Insurance Sector of India

The Emerging Insurance sector of India.
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
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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 1
2. INSURANCE SECTOR - A PREVIEW 3
3. LIFE INSURANCE INDEX ( COUNTRYWISE ) 6
4. WHY OPEN UP THE INSURANCE SECTOR ? 7
5. GOVERNMENT / RBI REGULATIONS 11
6. INDIAN PARTNER – FOREIGN TIE UP 16
7. WHY LIBERALISE, WHAT MARKET STRUCTURE 18
& ROLE FOR THE REGULATOR
8. AN ALTERNATIVE TO REINSURANCE 38
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
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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:
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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 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.
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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
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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 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
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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.
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INDIVIDUAL LIFE INSURANCE COVERAGE INDEX, 1994
COUNTRY NO. OF POLICIES PER 100 PERSONS

Indonesia 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)
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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 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,
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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
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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.
(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
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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 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 player’s strategies one might expect LIC
to react and drop its premia and upgrade its services.
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BOTTLENECKS – GOVERNMENT / RBI REGULATIONS :
The IRDA bill proposes tough solvency margins for private

insurance firms, a 26% cap on foreign equity and a minimum
capital of Rs.100 crores for life and general insurers and Rs. 200
crores for reinsurance firms. Section 27A of the Insurance Act
stipulates that LIC is required to invest 75% of its accretions
through a controlled fund in mandated government securities.
LIC may invest the remaining 25% in private corporate sector,
construction, and acquisition of immovable assets besides
sanctioning of loans to policyholders. These stipulations imposed
on the insurance companies had resulted in lack of flexibility in the
optimisation of risk and profit portfolio. If this 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)
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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
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 government’s insurance
services.
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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
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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.
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Nationalization brought some benefits. Insurance spread from an

urban-oriented, high-end business to a mass one. Today, 48 per cent
Of LIC's new business is rural. Net premium income in general
insurance grew from Rs.222 crore in 1973 to Rs.5,956 crore in 1995-
96. Yet, rigid controls hamper operational flexibility and initiative so
both customers service and work culture today are dismal. The
frontier spirit of the early insurers has been lost. Insurance companies
have also been timid in managing their investment portfolios.
Competition between the four GIC subsidiaries remains illusory.
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WHO’S 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
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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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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,
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(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
malpractice’s'. Another important justification for Nationalisation was
to raise the much-needed funds for rapid industrialization and self-
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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:
(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
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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
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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
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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
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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,

(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
NLDIMSR 26
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 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
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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 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.
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
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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
NLDIMSR 29
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 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
NLDIMSR 30
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
NLDIMSR 31
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
NLDIMSR 32
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
NLDIMSR 33
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 recom-
mended 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
NLDIMSR 34
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 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 infra-

structure of an economy, and its viability and strengths have far
reaching consequences for not only its money and capital markets,'
but also for its real sector. For example, if households are unable to
NLDIMSR 35
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 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
NLDIMSR 36
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
NLDIMSR 37
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. Industry all risk policies
2. Large projects risk cover
3. Risk beyond a floor level
NLDIMSR 38
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.
AN ALTERNATIVE TO REINSURANCE :-
NLDIMSR 39
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
NLDIMSR 40
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 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.
NLDIMSR 41
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 credit-
enhanced by a third party and rated by a credit rating agency.
In India, debt market is not deep and liquid enough to
receive products such as asset-backed securities. Moreover,
regulatory restrictions, such as high stamp duty and a not-so-efficient
judicial system, may act as deterrents. Finally the alternative risk
transfer market will only develop once the need for such risk transfer
assumes importance some time in the future.
CATASTROPHE BONDS :
NLDIMSR 42
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 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.
NLDIMSR 43
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.
NLDIMSR 44
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.
NLDIMSR 45
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 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 paid up
capital requirements. The Malhotra committee (1994) recommended
NLDIMSR 46
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).
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.
NLDIMSR 47
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
NLDIMSR 48
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.
NLDIMSR 49
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
NLDIMSR 50
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 exclu-
sive 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
NLDIMSR 51
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
NLDIMSR 52
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
NLDIMSR 53
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.
NLDIMSR 54
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.
NLDIMSR 55
THE PRESENT STATE OF AFFAIRS :
YEAR S.A. NO OF POL. P.INCOME INVEST. L.FUND

(Rs.Crore) (Lacs) (Rs.Crore) (Rs.Crore) (Rs.Crore)
1992-93 178120 566.79 7146.24 20545 21511

1993-94 208619 608.73 8758.19 24631 25455
1994-95 254572 655.29 10384.91 45287 48789
1995-96 295758 709.60 12093.63 65254 68542
1996-97 344619 777.50 14499.50 85236 95255
1997-98 406583 845.29 20582.35 105000 110255
1998-99 459201 917.26 25478.32 120445 127390
1999-00 536450 1013.89 30545.65 146364 154040
2000-01 645041 1131.11 34207.78 175491 186024
2001-02 811011 1258.76 48963.60 216883 227008
GENERAL INSURANCE BUSINESS :
 Under Tariff ,Outside Tariff

 Fire Insurance, Burglary and Housebreaking
 Consequential Loss (fire policy) all Risk: Jewelry and Valuables
 Marine, Cargo and Hull insurance ,Television Insurance
 Motor Vehicle Insurance, Baggage Insurance
NLDIMSR 56
 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
NLDIMSR 57
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
NLDIMSR 58
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
NLDIMSR 59
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
NLDIMSR 60
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.
NLDIMSR 61
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, concessions are still limited to a 20% tax shield.
Finally 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. 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,
NLDIMSR 62
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
NLDIMSR 63
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, 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.
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.
NLDIMSR 64
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.
NLDIMSR 65
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 : Economist Int. Unit
(5) The Insurance Sector : ICFAI ( Institute of Charter
Financial Analyst of India.
(6) Impossible guidelines editorials : Business India,
February 7-20, 2000
(7) Economic Times clippings.
(8) www.licindia.com
NLDIMSR 66

Insurance Sector of India

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Insurance Sector of India

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The Emerging Insurance sector of India.

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

SR CONTENTS PAGE NO.

Insurance may be described as a social device to reduce or

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

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

the payment being made from the accumulated contributions of all

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

INSURANCE SECTOR – A PREVIEW :

The insurance sector in India dates back to 1818, when

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

(c) The untapped potential for mobilizing long-term contractual

How big is the insurance market ?

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

population has no life insurance or pension cover. Health insurance of

include revitalizing and restructuring of the public sector companies,

INDIVIDUAL LIFE INSURANCE COVERAGE INDEX, 1994

COUNTRY NO. OF POLICIES PER 100 PERSONS

Source: Charted Financial Analyst May 1999. (Insurance in Asia:

WHY OPEN UP THE INSURANCE INDUSTRY ?

An insurance policy protects the buyer at some cost against the

innovation, and variety of products. It would also generate greater

merely for tax exemption, which is currently done. On the demand

Future course of Insurance Business :

One of the main differences between the developed economies and

and their premia on policies that offer pure protection are on a

insurance companies will probably offer is higher returns than

approach. They would be better qualified in assisting clients in

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

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

BOTTLENECKS – GOVERNMENT / RBI REGULATIONS :

The IRDA bill proposes tough solvency margins for private

levels of the prospective players will have to be 1% point lower than

OPENING UP OF INSURANCE SECTOR :

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

Can we overlook the cutthroat competition for acquiring

Nationalization brought some benefits. Insurance spread from an

WHO’S GOING WITH WHOM?

Indian Company Foreign Partner

The privatisation of the insurance sector would open up exciting new

WHY LIBERALIZE, WHAT MARKET STRUCTURE TO

The decision to allow private companies to sell insurance

The three questions that we address are

(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

reliance in heavy industries, especially since the country had chosen

commonly expressed fear is that there would be massive job losses

WHAT SHOULD BE THE MARKET STRUCTURE ?

Individuals buying an insurance contract pay a price (called the

THE ROLE OF IRA :

(a) The protection of consumers’ interest,

( a ) Protection of Customer Interests :

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

case of fraud or mismanagement. Since insurance business involves

( b ) Ensuring Solvency of Insurers :

wish to their consumers. All insurance companies would have an

( c ) Promoting Growth in the Insurance Industry :

adopt a more accommodating stance (the watchdog). Regulation is

LIBERALISATION OF INSURANCE INDUSTRY :

While no aspect of the reform process in India has gone

The insurance sector continues to defy and stall the course of