B.Com. (Prog.

) Semester-VI Commerce

Discipline Specific Elective (DSE-3)

Banking and Insurance
Reference Material
Unit : I, II, IV & V

SCHOOL OF OPEN LEARNING

University of Delhi

Department of Commerce
 CONTENT

UNIT -I
Lesson 1 Banking Sector in India
Lesson 2 Deposits and
nd Advances
Lesson 3 Structure off The Indian Banking
Lesson 4 Credit Delivery and Administration
Lesson 5 Export Credit
Lesson 6 nd Working Capital Finance
Assessment of Credit Needs for Project and
Lesson 7(a) Deficiencies in Indian Banking System
Lesson 7(b) Banking Sector Reforms

UNIT-II
Lesson 1 Electronic Banking
Ban
Lesson 2 Forms and
nd Types of Advances and Collaterals

UNIT-IV
Lesson 1 Introduction to Insurance
Lesson 2 Legal Framework – Life & General Insurance Business

UNIT-V
Lesson 1 n India
Insurance Products and State of Insurance Industry in
Lesson 2 Life Insurance
Lesson 3 Understanding of The Annual Report off Life Insurance Companies
Lesson 4 General Insurance Non Life Insurance – Fire/Marine
Lesson 5 General Insurance
Insurance–Motor–Health & Miscellaneous
Lesson 6 Understanding Annual Report of A Non-Life
Life Insurance Company

Edited by :
Sh. K.B.Gupta
Ms Rutika Saini

SCHOOL OF OPEN LEARNING

University of Delhi
5, Cavalry Lane, Delhi-110007
 UNIT I
LESSON 1

BANKING SECTOR IN INDIA

Dr. Pooja Goel
Shaheed Bhagat Singh College
University of Delhi

Objectives
After going through this lesson you should be able to:
• Understand the Concept of Banking
• Describe the Development of Banking in India
• Explain the Functions of Bank
• Differentiate Among Banking Sectors

Structure
1.1 Concept of Banking
1.2 Development of Banking in India
1.3 Functions of Bank
1.4 Banking Sectors
1.5 Summary
1.6 Test Question
1.7 Further Readings

The banking sector is the lifeline of any modern economy. It is one of the important pillars of the
financial system, which plays a vital role in the success/failure of an economy. Banks are one of
the oldest financial intermediaries in the financial system. They play an important role in
mobilization of deposits and disbursement of credit to various sectors of the economy. The
banking sector is dominant in India as it accounts for more than half the assets of the financial
sector.

1.1 Concept of Banking

Banks are institutions that accept various types of deposits and use those funds for granting
loans. The business of banking is that of an intermediary between the saving and investment
units of the economy. It collects the surplus funds of millions of individual savers who are
widely scattered and channelize them to the investor. According to section 5(b) of the Banking
Regulation Act, 1949, “banking” means the accepting, for the purpose of lending or investment,
of deposits of money from the public, repayable on demand or otherwise, and withdrawable by
cheque, draft, and order or otherwise. Banking company means any company which transacts the
business of banking in India. No company can carry on the business of banking in India unless it
uses as part of its name at least one of the words bank, banker or banking. The essential
characteristics of the banking business as defined in section 5(b) of the Banking Regulation Act
are:
Acceptance of deposits from the public, For the purpose of lending or investment
a) Withdraw able by means of any instrument whether a cheques or otherwise.

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1.2 Development of Banking in India

The history of banking dates back to the thirteenth century when the first bill of exchange
was used as money in medieval trade. There was no such word as ‘banking’ before 1640,
although the practice of safe-keeping and savings flourished in the temple of Babylon as
early as 2000 B.C. Chanakya in his Arthashastra written in about 300 B.C. mentioned about
the existence of powerful guilds of merchant bankers who received deposits, advanced loans
and issued hundis (letters of transfer). The Jain scriptures mention the names of two bankers
who built the famous Dilwara Temples of Mount Abu during 1197 and 1247 A.D.
The first bank called the ‘Bank of Venice’ was established in Venice, Itlay in 1157 to
finance the monarch in his wars. The bankers of Lombardy were famous in England. But
modern banking began with the English goldsmith only after 1640. The first bank in India
was the ‘Bank of Hindustan’ started in 1770 by Alexander & Co. an English agency house in
Calcutta which failed in 1782 with the closure of the agency house. But the first bank in the
modern sense was established in the Bengal Presidency as the Bank of Bengal in 1806.
History apart, it was the ‘merchant banker’ who first evolved the system of banking by
trading in commodities than money. Their trading activities required the remittances of
money from one place to another. For this, they issued ‘hundis’ to remit funds. In India, such
merchant bankers were known as ‘Seths’.
The next stage in the growth of banking was the goldsmith. The business of goldsmith
was such that he had to take special precautions against theft of gold and jewellery. If he
seemed to be an honest person, merchants in the neighborhood started leaving their bullion,
money and ornaments in his care. As this practice spread, the goldsmith started charging
something for taking care of the money and bullion. As evidence for receiving valuables, he
issued a receipt. Since gold and silver coins had no marks of the owner, the goldsmith started
lending them. As the goldsmith was prepared to give the holder of the receipt an equal
amount of money on demand, the goldsmith receipts became like cheques as a medium of
exchange and a means of payment.
The next stage in the growth of banking is the moneylender. The goldsmith found that on
an average the withdrawals of coins were much less than the deposits with him. So he started
advancing the coins on loan by charging interest. As a safeguard, he kept some money in the
reserve. Thus the goldsmith-money-lender became a banker who started performing the two
functions of modern banking that of accepting deposits and advancing loans.
In India our historical, cultural, social and economic factors have resulted in the Indian
money market being characterized by the existence of both the unorganized and the
organized sectors.

(a) Unorganized Sector: The unorganized sector comprises moneylenders and indigenous
bankers which cater to the needs of a large number of people especially in the rural areas.
They have been meeting the financial requirements of the rural populace since times
immemorial. Their importance can be gauged from the fact that Jagat Seths, hereditary
bankers of the Nawab of Bengal, were recognized even by Aurangzeb and the East India
Company who were compelled to borrow from them also publicly honored them.

The indigenous bankers are different from the proper banks in a number of ways. For
instance, they combine banking activities with trade whereas trading is strictly prohibited for

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 banks in the organized sector. They do not believe in formalities or paper work for making
deposits or withdrawing money. In fact, since a substantial percentage of their clientele is
illiterate, they frequently take a thumb impression of their customers on a blank paper. Even
if they use a ‘Hundi’ as a negotiable instrument yet it will not be indicated on its face
whether the transaction is supported by valuable consideration or it is merely as a result of
mutual accommodation. The rate of interest charged by them fluctuates directly with the need
of the borrower and may sometimes be as high as 300 percent! They are insulated from all
type of monetary and credit controls as they fall outside thy purview of RBI. Though they are
still the major source of funds for small borrowers, but now their market has started shrinking
because of the fast expansion of branches of banks in the unorganized sectors.

1.3 Functions of Bank

According to section 6 of the Banking Regulation Act, 1949, the primary functions of a bank are:
acceptance of deposits and lending of funds. For centuries, banks have borrowed and lent money
to business, trade, and people, charging interest on loans and paying interest on deposits. These
two functions are the core activities of banking. Besides these two functions, a commercial bank
performs a variety of other functions which can be categorized in two broad categories namely
(a) Agency or Representative functions (b) General Utility functions.
(a) Agency or Representative functions:
• Collection and Payment of Various Items: Banks carry out the standing
instructions of customers for making payments; including subscriptions, insurance
premium, rent, electricity and telephone bills, etc.
• Undertake government business like payment of pension, collection of direct tax
(e.g. income tax) and indirect tax like excise duty.
• Letter of Reference: Banks buy and sell foreign exchange and thus promote
international trade. This function is normally discharged by Foreign Exchange
Banks.
• Purchase and Sale of Securities: Underwrite and deal in stock, funds, shares,
debentures, etc.
• Government’s Agent: Act as agents for any government or local authority or any
other person or persons; also carry on agency business of any description
including the clearing and forwarding of goods, giving of receipts and discharges,
and otherwise acting as an attorney on behalf of customers, but excluding the
business of a managing Agent or Secretary and treasurer of a company.
• Purchase and Sale of Foreign Exchange: Banks buy and sell foreign exchange and
thus promote international trade. This function is normally discharged by Foreign
Exchange Banks.
• Trustee and Executor: Banks also act as trustees and executors of the property of
their customers on their advice.
• Remittance of Money: Banks also remit money from one place to the other
through bank drafts or mail or telegraphic transfers.

(a) General Utility functions:

• Locker facility: Banks provide locker facilities to their customers. People can keep
their gold or silver jewellery or other important documents in these lockers. Their
annual rent is very nominal.

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 • Business Information and Statistics: Being familiar with the economic situation of the
country, the banks give advice to their customers on financial matters on the basis of
business information and statistical data collected by them.
• Help in Transportation of Goods: Big businessmen or industrialists after consigning
goods to their retailers send the Railway Receipt to the bank. The retailers get this
receipt from the bank on payment of the value of the consignment to it. Having
obtained the Railway Receipt from the bank they get delivery of the consignment
from the Railway Goods Office. In this way banks help in the transportation of goods
from the production centers to the consumption centers.
• Acting as a Referee: If desired by the customer, the bank can be a referee i.e. who
could be referred by the third parties for seeking information regarding the financial
position of the customer.
• Issuing Letters of Credit: Bankers in a way by issuing letters of credit certify the
credit worthiness of the customers. Letters of credit are very popular in foreign trade.
• Acting as Underwriter: Banks also underwrite the securities issued by the government
and corporate bodies for commission. The name of a bank as an underwriter
encourages investors to have faith in the security.
• Issuing of Traveller’s Cheques and Credit Cards: Banks have been rendering great
service by issuing traveller’s cheques, which enable a person to travel without fear of
theft or loss of money. Now, some banks have started credit card system, under which
a credit card holder is allowed to avail credit from the listed outlets without any
additional cost or effort. Thus a credit card holder need not carry or handle cash all
the time.
• Issuing Gift Cheques: Certain banks issue gift cheques of various denominations e.g
some Indian banks issue gift cheques of the denomination of Rs. 101, 501, 1001 etc.
These are generally issued free of charge or a very nominal fee is charged.
• Dealing in Foreign Exchange: Major branches of commercial banks also transact
business of foreign exchange. Commercial banks are the main authorized dealers of
foreign exchange in India.
• Merchant Banking Services: Commercial banks also render merchant banking
services to the customers. They help in availing loans from non-banking financial
institutions.

1.4 Banking Sectors

The spectrum of needs and requirements of individuals, organizations and sectors of the
economy is very vast and diverse. Banks have come up with a whole range of banking products
and services to suit the requirements of their clients. Banking sectors include corporate banking,
international banking and rural banking.
Corporate Banking: Cooperative banking typically serves the financial needs of large
corporate houses- both domestic and multinational-public sectors and governments.
However, traditionally banks had primarily been focusing on production based activities and
financed working capital requirements as well as term loans to corporates due to following
reasons:
• From the beginning till the pre-reform era, business houses were heavily
dependent on banks for their financial needs. The capital markets were not well
developed, joint ventures norms had not been liberalized, mergers and

4
 acquisitions were not the preferred route and numerous restrictions were placed
on raising finance from overseas markets.
• The banking institutions too showed a preference for providing credit to the
corporates. This way their paper work was markedly reduced as the numbers of
clients were less. Not only the workload was eased but also the risk involved was
considerably less as corporate borrowings were made against collaterals after
verifying their capacity for repayment.
• The government had also earmarked priority sectors, and as such banks had to
comply with the targets allotted to them.
After liberalization, many corporates could not face the competition and went into
the red. Economic downturn and recessionary environment resulted in poor performance
of many borrowers. As a direct consequence of all these, the NPAs of banks started
mounting. However, according to the RBI annual report of 2005-06, the credit demand by
the corporate sector has turned robust on the back of strong industrial performance.
Furthermore, banks are expected to have greater financing opportunities in the area of
project finance, especially in the infrastructure sector, given the conversion of two major
financial institutions into banks. Banks have been focusing mainly on syndication of debt
to ensure wider participation in project finance and wholesale leading segment.
Features
Corporate banking serves the need of corporates, those having a legal entity. They offer
business current accounts, make commercial loans, participate in syndicated lending and
are active in inter-bank markets to borrow/lend from/ to other banks. Many banks offer
structured products, capital market services and corporate solutions. Corporate banking
involves comparatively fewer borrowers and the account size is usually large and
sometimes it can turn into billions of dollars.
Services
I. Corporate banking services include:
II. Working capital and terms loans, overdrafts, bill discounting, project
financing.
III. Cash management both short term holdings of cash as well as funds
held for longer periods.
IV. Financing of exports and imports including export credit
arrangements.
V. Project finance
VI. Transmission and receipt of money.
VII. Handling foreign currency and hedging against changes in value.

In recent times, there has been a marked shift from corporate to retail banking. The major
reason for avoiding corporate accounts is the mounting non-performing corporate
accounts. Difficulty in pricing the services and high risks involved are some of the other
reasons for overlooking corporate accounts. However this is very lucrative segment
provided care is taken in identifying and focusing on selected business segments and
catering to their requirements, e.g. for the SME segment, credit is paramount whereas for
big corporates, customized solutions are needed. Systematic account planning process
can help to identify the profitable customers, and pricing of services can help the bank to
get rid of asset quality problem. Most developed nation’s banks have separate corporate
bank divisions which help them to avoid the pitfalls of one size fits all policies.

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 (B) Retail Banking: With a jump in the Indian economy from a manufacturing sector,
that never really took off, to a nascent service sector, Banking as a whole is
undergoing a change. A larger option for the consumer is getting translated into a
larger demand for financial products and customization of services is fast becoming
the norm than a competitive advantage. With the Retail banking sector expected to
grow at a rate of 30% players are focusing more and more on the Retail and are
waking up to the potential of this sector of banking. At the same time, the banking
sector as a whole is seeing structural changes in regulatory frameworks and
securitization and stringent NPA norms expected to be in place by 2004 means the
faster one adapts to these changing dynamics, the faster is one expected to gain the
advantage. In this article, we try to study the reasons behind the euphemism regarding
the Retail-focus of the Indian banks and try to assess how much of it is worth the
attention that it is attracting. Retail banking is typical mass-market banking in
which individual customers use local branches of larger commercial banks. Retail
banking is banking that provides direct services to consumers. Many people with
bank accounts have their accounts at a retail bank and banks that offer retail banking
services may also have merchant and commercial branches that work with businesses.
For people with high net worth and special banking needs, private retail banking
services may be pursued. These offer a high level of service with a number of options
that are not available to average members of the public. Services offered include
savings and checking accounts, mortgages, personal loans, debit/credit cards and
certificates of deposit (CDs).The most basic retail banking services include savings
and checking accounts. Most retail banks, however, try to make themselves into a one
stop shop for banking customers. This increases customer retention and loyalty,
ensuring that the bank has a steady supply of customers. Expanding banking services
also provides more opportunities for the bank to turn a profit.

Characteristics of Retail Banking

1. Large Number of Small Customers: Retail banking is characterized by the existence

of a large number of small customers, who consumes personal banking and small
business services. The essential prerequisite of retail banking is its orientation
towards the consumer whether it is in size, price, delivery channels or product profile.
2. Multiple Products: A basket of products including flexi deposits, cards, insurance,
medical expenses, auto loans are offered to the consumers. Besides these, there are a
number of value added services like de-mat accounts, issue of free ATM cards,
portfolio management, payment of water, electricity and telephone bills.
3. Multiple Delivery Channels: To increase penetration and access banks are not
limiting themselves to branches but are making extensive use of internet, call centres,
kiosks, etc.

Origin of Retail Banking: Origin of retail banking in India can be traced to a number of
developments.

1. Financial Sector Reforms and Liberalization: Before opening up of the economy during
the decade of the nineties, corporate banking had been the preferred goal for bankers.
However, after the reforms it no longer remained so. Corporates could now go in for
external commercial borrowings from any internationally recognized bank, export credit
agency, international capital market or supplier of equipment. They could also opt for
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 mergers and acquisitions. So banks had to look for other avenues than the corporate
sector for growth and expansion.
2. Spreading of Risk: Another consequence of liberalization was industrial recession,
economic downturn, industrial sickness which resulted in failure of many big corporates.
Mounting non-performing assets made banks more cautious about lending to business
houses, and diverting their funds into the retail segment, as retail banking has the
advantage of minimizing the risk and maximizing the returns. The returns from retail
segment are three to four percent as compared to one to two percent from the corporate
segment.
3. Growth in Banking Technology and Automation of Banking Processes: Technology has
opened up new vistas for the banking industry and redefined its nature, scope and extent.
State-of-the-art electronic technology has helped to increase penetration through ATMs
without opening more branches. Internet has made possible banking to be done from
home. Telebanking and phone banking are some other new technologies which have
revolutionized banking.
4. Changing profile of Customers: An ever-increasing middle class, with more disposable
income, higher education and a desire for higher standard of living have fuelled the
demand for retail banking services. More and more people seemed to have embraced the
credit culture, and are demanding consumer goods, holidays, education and a host of
other value added banking services.

(C) Rural Banking: On the birth anniversary of Mahatma Gandhi on October 2, 1975, Rural
Banks were established with a view to stepping up rural credit. In 1975, the Government of
India appointed a working group under the Chairmanship of M. Narasimham, the Deputy
Governor of the Reserve Bank of India to review the flow of institutional credit to the people
in rural areas. The committee was to study the availability of institutional credit to the weaker
section of the rural population and to suggest alternative agencies for this purpose. The
committee concluded that the commercial banks would not be able to meet the credit
requirements of the weaker sections of the rural areas in particular and rural community in
general. The Government accepted the recommendations of the working group and passed an
ordinance in September 1977 to establish Regional Rural Banks.

Need to Establish Regional Rural Banks

The main need and objective of the RBBs was to provide credit and other facilities to the small
and marginal farmers, agricultural laborers and artisans, who had, by and large, not been
adequately served by the existing credit institutions namely, cooperative banks and commercial
banks:

1. Co-operative Banks: So far as the co-operative credit structure is concerned, it lacks the
managerial talent, post credit supervision and the loan recovery. They are also not in a
position to mobilize necessary resources.
2. Commercial Banks: These banks are mostly centralized in urban areas and are urban-
oriented. Although these can play a crucial role as far as the rural credit is concerned. For
this they have to adjust their methods, procedures, training and orientation in accordance
with the rural environment. Further, due to high salary structure, staffing pattern and high
establishment expenses their operational cost is also higher. Thus, under these
circumstances, the commercial banks cannot provide credit, to the weaker sections of the
rural areas, at a cheap rate.
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 3. Need of a New Institution: Thus in accordance with the rural requirements, the necessity
was felt to establish such an institution i.e. a rural oriented bank which may fulfill credit
needs of the rural people particularly the weaker section. It may also combine the merits
of the above two mentioned institutions, keeping aside their drawbacks. The RRBs, as
subsidization to nationalized banks, are expected in the long run not only to provide
credit to farmers and village industries but also to mobilize deposits from rural
households. They may form an integral part of the rural financial structure in India.

Difference Between RRBs and Commercial Banks

Although the RRBs are basically the scheduled commercial banks, yet they differ from each
other in the following respects

1. The area of the RRB is limited to a specified region comprising one or more districts of a
state.
2. The RRBs grant direct loans and advance only to small and managerial farmers, rural
artisans and agricultural laborers and others of small having small means for productive
purposes.
3. The lending rates of RRBs are not higher than the prevailing lending rates of co-operative
societies, in any particular state. The sponsoring banks and the Reserve bank of India
provide many subsidies and concessions to RRBs to enable it to function effectively.

Organisation

The RRBs have been established by ‘Sponsor bank’ usually a public sector bank. The steering
committee on RRBs identifies the districts requiring these banks. Later, the Central Government
sets up RRBs with the consultation of the state government and the sponsor bank. Each RRBs
operates within local limits with such as name as may be specified by the Central Government.
The bank can establish its branches at any place within the notified areas.

Capital

The authorized capital of each RRBs is Rs. 5 crore which may be increased or reduced by the
Central Government but not below its paid up capital of Rs. 25 lakh. Of this fifty percent is
subscribed by the Central Government, 15 percent by the State Government and 35 percent by
the sponsor bank. At present the formula for subscription to RRBs has been fixed at 60:20:20
between central government, state government and the sponsor bank. The Central Government’s
contribution is made through NABARD.

Management

Each RRB is managed by a Board of Directors. The general superintendence, direction and
management of the affairs and business of RRBs vests with the nine member Board of Directors.
The Central Government nominates 3 directors. The chairman, usually an officer of the sponsor
bank but is appointed by the central Government. The Board of Directors is required to act on
business principles and in accordance with the directives and guidelines issued by the Reserve
Bank. At the State Level, State Level Coordination Committee have also been formed to have
uniformity of approach of different RRBs.

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Functions

The RRB are required to perform the following functions or operations:

1. Operations Related to Agricultural Activities: To grant loans and advances to small and
marginal framers and agricultural laborers, whether individually or in groups or to
cooperative societies including agricultural marketing societies, agricultural processing
societies, cooperative farming societies, primary agricultural societies for agricultural
purposes or for other related purposes.
2. Operations Related to Non-Agricultural Activities: Granting of loans and advances to
artisans, small entrepreneurs and persons of small means engaged in trade, commerce and
industry or other productive activities within its area of operation.

(D) Micro-Credit: In spite of the phenomenal outreach of formal credit institutions, the rural
poor still depend upon the informal sources of credit. Two major causes for this are the large
number of small borrowers with small and frequent needs. Also the ability of these borrowers to
provide collateral is very limited. Besides, the long and cumbersome bank procedures and their
risk perception have also been limiting factors. Micro-credit has emerged as the most suitable
and practical alternative to conventional banking in reaching the hitherto untapped poor
population.

Micro-credit or micro-finance means providing very poor families with very small loans to help
them engage in productive activities or grow their tiny businesses. Over time, the concept of
micro-credit been broadened to include a whole range of financial and non-financial services like
credit, equity and institution building support, savings, insurance etc. Micro-finance institution is
an organization that provides financial services to people with limited income who have
difficulty in accessing the formal banking sector. The objective of micro finance is to provide
appropriate financial services to significant numbers of low-income, economically active people
in order to finance micro-enterprises and non-farm income generating activities including agro-
allied activities and ultimately improve their condition as well as that of local economies.’

As per RBI micro-finance is the provision of thrift, credit and other financial services and
products of very small amount to the poor in rural, semi-urban and urban areas for enabling them
to raise their income levels, and improve their living standard. Micro-credit institutions are those
that provide these facilities. The micro-finance approach has emerged as an important
development in banking for channelizing credit for poverty alleviation directly and effectively.
The micro-credit extended by banks to individual borrowers directly or through any agency is
regarded as a part of banks priority sector loans.

(E ) Self-Help Groups: SHGs have been launched to combat the problem of growing poverty at
the grass roots level. Small, cohesive and participative groups of the poor are formed who
regularly pool their savings to make small interest bearing loans to its members. In the process,
they lean the nuances of financial discipline. Initially bank credit is not primary objective. It is
only after the group stabilizes and gains ability to undertake productive activity and bear risk that
micro-credit comes into play.

The SHG bank linkage programme has proved to be the major supplementary credit delivery
system with a wide acceptance by banks, NGOs and various government departments. It
encourages the rural poor to build their capacity to manage their own finances, and then
9
negotiate bank credit on commercial terms. Certain norms have to be observed in the formation
of SHGs. To become a member, a person has to be below the poverty line. Only one member of
a family can become a member and that person cannot become a member of more than one SHG.
There is no limit of maximum number of members can be between 10 and 20. Members of SHGs
are supposed to meet regularly, that is, once a week or once a fortnight. However, registration is
optional and left to the discretion of the members.

(F) Non-Banking Financial Intermediaries: Non-Banking financial Intermediaries are a

heterogeneous group of financial institution, other than commercial and cooperative banks.
These institutions are an integral part of the Indian financial system. A wide variety of financial
institutions is included in it. These institutions raise funds from the public, directly and
indirectly, to lend them to ultimate spenders. The Development Banks (such as the IDBI, IFCI,
ICICI, SFCs, SIDCs, etc.) fall in this category. They specialize in making term loans to their
borrowers. LIC, GIC and its subsidiaries and the UTI are its other all India big term-lending
institutions. Out of these three, only UTI is a pure non-banking financial intermediary, the others
raise funds in the shape of premium from the sale of insurance. Besides this, there are provident
funds and post offices who mobilize public savings in a big way for onward transmission to
ultimate borrowers or spenders. A large number of small NBFs such as investment companies
loan companies, hire purchase finance companies and the equipment leasing companies, these
are private sector companies with only a few exceptions.

Functions of Non-Banking Financial Intermediaries: The main functions performed by NBFs

are as under:

1. Brokers of Loanable Funds: NBFs act as brokers of loanable funds and in this capacity
they intermediate between the ultimate saver and the ultimate investor. They sell indirect
securities to the savers and purchase primary securities from investors. Thus, they change
debt into credit. By doing so, they take risk on themselves and reduce the risk of ultimate
lenders. Not only that, by diversifying their financial assets they spread their risk widely
and thus reduce their own risk because low returns on some assets are offset by high
return on others.
2. Mobilization of Savings: These institutions mobilize savings for the benefit of the
economy. By providing expert financial services like easy liquidity, safety of the
principal amount and ready divisibility of savings into direct securities of different values
they are able to mobilize more funds and attract larger share of public savings.
3. Channelization of Funds into Investment The NBFs, by mobilizing savings, channelize
them into productive investments. Each intermediary follows its own investment policy.
For instance, savings and loan associations invest in mortgages; insurance companies
invest in bonds and securities etc. Thus this channelization of public savings into
investment helps capital formation and economic growth.
4. Stabilize the Capital Market These institutions trade in the capital market in a variety of
assets and liabilities, and thus equilibrate the demand for and supply of assets. Since they
function with a legal framework and rules and they protect the interests of the savers and
bring stability to the capital market.
5. Provide Liquidity Since the main functions of the NBF’s convert a financial asset into
cash easily, quickly and without loss in the capital value, they provide liquidity. They are
able to do so, because they advance short-term loans and finance them by issuing claims
against themselves for long periods and they diversify loans among different types of
borrowers.
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Types of Non Banking Financial Institutions: The main types of non-banking financial
institutions/intermediaries are as under:

The Life Insurance Companies: Life Insurance Corporation of India enjoys near monopoly of
life insurance in India. It is the biggest institutional investor. The LIC was established in 1
September, 1956 by nationalizing all the life insurance companies operating in India. Prior to
nationalization of insurance companies, 245 private insurance companies operate from 97
centres. The main objectives of LIC are (i) To carry on Life Insurance business in India. Life
insurance is a very important form of long term savings. (ii) The LIC aims in promoting savings.
(iii) To invest profitability the savings collected in the form of payments received from life
insurers. The LIC has two tier of capital structure- the initial capital, and premium capital. The
initial capital of LIC is Rs. 5 crore provided by the Government of India. The premium paid by
policy holders are the principal source of funds by LIC. Besides, the LIC receives interest,
dividends, repayments and redemptions which add to its investible resources. The LIC is
required to invest atleast 50% of its funds in government and other approved securities. LIC has
to invest 10% of its funds in other investments which include loans to state governments for
housing and water supply schemes, to Municipal Corporation, and corporation, and cooperative
sugar companies, loans to policy holders, fixed deposits with banks and cooperatives societies.
The main principle involved is security of funds rather than maximization of return on
investment.

General Insurance Companies: General Insurance Corporation of India was established in

January 1973, when General Insurance Companies were nationalized. At the time of
nationalization, there were 68 Indian companies and 45 non-Indian companies in the field. Their
business was nationalized and vested in the General Insurance Company and its four subsidiaries
viz., National Insurance Company Ltd. and United India Insurance Company Ltd. The GIC is
the holding company and its direct business is restricted only to aviation insurance; general
insurance is handled by the subsidiaries of GIC and they operate various types of policies to suit
the diverse needs of various segments of the society. They derive their income from insurance
premia and invest the funds in various types of securities as well as in the form of loans. GIC has
thus emerged as an important investment institution operating in Indian capital market.

Unit Trust of India: The UTI is an investment institution which offers the small investor a share
in India’s industrial growth and productive investment with minimum risk and reasonable
returns. The UTI was established as a Statutory Corporation in February 1964 under the UTI Act
1964. It commenced its operations from 1 July, 1964. The UTI was established with the
objective of mobilizing the savings of the community and channeling them into productive
investment. Its objective is to encourage widespread and diffused ownership of industry by
affording investors particularly the small investors, a means of acquiring shares assured of a
reasonable return with minimum risk. Thus, the primary objective of the Unit Trust in two fold
(i) To stimulate and pool the savings of the middle and low income groups (ii) To enable the unit
holders to share the benefits and prosperity of the rapidly growing industrialization in the
country. The UTI is managed by a board of trustees. It consists of a chairman and 9 other
trustees. The chairman is appointed by the government of India in consultation with the IDBI, 4
trustees nominated by the IDBI, one trustee each nominated by the RBI, LIC and SBI and 2
trustees selected by other institutions which contributed to the initial capital of the UTI. The head
office of UTI is in Mumbai. It has four zonal offices at Mumbai, Kolkata, Chennai and New
Delhi. It has 51 branch offices in various parts of the country.

11
(G) Mutual Funds: A mutual fund is a trust that pools the savings of a number of investors who
share a common financial gain. Anybody with an investible surplus of as little as a few thousand
rupees can invest in mutual funds. These investors buy units of a particular Mutual Fund Scheme
that has defined investment objective and strategy. The money thus collected is then invested by
the fund manager in different type of securities. The income earned through investments and the
capital appreciation realized by the scheme is shared by its unit holders in proportion to the
number of units owned by them. In India, the mutual fund industry started with the setting up of
Unit Trust of India in 1964. Public sector banks and financial institutions began to establish
mutual funds in 1987. The private sector and financial institutions were allowed to set up mutual
funds in 1993.

(H) Provident/ Pension Funds: These funds represent the most significant form of long-term
contractual saving of the household sector. At present the annual contribution to these funds is
running at double the rate than the rate of annual contribution to life insurance. In the financial
year 1999-2000, about Rs. 69.695 crore had accumulated in the provident fund and other
accounts with the Government of India. The resources mobilized by the funds during the same
year were Rs. 1,465 crore. The provident funds scheme practically started in the post-
independence period. Under the legalization, provident funds have been made compulsory in the
organized sector of industry, coal mining, plantation and services (such as government, banking,
insurance, teaching, etc.) There is a separate P.F. Legislation for coal mining, industries and
Assam tea plantations. With the growth of the organized sector of the economy and in wage
employment, savings mobilizations through PFs will growth further. The wage- earners are
encouraged to join, P.F. schemes and make contributions to them, because thereby alone they are
able to earn employers’ matching contribution to the fund.

(I) Post Offices: Post offices serve as the vehicle for mobilizing small savings of the public for
the government. These have been established with the sole motive of collecting people’s small
savings in urban, semi-urban and rural areas. They are generally known as “Savings Banks”. In
rural areas where majority of the population live, do not have such commercial banks. To create
banking habit among them and to collect their scattered small savings, the savings banks have
been opened. In India where there are no commercial banks, the Post-Office perform the
functions of commercial banks, they collect the deposits of the people, open their deposit
accounts and pay interest for the deposited money.

1.5 Conclusion
In simple words, bank refers to an institution that deals in money. This institution accepts
deposits from the people and gives loans to those who are in need. Besides dealing in money,
banks these days perform various other functions, such as credit creation, agency job and general
service. The spectrum of needs and requirements of individuals, organizations and sectors of the
economy is very vast and diverse. Banks have come up with a whole range of banking products
and services to suit the requirements of their clients. Banking sectors include corporate banking,
international banking and rural banking.

1.6 Test Questions

Q1. What is a Bank? Explain the main functions of a Bank.

Q2. Explain the various types of retail banking services offered by banks.
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Q3. Give an overview of different banking sectors in India.

1.7 Further Readings

Varshney P.N.& Mittal D.K. , “ Indian Financial System”, Sultan Chand &Sons
G. Ramesh Babu, “ Financial Markets and Institutions”, Concept Publishing Company.
Tripathi Prava Nalini, “ Financial Services”, Prentice Hall of India, 2008.
Jain T.R., “ Indian Financial System” , V.K. Publications.

13
 LESSON 2

DEPOSITS AND ADVANCES

Dr. Pooja Goel
Shaheed Bhagat Singh College
University of Delhi
Objectives

After going through this lesson you should be able to:

• Know about Different Deposit Account
• Understand Principles of Sound Lending
• Explain the Methods of Granting Advances
• Analyze Different Modes of Creating Charges
Structure
2.1 Accepting of Deposits
2.2 Principles of Sound Lending
2.3 Methods of Granting Advances
2.4 Secured Advances
2.5 Modes of Creating Charges
2.6 Legal Mortgage vs. Equitable Mortgage
2.7 Summary
2.8 Test Question
2.9 Further Readings

Banks deal mainly with money and credit. They are manufacturers of money. Industrial and
economic evolution would not have occurred in the absence of banks. They play significant role
in the shaping and in the advancing of modern societies. They distribute the funds equitably,
reduce cyclical fluctuations. The industrial development will not be possible without the help of
the banks. They purchase and sell money and credit. Creation of credit is a special function of
banks. They are the architecture of the digital economy. They encourage trade and industry.

The functions are the main income sources of money. Every bank must follow these functions.
The basic functions of a bank are (1) Accepting of Deposits (2) Advancing of Loans (3) Secured
Advances

2.1 Accepting of Deposits

Deposits are the most important element in the banking sector. They collect surplus money from
the public. The deposits will be mobilized by banks. The money collected from the public are
preserved by banks and interest will be paid by the banks. The depositors are benefited and their
amount of money is safe at the banks. In this situation the banks can earn a sum of money on the
amount collected by them. The banks create credit on the basis of deposits. The level of creation
of credit depends upon the amount of deposits. The banks have introduced different types of

14
deposits to suit the various requirements of the depositors. The types of deposit schemes are
briefly discussed below:
(a) Fixed Deposits
(b) Current account
( c) Savings Bank Account
(d) Money Multiplier Account
(e) Other Accounts

Fixed Deposits: Under this scheme the banks mobilizes the deposits which are repayable after
the expiry of three months to five years. The banks are free to use the deposits for a certain
period. They grant loans at higher rate of interest on these deposits. They can use the deposits
money for a certain period of time for more remunerative purposes. The small savers will get
benefits from the scheme. The small customers are unable to make investments in the industrial
securities market. They do not want to take risk from the securities market. A large number of
savers prefer this mode of investment. The fixed deposit has become more lucrative as rate of
interest has increased up to 10 percent. The customers can earn more by combining the Fixed
Deposit account with recurring deposit account. The interest on FDR will be credited to the
recurring deposit account. The amount of fixed deposit cannot generally be withdrawn before the
expiry of the period of deposits. However banks can advance money of the security of fixed
deposits if the depositors are not willing to withdrawn the amounts deposited.
The fixed deposits are also known as Term Deposit. Fixed deposits have grown in
importance and popularity in India during recent years. These deposits constitute more than half
of the total bank deposits. The rate of interest and other terms and conditions are regulated by the
RBI. The RBI revised the rate of interest on fixed deposits several times. The main object of the
step was to make bank deposits more attractive as compared to other savings instruments.

Current Account: Current account is more beneficial to those who withdraw several times from
the account of deposits. No interest is paid on this account. Cheques are generally used for
withdrawing a certain amount from the deposits. Current accounts are more useful to the
businessmen. They can produce this account as an evidence of revenue for the assessment of
Income Tax. The businessmen are not required to keep with them a large amount of money. He
will make payments by issuing cheques to the parties. The cheques can be transferred to any
person for the settlement of dues. The current account is opened subject to the conditions.
Generally no interest is paid on the amount of deposit balances and no charges are required for
maintaining such account. Current accounts are more useful to the businessmen, firms,
companies and individuals.

Savings Bank Account: Savings bank account is useful to middle and low income groups. They
can save certain amount during a certain period. It is a flexible account. In this account, the
depositor can withdraw money about thrice a week. The account holder can deposit money at
any time. The interest is calculated on the minimum balance maintained each month. A person
wishing to open saving bank account will have to fill up a form. He has to furnish his specimen
signature. A passbook will be issued to the account holder. If the depositor wants to withdraw
money he must fill up a withdraw money he must fill up a withdrawal form and must present his
book for payment. Now some banks extended the cheques facility to the savings bank customers.

15
Money Multiplier Account: The persons who are interested to deposit money for more money
at short period of time. Under this scheme the amount of interest is also redeposited. The rate of
interest is highest on this deposit. The depositor can withdraw the accumulated money after
stipulated period. The depositor can withdraw the whole amount either in lump-sum or in
installments. If the depositor opted for installments higher amount is returned to the person. This
is most suitable for old age provision.

Other Accounts: There are so many saving deposit accounts like Recurring deposit account,
private savings account and special saving account. Recurring deposit accounts are more popular
in India. A fixed amount is deposited at a regular interval and it attracts accumulated at
compound rate of interest. Under this scheme the interest and the principal amount is returned to
the depositor after the fixed period. The rate of interest is higher than of saving account and
lower than of fixed deposit account. It is a great source of stimulating short deposits. These
schemes are designed to meet the requirements of education and marriage.

2.2 Principles of Sound Lending

The business of lending carries certain inherent risk, and banks can afford to take only calculated
risks as they deal in other people’s money. Another important facet of bank operations is the
need to have ready cash as a bank is under an obligation to return the customer’s money
whenever it is demanded. Hence, the nature of bank functions is such that it requires a very
prudent and diligent handling of bank funds. It is advisable that the following general principles
of sound lending should be followed by a banker at the time of granting advances.

1. Liquidity: Liquidity is an important principle of bank lending. Banks lend for short
periods only because they lend public money which can be withdrawn at any time by
depositors. They, therefore, advance loans on the security of such assets which are easily
marketable and convertible into cash at a short notice. A bank chooses such securities in its
investment portfolio which possess sufficient liquidity. It is essential because if the bank
needs cash to meet the urgent requirements of its customers, it should be in a position to sell
some of the securities at a very short notice without disturbing their price much. There are
certain securities such as central, state and local government bonds which are easily saleable
without affecting their market prices.
2. Safety: The safety of funds lent is another principle of lending. Safety means that the
borrower should be able to repay the loan and interest in time at regular intervals without
default. The repayment of the loan depends upon the nature of security, the character of the
borrower, his capacity to repay and his financial standing. Like other investments, bank
investments involve risk. But the degree of risk varies with the type of security. Securities of
the central government are safer than those of the state governments and local bodies. From
the point of view, the nature of security is the most important consideration while giving a
loan. Even then, it has to take into consideration the creditworthiness of the borrower which
is governed by his character, capacity to repay, and his financial standing. Above all, the
safety of bank funds depends upon the technical feasibility and economic viability of the
project for which the loan is advanced.
3. Diversity: In choosing its investments portfolio, a commercial bank should follow the
principle of diversity. It should not invest its surplus funds in a particular type of security but

16
in different types of securities. It should choose the shares and debentures of different types
of industries situated in different regions of the country. The same principle should be
followed in the case of state governments and local bodies. Diversification aims at
minimizing risks of the investment portfolio of a bank. The principle of diversity also applies
to the advancing of loans to varied types of firms, industries, businesses and trades. A bank
should follow the maxim: “Do not keep all eggs in one basket.” It should spread it risks by
giving loans to various trades and industries in different parts of the country.
4. Stability: Another important principle of a bank’s investment policy should be to invest in
those stocks and securities which possess a high degree of stability in their prices. The bank
cannot afford any loss on the value of its securities. It should, therefore, invest its funds in the
shares of reputed companies where the possibility of decline in their prices is remote.
Government bonds and debentures of companies carry fixed rates of interest. But the bank is
forced to liquidate a portion of them to meet its requirements of cash in case of financial
crisis. Thus bank investments in debentures and bonds are more stable than in the shares of
companies.
5. Profitability: This is the cardinal principle for making investment by a bank. It must earn
sufficient profits. It should, therefore, invest in such securities which assure a fair and stable
return on the funds invested. The earning capacity of securities and share depends upon the
interest rate and the dividend rate and the tax benefits they carry. It is largely the government
securities of the centre, state and local bodies that largely carry the exemption of their interest
from taxes. The bank should invest more in such securities rather than in the shares of new
companies which also carry tax exemption. This is because shares of new companies are not
safe investments.
6. Principle of Purpose: At the time of granting an advance the banker must enquire about
the purpose of the loan. If it is for speculative or unproductive purposes, it may prove to be a
burden on cash generation and repayment capacity of the borrower. On the other hand, it can
be reasonably anticipated that loans meant for productive purposes help generate incremental
income that results in prompt repayment of the loan.
7. Principle of Social Responsibility: At the time of evaluation of a loan project, bankers
should not put an overdue emphasis on the size of the borrower, and the security that he is
offering. The technical competency of the borrower and the economic viability of his project
should also be considered. The priority sector guidelines have also to be followed by the
bankers, if they want to contribute in the process of economic development by helping more
and more entrepreneurs to run successful ventures. The principle of social responsibility does
not, however, mean that adequate attention should not be paid to other principles.

2.3 Methods of Granting Advances

Bank deals with money of other persons. Bank does not lend its own money. It is the other’s
money in which it deals. The advances of bank may be granted in the form of loans,
overdraft, cash credit, credit discounting bills of exchange. The bank advances loan more
than the amount of deposits, because all the loans are not withdrawn immediately. Therefore
the loan creates deposits, while advancing loans; the bank gives priority to safety and next
profitability. In advancing loans, the principles of investment safety, liquidity and
profitability, diversification and social objectives are considered. The main methods of
granting advances in India may be classified as follows:

17
 (a) Loans
(b) Cash Credit
(c) Overdraft
(d) Discounting of Bills

Loans: Loans are important element of the profitability of the banks. They are made by debiting
the customers loan account and by crediting his current account. The customer is allowed to
withdraw the loan amount by installments. The regular customers are permitted loans by
crediting to their accounts; proper care is taken while granting the loans. All of the loans require
a proper security or mortgage. Sometimes only the personal security is required for advancing
the loan. The interest is charged on the loan amount. Loans involve low operating cost than other
kind of loans. Loans are given against the securing of movable and immovable assets. A brief
description follows:
I. Short- term Loans: Short-term loans are loans which are granted for a period not
exceeding one year. These are advanced to meet the working capital requirements, again
security of movable assets like goods, commodities shares, debentures, etc. They are
usually taken to meet the working capital requirements of business.
II. Term-Loans: Medium and long-term loans are usually called term loans. These loans are
extended for periods ranging from one year to about eight or ten years on the security of
existing industrial assets or the assets purchased with the loan. Term loans are used for
purchase of capital assets for establishment of new industrial units, for expansion,
modernization or diversification. They involve an element of risk as they are intended to
be repaid out of the future profits over a period of years. Consequently, apart from the
financial appraisal of such loans, the technical feasibility and managerial competency of
the borrower should also be studied. Banks can charge fixed rates of interest for the entire
period or different prime lending rates for different maturities, provided transparency
and uniformity of treatment is maintained.
III. Bridge Loans: Bridge loans are essentially short-term loans that are granted pending
disbursement of sanctioned term loans. These help borrowers to meet their urgent and
critical needs during the period when formalities for availing of the term loans sanctioned
are being fulfilled. They are repaid out of the amount of such loans or from the funds
raised in the capital market if these loans are granted by financial institutions.
IV. Composite Loans: If a loan is taken for buying capital assets as well as for meeting
working capital requirements, it is called a composite loan. Usually such are availed by
small entrepreneurs, artisans and farmers.
V. Consumption Loans: Traditionally, banks used to focus on loans for productive purposes,
but during the recent past banks have increasingly started giving loans for consumption
purposes like education, medical needs and automobiles.

Cash Credit: Cash credit is another method of advances made by banks. In this method the
banker grants his customer to borrow money upto a certain sanctioned limit. The bank requires
security of certain bonds, promissory notes, shares, other commodities. Sometimes commodities
are kept in the possession of the bank in its godowns. The borrower is charged interest on the
amount of advance. Generally the cash credit system provides adequate amount for meeting
essential expenditures of the business. The large amount of credit is granted through credit
system because the whole amount of credit is not required to be withdrawn at once. It is the best

18
method to suit the requirements of the business community. Generally raw materials are
purchased on the basis of this credit. This type of loan is mostly short-term credit. The borrowers
can withdraw the sanctioned loan according to their convenient. The interest will be charged on
the dates of withdrawal of the amount.

Overdraft: Bank overdraft is allowed to current account holders. The current account holders
may be allowed to overdraw. The overdraft facility is more advantageous to the customers
because interest is charged only on the amount withdrawn. There is no need to provide collateral
security for the facility of overdraft. It can be used at any time of requirement. It is used for long-
term purposes. It is the most useful form of loans to commercial and industrial units to avail from
time to time. The overdraft will be granted by the bank with the mutual agreement with the
customer and bank. This form of advances has undoubtedly more benefits.

Discounting of Bills: The banks involves in discounting of bills. They discount only clear and
reputed bills. Discounting of bills is one of the methods of advances made by the banks. The
banks involve is discounting of bills. The working capital of the corporate sector is mainly
provided by banks through cash credit, overdrafts, and discounting of the commercial bills. The
bills are used for financing a deal in goods that takes same time to complete. The bill of
exchange reveals that the liability to make the payment on a fixed date when the goods are
bought on mercantile basis. The bills of exchange will be treated as negotiable instrument. The
bills are drawn by the seller on the buyer for the value of the goods delivered by him. These bills
are called as trade bills. If the trade bills are accepted by the commercial banks are known as
commercial bills. If the seller provide some time for the payment of the bill payable at a future
date is known as usance bill. If the seller party is in need of finance, he may approach the bank
for discount of the bill. The commercial banks generally finance the business community through
bill discounting method. The banks can rediscount the bills in the discount market. A bill is
always drawn by the creditor on the debtor. A bill may be payable at sight or after the expiry of a
certain specified time. There will be 3 days of grace period for a bill. The discount amount on the
trade bill becomes income to the commercial banks. It is an income generating activity for the
banks. The RBI introduced a bill market scheme in 1952. According to the scheme, the banks are
required to select the borrowers after careful examination of their credit worthiness and
reputation.

2.4 Secured Advances

In accordance with the principles of safety and security of sound lending, commercial banks
prefer to make advances against securities. A secured advance is one which is made on the
security of either assets or against personal security or other guarantees. An advance which is not
secured is called an unsecured advance.
The basic objective of obtaining securities is to recover the unpaid amount of loan if
any, through the sale of these securities. Hence, the securities should be clearly identifiable be
easily marketable, have stability and their title should be clear and easily transferable.

19
Classification of Securities: Based on their nature, securities can be divided into various
categories:
1. Personal Securities: These are also called intangible securities. In case of these, the
banker has a personal right of action against the borrower, e.g. promissory notes, bills or
exchange, a security bond, personal liability of guarantor etc.
2. Tangible Securities: These are forms of impersonal security, such as, land, buildings and
machinery. In the event of recovery of loans, banks have to get such securities enforced
or sold through the intervention of court.
3. Primary Securities: These are those securities or assets which are created with the help of
finance made available by the bank, like machinery or equipment purchased with the help
of bank finance.
4. Collateral Security: This security is not what is financed out of the bank advance. It is
additional security given by the borrower where the primary security is not enough to
recover the loan amount at the time of realization, e.g. the land of the factory is given as
security along with the machinery purchased out of the bank loan.

2.5 Modes of Creating Charges

In case of secured loan, a charge is created on the asset in favour of the bank. In other words, the
banker obtains a legal right to get payment of the loan amount out of the security charged.
Charges can be of the following types such as lien, pledge, assignment and mortgage. Charges
can also be categorized according to their nature such as fixed charge or floating charge. A fixed
charge is created on assets whose identity does not change, e.g., land and building. In the case of
floating charge, the identity of the asset keeps fluctuating, e.g., stocks.
The legal provisions regarding modes of creating charge over tangible assets and the rights
and obligations of various parties are explained hereinafter:

Lien: Lien means the right of the creditor to retain the goods and securities owned by the debtor
until the debt due from him is repaid. The creditor gets only the right to retain the goods and not
the right to sell. Lien can be either particular or general. The right of particular lien can be
exercised by a person who has spent his time, money or labour on the goods, e.g. a car mechanic,
a tailor, etc. It can be exercised against only those goods for which charges have to be paid. A
banker, however, enjoys the right of general lien.
Features:
The right of general lien right of a banker is a blanket right, and is applicable in respect of all
amounts which are due from the debtor such as security handed over to the banker for a
machinery loan after its repayment can also be used by the banker in respect of any other
advances outstanding in his name, e.g., against an overdraft taken by the borrower.
Even though this right is conferred upon the banker by the Indian Contract Act, yet it is advisable
to take a letter from the customer mentioning that the goods have been entrusted to the banker as
security, and he may exercise his right of lien against it.
The bankers’ right of lien is tantamount to an implied pledge. Unlike as in the case of particular
lien the creditor can only retain the goods till the amount due is paid, the banker has the right to
sell the goods in case of default of the customer.
Sometimes even a negative lien can be entered into. Under this arrangement, the borrower has to
1. give a declaration that the assets given as security are free from any charge or encumbrance, 2.

20
That no charge will be created on them nor will the borrower dispose of those assets without the
consent of the banker. The banker’s interests are only partially safe by securitizing a negative
lien as he cannot realize his dues from these assets.

Pledge: Pledge is the bailment of goods as security for payment of a debt or performance of a
promise. When a borrower secures a loan through a pledge, he is called a pawner or pledger, and
the bank is called the pawnee or pledge.
Features
• The goods can be pledged by the owner, a joint owner with consent of other joint owners,
a mercantile agent or in some cases by an unpaid seller.
• The banker can retain the goods for the payment of the debt, for any interest that has
accrued on it as well as any expenses incurred by him for keeping the goods safe and
secure.
• Goods can be retained for any subsequent advances also, but not for any existing debt
which is not covered by the pledge.
• In case of non-payment, the banker has the right to sell the goods and recover the amount
of loan along with the interest and expenses, if any.
• In case of default by the pledger, the banker has the right either to
• File a civil suit against the pledger and retain the goods as additional security or
• Sell the goods. In case of sale, banker must give due notice of sale to the borrower before
making a sale.
• This right is not limited by the law of limitation.
• Banker’s right of pledge prevails over any other dues including government dues except
worker’s wages.

Hypothecation: Hypothecation is an extended idea of pledge, whereby the creditor permits the
debtor to retain possession of goods, either on behalf of or in trust for him. Hypothecation is a
charge made on movable property in favour of a secured creditor without delivery or possession.
Charge is created only on movable goods like stocks, machinery and vehicles. The borrower
binds himself to give the possession of the goods to the banker, whenever the latter desires. It is a
convenient device in the circumstances in which the transfer of possession is either inconvenient
or impracticable such as buses and taxies, which are given as security by taxi operators, but are
used by them. The agreement is entered into through a deed of hypothecation.
The bank cannot take possession without the consent of the borrower, but after taking
possession, the banker is free to exercise the right of pledge, and sell the assets without
intervention of the court.

Assignment: Assignment of a contract means transfer of contractual rights and liabilities to a

third party. The transferor or borrower is called the assignor, and the transferee or banker is
called the assignee. The borrower can assign any of his rights, properties or debts to the banker
as security for a loan. These might be existing or future. Generally the ‘actionable claims’ are
assigned by the borrower. An actionable claim is a claim to any debt, other than a debt secured
by mortgage of immovable property, or by hypothecation or pledge of movable property, or to
any interest in movable property not in the possession, either actual or constructive, of the
claimant which the civil court recognizes as affording ground of relief, whether such debt or
beneficial interest be existent, accruing, conditional and contingent. Usually the borrower may

21
assign books debts, money due from government or semi-government or semi-government
organizations or life insurance policies.
Although notice of assignment of the debtor is not required under law (section 130 of
Transfer of Property Act, 1881), nevertheless it is in the interest of the assignee to give notice to
the debtor because in the absence of the notice, the assignee is bound by any payments which the
debtor might make to the assignor in ignorance of the assignment. For example, if the borrower
assigns his life insurance policy in favour of his banker as security for a loan, the bank should
give a notice to the Life Insurance Corporation (LIC), otherwise if any payment is made by the
LIC to the borrower, the banker will not be able to claim it.
Assignment may be legal or equitable. A legal assignment is effected through an
instrument in writing signed by the assignor. The assignor too informs the debtor in writing
about the assignment, the assignee’s name and address. The assignee also serves a notice on the
debtor of the assignor, and seeks confirmation of assigned balance. If the above conditions are
not fulfilled, i.e. assignment is not done in writing, or notice of assignment is not given to debtor,
then such assignment is called equitable assignment.

Mortgage: When a customer secures an advance on the security of specific immovable property
the charge created thereon is called a mortgage. Section 58 of the Transfer of Property Act, 1882,
defines a mortgage as, The transfer of an interest in a specific immovable property for the
purpose of securing the payment of money advanced or to be advanced by way of loan, on
existing or future debt, or the performance of an engagement which may give rise to pecuniary
liability. The instrument through which it is affected is called a mortgage deed, the customer
(transferor) is called the mortgagor and the bank (transferee) is called the mortgagee. The
payment so secured which includes both the principal money and the interest thereon is called
the mortgage money.
Section 58 of Transfer of Property Act, recognizes six types of mortgagers which are
discussed hereinafter.
Simple Mortgage: In case of simple mortgage, the mortgagor does not give possession of
property, but binds himself personally to pay the mortgage money. He agrees expressly or
impliedly that in case he fails to make the payment according to the contract, then the mortgagee
shall have right to cause the mortgage property to be sold and proceeds of sale to be applied, as
far as may be necessary, in payment of the mortgage money. The mortgagee himself cannot sell
the property, but has to seek intervention of the court.
Mortgage by Conditional Sale: Under this form of mortgage the mortgager ostensibly (on the
face of it) sells the mortgaged property with any one of the following conditions:
I. On default of payment of mortgage money, the sale shall become absolute.
II. On payment being made on a certain date, the sale shall become void.
III. When the payment is made, the buyer shall transfer the property to the seller.

Usufructuary mortgage: Unlike the simple mortgage which is non-possessory, in case of

usufructuary mortgage, the mortgagor delivers possession of the mortgaged property. The
mortgagee is also entitled to receive rents and profits accruing from the property and appropriate
the same in lieu of interest or in payment of mortgaged money or both. When the debt is so
discharged or repaid, the mortgagor is entitled to recover possession of his property. There is no
personal liability on the mortgagor.

22
English Mortgage: In case of English mortgage, there is transfer of ownership on the condition
that the mortgagee will re-transfer the same on the payment of mortgage money. Further, the
mortgagor personally undertakes to repay the mortgaged money. In case of default, the
mortgagee has the right to sell the property without seeking permission of the court in the special
circumstances mentioned in section 69 of the Transfer of Property Act.

Mortgage by deposit of title deeds (equitable mortgage): This mortgage is affected by deposits of
title deeds of the property by the debtor in favour of the creditor to create a security thereon. This
type of mortgage is called equitable mortgage in English law. In India, it is restricted to the cities
of Delhi, Mumbai, Kolkata and Chennai or any other town which the concerned state
government may notify in the official gazette in this behalf. No registration is necessary and
delivery can be either actual or constructive. There is personal liability of the mortgagor to pay,
and the mortgagee can sell the property with the sanction of the court if the mortgaged money is
not repaid.
Anomalous Mortgage: A mortgage which is not simple mortgage, mortgage by conditional sale,
usufructuary mortgage, English mortgage and mortgage by deposit of title deeds (equitable
mortgage) is called an anomalous mortgage. If the terms of the mortgage do not strictly adhere to
any of the above five types, e.g. in case of simple mortgage if the mortgagee is allowed to use the
mortgage property, then it will not be called simple or usufructuary but an anomalous mortgage.
Under this the rights and liabilities of the parties are determined by the terms agreed upon in the
mortgage deed, and in the absence of such a deed by the local usage.

2.6 Legal Mortgage vs. Equitable Mortgage

From the point of view of transfer of title to the mortgaged property, a mortgage may either be a
legal mortgage or an equitable mortgage.

Legal Mortgage: legal mortgage can be enforced only if the mortgage money is Rs. 100 or
more. It is affected by transfer of legal title to the mortgage property by the mortgagor in favour
of the mortgagee. All this involves expenses in the form of stamp duty and registration charges.
At the time of repayment of mortgaged money, the property is retransferred to the mortgagor.

Equitable Mortgage: In case of equitable mortgage, only documents of title are transferred in
favour of the mortgagee and not the legal title. No registration is necessary and no stamp duty of
deposit, the mortgagor undertakes to execute a legal mortgage in case of default in payment
within the stipulated time. The reputation of the mortgagor is not affected, since in absence of
registration no one comes to know about the mortgage. However, this can prove risky also if
through negligence or fraud, another party is induced to advance money on the security of the
mortgaged property as the subsequent mortgagee will have priority over the first.

2.7 Conclusion

In conclusion, it is pertinent to mention that none of the principles should be considered in

isolation. While evaluating a loan proposal, judicious balance of all the cardinal principles of
sound lending are called for. This has become more imperative after 1991. Before liberalization,
banking business did not face much competition. As it was concentrated in a few hands, the

23
policy environment was characterized by close regulation and control, and profitability was not
the dominant criterion on which the banks were supposed to function. But now the commercial
principles of viability, efficiency, prudence and profitability are receiving as much attention as
social banking.

2.8 Test Questions

Q1. Describe the various ways in which a commercial bank renders financial assistance to
borrowers.
Q2. Discuss the secured and unsecured advances of a bank.
Q3. Compare the relative advantages and drawbacks of equitable and legal mortgage.

2.9 Further Readings

Varshney P.N.& Mittal D.K. , “ Indian Financial System”, Sultan Chand &Sons
G. Ramesh Babu, “ Financial Markets and Institutions”, Concept Publishing Company.
Tripathi Prava Nalini, “ Financial Services”, Prentice Hall of India, 2008.

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 LESSON 3

STRUCTURE OF THE INDIAN BANKING

Dr. Pooja Goel
Shaheed Bhagat Singh College
University of Delhi

Objectives

After going through this lesson you should be able to:

• Understand the Structure of Indian Banking System

• Explain the annual Reports of a Bank
• Describe the Items in the Balance sheet of Bank
Structure

3.1 Structure of Indian Banking System

3.2 Reserve Bank of India
3.3 Commercial Banks
3.4 Local Area Bank
3.5 Foreign Bank
3.6 Co-operative Banks
3.7 Regional Rural Banks
3.8 Annual Report
3.9 Balance Sheet of a Commercial Bank
3.10 Conclusion
3.11 Test Questions
3.12 Further Readings

The structure of banking varies widely from country to country. Often a country’s banking
structure is a consequence of the regulatory regime to which it is subjected. The banking system
in India works under the constraints that go with social control and public ownership.
Nationalization, for instance, was a structural change in the functioning of commercial banks
which was considered essential to better serve the needs of development of the economy in
conformation with national policy and objectives. Similarly, to meet the major objectives of
banking sector reforms, government stake was reduced up to 51 per cent in public sector banks.
New private sector banks were allowed and foreign banks were permitted additional branches.

3.1 Structure of Indian Banking System

The Indian financial system comprises a large number of commercial and cooperative banks,
specialized developmental banks for industry, agriculture, external trade and housing, social

25
security institutions, collective investment institutions, etc. The banking system is at the heart of
the financial system.
The Indian banking system has the RBI at the apex. It is the central bank of the country under
which there are the commercial banks including public sector and private sector banks, foreign
banks and local area banks. It also includes regional rural banks as well as cooperative banks.

Figure1
Indian Banking System

3.2 Reserve Bank of India

The central bank plays an important role in the monetary and banking structure of nation. It
supervises controls and regulates the activities of the banking sector. It has been assigned to
handle and control the currency and credit of a country. In older days, the central banks were
empowered to issue the currency notes and bankers to the Union governments. The first central
bank in the world was Riks Banks of Sweden which was established in 1656. The Reserve Bank
of India, the central bank of our country, was established in 1935 under the aegis of Reserve
Bank of India Act, 1934. It was a private shareholders institution till January 1949, after which it
became a state-owned institution under the Reserve Bank of India Act, 1948. It is the oldest
central bank among the developing countries. As the apex bank, it has been guiding, monitoring,
regulating and promoting the destiny of the Indian financial system.
Objectives of RBI
It plays a more positive and dynamic role in the development of a country. The financial muscle
of a nation depends upon the soundness of the policies of the central banking. The objectives of
the central banking system are presented below:
1. The central bank should work for the national interest of the country.
2. The central bank must aim for the stabilization of the mixed economy.
3. It aims at the stabilization of the price level at average prices.

26
 4. Stabilization of the exchange rate is also essential.
5. It should aim for the promotion of economic activities.
Constitution and Management
Reserve Bank of India has been constituted as a corporate body having perpetual succession and
a common seal. Its capital is Rs. 5 crore wholly owned by the Government of India. The general
superintendence and direction of the affairs and business of the Bank has been vested in the
Central Board of Directors. The Central Government, however, is empowered to give such
directions to the Bank as it may, after consultation with its Governor, consider necessary in the
public interest.
The Central Board of Directors consists of the following:
a) A Governor and not more than four Deputy Governor to be appointed by the Central
Government.
b) Four directors to be nominated by the Central Government, one from each of the four
local boards.
c) Ten directors to be nominated by the Central Government.
d) One Government official to be nominated by the Central Government.
Besides the Central Board of Directors, four Local Boards have also been constituted for each of
the four areas specified in the first schedule to the Act. A Local Board has five members
appointed by the Central Government to represent as far as possible, territorial and economic
interests and the interests of cooperative and indigenous banks. A Local Board advises the
Central Board on matters referred to it by the Central Board and performs such duties as are
delegated to it by the Central Board.
Functions of RBI
The RBI functions are based on the mixed economy. The RBI should maintain a close and
continuous relationship with the Union Government while implementing the policies. If any
differences arise, the government’s decision will be final. The main functions of the RBI are
presented below:
1. Welfare of the public
2. To maintain the financial stability of the country.
3. To execute the financial transactions safely and effectively.
4. To develop the financial infrastructure of the country.
5. To allocate the funds effectively without any partiality.
6. To regulate the overall credit volume for price stability.
Authorities
The RBI has the full authority in the following aspects:
1. Currency issuing authority
2. Monitoring authority
3. Banker to the Union Government
4. Foreign exchange control authority
5. Promoting authority.

27
1. Currency Issuing Authority- The RBI has the sole authority to issue the currency notes and
coins. It is the fundamental right of the RBI. The coins and one rupee notes are issued by the
Government of India and they are circulated through the RBI. The notes issued by the RBI issues
by the RBI will have legal identity everywhere in India. The RBI issues the notes of the
denomination of RS. 1000, 500, 100, 50, 20 and 10. The RBI has the authority to circulate and
withdraw the currency from circulation. It has also the authority to exchange notes and coins
from one denomination to other denominations as per the requirement of the public. The
currency notes may be distributed throughout the country through its 15 full pledged offices, 2
branch offices, and more than 4000 currency chests. The currency chests are maintained by
different banks in various locations. The RBI issues currency notes, based on the availability of
balances of gold, bullion, foreign securities, rupees, coins and permitted bills.
2. Monitoring Authority- The RBI has the full authority to control all the aspects of the banking
system in India. The RBI is known as the Banker’s Bank. The banking system in India works
according to the guidelines issued by the RBI. The RBI is the premier banking institute among
the commercial banks. All the commercial banks, foreign banks and cooperative urban banks in
India should obey the rules and regulations which are issued by the RBI from time to time. The
RBI controls the deposits of the commercial banks through the CRR and the SLRs. Every bank
should deposit a certain amount in the RBI. The commercial banks have the power to borrow the
money from the RBI when they are in need of finance. Hence it is known as the lender of the last
resort. The RBI has the authority to control the credit supply in the economy or monetary
systems of the nation.
3. Banker to the Union Government- Generally in any country all over the world the Central
bank dominates the banking sector. It advises the government on monetary policies. The RBI is
the bankers to the Union Government and also to the state governments in the country. It
provides a wide range of banking services to the government. It also transfers the funds, collects
the receipts and makes the payment on behalf of the Government. It also manages the public
debts. The Government will not pay any remuneration or brokerage to the RBI for rendering the
financial services. Any deficit or surplus in the Central Government account with the RBI will be
adjusted by creation or cancellation of the treasury bills. The treasury bills are known as the
Adhoc Treasury bills.
4. Foreign Exchange Regulation Authority- The RBI’s another major function is to control the
foreign exchange reserves position from time to time. It maintains the stability of the external
value of the rupee through its domestic policies and forex market. The RBI has the full authority
to regulate the market as discussed below:
• To monitor the foreign exchange control.
• To prescribe the exchange rate system.
• To maintain a better relation between rupee and other currencies.
• To interact with the foreign counterparts.

28
 • To manage the foreign exchange reserves.
It administers the FERA, 1973. It is replaced by the FEMA which would be consistent with full
capital account convertibility with policies of the Central Government.
The RBI administers the control through the authorized forex dealers. The RBI is the custodian
of the country’s foreign exchange reserves. The foreign exchange is precious and it takes the
responsibility of the better utilization.
5.Promoting Authority:
The RBI’s function is to look after the welfare of the financial system. It renders the promotion
services to strengthen the country’s banking and financial structure. It helps in mobilizing the
savings and diverting them towards the productive channel. Thus the economic development can
be achieved. After the nationalization of the commercial banks, the RBI has taken a number of
series of actions in various sectors such as agriculture sector, industrial sector, lead bank scheme
and cooperative sector.

3.3 Commercial Banks

Amongst the banking institutions in the organized sector, commercial banks are the oldest
institutions, some of them having their genesis in the nineteenth century. Initially, they were set
up in large numbers, mostly as corporate bodies with shareholdings by private individuals. In the
sixties of the twentieth century, a large number of weaker and smaller banks were merged with
other banks. As a consequence, a stronger banking system emerged in the country. Subsequently,
there has been a drift towards state ownership and control. Today 27 banks constitute strong
public sector in Indian commercial banking. Commercial banks operating in India fall under
different sub-categories on the basis of their ownership and control over management.
Public Sector Banks
Public sector in Indian banking emerged to its present position in three stages. First, the
conversion of the then existing Imperial Bank of India into the State Bank of India in 1955,
followed by the taking over of the seven state associated banks as its subsidiary banks, second
the nationalization of 14 major commercial banks on July 19, 1969 and last, the nationalization
of 6 more commercial banks on April 15, 1980. Thus 27 banks constitute the Public sector in
Indian Commercial Banking.
Private Sector Banks
After the nationalization of major banks in the private sector in 1969 and 1980, no new bank
could be set up in India for about two decades, though there was no legal bar to that effect. The
Narasimham Committee on Financial Sector Reforms recommended the establishment of new
banks in India. Reserve Bank of India, thereafter, issued guidelines for the setting up of new
private sector banks in India in January 1993.
These guidelines aim at ensuring that the new banks are financially viable and technologically
up-to-date from the start. They have to function in a professional manner, so as to improve the
image of commercial banking system and to win the confidence of the public.

29
 In January 2001 Reserve Bank of India issued new rules for the licensing of new banks in the
private sector. The salient features are as follows:
1. A new bank may be started with a capital of Rs. 200 crore. The net worth is to be raised
to Rs. 300 crore in three years.
2. The promoter’s minimum holding in the capital shall be 40 per cent with a lock-in-period
of 5 years. Excess holding over 40 per cent will have to be diluted within a year.
3. Non-resident Indians can pick up 40 per cent equity share in the new bank. Any foreign
bank or finance company may join as technical collaborators or as co-promoter, but their
equity participation will be restricted to 20 per cent, which will be within the ceiling of
40 per cent allowed to Non –resident Indians.
4. Corporates have been allowed to invest up to meet existing priority sector norms and
prudential norms and also to open 25 % of their branches in rural and semi-urban areas.
Preference will be given to promoters with expertise in financing priority areas and rural
and agro based industries.
5. Non-banking finance companies may convert themselves into banks if their net worth is
Rs. 200 crore, capital adequacy ratio is 12%, non performing assets below 5% and
possess triple A credit rating.
In addition to the above guidelines, the new banks are governed by the provisions of the Reserve
Bank of India Act, the Banking Regulation Act and other relevant statutes.

3.4 Local Area Bank

In 1996, Government decided to allow new local area banks with the twin objectives of
Providing an institutional mechanism for promoting rural and semi-urban savings, and For
providing credit for viable, economic activities in the local areas.
Such banks can be established as public limited companies in the private sector and can be
promoted by individuals, companies, trusts and societies. The minimum paid up capital of such
banks would be Rs. 5 crore with promoter’s contribution at least Rs. 2 crore. They are to be set
up in district towns and the area of their operations would be limited to a maximum of 3
geographically contiguous districts. At present, five Local Area Banks are functional, one each in
Punjab, Gujrat, Maharashtra and two in Andhra Pradesh.

3.5 Foreign Bank

Foreign Commercial Banks are the branches in India of the joint stock banks incorporated
abroad. Their number has increased to forty as on 31st March, 2002. These banks, besides
financing the foreign trade of the country, undertake normal banking business in the country as
well.
Licensing of Foreign Bank: In order to operate in India, the foreign banks have to obtain a
license from the Reserve Bank of India. For granting this license, the following factors are
considered:

30
 1. Financial soundness of the bank.
2. International and home country rating.
3. Economic and political relations between home country and India.
4. The bank should be under consolidated supervision of the home country regulator.
5. The minimum capital requirement is US $ 25 million spread over three branches - $ 10
million each for the first and second branch and $5 million for the third branch.
6. Both branches and ATMs require licenses and these are given by the RBI in conformity
with WTO’s commitments.
Function of Foreign Banks: The main business of foreign banks is the financing of India’s
foreign trade which they can handle most efficiently with their vast resources. Recently, they
have made substantial inroads in internal trade including deposits, advances, discounting of bills,
mutual funds, ATMs and credit cards. A large part of their credit is extended to large enterprises
and MNCs located mostly in the tier one cities- mainly the metros, though some banks are now
foraying in the rural sector as well. Technology used by these banks has been a major driver of
change in the Indian banking industry. A highly trained and efficient workforce and the huge
pool of capital resources at the disposal of these banks have created tremendous goodwill and
prestige of foreign banks in India.
Apart from their main businesses, foreign banks are also instrumental in shaping the attitudes,
perceptions and policies of foreign governments, corporates and other clients towards India,
especially in the following areas:
1. Bringing together foreign institutional investors and Indian companies.
2. Organizing joint ventures.
3. Structuring and syndicating project finance for telecommunication, power and mining
sectors.
4. Providing a thrust to trade finance through securitization of export loan.
5. Introducing new technology in data management and information systems.

Performance: Foreign banks are not subject to the stringent norms regarding opening of rural
branches, priority sector lending or bound by the social philosophy of Indian banks. These
factors combined with the financial, technical and human resources of the foreign banks have
ensured a healthy growth of these banks in India.

3.6 Co-operative Banks

Besides the commercial banks, there exist in India another set of banking institutions called co-
operative credit institutions. These have been in existence in India since long. They undertake the
business of banking both in urban and rural areas on the principle of co-operation. They have
served a useful role in spreading the banking habit throughout the country. Yet, their financial
position is not sound and a majority of co-operative banks has yet to achieve financial viability
on a sustainable basis.

31
 The cooperative banks have been set up under the various Co-operative Societies Acts enacted
by the State Governments. Hence the State Governments regulate these banks. In 1966, need was
felt to regulate their activities to ensure their soundness and to protect the interests of depositors.
Consequently, certain provisions of the Banking Regulation Act 1949 were made applicable to
co-operative banks as well. These banks have thus fallen under dual control viz., that of the State
Govt. and that of the Reserve Bank of India which exercises control over them so far as their
banking operations are concerned.
Features of Cooperative banks
• These banks are government sponsored government supported and government
subsidized financial agencies in India.
• Unlike commercial banks which focus on profits, cooperative banks are organized and
managed on principles of cooperation, self help and mutual help. They function on a “no
profit, no loss” basis.
• They perform all the main banking functions but their range of services is narrower than
that of commercial banks.
• Some of them are scheduled banks but most are unscheduled banks.
• They have a federal structure of three-tier linkages and vertical integration.
• Cooperative banks are financial intermediaries only, particularly because a significant
amount of their borrowings is from the RBI, NABARD, the central and state
governments and cooperative apex institutions.
• There has been a shift of cooperative banks from the rural to the urban areas as the urban
and non-agricultural business of these banks has grown over the years.

Weaknesses: Cooperative banks suffer from too much dependence on RBI, NABARD and the
government.
• They are subject to too much officialization and politicization. Both the quality of loans
assets and their recovery are poor. The primary agricultural cooperative societies- a vital
link in the cooperative credit system- are small in size, very week and many of them are
dormant.
• The cooperative banks suffer from existence of multiple regulation and control
authorities.
• Many urban cooperative banks have failed or are in the process of liquidation.
• Cooperative banks have increasingly been facing competition from commercial banks,
LIC, UTI and small savings organizations.

3.7 Regional Rural Banks

Regional Rural Banks are relatively new banking institutions which supplement the efforts of the
cooperative and commercial banks in catering to the credit requirements of the rural sector.
These banks have been set up in India since October 1975, under the Regional Rural Banks Act,

32
1976. At present there are 196 RRBs functioning in 484 districts. The distinctive feature of a
Regional Rural Bank is that though it is a separate body corporate with perpetual succession and
a common seal. It is very closely linked with the commercial bank which sponsors the proposal
to establish it and is called the sponsor bank. The central government establishes a RRB, at the
request of the sponsor bank and specifies the local limits within which it shall establish its
branches and agencies.
Business of a Regional Rural Bank
A Regional rural bank carries on the normal banking business i.e., the business of banking as
defined in section 5(b) of the Banking Regulation Act, 1949 and engages in one or more forms of
businesses specified in Section 6 (1) of that Act. A Regional rural bank may in particular,
undertake the following types of businesses, namely:
1. The granting of loans and advances, particularly to small and marginal farmers and
agricultural laborers, and to cooperative societies for agricultural operations or for other
connected purposes, and
2. The granting of loans and advances, particularly to artisans, small entrepreneurs and
persons of small means engaged in trade, commerce or industry or other productive
activities within the notified areas of a rural bank.
Regional Rural Banks are thus primarily meant to cater to the needs of the poor and small
borrower in the countryside.
Capital
The authorized capital of a RRB shall be Rs. 5 crore which may increased or reduced(not below
Rs. 25 lakh) by the Central Government in consultation with NABARD and the sponsor bank.
The issued capital shall not be less than Rs. 25 lakh. Of the issued capital, the Central
Government shall subscribe fifty percent, the sponsor bank thirty five percent and the concerned
State Government fifteen percent.
The shares of the Rural Banks shall be deemed to be included in the securities enumerated in
Section 20 of the Indian Trusts Act, 1882 and shall also be deemed to be approved securities for
the purpose of the Banking Regulation Act 1949.
Management
Each Rural Bank is managed by a Board of Directors. The general superintendence, direction
and management of the affairs and business vest in the Board. In discharging its functions the
Board of Directors acts on business principles and shall have due regard to public interests. A
regional rural bank is guided by the directions, issued by the Central Government in regard to
matters of policy involving public interest.

3.8 Annual Report

An annual report is a reflection of the company’s philosophy, policies, achievements and
shortcomings. The annual report gives general information regarding the name(s) of the
chairman/MD, chief executive officer and all the directors, the bankers and auditors of the

33
company, registered office, date, time and venue of the annual general meeting. An annual report
comprises two parts.

Part I: It includes

Notice of the meeting of the shareholders.

Directors’ Report: The chairman of the company presents the Director’s report which
usually highlights the company’s achievements in the given macro and micro-
environment, new initiatives/ products/ technology, etc. proposed to be used, constraints
if any faced by the company, future plans for modernization, diversification, etc.

The company’s philosophy that describes how the company does business, is delineated
in a separate section.

Social responsibility report: It has initiatives for environment conservation and corporate
social responsibility. Since banks do not manufacture goods, therefore, treatment of
effluents is not relevant. However, most banks do conduct a number of social outreach
programmes for education, training etc. for the poor and underprivileged sectors of the
society.

Corporate Governance report: Corporate Governance deals with conducting the affairs of
the organization with integrity, transparency and commitment to principles of good
governance. It has to be certified that all mandatory requirements as stipulated by
Securities and Exchange Board of India (SEBI) have been complied with.

Declaration of dividend (if any) is provided.

Retirement, reappointment of existing directors or appointment of new directors.

For the sake of uniformity and transparency in reporting, banks are also supposed to give
details of their non-performing assets (NPA). NPAs are those assets which have remained
unpaid for a period of ninety days. They are further categorized as sub-standard, doubtful
and loss.
Part II: The second part of the report deals with performance highlights of the organization.

It includes a balance sheet, a profit and loss account, cash flow statement and other
statements and explanatory material that are an integral part of the financial statements.

An auditors’ report certifying that the financial statements together present a true and fair
view of the company’s affairs, and are in compliance with existing accounting standards,
applicable laws and regulations.

3.9 Balance Sheet of a Commercial Bank

One of the best ways to learn about the business of banking is through a perusal of a typical
bank’s balance sheet. Balance sheet of a commercial bank is a statement of its assets and
liabilities at a particular point of time. It throws light on the financial health or otherwise of
the bank.
Another way of viewing a balance sheet is as a statement of the sources and uses of bank
funds. Banks obtain funds in the form of deposits (fixed, savings and current) by borrowing

34
from other banks (RBI, commercial banks, etc.) and by obtaining equity funds from the
owners (i.e. the shareholders of the bank) through the capital account. All these constitute the
liabilities of the bank. Banks use these funds to grant loans, invest in securities, purchase
equipment and hold cash items such as currency and deposits in other banks. All these are the
assets of the bank.
According to section 29 of the Banking Regulation Act, 1949, at the expiration of each
calendar year (or at the expiration of a period of twelve months ending with such date as the
Central Government may, by notification in the official gazette, specify in this behalf), every
banking company incorporated in India, in respect of all business transacted through its
branches in India, in respect of all business transacted through its branches in India, shall
prepare with reference to that year or period, as the case may be, a balance sheet and profit
and loss account as on the last working day of the year or the period, as the case may be, in
the forms set out in the third schedule or as near thereto as circumstances admit.
The balance sheet and profit and loss account shall be signed:
in the case of a banking company incorporated in India, by the manager or the principal
officer of the company. Where there are more than three directors of the company, by at least
three are more than three directors. Where there are not more than three directors, by all the
directors, and
in the case of a banking company incorporated outside India by the manager or agent of the
principal office of the company in India.

Audit
The balance sheet and profit and loss account prepared in accordance with section 29 shall be
audited by a person duly qualified under any law for the time being in force to be an auditor
of companies.
Where the Reserve Bank is of opinion that audit is necessary in the interest of the public or
the banking company or its depositors, it may, at any time order a special audit of the
banking company’s accounts, for any such transaction or class of transactions or for some
specific period or periods as it deems necessary. The RBI may through its order either
appoint a person duly qualified under any law for the time being in force to be an auditor of
companies or direct the auditor of companies or direct the auditor of the banking company
himself to conduct such special audit.
Submission of Returns
The accounts and balance sheet referred to in sanction 29 together with the auditor’s report
shall be published in the prescribed manner, and three copies thereof shall be furnished as
returns to the Reserve Bank within three months from the end of the period to which they
refer.
A banking company which furnishes its accounts and balance sheet in accordance with the
provisions of section 31 shall send three copies of such accounts, balance sheet and the
auditor’s report to the registrar.

35
 It is mandatory for all banking companies incorporated outside India that before the first
Monday in August of any year in which it has carried on business, it must display a copy of
its last audited Balance Sheet and profit and Loss Account prepared under section 29, in a
conspicuous place in its principal office and every branch office in India. These should be
kept on display until they are replaced by a copy of the subsequent Balance Sheet and profit
and Loss Account.

Items of the Balance Sheet of a Bank

The balance sheet of a commercial bank like any other balance sheet comprises two sides;
conventionally the left side shows liabilities and capital, while the right side shows assets. A
bank’s assets are indications of what the bank owns or the claims that the bank has on
external entities: individuals, firms, governments, etc. A bank’s liabilities are indications of
what the bank owes as claims which are held by external entities of the bank. The net worth
or capital is calculated by subtracting total liabilities from total assets.
Assets-Liabilities = Net worth
Or
Assets= Liabilities+ Net worth

Liabilities and Assets of a Bank

Many institutions offer financial services. It is the taking of deposits and granting of loans
that single out a bank from other financial institutions. Deposits are liabilities for banks,
which must be managed if the bank is to maximize profits. Likewise they need to manage the
assets created by lending. The liabilities and assets of a bank explained below:
Liabilities of a Bank
Liabilities of a commercial bank are claims on the bank. They represent the amounts which
are due from the bank to its shareholders, depositors, etc. Bank liabilities are the funds that
banks obtain and the debts they incur, primarily to make loans and purchase securities. The
major components of the liabilities of a bank are as follows:
1. Capital: Capital and reserves what the customer regards as an asset, the same bank
deposit is a liability for the bank as the customer gains claims over them. The paid up
share capital implies the liability of the bank to its shareholders. It is the amount
actually received by the bank out of the total subscribed capital. Adequate share
capital is considered as a source of strength for the bank as it provides confidence to
the depositors about the solvency of the bank.
2. Reserve Fund: Reserves are created out of the undistributed profits which are retained
over a period of years by the bank. Creation of reserve fund is a statutory requirement
in most of the countries of the world. Reserve requirements limit the portion of the
bank’s funds that it can use to give loans and purchase securities. Banks build up
reserves to strengthen their financial position and also to meet unforeseen liabilities or
unexpected losses. Reserve fund, together with capital represents the capital structure

36
 or net worth of the bank. Net worth is a residual term that is calculated by subtracting
total liabilities from total assets.
3. Deposits: Deposits constitute the major sources of funds for banks. What the
customer regards as an asset, the same bank deposit is a liability for the bank as the
customer gains claim over them. Banks get funds from investment and these are
indirectly the source of its income. Banks keep a certain percentage of its time and
demand deposits in cash and after meeting the liquidity requirement, they lend the
remaining amount on interest. Indian banks accept two main types of deposits,
demand deposits and term deposits. Demand deposits, as the name suggests, are
repayable on particular period. The prosperity, growth and goodwill of the bank
depend upon the amount of these deposits. Fixed deposits have specific maturity and
so can be used by banks to earn income. Demand deposits can be further subdivided
into current and savings. Current deposits are chequeable accounts with no restriction
on the number of withdrawals. It is possible to obtain clean on secured overdraft on
these accounts. Saving deposits are more liquid than fixed deposits as money can be
withdrawn when needed, though some banks restrict the number of withdrawals per-
month or per-quarter.
4. Borrowing from Other Sources: In case of need, banks can borrow from the Reserve
Bank of India, other commercial banks, development banks, non-bank financial
intermediaries like LIC, UTI, GIC, etc. Secured loans are obtained on the basis of
some recognized, securities whereas unsecured loans are out of its reserve funds lying
with the central bank.
5. Other Liabilities: Other liabilities include bills payable, bills sent for collection,
acceptance, endorsement, etc. The amounts of all such bills are shown on the liability
side of the balance sheet.
6. Contingent Liability: Contingent liabilities are those liabilities which may arise in
future but cannot be determined accurately, e.g. guarantee given on behalf of others,
outstanding forward exchange contracts, etc. These are shown on the liability side as
a rough estimate.
7. Profit or loss: Profit is unallocated surplus or retained earnings of the year after
paying tax and dividends to shareholders. As shareholders have claim over the bank’s
profit, it is shown as a liability. In case of loss, the figure will be shown on the assets
side.

Assets of a Bank
Like all other business firms banks also strive for profit. Commercial banks use their funds
primarily to purchase income earning assets, mainly loans and investments. These assets are
shown in the balance sheet of the bank in decreasing order of the liquidity. The major assets
of the bank include:

37
 1. Cash: Cash in hand and cash balances with the Reserve Bank of India are the most
liquid assets of a bank. Cash assets provide bank funds to meet the withdrawals of
deposits and to accommodate new loan demand. Maintaining of cash reserve ratio
with RBI is a statutory requirement for the banks.
2. Money at Call and Short Notice: This is the money lent by the banks to other banks,
bill brokers, discount houses and other financial institutions for a very short period of
time varying from 1 to 14 days. When these funds are repayable on demand without
prior notice, it is called money at call. On the other hand, if some prior notice is
required, it is known as money at short notice. In the balance sheet, both are shown as
a single item on the asset side. Banks charge very low rate of interest on these. If the
cash position continues to remain comfortable, these loans may be renewed day after
day.
3. Loans and Advances: Loans and advances are the bank’s earning assets. The interests
earned from these assets generate the bulk of commercial bank revenues. Loans may
be demand loans or term loans which may be repayable is single or in many
installments. Advances are usually made in the form of cash credit and overdraft.
4. Investments: Commercial banks use funds for investment in various types of
securities like the gilt edged securities of the central and state government as well as
shares and debentures of corporate undertakings. The securities issued by government
are safe from the risk of default though they are subject to risk from change in rate of
interest. These securities include treasury bills, treasury deposit certificates, etc. The
long-term investments have the greatest profitability.
5. Bills Receivable: Bills receivable and other credit instruments accepted by the
commercial banks on behalf of their customers are also shown on the asset side of the
balance sheet. The reason is that the bank has a claim on the payee, on whose behalf
it has accepted the bills. Thus, the same amount appears on assets as well as liabilities
sides of the balance sheet of the bank.
6. Other Assets: These include the physical assets of a bank like the bank premises,
furniture, computers, machine equipment, etc. These also include the collaterals
which the bank has repossessed from the borrowers in default.

3.10 Conclusion

The Indian financial system comprises a large number of commercial and cooperative banks,
specialized developmental banks for industry, agriculture, external trade and housing, social
security institutions, collective investment institutions, etc. The banking system is at the heart
of the financial system. The Indian banking system has the RBI at the apex. It is the central
bank of the country under which there are the commercial banks including public sector and
private sector banks, foreign banks and local area banks. It also includes regional rural banks
as well as cooperative banks. In India, only those banks are called Commercial Banks which
have been established in accordance with Indian Companies Act 1913. Important commercial

38
 banks in India are Punjab National Bank, Bank of Baroda, Indian Bank, Central Bank of
India, etc. State Bank of India and its 7 subsidiaries are not included in the category of
commercial banks because these were established under a separate act. One of the best ways
to learn about the business of banking is through a perusal of a typical bank’s balance sheet.
Balance sheet of a commercial bank is a statement of its assets and liabilities at a particular
point of time. It throws light on the financial health or otherwise of the bank.

3.11 Test Questions

Q1. Distinguish between Indian bank and Foreign bank..
Q2. Write a short note on Regional Rural Banks.
Q3. Explain the various assets and liabilities of a bank.

3.12 Further Readings

Varshney P.N.& Mittal D.K. , “ Indian Financial System”, Sultan Chand &Sons
G. Ramesh Babu, “ Financial Markets and Institutions”, Concept Publishing Company.
Tripathi Prava Nalini, “ Financial Services”, Prentice Hall of India, 2008.

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 LESSON 4

CREDIT DELIVERY AND ADMINISTRATION

Dr. Ashish Kumar
LBSIM
Who takes the decision to lend? Depending on the size of the bank, the loan size and type of
exposures planned, the final decision to lend may be taken by an authorized layer of the bank.
Typically, banks fix 'discretionary limits' -monetary ceilings up to which personnel at each level
can take credit decisions-for each layer of authority starting from credit officers themselves to
branch heads to senior and they move up the organizational hierarchy.
For all decision-makers above the level of loan officers, the loan officer's appraisal forms the
very basis of decision-making. Hence, the loan officer's role in the credit decision-making
process is extremely critical. Many banks create a separate channel in the hierarchy for grooming
and equipping credit officers with the essential attitude and skills for the lending function.
The hierarchical levels over and above the credit officer merely review the recommendations
made by the credit officer, and add their insights and comments before making the decision. It is
not necessary that a favourable recommendation from a credit officer after extensive research has
to be approved by the ultimate decision-maker. Accountability demands at every level of the
bank require that the decision-making authority forms an independent opinion of the borrower's
creditworthiness and takes decisions accordingly in the best interests of the bank.
Some very large banks have a centralized 'underwriting department'. This corporate service
essentially sources new business for the bank and manages select existing relationships. For
these select customers, this centralized department processes the credit request and conveys
approval 'in principle', in order to cut the process and time required for a sanction through the
regular process. Many large banks use customized software to evaluate credit requests. However,
as already emphasized, sophisticated tools can be used as aids, and not as substitutes, for the
credit officer's or the credit sanctioning authority's judgment.
Once a loan is approved, the officer communicates the sanction to the borrower through a
formal 'sanction letter'. The sanction letter is generally in the form of a 'loan agreement', to be
signed by the borrower(s) and guarantors, if any. The loan agreement contains the following
essential features.
• Nature/type of credit facility.
• Interest/discount/charges as applicable.
• Repayment terms.
• Stipulations regarding end use of each facility.
• Additional fees applicable such as processing fees, closing fees or commitment fees.
• Prime security for each credit facility.
• Full description of the collateral securities.
• Details of personal/third party guarantees.
• Covenants-terms and conditions under which the loan facilities are being granted.
• Events of default and penal provisions.
Loan Documentation
Different types of borrowers and different types of security interests necessitate loan
documentation procedures that would be valid in a court of law. Accordingly, once the loan
agreement is signed, the borrowers and guarantors execute the loan documents. The security

40
interest is said to be 'perfected' when the bank's claim on the borrower's assets forming the
security is senior to that of any other creditor. If the borrower defaults on a secured loan, the
bank has the right to take possession of the assets and liquidate them to recover its dues. Proper
loan documentation secures this right.
Terms and Conditions of Advances
These are very important ingredients of any loan agreement. The bank derives control over the
borrower's operations and also mitigates the risks of lending through this part of the loan
agreement. The terms and conditions comprise of three distinct portions:
(I) Conditions precedent: These are requirements that a borrower should satisfy before the
bank acquires the legal obligation to disburse the loan amount. Some illustrative and
commonly used conditions precedent are auditor's certificate for having brought in
the committed capital amount, relevant legal opinions sought for and board resolution
to borrow. An important condition precedent is a material adverse change clause that
covers the financial statements and projections. The clause protects the bank in the
event of a material change occurring after the loan is sanctioned but prior to
disbursement, which may jeopardize the bank's chance recovery of its dues from the
borrower.
(II) Representations and warranties: The assumptions based on which credit appraisal is done
and the bank agreed to lend money, emanate from the information the borrower
himself provides to the bank. In executing the loan agreement, the borrower is
assumed to confirm the truth and accuracy of the information provided to the bank.
Any misrepresentation constitutes an event of default and renders the agreement
invalid. The principal representations and warranties include the following:
• All information provided, including financial statements, is true and correct.
• The borrower is authorized by law to carry on the business.
• The signatories to the loan agreement are authorized to do so, and their
commitment is legal and binding.
• All statutory obligations, such as payments of taxes, have been met.
• There are no major legal proceedings pending or threatened against the
borrower.
• There are no factual omissions or misstatements in the information provided.
• Collateral and prime securities are unencumbered.
The third and most negotiated part of the loan agreement is the 'covenants' of the
borrower.
These are the operative part of the terms and conditions, and set standards
and codes of conduct for the borrower's future business, as long as the borrower is
indebted to the bank. The covenants are used by astute credit officers to mitigate
the risks of the borrower's business, in order that credit risk is mitigated for the
bank. Covenants are sacred, and any violation will be treated as an 'event of
default'. They normally take two distinct forms-'affirmative' and 'negative'.
(III) Affirmative covenants are those actions the borrower should take to legally and
ethically carry on the business. Illustrations of affirmative covenants include the
following.
• Ensuring that the funds are applied for the purpose for which they were
intended.
• The indicators ensuring financial health, such as a strong current ratio, a safe
debt to equity ratio, appreciable sales growth and a healthy return on equity

41
 (ROE).
• Ensuring that proper records and controls are maintained within the firm.
• Ensuring compliance with the law, and reporting requirements required under
statute.
• Ensuring compliance with infom13tion requirements by the bank and periodic
reporting of financial operating performance.
• Ensuring that the prime and collateral securities are adequately insured.
• Ensuring that property, fixed assets and other assets belonging to the
borrower's firm are properly maintained.
• The bank will retain its right of inspecting the assets offered as security at any
time, without prior notice.
(IV) Negative covenants place clear and significant restrictions on the borrower's
activities. Such covenants are intended to prompt managerial decisions that may
adversely impact cash flows and hence jeopardize the rower's debt service capacity.
Borrowers would generally be more inclined to negotiate negative covenants since
they may be perceived as restricting operational autonomy. Some typical negative
covenants are as follows:
• Limiting further capital expenditure.
• Limiting investment of funds.
• Restricting additional outside liabilities.
• Restricting investment in subsidiaries, other businesses.
• Restricting sale of assets, subsidiaries.
• Restricting dividend payouts.
• Restricting prepayment of other debts.
• Limits on debt in the capital structure.
• Restrictions on mergers or share repurchase.
• Restriction on starting or carrying on other business.
• Restriction on encumbering assets (negative lien).
The last restriction, negative lien, 18 is a covenant that is widely used by banks to
prevent the borrower creating encumbrances on assets, so as to benefit other creditors.
The bank may employ these restrictions and limitations selectively, to ensure that the
risks in the borrower's business are mitigated. The ultimate objective of these
restrictions is to ensure that the borrower's financial health is not impaired, and the
bank's dues are paid on time.
(V) Events of Default: Such events, when they happen, may trigger the end of the banker-
borrower relationship. An illustrative list of situations that may lead to an event of
default include the following:
• Failure to repay principal when due.
• Failure to service interest payments on due dates.
• Failure to honour a covenant.
• Misrepresentation of facts.
• Reneging on declarations made under representations and warranties.
• Diversion of funds without bank's knowledge to other creditors or other
accounts of the borrower.
• Change in management or ownership structure.
• Bankruptcy or liquidation proceedings.
• Falsification or tampering with records.

42
 • Impairment of collateral, or entering into invalid agreements.
• Material adverse changes that drastically change the assumptions under which
the loan agreement was entered into.
• All other force majeure events that imperil debt service.
The happening of which event of default may signify the end of the banker-borrower
relationship is left for the banker to decide on the merits of each case. Under certain
circumstances, where the risks of such events are considered less significant, the
loan agreement can provide the borrower a grace period within which to rectify the
breach of a covenant. In case the borrower is unable to rectify the breach within the
grace period, the bank can downgrade or recall the advances made; agree for the take
over of the borrowing account by another bank; or, if the borrower is not in a
position to repay the bank's dues, enforce the securities and liquidate the outstanding
advance.
In case of the third scenario given above, the bank will initially set off any
unencumbered deposits of the borrower" or cash margins'· against the advances
outstanding. It will then sell off the securities to realize its dues or invoke the outside
guarantees till the advance is completely liquidated. Since the banker-borrower
relationship is generally considered valuable by both parties, banks do not act in
haste in the event of default.
(VI) Updating the Credit File and Periodic Follow-Up The credit file has to be
continuously updated throughout the above process. Further, once the loan is
disbursed, the following activities have to be carried out either by the credit officer
himself or a team designated for the purpose.
• Process loan payments and send reminders in case loan payments are
received late. The simple practice of reminding the borrower for every
payment not received on due date, would ensure that defaults are noticed
on time by the bank and timely action taken in case defaults persist,
ultimately preventing a credit risk to the bank.
• The borrower will have to submit updates of financial performance
periodically or as per the accounting practices in force. The bank can call
for financial data at any point of time if it feels that the borrower's
financial health deserves mid-course scrutiny.
• The bank can call on the borrower at any time, even without prior
intimation. When the bank's representative visits the borrower, the primary
objective will be to ensure that the borrower's activities are in accordance
with the bank's expectations.

(VII) Credit Review and Monitoring: This is the most important step in credit
management, and one that lends value to bank financing. Banks that have
succeeded in credit management, and hence reduction of credit risk, are those that
have separated credit review and monitoring from credit analysis, execution and
administration.
The credit review and monitoring process is typically bifurcated into the distinct
functions of monitoring the performance of existing loans and problem accounts.
Monitoring performance of existing loans is done in two ways. One is a continuous

43
 monitoring of the transactions in the accounts of the borrower. This is best done at
the office from which the credit has been disbursed. The credit officers at the
disbursing office have to be alert to symptoms exhibited by day-to-day operations
in the borrower's loan account, and send warning signals to the borrower if they
detect signs of incipient deterioration of financial health or misdemeanor. The
second type of monitoring will be done through external or internal audit teams,
and will be periodic or continuous, depending on the size of credit exposures or the
importance of the credit disbursing office in the bank. The deficiencies in loan
documentation or conduct uncovered by the audit team will have to be rectified by
the credit team. The deficiency could be rectified simply by getting signatures on
loan documents or filing the required statutory returns for perfecting the security. If
the audit team points out violation of any loan covenant, then the credit team can
persuade the borrower to fall in line.
However, what causes most concern would be deterioration in the financial
condition of the borrower, which is manifested as the inability of the borrower to
meet debt service requirements. Such accounts would be put on a 'watch list' and
monitored closely, so that they do not turn 'non-performing'.22 Sometimes, banks
will have to modify the repayment terms in order to increase the probability of
repayment. Such modified terms include restructuring interest and principal payments
to suit the current cash flows of the borrower, or lengthening maturity of the loans. In
such cases, the bank may also seek additional securities or additional capital from the
borrower to compensate for the increased credit risk. It would be prudent to separate
the loans under restructuring from the general credit stream, so that monitoring would
be made more intense. Similarly, a separate set of specialists would man the credit
monitoring or restructuring function.
In some cases, the borrower's financial condition deteriorates to such an
extent that the loan will have to be 'recalled'. In such cases, liquidation of assets or
take over by another bank willing to take on the risk will be considered. It is more
likely that the former action will have to be instituted. If all other avenues of
restructuring and forbearance fail, the bank would resort to legal action. Once legal
action is under way, the borrower loses the option to restructure the loans or be
rehabilitated back to financial health. At this stage, many borrowers opt for 'out of
court settlement', thus avoiding long and protracted legal hassles.

DIFFERENT TYPES OF LOANS AND THEIR FEATURES

Though classified under the single nomenclature-loan-on the bank's balance sheet, every loan
or class of loans is unique. Each loan or type of loan has distinguishing features based on the
purpose, the collateral, the repayment period and the borrower profile. We will examine the
predominant characteristics of some popular loan types from ~e points of view of the borrower
as well as the credit officer.
Loans for Working Capital
Banks are generally considered primary lenders to working capital requirements of firms, small
and large. The rationale for banks having built up considerable expertise in funding short-term
working capital is explained by the nature of bank liabilities, which are essentially short-term in
nature.
A firm's Net Working Capital (NWC) is measured as the difference between its current
assets and current liabilities. If a firm's working capital is positive, it implies that its current

44
assets exceed its current liabilities, i.e., its current assets have been partly financed by
'spontaneous liabilities', such as trade creditors, and short-term bank debt and other current
debt, and partly by long-term funds, including equity. A positive NWC is construed as a sign of
healthy liquidity in the firm, since it is assumed that the liquidation of current assets at any
point of time would enable the firm to pay off its current creditors fully.
Every firm begins by investing cash in current assets. Manufacturing firms invest in raw
material that would be converted to finished goods to be sold in the market. Retail firms invest
in merchandize for display at their showrooms. Service firms need cash for operations and
office supplies. Almost all firms encourage credit sales to stimulate growth. Thus, there is a
time lag between the investment of cash and the realization of cash from sales. The longer the
firm takes to complete the cash-to-cash or 'working capital' cycle, the longer the firm has to
wait to get back its cash investment. During this time lag, operations liave to continue. The firm
will have to continue investing in raw material or merchandize or day-to-day expenses. Where
will the cash for this investment come from? As noted earlier, cash for operations will have to
come from external creditors or internal generation. Working capital management is, therefore,
a continuous process.
Each type of business depends on appropriate financing methods to stimulate investment
and growth. Some firms depend on trade credit to finance the current assets-that is, they defer
payment for inputs, in agreement with the supplier, for a specified number of days within which
they hope to realize cash from sales. Some firms additionally defer expenses till the cash comes
in from sales. However, the majority of firms depend on bank debt to manage the need for
working capital. Thus, bank debt is a predominant source of funding working capital for all
types of businesses and borrowers.
How much can a bank lend for working capital? The amount of loan will depend on the
envisaged 'working capital gap'(WCG), determined by the borrower's decision to take trade
credit offered, or defer payment of certain accrued expenses. In balance sheet terms, this would
represent the projected current assets less current liabilities, without bank borrowings being
taken into account. The working capital gap represents the borrower's need for cash for
uninterrupted operations, after taking into account sources of funds available in the natural
course of expect that the borrower brings in his stake to fund the gap. This is called the
'margin'. Bank debt with therefore, typically amount to the working capital gap less the margin.
Many businesses find that their working capital fluctuates over time. The reasons could
be unexpected fluctuations in demand, changes in market dynamics or seasonality. Of these,
seasonal sales are the easiest to predict and firms build up inventories temporarily and incur
higher operating expenses in time for the peak sales season. During the off-season, working
capital needs increase since the inventory has already been invested in, peak sales have not taken
place and cash flow from receivables will happen only when the inventories are liquidated. If
seasonal patterns are discernible, the bank assesses working capital needs as 'peak level' and
'non-peak level'. Thus two sets of working capital assessments would be required.
An important point to be noted here is that most firms have a stable level of working
capital in the system irrespective of seasonal and other fluctuations. In other words, just as fixed
assets are at a predictable level, there are always some inventories, accounts receivable and other
current assets that form a permanent part of the business. The only difference between the fixed
assets and these 'permanent' current assets is that the latter changes its composition, as and when
inventories are sold off and replaced, accounts receivable are realized and replace with fresh
ones, and so on. This 'permanent' working capital need, every year, is approximately equivalent
to the minimum level of current assets minus the minimum level of current liabilities, without
taking into consideration short-term bank debt and installments of long-term debt repayable in

45
the short term (within the next 12 month). This difference reflects the requirement of long-term
debt or equity financing for the 'permanent' current assets. It is important for borrowing firms
and banks to be able to assess such 'permanent' working capital requirements and fund them with
long-term investment. The increase over this 'permanent' working capital base due to sales
growth would be financed through short-term credit from banks.
Working capital loans are structured as loans against the prime securities of inventories
and/or book debts as credit limits against bills raised on buyers of the goods and services of the
borrowing firm. The price of the loan (the interest rate charged) depends on the additional
securities available as collateral, and the credit score rating of the borrower. The repayment of
the loan should closely match the working capital cycle, and the covenants should be able to
mitigate the risks and vulnerabilities in the borrower's business and financials.
It is extremely important for the bank and the borrower to assess the working capital
requirements accurately. A mistake often made by inexperienced credit officers is granting a
loan for a larger amount or for a longer maturity than what is required, especially to 'first class'
customers. In a purpose-oriented loan, such as for working capital irrespective of the standing
of or relationship with the borrower, it is imperative to estimate funding needs accurate in order
to help the borrower's business and minimize the bank's risks. Both under- and overestimation
have their pitfalls. If the working capital need is overestimated, the borrower may not use the
additional money judiciously may purchase assets over which the bank does not have lien." If
the working capital is underestimated, the borrower may face a liquidity crunch during the
operational cycle and may have to re-approach the bank for additional loan, or borrow from
outside sources at exorbitant rates. In both cases, the bank faces default risk by the borrower.
Loans for Capital Expenditure and Industrial Credit
Firms need to invest periodically in capital assets to expand, modernize or diversify their
business. In such case their credit needs will extend beyond a year. 'Term loans' are the
preferred choice in such cases-with maturities more than I year, repayment spread over the life
of the asset or depending on the repaying capacity of the borrower. Most term loans are granted
for purposes, such as a permanent increase in working capital (as discussed earlier for purchase
of fixed assets or to finance start up costs for a new project. They generally carry maturities
ranging from over 1-7 years. Though banks can, in theory, finance longer maturities, in practice
they do not find it prudent to do so, because of the typically short- to medium-term maturity of
bank liabilities. Lending for longer maturity may create a mismatch between asset and liability
maturities and lead to a liquidity problem in banks.
Since repayment runs into several years, the bank's decision to lend would be based
more on the long-term cash generation capacity of the borrower firm or the assets being
invested in. The benchmark ratio used predominantly is debt service coverage ratio (DSCR),
the minimum desirable level generally pegged at 2. The bank typically would require collateral
for long-term lending, more as a secondary source for repayment in case of borrower default.
The characteristics of term loans are determined by the use of the loan amount. In the
case of a term loan for purchase of a capital asset, the cost of the asset less a suitable margin is
disbursed in full (in most cases direct the supplier of the equipment) after the loan agreement is
executed. The repayment terms are a function of the useful life of the asset, and the borrower's
capacity to generate cash flows sufficient to service the debt. The interest charged reflects the
bank's perception of the default risk of the borrower and the collateral liquidation value over the
duration of the loan. The covenants are more stringent than for working capital loans, since
term loans extend over several years, and the borrowers may tend to dilute the negotiated terms.
From the bank's side too, the credit officer who was instrumental in getting the loan sanctioned
may no longer be available, and loan agreements may become unenforceable for lack of clarity.

46
Term loan repayments and interest payments could be structured in any of the following ways.
• Repayments in fully amortized equal annual/half yearly/quarterly installment. Each
periodic repayment will include interest and principal in varying amounts. The
installment are treated as annuities and equated to the present value of principal plus
interest to arrive at the installment. Interest is recovered in full in every installment, and
the remaining amount of the installment is taken towards principal repayment. As the
principal gets repaid, the interest component, calculated on declining principal balances,
decreases, and the principal component increases. Thus, in this method, the amount of
payment per period remains constant, but the composition of the payment (principal and
interest) varies from payment to payment.
• Repayment of principal in equal installments over the designated period, with interest
calculated separately on declining balances. In this case, the amount of debt service will
vary from period to period. In contrast to the annualized method of repayment, each
periodic payment in this mode will vary, but the amount of principal will remain
constant.
• Occasionally, the loan agreement may call for 'balloon repayments'. In this case, the
borrower is required to service only the periodic interest over the period of the loan. The
entire principal amount becomes due only on maturity (also called a 'bullet loan'). The
difference between a 'bullet' and 'balloon' repayments is that in the case of 'bullet
repayment' 100 per cent of the principal is due only at maturity while in the latter case,
the credit (interest and principal) gets partially repaid during the term and presents lumpy
repayment at maturity.
• In rare cases, a variation of the above method is used. The principal and interest are
amortized over a very long period, say 25 to 30 years. At the end of the period, the
remaining principal amount is repaid in full.
• For construction loans or project loans, the agreed amount is released in stages, as and
when progress is shown in construction/the project.
Loan Syndication
Large projects need enormous funding requirements. It may not be possible for one bank to
finance the project requirements, from the viewpoint of both capital regulations and the risk of
exposure. For the banks arranging the syndication and participating in it, syndication can be a
source of substantial fee income as well. In essence, arranging a syndicated loan allows the lead
bank to meet its borrower's demand for loan commitments without having to bear the market
and credit risk alone, and also earn non-interest income in the process.
Syndicated loans are credits granted by a group of banks to a borrower. They are hybrid
instruments combining features of relationship lending and publicly traded debt. They allow the
sharing of credit risk between various financial institutions without the disclosure and marketing
burden that bond issuers face.
Syndicated credits are a very significant source of international financing, with signings
of international syndicated loan facilities accounting for no less than a third of all international
financing, including bond, commercial paper and equity issues. Increasing trends of
privatizations in emerging markets have enabled banks, utilities and transportation and mining
companies from these regions to displace sovereigns as the major borrowers. However, and
understandably so, the amount of international syndicated loan facilities, showed a decline since
2007. Quarters 2 and 3 of2009 have shown a slight pick up, indicating confidence returning to
the market (Source: BIS locational statistics, December 2009).
In a syndicated loan, two or more banks agree jointly to make a loan to a borrower. Every
47
syndicate member has a separate claim on the debtor, although there is a single loan agreement
contract. The creditors can be divided into two groups. The first group consists of senior
syndicate members and is led by one or several lenders, typically acting as mandated arrangers,
arrangers, lead managers or agents. These senior banks are appointed by the borrower to bring
together the syndicate of banks prepared to lend money at the terms specified by the loan. The
syndicate is formed around the arrangers often the borrower's relationship banks-who retain a
portion of the loan and look for junior participants. The junior banks, typically bearing manager
or participant titles, form the second group of creditors. Their number and identity may vary
according to the size, complexity and pricing of the loan as well as the willingness of the
borrower to increase the range of its banking relationships. These bank roles have been
enumerated above in decreasing order of 'seniority', and the hierarchy plays a decisive role in
determining the syndicate composition, negotiating the pricing and administering the facility.
Junior banks typically earn just a margin and no fees. However, they may find it
advantageous to participate ill a syndicated loan-they may lack origination capability in certain
types of transactions, geographical areas or industrial sectors, or a desire to cut down on
origination costs. For these banks participation is also relationship building with the borrower
who may reward them later with more profitable and prestigious business opportunities.
Loans for Agriculture
Loans for agriculture are similar to other types of loans in the following respects.
• Most of the loans for agriculture are short-term loans.
• Agriculture being seasonal in nature, the norms for seasonal industries is applicable.
• They can be likened to working capital loans, in that the loan is used for purchase of
inventory, such as seeds, fertilizer and pesticides, and also to pay operating costs.
• The sales are realized when the harvested crops are sold in the market.
• Long-term loans for agriculture are given for investment in land, equipment or
livestock.
• Loans are paid out of cash flows arising from sale of crops harvested or produced
from livestock.
The fundamental difference between loans for agriculture and other loans arises from the
fact that agriculture is a vital national priority in many developed and developing countries. The
governments and central banks of these countries have framed policies and institutional support
systems to ensure that banks are involved in lending to this important sector, even when it
appears that the sector may incur losses for a particular period.
Therefore, though loans for agriculture are to be assessed on similar lines as other loans,
they are to be treated differently in terms of the outcome of such lending. Most countries have
framed elaborate policies and institutional framework to ensure that agriculture and its allied
activities are supported by banks.
Loans for Infrastructure-Project Finance
Project finance is a prominent form of 'Asset-based lending'. Simply put, project finance
involves the creation of a legally independent project company, with equity from one or more
sponsoring firms, and non- or limited recourse debt, for the purpose of investing in a single
purpose, industrial asset."
Structuring a project finance deal entails substantial transaction costs in the nature of fees
to lawyers, consultants and financial advisors, apart from obtaining necessary permits and
environmental clearances. A deal could typically take 5-7 years to structure, since it also
involves identifying and entering into suitable contracts with construction companies, suppliers

48
 of equipment and inputs, purchasers of output, operating companies and tying up the financing
with various capital providers. Project companies are characterized by their highly leveraged
structures with mean debts as high as 70 per cent, and the remaining equity contributed by the
group of sponsoring firms in the form of either equity or quasi equity (subordinated debt), debt
being non-recourse to the sponsors. The debt is also termed 'project recourse' since debt service
depends exclusively on project cash flows.
A predominant share of project finance comes from banks in the form of debt, syndicated
loans, or through subscription to bond issues of project companies. The risks for the lender are
high, since the bank has limited or no recourse to the sponsor, unlike in conventional corporate
financing. Thus, there are several supplementary credit arrangements that characterize project
financing.
The primary mode of credit delivery is through term loans. The challenge in credit
appraisal lies in the credit officer and the decision maker understanding the project and its risks
in detail and instituting suitable risk mitigation measures for ensuring timely debt service.
Loans to Consumers or Retail Lending
Individual consumers generally seek bank finance to purchase durable goods, education, medical
care, housing and other expenses. The average loan per borrower is small in relation to the bank's
lending to corporate or business borrowers. Most loans have repayment periods ranging from 1-5
years, can be longer in the case of housing loans, carry fixed interest rates and are repaid in equal
installments. Individual consumers are generally seen as more prone to defaulting on loan
repayment commitments than corporate borrowers. Interest rates on consumer loans are, thus,
higher to compensate for the higher default risk. However, the loss to the bank when an
individual customer defaults is not as great as when a corporate borrower does.
Consumer loans can also be classified based on repayment terms as installments loans,
credit cards and non-installments loans. Installment’s loans have a fixed periodic repayment
schedule, which requires that a portion of both principal and interest are paid periodically.
Payments on credit cards vary with the amount utilized. Non-installments loans are special
purpose loans, in which the individual expects a large cash inflow at a particular point of time
that will enable him repay the debt entirely. An example of this would be a bridge loan for
paying an advance for purchase of a new house, which will be repaid once the old house is sold
off.
Banks are increasingly resorting to retail lending to take advantage of increased consumer
spending and also because pools of such assets can be securitized thus leading to removal of
default risk and greater liquidity for the banks, which, in turn, would lead to improved
profitability.
Non-Fund Based Credit
LCs and BGs (BGs or letters of guarantee-LGs) are the common forms of non-fund-based credit
limits granted to borrowers to carry on their business. They are non-fund based since there is no
outlay of funds for the bank at the time of granting the facility. The income earned from these
services is classified under noninterest income.
The fact that this type of credit is granted with no funds disbursement at the outset, does
not render it free of credit risk. LCs and BGs are off-balance sheet exposures for the bank, but
they carry equal or more risks than on balance sheet credit exposures. Their risk arises from the
fact that the bank is called upon to pay the counterparty or beneficiary, if the applicant or
borrower fails to pay. The liability of the bank to the counterparty is determined by the relevant
statute and the bank will have to pay the agreed amount to the counterparty without demur. It is
then left to the bank to proceed legally or otherwise against the borrower or applicant to recover
the loss.

49
 It is, thus evident that the bank will have to assess any request for non-fund based credit
with the same rigor as it assesses the fund-based credit request. The default risk of the borrower
remains, whether the bank has exposed itself to fund-based or non- fund-based credit.

50
 LESSON 5
EXPORT CREDIT
Dr. Ashish Kumar
LBSIM

To promote the export in India, government of India started Export Credit Guarantee
Corporation of India (ECGC) and Export Import Bank India (EXIM Bank). Details of the two
are as follows:
Export Credit Guarantee Corporation of India (ECGC):
Export Credit Guarantee Corporation of India Limited, was established in the year 1957
by the Government of India to strengthen the export promotion drive by covering the risk of
exporting on credit. Being essentially an export promotion organization, it functions under the
administrative control of the Ministry of Commerce & Industry, Department of Commerce,
Government of India. It is managed by a Board of Directors comprising representatives of the
Government, Reserve Bank of India, banking, insurance and exporting community. ECGC is the
fifth largest credit insurer of the world in terms of coverage of national exports. The present
paid-up capital of the company is Rs.800 crores and authorized capital Rs.1000 crores.
Need and Objectives of ECGC:
Export credit insurance is essential for exporters to avoid the various risk factors. It offers
insurance protection to exporters against risk of payment, and gives guidance in all import export
related activities. Besides this, ECGC makes information available on various countries with its
own credit ratings, makes the process of obtaining export finance from banks/financial
institutions easy, provides information on credit-worthiness of the overseas buyer and helps
exporters in recovering bad debts.
Export Credit Guarantee Corporation is required for the smooth functioning of all aspects
relate to exports of goods. Payments for exports are prone to risks even in good times and in the
present political and economically changing scenario the risk is even higher in regards to the
payments. Factors like a coup, an outbreak of a war or civil war, problems in balance of payment
and such other risks can happen at any time. Besides all these, commercial risks of a foreign
buyer becoming bankrupt are enhanced due to the prevailing political and economic
uncertainties. To tackle all these and various other issues related to exports, it is very important
to have an organization like Export Credit Guarantee Corporation to safeguard the interest of the
exporter.
Product and Services of ECGC:
(I) Standard Policy of ECGC or Credit Insurance Policy:
ECGC has different products and services to take care of all the export credit insurance
needs of exporters. Shipments policy, well known as the standard policy is a policy that is ideal
to cover risks of goods exported on short term credit. The policy covers political and commercial
risks starting from the date of the shipment. This policy is issued to exporters whose expected
export turnover for the next twelve months is more than Rs.50 Lakh. Some of the commercial
risk covered by the standard policy includes bankruptcy of the buyer, failure by the buyer to
make the due payment within specified period and the buyer's failure to accept the goods, subject
to certain conditions.
Some of the political risks against which the Export Credit Guarantee Corporation
provides protection are: war, civil war, revolution or civil disturbances in the buyer's country,
imposition of limitation by the Government of the buyer's country which may block or delay the
transfer of payment made by the buyer, new import limitations or termination of a valid import
license in the buyer's country and any other cause of loss occurring outside India not normally
covered by general insurers, and beyond the control of both the exporter and the buyer.
51
a. Commercial Risks
Insolvency of the buyer.
• Failure of the buyer to make the payment due within a specified period, normally
four months from the due date.
• Buyer's failure to accept the goods, subject to certain conditions.
b. Political Risks
• Imposition of restriction by the Government of the buyer's country or any
Government action, which may block or delay the transfer of payment made by the
buyer.
• War, civil war, revolution or civil disturbances in the buyer's country. New import
restrictions or cancellation of a valid import license in the buyer's country.
• Interruption or diversion of voyage outside India resulting in payment of additional
freight or insurance charges which can’t be recovered from the buyer.
• Any other cause of loss occurring outside India not normally insured by general
insurers, and beyond the control of both the exporter and the buyer.
(II) Guarantee to Banks:
Timely and adequate credit facilities at the pre-shipment stage are essential for exporters
to realize their full export potential. Exporters may not, however, be easily able to obtain such
facilities from their bankers for several reasons, e.g. the exporter may be relatively new to export
business, the extent of facilities needed by him may be out of proportion to the equity of the
firms or the value of collateral offered by the exporter may be inadequate. The Packing Credit
Guarantee of ECGC helps the exporter to obtain better and adequate facilities from their bankers.
The Guarantees assure the banks that, in the event of an exporter failing to discharge his
liabilities to the bank, ECGC would make good a major portion of the bank's loss. The bank is
required to be co-insurer to the extent of the remaining loss. Any loan given to an exporter for
the manufacture, processing, purchasing or packing of goods meant for export against a firm
order or Letter of Credit qualifies for Packing Credit Guarantee. Pre-shipment advances given by
banks to parties who enter into contracts for export of services or for construction works abroad
to meet preliminary expenses in connection with such contracts are also eligible for cover under
the Guarantee. The requirement of lodgement of Letter of Credit or export order for granting
packing credit advances is waived if the bank grants such advances in accordance with the
instructions of the Reserve Bank of India in that respect.
(III) Special Schemes:
Exchange Fluctuation Risk Cover: The Exchange Fluctuation Risk Cover is intended to
provide a measure of protection to exporters of capital goods, civil engineering contractors and
consultants who have often to receive payments over a period of years for their exports,
construction works or services. Where such payments are to be received in foreign currency, they
are open to exchange fluctuation risk as the forward exchange market does not provide cover for
such deferred payments. Exchange Fluctuation Risk Cover is available for payments scheduled
over a period of 12 months or more, upto a maximum of 15 years. Cover can be obtained from
the date of bidding right up to the final installment. At the stage of bidding, an
exporter/contractor can obtain Exchange Fluctuation Risk (Bid) Cover. The basis for cover will
be a reference rate agreed upon. The reference rate can be the rate prevailing on the date of bid or
rate approximating it. The cover will be provided initially for a period of twelve months and can
be extended if necessary. If the bid is successful, the exporter/contractor is required to obtain
Exchange Fluctuation (Contract) cover for all payments due under the contract. The reference

52
rate for the contract cover will be either the reference rate used for the Bid Cover or the rate
prevailing on the date of contract, at the option of the exporter/contractor. If the bid is
unsuccessful 75 percent of the premium paid by the exporter/contractor is refunded to him.
Functions of ECGC:
• Offers insurance protection to exporters against payment risks
• Provides guidance in export-related activities
• Makes available information on different countries with its own credit ratings
• Makes it easy to obtain export finance from banks/financial institutions
• Assists exporters in recovering bad debts
• Provides information on credit-worthiness of overseas buyers
Export- Import Bank of India:
Export-Import Bank of India is the premier export finance institution of the
country, set up in 1982 under the Export-Import Bank of India Act 1981. Government of
India launched the institution with a mandate, not just to enhance exports from India, but
to integrate the country’s foreign trade and investment with the overall economic growth.
Since its inception, Exim Bank of India has been both a catalyst and a key player in the
promotion of cross border trade and investment. Commencing operations as a purveyor of
export credit, like other Export Credit Agencies in the world, Exim Bank of India has,
over the period, evolved into an institution that plays a major role in partnering Indian
industries, particularly the Small and Medium Enterprises, in their globalization efforts,
through a wide range of products and services offered at all stages of the business cycle,
starting from import of technology and export product development to export production,
export marketing, pre-shipment and post-shipment and overseas investment.
The Initiatives
• Exim Bank of India has been the prime mover in encouraging project exports from
India. The Bank provides Indian project exporters with a comprehensive range of
services to enhance the prospect of their securing export contracts, particularly
those funded by Multilateral Funding Agencies like the World Bank, Asian
Development Bank, African Development Bank and European Bank for
Reconstruction and Development.
• The Bank extends lines of credit to overseas financial institutions, foreign
governments and their agencies, enabling them to finance imports of goods and
services from India on deferred credit terms. Exim Bank’s lines of Credit obviate
credit risks for Indian exporters and are of particular relevance to SME exporters.
• The Bank’s Overseas Investment Finance programme offers a variety of facilities
for Indian investments and acquisitions overseas. The facilities include loan to
Indian companies for equity participation in overseas ventures, direct equity
participation by Exim Bank in the overseas venture and non-funded facilities such
as letters of credit and guarantees to facilitate local borrowings by the overseas
venture.
• The Bank provides financial assistance by way of term loans in Indian
rupees/foreign currencies for setting up new production facility,
expansion/modernization/upgradation of existing facilities and for acquisition of
production equipment/technology. Such facilities particularly help export oriented
Small and Medium Enterprises for creation of export capabilities and enhancement
of international competitiveness.
• Under its Export Marketing Finance programme, Exim Bank supports Small and
Medium Enterprises in their export marketing efforts including financing the soft

53
 expenditure relating to implementation of strategic and systematic export market
development plans.
• The Bank has launched the Rural Initiatives Programme with the objective of
linking Indian rural industry to the global market. The programme is intended to
benefit rural poor through creation of export capability in rural enterprises.
• In order to assist the Small and Medium Enterprises, the Bank has put in place the
Export Marketing Services (EMS) Programme. Through EMS, the Bank seeks to
establish, on best efforts basis, SME sector products in overseas markets, starting
from identification of prospective business partners to facilitating placement of
final orders. The service is provided on success fee basis.
• Exim Bank supplements its financing programmes with a wide range of value-
added information, advisory and support services, which enable exporters to
evaluate international risks, exploit export opportunities and improve
competitiveness, thereby helping them in their globalisation efforts.
Services provided by the EXIM Banks:
Exim Bank offers the following Export Credit facilities, which can be availed of by
Indian companies, commercial banks and overseas entities.
(I) Export Credit:
For Indian Companies executing contracts overseas
• Pre-shipment credit: Exim Bank's Pre-shipment Credit facility, in Indian Rupees
and foreign currency, provides access to finance at the manufacturing stage -
enabling exporters to purchase raw materials and other inputs.
• Supplier's Credit: This facility enables Indian exporters to extend term credit to
importers (overseas) of eligible goods at the post-shipment stage.
• For Project Exporters: Indian project exporters incur Rupee expenditure while
executing overseas project export contracts i.e. costs of mobilisation/acquisition of
materials, personnel and equipment etc. Exim Bank's facility helps them meet
these expenses.
• For Exporters of Consultancy and Technological Services: Exim Bank offers a
special credit facility to Indian exporters of consultancy and technology services,
so that they can, in turn, extend term credit to overseas importers.
• Guarantee Facilities: Indian companies can avail of these to furnish requisite
guarantees to facilitate execution of export contracts and import transactions.
For commercial Banks
• Exim Bank offers Rediscounting Facility to commercial banks, enabling them to
rediscount export bills of their SSI customers, with usance not exceeding 90 days.
• It also offer Refinance of Supplier's Credit, enabling commercial banks to offer
credit to Indian exporters of eligible goods, who in turn extend them credit over
180 days to importers overseas.
Other Facilities for Indian Companies
Indian companies executing contracts within India, but which are categorized as
Deemed Exports in the Foreign Trade Policy of India or contracts secured under
international competitive bidding or contracts under which payments are received
in foreign currency, can avail of credit under our Finance for Deemed Exports
facility, aimed at helping them meet cash flow deficits.
For Overseas Entities
• Buyer's Credit: Overseas buyers can avail of Buyer's Credit from Exim Bank, for
import of eligible goods from India on deferred payment terms.

54
 • Eligible Goods: Capital goods, plant and machinery, industrial manufactures,
consumer durables and any other items eligible for being exported under the 'Exim
Policy' of the Government of India.
(II) Term Finance (For Exporting Companies)
• Project Finance
• Equipment Finance
• Import of Technology & Related Services
• Domestic Acquisitions of businesses/companies/brands
• Export Product Development/ Research & Development
• General Corporate Finance
(III) (A) Working Capital Finance (For Exporting Companies)
• Funded
o Working Capital Term Loans [< 2 years]
o Long Term Working Capital [up to 5 years]
o Export Bills Discounting
o Export Packing Credit
o Cash Flow financing
• Non-Funded
o Letter of Credit Limits
o Guarantee Limits
(B) Working Capital Finance (For Non- Exporting Companies)
o Bulk Import of Raw Material

55
 LESSON 6
ASSESSMENT OF CREDIT NEEDS FOR PROJECT AND
WORKING CAPITAL FINANCE
Dr. Ashish Kumar
LBSIM
Working Capital
Apart from financing for investing in fixed assets, every business also requires funds on a
continual basis for carrying on its operations. These include amounts expenses incurred for
purchase of raw material, manufacturing, selling, and administration until such goods are sold
and the monies realized. Business transactions are generally carried on credit with a number of
days elapsing subsequent to the sale being effected for realization of proceeds1. While part of the
raw material maybe purchased by credit, the business would still need to pay its employees, meet
manufacturing & selling expenses (wages, power, supplies, transportation and communication)
and the balance of its raw material purchases. Working capital refers to the source of financing
required to by businesses on a continual basis for meeting these needs.
Thus the need for working capital arises from the prevalence of credit in business
transactions, need to fund manufacturing and support and to account for the variations in the
supply of raw material and demand for finished goods.
Characteristics of working capital
• It is continually required for a going concern
• However, the quantum of working capital fluctuates depending on the level of activity
• Working Capital is impacted by numerous transactions on a continual basis
The above characteristics render limit based financing from banks ideal for working capital
financing. This is because the client is charged interest only on the average outstanding utilized
and is saved with the bother of reinvesting short term surpluses arising out of low working
capital utilization at a point in time. Further since the transactions of the business are generally
routed through a current account with a bank, availing a credit limit from the same bank is really
convenient. Thus, working capital requirements are generally financed through limit based
financing from banks.
Bank Financing for Working Capital
The financing limits are granted based on assessment of the working capital requirement. The
assessment factors include various characteristics such as the nature of industry, industry norms,
actual level of activity for the previous year and the projected level of activity for the subsequent
year to arrive at the working capital requirement. The bank financing limit is thereafter decided
after factoring in margins on the different types of current assets forming part of the working
capital.
The Bank Financing Limit is fixed on an annual basis. However, since such limit is
provided to meet specific requirements, utilizing the limits is subjected to the Drawing Power,
which is decided on a monthly/ quarterly basis.
The effective bank financing is therefore to the extent of the lower of:
• Bank Financing Limit: Determined on an annual basis based on an assessment of the
current year’s projections and the actuals for the previous year.
• Drawing Power: Linked to the quantum of current assets (and current liabilities) owned
by the business with appropriate margins. Fixed on a monthly/ quarterly basis depending
on the submission of Monthly/Quarterly Information System returns indicating the
position of the stock statement, receivables, Work in Progress, payables, etc.

56
Forms of Bank Finance: Working capital advance is provided by commercial banks in three
primary ways: (1) cash credits/overdrafts, (2) loans (3) purchase / discount of bills. In addition to
these direct forms, commercial banks help their customers in obtaining credit from other sources
through the letter of credit arrangement.
1. Cash Credits/Overdrafts: Under a cash credit or overdraft arrangement, a pre-determined
limit for borrowing is specified by the bank. The borrower can draw as often as required
provided the out standings do not exceed the cash credit/overdraft limit. The borrower
also enjoys the facility for repaying the amount, partially or fully, as and when he desires.
Interest is charged only on the running balance, not on the limit sanctioned. A minimum
charge may be payable irrespective of the level of borrowing for availing of this facility.
This form of advance is highly attractive from the borrower’s point of view because
while the borrower has the freedom of drawing the amount in installments as and when
required, the interest is payable only on the amount actually outstanding.
2. Loans: These are advances of fixed amounts to the borrower. The borrower is charged
with interest on the entire loan amount, irrespective of how much he draws. In this
respect, this system differs markedly from the overdraft or cash credit arrangement
wherein interests is payable only on the amount actually utilized. Loans are payable
either on demand or in periodical installments. When payable on demand, loans are
supported by a demand promissory note executed by the borrower. There is often a
possibility of renewing the loan.
3. Purchase /Discount of bills: A bill arises out of a trade transaction. The seller of goods
draws the bill on the purchaser. The bill may be either clean or documentary (a
documentary bill is supported by a document of title to goods like a railway receipt or a
bill of lading) and may be payable on demand or after usance period which does not
exceed 90 days. On acceptance of the bill by the purchaser, the seller presents it to the
bank for discount/ purchase. When the bank discounts/purchases the bill, it releases the
funds to the seller. The bank presents the bill to the purchaser (acceptor of the bill) on the
due date and gets its payment.
4. Letter of Credit: A letter of credit is an arrangement whereby a bank helps its customer to
obtain credit from its (customer’s) suppliers. When a bank opens a letter of credit on
favor of its customer for some specific purchases, the bank undertakes the responsibility
to honor the obligation of its customer, should the customer fail to do so.

Estimation of Working Capital Requirement

Lack of adequate working capital is often stated as one of the major reasons for sickness in
industry (especially in case of SMEs). The counter arguments from the banks have been that
most firms face problems of inadequate working capital due to credit indiscipline (diversion of
working capital to meet long term requirements or to acquire other assets). In this context it
would be pertinent to understand the method adopted by banks in computing the working capital
requirement of the business and the quantum of bank financing to be provided by the bank.
Main factors considered in the estimation of working capital requirement
• The nature of business and sector-wise norms
Factors such as seasonality of raw materials or of demand may require a high level of
inventory being maintained by the company. Similarly, industry norms of credit allowed
to buyers determine the level of debtors of the company in the normal course of business.
• The level of activity of the business
Inventories and receivables are normally expressed as a multiple of a day’s production or
sale. Hence, higher the level of activity, higher the quantum of inventory, receivables and

57
 thereby working capital requirement of the business. So in order to arrive at the working
capital requirement of the business for the year, it is essential to determine the level of
production that the business would achieve. In case of well-established businesses, the
previous year’s actuals and the management projections for the year provide good
indicators. The problems arise mainly in the case of determining the limit for the first
time or in the initial few years of the business. Banks often adopt industry standard norms
for capacity utilization in the initial years.
Steps involved in arriving at the level of Working Capital Requirement
• Based on the level of activity decided and the unit cost and sales price projections, the
banks calculate at the annual sales and cost of production.
• The quantum of current assets (CA) in the form of Raw Materials, Work-in-progress,
Finished goods and Receivables is estimated as a multiple of the average daily turnover.
The multiple for each of the current assets is determined generally based on the industry
norms.
• The current liabilities (CL) in the form of credit availed by the business from its creditors
or on its manufacturing expenses are deducted from the current assets (CA) to arrive at
the Working Capital Requirement (WCR).
Standard Formulae for determination of Working Capital
The issue of computation of working capital requirement has aroused considerable debate and
attention in this country over the past few decades. A directed credit approach was adopted by
the Reserve Bank of ensuring the flow of credit to the priority sectors for fulfillment of the
growth objectives laid down by the planners. Consequently, the quantum of bank credit required
for achieving the requisite growth in Industry was to be assessed. Various committees such as the
Tandon Committee and the Chore Committee were constituted and studied the problem at length.
Norms were fixed regarding the quantum of various current assets for different industries
(as multiples of the average daily output) and the Maximum Permissible Bank Financing
(MPBF) was capped at a certain percentage of the working capital requirement thus arrived at.
Working Capital assessment on the formula prescribed by the Tandon Committee.

Working Capital Requirement (WCR) =

[Current assets i.e. CA (as per industry norms) – Current Liabilities i.e. CL]
Permissible Bank Financing [PBF} =
WCR – Promoter’s Margin Money i.e. PMM (to be brought in by the promoter)

As per Formula 1: PMM = 25% of [CA – CL] and thereby PBF = 75% of [CA – CL]
As per Formula 2: PMM = 25% of CA and thereby PBF = 75%[CA] – CL

As is apparent Formula 2 requires a higher level of PMM as compared to Formula 1.

Formula 2 is generally adopted in case of bank financing. In cases of sick units where the
promoter is unable to bring in PMM to the extent required under Formula 2, the difference in
PMM between Formulae 1 and 2 may be provided as a Working Capital Term Loan repayable in
installments over a period of time.
Illustrative Example:
Turnover of a manufacturing unit: Rs. 750 lakh p.a (assumed uniform across the year)
Assumed value addition norm: 50% (i.e. cost of raw material = 50% of Realisation)

Promoter Projections
Current Assets Current Liabilities

58
 - Raw materials Rs. 50 lakh - Payables Rs. 35 lakh
- Work in progress Rs. 25 lakh
- Finished Goods Rs. 60 lakh
- Receivables Rs. 125 lakh

Requirement assessed as per norms applicable for the industry:

Industry Amount as per Promoter Applicable

Norm (a) Norm (b) Projection (c) norm (d)
Current Asset
- Raw material 1 month Rs. 31.25 lakh Rs. 50 lakh Rs. 31.25 lakh
- Work in Progress (assumed at
10 days Rs. 15.62 lakh Rs. 25 lakh Rs. 15.62 lakh
50% complete)
- Finished Goods 15 days Rs. 31.25 lakh Rs. 60 lakh Rs. 31.25 lakh
- Receivables
1.5 months Rs. 112.50 lakh Rs. 125 lakh Rs. 112.50 lakh

Rs. 190.62 lakh Rs. 260.0 lakh Rs. 190.62 lakh

Current Liabilities
- Payables 15 days Rs. 18.80 lakh Rs. 35 lakh Rs. 18.80 lakh

Working Capital Requirement Rs. 171.82 lakh Rs. 225.0 lakh Rs. 171.82 lakh

Notes:
• Assumptions here include: No export turnover, uniform working capital requirement
through out the year
• Industry norms have been specified in the Tandon Committee Report for all important
industry categories
• Raw materials have been valued at cost of raw material (assumed at 50% of realization)
• Work in progress has been valued at 50% complete basis
• Applicable norm (d) is the more conservative of (b) or (c) from the bank’s point of view.

Computation of working capital requirement

Working Capital Requirement arrived at therefore is Rs. 171.82 lakh
Formula 1
PMM (Promoter Margin Money) as per formula 1 = 25% of 171.82 lakh = Rs. 42.95 lakh
Hence, Permissible Bank Finance 1 = Rs. 129 lakh
Formula 2
PMM as per formula 2 = 25% of Rs. 190.6 lakh = Rs. 47.65 lakh
Permissible Bank Financing as per formula 2 =[75% of 190.6 – Rs. 18.8] = Rs.124.1 lakh
The difference between the 2 methods is Rs. 4.90 lakh (which may be extended as a Working
Capital Term Loan in case of sick units.

Thus the PMM while being at 25% of the Working Capital requirement1 could actually translate
to as high as Rs. 225 lakh – Rs. 124 lakh i.e. Rs. 101 lakh assuming that the promoter projections

59
really reflect his genuine need for working capital. It should however be understood by the
entrepreneur that he ought to keep his working capital requirements to the minimum (whether or
not bank financing is available) to ensure that his interest burden and capital blocked is kept to
the minimum.
The following further points maybe worth mentioning here:
• In case of export financing sought by the entrepreneur, the quantum of bank financing for
the Working Capital build up for this purpose would normally be at a higher percentage
• Within the overall limits, there could be sub-limits for bills financing (in case of
receivables) with the result that such limits might not be fully available to the business.
• The Bank Financing Limit arrived above is the Overall limit for the year. The actual
quantum of bank financing that could be availed by the unit at a given point in time
depends upon its drawing power based on its periodical returns filed to the banker.

Procedures to avail working capital financing from banks

Banks exercise extreme caution in lending to first time applicants starting up their business. A
first time applicant would be asked for collateral in the form of land, building or residential
property. This would be in addition to a second charge on the fixed assets of the enterprise.
Sequence of steps to avail working capital
• Application for the working capital: Most of the large commercial banks are moving
towards the trend of specialized SSI branches near the industrial concentrations. The
applications for working capital are generally accepted and processed at these branches.
• List of Documents accompanying the application: The application for working capital
would need to have a covering letter containing a request for sanction of working capital
limits. The following documents would need to be enclosed along with:
o Detailed Project Report containing the detailed financials at projected levels of
operations for the next 5 years
o Memorandum and Articles of Association
o Copies of Incorporation documents (relating to formalities with the Registrar of
Companies in case of corporates)
o Statutory approvals obtained/ applied for such as for power, water, pollution
control, environment clearance, clearances from other agencies/ departments with
purview over the business.
o Other relevant documents – Letters of intent/ confirmed orders from prospective
buyers.
o Networth statement of promoters.
In case of the larger loans (above Rs. 5 crore in case of most banks), the projections are
generally submitted in the CMA format prescribed by Reserve Bank of India (earlier
mandatory).
• In- Principle Sanction for Working Capital: The timeframe for in-principle sanction
depends upon two factors:
o Time taken for submission of necessary documents
o The decision structure at the bank
Most of the large banks have specialized SSI branches at the industrial concentrations in
the country. These branches are headed by senior executives often with sanctioning
power of Rs. 5-6 crores at the branch. In such instances, delays for processing the
applications at the bank are limited. Infact the stage of in-principle sanction maybe
dispensed with and final sanction accorded on full appraisal.

60
 In other cases, such processing may take 30-45 days for according In-Principle Sanction
to the project. The newer private sector banks are generally faster in according such
approval. The significance of the in-principle sanction of working capital is that such
sanction is necessary for obtaining term funding from the financial institutions. While
these financial institutions accord sanction to a industry,
• Appraisal and Final Sanction: The appraisal and final sanction of the request for working
capital is based on a thorough appraisal of the Detailed Project Report (DPR). The
traditional banks generally have specified formats for submission of the DPR. The usual
coverage of the DPR includes:
o Overview of the business
o Background of promoters
o Details of products to be manufactured – manufacturing process and raw material
o Market overview and competition Sensitivity Analysis – ‘What if’ on Finished
Goods prices, raw material costs and so on
o Detailed financial projections covering the Balance Sheet, Profit and Loss
Account, Funds Flow and the Financial Ratios.
The timeframe for a Final Sanction in cases where all the requirements have already been
submitted by the borrowing unit is 90 days from the submission of the application.
• Post Sanction Requirements: Post sanction requirements involve completion of
documentation creating a charge in favour of the bank. This could include a charge on
assets related to the business and charge on collateral offered (if any). In case of the
assets of the business already being mortgaged with the term lending institution, a second
or third charge maybe created in favour of the bank. The financing facilities sanctioned
can thereafter be availed by the borrower.
• Monitoring and follow-up: Working capital financing is extended for the
current asset buildup of a business, which is linked to its activity level. These assets are
mobile (in case of inventory) and also easily convertible into cash. At best, the banks
have a second charge on the fixed assets of the enterprise and without the power of
Seizure (u/s Sec 29 as available to the state financial institutions) realizing money from
the security is time consuming. Hence, banks pay extremely high importance to the
monitoring and follow-up of the loan. The system of a current account through which all
the transactions are routed acts as an in-built check on the operations of the borrower. By
studying the current account transactions in detail, the banker is able to make an
assessment of the business. In addition to this, the banks also undertake other forms of
monitoring. These include:
• Stock Statements collected on a monthly basis from the borrower.
• Quarterly Operating Statement giving details of the operations for the quarter
In addition to these checks, banks often employ methods such as:
• Stock Audit by independent firms of chartered accountants.
• Branch Inspection conducted by the internal audit/ bank staff
In case of larger loans, Consortium meetings where the operations of the unit are jointly
reviewed are also undertaken.
• Review, enhancement of limits and adhoc limits: Review of limits is usually undertaken
on an annual basis. In cases where a request for enhancement of limits is made by the
borrower during the course of the year, such a request is processed based on the stock
statements and QoS submitted. In case of temporary need, an adhoc limit of upto 25% of
the existing limits could be granted on request.

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Self-Assessment Questions:
Question 1: Explain the credit analysis procedure of banks.
Question 2: Define the credit process and also state the various constituents of credit process.
Question 3: Explain various types of loans and their features.
Question 4: What do you mean by priority sector? Elaborate the features priority sector
advances.
Question 5: Writes a note on priority sector advances in India.
Question 6: What kind of steps Indian government taken to boost up export through improving
financing?
Question 7: Write short notes on:
(i) Export Import Bank
(ii) Export Credit Guarantee Corporation of India
(iii)Loan Syndication
(iv) Working Capital Financing
(v) Capital Expenditure Financing
(vi) Agriculture Financing
Question 8: Define the meaning of working capital. How commercial banks appraise the working
capital requirement of a concern?
Question 9: Define the procedure of determining working capital requirement of concern by
commercial banks.

Suggested Readings:
• Sundhram, K.P.M., Banking Theory Law and Practice, Sultan Chand & Co. Ltd., New
Delhi.
• Desai, Vasant, Banking and Financial System, Himalaya Publishing House, New Delhi
• Bihari, S.C. and Baral S.K., Modern Banking Management, Skylark Publications, New
Delhi.
• Suresh, Padmalatha and Paul, Justin, Management of Banking and Financial Services,
Pearson Publications, New Delhi.
• www.indiamarkets.com

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 LESSON 7 (a)

DEFICIENCIES IN INDIAN BANKING SYSTEM

Dr. Ashish Kumar
LBSIM
The banking system in India is significantly different from that of other Asian nations
because of the country’s unique geographic, social, and economic characteristics. India has a
large population and land size, a diverse culture and extreme disparities in income, which are
marked among its regions. There are high levels of illiteracy among a large percentage of its
population but, at the same time, the country has a large reservoir of managerial and
technologically advanced talents. Between about 30 and 35 percent of the population resides in
metro and urban cities and the rest is spread in several semi-urban and rural centers. The
country’s economic policy framework combines socialistic and capitalistic features with a heavy
bias towards public sector investment. India has followed the path of growth-led exports rather
than the “export led growth” of other Asian economies, with emphasis on self-reliance through
import substitution. These features are reflected in the structure, size, and diversity of the
country’s banking and financial sector. The banking system has had to serve the goals of
economic policies enunciated in successive five year development plans, particularly concerning
equitable income distribution, balanced regional economic growth, and the reduction and
elimination of private sector monopolies in trade and industry. In order for the banking industry
to serve as an instrument of state policy, it was subjected to various nationalization schemes in
different phases (1955, 1969, and 1980). As a result, banking remained internationally isolated
(few Indian banks had presence abroad in international financial centers) because of
preoccupations with domestic priorities, especially massive branch expansion and attracting
more people to the system. Moreover, the sector has been assigned the role of providing support
to other economic sectors such as agriculture, small-scale industries, exports, and banking
activities in the developed commercial centers (i.e., metro, urban, and a limited number of semi-
urban centers). The banking system’s international isolation was also due to strict branch
licensing controls on foreign banks already operating in the country as well as entry restrictions
facing new foreign banks. A criterion of reciprocity is required for any Indian bank to open an
office abroad. These features have left the Indian banking sector with weaknesses and strengths.
A big challenge facing Indian banks is how, under the current ownership structure, to attain
operational efficiency suitable for modern financial intermediation. On the other hand, it has
been relatively easy for the public sector banks to recapitalize, given the increases in
nonperforming assets (NPAs), as their Government dominated ownership structure has reduced
the conflicts of interest that private banks would face.
The banking industry in India is undergoing a major transformation due to changes in
economic conditions and continuous deregulation. These multiple changes happening one after
other has a ripple effect on a bank trying to graduate from completely regulated seller market to
completed deregulated customers market. So that’s why the Indian banking sector is facing
following challenges:
Deregulation: This continuous deregulation has made the Banking market extremely
competitive with greater autonomy, operational flexibility and decontrolled interest rate and
liberalized norms for foreign exchange. The deregulation of the industry coupled with decontrol
in interest rates has led to entry of a number of players in the banking industry. At the same time
reduced corporate credit off take thanks to sluggish economy has resulted in large number of
competitors batting for the same pie.

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New rules: As a result, the market place has been redefined with new rules of the game. Banks
are transforming to universal banking, adding new channels with lucrative pricing and freebees
to offer. Natural fall out of this has led to a series of innovative product offerings catering to
various customer segments, specifically retail credit.
Efficiency: This in turn has made it necessary to look for efficiencies in the business. Banks
need to access low cost funds and simultaneously improve the efficiency. The banks are facing
pricing pressure, squeeze on spread and have to give thrust on retail assets.
Diffused Customer loyalty: This will definitely impact Customer preferences, as they are bound
to react to the value added offerings. Customers have become demanding and the loyalties are
diffused. There are multiple choices, the wallet share is reduced per bank with demand on
flexibility and customization. Given the relatively low switching costs; customer retention calls
for customized service and hassle free, flawless service delivery.
Misaligned mindset: These changes are creating challenges, as employees are made to adapt to
changing conditions. There is resistance to change from employees and the Seller market
mindset is yet to be changed coupled with Fear of uncertainty and Control orientation.
Acceptance of technology is slowly creeping in but the utilization is not maximized.
Competency Gap: Placing the right skill at the right place will determine success. The
competency gap needs to be addressed simultaneously otherwise there will be missed
opportunities. The focus of people will be on doing work but not providing solutions, on
escalating problems rather than solving them and on disposing customers instead of using the
opportunity to cross sell.
Other Challenges: Beside the above said challenges Indian banking sector is facing some other
challenges too:
• Implementation of Basel II
• Implementation of latest technology
• How to reduce NPA
• Corporate governance
• Man power planning
• Talent management
• Loan waiver: A new challenge
• Risk management
• Transparency and disclosures
• Challenges in banking security
• Growth in business
• Enhancing customer service
• Financial Inclusion
• Coping up with new IFRS

Non-Performing Assets in Indian Banks

Non-performing Asset (NPA) has emerged since over a decade as an alarming threat to
the banking industry in our country sending distressing signals on the sustainability and
endurability of the affected banks. The positive results of the chain of measures affected under
banking reforms by the Government of India and RBI in terms of the two Narasimhan
Committee Reports in this contemporary period have been neutralized by the ill effects of this
surging threat. Despite various correctional steps administered to solve and end this problem,
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 concrete results are eluding. It is a sweeping and all pervasive virus confronted universally on
banking and financial institutions. The severity of the problem is however acutely suffered by
Nationalised Banks, followed by the SBI group, and the all India Financial Institutions.
An asset is classified as Non-performing Asset (NPA) if due in the form of principal and
interest are not paid by the borrower for a period of 180 days. However with effect from March
2004, default status would be given to a borrower if dues are not paid for 90 days. If any advance
or credit facilities granted by banks to a borrower becomes non-performing, then the bank will
have to treat all the advances/credit facilities granted to that borrower as non-performing without
having any regard to the fact that there may still exist certain advances / credit facilities having
performing status.
Though the term NPA connotes a financial asset of a commercial bank, which has
stopped earning an expected reasonable return, it is also a reflection of the productivity of the
unit, firm, concern, industry and nation where that asset is idling. Viewed with this perspective,
the NPA is a result of an environment that prevents it from performing up to expected levels.
The definition of NPAs in Indian context is certainly more liberal with two quarters norm being
applied for classification of such assets. The RBI is moving over to one-quarter norm from 2004
onwards.

Magnitude of NPAs
In India, the NPAs that are considered to be at higher levels than those in other countries
have of late, attracted the attention of public. The Indian banking system had acquired a large
quantum of NPAs, which can be termed as legacy NPAs. NPAs seem to be growing in public
sector banks over the years. The following table of gross and net NPAs of various sector banks
revealing the real picture.

GROSS AND NET NPAs OF SCHEDULED COMMERCIAL BANKS BANK GROUP-WISE

(Amount in Rupees crore)
Year Advances Non-performing assets (NPAs)
(end- Gross Net Gross Net
March) Amount As As Amount As As
Percentag Percent Percentage Percentag
e of gross age of of net e of Total
advances total advances Assets
assets
1 2 3 4 5 6 7 8 9
Scheduled Commercial Banks
1997-98 352696 325522 50815 14.4 6.4 23761 7.3 3.0
1998-99 399436 367012 58722 14.7 6.2 28020 7.6 2.9
1999-00 475113 444292 60408 12.7 5.5 30073 6.8 2.7
2000-01 558766 526328 63741 11.4 4.9 32461 6.2 2.5
2001-02 680958 645859 70861 10.4 4.6 35554 5.5 2.3
2002-03 778043 740473 68717 8.8 4.1 29692 4.0 1.8
2003-04 902026 862643 64812 7.2 3.3 24396 2.8 1.2
2004-05 1152682 1115663 59373 5.2 2.5 21754 2.0 0.9
2005-06 1551378 1516811 51097 3.3 1.8 18543 1.2 0.7

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2006-07 2012510 1981237 50486 2.5 1.5 20101 1.0 0.6
2007-08 2507885 2476936 56309 2.3 1.3 24730 1.0 0.6
2008-09 3038254 3000906 68973 2.3 1.3 31424 1.1 0.6
Public Sector Banks
1997-98 284971 260459 45653 16.0 7.0 21232 8.2 3.3
1998-99 325328 297789 51710 15.9 6.7 24211 8.1 3.1
1999-00 379461 352714 53033 14.0 6.0 26187 7.4 2.9
2000-01 442134 415207 54672 12.4 5.3 27977 6.7 2.7
2001-02 509368 480681 56473 11.1 4.9 27958 5.8 2.4
2002-03 577813 549351 54090 9.4 4.2 24877 4.5 1.9
2003-04 661975 631383 51537 7.8 3.5 19335 3.1 1.3
2004-05 877825 848912 48399 5.5 2.7 16904 2.1 1.0
2005-06 1134724 1106288 41358 3.6 2.1 14566 1.3 0.7
2006-07 1464493 1440146 38968 2.7 1.6 15145 1.1 0.6
2007-08 1819074 1797401 40452 2.2 1.3 17836 1.0 0.6
2008-09 2283473 2260156 45156 2.0 1.2 21033 0.9 0.6
Old Private Sector Banks
1997-98 25580 24353 2794 10.9 5.1 1572 6.5 2.9
1998-99 28979 26017 3784 13.1 5.8 2332 9.0 3.6
1999-00 35404 33879 3815 10.8 5.2 2393 7.1 3.3
2000-01 39738 37973 4346 10.9 5.1 2771 7.3 3.3
2001-02 44057 42286 4851 11.0 5.2 3013 7.1 3.2
2002-03 51329 49436 4550 8.9 4.3 2598 5.2 2.5
2003-04 57908 55648 4398 7.6 3.6 2142 3.8 1.8
2004-05 70412 67742 4200 6.0 3.1 1859 2.7 1.4
2005-06 85154 82957 3759 4.4 2.5 1375 1.7 0.9
2006-07 94872 92887 2969 3.1 1.8 891 1.0 0.6
2007-08 113404 111670 2557 2.3 1.3 740 0.7 0.4
2008-09 130352 128512 3072 2.4 1.3 1165 0.9 0.5
New Private Sector Banks
1997-98 11173 11058 392 3.5 1.5 291 2.6 1.1
1998-99 14070 13714 871 6.2 2.3 611 4.5 1.6
1999-00 22816 22156 946 4.1 1.6 638 2.9 1.1
2000-01 31499 30086 1617 5.1 2.1 929 3.1 1.2
2001-02 76901 74187 6811 8.9 3.9 3663 4.9 2.1
2002-03 94718 89515 7232 7.6 3.8 1365 1.5 0.7
2003-04 119511 115106 5983 5.0 2.4 1986 1.7 0.8
2004-05 127420 123655 4582 3.6 1.6 2353 1.9 0.8
2005-06 232536 230005 4052 1.7 1.0 1796 0.8 0.4
2006-07 325273 321865 6287 1.9 1.1 3137 1.0 0.5
2007-08 412441 406733 10440 2.5 1.4 4907 1.2 0.7
2008-09 454713 446824 13911 3.1 1.8 6253 1.4 0.8
Foreign Banks In India
1997-98 30972 29652 1976 6.4 3.0 666 2.2 1.0
1998-99 31059 29492 2357 7.6 3.1 866 2.9 1.1
1999-00 37432 35543 2614 7.0 3.2 855 2.4 1.0
2000-01 45395 43063 3106 6.8 3.0 785 1.8 0.8

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 2001-02 50631 48705 2726 5.4 2.4 920 1.9 0.8
2002-03 54184 52171 2845 5.3 2.4 903 1.7 0.8
2003-04 62632 60506 2894 4.6 2.1 933 1.5 0.7
2004-05 77026 75354 2192 2.8 1.4 639 0.8 0.4
2005-06 98965 97562 1928 1.9 1.0 808 0.8 0.4
2006-07 127872 126339 2263 1.8 0.8 927 0.7 0.3
2007-08 162966 161133 2859 1.8 0.8 1247 0.8 0.3
2008-09 169716 165415 6833 4.0 1.5 2973 1.8 0.7
Data Source: RBI Site

Causes for Non-Performing Assets

A strong banking sector is important for a flourishing economy. The failure of the
banking sector may have an adverse impact on other sectors. The Indian banking system, which
was operating in a closed economy, now faces the challenges of an open economy. On one hand
a protected environment ensured that banks never needed to develop sophisticated treasury
operations and Asset Liability Management skills. On the other hand a combination of directed
lending and social banking relegated profitability and competitiveness to the background. The
net result was unsustainable NPAs and consequently a higher effective cost of banking services.
One of the main causes of NPAs into banking sector is the directed loans system under
which commercial banks are required a prescribed percentage of their credit (40%) to priority
sectors. As of today nearly 7 percent of Gross NPAs are locked up in 'hard-core' doubtful and
loss assets, accumulated over the years. The problem India Faces is not lack of strict prudential
norms but
• The legal impediments and time consuming nature of asset disposal proposal.
• Postponement of problem in order to show higher earnings.
• Manipulation of debtors using political influence.
Macro Perspective Behind NPAs
A lot of practical problems have been found in Indian banks, especially in public sector
banks. For Example, the government of India had given a massive wavier of Rs. 15,000 Crs.
under the Prime Minister ship of Mr. V.P. Singh, for rural debt during 1989-90. This was not a
unique incident in India and left a negative impression on the payer of the loan.
Poverty elevation programs like IRDP, RREP, SUME, SEPUP, JRY, PMRY etc., failed on
various grounds in meeting their objectives. The huge amount of loan granted under these
schemes were totally unrecoverable by banks due to political manipulation, misuse of funds and
non-reliability of target audience of these sections. Loans given by banks are their assets and as
the repayment of several of the loans were poor, the quality of these assets were steadily
deteriorating. Credit allocation became 'Lon Melas', loan proposal evaluations were slack and as
a result repayment were very poor.here are several reasons for an account becoming NPA.
* Internal factors
* External factors

Internal factors:
1. Funds borrowed for a particular purpose but not use for the said purpose.
2. Project not completed in time.
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 3. Poor recovery of receivables.
4. Excess capacities created on non-economic costs.
5. In-ability of the corporate to raise capital through the issue of equity or other debt
instrument from capital markets.
6. Business failures.
7. Diversion of funds for expansion\modernization\setting up new projects\ helping or
promoting sister concerns.
8. Willful defaults, siphoning of funds, fraud, disputes, management disputes, mis-
appropriation etc.,
9. Deficiencies on the part of the banks viz. in credit appraisal, monitoring and follow-ups,
delay in settlement of payments\ subsidiaries by government bodies etc.
External factors:
1. Sluggish legal system
2. Scarcity of raw material, power and other resources.
3. Industrial recession.
4. Shortage of raw material, raw material\input price escalation, power shortage, industrial
recession, excess capacity, natural calamities like floods, accidents.
5. Failures, non payment\ over dues in other countries, recession in other countries,
externalization problems, adverse exchange rates etc.
6. Government policies like excise duty changes, Import duty changes etc.,

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 LESSON 7 (b)

BANKING SECTOR REFORMS

Dr. Ashish Kumar
LBSIM

The Indian financial system in the pre-reform period (i.e., prior to Gulf crisis of 1991),
essentially catered to the needs of planned development in a mixed-economy framework where
the public sector had a dominant role in economic activity. The strategy of planned economic
development required huge development expenditure, which was met through Government’s
dominance of ownership of banks, automatic monetization of fiscal deficit and subjecting the
banking sector to large pre-emptions – both in terms of the statutory holding of Government
securities (statutory liquidity ratio, or SLR) and cash reserve ratio (CRR). Besides, there was a
complex structure of administered interest rates guided by the social concerns, resulting in cross-
subsidization. These not only distorted the interest rate mechanism but also adversely affected
the viability and profitability of banks by the end of 1980s. There is perhaps an element of
commonality of such a ‘repressed’ regime in the financial sector of many emerging market
economies. It follows that the process of reform of financial sector in most emerging economies
also has significant commonalities while being specific to the circumstances of each country. A
narration of the broad contours of reform in India would be helpful in appreciating both the
commonalities and the differences in our paths of reforms.

Contours of banking reforms in India

• First, reform measures were initiated and sequenced to create an enabling environment
for banks to overcome the external constraints – these were related to administered
structure of interest rates, high levels of pre-emption in the form of reserve requirements,
and credit allocation to certain sectors. Sequencing of interest rate deregulation has been
an important component of the reform process which has imparted greater efficiency to
resource allocation. The process has been gradual and predicated upon the institution of
prudential regulation for the banking system, market behavior, financial opening and,
above all, the underlying macroeconomic conditions. The interest rates in the banking
system have been largely deregulated except for certain specific classes; these are:
savings deposit accounts, non-resident Indian (NRI) deposits, small loans up to Rs.2 lakh
and export credit. The need for continuance of these prescriptions as well as those
relating to priority sector lending have been flagged for wider debate in the latest annual
policy of the RBI. However, administered interest rates still prevail in small savings
schemes of the Government.
• Second, as regards the policy environment of public ownership, it must be recognized
that the lion’s share of financial intermediation was accounted for by the public sector
during the pre-reform period. As part of the reforms programme, initially, there was
infusion of capital by the Government in public sector banks, which was followed by
expanding the capital base with equity participation by the private investors. The share of
the public sector banks in the aggregate assets of the banking sector has come down from
90 per cent in 1991 to around 75 per cent in 2004. The share of wholly Government-
owned public sector banks (i.e., where no diversification of ownership has taken place)
sharply declined from about 90 per cent to 10 per cent of aggregate assets of all
scheduled commercial banks during the same period. Diversification of ownership has
69
 led to greater market accountability and improved efficiency. Since the initiation of
reforms, infusion of funds by the Government into the public sector banks for the purpose
of recapitalization amounted, on a cumulative basis, to less than one per cent of India’s
GDP, a figure much lower than that for many other countries. Even after accounting for
the reduction in the Government's shareholding on account of losses set off, the current
market value of the share capital of the Government in public sector banks has increased
manifold and as such what was perceived to be a bail-out of public sector banks by
Government seems to be turning out to be a profitable investment for the Government.
• Third, one of the major objectives of banking sector reforms has been to enhance
efficiency and productivity through competition. Guidelines have been laid down for
establishment of new banks in the private sector and the foreign banks have been allowed
more liberal entry. Since 1993, twelve new private sector banks have been set up. As
already mentioned, an element of private shareholding in public sector banks has been
injected by enabling a reduction in the Government shareholding in public sector banks
to 51 per cent. As a major step towards enhancing competition in the banking sector,
foreign direct investment in the private sector banks is now allowed up to 74 per cent,
subject to conformity with the guidelines issued from time to time.
• Fourth, consolidation in the banking sector has been another feature of the reform
process. This also encompassed the Development Financial Institutions (DFIs), which
have been providers of long-term finance while the distinction between short-term and
long-term finance provider has increasingly become blurred over time. The complexities
involved in harmonizing the role and operations of the DFIs were examined and the RBI
enabled the reverse-merger of a large DFI with its commercial banking subsidiary which
is a major initiative towards universal banking. Recently, another large term-lending
institution has been converted into a bank. While guidelines for mergers between non-
banking financial companies and banks were issued some time ago, guidelines for
mergers between private sector banks have been issued a few days ago. The principles
underlying these guidelines would be applicable, as appropriate, to the public sector
banks also, subject to the provisions of the relevant legislation.
• Fifth, impressive institutional and legal reforms have been undertaken in relation to the
banking sector. In 1994, a Board for Financial Supervision (BFS) was constituted
comprising select members of the RBI Board with a variety of professional expertise to
exercise 'undivided attention to supervision'. The BFS, which generally meets once a
month, provides direction on a continuing basis on regulatory policies including
governance issues and supervisory practices. It also provides direction on supervisory
actions in specific cases. The BFS also ensures an integrated approach to supervision of
commercial banks, development finance institutions, non-banking finance companies,
urban cooperatives banks and primary dealers. A Board for Regulation and Supervision
of Payment and Settlement Systems (BPSS) has also been recently constituted to
prescribe policies relating to the regulation and supervision of all types of payment and
settlement systems, set standards for existing and future systems, authorize the payment
and settlement systems and determine criteria for membership to these systems. The
Credit Information Companies (Regulation) Bill, 2004 has been passed by both the
Houses of the Parliament while the Government Securities Bills, 2004 is under process.
Certain amendments are being considered by the Parliament to enhance Reserve Bank’s
regulatory and supervisory powers. Major amendments relate to requirement of prior
approval of RBI for acquisition of five per cent or more of shares of a banking company
with a view to ensuring ‘fit and proper’ status of the significant shareholders, aligning the
70
 voting rights with the economic holding and empowering the RBI to supersede the Board
of a banking company.
• Sixth, there have been a number of measures for enhancing the transparency and
disclosures standards. Illustratively, with a view to enhancing further transparency, all
cases of penalty imposed by the RBI on the banks as also directions issued on specific
matters, including those arising out of inspection, are to be placed in the public domain.
• Seventh, while the regulatory framework and supervisory practices have almost
converged with the best practices elsewhere in the world, two points are noteworthy.
First, the minimum capital to risk assets ratio (CRAR) has been kept at nine per cent i.e.,
one percentage point above the international norm; and second, the banks are required to
maintain a separate Investment Fluctuation Reserve (IFR) out of profits, towards interest
rate risk, at five per cent of their investment portfolio under the categories ‘held for
trading’ and ‘available for sale’. This was prescribed at a time when interest rates were
falling and banks were realizing large gains out of their treasury activities.
Simultaneously, the conservative accounting norms did not allow banks to recognize the
unrealized gains. Such unrealized gains coupled with the creation of IFR helped in
cushioning the valuation losses required to be booked when interest rates in the longer
tenors have moved up in the last one year or so.
• Eighth, of late, the regulatory framework in India, in addition to prescribing prudential
guidelines and encouraging market discipline, is increasingly focusing on ensuring good
governance through "fit and proper" owners, directors and senior managers of the banks.
Transfer of shareholding of five per cent and above requires acknowledgement from the
RBI and such significant shareholders are put through a `fit and proper' test. Banks have
also been asked to ensure that the nominated and elected directors are screened by a
nomination committee to satisfy `fit and proper' criteria. Directors are also required to
sign a covenant indicating their roles and responsibilities. The RBI has recently issued
detailed guidelines on ownership and governance in private sector banks emphasizing
diversified ownership. The listed banks are also required to comply with governance
principles laid down by the SEBI – the securities markets regulator.

Features of banking Sector Reform in India

Recalling some features of financial sector reforms in India would be in order, before narrating
the processes.
• First, financial sector reform was undertaken early in the reform-cycle in India.
• Second, the financial sector was not driven by any crisis and the reforms have not been
an outcome of multilateral aid.
• Third, the design and detail of the reform were evolved by domestic expertise, though
international experience is always kept in view.
• Fourth, the Government preferred that public sector banks manage the over-hang
problems of the past rather than cleanup the balance sheets with support of the
Government.
• Fifth, it was felt that there is enough room for growth and healthy competition for public
and private sector banks as well as foreign and domestic banks. The twin governing
principles are non-disruptive progress and consultative process.

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Processes of banking reform
In order to ensure timely and effective implementation of the measures, RBI has been adopting a
consultative approach before introducing policy measures. Suitable mechanisms have been
instituted to deliberate upon various issues so that the benefits of financial efficiency and
stability percolate to the common person and the services of the Indian financial system can be
benchmarked against international best standards in a transparent manner. Let me give a brief
account of these mechanisms.
• First, on all important issues, workings group are constituted or technical reports are
prepared, generally encompassing a review of the international best practices, options
available and way forward. The group membership may be internal or external to the RBI
or mixed. Draft reports are often placed in public domain and final reports take account
of inputs, in particular from industry associations and self-regulatory organizations. The
reform-measures emanate out of such a series of reports, the pioneering ones being:
Report of the Committee on the Financial System (Chairman: Shri M. Narasimham), in
1991; Report of the High Level Committee on Balance of Payments (Chairman: Dr. C.
Rangarajan) in 1992; and the Report of the Committee on Banking Sector Reforms
(Chairman: Shri M. Narasimham) in 1998.
• Second, Resource Management Discussions meetings are held by the RBI with select
commercial banks, prior to the policy announcements. These meetings not only focus on
perception and outlook of the bankers on the economy, liquidity conditions, credit flow,
development of different markets and directions of interest rates, but also on issues
relating to developmental aspects of banking operations.
• Third, we have formed a Technical Advisory Committee on Money, Foreign Exchange
and Government Securities Markets (TAC). It has emerged as a key consultative
mechanism amongst the regulators and various market players including banks. The
Committee has been crystallizing the synergies of experts across various fields of the
financial market and thereby acting as a facilitator for the RBI in steering reforms in
money, government securities and foreign exchange markets.
• Fourth, in order to strengthen the consultative process in the regulatory domain and to
place such a process on a continuing basis, the RBI has constituted a Standing Technical
Advisory Committee on Financial Regulation on the lines similar to the TAC. The
Committee consists of experts drawn from academia, financial markets, banks, non-bank
financial institutions and credit rating agencies. The Committee examines the issues
referred to it and advises the RBI on desirable regulatory framework on an on-going basis
for banks, non-bank financial institutions and other market participants.
• Fifth, for ensuring periodic formal interaction, amongst the regulators, there is a High
Level Co-ordination Committee on Financial and Capital Markets (HLCCFCM) with the
Governor, RBI as the Chairman, and the Heads of the securities market and insurance
regulators, and the Secretary of the Finance Ministry as the members. This Co-ordination
Committee has authorised constitution of several standing committees to ensure co-
ordination in regulatory frameworks at an operational level.
• Sixth, more recently a Standing Advisory Committee on Urban Co-operative Banks
(UCBs) has been activated to advise on structural, regulatory and supervisory issues
relating to UCBs and to facilitate the process of formulating future approaches for this
sector. Similar mechanisms are being worked out for non-banking financial companies.
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 • Seventh, the RBI has also instituted a mechanism of placing draft versions of important
guidelines for comments of the public at large before finalisation of the guidelines. To
further this consultative process and with a specific goal of making the regulatory
guidelines more user-friendly, a Users’ Consultative Panel has been constituted
comprising the representatives of select banks and market participants. The panel
provides feedback on regulatory instructions at the formulation stage to avoid any
subsequent ambiguities and operational glitches.
• Eighth, an extensive and transparent communication system has been evolved. The
annual policy statements and their mid-term reviews communicate the RBI’s stance on
monetary policy in the immediate future of six months to one year. Over the years, the
reports of various working groups and committees have emerged as another plank of two-
way communication from RBI. An important feature of the RBI’s communication policy
is the almost real-time dissemination of information through its web-site. The auction
results under Liquidity Adjustment Facility (LAF) of the day are posted on the web-site
by 12.30 p.m the same day, while by 2.30 p.m. the ‘reference rates’ of select foreign
currencies are also placed on the website. By the next day morning, the press release on
money market operations is issued. Every Saturday, by 12 noon, the weekly statistical
supplement is placed on the web-site providing a fairly detailed, recent data-base on the
RBI and the financial sector. All the regulatory and administrative circulars of different
Departments of the RBI are placed on the web-site within half an hour of their
finalization.
• Ninth, an important feature of the reform of the Indian financial system has been the
intent of the authorities to align the regulatory framework with international best
practices keeping in view the developmental needs of the country and domestic factors.
Towards this end, a Standing Committee on International Financial Standards and Codes
was constituted in 1999. The Standing Committee had set up ten Advisory Groups in key
areas of the financial sector whose reports are available on the RBI website. The
recommendations contained in these reports have either been implemented or are in the
process of implementation. I would like to draw your attention to two reports in
particular, which have a direct bearing on the banking system, viz., Advisory Group on
Banking Supervision and Advisory Group on Corporate Governance. Subsequently, in
2004, we conducted a review of the recommendations of the Advisory Groups and
reported the progress and agenda ahead.

What has been the impact?

These reform measures have had major impact on the overall efficiency and stability of the
banking system in India. The present capital adequacy of Indian banks is comparable to those at
international level. There has been a marked improvement in the asset quality with the
percentage of gross non-performing assets (NPAs) to gross advances for the banking system
reduced from 14.4 per cent in 1998 to 7.2 per cent in 2004. The reform measures have also
resulted in an improvement in the profitability of banks. The Return on Assets (RoA) of the
banks rose from 0.4 per cent in the year 1991-92 to 1.2 per cent in 2003-04. Considering that,
globally, the RoA has been in the range 0.9 to 1.5 per cent for 2004, Indian banks are well
placed. The banking sector reforms also emphasized the need to review the manpower resources
and rationalize the requirements by drawing a realistic plan so as to reduce the operating cost and
improve the profitability. During the next five years, the business per employee for public sector
banks more than doubled to around Rs.25 million in 2004.
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 Considerable emphasis has been led down on appropriate mix between the elements of
continuity and change in the process of reform, but the dynamic elements in the mix are
determined by the context. While there is usually a consensus on the broad direction, relative
emphasis on various elements of the process of reform keeps changing, depending on the
evolving circumstances. Perhaps it will be useful to illustrate this approach to contextualizing the
mix of continuity and change.
The mid-term review in November 2003, reviewed the progress of implementation of
various developmental as well as regulatory measures in the banking sector but emphasized
facilitating the ease of transactions by the common person and strengthening the credit delivery
systems, as a response to the pressing needs of the society and economy. The annual policy
statement of May 2004 carried forward this focus but flagged major areas requiring urgent
attention especially in the areas of ownership, governance, conflicts of interest and customer-
protection. Some extracts of the policy statement may be in order:
"First, it is necessary to articulate in a comprehensive and transparent manner
the policy in regard to ownership and governance of both public and private
sector banks keeping in view the special nature of banks. This will also
facilitate the ongoing shift from external regulation to internal systems of
controls and risk assessments. Second, from a systemic point of view, inter-
relationships between activities of financial intermediaries and areas of
conflict of interests need to be considered. Third, in order to protect the
integrity of the financial system by reducing the likelihood of their becoming
conduits for money laundering, terrorist financing and other unlawful activities
and also to ensure audit trail, greater accent needs to be laid on the adoption
of an effective consolidated know your customer (KYC) system, on both assets
and liabilities, in all financial intermediaries regulated by RBI. At the same
time, it is essential that banks do not seek intrusive details from their customers
and do not resort to sharing of information regarding the customer except with
the written consent of the customer. Fourth, while the stability and efficiency
imparted to the large commercial banking system is universally recognised,
there are some segments which warrant restructuring."
The annual policy statement for the current year reiterates the concern for common person, while
enunciating a medium term framework, for development of money, foreign exchange and
government securities markets; for enhancing credit flow to agriculture and small industry; for
action points in technology and payments systems; for institutional reform in co-operative
banking, non-banking financial companies and regional rural banks; and, for ensuring
availability of quality services to all sections of the population. The most distinguishing feature
of the policy statement relates to the availability of banking services to the common person,
especially depositors.
The statement reiterates that depositors’ interests form the focal point of the regulatory
framework for banking in India, and elaborates the theme as follows:
“A licence to do banking business provides the entity, the ability to accept
deposits and access to deposit insurance for small depositors. Similarly,
regulation and supervision by RBI enables these entities to access funds from a
wider investor base and the payment and settlement systems provides efficient
payments and funds transfer services. All these services, which are in the
nature of public good, involve significant costs and are being made available

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 only to ensure availability of banking and payment services to the entire
population without discrimination”.
The policy draws attention to the divergence in treatment of depositors compared to borrowers
as:
“ … while policies relating to credit allocation, credit pricing and credit
restructuring should continue to receive attention, it is inappropriate to ignore
the mandate relating to depositors’ interests. Further, in our country, the
socio-economic profile for a typical depositor who seeks safe avenues for his
savings deserves special attention relative to other stakeholders in the banks”.
Another significant area of concern has been the possible exclusion of a large section of
population from the provision of services and the Statement pleads for financial inclusion. It
states:
“There has been expansion, greater competition and diversification of
ownership of banks leading to both enhanced efficiency and systemic resilience
in the banking sector. However, there are legitimate concerns in regard to the
banking practices that tend to exclude rather than attract vast sections of
population, in particular pensioners, self-employed and those employed in
unorganised sector. While commercial considerations are no doubt important,
the banks have been bestowed with several privileges, especially of seeking
public deposits on a highly leveraged basis, and consequently they should be
obliged to provide banking services to all segments of the population, on
equitable basis.”
Operationally, it has been made clear that RBI will implement policies to encourage banks which
provide extensive services while disincentivising those which are not responsive to the banking
needs of the community, including the underprivileged.
The quality of services rendered has also invited attention in the current policy.
“Liberalisation and enhanced competition accord immense benefits, but
experience has shown that consumers’ interests are not necessarily accorded
full protection and their grievances are not properly attended to. Several
representations are being received in regard to recent trends of levying
unreasonably high service/user charges and enhancement of user charges
without proper and prior intimation. Taking account of all these
considerations, it has been decided by RBI to set up an independent Banking
Codes and Standards Board of India on the model of the mechanism in the UK
in order to ensure that comprehensive code of conduct for fair treatment of
customers are evolved and adhered to”.
It is essential to recognize that, while these constitute contextual nuanced responses to changing
circumstances within the country, the overwhelming compulsion to be in harmony with global
developments must be respected and that essentially relates to Basel II.
Basel II and India
RBI’s association with the Basel Committee on Banking Supervision dates back to 1997 as India
was among the 16 non-member countries that were consulted in the drafting of the Basel Core
Principles. Reserve Bank of India became a member of the Core Principles Liaison Group in
1998 and subsequently became a member of the Core Principles Working Group on Capital.
Within the Working Group, RBI has been actively participating in the deliberations on the New
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Accord and had the privilege to lead a group of six major non-G-10 supervisors which presented
a proposal on a simplified approach for Basel II to the Committee.
Commercial banks in India will start implementing Basel II with effect from March 31,
2007. They will adopt Standardised Approach for credit risk and Basic Indicator Approach for
operational risk, initially. After adequate skills are developed, both at the banks and also at
supervisory levels, some banks may be allowed to migrate to the Internal Rating Based (IRB)
Approach.
The RBI had announced in its annual policy statement in May 2004 that banks in India
should examine in depth the options available under Basel II and draw a road-map by end-
December 2004 for migration to Basel II and review the progress made at quarterly intervals.
The Reserve Bank organized a two-day seminar in July 2004 mainly to sensitise the Chief
Executive Officers of banks to the opportunities and challenges emerging from the Basel II
norms. Soon thereafter all banks were advised in August 2004 to undertake a self-assessment of
the various risk management systems in place, with specific reference to the three major risks
covered under the Basel II and initiate necessary remedial measures to update the systems to
match up to the minimum standards prescribed under the New Framework. Banks have also been
advised to formulate and operationalize the Capital Adequacy Assessment Process (CAAP)
within the banks as required under Pillar II of the New Framework.
It is appropriate to list some of the other regulatory initiatives taken by the Reserve Bank of
India, relevant for Basel II. First, we have tried to ensure that the banks have suitable risk
management framework oriented towards their requirements dictated by the size and complexity
of business, risk philosophy, market perceptions and the expected level of capital. Second, Risk
Based Supervision (RBS) in 23 banks has been introduced on a pilot basis. Third, we have been
encouraging banks to formalize their capital adequacy assessment process (CAAP) in alignment
with their business plan and performance budgeting system. This, together with the adoption of
RBS would aid in factoring the Pillar II requirements under Basel II. Fourth, we have been
expanding the area of disclosures (Pillar III), so as to have greater transparency in the financial
position and risk profile of banks. Finally, we have tried to build capacity for ensuring the
regulator’s ability for identifying and permitting eligible banks to adopt IRB / Advanced
Measurement approaches.
As per normal practice, and with a view to ensuring migration to Basel II in a non-disruptive
manner, a consultative and participative approach has been adopted for both designing and
implementing Basel II. A Steering Committee comprising senior officials from 14 banks (public,
private and foreign) has been constituted wherein representation from the Indian Banks’
Association and the RBI has also been ensured. The Steering Committee had formed sub-groups
to address specific issues. On the basis of recommendations of the Steering Committee, draft
guidelines to the banks on implementation of the New Capital Adequacy Framework have been
issued.
Implementation of Basel II will require more capital for banks in India due to the fact that
operational risk is not captured under Basel I, and the capital charge for market risk was not
prescribed until recently. Though last year has not been a very good year for banks, they are
exploring all avenues for meeting the capital requirements under Basel II. The cushion available
in the system, which has a CRAR of over 12 per cent now, is, however, comforting.
India has four rating agencies of which three are owned partly/wholly by international rating
agencies. Compared to developing countries, the extent of rating penetration has been increasing
every year and a large number of capital issues of companies has been rated. However, since

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rating is of issues and not of issuers, it is likely to result, in effect, in application of only Basel I
standards for credit risks in respect of non-retail exposures. While Basel II provides some scope
to extend the rating of issues to issuers, this would only be an approximation and it would be
necessary for the system to move to rating of issuers. Encouraging rating of issuers would be
essential in this regard. In this context, current non-availability of acceptable and qualitative
historical data relevant to ratings, along with the related costs involved in building up and
maintaining the requisite database, does influence the pace of migration to the advanced
approaches available under Basel II.
Above all, capacity building, both in banks and the regulatory bodies is a serious challenge,
especially with regard to adoption of the advanced approaches. We in India have initiated
supervisory capacity-building measures to identify the gaps and to assess as well as quantify the
extent of additional capital which may be required to be maintained by such banks. The
magnitude of this task, which is scheduled to be completed by December 2006, appears daunting
since we have as many as 90 scheduled commercial banks in India.
In the current scenario, banks are constantly pushing the frontiers of risk management.
Compulsions arising out of increasing competition, as well as agency problems between
management, owners and other stakeholders are inducing banks to look at newer avenues to
augment revenues, while trimming costs. Consolidation, competition and risk management are
no doubt critical to the future of banking but I believe that governance and financial inclusion
would also emerge as the key issues for a country like India, at this stage of socio-economic
development.
Self-Assessment Questions:
Question 1: Discuss the main provisions of Banking Regulation Act, 1949?
Question 2: State the various statutory provisions of Reserve Bank of India Act 1934.
Question 3: Specify the various challenges faced by the Indian Banking system.
Question 4: What do you mean by NPA? What are the causes that an account turned as NPA?
State the Indian banks conditions in respect of NPAs.
Question 5: Specify the banking sector reforms taken place in India and discuss the effectiveness
of the same also.
Question 6: Explain the need for regulations of banking sector in India. Briefly discuss the
important reforms which have taken place in this sector.
Suggested Readings:
• Sundhram, K.P.M., Banking Theory Law and Practice, Sultan Chand & Co. Ltd., New
Delhi.
• Desai, Vasant, Banking and Financial System, Himalaya Publishing House, New Delhi
• Bihari, S.C. and Baral S.K., Modern Banking Management, Skylark Publications, New
Delhi.
• Suresh, Padmalatha and Paul, Justin, Management of Banking and Financial Services,
Pearson Publications, New Delhi.

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 UNIT-II
LESSON 1

ELECTRONIC BANKING
Dr. Pooja Goel
Shaheed Bhagat Singh College
University of Delhi
Objectives
After going through this lesson you should be able to:

• Understand the Concept of E-Banking

• Describe the New Dimensions & Products of Banking
• Differentiate Between Debit and Credit Card
• Explain the Risks in E-banking

Structure

1.1 Meaning of E-banking

1.2 Automated Teller Machine
1.3 Internet Banking
1.4 Telephone Banking
1.5 Electronic Clearing Service
1.6 Electronic Funds Transfer (EFT)
1.7 Credit Cards
1.8 Smart cards
1.9 Electronic Cheques
1.10 Debit Card
1.11 Risks in E-banking
1.12 Conclusion
1.13 Test Questions
1.14 Further Readings
The banking industry is now a very mature one and banks are being forced to change rapidly as
a result of open market forces such as threat of competition, customer demand, and
technological innovations such as growth of internet banking. If banks have to retain their
competitiveness, they must focus on customer retention and relationship management, upgrade
and offer integration and value added services. With the increasing customer demands, banks
have to constantly think of innovative customized services to remain competitive. That’s why
internet banking is becoming a necessity today.

1.1 Meaning of E-banking

Electronic banking (E-banking) is a generic term encompassing internet banking, telephone
banking, mobile banking etc. In other words, it is a process of delivery of banking services and
products through electronic channels such as telephone, internet, cell phone etc. The concept
and scope of E-banking is still evolving.

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 Electronic services allow a bank’s customers and other stakeholders to interact and transact
with the bank seamlessly through a variety of channels such as the internet, wireless devices,
ATMs, on-line banking, phone banking and telebanking. Other services offered under E-
banking include electronic fund transfer, electronic clearing service and electronic payment
media including the credit card, debit card and smart card. On-line banking helps consumers to
overcome the limitations of place and time as they can bank anywhere, anytime as these
services are available twenty four hours, 365 days a year without any physical limitations of
space like a specific bank branch, city or region. They also bypass the paper based aspect of
traditional banking.
As compared to other countries, e-banking growth and development is at a nascent stage in
India, yet the changing profile of customers and the resultant competition from establishment
of new private sector banks and foreign banks has provided a fillip to its growth. As a result,
India has emerged as one of the fastest growing markets in the world.
Several initiatives taken by the Government of India as well as the Reserve Bank of India
(RBI) have facilitated the development of E-banking in India. As a regulator and supervisor,
the RBI has made considerable progress in consolidating the existing payment and settlement
systems, and in upgrading technology with a view to establishing an efficient, integrated and
secure system functioning in a real-time environment, which has further helped the
development of E-banking in India. The Government of India enacted the IT Act, 2000 with
effect from October 17, 2000, which provides legal recognition to electronic transactions and
other means of electronic commerce.

1.2 Automated Teller Machine

The Automated Teller Machine (ATM) is seen everywhere. This machine has brought
innovations in the Banking sector all over the world. The advent of the ATM has made the
concept of round the clock banking a reality. The ATM has been helpful to both the bankers
and the customers. The long crowd of customers in the banking hall of a branch waiting for
their turn to collect cash is disappearing. The branch business timings have lost significance to
the customers after the introduction of ATM.
The ATM is a device used by the bank customers to process account transactions. The
customer inserts into the ATM, a plastic card i.e. encoded with information on a magnetic strip.
The strip contains an identification code that is transmitted to the bank’s central computer by
modem. Every cardholder should be given a PIN (personal identification number) that he
should enter and after verifying the same with the records, ATM would allow operations.
Functions of ATM: The functions of ATM differ from bank to bank. The following features
are available in the ATM of all the banks.

• Fast Cash: When you want to do the only activity of drawing cash in pre-determined
amounts like Rs. 500, Rs. 1,000, Rs. 2,000, Rs. 5,000 etc. you can use this option.
• Normal Cash Withdrawal: Every bank has fixed a maximum limit of cash withdrawal
per account per day. It ranges between Rs. 10-15000. While in some banks the
maximum amount may be drawn in one shot (HDFC, ICICI) and in some other banks it

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 should be drawn in lots (Syndicate Bank, State Bank of India). All withdrawals shall be
in multiple of Rs. 100 only.
• Balance Enquiry
• Mini statement of account: You get detail of last 5-10 transactions.
• Pin change:
• Cash Deposit: Varied procedures exist. Here special covers are available in the ATM
wherein the client has to fill up the challan, the denominations and key in these details.
Then, a window opens wherein the cover containing the cash has to be dropped. At the
end of the day, officials of the branch to which the ATM is attached, would open the
machine, take the cover and credit the account of the customer. If there is any cover, the
decision of the bank is final.
• Transfer transactions: If you want to transfer funds with in the bank i.e. from one
account to another at same branch or at different branch, you can use this option.
The ATMs are emerging as the most useful tool to ensure, “Any-Time Banking” and “Any-
where Banking” or “Any-Time Money”. While the benefits of ATM are immense, the cost of
ATM, though has come, down, it still prohibitive. An ATM costs between Rs. 8-10 lakh. If a
bank has to install 100 ATMs it should spend at least Rs. 8-10 crs. Added to this, is the
maintenance cost. Today any electronic device attracts and annual maintaing cost of Rs.8-12
per cent of capital cost. Besides this banks have to incur expenditure on the rent for retail
outlet, its ambience and on security personnel etc. While many public sector banks have gone
on a big way in opening ATMs there is a need for sufficient examination of their economic
viability. Already there is experience that the hits per ATM are less than 200 resulting in no big
gain for either the bank or customer. India with more population density should show a higher
average hit per day and this emerges as a critical factor in the overall ATM strategy towards
making the whole business idea profitable.
The rationale for banks introducing ATMs in 1970s, was to deliver their products more
cheaply than traditional branch networks which are loaded with expensive staff.

1.3 Internet Banking

Internet banking is the latest and the cheapest technology introduced in the banking industry. It
is acknowledged that the internet has already had a profound effect on delivery of financial
services and this likely to bring more radical changes. At the basic level, interknit banking can
mean the setting u of a web-page by a bank to give information about its products and services.
At an advance level, it involves provision of facilities such as accessing accounts, fund
transfer, and buying financial products or services online. This is called “Transactional Online
Banking”.
In general Internet Banking refers to the use if internet as a delivery channel for the banking
services, including traditional services, such as opening an account or transferring funds among
different accounts, as well as new banking services such as electronic bill presentation and
payment which allows the customers to pay and receive the bills on a bank’s website.
There are two ways to offer Internet Banking. First, an existing bank with physical offices
can establish a web-site and offer internet banking in addition to its traditional delivery
channel. Second, a bank may be established as a “branchless”, “Internet only”, or “Virtual

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bank”. Further internet banking sites offer financial services products to customer in three
basic formats

• Information Only: Informational only presents online information about the different
banks services and products to the customers as well as general public and may include
unsecured e-mail contract, with no customer identification or verification required.
• Information Exchange: Information Exchange Customer Information such as name,
address and account information may be collected or displayed, with possible secure e-
mail and/or data transfer, with verification of customer identification required. No
financial transactions are to be made.
• Transactional: Transactional customer account information enquiry, financial
transactions such as transfer of funds, payment of bill, application for loans and a
variety of other financial transactions, with strong customer authentication required.
When it was introduced for the first time, Internet Banking was used mainly as an
information presentation medium in which banks marketed their products and services on their
web sites with the development of asynchronous technologies; however more banks have come
forward to use internet banking both as a transactional as well as an informational medium.
A successful Internet Banking solution offers:

• Exceptional rate on savings CDs, and IRAS.

• Checking with no monthly fee, free bill payment and rebates on ATM surcharges.
• Credit card with low rates.
• Easy online applications for all accounts, including personal loans and mortgages.
• 24 hours account access.
• Quality customer service with personal attention.
Internet banking is a cost-effective delivery channel for financial institutions. All the
transactions are encrypted, using sophisticated multi-layer security architecture, including fire
walls and filters. Firewall is a protection device to shield a vulnerable area from some form of
danger. In Internet, a firewall system set up specifically, to shield a web from outside.
Typically, this allows insiders to have full access to services on the outside, while granting
access into the internal system, selectively based on log-in-name and password.
Internet banking is somewhat different from PC banking. PC banking is transactions
through PC at one’s office or home, which is connected to the branch through a modem. PC
banking is available only when branch is open and is available only through any PC. But,
internet banking enables to do the same through any PC connected to the internet, from
anywhere in the world.

Advantages of Internet Banking

• Anywhere and anytime banking as services are provided round the clock.
• Worldwide connectivity as it transcends geographical boundaries.
• Easy access to recent and historical data.
• Direct customer control of international movement of funds.
• Greater processing speed and accuracy.

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1.4 Telephone Banking
The banks are aiming to make them more accessible by introducing telephone banking.
Telephone banking refers to dialing one telephone number using a telephone to access the
account, transfer funds, request statements or cheque book simply by following recorded
message and touching the keys on your phone. It allows the customers to check account at
convenient time and get simple things done without visiting bank premises. Telephone banking
aims at providing 24 hour service that is fast, convenient and secured for all customers. In the
modern society everyone has to access to telephone. Registering for telephone banking cost
nothing although there is a small transactions charge for making bill payment and frequent
usage charges.

1.5 Electronic Clearing Service

In 1994, RBI appointed a committee to review the mechanization in the banks and also to
review the electronic clearing service. The committee recommended in its report that electronic
clearing service-credit clearing facility should be made available to all corporate
bodies/Government institutions for making repetitive low value payment like dividend,
interest, refund, salary, pension or commission. It was also recommended by the committee
Electronic Clearing Service- Debit clearing may be introduced for pre-authorized debits for
payments of utility bills, insurance premium and installments to leasing and financing
companies. RBI has been necessary step to introduce these schemes, initially in Chennai,
Mumbai, Calcutta and New Delhi.

1.6 Electronic Funds Transfer (EFT)

For making inter-city payments customer usually make payments through demand drafts, mail
transfers and telegraphic transfers. In 1996, RBI devised an electronic fund transfer (EFT)
system to facilitate fast transfer of funds electronically. The funds can be transferred between
any two bank accounts even if the sender and the receiver are located in different cities or deal
with different banks. EFT has accelerated the movement of funds across the globe. E-cash or
cyber cash plays a predominant role in world of commerce. Such electronic funds movements
amounting to a few trillion dollars are settled on a daily basis in major international financial
centers. Society for worldwide inter-bank financial telecommunication is a classic example of
EFT among banks with its own standards for messages, which ensures speed, reliability,
security and accuracy. SWIFT, as a co-operative society was formed in May 1973 with 239
participating banks from 15 countries with its headquarters at Brussels. It started functioning in
May 1977. Reserve Bank of India and 27 other public sector banks as well as 8 foreign banks
in India have obtained the membership of the SWIFT. SWIFT provides rapid, secure, reliable
and cost effective mode of transmitting the financial messages worldwide. At present more
than 3000 banks are the members of the network. To cater to the growth in messages, SWIFT
was upgrade in the 80s and this version is called SWIFT-II. Banks in India are hooked to
SWIFT-II system.
SWIFT is a method of the sophisticated message transmission of international repute. This
is highly cost effective, reliable and safe means of fund transfer.

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 • This network facilitate the transfer of messages relating to fixed deposit, interest
payment, debit-credit statements, foreign exchange etc.
• This service is available throughout the year, 24 hours a day.
• This system ensure against any loss of mutilation against transmission.
• It serves almost all financial institution and selected range of other users.
The objective of establishing an EFT system is to facilitate an efficient, secure, economical,
reliable and expeditious system of funds transfer and clearing in the banking sector throughout
India, and to relieve the stress on the existing paper based funds transfer and clearing system.

Advantages of EFT

• Funds can get transferred easily and conveniently without delays and paper work.
• Built-in security measures ensure safety of funds during transfer.
• Losses and frauds are minimized due to easy tracking of transactions/customers.

1.7 Credit Cards

There are various ways of making payment through the banking system. These include
cheques, direct debits, bank drafts, electronic transfer, international money orders, letters of
credit, etc. Increasing affluence combined with increasing complexity of life has led to the
phenomenon of Credit Cards. They provide convenience and safety in the purchasing process.
It is generally known as plastic money. The credit card are made of plastic is widely used by
the consumers all around the globe. The changes in consumer behavior and tastes led to the
tremendous growth of credit cards. Credit card is a card which enables the consumers to
purchase products or services without paying immediately. This credit concept is based on the
principle of “Buy now pay later”. Credit card is a document that can be used for purchase of
goods and services all over the globe.
The world’s first credit card was issued by Mobil in 1940. This card was initially issued by
the Company to give specialized services to its regular customers. It helped to boost sales and
increase the customer base. After the tremendous success of Mobil card various organisations
began to think about the use of cards in different segments of the business. The Diners Club,
American Express and Carte Blanche Cards have emerged. The credit cards were popularly
known in USA. During the second World War US saw the growth of the credit cards. The first
bank card was issued by Fanklin National Bank, USA in the year 1952. In 1960, the credit
card operating system was developed by Bank of America, USA. An international bank card
system known as “VISA” International was established. Another international bank card
system called “Mastercard” was established. At present the market is dominated by the VISA
and Master Card. In the year 1988, the first woman card was launched “My Card” by
international bank of Asia in HongKong.
The credit cards are made of plastic. It is widely used by the consumers all around the globe
in the digital economy. The card identifies its owner. The owner of the card is entitled to
purchase the goods without cash. It provides purchase services without money and be eligible
to get credit from a number of merchant establishments. The issuer of the card issues credit
cards depending on the credibility of the customers. The card issuer enters into a tie up with
different merchant vendors located indifferent geographical places in various fields of business

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activities. The card issuer will put up a credit limit for its card holders and a ceiling limit for
each vendor. The card offers the card holder an opportunity to buy air, rail tickets and stay at
hotels for payments. The card holder need only to present the card at the cash counter and has
to sign some firms. The credit cards can be considered as a substitute for cash and cheques.
The cards are not accepted by all the merchant vendors.

Process of Credit Card Business Cycle

Credit cards facilitate its holder to make purchases at various designated merchant
establishments. The establishments like travel agencies. Star hotels, Departmental stores will
accept all valid cards in lieu of cash payments. The card holder can avoid the risk of carrying
cash. The following steps are involved in the process of a transaction.
Step I: a card holder purchases goods and present the credit card to the designated merchant
establishment.
Step II: The retail vendor verifies the number on the card against the hot list provided to him
by the bank.
Step III: The card holder is required to sign on the voucher and the signature has to tally with
the one on the credit card.
Step IV: The Retailer has to present the sales vouchers to the bank for reimbursement for the
customers’ purchases. The bank also charges commission from the retailer.
Step V: The bank will make payment to the retailer on behalf of the card holder.
Step VI: After completion of the process. The bank sends the bill to the card holder and
received the money.

Benefits of the Credit Cards

The benefits of credit cards may be classified into two categories:
(A) Benefits to the Card Holders: There are so many benefits to the card holders for using the
cards:
• The card holder need not to carry cash at all times.
• The card holder will be covered by free insurance.
• The card can be used as identification card in some situations.
• The issuer of card offers rewards and gifts to the card holder.
• The card holders can avail special counters for Air and Travel reservations.
• The card holder can get complimentary magazines. For example, diners club
provide “signature” magazine to card holders.
• Family members of the card holder can avail this facility.
• The card holder can enjoy free credit uto 30 to 45 days.
• If the credit card is lost/stolen the liability is limited to a maximum of one
thousand rupees.
• Some credit holders will get free services such as confirmed ticket booking and
hotel reservations.

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 • Some card holders will get benefit from the world wide network, for example,
Master card, Amex, Visa etc.
(B) Benefits to the Card Holders: There are also advantages to credit issuers. Such advantages
are such as:
• This business offers higher profits.
• The issuers can also improve their name and image by serving large number of credit
card holder base.
• This business is an additional activity in the banking sector to enhance their
profitability.

(c ) Additional Facilities: The credit cards besides providing credit facility, the issuer extend
some additional facilities to attract more customers. These facilities and services are presented
below
a) Incidental Expenses: The credit card holders can use their cards to pay for incidental
expenses. They have to do is to call the issuer bank and instruct it to make payment like
telephone bills, electricity bills, payment to mutual funds, public issues etc.
b) Instant cash Withdrawal: Some issuers allows their credit card holder to withdraw
instant cash up to 60 percent of his credit line from ATMs in all metros. The card
holders can also draw cash in case of medical emergencies for meeting expenses on
treatment at other than their home town. This emergency medical advance facility is
available with all Indian and foreign banks.
c) 24× 7×365 Customer Service: The technology adopted by the banking sector makes
comfortable life to the customers. The revolutionary phone banking service ensures that
the banks are just a phone call away to assist the card holders around the clock. Foreign
banks provide a world class service to card holders. A credit card holder can call
“Citiphone banking” and ask for temporary credit line any time.
d) Free insurance: Some of the issuers, insures the card holder at free of cost for a
particular sum. Citibank offer a complimentary personal accident insurance. The Bank
of Baroda card extends insurance protection to card holders spouse also.
e) Buy Anything on Credit Card: The credit cards are well accepted by the public. The
card can be used for all occasions and seasons. The card is also useful for purchasing
essential commodities like groceries, fuel, auto accessories and cosmetics. The cards
are useful even passing customs duties and hospital bills. We can purchase everything,
anywhere at any time under the sum at designated locations.
f) Joint Credit card and ATM Facility: Indian banks and foreign banks have introduced a
joint card. The joint card holder can access his accounts with the bank through ATMs.
g) Hotel Discount Facility: The credit holders are entitled to get discounts at all leading
hotels and clubs. The card holders are eligible to avail the facilities as per the schemes
which were offered by the hotels, travel agencies and on air ticket. Even the consumer
products are also available in this method.
h) Fuel Facility at Petrol Pumps: The BOB, Citibank, Standard Chartered cards are
accepted at all Bharat petroleum outlets. This is very convenient foe card holders at all
leading metro cities.
i) Purchase Protection: The credit card facility protects the purchases against damage or
loss due fire and theft. For compensation the card holder can claim the value of the
product damaged or lost from The New India Assurance Company. This protection is

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 available for a limited period from the date of purchase of the product on the credit
card. Some of these facilities are exclusive offers, airport lounges, special hospital
facilities, special travel services.

Types of Credit Cards

The credit card system is becoming very popular in India and abroad. The system facilitates a
wide range of products and services. The growth of service sector depends on the pulse of the
customer. The needs of the customers are taken care off by different card issuers. The credit
cards can be classified into 4 basic types based on the issuers: Travel and entertainment card,
bank card, retail card, fuel card. There are many types of cards which are popular in India and
abroad. These cards can also be classified as follows:
a) Based on Geographical Territory: Under this category, the credit cards can be
categorised as Domestic cards and International cards. The domestic cards are
generally available from most of the banks. These cards will be valid in India and
Nepal only. All the transactions will be in rupees only. International cards will be
issued to persons who travel foreign countries frequently. These cards are subject to
the rules and regulations of the RBI. These cards will be honoured in throughout the
world except in India and Nepal.
b) Based on Franchise: The credit cards can be classified based on the tie-ups. They are
Visa card, Master card, Proprietary card and tie-up card. Visa card can be issued by
any bank which is having tie-up with VISA international USA. The card holder can
avail the facilities of Visa network for their transitions. Master card is a brand name
for another type of credit card. The issuer of the card has to obtain permission from the
master card corporation of USA. It will be honoured in the master card network
Proprietary card will be issued by the issuer bank on their own brand name. These
cards will be issued by banks in addition to their other tie-up cards. Tie-up cards are
issued by banks having a collaboration with domestic card brands.
c) Based on Status: This type of credit cards will be further classified as standard cards,
business cards and gold card. The standard card is a normal card generally issued by
all issuing banks. The card holder is offered limited privileges when compared to the
other cards. These cards are issued by some banks under the brand name of “classic”
card. Business card is meant for tax consultants, chartered accountants, small firms,
solicitors and executives etc. These cards are very useful for their business trips more
and more convenient. The business card facilitates more privileges than the standard
card. Some banks are issuing these cards in the brand name of “executive”.
d) Based on User: Under this category the credit cards are further classified as Individual
cards and corporate cards. The individual cards are issued to individual persons. All
the brands of cards will be given to individual corporate cards are issued to corporate
companies and business firms only. The corporate cards are issued on the name of the
company. The cards will be utilized by the executives and top officials the firms. The
bills will be paid by the company to the banks.
e) Based on Credit Recovery: These type of cards are again classified into two categories.
They are Revolving credit type card and charge card. The revolving credit card is
generally based on the revolving credit principle. According to this scheme, the card
holder has to pay a percentage of the outstanding credit for every month. The interest

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 is charged on the outstanding. The interest rate is charged on the outstanding amount.
The interest rate is more than 30 percent per annum charge card is a convenient
instrument. The issuer gives a consolidated bill for every month to the card holder.
The card holder shall pay the bills on presentation of the consolidation bills. Therefore,
there are no interest charges on this use of cards.

Credit Cards in India

The first credit card in India was Diners club card in the year 1964. Andhra Bank and Central
bank were the first to launch credit cards among the commercial banks. The Andhra bank
introduced the card in the year 1981 under the brand name of “Visa classic” followed by
Central bank of India in collaboration with Master Card Corporation in 1981. The other banks
Canara bank, bank of India and Bank of Baroda introduced credit cards in India. The foreign
banks such as Citi bank, Standard Chartered bank, Bank of America and American Express
bank have also introduced cards in India through their branches in India.

1.8 Smart cards

Smart card is a little plastic card. It is just like a credit card but it contains a micro-processor
and a storage unit. This card is developed with latest technology and it is an innovation that
overcomes all limitations. They are more expensive. The stored data is not exposed to physical
damage. These cards can store at least 100 times more data than magnetic strip cards. They are
more popular in Europe. They are categorized in two kinds; memory smart cards and
intelligent smart cards. Memory card contains less information and processing capabilities they
are used to record a monetary or unit value for a specific amount. Intelligent cards contain
more information and process a wider variety of information components than a memory smart
card. This card also has greater processing capabilities for programmed decision making for
various applications. The electronic purse is used to refer to monetary value, that is loaded on
to the smart cards microprocessor and that can be used by consumer for purchase. The
merchants, who are accepting the cards, must have a smart card reader. The smart card
technology may be used in either an online or offline mode as with magnetic strip cards.
Offline card technology can be used in underdeveloped countries. The functioning of offline
smart cards as presented below:
Step 1: Smart card holder inserts card into machine and downloads money from bank as to
microprocessor on the card.
Step 2: The consumer pays for merchandise/ service by inserting smart card into merchant’s
smart card reader.
Step 3: The merchant’s smart card reader records the transaction.
Step 4: At the end of the day, the merchant inserts a smart card to receive download of the
day’s sales.
Step 5: Take to bank for credit for day’s sale for cash.
Smart cards used in place of cash have the advantage of providing an electronic record for
purchases and the ability to printout transaction data which can serve as receipts.

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 The smart card holder inserts his card into smart card reader enter a valid password and the
amount of the purchase is deducted from the balance from the balance on the card. The card
reader computes a running total of the sales amounts deducted from the customers. The smart
card can be taken to the bank for immediate cash payment. If the merchant has a networked
personal computer and banking software then it may insert the smart card and transfer the
amount on the smart card directly into a bank account. The telephone manufacturers are
introducing smart card phones that can be used for a variety of purposes. The phones can be
used to:
I. Pay for items purchased over the phone,
II. Download money from bank accounts to a smart card,
III. Transfer balances between accounts, and
IV. Check bank balances.

1.9 Electronic Cheques

Another mode for internet payments is the electronic cheques. In this method, the payor
instructs its bank to pay a specific amount to another party, the payee. The financial EDI
systems have performed this function for years using private communication circuits such as
value added network. The new generation of electronic cheques provides the following
functions:
I. Present the bill to the payor,
II. Allow the payer to initiate payment of the invoice,
III. Provide remittance information,
IV. Allow the payer to initiate automatic payment authorization,
V. Interface with financial management software, and
VI. Allow payments to be made at first time.
Electronic payment system involves two parties, payor and payee. An electronic bill contains
the same information as a hard copy bill transported to the payor through the postal system. An
electronic bill does not have to be received, a payor or can make payments for bills received
through the postal system.
Most electronic cheques can accommodate situations where the payee does not have account
at a financial institution; therefore many electronic cheque service providers will produce a
hard copy check for these types of payments. Electronic payment of bills is expected to
increase substantially over the forthcoming years.

1.10 Debit Card

Debit Card is the innovative instrument in the financial services sector. It is the most
convenient method of payment to the merchant establishment. It needs involvement of many
banks. The card holder will present the card on completion of his purchases at the merchant
establishment on production of a debit card. The card details are fed through a terminal at the
merchant’s establishment. The card holder is immediately debited from the card holder’s
account and transferred to the account of merchant establishment. No overdrawing is allowed
in the case of debit card. A debit card is the variant of an ATM card. It has the following
features:

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 I. Whereas an ATM card can be used only where the ATM’s are provided by the banks,
and that too only for cash withdrawals, the debit card can be used in any merchant
outlet that is linked with the customer’s bank for making payment.
II. Credit card is issued to clients after a proper assessment of their credit standing. But for
a debit card holder there is no need to make such an assessment.
III. At the time of making payment through a debit card, the amount is instantly debited to
the customer’s account unlike payment made through the credit card where the account
of the customer is debited after a certain period.
IV. Debit card freeze the cardholder from carrying cash for his/her purchases.
V. Debit card is like a blank cheque, so it must be used carefully otherwise an
unscrupulous person can wipe the entire balance in the bank account of the holder.
VI. There are no chances of the debit card user to fall into the debt trap, since payment is
immediately debited to his account, as he can only use the money which is available in
his account.
VII. There are no transaction costs and no question of late fee payment in the use of debit
card.
VIII. Bankers also avoid the risk of bad debts.

1.11 Risks in E-banking

If internet banking has facilitated the banking service processes and made the customers life a
lot easier, it has also thrown new challenges in terms of various risks which may affect the
bank’s profitability, capital and reputation as well. Let us discuss some of the risk issues
related to the online banking.
1. Operational Risk: Operational risk is the price, which attaches to internet banking arising
from error, fraud and inability to provide services to customers or deliver products as per
the expectation, which may result in current and prospective loss to earnings of the bank.
Inaccurate processing of transactions, non privacy and confidentiality, attacks or
unauthorized access to banks systems and databases, weak technology adoption or
systems design or human factors like lack of awareness on the part of employees or
customers may lead to operational risk.
2. Credit Risk: Credit risk arises when a counter-party fails to settle an obligation when due
or any time henceforth for its full value. In internet banking scenario the credit worthiness
of the customer may not be properly evaluated. So any credit facilities provided to retail or
corporate customers requires proper evaluation and constant audit of lending as well as the
repayment progress at regular intervals to avoid such a risk.
3. Liquidity Risks: The bank may face liquidity crunch in short-term time horizon in internet
banking scenario as well. In this case, the outflow of fund may be sudden and hence the
banks, which are more exposed to internet banking, should ensure for sufficient liquidity
in case of redemption or settlement demands.
4. Foreign Exchange Risk: Due to the geographical and market extension of banks and
customers in internet banking scenario forex, legal and regulatory risk may arise. In cross
border transactions there would be difficulty in correctly assessing the counter parties
credentials and hence forex transaction against electronic money may lead to forex risk.
Different international cross-border jurisdiction can expose banks to legal and compliance
risks in view of different national rules, laws and regulations.

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5. Security Risk: Security risk is one of very important issue in internet banking systems. In
internet banking information is considered as an asset and so worthy of protection.
Firewalls are frequently used on internet banking systems as security measure to protect
internal systems and should be considered for any system connected to an outside
network. Firewalls are a combination of hardware and software placed between two
networks through which all traffic must pass, regardless of direction flow. They provide
gateway to guard against unauthorized individuals gaining access to the bank’s `network.
Therefore, awareness among the internet banking customers as well as adoption of
security mechanism is essential.
6. Compliance Risk: The bank may face compliance and regulatory risk if it does not adhere
or follow the guidelines given by the supervisor or the regulator. Due to lack of awareness
and transparency the bank may fail in this matter and hence more care is required in this a.
7. Reputation Risk: A bank offering internet banking suffers reputation loss due to negative
opinion if the systems failed or discontinued for a considerable time or when the banking
products offered not found to their expectation or even the fraudulent activities by the
internal/external people or hackers using bona fide customer’s credentials. The bank-
customer relationship may suffer due to this and this may also affect bringing prospective
customers to its fold.
8. Legal Risk: Internet banking being a relatively a new phenomenon, the legal issues or
risks are usually less crystallized or ambiguous. They may arise from the violation of, or
non-conformance with laws, rules, and regulations or prescribed practices. A bank may
also face legal actions from the customers in case of hushing attacks or any other
fraudulent activities where the terms and conditions have not been framed adequately by
the bank.
9. Strategic Risk: Strategic risk may emanate from adverse business decisions due to wrong
implementation of unfavorable market conditions related to either the banking products
offered through electronic channel, or any technology or strategic decisions like
outsourcing policy, etc. Therefore, a proper market as well as technological survey is
essential in this regard before taking any final decision.
10. Money Laundering Risk: In view of the lack of personal interaction among the bank staff
and the customers in the internet banking scenario, the know your customers norms may
not be implemented effectively as fund transfer transactions of dubious nature may be
done by the offenders without much of hassles.
11. Interest Rate Risk: In case of electronic money becoming widely prevalent in the payment
system, the interest rate risk and market risk will have an impact on the value of the banks
assets against its electronic money liabilities.

1.12 Conclusion
Popularity which internet banking has won among customers, owing to its speed, convenience
and round-the-clock access they offer, is likely to increase in the future. That’s why internet
banking is a successful strategic weapon for banks to remain profitable in volatile and
competitive marketplace of today. Banks are in a position to lead consumer views, as well as to
cater to existing demands. Clearly, despites of all the threats in banking industry, there is an
enormous opportunity for farsighted banks to reap the rewards available from internet banking.
Internet banking is going to develop much faster than most people imagine. With the

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revolution, a new financial system will evolve that in many ways will be far more secure than
the one we have today.

1.13 Test Questions

1. Discuss the various e-banking services offered by a bank.
2. ‘Plastic money has replaced paper money’. Critically analyze this statement. What are
the limitations of credit cards.
3. Write short notes on
a) Smart Card
b) ECS
c) Telebanking

1.14 Further Readings

“E-banking in India: Challenges and Opportunities” , Edited by R.K. Uppal and Rimpi jatana,
New Century Publications, New Delhi, India.
“Financial Services in India”, G.Ramesh Babu, Concept Publishing Company, New Delhi,
India.
“Financial Services”,Nalini Prava Tripathy, Prentice Hall of India, New Delhi.

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 LESSON 2
FORMS AND TYPES OF ADVANCES AND COLLATERALS
Dr. Ashish Kumar
LBSIM

Process And Documentation Of Bank Lending

The banking sector plays an important role in the mobilization of deposits and disbursement of
credit to various sectors of the economy. Traditional banking has come a long way through from
goldsmiths who were the initial bankers to the virtual banks. Banking is going through a
metamorphosis. Technology, deregulation, disintermediation and securitization are the major
forces that are producing ripples in the industry.
Supported by the latest technology, banks are working to identify new business niches to
develop customized services, to implement innovative strategy and to capture new market
opportunities. With further globalization, consolidation, deregulation of the financial industry,
the banking sector will become even more complex.
Over the past decade, there has been an increasing convergence between the activities of
investment and commercial banks because of the deregulation of the financial sector. Today
some investment and commercial banking institutions compete directly money market
operations, private placement, project finance, bonds underwriting and financial advisory work.
Furthermore, the modern banking industry has brought greater business diversifications. Some
banks in the industrialization world are entering into investments, underwriting of securities,
portfolio management and the insurance businesses. Taken together these changes have made
banks an even more important entity in the global business community.
Lending is an indispensable aspect of banking and a banker earn bulk of his income
through lending. The other major reason of lending function is to add value to bank. By lending
the funds moralization bank will be in position to earn spreads to sustain profitability.
Profitability through lending will be attainable if the bank is in a position to take and manage
credit risk that arises on account of the quality of the borrower and liquidity risk that may arise
by borrowing short and lending long in order to attain greater spreads. The lending decisions of a
bank are guided by its loan policy or credit policy.
The credit policy outlines the crucial lending decisions of a bank. It lays down the rules
and regulations that guide the sanctioning of loans. However, to sustain profitability, prudent
decision needs to be taken both prior to and after sanctioning the credit. These rules generally
relate to the amount of credit to be extended during financial year, the industries to focus on the
geographical spread, the type of credit to offer, the type of proposals to finance, the disbursal
mechanism, the collateral value, the method of pricing, the repayment schedule, the monitoring
process etc. these macro and micro level considerations of lending activity contribute to the
achievement of the banks’ objectives. The bank’s management should thus, ensure that lending
decision fall in line with the bank’s overall objectives.
The credit policy of a bank is primarily aimed at accomplishing this mission. It is a
byword of the bank's approach to sanctioning, managing and monitoring credit risk. Its

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main aim is to make the bank's systems and controls more effective. The policy applies to
the entire bank's domestic lending.

The policy is laid down by the top management and deals with the following:
• Exposure levels
• Credit risk assessment
• Credit appraisal standards
• Documentation standards
• Delegation of powers
• Pricing
• Review and renewal of advances
• Takeover of advances.
Besides the above, the policy deals with credit facilities to companies whose directors are
in the defaulters list of the RBI. The policy also lays down the norms of major and minor
deviations and the authority for sanctioning/ approving them. The policy also discusses
different kinds of advances such as personal loans, export credit, advances to priority
sector and maturity period of bank's advances. In the final pages, the policy details the
strengths, weaknesses and the prospects of the bank.
Lending Principles
Banks deal with the funds of a large number of depositors and banks are required to
return the money to the depositors with the promised amount of interest. Further, banks are
also required to monitor the loans and also ensure that the loans do not turn bad.
Consequently, they have to follow the principles of credit management to avoid the danger
of failing.
These fundamental principles are like a rudder to a ship, which have been guiding
the function of lending ever since banking has evolved as a profession. The fundamental
principles that are followed by a bank in managing the credit portfolio are safety, security,
liquidity and profitability. These principles have undergone changes with changing times
and developments in the banking industry.
Lending is a crucial activity for a bank as it enables the bank to generate income.
But to sustain income generation, prudent decisions need to be taken both prior to and
after sanctioning the credit. These decisions generally relate to the size, security and
repayment of credit to be extended during a financial year, the industries to focus on, the
geographical spread, the type of credit to offer, the type of proposals to finance, the
disbursal mechanism, the collateral value, the method of pricing, the repayment schedule,
the monitoring process, etc. The macro and micro level policies of the lending activity
contribute to the achievement of the bank's financial objectives. The bank's management
should thus, ensure that lending decisions fall in line to sub-serve the bank's overall
objectives of growth and stability.

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Credit Management in the Changing Scenario
The prevalent credit scenario in the near past was:
• Slackness in growth of quality credit
• Stiff competition to acquire blue-chip corporate business at PLR/Sub-PLR rates
• Reduction in rates of interest on loans and advances
• Slackness in industrial growth
• Declining and thinner spreads
• Stiff income recognition norms
• Increased operational costs.
In this changing scenario banks should have a wide mix of products wholesale banking,
retail banking, and consumer financing. Products should be dovetailed in such a way that
banks have loans for just about anything. Banks have to adopt quickly products/ services
(rates, charges) in tune with the market realities.
Easy documentation and quick delivery should be the strategy. Speedy processing
is also very important. Previously there were three Cs - capital, capacity, and character.
However in the recent past, a new 'C' - collateral - has emerged which refers to the assets
that are pledged as a security in a credit transaction. Collateral provides a secondary
source of repayment. It can be the asset financed by the loan or other assets owned by the
individual or the personal guarantee of a cosigner on the loan.
Credit operations have to be revved up. High value credit with low margins has
also to be added to bank's kitty, especially, with respect to top league companies. Banks
should go for increased fee-based income to reduce the cost of lending.
They should have different outlets for Mass banking and Quality banking even in
credit so that the approaches are different. Under Priority Sector Lending, focus should be
more on high yielding and well performing sectors, e.g. High yielding agro advances,
Self-Help Groups, Kisan Credit Card, etc.
There are too many tiers for credit decisions. Banks have to verify whether there is
value addition at each and every level. They have to curtail the number of layers in
lending decisions and also curtail the time taken in processing a proposal. Banks have to
modify the products (quality/cost) to meet the needs of the clients within the shortest
possible time. Quality service after credit delivery is also very vital.
Who Needs Credit?
Banks extend credit to different categories of borrowers for different purposes. For most of these
borrowers, barn credit is the primary and cheapest source of debt financing. Both the demand
and supply sides of the economy need bank credit. Consumers of goods and services constitute
the demand side of the economy, and they require bank credit to enable them acquire assets such
as consumer durables, housing or for plain consumption. Or the supply side, the need for credit
arises from the corporate and government sectors engaged in manufacturing trading and services.
These sectors require bank credit for capital investment in long-term projects and for day-to-day
operations.
In more common terms, financing the demand side of the economy, the large class of
consumers, is called retail banking (also termed mass banking). Financing the supply side of the

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economy, which is more customize, in nature and calls for specialized skills, is called wholesale
banking or corporate banking or class banking.
Features of Bank Credit
For a bank, good loans are its most profitable assets. And any loan is 'good' till the borrower
defaults in repayment. In its role as a financial intermediary, the direct assumption of financial
risk is the bank's defining characteristic.
Consequently, banks have to look for higher returns. Returns come in the direct form of
loan interest, or in the indirect form of fee-based ancillary services. Further, the borrowers may
also contribute to generation of deposits, which, in turn, can be invested by the bank. The most
prominent risk in lending is default risk (known as credit risk), which can arise due to several
factors. Borrowers may default due to industry downturns and business cycles (such as in real
estate) or due to specific problems related to the borrowers' firms or activities, such as
mismanagement, problems with labour, technological obsolescence and change in consumer
preferences. Banks, therefore, make it a practice to set aside substantial reserves (called
'provisions') to compensate for anticipated losses due to credit risk. 4
There can be another kind of risk associated with credit decisions-interest rate risk.'
Fluctuations in interest rates give rise to earnings volatility. Loan maturities, pricing and the
methods of principal repayments all impact the timing and magnitude of banks' cash inflows.
Keeping these prominent risks in view, risk-based capital standards require that banks
maintain a stipulated amount of capital for every loan created in their books.' This implies that
banks choosing to lend to a specific borrower, group or sector must mobilize additional capital to
keep growing. Banks have sought to circumvent these requirements by resorting to
'securitization" or 'off-Balance sheet lending arrangements', Under 'off-balance sheet lending',
the bank does not directly extend credit but involves itself with the borrower either as an
underwriter for arranging financing (as in 'Loan syndications"), or by issuing a letter of credit to
import inventory rather than finance acquisition of inventory. In both cases, the bank earns a 'fee-
based income' for its services, but creates a 'contingent liability' in its books." A contingent
liability is, however, not free of risks. If the borrower defaults, the bank becomes liable, i.e., the
bank's obligation to make payment under the contract arises from the happening of a contingent
event.
Types/Forms of Advances
Broadly, three types of advances can be identified:
• Fund-based Advances: This is the most direct form of lending. It is granted as a loan or
advance with an actual outflow of cash to the borrower .by the bank. In most cases, such
lending is supported by prime and/or collateral securities.'·
• Non-Fund-based Advances: There are no funds outlays for the bank at the time of
entering into an agreement with a counter party on behalf of the bank's customer.
However, such arrangements may crystallize into fund based advances for the bank if the
customer fails to fulfill the terms of his contract with the counterparty. Most 'contingent
liabilities' of the bank, more prominently, letters of credit (LCs) and bank guarantees
(BGs), fall under this category.
• Asset-based Advances: This is an emerging category of bank lending. In this type of

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 lending, the bank looks primarily or solely to the earning capacity of the asset being
financed, for servicing its debt. In most cases, the bank will have limited or no recourse
to the borrower. Specialized lending practices, such as securitization or project finance
fall under this category.
Fund-based advances can be further classified based on the tenure of the loans. The traditional
approach is to make the following distinction: short-term loans, long-term loans and revolving
credits. We will examine the basic features of these loans in the following paragraphs.
Short-Term Loans: Typically, these are loans with maturities of I year or less. Most of these
loans are granted with the primary purpose of financing working capital needs of the borrower,
resulting from temporary buildup of inventories and receivables. In the case of such loans,
repayments would flow out of conversion of current assets to cash.
Sometimes, seasonal lines of credit are granted to borrowers whose. businesses are
subjected to seasonal sales cycles, and hence, periodic peaking of inventory and other current
assets. The amount of credit is made available based on the estimated peak and non-peak funding
requirements of the borrowers. The borrowers draw upon the seasonal lines of credit during
periods of peak production to meet seasonal demand, and repay the loans as inventories are liq-
uidated and cash flows from sales come in. Interest accrues only on the amounts drawn down
from the line of credit.
Both the above types of loans are generally made as 'secured loans'. This implies that the
banks make the loans based on the strength of underlying securities, such as inventories,
receivables and other current assets. Such securities, the values of which directly affect the
amount that can be granted as loan, are called 'prime securities'. The other type of securities
backing the loan repayments is 'collateral securities'. Such securities are not directly linked to the
operations of the borrower, but are offered either in lieu of or along with prime securities, as a
cushion against probable default by the borrower. The idea is that banks can liquidate these
securities in the event of default and realize the amount due under the loan agreement.
A third category of short-term loans, granted for 'special purposes' , mayor may not be
secured. Such loans are called 'unsecured loans'. They may arise due to a host of reasons,
including temporary but unexpected or unusual increases in current assets, or a temporary cash
crunch in the borrower's firm. Such requests are considered as falling outside the borrower's
estimated needs for short-term working capital financing, and, depending on the borrower's
creditworthiness, may be granted as 'temporary' or 'ad hoc' loans. These loans are often granted
with terms and conditions different from those applicable to the assessed working capital needs
of the borrower. Such loans may require full payment of interest and principal at maturity, i.e., a
'bullet'. The term for such loans is determined by estimating the time at which the borrower can
generate cash flows to make the repayment. The risk in these loans arises from a change in the
assumed circumstances on which the decision to grant the loans were based.
Long-Term Loans: Bank lending, which used to traditionally focus on 'short-term' loans, started
looking at lending for periods longer than a year only from the 1930s onwards. These are called
'term loans' and have the following characteristics:
• Original maturities of more than I year.
• Repayments are structured based on future cash flows rather than on liquidation of short-
term assets.

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• The primary purpose of these loans could be acquisition of fixed assets (versus current
assets in the case of short-term loans), or funding expansion/modernization/diversification
plans of the borrower's firm.
• The term loans may be used as substitutes for equity or for financing permanent working
capital needs.
• Typically, these loans are fully disbursed at inception, and principal and interest are repaid
depending on the borrower's capacity to generate operating cash flows.
• The amount and structure of these loans will closely match the transaction being financed.
• Mostly, the securities for the term loans 'will be the bank's claims on assets purchased from
the term loan proceeds.
• Though banks do not customarily lend for very long periods," the maximum tenure
(maturity) of term loans is 10 years, the average ranging between 3 and 5 years.
Thus, long-term loans are generally structured to be more adaptable to borrowers' specific
requirements.

Revolving Credits: Revolving credits offer the most flexibility to borrowers. Assessed to meet
the borrowers' requirements over a period of I year or more, revolving credits permit drawings
from the line of credit at any time, and similarly, repay the whole or part of the outstanding loans
as and when cash inflows happen in the borrowers' firms. The revolving credit is usually a
secured loan, with terms and conditions as applicable to other types of loans. The amount of
revolving facility granted will be based on the assessed need of borrowers, underlying
securities and borrowers' creditworthiness.
In rare cases, revolving loans are structured to convert to term loans or automatically
renew on maturity. The automatic renewal facility, termed the 'evergreen' facility, continues till
the borrower gives notice of termination. Such arrangements, needless to say, will put the banks
more at risk of default than the other two types of lending.
THE CREDIT PROCESS
The risks involved in lending render it imperative that banks should have systems and controls
that enable bank managers to take credit decisions after objectively evaluating risk-return trade
offs. Whether it is consumer or commercial lending, credit decisions impact the profitability of
banks, and ultimately their competitiveness and survival in the industry,
Credit decisions are by no means easy. The credit officer has to deal with conflicting
objectives of increasing the loan portfolio (his targets) while maintaining loan quality (the risks
inherent in the loan portfolio as well as in individual loans). He also has to balance these
objectives with the bank's profitability and market value objectives, liquidity requirements and
constraints of capital. He should be able to investigate and appraise the risks inherent in every
opportunity to lend, and take decisions that will fit in with the overall strategy of the bank.
Above all, he should not take or lead the bank to a wrong credit decision.
Despite the availability of tools and techniques and a huge body of knowledge to support
decision-making, credit decisions are largely judgmental. However well versed the credit officer

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is in appraising and lending to risky projects, his contribution may not suit the bank if his
decisions do not fall in line with the overall strategy of the bank. Therefore, apart from their
expertise in credit appraisal, the strategic role of credit officers assumes utmost importance.
Constituents of the Credit Process
The Loan Policy : To ensure alignment of individual goals of credit officers to the bank's overall
goals, banks formulate 'loan policies'. These l\I"C written documents, authorized by individual
bank's Board of Directors, that formalize and set guidelines for lending to be followed by
decision-makers in the bank.
The loan policy specifies the bank's overall strategy for lending, identifies loan qualities and
parameters, and lays down procedures for appraising, sanctioning, granting, documenting and
reviewing loans. Loan policies emerge from and are fine-tuned by past experience of individual
banks in extending credit, and the best practices followed in the industry. While supervising bank
operations, regulators examine banks' documented loan policies to ensure that existing lending
practices conform to the organization's objectives and acceptable guidelines. The stance taken by
individual bank managements determines the extent and form of risk that the bank would be
willing to take.
Business Development and Initial Recommendations: With in the broad framework of the loan
policy of the bank, and based on the bank's goals in building its loan asset portfolio, credit
officers seek to reinforce the relationship with existing customers, build new clientele and cross
sell non-credit services. Though every employee of the bank, from the front office personnel to
the top management, is responsible for overall business development, credit development
requires a more focused approach. For one, not every prospective customer can be invited to be a
borrower. There are enormous risks attached to making a bad loan than bypassing an opportunity
for making a good loan.
Therefore, business development efforts for credit expansion should preferably begin
with market research and detailed credit investigation. The outcome of this research will be
reflected in the annual business plan of the bank, which would specify the broad industries, or
areas where the bank would like to expand, and the extent to which the bank would like
exposure to each industry or area.
Based on the plan, the bank embarks upon publicity for its proposed credit products in the
case of retail lending, or special campaigns for attracting target customers. In the case of
corporate borrowers, the credit officers formulate call programs. Once prospective credit
customers are identified, credit officers try to obtain formal loan requests from these customers.
The loan requests, once found acceptable in principle, would be processed further based on
various documents called for, such as the prospective borrower's financial statements, credit
reports, the relevant project report and the legal resolution to borrow.
Sufficient information is sought from the prospective borrower to analyse
creditworthiness. Credit appraisal is essentially an analysis of the risks or vulnerabilities in
respect of the borrower and his business. The risks are analysed with a view to determining how
each of them, individually or in combination, can affect the debt servicing capacity of the
borrower. A typical credit appraisal would deal with the following issues:
• What are the risks inherent in the borrower's business? These risks are classified into
market-related risks, technology-related risks, environment related risks and so on.

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 • What are the antecedents of the borrower? What is his reputation and integrity? How is
his track record?
• What are the financial risks inherent in the borrower's business? Is the project
economically viable? Is the project financially feasible?
• What risks are inherent in the operations of the business?
• What have the managers of the borrower firm done to mitigate these risks?
• Does the bank want to lend to this borrower in spite of the risks? If so, what steps should
the bank take to ensure that debt repayments are not hampered?
• What risks will the bank have to take if it decides to fund the borrower? How does the
bank propose to mitigate these risks?
The first three questions focus on appraisal of the borrower, his firm, the project for which he
has sought funds and his capacity to repay. The next two questions enable the credit analyst to
examine the internal management and operations of the firm. The analysis leads to a decision-to
lend or not to lend? Once the analyst decides to recommend lending, the safeguards in and
structure of the loan agreement has to be put in place.
Traditionally, key risk factors were analysed using pragmatic considerations, such as
creditworthiness of the borrower, security offered, prospects of the firm and longevity of the
relationship. These were considered the 'canons of lending', and were addressed as the 'five Cs',
(capacity, capital, collateral, conditions, character) or remembered through mnemonics such as
'CCC' (capital, character, capability) or 'PARTS'" (purpose, amount, repayment, terms, security),
or 'CAMPARI' (character, ability, means, purpose, amount, repayment, insurance).
In all these models, the inherent assumption was that the borrower's past would be
indicative of the future, an assumption that may not hold well in a highly dynamic or volatile
environment.
Modern credit analysis uses the traditional concepts in making subjective evaluation,
along with wide use of financial ratios and risk evaluation models to determine if a borrower is
creditworthy. The accent on risk evaluation implies that the banker lends only if he is satisfied
that risks are mitigated to ensure that the borrower's future cash flows (and hence debt service)
will not be affected.
Broad Steps to Credit Analysis
Step I-Building the 'credit file': The first step to effective credit analysis is gathering
information to build the 'credit file'. The preliminary information so obtained would throw light
on the borrower's antecedents, his credit history and track record. If the project is a Greenfield
project, the credit officer will have to do a thorough research into various aspects of the project,
as well as into the borrower's financial and managerial capacity to make the project a success. If
the borrower is an existing one, seeking additional credit, the information would be readily
available with the credit officer. The credit file is an important tool box for the credit officer. It
should contain all pertinent information on the borrower, including call report summaries, past
and present financial statements, cash flow projections and plans for the future, relevant credit
reports, details of insurance coverage, fixed and other assets, collateral values and security
documents. The file for an existing borrower should also contain copies of past loan agreements,

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comments by prior loan officers and all correspondence with the customer. In the case of long
standing borrowers, such credit files may run into several volumes. It is advisable for the credit
officer to peruse all the volumes of the credit file before embarking on credit analysis.
Step 2-Project and financial appraisal: Once the preliminary investigation is done, the internal
and external factors, such as management integrity and capability, the company's performance
and market value and the industry characteristics are evaluated. One of the important activities at
this stage is financial analysis. An illustrative list of inputs and activities is as follows:
• Past financial statements. While the borrower's audited financial statements are typically the
starting point / many banks additionally ask for financial statements presented in the bank's
own format. Typically, past financial statements pertain to the last 2-3 years, along with
estimates for the current year.
• Cash flow statements. This statement would reveal the usage of own and borrowed funds by
the borrower.
• The above data from the borrower enables the credit officer to analyse the liquidity position
of the borrower! his firm. Adequate liquidity is a vital indicator of the borrower's financial
health to the bank, as loss of liquidity through delayed cash flows or diversion of short-term
funds or leakage in cash, is bound to adversely affect the borrower's repayment capacity.
Liquidity is assessed through a set of financial ratios. Most banks recast the financial
statements of the borrower to reveal the true picture-for example, banks remove ageing
receivables or slow moving/obsolete inventory from current assets. Hence, more detailed
information is sought from the borrower before the financial statements are analysed.
• The financial risk of an entity is measured by the debt it has incurred in the course of
business compared with the owner's stake. Banks generally stipulate maximum debt to value
ratios for various categories of borrowers, beyond which the borrowers will have to increase
their stake in the business to avail more bank credit. Credit officers look more to the
'tangible net worth' on the borrower's books as the measure of owner's stake in the business.
'Tangible net worth' represents the net worth less intangible assets, such as losses or
goodwill.
• Once the borrower's current financial health is gauged, the projections are examined. The
borrower's debt servicing capacity is determined by assessing the quality of cash flow
projections given by the borrower. The experienced credit analyst questions the borrower's
projections, especially the sales. projections, till he satisfies himself that they are indeed
realistic, achievable, and more importantly, the cash flows are sufficient to service the debt
(principal + interest). Further, sensitivity analyses are carried out on the projections to test
the strength of the underlying assumptions and assess the impact on debt service capacity
under various stress conditions. While every scenario cannot be adequately tested, the worst
case scenario will indicate the most pessimistic outcome for the bank and it is then for the
bank to decide whether it wants to undertake the risk.
• Even the most scientifically done projections cannot predict the onslaught of future
uncertainties. Hence, the lender looks for a secondary source of repayment, which is
provided by the collateral securities. The credit officer evaluates the strength of the
collateral securities to determine the amount that can be recovered by liquidating these
securities in the worst possible scenario. It is to be noted that loans should not be made

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 based on the strength of the collateral securities alone. The securities should be treated as
the second line of defence and not the raison-d' etre of the loan itself.
Step 3-Qualitative analysis: Integrity is the most important quality that the banker looks for in a
borrower, and the most difficult to measure. So is assessment of the quality of the management
team. However, lenders will have to make qualitative assessment of the borrower on most of the
criteria by evolving suitable measures. Many poor credit decisions have been the result of not
knowing enough about the customer.
Step 4-Due diligence: Bypassing due diligence can be very costly for a bank. Many loans have
run into problems since bankers did not take this step seriously. This is a time-consuming
activity but well worth the effort. Due diligence can include checking on the borrower's address
(if a new borrower), pre-approval inspections of the borrower's workplace, and interviews with
the borrower's competitors, suppliers, customers and employees. A comprehensive due diligence
can also include-reviews of technology used by the borrower, planned capital expenditures, other
obligations to outsiders, credit reports from other debtors, the internal management control and
information system, industrial relations, employee compensation and benefits, and environmental
audit. Disclosure of contingent liabilities by the borrower is an essential part of due diligence,
since any such contingent claim on the borrower would directly impact the assessed debt service
capacity.
Step 5-Risk assessment: A key function of the credit officer is to identify and analyse the key
risks associated with the proposed credit. All potential internal and external risks are to be
identified and their severity assessed in terms of how these risks would impact the borrower's
future cash flows and hence the debt service capacity. The risk assessment would form an
important input for structuring the credit facility and the terms of the loan agreement.
Step 6---Making the recommendation: Finally, based on a thorough analysis of the project, the
borrower and the market, and after examining the 'fit' of the credit with the 'loan policy', the
credit officer makes his recommendations to consider the loan favourably or reject it outright.
Sometimes, in the case of clients with a long history of relationship with the bank, even if the
criteria for consideration of the current proposal fall short of expectations, the credit officer can
suggest procedures to improve the borrower's financial condition and the repayment prospects. If
warranted, the credit officer can also call for a revised credit proposal from the borrower. After a
preliminary negotiation with the borrower, the credit officer's recommendations would specify
the credit terms, including loan amount, maturity, pricing, repayment schedule, description of
prime and collateral securities and the required terms and conditions for the borrower's
compliance.

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 UNIT-IV
LESSON 1
INTRODUCTION TO INSURANCE
- Meenu
Asstt. Professor, SRCC,
University of Delhi.

Every risk involves the loss of one or other kind. In older time, the contribution by the
person was made at the time of loss. Today, only one business, which offers all walks of life, is
insurance business. Owing to growing complexity of life, trade and commerce, individual and
business firms and turning to insurance to manage various risks. Every individual in this world is
subject to unforeseen uncertainties which may make him and his family vulnerable. At this place,
only insurance helps him not only to survive but also recover his loss and continue his life in a
normal manner.

Insurance is an important aid to commerce and industry. Every business enterprise

involves large number of risks and uncertainties. It may involve risk to premises, plant and
machinery, raw material and other things. Goods may be damaged or may be destroyed due to
fire or flood. Some risk can be avoided by timely precautions and some are unavoidable and are
beyond the control of a business. These unavoidable risks can be protected by insurance.
What is Insurance
In D.S. Hamsell words, insurance is defined “as a social device providing financial
compensation for the effects of misfortune, the payment being made from the accumulated
contributions of all parties participating in the scheme”
In simple terms “Insurance is a co-operative device to spread the loss caused by a
particular risk over a number of persons, who are exposed to it and who agree to insure
themselves against the risk”
Thus, the insurance is
(a) A cooperative device to spread the risk;
(b) the system to spread the risk over a number of persons who are insured against the risk;
(c) the principle to share the loss of the each member of the society on the basis of
probability of loss to their risk; and
(d) the method to provide security against losses to the insured
Insurance may be defined as form of contract between two parties (namely insurer and
insured or assured) whereby one party (insurer) undertakes in exchange for a fixed amount of
money (premium) to pay the other party (Insured), a fixed amount of money on the happening of
certain event (death or attaining a certain age in case of life) or to pay the amount of actual loss
when it takes place through the risk insured (in case of property)
Terminology used in definition of Insurance
- Insurer or insurance company – The agency involved in Insurance business is known
as insurer
- Insured/ Assured – The person who gets his property/life insured is known as insured
- Policy - The agreement or contract which is put in writing is known as a Policy
- Premium – The consideration in return of which the insurer undertakes to make goods
the loss or give a certain amount in case of life insurance is known as premium

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Assurance and Insurance
The two words were used synonymously at one time, but there is fine distinction between
the two. ‘Assurance’ is used in those contracts which guarantee the payment of a certain sum on
the happening of a specified event which is bound to happen sooner or later, for example
attaining a certain age or death. Thus life policies comes under ‘assurance’.
Insurance, on the other hand, contemplates the granting of agreed compensation of the happening
of certain events stipulated in the contract which are not expected but which may happen, for
example risk relating to fire, accident or marine.
Nature of Insurance
Following are the main characteristics of insurance which are applicable to all types of
insurance (life, fire, marine and general insurance).
1. Sharing of Risks - Insurance is a device to share the financial losses which may occur to
individual or his family on the happening of certain events
2. Co operative Device – Insurance is a co-operative device to spread the loss caused by a
particular risk over a large caused by a particular risk over a large number of persons who
are exposed to it and who agree to insure themselves against the risk.
3. Value of Risk – Risk is evaluated at the time of insurance. There are several methods of
valuing the risk. Higher the risks, higher will be premium
4. Payment on Contingency -If the contingency occurs, payment is made; payment is
made only for insured contingency. If there is no contingency, no payment is made. In
life insurance contract, payment is certain because the death or the expiry of term will
certainly occur. In other insurance contract like fire, marine, the contingency may or may
not occur
5. Amount of Payment of Claim - The amount of payment depends upon the value of loss
occurred due to the particular insured risk. The insurance is there upto that amount. In life
insurance insurer pay a fixed sum on the happening of an event or within a specified time
period.
Example – In fire insurance, if fire occurs and half the property is destroyed, but the
whole property is insured, then payment of claim will be made only for that half building
that is destroyed not the whole amount of insured.
6. Insurance is different from Charity - In charity, there is no consideration but insurance
is not given without premium
7. Large number of Insured Person - Insurance is spreading of loss over a large number
of persons. Larger the number of persons, lower the cost of insurance and amount of
premium and incase lower the number of persons, higher the cost of insurance and
amount of premium.
8. Insurance is different from Gambling - In gambling, there is no guarantee of gain, by
bidding the person expose himself to risk of losing. Whereas in insurance, by getting
insured his life and property, he protect himself against the risk of loss.
Functions of Insurance
Functions of insurance can be divided into parts;
I Primary functions.
II Secondary functions.

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I Primary Functions
1. Certainty of compensation of loss: Insurance provides certainty of payment at the
uncertainty of loss. The elements of uncertainty are reduced by better planning and
administration. The insurer charges premium for providing certainty.
2. Insurance provides protection : The main function of insurance is to provide protection
against risk of loss. The insurance policy covers the risk of loss. The insured person is
indemnified for the actual loss suffered by him. Insurance thus provide financial
protection to the insured. Life insurance policies may also be used as collateral security
for raising loans.
3. Risk sharing : All business concerns face the problem of risk. Risk and insurance are
interlinked with each other. Insurance, as a device is the outcome of the existence of
various risks in our day to day life. It does not eliminate risks but it reduces the financial
loss caused by risks. Insurance spreads the whole loss over the large number of persons
who are exposed by a particular risk.
II Secondary Functions
1. Prevention of losses : The insurance companies help in prevention of losses as they join
hands with those institutions which are engaged in loss prevention measures. The
reduction in losses means that the insurance companies would be required to pay lesser
compensations to the assured and manage to accumulate more savings, which in turn,
will assist in reducing the premiums
2. Providing funds for investment : Insurance provide capital for society. Accumulated
funds through savings in the form of insurance premium are invested in economic
development plans or productivity projects.
3. Insurance increases efficiency : The insurance eliminates the worries and miseries of
losses. A person can devote his time to other important matters for better achievement of
goals. Businessman feel more motivated and encouraged to take risks to enhance their
profit earning. This also helps in improving their efficiencies.
4. Solution to social problems : Insurance take care of many social problems. We have
insurance against industrial injuries, road accident, old age, disability or death etc.
5. Encouragement of savings : Insurance not only provides protection against risks but
also a number of other incentives which encourages people to insure. Since regularity and
punctuality pf payment of premium is a perquisite for keeping the policy in force, the
insured feels compelled to save.
Principles of Insurance
The basic principles which govern the insurance are -
(1) Utmost good faith
(2) Insurable interest
(3) Indemnity
(4) Contribution
(5) Subrogation
(6) Causa proxima
(7) Mitigation of loss
1. Principle of utmost good faith : A contract of insurance is a contract of ‘Uberrimae
Fidei’ i.e., of utmost good faith. Both insurer and insured should display the utmost good
faith towards each other in relation to the contract. In other words, each party must reveal

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 all material information to the other party whether such information is asked or not.
There should not be any fraud, non disclosure or misrepresentation of material facts.
Example – in case of life insurance, the insured must revel the true age and details of the
existing illness/diseases. If he does not disclose the true fact while getting his life insured,
the insurance company can avoid the contract.
Similarly, incase of the insurance of a building against fire, the insured must disclose the
details of the goods stored, if such goods are of hazardous nature
A material fact means important facts which would influence the judgment of the insurer
in fixing the premium or deciding whether he should accept the risk, on what terms. All
material facts should be disclosed in true and full form
2. Principle of Insurable Interest: This principle requires that the insured must have a
insurable interest in the subject matter of insurance. Insurance interest means some
pecuniary interest in the subject matter of contract of insurance. Insurance interest is that
interest, when the policy holders get benefited by the existence of the subject matter and
loss if there is death or damage to the subject matter.
For example – In life insurance, a man cannot insured the life of a stranger as he has no
insurable interest in him but he can get insured the life of himself and of persons in
whose life he has a pecuniary interest. So in the life insurance interest exists in the
following cases:-
- Husband in the life of his wife and wife in the life of her husband
- Parents in the life of a child if there is pecuniary benefit derived from the life of a
Child
- Creditor in the life of debtor
- Employer in the life of an employee
- Surety in the life of a principle debtor
In life insurance, insurable interest must be present at the time when the policy is taken.
In fire insurance, it must be present at the time of insurance and at the time if loss if subject
matter. In marine insurance, it must be present at the time of loss of the subject matter.
3. Principle of Indemnity : This principle is applicable in case of fire and marine
insurance only. It is not applicable in case of life, personal accident and sickness
insurance. A contract of indemnity means that the insured in case of loss against which
the policy has been insured, shall be paid the actual cost of loss not exceeding the amount
of the insurance policy. The purpose of contract of insurance is to place the insured in the
same financial position, as he was before the loss.
Example – A house is insured against fire for Rs. 50000. It is burnt down and found that the
expenditure of Rs. 30000 will restore it to its original condition. The insurer is liable to
pay only Rs. 30000.
In life insurance, principle of indemnity does not apply as there is no question of actual
loss. The insurer is required to pay a fixed amount upon in advance in the event of
accident, death or at the expiry of the fixed term of the policy. Thus, a contract of a life
insurance is a contingent contract and not a contract of indemnity.
4. Principle of Contribution: The principle of contribution is a corollary to the doctrine of
indemnity. It applies to any insurance which is a contract of indemnity. So it does not apply
to life insurance. A particular property may be insured with two or more insurers against
the same risks. In such cases, the insurers must share the burden of payment in proportion
to the amount insured by each. If one of the insurer pays the whole loss, he is entitled to
contribution from other insurers

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Example – B gets his house insured against fire for Rs. 10000 with insurer P and for Rs. 20000
with insurer Q. a loss of Rs. 15000 occurs, P is liable to pay for Rs. 5000 and Q is labile
to pay Rs 10000. If the whole amount pf loss is paid by Q, then Q can recover Rs. 5000
from P. The liability of P &Q will be determined as under:

Sum insured with Individual insurer (i.e. P or Q ) x Actual Loss = Total sum insured

Liability of P = 10000 x 15000 = Rs.5000

30000

Liability of Q = 20000 x 15000 = Rs.10000

30000
The right of contribution arises when:
(a) There are different policies which related to the same subject matters;
(b) The policies cover the same period which caused the loss;
(c) All the policies are in force at the time of loss; and
(d) One of the insurer has paid to the insured more than his share of loss.
5. Principle of Subrogation : The doctrine of subrogation is a collorary to the principle
of indemnity and applies only to fire and marine insurance. According to doctrine of
subrogation, after the insured is compensated for the loss caused by the damage to the
property insured by him, the right of ownership to such property passes to the insurer
after settling the claims of the insured in respect of the covered loss.
Example – Furniture is insured for Rs. 1 lacs against fire, it is burnt down and the insurer
pays the full value of Rs. 1 Lacs to the insured, later on the damage Furniture is sold for
Rs. 10000. The insurer is entitled to receive the sum of Rs. 10000.
A loss may occur accidentally or by the action or negligence of third party. If the insured
suffer a loss because of action of third party and he is in a position to recover the loss
from the insurer then insured can not take action against third party, his right is
subrogated (substituted) to the insurer on settlement of the claim. The insurer, therefore,
can recover the claim from the third party.
If the insured recovers any compensation for the loss (due to third party), from the third
party, after he has already been indemnified by the insurer, he holds the amount of such
compensation as the trustee if the insurer.
The insurer is entitled to the benefits out of such rights only to the extent of the amount
he has paid to the insured as compensation
6. Principle of Causa Proxima : Causa proxima, means proximate cause or cause which,
in a natural and unbroken series of events, is responsible for a loss or damage. The
insurer is liable for loss only when such a loss is proximately caused by the peril insured
against. The cause should be the proximate cause and can not the remote cause. If the risk
insured is the remote cause of the loss, then the insurer is not bound to pay compensation.
The nearest cause should be considered while determining the liability of the insured. The
insurer is liable to pay if the proximate cause is insured.

Example – In a marine insurance policy, the goods were insured against damage by sea
water, some rats on the board made a hole in a bottom of the ship causing sea water to
pour into the ship and damage the goods. Here, the proximate cause of loss is sea water
which is covered by the policy and the hole made by the rats is a remote cause.
Therefore, the insured can recover damage from the insurer

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 Example – A ship was insured against loss arising from collision. A collision took palce
resulting in a few days delay. Because of the delay, a cargo of oranges becomes
unsuitable for human consumption. It was held that the insurer was not liable for the the
loss because the proximate cause of loss was delay and not the collision of the ship.
7. Principle of Mitigation of Loss: An insured must take all reasonable care to reduce the
loss. We must act as if the property was not insured.
Example – If a house is insured against fire, and there is accidental fire, the owner must
take all reasonable steps to keep the loss minimum. He is supposed to take all steps which
a man of ordinary prudence will take under the circumstances to save the insured
property.
Benefits of Insurance or Role and Importance of Insurance
Benefit of insurance can be divided into these categories -
1. Benefits to Individual
2 Benefits to Business or Industry
3. Benefits to the Society
It can be explained as under -
1. Benefits to Individual
(a) Insurance provides security & safety : Insurance gives a sense of security to the policy
holder. Insurance provide security and safety against the loss of earning at death or in old
age, against the loss at fire, against the loss at damage, destruction of property, goods,
furniture etc.
Life insurance provides protection to the dependents in case of death of policyholders and
to the policyholder in old age. Fire insurance insured the property against loss on a fire.
Similarly other insurance provide security against the loss by indemnifying to the extent
of actual loss.
(b) Encourage Savings : Life insurance is best form of saving. The insured person must
regularly save out of his current income an amount equal to the premium to be paid
otherwise his policy get lapsed if premium is not paid on time.
(c) Providing Investment Opportunity : Life insurance provide different policies in which
individual can invest smoothly and with security; like endowment policies, deferred
annuities etc. There is special exemption in the Income Tax, Wealth Tax etc. regarding
this type of investment
2 Benefits to Business or Industry
(a) Shifting of Risk : Insurance is a social device whereby businessmen shift specific risks
to the insurance company. This helps the businessmen to concentrate more on important
business issues.
(b) Assuring Expected Profits : An insured businessman or policyholder can enjoy normal
expected profits as he would not be required to make provisions or allocate funds for
meeting future contingencies.
(c) Improve Credit Standing : Insured assets are easily accepted as security for loans by the
banks and financial institutions so insurance improve credit standing of the business firm
(d) Business Continuation – With the help of property insurance, the property of business is
protected against disasters and chance of closure of business is reduced
3. Benefits to the Society
(a) Capital Formation : As institutional investors, insurance companies provide funds for
financing economic development. They mobilize the saving of the people and invest
these saving into more productive channels
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 (b) Generating Employment Opportunities : With the growth of the insurance business,
the insurance companies are creating more and more employment opportunities.
(c) Promoting Social Welfare : Policies like old age pension scheme, policies for education,
marriage provide sense of security to the policyholders and thus ensure social welfare.
(d) Helps Controlling Inflation : The insurance reduces the inflationary pressure in two
ways, first, by extracting money in supply to the amount of premium collected and
secondly, by providing funds for production narrow down the inflationary gap.
Type of Insurance
Insurance cover various types of risks and include various insurance policies which
provide protection against various losses.
There are two different views regarding classification if insurance:-
I. From the business point of view; and
II From the risk points of view
I. Business point of view
The insurance can be classified into three categories from business point of view
1. Life insurance;
2. General Insurance; and
3. Social Insurance.
1. Life Insurance: The life insurance contract provide elements of protection and
investment after getting insurance, the policyholder feels a sense of protection because he
shall be paid a definite sum at the death or maturity. Since a definite sum must be paid,
the element of investment is also present. In other words, life insurance provides against
pre-mature death and a fixed sum at the maturity of policy. At present, life insurance
enjoys maximum scope because each and every person requires the insurance.
Life insurance is a contract under which one person, in consideration of a premium paid
either in lump sum or by monthly, quarterly, half yearly or yearly installments,
undertakes to pay to the person (for whose benefits the insurance is made), a certain sum
of money either on the death of the insured person or on the expiry of a specified period
of time.
Life insurance offers various polices according to the requirement of the persons -
- Term Assurance
- Whole Life
- Endowment Assurance
- Family Income Policy
- Life Annuity Joint Life Assurance
- Pension Plans
- Unit Linked Plans
- Policy for maintenance of handicapped dependent
- Endowment Policies with Health Insurance benefits
2. General Insurance: The general insurance includes property insurance, liability
insurance and other form of insurance. Property insurance includes fire and marine
insurance. Property of the individual and business involves various risks like fire, theft
etc. This need insurance Liability insurance includes motor, theft, fidelity and machine
insurance

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 Type of General Insurance policies available are -
- Health Insurance
- Medi- Claim Policy
- Personal Accident Policy
- Group Insurance Policy
- Automobile Insurance
- Worker’s Compensation Insurance
- Liability Insurance
- Aviation Insurance
- Business Insurance
- Fire Insurance Policy
- Travel Insurance Policy
3. Social Insurance: Social insurance provide protection to the weaker sections of the
society who are unable to pay the premium. It includes pension plans, disability benefits,
unemployment benefits, sickness insurance and industrial insurance.
II Risk Points of View
The insurance can be classified into three categories from Risk point of view
1. Property Insurance
2. Liability Insurance
3. Other forms of Insurance
1. Property Insurance: Property of the individual and business is exposed to risk of fire,
theft marine peril etc. This needs insurance. This is insured with the help of:-
(i) Fire Insurance
(ii) Marine Insurance
(iii) Miscellaneous Insurance
(i) Fire Insurance: Fire insurance covers risks of fire. It is contract of indemnity. Fire
insurance is a contract under which the insurer agrees to indemnify the insured, in
return for payment of the premium in lump sum or by instalments, losses suffered by
the him due to destruction of or damage to the insured property, caused by fire during
an agreed period of time. It includes losses directly caused through fire or ignition.
There are various types of fire insurance policies.
- Consequential loss policy
- Comprehensive policy
- Valued policy
- Valuable policy
- Floating policy
- Average policy
(ii) Marine Insurance: Marine insurance is an arrangement by which the insurer
undertakes to compensate the owner of the ship or cargo for complete or partial loss
at sea. So it provides protection against loss because of marine perils. The marine
perils are collisions with rock, ship attack by enemies, fire etc. Marine insurance
insures ship, cargo and freight.
The following kinds of marine policies are -
- Voyage policy
- Time policy
- Valued policy
- Hull Policy
- Cargo Policy
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 - Freight Policy
(iii) Miscellaneous Insurance: It includes various forms of insurance including property
insurance, liability insurance, personal injuries are also insured. The property, goods,
machine, furniture, automobile, valuable goods etc. can be insured against the
damage or destruction due to accident or disappearance due to theft.
Miscellaneous insurance covers
- Motor
- Disability
- Engineering and aviation risks
- Credit insurance
- Construction risks
- Money Insurance
- Burglary and theft insurance
- All risks insurance
2. Liability Insurance: The insurer is liable top pay the damage of the property or to
compensate the loss of personal injury or death. It includes fidelity insurance, automobile
insurance and machine insurance.
The following are types of liability Insurance:-
- Third party insurance
- Employees insurance
- Reinsurance
3. Other forms of Insurance: It include export credit insurance, state employee insurance
etc. whereby the insurer guarantees to pay certain amount at the happening of certain
events.
The following are other form of Insurance-
- Fidelity Insurance
- Credit Insurance
- Privilege Insurance

INSURANCE

From Business From Risk point

point of view of view

Life Property Liability Other Forms

Insurance Insurance Insurance

General Fire Third Party Fiduciary

Insurance Insurance Insurance Insurance

Social Marine Employee Credit

Insurance Insurance Insurance Insurances

Miscellaneous Motor Privilege

Insurance Insurance

Reinsurance

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 LESSON 2
LEGAL FRAMEWORK – LIFE & GENERAL INSURANCE BUSINESS

- Meenu
Asstt. Professor, SRCC,
University of Delhi.

ESSENTIALS OF GENERAL CONTRACT (SECTION 10) OF INDIAN CONTRACT

ACT 1872
The law of contract in India is contained in the Indian Contract Act 1872, According to
section 2(h) of the Indian Contract Act 1872, “An agreement enforceable by law is a contract”
A contract, therefore, is an agreement the object of which is to create legal obligation i.e. a duty
enforceable by law.
Thus there are two main elements
I An agreement
II Legal obligation i.e a duty enforceable by law
An agreement comes into existence when one party makes a proposal or offer to the other
party and that other party signifies his ascent (i.e. gives his acceptance)
An agreement to become a contract must give rise to a legal obligation i.e. , a duty enforceable
by law.
To be enforceable by law, an agreement must possess the essential elements of a valid
contract as contained in section 10.
Essentials of a valid contract
In order to become a valid contract, an agreement must have the following essentials
elements:
1. Offer and Acceptance
There must be a ‘lawful offer’ and a ;lawful acceptance’ of the offer. There must be tow
parties to an agreement, one making the offer and the other accepting it. The offer must be
definite, unambiguous and certain. It must be communicated. Acceptance must be absolute and
unqualified i.e it should not be conditional. It must be communicated to the offeror.
2. Intention to create legal relationship
There must be an intention among the parties that the agreement should be attached by legal
consequences and create legal obligations. Agreement of a social or domestic nature does not
involve any legal obligations so they are not a contract.
3. Lawful consideration
Consideration means something in return. An agreement is enforceable only when each of
the parties to it gives something and get something consideration must be ‘something of value’.
It may be past, present or future.
4. Capacity of parties
The parties to an agreement must be competent to contract. Parties must be of the age of
majority and of sound mind and must not be disqualified form contracting by any law to which

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they are subject (Section 11). If any of the parties to the agreement suffers a from minority,
lunacy, idiocy, drunkenness, etc., the agreement is not enforceable
5. Free consent
One of the essentials of the valid contract is that there should be consensus ad idem, i.e. they
agree upon the same thing in the same sense at the same time and that their consent is free and
real.
Coercion is said to be free whom it is not caused by :-
(i) Coercion
(ii) Under influence
(iii) Misrepresentation
(iv) Fraud
(v) Mistake
When there is no consent, there is no contract.
6. Lawful object
The object of the contract must be lawful. It should not be illegal, immoral or opposed to
public policy. If the object of the agreement is performance of unlawful act, the agreement is
unenforceable, for example, An agreement to commit an assault or to beat a man has been held
unlawful and void.
7. Writing and registration
According to the Indian Contract Act, a contract may be oral or in writing. But in certain
special cases, it lays down that the agreement, to be valid, must be in writing or/and registered.
For example, it requires that an agreement to pay a time barred debt must be in writing and an
agreement to make a gift for natural love and affection must be in writing and registered.
8. Certainty
The terms of agreement must be certain and not vague, indefinite or ambiguous. For
example, A, agree to sell B” a hundred tons of oil.” There is nothing whatever to show what kind
of oil was intended, the agreement is void for uncertainty.
9. Possibility of performance
A contract must be capable of performance. An agreement to do an act impossible is itself is
void.
10. Agreement not declared void
The agreement must not be have been expressly declared void by any law in force in the
country. (Section 24-30 and Section 56).
Kind of Contracts
Contract may be classified on the following basis.
Classification according to enforceability:
From the point of view of enforceability, a contract may be
1 Valid Contract
2 Voidable Contract
3 Void Contract
4 Unforceable contract
5 Illegal or unlawful contract
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 1. Valid contract : An agreement that fulfills all the essentials requisites as per the
requirement of law is a valid contract.
2. Voidable contract : An agreement which is enforceable by law at the option of one or
more of the parties thereto, but not at the option of the option of the other or others, is
voidable contract. When a element of free consent is absent, a contract is said to be
voidable contract. For example, “C’ threatens to shoot ‘B’, if he does not let out his house
to him. ‘B” agree to let out his house to ‘C’. The consent of ‘B’ is not free, so it is
voidable at the option of ‘B’.
3. Void contract: Void contract means which is not enforceable by law. A contract is not
void from its beginning and it is valid and binding on the parties when originally entered
but may later on become void. For example, A agrees to sell B 100 bags of wheat at Rs.
650 per bag. Before delivery, the government bans private trading in wheat, the contract
becomes void.
4. Unenforceable contract : Contracts, which cannot be enforced in a court of law because
of some technical defects such as absence of writing or because the remedy has become
time barred are called unenforceable contracts.
5. Illegal or unlawful contract : An agreement is illegal and void it object or
consideration :-
(i) is forbidden by law; or
(ii) is of such a nature that , if permitted , it would defect the provisions of any law; or
(iii)is fraudulent; or
(iv) involves or implies injury to the person or property of another; or
(v) the court regards it as a immoral, or opposed to public policy.
Classification according to the mode of creation
It can be divided into
1. Express contract
2. Implied contract
3. Constructive or quasi contract
1. Express contract : Where both the offer and acceptance are made in words spoken or
written, it is an express contract.
2. Implied contract : Where both the offer and acceptance are made by acts and conduct of
the parties and not by words, it is an implied contract. For example, ‘P’ a coolie in
uniform takes up the luggage of ‘Q’ to be carried out of the railway station without being
asked by ‘Q’ and ‘Q’ allows him to do so , then the law implies that ‘Q’ agree to pay for
the services of ‘P’ and there is an implied contract.
3. Constructive or quasi contracts : It is based on the principle of justice that “a person
shall not be allowed to enrich himself un justify at the expenses of another”. For example,
if ‘A’ a salesman, leaves goods at ‘B’ house by mistake and ‘B’ treat the goods as his
own, then he is bound to pay for the goods.
Classification on the basis of extent of execution
From the point of view if the extent of execution a contract may be executed or executory.
1. Executed contract : An executed contract is one in which both the parties have executed
/discharge their respective obligation, i.e., completely performed their share of obligation.
For example, ‘A’ agrees to sell his house to’B’ for Rs. 15 Lacs and accordingly transfer
the house to ‘B’ on getting the agreed amount from ’B’. The contract is a duly executed
contract.

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 2. Executory contract : Executory contract is a contract in which both the parties are yet to
execute their respective obligations. Executory contracts are also known as Bilateral
contracts.
ESSENTIAL FEATURES OF INSURANCE CONTRACTS
Like any other contract, insurance contract are also governed by the provisions of the law
of contract as laid down in The Indian Contract Act, 1872. Therefore they have to fulfill the
essential features of a valid contract
The essentials of a valid contract have been discussed earlier.
LIFE INSURANCE CORPORATION ACT, 1956
The life insurance corporation Act, 1956 is an act
(I) to provide for the nationalisation of life insurance business in India
(II) to provide for the regulation and control of the business of the Corporation.
As per the act, 245 private insurance companies, provident societies, etc., were
amalgamated and the life insurance corporation of India was formed and has since then grown up
to be the largest insurance company in India.
Some of the important provisions are as follows —
Short title and commencement —
(1) This Act maybe called the Life Insurance Corporation Act, 1956
(2) It shall come into force on such date as the Central Government may, by Notifications in
the Official Gazette, appoint.
Important Definitions: Sec 2 of the act contains the definitions adopted under the act.
Some of the important definitions in this act, unless the context otherwise requires are:
(1) "Appointed day,” means the date on which the Corporation is established
under Section 3;
(2) "Composite insurer "means an insurer carrying on in addition to controlled business
any other kind of insurance business;
(3) "Controlled business" means—
(i) In the case of any insurer specified in sub-clause (a) or sub-clause (b) of clause (9) of
section 2 of the Insurance Act and carrying on life insurance business
(a) all his business, if he carries on no other class of insurance business;
(b) all the business appertaining to his life insurance business, if he carries on any
other class of insurance business also;
(c) all his business if his certificate of registration under the Insurance Act in respect
of general insurance business stands wholly cancelled for a period of more than
six months on the 19th day of January, 1956.
(ii) in the case of any other insurer specified in clause (9) ofsection2 of the Insurance Act
and carrying on life insurance business—
(a) all his business in India, if he carries on no other class of insurance business in
India;
(b) all the business appertaining to his life insurance business in India, if he carries on
any other class of insurance business also in India;
(c) all his business in India if he certificate of registration under the Insurance Act in
respect of general insurance business in India stands wholly cancelled for a period
of more than six months on the 19th day of January, 1956.
(4) "Corporation" means the Life Insurance Corporation of India established under section 3;
(5) "Insurance Act” means the Insurance Act, 1938(4of1938);
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 (6) "Insurer" means an insurer as defined in the Insurance Act who carries on life insurance
business in India and includes the Government and a provident society as defined in
section65 of the Insurance Act;
(7) "Member" means a member of the Corporation;
(8) "Prescribed" means prescribed by rules made under this Act;
(9) "Tribunal" means a Tribunal constituted under section17 and having jurisdiction in
respect of any matter under the rules made under this Act;
(10) All other words and expressions used herein but not defined and defined in the Insurance
Act shall have the meanings respectively assigned to them in that Act.
Establishment and incorporation of Life Insurance Corporation of India —
Sec 3 of the act provides that
(1) With effect from such date as the Central Government may, by notification in the Official
Gazette, appoint, there shall be established a Corporation called the Life Insurance
Corporation of India.
(2) The Corporation shall be a body corporate having perpetual succession and a common
seal with power subject to the provisions of this Act, to acquire, hold and dispose of
property, and may by its name sue and be sued.
Constitution of the Corporation—
According to sec 4 of the Act:
(1) The Corporation shall consist of such number of persons not exceeding 2 as the Central
Government may think fit to appoint thereto and one of them shall be appointed by the
Central Government to be the Chairman there of.
(2) Before appointing a person to be a member, the Central Government shall satisfy itself
that person will have no such financial or other interest as is likely to affect prejudicially
the exercise or performance by him of his functions as a member, and the Central
Government shall also satisfy itself from time to time with respect to every member that
he has no such interest; and any person who is, or whom the Central Government
proposes to appoint and who has consented to be, a member shall, whenever required by
the Central Government so to do, furnish to it such information as the Central
Government considers necessary for the performance of its duties under this sub-section.
(3) A member who is in anyway directly or indirectly interested in a contract made or
proposed to be made by the Corporation shall as soon as possible after the relevant
circumstances have come to his knowledge, disclose the nature of his interest to the
Corporation and the member shall not take part in any deliberation or discussion of the
Corporation with respect to that contact.
Capital of the Corporation—
(1) The original capital of the Corporation shall be five crores of rupees provided by the
Central Government after due appropriation made by Parliament bylaw for the purpose,
and the terms and conditions relating to the provision of such capital shall be such as
maybe determined by the Central Government.
(2) The Central Government may, on the recommendation of the Corporation, reduce the
capital of the Corporation to such extent and in such manner as the Central Government
may determine

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Functions of the Corporation—
These are as follows:
1) Subject, to the rules, if any, made by the Central Government in this behalf, it shall be the
general duty of the Corporation to carry on life insurance business, whether in or outside
India, and the Corporation shall so exercise its powers under this Act as to secure that life
insurance business is developed to the best advantage of the community.
2) Without prejudice to the generality of the provisions contained in sub-section (1) but
subject to the other provisions contained in this Act, the Corporation shall have power —

(a) To carryon capital redemption business, annuity certain business or reinsurance

business in so far as such re insurance business appertains to life insurance
business;
(b) Subject to the rules, if any, made by the Central Government in this behalf, to
invest the funds of the Corporation in such manner as the Corporation may think
fit and to take all such steps as may be necessary or expedient for the protection or
realization of any investment; including the taking over of and administering any
property offered as security for the investment until a suitable opportunity arises
for its disposal;
(c) To acquire, hold and dispose of any property for the purpose of its business;
(d) To transfer the whole or any part of the life insurance business carries on outside
India to any other person or persons, if in the interest of the Corporation it is
expedient so to do;
(e) To advance or lend money upon the security of any movable property or
otherwise;
(f) To borrow or raise any money in such manner and upon such security as the
Corporation may think fit;
(g) To carry on either by itself or through any subsidiary any other business in any
case where such other business was being carried on by a subsidiary of an insurer
whose controlled business has been transferred to and invested in the Corporation
under this Act;
(h) to carry on any other business which may seen to the Corporation to be capable
of being conveniently carried on in connection with its business and calculated
directly or indirectly to render profitable the business of the corporation;
(i) to do all such things as maybe incidental or conducive to the proper exercise of
any of the powers of the Corporation. In the discharge of any of its functions the
Corporation shall act so far as maybe on business principles.
Power of Corporation to impose conditions, etc—
(1) In entering into any arrangement, under section 6, with any concern, the Corporation may
impose such conditions as it may think necessary or expedient for protecting the interest
of the Corporation and for securing that the accommodation granted by it is put to the
best use by the concern.
(2) Where any arrangement entered into by the Corporation under section 6 with any concern
provides for the appointment by the Corporation of one or more directors of such
concern, such provision and any appointment of directors made in pursuance there of
shall be valid and effective notwithstanding anything to the contrary contained in the
Companies Act, 1956 (1 of1956),or in any other law for the time being in force or in the
memorandum, articles of association or any other instrument relating to the concern, and
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 any provision regarding share, qualification, age limit, number of directorships, removal
from office of Directors and such like conditions contained in any such law or instrument
aforesaid, shall not apply to any director appointed by the Corporation in pursuance of
the arrangement as aforesaid.
(3) Any director appointed as aforesaid shall-
(a) Hold office during the pleasure o f the Corporation any maybe removed or substituted by
any person by order in writing by the Corporation;
(b) Not incur any obligation or liability by reason only of his being a director or for anything
done or omitted to be done in good faith in the discharge of his duties as a director or
anything in relation thereto;
(c) Not be liable to retirement by rotation and shall not be taken into account for computing the
number of directors liable to such retirement.
Management of the Corporation
The central office of the Corporation shall be at such place as the Central Government
may, by notification in he Official Gazette, specify.The Corporation shall establish a zonal office
at each of the following places, namely, Bombay, Calcutta, Delhi, Kanpur and Madras, and,
subject to the previous approval of the Central Government, may establish such other zonal
offices as it thinks fit. The territorial limits of each zone shall be such as may be specified by the
Corporation.There may be established as many divisional offices and branches in each zone as
the Zonal Manager thinks fit.
Other Committees –
(1) The Corporation may entrust the general superintendence and direction of its affairs and
business to an Executive Committee consisting of not more than five of its members and
the Executive Committee may exercise all powers and do all such acts and things as may
be delegated to it by the Corporation.
(2) The Corporation may also constitute an Investment Committee for the purpose of
advising it in matters relating to the investment of its funds, and the Investment
Committee shall consist of not more than eight members of whom not less than four shall
be members of the Corporation and the remaining members shall be persons (whether
members of the Corporation or not) who have special knowledge and experience in
financial matters, particularly, matters relating to investment of funds.
It may appoint one or more persons to be the managing director or directors of the
Corporation, and every managing director shall be a whole – time officer of the Corporations,
and shall exercise such powers and perform such duties as may be entrusted or delegated to him
by the executive committee of the corporation.
Funds of the Corporation-
Corporation shall have its own fund and all receipts of the Corporation shall be credited thereto
and all payments of the Corporation shall be made there from.
Audit—
(1) The accounts of the Corporation shall be audited by auditors duly qualified to act as
auditors of companies under the law for the time being in force relating to companies,
and the auditors shall be appointed by the Corporation with the previous approval of the
Central Government and shall receive such remuneration from the Corporation as the
Central Government may fix.

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 (2) Every auditor in the performance of his duties shall have at all reasonable times access to
the books, accounts and other documents of the Corporation.
(3) The auditors shall submit their report to the Corporation and shall also forward a copy of
their report to the Central Government.
Annual report of activities of Corporation—
The Corporation shall, as soon as may be, after the end of each financial year, prepare
and submit to the Central Government in such form as maybe prescribed a report giving an
account of its activities during the previous financial year, and the report shall also give an
account of the activities, if any, which are likely to be undertaken by the Corporation in the next
financial year.
Liquidation of the Corporation
No provision of the law, as provided in the Companies Act, relating to the winding up of
companies or corporations shall apply to the corporation established under this act, and the
corporation shall not be placed in liquidation save by order of the central government and in such
manner as the central Government may direct.
THE GENERAL INSURANCE BUSINESS (NATIONALISATION) ACT,1972
The Life Insurance business was nationalised in 1956. at this stage, the General insurance
business was allowed to be continued in private hands. In 1971, General Insurance (emergency
provisions) ordinance was enacted.
The Government of India took over the management of all General Insurance Companies
operating in India whether they belonged to Indian or non-Indian shareholders. Subsequently, the
General Insurance (Emergency Provisions) Amendment Act, 1971 was passed withdrawing
certain rights of the Directors and Members of the Companies, which they were enjoying under
the Companies Act. General Insurance (Nationalization) Act, 1972 shortly followed and with
effect from 2nd January,1973 the provisions of the Act became effective.
The most significant provisions of the Act are
Definitions:
In this act, unless the context otherwise requires, acquiring companies: means any Indian
insurance company and, where a scheme has been framed involving the merger of one Indian
insurance company in another or the amalgamation of two or more such companies,means the
Indian insurance company in which any other company has been merged or the company which
has been formed as a result of amalgamation;
Appointed day means such day, not being a day later than the 2nd day of January, 1973,
as the central government may , by notification, appoint;
Companies act means the companies act, 1956;
Corporation means the general insurance corporation of India formed under section 9;
Existing insurer means every insurer the management of whose undertaking has vested in the
central government under section 3 of he general insurance (emergency provisions) act, 1971 an
d includes the undertaking of the life insurance corporation in so far as it relates to the general
insurance business carried on by it;
Foreign insurer means an existing insurer incorporated under the law of any country outside
India;
General insurance business means fire, marine or miscellaneous insurance business, whether
carried on singly or in combination with one or more of them, but does not include capital
redemption business and annuity certain business;
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Government company means a government company as defined in section 617 of the
companies act;
Indian insurance company means an existing insurer having a share capital who is a company
within the meaning of the companies act;
Insurance act means the insurance act, 1938;
life insurance corporation means the life insurance corporation of India established under the
life insurance corporation act, 1956;
Notification means a notification published in the official gazette;
Prescribed means prescribed by rules made under this act;
Schedule means the schedule to the act;
Scheme means the scheme framed under section 16;
Words and expressions used in this act but not defined herein or in the insurance act and
defined in the companies act, shall have the meanings respectively assigned to them in the
companies act.
Functions of Corporation
The functions of the Corporation are enumerated in Section18 of the Act, some of are as
follows:
The functions of the Corporation shall include:-

(a) The carrying on of any part of the general insurance business, if it thinks it desirable to do
so;
(b) Aiding, assisting and advising the acquiring companies in the matter of setting up of
standards of conduct and sound practice in general insurance business and in the matter
of rendering efficient services to holders of policies of general insurance;
(c) Advising the acquiring companies in the matter of the controlling their expenses
including the payment of commission and other expenses.
(d) Advising the acquiring companies in the matter of the investment of their funds;
(e) Issuing directions to acquiring companies in relation to the conduct of general insurance
business.
Functions of acquiring companies
(1) Subject to the rules, if any, made by the Central Government in this behalf and to its
memorandum and articles of association, it shall be the duty of every acquiring company
to carry on general insurance business.
(2) Each acquiring company shall so function under this Act as to secure that general
insurance business is developed to the best of the community.
(3) In the discharge of any of its functions, each acquiring company shall act so far as may
be on business principles and where any directions have been issued by the Corporation
shall be guided by such directions.
(4) For the removal of doubts it is hereby declared that the Corporations and any acquiring
company may, subject to the rules, if any, made by the Central Government in this
behalf, “enter into such contracts of reinsurance treaties as it may think fit for the
protection of its interests”.
Power to make rules
According to section 39,
The Central Government is also empowered to make rules to carry out the provisions of
the Act and such rules may provide for:
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 (a) Manner in which the profits and other moneys received by the Corporation may be dealt
with
(b) The conditions subject to which the Corporation and the acquiring companies shall carry
on general insurance business;
(c) The terms and conditions subject to which any re-insurance contract or treaties may be
entered into;
(d) Form and manner in which any notice or application may be made to the Central
Government;
(e) The reports which may be called for by the Central Government from the Corporation
and acquiring companies; and
(f) Any other matter which is required to be or may be prescribed.
Powers of the central government under the act
Power to transfer employees: under the provisions of sec 22 of the act, the corporation
may at any time transfer any officer or employee from an acquiring company or the corporation
to any other acquiring company or the corporation, as the case may be, and the officer or
employee so transferred, shall continue to have the same terms and conditions of service as were
applicable to him immediately before such transfer.
Power to issue directions: according to sec 23, the corporation and every acquiring
company shall, in the discharge of its functions, be guided by such directions in regard to matters
of policy involving public interest as the central government may give.
Power to frame/ amend a scheme
According to section 17,
If the central government is of opinion that for the more efficient carrying on of general
insurance business it is necessary so to do, it may, by notification, frame one or more schemes.
The central government may, by notification, add to, amend or vary any scheme framed under
this section . a copy of every scheme , and every amendment thereto, framed under this section
shall be laid, as soon as may be after it is made, before each House of Parliament
Power to regulate the terms and conditions of service of officers and other employees
According to section 17A, the central government may, by notification in the official
gazette, frame one or more schemes for regulating the pay scales and other terms and conditions
of service of officers and other employees of the corporation or of any acquiring company.

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 UNIT-V
LESSON 1
INSURANCE PRODUCTS AND STATE OF INSURANCE
INDUSTRY IN INDIA
- Meenu
Asstt. Professor, SRCC,
University of Delhi.

Terminologies under insurance

1. Insurer – Explained earlier
2. Insured – Explained earlier
3. Premium – Explained earlier
4. Indemnity – Explained earlier
5. Utmost good faith – Explained earlier
6. Insurable interest – Explained earlier
7. Proximate Cause – Explained earlier
8. Subrogation – Explained earlier
9. Contribution– Explained earlier
10. Reinsurance - Reinsurance is the transfer of insurance business from once insurance to
another. Reinsurance is an arrangement whereby an original insurer who has insured a
risk insures part of that risk again with another insurer, that is to say, reinsurance a part of
risk in order to diminish his own liability. The insurer transferring the business is called
the ‘principle’ or ‘ceding’ or ‘original’ of fire and the office to which the business is
transferred is called for ‘reinsurer’ or ‘guaranteeing office’. It is also a contract of
indemnity. Reinsurance is a contract between the reinsured (the insurer) and the reinsurer.
11. Peril of the Sea - Perils of the Sea is also known as Nautical/ marine perils/maritime. It
means all those perils that are consequential or incidental to sea journey. It include
collisions, war perils, captures, jettison, barratry. It does not include the typical action of
winds and waves.
12. Perils - A peril is defined as the cause if the loss. Examples of peril include fire,
tornadoes, heart attacks and criminal acts. Insurance policies provide financial protection
against losses caused by perils.
13. Jettison - Jettison means voluntary throwing away of the cargo or part of a vessel’s
equipment for the lightening or relieving the ship for common safety. The aim of the
intentional throwing away of the goods or property is to relive the vessel from the some
imminent peril. Accidental falling of the things does not constitute jettison
14. Actual Loss - Actual Loss is a material and physical loss of the subject matter insured.
Subject matter is completely destroyed or so damaged that it ceases to be a thing of the
kind insured. It is no longer the same as originally insured. For example, A ship is
entirely destroyed by the fire constitute total loss.
15. Constructive Total Loss - In constructive total loss, the ship or cargo insured is not
completely destroyed but is so badly damaged that the cost of repair of recovery would
be greater than the value of the property saved. In such a case, it is preferable to abandon
the destroyed property.
16. Partial Loss - A partial loss occurs when the subject matter of insurance is partially
destroyed or damaged. In marine insurance, a partial loss of vessel or cargo is called an
average.
17. General Average -General average refers to the sacrifice made during extreme
conditions for the purpose of rescuing the ship and the cargo from being damaged. It is
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 incurred for the benefits of all interests. It is always voluntary and intentional. This loss
has to be borne by all parties who have an interest in the marine adventure. For example,
damage to ship engine or machinery in attempting to raise a stranded ship, throwing part
of the cargo, equipment of the vessel overboard to lighten the load and save the vessel.
18. Particular Average Loss - Particular average loss is defined as ‘a partial loss’ of the
subject matter insured causes by a peril insured. It is accidental in nature. Such a loss is
borne by the underwriter who insured the object damaged.
19. Enemies - The ships belonging to the enemy may cause loss to the insured and is re
underwritten by the marine policy. This policy extends to all the persons of the enemy
country and to their hostile acts provided such acts form part if the enemy actions
20. Agent - A licensed person or organization authorizes to sell insurance by or on behalf of
an insurance company.
21. Broker - A licensed person or organization paid by you to look for insurance on your
behalf.
22. Claim - Notice to an insurer that under the terms of a policy, a loss may be covered.
23. Burglary – There are two type of burglary
(a) Theft of the property from the premises following upon entry if the said premises
by violent and forcible means
(b) Theft by a person in the premises who subsequently breaks our by the violent and
forcible means
24. Hazard - Hazard refers top those conditions or features or characteristics which create
or increase the chance of loss arising from a given peril.
There are two type of hazard
(a) Physical Hazard
(b) Moral Hazard
(a) Physical Hazard – Physical hazard refers to the risk arising from material
features of the subject matter of insurance, for example, Fire - wooden floor are
more prone to fire, greater the number of the storey in a building, the greater the
hazard.
(b) Moral Hazard - Moral hazard arises from human weaknesses, for example,
dishonesty, carelessness etc. or from general economic conditions like condition
of unemployment would result in a increased of burglaries.
25. Disability Insurance -This insurance provides compensation to the insured when
income is interrupted or terminated because of illness, sickness or due to injury because
of accident. It provides insurance against loss of income.
26. Warranties - Warrantee means a ‘guarantee’ or a condition which is basic to the
contract of insurancy. Any breach of insurance warranties goes to the root of the contract
and gives the aggrieved party the right to avoid the contract. Section 35 of marine
insurance Act define warranties as “ A warranty means a promissory warranty. It means
an undertaking by the assured that same particulars thing shall or shall not be done, or
that some condition shall be fulfilled or he affirms or negatives the existence of a
particular state of facts”.
In simple words, it means that the insured undertakes that some particular thing shall or
shall not be done, or that some stipulation shall be fulfilled, or that particular state of the
facts does not exist. If a warranty is not complied with by the insured, the contract comes
to an end / and the insured is going to suffer.
27 Total Loss - Total loss means that the subject matter insured is fully destroyed and it
totally lost to its owner.

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 28. Underwriting - Underwriting is the most important aspect for any insurance,
underwriting is a process of selecting applicants for insurance and classifying them
according to their degrees of insurability so that the appropriate premium rates may be
changed.
So underwriting include principle and practices concerning the acceptances or rejection
of risk, the total amount of acceptance, the total amount of retention for insurer’s own
amount and treatment of the balance through reinsurance
29. Workers Compensation Insurance -It provide four type of benefits (Medical care,
death, disability and rehabilitation) for employee job related injuries or disease as a
matter of right (without regard of fault)
30. Grace Period - A period (Usually 31 days) after the premium due date, during which an
overdue premium may be paid without penalty. The policy remains in force throughout
this period.
31. Material Misrepresentation - The policy holder/ applicant makes a false statement
regarding any material facts on his/her applications. For example, in case of life
insurance, the applicant may not reveal the true age and details of the existing illness/
diseases.
32. Risk - Risk means uncertainty concerning loss, and not the loss itself, or the cause of
loss; or the chance of loss. If, for example, the chance of loss by fire to a particular type
of residential house is 1 in 1000, a person who owns a single house cannot predicts his
loss. Either his flat will burn or will not burn. He has no basis for predicting the outcome.
He is faced with complete uncertainty even though the chance of loss is low.
New Insurance Products
1. Policies under LIC mutual Fund
LIC launched its mutual fund with promise to the investors to provide high returns along
with safety and security of investments. LIC mutual fund came up with 5 schemes which
provide distinct benefits to various cross sections of investors. The names of scheme are:-
- Dhanashree 1989
- Dhan 80 cc (1)
- Dhanvarsha
- Dhanvarsha 1989
- Dhanvridhi 1989
2. Jeevan Akshay –V
This can be purchased immediately through lump sum payment as single premium. The
plan provides for annuity payments, which are available throughout the lifetime of and
annuitant. Annuity may be paid either at monthly, quarterly, half yearly or yearly
intervals. Premium is paid as lump sum. Minimum purchase price of the policy is Rs.
50,000 or such amount which may secure a minimum annuity of Rs. 3000 per annum and
maximum no limit. Medical examination is not required. The minimum age of the
proposer should be 40 year & maximum should not exceed 79 years.
3. Jeevan Dhara
The payment of annuities in respect of policies under Jeevan Dhara has to start one month
after the completion of the deferment period.
4. Jeevan Kishore
This is an endowment assurance plan available for children of less than 12 years of age.
The policy may be purchased by any of the parents/ grand parents. Premiums are payable
yearly, half yearly, quarterly or monthly throughout the term of the policy or till earlier
death of child. This is a with profit plan i.e; get share of the profit in the form of bonus.
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 5. Jeevan Chhaya
This is an endowment assurance plan that provides financial protection against death
throughout the term of the plan.
6. New Jeevan Suraksha – I
These are deferred annuity plans that allow the policyholder to make provisions for regular
income after the selected terms. Premiums are payable yearly, half yearly, quarterly,
monthly or through deduction opted by the policyholder, throughout the term of the policy
or till earlier death. Premium can be paid in lump sum also.
Insurance in India – Historical Background
In India, the concept of insurance was prevalent even during ancient times. The reference of
insurance is found in ‘Rigveda’ with the name ‘yogakshema’ more or less related to the well
being and security of the people. Hammurabi in 2100BC, formalized the concept of the civic
responsibilities, bottomry and respondentia. Bottomry and respondentia loans refer to marine
contracts covering vessels and cargo. However, there is no evidence that insurance in its present
form was practiced prior to the twelfth century.
1. Marine Insurance – Insurance in the oldest form existed in the form if marine
insurance. there was a contract of Bottomry bond, under this, the system of credit and the
law of interest were well developed and were based on a appreciation of the hazards
involved and the means of safeguarding against it. If the ship was lost, the loan and
interest were forfeited. The contract of insurance was made a part of the contract of
carriage. Freight was fixed according to seasons and was very reasonable. Various risks
were involved with marine transport like heavy winds, highway robbery, capturing by
king’s enemies. So to safeguard that, the marine traders developed a method of spreading
that financial loss.
2. Fire Insurance -Marine insurance was followed by fire insurance. it had been originated
in Germany in the beginning if the sixteen century. In England in 1666 there was great
fire in which about 85 percent of the houses were burnt and property worth of sterling ten
crores were completely burnt off. Fire insurance office was established in 1681 in
England. After this, fire insurance spread all over the world.
In India, the general insurance started working with the establishment of the Triton
Insurance Calcutta in 1850. However general insurance could not progress much in India.
3. Life Insurance - Life insurance first started in England in the sixteen century. The first
life insurance policy was of Willam Gybbons on June 18,1653. The first registered life
office in England was the Hand – in – Hand Society established in 1696. The life
insurance did not progress much in the United States during the eighteenth century.
In India, some European started the first life insurance company in Bengal Presidency,
viz, the Oriental Life Assurance Company in 1818. Then in 1871, ‘ Bombay Mutual Life
Assurance Society was established. In 1874 another important life insurance office was
started ‘ Oriental Government Security Life Assurance Co. Ltd’ sooner than several
offices developed in India.
4. Miscellaneous Insurance - Miscellaneous Insurance take place at the later part of the
nineteenth century with the industrial revolution in England. Various insurance were
developed like accident insurance, fidelity insurance, liability insurance. The main
institution was Lloyd’s association. Now, various insurance are taking place like cattle
insurance, crop insurance, project insurance etc.
Reforms in the Indian Insurance Sector
After the nationalization of the life insurance industry in 1956 and general insurance
industry in 1972, the insurance industry confined only to the operations of Life Insurance
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Corporation of India and General Insurance Corporation of India and its four subsidiaries viz;
The National Insurance Company Limited, New India Assurance Company Limited, Oriental
Fire & General Insurance Company Limited and United India Fire & General Insurance
Company Limited. There was state monopoly, inefficient customer services, outdated
technologies. So in 1993, Malhotra Committee, led by former secretary and RBI Governor, R.N.
Malhotra, was formed to evaluate the Indian Insurance Industry and for recommending its future
directions.
Objectives of Malhotra Committe
1. To suggest the structure of the insurance industry, to assess strength and weaknesses, to
offer wide variety of insurance products with a high quality of service to the public.
2. To make recommendations for modifying structure of insurance industry for changing
general policy framework, etc.
3. To make specific suggestions for improving the functioning of Life Insurance
Corporation of India and General Insurance Corporation of India.
4. To make suggestions on regulation and supervision of the insurance sector in India
5. To give advice on role and working if surveyors, intermediaries like agents,etc. in the
insurance sector
6. To make recommendations on any other matter which is relevant for development of the
insurance industry in India.
Recommendations of Malhotra Committee
Malhotra committee submitted its report in 1994 and gave the following major
recommendations in respect of :-
(I) Structure
- Government stake in the Insurance companies to be brought down to 50%
- Government should take over the holding of General Insurance Corporation of India & its
subsidiaries so that these subsidiaries can act as independent corporations
- All the Insurance companies should be given freedom to operate
(II) Competition
- Private companies with minimum paid up capital of Rs. 1 billion should be allowed to
enter in industry.
- No company should deal in both life and general insurance through a single entity
- Foreign companies may be allowed to enter the industry in collaboration with the
domestic companies
- Postal life insurance should be allowed to operate in the rural market
- Only one state level life insurance company should be allowed to operate in each state.
- The insurance act should be changed
- The insurance regulatory body should be set up.
- Controller of insurance should be made independent
(III) Investment
- Mandatory investment of LIC life fund in Government Securities to be reduced from 75
percent to 50 percent
- GIC and its subsidiaries are not to hold more than 5% in any company
(IV) Customer Service
- LIC should pay interest on delays in payment beyond 30 days
- Insurance companies must be encouraged to set up unit linked pension plans
- Computerisation of operations and updating of technology to be carried out in the
insurance industry.

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 So the main emphasis was to improve the customer service and to opened up insurance sector
for the competition. But at the same time, the committee felt that new players could ruin the
public confidence in the industry. The recommendations of the committee were discussed at
different forum.
In 1999, keeping in view of the recommendations of Malhotra Committee, Insurance
Regulatory and Development Authority (IRDA) Bill was drafted. The Government has ruled out
privatization of public sector insurance companies, LIC and GIC. There will be dilution of 100
percent Government equity in LIC and GIC.
IRDA bill was formed by amending the Insurance Act, 1938, the Life Insurance Corporation
Act,1956 and General Insurance Business (Nationalisation Act,1972). This bill was enacted to
open up the insurance sector.
IRDA provides for a nine member regulatory body with statutory powers. It fixed minimum
capital requirement for Life and General Insurance at Rs. 100 Crores and for reinsurance firms at
Rs. 200 Crores.
There was some oppositions so Government reintroduced the bill with some changes. In
1999, the bill was finally passed and IRDA was formed to regulate and promote insurance
business in India.
Liberalisation of Insurance markets in India
Liberalisation are of two types :-
- Domestic Liberalisation
- External sector Liberalisation
Domestic Liberalisation consists of general curbs and guides on production, investment, price,
the role of market and resources allocation etc.
External sector Liberalisation consists of liberalization in term of international flow of goods,
services, technology and Capital
Liberalisation of insurance involves transformation of the industry from a government monopoly
to a competitive environment. Indian companies too should have chance to carry out its business
in a foreign country without much limitation.
Liberalisation of the insurance sector has contributed towards the economic development of the
country in the following ways :-
(i) Employment Generations as more demand for marketing experts, finance specialists,
human resources professionals, statisticians etc.
(ii) Allowing of foreign players in Indian Insurance Sector bring more funds in the economy.
(iii) Liberalisation helps in promoting industry ancillary to insurance industry, like,
advertising etc. New policy cover have been developed. Customer friendly pricing
structure was developed that would foster healthy competition throughout the insurance
industry. Various distribution channels were developed.
(iv) Modern techniques were developed like bancassurance to sell insurance products to
customers. Banks too have involved in the task of distributing insurance products.
Insurance companies are entering into tie ups with manufactures of consumers goods in
order to speed up the process of reaching the customer at their door steps.
(v) IT sector boost up. The need for quicker delivery of insurance products has provoked the
competing insurance players to follow more sophisticated, automated systems
Major Insurance Players in India
There are two types of insurance players
I Life Insurance
II Non Life Insurance
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I Following major players in life Insurance sector
1. Bajaj Allianz Life Insurance Company Limited:
It was incorporated on 12th March 2001 and get certificate of registration on 3rd April 2001.
It is a joint venture between Bajaj Auto Limited and Allianz AG of Germany. It conduct life
insurance business in India.
Products offered by the company are :-
- Risk Care Plan
- Cash Care Plan
- Life Care Plan
- Save Care Plan
- Invest Gain Plan
- Group Risk Care Plan – Employer - Employee
- Group Credit Care Plan - Employer - Employee
- Group Risk Care Plan – Non Employer - Employee
2. Birla Sun Life Insurance Company Limited :
It is a joint venture between Aditya Birla Group Sun life Corporation of U.S. Company offer
a unique products having features of
- Good Returns
- Security
- Liquidity
- Tax Benefits
- Transparency and
- Expediency
Products offered by the company are:-
- Flexi Save Plus endowment Plan
- Flexi life line whole life Plan
- Flexi Cash flow money back Plan
- Single Premium Plan
- Flexi secure life retirement plan (Pension)
- Birla sun life term plan
3. HDFC Standard Life Insurance Company Limited :
It is a joint venture between HDFC and Standard life. The company was incorporated on 14th
August 2000.
Products offered by the company are :-
- With profit endowment Assurance
- With profit money back
- Single Premium Whole Life
- Loan Cover term Assurance
- Personal Pension Plan
- Children’s Plan
- Group Term Insurance
- Development Insurance Plan
4. ICICI Prudential Life Insurance Company Limited :
It is a joint venture between ICICI Bank Limited and Prudential of UK. The company has
paid up capital of Rs. 230 Crores. The was incorporated on 26th November 2000 and it started its

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operation on 19th December 2000. Company offers wide range of products for Individual,
Investors and Corporates .
Products offered by the company are :
Individuals Plans – Cash and Back, Life Guard, Forever Life, Life Link Pension & Life Time
Pension
Investment Plans– Assure Invest, Life Link Plan etc.
Group Plans – Group Gratuity, Group Term Assurance
5. Life Insurance Corporation of India Limited :
Life Insurance Corporation of India Limited was established in 1956. it has 7 zonal and 100
divisional offices and 204 branches. It is the dominate leader in life insurance business in India.
The Company offers wide variety of products
Products offered by the company are :-
- Whole Life Plan
- Endowment Plan
- Children Plan
- Joint Life Plan
- Group Term Insurance Plan
6. Tata AIG Life Insurance Company Limited :
It is a joint venture between Tata Group and AIG of America. The company has paid up
capital of Rs. 185 Crores.. Company offers wide range of products
Products offered by the company are :-
- 15 year life line (With return of premium) Plan
- Money Saver Plan
- Security and Growth Plan
- Mahalife Plan
7. SBI Life Insurance Company Limited :
It is a joint venture between SBI and Cardiff S.A. France. The company has paid up capital
of Rs. 250 Crores.. Company offers wide range of products
Products offered by the company are :-
- Sanjeevan Plan
- Sudarshan Plan
- Young Sanjeevan Plan
- SBI Scholar Plan
8. OM Kotak Mahindra Life Insurance Company Limited :
It is a joint venture between Kotak Mahindra Finance Limited and Old Mutual Public Ltd.
The company has paid up capital of Rs. 150 Crores.
The major products offered are
- Insurance Bond Plan
- Gramin Bima Yojana Plan
- Retirement Plan
- Capital Multiplier Plan
- Annuity Plan
- Child Advantage Plan

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9. Max New York Life Insurance Company Limited :
It is a joint venture between Max India Limited and New York life. The company has paid up
capital of Rs. 250 Crores..
The company offers wide range of insurance plans. Products offered are
- Whole Life Endowment Plan
- Term Assurance Plan
10. ING Vyasya Life Insurance Company Limited :
It is a joint venture between ING, Vyasa bank and GMR Group. The company has paid up
capital of Rs. 110 Crores.
The major products offered are
- Reassuring Life Endowment Assurance Plan
- Fulfilling Life Anticipated Whole Life Plan
- Maximising Life Money bank Plan
- Conquering Life Plan
11. AVIVA Life Insurance Company Limited :
It is a joint venture between Dabur India and CGU, a Wholly subsidiary AVIVA Public
Limited Company (PLC). The company has paid up capital of Rs. 110 Crores.
The major products offered are
- Life Long Plan
- Life Saver Plan
- Life Bond Plan
- Corporate Life Plan
- Credit Plus Plan
- Secure Life Plan
- Easy Life Plan
- Pension Plus Plan
12. AMP Sanmar Assurance Company Limited :
It is a joint venture between AMP and Sanmar Group.
The major products offered are
- Dhan Shree Plan
- Subha Shree Plan
- Nitya Shree Plan
- Rakash Shree Plan
- Yuva Shree Plan
- Bhagya Shree Plan
II Following major players in Non life Insurance sector
1. Bajaj Allianz General Insurance Company Limited :
It was incorporated on 19th September 2000 and get certificate of registration on 2nd may
2001. It is a joint venture between Bajaj Auto Limited and Allianz AG of Germany. It conduct
general insurance business (Including health insurance business) in India. Its paid up capital is
Rs. 110 Crores
Company offer following categories of products
- Fire insurance
- Motor Insurance
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 - Workmen Compensation
- Consequential loss (fire) insurance
- Engineering (Including electronics equipments, machinery, boiler explosion etc.
- Health insurance
- Personal accident
- Householders
- Overseas travel
2. ICICI Lombard General Insurance Company Limited
It is a joint venture between ICICI Bank Limited and Lombard Canada Limited (Oldest
property and casualty insurance company in Canada). ICICI Lombard offer a wide range of retail
and corporate general insurance customized product as under :
- Home Insurance
- Personal Care
- Fire and Special Peril Policy
- Consequential loss (fire) insurance
- Burglary Insurance
- Liability products like Public liability insurance act policy, Workmen
Compensation
3. IFFCO – TOKIO General Insurance Company Limited
It is a joint venture between IFFCO and Tokio marine & fire Insurance Company
Limited, Japan. Its paid up capital is Rs. 100 Crores. It is among India’s top three private sector
general insurance companies. The company offer a wide range of unique customized policies ,
some of major products as under :
- Industrial All Risks
- Machinery Breakdowns
- Machinery Loss of Project
- Product Liability
- Marine (Cargo)
- Motor (Private/ personal Car/ Commercial Vehicles)
- Overseas Travel Insurance
- Cash Insurance
4. National Insurance Company Limited
National Insurance Company Limited was incorporated in 1906 and nationalised in 1972.
Company carry out general insurance business. 1972, 22 foreign companies and 11 Indian
Insurance Companies were amalgamated with National Insurance Company Limited as a
subsidiary of General Insurance Corporation of India . Then in 2002, the company was de linked
from General Insurance Corporation of India and now working as independent company.
Company offers a wide variety of products and also carrying out reinsurance and foreign
operations
5. New India Assurance Company Limited
New India Assurance Company Limited was incorporated in 1919 and was nationalised
in 1972. Company carry out general insurance business. In 2002, the company was de linked
from General Insurance Corporation of India and now working as independent company.
Company offers a wide variety of products and also carrying out reinsurance and foreign
operations
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6. Oriental Insurance Company Limited
Oriental Insurance Company Limited was incorporated in 1947 as a subsidiary of
Oriental Government Security Life Assurance Company Limited. In 1956 Oriental Insurance
Company Limited becomes subsidiary of LIC. On 13th May 1971, Government of India took
over the management of all general insurance companies in India, then in 1973, General
insurance business was nationalized and General Insurance company came under the General
Insurance Corporation of India . Then in 2002, the company was de linked from General
Insurance Corporation of India and now working as independent company. Company offers a
wide variety of products and also carrying out reinsurance and foreign operations. The Company
head office is in New Delhi
7. United India Insurance Company Limited
It was one of the subsidiary General Insurance Corporation of India, In 2002, the
company was de-linked from General Insurance Corporation of India and now working as
independent company. Company offers a wide variety of products such as sports insurance,
mediclaim policy, T.V. Policy , Floriculture Insurance, Agricultural Insurance etc. The
Company head office is in Chennai
8. Tata AIG General Insurance Company Limited
It is a joint venture between Tata Group and AIG (American International Group Inc.). Its
paid up capital is Rs. 125 Crores. It is the first Indian Insurance company which offers a
comprehensive policy to cover various risks in the IT sector. Other products offered are property,
casualty, marine, director and officers liability, accident, health, home owners and automobiles
insurance
9. Royal Sundaram General Insurance Company Limited
Royal Sundaram General Insurance Company Limited is a joint venture between Royal
and Sun Alliance Insurance and Sundaram Finance Limited. It started its operations from March
2001. The products offered by the company are:
- Travel Shield
- Accident Shield
- Health Shield
- Home Shield
10. Cholamandalam General Insurance Company Limited
Cholamandalam General Insurance Company Limited is promoted by Chennai based
Murugappa group. The Company has capital of Rs. 105 crores. The products offeres following
products
- Motor Insurance
- Home Insurance
- Electronic Insurance
- Neon Sign Insurance
- Machinery breakdown Insurance
- Marine Insurance
- Pet Insurance
11. Reliance General Insurance Company Limited
It is one of the fastest growing general insurance company in India. Reliance General
Insurance Company Limited is a subsidiary of Reliance Capital. It provide insurance coverage to
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all categories of people and offers a wide range of insurance products. The company has a
unique features covering customers centric products, multiple distribution channels and new
modern technology.
12. Export Credit Guarantee Corporation of India Limited
Export Credit Guarantee Corporation of India Limited was established in 1957 by the
Government of India. It function under the administrative control of the Ministry of Commerce,
Government of India. The main objective was to strengthen the export promotion campaign by
insuring the risk associated with exporting on credit. It is the fifth largest credit insurer of the
world in term of coverage of national exports. The paid up capital of the company is Rs. 500
Crores.
The insurance products offered by the corporation includes
- Turnover Policy
- Small Exporter Policy
- Standard Policy
- Buyer wise Policy
- Insurance cover for buyer’s credit and line of credit service policy
- Construction Work Policy

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 LESSON 2

LIFE INSURANCE
Dr Ashish Kumar
LBSIM
Introduction
Life Insurance is universally acknowledged as a tool to eliminate risk, substitute certainty
for uncertainty and ensure timely aid of the family in the unfortunate event of the death of the
breadwinner. In other words, it is the civilized world's partial solution to the problems caused by
death. In other words, Life insurance is protection against financial loss resulting from insured
Individual’s death. In realistic terms, life insurance provides you and your family the financial
security and certainty to deal with the aftermath of any unseen unfortunate events.
Life Insurance is a contract for payment of a sum of money to the person assured (or
failing him/her, to the person entitled to receive the same) on the happening of the event insured
against. Usually the insurance contract provides for the payment of an amount on the date of
maturity or at specified dates at periodic intervals or at unfortunate death if it occurs earlier.
Obviously, there is a price to be paid for this benefit. Among other things, the contract also
provides for the payment of premiums by the assured.
In a nutshell, life insurance helps in two ways: premature death, which leaves dependent
families to fend for itself and old age without visible means of support. Any person who has
attained majority and is eligible to enter into a valid contract can take out a life insurance policy
for himself / herself. Policies can also be taken out, subject to certain conditions, on the life of
one’s children.
The need for life insurance will change as you grow older. When you are young, you may
believe you have no need for life insurance. But as you grow older, possibly get married and take
on more responsibilities, your desire to take out an insurance policy increases.
What is the reach and significance of Life Insurance as an economic activity?
So long as the maintenance of a family depends on the earning power of the bread-
winner.
So long as the earning can be destroyed by death, old age or disability.
Just so long life as insurance continues to be the keystone of the individual and those who
are dependent on him.
Thus, life insurance is universal and will play a useful role as long as the family set up survives.
Life Insurance caters to an important social need.
Need For Life Insurance
The need for life insurance comes from the need to safeguard our family. If you care for
your family’s needs you will definitely consider insurance. Today insurance has become even
more important due to the disintegration of the prevalent joint family system, a system in which
a number of generations co-existed in harmony, a system in which a sense of financial security
was always there as there were more earning members. Times have changed and the nuclear

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family has emerged. Therefore you need to save a part of income for the future too.This is where
insurance helps us.
Factors such as fewer numbers of earning members, stress, pollution, increased
competition, higher ambitions etc. are some of the reasons why insurance has gained importance
and where insurance plays a successful role. Insurance provides a sense of security to the income
earner as also to the family. Buying insurance frees the individual from unnecessary financial
burden that can otherwise make him spend sleepless nights. The individual has a sense of
consolation that he has something to fall back on. From the very beginning of your life, to your
retirement age insurance can take care of all your needs. Your child needs good education to
mold him into a good citizen. After his schooling he need to go for higher studies, to gain a
professional edge over the others - a necessity in this age where cut-throat competition is the
rule. His career needs have to be fulfilled. Insurance is a must also because of the uncertain
future adversities of life. Accidents, illnesses, disability etc. are facts of life which can be
extremely devastating. Disability can be taken care of by insurance. Your family will not have to
go through the grind due to your present inability.
Moreover, retirement, an age when every individual has almost fulfilled his
responsibilities and looks forward to relaxing can be painful if not planned properly. Have we
considered the increasing inflation and taxes? Will our investment offer us attractive returns
under such circumstances? Will it take care of our family after us? An insurance policy will
definitely take care of these and a lot more. Insurance has become a necessity today. It provides
timely financial as also rewards with bonuses. Life Insurance has come a long way from the
earlier days when it was originally conceived as a risk covering medium for short periods of
time, covering temporary risk situations, such as sea voyages.
Therefore after going through the discussion let us summarize our points and understand
the need of life insurance :
a) Temporary needs / threats: The original purpose of life insurance remains an important
element, namely providing for replacement of income on death etc.
b) Regular Savings / Family Protection: Providing for one's family and oneself, as a medium
to long term exercise (through a series of regular payment of premiums). This has become more
relevant in recent times as people seek financial independence for their family.
c) Investment: Put simply, the building up of savings while safeguarding it from the ravages of
inflation. Unlike regular saving products, investment products are traditionally lump sum
investments, where the individual makes a one off payment.
d) Old age provision: Provision for later years becomes increasingly necessary, especially in a
changing cultural and social environment. One can buy a suitable insurance policy, which will
provide periodical payments in one's old age.
e) Children benefit: Provision for the education, marriage and start in life for the children.
f) Special needs provision: Protection against loss arising out of accident, disability, sickness,
loan repayment on death.
g) Tax benefits: Under the Income Tax Act, premium paid is allowed as a deduction from the
total income under section 80C.

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Why Is Insurance Superior To Other Form Of Savings?
An immediate estate is created in favor of the policy holder
Protection in case of death
Liquidity in case of need
Tax relief – income tax, wealth tax etc.
Policies can be offered as collateral security
Policies can be taken under M.W.P. Act 1874, to protect against creditors
Let us take an example to understand the need for insurance:
Mr. Atul is 45 and self-employed. His wife Nandini, who is a housewife, looks after their two
children aged 3 and 7 years. They stay in a rented accommodation, where the rent is 15,000
rupees per month. Mr. Atul has taken up a loan of Rs. 2 lakh. His monthly earnings on average
are 40,000 rupees. Mr. Atul passes away in an unfortunate road accident. What are some of the
financial implications of his death on his family.
There may be several financial implications on his family. Some of these are:
a) The monthly income, previously provided by Mr. Atul would stop.
b) His wife and children may have to seek financial assistance from other relatives.
c) His wife may not have enough money to pay back the loan of Rs. 2 lakhs.
d) The family may have to move into a cheaper accommodation.
e) His widow may have to take up work to earn money.
f) The education of his children may suffer.

This simple example illustrates the impact premature death can have on a family, where the main
earner has no life cover. Had Mr. Atul taken life cover, his family would not have faced such
hardships in the event of his unfortunate death. A simple life insurance policy could have
provided Mr. Atul's family with a lump sum that could have been invested to provide an income
equal to all or part of his income. In simple words, insurance protects against untimely losses.
Insurance has been found useful in the lives of persons both in the short term and long term.
Short term needs like sudden medical costs and long term needs like marriage expenses etc can
be met with using life insurance.
Basic Principles Of Life Insurance Contract.
Life insurance is a contract under which the insurer (Insurance Company) in
consideration of a premium paid undertakes to pay a fixed sum of money on the death of the
insured or on the expiry of a specified period of time whichever is earlier. So basic principles of
life insurance contract are as follows:
1. Insurable interest: The insured must have insurable interest in the life assured. In absence of
insurable interest, Contract of insurance is void. Insurable interest must be present at the time of
entering into contract with insurance company for life insurance. It is not necessary that the

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assured should have insurable interest at the time of maturity also.Insurable interest exists in the
following cases:
a) A person has an unlimited insurable interest in his/her own life.
b) A person has an insurable interest in the life of his/her spouse.
c) A father has an insurable interest in the life of his son or daughter on whom he is
dependent. Likewise a son may have insurable interest in life of his parents.
d) A creditor has an insurable interest in the life of the debtor, to the extent of the debt.
e) A servant employed for a specified period has insurable interest in the life of his
employer.
2. Utmost good faith: The contract of life insurance is a contract of utmost good faith. The
insured should be open and truthful and should not conceal any material fact in giving
information to the insurance company, while entering into a contract with insurance company.
Misrepresentation or concealment of any fact will entitle the insurer to repudiate the contract if
he wishes to do so.
3. A contract of indemnity: The life insurance contract is not a contract of indemnity. A Contract
of life insurance is not a contract of indemnity. The loss of life cannot be compensated and only
a fixed sum of money is paid in the event of death of the insured. So, the life insurance contract
is not a contract of indemnity. The loss resulting from the death of life assured cannot be
calculated in terms of money.
Types Of Insurance Policies
Though there are a lot of policies available in the market under different names and by
different companies, the policies can broadly be classified into the following categories:
Term Insurance Policy
Whole Life Policy
Universal Life Insurance Policy
Money Back Policy
Endowment Policy
Pension Plans or Annuities
Joint Life Policy
Group Insurance Policy
Unit Linked Insurance Plan
Term Insurance Policy
Term insurance provides life insurance coverage for a specific period of time. Presently
one year, five year, ten year, and fifteen year, are the periods one can buy term life insurance
policy. If the insured person dies during the period the insurance is in force, the insurance
company pays off the face value of the policy. If the insured lives longer than the term of the
policy, the policy is no longer in effect and nothing is paid. Term insurance is the least expensive
form of life insurance. It is commonly used when the insured needs temporary protection or can’t
afford the premiums for the other forms of life insurance. The other reason an insured may want

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term insurance is to purchase life insurance and invest the difference between the term policy
and cash value policy elsewhere.
Term insurance comes in several forms. There is renewable & non – renewable. Non –
renewable means that on the expiry of your policy you must go under another physical test and
filling out another questionnaire. On the other hand, with renewable policy you don’t need to
undergo these formalities again and you automatically re – qualify to continue your policy.Then
there is convertible & non – convertible policy. Convertible policy is the one which can be
converted into a permanent policy, whereas non – convertible is the one which cannot be
converted into a permanent policy or in other words the policy cannot be converted to any other
form of life insurance policy.
Whole Life Policy
The whole life policy provides insurance coverage for the entire life of the insured
regardless of how many years the insurance is paid. Premiums may be paid throughout the
insured’s entire life or for a portion of his life. Additionally, the premium can be paid in one
lump – sum when the policy is taken out. This is referred to as a single premium whole life
policy. When the premium is paid throughout the life it is known as straight life policy, but when
the premium is paid for a specified period of time it is known as limited life policy.
The premiums are higher for Whole life insurance as opposed to term insurance. The
reason for this is that the policy has investment features as well as death benefits. The cash value
portion of the whole life insurance belongs to the insured. One can take it out in the form of
policy loans or can cash the policy in. Another advantage of whole life insurance is that the
premiums are fixed, i.e. regardless of your age, you pay the same amount for the coverage each
year.
Universal Life Insurance Policy
Universal Life is a type of permanent life insurance based on a cash value. That is, the
policy is established with the insurer where premium payments above the cost of insurance are
credited to the cash value. The cash value is credited each month with interest, and the policy is
debited each month by a cost of insurance (COI) charge, and any other policy charges and fees
which are drawn from the cash value if no premium payment is made that month. The interest
credited to the account is determined by the insurer; sometimes it is pegged to a financial index
such as a bond or other interest rate index.
Money Back Policy
Money back policies provide for periodic payments of partial survival benefits during the
term of the policy, as long as the policy holder is alive. An important feature of this type of
policies is that in the event of the death at any time within the policy term, the death claim
comprises the full sum assured, without deduction of any survival benefit amounts, which may
have already been paid as money back components. Similarly the bonus is also calculated on the
entire sum assured.
Endowment Policy
An endowment policy covers the risk for a specified period, at the end of which the sum
assured is paid back to the policy holder, along with the bonus accumulated during the term of
the policy. This feature of payment of endowment to the policy holder when the policy’s term is

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complete is responsible for the popularity of endowment policies. The amount received on
maturity can either be utilized either to buy an annuity policy to generate a monthly pension for
the rest of the life, or put it into any other suitable investment of our choice. This is one
important benefit which the endowment policy offers over a whole life insurance policy.
Overall, endowment policies are the most suitable of all insurance plans for covering the
risks to a family breadwinner’s life. Not only do these policies provide financial risk cover for
the family, were the policy holder to die prematurely but the insurance amount is also repaid
once this risk is over. The endowment amount can then be used for meeting major expenditures
such as children’s education and marriage, etc.
Alternately, the endowment sum is available for a suitable investment geared to
providing an income for the remainder of one’s own life. These types of plans are particularly
suitable to those who other than having a risk cover are also interested in a savings component
simultaneously.
Pension Plan or Annuities
An annuity is an investment that we make, either in a single lump sum or through
installments paid over a certain number of years, in return for which we receive a specific sum
every year, every half – year or every month, either for whole life or a fixed number of years.
After the death of an annuitant or after the fixed annuity period expires for annuity payments, the
invested annuity fund is refunded, perhaps along with a small addition, calculated at that time.
Annuities differ from all the other form of life insurance in one fundamental way – an annuity
does not provide any life insurance cover but, instead offers a guaranteed income either for life
or a certain period.
Typically annuities are bought to generate income during one’s retired life, which is why
they are also called pension plans. Annuity premiums and payments are fixed with reference to
the duration of human life.
Joint Life Policy
Joint life insurance policies are similar to endowment policies as they too offer maturity
benefits to the policyholders, apart form covering risks like all life insurance policies. But joint
life policies are categorized separately as they cover two lives simultaneously, thus offering a
unique advantage in some cases, notably, for a married couple or for partners in a business
firm. Under a joint life policy the sum assured is payable on the first death and again on the
death of the survivor during the term of the policy. Vested bonuses would also be paid besides
the sum assured after the death of the survivor. If one or both the lives survive to the maturity
date, the sum assured as well as the vested bonuses are payable on the maturity date. The
premiums payable cease on the first death or on the expiry of the selected term, whichever is
earlier.
Accident benefits equivalent to the sum assured are available under Joint life insurance
policies on the first death. In case both the lives are covered under Double Accident Benefit
(DAB), the surviving life is covered under DAB until the end of the policy year, in which the
first life dies under the cover of the policy. Both the policy holders can avail these benefits, if
• Both the policy holders die simultaneously owing to an accident. To avoid such an
eventuality, nomination is allowed under the policy OR

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 • Both of them die within the specified period as a result of the same accident OR
• The second policy holder also dies in the same policy year as result of another accident.
To avoid such an eventuality, nomination is allowed under the policy.
Joint life insurance policy is ideal for married couples as it provides financial security and risk
protection to both the individuals.
Group Insurance Policy
Group insurance offers life insurance protection under group policies to various groups
such as employers-employees, professionals, co-operatives, weaker sections of society, etc. It
also provides insurance coverage for people in certain approved occupations at the lowest
possible premium cost. Group insurance plans have low premiums. Such plans are particularly
beneficial to those for whom other regular policies are a costlier proposition. Group insurance
plans extend cover to large segments of the population including those who cannot afford
individual insurance. A number of group insurance schemes have been designed for various
groups. These include employer-employee groups, associations of professionals (such as doctors,
lawyers, chartered accountants etc.), members of cooperative banks, welfare funds, credit
societies and weaker sections of society.
Many employees see group insurance coverage as a major perk for faithful company
service. The premium payments are usually deducted automatically from the pay itself. Some
companies will absorb the entire cost of the policy as a benefit for employees. The main
advantages of the group insurance schemes are low premium and simple insurability conditions.
Premiums are based upon age combination of members, occupation and working conditions of
the group.
A major feature of group insurance is that the premium cost on an individual basis may
not be risk-based. Instead it is the same amount for all the insured persons in the group. Another
distinctive feature is that under group insurance a person will normally remain covered as long as
he or she continues to work for a certain employer and pays their insurance premiums. This is
different from the individual insurance policy where the insurance company often has the right to
reject the renewal of a person's policy, depending on his risk profile.
Unit Linked Insurance Plan
Unit linked insurance plan (ULIP) is life insurance solution that provides for the benefits
of risk protection and flexibility in investment. The investment is denoted as units and is
represented by the value that it has attained called as Net Asset Value (NAV). The policy value
at any time varies according to the value of the underlying assets at the time.
In a ULIP, the invested amount of the premiums after deducting for all the charges and premium
for risk cover under all policies in a particular fund as chosen by the policy holders are pooled
together to form a Unit fund. A Unit is the component of the Fund in a Unit Linked Insurance
Policy.
The returns in a ULIP depend upon the performance of the fund in the capital market.
ULIP investors have the option of investing across various schemes, i.e, diversified equity funds,
balanced funds, debt funds etc. It is important to remember that in a ULIP, the investment risk is
generally borne by the investor. In a ULIP, investors have the choice of investing in a lump sum
(single premium) or making premium payments on an annual, half-yearly, quarterly or monthly
basis. Investors also have the flexibility to alter the premium amount during the policy's tenure.

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For example, if an individual has surplus funds, he can enhance the contribution in ULIP.
Conversely an individual faced with a liquidity crunch has the option of paying a lower amount
(the difference being adjusted in the accumulated value of his ULIP). ULIP investors can shift
their investments across various plans/asset classes (diversified equity funds, balanced funds,
debt funds) either at a nominal or no cost. Expenses Charged in a ULIP are as follows:
Premium Allocation Charge: A percentage of the premium is appropriated towards charges
initial and renewal expenses apart from commission expenses before allocating the units under
the policy.
• Mortality Charges: These are charges for the cost of insurance coverage and depend on
number of factors such as age, amount of coverage, state of health etc.
• Fund Management Fees: Fees levied for management of the fund and is deducted before
arriving at the NAV.
• Administration Charges: This is the charge for administration of the plan and is levied by
cancellation of units.
• Surrender Charges: Deducted for premature partial or full encashment of units.
Fund Switching Charge: Usually a limited number of fund switches are allowed each
year without charge, with subsequent switches, subject to a charge.
• Service Tax Deductions: Service tax is deducted from the risk portion of the premium.
Pricing
For life insurance policy you must pay a price in terms of premium. All insurance
companies employ actuaries to fix the premiums of their policies. The actuaries need to consider
various factors (both measurable and non-measurable) and build them into the premiums. There
are some factors that the actuaries already have information on (like mortality rate, claims paid
percentages, etc.,) and the rest of the information comes from the applicant. We will first look at
the information provided by the applicants that play a part in Life Insurance Price, one by one.
• Age: Young, fit people who are just about to begin the most productive part of their lives
are the ones who get the cheapest policies. The premium component gradually increases
as the age of the applicant progresses. There is no intentional discrimination here against
older people. Mortality trends state that the chances of mortality increase is directly
proportional to age increase and the insurance companies base their calculations on the
age risk factor. So, the older you are the higher you pay!
• Type of policy: There are various types of policies; term, partial payment, pension plans,
cash value…..etc., As a general rule, you can be sure that premiums increase directly
proportional to the cash value benefits and complexity. Term plans are the cheapest and
any other investment based policy will cost you higher. The coverage amount also plays a
part. Higher the coverage, higher the premium.
• Duration of the policy: This plays a more important part in wealth building insurance
policies but even otherwise, longer duration policies are priced cheaper.
• Medical history and health: History of previous illness is a risk while underwriting a
policy and therefore carries such people carry higher premium. This is a very important
factor and if an applicant has illness history or have existing ailments, they have to be
disclosed to the company, otherwise, the insurance company will outright reject the claim
(when the need arises) citing suppression of vital information. Height and weight details
are also used as factors.

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 • Personal habits and occupation: Habitual smokers and drinkers will be charged higher, as
will people employed in hazardous jobs (Fire fighters, scuba divers). Some hobbies
(bungee jumping, car racing) are also deemed high risk and will attract higher premiums.
• Other factors: Apart from the information provided by the applicant, the insurance
actuaries need to input many other factors listed below:
o Mortality – Life insurance is based on the sharing of the risk of death by a large
group of people. The amount at risk must be known to predict the cost to each
member of the group. Mortality tables are used to give the company a basic
estimate of how much money it will need to pay for death claims each year. By
using a mortality table a life insurer can determine the average life expectancy for
each age group.
o Interest – The second factor used in calculating the premium is interest earnings.
Companies invest your premiums in bonds, stocks, mortgages, real estate, etc.,
and assume they will earn a certain rate of interest on these invested funds.
o Expense – The third consideration is the expenses of operating the company.
The company estimates such expenses as salaries, agents’ compensation, rent,
legal fees, postage, etc. The amount charged to cover each policy’s share of
expenses of operation is called the expense loading. This is a cost area that can
vary from company to company based on its operations and efficiency
Underwriting
The process of assessing the risk profile of the life insurance applicant whether individual
or group and then fixing the rate of premium is called risk classification or underwriting. The
methods by which an insurer manages risks are:
[a] Risk avoidance
[b] Risk transfer
[c] Risk sharing, and
[d] Risk acceptance and management.
Risk acceptance would be through a process of underwriting. The typical underwriting decisions
[on a proposal] of a life insurer are as follows:
• Accepted [on ordinary terms/rates], that is, the insurer has decided to undertake the risk
on the proposed life on standard terms of the company.
• Accepted [on terms other than those suggested] and offered some other plan /term / other
condition like imposing an extra premium to meet higher health/occupation risk etc. for
undertaking risk on the proposed life.
• Postponed, consideration of the proposal is postponed anticipating that the effects of
some of the high risk factors faced by the proposed life may come down in future.
• Declined, the proposed life would almost definitely result in a claim by death within the
proposed term.
Underwriters of insurance Companies arrive at the above decisions, or rather conclusions, based
on the analysis of the risks they are likely to face on the life of the proposer or applicant for
insurance. Risks on a life are associated with his family history, personal history, individual and
social habits, occupation, hobbies and the future possibilities of joining the armed forces or Para

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trooping, diving or hazardous researches etc. Broadly speaking these factors usually consider for
appraising the risk of an applicant:
• Age
• Sex (except in several states that require "uni-sex" rates, even though actuarial data
shows women live longer than men)
• Height and weight,
• Health history (and often family health history -- parents and siblings),
• The purpose of the insurance (such as for estate planning, or business or for family
protection)
• Marital status and number of children
• The amount of insurance the applicant already has, and any additional insurance s/he
proposes to buy (as people with far more life insurance than they need tend to be poor
insurance risks)
• Occupation (some are hazardous, and increase the risk of death)
• Income (to help determine suitability)
• Smoking or tobacco use (this is an important factor, as smokers have shorter lives)
• Alcohol (excessive drinking seriously hurts life expectancy)
• Certain hobbies (such as race car driving, hang-gliding, piloting non-commercial aircraft)
and
• Foreign travel (certain foreign travel is risky).

The guidelines and regulations for underwriting are different for different insurance
companies. As mentioned above, the life insurance underwriting process takes a series of factors
into consideration to decide the premium amount for an applicant for a particular coverage
policy. After an individual applies for a life insurance quote, the insurance company will
circulate a questionnaire form that the applicant has to fill up with the answers. Underwriting is
confidential, which is maintained under strict regulations. Depending upon the underwriting
standards of the insurance company, the questions may vary. After the applicant fills up the
answers to these queries, the form is sent back to the insurance company.
Once the form is received, the underwriters of the life insurance company review the risk
profile of the applicant and accordingly, the final premium amount is charged to the
policyholder. In general there are four categories of risks, which are classified according to the
standard underwriting guidelines. The four risk classifications include proffered (charge with low
premium), standard (standard premium amount), rated (relatively high premium amount) and
declined (uninsurable). This way, life insurance underwriting process is a crucial step to
calculate the premium amount for policyholders.
For better understanding about life insurance underwriting, let's take an example of two
individuals applying for the same life insurance quote. Let's consider that first is below 30 years
without any underlying health condition (low death risk), while the second applicant is above 45
years with hypertension condition (high death risk). With underwriting process, the death risks
for the two applicants are examined, after which the insurance company will charge a low
premium for the first applicant (preferred), while charging a higher premium rate for the second
policyholder (rated).

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Documentation
The contract for the life insurance starts with the proposal made by the proposer in
standard application form available with insurance company and then various other documents
are prepared.
Proposal Forms
The proposal form is a standardized form. The proposal form is a type of an application form,
which a proposer has to fill all the relevant details about the life to be assured. The agent has the
proposal form with him provided by the insurer. There are different types of policies and so the
different types of proposal forms are there. It has the entire details regarding the duration of the
policy, type of plan, mode of payment, etc. A proposal form is to be to be completed by the
proposer in his own handwriting and signed in the presence of the agent. The proposal form
contains a declaration at the end, to ensure the authenticity of the information given.
Usually the proposal form contains the following information to be filled by the
prospective insured:
1. Name of life assured
2. Address
3. Date of Birth
4. Occupation
5. Age
6. Name of the employer (if any)
7. Sum assured of the proposed policy
8. Number and age of the family members
9. Family medical history
10. Proposer’s Medical history
Besides these there are other related forms regarding health, occupation, the agent’s confidential
report and many others. In addition there is a consent letter which shows the consent of the life
assured to the imposition of some clause or extra premium, duly signed by the life assured.
First Premium Receipt
The agent provides the proposal form and other related documents and the underwriter
examines the form and other documents and then determines the terms on which to accept the
risk or reject the same. The consent of the person assured is obtained in the form of payment of
premium. After receiving the payment, the insurance company issues the First Premium Receipt,
which acknowledges the proposal of the life-assured. It contains all particulars of the policy. It
has the details of the next premium to be paid. The policy bond is sent within 45-50 days from
the date of first premium receipt to the life assured. The First Premium Receipt is an important
and powerful document on the basis of which the life-assured can ask the insurer to issue the
policy bond, which is treated as Evidence of the Contract of Life assurance.
Policy Bond

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 After issuing the First Premium Receipt, the next step is that of the insurer of sending the
policy bond to the life-assured and this document is also known as Policy Contract, which is the
ultimate evidence of the life-assured. The Policy Contract contains all the terms and conditions
of the contract between insurance company and the life assured, duly stamped as per the Indian
Stamp Act. The policy is sent to the life assured by the insurer. The policy contract contains the
details of the insurance such as duration of the policy, the type of policy, sum assured, premium
amount and the date of maturity, extra premium, nominee, assignee etc.
Alterations and Endorsements
Endorsement is an authenticated noting on the back of Policy Contract and forms a part
of the contract. In the case of lack of space, the endorsements can be put on a separated sheet of
papers and attached to the policy. Endorsements are required because life assurance is a long-
term contract and the life assured may want certain changes in the terms of contract. There are
different type of alterations or modifications that can be made during the tenure of the policy
such as changes regarding increase or reduction in the sum assured, mode of payment of
premium, modification related on account of mistakes in the preparation of the policy by the
insurer, modifications related to reduction in term, conversion from “Non-profit” to “With
Profit” and similar other like change of name, plan-term and so on.
Reminding Notice
It is basically information sent by the insurer to the policyholder, reminding the latter
about the due date of a particular premium and the amount of premium. However it is not the
duty of the insurance company (insurer) to do so. The insurer also informs the policyholder about
the lapse of a policy if the premiums are not paid in time.
Other Documents
Apart from other documents there are some other specialized documents, which are as
follows:
i. Proposal on the lives of Non Resident Indians, which consists of some special
questionnaire asking for relevant information.
ii. Partnership Insurance which consist of papers asking for the Profit & Loss account of the
firm for the last three years, the insurance of the partner, the partnership deed and the
deed of variation allowing the purchase of the assurance policy.
Policy Servicing And Settlement Options
Servicing of policy holders include:
(1) Proof of age: The age of the life assured must be proved either during the period of the
policy or after the claim arises, because age is an important factor for calculating at the rate of
premium to be charged for a particular policy.
(2) Nomination: The Policyholder should be advised for nomination, if no nomination was
effected. When nomination or assignment is effected by a policyholder, it should be scrutinized
thoroughly to see whether it was in order or not. If there is any material omission or mistake, it
may be returned to the policyholder or the assignee with a covering letter giving instructions as
to the corrections to be made in the assignment or nomination. When a document is sent for
correction, reminders should be sent every fortnight until the requirements are complied with.
The policyholder should follow the instructions printed on the back of assignment or nomination.

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(3) Assignment: Assignment is a means whereby the right and title under a policy gets
transferred from assignor to assignee. Assignor is the policyholder who transfers the title and
assignee is the person who gets the title of the policy from the assignor. Assignment can be made
either by endorsement on the policy or on a separate paper duly stamped. Assignor must be a
major. Assignment must be in writing and assignor’s signature along with a witness is required.
Notice of assignment should be submitted to the insurer by the assignor.
(4) Alteration / Changes: After issue of a Policy, the Policy holder desires an alteration in the
terms thereof to suit his convenience, e.g., an alteration in the mode of payment of premiums,
Plan of Assurance, reduction in the premium-paying period, etc. An alteration may be allowed
provided the policy is in force and has not become fully paid up. It is stated in the prospectus that
no alteration from one class of Assurance to another subject to a lower scale of premium is
permissible. However, an alteration from the with profits Limited Payment plan to the with
profits Endowment Assurance Plan with premiums payable for a term not exceeding the original
premium-paying term will be allowed even if the premium payable on alteration is lower.
Alterations from certain Classes of Assurance to certain other Classes are not allowed at all.
(5) Paid up value & surrender value: When a policyholder wants to terminate the policy, he
may convert the same into paid-up policy. In this case, the amount of paid-up value is payable to
the insured only after the full term (maturity) of the policy. The option of converting the policy
into paid up policy and stop paying the further premiums can be taken only if the policy has been
in force for at least two years.
If the insured is unwilling or unable to pay the premium of the policy, he may surrender
the policy and ask for its surrender value. Surrender value is the cash value payable by the
insurance on voluntary termination of the policy contract by the life assured before the expiry of
the term of the policy. Surrender value depends on the type of policy and number of premia paid.
A policy can be surrendered only when the premia is paid for the three years.
Settlement:
The easy and timely settlement of a valid claim is an important function of an insurance
company. The yardstick to judge insurance company’s efficiency is as to how quick the claim
settlement is. The speed, kindness and fairness with which an insurer handles claims show the
maturity of the company and may lead to great satisfaction of the client. In every insurance
company claim handling is of immense importance. It is the liability of the insurance company to
honour valid and legal claims. At the same the company must identify the fraudulent and invalid
claims. A claim may arise:
• On death of Policyholder before the maturity date.
• On maturity, i.e. after expiry of the endowment period specified in the policy contract
when the policy money becomes payable.

Certain features are common to all life insurance claims. These are:
1. Policy must be in force at the time of claims.
2. Insured must be covered by the policy.
3. Nothing was outstanding to the insurer at the time of claim.

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4. Claim is covered by the policy.
Death Claims
I. Intimation of Death
The death of the life assured has to be intimated in writing to the insurer. It can be done
by the Assignee or nominee under the policy or from a person representing such Assignee or
Nominee or when there is no nomination or assignment by a relative of the life assured, the
employer, the agent or the development officer. Where policy is assigned to a creditor or a bank
for valuable consideration, intimation of death may be received from such assignee. Sometimes,
the office need not wait till the intimation of claim is received. The concerned agent, newspaper
reports in case of accidents or air crashes, obituary columns may give information and claim
action can be started. However, the identity of the deceased should be established carefully. The
intimation of the death of the life assured by the claimant should contain the following
particulars: (1) his or her relationship with the deceased, (2) the name of the policyholder, (3) the
number/s of the policy/policies, (4) the date of death (5) the cause of death and (6) sum assured
etc. If any of these particulars are missing the claimant can be asked to furnish the same to the
insurer. The intimation must satisfy two conditions (1) It must establish properly the identity of
the deceased person as the life assured under the policy, (2) It must be from a concerned person.
II. Proof of Death and Other Documents
In case of claim by death, after the receiving the intimation of death the insurance
company ensures that the insurance policy has been in force for the sum assured on the date of
death and the intimation has been received from assignee, nominee or other claimant.
The following documents are required:
(i) Certificate of death.
(ii) Proof of age of the life assured (if not already given).
(iii) Deeds of assignment / reassignments.
(iv) Policy document.
(v) Form of discharge.
If the claim has accrued within three years from the beginning of the policy, the following
additional requirements may be called for:
a) Statement from the hospital if the deceased had been admitted to hospital.
b) Certificate of medical attendant of the deceased giving details of his/her last illness.
c) Certificate of cremation or burial to be given by a person of known character and
responsibility present at the cremation or burial of the body of the deceased.
d) Certificate by employer if the deceased was an employee.
Proof of death and other documents to be submitted will depend upon the cause of death and
circumstances of each case.
1. In case of an air crash the certificate from the airline authorities would be necessary
certifying that the assured was a passenger on the plane. In case of ship accident a
certified extract from the logbook of the ship is required. In case of sudden cardiac arrest,
murder the doctors’ certificate may not be available.

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 2. The insurance may waive strict evidence of title if the sum assured of the policy is small
and there is no dispute among the survivors of the policy moneys.
3. If the life assured had a death due to accident, suicide or unknown cause the police
inquest report, panchanama, post mortem report, etc would be required.
If by any chance policy contract is lost, advertisement of the lost of policy is to be given.
Payment can be made on the basis of an indemnity given by the policyholder. If the deceased has
taken out policies with more than one branch and the claimant has produced proof of death to
any one of them and desires that the other branch or branches, may act on the same proof, his
request should be complied with. The Branch requiring proof of death should directly call for the
certified copies from the branch concerned.
III. Net Payable Amount of Claim
After receiving the required documents the company calculates the amount payable under
the policy. For this purpose, a form is filled in which the particulars of the policy, assignment,
nomination, bonus etc. should be entered by reference to the Policy Ledger Sheet. If a loan exists
under the policy, then the section dealing with loan is contacted to give the details of outstanding
loan and interest amount, which is deducted from the gross policy amount to calculate net
payable claim amount. The net amount of claim payable is calculated and is called payment
voucher. In the case of ‘in force’ policy unpaid premiums if any due before the Assured’s death
with late fee where necessary and the premium falling due in the policy year current at the time
of death should be deducted from the claim amount.
Maturity Claims
If the life insured survives to the full term, then basic sum assured is payable. This
payment by the insurer to the insured on the date of maturity is called maturity payment. The
amount payable at the time of the maturity includes a sum assured and bonus/incentives. The
insurer sends in advance the intimation to the insured with a blank discharge form for filling
various details in it. It is to be returned to the office along with
• Original Policy document
• Age proof if age is not already submitted
• Assignment /reassignment, if any. .
Legally no claim is acceptable in respect for a lapsed policy or death of the Life assured
happening within 3 years from the date of beginning of the policy. However, some concessions
are given and payment of claims is made:
• If the Life assured had paid at least 3 years' premiums and thereafter if premiums have
not been paid, the nominees/life assured get proportionate paid up value.
• In the event of the death of' the Life assured within 3 years and the policy is under the
lapsed position, nothing is payable.
Procedure of the Maturity Claims
Settlement procedure for maturity claim is simple after receipt of completed and stamped
discharge form from the person entitled to the policy money along with policy documents, claim
amount will be paid by account payee cheque.

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 • If the life assured is reported to have died after the date of maturity but before the receipt
is discharged, the claim is to be treated as the maturity claim and paid to the legal heirs.
In this case death certificate and evidence of title is required.
• Where the assured is known to be mentally deranged, a certificate from the court of law
under the Indian Lunacy Act appointing a person to act as guardian to manage the
properties of the lunatic should be called.
Additional Benefits apart from Regular Claims
Double Accident Benefit: For claiming the benefits under the Double Accident Benefit the
claimant has to produce the proof to the satisfaction of the Corporation that the accident is
defined as per the policy conditions. Normally for claiming this benefit documents like FIR,
Post-mortem Report are required.
Disability Benefit Claims include waiver of all premiums to be paid in future till the expiry of the
policy of the life assured if a person is totally and permanently disabled and cannot earn any
wage/compensation/profit as a result of the accident.
Presently, all over the country there are 12 centers where the Insurance Ombudsman has
been appointed. They are part of grievance redressal machinery. They consider the complaints
regarding disputes related to premiums, claims etc.
Distribution Channel
The channel of distribution (place) is an important ingredient of marketing mix as
however useful the product might be and how so ever suitable its price be, unless and until the
products/services are mad available to consumers at ‘centres of convenient buying’ the
consumers will not be buying the same. Insurance being a service business requires marketing
department to play a key role in delivery of service.
The marketing department conducts research for identification of target customers, help
in maintaining and promoting the distribution system and also plays an active role in
development of new products. It is the most vibrant department in an insurance organization
since it has to necessarily deal with all the other department of the organization. Insurance
business is business of law of large numbers. The law requires the insurer to attract a sufficient
number of exposures to allow credible ratio prediction.
The major task of sales managers in charge of the sales section of insurance company is
the supervision of the sales functions of the branches. This section is also responsible for
spreading awareness among the general public about the benefits of life Insurance. Sales training
section is entrusted with responsibility for training in product, in selling and sales planning in the
personnel such as development officers and agents.
Insurance policies are mainly sold by the agents of insurance company. Beside insurance
agents, Banks and cooperative societies have emerged as strong business partners amongst
alternate channels in terms of first premium mobilization.
Life Insurance Sector In India
In India, insurance has a deep-rooted history. It finds mention in the writings of Manu (
Manusmrithi ), Yagnavalkya ( Dharmasastra ) and Kautilya ( Arthasastra ). The writings talk in
terms of pooling of resources that could be re-distributed in times of calamities such as fire,

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floods, epidemics and famine. This was probably a pre-cursor to modern day insurance. Ancient
Indian history has preserved the earliest traces of insurance in the form of marine trade loans and
carriers’ contracts. Insurance in India has evolved over time heavily drawing from other
countries, England in particular.
1818 saw the advent of life insurance business in India with the establishment of the
Oriental Life Insurance Company in Calcutta. This Company however failed in 1834. In 1829,
the Madras Equitable had begun transacting life insurance business in the Madras Presidency.
1870 saw the enactment of the British Insurance Act and in the last three decades of the
nineteenth century, the Bombay Mutual (1871), Oriental (1874) and Empire of India (1897) were
started in the Bombay Residency. This era, however, was dominated by foreign insurance offices
which did good business in India, namely Albert Life Assurance, Royal Insurance, Liverpool and
London Globe Insurance and the Indian offices were up for hard competition from the foreign
companies.
In 1914, the Government of India started publishing returns of Insurance Companies in
India. The Indian Life Assurance Companies Act, 1912 was the first statutory measure to
regulate life business. In 1928, the Indian Insurance Companies Act was enacted to enable the
Government to collect statistical information about both life and non-life business transacted in
India by Indian and foreign insurers including provident insurance societies. In 1938, with a view
to protecting the interest of the Insurance public, the earlier legislation was consolidated and
amended by the Insurance Act, 1938 with comprehensive provisions for effective control over
the activities of insurers.
The Insurance Amendment Act of 1950 abolished Principal Agencies. However, there
were a large number of insurance companies and the level of competition was high. There were
also allegations of unfair trade practices. The Government of India, therefore, decided to
nationalize insurance business. An Ordinance was issued on 19th January, 1956 nationalising the
Life Insurance sector and Life Insurance Corporation came into existence in the same year. The
LIC absorbed 154 Indian, 16 non-Indian insurers as also 75 provident societies—245 Indian and
foreign insurers in all. The LIC had monopoly till the late 90s when the Insurance sector was
reopened to the private sector.
Following the recommendations of the Malhotra Committee report, in 1999, the
Insurance Regulatory and Development Authority (IRDA) was constituted as an autonomous
body to regulate and develop the insurance industry. The IRDA was incorporated as a statutory
body in April, 2000. The key objectives of the IRDA include promotion of competition so as to
enhance customer satisfaction through increased consumer choice and lower premiums, while
ensuring the financial security of the insurance market.
The IRDA opened up the market in August 2000 with the invitation for application for
registrations. Foreign companies were allowed ownership of up to 26%. The Authority has the
power to frame regulations under Section 114A of the Insurance Act, 1938 and has from 2000
onwards framed various regulations ranging from registration of companies for carrying on
insurance business to protection of policyholders’ interests. In December, 2000, the subsidiaries
of the General Insurance Corporation of India were restructured as independent companies and at
the same time GIC was converted into a national re-insurer. Parliament passed a bill de-linking
the four subsidiaries from GIC in July, 2002. Today there are 24 general insurance companies
including the ECGC and Agriculture Insurance Corporation of India and 23 life insurance

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companies operating in the country. The insurance sector is a colossal one and is growing at a
speedy rate of 15-20%. Together with banking services, insurance services add about 7% to the
country’s GDP. A well-developed and evolved insurance sector is a boon for economic
development as it provides long- term funds for infrastructure development at the same time
strengthening the risk taking ability of the country.
Check List For Buying The Right Policy
DO’S
Look out for no commission policies.
“ low load “ life insurance policies have fewer expenses built into them, such as agent
commissions and fees for marketing. This can translate into lower premiums or for
variable life insurance, these lower expenses mean that a higher percentage of your
premium goes to work for you right away so that you can build your cash faster.
Buy as soon as the need exists
An advantage to buy life insurance earlier in life is that your premiums will be low. As
you grow old, the likelihood that you will die increases, which is why older individuals
pay more for life insurance.
DONT’S
Don’t buy a guaranteed issue policy if you are healthy
“ Guaranteed issue” term life insurance policies normally require no medical exam and
are sold to anyone who comes along. While these policies can be a great way for people
who have medical problems to obtain a life insurance policy, if you are healthy don’t buy
these policies as you will get better rates by taking the tests.
Don’t buy more or less than you need
Many experts say the best way to pinpoint a smart life insurance benefit amount is
through a needs analysis which can be broken into a simple formula
Short term needs + long term needs – resources = how much life insurance you need
Self-Assessment:
1. Explain Fundamental Principles of Life Insurance contract.
2. Discuss various documents prepared by the insurance company while entering a life
insurance contract with the proposer.
3. Explain the procedure of settlement of claims in case of maturity of the policy.
4. Explain the claim settlement procedure in case of death of the assured.
5. Explain the procedure of underwriting of new business.
6. Discuss various life insurance pricing elements.
References:
• Mishra M.N., Life Insurance, Administration and Management, Sultan Chand & Co.,
New Delhi.
• Gupta C.B., Business Organization and Management, 2005, Sultan Chand & Co., New
Delhi.

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• Gupta P.K. ‘Insurance and Risk Management’, 2005, Himalaya Publishing House, New
Delhi.
• Ray R.M. ‘Life Insurance in India’, 1999, Indian Institute of Public Administration.
• Mann T.S., ‘Law and Practice of life Insurance in India’, 2000, Deep and Deep
Publication, New Delhi.
• www.licindia.com
• www.irdaindia.org

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 LESSON 3
UNDERSTANDING OF THE ANNUAL REPORT
OF LIFE INSURANCE COMPANIES
Dr Ashish Kumar
LBSIM
Introduction:
The primary legislations including the Insurance Act, 1938 and the IRDA Act, 1999 that deal with
insurance business in India provide the legal framework of insurance accounting in India, over and
above the principles and practices prescribed by Generally Accepted Accounting Principles (GAAP)
and the various Accounting Standards (AS) issued by the Institute of Chartered Accountants of
India(ICAI) and the international organization Financial Accounting Standards Board (FASB).
However, the following statutes, rules and regulations are the major considerations for accounting and
financial management for insurance companies in India:
1. The Insurance Act, 1938 and Insurance Rules, 1939
2. The Insurance Regulatory and Development Authority Act, 1999
3. The Companies Act, 1956
4. The Life Insurance Corporation Act, 1956
5. The General Insurance Business (Nationalization) Act, 1972
Section 11 of the Insurance Act, 1938 provides that every insurer, on or after the commencement of
the IRDA Act, 1999 in respect of insurance business transacted by him and in respect of his
shareholders' fund, shall at the expiration of each financial year, prepare a Balance Sheet, a Profit and
Loss account, a separate Account of Receipts and Payments (Cash Flow Statement), Revenue
Accounts in accordance with the regulations made by the Authority. Every Insurer shall keep separate
accounts relating to funds of shareholders and policyholders.

Accounting Regulations and Financial Statements:

The IRDA (Preparation of Financial Statements and Auditor's Report of Insurance Companies)
Regulations, 2002 provide that-
• An insurer carrying on life insurance business shall comply with the requirements of Schedule' A' to
prepare financial statements.
• An insurer carrying on general insurance business shall comply with the requirements of Schedule
'B' to prepare financial statements.
• The Report of the Auditors on the Financial Statements of every insurer/ re-insurer shall be in
conformity with the requirements of Schedule 'C'.
The said regulation further provides that financial statements comprising (i) Balance Sheet, (ii)
Receipts and Payments Account (Cash Flow Statement) (iii) Profit & Loss Account (Shareholders'
Account) and (iv) Revenue Account (policyholders' Account) shall be in conformity with the
Accounting Standards (AS) issued by the Institute of Chartered Accountants of India to the extent
applicable to the insurer except that:
• Accounting Standard 3-Cash-flow Statement shall be only under Direct Method
• Accounting Standard 13-Accounting for Investment shall not be applicable
• Accounting Standard 17-Segment reporting shall apply to all insurers irrespective of the
requirements for listing and turnover mentioned therein.

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 Section 2C of the Regulation provides that all words and expressions used herein and not
defined in the Insurance Act, 1938 or in the IRDAAct, 1999 or in the Companies Act, 1956 shall have
the meanings respectively assigned to those Acts. However, regulatory provisions prescribed by the
IRDA and the specific and relevant Accounting Standards promulgated by the Institute of Charted
Accountants of India are being separately discussed in detail in subsequent units.
Financial statements of insurance companies comprise the following as stated earlier:
• Balance sheet,
• Revenue accounts,
• Profit and loss account, and
• Receipts and payments account
Besides the financial statements, the annual reports of an insurance company also contain the
following statutory documents for the review and analysis of the various interested groups including
shareholders, policyholders, regulators, reinsurers, employees, co-insurers, etc.
1. Report of the board of directors
2. Management report
3. Auditors report
4. Segment reporting
5. Significant accounting policies
6. Notes and disclosures forming part of accounts
Let us now discuss the above financial statements and reports with reference to legal
requirements, accepted principles and practices with a few examples and exercises. Certain examples
with hypothetical data are also given in Annexure for clarity of understanding of students in respect of
financial statements
Directors’ Report: legal Requirement as Regards Directors’ Report (Companies Act 1956)
As per Section 217 of the Companies Act, 1956 there shall be attached to every balance sheet
laid before a company general meeting a report by its Board of Directors with respect to following
particulars:
• The state of affairs of the company.
• The amounts, if any, which it proposes to carry to any reserve in balance sheet.
• The amount, if any, which it recommends, should be paid by way of dividend.
• The material changes and commitments, if any, affecting the financial position of the company,
which have occurred between the end of the financial year of the company to which the
balance relates and the date of the report.
• The technology absorption, foreign exchange earnings and outgo and the manners thereof.
• The material changes, if occurred during the financial year in respect of the nature and class of
business of the company or its subsidiary.

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 • The statement showing the name of every employee of the company who, if employed
throughout the financial year, was in receipt of remuneration for that year, which in the
aggregate was not less than Rs. 24,00,000 per annum or if employed for a part of the financial
year was not less than Rs. 2,00,000 per month. Such state shall also indicate that whether any
such employee is a relative of any director or manager of the company.
• The Directors' Responsibility Statement must mention that
a) In the preparation of the annual accounts, the applicable accounting standards have
been followed along with proper explanations relating to material departure,
b) The directors had selected such accounting policies and applied them consistently,
c) The results and estimates are reasonable and prudent so as to give.a true and fair view
of the state of affairs of the company at the end of the financial year and of the profit or
loss of the company for that period,
d) That the directors had taken proper and sufficient care for the maintenance of adequate
accounting records in accordance with the provisions of the Companies Act, 1956 for
safeguarding the assets of the company and for preventing and detecting frauds and
other irregularities and that the directors had prepared the annual accounts on a going
concern basis.
• The reasons for the failure, if any, to complete the buy back within the time specified in
Section 77 A of the Act.
• The fullest and explanations on every reservation, qualification or adverse remarks contained
in the auditors' report.

Common Disclosures in Directors’ Report Contained in the Annual Report of a General

Insurance Company:
Director report of an insurance company generally furnishes the following information specifically as
per the above requirements of the Companies Act, 1956:
1. Comparative Performance Analysis (Class-wise Underwriting Performance) for the financial
year under report with reference to previous year) as appended in Annexure A.2 showing
performance analysis of XYZ General Insurance Co. Ltd. in respect of the following
performance review for FY 2005-06.
• Gross direct premium and percentage of growth over previous year
• Reinsurance premium ceded
• Reinsurance accepted
• Net premium and percentage of growth over previous year
• Increase in unexpired risks reserve and percentage to net premium
• Net premium earned
• Net incurred claims and percentage to net premium
• Others
2. Review of accounts as an annexure to accounts
3. Profit before tax and after tax
4. Proposed dividend
5. General reserves and current year transfer of profit to that reserve
6. Total assets and the contribution of increase of fair value change account

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 7. Total investments, its composition/portfolio, its increase over the last year
8. Solvency margin and its change over the previous year
9. Compliance with Section 40C in regard to prescribed % of expenses

Financial Statements:
As mentioned earlier, as per the IRDA (Preparation of Financial Statements and Auditors'
Report of Insurance companies) Regulations, 2000, an insurer shall prepare the Financial Statements
including Balance sheet, Revenue Account (Policyholders Account), Receipts and Payments
Account (Cash Flow Statements) and Profit and Loss Account (Shareholders' account) as
Accounting Standard (AS) issued by the ICAI to the extent applicable to the insurers except that:
1. Accounting Standard 3 (AS 3) and Accounting Standard 17 (AS 17) in case of insurers carrying
on life insurance business
2. Accounting Standard 3 (AS 3), Accounting Standard 13 (AS 13) and Accounting Standard 17
(AS17) in case of insurers carrying on non-life insurance business

Cash flow statements will be prepared only under direct method and segment reporting shall apply
irrespective of whether the securities of the insurer are traded publicly or not in both the cases and in
case of non-life insurance company AS 13-Accounting for investments shall not be applicable.

Financial Statements for life Insurers:

Life Insurers shall prepare Financial Statements as per specified Forms such as Revenue
Account (Form A-RA), Profit and Loss Account (Form A-PL) and Balance Sheet (Form A-BS) as per
Part V in Schedule A of Regulation III. The said financial statements will be prepared in accordance
with General Instructions for preparations as per Part III. The said financial statements shall be
supported by disclosures forming part of financial statements and the comments of management report
as per Part II and Part IV respectively, of the Schedule A. The specified forms of financial statements
are given hereinafter as ready reference.
Form A-BS
Balance Sheet of Life Insurance Company

Current Previous
Particulars Schedule No.
Year Year
SOURCES OF FUNDS
Shareholders' Funds:
Share capital
Reserves and surplus
Credit/debit fair value change account
Sub-total
Borrowings
Policyholders' Funds:
Credit/debit fair value change account
Policy liabilities
Insurance reserves
Provision for linked

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liabilities
Sub-total
Funds for Future Appropriations
Total (Sources of Funds)
APPLICATION OF
FUNDS
Investments
Shareholders'
Policyholders'
Assets Held to Cover linked liabilities
loans
Fixed Assets
Current Assets
Cash & bank balances
Advances and other assets
Sub-total (A)
Current liabilities
Provisions
Sub-total (B)
Net Current Assets (C ) = (A-B)
Miscellaneous Expenditure (not written off)
Debit Balance in Profit & loss Account
(Shareholders' account)
Total (application of

Form A-RA
Revenue Account of Life Insurance Company
Policyholder’s Account

Particulars Schedule Current Previous

Premiums Earned-(Net)
(a) Premium 1
(b) Reinsurance ceded
(c) Reinsurance accepted
Income from Investments
(a) Interest, dividends & rent-(Gross)
(b) Profit on sale/redemption of investments
(c) Loss on sale/redemption of investments
(d) Transfer/Gain on revaluation/change in fair value*
Other Income (to be Specified)
TOTAL (A)
Commission 2
Operating Expenses Related to Insurance Business 3

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 Provision for DoubUul Debts
Bad debts written off
Provision for Tax
Provisions (other than taxation)
(a) For diminution in the value of
(b) Others (to be specified)
TOTAL (B)
Benefits Paid (Net) 4
Interim Bonuses Paid
Change in Valuation of liability in Respect of life
Policies
(a) Gross
(b) Amount ceded in reinsurance
(c) Amount accepted in reinsurance
TOTAL (C)
Surplus/Deficit (D) = (A)-(B)-(C)
APPROPRIATIONS
Transfer to Shareholders' Account
Transfer to Other Reserves (to be Specified)
Balance Being Funds for Future Appropriations
TOTAL (D)

The above financial statements are to be prepared in accordance with applicable accounting standard
issued by leAL These financial statements will be supported by specified schedules giving the required
details as per regulations.

Disclosures forming part of financial statements (Life Insurer) Part II

A. The following shall be disclosed by way of notes to the balance sheet:
1. Contingent liabilities:
• Partly-paid up investments
• Underwriting commitments outstanding
• Claims, other than those under policies, not acknowledged as debts
• Guarantees given by or on behalf of the company
• Statutory demands/liabilities in dispute, not provided for
• Reinsurance Obligations to the extent not provided for ill accounts
• Others (to be specified).
2. Actuarial assumptions for valuation of liabilities for life policies in force.
3. Encumbrances to assets of the company in and outside India.
4. Commitments made and outstanding for Loans, Investments and Fixed Assets.
5. Basis of amortization of debt securities.
6. Claims registered and remaining unpaid for a period of more than six months as on the balance
sheet date.
7. Value of contracts in relation to investments, for:

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 • Purchases where deliveries are pending;
• Sales where payments are overdue.
8. Operating expenses relating to insurance business: basis of allocation of expenditure to various
segments of business.
9. Computation of managerial remuneration.
10. Historical costs of those investments valued on fair value basis.
11. Basis of revaluation of investment property.

B.Following accounting policies shall form an integral part of the financial statements:
1. All significant accounting policies in terms of the accounting standards issued by the ICAI,
and significant principles and policies given in Part I of Accounting Principles. Any other
accounting policies, followed by the insurer, shall be stated in the manner required under
Accounting Standard AS 1 issued by the ICAL
2. Any departure from the accounting policies shall be separately disclosed with reasons for such
departure.

C.The following information shall also be disclosed:

1. Investments made in accordance with any statutory requirement together with its amount,
nature, security and any special rights in and outside India;
2. Segregation into performing/non performing investments for income recognition.
Assets to the extent required to be deposited under local laws Percentage of business sector-wise;
A summary of financial statements for the last five years, in the manner as may be prescribed by the
Authority;
Bases of allocation of investments and income thereon between Policyholders' Account and
Shareholders' Account;
Accounting Ratios as may be prescribed by the Authority.
Example:

Financial Statements for non-life Insurance

Non-life Insurers shall prepare Financial Statements as per specified Forms such as Revenue Account
(Form A-RA), Profit and Loss Account (Form A-PL) and Balance Sheet (Form A-BS) as per Part V in
Schedule B of Regulation 3. The said financial statements will be prepared in accordance with General
Instructions for preparations as per Part III. The said financial statements shall be supported by
disclosures forming part of financial statements and the comments of management report as per Part II
and Part IV respectively, of the Schedule B.
The specified forms of financial statements are given hereinafter as ready reference for the
purpose of necessary discussion and analytical study for financial management based on insurance
accounting.
Form B-BS
Balance Sheet: Non-Life Insurer
Particulars Schedule No. Current Year Previous
SOURCES OF FUNDS
Share capital 5
Reserves and surplus 6
Fair value change account

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Borrowings 7
TOTAL
APPLICATION OF FUNDS
Investments 8
Loans 9
Fixed assets 10
Current Assets
Cash and bank balances 11
Advances and other assets 12
Sub-total (A)
Current Liabilities 13
Provisions 14
Sub-total (B)
Net Current Assets (C) = (A - B)
Miscellaneous Expenditure (not written off ) 15
Debit Balance in pal Account
TOTAL

The above financial statements are to be prepared according to the general instruction for preparation
of financial statements as specified in Part III of the IRDA Regulation. Again said financial statements
will be supported by specific disclosure forming part of financial statements as specified by Part II and
comments of management report specified by Part IV of Schedule B of the Regulation. It should also
mention about the contingent liability in respect of the following items:
• Party paid-up investments.
• Underwriting commitments outstanding.
• Claims, other than those under policies, not acknowledged as debts.
• Guarantees given by or on behalf of the company.
• Statutory demands/liabilities in dispute, not provided for.
• Reinsurance obligations to the extent not provided for in accounts.
• Others (to be specified).

Form B-RA
Non-life Revenue Account

Particulars Schedule No. Current Year Previous

1. Premium earned (Net) 1
2. Profit/loss on sale/redemption of investments
3. Others (to be specified)
4. Interest, dividend & rent (Gross)
TOTAL (A)
1. Claims incurred (Net) 2
2. Commission 3

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 3. Operating expenses related to insurance 4
TOTAL (B)
Operating profit/loss from Fire/Marine/Misc.
Business C = (A - B)
APPROPRIATIONS
Transter to Shareholders' Account
Transfer to Catastrophe Reserve
Transfer to Other Reserves (to be specified)
TOTAL (C)

Form B-PL
Profit and Loss A/c of a General Insurance Company
Particulars Schedule No. Current Year Previous Year
1. Operating profits/loss
(a) Fire insurance
(b) Marine insurance I
(c) Miscellaneous insurance
2. Income from investments
(a) Interest, dividends & rents (Gross)
(b) Profit on sale of investments
3. Other income (to be specified)
TOTAL (A)
4. Provisions (other than taxation)
(a) For diminution in value of investment
(b) For doubtful debts
(c) Others (to be specified)
5. Other expenses
(a) Expenses other than those related to Ins. Business
(b) Bad debts written off
(c) Others (to be Specified)
TOTAL (B)
Profit before tax
Provisions for taxation
Appropriations
(a) Interim dividend paid during the year
(b) Proposed final dividend
(c) Dividend distribution tax
(d) Transfer to any reserve or other account
Balance of Profit/loss Brought Forward from Last yr.
Balance Carried Forward to Balance Sheet

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 Ratio Analysis:
Importantly, the users of financial statements cannot form any opinion on any of the trends for their
economic decisions with the company only on the basis of financial statements unless they use various
ratio analysis and trend analysis with comparative and classified accounting or financial statement. In
using the financial statement including balance sheet, and income statements along with required
disclosure and management report and computing percentage change, trend change, component
percentages, and ratios as exemplified in annexure, the finance manager and analyst constantly search
for some standard of comparison to establish whether the information and relationship they have found
are favourable or adverse for their future economic decisions. Generally two standards of comparison
used by financial analysts are (i) the past performance of the company, and (ii) the position of the
company with respect to industry performance in the country and overseas. The insurance business is
carried on with international process, principle and perspective because of its very nature of
international character. So its trend analysis or trend percentage needs to be compared with industry
data and international standard to judge the company's position in respect of growth, profitability,
liquidity, solvency, etc. In the following table, certain performance analysis has been done with some
hypothetical figures just to show accounting information are used for trend analysis.

Performance Analysis and Trend Percentage (rs. In Lakh) of Ram Insurance Ltd.

Information 2009-10 2010-11 Remarks/Observations of Analyst

1 Gross direct premium 5,676 5,103 Growth in the current year
2 Percentage growth 11% 4% Better growth in the current year
3 Reinsurance accepted 332 314 More acceptance in the current year
4 Reinsurance Ceded 1665 1522 More retention in the current year
5 Net premium 4342 3895 Net premium increase in the current year
Increase over previous year 11% 7% Better growth trend in the current year
% to gross premium 77% 76% Better trend in current year
These ratios are the most vital tools of financial analysis in management accounting. The corporate
management will take many financial decisions for their strategic issues. With this accounting
information many more analysis like the following few can be done.
Gross Premium to Shareholders' Funds Ratio (Rs. in lakh)
2009-10 2010-11
1. Gross Premium 5675.54 5103.16
2. Shareholders' Fund 4161.69 3735.22
3. Ratio (times) 1.36 1.37

Better the ratio, greater is the capacity utilization and better will be the return. But again this ratio must
be within permissible limits laid down by regulators.

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Net Retention Ratio
Gross Premium Net Premium Retention Ratio P. Y. Retention
Fire 1,103.49 830.76 75.28% 78.12%
Marine 349.33 164.38 47.05% 55.97%
Misc. 4,222.73 3,347.52 79.27% 77.46%
Total 5,675.54 4,342.65 76.52% 76.33%
What does it indicate? What is the necessity of comparative study?
What does excessively high or abnormally low retention ratio imply?

Fund and Investment: How to calculate Shareholders' Fund and Policyholders' Fund.
Shareholders' Fund (2010-11) (Rs. in lakh)
• Share Capital 200.00
• Capital Reserve 0.06
• General Reserve 4,622.79
• Misc. Reserve (-)14.82 4,808.03
Policyholders' Fund (2010-11) (Rs. in lakh)
• Unexpired Reserves 2,253.51
• Outstanding Claims 5,505.40 7,758.91
Total Funds 12,566.94
Ratio between the two funds: 38:62

Total Investments 2010-11 2009-10

• In India 20344.89 14238.54
• Outside India 30.36 336.69
Total Investments 20375.25 14575.23

• Long Term 20274.07 14195.57

• Short Term 391.18 379.66
Total Investments 20665.25 14575.23

• Government Investment 4459.81 3989.16

• Equity & Debt 16205.44 10586.07
Total Investments 20665.25 14575.23

Cash Flow Statement

Cash flow statement is useful in providing users with financial statements with a basis to assess the
ability of the firm to generate cash and cash equivalent and the needs of the firm to utilize those cash
flows. The financial decisions that are taken by users require an evaluation of the ability of the firm to
generate cash and cash equivalent and the timing and certainty of their generation. In insurance
industry, the cash flow statement is of prime importance to the users of the financial statements as the
insurance company carries on risk-taking business dealing with intangible product, i.e., promise to
indemnity loss in future as and when accident will occur in consideration of premium collected

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currently. The insurance companies need to have both solvency and liquidity sufficiently to pay off
their liabilities for claims at the time of accident, i.e., occurrence of perils. Thus, an insurer should
always prepare a cash flow statement and should present it for each period for which financial
statements are presented as per regulatory norms and forms. As per the IRDA Regulations, Cash Flow
statement in an insurance company is to be prepared in a Direct Method where AS 3 will not be
applicable. A cash flow statement, if used in conjunction with other financial statements, provides
information that enables the User to evaluate the charges in the net assets of the insurance company
and its financial structure (including its liquidity and solvency). For the purpose of preparation of cash
flow statement of an insurance company, following terms need to be defined for proper interpretation
and use.
1. Cash comprises on hand and demand deposits with banks of the corporate office and its all
operational units including overseas ones.
2. Cash equivalents are short term, highly liquid investments that are readily convertible into known
amounts of cash and which are subject to an insignificant risk of changes in value.
3. Cash flows are inflows and outflows of cash and cash equivalents.
4. Operating activities are the principal revenue-producing activities of a firm (insurer) and other
activities that are not investing or financing activities. In insurance company cash flow from
operating activates (insurance activities) is a key indicator of the extent to which the operations of
the enterprise have generated sufficient cash flows to maintain the operating capability of the
insurers, pay claims, commission, management expenses and dividends, and repay loans and
borrowings.
5. Investing activities are the acquisitions and disposals of long term assets and other investments not
included in cash equivalent.
6. Financing activities are activities that result in changes in the size and composition of the
shareholders' funds and policyholders' funds (in case of insurance company) and borrowings of the
firm.
7. Preparation of cash flow statement Includes classification and segregation of operating, investing
and financing activities.

Direct Method of cash Flow Statement

Cash Flows from Operating Activities Amount Total
Cash receipts from customers .
Cash paid to suppliers and employees
Cash generated from operations
Income taxes paid
Cash flow before extraordinary item
Proceeds from earthquake disaster settlement
Net cash from operating activities
Cash Flows from Investing Activities
Purchase of fixed assets
Proceeds from sale of equipment
Interest received

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Dividends received
Net cash from investing activities
Cash Flows from Financing Activities
Proceeds from issuance of share capital
Proceeds from long-term borrowings
Repayment of long-term borrowings
Interest paid Dividends paid
Net cash used in financing activities
Net increase in cash and cash equivalents
Cash and Cash Equivalents at Beginning of Period
Cash and Cash Equivalents at End of Period

Indirect Method of Cash Flow Statement

Cash Flows from Operating Activities Amount Total
Net profit before taxation, and extraordinary item
Adjustments for
Depreciation
Foreign exchange loss
Interest income
Dividend income
Interest expense
Operating profit before working capital changes
Increase in sundry debtors
Decrease in inventories
Decrease in sundry creditors
Cash generated from operations
Income tax paid
Cash flow before extraordinary item
Proceeds from earthquake disaster settlement
Net cash from operating activities
Cash Flows from Investing Activities
Purchase of fixed assets
Proceeds from sale of equipment
I nterest received
Dividend received
Net cash flows from financing activities
Cash Flows from Financing Activities
Proceeds from issuance of share capital
Proceeds from long-term borrowings
Repayment of long-term borrowings
Interest paid

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Dividend paid
Net cash used in financing activities
Net increases in cash and cash equivalents
Cash and Cash Equivalents at Beginning of Period
Cash and Cash Equivalents at End of Period
Example of Financial Statement of a Non-life insurance companies:

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166
167
Example of Financial Statements of Life Insurance Companies

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169
170
Self-Assessment Questions:
Question 1: Define the legal requirements of Directors’ Report as per the Companies Act 1956.
Question 2: State IRDA requirements regarding the Financial Statements.
Question 3: Draft Balance sheet and Revenue Account of a life insurance company using imaginary
figures.
Question 4: Prepare the dummy financial statements of a non-life insurance company.

References:
• Mishra, K.C. and Guria, R.C.(2009), Practical Approach to General Insurance Underwriting,
Cengage Learning, Delhi.
• Gupta C. B., (2005), Business Organization and Management, Sultan Chand & Sons, New
Delhi.
• Gupta P. K., (2005), Insurance and Risk management, Himalaya Publisher, New Delhi.

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 LESSON 4
GENERAL INSURANCE NON LIFE INSURANCE –
FIRE/MARINE
Dr Ashish Kumar
LBSIM
Meaning And Importance Of General Insurance
Insurance other than Life Insurance falls under the category of General Insurance.
General Insurance comprises of insurance of property against fire, burglary etc., personal
insurance such as Accident and Health Insurance, and liability insurance which covers legal
liabilities. There are also other covers such as Errors and Omissions insurance for professionals,
credit insurance etc. Non-life insurance companies have products that cover property against Fire
and allied perils, flood storm and inundation, earthquake and so on. There are products that cover
property against burglary, theft etc. The non-life companies also offer policies covering
machinery against breakdown, there are policies that cover the hull of ships and so on. A Marine
Cargo policy covers goods in transit including by sea, air and road. Further, insurance of motor
vehicles against damages and theft forms a major chunk of non-life insurance business.
A non-life insurance contract is different from a life insurance contract. A life insurance
contract is a long term contract, while general insurance contract is a one-year renewable
contract. The risk namely ‘death’ is certain in life insurance. The only uncertainty is as to when it
will take place, whereas in general insurance, the insured event may or may not take place. It is
difficult to determine the economic value of life, whereas the financial value of any asset to be
insured under a general insurance policy can be determined. Because of these peculiar features, a
non life insurance contract is different from a life insurance contract. In this lesson we will learn
in detail the treatment of each type of non-life insurance.
Section 2(6B) of the Insurance Act 1938, defines general insurance business. According
to this general insurance business means fire, marine, or miscellaneous insurance whether carried
separately or in combination. General Insurance Corporation of India (GIC) was set up with
exclusive privilege for transacting General Insurance business. After the passage of IRDA Act
1999, GIC has been delinked from its subsidiaries and has been assigned the role of Indian
reinsurer.
General Insurance covers are necessary for every family. It is important to protect one’s
property, which one might have acquired from one’s hard earned income. A loss or damage to
one’s property can leave one shattered. Losses created by catastrophes such as the tsunami,
earthquakes. Cyclones etc. have left many homeless and penniless. Such losses can be
devastating but insurance could help mitigate them. Property can be covered, so also the people
against Personal Accident. A Health Insurance policy can provide financial relief to a person
undergoing medical treatment whether due to a disease or an injury. Industries also need to
protect themselves by obtaining insurance covers to protect their building, machinery, stocks etc.
They need to cover their liabilities as well. Financiers insist on insurance. So, most industries or
businesses that are financed by banks and other institutions do obtain covers. But are they
obtaining the right covers? And are they insuring adequately are questions that need to be given
some thought. Also organizations or industries that are self-financed should ensure that they are
protected by insurance.

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Types of General Insurance
Basically there are four type of general insurance stated below. Beside these a number of
different kinds of policies for hedging against the various kind of risk are available in the market
these days.
• Fire Insurance
• Marine Insurance
• Motor Insurance
• Health Insurance
• Miscellaneous Insurance

Fire Insurance
Fire is hazardous to human life as well as property. Loss of life by fire is covered under
Life insurance and loss of property by fire is covered under fire insurance. Fire causes enormous
damage by physically reducing the materials to ashes. A fire insurance policy provides protection
strictly against fire. There could be enormous reasons for fire. In practice certain other related
perils are also covered by the fire insurance policy. The General Insurance Act (Tariff)
recommends the form of the contract in which a fire insurance is to be written. The policy form
contains a preamble and operative clause, general exclusions and general conditions. Fire
Insurance comes under tariff class of business. All India Fire Tariff is the revised fire insurance
tariff, which came into force on May1, 2001. Now a single policy was introduced to cover all
property risks called standard fire and special peril policy in the place of three standard policies
i.e. A, B&C.
A contract of fire insurance can be defined as a contract under which one party ( the
insurer) agrees for consideration (premium) to indemnify the other party (The insured) for the
financial loss which the latter may suffer due to damage to the property insured by fire during a
specified period of time and up to an agreed amount. The document containing the terms and
conditions of the contract is known as ‘Fire Insurance Policy’. A fire policy contains the name of
the parties, description of the insured property, the sum for which the property is insured, amount
of premium payable and the period insured against. The premium may be paid either in single
installment or by way of installments. The insurer is liable to make good the loss only when loss
is caused by actual fire. The phrase ‘loss or damage by fire’ also includes the loss or damage
caused by efforts to extinguish fire.

Scope of cover
Standard Fire and special perils policy usually cover loss due to the following perils:
1. Fire: Destruction or damage to the property insured by its own fermentation, natural heating
or spontaneous combustion or drying process can not be treated as damage due to fire.
2. Lightning: It may result in fire damage or other type of damage, such as cracks in a building
due to a lightning strike.
3. Explosion: An explosion is caused inside a vessel when the pressure within the vessel exceeds
the atmospheric pressure acting externally on its surface. This policy, however, does not cover
destruction or damage caused to the boilers or other vessels where heat is generated.
4. Storm, cyclone, typhoon, hurricane, tornado, landslide: These are all various types of
violent natural disturbances accompanied by thunder or strong winds or heavy rain fall. Loss or

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damage directly caused by these disturbances are covered excluding those resulting from
earthquake, volcanic eruption etc.
5. Bush fire: This covers damage caused by burning of bush and jungles but excluding
destruction or damage caused by forest fire.
6. Riot, strike, malicious, and terrorism damages: Any loss or physical damage to the
property insured directly caused by such activity or by the action of any lawful authorities in
suppressing such disturbance is covered.
7. Aircraft damage: Loss, destruction or damage caused by Aircraft, other aerial or space
devices and articles dropped there from excluding those caused by pressure waves.
8. Overflowing of water tanks and pipes etc.: Loss or damage to property by water or
otherwise on account of bursting or accidental overflowing of water tanks, apparatus and pipes is
covered.
9. Add-on Covers: The insurer can issue the standard fire policy with added benefits at the
option of the policyholders by charging additional premium. These added benefits are as follows:
1. Architects, Surveyors and Consulting engineer’s fees ( in excess of 3% claim amount)
2. Debris removal ( in excess of 1% of claim amount)
3. Deterioration of stocks in cold storage due to power failure
4. Forest fire
5. Spontaneous combustion
6. Earthquake as per minimum rates and excess applicable as specified in the tariff.
7. Omission to insure additions, alterations or extensions.

The following types of losses, however, are not covered by a fire policy:
• Loss by theft during and after the occurrence of fire.
• Loss caused by burning of property by order of any public authority.
• Loss caused by underground fire.
• Loss or damage to property occasioned by its own fermentation or spontaneous
combustion.
• Loss happening by fire which is caused by earthquake, invasion, act of foreign enemy,
warlike operations, civil wars, riot etc.
In all the above cases the insurer is not liable, unless specifically provided for in the fire
insurance policy. The insurer can issue the standard fire policy as per the New Fire Tariff along
with added benefits at the option of the policyholders by charging additional premium.

Types of Fire Policies

The important fire insurance policies are discussed below:
(i) Valued Policy. They are the exception in fire insurance. Under valued policy, the
value declared in the policy is the amount the insurer will have to pay to the insured
in the event of a total loss irrespective of the actual value of loss. The policy violates
the principle of indemnity. The insurer has to pay a specified amount quite
independent of the market or actual value of the property at the time of loss. So such a
policy is very rarely issued. It may be issued only on artistic work, antiques and
similar rare articles whose value cannot be determined easily.

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(ii) Specific Policy. Under this policy, the insurer undertakes to make good the loss to the
insured upto the amount specified in the policy. Supposing, a building worth
Rs.2,00,000 is insured against fire for Rs. 1,00,000. If the damage to the property is
Rs.75,000 the insurer will get the full compensation. Even if the loss is Rs.1,00,000
the insurer will get the full amount. But if the loss is more than Rs. 1, 00,000 the
insured will get Rs. 1,00,000 only. Hence, the value of property is not relevant in
determining the amount of indemnity in case of a specific policy.
(iii) Average Policy. Under a fire insurance policy containing the ‘average clause’ the
insured is liable for such proportion of the loss as the value of the uncovered property
bears to the whole property. e.g. if a person gets his house insured for Rs. 4,00,000
though its actual value is Rs. 6,00,000 , if a part of the house is damaged in fire and
the insured suffers a loss of Rs. 3,00,000 , the amount of compensation to be paid by
the insurer comes out to Rs. 2,00,000 calculated as follows:

Amount of claim= (Insured amount X Actual loss) /Actual value of

property
(4,00,000 X 3,00,000)/6,00,000 =2,00,000
(iv) Floating policy. A floating policy is used for covering fluctuating stocks of goods
held in different lots for one premium. With every transaction of sale or purchase, the
quantities of goods kept at different places fluctuate. It is difficult for the owner to
take a policy for a specific amount. The best way is to take out a floating policy for
all the stocks of goods.
(v) Reinstatement Policy. In such a policy, the insurer has the right to reinstate or
replenish the property destroyed instead of paying compensation to the insured in
cash. It may be granted on building, machinery, furniture, fixture and fittings only.
(vi) Consequential loss Policy. Sometimes the insured has to suffer a greater financial loss
on account of dislocation of business caused by fire .e.g. close down business after
fire for repair, to meet fixed expenses such as rent, salaries, taxes and other expenses
as usual. Such considerable loss to the insured is not covered by the ordinary fire
policy. In order to cover such loss by fire, the ‘Consequential Loss Policy’ has been
introduced. The loss so suffered is separately calculated from the loss actually
suffered.
(vii) Comprehensive policy. This policy covers the risks of the fire arising out of any cause
that is civil commotion, lightening, riots, thefts, labor disturbances and strikes etc. It
is also known as ‘all insurance policy’.
(viii) A Blanket policy. This policy is issued to cover all the fixed and current assets of an
enterprise by one insurance.
(ix) Declaration policy. In this policy, trader takes out a policy for the maximum value of
stock which may be expected to hold during the year. At a fixed date each month, the
insured has to make a declaration regarding the actual value of stock at risk on that
date. On the basis of such declaration, the average amount of stock at risk in the year
is calculated and this amount becomes the sum assured.
(x) Sprinklers leakage policy. It covers the loss arising out of water leakage from
sprinklers which are setup to extinguish fire.

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Claim Procedure for Fire Insurance
1. In the event of fire the insured must immediately give the insurer a notice about the loss
caused by fire. A written claim should be delivered with in 15days from the date of loss.
The insured is required to furnish all plans, invoices, documents, proofs and other
relevant informations required by the insurer. If the insured failed to submit these
documents within 6 months from the date of loss, the insurer has the right to consider it
as no claim.
2. On receipt of the claim the insurer verifies whether the essentials of a valid claim are
satisfied or not. e.g. The cause of fire should be an insured peril.
3. The insured completes the form, signs the declaration given in the form as to the
truthfulness and accuracy of the information and returns the same.
4. An official employed by the insurer investigates small and simple claims. For large
claims, the insurance company employs independent loss surveyor.
5. On the basis of the claim form and the investigation report, the company then settles the
claim.

Marine Insurance
Marine insurance covers the loss or damage of ships, cargo, terminals, and any transport
or cargo by which property is transferred, acquired, or held between the points of origin and final
destination. Cargo insurance discussed here is a sub-branch of marine insurance, though Marine
also includes Onshore and Offshore exposed property (container terminals, ports, oil platforms,
pipelines); Hull; Marine Casualty; and Marine Liability.
The general principles of marine insurance are the same as with other types of insurance
in that there are two parties: the assured and assurer (or carrier). The assured or insured agrees to
pay a premium and the insurer agrees that, if certain losses or damage occurs to certain interests
of the insured, the insurer will indemnify the insured. The similarities pretty much end here. The
complex circumstances involved in sea voyages require very specific arrangements for the
provision of marine insurance. The fixing of rates and special conditions, for example, requires a
vast knowledge of the nature of vessels and cargos and of the conditions of navigation.
The marine policy may cover the risks of a single voyage, or may insure for a certain
period of time. Cargo is almost always insured by voyage. Vessels are usually insured for certain
duration of time, usually year by the year. Cargo policies may be on a single lot or may be open
to cover cargo as shipped by the insured. Hull insurance, or vessel insurance, may cover a ship or
a whole fleet.
Typical of marine insurance is the principle that no contract of marine insurance is valid
unless the insured has an insurable interest in the subject matter at the time of loss. The term
insurable interest has been variously defined. According to the English Marine Insurance Act of
1906, "every person has an insurable interest who is interested in a marine adventure.... a person
is interested in a marine adventure where he stands in any legal or equitable relation to the
adventure or to any insurable property at risk therein, in consequence of which he may benefit by
the safety or due arrival of insurable property, or may be prejudiced by its loss, or damage
thereto, or by the detention thereof, or may incur liability in respect thereof".
The nature and scope of marine insurance is determined by reference to s. 6 of the Marine
Insurance Act and by the definitions of “marine adventure” and “maritime perils”. A contract of

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marine insurance is a contract whereby the insurer undertakes to indemnify the insured, in the
manner and to the extent agreed in the contract, against losses that are incidental to a marine
adventure or an adventure analogous to a marine adventure, including losses arising from a land
or air peril incidental to such an adventure if they are provided for in the contract or by usage of
the trade; or losses that are incidental to the building, repair or launch of a ship.
"Marine adventure" means any situation where insurable property is exposed to maritime
perils, and includes any situation where the earning or acquisition of any freight, commission,
profit or other pecuniary benefit, or the security for any advance, loan or disbursement, is
endangered by the exposure of insurable property to maritime perils, and any liability to a third
party may be incurred by the owner of, or other person interested in or responsible for, insurable
property, by reason of maritime perils. "Maritime perils" means the perils consequent on or
incidental to navigation, including perils of the seas, fire, war perils, acts of pirates or thieves,
captures, seizures, restraints, detainments of princes and peoples, jettisons, barratry and all other
perils of a like kind and, in respect of a marine policy, any peril designated by the policy.

Subject Matter of Marine Insurance

The insured may be the owner of the ship, owner of the cargo or the person interested in
freight. In case the ship carrying the cargo sinks, the ship will be lost along with the cargo. The
income that the cargo would have generated would also be lost. Based on this we can classify the
marine insurance into four categories:
1. Hull Insurance: Hull refers to the ocean going vessels (ships trawlers etc.) as well as its
machinery. The hull insurance also covers the construction risk when the vessel is under
construction. A vessel is exposed to many dangers or risks at sea during the voyage. An
insurance effected to indemnify the insured for such losses is known as Hull insurance.
2. Cargo Insurance: Cargo refers to the goods and commodities carried in the ship from one
place to another. The cargo transported by sea is also subject to manifold risks at the port
and during the voyage. Cargo insurance covers the shipper of the goods if the goods are
damaged or lost. The cargo policy covers the risks associated with the transshipment of
goods. The policy can be written to cover a single shipment. If regular shipments are
made, an open cargo policy can be used that insures the goods automatically when a
shipment is made.
3. Freight Insurance: Freight refers to the fee received for the carriage of goods in the ship.
Usually the ship owner and the freight receiver are the same person. Freight can be
received in two ways- in advance or after the goods reach the destination. In the former
case, freight is secure. In the latter the marine laws say that the freight is payable only
when the goods reach the destination port safely. Hence if the ship is destroyed on the
way the ship owner will loose the freight along with the ship. That is why, the ship
owners purchase freight insurance policy along with the hull policy.
4. Liability Insurance: It is usually written as a separate contract that provides
comprehensive liability insurance for property damage or bodily injury to third parties. It
is also known as protection and indemnity insurance which protects the ship owner for
damage caused by the ship to docks, cargo, illness or injury to the passengers or crew,
and fines and penalties.

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Types of Marine Policy
There are different types of marine policies known by different names according to the manner
of their execution or the risk they cover. They are:
(i) Voyage Policy: Under the policy, the subject matter is insured against risk in respect of a
particular voyage from a port of departure to the port of destination, e.g. Mumbai to New
York. The risk starts from the departure of ship from the port and it ends on its arrival at
the port of destination. This policy covers the subject matter irrespective of the time
factor. This policy is not suitable for hull insurance as a ship usually does not operate
over a particular route only. The policy is used mostly in case of cargo insurance.
(ii) Time Policy: It is one under which the insurance is affected for a specified period of time,
usually not exceeded twelve months. Time policies are generally used in connection with
the insurance of ship. Thus if the voyage is not completed with in the specified period,
the risk shall be covered until the voyage is completed or till the arrival of the ship at the
port of call.
(iii) Mixed Policies: It is one under which insurance contract is entered into for a certain time
period and for a certain voyage or voyages, e.g., Kolkata to New York, for a period of
one year. Mixed Policies are generally issued to ships operating on particular routes. It is
a mixture of voyage and time policies.
(iv) Valued Policies: It is one under which the value of subject matter insured is specified on
the face of the policy itself. This kind of policy specifies the settled value of the subject
matter that is being provided cover for. The value which is agreed upon is called the
insured value. It forms the measure of indemnity in the event of loss. Insured value is not
necessarily the actual value. It includes (a) invoice price of goods (b) freight, insurance
and other charges (c) ten to fifteen percent margin to cover expected profits.
(v) Unvalued policy: It is the policy under which the value of subject matter insured is not
fixed at the time of effecting insurance but has to be ascertained wherever the subject
matter is lost or damaged.
(vi) Open policy: An open policy is issued for a period of 12 months and all consignments
cleared during the period are covered by the insurer. This form of insurance Policy is
suitable for big companies that have regular shipments. It saves them the tedious and
expensive process of acquiring an insurance policy for each shipment. The rates are fixed
in advance, without taking the total value of the cargo being shipped into consideration.
The assured has to declare the nature of each shipment, and the cover is provided to all
the shipments. The assured also deposits a premium for the estimated value of the
consignment during the policy period.
(vii) Floating Policy: A merchant who is a regular shipper of goods can take out a ‘floating
policy’ to avoid botheration and waste of time involved in taking a new policy for every
shipment. This policy stands for the contract of insurance in general terms. It does not
include the name of the ship and other details. The other details are required to be
furnished through subsequent declarations. Thus, the insured takes a policy for a huge
amount and he informs the underwriter as and when he makes shipment of goods. The
underwriter goes on recording the entries in the policy. When the sum assured is
exhausted, the policy is said to be “fully declared” or “run off”.
(viii) Block Policy: This policy covers other risks also in addition to marine risks. When goods
are to be transported by ship to the place of destination, a single policy known as block
policy may be taken to cover all risks. E.g. when the goods are dispatched by rail or road

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 transport for shipment, a single policy may cover all the risks from the point of origin to
the point of destination.
Assignment of Marine Policy
A marine insurance policy may be transferred by assignment unless the terms of the
policy expressly prohibit the same. The policy may be assigned either before or after loss. The
assignment may be made either by endorsement on the policy itself or on a separate document.
The insured need not give a notice or information to the insurer or underwriter about assignment.
In case of death of the insured, a marine policy is automatically assigned to his heirs. At the time
of assignment, the assignor must possess an insurable interest in the subject matter insured. An
insured who has parted with or lost interest in the subject matter insured cannot make a valid
assignment. After the occurrence of the loss, the policy can be assigned freely to any person. The
assignor merely transfers his own right to claim to the assignee.
Clauses in a Marine Policy
A policy of marine insurance may contain several clauses. Some of the clauses are
common to all marine policies while others are included to meet special requirements of the
insured. Hull, cargo and freight policies have different standard clauses. There are standard
clauses which are invariably used in marine insurance. Firstly, policies are constructed in
general, ordinary and popular sense, and, later on, specific clauses are added to them according
to terms and conditions of the contract. Some of the important clauses in a marine policy are
described below:
1. Valuation Clause. This clause states the value of the subject matter insured as agreed
upon between both the parties.
2. Sue and Labour clause. This clause authorizes the insured to take all possible steps to
avert or minimize the loss or to protect the subject matter insured in case of danger. The
insurer is liable to pay the expenses, if any, incurred by the insured for this purpose.
3. Waiver Clause. This clause is an extension of the above clause. The clause states that any
act of the insured or the insurer to protect, recover or preserve the subject matter of
insurance shall not be taken to mean that the insured wants to forgo the compensation,
nor will it mean that the insurer accepts the act as abandonment of the policy.
4. Touch and Stay Clause. This clause requires the ship to touch and stay at such ports and
in such order as specified in the policy. Any departure from the route mentioned in the
policy or the ordinary trade route followed will be considered as deviation unless such
departure is essential to save the ship or the lives on board in an emergency.
5. Warehouse to warehouse clause. This clause is inserted to cover the risks to goods from
the time they are dispatched from the consignor’s warehouse until their delivery at the
consignee’s warehouse at the port of destination.
6. In charge Clause. This clause covers the loss or damage caused to the ship or machinery
by the negligence of the master of the ship as well as by explosives or latent defect in the
machinery or the hull.
7. F.P.A. and F.A.A. Clause. The F.P.A. (Free of Particular Average) clause relieves the
insurer from particular average liability. The F.A.A. ( free of all average) clause relieves
the insurer from liability arising from both particular average and general average.
8. Lost or Not Lost Clause. Under this clause, the insurer is liable even if the ship insured is
found not to be lost prior to the contact of insurance, provided the insurer had no

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 knowledge of such loss and does not commit any fraud. This clause covers the risks
between the issue of the policy and the shipment of the goods.
9. Running down Clause. This clause covers the risk arising out of collision between two
ships. The insurer is liable to pay compensation to the owner of the damaged ship. This
clause is used in hull insurance.
10. Free of Capture and Seizure Clause. This clause relieves the insurer from the liability of
making compensation for the capture and seizure of the vessel by enemy countries. The
insured can insure such abnormal risks by taking an extra ‘war risks’ policy.
11. Continuation Clause. This clause authorizes the vessel to continue and complete her
voyage even if the time of the policy has expired. This clause is used in a time policy.
The insured has to give prior notice for this and deposit a monthly prorate premium.
12. Barratry Clause. This clause covers losses sustained by the ship owner or the cargo owner
due to willful conduct of the master or crew of the ship.
13. Jettison Clause. Jettison means throwing overboard a part of the ship’s cargo so as to
reduce her weight or to save other goods. This clause covers the loss arising out of such
throwing of goods. The owner of jettisoned goods is compensated by all interested
parties.
14. At and From Clause. This clause covers the subject matter while it is lying at the port of
departure and until it reaches the port of destination. It is used in voyage policies. If the
policy consists of the word ‘from’ only instead of ‘at and from’, the risk is covered only
from the time of departure of the ship.
Warranties
Warranty means a promissory warranty by which the insured undertakes that some
particular thing will or will not be done or that some condition will be fulfilled; or affirms or
negates the existence of particular facts. A warranty may be an implied warranty and express
warranty.
Express Warranties: An express warranty may be in any form of words from which the
intention to warrant may be inferred. (2) An express warranty must be included in, or written on,
the marine policy or be contained in a document incorporated by reference into the policy. It
does not exclude an implied warranty, unless they are inconsistent.
An express warranty may be in any form of words from which the intention to warrant may be
inferred. Unfortunately, it has proven difficult for insurers to find the exact words that will lead
to the required inference. Words such as “warranted that” have been held to not necessarily
delineate a warranty. Similarly, the words “warranted free from any claim...” were held not to
delineate a warranty. Examples of express warranties are as follows:
The number and type of express warranties are limited only by the imagination and
ingenuity of underwriters. Almost anything can be made to be an express warranty provided the
proper words are used. Notwithstanding this total freedom to make almost anything a warranty
most policies contain relatively few. The more common express warranties are:
• Navigation and trading warranties that limit the geographical areas in which a vessel may
operate;
• Laid up and out of commission warranties that require a vessel to be laid up for a defined
period or generally;
• Identity of the master warranties that require a named person to command the vessel;

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 • Towing warranties that prohibit the insured vessel from being towed except where
customary or when the vessel is in need of assistance;
• Private pleasure use warranties that prohibit any commercial use of a yacht; and
• Warranties regarding surveys and inspections that require inspections to be conducted or
recommendations by surveyors to be complied with.
Implied Warranty: these are the warranties which are not expressly mentioned in the contract
but the law takes it for granted that such warranty exists. An express warranty does not exclude
implied warranty unless it is inconsistent therewith. Implied warranties do not appear in the
policy documents at all, but are understood without being put into words, and as such, are
automatically applicable. These are included in the policy by law, general practice, long
established custom or usage. There are three warranties implied by the Act. They are the
warranty of legality, neutrality and
seaworthiness.
• Legality: The warranty of legality is one which is often expressly included in policies as
well as implied. The journey undertaken by the ship must be for legal purposes. Carrying
prohibited or smuggled goods is illegal and therefore, the insurer shall not be liable for
the loss.
• Neutrality: Where in any marine policy insurable property is expressly warranted to be
neutral, there is an implied condition in the policy (a) that the property will have a neutral
character at the commencement of the risk and that, in so far as the insured has control,
that character will be preserved during the risk; and (b) where the property is a ship, that,
in so far as the insured has control, the papers necessary to establish the neutrality of the
ship will be carried on the ship and will not be falsified or suppressed and no simulated
papers will be used.
• Seaworthiness: There is an implied warranty in every voyage policy that, at the
commencement of the voyage, the ship will be seaworthy for the purpose of the particular
marine adventure insured.
Types of Marine Losses
A loss arising in a marine adventure due to perils of the sea is a marine loss. Marine loss may be
classified into two categories:
• Total loss: A total loss implies that the subject matter insured is fully destroyed and is
totally lost to its owner. It can be Actual total loss or Constructive total loss. In actual
total loss subject matter is completely destroyed or so damaged that it ceases to be a thing
of the kind insured. e.g. sinking of ship, complete destruction of cargo by fire, etc. In case
of constructive total loss the ship or cargo insured is not completely destroyed but is so
badly damaged that the cost of repair or recovery would be greater than the value of the
property saved. e.g. a ship dashed against the rock and is stranded in a badly damaged
position. If the expenses of bringing it back and repairing it would be more than the
actual value of the damaged ship, it is abandoned.
• Partial loss: A partial loss occurs when the subject matter is partially destroyed or
damaged. Partial loss can be general average or particular average. General average refers
to the sacrifice made during extreme circumstances for the safety of the ship and the
cargo. This loss has to be borne by all the parties who have an interest in the marine

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adventure. e.g. A loss caused by throwing overboard of goods is a general average and
must be shared by various parties. Particular average may be defined as a loss arising
from damage accidentally caused by the perils insured against. Such a loss is borne by the
underwriter who insured the object damaged. e.g. If a ship is damaged due to bad weather
the loss incurred is a particular average loss.

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 LESSON 5

GENERAL INSURANCE–MOTOR–HEALTH
& MISCELLANEOUS
Dr Ashish Kumar
LBSIM
Introduction:
The primary legislations including the Insurance Act, 1938 and the IRDA Act, 1999 that deal
with insurance business in India provide the legal framework of insurance accounting in India,
over and above the principles and practices prescribed by Generally Accepted Accounting
Principles (GAAP) and the various Accounting Standards (AS) issued by the Institute of
Chartered Accountants of India(ICAI) and the international organization Financial Accounting
Standards Board (FASB). However, the following statutes, rules and regulations are the major
considerations for accounting and financial management for insurance companies in India:
1. The Insurance Act, 1938 and Insurance Rules, 1939
2. The Insurance Regulatory and Development Authority Act, 1999
3. The Companies Act, 1956
4. The Life Insurance Corporation Act, 1956
5. The General Insurance Business (Nationalization) Act, 1972
Section 11 of the Insurance Act, 1938 provides that every insurer, on or after the
commencement of the IRDA Act, 1999 in respect of insurance business transacted by him and
in respect of his shareholders' fund, shall at the expiration of each financial year, prepare a
Balance Sheet, a Profit and Loss account, a separate Account of Receipts and Payments (Cash
Flow Statement), Revenue Accounts in accordance with the regulations made by the Authority.
Every Insurer shall keep separate accounts relating to funds of shareholders and policyholders.
Accounting Regulations and Financial Statements:
The IRDA (Preparation of Financial Statements and Auditor's Report of Insurance Companies)
Regulations, 2002 provide that-
• An insurer carrying on life insurance business shall comply with the requirements of
Schedule' A' to prepare financial statements.
• An insurer carrying on general insurance business shall comply with the requirements of
Schedule 'B' to prepare financial statements.
• The Report of the Auditors on the Financial Statements of every insurer/ re-insurer shall be in
conformity with the requirements of Schedule 'C'.
The said regulation further provides that financial statements comprising (i) Balance
Sheet, (ii) Receipts and Payments Account (Cash Flow Statement) (iii) Profit & Loss Account
(Shareholders' Account) and (iv) Revenue Account (policyholders' Account) shall be in
conformity with the Accounting Standards (AS) issued by the Institute of Chartered
Accountants of India to the extent applicable to the insurer except that:
• Accounting Standard 3-Cash-flow Statement shall be only under Direct Method
• Accounting Standard 13-Accounting for Investment shall not be applicable
• Accounting Standard 17-Segment reporting shall apply to all insurers irrespective of the

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 requirements for listing and turnover mentioned therein.
Section 2C of the Regulation provides that all words and expressions used herein and not
defined in the Insurance Act, 1938 or in the IRDAAct, 1999 or in the Companies Act, 1956
shall have the meanings respectively assigned to those Acts. However, regulatory provisions
prescribed by the IRDA and the specific and relevant Accounting Standards promulgated by the
Institute of Charted Accountants of India are being separately discussed in detail in subsequent
units.
Financial statements of insurance companies comprise the following as stated earlier:
• Balance sheet,
• Revenue accounts,
• Profit and loss account, and
• Receipts and payments account
Besides the financial statements, the annual reports of an insurance company also contain
the following statutory documents for the review and analysis of the various interested groups
including shareholders, policyholders, regulators, reinsurers, employees, co-insurers, etc.
1. Report of the board of directors
2. Management report
3. Auditors report
4. Segment reporting
5. Significant accounting policies
6. Notes and disclosures forming part of accounts
Let us now discuss the above financial statements and reports with reference to legal
requirements, accepted principles and practices with a few examples and exercises. Certain
examples with hypothetical data are also given in Annexure for clarity of understanding of
students in respect of financial statements
Directors’ Report: legal Requirement as Regards Directors’ Report (Companies Act 1956)
As per Section 217 of the Companies Act, 1956 there shall be attached to every balance
sheet laid before a company general meeting a report by its Board of Directors with respect to
following particulars:
• The state of affairs of the company.
• The amounts, if any, which it proposes to carry to any reserve in balance sheet.
• The amount, if any, which it recommends, should be paid by way of dividend.
• The material changes and commitments, if any, affecting the financial position of the
company, which have occurred between the end of the financial year of the company to
which the balance relates and the date of the report.
• The technology absorption, foreign exchange earnings and outgo and the manners
thereof.

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 • The material changes, if occurred during the financial year in respect of the nature and
class of business of the company or its subsidiary.
• The statement showing the name of every employee of the company who, if employed
throughout the financial year, was in receipt of remuneration for that year, which in the
aggregate was not less than Rs. 24,00,000 per annum or if employed for a part of the
financial year was not less than Rs. 2,00,000 per month. Such state shall also indicate that
whether any such employee is a relative of any director or manager of the company.
• The Directors' Responsibility Statement must mention that
a) In the preparation of the annual accounts, the applicable accounting standards
have been followed along with proper explanations relating to material departure,
b) The directors had selected such accounting policies and applied them consistently,
c) The results and estimates are reasonable and prudent so as to give.a true and fair
view of the state of affairs of the company at the end of the financial year and of
the profit or loss of the company for that period,
d) That the directors had taken proper and sufficient care for the maintenance of
adequate accounting records in accordance with the provisions of the Companies
Act, 1956 for safeguarding the assets of the company and for preventing and
detecting frauds and other irregularities and that the directors had prepared the
annual accounts on a going concern basis.
• The reasons for the failure, if any, to complete the buy back within the time specified in
Section 77 A of the Act.
• The fullest and explanations on every reservation, qualification or adverse remarks
contained in the auditors' report.

Common Disclosures in Directors’ Report Contained in the Annual Report of a General

Insurance Company:
Director report of an insurance company generally furnishes the following information
specifically as per the above requirements of the Companies Act, 1956:
1. Comparative Performance Analysis (Class-wise Underwriting Performance) for the
financial year under report with reference to previous year) as appended in Annexure
A.2 showing performance analysis of XYZ General Insurance Co. Ltd. in respect of the
following performance review for FY 2005-06.
• Gross direct premium and percentage of growth over previous year
• Reinsurance premium ceded
• Reinsurance accepted
• Net premium and percentage of growth over previous year
• Increase in unexpired risks reserve and percentage to net premium
• Net premium earned
• Net incurred claims and percentage to net premium
• Others
2. Review of accounts as an annexure to accounts
3. Profit before tax and after tax

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 4. Proposed dividend
5. General reserves and current year transfer of profit to that reserve
6. Total assets and the contribution of increase of fair value change account
7. Total investments, its composition/portfolio, its increase over the last year
8. Solvency margin and its change over the previous year
9. Compliance with Section 40C in regard to prescribed % of expenses

Financial Statements:
As mentioned earlier, as per the IRDA (Preparation of Financial Statements and
Auditors' Report of Insurance companies) Regulations, 2000, an insurer shall prepare the
Financial Statements including Balance sheet, Revenue Account (Policyholders Account),
Receipts and Payments Account (Cash Flow Statements) and Profit and Loss Account
(Shareholders' account) as Accounting Standard (AS) issued by the ICAI to the extent
applicable to the insurers except that:
1. Accounting Standard 3 (AS 3) and Accounting Standard 17 (AS 17) in case of insurers
carrying on life insurance business
2. Accounting Standard 3 (AS 3), Accounting Standard 13 (AS 13) and Accounting Standard
17 (AS17) in case of insurers carrying on non-life insurance business

Cash flow statements will be prepared only under direct method and segment reporting shall apply
irrespective of whether the securities of the insurer are traded publicly or not in both the cases and in
case of non-life insurance company AS 13-Accounting for investments shall not be applicable.
Motor Insurance
Motor insurance policy is a contract between the insured and the insurer in which the
insurer promises to indemnify the financial liability in event of loss to the insured. Motor
Vehicles Act in 1939 was passed to mainly safeguard the interests of pedestrians. According to
the Act, a vehicle cannot be used in a public place without insuring the third part liability.
According to Section 24 of Motor Vehicles Act, “No person shall use or allow any other person
to use a motor vehicle in a public place, unless the vehicle is covered by a policy of insurance.”
Classification of Motor Vehicles As per the Motor Vehicles Act for the purpose of insurance the
vehicles are classified into three broad categories such as.
Private cars:
a) Private Cars - vehicles used only for social, domestic and pleasure purposes
b) Private vehicles - Two wheeled
1. Motorcycle / Scooters
2. Auto cycles
3. Mechanically assisted pedal cycles

Commercial vehicles:

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 1. Goods carrying vehicles
2. Passengers carrying vehicles
3. Miscellaneous & Special types of vehicles

The risks under motor insurance are of two types:

1) Legal liability due to bodily injury, death or damage caused to the property of others.
2) Loss or damage to one’s own vehicle\ injury to or death of self and other occupants of the
vehicle.
Types of motor policies
When you buy a motor vehicle, you need to buy a motor insurance. There are, however, many
types of motor insurance policies available. The common types are:
• Third party cover - This policy insures you against claims for bodily injuries or deaths
caused to other persons (known as the third party), as well as loss or damage to third
party property caused by your vehicle.
• Third party, fire and theft cover - This policy provides insurance against claims for third
party bodily injury and death, third party property loss or damage, and loss or damage to
your own vehicle due to accidental fire or theft.
• Comprehensive cover - This policy provides the widest coverage, i.e. third party bodily
injury and death, third party property loss or damage and loss or damage to your own
vehicle due to accidental fire, theft or an accident.
Exclusions/Extensions
A standard motor insurance will not cover certain losses, such as your own death or
bodily injury due to a motor accident, your liability against claims from passengers in your
vehicle (except for passengers of hired vehicles such as taxis and buses) and loss or damage
arising from an act of nature, such as flood, storm and landslide. However, you may pay
additional premiums to extend your policy to cover flood, landslide, landslip as well as cover
your passengers. It is important to check your policy for the exclusions.
Important points to consider when buying motor insurance policies
Insured value/sum insured: If you are buying a policy against loss/damage to your vehicle, you
must ensure that your vehicle is adequately insured as it will affect the amount you can claim in
the event of loss/damage. For a new vehicle, the insured value will be the purchase price while
for other vehicles, the insured value is the market value of the vehicle at the point you apply for
the insurance policy.
• Under-insurance – If you insure your vehicle at a lower sum than its market value, you
will be deemed as self-insured for the difference, i.e. in the event of loss/damage, you
will only be partially compensated (up to the proportion of insurance) by your insurance
company.

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 • Over-insurance – Should you insure your vehicle at a higher sum than its market value, the
maximum compensation you will receive is the market value of the vehicle as the policy
owner cannot ‘profit’ from a motor insurance claim.
Duty of disclosure: You should disclose fully all material facts, including previous accidents (if
any), modification to engines, etc. When in doubt as to whether a fact is relevant or not, it is best
to ask your insurance company. If you fail to disclose any material fact, your insurance company
may refuse to pay your claim or any claim made by a third party against you. In such cases, you
are personally liable for such claims.
Price: The price you pay for your motor insurance will depend on the type of policy selected.
The insurance premium charged by your insurance company is the standard minimum rate in
accordance with the Motor Tariff. However, in addition to the standard minimum rate, your
insurance company may impose additional premiums known as loadings to the premium payable
in view of higher risk factors involved such as age of vehicle and claims experience.
No-claim-discount: The premium payable may be reduced if you have no-claim-discount
(NCD) entitlement. NCD is a ‘reward’ scheme for you if no claim was made against your policy
during the preceding 12 months of policy. Different NCD rates are applicable for different
classes of vehicles. For a private car, the scale of NCD ranges from 25% to 55% as provided in
the policy.
Transfer of ownership: In case of any sale of vehicle involving transfer of policy, the insured
should apply to the insurer for consent to such transfer. The transfer is allowed, if within 15 days
of receipt of application, the insurer does not reject the plea. The transferee shall apply within
fourteen days from the date of transfer in writing to the insurer who has insured the vehicle, with
the details of the registration of the vehicle, the date of transfer of the vehicle, the previous
owner of the vehicle and the number and date of the insurance policy so that the insurer may
make the necessary changes in his record and issue fresh Certificate of Insurance.
Excess: Also known as a ‘deductible’. This is the amount of loss you have to bear before your
insurance company will pay for the balance of your vehicle damage claim. The types of excess
applicable are as follows:
• Compulsory excess of RM400: If your vehicle is driven by a person not named in
your policy or a person named in your policy who is under the age of 21, the holder of
a provisional (L) driving license or the holder of a full driving license of less than two
years.
• Other excess: applicable at the discretion of your insurance company and in some
cases, no excess is imposed. You can negotiate with your insurance company on this
excess.
What you should do in the event of an accident/loss
• Take notes of the accident – If you are involved in a motor accident, take notes of the
accident, i.e. the names and addresses of all drivers and passengers involved, vehicle
registration numbers, make and model of each vehicle involved, the drivers’ licence numbers
and insurance identification as well as the names and addresses of as many witnesses as
possible

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 • Make a police report – You are required by law to lodge a police report within 24 hours of a
road accident.
• Notify your insurance company – You must notify your insurance company in writing with
full details as soon as possible. Depending on the type of claim you intend to make, you may
have to notify other insurance companies. If you fail to report the accident, you will be liable
for your own loss as well as any third party claim against you.
• Select the workshop – You must send your damaged vehicle to a workshop approved by
your insurance company. If the accident occurs during office hours, you may call the hotline/
emergency assistance numbers provided by your insurance company. Otherwise, you may
call your insurance company for the nearest approved workshop. Should the accident occur
outside office hours and you are making a claim against your policy, i.e. an own damage
claim, you should ensure that your vehicle is towed to a workshop approved under Repairers
Scheme.
Claim Settlement
Claim arises when:
1) The insured’s vehicle is damaged or any loss incurred.
2) Any legal liability is incurred for death of or bodily injury
3) Or damage to the third party‘s property.
The claim settlement in India is done by opting for any of the following by the insurance
company.
• Replacement or reinstatement of vehicle
• Payment of repair charges
In case, the motor vehicle is damaged due to accident it can be repaired and brought back to
working condition. If the repair is beyond repair then the insured can claim for total loss or for a
new vehicle. It is based on the market value of the vehicle at the time of loss. Motor insurance
claims are settled in three stages. In the first stage the insured will inform the insurer about loss.
The loss is registered in claim register. In the second stage, the automobile surveyor will assess
the causes of loss and extent of loss. He will submit the claim report showing the cost of repairs
and replacement charges etc. In the third stage, the claim is examined based on the report
submitted by the surveyor and his recommendations. The insurance company may then authorize
the repairs. After the vehicle is repaired, insurance company pays the charges directly to the
repairer or to the insured if he had paid the repair charges.
Section 110 of Motor Vehicle Act, 1939 empowers the State Government in establishing
motor claim tribunals. These tribunals will help in settling the third party claims for the
minimum amount
Theft claims
• After submission of the claim form, you must cooperate fully with your insurance company
or its representative during the course of investigation of the theft claim.
• In view that the police and your insurance company will require time to investigate your
claim, you will receive the offer of settlement from your insurance company within six

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 months from the theft notification or upon completion of police investigations, whichever
is earlier
Heath Insurance
Health insurance, like other forms of insurance, is a form of collectivism by means of
which people collectively pool their risk, in this case the risk of incurring medical expenses. The
collective is usually publicly owned or else is organized on a non-profit basis for the members of
the pool, though in some countries health insurance pools may also be managed by for-profit
companies. It is sometimes used more broadly to include insurance covering disability or long-
term nursing or custodial care needs. It may be provided universally through government as a
feature of social solidarity, as is typical in many industrial countries, or as form of government
charity such as the United States Medicaid program. It may be purchased privately on a group
basis (e.g., by a firm to cover its employees) or purchased by an individual for himself or his
family. In each case, the covered groups or individuals pay a fee, premium, or tax, to help protect
themselves from health care expenses.
“Health insurance is an insurance, which covers the financial loss arising out of poor
health condition or due to permanent disability, which results in loss of income.” A health
insurance policy is a contract between an insurer and an individual or group, in which the insurer
agrees to provide specified health insurance at an agreed upon price (premium). It usually
provides either direct payment or reimbursement for expenses associated with illness and
injuries. The cost and range of protection provided by health insurance depends on the insurance
provider and the policy purchased.

Health Insurance Policies and Main Features:

Types of Health Insurance Policies:
Health Insurance policies are broadly classified into types-Individual Health Insurance and
Group Health Insurance. The following Health Insurance policies are available in India:
1. Individual Mediclaim Insurance
2. Group Mediclaim Insurance
3. Overseas Mediclaim Insurance
4. UHI
5. Health Plus Medical Expenses Policy
6. Group Health Plus Medical Expenses Policy
Major Characteristics of Individual Health Insurance Policy
Coverage: Individual coverage are generally classified into the following broad heads:
1. Hospital Surgical Insurance
2. Major Medical Insurance
3. Long-term Care Insurance
4. Disability Income Insurance

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Hospital Surgical Insurance: It covers the following expenses:
• Hospital expenses: A typical Individual Health Insurance policy covers impatient
hospital expenses subject to a specified limit and subject to certain amount of
deductible or co-insurance
• Surgical expenses
• Cost of medicines and nursing
• Domiciliary expenses up to certain limits
Major characteristics of Medical Insurance :It covers major or broader coverage than basic
coverage with the following characteristics:
1. Broad coverage for hospital charges, drugs, nursing, medical equipments, etc.
2. High maximum limit, say Rs. 5,00,000 or Rs. 10,0000, etc.
3. Benefit period: maximum amount paid under a major benefit policy depending on the
length of the policy
4. Deductible that must be satisfied before the benefit is granted, which may be
yearly deductible, family deductible, etc.
5. Co-insura'lce is provided in most of the policies to avoid moral hazards
6. Taxation benefits subject to compliance of certain requirements
7. Pre-exiting conditions clause to avoid adverse selection
Common exclusions
1. Expenses caused by war or military conflict
2. Cosmetic surgery
3. Dental care except as a result of an accident
4. Eye and examination aids unless there is an accident
5. Pregnancy or childbirth unless specifically provided
6. Expenses covered under W.C. laws or similar laws
7. Services furnished by governmental agencies unless the patient has the obligation to
pay
8. Experimental surgery
Standard Individual Mediclaim Insurance- Underwriting Guidelines
Coverage: This policy covers reimbursement of hospital is at ion or domiciliary hospitalization
expenses for illness or diseases or injury sustained. In the event of any claim becoming
admissible under this scheme, the insurer will pay to the insured person the amount of such
expenses as would fall under different heads of medical expenses mentioned below and as are
reasonable and necessarily incurred by or on behalf of such insured persons but not exceeding
the sum insured in anyone period of insurance:

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 1. Room and boarding expenses provided by hospital or nursing home
2. Nursing expenses
3. Fees of surgeon, anesthetist, consultant etc.
4. Anesthesia, blood oxygen, OT, X-ray, surgical appliances, medicines etc.
The sum insured in this policy varies from ` 15,000 to 5,00,000 per person. This policy
provides for family discount on total premium for the members of the family. In case of no
claim, cumulative discount is also available as per the company's underwriting policy. In case of
cost of health check, as per the policy conditions, generally once in four years is available.
Underwriting Guidelines: Individual Mediclaim Insurance has been showing very high incurred
claim ratio since long. In the tariff market, this product has been sold by almost all underwriters
with huge cross-subsidy from profitable products like fire and engineering. But in the de-tariff
market, the prevalence of cross-subsidy is ruled out. Every product must stand on its own
revenue. One product cannot subsidize other product. In view of our huge claim ratio of around
140 per cent of Individual Mediclaim Insurance, the underwriters have adopted the following
underwriting measures to ensure prudent underwriting for this product today:
1. Fresh proposal for a single person above 45 years of age is discouraged.
2. Though mediclaim policy is available to persons between 5 years and 80 years of age, fresh
acceptance of cover for a person beyond 60 years is discouraged, unless he is a member of a
big family or group to be covered or otherwise potential.
3. Policy already in force for insured exceeding 75 years of age may be renewed on the basis of
claim experience and risk evaluation with or without restrictive condition as per the risk
analysis findings.
4. Cancellation of policy is done subject to the following underwriting policy:
a. Policy to be renewed by mutual consent.
b. Company is not bound to notify that policy is due for renewal.
c. Policy may be cancelled by company after giving 30-days notice and pro rata premium to
be refunded, provided no claim has been paid under this policy.
d. Company remains liable for any claim arising prior to date of cancellation.
e. The insured may cancel the policy any time; the company would refund premium subject
to 'No-claim' during the policy period.
5. Renewal of policy is done on the basis of the following norms:
a. In case renewal is agreed, the illness for which the expenses have been paid in previous
policy are not to be excluded. Renewal is done on earlier terms.
b. If policy is renewed for enhanced sum insured, reimbursement of illness occurred in the
previous policy shall be restricted to old sum insured.
6. Cost of health check up is allowed up to I per cent of average sum insured of four claims-free
underwriting years.
7. Issuance of policies for period less than one year is prohibited.
8. Policies for persons above 75 years to be decided on the claim experience merit.

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9. Extension for suspended mediclaim may be allowed only when overseas mediclaim policy
has been taken by an individual or family as whole when one of the person goes abroad by
taking overseas mediclaim policy.
10. Tax-benefit under Section 80D of the IT Act available when premium is paid by cheque.
11. General exclusions: provided under the policy:
a. All diseases or injuries which are pre-existing when the cover incepts for the first time.
b. Any diseases other than those mentioned below contracted by the insured person during
the first thirty days from the commencement of the policy.
c. During the first year of the operation of insurance cover, the expenses on treatment of
diseases such as cataract, benign prostatic hypertrophy, hysterectomy for menorrhagia
or fibromyoma, hernia, hydrocele, congenital internal diseases, fistula in anus, piles,
sinusitis and related disorders.
d. Injury or disease directly or indirectly caused by or arising from or attributable to war,
invasion, act of foreign enemy, war-like operations (whether war be declared or not).
e. Circumcision unless necessary for treatment of a disease not excluded hereunder or as
may be necessitated due to an accident, vaccination or inoculation or change of life or
cosmetic or aesthetic treatment of any description, plastic surgery other than as may be
necessitated due to an accident or as a part of any illness.
f. Cost of spectacles, contact lenses, hearing aids.
g. Any dental treatment or surgery which is a corrective, cosmetic or aesthetic procedure,
including wear and tear, unless arising from disease injury and requires hospitalisation
for treatment.
h. Convalescene, general debility, 'run-down' condition or rest corrective, congenital
external disease defects or anomalies, sterility, venereal disease, intentional self-injury
and use of intoxicating drugs or a1chol.
1. All expenses arising out of any condition directly or indirectly caused to or associated
with human T cell lymph tropic virus type III (HTD-III) or lymphadinopathy-associated
virus (LAV) or the mutants derivative or variations deficiency syndrome or any HTTB-
III syndrome or condition of a similar kind commonly referred to as AIDs.
J. Charges incurred at hospital or nursing home primarily for diagnostic, X-ray or
laboratory examinations not consistent with or incidental to the diagnosis and treatment
of the positive existence or presence of any ailment, sickness or injury for which
confinement is required at a hospital or nursing home.
k. Expenses on vitamins and tonics unless forming part of treatment for injury or disease as
certified by the attending physician.
1. Injury or disease directly or indirectly caused by or contributed to by nuclear weapons or
materials. '
m. Treatment arising from or traceable to pregnancy, childbirth, miscarriage, abortion or
complications of this kind, including caesrian section.
n. Naturopathy treatment.

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Guidelines for Group Mediclaim Policy: The underwriters generally follow the underwriting
procedures mentioned below to ensure prudent underwriting and high incurred claim ratio:
1. Group policy will be issued for named persons only.
2. Group shall be of any of seven specified categories, namely, (i) Employer-employee
relationship, (ii) Pre-defined segment where premium is paid by Government, (iii)
Members of a registered club, (iv) Members of a registered co-society, (v) Holders of
credit cards of banks, visa or master cards (vi) Holders of deposit certificates of banks
/NBFC, and (vii) Shareholders of a company.
3. Group discount generally varies from 2.5 per cent to 30 per cent available for various
groups from 101 to 50,000 and above.
4. Monthly endorsement for any addition or deletion of any number of members shall be
without any change in discount.
5. Group below 100 persons may be given group policy without discount.
6. Maternity benefit up to Rs. 50,000 available with 10 per cent loading on basic premium.
7. Cost of health check-up will not be available in group policy.
8. 5 per cent service charges on group policy.
Universal Health Insurance
This Health Insurance is a very important policy for people below the poverty line and is thus of
great importance for social security and National Health Policy. Let us now discuss the
important provisions of such Health Insurance as a matter of case study on underwriting of a
Health Insurance product essential for National Health Policy.
Sum Insured:
1. Section I: Hospitalisation benefit per family-Rs. 30,000
2. Section II: Accidental death benefit for head of family-Rs. 25,000
3. Section III: Disability compensation on hosptalisation for head of family for maximum
period of 15 days- Rs. 50 per day
Premium:
1. Individual person: Rs. 365 p.a.
2. Family of five persons (insured + spouse + 3 children): Rs. 548 p.a.
3. Family of seven persons (as above + parents): Rs. 730 p.a.
Benefits
Section I
1. Reimbursement of total medical expenses for anyone accident: Rs. 15,000
2. Reimbursement for a member of family-individually or collectively: Rs. 30,000, subject to
following sub-limits of hospital expenses:
a. Room or boarding expenses: up to Rs. 150 per day

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 b. ICU reimbursement: up to Rs. 150 per day
c. Fees of surgeon, anaesthesist, consultant, etc.: up to Rs. 4,500 per illness
d. Anesthesia, blood, oxygen, QT, X-ray, surgical appliances, medicines, etc.: up to Rs.
4,500 per illness
The insurer's liability in respect of all claims admitted during period of insurance shall not
exceed the SI ofRs. 30,000 per person or per family.
Section II
Death Compensation for earning head of the family solely and directly due to accident caused by
outward, violent and visible means will be to SI, i.e. Rs. 25,000

Section III
Disable compensation for earning head the family solely and directly due to accident for which a
valid claim under Section I is admitted will be up to Rs. 50 per day with excess of three days for
a maximum period of 15 days.
General Exclusions:
1. All pre-existing diseases are not admissible.
2. Any disease other than those stated in the policy contracted by the insured person
during the first 30 days of commencement of the policy, provided that in the opinion
of panel doctors the insured could not have known the existence of the disease or any
symptom and had not taken any consultation treatment or medication.
3. Some diseases like cataract, benign prostate hypertrophy, hysterectomy, hernia,
menorrhagia or fibromyoma, hydrocele, congenital, internal disease, fistula, piles,
sinusitis and related disorders are not payable.
4. Disease arising from or attributable to war or war-like operations.
5. Circumcision unless necessary for treatment or due to accident.
6. Cost of spectacles, contact lenses and hearing aids.
7. Dental treatment, which is cosmetic, corrective or aesthetic.
8. Convalescence general debility, 'run down' condition or rest cure, congenital external
disease or defects or anomalies, sterility, venereal disease, intentional self-injury and
use of drugs.
9. Any cosmetic treatment or surgery, sterility, venereal disease, HIV, AIDS 10.
10. Diagnostic, X-ray or laboratory examination not consistent with diagnosis
11. Vitamins and tonics not forming part of treatment.
12. Disease or injuries attributable to nuclear weapons.
13. Treatment arising from pregnancy, childbirth, miscarriage, etc.
14. Naturopathy treatment.

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Specific Exclusion for Section II
1. Compensation in respect of death directly or indirectly contributed or traceable to any
disability existing on the commencement of the policy.
2. Death arising directly or indirectly from:
a. Internal self-injury or suicide.
b. Pregnancy or any complication thereof.
c. Whilst engaging in aviation, ballooning, mounting or traveling in any
aircraft other than as a passenger.
d. Whilst under the influence of intoxication, liquor or drugs.
e. Directly or indirectly caused by venereal diseases or insanity.
f. Breach of law with criminal intent.
General Conditions:
1. Only one policy will be issued to one family.
2. The pre- and post-hospitalization expenses are excluded.
3. Proposal form and prospectus to be signed by the proposer with all details.

Health Insurance Policies in India: The health insurance policies available in India are:
(a) Mediclaim policy (individuals and groups)
(b) Overseas mediclaim policy
(c) Raj Rajeshwari Mahila Kalyan Yojna
(d) Bhagyashree Child Welfare Policy
(e) Cancer Insurance Policy
(f) Jan Arogya Bima Policy
• Mediclaim policy (individuals and groups): Mediclaim policy is offered to individuals
and groups exceeding 50 members. It covers the hospitalization for diseases or sickness
and for injuries. Under group mediclaim policy, group discount is allowed to groups
exceeding 101 people. The medical expenses will be reimbursed only if the insured is
admitted in the hospital for a minimum duration of 24 hours. Cost of treatment includes
consultation fee of doctors, cost of medicines and hospitalization charges. Health
insurance in India is available at very economical rates. It is very popular among
professionals like Chartered accountants, Advocates, Engineers etc. It is very suitable for
self-employed persons because it covers risks against several general and serious
diseases.
• Overseas Mediclaim Policy: In 1984, the Overseas Mediclaim Policy was developed.
This policy will reimburse the medical expenses incurred by Indians upto 70 years of age
while traveling abroad. The premium will be charged based on their age, purpose of
travel, duration and plan selected by the insured under the policy. This policy is provided

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 is provided to businessmen , people going on holiday tour, traveling for educational
professional and official purposes.
• Raj Rajeshwari Mahila Kalyan Yojna: It is a personal accident policy offered by an
insurance company for the welfare of women. It is offered to women residing in rural and
urban areas. Women between 10-75 years of age are eligible for this policy irrespective
of their occupation and income level.
• Bhagyashree Child Welfare Policy: It is offered to girls between 0-18 years. The age of
the parents of the girls shouldn’t be more than 60 years. It provides coverage to one girl
child in a family who loses her father or mother in an accident.
• Cancer insurance policy: It is designed for cancer patients aid association members. The
persons insured under this policy will pay premium to their association along with the
membership fee. This policy will offer coverage to the insured in case he develops
cancer. All the expenses incurred for treatment of cancer not exceeding the sum insured
will be paid directly to the insured person.
• Jan Arogya Bima Policy: This policy provides medical insurance to poorer section of the
people. This policy covers illness like heart attack, jaundice, food poisoning, and
accidents etc. that requires immediate hospitalization.
Miscellaneous Insurance:
Personal Accident Insurance: Personal Accident is an insurance cover wherein, in the event of
the person sustaining bodily injuries resulting solely and directly from an accident caused by
EXTERNAL, VIOLENT & VISIBLE means , resulting into death or disablement. An accident
may include events like: Rail / Road / Air Accident, Injury due to any collision/fall, Injury due to
Bursting of gas cylinder, Snake-bite, Frost bite/Dog bite , Burn Injury, Drowning, Poisoning etc.
Personal Accidental policy covers accidental death, loss of limbs, permanent total and
partial disablement as selected and granted by the insurance companies based on the
underwriting norms. On payment of additional premium, medical expenses reimbursement can
be covered. These expenses are payable, in case, if the claim is admitted under the basic policy
cover. In addition to the Personal Accident Insurance cover the policies available are : Nagrik
Suraksha Poicy, Janta Personal Accident Policy, Gramin Personal Accidental Policy , Student
Package Policies for students, Bhagashree for Girl-children, Raj Rajeshwari for Women etc.
Further as an ad-on cover Motor Vehicle Package Policy & Overseas Mediclaim Policy too offer
personal accidental injuries cover.
Sum insured is based on various factors namely:
(1) Income from gainful employment,
(2) Type of occupation,
(3) Age as on date of proposal,
(4) Period of insurance
(5) Conditions prevailing at the place from where the proposal is made etc.
(6) As regards the non-earning spouse of the insured the sum insured in respect of such spouse
shall not exceed 50% of the eligibility of the insured, subject to a limit of Rs. One Lakh
under benefits available under Table III of the policy.

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(7) Dependent children can be offered a sum insured not exceeding Rs.50000/- to cover death
and disablement only. No temporary disablement cover shall be offered.
Generally Personal Accident policies are maximum for one year only. However, depending upon
the requirement of the proposer it can be offered for a period which could even be lesser than 12
months.

Fidelity Insurance: Fidelity insurance protects organizations from loss of money, securities, or
inventory resulting from crime. Common Fidelity claims allege employee dishonesty,
embezzlement, forgery, robbery, safe burglary, computer fraud, wire transfer fraud,
counterfeiting, and other criminal acts. These schemes involve every possible angle, taking
advantage of any potential weakness in your company’s financial controls. From fictitious
employees, dummy accounts payable, non-existent suppliers to outright theft of money,
securities and property. Fraud and embezzlement in the workplace is on the rise, occurring in
even the best work environments. Liabilities covered by crime insurance usually fall into two
categories, although many polices combine both types of coverage:
• Money and security coverage pays for money and securities taken by burglary, robbery,
theft, disappearance and destruction.
• Employee dishonesty coverage pays for losses caused by most dishonest acts of your
employees, such as embezzlement and theft.
Fidelity insurance includes comprehensive coverage of:
• Employee theft
• Money and securities while on premises or in transit
• Forgery
• Funds transfer fraud
• Computer fraud
• Money order and counterfeit currency fraud
• Credit card fraud
• Optional client coverage
• Coverage for investigative costs for covered losses
• Responds to Employee Retirement Income Security Act of 1974 (ERISA) plan bonding
requirement.
• Broad definition of employee, including directors and officers; employees, including
part-time, leased, temporary, and seasonal employees; and volunteers.
• Worldwide coverage.

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Burglary Insurance: Such a policy provides protection against loss or damage caused by
housebreaking, robbery or theft. It is also known as ‘robbery, theft or larceny insurance’. For this
purpose a comprehensive policy may be taken or each risk may be separately insured. Full
details of the article insured are given in the policy. Insured items include gold and gold
ornaments and other assets including household items such as TV, fridge, air conditioner etc. A
burglary policy for business premises would provide cover against loss to damage by house
breaking and burglary of stock-in -trade, goods in- transit, cash-in-safe, fixture and fittings etc.

Credit Insurance: Credit insurance policy is taken to cover the loss which may arise due to bad
debts or non-payment of dues by the debtors. This insurance is very useful to businessmen who
sell goods on credit. It protects them from loss arising out of insolvency of their debtors. In India,
Export Credit and Guarantee Corporation (ECGC) provide credit insurance to exporters.

Workmen’s Compensation Insurance: In India, Workmen’s Compensation Act was passed in

1934 and 1946. According to this act, an employer is required to pay compensation to his
workers who receive injuries or contract occupational diseases during the course of their work.
An employer may obtain an insurance policy to cover such liability. The premiums are payable
usually on the basis of wages. It is also known as ‘Employers Liability Insurance’. This policy is
essential to every employer who employs ‘workmen’ as defined under the Workmen’s
Compensation Act in order to protect himself against the legal liabilities arising out of death or
bodily injury to this workman. It also extends coverage through reimbursement of medical,
surgical and hospitalization expenses including transportation costs on the payment of additional
premium. The National Insurance Company Ltd, United India Insurance Company Ltd, Oriental
Insurance Company Ltd, and the New India Assurance Company Ltd offer workmen’s
compensation policies.

Travel Insurance: Travel insurance covers travel related accidents also. While traveling outside
India, individuals face risks such as loss of baggage, accidents involving injuries, illnesses and
medical emergencies requiring hospitalization treatment. All this can pose serious consequences
to the overseas travellers. A rational person should therefore secure the required coverage before
leaving his home country. In India travel insurance has become popular among International
travellers. The coverage offered under travel insurance policies in India are as follows:
• Medical assistance in case of an emergency
• Covers Personal Accident, Medical Expenses & Medical Evacuation & Repatriation
• Loss & delay of Checked Baggage
• Covers pre-existing medical conditions
• Convalescence after hospitalization
• Takes care of sudden and unforeseen expenditure Convenient and hassle free trip for
the family

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Wedding Insurance: These days, weddings have become quite an expensive and elaborate
affair. People do take care to make this once-in-a-lifetime event a memorable one. In case of any
postponement or cancellation, there is a certain risk of monetary loss. The wedding insurance
package can compensate for the monetary loss. This unique product covers the specific risks
related to weddings. This Policy can protect you against certain types of financial losses you may
incur in the event of unpredictable situations during the period leading up to and including your
wedding day. The period of insurance will be 24 hours prior to the start of the customary
functions or rituals or programmes of events mentioned in the printed invitations till the end of
the function or five days from the beginning whichever occurs earlier. This policy provides cover
for expenses actually and already incurred or advances paid in connection with marriage hall,
catering, pandit, guests, music parties, photos and videography, loss on cancellation of travel
tickets etc. Liability is restricted only when such cancellation arises out of cancellation or
postponement of marriage. The policy does not cover any loss arises when marriage is cancelled
or postponed because of dispute between marriage parties, willful negligence and criminal
misconduct of the bride, bridegroom or their parents.

Employee State Insurance Scheme: The Employee State Insurance Scheme (ESIS) is an
insurance system which provides both the cash and medical benefits. It is managed by the
Employee State nsurance Corporation (ESIC), a wholly government-owned enterprise. It was
conceived as a compulsory social security benefit for workers in the formal sector. The original
legislation creating the scheme allowed it to cover only factories which has been using power
and employing 10 or more workers. However, since 1989 the scheme has been expanded, and it
now includes all such factories which are not using power and employing 20 or more persons.
Mines and plantations are explicitly excluded from coverage under the ESIS Act.

Unemployment Insurance: Unemployment insurance is designed to provide short term

protection for regularly employed persons who lose their jobs and who are willing and able to
work. Unemployment insurance has several basic objectives:
1) Provide cash income during involuntary unemployment.
2) Help unemployed workers find jobs.
3) Encourage employees to stabilize employment.
4) Help stabilize economy.
Unemployment insurance is a popular concept in developed countries like U.S. where they have
well defined laws and regulations. However in India it will take a long time to come.
Personal Liability Insurance: Personal liability insurance provides protection against the legal
liability, which arises due to insured’s personal acts. The insurance company will pay for legal
defense to third party damages or injuries up to policy limit. Except legal liability, which arises
due to automobile accidents and professional liability, most other personal acts are covered under
personal liability insurance. The personal liability insurance covers damages caused to properties
and injuries to other people due to the negligence of the insured. Under this policy, the insurance
company is bound to defend the insured, should the matter go to court of law. It can also settle
the matter out of court by negotiating with parties for a settlement within the policy limit.

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Personal liability policy offers very wide coverage. The following instances of loss, damages or
injuries caused by an insured individual come under the purview of personal liability insurance
in which coverage will be available up to the policy limit.
• Accidental fire to neighbor’s house as a result of insured’s negligence
• Accidental injury to a third party while playing
• Damaging costly antique accidentally belonging to neighbor
• Injuring another person while riding a bicycle

Self Assessment Questions

1) Define fire insurance. What are the essential features of a fire insurance contract?
2) What is the claim settlement procedure followed for a fire insurance policy?
3) What is a floating policy?
4) What is marine insurance? How it is different from fire insurance?
5) What is meant by “perils of the sea”?
6) Briefly describe the different types of losses under marine insurance.
7) Is third party insurance a must under motor vehicle Act?
8) How is subrogation helpful to the insurer?
9) What would be the status of the claim if the vehicle were covered under liability policy?
10) Explain Travel insurance.
11) Explain the scope of Fidelity insurance.
12) Discuss the main clauses of marine policies.
13) Enumerate the various types of marine insurance policies.
14) What do you mean by ‘assignment of policy’? Indicate the manner in which a marine policy
can be assigned.
15) Distinguish between express warranties and implied warranties in relation to marine
insurance policy.
16) Write a short note on the following:
i) Unemployment insurance
ii) Wedding insurance

References:
• Bhatia R.C., (2005), Business Organization and Management, One Books, New Delhi.
• Gupta C. B., (2005), Business Organization and Management, Sultan Chand & Sons,
New Delhi.
• Gupta P. K., (2005), Insurance and Risk management, Himalaya Publisher, New Delhi.

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• Prakash Jagdish, (1995), Business Organization and Management, Kitab Mahal, New
Delhi.
• Singh B.P. & Chhabra T.N., (2004), Business Organization and Management, Dhanpat
Rai & Co., New Delhi.
• Mishra, K.C. and Guria, R.C.(2009), Practical Approach to General Insurance
Underwriting, Cengage Learning, Delhi.

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 LESSON 6
UNDERSTANDING ANNUAL REPORT OF A NON-LIFE
INSURANCE COMPANY
Dr Ashish Kumar
LBSIM
Introduction:
The primary legislations including the Insurance Act, 1938 and the IRDA Act, 1999 that deal
with insurance business in India provide the legal framework of insurance accounting in India,
over and above the principles and practices prescribed by Generally Accepted Accounting
Principles (GAAP) and the various Accounting Standards (AS) issued by the Institute of
Chartered Accountants of India(ICAI) and the international organization Financial Accounting
Standards Board (FASB). However, the following statutes, rules and regulations are the major
considerations for accounting and financial management for insurance companies in India:
1. The Insurance Act, 1938 and Insurance Rules, 1939
2. The Insurance Regulatory and Development Authority Act, 1999
3. The Companies Act, 1956
4. The Life Insurance Corporation Act, 1956
5. The General Insurance Business (Nationalization) Act, 1972
Section 11 of the Insurance Act, 1938 provides that every insurer, on or after the
commencement of the IRDA Act, 1999 in respect of insurance business transacted by him and
in respect of his shareholders' fund, shall at the expiration of each financial year, prepare a
Balance Sheet, a Profit and Loss account, a separate Account of Receipts and Payments (Cash
Flow Statement), Revenue Accounts in accordance with the regulations made by the Authority.
Every Insurer shall keep separate accounts relating to funds of shareholders and policyholders.
Accounting Regulations and Financial Statements:
The IRDA (Preparation of Financial Statements and Auditor's Report of Insurance Companies)
Regulations, 2002 provide that-
• An insurer carrying on life insurance business shall comply with the requirements of
Schedule' A' to prepare financial statements.
• An insurer carrying on general insurance business shall comply with the requirements of
Schedule 'B' to prepare financial statements.
• The Report of the Auditors on the Financial Statements of every insurer/ re-insurer shall be in
conformity with the requirements of Schedule 'C'.
The said regulation further provides that financial statements comprising (i) Balance
Sheet, (ii) Receipts and Payments Account (Cash Flow Statement) (iii) Profit & Loss Account
(Shareholders' Account) and (iv) Revenue Account (policyholders' Account) shall be in
conformity with the Accounting Standards (AS) issued by the Institute of Chartered
Accountants of India to the extent applicable to the insurer except that:
• Accounting Standard 3-Cash-flow Statement shall be only under Direct Method
• Accounting Standard 13-Accounting for Investment shall not be applicable
• Accounting Standard 17-Segment reporting shall apply to all insurers irrespective of the
requirements for listing and turnover mentioned therein.
Section 2C of the Regulation provides that all words and expressions used herein and not
defined in the Insurance Act, 1938 or in the IRDAAct, 1999 or in the Companies Act, 1956
shall have the meanings respectively assigned to those Acts. However, regulatory provisions
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prescribed by the IRDA and the specific and relevant Accounting Standards promulgated by the
Institute of Charted Accountants of India are being separately discussed in detail in subsequent
units.
Financial statements of insurance companies comprise the following as stated earlier:
• Balance sheet,
• Revenue accounts,
• Profit and loss account, and
• Receipts and payments account
Besides the financial statements, the annual reports of an insurance company also contain
the following statutory documents for the review and analysis of the various interested groups
including shareholders, policyholders, regulators, reinsurers, employees, co-insurers, etc.
1. Report of the board of directors
2. Management report
3. Auditors report
4. Segment reporting
5. Significant accounting policies
6. Notes and disclosures forming part of accounts
Let us now discuss the above financial statements and reports with reference to legal
requirements, accepted principles and practices with a few examples and exercises. Certain
examples with hypothetical data are also given in Annexure for clarity of understanding of
students in respect of financial statements
Directors’ Report: legal Requirement as Regards Directors’ Report (Companies Act 1956)
As per Section 217 of the Companies Act, 1956 there shall be attached to every balance
sheet laid before a company general meeting a report by its Board of Directors with respect to
following particulars:
• The state of affairs of the company.
• The amounts, if any, which it proposes to carry to any reserve in balance sheet.
• The amount, if any, which it recommends, should be paid by way of dividend.
• The material changes and commitments, if any, affecting the financial position of the
company, which have occurred between the end of the financial year of the company to
which the balance relates and the date of the report.
• The technology absorption, foreign exchange earnings and outgo and the manners
thereof.
• The material changes, if occurred during the financial year in respect of the nature and
class of business of the company or its subsidiary.
• The statement showing the name of every employee of the company who, if employed
throughout the financial year, was in receipt of remuneration for that year, which in the
aggregate was not less than Rs. 24,00,000 per annum or if employed for a part of the
financial year was not less than Rs. 2,00,000 per month. Such state shall also indicate that
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 whether any such employee is a relative of any director or manager of the company.
• The Directors' Responsibility Statement must mention that
a) In the preparation of the annual accounts, the applicable accounting standards
have been followed along with proper explanations relating to material departure,
b) The directors had selected such accounting policies and applied them consistently,
c) The results and estimates are reasonable and prudent so as to give.a true and fair
view of the state of affairs of the company at the end of the financial year and of
the profit or loss of the company for that period,
d) That the directors had taken proper and sufficient care for the maintenance of
adequate accounting records in accordance with the provisions of the Companies
Act, 1956 for safeguarding the assets of the company and for preventing and
detecting frauds and other irregularities and that the directors had prepared the
annual accounts on a going concern basis.
• The reasons for the failure, if any, to complete the buy back within the time specified in
Section 77 A of the Act.
• The fullest and explanations on every reservation, qualification or adverse remarks
contained in the auditors' report.

Common Disclosures in Directors’ Report Contained in the Annual Report of a General

Insurance Company:
Director report of an insurance company generally furnishes the following information
specifically as per the above requirements of the Companies Act, 1956:
1. Comparative Performance Analysis (Class-wise Underwriting Performance) for the
financial year under report with reference to previous year) as appended in Annexure
A.2 showing performance analysis of XYZ General Insurance Co. Ltd. in respect of the
following performance review for FY 2005-06.
• Gross direct premium and percentage of growth over previous year
• Reinsurance premium ceded
• Reinsurance accepted
• Net premium and percentage of growth over previous year
• Increase in unexpired risks reserve and percentage to net premium
• Net premium earned
• Net incurred claims and percentage to net premium
• Others
2. Review of accounts as an annexure to accounts
3. Profit before tax and after tax
4. Proposed dividend
5. General reserves and current year transfer of profit to that reserve
6. Total assets and the contribution of increase of fair value change account
7. Total investments, its composition/portfolio, its increase over the last year
8. Solvency margin and its change over the previous year
9. Compliance with Section 40C in regard to prescribed % of expenses

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 Financial Statements for life Insurers:
Life Insurers shall prepare Financial Statements as per specified Forms such as Revenue
Account (Form A-RA), Profit and Loss Account (Form A-PL) and Balance Sheet (Form A-BS)
as per Part V in Schedule A of Regulation III. The said financial statements will be prepared in
accordance with General Instructions for preparations as per Part III. The said financial
statements shall be supported by disclosures forming part of financial statements and the com-
ments of management report as per Part II and Part IV respectively, of the Schedule A. The
specified forms of financial statements are given hereinafter as ready reference.

Form A-BS
Balance Sheet of Life Insurance Company

Current Previous
Particulars Schedule No.
Year Year
SOURCES OF FUNDS
Shareholders' Funds:
Share capital
Reserves and surplus
Credit/debit fair value change account
Sub-total
Borrowings
Policyholders' Funds:
Credit/debit fair value change account
Policy liabilities
Insurance reserves
Provision for linked
liabilities
Sub-total
Funds for Future Appropriations
Total (Sources of Funds)
APPLICATION OF
FUNDS
Investments
Shareholders'
Policyholders'
Assets Held to Cover linked liabilities
loans
Fixed Assets
Current Assets
Cash & bank balances
Advances and other assets
Sub-total (A)
Current liabilities
Provisions
Sub-total (B)
Net Current Assets (C ) = (A-B)

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 Miscellaneous Expenditure (not written off)
Debit Balance in Profit & loss Account
(Shareholders' account)
Total (application of

Form A-RA
Revenue Account of Life Insurance Company
Policyholder’s Account

Particulars Schedule Current Previous

Premiums Earned-(Net)
(a) Premium 1
(b) Reinsurance ceded
(c) Reinsurance accepted
Income from Investments
(a) Interest, dividends & rent-(Gross)
(b) Profit on sale/redemption of investments
(c) Loss on sale/redemption of investments
(d) Transfer/Gain on revaluation/change in fair value*
Other Income (to be Specified)
TOTAL (A)
Commission 2
Operating Expenses Related to Insurance Business 3
Provision for DoubUul Debts
Bad debts written off
Provision for Tax
Provisions (other than taxation)
(a) For diminution in the value of
(b) Others (to be specified)
TOTAL (B)
Benefits Paid (Net) 4
Interim Bonuses Paid
Change in Valuation of liability in Respect of life
Policies
(a) Gross
(b) Amount ceded in reinsurance
(c) Amount accepted in reinsurance
TOTAL (C)
Surplus/Deficit (D) = (A)-(B)-(C)
APPROPRIATIONS
Transfer to Shareholders' Account
Transfer to Other Reserves (to be Specified)
Balance Being Funds for Future Appropriations
TOTAL (D)

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The above financial statements are to be prepared in accordance with applicable accounting
standard issued by leAL These financial statements will be supported by specified schedules
giving the required details as per regulations.

Disclosures forming part of financial statements (Life Insurer) Part II

A. The following shall be disclosed by way of notes to the balance sheet:
1. Contingent liabilities:
• Partly-paid up investments
• Underwriting commitments outstanding
• Claims, other than those under policies, not acknowledged as debts
• Guarantees given by or on behalf of the company
• Statutory demands/liabilities in dispute, not provided for
• Reinsurance Obligations to the extent not provided for ill accounts
• Others (to be specified).
2. Actuarial assumptions for valuation of liabilities for life policies in force.
3. Encumbrances to assets of the company in and outside India.
4. Commitments made and outstanding for Loans, Investments and Fixed Assets.
5. Basis of amortization of debt securities.
6. Claims registered and remaining unpaid for a period of more than six months as on the
balance sheet date.
7. Value of contracts in relation to investments, for:

• Purchases where deliveries are pending;

• Sales where payments are overdue.
8. Operating expenses relating to insurance business: basis of allocation of expenditure to
various segments of business.
9. Computation of managerial remuneration.
10. Historical costs of those investments valued on fair value basis.
11. Basis of revaluation of investment property.

B.Following accounting policies shall form an integral part of the financial statements:
1. All significant accounting policies in terms of the accounting standards issued by the
ICAI, and significant principles and policies given in Part I of Accounting Principles.
Any other accounting policies, followed by the insurer, shall be stated in the manner
required under Accounting Standard AS 1 issued by the ICAL

2. Any departure from the accounting policies shall be separately disclosed with reasons
for such departure.

C.The following information shall also be disclosed:

1. Investments made in accordance with any statutory requirement together with its
amount, nature, security and any special rights in and outside India;
2. Segregation into performing/non performing investments for income recognition.
Assets to the extent required to be deposited under local laws Percentage of business sector-wise;
A summary of financial statements for the last five years, in the manner as may be prescribed by
the Authority;
Bases of allocation of investments and income thereon between Policyholders' Account and
Shareholders' Account;
Accounting Ratios as may be prescribed by the Authority.
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 Example:

Financial Statements for non-life Insurance

Non-life Insurers shall prepare Financial Statements as per specified Forms such as Revenue
Account (Form A-RA), Profit and Loss Account (Form A-PL) and Balance Sheet (Form A-BS)
as per Part V in Schedule B of Regulation 3. The said financial statements will be prepared in
accordance with General Instructions for preparations as per Part III. The said financial
statements shall be supported by disclosures forming part of financial statements and the
comments of management report as per Part II and Part IV respectively, of the Schedule B.
The specified forms of financial statements are given hereinafter as ready reference for
the purpose of necessary discussion and analytical study for financial management based on
insurance accounting.
Form B-BS
Balance Sheet: Non-Life Insurer
Particulars Schedule No. Current Year Previous
SOURCES OF FUNDS
Share capital 5
Reserves and surplus 6
Fair value change account
Borrowings 7
TOTAL
APPLICATION OF FUNDS
Investments 8
Loans 9
Fixed assets 10
Current Assets
Cash and bank balances 11
Advances and other assets 12
Sub-total (A)
Current Liabilities 13
Provisions 14
Sub-total (B)
Net Current Assets (C) = (A - B)
Miscellaneous Expenditure (not written off ) 15
Debit Balance in pal Account
TOTAL

The above financial statements are to be prepared according to the general instruction for
preparation of financial statements as specified in Part III of the IRDA Regulation. Again said
financial statements will be supported by specific disclosure forming part of financial statements
as specified by Part II and comments of management report specified by Part IV of Schedule B
of the Regulation. It should also mention about the contingent liability in respect of the following
items:
• Party paid-up investments.
• Underwriting commitments outstanding.
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 • Claims, other than those under policies, not acknowledged as debts.
• Guarantees given by or on behalf of the company.
• Statutory demands/liabilities in dispute, not provided for.
• Reinsurance obligations to the extent not provided for in accounts.
• Others (to be specified).

Form B-RA
Non-life Revenue Account

Particulars Schedul Current Previou

1. Premium earned (Net) 1
2. Profit/loss on sale/redemption of investments
3. Others (to be specified)
4. Interest, dividend & rent (Gross)
TOTAL (A)
Particulars Schedu 2
2. Commission 3
3. Operating expenses related to insurance business 4
TOTAL (B)
Operating profit/loss from Fire/Marine/Misc.
Business C = (A - B)
APPROPRIATIONS
Transter to Shareholders' Account
Transfer to Catastrophe Reserve
Transfer to Other Reserves (to be specified)
TOTAL (C)

Form B-PL
Profit and Loss A/c of a General Insurance Company

Ratio Analysis:
Importantly, the users of financial statements cannot form any opinion on any of the trends for
their economic decisions with the company only on the basis of financial statements unless they
use various ratio analysis and trend analysis with comparative and classified accounting or
financial statement. In using the financial statement including balance sheet, and income
statements along with required disclosure and management report and computing percentage
change, trend change, component percentages, and ratios as exemplified in annexure, the finance
manager and analyst constantly search for some standard of comparison to establish whether the
information and relationship they have found are favourable or adverse for their future economic
decisions. Generally two standards of comparison used by financial analysts are (i) the past
performance of the company, and (ii) the position of the company with respect to industry
performance in the country and overseas. The insurance business is carried on with international
process, principle and perspective because of its very nature of international character. So its
trend analysis or trend percentage needs to be compared with industry data and international
standard to judge the company's position in respect of growth, profitability, liquidity, solvency,
etc. In the following table, certain performance analysis has been done with some hypothetical
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 figures just to show accounting information are used for trend analysis.

Performance Analysis and Trend Percentage (rs. In Lakh) of Ram Insurance Ltd.

Information 2009-10 2010-11 Remarks/Observations of Analyst

1 Gross direct premium 5,676 5,103 Growth in the current year
2 Percentage growth 11% 4% Better growth in the current year
3 Reinsurance accepted 332 314 More acceptance in the current year
4 Reinsurance Ceded 1665 1522 More retention in the current year
5 Net premium 4342 3895 Net premium increase in the current year
Increase over previous year 11% 7% Better growth trend in the current year
% to gross premium 77% 76% Better trend in current year
These ratios are the most vital tools of financial analysis in management accounting. The
corporate management will take many financial decisions for their strategic issues. With this
accounting information many more analysis like the following few can be done.
Gross Premium to Shareholders' Funds Ratio (Rs. in lakh)
2009-10 2010-11
1. Gross Premium 5675.54 5103.16
2. Shareholders' Fund 4161.69 3735.22
3. Ratio (times) 1.36 1.37

Better the ratio, greater is the capacity utilization and better will be the return. But again this ratio must
be within permissible limits laid down by regulators.

Net Retention Ratio

Gross Premium Net Premium Retention Ratio P. Y. Retention
Fire 1,103.49 830.76 75.28% 78.12%
Marine 349.33 164.38 47.05% 55.97%
Misc. 4,222.73 3,347.52 79.27% 77.46%
Total 5,675.54 4,342.65 76.52% 76.33%
What does it indicate? What is the necessity of comparative study?
What does excessively high or abnormally low retention ratio imply?

Fund and Investment: How to calculate Shareholders' Fund and Policyholders' Fund.
Shareholders' Fund (2010-11) (Rs. in lakh)
• Share Capital 200.00
• Capital Reserve 0.06
• General Reserve 4,622.79
• Misc. Reserve (-)14.82 4,808.03
Policyholders' Fund (2010-11) (Rs. in lakh)
• Unexpired Reserves 2,253.51
• Outstanding Claims 5,505.40 7,758.91
Total Funds 12,566.94

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Ratio between the two funds: 38:62

Total Investments 2010-11 2009-10

• In India 20344.89 14238.54
• Outside India 30.36 336.69
Total Investments 20375.25 14575.23

• Long Term 20274.07 14195.57

• Short Term 391.18 379.66
Total Investments 20665.25 14575.23

• Government Investment 4459.81 3989.16

• Equity & Debt 16205.44 10586.07
Total Investments 20665.25 14575.23

Cash Flow Statement

Cash flow statement is useful in providing users with financial statements with a basis to assess
the ability of the firm to generate cash and cash equivalent and the needs of the firm to utilize
those cash flows. The financial decisions that are taken by users require an evaluation of the
ability of the firm to generate cash and cash equivalent and the timing and certainty of their
generation. In insurance industry, the cash flow statement is of prime importance to the users of
the financial statements as the insurance company carries on risk-taking business dealing with
intangible product, i.e., promise to indemnity loss in future as and when accident will occur in
consideration of premium collected currently. The insurance companies need to have both
solvency and liquidity sufficiently to pay off their liabilities for claims at the time of accident,
i.e., occurrence of perils. Thus, an insurer should always prepare a cash flow statement and
should present it for each period for which financial statements are presented as per regulatory
norms and forms. As per the IRDA Regulations, Cash Flow statement in an insurance company
is to be prepared in a Direct Method where AS 3 will not be applicable. A cash flow statement, if
used in conjunction with other financial statements, provides information that enables the User to
evaluate the charges in the net assets of the insurance company and its financial structure
(including its liquidity and solvency). For the purpose of preparation of cash flow statement of an
insurance company, following terms need to be defined for proper interpretation and use.
1. Cash comprises on hand and demand deposits with banks of the corporate office and its all
operational units including overseas ones.
2. Cash equivalents are short term, highly liquid investments that are readily convertible into
known amounts of cash and which are subject to an insignificant risk of changes in value.
3. Cash flows are inflows and outflows of cash and cash equivalents.
4. Operating activities are the principal revenue-producing activities of a firm (insurer) and other
activities that are not investing or financing activities. In insurance company cash flow from
operating activates (insurance activities) is a key indicator of the extent to which the
operations of the enterprise have generated sufficient cash flows to maintain the operating
capability of the insurers, pay claims, commission, management expenses and dividends, and
repay loans and borrowings.

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5. Investing activities are the acquisitions and disposals of long term assets and other
investments not included in cash equivalent.
6. Financing activities are activities that result in changes in the size and composition of the
shareholders' funds and policyholders' funds (in case of insurance company) and borrowings
of the firm.
7. Preparation of cash flow statement Includes classification and segregation of operating,
investing and financing activities.

Direct Method of cash Flow Statement

Cash Flows from Operating Activities Amount Total
Cash receipts from customers .
Cash paid to suppliers and employees
Cash generated from operations
Income taxes paid
Cash flow before extraordinary item
Proceeds from earthquake disaster settlement
Net cash from operating activities
Cash Flows from Investing Activities
Purchase of fixed assets
Proceeds from sale of equipment
Interest received
Dividends received
Net cash from investing activities
Cash Flows from Financing Activities
Proceeds from issuance of share capital
Proceeds from long-term borrowings
Repayment of long-term borrowings
Interest paid Dividends paid
Net cash used in financing activities
Net increase in cash and cash equivalents
Cash and Cash Equivalents at Beginning of Period
Cash and Cash Equivalents at End of Period

Indirect Method of Cash Flow Statement

Cash Flows from Operating Activities Amount Total
Net profit before taxation, and extraordinary item
Adjustments for
Depreciation
Foreign exchange loss
Interest income
Dividend income
Interest expense
Operating profit before working capital changes

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Increase in sundry debtors
Decrease in inventories
Decrease in sundry creditors
Cash generated from operations
Income tax paid
Cash flow before extraordinary item
Proceeds from earthquake disaster settlement
Net cash from operating activities
Cash Flows from Investing Activities
Purchase of fixed assets
Proceeds from sale of equipment
I nterest received
Dividend received
Net cash flows from financing activities
Cash Flows from Financing Activities
Proceeds from issuance of share capital
Proceeds from long-term borrowings
Repayment of long-term borrowings
Interest paid
Dividend paid
Net cash used in financing activities
Net increases in cash and cash equivalents
Cash and Cash Equivalents at Beginning of Period
Cash and Cash Equivalents at End of Period

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Example of Financial Statement of a Non-life insurance companies:

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Example of Financial Statements of Life Insurance Companies

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Self-Assessment Questions:
Question 1: Define the legal requirements of Directors’ Report as per the Companies Act 1956.
Question 2: State IRDA requirements regarding the Financial Statements.
Question 3: Draft Balance sheet and Revenue Account of a life insurance company using
imaginary figures.
Question 4: Prepare the dummy financial statements of a non-life insurance company.

References:
• Mishra, K.C. and Guria, R.C.(2009), Practical Approach to General Insurance
Underwriting, Cengage Learning, Delhi.
• Gupta C. B., (2005), Business Organization and Management, Sultan Chand & Sons,
New Delhi.
• Gupta P. K., (2005), Insurance and Risk management, Himalaya Publisher, New Delhi.

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