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1.1 What is life insurance? Life insurance is an agreement between you (the insured) and an insurer. Under the terms of a life insurance contract, the insurer promises to pay a certain sum to someone (a beneficiary) when you die, in exchange for your premium payments. 1.2 Why would you need life insurance? The most common reason for buying life insurance is to replace the income lost when you die. For example, say that you work, and that your income is used to support yourself and your family. When you die, and your paychecks stop, the life insurance proceeds can be used to continue to support the family members you've left behind. Another common use of life insurance proceeds is to pay off any debts you leave behind. For example, mortgages, car loans, medical bills, and credit card debts are often left unpaid when someone dies. These obligations must be paid from the assets left behind. This can deplete the resources that your family needs. Life insurance can be used to pay off these debts, leaving your other assets intact for your family to use. Life insurance provides liquidity to your estate. When you die, you may leave some liquid assets (such as cash, CDs, and savings bonds), and some illiquid assets (such as real estate, an automobile, and stocks). Your liquid assets may not be enough to pay all the debts that you leave behind, plus all the expenses that arise because of your death (such as funeral expenses and estate taxes). Your illiquid assets may
have to be sold in order to meet these obligations when they come due. This may cause a financial loss if the assets must be sold cheaply in order to get the money on time. Life insurance can avert this situation, because the proceeds are available almost immediately upon your death. Life insurance creates an estate for your heirs. After your debts and expenses are paid, there may not be much left over for your family. Life insurance can automatically provide assets for them after your death. Life insurance is a great way to give to charity when you die. You may have always had a great philanthropic desire, but not the means to make it a reality. Life insurance can do that for you. Life insurance can be a critical component for specialized business applications, such as funding a buy-sell agreement. Under a buy-sell agreement, life insurance can be used to provide cash for the purchase of a deceased owner's interest in the business. Finally, life insurance can be an investment vehicle. Some types of life insurance policies may actually make money for you, as well as provide the benefits described above. This can help you with long-term financial goals. 1.3 What do you need to know about life insurance? You need to know that there are several kinds of policies that may be available to you, if you are healthy enough. Term life insurance policies provide life insurance protection for a specific period of time or term. If you die during the coverage period, the beneficiary named in your policy receives the policy death benefit. If you don't die during the term, your beneficiary receives nothing. 3
Permanent insurance policies provide insurance protection for your entire life as long as the policy remains in force. In addition to the insurance protection provided, this type of policy also builds internal cash values, often described as a savings account within the policy. A life insurance contract is made up of provisions, options, and riders. Provisions describe or explain features, benefits, conditions, or requirements of the contract. Options are features of the agreement that require you to make a choice regarding some aspect of coverage. Riders are additional coverage (or endorsements) offered by the insurer at the time of application and added to the standard agreement in return for an additional premium. Finally, you need to know the tax consequences of owning life insurance.
Life insurance premium payments are not tax-deductible expenses.
In general, the death benefit paid to the beneficiary is not included in gross income for federal income tax purposes, because it is paid with after-tax dollars.
You must be very careful about who owns the policy and who the beneficiaries are, in order to avoid estate taxes on the proceeds when you die.
1.4 LIFE INSURANCE NEEDS AT VARIOUS LIFE STAGES Your need for life insurance changes as your life changes. When you're young, you typically have no need for life insurance, but this changes as you take on more responsibility, and as your family grows. Then, as your responsibilities once again begin to diminish, your need for life insurance drops off. Let's look at how your life insurance needs change throughout your lifetime. 1.4.1 School days Childhood is typically a time of no worries, no cares, and no responsibilities. A child depends on others to take care of them, not the other way around. Although it would be tragic, a child's death would likely have little financial impact on the child's family. Thus, there is generally no need for life insurance at this point in an individual's life. A child's death does create one short-term financial problem: funeral expenses. But buying a life insurance policy just for that purpose doesn't really make sense. Instead, think about saving the money you would spend on insurance premiums and open a savings account, or put the money in some type of investment vehicle. That way, the money can be used for college expenses or a first home, but it will also be available in case of a tragedy. Alternatively, a burial policy provides enough money for funeral expenses, at a much lower cost than a typical life insurance policy.
1.4.2 Footloose and fancy-free
As a young adult, you become more independent and self-sufficient. You no longer depend on others for your financial well being. But in most cases, your death would still not create a financial hardship for others. For most young singles, life insurance is still not a priority. Some would argue that you should buy life insurance now, while you're healthy and the rates are low. This may be a valid argument if you are at a high risk for developing a medical condition (such as diabetes) later in life. But you should also consider the earnings you could realize by investing the money now instead of spending it on insurance premiums. If you have a mortgage or other loans that are jointly held with a cosigner, your death would leave the cosigner responsible for the entire debt. You might consider purchasing enough life insurance to cover these debts in the event of your death. Funeral expenses are also a concern for young singles, but it is typically not advisable to purchase a life insurance policy just for this purpose. Instead, consider investing the money you would spend on life insurance premiums, or purchasing a small burial policy. Your life insurance needs increase significantly if you are supporting a parent or grandparent, or if you have a child before marriage. In this case, life insurance could provide continued support for your dependent(s) if you were to die.
1.4.3 Your growing family
When you have young children, your life insurance needs reach a climax. In most any situation, life insurance for both parents is appropriate. Single-income families are completely dependent on the income of the breadwinner. If he or she dies without life insurance, the consequences could be disastrous. The death of the stay-at-home spouse would necessitate costly daycare expenses. Both spouses should carry enough life insurance to cover the expenses that would result from their death. Dual-income families need life insurance, too. If one spouse dies, it is unlikely that the surviving spouse will be able to keep up with the household expenses and pay for childcare with the remaining income. 1.4.4 Moving up the ladder For many people, career advancement means starting a new job with a new company. At some point, you might even decide to be your own boss and start your own business. It might not be your top priority, but it is important to review your life insurance coverage any time you leave an employer. Keep in mind, you probably won't be able to keep any life insurance that was provided by your employer. If you're going to work for a new company, you might receive a comparable life insurance benefit. But if you're going into business for yourself, you'll need to purchase an individual life insurance policy. Make sure the amount of your coverage is up-to-date, as well. The policy you purchased right after you got married might not be adequate anymore, especially if you have kids, a mortgage, and college expenses to consider. Business owners may also have business debt 7
to consider. If you were not incorporated, your family would have to pay those bills if you die. 1.4.4 Single again Unfortunately, divorce has become a fact of life in our society. You'll have to make many financial decisions during this stressful time, including the decision of what to do about your life insurance. Divorce raises both beneficiary issues and coverage issues. And if you have children, these issues become even more complex. If you and your spouse have no children, it may be as simple as changing the beneficiary on your policy and adjusting your coverage to reflect your newly single status. However, if you have kids, you'll want to make sure that they are provided for in the event of your death. This may involve purchasing a new policy and naming them as beneficiaries. The custodial and non-custodial parent will need to work out the details of this complicated situation. If you can't come to terms, the court may make the decisions for you. 1.4.6 The golden years Once your children are grown, your life insurance needs decrease. You'll live off your retirement savings, and hopefully you have accumulated assets that can be passed on to your heirs when you die. Not only is life insurance expensive at this point, but it's probably unnecessary. One exception: if you will be leaving a large estate when you die, your heirs may be stuck paying a hefty estate tax bill. Consider obtaining cash value life insurance policy, because you don't actually know when you're going to die. Your heirs can then use the death benefit to pay
the IRS. If the policy is held by a trust, the proceeds won't be included in your estate
INDIAN INSURANCE INDUSTRY: A PERSPECTIVE
A. Life Insurance Life insurance in its existing form came in India from United Kingdom (UK) with the establishment of a British firm, Oriental Life Insurance Company in 1818 followed by Bombay Life Assurance Company in 1823, the Madras Equitable Life Insurance Society in 1829 and Oriental Life Assurance Company in 1874. Prior to 1871, Indian lives were treated as sub-standard and charged an extra premium of 15% to 20%. Bombay Mutual Life Assurance Society, an Indian insurer that came into existence in 1871, was the first to cover Indian lives at normal rates. The Indian Life
Assurance Companies Act, 1912 was the first statutory measure to regulate life insurance business. Later, in 1928 the Indian Insurance Companies Act was enacted, inter alia, to enable the government to collect statistical information about life and non-life insurance business transacted in India by Indian and foreign insurers, including the provident insurance societies. In 1938, with a view to protecting the interest of insuring public, earlier legislation was consolidated and amended by Insurance Act, 1938 with comprehensive provisions for detailed and effective control over the activities of insurers. In order to administer the aforesaid legislation, an insurance wing was established and attached first with the Ministry of Commerce and then Ministry of Finance. This ministry was
administratively responsible for policy matters pertaining to insurance. The actuarial and operational matters relating to the insurance industry were looked after by an attached office in Shimla, headed first by Actuary to the Government of India, then by Superintendent of Insurance and finally by the Controller of Insurance. The act was amended in 1950, making farreaching changes such as requirement of equity capital for companies, carrying on life insurance business, ceilings on shareholdings I such companies, stricter control on investment of life insurance companies, submission of periodical returns relating to investments and such other information to the Controller as he may call for, appointments of administrators for mismanaged companies, ceilings on expenses of management and agency commission, incorporation of the Insurance Association of India and formation of councils and committees thereof. By 1956, 154 Indian insurers, 16 non-Indian insurers and 75 provident societies were carrying on life insurance business in India. Life insurance
business was confirmed mainly to cities and better off segments of the society. On 19th January 1956 the management of life insurance business of 245 Indian and foreign insurers and provident societies, then operating in India, was taken over by the Central Government and then nationalized on 1st September 1956. LIC was formed in September 1956 by an Act of Parliament, viz. LIC Act, 1956, with capital contribution of Rs. 5 crore from the Government of India. The then Finance Minister, Shri S.D.Deshmukh, while piloting the bill for nationalization, outlined the objectives of LIC thus: to conduct the business with utmost economy, in a spirit of trusteeship; to charge premium no higher than warranted by strict actuarial considerations; to invest the funds for obtaining maximum yield for the policy holders consistent with safety of the capital; to render prompt and efficient service to policy-holders.
The recommendations of the Administrative Reforms Commission are as under: a.To spread life insurance much more widely and in particular to the rural areas and to the socially and economically backward classes b.To making mobilization of people’s savings by making insurance linked savings adequately attractive. c.To bear in mind, in the investment of funds, the primary obligation to its policyholders, whose money it holds in trust without losing sight of the interest of the community as a whole 11
d.To conduct business with utmost economy and with the full realisation that money belongs to the policy- holders. e.To act as trustees of the insured public in their individual and collective capacities. f.To meet various life insurance needs of the community that would arise in the changing social and economic environment. g.To promote amongst all agents and employees of the Corporation a sense of participation, pride and job satisfaction through discharge of their duties with dedication towards achievement of corporate objectives. B. General Insurance General Insurance developed in India with industrial revolution in the West and consequent growth of seafaring trade and commerce in the seventeenth century. It came to India from UK. The first general insurance company, Triton Insurance Company Ltd. was established in Calcutta in 1850 whose shares were mainly headed by Britishers. The first general insurance company established by an Indian was Indian Mercantile Insurance Company Ltd. in Bombay in 1907. In 1957,the General Insurance Council, a wing of the Insurance Association of India framed a code of conduct for ensuring fair conduct and sound business practices in the general insurance industry. An administrative set-up headed by the Controller of Insurance was set up at Delhi in 1957 with a branch office at Bombay, Calcutta, and Madras for administrating code of conduct. Further in order to retain the business of general insurance in India, the insurers started a reinsurance company, viz. India Reinsurance Corporation Ltd. In 1956 to which they voluntarily ceded 10% of their gross direct business. In 1961, by arrangement to 12
Insurance Act, this voluntary arrangement was formalised by notifying the Indian Guaranty and General Insurance Company Ltd., a government company, along with the Indian Reinsurance Corporation as ‘Indian Reinsures’. In 1968, the Insurance Act was amended to provide for extension of social control over insurers transacting general insurance. The amendments provided, inter alia for regulation of assets, setting up of the Tariff Advisory Committee (TAC) under the chairmanship of Controller of Insurance. Before the amendments of the act could be implemented, management of non-life insurers was taken over by the Central Government in 1971 as a prelude to nationalisation. General insurance business was nationalised with effect from 1.1.73. , by the General Insurance Business Act, 1972. Prior to 1973, general insurance was more cities oriented, catering to the needs of trade and industry. One hundred and seven insurers including branches of foreign companies operating here were amalgamated and grouped into four companies, viz. the National Insurance Company Ltd., the New India Assurance Company Ltd., the Oriental Insurance Company Ltd., and the United India Assurance Company Ltd. GIC was incorporated as a company in November, 1972 and it commenced business on January 1, 1973. Government of India and that of four companies subscribe the capital of GIC by GIC. All the five entities are Government companies, registered under the Companies Act. The purpose of establishment of GIC as a holding company of the four operating companies as stated in General Insurance Business Act is superintending, controlling, and carrying on the business of general insurance.
World Insurance Environment
In 1999 global premium income in the insurance industry, adjusted for inflation, recorded strong growth of 4.5%. Booming life insurance and an increase in non-life insurance business were the drivers of the growth. Life insurance benefited as a result of shift from public to private pension provision whereas non-insurance was adversely affected by low prices. Some Highlights of World Insurance: • 60% of all premiums are from life insurance. Worldwide premium volume amounted to USD 2324 billion, with life insurance accounted for 61% and non-life insurance accounted for 39%. Japan and Switzerland spent the most per capita on life and noninsurance respectively. • Boom in Life Insurance –apart from Asia Life Insurance Companies benefited in 1999 from low interest rates and the increasing significance of private pension provision .At 6.9%, growth was two percentage points higher than the average over the previous ten years and considerably than the global economic growth over the same period. • Waiting for the turnaround in non-life insurance sector Non-life growth of +1.2% in 1999 was below the long-term average, although it did improve slightly over the previous year. Since 1994 nonlife premium growth has been lower than overall GDP.
Growth in U.S.A. (+1.3%) remained significantly below economic growth. Japan registered a decline in premium for the third consecutive year (-3.0%). South East Asian countries, which had to contend with sharp falls in premiums last year as a result of the Asian crises, recovered to a certain extent.
Introduction to Funds Flow and Cash Flow
4.1 Meaning of Fund In a narrow sense, the fund is synonymous with cash. In this sense, the funds flow statement is simply a statement of cash receipts and payments. Such a statement is called cash flow statement; it portrays the inflow and outflow of cash during a period. The term “ Funds”, however, is broader than cash; it means working capital, i.e., the difference between current assets and current liabilities or the excess of current assets over current liabilities. 4.2 Meaning of Flow The term flow means change. Therefore, the term “Flow of Funds” refers to the movement of funds as a flow in and out of the working capital area. All the flow of funds pass through working capital. In other words any increase or decrease in working capital means, “ flow of Funds”. 4.3 Meaning of Funds Flow Statement The balance sheet at the end of the period is generally different from the balance sheet at the beginning of the year. The analysis method, which discloses these changes, clearly is called “Funds Flow Statement”. In short, funds flow statement is a statement, which is prepared to disclose the changes in financial assets of balance sheets of two periods. Thus the flow of funds could be studied with the help of funds flow statement. 4.4 Objectives of funds flow statement The basic objectives of funds flow statement is to indicate whether funds came from and where they are used between two balance sheet dates. Funds flow statements a useful tool in the financial manager’s analytical
kit. Financial managers, financial analysts and credit granting institutions use it. Funds Flow Statement is prepared to know the periodic increase or decrease of working capital of a business concern. It also enables the management to know with reasons the basic causes of the changes in net working capital. Funds Flow Statement highlights the sources and applications of funds and reveals changes in the financial structure of the firm between the two Balance sheet dates. 4.5 Funds flow statement throws some light materially on the financial aspects of the answers to the questions such as: 1) How much funds have been generated from recurring and nonrecurring activities? 2) How much funds have been raised from external sources? 3) Where did the profits go? 4) How was it possible to distribute dividends in excess of current earnings, or in the presence of net loss for the period? 5) Why are the net current assets up even though there was a net loss for the period? 6) How was the expansion of the plant and equipment financed? 7) How was the increase in working capital financed? Thus Funds Flow Statement is able to present that information which either is not available or not readily apparent from an analysis of other financial statements.
4.6 Distinction between Funds Flow Statement and Balance Sheet. 1) Funds Flow Statement is based in flow concept as it reveals reasons for changers in working capital that have taken place over a period of time, whereas Balance Sheet is based on stock concept as it shows assets and liabilities of the business firm at a point of time. 2) Funds Flow Statement is prepared to know the sources and applications of the working capital, whereas Balance Sheet is prepared to show the financial position of the concern at a point of time. 3) Balance Sheet is to be prepared in a prescribed form, whereas no such form is prescribed for presentation of Funds Flow Statement. 4) Preparation and presentation of the Funds Flow Statement at the annual general meeting is discretionary, whereas preparation of the Balance Sheet and its presentation at there annual general meeting is mandatory. 5) Funds Flow Statement is prepared with their help of the consecutive Balance Sheet, Profit & Loss account and other schedules, etc. 4.7 Meaning of Cash Flow Statement A Cash Flow Statement is not much very different from a ‘Funds Flow Statement’. In preparation of Funds Flow Statement, the sources and
uses of the funds raised are taken into account while in preparation of Cash Flow Statement, the sources and used of cash and cash equivalents alone are taken into account. Thus the focus is on movement of casual cash equivalents rather than on ‘net working capital’. The term ‘cash and cash equivalents’ here stands for cash and bank balances. Cash is part of working capital but working capital does not necessarily mean change in cash. Therefore, Cash Flow Statement is prepared to show the impact of
various transactions on the cash position of the firm. It takes into account the transactions resulting in cash inflows and cash outflows only. It provides the details in respect of cash generated and applied during the accounting period. Thus, a Cash Flow Statement may be defined as summary of receipts and disbursements (or payment), reconciling the opening cash (and bank) balance with the closing balances of the concerned period with information about the various items appearing in the Balance Sheet and the profit and loss account. Thus, a Cash Flow Statement explains reasons for the changes in the cash position of the firm. Transactions, which increase the cash position of the entity, are labeled as ‘ inflow’ of cash and those, which decrease the cash position as ‘ outflow’ of cash. Cash Flow Statement traces the various fixed assets, redemption f debentures and preference shares and other long-term debts for cash. In short, a Cash Flow Statement shows the cash receipts and disbursements during the period.
1. Funds Management
In narrow sense fund the word fund is synonymous with cash. However in broader sense funds means working capital. They are used in same sense so Funds management is same as working capital management current asset management. In any business working capital is one of the most important areas of management. Interaction forms current assets and current liabilities in such a way that a satisfactory level of working capital is maintained and this is the main theme of working capital management. The basic ingredients of theory of working capital management are 1. Optimum level of current assets. 2. The trade off between profitability and risk, which is associated with level of current assets and current liabilities. 3. Financing mix strategies. For our purpose first two are important since 3rd is largely determined by legal provisions. There is always conflict between profitability and liquidity (risk). If a form does not have adequate working capital, i.e. it does not invest sufficient funds in current assets it may become illegal and consequently may not have ability to its current obligations and thus risk of bankruptcy. If current assets are too large profitability is adversely affected. The key strategies and considerations in enduring a trade off between profitability and liquidity is one major dimension of working capital. In addition to this current assets should be efficiently managed so those neither inadequate nor unnecessary funds are locked up. The management of working capital has two basic ingredients: 22
1. An overview of working capital as a whole 2. Efficient management of the current such as cash, receivable and inventories. Moreover in developing countries like India, importance of basic infrastructure could not be underestimated. LIC are the backbone if funds mobilization institutions in the country. Any asset management mismatch could bring the whole financial system to a halt. In the past it has been found that mismanagement of funds is the major reason for liquidation of the company. The companies which turned insolvent due to the mismanagement of funds in the year 1999 Company State Total Assets Family Guaranty Life Insurance Co. Mississippi $28.9 million Farmers & Ranchers Life Insurance Co. Oklahoma $13.7 million First National Life Insurance Co. of America Mississippi $126.2 million Franklin American Life Insurance Co. Tennessee $76.1 million Franklin Protective Life Insurance Co. Mississippi 23
$30.1 million General American Life Insurance Co.1 Missouri $14.1 billion Integrity Life Insurance Co. Arizona $7.4 billion International Financial Services Life Insurance Co. Illinois $206.9 million Life Insurance Co. of Alaska Alaska Not available National Affiliated Investors Life Insurance Co. Louisiana $4.6 million Settlers Life Insurance Co.2 Virginia $205.9 million Universal Life Insurance Co. Tennessee
2. Objectives of Funds Management or Liquidity Management
Maintaining adequate funds for routine business activities like: settlement of claims, payment of commission to agents, general expenses for management of business.
• • • •
Maintain liquidity at operating units. Effective deployment and profit maximization. Ensure liquefying assets. Flexibility for re-mix and composition.
3. Liquidity Flow Cycle
• • • •
Premium minus Reinsurance Income from Investments Commission on Reinsurance ceded Other Income like Rent etc.
• • • • • • • • •
Settlement of Claims. Commission on Reinsurance Accepted. Expenses on Management. Payment of Ex-Gratia /Arrears for Salary. Staff Loans, Housing, and Vehicles etc. Payment for purchase of capital items. Other Miscellaneous Disbursements. Investments. Money Market Lending (Loans)
As clear from the above cycle, the sources of cash flow can be divided into three groupings. 1. New Money arising from the net savings of policy holders in life insurance companies; This portion is made up of the inflow from 26
premiums, investment income, consideration for annuities, and other types of income, less the outflow of funds for death claims and other benefits, commissions, expenses, taxes and other disbursements. In simplified terms new money is roughly equivalent to net savings of policyholders in life insurance. More technically, the new money portion of cash flow is made up of net investment income plus net income from insurance operations, less the net increase in policy loans. The later are investment assets but don’t represent investments under the control of financial officers. Hence a rise in policy loans means a decline in cash flow available for long-term investments in the capital markets. 2. Return flow from invested arising from amortization, maturities and other repayments of bonds and mortgages. They constitute an important source of funds available for new investments. In the case of mortgage loans, the bulk of this flow is rarely stable since it is derived from contractual amortization payments which are typically on a monthly basis for residential mortgage loans but often on an annual or semi annual basis for commercial, industrial and farm mortgages. The above listed forms of cash flow may be considered as the basic cash flow against which investment officers may design their future investment programs and issue forward investment commitments. These forms of cash flow are beyond the direct control of investment officers since they depend upon the decisions of policyholders to save through life insurance, or upon scheduled repayments of bonds and mortgages, or upon certain repayment options made available to the borrower.
3. The third major form of cash flow constitutes outright sales and advancement of cash position. The sale of Government securities may often involve taking if capital loses. A switch from Governments bonds into private bonds or mortgages, therefore, requires a significantly higher rate of return to recoup the loss incurred on sales below par. Decisions to liquidate these securities, however, are likely to additional factors such as the desire to broaden the diversification of bond portfolio or to move out of securities in which the borrower’s credit standing has deteriorated. For example, if it were considered desirable to purchase a new bond being offered on the market, the only source of available funds might be the liquidation present holdings, which are relatively less attractive for a variety of reasons. 4. Few companies prefer to hold their cash position to a minimum level and meet seasonal or temporary needs for cash through borrowing at commercial banks for short periods.
4. Basic Steps In Funds Management
4.1 Basic funds management steps can be summarized under following heads: 1. Receiving cheques for collections or cash payments. 2. Encashing the cheques as soon as possible by reducing the transaction time to the minimum or depositing the cash in the central pool account. 3. Estimating the liquidity requirements. 4. Investing the funds appropriately. 5. Prolonging the payments without forgiving the social objectives. 4.2On basis of above steps the basic strategies are: 1. Speedy collection of accounts receivable (covering first and second step). 2. Proper estimation and efficient investment management (covering third and fourth step). 3. Stretching Accounts payable (covering fifth step). 4.2.1 Strategy 1 and Strategy 3 the companies could either set up their own networks or could take the help of established bank networks of various commercial banks providing cash management services package. The broad Business situations, which arises in normal coarse of business of Insurance
Companies and their probable solutions could be as follows: Business Situation: one
Insurance Companies with many locations will have to keep separate bank account for each location and must separately reconcile each account. Managing accounts from numerous banks can be a hard task. Managing treasury activities across the city with many different bank accounts can be frustrating. Example: A co ‘X’ is selling products BC in north India covering Delhi, Lucknow, Meerut, Allahabad, Dehradun, Shimla and many other areas in Punjab and UP. It is selling the product FG in west and east if x has a separate band account for each of these 60 locations and may be with different banks all together the head will receive 60 or more statements in different banks all together the head office will receive 60 or more statements in different formats to reconcile. It is hard task. Managing treasury activities may be more frustrating when in spite of having money in one bank account Co borrows at a higher rate. Business Situation: two Insurance Companies have sales office, regional office at various locations. Managing separate bank accounts for each of these locations means locking funds with many different Banks. Example: suppose ‘A’ opens 60 or more accounts at all locations. Each account having a minimum balance of Rs 1000(on an average), the co will block Rs. 60000 or more of its funds with no returns. Moreover if these are current accounts then minimum balance requirement would be in the range of Rs. 5000 to Rs. 10000 each and with no interest. Business Situation: three 30
Insurance Companies with many locations or distribution / sales network or franchise network will have collection from these locations. Often companies are deprived of access to the funds of their own for profitable deployment. Whatever efforts are made to streamline the process of collection and to get the funds as early as possible with the given constraints there ate always problems due to improper information systems or strategic manpower which defeats the very purpose. Example: ’ A’ Collects cheques and drafts from 60 or more centers. Funds are kept at various Bank accounts across the country. The company does not have the access to its own funds for profitable deployment. If ‘A’ make bulk investments from Head Quarters then it could negotiate on the interest rates as against separate deposits. Business Situation: Four Insurance Companies have multi location distribution and sales. Collecting outstation instruments received in the course of business is an important banking service needed by a company. Proceeds of cheques sent for collection to the banks on any given day would normally be credited to the account as and when such instruments are realized. Companies will not normally know when the cheques tendered for collection will be realized and relative proceeds will be credited to its account. Sometimes such realizations take considerable time. At times although cheques are paid by the drawee bank at the destination & there is considerable delay in ultimate credit into the companies account.
Estimate the cash flow based on the outstation cheques tendered for collection is difficult. Example: ‘A’ has accounts in major cities but it sells the product in countryside areas also. It receives outstation cheques in the due course of business. The company normally does not know when it will get credit for outstation cheques. It could not plan its investment. Even it could not match its payoff schedules. Business Situation: Five Insurance Company wants to transfer salaries to its employees at various locations at it wants to give dividends to its agents and distributors. How will it do these transactions? Traditional method is to keep the funds engaged in until they reach the other end. However the companies loose a lot of interest. These cash management services also helps in stretching of accounts payable. All the cheques are issued from central pool account. The firm can play with the Float (cheque kiting) In between the time when they are issued and actually paid. At present the major providers of Cash MANAGEMENT SERVICES are: • Vysya Bank: with following services Cash concentration account Zero balance account Rapid collection service Vyswift collection service Telegraphic transfer service • Citibank: with following services 32
Citibanking online Citicheck anywhere • Bank Of Tokyo –Mitsubishi Camslink service And various other banks like ABN- AMRO Bank, Standard Chartered Grindlays Bank, Hong Kong Bank, Corporation Bank. 4.2.2 The second strategy i.e. Proper estimation and efficient investment management, has two parts. Proper estimation of funds requirement on daily, monthly, quarterly and yearly bases needs accurate Assets Liability Management. And efficient investment of funds requires answers to various questions mentioned in next section.
ASSET LIABILITY MANAGEMENT The liabilities of an insurance company do not pertain to the year in which the policy is purchased. It runs through out the life of the policy. Hence the chances of asset liability miss match in an insurance company are very high. Moreover the investments, which are made by the life insurance Company, are also made for a long term so if a contingency arises in the middle of a year care has to be taken to provide for such contingencies. Thus proper asset liability management in an insurance company is very important. The goal of asset-liability management (ALM) is to measure and manage the investment and liability risks of life insurance companies so that they can meet their solvency and profitability objectives. The purpose of this section is to look at factors affecting successful asset-liability management practices and suggests how to achieve companies’ objectives. 33
. A life insurance company offers a variety of product lines, which include life insurance, disability income, and annuities. Selling these products involves collecting premiums from customers on a one-time or periodic payment basis in return for future promises, also called liabilities, which provide protection or benefits in case of death, disability, or retirement. . A life insurance company’s success is greatly influenced by a variety of risk factors because of the nature of its business; therefore, it should emphasize implementing adequate risk management practices that identify, measure, and control risks.
Why Take Risks? Why do companies take risks? There are two basic reasons. First, because they can make money at it. Second, because they have no choice — it is just part of being in business. Let's look at the four different types of risk from this perspective.
C1 — Companies can earn extra investment return for taking on C1 risk. Higher risk means higher return. This is a risk that insurers are willing to take because they can make money at it, though some are more willing to take this risk than others.
C2 — Companies earn profit margins for taking on C2 risk. For example, the risk of dying too early is very high for an individual person, but adding one person to a large group of insured people doesn't add much risk to the insurer. Therefore, the insurer can charge a price, which is higher than the break-even cost to itself,
but lower than the benefit, is worth to the person. That's a win-win situation.
C3 — Some people believe that they can make money by predicting how interest rates will move and setting themselves up to profit when rates move in the direction predicted. Others think that interest rate movements are inherently unpredictable and don't try to speculate for profit on interest rate movements.
C4 — General management risk exists in every company in every industry. It's not a risk that you can make money at. Its just risk that you inevitably become exposed to in the process of doing business.
Risks Affecting Management Risk can be defined as the cause for change in an expected outcome. Risk is difficult to measure and should be well integrated with a company’s overall business and financial strategy. It is essential for management of life insurance companies to understand the risks on both sides of the balance sheet in order to mitigate the threat of insolvency. There are various kinds of actuarial and financial risks that life insurers identify in developing strategic asset-liability management (ALM) processes. Financial Risks Six general types of financial risks face the insurance industry. These include:
• • • • • •
Actuarial Systematic Credit Liquidity Operational, and Legal risks
As these risks vary with the type of services provided, management of life insurance companies work very hard to define the inherent financial risks that can alter their course of success. Actuarial risks arise from raising funds by means of issuing policies and other liabilities. The two risks that affect companies are (1) paying too much for the funds received and (2) receiving too little for the risks taken. Systematic risk, also called the market risk, deals with changes in value of assets and liabilities. These include interest rates and basis risk. Life 36
insurers measure and manage their vulnerability to interest rate movements. Companies with common stock holdings, large corporate bonds, and mortgages watch closely swings in the basis rate. Any movement in the rates affects the yields on those instruments. Life insurers invest in assets that vary in credit quality, liquidity, and maturity, which subject them to market value variations independent of fluctuating liability values. Credit risk takes considers that borrowers will not fulfill their obligations and is affected by borrowers’ financial condition and the value of their collateral. Life insurers need to be concerned with this type of risk, because investments in bonds form part of their asset portfolios Liquidity risk may present potential funding crises connected with unexpected events in the market. Because of the long-term nature of risk associated with this type of business, life insurers undertake long-term investments to fulfill their contractual obligations as they fall due. Unexpected situations such as disinter mediation can arise when policyholders make increased withdrawals and surrenders due to high interest rates offered in the market. Such actions taken by policyholders could force companies to sell off long-term assets at losses to pay for these unexpected events. Operational risk not only looks at management and employees but also at management information systems used for processing data and record keeping. Inefficiency in this area can produce costly outcomes for life insurance companies. Legal risk should be of great concern to the life insurance industry. New legal trends can be observed in litigation outcomes, especially in the U.S., and globalization adds new meaning to the legal environment. Other 37
reasons such as fraud, violation of regulations, and misinterpretation of contracts by policyholders add to the complexity of this kind of risk. This legal risk can result in catastrophic losses to life insurance companies. Actuarial Risk Actuaries have developed a system of classifying the different types of risks to which insurance companies are exposed which divides risk into four categories:
C1 — asset default risk, or credit risk. C1 risk is the risk that the company's investments go bad. Junk bonds in the 1980s and commercial real estate in the 1990s were sources of huge losses for many insurers and several U.S. insolvencies.
C2 — pricing risk, or insurance risk. C2 risk is the risk that mortality, morbidity, persistency or expense experience will be worse than the company charged for in its prices. This is the type of risk that people normally associate with insurance.
C3 — interest rate risk. C3 risk is the risk that the company will lose money because of an unfavourable change in interest rates. The example introduction in provides the a
sense for how this risk could occur.
management risk. C4 risk is the risk that
management will make an error or that systems will fail or any similar incident that causes the company to lose money. 38
Asset-Liability Management (Alm) Strategies Life insurers operate either as mutual or stock companies and their overall financial objectives generally involve a target return on capital and the ability to provide prompt payments to their customers arising out of contractual obligations. Thus, management’s role in a life insurance company is to be proactive in scanning the environment. As shown in this chart, this helps management to understand the trends that are happening so that they can incorporate that understanding in planning and design of asset-liability portfolios. After management has developed comprehensive and understandable asset-liability portfolios, it is necessary that these be communicated to all levels in an organization. To accomplish the objectives, it is also important that life insurance companies provide adequate technology and develop organizational structures to Assist management in performing its task. Organizational structures, however, vary with life insurers and no one structure will work equally well for all of them. Thus, in planning effective organizations "structure follows strategy" (LOMA, 41). This implies that organizational structure should be a result of asset-liability management’s objectives based on each insurer’s strategies and levels of risk tolerance to reduce ineffectiveness in realizing a company’s target. To achieve the determined objectives several suggestions are made which include appointing a high-level asset-liability committee and appropriating segmentation of investments and financial measurements. Strategy Second: Part Two Effects of investment on funds management
Since working capital management mainly deals with the management of trade off between risk and liquidity, the investment decisions plays an important role together with the fact that roughly 35% in 1999-2000 and 36% in 1998-1999 of the total income of LIC is earned from returns from investments. The investment manager should take the following important decisions: a) What type of securities to invest in Whether to invest in equities, debt, bonds, gilt, municipal bonds, and infrastructure bonds largely depends on legal framework and companies policies. In USA the law relating to investment is less stringent so the company are investing 10% of their funds in US govt. securities in 1960 as compared to more than 54.78% of total funds in case of LIC in the year 1999-2000. It shows in 1960 US insurance companies were so liberal that we are not even today.
A B C D E F G H I
54.78 0.2 4.4 0.46 1.24 6.98 0.97 18.43 3.12
Govt. of India, State Govt. and other securities Loans to state road transport corporations. Loans to state electricity Boards House property and land Loans for water supply & Sewerage Loans for housing development Other social Sector Investments Investments in corporate sector Loans to insure policies
Other investments Other assets
Assets of LIC
a b c d e f g h I j k
b) Which specific of the selected type to invest in The specific securities in the type depends upon past records, and return of these securities c) How much of our proportion of our fund to invest in each type of securities The percentage of funds to invest in each depends upon the risk return continuum and the expected % of return by the policyholders. d) What is the approximate level of funds needed on each day, week, and month, quarter, year? It depends upon the past trends of outstanding claims on account of maturity death and surrender and estimates about level of working capital
5. INVESTMENT POLICY OF LIFE INSURANCE COMPANIES.
5.1 Introduction It is axiomatic that as a life company grows over a period of time the level of premium income also grows, adding additional amounts to the life funds every year. Besides the receipts of investments from the previous year would provide additional source of finance for additional purposes. As the funds placed at the disposal of the life company are long term in nature there is a assumption that on an average claims against the addition to the policy reserves will not materialize for many years hence, i.e., usually upon the death of the insured or at the maturity of the endowment policy. As such, it is considered that investment of these reserves must be in longterm obligations, such as govt. securities, real estates and mortgages. Before life insurance contracts are entered into by life company, premium rates are fixed making the requisite assumption regarding the rate of interest at which earnings and policy holder reserves can be compounded over the period of a life contract. Such an assumption regarding the rate of interest allows the life company in placing its funds in those investment outlets, which yield a fixed rate of return, a fairly regular payment of interest over the life of the investment and assured repayment of a fixed sum of rupees at the end of the investment period. Investment sin longterm obligation satisfies these essential requirements. The advantages of investing in long-term securities are
1) Higher rate of return 2) Elimination of transaction cost involved in frequent switching of a portfolio. 3) Fairly stable rate of return Maximizing investment earnings is dependent not only on the gross yield on a particular of investments but also on the level of expenses connected with the investment outlet. 5.2 PORTFOLIO CHOICE OF LIFE COMPANIES. The theory of portfolio selection, which is relevant for financial institutions like a life insurance company, has to be somewhat different from that which is applicable to the individual investors. TRADITIONAL THINKING Traditional theories of portfolio selection under conditions of uncertainty postulated that the individual investors choose the assets to be included in the portfolio, taking into account the [probability distribution of returns attach to each security or asset. The investor is expected to opt for a portfolio, which maximizes the expected value of his utility function. MARKOWITZ’S HYPOTHESIS Harry Markowitz has rejected this traditional thinking on portfolio selection under conditions of uncertainty. According to him investors are assumed to choose among alternative portfolio of assets on the basis of two criteria. Expected yield or return and risk. Asset or portfolio risk is measured under this theory, by the variance of standard deviation of returns of the assets or the portfolio. Once the investor has the information on the values of the first two moments of the probability distribution of returns associated with each security or asset how will e in a position to isolate from among the 44
set of available portfolios that set of portfolios which represent an efficient combination of expected return and standard deviation of return when these efficient combinations are plotted hey will yield an what is called an “ opportunity locus”. There is however a number of practical difficulties in applying Markowitz portfolio theory for an empirical study into an investment behavior, particularly of financial institutions such as life insurance companies. There is question whether variance of standard deviation completely reflects what is called as default risk. Similarly the problems of marketability and maturity of the financial assets, which are largely ignored in the portfolio theory, are some of the attributes, which have a bearing on the portfolio risk. 5.3 Yield Risk It can be sub divided into two heads: capital value risk and income risk. Capital Value Risk arises when the liquidity position of the company becomes of bad as to necessitate a sale of security in the market before maturity date, which results in a capital loss. The income risk arises when there is possibility that the market rate of interest will change either during the period life insurance contract is in force or at the time of deployment of funds consequent on the maturity of securities. The first type of income risk is peculiar to life insurance contract as premium are received at different points in time while the rate of interest to be earned on those funds has to be stipulated at the time the insurance contact is entered into. 5.4 Precautionary motive and speculative motive For Precautionary motive life insurance companies maintain various kinds of funds. It is not possible for the investment managers for life companies to delay investment of funds at their disposal beyond a short period of 45
time, when there are significant excratios to these funds. Consequently the companies cannot normally postpone investment purposes out of current income, so they have weak speculative motive. 5.5 Income risk It is axiomatic that a life insurance company must earn at least the rate of return assumed in fixing the premium rates the question that need to be discussed here related to the risk that arises as a result of uncertainty about future variations in interest rates. This type of risk is particularly relevant, as substantial portion of funds required to meet obligations emanating from the existing life insurance contracts will only be received at future dates. The funds that will become available for investments in future arise mainly from two sources. First, premium payable in future on existing life insurance contracts. Second, realization of previously invested funds. The second source namely the turnover of the funds invested in the past is n important problem. Suggestion offered for tackling this problem is in the nature of matching and those, which are based on the basis on the consideration of the expected yield. According to Clark, the investment policy of Life Company must aim at maximizing the expected yield, with minimum deviation of such yield from the realized yield. Some other factors, which have an overbearing influence on funds management of life insurance companies, are as follows:
1. Effect of Guidelines as issued by Insurance Regulatory Authority, India. These guidelines govern the overall pattern of investments, reinvestments, premium repatriation, creation of funds etc. 2. Effect of premature withdrawal: Pre-maturities could be of two kinds: by death and by surrender. Life insurance companies calculate to a high degree death pre-maturities on the basis of mortality tables. It is surrender of policies that makes a problem. Proper consideration should be given to them.
Part-C Case StudyL.I.C.
1. LIFE INSURANCE CORPORATION OF INDIA (LIC)
The LIC has a network of 7 zones, 100 divisions and over 2,000 branches. LIC personnel exceed 700,000, with approximately 125,000 employees and over 550,000 agents. The Life Fund of the LIC, which was established in 1956 to conduct life insurance transactions, has grown to approximately USD 25 billion from a mere USD 94 million in its inaugural year. Over 100 million lives are covered. The annual premium income, which was USD 21 million in 1956, was estimated at USD 4.5 billion in 1997-98. Presently, business investments of the LIC total over USD 23 billion. 1.1 Growth Of The Life Insurance Corporation (LIC) Today the Life Insurance Corporation Of India has 2046 branches. It is made up of 100 divisions, which are divided, into 7 zones. There are 558,000 LIC agents in the country. The table below shows the expanding business over the years of the LIC. YEAR Total new Business Individual (Rs. in billion) Individual (Rs in billion) Group (Rs in billion) No. Of policies in force (million) Year Group business (million) Life fund (Rs in billion) 1957 1974-75 1979-80 3.37 17.73 72 13.4 52.62 14.7 118.52 192.43 .05 14.57 61.37 5.69 18.8 22.09 1957 1974-75 1789-80 n.a. 2.33 5.84 4.10 30.34 58.18 1996-97 569.9 775.59 344.62 64.61 77.75 1996-97 24.45 877.59
1.2 Investments: 49
The Investment pattern of LIC has undergone a change with it today parking a lot of funds in the infrastructure sector as compared to before. The following table indicates the above. Type of Investment (Rs. in billion) Central Govt. Securities State Govt. & Other Govt. Guaranteed Marketable Securities Electricity Housing Water Supply & Sewerage State Road Transport Corporations Loans to Industrial Estates Loans to Sugar Cooperative Development AuthorityNagaland Roadways Power Generation (Private Sector) Municipality Total - 0.61 - 1.21 - 0.16 -0 0 7.33 6.18 2.03 0.1 0.22 26.03 75.80 82.14 18.72 87.31 109.67 7.18 18.81 20.28 1.80 0.37 0.37 0.01 4.77 0.45 0.37 0.01 5.40 0.45 0.37 0.01 91.53 122.42 22.64 5.51 0.45 0.37 0.01 0.25 2.76 0.04 809.45 Investments Up to 1957 1967 1977 1987 1996 1997 1998 1.85 3.35 9.81 46.75 293.9 373.30 458.76 0.70 2.63 7.15 5 16.83 75.45 89.06 104.71
2.55 7.99 32.81 118.06 556.9 680.68 2
Note: Items (1 & 2) are shown at Book Value and Items (3 to 12) are Gross Investments.
1.3 Life Fund: The Life fund of LIC has crossed Rs. 1,200 billion at the end of fiscal 1999 as compared to Rs.1,05 8.3 billion recorded in the previous fiscal. Position as on 31st March (Rs. in billion) YEAR 1993 1994 1995 1996 1997 1998 1.4 Claims Settlement: Over 110 million lives have been covered by the LIC under the Individual, Group and Social Security schemes as on March 1998. Claims settlement as on 31.3.98 Number – 5.65 million Amount – Rs.66.77 billion LIC settles over nineteen thousand claims amounting to around Rs 230 million every working day. FUND 409.98 496.65 599.79 727.80 877.60 1,05 8.32
Claims settled in Rs. billion Year 1975-76 1984-85 1990-91 1994-95 1995-96 1996-97 Death 0.38 1.10 3.12 6.88 7.98 10.01 51 Maturity 1.28 5.29 14.38 33.88 37.34 46.90 Total 1.66 6.39 17.51 40. 45.32 56.91
1997-98 1.5 Highlights of 1998-99:
The first premium income, which is really the indicator of growth in the business of Life Insurance, has grown by 28% during 1998-99. The LIC has collected Rs.26.91 billion during the year, up from Rs.20.99 billion in 1997-98. About 14,843,680 new policies were added in 1998-99 to the existing 80 million policies. The total sum assured is pegged at Rs.753.16 billion during 1998-99 up from Rs.631.67 billion during 1997-98.This would give a new business premium of Rs.26.91 billion. The individual Pension business grew with the sale of 105,638 policies generating a first premium income of Rs. 1.11 billion posting growth rates of 63% and 131% respectively. Under the group Insurance scheme a total of 1.27 billion lives were covered generating a new business premium of Rs. 4.43 billion registering a growth of 195% and 295% respectively. The institutions total fund size has crossed Rs.1,200 billion during the year. The growth in policies, minimum sum assured and the premium incomes during the last five years has been highlighted below Growth In Percentage POLICIES 1994-95 1995-96 1996-97 1997-98 1998-99 1.4 1.3 11.3 8.5 11.5 SUM ASSURED 32.1 -6.2 9.5 12.1 18.4 FIRST PREMIUM INCOME 5.3 20.7 21.5 15.6 28.2
1.6 LIC and the Five-year Plans LIC has consistently supported the five-year plans of India 52
Contribution to 8th plan: Rs.561 billion Contribution to 9th plan till date: Rs. 404 billion Contribution upto31.3.98 in
• • • •
Housing: Rs.122.42 billion Electricity: Rs.94.29 billion Water supply and sewerage: Rs. 22.68 billion Road Transport: Rs. 5.51 billion
Assets of U.S. Life Insurance Companies Year Utility Local Bonds Bonds 1940 5,767 (18.7%) 1945 20,583 (45.9%) 1950 13,549 (21.0%) 1955 8,756 (9.5%) 1970 6,427 (5.4%) 2,392 (7.8%) 1,047 (2.3%) 1,547 (2.4%) 2,696 (3.0%) 4,576 (3.8%) 2,830 (9.2%) 2,948 (6.6%) 3,187 (5.0%) 3,912 (4.3%) 3,668 (3.1%) 4,273 (13.9%) 5,212 (11.6%) 10,587 (16.5%) 13,968 (15.5%) 16,719 (14.0%) Bonds U.S. Govt. Sec. State and Rail-Road Public
Some Trends • Less than half of the finance is raised from internal sources and more than half is raised externally. • The growing substitution of private debt for govt. debt. Govt. Bonds serve as residual sources and uses of funds, they are the primary standard in terms of which the investment qualities of alternate investments are judged. As a rule they turn to govt. securities, first, when there is a lack of high yielding private obligations processing sufficient safety features and, secondly when the structure of interest rates changes in a way that narrows the spread between the yield on govt. and that on private obligations. • They have dominating position in corporate bonds market.
1. Government securities constituted by far the most important asset
in the portfolio of the L.I.C. throughout the period, they are increasing but the importance of these securities in the portfolio registered a decline over the period (from 50% to 54% during 1957 to 1963 to 36% by the end of march 1975). 2. Loans to State Electricity Boards, statutory authorities, housing
loans and loans guaranteed by Central and State Govt. progressively because an important outlet for investment funds of the corporation. 3. Minimum operation in short terms market. Generally relying on longterm investments and thus losing opportunities for earning. 4. L.I.C. gross yield performance has increased over time. Year Prior to 1963-64 1969-70 1974.75 gross yield less than 5% 6% 6.93
But it is less impressive than the rise in yield earned by the leading British and U.S. life companies (their yield is approx. more than 7%).
There is a rise in the amount of policy loans advanced by the L.I.C. as well corporate investment in land and house property
On the whole it has been observed that frequent govt. intervention and handicap autonomy in taking investment decisions is affecting the performance of L.I.C. Increasingly it has been used as an instrument to bring back the stock markets in line. Whenever there is a sharp decline in stock markets it is asked to invest large amounts of funds in the stock markets. Lack of Professionalism is also possible for its poor performance. Under the Insurance Regulatory Development Act (IRDA) banks, private sectors bank, public limited company have been allowed to enter into insurance services whether its is life insurance of non-life insurance sector. In the year 2001 three private sector banks/public sector companies have applied to Reserve Bank of India/ IRDA to procure licenses for setting up the insurance business. Only one public sector bank that is State Bank of India has entered joint venture with Cardiff, PLC of France with 26% equity participation to set up Life Insurance Business which is supplied to its customer under the umbrella of Banc Assurance means to provide Insurance services to the P segment customers. Mr. R. Krishna Murthy as CEO of SBI Life Insurance Subsidiary has started functioning from its corporate center at Mumbai.
With the opening of insurance sector to private players, large-scale reforms are needed in its functioning. There should be change in the mindset of the govt. that L.I.C. is the largest funds mobilizer in the country should its financial performance along with satisfying the social considerations. The broad changes necessary in its functioning could be • Political intervention should be reduced and greater autonomy should be given to L.I.C. in its operations. It will also help in taking quick decisions in fast changing economic scenario. • It should be much more professional in its approach. Initiatives should be taken to launch alternative competitive policies. • Greater transparency should be brought in functioning. Its investment portfolio should be declared open. • Yield risk may be sub-divided under two heads: (a) capital value risk: and (b) income risk. L.I.C. during the 70`s and 80`s did not care about its capital value risk. It cares only for income risk. It used to neglect it because of high degree of accuracy with which actuaries can forecast mortality rates. However, the situations will not remain same in the open and competitive market. They have to make suitable policies for it. The need for its consideration will increase due to two reasons: (a) The privilege that is granted to policy holders to receive surrender values of their policies by premature termination (b) The right to secure loans from life companies up to a ceiling of the surrender values. 57
With the permission to invest greater percentage in stock markets and highly volatile markets, it should not generally postpone buying decisions expecting higher rates of return nor do they “ over commit themselves in anticipation of declined of returns.
L.I.C. should be careful while taking investment decisions. Here are a six of the most important decisions it must take before making investments 1. Goals and objectives of the investment function What is more important to your company? Yield, total returns, some combination? If a combination, how is the importance of yield and total return weighted in importance for your company? Are taxes important? To what extent will review after tax total return be important to your company? Finally, what are the overall financial objectives of your company? Maximizing short-term earnings? Maximizing long-term economic value? Maximizing shareholder value? Maximizing return on equity? All of these questions must be answered to determine the overall direction in which the investments should be made. 2. Investment policy Does the current investment policy accurately reflect the purpose and goals of the investment function you have just outlined? The policy should not start with the basis of what other companies are doing? That is one of the many problems to which all human decision-making is subject. It is called farming, and it means we automatically use to comfortable frame of references within which to make decisions. Setting forth even a draft of an investment policy requires a complex set of decisions. Of course, that does not mean that your company’s investment policy will not look like
many other insurer policies. After all, similar investors with similar goals and constraints will tend to have similar policies. However, it does mean that the investment manager will have considered asset classes and policy issues that, perhaps, he might have not fully considered in the past. And the result may indeed be investment results. 3. Liability characteristics What does the manager know about the company’s liabilities, and what more does he needs to know to fashion an appropriate investment policy? Your company has funds to invest to satisfy two major constituencies: policyholders and stockholders. For stock companies, that means
understanding the impact of your company’s capital structure on the investment portfolio. For stock or mutual companies, that means
understanding more than just what duration of liabilities are, but it means understanding how the liabilities will react in different economic, market and underwriting environments. Duration might be the most overly relied upon and ill-used financial. A duration of 5 years on liabilities means assets must have the same duration, more or less. For any single duration numbers there are literally countless combinations of cash flows that will produce the same number. Thus duration is only part of the story – amount, timing and variability of the amount and timing to cash flows for both assets and liabilities must be considered. 4. Asset allocation A company’s asset allocation decision will decide 80-90% of the returns on the portfolio. However, many times there is insufficient attention given to this most important decision. So we should ask what standards the investment manger would use to judge the usefulness of asset allocation 59
and other modeling done for us? Let’s face it there really isn’t all that much difference in core fixed income manager performance – certainly nowhere near the amount of variability found in the world of equities. Thus, in an effort to differentiate what is largely similar core fixed income performance, investment managers have resorted to a variation on the old bromide. “Baffile them with b.s.” This has meant a proliferation of various asset allocation models, some well, some bad, many ugly. In every case, these models are really more to protect the manager legally (due diligence has been done), and put the company’s senior management at ease (we used a really more to protect the manager legally (due diligence has been done), and put the company’s senior management at ease (we used a really advanced process, right?), than to really add significant value to the investment process. Hence, a few words of caution: First, all of these models invariably assume that we human beings are rational and always act that way. Thus, any significant deviations are accounted for within bounds of confidence inside the models. We trust these models implicitly, despite the fact that none of us really know any 100% rational humans. And it is those times of
irrationality that can truly wreak havoc with our company’s financial statements. Second, all of these models must be questioned on three basic levels – assumptions, model structure (how the thing works), and output (what all that stuff means). In other words, look inside the black. If it is difficult to understand it may be just as difficult to support the next time on the ‘unusual’ events occur and you have to explain why your company did what it did to the board of directors, rating agencies or regulators. The examples of not being able to successfully do this before following the models’ recommendations are
myriad, but we’ll name there recent ones: General American, ARM Financial and Long Term Capital Management. Go ahead and add a few names of your own to the list. Of Course, for many companies, simply following what other insurers are doing seems to be the answer to the asset allocation question. This is an answer that should, in itself, be questioned, for the reasons noted in number 2 above. It will be inevitable spell investment under performance – a recipe for problems in an increasingly competitive market. 5. Investment benchmarks What types of benchmarks will we use to judge investment performance? Notice this does not require the fund manager to choose a benchmark yet. It does require that you decide what type of benchmarks he wants. What will be the purpose of the benchmark? When will it be used to warm or fire the manger? If the purpose of benchmark is simply to see how the
manager did against a generic universe of similar securities of similar securities, one of the generic benchmarks (e.g. S&P 500, Lehman Aggregate) will do. However, if the purpose is to see how the manager did in meeting your company’s goals and objectives, then the company will need to use a more customized benchmark. A world of caution here: In their continuing effort to keep the business, the manager will spend a lot of time fashioning a benchmark that should be relatively easy to beat. If the company would like to maintain relationship with the investment manager no matter his performance, this is an excellent solution. However, if superior performance is a goal, setting the bar as high as possible should be your company’s goal.
6. Manager monitoring Under what circumstances will you consider replacing your manager? This is important, even when hiring a brand new manager. The company must ask itself the question that “value” investors ask every day. Based upon what investment has been done for so far, would the company continue to own it. Annually, the company should carefully review if the existing manager is meeting the needs of the company. If not, what should be done to get them there and how? If this does not appear immediately feasible, you have begun making the case for a manager search. Here are the six key investment decisions, which should be made by a company before investing. Not easy decisions by any means, but
important decisions that will set the tone for a successful, high performance investment operation.
Model 1 In the following model, I tried to reshuffle the portfolio of the LIC, taking into account the average of the opening and closing balances and tried to suggest better allocation of funds available with the LIC. In the first two tables, returns on the investments of the year 1998 and 1999 have been calculated. As either opening or closing balance cannot give the actual picture of the funds invested over the year so that average of the opening and closing balances has been taken in to consideration for the calculation of the return. In table 3, total investment funds inclusive of percentage investment in the each category for the year 2000 has been shown. And return has been calculated on that. In next table, reshuffled portfolio has been shown and return on the new portfolio has been calculated. All though the minimum limit for investing in Government Securities is 50% but to play safe we have invested 53% of the total funds in the government Securities. This is also done because the proportion of investments has to be 50% minimum on any given date so by investing 53% we provide a margin of 3%. All though the returns in the non approved security are high but still we have invested 28.5% of the funds and not the entire 30%, this is done because such securities carry along with them a high risk factor also. So we have invested 28.5% only. Here, we can see that after the reshuffling of the portfolio, percentage return has just increased to 11.33% from 11.24%, but in the actual monetary terms it results in increment of Rs. 132.68 crores.
Exposure/ Prudential Norms Without prejudice to anything contained in Sections 27A and 27B of the Act, every insurer shall limit his investments based on the following exposure norms: A) Exposure Norms Type of Investment Limit for Investee Company Limit for the entire group to which the investee company belongs (i) As on any date Not exceeding 15% of the total capital employed* of the group companies. (ii) During the year Not exceeding 10% of estimated annual accretion of funds. Limit for the industry sector to which the investee company belongs Not exceeding 15% of the total capital employed* in all such companies.
(a) Equity/ Preference Shares/ Convertible portion of Debentures at face value. (b) Debentures - (face value) including private placed NCD and Non-convertible portion of Convertible Debentures. (c) Short/ Medium/ Long Term Loans and any other direct financial assistance.
(i) As on any date Not exceeding 20% of the total capital employed*.
(ii) During the year Not exceeding 5% of estimated annual accretion of funds.
* Total capital employed means total of equity shares, preference shares, debentures, long/ medium/ short term loans (excluding public deposits), free reserves but excluding revaluation reserves, of the investee company as shown in its last audited balance sheet.
Exposure Norms for Investment in Public Financial Institutions
Equity Share and Preference Shares (at their face value). Not exceeding 15% in general of the paid up equity/ preference capital of the institution or the existing holding % level, if higher. Investment in Equity Capital, Bonds, Debentures, Term Loans. Not exceeding 10% of the capital employed by an institution as per the last audited Balance Sheet. Total Investment vis-à-vis Net Worth of the Company. Total Investment in a Financial Year. Total Investments in all the Financial Institutions. Not exceeding 60% of Net Worth of the institution. 7.5% of annual accretions. Annual aggregate financial assistance to all Development Financial Institutions put together in a single year shall not exceed 20% of the estimated annual accretions for the year.
The prudential norms for various instruments shall be as under: i) Debentures:
Norms for Fully Convertible Debentures and Partly Convertible Debentures: Investment decisions are related to attractiveness of equity shares to be received as a result of conversion. Due consideration is also given to the factors, viz
a) Rate of interest at the time of subscription to said debentures, b) Appreciation and c) Dividend income likely to be received from the equity shares. Similar considerations also apply for Non-Convertible (NC) Debentures with detachable warrants attached to it. Norms for Non-Convertible Debentures and Non-Convertible Debentures with warrants attached: 1. a) Eligibility Amount Working Capital Debentures 20% of the current assets, loans and advance minus outstanding amount of existing working capital NC Debentures. b) c) Project Finance Normal Capital Expenditure As appraised by the Investment Committee As assessed by the Investment Committee
Asset Cover (as specified in Schedule III): First pari passu charge on fixed assets of the company offered as security with a minimum of 1.25 times including proposed borrowings (excluding revaluation of assets). Debt Equity Ratio (as specified in Schedule III): Not to exceed 2:1 including the proposed NC Debenture issue. However, in case of capital-intensive project debentures, higher ratio up to 4:1 may be considered. Interest Cover (as specified in Schedule III): Not less than 2 times for the latest year or on the basis of the average of the immediately preceding three years after including the interest on the proposed debentures at the applicable rate. Dividend Payout: Minimum dividend of 10% in each of the two years out of the immediately preceding three years including the latest year. Term Deposits and Loans with Non Banking Companies: The insurers need to place the deposits with a view to cater to working capital needs of the corporate sector. The placement of the deposit is to be decided after evaluating financial and non-financial aspects of the performance parameters of the companies. The analysis need to include study of financial position, track record and other features such as quality of management, future prospects and market potential for the company's products. Credit rating of borrower should be uniformly maintained at a position which is indicative of a very strong financial position being not less than AA of Standard and Poor or equivalent rating of any other reputed and independent rating agency. 67
The maximum amount of Short Term Deposit that may be placed with any company is restricted to Rs 2 crores or 10% of net worth whichever is less. The various norms/ parameters for the placement of term loans are as under: Particulars Unsecured borrowing as a % of net worth. Interest Cover. Debt/ Equity Ratio. Current Ratio. Dividend Record. Listing Limits Not to exceed 25% of net worth including the proposed loan, subject to net worth of the borrowing company being not less than Rs. 15 crores. At least 2.5 times including interest on proposed loans. Not to exceed 2:1. Not less than 1.33:1. At least 10% for the last 5 years or 15% and above for 3 out of 5 years. Equity shares of the Company shall be listed on any recognised stock exchange and the price should continuously been quoting above par at least for 12 months prior to the date of sanction of loan. Collateral Security Cheques shall be obtained for principal and interest amount. Personal guarantee of promoters and pledge of shares may be taken.
iii) Infrastructure and Social Sector: In the case of projects/ works in the infrastructure and social sector undertaken by a person other than a company, the norms indicated in the table above shall have to be met to the extent applicable. 68
Guidelines on subscription to Preference Shares: a) Companies whose preference shares are selected for investment should have sound financial position and steady income earning capacity. b) The dividend payable on the preference shares should be cumulative. c) The preference shares shall be redeemable. d) Preference capital after proposed issue shall not exceed 100% of equity capital. e) Dividend should have been paid on equity shares for two years out of immediately preceding three years. f) Preference dividend should have been paid for 3 years or 3 out of 4 or 5 years including latest 2 years if the preference shares are issued earlier. g) Non-dividend paying preference shares should not be considered for investment. h) Dividend cover on the basis of average profit of last 3 to5 years should be 3 times.
Returns to be submitted by the Insurer: Every insurer shall submit to the Authority the following returns within such time, at such intervals and verified / certified in such manner as indicated there against. These returns shall be in addition to those prescribed in Insurance Rules, 1939.
S.No Form No as Short description annexed these regulations 1 Form 1 Statement investment income investment to
Time limit for Verified/ Certified by
of Yearly and on
Within 30 days Principal from the date Chief of approval audited accounts.
Board (Investment) of
Statement of down Quarterl graded investments. y
Within 21 days Principal of the end of Chief each quarter.
Form 3 A
Statement Investment Controlled
of Quarterl of y Fund
Within 21 days Principal of the end of Chief each quarter.
(Life) – Compliance Report 4 Form 3 B Statement of Quarterl Within 21 days Principal of the end of Chief each quarter. (Investment) Officer/
Investment of Total y Assets (General) – Compliance Report 5 Form 4 Prudential Investment Norms – Compliance Report Yearly
Within 30 days Principal from the date Chief of approval audited accounts.
Board (Investment) of
The Authority may, by any general or special order, modify or relax any requirement relating to the above. Power to call for additional information The Authority may, by general or special order, require from the insurers such other information in such manner, intervals and time limit as may be specified therein. Duty to Report extraordinary events affecting the investment portfolio Every insurer shall report to the Authority forthwith, the effect or the probable effect of any event coming to his knowledge, which could have an adverse impact on the investment portfolio held by him.
Constitution of Investment Committee Every insurer shall constitute an Investment Committee which shall consist of a minimum of two non-executive directors of the Insurer, the Principal Officer, Chiefs of Finance and Investment divisions, and wherever appointed actuary is present, the Appointed Actuary. The decisions taken by the Investment Committee shall be properly recorded and be open to inspection by the officers of the Authority. Miscellaneous (1) Valuation of Assets and Accounting of Investments shall be as per the Insurance Regulatory and Development Authority (Preparation of Financial Statements and Auditor’s Report of Insurance Companies) Regulations, 2000. (2) The Authority may, by any general or special order, modify or relax requirement relating to regulation 5. 71
SCHEDULE I (See Regulation 3) LIST OF APPROVED INVESTMENTS FOR LIFE BUSINESS ‘Approved Investments’ for the purposes of Section 27A of the Act shall be as follows: a. All approved investments specified in Section 27A of the Act except i) Clause (b) of sub-section (1) of section 27A of the Act; ii) First mortgages on immovable property situated in other country as stated in clause (m) of subsection (1) of section 27A of the Act iii) Immovable property situated in other country as stated in clause (n) of subsection (1) of section 27A of the Act In addition the Authority under powers given vide clause (s) of sub-section (1) section 27A of the Act declares the following investments as approved investments: b. All secured loans, deposits, debentures, bonds, other debt instruments, shares and preference shares rated as ‘very strong’ or more by a reputed and independent rating agency (e.g. AA of Standard and Poor); c. Deposits with banks (e.g. in current account, call deposits, notice deposits, term deposits, certificates of deposits, etc) and with Primary Dealers recognised by RBI included for the time being in the Second Schedule to the Reserve Bank of India Act, 1934 (2 of 1934); d. Commercial papers issued by a company having a ‘very strong’ or more rating by a reputed and independent rating agency (e.g. AA of Standard and Poor);
organisations, which have a proven track record and have been, rated ‘very strong’ or more by a reputed and independent rating agency (e.g. AA of Standard and Poor). Explanation: For this purpose any investment in the shares or debentures or short or medium or long-term loans or deposits with private limited companies shall not be treated as ‘approved investments’.
TOPICS PART-A Introduction Indian Insurance Industry: A Perspective World Insurance Environment in 1999 Introduction to Funds Flow and Cash Flow PART-B Funds Management Objectives of funds Management or Liquidity Management Liquidity Flow Cycle Basic Steps in Funds Management Investment policy of Life Insurance companies PART-C Life Insurance Corporation of India Conclusion Recommendations Annexure PAGE NO 2 10 15 17 22 25 26 29 43 48 57 59 66
REPORT OF THE PROJECT
FUNDS MANAGEMENT OF INSURANCE COMPANY
ANURAG BHATNAGAR MAX NEW YORK LIFE INSURANCE CO. LTD. NEW DELHI.
MANISH GAUTAM ENROLMENT NUMBER # 980135177 REGIONAL CENTRE # New Delhi PROJECT PROPOSAL NUMBER # 100000
SCHOOL OF MANAGEMENT STUDIES INDIRA GANDHI NATIONAL OPEN UNIVERSITY MAIDAN GARHI NEW DELHI.
THIS IS TO CERTIFY THAT THE PROJECT TITLED
FUNDS MANAGEMENT OF INSURANCE COMPANY
MANISH GAUTAM ENROLMENT NUMBER # 981035177 STUDY CENTRE # REGIONAL CENTRE # New Delhi PROJECT PROPOSAL NUMBER # HAS BEEN COMPLETED UNDER MY GUIDANCE AT NEW DELHI AND I AM SATISFIED WITH THE WORK CARRIED OUT BY HIM. THE WORK IS AN ORIGINAL ONE AND HAS NOT BEEN SUBMITTED EARLIER TO ANY OTHER INSTITUTION FOR FULLFILMENT OF THE REQUIREMENT OF A COURSE OF STUDY.
ANURAG BHATNAGAR MAX NEW YORK LIFE INSURANCE CO. LTD. NEW DELHI
THE COMPILATION AND PRESENTATION OF THIS OPUSCULE HAS BESTOWED ME WITH AN OPPURTUNITY TO SHOW MY GRATITUDE TO THOSE SUBSERVENT TO IT. I AM HIGHLY INDEBTED TO MY GUIDE MR. ANURAG BHATNAGAR WHO HAS BEEN THE HALLMARK OF THIS EFFORT. HIS GUIDELINES MADE ME COMPHREHEND THE ENIGMATICAL PORTION OF THE SUBJECT AND WERE THE SOLE ANIMATING FORCE THAT COERCED ME TO MELIORATE MY EFFORTS WITHOUT THE SUPPORT AND GUIDANCE THE PROJECT REPORT WOULD NOT HAVE TAKEN SHAPE. SPECIAL THANKS ARE FORWARDED TO STAFF MEMBERS OF LIFE INSURANCE CORPORATION OF INDIA & MAX NEW YORK LIFE FOR
PROVIDING ME WITH THE INFORMATION AND FACILITIES AT THEIR PREMISES FOR THE PROJECT WORK. MANISH GAUTAM