Lecture XIX Insurance Companies and Pension Funds

PART I
FINANCIAL INSTITUTIONS INSURANCE COMPANIES

Trimester II
FIM

Insurance Companies and Pension Funds

These two non bank institutions also take funds from one sector and invest them in another, like other financial intermediaries

Insurance Companies
Insurance companies assume the risk of their clients in return for a fee, called the premium Most people purchase insurance because they are risk-aversethey would rather pay a certainty equivalent (the premium) than accept a gamble Insurance benefits peoples lives by reducing the size of reserves they would have to maintain to cover possible loss of life or property

Seven basic principles applicable to all insurance companies

1. There must be a relationship between the insured and the beneficiary. Further, the beneficiary must be someone who would suffer if it werent for the insurance. 2. The insured must provide full and accurate information to the insurance company. 3. The insured is not to profit as a result of insurance coverage. 4. If a third party compensates the insured for the loss, the insurance companys obligation is reduced by the amount of the compensation.

Seven basic principles contd.

5. The insurance company must have a large number of insured so that the risk can be spread out among many different policies. 6. The loss must be quantifiable. For example, an oil company could not buy a policy on an unexplored oil field. 7. The insurance company must be able to compute the probability of the losss occurring.

Adverse Selection and Moral Hazard in Insurance

Asymmetric information plays a large role in the design of insurance products. As with other industries, the presence of adverse selection and moral hazard impacts the industry, but is fairly well understood by the insurance companies.

Adverse Selection in Insurance

The adverse selection problem raises the issue as to which policies, an insurance company should accept. Those most likely to suffer loss are most likely to apply for insurance. In the extreme, insurance companies should turn down anyone who applies for an insurance policy.

Response to the Problem of Adverse Selection in Insurance

Insurance companies have found reasonable solutions to deal with this problem: Screening of applications Risk based premium Health insurance policies require a physical exam

Pre-existing conditions may be excluded from the policy

Moral Hazard in Insurance

Moral hazard occurs in the insurance industry when the insured fails to take proper precautions (or takes on more risk) to avoid losses because losses are covered by the insurance policy. Insurance companies use deductibles to help control this problem.

Types of Insurance
Insurance is classified by which type of undesirable event is covered: Life Insurance

Health Insurance
Property and Casualty Insurance

Growth and Organization of Life Insurance Companies in the US

The number of insurance companies grew steadily until 1988, and since then the number has fallen steadily. This can be seen in the next slide.

Growth of Life Insurance Companies in US

Number of Life Insurance Companies in the U.S., 1950-2002

Organization of Life Insurance Companies

The previous slide also shows that Life insurance companies may be organized in two different ways:
A stock company is owned by shareholders and has a profit motive A mutual insurance company is owned by the policyholders and attempts to provide the lowest cost insurance

At the end of 2002, only 83 of 1159 Life insurance companies in the US were mutual insurance companies.

Life Insurance
Life insurance policies come in many forms. Some of the typical policies include: Term Life: the insured is covered while the policy is in effect, usually 1020 years.

Whole Life: similar to term life, but allows the policyholder to borrow against the policies cash value. When the term of policy expires, the insured can get the then cash value of the policy.

Some more typical policies

Universal Life: includes both a term life portion and a savings portion.

Annuities: pays a benefit to the insured until death, to cover retirement years.

Expected Life of Persons at Various Ages in US

Basic Principles for Investments

Because life insurance liabilities are very predictable, these insurers are able to invest in long term assets Property and casualty insurance companies have to keep their assets more liquid to pay out on unexpected losses

Life Insurance Companies: Liabilities

Life insurance companies have two primary liabilities:
Life insurance payouts

Pension fund payouts

Life Insurance Companies

Inflow of funds and Investment of Assets
Life insurance companies derive funds from two sources: They receive premiums that must be used to payout future claims when the insured dies They receive premiums paid into pension funds managed by the life insurance company The next two slides show the distribution in US of the typical life insurance companys assets (2003) in various classes, including mortgages (the term represents mortgage loans & direct real estate investment; and trend of assets invested in mortgages (from 1920 to 2004). The decline therein reflects a shift to lower-risk assets (as a consequence of losses suffered by some insurance companies in the 80s) and the decline has been offset by increased investment in corporate bonds and government securities

Life Insurance Company in US Assets Break up

Distribution of Life Insurance Company Assets (beginning of 2003)

Life Insurance Company Assets invested in Mortgages

Percentage of Life Insurance Company Assets Invested in Mortgages

Health Insurance mostly through Group Policies

Health insurance policies are highly vulnerable to the adverse selection problem. Those with known or expected health problems are more likely to seek coverage. Thus mostly health insurance is offered through group policies.

Individual policies are priced assuming adverse selection.

Meaning of Named-Peril & Open-Peril Policies

Property Insurance: protects businesses and owners from the risk associated with ownership. Named-peril policies: insures against any losses only from perils specifically named in the policy Open-peril policies: insures against any losses except from perils specifically named in the policy

Property Insurance & Casualty Insurance

Re-insurance
Casualty Insurance: also known as liability insurance, protects against liability for harm the insured may cause to others as a result of product failure or accidents. Motor insurance in a combination of property & casualty insurance Re-insurance: allocates a portion of the risk to another company in exchange for a portion of the premium.

Insurance Regulation in US
The McCarran-Ferguson Act of 1945 explicitly exempts insurance companies from any type of federal regulation. In the US, most insurance regulation is at the state level Regulation is typically designed to protect policyholders from losses, or expand insurance coverage in the state. Who takes care of regulation of insurance in India?

Indian Regulator
Insurance Regulatory and Development Authority

Composition of Authority under IRDA Act, 1999

Section 4 of IRDA Act 1999, specifies the composition of Insurance Regulatory and Development Authority (IRDA). The Authority is a ten member team appointed by the Government of India consisting of (a) a Chairman; (b) five whole-time members; (c) four part-time members.

INDIAN INSURANCE INDUSTRY Historical Background

Insurance industry, as on 1.4.2000, comprised mainly just two players, both state-owned: Life Insurer: Life Insurance Corporation of India (LIC) General Insurer: General Insurance Corporation of India (GIC) (with effect from Dec 2000, a National Reinsurer) GIC had four subsidiary companies, namely (with effect from Dec 2000, these subsidiaries were de-linked from the parent company and made independent insurance companies. The Oriental Insurance Company Limited The New India Assurance Company Limited National Insurance Company Limited United India Insurance Company Limited.

The story of private insurance began in India during 2000

Life Insurance: 10 New Entrants in 2000 & 2001 Non Life Insurance : 6 New Entrants during 2000 & 2001 (largest sub-segments in descending order include motor over 40%, health, fire & marine) 26 companies have entered the business of life (12) & non-life (14) insurance thereafter Two of the companies which are in the non-life insurance business are exclusively providing health insurance

INSURANCE BUSINESS: BASICS

Life Insurers transact life insurance business; general Insurers transact the rest. No composites are permitted as per law. LEGISLATION: Insurance is a federal subject in India. The primary legislations that deal with insurance business in India are: Insurance Act, 1938, and Insurance Regulatory & Development Authority Act, 1999

Insurance Products: An Overview

Life Insurance: Popular Products: Unit linked Insurance Policies (ULIPS), Endowment Assurance (Participating), and Money Back (Participating) are the popular products. Various other products have also been launched by life insurers Money back policy provides for periodic payments of partial survival benefits during the term of the policy, as long as the policyholder is alive. They differ from endowment policy in the sense that in an endowment policy survival benefits are payable only at the end of the endowment period. General Insurance: Motor Vehicle insurance is compulsory. Thereafter, Fire and Health insurance businesses are predominant. Tariff Advisory Committee (TAC) used to earlier lay down tariff rates for some of the general insurance products

CUSTOMER PROTECTION:
Insurance Industry has Ombudspersons in 12 cities Each Ombudsman is empowered to redress customer grievances in respect of insurance contracts on personal lives, where the insured amount is less than Rs. 20 lakhs, in accordance with the Ombudsman Scheme

APPROVED INVESTMENTS
Exhaustive lists are given in the guidelines issued by IRDA for investment of funds by the insurance companies. Broadly, the various categories of approved investments include the following: CENTRAL GOVERNMENT SECURITIES STATE GOVERNMENT/OTHER APPROVED SECURITIES/OTHER GUARANTEED SECURITIES APPROVED TERM LOANS/BONDS/DEBENTURES RELATED TO HOUSING & LOANS TO STATE GOVERNMENTS FOR HOUSING AND FIRE FIGHTING EQUIPMENTS APPROVED INFRASTRUCTURE/SOCIAL SECTOR INVESTMENTS CERTAIN APPROVED INVESTMENTS SUBJECT TO EXPOSURE NORMS CERTAIN OTHER CATEGORIES, OTHER THAN ABOVE MENTIONED APPROVED INVESTMENTS

Approval of Products by IRDA

The products offered by the insurance companies are approved by IRDA For every product/rider, there is a UIN (Unique Identification Number) allotted by IRDA Micro Insurance Products (MIP) offered by various companies are also approved by IRDA and a UIN is allotted to each MIP

Insurance Agents: Training

Agents are not on the payroll of the insurance company. The insurance agents get a fixed commission on each policy they sell Composite Agent is one who sells both life and general insurance policies The applicant has to undergo at least 100 hours practical training in life or general insurance business which may be spread over three to four weeks, where such applicant is seeking license for the first time to act as an insurance agent. The training institutes are required to cover the syllabus prescribed by the Authority during this period Once the training is complete, the candidate is eligible to appear for an online examination conducted by IRDA, and would require at least 50% marks for qualifying The agent is supposed to renew his license after three years, by putting in another 25 hours (and 50 hours for composite insurance agent) of training

Comprehensive Regulations: IRDA

There are comprehensive guidelines issued by IRDA, in regard to various aspects, including: Appointment of actuaries Insurance Agents Training of insurance agents Corporate Agents Ombudsmen Surveyors TPAs for health services

Submission of annual and other reports

Insurance awareness campaigns Grievance cells

Insurance Companies and Pension Funds

Pension Funds

Trimester II FIM Lecture XIX Part II

Pensions: The US Perspective

Definition: A pension plan is an asset pool that accumulates over an individuals working years and is paid out during the non-working years. Developed as Americans began relying less on their children for care during their later years. Also became popular as life expectancy increased.

Types of Pensions: Defined Benefit Plan

Defined-Benefit Pension Plans: a plan where the sponsor promises the employee a specific benefit when they retire. For example:

Monthly Retirement Payment =

(50% of monthly average of Last 12 months Basic Pay plus dearness Allowance) * (No of years of service / 30)

More on Defined Benefit Pension Plans

Defined-Benefit Pension Plans place a burden on the employer to properly fund the expected retirement benefit payouts.
Fully funded: sufficient funds are available to meet payouts

Over-funded: funds exceed the expected payout

Under-funded: funds are not expected to meet the required benefit payouts

Some other types of Pension Plans

Defined-Contribution Pension Plan: a plan where a set amount is invested for retirement, but the benefit payout is uncertain. Benefits depend on the returns generated by the plans

Private Pension Plans: any pension plan set up by employers, groups, or individuals Most private pension plans in US are insured by the Pension Benefit Guarantee Corporation, which pays benefits when the plans sponsor goes bankrupt or is otherwise unable to make payments

Public Pension Plan:

Any pension plan set up by a government body for the general public (e.g., Social Security in the US, which is the largest public pension plan)

Investment of Private Pension Plan Assets

Distribution of Private Pension Plan Assets (end of 2003) LOOK AT THE PROPORTION OF FUNDS INVESTED IN STOCKS

Worries on Social Security in US

Social Security System in the US is a Pay as you go system, where current funding is used (partially) to pay current benefits So, in a way, the current retirees are receiving payments from current workers Projected number of workers is falling while projected number of retirees is increasing This is receiving increasing attention because of the fear that the amount being paid into the social security system in future may not be sufficient for the sums to be paid out

Past Social Security Assets: 1957-2003

Social Security Fund Assets, 19572003

Projected Social Security Assets: 1998-2038

Projected Social Security Trust Fund Assets

Big Jump in Pension Plans after a Supreme Court Ruling in US

A major U.S. Supreme Court decision in 1949 established that pension benefits were a legitimate part of collective bargaining. The number of plans increased after this as unions negotiated for such plans.

Regulation of Pension Plans in US

Employee Retirement Income Security Act of 1974

ERISA established guidelines for funding

Allowed plan credit to transfer with employees Established vesting requirements to gain plan benefits Increased disclosure requirements Assigned regulatory oversight by department of labor

401(K) Plans, IRAs and Roth IRAs in US

In 1978, the congress amended the Internal Revenue Code by adding section 401(k), whereby employees are not taxed on income they choose to receive as deferred compensation rather than direct compensation. The law went into effect on 1 Jan 1980 In the mid-1980s, there were fewer than 8 million participants with less than $100 billion of assets in 401(k) plans. By 2006, there were seventy million participants with more than $3 trillion of assets in 401(k) plans Section 401(k) plan proved popular with workers at all levels because it had higher yearly contribution limits than the Individual Retirement Accounts (IRA); it usually came with a company match, and in some ways provided greater flexibility than the IRA The other variant of the IRA account is the Roth IRA. In contrast to a traditional IRA, contributions to a Roth IRA are not tax-deferrable. Withdrawals are generally tax-free

The Future of Pension Funds

We can expect their growth and popularity as the average age of population continues to grow. Variety of pension fund offerings may increase as well. Pension funds may gain significant control of corporations as their stock holdings increase.

Lot of big companies in the world also in deep waters

Japans top 278 companies were a combined 21.5 trillion yen ($235.7 billion) behind on their pension funding in fiscal 2009, a 50 percent increase from the previous year, according to the Daiwa Institute of Research in Tokyo. Hitachis unfunded liabilities totaled 1.1 trillion yen The pension plans suffer from two decades of slumping markets, an aging population and a dependence on packages that are immune to investment performance. Japan Inc. stuck with defined-benefit plans even as the countrys stock market has slid and interest rates have hovered near zero.

JAL Pension Shortfall May Prompt Japan Inc. to Change Its Ways
The news about Japan Airlines Corp.s $25.5 billion bankruptcy a year ago may be the impetus for companies including Hitachi Ltd. and Toyota Motor Corp., Japans biggest private employers, to shore up their deficit-ridden pension plans.

Worldwide moves towards Private Retirement Systems Driven by fears about the un-sustainability of their social security programmes, many countries have initiated the development of multi-pillar pension systems, which seek to integrate both public and private components. This has led to a rapid growth of mandatory as well as voluntary privately managed pension funds and reduced the reliance on public social security systems. These new private retirement systems are often supported by the state with tax incentives. When mature, they will control a substantial portion of the financial assets in an economy and exercise considerable influence over the allocation of capital and the financial well-being of a large section of the populace.

Present Indian pension system

The present Indian pension system is largely publicly managed and tightly controlled. Proposals have been made over the years suggesting introduction of private participation, in order to:
expand coverage,

increase returns, and

improve efficiency.

Absence of a social security programme in India India does not have what is commonly referred to as a first pillar social security programme, that provides significant income replacement for the majority of the population, as is common in most advanced countries. The central government operates a variety of poverty alleviation programmes funded out of its general tax revenues targeted at people below the poverty line.

However, there is no public system run out of the governments budget to which citizens contribute and receive benefits.

Mandatory Occupational Plans for organized sector for provision of Retirement Income Security in India
Mandatory occupational plans forming what is typically termed a second pillar are presently the mainstay of retirement income security.

These plans, however, cover only the salaried workers employed in specified industries and classes of establishments that are notified by the government, which cover most of the organised sector. Such occupational arrangements utilise a dual benefit structure, with each employee generally being a member of a DC plan that is not annuitised and allows early withdrawals for some specified purposes (called a provident fund), as well as a DB plan that pays a life pension (called a pension fund). Rates of contribution are high, ranging from 20% to 24% of salary.
In addition, most of the salaried workers in the organised sector are also entitled to a lump-sum retirement benefit called gratuity, generally computed at half-months salary for every year of completed service.

Third Pillar for the Un-organized Sector

The majority of the labour force consisting of selfemployed workers, casual workers and most of those employed in the unorganised sector do not have mandatory coverage. For them, voluntary individual saving (the third pillar in a multi-pillar system) is the only means of providing for income in old age. The government and the insurance companies offer longterm savings plans that are aimed at enabling such workers to save for their retirement. These individual voluntary plans as also the mandatory occupational plans are supported in India with strong tax incentives.

Mandatory coverage for salaried employees

The total number of regular salaried workers in the country is over 6 crores. Mandatory coverage for retirement plans in India extends only to salaried employees who can be categorised as follows: Government employees who are covered under the governments pension system,

Salaried employees in establishments covered by the EPF Act,

Salaried employees in establishments covered under special Acts, and Salaried employees in establishments not covered under the EPF Act but have equivalent voluntary arrangements (such establishments are mostly in the public sector).

Regulatory Framework for Pension System in Recent Times

Until recently, regulation of provident and pension funds in India came out of three sources: o Income Tax Act of 1961, o EPF Act of 1952 (or other special Act governing the fund), and

o Indian Trusts Act of 1882.

Every provident and pension fund trust, as also every gratuity and superannuation trust, is required to obtain approval under the Income Tax Act for its income to be treated as tax-exempt.

Such an approved trust is required to comply with the provisions of Schedule IV to the Income Tax Act.
The chief requirement under Schedule IV is compliance with the investment limitations prescribed by the Ministry of Finance.

The effect of this provision is that a common investment pattern applies to all types of provident, pension, superannuation and gratuity funds in India, whether or not they are governed by the EPF Act.
The above is not applicable to the recently introduced NPS.

Need for Unified Regulation

The EPF Act governs the EPFO and is also the chief source of regulation for the Exempted Funds The Indian Trusts Act applies to all trusts and deals with the rights and obligations of the trustees and the beneficiaries The legislation governing supervision of provident and pension funds has thus been fragmented and there was no one regulator who supervises all funds Pension reforms in India needed to establish unified regulation affecting all retirement funds and an independent regulator with jurisdiction over all funds A major step forward has since been taken with the establishment of Pension Fund Regulatory and Development Authority (PFRDA) by the Government of India on 23rd August 2003, which is dealt with later

Employees Provident Fund Organisation

The Organisation functions under the overall superintendence of the policies framed by the Central Board of Trustees, a tripartite body headed by Union Minister for Labour as Chairman. The Chief Executive Officer of the organisation is the Central Provident Fund Commissioner, who is also a member of the board and its secretary.

EPFO - Operational Statistics: 31.3.09

No. of covered establishments as on 31.03.2009: 573063 Membership of persons as on 31.03.2009 in crores: In Employees Provident Fund: 4.71 In Pension Fund: 4.49 Cumulative contributions (Rs in crores):In Employees Provident Fund: In Pension Fund: Employees Deposit Linked Insurance Fund : Total Contribution

211677.37 98242.05 7457.69 317377.11

Trust organisation for managing funds

All provident, pension, superannuation and gratuity funds have been required to be set up as independent trusts. Exempted Funds are set up as irrevocable trusts sponsored by the employer. Trust deeds are required to be registered and filed with the EPFO for obtaining exemption. The Indian Trusts Act of 1882 governs all trusts, addressing many of the agency issues. The fiduciary duties, powers and liabilities of a trustee and the rights of a beneficiary are defined in the Trusts Act.

PFRDA
PFRDA was established by Government of India on 23rd August, 2003. The PFRDA Bill, 2005 is awaiting approval of Parliament. Pending passage of the Bill, the Government has, through an executive order dated 10th October 2003, mandated PFRDA to act as a regulator for the pension sector. The mandate of PFRDA is development and regulation of pension sector in India.

Current Scenario: Standardized Plans/Portability

Employers are granted permission, by the government in consultation with the EPFO, to set up Exempted Funds if their contribution and benefit structure are not inferior to the EPF plans. In practice, the contribution rates, benefits and the rights of beneficiaries including vesting rights are almost identical across the country.

Due to the restrictions imposed by the investment regulations there was no choice regarding portfolios to the employers or the employees.
Portability is an important principle of pension regulation; it was made easy in India by the dominance of the EPFO. As most of the employers subscribed to EPFO plans, relocation of workers among those was handled by a simple declaration to the EPFO.

Earlier highly Restrictive Investment Regulations

Investment requirements and limitations are the core of the regulation and control of provident and pension funds.

The laws of the country had imposed what was often viewed as a highly restrictive investment regulation regime. Funds in India could not earlier invest in stocks or mutual funds.
No investments were also permitted in nontradable investments such as loans or deposits (including bank deposits). Investments were mostly directed to the government and its enterprises.

Non-sustainability of the earlier System

While the model may have worked in the past, a virtually publicly managed system with administered returns could not be supported in the liberalised era

The government has so far implicitly assumed responsibility for all retirement savings by directing such savings to be channeled to itself or its enterprises and paying what would be considered an attractive return
In effect, the government had underwritten the pension system with tax-payers money The government had also assumed fund management responsibility, with more than 70 percent of the corpus of provident and pension funds being under the EPFO plans.

Huge contingent liability for DB pension plan of EPFO

The government has assumed the huge contingent liability for any deficit in the DB pension plan of the EPFO, which is unsustainable. Pension plans all over the world have tended to migrate to DC plans from DB plans. Where DB plans do exist, the liability for them rightfully belongs to the employer and not the tax-payer. Inevitably, the DB plan of EPFO will need to be reformed into a DC plan or a privately managed DB plan for which the employer assumes liability.

Central Government Employees Pension Plan

The governments own pension system also has evidently been in need of reform. The solution was transition to privately managed and funded plans based on defined contributions, which has now come about with the move to NPS for the new recruits of the central government.

New Employees of Central Govt. move to NPS

The New Pension System (NPS) reflects the Governments effort to find sustainable solutions to the problem of providing adequate retirement income. As a first step towards instituting pension reforms, the GOI moved from a defined benefit pension to a defined contribution based pension system by making it mandatory for its new recruits (except armed forces) w. e. f. 1st January, 2004. Since 1st April, 2008, the pension contributions of Central Govt. employees covered by NPS are being invested by professional Pension Fund Managers.

The Basics of NPS

NPS is the lowest cost, portable and no-load product that is possibly the best in terms of its structure, across the world. The account-holders contribution goes into a fund of his choice out of a universe of six fund managers, offering a choice of three funds each. At the most, half the money can go into an indexlinked equity fund, the rest in safer debt products. This account is locked till the age of 60. On maturity, the person can withdraw up to 60% of the corpus as lump sum and the rest will buy an annuity, from any of the insurers. If the account-holder does not want to choose the fund, the default option puts him in an asset allocation that is linked to his current age. As the person ages, the allocation will change in favour of debt.

Some more basics of NPS

A Central Record keeping Agency, National Stock Depository Limited (NSDL), which is the sole CRA under the system, acts as the backbone of the NPS by hosting and facilitating transactions. The CRA allots a unique permanent retirement account number (PRAN). This number is portable across geographical locations, banks and employers. Costs is another area that puts NPS ahead of other competing products Portability across funds, once a year, also allows greater flexibility to the investor. The regulator has also launched the Tier II account, which works on a similar backbone. The only difference is that of flexibility - you can withdraw anytime you like. Both contribution & maturity are however subject to tax.

Budget 2010: NPS

New Pension Scheme Push A renewed push has been given to the New Pension Scheme in the last Budget. Till now the New Pension Scheme has not found much favour from the public due to teething problems related to its implementation and certain other factors.

Budget 2010 had proposed to give Rs.1000/- as a starting incentive to all accounts of NPS opening in the next 3 years.
This is a welcome measure, as NPS will possibly become the key Contributory Social Security Scheme in India.