EXECUTIVE SUMMARY :

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. Catastrophe bonds 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.

INDEX :
SR

CONTENTS

PAGE NO.

NO .
1.

INTRODUCTION

2.

INSURANCE SECTOR - A PREVIEW

3.

LIFE INSURANCE INDEX ( COUNTRYWISE )

4.

WHY OPEN UP THE INSURANCE SECTOR ?

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

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
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,

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 :

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.

(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 a 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 threefourths of Indias insurable population has no life insurance or pension
cover. 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
Indonesia

NO. OF POLICIES PER 100 PERSONS

2.0

Philippines

5.6

India

12.4

Thailand

14.7

Malaysia

35.5

Hong Kong

69.4

South Korea

70.5

Taiwan

75.2

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 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 both 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.
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.

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.

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.

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

customising products to suit individual needs.

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.

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-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;

that there would be massive retrenchment and job losses

due

to computerization and modernization; and

c

that private and foreign firms 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 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
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
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 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 urbanoriented, 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.

WHOS GOING WITH WHOM?

Indian Company

Foreign Partner

Kotak Mahindra

Chubb, US

Tata Group

AIG, US

Sundram Finance

Winterthur, SWITZERLAND

Sanmar Group

GIO of Australia

M A Chidambaram

MetLife

Bombay Dyeing

General Accident, UK

DCM 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

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.

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?

(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 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 "semipublic 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:
(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 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 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 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 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,

To ensure financial soundness of the insurance industry

To ensure healthy growth of the insurance market.

and

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 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
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.
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
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
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
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.

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. 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 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 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 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 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
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
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 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 :

Associated Market Quest after a study of some of the international markets,
points out the following areas for new product development: 1.
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.

Industry

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 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 investors. The private insurer can float a SpecialPurpose 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 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 creditenhanced 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 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. Life Insurance premia are
generally perceived as being too high while general insurance (especially
motor insurance) is priced too low. 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
Advisory Committee (TAC)
2. Those that fall outside tariff regulations.

INVESTMENT OF INSURANCE FUNDS :

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
investments

in

private

accretions may be invested by LIC for

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 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 19972007 (LIC, 1997).
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 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 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,
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 :

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
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 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.
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 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 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.

(Rs.Crore)

(Lacs)

P.INCOME

INVEST.

L.FUND

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

1992-93

178120

566.79

7146.24

20545

21511

1993-94

208619

608.73

8758.19

24631

25455

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

1131.11

34207.78

175491

186024

2000-01

645041

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 and Valuables
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

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 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 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, 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,"
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 of financial
intermediaries calls for government action and usually affects the
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.

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,

tax rates are not so high as they used to be.

Secondly,
Finally

concessions are still limited to a 20% tax shield.

other tax saving schemes, like public provident fund 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. Thats 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 insurance- have more
than 150 products to sell. But awareness is even 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 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 non-life segment.
Companies would offer products for niche segment, like disability products,
workers compensation insurance, renters 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.
Disability policy Covers disability to a longer tenure to life time disability.
First to die policy Beneficial for a couple and low premium outgo.
Replacement policy Saves the customer the trouble of making claims and
repurchasing the products.
Flexibility in Home insurance policy

Policyholder has the flexibility of

choosing one of the risk covers instead of the entire package.

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 24-hour 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 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 Development

Report 1999-2000
(2) Insure for life: Navjit Gill

: Business World, 28 February

2000.
(3) Complete Guide to Business Risk Management

: Kit

Sadgrove
(4) Risk Management Excellence
(5)

The Insurance Sector

: Economist Int. Unit

ICFAI ( Institute of Charter

Financial Analyst of India.

(6) Impossible guidelines editorials : Business India, February 720, 2000
(7) Economic Times clippings.
(8) www.licindia.com