The Hindu : Unwarranted move to change provision

Online edition of India's National Newspaper
Monday, Sep 15, 2003

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Unwarranted move to change provision

Any amount transferred by the shareholders to the policyholders' fund at any time will be the first charge on future surpluses. At first sight, the proposed amendment may appear simple, harmless and reasonable. But, is it really so, asks R. Ramakrishnan

THE LAW Commission of India was recently entrusted with the work of revising the Insurance Act, 1938 and prepare a comprehensive Act, merging related Acts and Rules. A couple of months back, the Commission had brought out an exposure draft of the proposed changes and invited comments from the stakeholders and interested persons. An article in The Hindu regarding one of the vital changes proposed may be the best way to invoke some interest in the minds of the present and prospective policyholders and initiate a public debate on the issues involved.

Section 49 is one of the most important sections of the Insurance Act from the point of view of financial governance of a life insurance company. As per this section, a life insurance company can declare bonus to its policyholders only if a surplus is shown in the valuation and, the shareholders are not eligible for more than 10 per cent of such surplus. It is now being proposed to remove this ceiling on shareholders' share of surplus, under certain circumstances, through an amendment to this section.

As per this amendment, "an amount not exceeding the aggregate amount transferred from shareholders' fund in the previous years shall be transferred back to shareholders' fund in case of surplus, prior to the declaration of bonus to the policyholders". In short, any amount transferred by the shareholders to the policyholders' fund at any time will be the first charge on future surpluses. At first sight, the proposed amendment may appear simple, harmless and reasonable. But, is it really so?

The question to be answered is, "Under what circumstances will the shareholders be constrained to transfer any amount to the policyholders' fund?" The answer is, none. The next logical question is, "What then is the need for the proposed amendment to confer on the amounts transferred by the shareholders the status of first charge on future surpluses?"

Transfer from shareholders' fund

During the first one or two years after a life insurance company is established, the policyholders' fund will be negative, mainly because of heavy overhead expenses, and it would take a minimum of four to five years before it can exceed the liability as estimated by the Actuary and a surplus can emerge. The Insurance Act recognises this fact and does not stipulate that the policyholders' fund should be greater than the liability right from the first year. It is enough if it is ensured that the (policyholders' fund + shareholders' capital) is not less than the liability. If it is less, then the shareholders have to bring in additional capital. They need not, however, transfer any amount to the policyholders' fund.

However, as per Sec. 49 of the Insurance Act, bonus to policyholders can be declared only if the policyholders' fund is greater than the liability and a surplus emerges. In their zeal to demonstrate that they could achieve, in the very first year of operation, the level of bonus rates achieved by the LIC of India over four decades, some of the insurance companies transferred significant sums from the shareholders' fund to the policyholders' fund and declared bonus out of this artificially generated surplus. After succeeding in creating this illusion in the minds of the public, these companies are trying to get back the money used for creating this illusion.

The proposed amendment to Sec. 49 will enable these companies to succeed in their efforts. It appears that full facts were not placed before the Law Commission and it was not informed that,

* The amounts transferred by these life insurance companies from the shareholders' fund to policyholders' fund were purely voluntary in nature and,

* Only for the purpose of gaining publicity and,

* With the full knowledge that, as per Sec.49, the money once transferred cannot be re-transferred.

The status of "first charge on future surpluses" can be given only if the shareholders say that the amount transferred to the policyholders' fund is neither a gift nor a grant, but a loan. If it is treated as loan, it has then to be treated as a liability and shown as "Amount recoverable from the policyholders' fund". In which case, no artificial surplus will get generated. To circumvent this problem it has been suggested by some that the amount transferred be treated as a `notional loan', and perhaps placed just as a foot note to the balance sheet.

However, no prospective policyholder ever looks at the balance sheet of the life insurance company. Less still at the foot notes. He looks only at the product brochure and the bonuses declared in the last few years. This procedure will therefore lack transparency and tantamount to misleading the policyholders.

Misleading the policyholders

This situation would not have arisen if Sec.49 had been enforced in both letter and spirit. Artificial surpluses were allowed to be generated by transfer of money from the shareholders' fund, conveying a false view of a company's prosperity in the minds of the public. After allowing it to happen it is unfair, not only to policyholders but also to companies that did not adopt such tactics, if Sec. 49 were to be amended to allow these companies to take back the money already transferred.

Requesting the Law Commission to go into the Insurance Act and prepare a Comprehensive Act was a good move. The opportunity could have been utilised to get approval for the second tier capital to be used for the purpose of demonstrating solvency margin requirements. This would have brought considerable relief, not only to new insurance companies but also to existing ones. Once this is done, new insurance companies would be able to declare bonus in the very first year of operation, within the existing provisions (in both letter and spirit) of the Insurance Act and, without any financial strain.

It is now for the Insurance Regulatory and Development Authority to place the full facts before the Law Commission and arrive at a solution that is fair to all.

(The author is an Actuary)

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