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Solvency margin requirements of life insurance companies

As in the case of any commercial undertaking, a life insurance company has to ensure that the value of its assets is not less than its liabilities.

ABOUT A year ago, on June 30, 2003, to be exact, in an article titled `LIC in sound position,' I wrote about some shortcomings in the regulatory provisions governing `Solvency Margin' requirements relating to a life insurance company. Since no remedial measures have been taken till now, it has become necessary to re-visit the issue and analyse the implications of not rectifying these short- comings.

As in the case of any commercial undertaking, a life insurance company has to ensure that the value of its assets is not less than its liabilities. As per accounting norms, the lesser of book value and market value has to be taken as the value of assets.

The excess of assets over liability (as determined by the actuary) is known as `Surplus.' The balance surplus, after payment of tax (at 5 per cent plus surcharge), does not belong fully to the shareholders, but has to be shared between the policyholders and shareholders. A maximum of one ninth of the amount allocated to policyholders in the form of bonus can be transferred to shareholders as their share of surplus.

To maximise return to its shareholders, the board of a life insurance company will try to allocate to policyholders 90 per cent of the surplus after tax in the form of bonus (so that shareholders can get 10 per cent), keeping nothing in reserve for the rainy days. The solvency margin regulations were framed just to prevent this from happening.

Solvency margins

The term `Solvency Margin' came into vogue in the 1970s, in Europe. Till then, the only requirement to be satisfied by a life insurance company was that, after the distribution of surplus, if any, the value of its assets should not be less than the value of its liabilities. Instead, it was stipulated that the value of assets should exceed the value of liabilities by a certain margin. This margin was known as the Solvency Margin. No mathematical technique has so far been developed to determine the quantum of margin required. The European Union developed an empirical formula based on past experience and the same has now been adopted in India, with some modifications.

In order to satisfy the solvency margin requirements, the companies have to systematically build up reserves, by holding back a part of the surplus, and transferring it to a special reserve called Solvency Margin Reserve. However, holding back too much of the surplus will result in excessive reduction in bonus rates declared and make life insurance unattractive vis-a-vis other financial instruments. So, only a part of the amount needed to meet solvency margin requirements can come from the surplus held back.

The balance requirement has to be met by the difference between the market value and book value of assets, the share capital and free reserves in the shareholders' fund. This is the position inmost of the developed countries.

During the early years of a life insurance company, the share capital will be the dominating factor in the demonstration of solvency margin. Gradually, the importance of share capital will decline and, after about 15 years, the solvency margin reserve will become a more dominating factor. As the company grows further in size, the solvency margin required will become hundreds of times the size of share capital, and the solvency margin reserve, together with the difference between the market value and book value of assets, will be the main source for demonstration of solvency margin.

LIC's huge reserve

After almost five decades of existence, the LIC has today reached this stage. The excess of market value of its assets over the book value, standing at more than Rs. 20,000 crores, is by itself more than sufficient to meet the solvency margin requirements. In addition, it has built up a Solvency Margin Reserve of about Rs. 15,000 crores over the last few years, by holding back a part of the valuation surplus, with consequent reduction in bonus rates. This reserve is also marginally higher than the solvency margin required. Together with hidden margins, the total available solvency margin of the Corporation is about Rs. 50,000 crores. That is, more than 300 per cent of the solvency margin required.

But, the corporation may still face problems due to some ambiguities in Indian insurance regulations. Though the regulations in many of the developed countries explicitly allow the difference between the market value and book value of assets to be included in the demonstration of solvency margin, it is not stated explicitly in the Indian regulations. Even this would not have mattered, but for a circular issued by the Regulator stipulating that the Available Solvency Margin (ASM) should not be less than 150 per cent of the Required Solvency Margin (RSM). So, the LIC may find itself in a peculiar position. It will be satisfying the solvency margin requirements laid down in all countries except India.

The IRDA studied the insurance regulations of many countries, and also visited these countries for holding personal discussions, before framing the current regulations. In all the countries visited, the market value of the assets is being used for demonstrating solvency margin. It is therefore surprising to note that no explicit provision has been made for this in Indian regulations. Not only that. The requirement that ASM should not be less than 150 per cent of the RSM has no legislative sanction.

What is the implication of this ambiguity? It would make it appear as if the LIC is not able to demonstrate solvency. This in turn may be exploited by some vested interests to create an illusion that a heavy infusion of capital is required and that the same cannot be achieved without disinvestment and allowing foreign participation. Rather than trying to find how such a serious ambiguity crept into the regulations, it would be better to initiate corrective measures immediately. Such ambiguities, with high potential for damaging an institution's reputation and enabling back door entry of foreign investments, should not be allowed to continue indefinitely.

The surplus held back

Will not holding back systematically a part of the surplus and transferring it to solvency margin reserve result in denying the policyholders their due share of surplus, one may ask. A pertinent point indeed. A life insurance company can hold back a part of the surplus only for a certain period, but not permanently. On the final exit of a policy (by say, death or maturity), its share in the portion of surplus held back each year is meant to be returned, in the form of Final Additional Bonus.

Here too there is a problem. It appears that according to the regulator, if a life insurance company feels that it has to return the amount held back each year to the policyholder, at the time of exit of the policy, it has to treat the amount it intends to return as an additional liability!!! In other words, if out of the surplus after tax of, say, Rs. 5000 crores, Rs. 500 crores is held back for transfer to Solvency Margin Reserve, the liability has to be increased by Rs. 500 crores if it is intended to return to each policy, at the time of its final exit, the amount earlier held back. This problem is not the result of any ambiguity in the regulations but due only to its interpretation.

It is not being appreciated that when a policy becomes an exit by surrender, death or maturity, along with it goes also the liability. Once the liability goes, there is no need for any solvency margin reserve in respect of that policy and any reserve held in this regard has to be returned to the policyholder. Any interpretation that denies to a policyholder his due share of surplus will not stand legal scrutiny.

Private insurers' position

These problems will arise only when an insurance company builds up a substantial amount of solvency margin reserve and the market value of its assets exceeds the book value by a significant amount. It would take not less than 10 years for the new insurance companies to reach the thresholds of this stage. Only then they may begin pressing for the removal of ambiguities and proper interpretation of regulations.

Let us hope that the Regulator, instead of waiting for another 10 years, will appreciate the issues involved and initiate corrective measures, in fairly quick time.

R. Ramakrishnan

(Actuary)

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