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Aparna Viswanathan. International Financial Law Review. London: Mar 2000. Vol. 19, Iss. 3; pg. 28
In one historic sweep India has privatized its insurance market by allowing private companies to undertake general and life insurance. On December 2, 1999, India's parliament passed the Insurance Regulatory and Development Authority (IRDA) Bill 1999, ending a decade long dispute with the US over opening the Indian insurance market to competition. The new private players in the Indian insurance market are Indian insurance companies which obtain a certificate of registration from the IRDA. An Indian insurance company is a company incorporated under Indian law in which the aggregate holding of equity shares by a foreign company does not exceed 26% of the paid up equity capital.
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[Headnote] After 10 years of wrangling, the Indian government has privatized its insurance industry. Aparna Viswanathan of Viswanathan & Co asks whether the legislative reforms have created an adequate regulatory framework
In one historic sweep India has privatized its insurance market by allowing private companies to undertake general and life insurance business. On December 2 1999 India's parliament passed the Insurance Regulatory and Development Authority (IRDA) Bill 1999, ending a decade long dispute with the US over opening the Indian insurance market to competition. The IRDA Act amended the Life Insurance Corporation Act 1956 so as to divest the Life Insurance Corporation of India (LIC) of the exclusive privilege of carrying on life insurance business in India, and amended the General Insurance Business (Nationalization) Act 1972 to divest the General Insurance Corporation of India (GIC) of the exclusive privilege of carrying on the general insurance business in India. The LIC and GIC along with the state-owned Oriental Insurance Company and New India Assurance Company will remain the market incumbents who will compete against the new private entrants. The new private usurers The new private players in the Indian insurance market are Indian insurance companies which obtain a certificate of registration from the Insurance Regulatory and Development Authority (IRDA). An "Indian insurance company" is a company incorporated under Indian law, whose sole purpose is to carry on life insurance, general insurance or re-insurance business, and in which the aggregate holding of equity shares by a foreign company either by itself or through its subsidiary companies or its nominees does not exceed 26% ofthe paid up equity capital. "Foreign company", in turn, means a company which is not incorporated in India or a corporation, association, institution or other body which does not have its principal office in India. A promoter may not, at any time, hold more than 26% of the paid up equity capital in an Indian insurance company. Ifthe promoter owns more than 26% of the paid up equity capital at the time of commencement of business, the excess must be divested 10 years from the commencement date. This divestment requirement does not, however, apply to promoters which are a foreign company.
The question left open is whether the 74/ remaining equity in an Indian insurance company may be held by a company incorporated in India in which foreign companies have an equity stake. Indirect holdings of equity by foreign companies have been expressly allowed in the telecom sector and the issue of whether tiered holding company structures can be created in the insurance context has not been addressed by the IRDA Act. By creating tiered holding company structures in which a foreign company owns shares in the Indian company which, in turn, owns 74% of the Indian insurance company, foreign investors could increase their effective control over the insurer. Capital requirements and share transfers The new insurers must have a minimum paid up equity of Rsl billion ($22.7 million) for life or general insurance and a minimum paid up equity ofRs2 billion for reinsurance business. The prior approval ofthe new statutory regulator, the IRDA, must be obtained for the transfer of shares where the nominal value of the shares intended to be transferred by any individual, firm, group, constituents of a group or body corporate under the same management, jointly or severally exceeds 1% ofthe paid up equity capital of the insurer. The definition of "group" and "same management" have been taken from the Monopolies and Restrictive Trade Practices Act, 1969 (MRTP Act). "Group" means a group of two or more individuals, association of individuals, firms, trusts, trustees or bodies corporate (excluding financial institutions) or any combination thereof which exercises or is in a position to exercise control, directly or indirectly, over any body corporate, firm or trust. "Group" also means a group of associated persons, among other things, a director of a company and his relative, or a partner of a firm and a relative of such partner or two trustees of a trust. Two bodies corporate are deemed to be "under the same management" if, for example, they share the same managing director or manager or one owns one-fourth of the shares or controls composition of one-fourth of the board of directors of the other. Various other examples of operating under the same management are provided by the MRTP Act. In short, in order to obtain a licence as an insurer, a company must be incorporated under Indian law, have a minimum paid up capital ofRs1 billion (or Rs2 billion for reinsurance) and may have foreign equity participation up to 26%. The IRDA Act imposes a series of operating restrictions on the insurers in terms of deposit requirements, solvency margins, separation of policyholders and shareholders funds, profit entitlement, expense regulations and taxation. As discussed below, several of these restrictions depart from international practice and raise questions regarding the viability of the regulatory framework. Every insurer must deposit with the Reserve Bank of India (RBI) cash or approved securities as follows: * life insurance - a sum equivalent to 1% of his total gross premium written in India in any financial year commencing after March 31 2000 not exceeding Rs100 million. * general insurance - a sum equivalent to 3% of his total gross premium written in India in any financial year commencing after March 31 2000 not exceeding Rs100 million. * reinsurance business - Rs200 million. The Act also requires insurers to maintain a prescribed solvency margin defined as the excess ofthe value of assets over the amount of liabilities. The minimum solvency margin for life insurance is the higher ofthe aforesaid Rs500 million (RsIs billion for reinsurance) or a sum not exceeding 5% of the mathematical reserves for direct business and reinsurance acceptances without any deduction for reinsurance cessions or a sum not exceeding 1% of the sum at risk for the policies on which the sum at risk is not a negative figure. In the case of general insurance, the solvency margin is the highest of Rs500 million (Rsl billion for reinsurance) or a sum equivalent to 20% of net premium income or a sum equivalent to 30% of net incurred claims subject to credit for reinsurance in computing net premiums
and net incurred claims. The minimum solvency margin of 50% has been viewed as high by international insurers particularly in view of the profit distribution rules and taxation rules as discussed below. Investments There are two main methods of regulating investments by insurers. In some countries, including India, the law prescribes allocation of assets. In other jurisdictions, no asset allocations are prescribed, instead, the prescribed minimum solvency may be met only by "eligible assets". The Report ofthe Expert Group on Technical Issues related to Life and Non-Life Insurance Companies issued by the Confederation of Indian Industry (CII) in September 1999 (CII Report") has suggested that Indian law shift from prescribing asset allocation and investment limitations to the concept of eligible assets which would back the prescribed minimum solvency margins discussed above. However, the IRDA Act fails to make this regulatory transition and continues to prescribe allocation of assets. The IRDA Act provides that no insurer may directly or indirectly invest the funds of policyholders outside India. The IRDA may specify the time, manner and other conditions of investment of assets to be held by an insurer. However, the Insurance Act, 1938 already specifies an elaborate list of "approved investments" and "approved securities" which has not been amended by the IRDA Act. Therefore, in the absence of further legislative amendments, any regulations promulgated by the IRDA must be within the parameters of the existing regulations governing asset allocation. The IRDA Act also provides that every insurer must undertake such percentages of life insurance, general insurance in the rural or social sector as may be specified by the IRDA. The Insurance Act, 1938 requires insurers to establish a fund for the business oflife insurance called the life insurance fund. The Valuation Balance Sheet (Form 1 to the Insurance Act, 1938), states that ifthe proportion of surplus allocated to the shareholders is not uniform in respect ofall classes ofinsurance, the surplus must be shown separately for the classes to which the different proportions relate. This note indicates that separate funds should be maintained for different classes oflife insurance business although the 1938 Act does not expressly so provide. Importantly, the IRDA Act does not provide that separate funds must be maintained for different types of life insurance business such as participating and non-participating businesses. It envisions that the existing practice of maintaining a single fund and a single surplus will continue. However, as pointed out in the CII Report, this concept of a single fund and a single surplus is not in line with modem life insurance business. Life insurance business may be either particigating; in which the policyholders pay a higher premium for the right to participate in the surplus generated or nonparticipating in which the policyholders do not share in the surplus. The shareholders instead get most or all of the surplus because they bear allthe financial risks involved in providing the life insurance products. Life insurance products may also impose the entire risk on shareholders (term assurance) or on policyholders (unit linked). Therefore, the law must reflect these developments in insurance practice and provide for different funds for different Masses of policyholders. In addition, the share of surplus which may be allocated to shareholders should vary according to each type of fund so as to adequately balance the interests of policyholders and shareholders. Even more importantly, the following legal rules governing profit entitlement must be re-examined. The Insurance Act, 1938 places restrictions on payment of dividends to shareholders and bonuses to policyholders. The 1938 Act provides that no life insurer shall for the purpose of paying any dividend to shareholders or any bonus to policy holders or of making any payment in service of any debentures utilize any portion of the life insurance fund except a surplus shown in the valuation balance sheet submitted to the Authority as a result ofan actuarial valuation of the assets and liabilities of the insurer. Further, the share of any such surplus allocated to or reserved for the shareholders, including any amount for the payment of dividends guaranteed to them, may not exceed 7.5 % of such surplus. In other words, 93.5 % of the surplus must be reserved for the policyholders for distribution as bonus and cannot be used for payment of dividends to the shareholders. The percentage oE92.5 % is particularly high. The CII Expert Report has recommended that a minimum of90% ofthe surplus from a
participating fund be allocated to the policyholders as bonus and the distribution of the balance 10% be left to the discretion of the individual companies. Insurers have taken the view that a 7.5% share of the surplus for shareholders is an unviable return which is unlikely to attract foreign investment in Indian insurance companies. The return becomes even less attractive for products such as term assurance where the entire risk is borne by shareholders. As the CII Expert Report points out, if the products are non-participating, the policyholders are fully compensated provided the guaranteed benefits are paid and they do not have a right to claim part of the surplus. If only 7.5% of the surplus can be transferred to the shareholders fund, who receives the remaining 97.5% of the surplus ? Perhaps the ownership oFthese assets could remain ambiguous in the era of the state-owned insurers. However, in the new privatized market, shareholder funds will not be attracted if shareholders are not going to be compensated for their investment by an adequate rate of return. Although this issue raises a question over the viability of the new regulatory regime, it has not been addressed in the IRDA Act. The IRDA Act also fails to allow for the transfer of any or all of the surplus from a non-participating fund to shareholders to compensate them for the risks borne by the shareholders. The new legislation moreover does not provide insurers the option to fund non-participating life insurance business from either the profits fund or the shareholders fund. 1 he foregoing restrictions on the shareholders share of the surplus render the regulatory regime unreasonable because insurers will not be able to offer potential shareholders an adequate rate of return on their funds. As these restrictions are contained in the Insurance Act, 1938, they can be amended only by an Act of Parliament and not by rules and regulations issued by the new statutory regulator, the IRDA. Expense regulations The Insurance Rules, 1939 prescribe limits on expenses of management of life insurance and general insurance business not-withstanding the fact that expense regulations are not common in market economies. The Rules prescribe the following limits which are expressed as a percentage of life insurance premiums (less reinsurance) received during the year: As stated above, the prescribed limit on expenses for the first four years is 100% ofthe premium. However, insurers have taken the view that it is not possible for a company to limit expenses to the 100% expense ratio during the first four years of operation. In India, start up costs are very high and the expense ratios will reduce only over time. However, the IRDA Act does not amend or even address the issue of expense regulations notwithstanding the fact that no new insurer will be able to show an expense ratio of 100% during the first four years of operation in its Business Plan. It is important to note that expense regulations are not included in the matters over which the regulator, the IRDA, can make regulations. Moreover, the IRDA can only make regulations consistent with the Insurance Rules, 1939, therefore, it does not have jurisdiction to amend the foregoing expense regulations. Tax issues In India, life insurance business is taxed as follows. The taxable profits of life insurance business are the annual average of the surplus arrived at by adjusting the surplus or deficit disclosed by the actuarial valuation made in accordance with the Insurance Act, 1938 in respect ofthe last intervaluation period ending before the commencement ofthe assessment year. This tax rate applicable to such income is the flat rate of 12.5%. The taxable profits of nonlife business are the Insurer's Profit Before Tax (PBT) determined in the annual financial statements required under the Insurance Act, 1938 minus the amounts carried to reserves for unexpired risks. There are a number of critical tax issues which affect the viability of the new regulatory regime. However, none of these issues have been addressed by the IRDA Act. In the initial years, the new private insurers will make losses particularly in view ofthe need to declare bonuses to policy holders in order to compete against the LIC and GIC. The losses and the bonuses which must be declared will be financed by transfers of funds from the shareholders funds to the policyholders fund. However, this transfer of funds from the shareholders fund may be deemed to be a taxable surplus. Therefore, as recommended by the CII Expert Report, the First Schedule of the Income Tax Act, 1961 should be amended to provide that any amounts transferred from the Shareholders Fund to the Policyholders Fund must be deducted in
computing the taxable surplus. Furthermore, if, after such deduction, the resulting amount is a deficit, such deficit should be carried forward as a business loss to be offset against the taxable surplus in subsequent years. However, the IRDA Act does not address any tax issues and there is no proposal to amend the relevant provisions ofthe Income Tax Act,1961. The regulator The Act creates a statutory regulator, the Insurance Regulatory Development Authority (IRDA), which is vested with the duty to regulate, promote and ensure the orderly growth of the insurance and reinsurance business. The IRDA will replace the existing administrative body, the Insurance Regulatory Authority (IRA). The chairman ofthe IRDA, N Rangachary and member (non-life), H Ansari, have already been appointed as full time members. A total of five full time members and four part time members are expected to be appointed this Spring. The powers of the IDRA are, first, licensing of the new private insurers by issuing certificates of registration. The IRDA is expected to issue rules and regulations, including procedures for obtaining a licence, by April 2000. The second area of jurisdiction ofthe IRDA is tariff setting. It is important to note that the IRDA may only control the rates, terms and conditions that may be offered by general insurance business not so controlled and regulated by the Tariff Advisory Committee (TAC) under section 64U of the Insurance Act 1938. However, section 64U consists of very broad language which mandates the TAC to "control and regulate the rates, advantages, term and conditions that may be offered by insurers in respect of general insurance business". According to this sweeping language, the TAC is statutorily vested with the power to regulate all aspects of the rates, terms and conditions ofthe general insurance business. It is thus unclear what aspects of tariffsetting remain to be regulated by the IRDA and this ambiguity may raise issues of overlapping jurisdiction between the TAC and the IRDA. Third, the IRDA is to regulate the operating issues discussed above such as investment of funds, business to be undertaken in the rural sector, and margin of solvency. However, as mentioned above, the IRDA may only make regulations consistent with the Insurance Act, 1938 and the Insurance Rules, 1939. Therefore, the IRDA will not have the power to, for example, lower the minimum Rs500 million solvency margin. Fourth, the IRDA will regulate intermediaries by specifying qualifications, a code of conduct and practical training for insurance intermediaries and agents, a code of conduct for surveyors and loss assessors, regulating professional organizations, inspecting, investigating and adjudicating disputes between insurers and intermediaries, and specifying the percentage of premium income of the insurer to finance regulation of professional organizations. Finally, the IRDA is to protect the interests of policyholders in matters concerning assignment of policy, nomination by policyholder, insurable interest, settlement ofinsurance claim, surrender value of policy and other terms and conditions of the insurance contract. However, this means that the IRDA will have overlapping jurisdiction with the state-level and National Consumer Commission which have been hearing coverage cases filed by insureds against the state owned insurers. It is now unclear whether the proper forum for a coverage dispute will be a consumer commission or the IRDA. Of even greater concern is the language in the IRDA Act which provides that the IRDA shall be bound by such directions on questions of policy, other than those relating to technical and administrative matters as the central government may give in writing to it from time to time. Although the IRDA shall be given an opportunity to express its views before any direction is given, the decision ofthe Central Government whether a question is one of policy or not shall be final. This language is identical to that contained in the Telecom Regulatory Authority of India Act, 1997 which has permitted the Department of Telecommunications (DoT) to interfere with the functioning of the Telecom Regulatory Authority of India (TRAI). Various telecom issues have been deemed policy issues so as to permit the Government, through the DoT, to interfere with the independence of the statutory regulator.
The provision binding the IRDA to the Government's policy decisions is, in effect, a way to allow the executive branch of government to interfere with the statutory regulator and exceed the proper bounds ofits authority. This language in the IRDA Act constitutes excessive delegation of legislative power to the executive which is both contrary to the principle of separation of powers between the three branches of government and in violation ofthe Constitution of India. The outlook The foregoing analysis reveals that several major issues undermine the attempts to create an adequate regulatory regime for the newly privatized insurance sector. First, the Insurance Act, 1938 must be amended to increase the share of surplus which can be distributed from the policyholders fund to the shareholders fund. The current 7.5% share of surplus available to shareholders is inadequate to attract investor funds. Second, the limitations in the Insurance Rules,1939 on expenses which may be incurred during the initial years must be relaxed as the present limits will not be part of any viable business plan. Third, the Income Tax Act, 1961 must be amede cn that funds contributed from the shareholders funds try the policyholders funds in order to make up a deficit, particularly in the start-up years, are deducted from taxes and the deficit is carried forward as a loss. Unless the foregoing changes are made, the legal framework will not provide a reasonable regulatory environment. However, the foregoing reforms require legislative changes which are beyond the jurisdiction of the IRDA and will require an Act of Parliament. Although the IRDA is expected to issue rules and regulations by April 2000, it does not have the jurisdiction to reform any of the three issues discussed above. Therefore, in view of the fact that there is no timetable for further legislative reforms, it is not possible to estimate the time required for the emergence of a regulatory framework conducive to attracting invest-nent and doing business. Furthermore, the new regulatory regime fails to create an independent statutory regulator because the government has reserved the right to intervene and issue directives to the IRDA on matters of policy. This provision in the IRDA Act subjects a statutory authority to the discretion of the executive branch thereby violating the separation of powers of the executive and the legislature which is a basic feature of India's constitution. Unless the IRDA Act is amended to delete this provision allowing the government to issue policy directives, an independent statutory regulator will not be in place, thereby undermining the entire regulatory regime. In sum, while the new IRDA Act is a dramatic step forward to an open insurance market, further legislative reforms are necessary before an adequate regulatory environment will be in place.
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Insurance industry, Legislation, Privatization, Regulation 9179 Asia & the Pacific, 8200 Insurance industry, 4310 Regulation India Aparna Viswanathan Feature International Financial Law Review. London: Mar 2000. Vol. 19, Iss. 3; pg. 28
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