THE WIDENING SCOPE OF INSURANCE
Convocation Address at the Institute of Insurance and Risk Management
Dr. C. Rangarajan
Economic Advisory Council to the Prime Minister
July 27, 2006
THE WIDENING SCOPE OF INSURANCE
It gives me great pleasure to be here in your midst this morning on the occasion of the Convocation Ceremony for the II batch of IPGDI students and inauguration of the III batch of students of IPGDI programme2006-07. I am grateful to Mr. C.S. Rao, Chairman, IRDA and Mr. Vepa Kamesam, Managing Director of the Institute of Insurance and Risk Management for inviting me to deliver the Convocation Address. The insurance industry in our country is on the threshold of a new era of rapid expansion. A more competitive environment is emerging with new participants entering the insurance industry. We need specialists who can work in insurance industry. Risk management has a wide application. It is relevant not only to insurance industry but also to many other organisations in the fields of business and finance. To understand risk, measure it and weigh its consequences are an integral part of management. Financial institutions in the management of the funds placed with them have to reckon with market risk, credit risk, counter party risk and liquidity risk. To mitigate the impact of various risks is the essence of risk management. I am happy that IRDA decided to set up the Institute of Insurance and Risk Management. I congratulate all of you who are graduating today. You have a big future ahead. You have also the opportunity to shape the insurance industry.
What is Insurance?
An insurance contract provides risk coverage to the insuree. A purchaser of insurance pays a fixed premium in exchange for a promise of compensation in the event of some specified loss. Insurance is bought because it gives peace of mind to the holders. This comfort level is important in personal and business life. Though the primary purpose of insurance is to provide risk coverage, when the contract period extends over a long time, as in the case of life insurance, premium payments comprise of two components – one for buying risk coverage and the other towards savings. This bundling together of risk coverage and savings is peculiar to life insurance and is more common in developing countries like India. In the industrially advanced countries, this is not necessarily so and short duration life insurance contracts without a savings component are equally popular. In the developing economies because of the savings component and the long nature of the contract, life insurance has become an important instrument of mobilising long-term funds. The savings component puts the life insurance in direct competition with other financial institutions and savings instruments.
The total investment portfolio of the insurers in India as at the end of March, 2005 was Rs. 4,65,864 crore. The total premium collected by the insurers both life and non-life in 2004-05 was Rs.1,00,335 crore. The major contribution came from life insurance. The insurance penetration i.e., premia as percentage of GDP was 3.17 per cent in 2004. While this ratio is steadily increasing, it is far below the world average of 8.06 per cent. This shows the vast potential that exists.
Insurance and Growth
Insurance and economic growth mutually influence each other. As the economy grows, the living standards of people increase. As a consequence, the demand for life insurance increases. As the assets of people and of business enterprises increase in the growth process, the demand for general insurance also increases. In fact, as the economy widens the demand for new types of insurance products emerges. Insurance is no longer confined to product markets; they also cover service industries. It is equally true that growth itself is facilitated by insurance. A well-developed insurance sector promotes economic growth by encouraging risk-taking. Risk is inherent in all economic activities. Without some kind of cover against risk, some of these activities will not be carried out at all. Also insurance and more particularly life insurance is a mobilizer of long term savings and life insurance companies are thus able to support infrastructure projects which require long term funds. There is thus a mutually beneficial interaction between insurance and economic growth. The low income levels of the vast majority of population has been one of the factors inhibiting a faster growth of insurance in India. To some extent this is also compounded by certain attitudes to life. The economy has moved on to a higher growth path. The average rate of growth of the economy in the last three years was 8.1 per cent. This strong growth will bring about significant changes in the insurance industry.
At this point, it is important to note that not all activities can be insured. If that were possible, it would completely negate entrepreneurship. Professor Frank Knight in his celebrated book “Risk Uncertainty and Profit” emphasised that profit is a consequence of uncertainty. He made a distinction between quantifiable risk and non-quantifiable risk. According to him, it is non-quantifiable risk that leads to profit. He wrote “It is a world of change in which we live, and a world of uncertainty. We live only by knowing something about the future; while the problems of life, or of conduct at least, arise from the fact that we know so little. This is as true of business as of other spheres of activity”. The real management challenges are uninsurable risks. In the case of insurable risks, risk is avoided at a cost.
Assessment of Risks
An important function of an insurer is to assess the average level of risk borne while offering a product. This assessment depends upon a variety of factors and actuarial calculations become necessary. This is a highly technical area involving theories of probability. The premium charged by an insurer is based on the calculated average risk. Obviously this premium will be high for people who perceive themselves to be in a low risk category. However, for insurance as an activity to succeed, the population to which a product is offered must consist of categories with different degrees of risk. That is why the larger the coverage, the lower the average risk and lower the premium. Diversification is the way to reduce the average risk.
As in the case of all financial institutions, insurance is an activity that needs to be regulated. This is so because the smooth functioning of business depends on the trust and confidence reposed by the customers in the solvency of the financial institutions. Insurance products are of little value to customers, if they cannot trust the company to keep its promise. The regulatory framework in relation to the insurance companies seeks to take care of three major concerns – (a) protection of consumers’ interest, (b) to ensure the financial soundness of the insurance industry, and (c) to help the healthy growth of the insurance market. So long as insurance remained the monopoly of the Government, the need for an independent regulatory authority was not felt. However, with the acceptance of the idea that there can be private insurance entities, the need for a regulatory authority becomes paramount. With the passing of the Insurance Development and Regulatory Act in 2000, the insurance regulatory authority has become a statutory authority. Protecting consumer interest involves proper disclosure, keeping prices affordable, some mandatory products and standardization. Most importantly, it has to make sure that consumers get paid by insurers. From the consumers’ point of view, the most important function of the regulatory authority will be to ensure quick settlement of claims without unnecessary litigation. With respect to solvency and financial health, regulations will have to be introduced to ensure that insurance companies follow appropriate prudential norms such as solvency margins. Large funds are under the custody of the insurers and they get invested to produce additional returns. The management of these funds is important to the insurer, the insured and the economy. Entry into the insurance industry must also be regulated with suitable capital adequacy norms. The third role should be one of development. The insurance industry in India has a large potential and the framework of regulation must enable the industry to tap this vast potential.
IRDA over the last decade has brought into force a number of regulations which are well conceived. They have received wide spread appreciation. The recent decision of IRDA to move to a free tariff regime for several general insurance products is welcome. The prescription of tariff is contrary to market principles and insurance products need to be priced based on market forces.
The reform of the insurance sector is part of the overall economic reform process that is underway. The basic philosophy underlying the new economic policy is to improve the productivity and efficiency of the system. This is sought to be achieved partly by creating a more competitive environment. The growth of the real economy depends upon the efficiency of the financial sector. A greater element of competition is being injected into the financial system as well.
All regulators need to keep in mind that there is a fine distinction between regulations and controls. Regulations lay down norms while controls have a propensity to micromanage institutions. Regulators must take care to ensure that regulations do not slide into controls.
The insurance industry in our country underwent a big change in 2000 when private participants were allowed into the industry along with a streamlined regulatory and supervisory regime. There are at present 14 private life insurance companies along with LIC and 12 entities in non-life sector. There is evidence to show that competition has done good to insurance industry. The rate of growth of the industry in the post liberalization period has been faster. It has also developed in terms of product innovation and the use of alternative distribution channels.
The insurance sector has a vast potential not only because incomes are increasing and assets are expanding but also because the volatility in the system is increasing. In a sense, we are living in a more risky world. Trade is becoming increasingly global. Technologies are changing and getting replaced at a faster rate. In this more uncertain world, for which enough evidence is available in the recent period, insurance will have an important role to play in reducing the risk burden individuals and businesses have to bear. In the emerging scenario, the insurance industry must pay attention to (a) product innovation, (b) appropriate pricing, and (c) speedy settlement of claims. The approach to insurance must be in tune with the changing times.
The mission of the insurance sector in India should be to extend the insurance coverage over a larger section of the population and a wider segment of activities. The three guiding principles of the industry must be to charge premium no higher than what is warranted by strict actuarial considerations, to invest the funds for obtaining maximum yield for the policy holders consistent with the safety of capital and to render efficient and prompt service to policy holders. With imaginative corporate planning and an abiding commitment to improved service, the mission of widening the spread of insurance can be achieved. As I said at the beginning, you who are graduating today have an important role in fulfilling this mission..