A significant part of the activities of the insurance industry of an economy entails mobilisation 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 discUS$ed above, these contracts can significantly affect behaviour of economic agents and, in general, are perceived to lead to better outcomes for economies.
Herein lies the importance of the viability of insurance companies: insolvency/bankruptcy of an insurance company can be fast transformed into a systemic problem in two different ways. The part of the systemic crisis that can be attributed to the quasi bank like function of a section of the insurance industry is easily understood.
However, even if an insurance company does not default on its credit and investment related obligations, and merely reneges on its insurance obliga¬tions, the adverse impact of such default on the economy and the society at large can be quite devastating. For example, it is not difficult to imagine the closure of a company that had not made provisions for damages on account of (say) product related liability because it had believed that it was pro¬tected from such damages by an insurance policy."
The consequent insolvency of the company can affect a number of banks and other companies adversely, and a systemic problem will be precipitated. In other words, the insurance industry in any country should be subjected to regulations that are at least as stringent as, and perhaps more stringent than those governing the activities of other financial organisations.
It is evident from the above discUS$ion 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 opportu¬nity 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 policyhold¬ers by way of tax breaks, but might pose a serious problem if liberalisation leads to "price" competition among a large number of insurance companies
It might be argued that if the insurance and pension fund industries are 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 signifi¬cantly to their portfolio risk.
The problem, however, is that till the imperfect character of the bond market is removed to a significant extent, the insur¬ance 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 liberalisation, the Indian insurance industry might also be at the receiving end of regulations governing insurance prices / premia. Specifically, there might be highly politicised 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 financial realities, it might be better to subsidise 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
At the same time, however, they guaranty minimum payoffs to both individuals and companies by way of the put like insurance contracts. As discUS$ed above, these contracts can significantly affect behaviour of economic agents and, in general, are perceived to lead to better outcomes for economies.
Herein lies the importance of the viability of insurance companies: insolvency/bankruptcy of an insurance company can be fast transformed into a systemic problem in two different ways. The part of the systemic crisis that can be attributed to the quasi bank like function of a section of the insurance industry is easily understood.
However, even if an insurance company does not default on its credit and investment related obligations, and merely reneges on its insurance obliga¬tions, the adverse impact of such default on the economy and the society at large can be quite devastating. For example, it is not difficult to imagine the closure of a company that had not made provisions for damages on account of (say) product related liability because it had believed that it was pro¬tected from such damages by an insurance policy."
The consequent insolvency of the company can affect a number of banks and other companies adversely, and a systemic problem will be precipitated. In other words, the insurance industry in any country should be subjected to regulations that are at least as stringent as, and perhaps more stringent than those governing the activities of other financial organisations.
It is evident from the above discUS$ion 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 opportu¬nity 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 policyhold¬ers by way of tax breaks, but might pose a serious problem if liberalisation leads to "price" competition among a large number of insurance companies
It might be argued that if the insurance and pension fund industries are 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 signifi¬cantly to their portfolio risk.
The problem, however, is that till the imperfect character of the bond market is removed to a significant extent, the insur¬ance 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 liberalisation, the Indian insurance industry might also be at the receiving end of regulations governing insurance prices / premia. Specifically, there might be highly politicised 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 financial realities, it might be better to subsidise 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