The Geneva Papers on Risk and Insurance Vol. 26 No. 1 (January 2001) 54±70

Insurance Regulation: Some Issues by Somesh K. Mathur

1.

Introduction

Prior to 1956 the insurance business in India was owned and managed by private companies. The management of life insurance business was taken over and nationalized by the Government of India in September 1956 by an act of parliament. Later, the General Insurance Corporation (GIC) was set up in 1972 to deal in non-life insurance services like property and casualty insurance and reinsurance. Insurance in India is a Rs 400 billion (approximately US$9 billion) business. Gross premium collection is about 2 per cent of GDP and grew at nearly 20 per cent per annum between 1990 and 1997. India has the highest number of life insurance policies in force in the world and the total investable funds with the Life Insurance Corporation (LIC) is almost 8 per cent of GDP (Ranade and Ahuja, 1999). However about three quarters of India's insurable population has no life insurance cover. Health insurance of any kind is negligible and other forms of non-life insurance are much below international standards. The potential for growth and spread of life insurance is high in India due to stronger economic growth, rapid aging of population and a weak social security and pension system, which leaves a vast majority of workers with no old age income security. It may call for privatization of the Indian insurance market and foreign participation in it. The Malhotra Committee Report (1994) advocated liberalization of the insurance sector in India. The report made a strong case for activating professional regulation as a matter of priority, almost as a condition precedent to the further opening up of the insurance sector to private participation. It was not until recently (1999) that the Insurance Regulatory and Development Authority (IRDA) was formed with Mr N. Rangachary as its chairman. The role of IRDA is to ensure orderly growth of the insurance market in India. It must ensure ®nancial soundness of the insurance industry and protection of consumer interest1 through professional regulation. This development came in the wake of the passing of the IRDA Bill in Parliament. The IRDA Bill which was placed before Parliament in October 1999 is an improvement on its predecessor, the Indian Regulatory Authority (IRA) Bill, 1996. The new Bill is broader not only in its title but also in its reach and content (Pant, 1999). The IRDA Act marks the end of the government's monopoly in the insurance sector because it seeks to promote the private sector (including limited foreign equity) in the insurance sector (Economic Survey of India, 1999±2000). It covers major amendments to the Insurance Act 1938, the Life Insurance Corporation (LIC) Act 1956, and the General Insurance  Paper presented at the 16th International PROGRES Seminar, Geneva, September 2000.  Lecturer, Department of Economics, Jamia Millia Islamia, New Delhi-110025, India, e-mail (R):[email protected].(O);[email protected] 1 Consumer protection has two aspects: protection-against losses arising from the insolvency of institutions, and protection against losses caused by fraudulent practices.

# 2001 The International Association for the Study of Insurance Economics. Published by Blackwell Publishers, 108 Cowley Road, Oxford OX4 1JF, UK.

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Corporation (GIC) business (Nationalization) Act 1972. These amendments to the LIC and GIC Acts pave the way for the entry of private players, and possibly the privatization of the public monopolies, LIC and GIC. The insurance business is estimated to be roughly 400 billion rupees (approximately US$9 billion) per year in India, as stated above, and is expected to grow at more than 20 per cent per year, even leaving aside the relatively undeveloped sectors of health insurance, pensions and annuities. Ranade and Ahuja (2000) feel that in India regulation is imperative at the commencement of competition, especially in the insurance sector which is vulnerable to market failure. They note that ``apart from the protection of the consumer interest, in the Indian context, the regulator's main brief would also be to conduct a fair competition, but not let it become `cut throat competition' that results in multiple bankruptcies and market implosion.'' This is probably true with the entry of private players in the Indian insurance market. It is to be noted that the current competition between the four subsidiaries of the present GIC is only notional, since there is not much pricing and strategic autonomy. Also regulating a public monopoly such as LIC is virtually redundant, since the pro®t motive and protecting its monopoly status may not be a paramount objective of a public sector ®rm, and there may be inbuilt procedures in its operations to deal with issues normally addressed by a regulator. As is discussed in this paper, in most of countries with a longer tradition of competitive insurance industry, the primary objective of regulation has been the protection of consumer interests. It may be noted that in most of the developed countries the current trend is to move away from regulation and controls which limit competition to those which focus on the ®nancial soundness of the insurers. This trend is also seen in the regulation of terms and conditions of insurance contracts, and are in the form of general prohibitions against certain terms. This paper discusses some selected issues relating to regulating insurance business with particular reference to India. The study concludes that in the Indian insurance market, the regulator must assure new entrants of a level playing ®eld vis-aÁ-vis the monopoly giants LIC and GIC. The initial focus of the regulator must be on the ®nancial soundness and prior experience of entrants. Tariff and contract standardization must also be done in the initial stage. The objective of serving the weaker sections of society will be better served with a separate instrument. We begin, in section 2, with a discussion on the rationale of regulation in a globalizing world. In section 3 we discuss some principles of insurance that apply to the insurance sector. Section 4 discusses two main categories of regulation: solvency and market supervision and some observed practices followed by different countries of the world. In section 5 we discuss the world insurance industry. Section 6 discusses the regulatory regime in China. Section 7 notes some possible lessons for India. The last section gives some concluding remarks. 2.

The rationale for regulation

There are different schools of thought on the question of regulation in the insurance sector. Some economists believe that an ef®cient market is the necessary and suf®cient condition for the healthy growth of insurance. They believe that competition will generally produce the greatest bene®ts to society. Yet even they agree that some form of regulatory control is necessary. They want regulatory control which maintains and furthers competition and counters the development of a monopoly. Another set of economists does not fully trust the market. They believe that the lesson of history is that proactive regulation is needed to prevent the abuse of consumers. They outline that insurance is a business different from any other, primarily because of its ®duciary nature and the uncertainties inherent in the insurance-

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pricing process. Further, it has a much more pervasive in¯uence over individuals and the economy than banking. Insurer failures would affect a larger body of persons than those directly involved with insurance regulation. Whether proactive or reactive, regulation of economic affairs such as insurance has essentially a prudential air about it. This is where it is different from ``government'', which is formally an administrative device. Although, therefore, in the tripartite division of state policy into legislature, judiciary and executive, the economic regulatory institutions are placed within the executive, the need to insulate ``regulation'' from the core executive is being increasingly recognized. Regulation is not so much about enforcing pre-set laws, as about promotion, development and facilitation of the spread of prudential practices of business and ®nancial reporting. This requires the regulators to develop acutely sensitive eyes and ears for market developments. Regulation must provide legal, non-arbitrary, policy responses to roadblocks of the business, especially where business itself fails to respond by its self-®xing mechanism. In a parliamentary form of democracy such as India, the dividing line between the functions of the political and permanent executive has become progressively thinner. Further, here the political executive retains the legislative initiative for economic affairs. It is necessary to minimize, if not prevent, the con¯ict of roles and interests between legislative intention and executive action in regulatory matters by making the former as explicit as possible. However, the assertion of the development nature of regulation by the IRDA is a welcome step. 3.

Regulatory principles of the insurance sector

A regulator's main objective is to promote competition and ef®ciency. A consequence of the ®rst principle is the issue of ensuring a level playing ®eld. This level playing ®eld is not only between sellers of insurance, but also between buyers and sellers. It is in this context that the disclosure norms and regulation regarding ``®ne print'' is important. This function of the regulator should not be confused with meeting other social objectives, such as providing services to the disadvantaged. This aspect is discussed below under service obligations. The ef®ciency objective of the regulator, particularly in developed countries, aims at protecting the interests of the insurance-buying public. In fact, the basic objective of insurance supervision is to ensure that insurers will have the ®nancial resources required to pay all claims as they become due, and that insurers will treat consumers in an equitable manner in all ®nancial dealings. This has been done ®rstly by ensuring that policyholders and bene®ciaries are given fair and reasonable treatment by insurance agents; and secondly by ensuring the ®nancial soundness of the ®rms themselves and their capital, reserves and investments. These functions are performed under the two main categories of regulation-solvency regulation and market regulation, which will be covered in section 4. The former is mainly about capital adequacy, and restrictions on investments based on risk of the institution product pro®le, whereas the latter involves supervision of products, pricing, contract details, other trade practices, grievance redressal, and so on. To the extent that competition might not lead to ef®ciency due to various reasons such as asymmetric information and imperfect information these concerns are addressed in the nuts and bolts of regulatory design. Also the objective of ef®ciency is not to be confused with the objective of promoting welfare or other social goals, which are functions of the government. Promoting welfare involves a subjective judgement of the social welfare function (i.e. trading off the welfare of the rich (advantaged) versus the poor (disadvantaged)), which in turn is a matter of social choice manifested by probably electoral

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politics. Thus the regulator's job is only to promote ef®ciency, both in static and dynamic sense. The provision of some products at a lower cost by LIC, India to socially disadvantaged group may be a norm. However, with the entry of private players, such obligations create distortions or are inconsistent with the pursuit of ef®ciency. This objective is best pursued by a separate instrument (such as voucher entitlements) or a fund which explicitly provides subsidy, or an obligation which is tradable. For example, the Telecom Regulatory Authority of India (TRAI), proposes to set up an initial corpus of Rs 2000 crore (the Universal Service Obligation Fund) to provide subsidy on uneconomic networks. This may be done by slapping a 5 to 7 per cent levy on operators ( Hindustan Times, New Delhi, 27 July 2000). IRDA in their guidelines, as reported in the Hindustan Times, 24 July 2000, have ®xed a 15 per cent rural obligation for private sector applicants along with foreign partners. This is less than the obligatory limit imposed for the existing players. In the case of existing insurers, the rural obligation will be decided in accordance with the quantum of business recorded by them for the accounting year ending March 2000. As already stated in section 2 the responsibility of the regulator is to conduct fair competition and additionally with the development and growth of insurance industry. This entails, at times, allowing anti-competitive practices which are really in the interest of long term growth and competition. An example would be through product innovation, which creates a monopoly for the innovator, but which is soon imitated by other ®rms, thus eroding monopoly powers. An unduly harsh stance which prohibits innovation might harm long-term growth prospects. It is well known from theoretical considerations that insurance markets are vulnerable to the twin objectives of moral hazard (the tendency of the insured to aggravate risks) and adverse selection (the inability to distinguish between high and low risk customers and the resulting pricing of average risk which can only attract high risk customers). However, in practice both phenomena can be dealt with or mitigated by various mechanisms like deductibles and by offering a menu of insurance products. This leads to competitive market outcomes which are not ``®rst best'' because of informational constraints but ``second best'' or constrained optimum. The regulator has to aim to reach outcomes which are constrained optimum, since typically ef®ciency cannot be increased further. Insurance is basically a long-term contract between the buyer and seller. Regulatory bodies have to be responsive to the contract enforcement regime so as to enable insurers to meet their ®nancial obligation in volatile and sometimes adverse economic conditions prevailing in developing countries. Insurance business is essentially cyclical and is dependent on a host of internal and external factors. It is the primary function of the insurers to contain this cyclicality by loss control and risk management devices. Insurance contracts are also more complex than those in banking and other ®nancial activities. These contract complexities tend to put insurers in an advantageous position vis-aÁvis the buyer of insurance. In an economy with low literacy and low levels of sophistication in processing ®ner points of ®nancial contracts, with a weak contract enforcement regime this calls for standardization of contracts. Some standardization is desirable even in product markets and takes the form of information, standardization of pack size, and so on. Standardization does not restrict competition but helps consumers to compare products and make informed decisions. This logic applies with greater force in ®nancial transactions where the products are sold by contract. Contract terms and conditions may be worded so as to dupe the customers. Standardization may not impede innovation. Such restrictions depend on

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the degree of customer sophistication in understanding the terms of contracts, and restrictions can decline as consumer awareness evolves. While regulations should strive to promote competition and growth in the insurance business, there are some speci®c features of the insurance sector that call for regulatory practice to ignore monopoly and anti-trust concerns. Some of these features are the need for sharing loss information, co-operation in the insurance of large risks (co-insurance), agreements related to claim settlement, co-operation on risk reduction activities, and so on, and these must be taken into consideration when applying the anti-trust law (OECD, 1998). 4.

Market supervision and solvency

4.1.

Market regulation

The material in this section is drawn mainly from Savage (1998) and Klein (1995). Market regulation refers to regulatory practices that affect the conduct of insurance ®rms. The various categories under which market regulation is applied are pricing, products (including contractual details) and trade practices. Market supervision applies to rates and tariffs, operation of an industry-funded guarantee fund, speci®cation of ``®ne print'' language in products and contracts, grievance redressal and dispute resolution, arbitration, etc. At one extreme, supervision can be through a governmental agency administered by public servants, or at the other extreme through selfregulation by insurers. In between, there may be several combinations where supervisory responsibilities can be shared by government, by the insurer's board of directors, by independent professionals such as auditors and actuaries, and by an industry association that can evolve its own codes and ethics. Developing countries should focus on having more self-regulatory organizations than in developed countries. Because the industry has better information than a government supervisory body, self-regulation tends to cost less than government supervision, and shifts the cost of supervision directly onto industry: selfregulation is considered to be superior to government supervision. A robust supervisory system with an increasing component of self-regulation through procedures of sound corporate governance is more likely to be able to cope with the growing capacity of a rapidly emerging ®nancial sector than government supervision. Hence the system adopted by developing countries should be such that it allows the phasing in of these elements over a period of time. Pant (1999) suggests that as far as the pricing of insurance products is concerned, IRDA must exercise promotional supervision of the Tariff Advisory Committee (TAC); the latter needs its operational autonomy. IRDA's supervisory association must remain at arm's length with TAC. These suggestions are in line with the Malhotra Committee (1994) recommendations of delinking TAC from GIC and becoming a separate body under the supervision of IRDA without actually becoming a part of it. It had apparently in mind the quasi judicial responsibility of IRDA in regulating the insurance product pricing. In¯uence by IRDA over TAC decisions would con¯ict with its regulatory function of insurance pricing; and would perhaps also not be in tune with its development role. However, we ®nd that even now a good number of items are outside the tariff regime of the TAC. The various issues in market regulation and some observed practices are listed below: ·

Rate regulation: The issue is whether to impose a price ¯oor, or price ceiling or both on premiums. The justi®cation for price ¯oor is that price competition in insurance can be

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·

·

·

·

59

unhealthy as it might bring some ®rms close to insolvency or bankruptcy, which can cause a panic and ``bank run'' type of domino effect. High rates of in¯ation can also lead to premiums being insuf®cient to cover claims and hence justify price ¯oors. On the other hand price ceilings are justi®ed because of the presence of consumer search costs that impede competition and results in excessive prices and pro®ts. In many lines of business governments require premium rates to be ®led with the supervisor for approval. In general in developed countries there is clear trend towards deregulation of controls on insurance premiums. In the U.S. where insurance regulation is under the domain of states, rates and policy forms are subject to regulatory approval. U.S. state laws typically require that rates should not be inadequate, excessive or unfairly discriminatory. With the exception of workers' compensation and medical practice, commercial property/casualty in most states of the U.S. are also subject to competitive rating approach. Premiums for life insurance and annuity products are generally not subject to regulatory approval, although regulators may seek to ensure that policy bene®ts are commensurate with the premiums charged. For more details of the U.S. life and non-life insurance industry, see Wright (1992) and Grace and Barth (1993), respectively. Guarantee fund: This is a fund created by contributions from insurers. The purpose of this guarantee fund is to cover an insolvent insurer's ®nancial obligation within statutory limits to policy-owners, annuitants, bene®ciaries and third-party claimants and to compensate accident victims of uninsured or unidenti®ed drivers. There are arguments both against and in favour of guarantee funds. On the negative side, it has a free rider problem effect: it takes away the incentive for the public to deal with ®nancially strong, well run companies; and it reduces the incentive of insurance ®rms to be more prudent about their investment and business decisions. On the other side it is said that few consumers are in a position to assess the ®nancial strength and that owners and managers still stand to lose their capital and livelihood. A system of co-insurance and deductibles can be designed to ensure that both consumers and company of®cials have the requisite incentive. If a guarantee plan is to be established it must be done under supervision of the regulator. Contract design and disclosure: Insurance salespersons generally require licensing by the government, and most governments establish standards of knowledge and competence that must be attained. It is also important to ensure that insurance agents actually communicate an appropriate amount of relevant information to the consumer. Thus it is ensured through contracts written in plain language, salespersons' code of ethics, need analysis, cooling-off period (provide time to change or reconsider purchase decision), and providing other sources of insurance information such as government providing useful brochures. The regulator also is responsible for enhancing consumer information about insurers' prices, products and ®nancial strength. Dispute resolution: This aspect of market regulation deals with grievance redressal, arbitration, etc. Recourse to courts is not usually a satisfactory option for consumers. Dispute resolution could be designed that encourages mediation which involves having the parties meet with a trained mediator as the ®rst step. If this breaks down then, as a second stage, a dispute resolution process involving binding arbitration is made available. Complaint monitoring by an insurance ombudsman is another possibility. The IRDA has created the institution of insurance ombudsmen in India in 1999. However, this functions as an independent body and the IRDA intervenes at times. Regulation of intermediaries: Insurance in most countries has been sold through intermediaries, as they are indispensable in the provision of such services. They are subject to both occupational licensing and consumer protection regulation. Recent trends

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in technology (e.g. telecom, Internet) are, however, leading to the lack of intermediaries in many ®nancial services, including insurance. However, we expect that in India and China intermediaries like agents, brokers, consultants and surveyors will continue to play an important role. However, the IRDA chairman has categorically said that ``IRDAwill come out with guidelines on the entry and functioning of intermediaries by the end of July 2000 to check their indulgence in activities like rebating, twisting, fraudulent practices, and misappropriation of funds, if any'' (reported in the Hindustan Times, 25 July 2000). 4.2.

Solvency and capital adequacy

Solvency regulation, of which capital adequacy is a major component, is to ensure the ®nancial soundness of insurers and the need for it generated by costly information and by agency problems (limited liability diminishes incentive to maintain safety). To check against solvency risk, regulators require that insurers maintain a minimum amount of capital to meet their ®nancial obligations. Capital adequacy regulation is applied almost everywhere in the ®nancial services industry. Besides capital adequacy requirements, solvency regulation includes additional restrictions on investments, reinsurance, reserves, asset-liability matching, etc. For example, all insurance companies operating in India will be asked to reinsure 20 per cent (with the upper limit not exceeding 30 per cent) of the sum assured on each insurance policy with the Indian reinsurer. Also, IRDA have spelled out the investment norms for life and general insurance ®rms operating in the Indian insurance market (cf. Table 1). Capital and reserves act as a cushion against unexpected increases in liabilities and decrease in the value of assets. Capital is also used to fund rehabilitation or liquidation with minimal losses to policyholders and claimants in case of bankruptcies. Restrictions are also placed on the ownership of insurance companies in several countries, to limit in¯uence and contagion effects in case of insolvencies. Ideally, the capital adequacy requirements should depend only on the risk of the ®nancial institution as a whole. The risk in turn depends on the products it provides and the portfolio of assets and liabilities it holds. As the recent report on insurance regulation (OECD, 1998) points out, competitive distortions can occur if capital adequacy is not set appropriately Table 1: Investment norms for insurance markets in India Options

Life (%)

General (%)

Centre, State government and approved securities (a) Centre-minimum (b) States and others

50 25 25

30 20 10

Infrastructure and social sectors Housing Private sector (a) Equity, preference shares, CDs, NCDs loans in rated companies (b) Other than approved investments

15 Ð 35 20

10 5 55 30

15

25

Source: Hindustan Times 18 August 2000

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between two competing products. In fact, competing products with similar characteristics should face similar regulatory requirements, independent of the sector in which they are produced. The three different approaches of regulatory requirement and capital adequacy are summarized in Figures 1, 2 and 3 (adapted from OECD, 1998). The ®rst approach, the Pillars approach, treats banking, insurance and securities markets separately from one another and hence has a separate regulator for them. This has the advantage of accurately setting capital adequacy requirement. But the ¯ip side of this approach is that the line of business restriction and ownership restriction it imposes limit exploitation of economies of scope in production. Moreover, it increases the cost of bundling products that cross sectoral boundaries. The second approach, the Conglomerate approach, which allows a ®rm in one sector to enter another sector through a subsidiary, does not limit economies of scope and bundling of cross-sectoral products. But capital adequacy under this approach may not be applied appropriately, thereby leading to competitive distortion. This approach is far the most common approach among OECD countries. The third regulatory approach, which is in some sense a re®nement of the Conglomerate approach, allows co-operation and co-ordination between regulators to ensure that the overall capital requirement on the conglomerate takes some account of the risk of the ®nancial institution as a whole. This approach, while overcoming the disadvantages of the other two approaches, tends to duplicate the regulatory approach. Moreover, in this approach ®rmwide risk assessment may be dif®cult (for a detailed account of capital adequacy see OECD, 1998). The approach to capital adequacy is evolving. Capital adequacy norms re¯ect the twin phenomena of (a) a convergence in the provision of ®nancial services by insurers and banks, and (b) the international and cross-border nature of this provision. The Basle Committee on Banking Supervision which developed norms for capital adequacy in banking, now also

Figure 1: Pillars approach

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Figure 2: Conglomerate approach requires that all international banks must be supervised on a consolidated basis (i.e. looking at the entire business worldwide) by a capable authority in which they have their head of®ce. At the same time, if other countries in which the bank has branches do not think that the ``home country''supervisor is doing a good job, they can restrict the bank's activities there. Financial markets are different from other markets in the sense that ®nancial decisions rely on availability and analysis of large data on the current ®nancial position and future prospects of a borrower. This handling of data is subject to economies of scale. What is true of capital adequacy is also true of other ®nancial restrictions. Most OECD countries separately regulate banks, securities ®rms, life insurers, general insurers, pension funds and mutual funds. This separation is ensured through line of business restriction and through cross-sectoral restriction. Line of business restriction can be circumvented through the formation of subsidiaries or letting a ®rm be owned by another company. Therefore, line of business usually accompanies ownership restrictions. Banks in OECD countries were not allowed to directly produce insurance products and vice-versa. Also, most OECD countries allow banks to distribute (not underwrite risk) insurance products, whereas insurers are not allowed to produce or distribute banking products. Due to a variety of reasons such as (a) technological changes, (b) increase in competition from substitute ®nancial products, (c) liberalization in ®nancial services, (d) globalization, and (e) greater customer satisfaction, it is increasingly dif®cult for regulators to maintain separate control over different arms of the ®nancial sector. Information technology induced ®nancial innovations give rise to sophisticated and complex ®nancial products. This has also increased economies of scope for the production of these products, which has in turn blurred the boundaries between traditional pillars of ®nancial products. Furthermore, competitive

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Figure 3: Co-ordinated approach pressures have caused insurers to take on increased ®nancial risk. This has made solvency oversight more dif®cult for the regulator. The entire ®nancial industry is increasingly being viewed as competing in one market ± the market for risk management services. Regulatory developments that this has given rise to are the relaxation of regulatory control over prices and ownership permitting formation of ®nancial conglomerates, and the erosion of functional boundaries between different types of ®nancial institutions. 5.

The world insurance industry

The world insurance industry recorded a growth in premium volume (U.S. $1803 billion) of around 6 per cent in 1993 over the previous year in real terms. Over the period 1986±1993 there has been a 7 per cent average growth in world insurance business, and the life insurance sector has shown more than a 7 per cent average growth rate (Table 2). Asia, America and Europe together contribute more than 90 per cent of the total world insurance business in terms of premium income. Life insurance business accounts for the bulk of the total insurance business, 76.8 per cent in Asia, 22 per cent in Latin America and between 40 and 70 per cent in other continents. Thus on an average life insurance business was more than 50 per cent of the total insurance business in the world in 1993. The Asian life

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Table 2: Structure of world insurance Premium income (US$ billion) Total insurance business Continent North America Europe Asia Africa Latin America Oceania Unclassi®able World total

1986

1990

483 (39.87) 375 (31.03) 311 (25.70) 13 (1.09) 7 (0.58) 21 (1.75)

514 (37.95) 460 (33.93) 334 (24.64) 14 (1.06) 10 (0.57) 24 (1.77)

1210

1356

1993 600 (33.29) 491 (27.22) 628 (34.84) 18 (0.98) 22 (1.21) 23 (1.23) 21 (1.18) 1803

Life business 1986

1990

1993

203 (31.97) 182 (28.79) 228 (36.02) 8

222 (31.85) 239 (31.44) 222 (33.83) 9 (1.31) 2 (0.32) 12 (1.76)

252 (24.96) 247 (47.42) 482 (47.72) 12 (1.20) 5 (0.48) 12 (1.20)

2 (0.27) 11 (1.69) 634

707

1010

Note: Figures in parentheses refer to percentage share in world total. Source: SIGMA; Swiss Re, 2/91, 4/92, 5/95.

market recorded 5.5 per cent real growth and constituted 47.72 per cent of the world premium income in the life sector. The Indian life insurance business with a real growth of 14.6 per cent accounted for 0.32 per cent of the world share in 1993 and was ranked 20th in the world in terms of total life insurance business in the same year (Table 3). Japan was the leader in the total life insurance Table 3: World share of largest insurance markets Total insurance Country United States Japan Germany Great Britain France South Korea China India

Life insurance

Rank

World share

Rank

World share

1 2 3 4 5 6 25 23

31.31 30.36 6.44 6.15 5.27 2.12 0.30 0.26

2 1 5 3 4 6 26 20

23.82 42.61 4.54 7.05 5.67 2.95 0.16 0.32

Source: SIGMA; Swiss Re. 5/95.

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business in 1993 followed by the U.S. While the U.S. was ranked ®rst in the terms of total insurance business in 1993, India ranked 23rd in the world with total insurance business (Table 3). The insurance industry in India has shown signs of development consequent to economic growth including industrial and other activities of the world economies. However, the spread and development of the insurance industry are unevenly distributed across the regions. The world insurance business is dominated by industrially developed economies. This dominance can be seen from the market share of industrial economies as indicated in Table 3. From Table 2 one might note that more than 80 per cent of the total and life insurance market is shared by six industrial economies such as the U.S., Japan, Germany, Great Britain, France and South Korea. Similarly, though the Asian region accounts for 34.84 per cent of the total insurance business in 1993, among the Asian countries Japan alone contributes 30.36 per cent. The developing countries hold a very small share in the international insurance markets. China and India, the potential markets together account for less than 1 per cent. The unequal development of the insurance market will be clearer from the meagre share of developing countries in the world insurance market (Table 4). Further, different regions and speci®c countries recorded altogether different performances. It is important to note that the contributions to the Less Developed countries' (LDCs') share in the world insurance business mostly come from the Asian LDCs. Therefore, it is clear that the industrially advanced regions dominate the world insurance market both in life and nonlife insurance business. The reasons for the skewed development of insurance business are many. First, insurance is highly sensitive to the general socio-economic conditions of the region/country concerned. And there seems to be a positive correlation between economic development of a country and the amount people spend on insurance (Agarwala, 1961; UNCTAD, 1993). The point that insurance in general and life insurance business in particular is correlated with the economic development of the country can be substantiated by examining the life insurance standards in terms of life insurance indicators such as life insurance density and life insurance penetration. Life insurance density is the ratio of life insurance premiums paid during a given year to the total population in a given year. Life insurance penetration is life insurance premium income paid during a given year as a percentage of the volume of the GDP. From cross-country analysis, it is evident that the developed countries have a far more developed insurance business compared to LDCs. Their high life insurance penetration (the

Table 4: Developing countries' share in world insurance business Total insurance business

Life insurance business

Regions

1988

1990

1988

1990

Developing countries Africa Asia Latin America

3.94 0.34 2.86 0.74

4.56 0.26 3.61 0.70

3.68 0.10 3.29 0.29

4.79 0.08 4.39 0.32

Source: SIGMA, Swiss Re, 4/90, 2/91, 4/92; and UNCTAD, January 1993.

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Table 5: Life insurance density and life insurance penetration Country South Korea Japan Great Britain Australia U.S. Zimbabwe Chile Malaysia Philippines India Pakistan Indonesia China Argentina USSR Czechoslovakia Hungary Romania Poland

Life insurance Life insurance penetration (%) density (%) 523.36 2252.49 1775.15 1296.50 1928.66 20.84 33.80 32.68 7.38 5.60 1.53 1.34 0.53 2.89 67.21 17.92 13.99 3.65 1.42

9.45 6.42 6.24 3.93 3.79 3.34 1.77 1.37 1.19 1.11 0.44 0.23 0.18 0.09 1.57 0.98 0.44 0.35 0.08

Note: Life insurance density±premium in US$ per capita; life insurance penetration±premium incomes as a percentage of GDP. Source: SIGMA; Swiss Re, 4/92.

income elasticity of life insurance) indicates that they have a high amount of life insurance per head compared to LDCs (Table 5). India's position is far behind developed countries but reasonably good compared to other LDCs with real growth higher than both groups. Other than socio-economic conditions, the business depends on the way insurance operations are carried out. These are the conditions under which the insurance market operates: the market structure, inadequate capital, investment regulations, evaluation of underwriting losses and unsatisfactory claim settlement operations. In this respect the LDCs' insurance markets, where both state and private insurers operate, feature monopolies or oligopolies. Also, the developed countries where private insurance operates feature highly centralized insurance markets. Usually monopolistic and oligopolist markets are viewed as detrimental to the growth of the insurance business. The former are believed to leave limited operations to the consumers in terms of product choices. In the latter case the interests of consumers may be overlooked with the formation of collusive oligopolies. At the same time, when too many insurers operate, there exists the possibility of price wars leading to cut throat competition where the viability of small insurers is threatened. Therefore, it is argued that a concentrated ef®cient

# 2001 The International Association for the Study of Insurance Economics.

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INSURANCE REGULATION: SOME ISSUES

market may serve consumers' interest with minimum risk. Most countries, whether developed or developing, where state and private insurers operate, feature highly concentrated markets (Table 6). The foreign licence insurers' business in the domestic markets of the U.S. and Japan is 3 per cent and in European countries like Great Britain, France and Switzerland, 5 per cent. These countries can play a major role in the foreign markets (LDCs) because of their advantage of superior technology and managerial skill. In this respect, the degree of internationalization (the involvement of a country in international business) of Great Britain is 56 per cent, France, 35 per cent, and Switzerland, 56 per cent, but for the U.S. and Japan it is 3 per cent (Samarth, 1994). This brings out the signi®cant point that the U.S., which is pressing hard for the opening up of the insurance industry of India does not have a dominant share in the global portfolio nor do foreign insurers have any major in¯uence in its domestic market. 6.

The Chinese experience

In China, the need for regulation did not become signi®cant in the insurance markets, since the state owned ®rm had a complete hold. China's state-owned ®rm PICC had a monopoly in the Chinese insurance market since its inception in 1949, save for the period 1958 to 1979 when PICC suspended its domestic operations as insurance was considered to be a capitalistic concept under the ``Great Leap Forward''. In order to improve the competitiveness of China's insurance, the government broke the PICC monopoly by allowing domestic private players by 1988. A few regulations were in place Table 6: Degree of concentration in insurance market Market share (%)

Countries

Life

Nonlife

Total

U.S. Great Britain Japan Australia Argentina Mexico Chile Poland Czechoslovakia

41.4 62.6 91.5 84.4 Ð Ð Ð 100 100

47 76.9 88.7 87 Ð Ð Ð 86.4 96.5

Ð Ð Ð Ð 50 76.4 80.6 Ð Ð

Market Total share by companies no. of in the companies market 15 15 15 15 15 6 8 3 3

3500 800 25 Ð 230 36 28

Note: Market concentration of all countries except Poland and Czechoslovakia (data for 1993) relates to 1989. Source: Insurance Research Letter, November, 1990, October, 1995; SIGMA Re, 1/92; and Samarth (1994).

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at that time. The Chinese insurance industry strengthened when the Chinese Government, experimenting with foreign competition, allowed American International Group (AIG) to set up a branch in 1992, and Tokyo Marine and Fire Insurance in 1994 and 1995: Guangzhou was made the second pilot area for foreign insurance operations and AIG was given permission to set up two branches there for life and property insurance respectively. Higher savings rates together with some competition in the insurance industry led to the rapid growth in insurance premiums (with an average annual growth rate of about 37 per cent during 1985 to 1995). Much of this growth occurred in life and in property and casualty insurance. Competition in insurance industry has accelerated market growth, leading to wider coverage, better service, lower prices, and improved market sophistication. Because of its cautious approach in allowing companies to underwrite risk the Chinese Government could afford not to have an appropriate regulatory body in place. It was not until 1995 that China promulgated an insurance law and introduced a couple of complementary regulations in 1996. Prior to that, the Chinese Government passed a series of notices and administrative orders to regulate insurance business in China. Weak regulation of the Chinese insurance market in fact adversely affected development of the market (Lu and Zhang, 1999). Introduction of competition without proper regulation resulted in cut throat competition which hindered the healthy development of the insurance market. Lack of solvency control led to the insolvency of the Yongan Property Insurance Company within nine months of its establishment. The regulatory team in China lacks experience and has yet to resolve methods and practices to detect ®nancial juggling by the insurers. The strong restriction on investment of insurance companies led to a lower return on funds compared to other ®nancial instruments. The insurance regulation body was made independent in 1998. The insurance law of the PRC was promulgated in 1995. Following its implementation, ®ve domestic insurance companies were granted licences and started operations in 1996. The law requires maintaining technical reserves and other statutory funds, satisfying a solvency requirement, investing prudently, compulsory reinsurance and information disclosure. On the demand side, increase in personal savings made possible by a sustained high growth rate is creating strong demand for insurance. On the supply side, a move away from the state-owned sector towards a competitive market is creating greater awareness of the need for insurance. A high proportion of the population (9.45 per cent) over 60 years, the one child norm and high growth prospects all favour high demand for pension and life insurance products. However, the Chinese insurance market is dominated by three domestic insurers. Their combined share is about 98 per cent of the market. Even though the PICC share has declined from 98 to 74.4 per cent, it still remains the largest insurer in China. PICC is expected to remain a dominant player for many years to come. The role of foreign insurers has been insigni®cant due to entry and operational restriction imposed by the authority. Restrictive regulations on foreign insurers include restriction on ownership, capital, licence, type of line, investment, and geographic area. There are different regulations for domestic and foreign insurers. Domestic ®rms still largely sell insurance. The three domestic ®rms cover roughly 99 per cent of the market. Lack of proper regulation has affected development of the market. China has protected its domestic market from foreign competition. It encourages growth of domestic industry, giving second priority to foreign industry.

# 2001 The International Association for the Study of Insurance Economics.

INSURANCE REGULATION: SOME ISSUES

7.

69

Lessons for India

A developing country like India has regulatory concerns due to lack of regulatory or bench mark experience.2 In the initial phase the insurance regulator IRDA would have to be concerned more with the entry guidelines and capital requirement rather than regulatory details of market supervision. It must be mentioned that the levels of insurance penetration and density in China are only now, comparable to those of India and in pre-liberalization times these statistics were way behind those of India. Further, since China is not yet a member of the WTO, it has been able to have a differential policy towards foreign ®rms (a deviation from the national treatment clause of GATS), and has also been able to pursue gradual and regionspeci®c liberalization, both of which will be unfeasible in India. In the Indian context there are separate regulators for banking, insurance and capital market. This is what has been de®ned as the pillars approach to regulation. In fact a separate regulator for pension funds was proposed by the Dave Committee on Pension Reforms (OASIS, 2000). Also, institutional investors, pension funds, mutual funds and insurance companies are expected to grow in importance at the expense of banks; since life insurance is as much about savings as about protection, it would increasingly compete with banks and mutual funds for people's savings. The initial focus of IRDA must be ®nancial soundness and the prior experience of entrants. Development of the market and competition issues would not be paramount in the early stages. The initial stage would also bene®t from tariff and contract standardization, even if this comes at the cost of hindering competition and innovation. This is important for several reasons, such as lack of sophistication of buyers, a relatively poor legal environment for enforcement of contracts, and uninformed sellers who need time to build their database and be better equipped to estimate demand, categorize risk, etc. Social considerations, such as how to serve the relatively backward sections of society both in rural and urban sectors and agricultural farmers is best undertaken with a separate instrument. This could be in the form of entitlement vouchers or social obligations on all players, which can be tradable. Mandatory co-insurance arrangements with LIC or GIC could also be an option. Agricultural insurance, for instance, is largely government administered insurance even in the U.S. and Canada, but the private insurance companies are required by law to market and sell the related insurance products. Similarly, there are provisions in U.S. insurance laws to make affordable insurance services available to under-served segments of the society. In a country like India with an evolving ®nancial sector, the IRDA may not feel that corporate responsibility has reached a point where investment functions are left to directors and senior managers of insurance ®rms. Hence investment norms initially would tend to be much more detailed and strict, with gradual phase-out. 8.

Concluding remarks

Insurance regulation in India is challenging and necessary for the healthy growth of the industry. It is a challenge mainly because of lack of prior experience, and the need to build a 2 The telecom regulator TRAI has had a tough time dealing with monopoly incumbents and assuring new private entrants of level playing ®eld. Similarly, the Securities and Exchange Board of India (SEBI)'s initial forays in regulating brokers and being alert to abuses in the stock markets were only partly successful.

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strong and credible regulator that can assure new entrants of a level playing ®eld in the presence of LIC and GIC. The challenge for the regulator then is to maintain equal distance between the private players and government in the garb of incumbent. Insurance is a big business and will certainly grow. Insurance along with mutual funds and pension funds are the domain of big institutional investors who will play an important role in the functioning and deepening of the ®nancial sector and more importantly also in corporate governance. The regulatory experience in developed countries shows a trend towards a conglomerate line to the Pillars approach. While India is beginning with the Pillar approach it is inevitable that convergence in ®nancial sector products and distribution will call for a co-ordinated approach to regulation. REFERENCES AGARWALA, A.N., 1961, Life Insurance in India: A Historical and Analytical Study. Allahabad: Law Journal Company. GOVERNMENT OF INDIA, 1999±2000, Economic Survey of India. Publication of the Economic Division, Ministry of Finance. GRACE, M.F and BARTH, M.M., 1993, ``The Regulation and Structure of Nonlife Insurance in the United States'', World Bank Working Paper no 1155, Washington, DC: The World Bank. Hindustan Times, New Delhi, India (various issues). KLEIN, R.W., 1995, ``Insurance Regulation in Transition'', paper available at the NAIC www site (www.naic.org). LU, W. and ZHANG, H., 1999, ``Chinese Insurance Regulatory System: Problems and Outlook'', paper presented in APRIA Third Annual Conference, 19±21 July. MALHOTRA, R.N., 1994, Report on Insurance Sector submitted to the Government of India (GOI). OASIS, 2000, Old Age Social and Income Security. Project of the Ministry of Social Justice. OECD, 1998, ``Competition Issues Arising in the Insurance and Financial Services Industries'', OECD Background Note, DAFFE/CLP(98), 20. PANT, N., 1999, ``The Insurance Regulation and Development Bill: An Appraisal'', Economic and Political Weekly, 34, No. 45, November, pp. 6±12. RANADE, A. and AHUJA, R., 1999, ``Insurance'', in Parikh, K.S. (ed.), India Development Report, 1999±2000. Oxford: Oxford University Press. RANADE, A. and AHUJA, R., 2000, ``Issues in Regulation of Insurance'', Economic and Political Weekly, 35. SAMARTH, R.D., 1994, ``Commutisation of Indian General Insurance Industry'', Dnyanajyoti, 94, NIA, Pune, India. SAVAGE, L., 1998, ``Re-engineering Insurance Supervision'', World Bank Working Paper No. 20, Washington, DC: World Bank. SWISS RE, SIGMA, Zurich, various issues. UNCTAD, 1993, ``Insurance in Developing Countries: Privatization and Insurance Enterprises and Liberalization of Insurance Markets'', 19 January. WRIGHT, K.M., 1992, ``The Life Insurance Industry in the United States: An Analysis of Economic and Regulatory Issues'', World Bank Working Paper No 857, Washington, DC: The World Bank.

# 2001 The International Association for the Study of Insurance Economics.