India privatizes insurance: Will it attract investor funds?

Aparna Viswanathan. International Financial Law Review. London: Mar 2000. Vol. 19, Iss. 3; pg. 28

Abstract (Summary)

In one historic sweep India has privatized its insurance market by allowing private companies to
undertake general and life insurance. On December 2, 1999, India's parliament passed the Insurance
Regulatory and Development Authority (IRDA) Bill 1999, ending a decade long dispute with the US
over opening the Indian insurance market to competition. The new private players in the Indian
insurance market are Indian insurance companies which obtain a certificate of registration from the
IRDA. An Indian insurance company is a company incorporated under Indian law in which the
aggregate holding of equity shares by a foreign company does not exceed 26% of the paid up equity
capital.

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Full Text

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Copyright Euromoney Publications PLC Mar 2000

[Headnote]
After 10 years of wrangling, the Indian government has privatized its insurance industry. Aparna
Viswanathan of Viswanathan & Co asks whether the legislative reforms have created an adequate
regulatory framework

In one historic sweep India has privatized its insurance market by allowing private companies to
undertake general and life insurance business. On December 2 1999 India's parliament passed the
Insurance Regulatory and Development Authority (IRDA) Bill 1999, ending a decade long dispute with
the US over opening the Indian insurance market to competition.

The IRDA Act amended the Life Insurance Corporation Act 1956 so as to divest the Life Insurance
Corporation of India (LIC) of the exclusive privilege of carrying on life insurance business in India, and
amended the General Insurance Business (Nationalization) Act 1972 to divest the General Insurance
Corporation of India (GIC) of the exclusive privilege of carrying on the general insurance business in
India. The LIC and GIC along with the state-owned Oriental Insurance Company and New India
Assurance Company will remain the market incumbents who will compete against the new private
entrants.

The new private usurers

The new private players in the Indian insurance market are Indian insurance companies which obtain a
certificate of registration from the Insurance Regulatory and Development Authority (IRDA). An "Indian
insurance company" is a company incorporated under Indian law, whose sole purpose is to carry on
life insurance, general insurance or re-insurance business, and in which the aggregate holding of
equity shares by a foreign company either by itself or through its subsidiary companies or its nominees
does not exceed 26% ofthe paid up equity capital.

"Foreign company", in turn, means a company which is not incorporated in India or a corporation,
association, institution or other body which does not have its principal office in India. A promoter may
not, at any time, hold more than 26% of the paid up equity capital in an Indian insurance company.
Ifthe promoter owns more than 26% of the paid up equity capital at the time of commencement of
business, the excess must be divested 10 years from the commencement date. This divestment
requirement does not, however, apply to promoters which are a foreign company.
The question left open is whether the 74/ remaining equity in an Indian insurance company may be
held by a company incorporated in India in which foreign companies have an equity stake. Indirect
holdings of equity by foreign companies have been expressly allowed in the telecom sector and the
issue of whether tiered holding company structures can be created in the insurance context has not
been addressed by the IRDA Act. By creating tiered holding company structures in which a foreign
company owns shares in the Indian company which, in turn, owns 74% of the Indian insurance
company, foreign investors could increase their effective control over the insurer.

Capital requirements and share transfers

The new insurers must have a minimum paid up equity of Rsl billion ($22.7 million) for life or general
insurance and a minimum paid up equity ofRs2 billion for reinsurance business. The prior approval
ofthe new statutory regulator, the IRDA, must be obtained for the transfer of shares where the nominal
value of the shares intended to be transferred by any individual, firm, group, constituents of a group or
body corporate under the same management, jointly or severally exceeds 1% ofthe paid up equity
capital of the insurer. The definition of "group" and "same management" have been taken from the
Monopolies and Restrictive Trade Practices Act, 1969 (MRTP Act).

"Group" means a group of two or more individuals, association of individuals, firms, trusts, trustees or
bodies corporate (excluding financial institutions) or any combination thereof which exercises or is in a
position to exercise control, directly or indirectly, over any body corporate, firm or trust. "Group" also
means a group of associated persons, among other things, a director of a company and his relative, or
a partner of a firm and a relative of such partner or two trustees of a trust. Two bodies corporate are
deemed to be "under the same management" if, for example, they share the same managing director
or manager or one owns one-fourth of the shares or controls composition of one-fourth of the board of
directors of the other. Various other examples of operating under the same management are provided
by the MRTP Act.

In short, in order to obtain a licence as an insurer, a company must be incorporated under Indian law,
have a minimum paid up capital ofRs1 billion (or Rs2 billion for reinsurance) and may have foreign
equity participation up to 26%.

The IRDA Act imposes a series of operating restrictions on the insurers in terms of deposit
requirements, solvency margins, separation of policyholders and shareholders funds, profit
entitlement, expense regulations and taxation. As discussed below, several of these restrictions depart
from international practice and raise questions regarding the viability of the regulatory framework.

Every insurer must deposit with the Reserve Bank of India (RBI) cash or approved securities as
follows:

* life insurance - a sum equivalent to 1% of his total gross premium written in India in any financial year
commencing after March 31 2000 not exceeding Rs100 million.

* general insurance - a sum equivalent to 3% of his total gross premium written in India in any financial
year commencing after March 31 2000 not exceeding Rs100 million.

* reinsurance business - Rs200 million.

The Act also requires insurers to maintain a prescribed solvency margin defined as the excess ofthe
value of assets over the amount of liabilities. The minimum solvency margin for life insurance is the
higher ofthe aforesaid Rs500 million (RsIs billion for reinsurance) or a sum not exceeding 5% of the
mathematical reserves for direct business and reinsurance acceptances without any deduction for
reinsurance cessions or a sum not exceeding 1% of the sum at risk for the policies on which the sum
at risk is not a negative figure. In the case of general insurance, the solvency margin is the highest of
Rs500 million (Rsl billion for reinsurance) or a sum equivalent to 20% of net premium income or a sum
equivalent to 30% of net incurred claims subject to credit for reinsurance in computing net premiums
and net incurred claims. The minimum solvency margin of 50% has been viewed as high by
international insurers particularly in view of the profit distribution rules and taxation rules as discussed
below.

Investments

There are two main methods of regulating investments by insurers. In some countries, including India,
the law prescribes allocation of assets. In other jurisdictions, no asset allocations are prescribed,
instead, the prescribed minimum solvency may be met only by "eligible assets". The Report ofthe
Expert Group on Technical Issues related to Life and Non-Life Insurance Companies issued by the
Confederation of Indian Industry (CII) in September 1999 (CII Report") has suggested that Indian law
shift from prescribing asset allocation and investment limitations to the concept of eligible assets which
would back the prescribed minimum solvency margins discussed above. However, the IRDA Act fails
to make this regulatory transition and continues to prescribe allocation of assets.

The IRDA Act provides that no insurer may directly or indirectly invest the funds of policyholders
outside India. The IRDA may specify the time, manner and other conditions of investment of assets to
be held by an insurer. However, the Insurance Act, 1938 already specifies an elaborate list of
"approved investments" and "approved securities" which has not been amended by the IRDA Act.
Therefore, in the absence of further legislative amendments, any regulations promulgated by the IRDA
must be within the parameters of the existing regulations governing asset allocation. The IRDA Act
also provides that every insurer must undertake such percentages of life insurance, general insurance
in the rural or social sector as may be specified by the IRDA.

The Insurance Act, 1938 requires insurers to establish a fund for the business oflife insurance called
the life insurance fund. The Valuation Balance Sheet (Form 1 to the Insurance Act, 1938), states that
ifthe proportion of surplus allocated to the shareholders is not uniform in respect ofall classes
ofinsurance, the surplus must be shown separately for the classes to which the different proportions
relate. This note indicates that separate funds should be maintained for different classes oflife
insurance business although the 1938 Act does not expressly so provide. Importantly, the IRDA Act
does not provide that separate funds must be maintained for different types of life insurance business
such as participating and non-participating businesses. It envisions that the existing practice of
maintaining a single fund and a single surplus will continue.

However, as pointed out in the CII Report, this concept of a single fund and a single surplus is not in
line with modem life insurance business. Life insurance business may be either particigating; in which
the policyholders pay a higher premium for the right to participate in the surplus generated or non-
participating in which the policyholders do not share in the surplus. The shareholders instead get most
or all of the surplus because they bear allthe financial risks involved in providing the life insurance
products. Life insurance products may also impose the entire risk on shareholders (term assurance) or
on policyholders (unit linked). Therefore, the law must reflect these developments in insurance practice
and provide for different funds for different Masses of policyholders. In addition, the share of surplus
which may be allocated to shareholders should vary according to each type of fund so as to
adequately balance the interests of policyholders and shareholders. Even more importantly, the
following legal rules governing profit entitlement must be re-examined.

The Insurance Act, 1938 places restrictions on payment of dividends to shareholders and bonuses to
policyholders. The 1938 Act provides that no life insurer shall for the purpose of paying any dividend to
shareholders or any bonus to policy holders or of making any payment in service of any debentures
utilize any portion of the life insurance fund except a surplus shown in the valuation balance sheet
submitted to the Authority as a result ofan actuarial valuation of the assets and liabilities of the insurer.
Further, the share of any such surplus allocated to or reserved for the shareholders, including any
amount for the payment of dividends guaranteed to them, may not exceed 7.5 % of such surplus.

In other words, 93.5 % of the surplus must be reserved for the policyholders for distribution as bonus
and cannot be used for payment of dividends to the shareholders. The percentage oE92.5 % is
particularly high. The CII Expert Report has recommended that a minimum of90% ofthe surplus from a
participating fund be allocated to the policyholders as bonus and the distribution of the balance 10%
be left to the discretion of the individual companies. Insurers have taken the view that a 7.5% share of
the surplus for shareholders is an unviable return which is unlikely to attract foreign investment in
Indian insurance companies. The return becomes even less attractive for products such as term
assurance where the entire risk is borne by shareholders. As the CII Expert Report points out, if the
products are non-participating, the policyholders are fully compensated provided the guaranteed
benefits are paid and they do not have a right to claim part of the surplus. If only 7.5% of the surplus
can be transferred to the shareholders fund, who receives the remaining 97.5% of the surplus ?
Perhaps the ownership oFthese assets could remain ambiguous in the era of the state-owned
insurers. However, in the new privatized market, shareholder funds will not be attracted if shareholders
are not going to be compensated for their investment by an adequate rate of return. Although this
issue raises a question over the viability of the new regulatory regime, it has not been addressed in the
IRDA Act.

The IRDA Act also fails to allow for the transfer of any or all of the surplus from a non-participating fund
to shareholders to compensate them for the risks borne by the shareholders. The new legislation
moreover does not provide insurers the option to fund non-participating life insurance business from
either the profits fund or the shareholders fund. 1 he foregoing restrictions on the shareholders share
of the surplus render the regulatory regime unreasonable because insurers will not be able to offer
potential shareholders an adequate rate of return on their funds. As these restrictions are contained in
the Insurance Act, 1938, they can be amended only by an Act of Parliament and not by rules and
regulations issued by the new statutory regulator, the IRDA.

Expense regulations

The Insurance Rules, 1939 prescribe limits on expenses of management of life insurance and general
insurance business not-withstanding the fact that expense regulations are not common in market
economies. The Rules prescribe the following limits which are expressed as a percentage of life
insurance premiums (less reinsurance) received during the year:

As stated above, the prescribed limit on expenses for the first four years is 100% ofthe premium.
However, insurers have taken the view that it is not possible for a company to limit expenses to the
100% expense ratio during the first four years of operation. In India, start up costs are very high and
the expense ratios will reduce only over time. However, the IRDA Act does not amend or even address
the issue of expense regulations notwithstanding the fact that no new insurer will be able to show an
expense ratio of 100% during the first four years of operation in its Business Plan. It is important to
note that expense regulations are not included in the matters over which the regulator, the IRDA, can
make regulations. Moreover, the IRDA can only make regulations consistent with the Insurance Rules,
1939, therefore, it does not have jurisdiction to amend the foregoing expense regulations.

Tax issues

In India, life insurance business is taxed as follows. The taxable profits of life insurance business are
the annual average of the surplus arrived at by adjusting the surplus or deficit disclosed by the
actuarial valuation made in accordance with the Insurance Act, 1938 in respect ofthe last inter-
valuation period ending before the commencement ofthe assessment year. This tax rate applicable to
such income is the flat rate of 12.5%. The taxable profits of nonlife business are the Insurer's Profit
Before Tax (PBT) determined in the annual financial statements required under the Insurance Act,
1938 minus the amounts carried to reserves for unexpired risks. There are a number of critical tax
issues which affect the viability of the new regulatory regime. However, none of these issues have
been addressed by the IRDA Act. In the initial years, the new private insurers will make losses
particularly in view ofthe need to declare bonuses to policy holders in order to compete against the LIC
and GIC. The losses and the bonuses which must be declared will be financed by transfers of funds
from the shareholders funds to the policyholders fund. However, this transfer of funds from the
shareholders fund may be deemed to be a taxable surplus. Therefore, as recommended by the CII
Expert Report, the First Schedule of the Income Tax Act, 1961 should be amended to provide that any
amounts transferred from the Shareholders Fund to the Policyholders Fund must be deducted in
computing the taxable surplus. Furthermore, if, after such deduction, the resulting amount is a deficit,
such deficit should be carried forward as a business loss to be offset against the taxable surplus in
subsequent years. However, the IRDA Act does not address any tax issues and there is no proposal to
amend the relevant provisions ofthe Income Tax Act,1961.

The regulator

The Act creates a statutory regulator, the Insurance Regulatory Development Authority (IRDA), which
is vested with the duty to regulate, promote and ensure the orderly growth of the insurance and
reinsurance business. The IRDA will replace the existing administrative body, the Insurance
Regulatory Authority (IRA). The chairman ofthe IRDA, N Rangachary and member (non-life), H Ansari,
have already been appointed as full time members. A total of five full time members and four part time
members are expected to be appointed this Spring.

The powers of the IDRA are, first, licensing of the new private insurers by issuing certificates of
registration. The IRDA is expected to issue rules and regulations, including procedures for obtaining a
licence, by April 2000.

The second area of jurisdiction ofthe IRDA is tariff setting. It is important to note that the IRDA may
only control the rates, terms and conditions that may be offered by general insurance business not so
controlled and regulated by the Tariff Advisory Committee (TAC) under section 64U of the Insurance
Act 1938. However, section 64U consists of very broad language which mandates the TAC to "control
and regulate the rates, advantages, term and conditions that may be offered by insurers in respect of
general insurance business". According to this sweeping language, the TAC is statutorily vested with
the power to regulate all aspects of the rates, terms and conditions ofthe general insurance business.
It is thus unclear what aspects of tariffsetting remain to be regulated by the IRDA and this ambiguity
may raise issues of overlapping jurisdiction between the TAC and the IRDA.

Third, the IRDA is to regulate the operating issues discussed above such as investment of funds,
business to be undertaken in the rural sector, and margin of solvency. However, as mentioned above,
the IRDA may only make regulations consistent with the Insurance Act, 1938 and the Insurance Rules,
1939. Therefore, the IRDA will not have the power to, for example, lower the minimum Rs500 million
solvency margin.

Fourth, the IRDA will regulate intermediaries by specifying qualifications, a code of conduct and
practical training for insurance intermediaries and agents, a code of conduct for surveyors and loss
assessors, regulating professional organizations, inspecting, investigating and adjudicating disputes
between insurers and intermediaries, and specifying the percentage of premium income of the insurer
to finance regulation of professional organizations.

Finally, the IRDA is to protect the interests of policyholders in matters concerning assignment of policy,
nomination by policyholder, insurable interest, settlement ofinsurance claim, surrender value of policy
and other terms and conditions of the insurance contract. However, this means that the IRDA will have
overlapping jurisdiction with the state-level and National Consumer Commission which have been
hearing coverage cases filed by insureds against the state owned insurers. It is now unclear whether
the proper forum for a coverage dispute will be a consumer commission or the IRDA.

Of even greater concern is the language in the IRDA Act which provides that the IRDA shall be bound
by such directions on questions of policy, other than those relating to technical and administrative
matters as the central government may give in writing to it from time to time. Although the IRDA shall
be given an opportunity to express its views before any direction is given, the decision ofthe Central
Government whether a question is one of policy or not shall be final. This language is identical to that
contained in the Telecom Regulatory Authority of India Act, 1997 which has permitted the Department
of Telecommunications (DoT) to interfere with the functioning of the Telecom Regulatory Authority of
India (TRAI). Various telecom issues have been deemed policy issues so as to permit the
Government, through the DoT, to interfere with the independence of the statutory regulator.
The provision binding the IRDA to the Government's policy decisions is, in effect, a way to allow the
executive branch of government to interfere with the statutory regulator and exceed the proper bounds
ofits authority. This language in the IRDA Act constitutes excessive delegation of legislative power to
the executive which is both contrary to the principle of separation of powers between the three
branches of government and in violation ofthe Constitution of India.

The outlook

The foregoing analysis reveals that several major issues undermine the attempts to create an
adequate regulatory regime for the newly privatized insurance sector. First, the Insurance Act, 1938
must be amended to increase the share of surplus which can be distributed from the policyholders
fund to the shareholders fund. The current 7.5% share of surplus available to shareholders is
inadequate to attract investor funds. Second, the limitations in the Insurance Rules,1939 on expenses
which may be incurred during the initial years must be relaxed as the present limits will not be part of
any viable business plan. Third, the Income Tax Act, 1961 must be amede cn that funds contributed
from the shareholders funds try the policyholders funds in order to make up a deficit, particularly in the
start-up years, are deducted from taxes and the deficit is carried forward as a loss. Unless the
foregoing changes are made, the legal framework will not provide a reasonable regulatory
environment.

However, the foregoing reforms require legislative changes which are beyond the jurisdiction of the
IRDA and will require an Act of Parliament. Although the IRDA is expected to issue rules and
regulations by April 2000, it does not have the jurisdiction to reform any of the three issues discussed
above. Therefore, in view of the fact that there is no timetable for further legislative reforms, it is not
possible to estimate the time required for the emergence of a regulatory framework conducive to
attracting invest-nent and doing business.

Furthermore, the new regulatory regime fails to create an independent statutory regulator because the
government has reserved the right to intervene and issue directives to the IRDA on matters of policy.
This provision in the IRDA Act subjects a statutory authority to the discretion of the executive branch
thereby violating the separation of powers of the executive and the legislature which is a basic feature
of India's constitution. Unless the IRDA Act is amended to delete this provision allowing the
government to issue policy directives, an independent statutory regulator will not be in place, thereby
undermining the entire regulatory regime. In sum, while the new IRDA Act is a dramatic step forward to
an open insurance market, further legislative reforms are necessary before an adequate regulatory
environment will be in place.

Indexing (document details)

Subjects: Insurance industry, Legislation, Privatization, Regulation

Classification 9179 Asia & the Pacific, 8200 Insurance industry,
Codes
4310 Regulation
Locations: India
Author(s): Aparna Viswanathan
Document types: Feature
Publication title: International Financial Law Review. London: Mar
2000. Vol. 19, Iss. 3; pg. 28
Source type: Periodical
ISSN: 02626969
ProQuest 51976963
document ID:
Text Word Count 3683
Document URL: http://proquest.umi.com/pqdweb?
did=51976963&sid=2&Fmt=3&clientId=97393&RQT=309&VName=PQD

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