Problems pertaining to Reinsurance Business in India

Everybody is familiar with the term insurance. It is a contract entered between two parties where one party (insured) pays the other (insurer) an amount (referred to as premium) to compensate itself or a third party in case of some financial or personal loss. Thus, insurance is nothing but a way to transfer risks from one party to another party in exchange of a small amount. The question arises as to why a small amount is enough for the other party when the expected payout if that risk materialises is huge? The answer is simple. The party that insures the other collects these small amounts from thousands or lakhs or millions of people. Accordingly, these insurers work on probability and other complicated mathematical and statistical models to mitigate their risk and eventually turn out to be profitable by collecting these small amounts and paying for any claims lodged by the insured public.

However, the above risk management leaves one small loophole to be covered. What if an earthquake or a hurricane or a tsunami strikes and causes damage to lives and properties of thousands of people. Even a large insurance company would have to suffer huge losses in the form of extremely high payouts. Accordingly, these insurance companies also buy insurance protection to protect themselves against these situations. This phenomenon of buying insurance protection by insurance companies themselves is referred to as reinsurance. A reinsurer may be either a specialist reinsurance company, which only undertakes reinsurance business, or another insurance company. Some of the famous reinsurance companies of the world are – Munich Re, Swiss Re, Berkshire Hathaway (General Re), Hannover Re, SCOR, etc.

In India, insurance sector, moved from being an unregulated sector to a completely regulated sector to partly deregulated sector now. India being a developing country and one of the least penetrated insurance markets in the world, there is tremendous scope of growth for insurance and reinsurance business. Since the reinsurance business involves managing risks of the entities that themselves manage risks, it involves not only immense expertise but also huge amount of capital to run the business profitably for a considerable amount of time. It is these risks and the expertise required that makes it very difficult to become profitable. Presently, India has only one specialised reinsurer – General Insurance Corporation of India (GIC Re). Besides GIC Re, reinsurance contracts are entered by other Indian insurance companies or foreign reinsurers.

The above facts clearly indicate that if adequate support is given by the regulators and the Government, India can be a destination for large reinsurance businesses. However, there are certain regulations and rules that impede the growth of this business in India –

·        Every insurance company has to mandatorily cede (give away) 10% of its premium to GIC Re which then assumes 10% of the risk covered in that policy. If the insurance company wishes to reinsure above 10% of the policy amount, it can do so but has to preferably try to offer to Indian insurance companies and only balance left is to be offered to foreign reinsurers. However, no specific foreign reinsurer can reinsure risks individually in excess of 10% of the policy amount.

The above cession to reinsurers (whether mandatory or otherwise) fetches commission to insurance companies as they are getting business for reinsurance companies. Thus, what tends to happen is that when 10% of the mandatory or obligatory cession to GIC Re takes place, many loss making insurance portfolios are transferred to it which GIC Re would never have taken up if it would not have been mandated to do so. Recently, getting frustrated by the losses it has to bear on the obligatory business, GIC Re is planning to remove reinsurance commission on certain portfolios being ceded to them. Accordingly, this mandatory cession should pave way for cession in a manner a free market economy would have.

Furthermore, the attempt by the IRDA (Insurance Regulatory and Development Authority) regulations to retain maximum reinsurance business in India mandates insurance companies to try to offer these products to other Indian insurance companies first and then to foreign reinsurers. Rather than this, attempt should be made to appropriately capitalise Indian reinsurance sector by easing FDI limits from existing 26%. Even though the proposed Insurance (Amendment) bill plans to increase FDI limits to 49% only, it would be even better if this limit is increased to 74% or 100% for specifically reinsurance service providers due to huge amount of capital requirements for that sector. This would lead to reduced dependence of insurance companies on the obligatory services of GIC Re and unregulated foreign reinsurers.

·        Next absurdity that needs to be mentioned is that no amount is to be paid by foreign reinsurers as margins or a portion of premiums as a security to do business in India, unlike when GIC Re goes abroad to do business in Malaysia, Singapore, USA, etc.

Even though I am a staunch proponent of free market, capitalism and lesser regulated businesses but these situations should not be at the cost of security of stakeholders of the businesses. Suppose there is a claim and the foreign reinsurer is not in a position to pay due to some huge losses suffered recently in some other reinsurance operations, insurers in India would have to go abroad and fight the case (which would be a costly and time consuming affair in itself). Besides, the law mandates the insurer to pay the amount regardless of the recovery from the reinsurer. Thus, it would be a blow to the Indian insurer. However, if a portion of premium is held as security with the IRDA and such premiums from different foreign reinsurers are pooled together, they can create a sizeable reserve and can be used during dire times by IRDA to extend help to Indian insurers.

Even though foreign reinsurers should enjoy a rating of at least BBB (with Standard & Poor) or equivalent rating of any other international rating agency before any business is placed with them, it would still be a wise idea to collect some amount in the nature of security from them as mentioned above. Furthermore, some slight regulations on their operations with regard to Indian businesses are needed except just a mere review of the reinsurance treaty between insurer and reinsurer by IRDA.

·        Next, I would like to highlight is the problem of TDS (Tax Deducted at source) on payment of reinsurance premium by insurance companies. Reinsurance premium payments are characterised in the nature of income of the reinsurers by the tax department and thus, liability to pay TDS by insurance companies arises on payments made to either Indian or foreign reinsurers.

TDS and other forms of taxation lead to lower payments being collected by the receiver, which in this case is the reinsurer. To blossom the extremely low penetrated general insurance sector and the reinsurance pertaining to that sector, reduced or nil taxation on reinsurance premium is necessary so that easy pass-through of premium and easy mitigation of insurance risks can be done.

·        Lastly, I wish to comment on a proposed move by IRDA to cap the risks passed to reinsurance firms. It is proposed that insurance companies whose period of operation is upto 10 years can pass only 50% of their risks while the companies whose period of operation is beyond 10 years can pass only 30% of their risks.

IRDA contends that if an insurer has low retention limit, then such insurers only act as an insurance service provider than as a risk bearing insurer. However, I feel that this is one of the most absurd and unneeded moves proposed by IRDA especially when insurance business has such low penetration in India. Lower amount being passed to reinsurers means that to maintain higher amount of insurance premium collections, larger risk bearing capacity should be there, which entails higher capital requirements. Proposed move to induct FDI upto 49% from existing 26% may help somewhat but overall it needs to be mentioned that IRDA should not tell the insurers as to how to manage their risks or do their business. This move, if announced, would be nothing more than a fracture in the leg of a young footballer learning how to play well.

It is needed to be highlighted that regulations should not be introduced for regulations sake but should pave the way for growth of businesses in a manner conducive for all stakeholders. If the authorities take a note of the above issues and corresponding suggestions into account and of course other issues not mentioned above, India, with its extremely intelligent workforce can make reinsurance as one of the fastest growing businesses in the country.

Credit Default Swaps – Financial Weapons of mass destruction or effective way to mitigate credit risks?

In October 2009, the Reserve Bank of India (RBI) had announced in the second quarter review of monetary policy that it plans to introduce over-the-counter Credit Default Swaps (CDS) for resident entities and appointed an internal working group to finalise the operational framework in consultation with the market participants. Finally in May, 2011 the final guidelines on the same were published in the RBI website and the guidelines were made operational from December 1, 2011. Any person having advanced level knowledge of what happened in 2008 U.S. recession would have shivers down his spine whenever the names like CDS or CDOs (collateralized debt obligations) are mentioned. CDS and CDO are arguably, regarded as “exotic” derivative contracts that let the 2008 economic downturn to assume such massive proportions. Then why did the ever conservative and careful RBI introduce such a financial instrument in the Indian capital markets?

The above answer and the answer to the question mentioned in the topic can only be given if we analyse and understand few basic terminologies. Firstly, what is a derivative? A derivative is a financial instrument that derives its value from the value of the underlying instrument. Eg. A future contract is a derivative of the underlying equity share or commodity and would derive its value (that is, trade at a premium or discount) based on the value of share or commodity. Similarly, CDS is also a derivative. It is a credit derivative contract in which one party (protection buyer) pays a periodic fee to another party (protection seller) in return for compensation for default (or similar credit event) by a reference entity. CDS contract acts in the nature of an insurance contract (credit insurance). The entity or company or bond or share or asset on which CDS contract is made is referred to as “reference entity”. It can act as a great hedging tool in case the underlying asset tends to show drastic fall in price due to some events (credit events like failure to pay, restructuring and bankruptcy, etc.). In further simpler terms, CDS on a company that has filed for bankruptcy would trigger a credit event and entail payment as per CDS contract.  

Just by the above definition, it is crystal clear that a properly regulated and well structured CDS contract can create economic balance and financial discipline among the parties to the contract. However, it is not very hard to imagine the repercussions of a badly structured CDS contract. It can create economic havoc in banks and other financial institutions. In India, RBI has come out with regulations for CDS contracts for Indian banks and other financial institutions that allow CDS contracts to be pure hedging instruments. In other words, parties are not allowed to take “naked” positions in the CDS contracts or positions without having exposure to the underlying asset. Eg. A CDS on XYZ Ltd. 9% Bonds (maturity 10 years) can only be bought if one has bought the above mentioned bonds as then CDS would act as a hedge. Banks and few specified financial institutions would act as market makers in the above transaction. These regulations ensure the CDS market to act in its true spirit – insuring the credit risks but do not allow scope for widening the credit derivatives market.

These regulations are in stark contrast to the unregulated CDS market in the USA and Europe which exists even now. There, CDS can be used as a speculative as well as a hedging tool. Financial institutions can enter into sell or buy transactions in CDS regardless of any exposure to the underlying asset. When the market player enters into a CDS contract without having any exposure to the underlying asset, it is referred to as “naked” position. These “naked” positions which are speculative in nature are expected to account for 80 percent of the overall CDS market (which had outstanding contracts worth $62.2 trillion by 2007 end and falling to $26.3 trillion by mid-year 2010 but reportedly $25.5 trillion in early 2012). It is these positions that had created a financial bubble that ultimately burst in 2008. No doubt it was the default on subprime real estate loans (loans given to borrowers for buying houses who do not have credit worthiness) that was the base of the financial crises but CDS contracts on them actually sparked the massive economic fire. Some financial experts have described these “naked” positions being in the nature of buying fire insurance on your neighbour’s house. It creates a huge incentive to burn down the neighbour’s house as there is no insurable interest in that house. Similarly, a buyer of a CDS contract who does not hold any position in the reference entity would want the reference entity to “fail” or go bankrupt and thus, collect huge gains on the CDS contract.

Furthermore, the CDS market in the USA and Europe has few more interesting points. The reference entity is not a party to the overall contract of CDS (This is the same for Indian regulations also). The company’s bonds are traded on the stock exchange while CDS contracts that act as insurance against the exposure to the reference entity are traded over the counter between two contracting parties (having or not having exposure to the reference entity). However, an interesting point arises that the outstanding value of the bonds issued by the reference entity has no relation to the outstanding amount of CDS contracts traded against those bonds. Eg. The outstanding amount of bonds of a company may be $500 million. However, the outstanding contracts of CDS can be worth as much as or even greater than $5billion (10 times against value of those bonds).

There are arguments both in favour and against the overcapitalisation. Those against it would argue as to how can “protection” exceed the value of the “protected”. It is immoral and unethical and defies common sense. It promotes trading sans any substance to back them except for a contract paper. Wealth is generated in the most artificial fashion. Money flows and liabilities are assumed without any asset being purchased except bits of paper changing hands.

However, those favouring the overcapitalisation may argue that these contracts are totally independent to the reference entity and would be negotiated over the table (over the counter or OTC) between two parties – one who is willing to give protection and another party who is willing to buy that protection against any possible or hypothetical exposure to the reference entity. The fact that the outstanding CDS contracts are much more in value than the outstanding bonds stands pointless so long as there is a market and an appetite for a financial instrument (that is, there is a buyer and a seller for the contract). However, sometimes it so happens that the financial risks are so intertwined that these huge naked positions, rather than acting as any usual financial transaction have the power to create a financial “tsunami”. This is what happened when the investment bank Lehman Brothers’ got bankrupt in September 2008. Lehman Brothers’ had approximately $155 billion of outstanding debt but around $400 billion notional value of CDS contracts had been written that referenced this debt. Thus, not only lenders of Lehman Brothers’ were on tenterhooks after bankruptcy, but also those who had sold protection on such debt (that is, held a sell position on CDS contracts) were in deep financial trouble. Accordingly, even though marketability argument is fine, the collateral damage due to creation of these huge outstanding “naked” positions is a greater concern.

There are many more intricacies involved in CDS contracts and the even more complex CDOs (collateralised debt obligations) that caused the great financial trouble in 2008 and are still unregulated. No doubt, nobody wants regulation for regulation’s sake. Unregulated businesses in the private sector, throughout the world, have the potential to reach new heights, encourage innovation and lead to greater economic gain for the country and the world as a whole. However, sometimes regulations by the legislature are necessary if the businesses do not regulate themselves. CDS contracts need not be over regulated as is the case with India or unregulated as is the case with USA and Europe. The legislature should give enough room to widen the market but not let it attain monstrous proportions. In this way they would not be financial weapons of mass destruction but instead effective financial instruments to trade in and mitigate credit risk.