Insurance Sector of India

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PROJECT ON “insurance sector in India” Bachelor of CommerceBanking & 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

Insurance sector of India.

PROJECT ON “insurance sector in India” Bachelor of CommerceBanking & 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.

CERTIFICATE
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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Insurance sector of India.

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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Insurance sector of India.

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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Insurance sector of India.

EXECUTIVE SUMMARY:

6

Insurance sector of India. 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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Insurance sector of India.

INDEX :
SR NO. NO .
1. 1 2. 3 3. 6 4. 7 5. 11 6. 16 7. 18 & ROLE FOR THE REGULATOR 8. 38 AN ALTERNATIVE TO REINSURANCE WHY LIBERALISE, WHAT MARKET STRUCTURE INDIAN PARTNER – FOREIGN TIE UP GOVERNMENT / RBI REGULATIONS WHY OPEN UP THE INSURANCE SECTOR ? LIFE INSURANCE INDEX ( COUNTRYWISE ) INSURANCE SECTOR - A PREVIEW INTRODUCTION

CONTENTS

PAGE

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Insurance sector of India.

9. 44

INVESTMENT AND CAPITAL NORMS 10. ROLE OF THE PORTFOLIO 46

MANAGER 11. 53 12. 56 13. 60 14. 64 BIBLIOGRAPHY

RESTRUCTURING OF LIC & GIC POINTERS FOR THE INDIAN POLICYMAKERS CURRENT SCENARIO

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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Insurance sector of India.

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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Insurance sector of India.

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 insurer’s 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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Insurance sector of India.

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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Insurance sector of India.

(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 India’s 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 India’s insurable population has no life insurance or pension cover.

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Insurance sector of India.

Health insurance of any kind is negligible and other forms of nonlife 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 PERSONS Indonesia Philippines India Thailand Malaysia Hong Kong South Korea Taiwan 2.0 5.6 12.4 14.7 35.5 69.4 70.5 75.2 NO. OF POLICIES PER 100

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Insurance sector of India.

Singapore Japan Source:

112.6 198.4 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 India’s share of world insurance market has shown an increase of 10% from 0.31% in 1996-97 to 0.34% in 1997-98. India’s market share in the life insurance business showed a real growth of 11% thereby outperforming the global

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Insurance sector of India.

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 are bought in the former while these are sold in latter. Focus of insurance industry is changing towards providing a mix of

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Insurance sector of India.

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 LIC’s 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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Insurance sector of India. (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) LIC’s policies are not flexible according to the customer’s

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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Insurance sector of India.

(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 player’s strategies one might expect

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

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Insurance sector of India.

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 inflexibility continues, 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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Insurance sector of India.

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 FI’s 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 India’s 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 and
(c)

due to computerization and modernization;

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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Insurance sector of India.

provide a benchmark to evaluate the government’s 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 firmly established 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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Insurance sector of India.

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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Insurance sector of India.

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 subsidiaries remains illusory. the four GIC

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Insurance sector of India.

WHO’S GOING WITH WHOM? Indian Company
Kotak Mahindra Tata Group Sundram Finance Sanmar Group M A Chidambaram Bombay Dyeing DCM Shriram Dabur Group Godrej ITC S K Modi Group CK Birla Group Ranbaxy Alpic Finance 20th Century Finance Vyasa Bank Cholmandalam SBI HDFC

Foreign Partner
Chubb, US AIG, US Winterthur, SWITZERLAND GIO of Australia MetLife General Accident, UK Royal Sum Alliance, UK Liberty Mutual Fund, USA J. Rothschild, UK Eagle star, UK Legal and General, Australia Zurich Insurance, Switzerland Cigna, US Allianz, GERMANY Canada Life ING Guardian Royal Exchange, UK Alliance Capital Standard Life, UK

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Insurance sector of India.

ICICI IDBI Max India

Prudential, UK Principal 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 LIC’s 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 (world’s 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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Insurance sector of India.

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) players should 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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Insurance sector of India.

(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 Insurance Corporation of India (LIC) was formed in 1956, when the Government of India brought together over two hundred odd

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Insurance sector of India.

private

life

insurers

and

provident

societies,

under

one

nationalized monopoly corporation, in the wake of several bankruptcies and malpractice’s'. 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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Insurance sector of India.

(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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Insurance sector of India.

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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Insurance sector of India.

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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Insurance sector of India.

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 event occurs. 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 sector of India.

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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Insurance sector of India.

(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. IRA’s 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 : IRA’s 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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Insurance sector of India.

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 consumer’s 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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Insurance sector of India.

adjudication, arbitration and conciliation. The second area of IRA’s activity concerns monitoring insurer behavior to ensure fairness. It is especially here that IRA’s 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. cooperation among the insurance However, some could be companies

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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Insurance sector of India.

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

38

Insurance sector of India.

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 1980’s. 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 IRA’s 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

39

Insurance sector of India.

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

40

Insurance sector of India.

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.

41

Insurance sector of India.

LIBERALISATION OF INSURANCE INDUSTRY :
While no aspect of the reform process in India has gone smoothly since its inception in 1991, no individual initiative has stirred 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 potential to adversely affect the pricing of risks, especially in the non-life industry, and hence the viability of the insurance companies.

42

Insurance sector of India.

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 of government 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 management of the portfolios of these companies, and proposed that

43

Insurance sector of India.

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 (NRI’s), Overseas

44

Insurance sector of India.

corporate bodies (OCB’s) and Foreign institutional investors (FII’s). 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 infrastructure 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

45

Insurance sector of India.

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 investment 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 Lloyd’s 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

46

Insurance sector of India.

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

47

Insurance sector of India.

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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Insurance sector of India.

Associated Market Quest after a study of some of the international markets, points out the following areas for new product development: 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. Industry all risk policies Large projects risk cover Risk beyond a floor level Extended public and product liability cover Broking and captivities. Alternative risk financing Disability insurance Antique insurance Mega show insurance Celebrity visits to the country.

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Insurance sector of India.

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 policyholders against 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

50

Insurance sector of India.

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

51

Insurance sector of India.

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

52

Insurance sector of India.

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-soefficient 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

53

Insurance sector of India.

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 insurer’s 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. Life Insurance premia are generally perceived as being too high while general insurance (especially motor insurance) is priced too low.

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Insurance sector of India.

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

55

Insurance sector of India.

Advisory Committee (TAC) 2. Those that fall outside tariff regulations.

INVESTMENT OF INSURANCE FUNDS :

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Insurance sector of India.

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. These stipulations 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

57

Insurance sector of India.

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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Insurance sector of India.

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 car accidents 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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Insurance sector of India.

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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Insurance sector of India.

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 coopted 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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Insurance sector of India.

(i) (ii) (iii) (iv)

look out for arbitrage opportunities in the market place both across markets and over time, use value at risk modeling to ensure that their reserves are adequate to absorb market related shocks, ensure that there is no mismatch of duration between their assets and liabilities, and 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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Insurance sector of India.

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 have increasingly 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

63

Insurance sector of India.

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 the nature of regulation of property liability companies. Regulation of the former has typically emphasized asset quality, while the

64

Insurance sector of India.

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.

65

Insurance sector of India.

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

66

Insurance sector of India.

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 than a private company can hope to generate. The envisaged private sector participation in the insurance sector is unlikely to take this

67

Insurance sector of India.

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 L.FUND (Rs.Crore) (Rs.Crore) 1992-93 21511 1993-94 25455 208619 608.73 8758.19 24631 178120 566.79 7146.24 20545 (Lacs) (Rs.Crore) (Rs.Crore) S.A. NO OF POL. P.INCOME INVEST.

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Insurance sector of India.

1994-95 48789 1995-96 68542 1996-97 95255 1997-98 110255 1998-99 127390 1999-00 154040 2000-01 186024 2001-02 227008

254572 295758 344619 406583 459201 536450 645041 811011

655.29 709.60 777.50 845.29 917.26 1013.89 1131.11 1258.76

10384.91 12093.63 14499.50 20582.35 25478.32 30545.65 34207.78 48963.60

45287 65254 85236 105000 120445 146364 175491 216883

GENERAL INSURANCE BUSINESS :
 Under Tariff ,Outside Tariff  Fire Insurance, Burglary and Housebreaking  Consequential Loss (fire policy) all Risk: Jewelry and Valuables

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Insurance sector of India.

 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

70

Insurance sector of India.

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 the viability 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 obligations, the adverse impact of such default on the economy and the

71

Insurance sector of India.

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, insurance companies are usually subjected to stringent asset quality norms. Indeed, while a part of their portfolio might comprise of equity, mortgages and other relatively risky securities, much of their portfolio is made up of bonds and. liquid (and highly rated) mortgage backed securities. An Indian insurance company, on ,the other hand, is constrained by the fact that the market for fixed income securities is very illiquid such that

72

Insurance sector of India.

only gilts and AAA and AA+ rated corporate bonds have liquid markets. At the same time, absence of a market for liquid mortgage backed securities denies these companies the opportunity to enhance the yield on their investment without significantly adding to portfolio risk. This might not pose a problem in the absence of competition, especially if the government helps to increase the returns to the policyholders by way of tax breaks, but might pose a serious problem if liberalization leads to "price" competition among a large number of insurance companies It might be argued that if the insurance and pension fund industries are liberalised, and if the fund managers of all these companies indulge in active portfolio management, the liquidity of the bond market will increase significantly. Such increase in liquidity across the board would enable the fund managers to invest in investment grade bonds of lower rating and thereby add to the average yield of their investment without adding significantly to their portfolio risk. The problem, however, is that till the imperfect character of the bond market is removed to a significant extent, the insurance companies might either have to operate with thinner margins or remain exposed to unacceptably high levels of liquidity risk. It might, therefore, be prudent for the policymakers to impose stringent capital and reserve norms on the insurance companies,

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Insurance sector of India.

in order to ensure their viability in the short to medium run." Subsequent to liberalization, the Indian insurance industry might also be at the receiving end of regulations governing insurance prices / premia. Specifically, there might be highly politicized interventions in the markets for workers' compensation and medical insurance. The government might also be under pressure to "regulate" the prices of infrastructure related lines like freight and marine insurance. In principle, the risks associated with such liability insurance policies may be hedged by way of reinsurance. But if the reinsurers price the risks' accurately and the Indian insurance companies are forced to underprice the risks, the margins of the insurance companies will be affected adversely, thereby reducing their long term viability. In view of these political and financial realities, it might be better to subsidies the policyholders of politically sensitive lines directly or indirectly through tax benefits, if at

all, rather than distort the pricing of the risks themselves. At the end of the day, it has to be realised that while competition enhances the efficiency of market participants, the process of "creative destruction,"

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Insurance sector of India.

which ensures the sustenance and enhancement of efficiency, is not strictly applicable to the financial markets. Hence, while exit is perhaps the most efficient option for insolvent firms in many markets, insolvency action of and financial usually intermediaries affects the calls for government governments'

budgetary positions adversely. At the same time, other things remaining the same, the risk of insolvency is perhaps higher for insurance companies than for other financial intermediaries because of the option like nature of their liabilities. Therefore, competition in the insurance industry has to be tempered with appropriate prudential norms, regular monitoring and other regulations, thereby making the robustness of the industry critically dependent on the efficiency of and regulatory powers accorded to the proposed Insurance Regulatory Authority.

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Insurance sector of India.

THE CURRENT SCENARIO: EFFECTS ON POLICY HOLDERS :
The primary reasons for buying an insurance policy, whether life or non-life is to protect us from vagaries of life. We do not invest in insurance for returns; rather we invest in it for regrettable necessities. Though a large proportion of policies available in the country provides for returns, but nobody is looking for returns to the inflation rate. Some people do look for tax concessions, but lots of things have changed now. First, Finally tax rates are not so high as they used to be. concessions are still limited to a 20% tax shield. other tax saving schemes, like public provident fund Secondly,

offers better returns. So what does insurance offer, perhaps peace of mind, but even that takes time, due to poor claim performance. In India insurance is sold and not bought. Life Insurance Corporation has nearly eighty products, but investors know only about a handful. That’s because the agents of LIC push policies with the highest premium to pocket a higher premium. Same is the case with General insurance. Companies offering General insurance products-like medical, housing, motor and industrial insurancehave more than 150 products to sell. But awareness is even

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Insurance sector of India.

lower than life insurance products. It becomes obvious that GIC lacks the marketing results. Change whether public sector companies like it or not change is the around the corner. General insurance sector will soon be opened up to private and foreign competition. The potential for the new entrants is immense; life and non-life premiums add up to around 2% of the GDP, where as the global average stands at 8%. Indians as such have a high savings rate and bridging the existing gap points at immense potential.

What does this mean for the consumer?
Insurance companies will introduce more term policies. These policies provide protection for a specified time period, and do not offer any returns. These will cover simple requirements of the insurance for the investor. In effect term policies translates into low premium outgo, which frees the capital for investment into other investment vehicles, which offer better returns. Currently term policies constitute only1% of the total number of policies issued by LIC, while the global average is 15-20 per cent. Apart from the plain vanilla policies, new entrants will also offer consumers a choice of products with low premiums. Endowment policies will change too. The insurer, in line with his precise risk

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Insurance sector of India.

appetite, will be able to invest in a variety of indices or sector specific where in the returns would be higher. Instead of current fixed returns schemes insurance companies will issue unit linked schemes, indexed funds, or even real estate funds. Another opportunity is offered by a pension contract. Here the options offered could be indexed annuity, immediate annuity or a deferred annuity. The scope of new products is also immense in the nonlife segment. Companies would offer products for niche segment, like disability products, workers compensation insurance, renter’s coverage and employment practices liability insurance. The general insurance industry is expected to grow at the rate of 25% per annum. Scared of new entries in the insurance sector, GIC has started offering new policies like Raj Rajeshwari. It covers disability from accidents, the accidental death of the spouse and legal expenses resulting from the divorce. At present some of the good policies offered to consumer with their respective benefits are.

PRODUCTS BENEFITS :
Pure term insurance (pure life without insurance policy.) Very low premiums and effective risk coverage.

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Insurance sector of India.

Disability policy Covers disability to a longer tenure to life time disability. First to die policy Beneficial for a couple and premium outgo. Replacement policy Saves the customer the trouble of making claims and repurchasing the products. Flexibility in Home insurance policy package. Policyholder has the flexibility of choosing one of the risk covers instead of the entire low

CHANNELS :
Insurance companies will also get savvy in distribution. Enhanced marketing thus will be crucial. Already many companies have full operation capabilities over a 12-hour period. Facilities such as customer service center are already into 24hour mode. These will provide services such as motor vehicle recovery. Technology will also play a important role on the market. Effects of technologies are discussed in another section.

RURAL AREAS :
According to Malhotra committee report the penetration of insurance in India is around 22%. This indicates that a vast

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Insurance sector of India.

majority of rural population is not covered. Though GIC offers many products for this segment like, crop policy, silk worm policy etc, But due to poverty majority of the population cannot offered to get insured. Despite this, new entrants are hopeful of covering the vast tracts of rural masses.

BIBLIOGRAPHY (1) Insurance : Ajit Ranade and Rajeev Ahuja; India : Business World, 28 :

Development Report 1999-2000 (2) Insure for life: Navjit Gill February 2000. (3) Complete Guide to Business Risk Management Kit Sadgrove (4) Risk Management Excellence Unit : Economist Int.

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(5) The Insurance Sector Financial Analyst of India.

: ICFAI ( Institute of Charter : Business India,

(6) Impossible guidelines editorials February 7-20, 2000 (7) Economic Times clippings. (8) www.licindia.com

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