Mr. J. Hari Narayan (JHN) the immediate past chairman of the
Insurance Regulatory & Development Authority of India (IRDA)
in conversation with Abraham Kuruvilla (AK) on issues relating
to adoption of a ‘risk based capital’ framework by the Indian
insurance industry.
AK : Hello Mr Hari Narayan, how important is it for
the Indian Insurance industry to adopt a risk-based
capital framework and are they ready for it?
JHN: There is a risk-based capital concept in India,
but it is not within the terms of what is understood
in international parlance. And particularly after the
Solvency-II directive has come out! That’s the first
thing we must understand. Now, within the
risk-based solvency framework that they are
talking about, companies are expected to assess
their own risk, and create an internal model as they
call it, to assess the risk which they have on their
liabilities side, as well as their assets side.
Now they are entitled to use their own model and
calculate their risk based upon that particular
model. The model however is subject to oversight
by the regulator. In the event a company doesn’t
choose to develop its own model, or if the model
developed is inadequate, then the regulator may
prescribe a model, which the company is bound to
follow. So fundamentally, that is the pattern they
follow – or rather what they have adopted within
the terms of Solvency–II. Now in India, we have a
different concept of solvency and we believe that
our system is far more robust
AK :: Related to the problems that Europe is 
having with Solvency–II, what do you foresee as some of the problems that
India would have in adopting the framework?
JHN: See, merely because it is adopted in Europe, that doesn’t
mean it’s the best model to go by. Having said that, the need for
solvency is a cornerstone of the financial structure of an
insurance company, and it is so across the entire world. Briefly,
what it says is that at any point of time, the insurance company
must have assets which are sufficient to meet its liabilities. That
law applies not just in Europe, it applies all over the world and in
India too, and it is always applied in India. The question now is,
how are you going to measure your assets, and how do you
measure your liabilities. And how are you ensuring that one equals the other. That’s the question!
So when they are talking about risk and risk-based
assessments, they’re really talking about the accuracy of
estimates. For an insurance company, whether it be liabilities or
assets, both are only estimates. No doubt competent estimates,
professionally executed estimates, but estimates nevertheless.
Take for example the question of estimating liabilities; typically,
insurance companies look at these liabilities based largely on the
past data and past track record, and project the liabilities in the
future. Now, this might work well, but I think you know about the
‘Black Swan’ event don’t you?
AK : Yes, I’ve some idea!
It is a term which has become very popular after the 2008
financial crisis –fundamentally, the question is: how are you
going to, based on past experience project, for instance, a
disaster like a Fukushima, or the Christchurch earthquake, or
even the Kedarnath landslide and floods and all
that? Disasters of this dimension are very difficult
to predict. That’s why the estimate of liabilities is
always shaky. It is founded, no doubt, on statistical
mathematics, but fundamentally, since it’s based
upon the past, is that a very reliable indicator to the
future or not, is a debate that is going on at a very
esoteric level in the world of mathematics.
But having said that, essentially when you’re saying
‘risk-based’, what you’re saying is: a) we need to
assess what might be our liabilities at a point of
time, and b) the same thing holds with regard to
assets – what is the value of assets which an
insurance company holds. If you take insurance
companies in India, for instance – and that’s largely
true across the world, the pattern is not very
dissimilar – in India, for instance, insurance
companies hold about 15% of their assets in
equities. And the other 85%, bulk of it – about 55%
to 60% - is held in government securities, and the
balance 25% to 30% is held in corporate debt. So
you’ve got government debt, corporate debt and
equities. As far as equities are concerned, there is
no problem, because on the date when you are
going to assess, the value of a given asset, there is
a market value because there is discovery in most
of these shares. That is why in India, for instance, we do not allow
insurance companies to invest in the equities of non-listed
companies. The reason is, there is not sufficient discovery of
price in such instruments. But that in any case amounts to only
15% of the portfolio, generally. So the question is: how are you
going to assess the debt? What is the value of the debt which
one has? And that is the issue, as far as India is concerned.
AK : Could you elaborate?
JHN: There is a myth that all government securities are risk-free.
Now we have seen in the 2008 crisis that that may or may not be
a valid proposition. There are several government debts, for
example, which certainly were not risk-free. So the question is
whether it is wise to look at Indian government debt as risk-free.
And even government debt in India is of two kinds; one is, you’ve
got the central government debt, there are also state government debts, and there is also the debt, or the bonds issued by state
government instrumentalities, like for example Power Finance
Corporation and other corporations and so on. So what is the
value of this debt? Is it risk-free, truly? 
And then there is the question of corporate debt, and where
exactly the corporate debt is. If you look at the banks now, banks
have lent money to very big corporates, and several of them are
in distress, because of various reasons, the repayment of the
loans taken by the corporates is not as per schedule, which is
why they’ve got a problem of the asset quality, and they have to
make provisions for asset quality. So when we’re looking at the
portfolio of an insurance company’s assets, the question is: what
provisions do we need to make for different classes of debt? That
is the question. And we don’t have a sufficiently robust and deep
statistical basis on which one can assess that the risk in a given
instrument is so much. The banks have done it.
AK : So, Sir how do we do it?
JHN: The system we follow in India is, that the liabilities side can
be fairly well-assessed, because as far as life insurance
companies are concerned, there’s little problem in estimating
liabilities, because the statistical basis of life and life probabilities
and events and so on is very well-charted, and you can do it very
accurately. The same doesn’t hold good for non-life companies,
that’s general insurance companies, which deals with
miscellaneous types of perils, like for example, as I mentioned,
the Uttarkashi issue, or the Bombay flooding and things like this.
But in India, fortunately, those secular kinds of perils are not very
widely insured. The bulk of our insurance is in motor car
insurance and in health insurance, and these are very well
tracked. So there’s not much of a problem. The problem comes
only when you’ve really got vast property holdings, and then the
issue of assessment of risk is of far greater importance.
So coming back, in India, what we do – we require insurance
companies at all times to maintain one and a half times the
assets over the liabilities as solvencies. In other words, it is not
equal to, but it is one and a half times greater than. And that’s
how I believe it’s a very robust thing. But on the downside,
because we haven’t got well developed markers to assess what might be the quality inherent in, let us say, corporate debt, or
even in a government debt, we’ve hiked up the percentage,
partly to meet the inaccuracy in estimating the risk on that factor,
and secondly it’s also the question of time.
Supposing we find that a company’s assets are eroding, or their
liabilities are increasing over their assets, it takes some time
before that can be recognized. Their system of accounting has to
come up from that, it has to be recognized, it has to be reported,
and so on. And having recognized it, we will again require time –
of both the management and the regulator – to take sufficient
steps to restore the equilibrium of the company. That also takes
time. And in order to allow for this time, as also allowing for a
certain uncertainty in the quality of the debt, we’ve insisted on a
margin of a 150%. So that gives us enough time – partly because
they have not really estimated the value of the debt, meaning
what is the risk associated with a different class of debt. Let us
say, if you’ve got 100 crores of bonds which are say rated at BB
and let us say it is an 8% bond – what are the chances of a
default on that? Is it more, or is it less than if you had 8% on let
us say an AAA bond. Is it more or is it less? How much more or
how much less? This kind of arithmetic and details for it are not
there. And that is why we believe that our system has met our
needs; there have been no failures of insurance companies
unlike in the west – in the west, every year, about half a dozen
insurance companies collapse, and therefore it’s a far greater
concern for them.
AK : They say technology could be a crucial driver in sort of
balancing this risk. Now, what would be needed to business assure
these technologies? Would you like to add something on that?
JHN: I don’t think it is much of a technology issue. It’s a data issue,
a question of data reliability. The calculation of a risk is no big deal.
If you’ve got the statistics, it’s just a fifteen minute job. So it’s not
really a technology issue. It’s an issue of whether we have the
quality and depth of the data we require, and have we captured all
transactions accurately at a point of time. And do it systematically,
you know, quarter by quarter, month by month, or even daily for
that matter!
To some extent, the Reserve Bank of India does it, and therefore
what they have done for different classes of assets held by banks, they have calculated what should be the risk weights associated
with different classes. So the IRDA had considered that, and
based upon the expertise of the RBI on such matters, they had
calculated and sent an exposure draft, saying that we could
recalibrate our estimates based upon the risk weights as
calculated by the Reserve Bank, and then require companies to
make provisions accordingly. The question really is this:
Companies are trying to balance between the need for security of
an investment portfolio – rather, of an insurance portfolio, at the
same time, to minimize the capital required to do so. Capital is
expensive. So in countries such as in Europe, what they found as
a result of the 2008 issue was it’s always in the shareholders’
interest to keep the capital as low as possible. So they used to
keep it very low. They were skating on thin ice. And that is what
they are trying to redress. So one of the concerns which Europe
and European insurance companies have, is that they believe the
Solvency–II requirement might require companies to recapitalize
quite substantially, and that poses a problem for shareholders, for
the economy at large, and that is the question which they are
facing.
AK : Thank you Sir, have a nice day!
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