always present

to help me whenever I had a doubt.

A research can never be over without access to a good

library and in this case I was blessed as our college library,

is very well stocked with books. And the lending policy

made life a lot easier. And not to forget the unconditional

support provided by my parents and friends.

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EXECUTIVE SUMMARY:

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Insurance sector in INDIA is booming up but not to level

comparative with the developed economies such as Japan,

Singapore etc. Also with the opening of the insurance sector to the

private players have provided stiff competition resulting into quality

products. Also there is a need to restructure the Indian Government

owned Life insurance Corporation of India so as to maximize

revenue and in turn profits. IRDA regulations and norms for the

allocation of funds need to have a comprehensive look. In the phase

of declining interest rates and rising inflation the funds need to be

applied in productive areas so as to generate high returns. Also in

terms of clients servicing areas such as premium payments, after

sales service, policy dispatch, redressal of grievances has to be

amended. In the current scenario, LIC has to provide flexible products

suited to the customers requirements. Also a proper and systematic

risk management strategy needs to be adopted. After the increase in

terrorism and destructive events around the global world such as

September 11 attack on World Trade Centre, US Taliban war, US

Iraq war etc.. an alternative to reinsurance such as asset backed

securities is emerging out in the developed economies. A catastrophe

bond is one of the alternatives for reinsurance. Finally some policies

such as pure term and pension schemes needs to be addressed

massively at both the urban and the rural segment so as to generate

high premium income which will help in the development and growth

of the economy.

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INDEX :

SR CONTENTS PAGE

NO.

NO .

1. INTRODUCTION

1

2. INSURANCE SECTOR - A PREVIEW3

3. LIFE INSURANCE INDEX ( COUNTRYWISE )

6

4. WHY OPEN UP THE INSURANCE SECTOR ?

7

5. GOVERNMENT / RBI REGULATIONS

11

6. INDIAN PARTNER FOREIGN TIE UP

16

7. WHY LIBERALISE, WHAT MARKET STRUCTURE

18

& ROLE FOR THE REGULATOR

8. AN ALTERNATIVE TO REINSURANCE

38

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9. INVESTMENT AND CAPITAL NORMS

44 10. ROLE OF THE PORTFOLIO

MANAGER 46

11. RESTRUCTURING OF LIC & GIC

53

12. POINTERS FOR THE INDIAN POLICYMAKERS

56

13. CURRENT SCENARIO

60

14. BIBLIOGRAPHY

64

INTRODUCTION:

Insurance may be described as a social device to reduce or

eliminate risk of loss to life and property. Under the plan of

insurance, a large number of people associate themselves by

sharing risks attached to individuals. The risks which can be

insured against, include fire, the perils of sea, death and

accidents and burglary. Any risk contingent upon these, may be

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insured against at a premium commensurate with the risk

involved. Thus collective bearing of risk is insurance.

DEFINITION:

General definition:

In the words of John Magee, Insurance is a plan by which large

number of people associate themselves and transfer to the

shoulders of all, risks that attach to individuals.

Fundamental definition:

In the words of D.S. Hansell, Insurance may be defined as a

social device providing financial compensation for the effects of

misfortune,

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the payment being made from the accumulated contributions of

all parties participating in the scheme.

Contractual definition:

In the words of justice Tindall, Insurance is a contract in which a

sum of money is paid to the assured as consideration of insurers

incurring the risk of paying a large sum upon a given

contingency.

Characteristics of insurance:

Sharing of risks

Cooperative device

Evaluation of risk

Payment on happening of a special event

The amount of payment depends on the nature of losses

incurred.

INSURANCE SECTOR A PREVIEW :

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The insurance sector in India dates back to 1818, when

Oriental Life Insurance Company was incorporated at Calcutta.

Thereafter, few other companies like Bombay Life Assurance

Company, in 1823 and Triton Insurance Company, for General

Insurance, in 1850 were incorporated. Insurance Act was passed

in 1928 but it was subsequently reviewed and comprehensive

legislation was enacted in 1938. The nationalisation of life

insurance business took place in 1956 when 245 Indian and

Foreign Insurance provident societies were first merged and then

nationalized. It paved the way towards the establishment of Life

Insurance Corporation (LIC) and since then it has enjoyed a

monopoly over the life insurance business in India. General

Insurance followed suit and in 1968, the insurance act was

amended to allow for social control over the general insurance

business. Subsequently in 1973, non-life insurance business was

nationalised and the General Insurance Business

(Nationalisation) Act, 1972 was promulgated. The General

Insurance Corporation (GIC) in its present form was incorporated

in 1972 and maintains a very strong hold over the non-life

insurance business in India. Due to concerns of

(a) Relatively low spread of insurance in the country.

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(b) The efficient and quality functioning of the Public Sector

insurance companies

(c) The untapped potential for mobilizing long-term

contractual savings funds for infrastructure the (Congress)

government set up an Insurance Reforms committee in

April 1993.

The Committee submitted its report in January 1994,

recommended a phased program of liberalization, and called for

private sector entry and restructuring of the LIC and GIC. But now

the parliament has given a nod to the Insurance Regulatory and

Development Authority (IRDA) bill with some changes in the

original structure.

How big is the insurance market?

Insurance is an Rs.400 billion business in India, and together with

banking services adds about 7% to Indias GDP. Gross premium

collection is about 2% of GDP and has been growing by 15-20%

per annum. India also has the highest number of life insurance

policies in force in the world, and total investible funds with the

LIC are almost 8% of GDP. Yet more than three-fourths of Indias

insurable population has no life insurance or pension cover.

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Health insurance of any kind is negligible and other forms of non-

life insurance are much below international standards. To tap the

vast insurance potential and to mobilize long-term savings we

need reforms which include revitalizing and restructuring of the

public sector companies, and opening up the sector to private

players. A statutory body needs to be made to regulate the

market and promote a healthy market structure. Insurance

Regulatory Authority (IRA) is one such body, which checks on

these tendencies.

INDIVIDUAL LIFE INSURANCE COVERAGE INDEX,

1994

COUNTRY NO. OF POLICIES PER 100

PERSONS

Indonesia 2.0Philippines 5.6

India 12.4

Thailand 14.7

Malaysia 35.5

Hong Kong 69.4

South Korea 70.5

Taiwan 75.2

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Singapore 112.6

Japan 198.4

Source: Charted Financial Analyst May 1999. (Insurance in

Asia: The financial times, quoted from Tillinghast study)

WHY OPEN UP THE INSURANCE INDUSTRY ?

An insurance policy protects the buyer at some cost against

the financial loss arising from a specified risk. Different situations

and different people require a different mix of risk-cost

combinations. Insurance companies provide these by offering

schemes of different kinds. Unfortunately the concept of

insurance is not popular in our country. As per the latest

estimates, the total premium income generated by life and

general insurance in India is estimated at around a meagre

1.95% of GDP. However Indias share of world insurance market

has shown an increase of 10% from 0.31% in 1996-97 to 0.34%

in 1997-98. Indias market share in the life insurance business

showed a real growth of 11% thereby outperforming the global

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average of 7.7%. Non-life business grew by 3.1% against global

average of 0.20%. In India insurance spending per capita was

among the lowest in the world at $7.6 compared to $7 in the

previous year. Amongst the emerging economies, India is one of

the least insured countries but the potential for further growth is

phenomenal, as a significant portion of its population is in

services and the life expectancy has also increased over the

years. The nationalized insurance industry has not offered

consumers a variety of products. Opening of the sector to private

firms will foster competition, innovation, and variety of products. It

would also generate greater awareness on the need for buying

insurance as a service and not merely for tax exemption, which is

currently done. On the demand side, a strong correlation between

demand for insurance and per capita income level suggests that

high economic growth can spur growth in demand for insurance.

Also there exists a strong correlation between insurance density

and social indicators such as literacy. With social development,

insurance demand will grow.

Future course of Insurance Business:

One of the main differences between the developed economies

and the emerging economies is that insurance products arebought in the former while these are sold in latter. Focus of

insurance industry is changing towards providing a mix of

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protection / risk over and long-term investment opportunities.

Some of the major international players in the insurance

business, which might try to enter the Indian market, are Sun

Life of Canada, Prudential of the United Kingdom, Standard Life,

and Allianz etc. Although the insurance sector is officially open to

private players, they still need a license from the IRDA, which will

announce its guidelines in May 2000. Following might be the

future strategies of insurance companies.

(1) The new entrants cannot compete with the state owned

LIC on price alone. Due to its size, LIC operates at very

low costs and their premia on policies that offer pure

protection are on a par with comparable schemes across

the globe. What the new

insurance companies will probably offer is higher returns

than the annualized 9-10% one can hope to earn from LICs

policies. This will put pressure on LIC to offer more

attractive returns.

(2) Consumers can also expect product innovations. For

instance,

at present, LIC provides cover for permanent disability and

what the new companies could offer is temporary disability

insurance as well.

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(3) Apart from the basic term insurance, most insurance

products worldwide are sold as long-term investment

opportunities with the protection component being clearly

spelt out in the scheme.

(4) LICs policies are not flexible according to the customers

needs. New entrants have planned to offer universal life

and variable life insurance products that allow the holder

flexibility in deciding how his premia are split between

protection and savings. New products would also enable

product combinations that allow greater customisation.

(5) Private insurers would compete furiously on the service

platform. These would not only include faster claims

settlement and other after-sales service but there agents

would be trained in pre-sales interaction to usher in a

customer-oriented approach. They would be better

qualified in assisting clients in financial planning.

(6) Foreign companies would also use superior software (like

APEX) that will give them an edge over the in-house LIC

software. This technology will help private insurers in

product development and customizing products to suit

individual needs.

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(7)The foreign players will probably introduce a lot of

innovation and competition on Surrender value. LIC pays

surrender value only after three years but private insurance

companies are likely to offer sops by way of better and

timely surrender value to clients.

(8)Access to insurance too will probably become more

widespread. Role of intermediaries would decrease and

sale of insurance through direct channels and banks would

increase. Simple products like term insurance might be sold

through the telephone or direct mail to high net worth

clients.

(9) In reaction to foreign players strategies one might expect

LIC to react and drop its premia and upgrade its services.

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BOTTLENECKS GOVERNMENT / RBI

REGULATIONS:

The IRDA bill proposes tough solvency margins for

private insurance firms, a 26% cap on foreign equity and a

minimum capital of Rs.100 crores for life and general

insurers and Rs. 200 crores for reinsurance firms. Section

27A of the Insurance Act stipulates that LIC is required to

invest 75% of its accretions through a controlled fund in

mandated government securities. LIC may invest the

remaining 25% in private corporate sector, construction, and

acquisition of immovable assets besides sanctioning of

loans to policyholders. These stipulations imposed on the

insurance companies had resulted in lack of flexibility in the

optimisation of risk and profit portfolio. If this inflexibilitycontinues, the insurance companies will have very little leverage

to earn more on their investments and they might not be able to

offer as flexible products as offered abroad.

The government might provide more autonomy to insurance

companies by allowing them to invest 50 % of their funds as per

their own discretions. Recently RBI has issued stiff guidelines,

which had dealt a severe blow to the plans of banks and financial

institutions to enter the insurance sector. It says that non-

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performing assets (NPA) levels of the prospective players will

have to be 1% point lower than the industry average (presently

7.5%). RBI has also stipulated that all prospective entrants need

to have a net worth of Rs. 500 crores. These guidelines have

made it virtually impossible for many banks to get into the

insurance business. Also banks and FIs who are planning to

enter the business cannot float subsidiaries for insurance. RBI

has taken too much caution to make sure that the new sector

does not experience the kind of ups and downs that the non-bank

financial sector has experienced in the recent past. They had to

rethink about these guidelines if Indias strong banks and

financial institutions have to enter the new business. The

insurance employees union is offering stiff resistance to any

private entry. Their objections are

(a) that there is no major untapped potential in insurance

business in India;

(b) that there would be massive retrenchment and job

losses due to computerization and modernization;

and

(c) that private and foreign firm would indulge in reckless

profiteering and skim the urban cream market, and

ignore the rural areas.

But all these fears are unfounded. The real reason behind the

protests is that the dismantling of government monopoly would

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provide a benchmark to evaluate the governments insurance

services.

OPENING UP OF INSURANCE SECTOR :

Indian History: Time to turn the clock back-and open up

insurance. For two years, around 30 foreign insurers have

eagerly explored the nationalized Indian insurance market,

preparing to leap in when private participation is allowed. But it

seems they have an endless wait before the sector is opened up.

That's ironical: in 1947, many of these insurers were firmlyestablished here. BAT subsidiary Eagle Star, for example,

opened offices in Calcutta in 1894. By 1921, it was doing

business with Brooke Bond and the Birlas. Prudential's first Asia

office was opened In India in 1923. Fifty years ago, India had a

bustling, if somewhat chaotic, entirely private insurance industry.

The year after Independence, 209 life Insurance companies were

doing business worth Rs712.76 crore (which grew to an amazing

Rs 295,758 crore in 1995-96). Foreign insurers had a large

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market share 40 per cent for general insurance but there were

also plenty of Indian companies, many promoted by business

houses like the Tatas and Dalmias. The first Indian-owned life

insurance company, the Bombay Mutual Life Assurance Society,

was set up in 1870 by six friends. It Insured Indian lives at the

normal rates instead of charging a premium of 15 to 20 percent

as foreign insurers did. Its general insurance counterpart, Indian

Mercantile Insurance Company Ltd., opened in Bombay in 1907.

A plethora of insufficiently regulated

players was a sure recipe for abuse, especially because there

was no separation between business houses and the insurance

companies they promoted. The Insurance Act, 1938, introduced

state controls on insurance, including mandatory investments in

approved securities, but regulation remained ineffective. In 1949,

Purshottamdas Thakurdas, chairman of the Oriental Assurance

Company, admitted: "We cannot deny that, today, there is a

tendency on the part of insurance companies in general to make

illicit gains.

Can we overlook the cutthroat competition for acquiring

business?And still worse is the dishonest practice of adjusting

of accounts." After a 1951 inquiry, the government was dismayed

that companies had high expense and premium rates, were

speculating in shares, and giving loans regardless of security. No

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wonder that between 1945 and 1955, 25 insurers went into

liquidation and 25 transferred their business to other companies.

This reckless record stoked the pro-nationalisation fires. The

1956 life insurance Nationalisation was a top-secret intrigue; for

fear that unscrupulous insurers would siphon funds off if warned.

The government resolved to first take over the management of

life insurance companies by ordinance, then their ownership.

The ordinance transferred control of 245 insurers to the

government. LIC, established eight months later, took over their

ownership. General Insurance had its turn in 1972, when 107

insurers were amalgamated into four companies headquartered

in the four metros, with GIC as a holding company.

Nationalization brought some benefits. Insurance spread from an

urban-oriented, high-end business to a mass one. Today, 48 per

cent Of LIC's new business is rural. Net premium income in

general insurance grew from Rs.222 crore in 1973 to Rs.5,956

crore in 1995- 96. Yet, rigid controls hamper operational flexibility

and initiative so both customers service and work culture today

are dismal. The frontier spirit of the early insurers has been lost.

Insurance companies have also been timid in managing their

investment portfolios. Competition between the four GIC

subsidiaries remains illusory.

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WHOS GOING WITH WHOM?

Indian Company Foreign PartnerKotak Mahindra Chubb, US

Tata Group AIG, US

Sundram Finance Winterthur, SWITZERLAND

Sanmar Group GIO of Australia

M A Chidambaram MetLife

Bombay Dyeing General Accident, UKDCM Shriram Royal Sum Alliance, UK

Dabur Group Liberty Mutual Fund, USA

Godrej J. Rothschild, UK

ITC Eagle star, UK

S K Modi Group Legal and General, Australia

CK Birla Group Zurich Insurance, Switzerland

Ranbaxy Cigna, US

Alpic Finance Allianz, GERMANY

20th Century Finance Canada Life

Vyasa Bank ING

Cholmandalam Guardian Royal Exchange, UK

SBI Alliance Capital

HDFC Standard Life, UK

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ICICI Prudential, UK

IDBI Principal

Max India New York Life

The privatisation of the insurance sector would open up exciting

new career options and new jobs would be created. A few

insurers estimated a figure of 1lakh, after comparing the work

forces in India and the UK. At present, life products comprise a

big chunk, or 98%, of LICs business. Pension comprises a mere

2%. Now with increase in life expectancy rate, people have to

start planning their retirements. Hence pension business is

expected to grow once the industry opens. The demand for

healthcare is growing due to population increase, greater urban

migration and alarming levels of pollution. Healthcare insurance

is more important for families with smaller savings because they

would not be able to absorb the financial impact of adverse

events without insurance cover. Foreign insurance companies

like Aetna (worlds largest healthcare insurance provider) and

Cigna have been providing Managed Care services across the

globe. Managed Care integrates the financing and delivery of

appropriate health care services to covered individuals.

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WHY LIBERALIZE, WHAT MARKET STRUCTURE TO

HAVE FINALLY, WHAT ROLE FOR REGULATOR?

Introduction:

The decision to allow private companies to sell insurance

products in India rests with the lawmakers in Parliament. These

are the passage of the Insurance Regulatory Authority (IRA) Bill,

which will make IRA a statutory regulatory body, and amending

the LIC and GIC Acts, which will end their respective monopolies.

In 1994 the government appointed a committee on insurance

sector reforms (which is known as the Malhotra Committee)

which recommended that insurance business be opened up to

private players and laid down several guidelines for orchestrating

the transition. In particular, we do not address many other related

questions such as whether foreign (and not just private) playersshould be allowed, what cap should there be on foreign equity

ownership, whether banks and other financial institutions should

be allowed to operate in the insurance business, whether firms

should be allowed to sell both life and -non-life insurance, and so

on.

The three questions that we address are

(a) Why should insurance be opened up to private players?

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(b) If opened up, what should be the appropriate market

structure?

(many unregulated players or a few regulated players); and

finally,

(c) What is the role of the regulator in insurance business?

Why allow entry to private players?

The choice between public and private might amount to choosing

between the lesser of two evils. An insurance contract is a

"promise to pay" contingent on a specified event. In the case of

insurance and banking, smooth functioning of business depends

heavily on the continuation of the trust and confidence that

people place on the solvency of these financial institutions.

Insurance products are of little value to consumers if they cannot

trust the company to keep its promise. Furthermore, banking and

insurance sectors are vulnerable to the "bank run" syndrome,

wherein even one insolvency can trigger panic among consumers

leading to a widespread and complete breakdown. This implies

the need for a public regulator, and not public provision of

insurance. Indeed in India, insurance was in the private sector for

a long time prior to independence. The Life InsuranceCorporation of India (LIC) was formed in 1956, when the

Government of India brought together over two hundred odd

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private life insurers and provident societies, under one

nationalized monopoly corporation, in the wake of several

bankruptcies and malpractices'. Another important justification for

Nationalisation was to raise the much-needed funds for rapid

industrialization and self-

reliance in heavy industries, especially since the country had

chosen the path of state planning for development. Insurance

provided the means to mobilize household savings on a large

scale. LIC's stated mission was of mobilizing savings for the

development of the country.

The non-life insurance business was nationalized in 1972

with the formation of General Insurance Corporation (GIC).

Thus the fact that insurance is a state monopoly in India is an

artifact of recent history the rationale for which needs to be

examined in the context of

liberalization of the financial sector. If traditional infrastructure and

"semi-public goods" industries such as banking, airlines, telecom,

power, and even postal services (courier) have significant, private

sector presence, continuing a state monopoly in provision of

insurance is indefensible. This is not to deny that there are some

valid grounds for being cautious about private sector entry. Some

of these concerns are:

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(a) That there would be a tendency of private companies to

"skim" the markets; thus private players would concentrate on the

lucrative mainly urban segment leaving the unprofitable segment

to the incumbent LIC.

(b) That without adequate regulation, the funds generated may

not be deployed in sectors (which yield long-term social benefits),

such as infrastructure and public goods; similar without

regulation, private firms may renege on their social sector

investment obligations. Meeting these concerns requires a strong

regulatory body. Another

commonly expressed fear is that there would be massive job

losses in the industry as a whole due to computerization. This

however does

not seem to be corroborated by the countries' experience'.

Moreover, apart from consideration based on theoretical

principles alone, there is sufficient evidence that suggests that

introduction of private players in insurance can only lead to

greater benefits to consumers. This can be seen from the fact

that the spread in insurance in India is low compared to

international benchmarks. The two convention measures of the

spread of insurance are penetration and density. The former

measure (premiums per unit) of GDP, and the latter, premiums

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per capita. Less than 7% of the population in India has life

insurance cover. In Singapore, around 45 per cent of the people

are covered and in Japan, this is close to 100 per cent. In the US,

over 81 per cent the households have insurance cover. India has

the biggest life insurance sector in the world if we go by the

number of policies sold, but the number of policies sold per 10

persons is very low. The demand for insurance is likely to

increase with rising per-capita incomes, rising literacy rates and

increase of the service sector, as has been seen from the

example of several other developing countries. In fact, opening

up of the insurance sector is an integral part of the liberalization

process being pursued by many developing countries. After

Korean and Taiwanese insurance sectors were liberalized, the

Korean market has grown three times faster than GDP and in

Taiwan the rate of growth has been almost 4 times that of its

GDP. Philippines opened up its insurance sector in 1992. There

are

several other factors that call for private sector presence. Firstly,

a state monopoly has little incentive to innovate or offer a wider

range of products. This can be seen by a lack of certain products

from LlC's portfolio, and lack of extensive risk categorization in

several GIC products, such as health insurance. In fact, it seems

reasonable to conclude that many people buy life insurance just

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for the tax benefits, since almost 35 per cent of the life insurance

business is in March, the month of financial closing. This

suggests that insurance needs to be sold more vigorously. More

competition in this business will spur firms to offer several new

products, and more complex and extensive risk categorization.

The system of selling insurance through commission agents

needs a better incentive structure, which a state monopoly tends

to stifle. For example LIC pays out only 5 per cent of its income

as commissions, whereas this share in Singapore is 16 per cent,

and in Malaysia it is close to 20 percent. Private sector presence

will also mean that the current investment norms, which tie up

almost 75 per cent of insurance funds in low yielding government

securities, will have to go. This will result in more proactive and

market oriented investment of funds. This needs to be tempered

by prudential regulation to ensure solvency'. Of course, this also

implies that cross-subsidizing across policyholders of different

types that is seen both in life and non-life insurance will diminish.

Since public sector firms are required to sell subsidized insurance

to weaker sections of society, a separate subsidy mechanism will

have to be designed. The India Infrastructure Report (GOI, 1996)

estimates that

the funds required in the next two decades are more than Rupees

4000 billion. Finally, private sector entry into insurance might be

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simply a fiscal necessity. Since large scale funds form long term

contractual savings need to be mobilized, especially for

investment in infrastructures the option of not having more

(private) players in the insurance sector is too costly.

WHAT SHOULD BE THE MARKET STRUCTURE ?

Individuals buying an insurance contract pay a price (called

the "premium") to the insurance company and the insurance

company in turn provides compensation if a specified eventoccurs. By making such contractual arrangements with a large

number of individuals and organizations the insurance company

can spread the risk. This gives insurance its "social" character in

the sense that it entails pooling of individual risks. The price of

insurance i.e., the premium is based on average risk. This

premium is too high for people who perceive themselves to be in

a low risk category. If the insurer cannot accurately determine the

risk category of every customer and prices insurance on the basis

of average risk, he stands to lose all the low risk customers. This

in turn increases the average risk, which means premia have to

be revised upwards, which in turn drives away even more

customers and so on. This is known as the problem of "adverse

selection". Adverse selection problem arises when a seller of

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insurance cannot distinguish between the buyer's type i.e.,

whether

the buyer is a low risk or a high type. In the extreme case, it may

lead to the complete breakdown of insurance market. Another

phenomenon, the problem of "moral hazard" in selling insurance,

arises when the unobservable action of buyer aggravates the risk

for which insurance is bought. For example, when an insured

car driver exercises less caution in driving, compared to how he

would have driven in the absence of insurance, it exemplifies

moral hazard. Given

these problems, unbridled competition among large number of

firms is considered detrimental for the insurance industry.

Furthermore, even the limited competition in insurance needs to

be regulated. Insurance companies can differentiate among

various risk types if there is a wide difference in risk profile of the

buyers insuring against the strong insurers. It also called for

keeping life insurance separate from the general insurance. It

suggested the regulation of insurance intermediaries by IRA and

the introduction of brokers for better professionalisation'.

THE ROLE OF IRA :

(a) The protection of consumers interest,

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(b) To ensure financial soundness of the insurance

industry and

(c) To ensure healthy growth of the insurance market.

These objectives must be achieved with minimum government

involvement and cost. IRAs functioning can be financed by

levying a

small fee on the premium income of the insurers thus putting zero

cost on the government and giving itself autonomy.

( a ) Protection of Customer Interests :

IRAs first brief is to protect consumer interests. This

means ensuring proper disclosure, keeping prices affordable but

also insisting on some mandatory products, and most importantly

making sure that consumers get paid by insurers. Ensuring

proper disclosure is called Disclosure Regulation. Insurance

contracts are basically contingency agreements. They can be full

of inscrutable jargon and escape clauses. An average consumer

is likely to be confused by them. IRA must require insurers to

frame transparent contracts. Consumers should not have to wake

up to unpleasant surprises, finding that certain contingencies are

not covered. The IRA also has to ensure that prices of products

stay reasonable and certain mandatory products are sold. The

job of keeping prices reasonable is relatively easy, since

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competition among insurers will not allow any one company to

charge exorbitant rates. The danger often is that prices may be

too low and might take the insurer dangerously close to

bankruptcy. As for mandatory products, those that involve

common and well-known risks, certain standardization can be

enforced. Furthermore, IRA can insist that for such products the

prices also be standardized. From the consumers point of view

the most important function of IRA is ensuring claim settlement.

Quick settlement without unnecessary litigation should be the

norm. For example, in motor

vehicle insurance, adopting no-fault principle can speed up many

settlements. Currently, LIC in India has a claims settlement ratio

of 97%, an impressive number by any standards. However, it

hides the fact that this settlement is plagued by long delays,

which reduce the value of settlement itself. If consumers have a

complaint against an insurer they can go to a body formed by

association of insurers. The decision of such a body would be

binding on the insurers, but not on the complainant. If

complainants are not satisfied, they can go to court. Some

countries such as Singapore have such a system in place. This

system offers a first and quicker choice of settling out of court.

IRA can encourage the insurers to have such a grievance

redressal mechanism. This system can serve the function of

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adjudication, arbitration and conciliation. The second area of

IRAs activity concerns monitoring insurer behavior to ensure

fairness. It is especially here that IRAs choice of being a

bloodhound or a watchdog would have different implications. We

think that an initial tough stance should give way to a more

forbearing and prudential approach in regulating insurance firms.

When the industry has a few firms there is some chance of

collusion. IRA must be alert to collusive tendencies and make

sure that prices charged remain reasonable. However, some

cooperation among the insurance companies could be

considered desirable. This is especially in lines where claim

experience of any one company is not sufficient to make accurate

forecasts. Collusion among companies on information sharing

and rate setting is considered fair. IRA must have severe

penalties in

case of fraud or mismanagement. Since insurance business

involves managing trust money, in some countries the

appointment of senior managers and key personnel has to be

approved by the insurance regulatory agency.

( b ) Ensuring Solvency of Insurers :

There are basically four ways of ensuring enough

solvencies.

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First is the policy of a price floor.

Second is the restriction on capital and reserves, i.e., on what

kind of investments and speculative activities firms can make.

Third is putting in place entry barriers to restrict the number of

competitors.

Fourth is the creation of an industry financed guarantee fund to

bail out firms hit by unexpectedly high liabilities. Entry restrictions

of the IRA are implemented through a licensing requirement,

which involves

capital adequacy among other things. Since there are economies

of scale and scope in insurance operations it might be better to

have only a few large firms. There is however no magic number

regarding the optimal number of firms. Restricting competition

provides a scope for higher profits to the companies thereby

strengthening their solvency position. After qualifying, the

entrants are continuously subjected to restrictions on reserves

and investments, which ensure ongoing solvency. Additionally, a

guarantee fund, created by mandatory contributions from all

insurance companies is used to bail out any insurance company,

which might be in financial trouble. This guarantee fund does not

imply that firms can charge whatever they wish to their

consumers. All insurance companies would have an incentive to

monitor the activities of their rival peer firms. This is because

insolvency of any insurance company would entail a price, which

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all the insurance companies would have to shoulder. Peer review

of accounts can also be institutionalized.

IRA can have several ways for early detection of a potential

insolvency. For example, in the USA there is an Insurance

Regulatory Information System (IRIS) that regularly computes

certain key financial ratios from financial statements of firms. If

some of these ratios fall outside given limits the company is

asked to take corrective action. Insolvency can also arise out of

reinsures abandoning insurance companies in the lurch, as

witnessed in the USA in 1980s. Reinsurance is a bigger business

dominated by large international reinsurers. Such litigation

between reinsurer and insurance companies involves cross

boundary legalities and can drag on for years. IRA must evolve a

set of operational guidelines to deal with reinsurance matters.

Insurance intermediaries such as agents, brokers,

consultants and surveyors are also under IRAs jurisdiction. IRA

has to evolve guidelines on the entry and functioning of such

intermediaries. Licensing of agents and brokers should be

required to check against their indulging in activities such as

twisting, rebating, fraudulent practices, and misappropriation of

funds. IRA can also consider allowing banks to act as agents

(as opposed to underwriters) of insurers in mass base types of

products. Given their

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wide network of branches and their customer base, the banks

can access this market for insurance products and also earn

commission income. The incremental cost of providing such

insurance products would be much lower.

( c ) Promoting Growth in the Insurance Industry :

A society experiences many benefits from the spread of

insurance business. Insurance contributes to economic growth by

enabling people to undertake risky but productive activity. In the

past,

growth of trade has been facilitated by the development of

insurance services. One only needs to look at the history of

insurance to see how evolution of insurance helped trade flows

along various trade routes. Promotion of insurance also provides

for long-term funds, which are utilized to fund big infrastructure

projects. These projects typically have positive externalities,

which benefit society at large. IRA can ensure growth of

insurance business with better education and protection to

consumers, and by making the insurance business a level playing

field. They can also support Indian insurance companies in the

international field. IRA thus has to frame the rules, design

procedures for enforcement and also make operational

guidelines. All this with virtually no relevant historical data makes

the task very difficult. An initial conservative approach (the

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bloodhound) is justified since there is no prior experience to fall

back on, and it would be prudent to err by regulating more rather

than less. As experience accumulates, the IRA can relax its initial

harsh stance and

adopt a more accommodating stance (the watchdog). Regulation

is always an evolutionary process and experience constantly has

to feed into policy making. Care must be taken so that this

process does not slow down and cause regulatory lags. IRA can

also consider allowing banks to act as agents (as opposed to

underwriters of insurers in mass base types of products. Given

there wide network of branches their customer base, the banks

can access this market for insurance products and also

commission income. The incremental cost of providing such

insurance products would be much lower. Such a move of

allowing banks to operate insurance business and vice versa is

consistent with a worldwide trend of greater integration of banking

and insurance. The major insurance markets in South and East

Asia are in varying degrees opposite. This range from

comparative free markets of Hong Kong and Singapore to

increasingly more liberal markets of South Korea and Taiwan to

more densely regular insurance sectors of Thailand and

Malaysia.

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LIBERALISATION OF INSURANCE INDUSTRY :

While no aspect of the reform process in India has gone

smoothly since its inception in 1991, no individual initiative hasstirred the proverbial hornets' nest as much as the proposal to

liberalise the country's insurance industry. However, the political

debate that followed the submission of the report by the Malhotra

Committee has presumably come to an end with the ratification of

the Insurance

Regulatory Authority (IRA) Bill both by the central Cabinet and

the standing committee on finance. This section traces the

evolution of the life insurance companies in the US from firms

underwriting plain vanilla insurance contracts to those selling

sophisticated investment contracts bundled with insurance

products. In this context, it brings into focus the importance of

portfolio management in the insurance business and the nature

and impact of portfolio related regulations on

the asset quality of the insurance companies. It also provides a

rationale for the increased autornatisation of insurance

companies, and the increased emphasis on agent independent

marketing strategies for their products. If politicized, regulations

have potentialto adversely affect the pricing of risks, especially in the non-life

industry, and hence the viability of the insurance companies.

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Finally, the backdrop of US experience provides some pointers

for Indian policymakers.

Introduction :

The insurance sector continues to defy and stall the course of

financial reforms in India. It continues to be dominated by the two

giants, Life Insurance Corporation of India (LIC) and the General

Insurance Corporation of India (GIC), and is marked by the

absence of a credible regulatory authority. The first sign ofgovernment concern about the state of the insurance industry

was revealed in the early nineties, when an expert committee

was set up under the

chairmanship of late R.N.Malhotra. The Malhotra Committee,

which submitted its report in January 1994, made some far--

reaching recommendations, which, if implemented, could change

the structure of the insurance industry. The Committee urged the

insurance companies to abstain from indiscriminate recruitment

of agents, and stressed on the desirability of better training

facilities, and a closer link between the emolument of the agents

and the management and the quantity and quality of business

growth. It also emphasized the need for a more dynamic man-

agement of the portfolios of these companies, and proposed that

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a greater fraction of the funds available with the insurance

companies be invested in non government securities. But, most

importantly, the Committee recommended that the insurance

industry be opened up to private firms, subject to the conditions

that a private insurer should have a minimum paid up capital of

Rs. 100 crore, and that the promoter's stake in the otherwise

widely held company should not be less than 26 per cent and not

more than 40 per cent. Finally, the Committee proposed that the

liberalised insurance industry be regulated by an autonomous

and financially independent regulatory authority like the Securities

and Exchange Board of India (SEBI). Subsequent to the

submission of its report by the Malhotra Committee, there were

several abortive attempts to introduce the Insurance Regulatory

Authority (IRA) Bill in the Parliament. It is evident that there was

broad support in favour of liberalisation of the industry, and that

the bone of contention was essentially the stake that foreign

entities were

to be allowed in the Indian insurance companies. In November

1998, the central Cabinet approved the Bill which envisaged

a ceiling of 40 per cent for Non Indian stakeholders: 26 per

cent for Foreign collaborators of Indian promoters, and 14

per cent for Non resident Indians (NRIs), Overseas

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corporate bodies (OCBs) and Foreign institutional investors

(FIIs).

However, in view of the widespread resentment about the

40 per cent ceiling among political parties, the Bill was referred to

he standing committee on finance. The committee has since

recommended at each private company be allowed to enter only

one of the three areas of business life insurance, general or non

life insurance, and reinsurance and that the overall ceiling for

foreign stakeholders in these companies be reduced to 26 per

cent from the proposed 40 per cent. The committee has also

recommended that the minimum paid up share capital of the new

insurance companies be raised to Rs. 200 crore, double the

amount proposed by the Malhotra Committee.

Economic Rationale :

The insurance industry is a key component of the financial infra-

structure of an economy, and its viability and strengths have far

reaching consequences for not only its money and capital

markets,' but also for its real sector. For example, if households

are unable to

hedge their potential losses of wealth, assets and labour and non

labour endowments with insurance contracts, many or all of them

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will have to save much more to provide for events that might

occur in the future, events that would be inimical to their interests.

If a significant proportion of the households behave in such a

fashion, the growth of demand for industrial products would be

adversely affected. Similarly, if firms are unable to hedge against

"bad" events like fire and the job injury of a large number of

labourers, the expected payoffs from a number of their projects,

after factoring in the expected losses on account such "bad"

events, might be negative. In such an event, the private invest-

ment would be adversely affected, and certain potentially

hazardous activities like mining and freight transfers might not

attract any private investment. It is not surprising; therefore, that

economists have long argued that insurance facility is necessary

to ensure the completeness of a market.

ORGANISATIONAL STRUCTURES AND THEIR

IMPLICATIONS :

Insurance companies can be broadly divided into four

categories: stock companies, mutual companies, reciprocal

exchanges, and Lloyds companies. The former two are the

dominant forms of organisational structures in the US insurance

industry. A stock company is one that initially raises capital by

issue

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of shares, like a bank or a non bank financial institution, and

subsequently generates more funds for investment by selling

insurance contracts to policyholders. In other words, there are

three sets of stakeholders in a stock insurance company, namely,

the shareholders, managers and the policyholders. A mutual

company, on the other hand, raises funds only by selling policies

such that the policyholders are also partners of the companies.

Hence, a mutual company has only two groups of stakeholders,

namely, the policyholder cum part owners and the managers. As

in any organisation, the objectives of the owners, managers and

policyholders are significantly different, giving rise to conflicts of

interest. Specifically, owners and managers are often more keen

to undertake risky activities than are the policyholders, largely

because the former have limited liability such that, in the event of

an unfavorable outcome, the policyholders will have to bear the

lion's share of the loss. However, it is unlikely that in a company

that the appetite of the owners and the managers will be similar,

and this provides the owners with a rationale to monitor the

managers. In principle, both the shareholders in a stock company

and the policyholder owners in a mutual company have it in their

interest to monitor, the managers. But whereas stockholders can

exit a company easily by selling its shares in the secondary

market, thereby paving the way for a take over, the policyholder

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owners find it more difficult to exit because they then have to

incur the informational cost of associating themselves with

another (viable) company. In other

words, the threat of exit by owners, and the associated threat of

overhaul of the incumbent management by the owners, is more

credible for stock insurance companies than for mutual insurance

companies. Hence, policyholder owners of mutual companies are

likely to allow the managers of these companies less operational

flexibility than the flexibility of the managers in stock insurance

companies. As a consequence, the mutual insurance companies

are likely to be more conservative with respect to risk taking than

the stock companies. Alternatively, if an insurance company

writes lines of business that do not require a significant amount of

managerial discretion, then it might be profitable for the company

to adopt the mutual ownership structure and thereby eliminate the

agency conflicts that can potentially arise between the owners

and the policyholders.

Some insurance products not available in India :

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Associated Market Quest after a study of some of the

international markets, points out the following areas for new

product development: 1. Industry all risk policies

2. Large projects risk cover

3. Risk beyond a floor level

4. Extended public and product liability cover

5. Broking and captivities.

6. Alternative risk financing

7. Disability insurance

8. Antique insurance

9. Mega show insurance

10. Celebrity visits to the country.

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AN ALTERNATIVE TO REINSURANCE :-

Reinsurance is a process by which private insurers

transfer some part of their risk to reinsurers. That is, the reinsurer

reimburses the private insurer any sum paid to the policyholdersagainst the claims lodged. The need for reinsurance assumes

importance given the increasing uncertainty faced by individuals

and businesses. Consider for instance, the earthquake in Gujarat

that has left millions homeless and damaged property worth

crores of rupees. Will the private insurers be in a position to

honour claims of such magnitude?

The answer is No. The reason? The policy premiums are

priced by the insurers based on the probability of claims. But if

the man-created stock market is itself so difficult to predict, how

can the insurance company predict with any reasonable degree

of certainty the quantum of claims that could arise due to natural

causes?

This means private insurers need to maintain adequate

contingency funds to honour such claims. Private insurers cannot

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resort to high levels of debt and equity to finance their business

for the earnings uncertainty will dampen the returns. Will the

private insurer be able to transfer their risk to reinsurers? That is

indeed, a moot point, for two reasons. First the basket of

insurance products is likely to expand once private insurers enter

the market. The rationale is this: at present General Insurance

Corporation (GIC) offers products of a general nature, such as

theft and accident insurance. The corporation may enjoy a price

advantage over the private

insurers, as it is not compelled to work on a profit motive, thanks

to being a government arm. And second, it is unlikely that the

reinsurance market will match the pace of the insurance market.

The reason? If a natural disaster occurs, the losses suffered on

account of the claims can cripple the reinsurers. This factor could

inhibit the growth of reinsurers in the country.

SO WHAT CAN THE PRIVATE INSURERS DO ?

A variable risk transfer mechanism is the capital market. This is

because capital market is huge and can take on the risk that

insurance companies run. The solution is Asset-backed

securities (ABS). A private insurer can bundle off policies with

similar maturity and quality and sell them as securities to retail

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investors. The private insurer can float a Special-Purpose

Vehicle(SPV) and sell the policies concerned to this entity. The

SPV can bundle the policies and sell them as securities to retail

investors at attractive yields. The premium on the policies

underlying the ABS can be invested by the SPV in low-risk, highly

liquid instruments. The benefits of the SPV are First; the SPV is

a separate entity from the insurer. This enables easy rating of the

ABS, as the credit rating agency will be able to identify the

underlying assets. Second, by selling the policies to the SPV, the

insurer removes the assets from its balance sheet. This means

that the private insurer frees capital that can be used for

further business and lastly, the SPV is not affected by the

financial health of the insurer.

So when the policyholders (underlying the ABS) lodge the

claims with the private insurer, the private insurer simply passes

on the claims to the SPVs. The SPV, in turn will liquidate its

investments and meet the claims. The SPV will stop paying

interest on the ABS. The retail investors, therefore, bear a sizable

portion of claims of the policyholders. There can of course be

many variants to the ABS. The most risky ABS, from the

investors angle, will be those that stop interest payments and

delay principal repayments of claims are honored. Also buying

ABS helps retail investors truly diversify their portfolio. This is

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because probability of claims from, say, a hurricane is largely

unrelated to the economic factors or industry-specific factors that

drive equity and bond values. Besides, investors get attractive

yields for taking the risk. If mutual funds invest in ABS, retail

investors need not estimate the risk associated with the

investment, the fund manager will do the needful. The problem of

adverse selection, on the other hand, can be reduced if the ABS

are credit-enhanced by a third party and rated by a credit rating

agency.

In India, debt market is not deep and liquid enough to

receive products such as asset-backed securities. Moreover,

regulatory restrictions, such as high stamp duty and a not-so-

efficient judicial system, may act as deterrents. Finally the

alternative risk transfer market will only develop once the need for

such risk transfer assumes importance some time in the future.

CATASTROPHE BONDS :

Catastrophe ( CAT ) bonds are one class of securities that

provide reinsurers access to the capital markets. In a typical CAT

bond, a special purpose vehicle acts as the reinsurer by issuing

debt in the capital markets and providing a reinsurance policy to

the ceding insurer. Generally, a predefined loss limit is set, above

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which the reinsurer provides the coverage in the amount of the

bond issuance. This loss limit, which functions like a deductible,

is known as the attachment point. Should there be an event

causing losses in excess of the attachment point, proceeds that

otherwise go to the bondholders are used to pay the claims.

Besides structural and issuance-related concerns, modeling the

risks for the ceding insurers book of business is critical to the

proper analysis of the CAT bond transaction. Catastrophe

reinsurance bonds are gaining popularity as an alternative source

of funding for property and casualty reinsurance. This results

from the combination of population growth in areas subject to

catastrophic perils and a consolidation of the global reinsurance

industry that has put greater demands on viable funding sources.

Product pricing :

Pricing of insurance products, as empirically available in India,

shows that pricing is not in consonance with market realities. LifeInsurance premia are generally perceived as being too high while

general insurance (especially motor insurance) is priced too low.

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LIC has, over a period of time, affected price reduction. For

instance on 'without profit policies' (that is, those which are not

eligible for bonuses), the premium rates were reduced between 2

percent to 7 percent during the 1970's. Subsequently in 1986, the

premium rates were further reduced by 17% for such policies.

Practices, such as charging extra premium on female insurance,

were also discontinued. However, these instances are an

inadequate response to the changes taking place in the market.

One of the most significant changes has been the improvement in

Life Expectancy of individuals. For males this has improved from

41.89 years in 1961 to 62.80 years

in recent times. Similarly, female life expectancy has improved

from 40.55 years in 1961 to 64.20 years. The problem faced by

LIC in incorporating the trends in life expectancy in to their

actuarial calculation has been partly technological and partly

organizational. Recognizing this LIC has indicated in its corporate

plan 1997-2007 that they hope to put in place a year to year

revision of mortality rates in the calculation of premia. Currently,

the LIC uses the 1970-73 mortality tables for most of the premium

calculations and for "without profit policies", the 1975-79 mortality

rates are used.

In the case of general insurance the issue of product pricing

can be grouped into two categories.

1. Those that fall under tariff regulations and controlled by Tariff

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Advisory Committee (TAC)

2. Those that fall outside tariff regulations.

INVESTMENT OF INSURANCE FUNDS :

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Any reform of the insurance sector must necessarily

consider aspects related to the investment of insurance funds.

Under sec 27A of the insurance act and its application in the LIC

act, the manner in which LIC can deploy its funds is stated. Under

the current guidelines, the LIC is required to invest 75% of the

accretions through a controlled fund in certain approved

investments. 25% of accretions may be invested by LIC for

investments in private corporate sectors, loans to policyholders,

construction and acquisition of immovable assets. Thesestipulations have resulted in the lack of flexibility in the

optimization of its risk and profit portfolio.

It has been reported that the government is planning to

offer greater autonomy to LIC through the following:

It is proposed that the deployment of the balance of 50% of the

funds will be left to discretion of LIC. Similarly, it is proposed that

the GIC will be subject to the following guidelines:

CAPITAL NORMS FOR NEW INSURANCE

COMPANIES :

One of the contentious issues raised by foreign companies

seeking an entry into the insurance sector in India is the minimum

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paid up capital requirements. The Malhotra committee (1994)

recommended

Rs 100 crores as the norm. The multilateral insurance working

group (an industry forum representing most of the interested

foreign and Indian companies seeking an entry into the insurance

sector) has recommended Rs. 50 crore. The IRA is also reported

to considering a

graded pattern for capitalization of the companies keeping in

mind the volume of business likely to be handled by them.

The Insurance Potential :

The main reason why the leading insurance companies in

the world and the leading corporate group in India have shown a

keen interest in the insurance sector, is the vast potential for

future business. Restricted, as the market has been, through the

operations of the two monopolies (LIC and GIC), it is generally

felt that the sector can grow exponentially if it is opened up. The

decade 1987-97 has witnessed a compounded growth rate of

marginally more than 10% in life insurance business. LIC predicts

for itself that its business has potential to grow by 16.27% p.a. in

a decade 1997-2007 (LIC, 1997).

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If we take a look at insurance coverage index for the age group of

20-59 years a considerable gap between India and other

countries in Asia can be observed. In this scenario, naturally

insurance companies see a vast potential.

THE ROLE OF PORTFOLIO MANAGEMENT :

Portfolio and asset liability management are important for

both life and property liability insurance companies. However, the

latter face the problem that their liabilities are far more

unpredictable than the liabilities of the life insurance companies.

For example, given a stable mortality table and other historical

data, it is easier to predict the approximate number of death

claims, than the approximate number of claims on account of caraccidents and fire. As a consequence of such uncertainty, and

perhaps also moral hazard stemming from reinsurance facilities,

asset liability management of property liability companies in the

US has left much to be desired. Hence, a meaningful discussion

about the changing nature and role of portfolio management for

US's insurance companies is possible only in the context of the

experience of its life insurance companies. Although the role of

an insurance policy is significantly different from that of

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investments, economic agents like households have increasingly

viewed insurance contracts as a part of their investment portfolio.

This change in perception has not affected much the status of the

property liability or non life insurance policies, which are still

viewed as plain vanilla insurance contracts that can be used to

hedge against unforeseen calamities. However, the perception

about life insurance contracts has perhaps been irrevocably

altered, and it has changed the nature of fund management of

insurance companies significantly, forcing them to move away

from passive portfolio

management to active asset liability management. The change in

perception of the households became apparent during the 1950s,

when stock prices rose sharply in the US. Given the steep

increase in the opportunity cost of funds, households shied away

from whole life insurance products and opted for term life

insurance policies! During the earlier part of a policyholder's life,

the premium for a term insurance policy is lower than the

premium for a whole life policy. Hence it was in a (young)

household's interest to opt for term insurance, and invest the

difference between the whole life premium and term life premium

in the equity market. As a consequence, the life insurance

companies were forced to think about development of new

products that could give the investors returns commensurate with

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the pins in the stock market. The immediate impact of the

financial volatility on portfolio or asset liability management came

by way of a change in the design of the life insurance products.

The insurance companies started offering universal life, variable

life, and flexible premium variable life products. These policies

bundled insurance coverage with investment opportunities, and

allowed policy holders to choose the amount of their annual

premium and/ or the nature of the portfolio into which the

premium would be invested. Most of these contracts carried

guaranteed Minim urn death benefits, but returns over and above

that were determined by the inflow of premia and the subsequent

investment experience. Some of the policies could also be forced

into expiration if the afore mentioned inflow and experience fell

below some critical minimum levels.

Further, policy loans were offered only at variable rates of

interest. In other words, the policyholders were increasingly co-

opted into sharing market and interest rate risks with the

insurance companies. As a consequence of these changes,

which brought about a bundling of insurance and investment

products, portfolio management of life insurance companies

today is similar to that of a bank or non bank financial company.

They have to,

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(i) look out for arbitrage opportunities in the market place

both across markets and over time,

(ii) use value at risk modeling to ensure that their reserves

are adequate to absorb market related shocks,

(iii) ensure that there is no mismatch of duration between

their assets and liabilities, and

(iv) ensure that the risk return trade off of their portfolios

remain at an acceptable level.

During the 1980s, the life insurance companies gradually reduced

the duration of the fixed income securities in their portfolio,

thereby ensuring greater liquidity for their assets. They also

moved away from long term and privately placed debt

instruments and increasingly invested in exchange traded

financial paper, including mortgage backed securities. However,

while the increased liquidity of their portfolios reduced their risk

profiles, they also required active management of these portfolios

in accordance with the changing liability structures and market

conditions. Today, while life insurance companies compete for

market share by changing the nature and

structure of their products, their viability is critically dependent on

the quality of their portfolio and asset liability management.

IMPLICATIONS OF COST MANAGEMENT :

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As is the case with most competitive industries, profitability

and viability of a firm in the insurance industry significantly

depends on its market share, and its ability to minimise its cost of

operations without compromising the quality of its service and risk

management. Perhaps the easiest way to reduce cost is to

reduce the cost of processing and underwriting policy

applications. In the US, the average cost of processing and

underwriting an application has been estimated to be in excess of

US $250. As a consequence, insurance companies haveincreasingly resorted to replacement of personnel by computer

based "expert" systems which apply the vetting models used by

the companies' (human) experts to a wide range of problems."

However, the US companies have found it more difficult to

reduce their cost of marketing and distribution. A significant part

of these expenses accrue on account of the commissions paid to

exclusive and/or independent agents, the usual rate of

commission being 15 to 30 per cent, depending on the line of

business. As such, independent agents have greater bargaining

power than the exclusive agents because they "own" the

insurance contracts held by the policyholders, and can switch

from one insurance company to another at will. These agents

also benefit from the perception that, as

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outsiders having bargaining power vis a vis the insurance

companies, they will be able to ensure better service for the

policyholders. In order to mitigate the cost related problem,

insurance companies in the US are increasingly looking at

alternative ways to market and distribute their products. Direct

marketing has gained popularity, as has marketing by way of

selling insurance products through other financial organizations

like banks and brokers. These actions might lead to significant

reduction of cost of operations of insurance companies, but it is

not obvious as yet as to how the small policyholders will fare in

the absence of powerful intermediaries with bargaining power vis

a vis the insurance companies.

The Impact of Regulation :

While portfolio and cost management are important determinants

of the viability of insurance companies, the US experience

indicates that the nature and extent of regulation too plays a key

role in determining the viability of these companies. The

insurance industry in the US has historically been one of the most

regulated financial industries. The nature of regulation of life

insurance companies, however, has differed significantly from thenature of regulation of property liability companies. Regulation of

the former has typically emphasized asset quality, while the

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regulation of the latter has largely concerned itself with

policyholder's "welfare." The regulations had impact on the

quality of bonds held by the life insurance companies. New York's

insurance regulatory laws require that life insurance companies

ensure that, for all bonds purchased by them, the companies

issuing the bonds have had enough earnings to meet debt

obligations for the previous five years. The bond issuing

companies are also required to have net earnings 25 per cent in

excess of the annual fixed charges, and they should not be in

default with respect to either principal or interest payments.

Further, regulation of various states impose quantitative

restrictions on the amount of "risky" bonds that can be purchased

by the insurance companies. Finally, regulations of all states are

subject to the life insurance asset portfolios to the Mandatory

Security Valuation Reserve (MSVR) requirement. According to

this requirement, which came into effect in June 1990, life

insurance companies are required to make mandatory provisions

for all corporate securities. The minimum provisioning, for A rated

and higher quality bonds, is 0.1 per cent of par value, and the

maximum provisioning of 5 per cent is required for Caa rated (or

equivalent) and lower quality bonds. If the issuer of a bond goes

into default, the relevant loss is adjusted against the MSVR

account rather than against the company's surplus.

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Further, the non life industry has suffered significantly as a

consequence of changing legal ethos. In the recent past, the US

courts have retroactively granted citizen policyholders coverage

against hazards, like those from use of asbestos, that were not

factored into the actual insurance contract. As a consequence,

the

premia actually earned by the property liability companies fell

short of the "fair" prices of these contracts, and hence these

companies had to bear huge losses on account of these policies.

However, while politics and changing ethos might together have

dealt an unfair blow to the non life insurance companies, the

importance of regulation cannot be overemphasized. The cyclical

nature of the firms profitability requires that they be

monitored/regulated such that they are not in default during the

unfavorable phases of the cycle. The property liability cycle is

typically initiated by an exogenous shock which increases the

industry's profits. The higher profits enable the companies to

underwrite more policies at a lower price. During this phase, the

insurance market is believed to be "soft." The decrease in price

during the soft phase, in turn, reduces the profitability of the

companies, and initiates the downturn in the cycle leading to the

"hard" phase. Hard markets are characterized by higher prices

and reduced volumes. Once the higher prices restore the

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industry's profitability, the market softens again and the cycle

starts again.

RESTRUCTURING OF LIC AND GIC :

In the insurance sector as of today and in all probabilities for a

long time to come, LIC and GIC will form a very significant part.

The reasons for these are many.

Firstly, they have been in business for a long time and therefore,

are in position to know business conditions better than any new

entrant. Secondly, the network of branches and agents is large,

deep and penetrating, which will take a long time for any other

entrant to replicate.

Thirdly, (especially the LIC), has a kind of government backing

which instills faith in all would-be policy holders, much more thana private company can hope to generate. The envisaged private

sector participation in the insurance sector is unlikely to take this

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advantage away from LIC and GIC. In the short run atleast. LIC

and GIC will continue to command a very high market presence

and in the long run it will take a very good market player to

dislodge LIC and GIC from their prime positions. This also means

that the reform in insurance sector will necessarily mean the

reform of LIC and GIC.

THE PRESENT STATE OF AFFAIRS :

YEAR S.A. NO OF POL. P.INCOME INVEST.

L.FUND

(Rs.Crore) (Lacs) (Rs.Crore) (Rs.Crore)

(Rs.Crore)

1992-93 178120 566.79 7146.24 20545

21511

1993-94 208619 608.73 8758.19 24631

25455

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1994-95 254572 655.29 10384.91 45287

48789

1995-96 295758 709.60 12093.63 65254

68542

1996-97 344619 777.50 14499.50 85236

95255

1997-98 406583 845.29 20582.35 105000

110255

1998-99 459201 917.26 25478.32 120445

127390

1999-00 536450 1013.89 30545.65 146364

154040

2000-01 645041 1131.11 34207.78 175491

186024

2001-02 811011 1258.76 48963.60 216883

227008

GENERAL INSURANCE BUSINESS :

Under Tariff ,Outside Tariff

Fire Insurance, Burglary and Housebreaking

Consequential Loss (fire policy) all Risk: Jewelry andValuables

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Marine, Cargo and Hull insurance ,Television Insurance

Motor Vehicle Insurance, Baggage Insurance

Personal Accident (Individuals and group up to 500

persons) Mediclaims

Personal Accident (Air travel), Overseas Mediclaims

Engineering Compensation Personal Accident (group over

500 people)

Bankers Indemnity Policy - Bhavishya Arogya

Carrier's Legal Liability

Public Liability Act Policy

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POINTERS FOR INDIAN POLICYMAKERS:

A significant part of the activities of the insurance industry

of an economy entails mobilization of domestic savings and its

subsequent disbursal to investors. At the same time, however,

they guaranty minimum payoffs to both individuals and

companies by way of the put like insurance contracts. As

discussed above, these contracts can significantly affect behavior

of economic agents and, in general, are perceived to lead to

better outcomes for economies. Herein lies the importance of theviability of insurance companies: insolvency/bankruptcy of an

insurance company can be fast transformed into a systemic

problem in two different ways. The part of the systemic crisis that

can be attributed to the quasi bank like function of a section of the

insurance industry is easily understood. However, even if an

insurance company does not default on its credit and investment

related obligations, and merely reneges on its insurance obliga-

tions, the adverse impact of such default on the economy and the

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society at large can be quite devastating. For example, it is not

difficult to imagine the closure of a company that had not made

provisions for damages on account of (say) product related

liability because it had believed that it was protected from such

damages by an insurance policy." The consequent insolvency of

the company can affect a number of banks and other companies

adversely, and a systemic problem will be precipitated. In other

words, the insurance industry in any country should be subjected

to

regulations that are at least as stringent as, and perhaps more

stringent than those governing the activities of other financial

organizations.

It is evident from the above discussion that decisions about

what constitutes acceptable portfolio quality, and the extent of

price regulation hold the key to insurance regulation in a post

liberalisation insurance market. As the US experience suggests,

insura

insurance sector of india

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