Importing Risk into Insurance

C.P. Chandrasekhar

On October 4, in a cabinet decision that had been predicted by the media and expected by the stock market, the United Progressive Alliance (UPA II) government announced hikes in the ceiling on foreign equity ownership from 26 to 49 per cent in units in the insurance sector and from nil to 49 per cent in the pension fund industry.

The immediate motivation for approving these measures was the government’s declared intent of winning the approval of international rating agencies and foreign investors. To that end, the insurance reforms were presented as part of a set of decisions, including clearance for FDI in multi-brand retail and civil aviation, hikes in diesel and LPG prices and changes to the forward contracts regime, announced end-September and early-October.

This combined reform thrust was aimed at establishing that the government was not just committed to reform, but also not paralysed on the policy front. Thus, the measures also would, according to Finance Minister P. Chidambaram, “one, stabilise the rupee; two, reverse the direction of capital flows from outflow to inflow; and three, control expenditure” (in order to reduce the fiscal and current account deficits). However, as of now, the liberalisation of foreign investment norms in the insurance and pension fund industries is still symbolic. The cabinet decision requires parliamentary approval before it becomes law and can be implemented. To secure support, the increase in the FDI cap is being justified as a measure aimed at attracting much-needed capital for the insurance industry itself.

As the Finance Minister put it: “The estimated capital requirement in the insurance sector is about $5-6 billion in the immediate future,” ostensibly to increase insurance penetration. Hari Narayan, the Chairman of the Insurance Regulatory and Development Authority, has declared that FDI in insurance was in any case required, and that the new measure could attract the 300 billion rupees the industry requires over the next five years. More capital in insurance is also seen as the base required for mobilising the resources needed to finance crucial investments in the infrastructure sector, even though a small proportion of insurance funds flow directly to the infrastructure sector at present. For example, the figure is four per cent in the case of the life insurance companies.

The validity of these claims is suspect. Moreover, what is being underplayed here is the implication for financial stability of allowing easy entry for profit-seeking players known to adopt practices that have had adverse consequences even in countries like the US. Insurance has always been a highly regulated sector, with some emphasis on restricting rather than encouragingcompetition. This is because what the industry sells as “products” are mere promises to pay specified amounts, if and when, specified events occur. The buyers of insurance seek to insulate themselves from risks such as fire, theft or illness or to provide for dependents in case of death.

To that end they enter into contracts requiring them to pay in advance large sums in the form of premia, in lieu of a promise that the insurer would meet in full or part the costs of some futureevent, the occurrence of which is uncertain. The difficulty is that the distance in time between thepayment of the advance premia and the registration of any likely claim is large, during which time the insurer would have to deploy funds in investments that are safe and offer returns that ensure the availability of adequate funds to meet those claims from the insured.

There are many risks here. Given the likelihood of the event insured against afflicting any amongthe insured, the insurance company would have to price the contract such that the sums collected and invested yield stable returns needed to cover claims that arise. The contract may be underpriced. The probability of claims arising may be underestimated. The insured may not take adequate precautions to prevent the occurrence of the event insured against, such as ill health or fire. The insurer may make wrong investment choices. As a result of any one or a combination ofthese either the insurer or the insured (or both) can suffer losses.

This makes excessive competition in insurance a problem. In an effort to expand their business volumes and earn higher profits, insurance companies could underprice their insurance contracts, not obtain or ignore information on policy holders, and invest their funds in high-risk, ventures that promise higher returns. 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 noted 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 $170 billion bail-out of global insurance major American International Group (AIG) during the 2008 crisis made clear. AIG was the world’s biggest insurer when assessed in terms of market capitalisation. It failed because of huge 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 one witness at a post-crisis hearing of a Senate committee on AIG put it: “At AIG, it was not enough to insure lives or property or health. A largely unregulated corner of the company decided it would make enormous bets on exotic financial arrangements, providing insurance where there were no actuarial tables, almost no actual experience, and no Government regulation and no oversight.”

When a lot of the assets turned worthless AIG could not be allowed to go because of the systemic effects it would have, necessitating a tax payer-financed bail-out that amounted to nationalization. It is firms like this that are now being offered a foothold in the Indian market, with even less experience of regulation. Through much of the post-Independence period, risks of insurance company failure were substantially reduced in India because of two factors: regulation, especially of the investments undertaken by insurance companies; and public ownership, which helped government ensure that insurance managers adopted sound business practices. Both of these are now being diluted. That may appeal to foreign investors and temporarily enthuse speculators in stock markets. But the consequences in the long run are likely to be the return of fragility and increased failures.

This article was originally published in the Frontline Vol. 29: No. 21, Oct 20 – Nov 02, 2012.

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