Thursday, October 22, 2020 / 09:50 PM /By
Nachiket Mor / Header Image Credit: The Island
It is well known that there is a high degree of impoverishment among Indian households each year on account of catastrophic healthcare expenditures, estimated at 8%, or 2 crore additional households, each year.
Over the last two decades, the level has only grown because the dominant and often the only route available to most households to pay even for high cost and infrequent healthcare expenditures is not insurance but out-of-pocket payment.
It is also possible that, for this very reason, there are several households who 'choose' to forego care entirely and risk death or long-term disability. For this reality to change, insurance penetration needs to grow rapidly in India.
For that to happen, among other things, against the current situation of fewer than 60 insurance companies, it is imperative that many more smaller, regionally-focused insurers be permitted to emerge in India.
Germany, a highly conservatively managed insurance system, despite having a population comparable to the state of Rajasthan, has over 500 insurers, with almost 100 dedicated health insurance companies. In the United States, which has a population that is less than a quarter of India's, the number of insurers is 50 times higher even than Germany.
An insurance product, in its most generic sense, takes on a combination of the risks that are similar to those associated with both the savings and the lending functions of a bank. This is the reason insurers are often referred to as para-banks because while they perform 'bank-like functions' they are not regulated by the banking regulator.
When an insurer receives premiums, it either can be seen as a simple sale of a risk-management product (like a derivative) by the insurers to the consumer, or, as is more often the case, as the acceptance of a deposit by it, particularly when it comes bundled with some form of an investment product.
Even in its purest form, as in the case of a savings deposit with a bank, the insured person takes the risk on the continued solvency of the insurance company and the ability of the insurer to honour the claim when called upon to do so.
The Question Of Size: Scale, Design, Risk
Like a lender, the insurer assumes that all of the health, life, or property-related risks that it is taking on are fully visible to it, and have been properly priced into the policy at the time that the policy is sold, i.e., there is no adverse selection.
Given these similarities, it is not surprising that many of the principles that are used to ensure that banks are prudently managed and have the capacity to honour all of their current and future obligations, apply to insurance companies as well.
The insurance function relies on the application of the so-called 'law of large numbers'. If the insurer can get a sufficiently large number of customers, under most conditions the level of uncertainty that it will experience concerning aggregate annual claims payments, will be low.
This is even as at the level of its individual customers, the amounts of claims payouts will vary quite considerably.
However, given all of the risks that an insurer takes on and the very real possibility of adverse selection, there are safeguards (or systems) in place to ensure that the firms honour any and all valid claims that are made.
Insurers are required by the regulator to maintain a certain level of capital, referred to as the Solvency Capital Requirement.
The same is the case for banks in so far as their savings accounts are concerned. There is wide-spread recognition from around the world that smaller, regionally concentrated, financial institutions such as banks and insurance companies are much better at product and channel-design, and in their ability to truly understand and meet the needs of their customers.
However, a significant challenge associated with allowing the creation of such institutions is that the level of residual risk retained by them, whether as banks or insurers, goes up substantially because there is inadequate diversification of risks borne by them.
In theory, a smaller institution with a larger capital adequacy requirement could lower the absolute amount of capital it needs, by underwriting less risk.
But, there comes a point when the revenues from the underwritten risks become too small. They won't support even the minimum operating costs associated with running an insurance company (or bank) and to provide an adequate return on the capital that is required to support these risks.
All regulators and licensing authorities grapple with this issue of risk and capital. It was examined in some detail in 2013 by the RBI Committee on Comprehensive Financial Services for Small Businesses and Low-Income Households in the context of banks, and more recently in 2020 for insurers by the IRDAI Committee on Standalone Micro-insurance Company.
The RBI committee found that while this is a real issue, it has been resolved very well by the German and Swiss designs. The regionally-focused German Sparkassen banks, for example, are part of a national system that spreads risk across a well-integrated network of regional banks and national institutions.
Such a system lowers the capital requirement of the risk-originating regional bank while allowing it to preserve both its soundness and its ability to serve its regional consumers.
While such an approach towards risk-reduction is relatively unusual in the banking context, in the insurance industry, it is akin to the re-insurance function, which is already well-established worldwide as well as in India.
The IRDAI committee found that this approach towards risk and capital management has allowed highly conservative and mature insurance regulators in the European Union and Australia to keep minimum capital requirements to under Rs 25 crore even for their mainstream insurance companies, thus ensuring a vibrant insurance market, while maintaining the financial soundness of their insurance system.
In the committee's view, this is perhaps also the most important reason why penetration of micro-insurance remains so low in India even after all of the efforts, over multiple decades, of the insurance regulator. In its report, the IRDAI committee has recommended lowering this to Rs 20 crore.
The other potential challenge is that while a much larger number of smaller institutions would almost certainly improve access to insurance services, it would become that much more difficult to license, regulate, and supervise them.
On this front India is an exception. As mentioned earlier, despite its large population and geographical size, India has a much smaller number of insurers than any other market of comparable size, which have been able to supervise them quite successfully.
The high levels of automation and centralisation that are now an integral part of any financial institution in India, also make it that much easier for the regulator to supervise and regulate a large number of diverse financial institutions.
The inability to offer financial protection to the vast majority of Indians is exposing them to risks that they are not in a position to take on. A rapid growth in the penetration of insurance services, through the entry of many more much smaller insurers, with a significantly lowered capital requirement, is imperative if this challenge is to be addressed.
And, as has been discussed here, this type of growth need not come at the cost of the prudential management of the insurance sector.
About the Author
Nachiket Mor was a member of the IRDAI's committee on the development of standalone micro-insurers.
Related to Recapitalization