Insurance Bill

Missing the Forest for the Trees

Kavaljit Singh

Many commentators have viewed the ongoing stalemate over the passage of controversial Insurance Laws (Amendment) Bill, 2008—which, inter alia, proposes to raise foreign shareholding in the insurance sector from 26 to 49 percent—as nothing but sheer political opportunism of country's two main political parties—Congress and Bharatiya Janata Party (BJP). Undeniably, it was the Congress-led UPA government which introduced this Bill in 2008 but the then main opposition party (BJP) strongly opposed it and the Bill was sent to the Parliamentary Standing Committee on Finance headed by Yashwant Sinha, senior BJP leader, for scrutiny. In its Report to Parliament, the Standing Committee opposed the move to increase the foreign investment limit in the insurance sector.

On July 24, 2014, the newly elected BJP-led NDA government approved the Bill (with a few amendments) but the Congress vehemently opposed these amendments and forced the government to send the Bill to the Select Committee of the Upper House for further deliberations. Unlike the Lower House, the NDA does not enjoy a majority in the Upper House to pass the Bill. The 15-member Select Committee is expected to submit its report in the winter session of Parliament, beginning in November 2014.

In truth wider ramifications of this major policy change are being overlooked in the political imbroglio. Very few commentators have questioned the rationale behind increasing the foreign ownership to 49 percent. What has been the experience of allowing the entry of private and foreign players in the domestic insurance sector? Were the policy objectives proclaimed at the time of liberalization achieved? What are the potential benefits and risks? Who would benefit? Who would lose?

In India, the insurance sector was liberalized in 2000 and currently 52 companies are operating in the life and non-life segments of the domestic market, out of which only 5 companies are state-owned. Most of well-known international insurers (such as Allianz, AIG, Standard Life, Prudential, Lombard and Tokio) are operating in India through joint ventures with the Indian partners. Hence, the assertion that the current 26 percent cap acts as an entry barrier for foreign insurers lacks evidence. The state-owned General Insurance Corporation of India is the sole re-insurer for all insurance companies. The share of life insurance segment in the total insurance market of India is very high at 80.2 percent.

In terms of number of policies, India's life insurance industry is the largest in the world—with 360 million policies in force. The latest Sigma Report (published by Swiss Re in 2014) has ranked India 11th in terms of life insurance premium collected. Despite more than a decade of liberalization, the state-owned Life Insurance Corporation of India (LIC) is still a dominant player in the life insurance segment with a market share of 71 percent. According to the official data, 17 insurers (including LIC) reported profits out of total 24 firms in the life insurance segment during 2012-13.

The Indian non-life insurance sector (which includes health, motor and fire segments) has been growing in double digits for the past many years. In the non-life segment, 13 insurers (including four state-owned firms) reported net profits during 2012-13.

It is important to note that the Indian insurance market is growing faster than most developed markets. According to Sigma Report, the growth in total premium (both life and non-life segments) in local currencies was 10.8 percent at Rs 3972412 million in India in 2013, as compared to—1.1 percent in the US, 2.8 in Spain, 2.9 in Germany, and 2.4 percent in Japan. The total premium growth in the world was 1.4 percent in the real terms (adjusted for inflation) in 2013.

In the large context, an immense shift is taking place in the global insurance landscape. The big insurance firms headquartered in the developed countries are seeking to gain a foothold in the new geographic markets, especially in the rapidly growing developing countries where premium growth opportunities are much larger than servicing clients in the saturated markets of the developed world.

No wonder, big insurers are currently seeking a greater presence in the local markets of India, China, Thailand, Malaysia, Indonesia, Philippines, South Africa, Brazil, Mexico and Turkey.

The liberalization of insurance sector in these countries has provided significant opportunities to big players for international growth and expansion. Besides, the financial system in many of these countries is relatively healthy, resilient and well-capitalized.

The level of development of insurance sector in a country could be gauged through two benchmarks—insurance penetration (the ratio of total insurance premiums to GDP) and insurance density (the ratio of total insurance premiums to total population).

In 2013, the insurance penetration (consisting of both life and non-life business) was 3.9 percent in India, as compared to 7.5 in the US, 6.7 in Germany, 5.3 in Spain, and 11.1 percent in Japan.

In the life insurance segment, however, India is not lagging far behind many developed and mature markets. India's insurance penetration in the life insurance segment at 3.1 percent is on an equal footing with US (3.2), Canada (2.9), Germany (2.1), Netherlands (3.2) and Spain (2.5 percent).

There are several factors responsible for increasing the level of insurance penetration in India including higher economic growth in the past one decade, high disposable income of urban households, favourable demographic and greater awareness among urban households about insurance products.

On the other hand, India's insurance density (also called per capita premium) at $52 is much lower than developed markets (e.g., $3979 in the US), primarily due to country's lower per capita GDP.

The government and business lobby groups strongly argue that the greater presence of foreign insurers in the Indian insurance sector will ensure higher capital inflows, access to better products, introduction of superior technology, innovations in product distribution, better risk management and world-class business practices.

These arguments are highly overstated and backed by very little evidence. To begin with, take the case of total capital requirements of the domestic insurance sector. The forecasts made by the Insurance Regulatory and Development Authority (IRDA.)—India's regulatory authority—that the domestic insurance industry need a large capital requirement of Rs 61 billion ($10.2 bn) over the period 2010-15 are based on unrealistic assumptions. In a deposition before the Parliamentary Committee, the then IRDA Chairman was asked to explain the rationale behind projected capital requirements. He admitted that "This is just an arithmetic... These are just projection... This is just-an indication of what we are looking at and whether the order of what we are saying is correct or not and whether it seems to be feasible or not. It is not that it is a very accurate kind of an assessment. It is only just a general estimate of where we stand."

Unfortunately, there are currently no accurate estimates backed by sound basis about the total capital requirements of the Indian insurance industry. Taking a major policy decision based on pure guesswork does not bode well for the future of domestic insurance sector.

Secondly, most private insurance companies are in a position to raise additional capital domestically through investment by the Indian partners or launching an Initial Public Offering (IPO) under which shares are sold to the public. Since majority of private insurance companies in India are subsidiaries of big corporate and financial conglomerates with strong balance sheets, highest ratings and healthy capital reserves (such as Reliance, Tata Group, Birlas, ICICI and HDFC), they could easily mobilize substantial funds internally and/or through IPOs. In July 2014, Tata Group announced its plans to spend $35 billion over the next three years to strengthen its existing businesses across sectors. Similarly, Reliance Group has recently committed to invest $30 billion in the next three years to expand its businesses. These corporate conglomerates can invest a portion of their funds into insurance subsidiaries.

Thirdly, there is no assurance that the new capital infused by the foreign partner (in case the limits are raised from 26 to 49 percent) would expand the capital base of insurance firm. Rather the foreign partner may simply buy shares of the existing domestic promoter. In such a scenario, a transfer of ownership from domestic promoter to foreign investor may take place with no change in the actual capital base of an insurance company.

The Insurance Bill allows investments by foreign institutional investors (FIIs) in an insurance company within the 49 percent equity cap for foreign investors. It is a well-known fact that the investments undertaken by FIIs are for short-term speculative gains rather than managerial control over the companies. The FIIs can buy and sell their stocks more quickly than other investors.

Prone to sudden reversals, such speculative capital flows respond quickly to higher returns offered elsewhere and to higher risks in the host countries. Several episodes of financial crisis in Mexico, Southeast Asia and Turkey in the 1990s point to the preeminent role of such investors in precipitating a financial crisis.

Such types of foreign capital flows are highly inappropriate for India's insurance sector which needs patient capital that has long time horizons and a high tolerance for risk.

Arguments in favor of higher foreign investments in the insurance sector are often based on an analogy between insurance and any other businesses (say footwear). Such an analogy is fallacious not merely because insurance and footwear companies deal with different products but, more importantly, their operations are vastly different and they follow different business models and regulatory standards.

To illustrate, a footwear company would happily sell its products to anyone who could afford to buy them but an insurance company would hesitate in selling policies to everyone and would charge varying premiums based on factors such as age, health status, income and gender. Since insurance is a contractual promise to pay, insurance companies are concerned with future premium payments and the quality of underwriting.

Further, if a footwear company fails, it will not have a wider impact on the macro economy. But if a big insurance company fails, the impact would be much more widespread and damaging on the macro economy due to its inter-linkages with the rest of financial system.

Given the fact a number of insurance companies in India are subsidiaries of big financial conglomerates (such as ICICI, HDFC and State Bank of India), a bankruptcy can transmit systemic shocks widely, impairing the parent banks as well as the banking system.

A collapse of an internationally active big insurance firm in a country could create a chain reaction of enormous proportion in the global financial system. That's why; the activities of insurance firms (and banks) are regulated by regulator/ authorities to contain potential spillover effects and systemic risk, unlike footwear or apparel companies. Since risk is inherent in insurance business, insurance firms are subject to specific regulations like solvency margins, minimum guaranteed surrender value, and limits on agents' commission.

Do private insurers provide better products and services than state-owned firms? Contrary to popular perception, the product portfolios of private insurers are not vastly different (in terms of quality and quantity) from their state-owned counterparts. The number of insurance products varies from year to year and all insurers need approval from IRDA before launching their products in the domestic market. In 2013, LIC was offering as many as 48 products in the pyramid-shaped domestic market.

The timely processing and payment of claim is a prime function of an insurance company. The claim settlement ratio is an objective yardstick to judge the efficiency of an insurance company. A 100 percent claim settlement ratio means all claims submitted by customers are settled by the insurance company.

Do state-owned insurers perform poorly than private firms in settlement of claims? The answer is No. As per the data provided by IRDA in its Annual Report 2012-13, the claim settlement ratio of LIC was much higher than that of the private life insurance firms, many of which are operating in the country for the past 10 years. The LIC had the best claim settlement ratio in the country at 97.7 percent while the average settlement ratio of 23 private firms was 88.6 percent during 2012-13. Only 5 private firms had a claim settlement ratio of over 90 percent.

Under the current regime, the existing firms (both public and private) are investing heavily in training, skills enhancement and technological upgradation. Most insurers hire the Indian IT and ITES companies for technological support and back-end services.

In the post-liberalization period, India witnessed a rampant mis-selling of market-linked insurance product, Unit Linked Insurance Plan (ULIP). The mis-selling of ULIPs is also a textbook case of regulatory failure. The ULIPs are considered to be more risky than traditional life insurance plans because of its market-linked portfolio. Such products are only suitable for investors who have a high risk appetite.

The private insurers were the dominant players in the ULIPs. In 2009-10, 76 percent of their total business was linked to capital markets, as compared to 17 percent of LIC. For many private insurers, the contribution of ULIPs was as high as 90 percent of their total new business premium.

Instead of selling ULIPs as the long-term life insurance products, private insurance firms and agents sold them as a combination of short-term investment as well insurance. The insurance agents were keen to selling these market-linked products because of very high first-year commission (above 40 percent) on the premium.

Attracted by short-term returns, investments in ULIPs turned out to be an expensive affair for countless customers (both financially illiterate and sophisticated urban rich) as they suffered huge losses. It has been estimated that the customers lost about Rs 1500 bn ($25 bn) owing to mis-selling of ULIPs during the 2004-12 period. Perhaps for the first time in the post-Independence period, such a large-scale customer protection failure in the insurance sector was witnessed in the country.

The private insurance firms selling these products made a killing by levying high surrender fees on customers who could not continue with such financially unviable plans. The lapsed policies also generated huge profits for the insurers. According to a report by Goldman Sachs (October 2012), six private insurers (which include Bajaj Allianz Life, HDFC Life and ICICI Pru Life) generated a profit of Rs 15530 million (39 percent) from lapsed ULIP policies out of the total profit after tax of Rs 39520 million during the fiscal year 2011-2012. The rampant mis-selling of ULIPs continued till September 2010 when stringent regulatory guidelines were introduced by IRDA.

Furthermore, ULIPs, by definition, are linked to capital markets and therefore their contribution in the financing of infrastructure was meager. In contrast, traditional insurance policies are bought for long-term and therefore their flow of funds to the infrastructure and long-term industrial development has been substantial.

Concerned over the rising trend in mis-selling of insurance products, the Reserve Bank of India in its Financial Stability Report (December 2013) cautioned that "complaints of mis-selling could impact the continuation of policies affecting the cash flows of insurance companies. More importantly, it seriously affects the demand for insurance which could have serious implications on insurance as an avenue of tapping savings for long term investments for the economy."

One of the biggest challenges before the domestic insurance industry is to augment the reach of the insurance services to millions of Indian citizens who lack access to affordable insurance products. There is a vast potential to increase insurance penetration in India as the rural markets have largely remained untapped. The rural areas are still home to some 700 million people, majority of them living on less than $2 a day. After all, it is the poorest people who need greater security to overcome a number of risks including natural, health-related, economic and social risks. Despite recent efforts to expand microfinance in the rural areas, the bulk of 700 million people still lack access to insurance services.

In India, the private sector insurers are lagging behind state-owned firms in expanding the reach of insurance in the rural and remote areas. The latest IRDA statistics reveal that LIC has offices in 579 districts (out of total 640 districts in the country) whereas the rest 23 private players together have a presence in 555 districts. Further, the private insurers closed 1097 offices in the country during 2012-13 while not a single office was closed by the LIC during this period. In the non-life segment, four state-owned firms have offices in 573 districts while the private firms operate only in 280 districts.

To tap under-served low income markets in the rural areas, the insurance companies will have to design affordable insurance products as the premium-paying capacity of people is lower. Besides, the income of the rural households is not stable and permanent. The insurance companies also need to develop cost-effective models and new distribution mechanism to serve the rural and remote areas. All these policy challenges require better understanding of the diverse and heterogeneous local markets to launch need-based products. A strategy purely based on transferring knowhow and managerial skills developed internationally is unlikely to work in the context of Indian markets.

It is highly unlikely that the business interests of foreign insurance firms would match with the needs of underserved, underinsured population of India. What specialization and experience do foreign partners have when it comes to providing insurance products to landless rural workers, urban poor dwellers and informal sector? Do they have a success story?

The proponents of Insurance Bill strongly argue that raising foreign investment cap in insurance will encourage foreign partners to introduce better risk management models and world-class business practices in the Indian markets. The proponents believe that foreign insurance firms adhere to best practices in the industry and their risk management models are robust.

Such arguments, however, fly in the face of recent experience. In September 2008, the world witnessed the near collapse of the American International Group (AIG)—the world's biggest insurer with $1 trillion in assets spread over in 140 countries. AIG was a big player in the credit default swaps linked to the US real estate market.

Facing the worst financial crisis since the Great Depression, the US government immediately bailed out AIG with $85 billion (Rs 510000 crore) over the concerns that its collapse would trigger cascading losses to the US banking system due to its inter-linkages with the financial system. If the US government had not intervened, the world's biggest insurer involved in the business of providing protection to individuals and corporations would have gone bankrupt.

In Europe, the Dutch government paid out billions of euros to rescue insurer Aegon and bancassurer SNS Reaal. Post-crisis, the policymakers in the developed countries have introduced new regulatory measures in the insurance and banking sectors to avoid the repeat of the 2008 global financial crisis. The demand for breaking up "too big to fail" banks and insurance firms is gaining popular support in the crisis-hit countries.

The global financial crisis has put a big question mark about their efficiency, "best practices" and state-of-the-art risk management models. The crisis has also exposed the poor corporate governance and transparency norms of several big insurance firms operating on a global scale.

The Indian government needs to realize that the foreign insurance firms can be a source of cross-border contagion from adverse shocks originated in home or other countries. Hence, India cannot remain insulated from the turmoil in the international insurance markets if there is a large presence of foreign insurers in the domestic market.

As observed in Latin America, a greater role for foreign players may encourage rapid consolidation in the domestic market through mergers and acquisitions with adverse consequences on market competition.

The foreign partner may reduce exposure or exit from India due to losses suffered in the home or other countries. In the aftermath of global financial crisis, AIG sold its 26 percent stake in Tata AIG General Insurance Company to American International Assurance, a wholly owned subsidiary of AIG. In 2012, New York Life sold its 26 percent ownership in a life insurance joint venture with Max India to Japan's Mitsui Sumitomo. The ING sold its 26 percent stake in Vysya Life Insurance to the local partner (Exide Industries) in 2013 as part of its decision to pull out from the Asian insurance markets. The UK-based Aviva Pic is contemplating selling its 26 percent stake in Aviva India as part of its strategy to focus on a few international markets.

In many important ways, a large presence of foreign insurance firms poses new challenges to regulation and supervision. The rampant mis-selling of ULIPs has already exposed the underlying weaknesses in the current regulatory regime.

Besides, there are several long-pending structural issues which need to be urgently addressed because the much-touted benefits associated with the entry of private (and foreign) players in the insurance sector are yet to be materialized.

All these developments have important ramifications on the future health of domestic insurance industry. Needless to say, a robust and stable insurance sector is vital for economic development as it mobilizes domestic savings for infrastructure and provides economic and social security to the people.

Vol. 47, No. 10, Sep 14 - 20, 2014