Diluting Insurance against Risk

03 January, 2009, C.P. Chandrasekhar

In moves that have surprised many, the UPA government has, in the midst of a global financial crisis whose lessons are still being distilled, decided to press ahead with liberalization of the insurance sector. At the fag end of its term and in a truncated parliament session that has other important business to deal with, the government appeared to be in a desperate rush to table two bills to amend the laws applicable to the insurance sector. The two bills—The Insurance Laws (Amendments) Bill and the Life Insurance Corporation (Amendment) Bill—were introduced in the Rajya Sabha and Lok Sabha respectively on December 22 without adequate discussion in the midst of the din generated by the BJP’s demand for the resignation of Minority Affairs Minister A R Antulay. Whether consciously or not, the BJP has helped the government to keep alive the issue of insurance privatization.

While it is unlikely that the government would be able to pass these bills during its current term, it has by tabling them kept the process of insurance sector liberalization and privatization open, despite the global shift in favour of public ownership in the wake of the financial crisis. The aim is obviously to keep the focus on privatization with dilution of public control and provision of a greater role for foreign firms in the insurance sector. This emphasis comes through from the four principal elements of the current legislative effort. The first is to permit public insurance companies to mobilize additional money from the markets. The second is to relax the cap on foreign direct investment or ownership by foreign players in the insurance sector as a whole. The third is to reduce the capital requirements for private players in certain areas, such as the health insurance sector. And the fourth is to emphasis self-regulation with capital adequacy over structural regulation of the sector.

In the case of the general insurance sector, besides raising the FDI cap from 26 to 49 per cent, the relevant bill allows the four state-owned general insurance companies—Oriental Insurance Company, New India Assurance, United India Insurance and National Insurance Company—to tap capital markets for funds after obtaining permission from the government. The bill also allows insurance companies "to raise newer capital through newer instruments on the pattern of banks".

Moreover, in a move widely seen as aimed at helping Lloyds of London in the first instance, the bill seeks to allow foreign re-insurance companies to open offices and conduct business in the country with a minimum capital of Rs. 200 crore. Thus far, only the General Insurance Corporation could provide reinsurance in India. In addition, to make entry into the rapidly expanding health insurance market easier for private players, the bill proposes to reduce minimum investment limit for health insurance companies from Rs. 100 crore to Rs. 50 crore. Also, the bill seeks to do away with the requirement that promoters have to divest specified part of their equity after ten years, allowing promoters to retain control of these corporations. Finally, as part of the new regulatory framework, a Life Insurance Council and General Insurance Council are to be set up as self-regulating bodies.

While these are major changes, the big story is what this government or any version of it that may come to power after the next election has in store for the Life Insurance Corporation. The Life Insurance Corporation Amendment Bill is presented as an innocent piece of legislation aimed at increasing the capital base of LIC, to bring it on par with private insurers. The problem arises when this is read along with the changes being pushed through in the general insurance sector. The government plans to allow government-owned insurance companies to mobilize money from the capital market, allowing for a dilution of the government’s shareholding. And this comes along with the decision to raise the cap on foreign direct investment in the insurance sector from 26 per cent to 49 per cent. If in time, these provisions are extended to cover the LIC, the government would recapitalize LIC not with its own money but with money mobilized from the market and from foreign investors. 

This fear stems from the implicit effort to homogenize the insurance sector, bringing the LIC on par with the private sector. This does signify a move to accelerate the shift in the form of regulation away from direct control through public ownership of institutions in the life and general insurance sectors to self-regulation based on IRDA norms and guidelines and capital adequacy requirements. The use of capital adequacy is reflected in the provision in the bill to cap the sovereign guarantee provided to those insured by the LIC and replacing it with a provision that a part of the surplus—which is the excess of assets over liabilities actuarially calculated—must be treated as a solvency margin and placed in a reserve fund, which the corporation can access in times of need. As of now, 95 per cent of these surpluses are distributed to policy holders as bonuses and the rest is transferred to the government as dividend against its Rs. 5 crore investment. The bill provides for the transfer to policyholders to be capped anywhere between 90 and 95 per cent, with the balance divided between the government and the reserve fund. Thus, state control and state guarantee are to be replaced with self regulation, capital adequacy and solvency margins. This is clearly a sign of long-term intentions.

It should be clear that these bills are aimed at making the insurance sector private dominated, self-regulated and “competitive”. Is there a case for such a transition? There is much evidence on the adverse consequences of such competition and the beneficial effects of government intervention in the insurance sector. The insurance industry delivers "products" that are promises to pay, in the form of contracts, which help lessen the incidence of uncertainty in various spheres. The insured pays to fully or partially insulate herself from risks such as an accident, fire, theft or sickness or provide for dependents in case of death. In theory, to enter such a contract, the insured needs information regarding the operations of the insurer to whom she pays in advance large sums in the form of premia, in lieu of a promise that the latter would meet in full or part the costs of some future event, the occurrence of which is uncertain. These funds are deployed by the insurer in investments being undertaken by agents about whose competence and reliability the policy holder makes a judgment based on the information she has. The viability of those projects and the returns yielded from them determine the ability of the insurer to meet the relevant promise. To the extent that the different kinds of information required are imperfectly available, the whole business is characterised by a high degree of risk.

This makes excessive competition in insurance a problem. In an effort to drum up more business and earn higher profits, insurance companies could underprice their insurance contracts, be cavalier with regard to the information they seek about policy holders, and be adventurous when investing their funds by deploying them in high-risk, but high-return ventures. Not surprisingly, countries where competition is rife in the insurance industry, such as the US, have been characterised by a large number of failures. As far back as 1990, a Subcommittee of the US House of Representatives noted in a report on insurance company insolvencies revealingly titled "Failed Promises", that a spate of failures, including those of some leading companies, was accompanied by evidence of "rapid expansion, overreliance on managing general agents, extensive and complex reinsurance arrangements, excessive underpricing, reserve problems, false reports, reckless management, gross incompetence, fraudulent activity, greed and self-dealing." The committee argued that "the driving force (of such 'deplorable' management practices) was quick profits in the short run, with no apparent concern for the long-term well-being of the company, its policyholders, its employees, its reinsurers, or the public." The case for stringent regulation of the industry was obvious and forcefully made. 

Things have not changed much since, as the failure and $150 billion bail-out of global insurance major American International Group (AIG) in September made clear. AIG was the world’s biggest insurer when assessed in terms of market capitalisation. It failed because of huge marked-to-market losses in its financial products division, which wrote insurance on fixed-income securities held by banks. But these were not straightforward insurance deals based on due diligence that offered protection against potential losses. It was a form of investment in search of high returns, which allowed banks to circumvent regulation and accumulate risky assets. As the Financial Times (September 17, 2008) noted, “banks that entered credit default swaps with AIGFP could assure auditors and regulators that the risk of the underlying asset going bad was protected, and with a triple A rated counterparty.” That is, AIG used policy-holder money and debt to invest like an investment bank through its financial products division. When a lot of its assets turned worthless AIG could not be let go, because that would have systemic implications. The alternative was nationalization.

It is in this background that we need to address the question of the "efficency" of competition from private entrants. To start with, against the promised private gains in terms of the efficiency of service providers, we need to compare the potential private loss in the form of increased risk and the social loss in the form of the inability of the state as a representative of social interest to direct investments by the insurance industry. Further, if insolvencies become the order of the day, there could be private losses as well as social losses because the state is forced to emerge as the "insurer of last resort". The losses may far exceed the gains, implying that the industry should be restructured with the purpose of realising in full the advantages of public ownership.

Yet India’s government pushes ahead with privatization, despite the fact that there is no evidence of the nationalised insurance industry failing on grounds of meeting its obligations either to the insurees or to the government. The LIC has not merely put at the Government's disposal large volumes of capital for investment but also addressed the problems of insurance for the poor. It is not only the global experience with privatized insurance but the Indian experience with nationalised insurance that does not seem to matter. In the circumstance, the two insurance bills appear to be declarations of India's intentions to globalise further during the current Prime Minister’s tenure, independent of the consequences for its people.

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