DETARRIFICATION

Detarrifing is the act of removing the pricing regulations of an industry, set forth by tariffs created by a regulatory body. Detariffing allows an industry to price its goods or services at market value, as regulation is discontinued to promote market equilibrium. As of 1st January 2007 the IRDA (the Indian insurance market regulator) freed pricing within certain parameters, but Insurers were to continue using the forms approved by the Tariff Advisory Committee until 31st March 2008

Opening New Vistas - Detariffication

Come January 2007, the first phase of detariffication is set to kick in 'detariffed motor insurance regime' wherein the premiums will move from tariff based to risk based. Tariff free Insurance regime is expected to open up new opportunities and to present new challenges for both Insurer and Automobile Dealer. Quite a few interesting changes are going to take place in the market post detariffication. Two major developments that de-tariffication is set to bring about are:

1. Transition from administered pricing to risk based pricing: meaning that the premium rating will be based on features of the vehicle and the person driving it. And we anticipate increased participation from customers in rating a risk. As is the case in developed markets, the information provided by the customer will become crucial in deciding the pricing. In the case of motor insurance, a combination of a host of factors including the make, model, location, driver's age & experience, security features of thecar and usage will all have a impact on the final premium that the customer will shell out.

2. 'Product Differentiation': which will probably represent the second phase of the de-tariff process. Insurers will be able to provide products packaged to meet a customer's unique requirements, and price them according to customer profile and product features.

Detariffing advantages
The IRDA has prepared a road map for detariffing all categories of general insurance business from January 1, 2007. According to the IRDA, the advantages of the detariffing are encouragement to scientific rating and adoption of better risk management practices; elimination of cross-subsidisation leading to independent pricing for each line of business; development of innovative practices, and generating customer-friendly options for the policyholders. The proposed detariffing in the general insurance industry would lead to a major shift in the focus of the companies, resulting in higher penetration in the country. Detariffing entails moving from rule-based underwriting systems and practices to risk-based decision-making of the subject matter offered for underwriting. It means that the pricing of insurance policies is left to the individual insurance company, based on an analysis and perception of risk. Competition is expected to whittle down the fat margins that insurers enjoy in fire and engineering insurance, eliminate cross-subsidies and force companies to look at small businesses.

How does it matter to consumers?

The consumer has not benefited much from the insurance liberalisation process. Under the market regime, the insurance companies will be forced to rate risks scientifically. The only way insurance companies can make profit and, thereby, maintain their solvency ratio without going back to their shareholders is by prudent underwriting. The downside is that the balance-sheets of non-life insurance companies could be splashed in red, and buyers with small insurance needs may be ignored. On detariffing, the rating will be based on the risk profile of the customer; it will be in the customers' interest to make his risk profile better. A risk should be judged on its own merits and detariffing will force insurers to scale up their risk-assessment capability and give the underwriting function its due importance in the insurance process. After all, this is the core function of analysing and pricing transfer of risk. By far the biggest impact of detariffing would be on motor insurance. Here too, good customers would gain. Now, a car-owner with no claims subsidises another who makes large claims. In the detariff regime, car-owners with a good track record will gain. Barring commercial motor vehicles and medical insurance, premium on assets (that is, fire, engineering and property risk covers) are forecast to drop by at least 40 per cent in a detariffed regime due to intense competition. The premium for trucks and other transport vehicles is expected to go up substantially as the related claims ratio, especially for the third party legal liability segment, has been very high and the premium charged has not been commensurate with the risk exposure.

Impact on Insurance Companies

Falling premium income without a concomitant reduction in claims is likely to bring down the profits of insurance companies, their solvency ratios and, consequently, their international ratings which, in turn, would affect their reinsurance placements and underwriting capability. Only the fire and engineering risk business is profitable based on current tariffs, and the profit margins on these segments would now be put to severe strain due to competitive pressures. Conversely, customers must also be on their guard to keep an eye on the financial health of their insurance company to avoid bankruptcy, which is a common phenomenon in the international market. Automobile companies will also be under pressure to reduce repair cost. The move to detariff is also likely to hasten the process of infusing more capital into the private insurance companies as and when the parliamentary approval is obtained for the Finance Ministry proposal for increasing the foreign direct investment limit from the present 26 per cent to 49 per cent.

Issues of detariffication in India

Despite a promising start, rising competitive pressure has exposed weaknesses within the industry that will require stronger ongoing supervisory attention. Considerable rigidities still exist which adversely impact profitability and deter new initiatives. The prevalence of market tariffs and the cap on foreign ownership are two of the major liberalisation issues India will have to tackle. Various reasons have been put forward to justify these restrictions, including to protect consumers and to preclude capital outflows. However, international experience suggests that a liberal insurance regime caters to these concerns much better than a restrictive one, while at the same time helping the local economy to reap the full benefit of insurance.

One controversial aspect of Indias non-life insurance industry is its tariff regime, which dates back to the 19th century and is still very much in evidence today. The Tariff Advisory Committee (TAC) was established in 1968, and in 1999 became the rating arm of the IRDA. At present, the tariff rates set by the TAC cover major lines like motor and fire insurance, and are applied to around 70% of general insurance premiums. While the tariff system has been praised on the grounds of market stability and consumer protection, it has also been blamed for market distortions. Where price competition is pre-empted by tariffication, the insurers engage in nonprice forms of competition from which consumers do not benefit.

One example is the well-known underpricing of third-party motor risks which has undermined the industrys profitability and has led to cross-subsidisation across business lines. This is because the Motor Vehicles Act, 1938, not only mandated third party liability (TPL) but also made it illegal for insurers to refuse TPL cover for any automobile as long as it had a fitness certificate. Furthermore, a later amendment of the law made TPL an unlimited liability, yet political pressure from transporters has prevented a rise in premiums to reflect the higher risk from this change. As a result, despite the dominant position of the motor business, newly formed companies were until recently reluctant to enter this market, as the line had traditionally been loss-making under the previous tariff structure mandated by the TAC. The TAC adopted a more differentiated pricing scheme in July 2002 in an attempt to make the portfolio self-sustaining, yet it is clear that similar problems also prevail in other lines of business. At the same time, while detariffication as a further step is under consideration, it is not expected to materialise in the near to medium term. This may mean that the industrys performance will continue to be exposed to problems of cross-subsidisation and adverse selection. The controversy surrounding tariffication has not subsided with the introduction of private sector competition in recent years. Rather, the authority has come under criticism for its asymmetric approach that mandates the provision of motor insurance by public insurers but not their private sector counterparts. While the industry is expected to move towards market-based pricing, it is proceeding at a very slow pace. A previous effort to detariff the marine business in 1994 was blamed for a sharp fall in premiums in the ensuing years. In the case of motor lines, the authorities would be equally worried, if not more so, about a sharp rise in motor premiums. A current recommendation is for a phased detariffication of motor lines that will start with the own damage category in 2005 but proceed to wide-range detariffication a year later.

Conclusion
As far as possible, India will shortly enter the first phase of a tariff free regime through a smooth transition. The removal of tariff is going to be an exciting challenge for insurers as well as automobile dealers. The Automobile and Insurance industry can bond together to give our customers a good driving experience. As such, for the industry to benefit from detariffication, it will have to strengthen its operation over a wide range of parameters. On a policy level, there is also room for government involvement in pushing for greater data sharing among insurers and participation among motorists. Also, while it seems inevitable that motor premiums will be higher than they were after detariffication, one task of the IRDA will be to make sure that it is a product of competition and not collusion.

KEY POINTS
The Rs. 348 billion Indian general insurance industry went through a challenging period during 2007-10 that was marked by de-tariffing of the Fire, Motor and Engineering lines of insurance, besides a slowdown in economic growth. The result was a compounded annual growth rate (CAGR) of 11.5% during this period, as against 16.8% during 2004-07. To attain scale and size, few players aggressively targeted the profitable lines of Fire, Engineering and Motor Own Damage in the de-tariffed scenario, which led to steep price discounts that ignored rate adequacy and risk-based pricing to a large extent. As a result, while premium growth remained muted, risk coverage increased and this led to a rise in claims for both public and private sector entities. The formation of the Motor Third Party pool which pools all Commercial Vehicles Third party premiums and apportions losses in the ratio of the overall market shares of the players further impacted the bottom lines of the private sector entities and caused a drain on profitability. The health portfolio, especially Group Health, continues to bleed most insurers because of pricing inadequacy, fierce competition from new players, and other factors such as moral hazards. In terms of growth, the health portfolio, especially retail health, offers attractive growth opportunities, with increasing income, rising health awareness and under-penetration being the primary drivers. The softening pricing regime appears to have stabilised at the current levels although pricing sufficiency is still under strain for most lines of business. Investment income continues to drive net profitability for both public and private sector players who are incurring losses at the underwriting level. Given the underwriting losses and the capacity expansion happening through the entry of new players, the industry may resort to consolidation via mergers and acquisitions (M&As) to achieve economies of scale and reduce costs. Public sector players are well capitalised to support future growth arising out of unrealised capital gains from past investments. On the other hand, private sector players with relatively short operating history and low market share will need capital to fund future growth. In the near to medium term, underwriting losses are expected to persist owing to pricing insufficiency and fight for market share, besides the recent entry of new players, which will expand capacities further. Nevertheless, pursuit of profitable growth is expected to prompt the industry to follow risk-based pricing in the long term coupled with low penetration levels and favourable long term economic growth potential, for which the outlook remains healthy.