Insurance in India

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Actions of human beings can be subjected to uncertain outcomes due to lack of information or uncertainty about the future. This lack of information or uncertainty about the future is related to risks associated with individuals’ actions that can lead to undesirable results/changes or losses. For example, theft of money, mobile phone, etc. or house destroyed by fire or sudden accidents of an employee in a manufacturing plant. Some risks however can be avoided by not undertaking a particular action especially when risks are known. For example, money can be deposited in a bank or ensuring that mobile phones are safely placed inside a bag or pockets. But risk of sudden earthquakes, floods, etc cannot be controlled and individuals experiencing losses caused by such risks may have to suffer the consequences. Some of these risks can be transferred to a group of individuals or an organisation that is willing to bear the risks. This group of individuals or organisation use certain financial tools and techniques to manage these risks and are known as insurers or insurance companies. However, the first step individuals need to consider prior to transferring these risks to insurers would be identifying various risks associated to the individuals’ actions. These risks are explained in the following section.

Risks

Risk can be defined, “as the possible variation in an outcome from what is expected to happen” – From Risk Awareness and Corporate Governance by Brian Coyle. Accordingly, the elements of risks are:

  1. Variability (or frictions) due to uncertainty of future events. For example, physical injury to a batsman while playing one-day cricket.
  2. Related to expectations. For example, gambler would take a chance by placing bets in huge amounts with the expectations of winning the bet.
  3. Differences in what actually happens to what is expected. For example, a summer holiday planned in Goa would be cancelled in the last minute due to an unexpected cyclone.

Study on risks is critical because risks can affect a business in the form of varying profits or losses. These risks also affect investors, who have invested in a business, in terms of varying returns from their investments. Risks can be broadly classified into “Pure” and “Speculative” risks. Pure risks are risks, which cannot be avoided or are uncontrollable and losses are inevitable. For example, an employee experiences an accident at work place, or business property suffers from a fire, flooding or burglary. These risks are unavoidable though the possibilities of such events occurring may encourage a business for taking insurance claims on damage to business property or accidents on employees. Alternatively, speculative risks are risks naturally occurring from businesses and are caused by actions of stakeholders internally or externally influencing the functioning of the business. These risks also lead to losses that can be avoidable depending upon the willingness or ability of the stakeholders to take suitable actions to minimize losses. Pure and speculative risks can be further classified under following categories:

  1. Business risks – Business risks are risks arising from the nature, operations and condition of business. These risks can be further characterised as follows:
  • Product risk – This risk arises from buying behaviour of consumers, which implies whether consumers would be willing to purchase the products / services. This risk is also associated with regards to the performance or quality of products / services and existing competition that influences the buying behaviour. Price wars between network providers in telecommunication lead to changes in consumers’ usage of services or applications.
  • Macroeconomic risk – This risk refers to the effect on a business due to unexpected changing economic conditions. For example, demand for necessary goods is higher during a economic slowdown or a recession than for durable or luxury items.
  • Technological risks – This risk is associated with any change in technology leads to changes in the production or delivery of services. For example, the emergence of Internet banking and ATM services by private and foreign banks in India have forced most public-sector (government) banks like State Bank of India (SBI) to introduce the same to retain their existing customers.
  • Strategy risks – There are risks associated with choosing or changing a particular strategy by a business. For example, marketing strategy used to promote a snack through television or by directly meeting people in malls or market places for tasting the snack
  • Enterprise risks – This risk refers to the success or failure of a business operation and whether it should have been undertaken in the first place. For example, changing a handloom- run (labour-intensive) textile business into a powerloom –run (capital intensive) business.
  • Property / Casualty risks – A business is exposed to risks related to loss of property or accidents (or death) of employees at the work place. These risks are associated with health and safety risks.

Among the abovementioned categories of business risks, all are speculative risks except property / casualty risks, which is a pure risk.

  1. Financial risks – Risks that are financial in nature and arises from factors internal / external to a business are financial risks, which are further categorised as follows:
  • Credit – Risk associated with default in credit payment to creditors. Some companies lose value in market due to a low credit-rating that reflects the company’s ability to make loan repayments
  • Foreign Exchange – Risks associated with fluctuations in exchange rates. Companies involved in import and export of raw materials and/or finished goods are the ones who are exposed to foreign exchange risk
  • Interest Rate – These are risks associated with changes in interest rates especially when interest rates increase, businesses need to pay high interest on loans.
  • Market – Adverse changes in market prices (securities market like stock market, money markets, etc) can have adverse effects on foreign exchange rate and interest rates
  • Liquidity – Also known as cash flow risk, refers to a possibility of unexpected shortage of cash which could result to inability to pay debt or loan obligations
  • Operational – This risk is linked to financial losses arising from human or technological errors. For example, faulty machines manufacturing out-of-shape containers or human erroneously dispatching finished products to a different location instead of the designated or labelled location.
  • Gearing – Gearing risks refers to risks of high borrowing in relation to the amount of shareholders’ capital in the business. A high level of debt could increase the earnings per share of leading to price volatility. Also, high-borrowing could indicate the businesses’ inability to make loan repayments
  • Commodity price – Companies dealing in commodities (such as gold, rice, wheat, oil, etc.) face the risk of fluctuating commodities’ prices. For example, rise in oil prices increase the cost of distributing food across the country leading to rise in inflation
  • Capital adequacy – Capital adequacy is mostly associated with banks who are required to have sufficient capital to support the volume of its business

All financial risks are speculative risks.

  1. Event risks – Event risks are uncontrollable risks for a business. These risks can be categorized as follows:
  • Physical – These are risks associated with climate and geology. For example, floods, earthquakes, ill-health, etc
  • Social – Changes in tastes and preferences of consumers or demographic changes (for example, increase in child mortality may influence the need for medical facilities or medicines)
  • Political – Change in government leading to changes in political decisions.
  • Legal – Changes in legislation or regulations or failing to fulfil duties or obligations by law ( For example, not filing property taxes or income taxes)
  • Operational – These are risks generated by an organization while carrying out its activities. For example, wastes and effluents emitted in the surrounding causing health and safety risks for people living in the surrounding areas.

All event risks are pure risks, except operational risks that are speculative risks

  1. Systemic risks – Systemic risk refers to errors or failures of one participant in the economic system that causes a chain reaction or ripple effect on all other industries, sectors and businesses leading to financial difficulties. For example, if a large infrastructure-related bank cannot repay its debt obligations, then it could lead to less liquidity available for construction companies. This in turn would lead to financial difficulties to construction companies who need to repay suppliers of cement, steel and other raw materials, which is turn affects loan repayment problems for cement and steel producing companies thus systemically affecting the construction sector and end-consumers (citizens) who have invested (through their savings) in real estate properties.

About Insurance

Based on the risks identified by individuals, businesses or investors there are several insurance products or services offered by insurers or insurance companies. Insurance is a promise of compensation for potential losses caused by risks on an individual’s life or assets in the future. The characteristics of insurance are as follows:

  1. The participants are individuals who are seeking financial protection for future losses caused by risks on life or an asset and insurance company that is capable is compensating for the financial losses when the unexpected occurs.
  2. The individuals and insurance company enter into a contract or an agreement that states periodic payments that should be made by individuals to the insurance companies and the promise insurance company makes to compensate the money saved for future
  3. The insurance products provided by insurance companies are provided on the basis of the probability of risk that can occur in the future. Hence identification of risk is an important task for individuals before they undertake any action related to business, investment, etc
  4. Major life insurance companies in India are Life Insurance Corporation (LIC) and General Life Insurance Corporation (GIC)

Insurance can be classified as life insurance and non-life insurance in accordance to which individuals can consider relevant insurance options. Life insurance protects individual’s family or dependents with finances after the individual’s death whereas non-life insurance protects an individual’s asset (home, property, business, cars, machinery, etc) from possible losses through finances. Life insurance is associated with uncertainty to life of an individual whereas non-life insurance is associated with uncertainty with material losses.

Life Insurance

Life insurance products are very popular in India. Life insurances are of two kinds – Term life insurance and permanent life insurance.

Example of term life insurance: IndiaFirst life insurance provides a term plan for a period of up to 30 years for which the minimum cover is Rs 10,00,000 and a maximum cover is of Rs 49,00,000. This plan provides an option to pay monthly, six monthly, yearly or lump sum premium for the whole plan period and the family gets tax break on benefits. When the policy term ends and policy holder is still alive, then the policy can be converted to a permanent life insurance. The characteristics of term life insurance are: –

  • Term life insurance provides temporary protection from possible accidental death in the future
  • These insurance policies are meant for short-term periods – 5 years, 10 years, 15 years, 20 years or 30 years
  • The term policies are available at affordable premiums unlike permanent life insurance
  • These policies are flexible and provide tax incentives
  • A policy holder or individual investing in term insurance policy should be careful to select plans that allow possible conversion to another extended policy otherwise the money stays with the insurance company and cannot be easily redeemed.

Example of permanent life insurance: Aegon Religare provides a life insurance in which policy holders’ premiums are invested in a fund comprising debt and equities through which, policy holders’ receive their premiums as well as high returns through the fund. The policy holder can select the portfolio mix of debt and equities in the fund based on which the returns on the premiums will be provided when they claim their policy. The maximum maturity age of the policy is 75 years but you can choose to continue the policy by paying higher premiums for life. The minimum entry age to obtain this policy is 18 years and maximum age is 45 though premiums will be higher with higher age. This policy provides complete tax exemption. Thus the characteristics of permanent life insurance are as follows:

  • These policies provide permanent insurance protection
  • The money is locked till the policy holder dies but the benefits will be provided only to the dependents or family members of the policy holder
  • The premiums are higher and expensive than term life insurance policies
  • The policy offers savings and investment component combined. It provides lump-sum money as well as returns from investment of premiums in a portfolio fund
  • Loans can be obtained against the policy if it is not possible for the policy holder to pay premiums through their incomes or savings
  • Builds cash value.

Investment in insurance policies requires thorough study on the details of the insurance policy. Accordingly the main features that one is required to be aware of include the following:

  1. Whether the insurance policy is a term plan or non-term plan
  2. Term period and age of maturity
  3. Premium payment types (via loan, credit card, debit card, etc) and frequency (monthly, quarterly, annually, or lump sum)
  4. Policy holder under whose name the insurance is taken
  5. Nominee is the person or group of individuals (mostly family members) who will receive the financial benefits of the policy after death of the policy holder
  6. Appointee is a person appointed if one nominee is minor (before 18 years of age)
  7. Minimum and maximum life cover – the amount covered under the policy
  8. Tax benefits (whether tax is deferred or completely exempted)
  9. Loan benefits – if the policy holder can obtain a loan for paying premiums on the insurance policy

Non-Life Insurance

Non-life insurance policies or general insurance policies are policies for certain assets of a business, home or property. The types of non-life insurance available in India include – marine insurance, automobile insurance, health insurance, fire insurance, aviation insurance and engineering insurance. These policies not cover for losses caused to assets like cars, homes, machinery, etc but also cover for health or death of individuals associated with the losses. Fire insurance protects against financial losses for damage to buildings, furniture, fixtures and other personal property as a result of fire, whereas marine insurance also protects against financial losses except for property exposed to transportation hazards. Similarly, car and health insurance is an insurance against loss by sickness or accidental bodily injuries. The loss incurred through sickness and accidents could include the loss of wages, expenses for doctor bills, hospital bills, medicines, etc. Non-life insurance policies can be short-term or compulsory like the car insurance which is compulsory in India. Few other characteristics of Non-life insurance are highlighted below:

  1. Policies are mostly short-term policies like insurance on goods exported to another country or car insurance is an annual policy. Fire insurance can be long-term policies
  2. Policy covers the value of the asset that could be either the market value of the asset or the cost of replacement or repairing
  3. Premium payments are made in advance unlike life insurance
  4. There are many conditions and exclusions depending upon the capability of the insurance company to manage large insurance covers.

Risks and Insurance

There are several risks an insurance company considers to provide insurance services. These risks can be view separately in actuarial[1] and financial perspectives. In actuarial perspective risks can be: asset risk, pricing risk, asset/liability matching risk and miscellaneous risk. Asset risks are those risks caused by decline in assets by borrowers who fail to repay or decrease in the market value of the company’s investments; Pricing risk is a result of uncertainty about future operating income that includes investment income, mortality, frequency and severity of claims and losses. Administrative expenses, sales and lapses; Asset/liability matching risk arises from fluctuations and uncertainty about interest and inflation rates on the values of assets and liabilities and; Miscellaneous risks include tax and regulatory changes, poor training of employees and sales agents or misconduct of managers or employees. Risks evaluated in the actuarial perspective focuses on risks in isolation and identify its effects on the statutory accounting statements, but does not encourage management of risk measures by the firms in an aggregate level. In financial perspective risks generically consist of actuarial, systematic, credit, liquidity, operational and legal risks.

Actuarial risk is a risk that arises from raising funds by issuing insurance policies and liabilities. These risks are related to the underwriting profits or losses an insurance company attains. An underwriting profit or loss is the difference between net premiums earned and a sum of underwriting expenses and claims. Life insurance companies are subjected to actuarial risks related to changes in interest rates. The premiums of life insurance policies are stable with consistent interest rates. However with volatile changes in the interest rates, the premiums prices also fluctuate thus affecting the underwriting profits of the insurer. Unlike life insurance, the premiums of non-life insurance are not influenced by interest rate risks. Premium rates are dependent upon age, gender, occupation, academic qualification, property characteristics nature of business, etc. Non-life insurers thus face risks related to administrative and operating expenses. The major actuarial risk faced by life and non-life insurers is varying methods of incentives provisions between the firms and the sales and marketing staff. The sales and marketing staff receives commission-based incomes creating a risk of selling insurance products that may or may not be profitable.

Systemic risk also known as the market risk related to the changes in assets and liabilities (balance sheet of insurance companies) due to changes in economic factors such as changes in interest rates & inflation and basis risk[2]. Systemic risks create risks related to management of assets and liabilities. Interest rate risk is crucial on the liability side of life insurers and prominent but less dominating on the asset side of non-life insurers. This is because there are other risks such as default risk, liquidity risk, prepayment risk, inflation risk and equity risk that also affect the asset side of property/casualty insurers. These risks are useful for assessing the impact of interest rate and on assets and liabilities of insurance companies’ management. Insurance companies are concerned about the liability side because their assets must be able to produce the cash flow to meet payments, which are promised to make in a timely manner. Due to uncertainty, it is likely that insurance companies land up paying more than selling more policies.

Credit risk is risk arising from non-repayment of borrowings by borrowers, which in turn reduce the current value of underlying collateral and fluctuations in the performance of the company’s investment portfolio. Credit risks are default risks on the insurance companies’ significant investments. These risks are measured through credit ratings that monitor the credit risk of assets and the underlying deposits of the company. The measurement of credit risks consists of assessing portfolio of investments in an industry, geographic region, business and company.

Liquidity risk is associated with funding crises that arises from an unexpected event resulting into large claims or loss of confidence. Unexpected events include natural catastrophes or massive requests for policy withdrawals. Liquidity risk is not a big concern for life insurers since the policies are provided at rates converging to the market interest rates. However, liquidity risk is a major concern for property-casualty insurers since it is subjected to uncertain event or catastrophe. The non-life insurers avoid some of these risks by diversifying their risk portfolios geographically, by industry and by type of risk

Operational risk is associated with operating activities of a company that include accurately processing claims, settling, and taking deliveries on trade in exchange of cash, record keeping, processing system failures and other administrative activities. Legal risks arise from preparing financial contracts that indicate new statutes, court opinions and regulations to carry out transactions with various parties. Legal risks are crucial for insurance businesses to sustain in the market. The insurance firms spend substantial time to ensure that the reputation of the insurance companies is restored.

These risks can be managed through risk control and risk financing, which are based on four basic techniques that include the following: Avoidance, Reduction, Retention and Transfer.

  1. Risk avoidance procedure includes avoiding the risk of liability associated with a hazardous product by providing another product line. This requires standardisation of process, insurance policies, contracts and procedures to prevent incorrect financial decisions. Further, an insurance company could apply the concept of law of large numbers where the risk exposure to liabilities is balanced by large number of insurance products sold and/or the concept of central limit theorem that reduces the effects of any single loss experience.
  2. Risk reduction includes spreading awareness to insurance buyers about minimising risks to acquire cost effective insurance.
  3. The insurance companies can also retain risk by holding some of the assets in liquid or semi-liquid form to manage certain operations of the firm. The risk can also be transferred into various capital market instruments.
  4. Interest rate risk can be hedged or transferred through interest rate products such as swaps, futures or derivative products. In addition, an insurance company can also offer products that absorb financial risk while transferring other risks to the policy holder (for example, investment fund-based permanent life insurance policy). The insurance company can buy or sell financial claims to diversify or concentrate the risk that result from servicing its customer base.


[1] Actuary means specialization in mathematics or statistics for computing risks and insurance premiums

[2] Basis risk is related to underlying risk in varying yields on instruments, credit quality, liquidity and maturity.