Financial Sector Reforms: A status report, 2017

by Ashish Aggarwal.

In this article, I piece together information in the 2017 budget to write a status report on financial sector reforms.

1. Consumer protection: Three important initiatives are in progress: -

   Financial Redress Agency (FRA): The FRA is expected to provide a unified, speedy and convenient complaint settlement mechanism to retail financial consumers. In the Budget speech of 2015, the Finance Minister had proposed to create a Task Force to establish a sector-neutral FRA. In June 2016, the Task Force recommended enacting a financial sector consumer protection law and proposed an implementation blueprint. It also addressed concerns expressed by RBI and SEBI. RBI has supported the idea of a single grievance redress agency. One example is their submission in the context of regulating deposit taking activities across regulators and State Governments (Twenty-first Standing Committee on Finance, 2015-16, Para 59). The government had recently invited public comments on the Task Force's report. The next steps in this journey consist of draft Bill on the proposed law, and the establishment of the FRA.

   Curbing illicit deposit taking schemes: There is considerable understanding of the problem of ponzi schemes. The twenty-first report of the Standing Committee on Finance (referred above) had recommended various measures to plug the regulatory gaps and overlaps related to deposit taking activities. This year, the Finance Minister has promised to introduce the Banning of Unregulated Deposit Schemes and Protection of Depositors' Interests Bill soon. This is the second version of the draft law and was released in November 2016 for comments. The Government had promised this law in last year's budget as well as in the ATR on the above report. The proposed law aims to empower the State Governments to regulate deposit schemes which today slip through the regulatory cracks. It allows the designated courts to impose significant penalties (Jail up to 10 years and fine of up to twice the amount of total funds collected). It proposes significant powers to the State Governments and the police.

   The Government should use concepts from the draft Indian Financial Code to strengthen the regulating of deposit taking activities by the State Governments. For example, provisions related to accountability (Chapter 14), regulation making (Chapter 17), show cause notices and orders (chapter 25) could be adapted to strengthen the proposed Bill. The clause on warrant-less searches should consider the provisions related to investigation in the draft IFC (chapter 22). These would help improve the balance of regulatory powers with accountability. This year, the Finance Minister has also promised to plug the regulatory gaps in the Multi State Cooperative Societies Act, 2002, as part of the follow up to the recommendations of the above Standing Committee. As part of the clean up, the Government is also expected to soon introduce a Bill to amend the Chit Funds Act, 1982, though that has not been mentioned in the budget documents. Given the extensive nature of changes, it would be doubly useful to harness the work embedded in the draft IFC.

   Securities Appellate Tribunal (SAT): SAT's jurisdiction today covers SEBI, IRDAI and PFRDA. Orders by RBI are still not appealable at a tribunal. Other than that, the scope of SAT now approaches that of the Financial Sector Appellate Tribunal (FSAT), proposed in 2014. In light of the expanded jurisdiction, the Finance Bill, 2017 (S.145) proposes to provide for more members and benches of the SAT, including benches outside Mumbai. This would be achieved by amending the Securities and Exchange Board of India Act, 1992.

   The Government should consider modernisation of SAT's processes and administrative functions. Tribunal members should be able to focus on their case load instead of the day to day aspects of administrative functions like finance, human resource and information technology (Datta, 2016, Towards a Tribunal Services Agency). This would help reduce the time taken to dispose off cases.

2. Systemic Risk Regulation: Financial Data Management Centre (FDMC) is expected to provide for a nation-wide integrated repository of information relating to the financial sector. It would be used to study systemic risk, system-wide trends and facilitate a discussion about policy alternatives. Para 90(iii) of Budget document on implementation of last year's announcements (Implementation Document) notes that a draft Bill to set up the FDMC is proposed to be placed for public consultation. Last year, a draft Cabinet Note on setting up of a non-statutory FDMC was circulated. Based on the feedback received, the Finance Minister had approved creation of a statutory FDMC. Thereafter, a Committee to suggest a draft law was set up. In October 2016, this Committee submitted its report which included a draft Bill titled Financial Data Management Centre Bill 2016.

   The Government should focus on ensuring that FDMC has the statutory ability to: (i) create a truly integrated repository; (ii) develop capacity to provide research and analysis support to the Government and (iii) ensure that the Data Centre has the ability to evolve with the changing requirements over a period of time. It would be a sub-optimal if the FDMC would need to rely on the executive powers of the Government/ FSDC or the willingness of the regulators to achieve its objectives.

3. Digital Payments: The Committee to review framework related to digital payments has, as part of its report, suggested that regulation of payments should be separated from the central banking function of the RBI. This year, the Finance Minister has proposed creation of a Payments Regulatory Board (PRB) within the overall framework of RBI to regulate payments. The proposed PRB has equal representation from RBI and nominees of the Central Government, with the RBI Governor being the chair (S.148, The Finance Bill, 2017). In the proposed PRB design, no decision can be taken unless RBI agrees. However, this is an improvement over the present regime where a sub-committee of the Board of RBI is regulating payments.

   The Finance Minister has said in his budget speech that the Government will undertake a comprehensive review of the Payment and Settlement Systems Act, 2007 and bring about appropriate changes. This would be a major reform in this field.

4. Monetary Policy: In March 2015, as part of its monetary policy framework agreement, India had established inflation targeting as a goal for RBI. In June 2016, the Parliament amended the RBI Act to require the Government to set a CPI based inflation target once in every five years (S.45ZA). A six member Monetary Policy Committee (MPC) was designed to determine the Policy Rate required to achieve this target (S.45ZB). RBI and Central Government have three votes each on this Committee. In case of a tie, the RBI Governor has a second vote. In addition to creating institutional capacity, this reform brings transparency to the decision making process. Section 45ZI(11) requires each member of the Committee to record the reasons for voting in favour or against the resolution. Section 45ZL requires the RBI to publish the minutes of the meeting with details of vote of each member and the reasons recorded by them. Para 90(ii) of this year's Implementation Document notes that action on this reform has been completed.

   The Government should re-visit the design of the MPC in the future. In the current design, the RBI does not need to convince even one non-RBI Committee member on its policy stance for the decision to go through.

   The Government should use the MPC meeting process to develop a cookie cutter approach to improve working of regulatory forums. The effect of these amendments is immediately visible. Contrast the detailed minutes of the MPC with the brief disclosures of the meeting of the Central Board of RBI, held around the same time (Minutes of MPC meeting, December 6, 2016 vs. Release on the 562nd meeting of the Central Board, December 15, 2016). The meeting of the Central Board is summarised in 150 characters, excluding details of attendance etc. The tweet style disclosure of the Central Board meeting is not a one-off. The immediately previous meeting details are also 150 characters long and are, co-incidently, exactly the same in content. The gaps in the quality of disclosures are glaring when we make international comparisons (Patnaik and Roy, 2017, The RBI board: Comparison against international benchmarks).

5. Capital Controls: This year's budget speech proposes the abolition of the Foreign Investment Promotion Board (FIPB) in 2017-18. It notes that the FIPB has successfully implemented e-filing and online processing of the FDI applications. It proposes that the road map for abolition of FIPB would be announced over the next few months. The Government has also indicated its desire to further liberalise the FDI policy. The abolition of FIPB would be a significant step if abolition is achieved in substance.

   Government needs to ensure that important reform steps do not slip through or get stalled. Control on all capital flows is exercised by the RBI, in consultation with the Government. The Finance Act of 2015 (S.139) had amended Section-6 of the Foreign Exchange Management Act, 1999 (FEMA) to provide that control on non-debt capital flows would be exercised by the Government, in consultation with the RBI. This amendment has not yet been notified. This requires the Government to first issue a notification distinguishing debt and non-debt instruments. One would have assumed that once the Parliament has amended a law, the government would be able to notify the same in a reasonable time.

6. Government debt management and its bond market: Two important initiatives are in progress: -

   Public Debt Management Agency (PDMA): In October 2016, the Government took first step by setting up an advisory Public Debt Management Cell (PDMC). The Office Memorandum notes the functions of PDMC and mentions a two-year (October 2018) journey towards a statutory PDMA. The Finance Bill, 2015 (Chapter VII) had proposed setting up a PDMA but the move was rolled back in April that year. This reform appears to be back on track. However, the first real progress would be to introduce a law that would establish the agency (Pandey and Patnaik, 2016, Legislative strategy for PDMA).

   Unified market for government securities: This reform appears to have lost traction after the 2015 roll back of the move to shift regulation of bond market from RBI to SEBI. The Finance Bill, 2015 (S.157) had proposed to create a unified market for government securities. There is some action in this Budget aimed at improving retail participation in government securities. It also captures some initiatives aimed at deepening of the corporate bond market.

7. Recovery of debt: DRTs deal with cases related to debt due to banks and financial institutions. Last year's budget had said that the Government would focus to strengthen the DRTs through computerised processing of court cases. This year, the budget notes that the Government is providing appropriate infrastructure, filling up vacancies and providing training to DRT staff. Recent reports put the Debt Recovery Tribunals (DRTs) case backlog at over 95,000 cases. This year's Budget further note that along with the SARFAESI Act, the Recovery of Debts Due to Banks and Financial Institutions Act, 1993 (RDDB & FI Act) has been amended through The Enforcement of Security Interest and Recovery of Debts Laws and Miscellaneous Provisions (Amendment) Act, 2016. This is expected to facilitate expeditious disposal of recovery applications. Harmonisation of provisions of IBC, 2016 with the provisions of the SARFAESI and the RDDB & FI Act is expected to help to improve the credit and recovery environment.

   The Government should prioritise the capacity building efforts at the DRTs. Going forward, based on the Insolvency and bankruptcy Code, 2016 (IBC, 2016), the corporate cases are expected to shift to NCLT. However, the rules and judicial procedures need to be redesigned for both NCLT and DRT to deliver the expected outcomes (Understanding judicial delays in India: Evidence from Debt Recovery Tribunals).

8. Market for stressed assets: A well function market for stressed assets should encourage a lender sell its NPAs to an Asset Reconstruction Company (ARC). An ARC should be able to raise funds by issuing NPAs backed Security Receipts (SRs). It should then be able to sell the NPAs to redeem the SRs at a profit. This year, the Finance Minister has permitted listing and trading of SRs issued by a securitisation company or a reconstruction company in a registered stock exchange. This is aimed at enhancing capital flows into the securitisation industry and help deal with bank NPAs. This should help efforts to develop the market. Last year's budget proposal to enable the sponsor of an ARC to hold up to 100% stake in the ARC and permit non-institutional investors to invest in SRs have been effected. These have been achieved by amending the SARFAESI Act through The Enforcement of Security Interest and Recovery of Debt Laws and Miscellaneous Provisions (Amendment) Act, 2016 in August 2016.

9. Mechanism to close down failed financial firms: This year, the Finance Minister has promised to introduce the Bill relating to resolution of financial firms in the current Budget Session. He noted that together with the IBC, 2016, a resolution mechanism for financial firms would ensure comprehensiveness of the resolution system in our country. Last year, the budget had recognised the need for a specialised resolution mechanism to deal with bankruptcy situations in banks, insurance companies and financial sector entities so that losses are minimised. This year's budget notes that the draft law -- The Financial Resolution and Deposit Insurance Bill, 2016 is under vetting by Ministry of Law and Justice (See: Report of Committee to Draft Code on Resolution of Financial Firms). The Insolvency and Bankruptcy Board of India has already been constituted in October 2016. With the above work, the stage is now set for a resolution law. This would lead to creation of a Resolution Corporation (RC).

10. Taxation: Taxation of finance contains serious problems. The Government needs to re-engage with the task of enabling a simpler direct tax law. The Direct Tax Code Bill of 2009, which promised this, went through several amendments before being finally shelved (Para 129, Budget speech, 2015). The said speech made a case that the Income Tax Act had incorporated most of the suggestions. This assertion is a subject of debate (India still needs the Direct Tax Code, Requiem for a Code). The proposed amendments in this year's Financial Bill related tax administration are retrograde and need to be reconsidered (See: Rai, 2017, Notes on Union Budget 2017-18)

Outside of the above ten areas, the bad loans of the Public Sector Banks (PSBs) present a major concern for the Government. Based on RBI's data table, the net NPAs (gross bad loans less provisions) of nationalised banks and SBI stood at over Rs 3.2 trillion or about 2.4% of GDP at the end of March 2016. The problem of PSBs is an outcome of Government ownership. Unlike PSBs, the NPAs of private sector banks are relatively small at Rs 266.7 billion (7% of the PSBs' figure). RBI's recent Financial Stability Report (FSR, December 2016) forecasts that PSB category may continue to register the highest GNPA ratio (ratio of gross NPA to gross advances). Attempts at reforms are moving rather slowly. The road map for consolidation of banks is being drawn up. However, no specific progress is listed in this year's Budget. The Banking Bureau's job list is expanding but it seems to be struggling with relatively small battles. Last year, the Government had allocated Rs 229 billion for recapitalisation to 13 PSBs. This year, another Rs 100 billion has been budgeted with promise of more. However, over the years, infusing capital has not yielded the desired results.

There is much to look forward to in 2017-18. Most of the reforms seems to be headed in the correct direction. Direct tax administration and the NPA problem of PSBs seem to be the exceptions.

 

Ashish Aggarwal is a researcher at National Institute of Public Finance and Policy.

Evaluating IRDA's orders

by Ashish Aggarwal and Rhythm Behl.

Regulators are mini-States, combining legislative, executive and quasi-judicial functions. In the quasi-judicial function, regulators write orders, which impose punishment. In each of the last three years, the insurance regulator (IRDAI) has issued orders against nearly thirty per cent of India's insurance companies. In the orders passed in January-May 2016, half of the life insurers companies were accused of more than ten violations each. In the same period, three out of seven general insurance companies were accused of over twenty violations each.

Moreover, the same companies have been repeatedly found to be involved in different violations. As an example, Future Generali India Life Insurance Company Limited, Tata AIA Life Insurance Company Limited, Sahara India Life Insurance Company Limited have been issued final orders for three consecutive years from 2014.

In this article, we evaluate IRDAI's orders against four principles of natural justice:

1. The accused party must be provided the evidence that is relied upon to decide the alleged violation.
2. The accused party must be provided with an opportunity to be heard.
3. An order should be reasoned and a speaking order.
4. The authority responsible for passing orders should deal with their case-load within a reasonable time.

To preview the results, we find that IRDAI passes muster on the first two principles but fails on the remaining two. These are important failures. A reasoned and speaking order safeguards against arbitrariness. It indicates whether the authority has applied its mind or not. It provides the aggrieved party an opportunity to demonstrate before the appellate court that the reasons, which persuaded the authority to reject his case were erroneous. The importance of disposing a case in a reasonable time frame is best summed up in the saying Justice delayed is justice denied.

This research helps us understand the extent to which State capacity has come about at IRDAI, and the areas where improvements are required. This work is particularly relevant as IRDAI orders can now be appealed at the Securities Appellate Tribunal, which is now the forum for appeals against orders by all financial regulators other than RBI. This research forms part of a recent literature that analyses the working of regulators in India.

Research Design

We analysed all the seventeen final orders published during January-May 2016 against life and general insurance companies. The earliest of these cases was instituted in 2010 and the last in 2013.

We captured:

• Information on accused entity and colluding agencies,
• Date of inspection,
• Date of first communication and first response,
• Show cause notice date along with the date of reply to the notice,
• Details of additional communications,
• Date of personal hearing and the date of final order.

In addition, our dataset includes:

• Every charge levied against the entity along-with details of the charges, regulations violated, violation amount, and violation description.
• Penalty against each charge, and any other regulatory action (If the insurer was held guilty).
• Rationale for the decision and details of the signing authority.

The research yielded 178 charges in seventeen orders or about ten charges per order. Interestingly, 120 of these charges were located in the eight orders against the general insurers with an average of fifteen charges per order as against six charges per life order. Charges, here, refer to the infringements the insurance companies have been booked for, by the IRDAI. For example, three life and six non-life insurance companies included in our analysis have been charged for using wrongful means and practices for solicitation of business. Further, three life and seven non-life insurance companies have been charged for making unnecessary and illegitimate payments to corporate agents or other intermediaries.

Further, we summarised some commonly repeated offences and the number of companies accused of the same, along with the form of penalty issued to reflect upon the difference in treatment of similar offences across companies and the resulting lack of effectiveness.

The dataset is released here.

Delays

Avoidable adjournments are a good proxy for delays in a court case. In the case of regulatory actions, the regulator and the accused entity drive the process and therefore it becomes easier to assess which party was responsible for each step of the delay. The process followed by IRDAI runs through the following steps:

1. IRDAI carries out an inspection of the insurer.
2. A copy of the inspection report is shared with the insurer.
3. In response, the insurer makes necessary explanations and submissions.
4. IRDAI raises further clarifications/queries, if any, at this stage.
5. A show cause notice is issued to the insurer.
6. After a response from the insurer is received, IRDAI grants a date for personal hearing.
7. Based on this, a final order is issued. This is signed by a whole time member of IRDAI.

We measure the delay by calculating the time taken by the regulator at each step of the whole process - from the date of inspection to the final decision. For all the seventeen orders issued in January-May 2016, we find that the related inspections were conducted at least three years before: either in 2013 or earlier.

For general insurance companies, after IRDAI received the first response to the inspection report (step three in the process above), there was no communication from its side for three to four years (six years in some cases) before a show cause notice was finally issued.

For life insurance companies, where clarifications to the submissions made by insurer were demanded, the same was done only after a period of two years.

There is inconsistency in the treatment of life versus general insurance cases. For instance, no further queries were raised in general insurance cases on submissions made by the insurers. But with life insurance, IRDAI took over two years to raise further queries. Further, in the case of life insurers, IRDAI took about four months to issue a show cause notice but in the case of general insurance companies it took an average of four years for the same step. This twelve times delay may be inconsistent with equal treatment.

On the basis of our analysis, we constructed a timeline of the investigation process based on the average time taken at each step for both life and general insurance companies. The table below established long spells of hibernation at IRDAI's end in raising queries to insurer's submissions. Similarly, the time taken by IRDAI to forward the inspection report to the insurer and issue show cause notice appear to be well beyond a reasonable time frame. The reasons, if any, which explain the time taken have not been explained in the orders and remain unclear. In addition, IRDAI has not provided any guidance or regulation of what it benchmarks as reasonable time for each stage of the process.

Delays in Investigation Process and Glaring Inconsistencies
This table shows the average time taken at each step of the investigation process till the issue of a final order by IRDAI
Particulars	Life	General
Inspection	10 Days	7 Days
Report forwarded to the Insurer	3.5 months	4 Months
Insurer's Reply	1 month	1 Month
Further Queries to Insurers' Submissions	2.5 years	No Clarifications raised
Insurer's Reply	1 month	NA
Issue of Show Cause Notice	4.5 months	4 Years
Insurer's Reply	1 month	1 Month
Date of Personal Hearing	1.5 month	2 Months
Final Order	1 month	5 Months

Some explanations that are offered for these delays are:

• Inadequate staff capacity,
• The evolving enforcement and inspection mechanism at IRDAI in recent years, and
• The seven year delay in the enactment of the Insurance Laws (Amendment) Act, 2015.

These superficial explanations do not change the fact that the State is not permitted to violate the rule of law.

Lack of speaking orders

Important details in the IRDAI's orders were absent. For example, the monetary loss in question was not specified, wherever required. As an example, the quantum of payouts made to corporate agents, master policyholders and other intermediaries remains unspecified. The monetary value of business solicited through wrongful means, the monetary value of claims repudiated due to non-disclosure or non-submission of documents and so on, finds no mention in the orders. Further, the names of colluding agencies, details of the documents examined during inspection and the features of the regulations violated were missing in more than half the orders. This violates the principle of natural justice which requires that the accused should be given all relevant documents that have been relied on, and any exculpatory evidence.

IRDAI provides the investigation reports to insurance companies. However, it is not evident if exculpatory evidence is included in these investigation reports. It is possible to have clarity on these aspects if IRDAI publishes its norms around investigation and contents of the report.

There was a noticeable difference between the orders issued against life insurance companies and those issued against general insurance companies. The above details were more frequently revealed in the orders issued against general insurance companies. Interestingly, the orders for both life and general were signed by the same authority.

Details Specified in the Orders
Particulars	Amount of Violation	Names of Colluding Agencies	Features of Regulations Violated	Details of Documents examined
Life Insurance Orders	No	No	No	No
General Insurance Orders	No	Yes	Yes	Yes

Inconsistency of punishment

There is some evidence that IRDAI has issued different penalties for similar offences. In 2016, M/s. Kotak Mahindra Old Mutual Life Insurance Company Limited and M/s. Exide Life Insurance Company Limited both settled claims in the favour of master policyholders. While the former was issued a warning, the latter had to pay a fine of Rs.100,000.

However, in case of general insurance companies, the penalties with respect to violations were relatively consistent across firms. M/s. Future Generali India Insurance Company Limited and M/s. Royal Sundaram Alliance Insurance Company Limited both offered discount on premium beyond specified limits and both were penalised with an amount of Rs.500,000. In cases where there was a difference, the justification was provided in orders related with general insurance companies.

Another point of difference between orders against life and general insurance companies was that life insurance companies were in many instances let off with warnings, whereas the general insurance companies usually faced penalties.

Penalty Charged for Common Offences
This table shows the inconsistency in penalties charged to different companies for the same offence.
Charge	Regulation Violated	Number of Companies Accused	Number of cases in which penalty is imposed	Number of cases in which warnings have been issued	Number of cases in which no charges have been pressed
Life Insurance Orders
Settlement of Death Claims in favour of Master Policy Holders	Clause C-4 of Group Insurance Guidelines 015/IRDA/Life/Circular/GI Guidelines/2005 dated 14/07/2005	3	2	Nil	1
Payout made to Master Policyholders for advertising purposes	Clause B-2 and C-4 of Group Insurance Guidelines 015/IRDA/Life/Circular/GI Guidelines/2005 dated 14/07/2005	3	1	2	Nil
Use of Wrongful Practices in Solicitation of Business	Regulation 9(ii)(a) of IRDAI (Licensing of Corporate Agents) Regulations, 2002 and IRDAI circular no. IRDA/CIR/010/2003 dated 27.03.2003	4	1	1	2
General Insurance Orders
Issues with respect to solicitation of business	Authority's circular IRDA/CIR/011/2003, dated 27-03-2003	6	5	Nil	1
Payments made to intermediaries above the commission amount	clause 21 of Corporate Agents Guidelines ref.no.017/IRDA/Circular/CA guidelines/2005	3	2	Nil	1
Discount offered on Premium beyond permissible limits	Circular No. 021/IRDA/F&U/Sep. 06, dated 28-9-2006 and Circular No. IRDA/NL/Cir/F&U/003/01/2011 dated 6th Jan, 2011	4	3	Nil	1

At times, operational factors lead to levy of varying penalties for similar violations by IRDAI. For example:

• The extent of documents in support of violation varies in different cases; and
• Non-submission of necessary documents by insurers is construed by IRDAI as a suppression of material fact, resulting in a higher penalty.

However, the orders do not explain these factors as the reasons. Therefore, it is not possible to link these reasons with variations in penalties.

In addition to cases of repeat offenders illustrated in the beginning of this article, we find similar kind of infringements across insurance companies. For example, four out of eight life insurance companies were charged for being non-compliant with the specified limits on expenses on management. All seven general insurance companies were charged for making payments to corporate agents, individual agents or other intermediaries over and above the commission amount. Ten out of twelve insurance companies, which were issued orders in 2016 on the basis of inspection conducted in the past, were charged for using wrongful practices in solicitation of business.

This suggests a need for IRDAI to strengthen its internal feedback loop, whereby the experience of cases goes back into improving the regulations, strengthening the investigation and enforcement functions of the regulator and creating effective deterrence.

Key Violations and Number of Insurers Accused
Charge	Number of Companies accused in 2016
Life Insurance
Use of wrongful practices for solicitation of business	4
Non-compliance with the expenses on management	4
Settlement of claims in favour of Master Policy Holders	3
General Insurance
Payments made to corporate agents/individual agents/other intermediaries	7
Use of wrongful practices for solicitation of business	6
Outsourcing of core Activities	5

Summary

Our analysis establishes three things:

1. There are large and unexplained delays in the process from investigation to passing of a decision order.
2. The orders do not specify important details and fall short of being speaking orders.
3. The reasons for imposing different penalties for similar offences are not clearly established in the orders. This places them open to be challenged as being arbitrary.

Conclusion

There is room for improvement in IRDAI's investigation-decision order process.

India has many regulators. The present article is one building block of knowledge towards understanding IRDAI. This is part of an emerging literature which is exploring similar questions. Prashant and Sane (2016) have identified failures of enforcement at IRDA. Burman and Zaveri (2016) have evaluated regulatory responsiveness at TRAI and SEBI. There is a need for more research towards the objective of better understanding India's regulators, and building State capacity in them.

Acknowledgements

We thank Anirudh Burman, Monika Halan, Renuka Sane, Suyash Rai and Smriti Parsheera for useful conversations.

Ashish Aggarwal is a researcher at NIPFP. Rhythm Behl was an intern at NIPFP in Summer 2016.

Author: Ashish Aggarwal

Ashish Aggarwal is a researcher at the National Institute for Public Finance and Policy.

On this blog:

• Financial Sector Reforms: A status report, 2017, 17 February 2017.
  
• Evaluating IRDA's orders, 2 Novembr 2016.
  
• Regulatory mistakes on the treatment of investment products sold by insurance companies , 24 April 2016.
  
• Financial sector reforms: A status report , 12 March 2016.
  
• Draft IRDAI regulations on insurance commissions: Going back to the beginning, 30 January 2016.
  

• Concerns about fundamental changes in the New Pension System, 30 October 2015.
  
• Release of information in machine-readable format, 21 June 2015.
  

Regulatory mistakes on the treatment of investment products sold by insurance companies

by Ashish Aggarwal.

There are cost and commission differences in what are essentially investment products across insurance, mutual funds and pension. These tilt the market towards products with higher commissions. In insurance, the commissions are both high and front loaded. This causes serious problems, particularly in conjunction with poor persistency (high percentage of customers discontinuing their policies midway), which is often an outcome of mis-selling. Let us examine the evidence about these problems and the regulatory failures.

The large scale mis-selling in ULIPs was prompted by high front loaded commissions, helped by high costs and poor disclosures. Research shows that investors lost more than a trillion rupees on account of these mis-sales. Similar problems continue to plague the traditional insurance products, whose sales shot up after regulation of ULIPs was improved.

The Sumit Bose Committee on curbing mis-selling and rationalising distribution incentives had in August 2015, recommended:

1. Investment products and investment components of bundled products should have no upfront commissions.
   
   
2. All investment products and investment portions of bundled products should move to Asset Under Management (AUM) based trail fee.
   

Eight months later, IRDAI has not made progress in these directions. Even as SEBI has improved consumer protection, IRDAI has weakened consumer protection. Regulatory arbitrage between similar products is getting worse (Sebi tightens disclosure norms, versus IRDAI plans to increase commissions, and IRDAI removes persistency norms for distributors, specified in 2011).

High Costs

Life insurers are allowed to charge 90 percent of the first year and 15 percent of the renewal premium as cost for policies of over eleven years (Rule 17D prescribed by the Central Government under the Insurance Rules, 1939). Section 40B and 40C of the recently enacted Insurance laws (Amendment) Act, 2015 have made the above cost caps defunct and allowed IRDAI to regulate the same. Why did the government persist with such high cost structures for over 75 years? This continued even after IRDAI was established in 1999.

IRDAI's proposed reform as outlined in the draft on Expenses of management of Insurers transacting the business of life was released in December 2015. This suggests reducing the cap to 70 percent in the first year and 12 percent thereafter. The analysis that we present ahead shows that these numerical values are unjustifiable.

All insurance, other than protection (called term plans), are basically investment products with about 5 percent of the premium going towards protection. Consider a traditional plan with an annual premium of Rs 1 lakh and protection of Rs 10 lakhs. A standalone protection plan of same amount is priced between Rs 3,000-4,000 per annum (for 15 years, for a 40 year old). In other words, about Rs 96,000 of the premium is available for investment. No other product allows its manufacturer to charge upto 90/70 percent of this as cost in the first year.

High costs impact returns. This is amplified in case of traditional plans where the portfolio design is low risk. As shown by the table in Bose Committee report, the nominal returns on maturity can be very low. They can turn negative, even in nominal terms, if the policy is discontinued/ surrendered, after being held for many years!

Traditional Plan (Non Linked Participating)
This table shows the net yield on premiums (net of mortality costs) in case of premature exit for a 35 year tenure policy with an annual premium of Rs 2,881 and a sum assured of Rs 100,000. The customer age on joining is 30 years. For example, based on the above scenario, in case of surrender after 25 years, a customer would have earned a net negative yield of -0.1 percent on investment
Years	At 4% returns	At 8% returns
5	-27.2%	-23.5%
10	-9.7%	-6.3%
15	-4.8%	-2.6%
20	-2.5%	-0.9%
25	-1.3%	-0.1%
30	-0.4%	0.6%
35	2.4%	5.3%

 

High front loaded commissions

A life insurance product is usually for 15-25 years. In a 15 year traditional plan, the distributors could get 33 percent of the total commissions over 15 years in first year itself. In a ULIP, this could be 17 percent. On an NPV basis, they could earn 62 percent and 48 percent of the total commissions in the respective plans, in the initial three years. See:

UlIP/ Traditional Plans: Front loading of commissions
Particulars	Year 1	Year 2	Year 3	Year 15
Annual Premium	100,000	100,000	100,000	100,000
ULIP Commission	15%	7.5%	5%	5%
Yearly Commissions	15,000	7,500	5,000	5,000
Cumulative Commission (A)	15,000	22,500	27,500	87,500
Cumulative Commission on an NPV basis (discount rate of 10%) (B)	15,000	21,818	25,950	54,106
Cumulative Commission as a % of total commissions (A)/87,500	17.1%	25.7%	31.4%	100%
Cumulative Commission (NPV) as a % of total commissions (NPV) (B)/54,106	27.7%	40.3%	48%	100%
Traditional Plan Commission	35%	7.5%	5%	5%
Yearly Commissions	35,000	7,500	5,000	5,000
Cumulative Commission (A)	35,000	42,500	47,500	107,500
Cumulative Commission on an NPV basis (discount rate of 10%) (B)	35,000	41,818	45,950	74,106
Cumulative Commission as a % of total commissions (A)/107,500	32.6%	39.5%	44.2%	100%
Cumulative Commission (NPV) as a % of total commissions (NPV) (B)/74,106	47.2%	56.4%	62%	100%
Commissions: ULIPs - Y1 15%, Y2 7.5% and Y3 onwards 5%
Commissions: Traditional Plans - Y1 35%, Y2 7.5% and Y3 onwards 5%

While front loaded commissions drive sales, they leave distributors with little incentive to worry about investors staying put. For a long term product, this can be a recipe for mis-selling. In insurance, this usually means pushing low-return high-cost products. The front loading also incentivises churn, i.e. encourage customers to drop-off from the plan and then sell them a new policy, to make high commissions in the initial years, all over again.

Consumers interested in higher returns, could easily buy a term plan for protection, and mutual funds for investment. Clearly, most consumers do not understand this option. Even with online purchase removing the need for a distributor, the term segment constitutes less than 10 per cent of the insurance industry business. A pan India survey sponsored by IRDAI shows that only 38.23 percent of household replied felt that they were reducing risk by purchasing insurance products. The same survey reported that majority of insured perceived insurance as a bundle of savings and protection (see table).

Perception of Insurance
Perception	Insured Households			Uninsured Households
	Rural	Urban	Total	Rural	Urban	Total
Savings tool	10.5	9.3	9.9	10.0	10.0	10.0
Protection tool	20.5	20.8	20.7	15.6	17.6	16.8
Both	49.7	15.6	51.6	26.5	26.0	26.2
None	19.3	16.4	17.8	48.0	46.4	47.1
All	100.0	100.0	100.0	100.0	100.0	100.0
Total number of households	11,301	10,866	22,167	3,237	4,774	8,011
Source: IRDAI sponsored Pre-launch Survey Report of Insurance Awareness Campaign, NCAER, 2011

In a term plan, distributors earn about 25 percent commission in year one and five percent thereafter. In rupee value and in comparison to investment plans, this offers them no motivation. A Rs 10 lakh term plan, as described earlier, would earn Rs 750-1,000 in the first year. As against this, a traditional plan/ ULIP with an annual premium of Rs 1 lakh could earn Rs 35,000/ 15,000 in the first year.

The argument that customers make informed purchases does not tie up with the high discontinuance. The persistency is at just 65 percent at first year, meaning, 35 percent of the customers drop off within the first year. At the end of five years, 63 percent drop off. The Bose committee noted that, in the case of LIC, the 61st month persistency in 2013-14 was just 44 percent.

Source: McKinsey & Company, India Insurance Vision 2025, Prepared for Confederation of Indian Industry, 2015

Problem of partial fixes

IRDAI has since 2010, improved the regulation of ULIPs. These improvements include mandating charges to be evenly distributed during the lock-in, to reduce the high front end expenses. IRDAI also imposed cost cap as a percentage of the yield on the product. This resulted in the following trend in sales:

Shift in sales from ULIPS to traditional plans. Source:Bose Committee report

Sales of ULIP declined dramatically. The distributors shifted to sell the more toxic (expensive - no cap on reduction in yield; and opaque - customer is not explicitly disclosed costs or the the net return on investment) traditional products which were left out of the clean up. This phenomenon is also reflected through an audit study of insurance agents carried out by Anagol, Cole, and Sarkar (2012).

Problem of sectoral arbitrage

Mutual funds too faced similar problem, albiet on a smaller scale. Over the years, SEBI cleaned this up (removed initial issue expenses in 2008, banned upfront loads in 2009, required funds to offer direct plans in 2012). AMFI, the industry body, followed this up in 2015 and capped upfront commissions to one percent and banned payment of advance commissions. Anecdotal evidence suggests that some distributors are moving to an advisory or online sales model. The remainder have either exited the business or have shiftd to selling insurance plans. In less than four years of SEBI directions, retail investments in mutual funds from direct purchase (without any intermediary) have grown to 13 percent of the total.

However, with IRDAI not keeping keeping pace, the disclosure and product structure norms do not allow consumers to compare basic features like costs and returns with mutual funds and NPS. This further helps distributors to push insurance as the preferred long term investment instead of mutual funds (where the commissions are backloaded) or NPS (where the commissions are low and evenly spread).

Sectoral arbitrage: Front loading of commissions
First year commission as a percentage of total commissions payable (Nominal basis)
Tenure	Mutual Funds	ULIPS	Traditional Plans
30 yrs	0.35%	9%	19%
25 yrs	0.54%	11%	22%
20 yrs	0.91%	13%	26%
15 yrs	1.70%	17%	33%
The AUM based trail fee for mutual funds is assumed at one percent in the first year and 0.4 percent thereafter.

The point in the table above is not that the commissions in mutual funds are overall less than insurance. Since the commissions are back loaded, mutual funds would deliver higher commissions only if a consumer is persistent and the corpus grows over 20-25 years. When this happens, the incentive of the distributor are aligned with that of the consumer.

Conclusion

IRDAI needs to review the cost and commissions in investment oriented plans, specially the traditional plans, with the objective of making the products less expensive and more transparent. It needs to reduce the regulatory arbitrage by adopting SEBI's norms on costs and distribution incentives for investment portion of its bundled products.

The Bose Committee had representation from insurance and was a unanimous report. It is awaiting implementation.

We must ask deeper questions. IRDA is composed of intelligent people. Why has IRDA made mistakes in regulation of products sold by insurance companies, for decades? There are two factors at work. The first is the problem of the underlying legislations, which do not enshrine consumer protection as the central objective. The second is the problem of sectoral regulation, where persons in the organisation tend to get co-opted into the profit motive of the industry that they deal with. Both these problems are solved by the Indian Financial Code.


Ashish Aggarwal is a researcher at the National Institute for Public Finance and Policy.

Financial sector reforms: A status report

by Ashish Aggarwal.

A broad consensus on India's financial sector reforms has come together in the past decade, through a series of expert committee reports: Percy Mistry's report emphasising international financial services (2007), Raghuram Rajan's report emphasising domestic finance (2009), U. K. Sinha's report on capital controls (2010) and Dhirendra Swarup's report on consumer protection (2009, released 2014). These led up to Justice Srikrishna's Financial Sector Legislative Reforms Commission (2013), which has given version 1.1 of the Indian Financial Code in 2015.

In this article, we locate the new information that has unfolded in the Budget packet, for 2016, in the context of the larger journey of financial sector reforms.

Monetary Policy Law

The Finance Bill, 2016, embeds a block of well drafted law which will amend the RBI Act. This carries the work of monetary policy reform forward after the Monetary Policy Framework Agreement of February 2015. It establishes CPI inflation as the objective of RBI, and shifts power on rate setting from the government and the governor to a `Monetary Policy Committee'.

There has been a lot of focus on the composition of the MPC. The quick summary of this journey is:

Differences in the constitution of the MPC
Particulars	Members appointed by RBI	External members appointed by Central Government	Members appointed by Central Government, in consultation with RBI	Governor veto
IFC 1.0	2	3	2	Yes
IFC 1.1	3	4	0	No
Finance Bill 2016	3	3	0	No

The Finance Bill, 2016 requires the Central Government to appoint the external members as per the recommendations of a Search and Selection Committee which will comprise of the Cabinet Secretary, Secretary (DEA), the RBI Governor and three experts in the field of economics, banking, monetary policy or finance, to be nominated by the Central Government.

PDMA and the bond market

The last year budget had proposed setting up a PDMA which will bring both India’s external borrowings and domestic debt under one roof. However, the proposal was later withdrawn. The implementation document about Budget 2015 merely states that while the Government is committed to setting up the PDMA, it is in the process of preparing a detailed roadmap separating the debt management functions from the RBI in consultation with RBI.

This leaves us in the status quo of difficulties in debt management for the government and the lack of a government bond market, and the lack of a corporate bond market. The Budget 2016 has some small actions which are supposed to constitute corporate bond market development, but they are not connected with the main project of financial sector reforms, and will not matter.

Financial Redress Agency

Budget 2015 had proposed to create a Task Force to establish a sector-neutral Financial Redress Agency that will address grievances against all financial service providers. The budget-implementation document merely states that the Task Force was set up on June 5, 2015.

Capital Controls

Last year's Finance Bill amended Section-6 of FEMA to clearly provide that control on capital flows as equity will be exercised by the Government, in consultation with the RBI. The implementation document merely notes that the process of consulting Reserve Bank on Debt and Non-debt instruments classifications is on.

Specialised Resolution Regime

The Budget Speech proposes the tabling of a comprehensive law establishing a specialised resolution regime for banks and financial institutions during 2016-17. This Code will provide a specialised resolution mechanism to deal with bankruptcy situations in banks, insurance companies and financial sector entities. This Code, together with the Insolvency and Bankruptcy Code 2015 (now referred to a JPC in December 2015), will provide a comprehensive resolution mechanism.

This is a welcome move. However, the Government must hit the road running in building the Resolution Corporation so that when the law gets enacted, the resolution machinery actually works as it is intended to.

Financial Data Management Centre (FDMC)

The Budget Speech proposes setting up a FDMC under the aegis of the Financial Stability Development Council (FSDC) to facilitate integrated data aggregation and analysis in the financial sector. Details about how this will be done are awaited.

The FSLRC's vision for this Data Centre was to provide for a nation-wide integrated repository of information relating to the financial sector, which can be used to study systemic indicators in the economy and further research in this field. As a nerve-centre for regulatory data cutting across various segments of the financial sector, the importance of this centre cannot be underestimated. This, and the obligation on regulators to share the information with the Data Centre, underscore the importance of a statutory instrument to make the Data Centre work.

Merger of SEBI-FMC

One of the important proposals made by the FSLRC was to constitute a unified regulator for financial products and financial services, except for the purposes of banking. As a step towards integration, the FMC was merged into SEBI under the Finance Act, 2015. The merger was effected in September 2015 and SEBI now regulates the commodities and the securities markets. Budget 2016 said that new commodity derivatives products would come about this year, as a consequence of this merger last year.

Building other agencies envisaged by FSLRC

In 2014-15, the Government had constituted four task forces for building the institutions envisaged under the Indian Financial Code. This could easily be classified as a first attempt of its kind by the Central Government to build institutional capacity of this scale in India.

The Task Forces submitted their recommendations in June 2015. The budget-implementation document states that the Central Government is in the process of considering the recommendations made by the Task Forces.

Indian Financial Code

In June 2015, the Ministry of Finance released for public comments a version of the Indian Financial Code (IFC1.1) which was refined and revised on the basis of public feedback received from March 2013 onwards. The implementation document states that the Government has consolidated the comments received during Public Consultation in July-August 2015 and the government is in process of responding to public comments, and is assessing the preparatory work involved to gauge a realistic target for introducing IFC1.1 in Parliament.



The author is a researcher at the National Institute for Public Finance and Policy.

Draft IRDAI regulations on insurance commissions: Going back to the beginning

by Ashish Aggarwal and Renuka Sane

On 13 January 2016, the Insurance Regulatory and Development Authority of India (IRDAI) released the draft (Payment of commission or remuneration to insurance agents and insurance intermediaries) Regulations, 2016 and invited public comments. The regulations propose a substantial increase in commissions for life insurance distributors starting April 2016.

In their present form, the proposals will be detrimental to consumer interest, increase the regulatory arbitrage in favour of products regulated by the IRDAI and undermine the recent attempts by the government towards curbing mis-selling and rationalisation of incentives for financial product distribution.

The regulations are intended to govern payments by an insurance company to individual agents or intermediaries (which include corporate agents, insurance brokers, web aggregators, insurance marketing firms, and any other entity as may be recognised by the IRDAI) for soliciting and procuring an insurance policy. Payments may be in the form of a commission (paid to agents), remuneration (paid to intermediaries) or a reward (any direct or indirect benefit over and above the commission). The Bill proposes that the Board of every insurance company will approve the commissions and reward policy. The draft Regulations propose two big changes.

Big change 1: Raise the overall commission rates

For bundled products, such as ULIPs and traditional plans, with a tenure of twelve years or more, an insurance company would be able to pay intermediaries 49% of the first year premium as commission and reward. This cap is proposed at 42% for insurance agents (See Table). The commissions for subsequent years has been increased to 7.5% of premium for year 2 to 6. Earlier, the cap from year 4 onwards was 5%. The 5% cap is now applicable from year 6 onwards.

Pure risk cover, or term plans, will have a maximum first year commission rate of 50% for policies of tenure 12 years or more. For those between 5 and 11 years, commission will be capped at 40%. Subsequent year commissions will be capped at 10%. The addition of rewards to these implies that the maximum cost cap for term policies of duration 5 to 11 years will become 48% for agents and 56% for intermediaries. For policies more than 12 years, the caps will be 60% for agents and 70% for intermediaries.

First Year Life Insurance Commissions and Rewards
Category	Proposed	Existing
Policies with premium paying term of 5-11 year:	ULIP/ Traditional - 42% for intermediary and 36% for agent Term - 56% for intermediary and 48% for agent [Note 1]	15% to 33% based on premium paying tenure of the policy [Note 2]
Policies with premium paying term of 12 years and more:	ULIP/ Traditional - 49% for intermediary and 42% for agent Term - 70% for intermediary and 60% for agent [Note 3]	35%
Note 1: Commission:- 30% of premium (ULIP/Traditional), 40% of premium (Term), Reward - 20% of Commission for agent and 40% for intermediary.
Note 2: Tenure and Commission:- 5 year - 15%, 6 years - 18%, 7 years - 21%, 8 years - 24%, 9 years - 27%, 10 years - 30% and 11 years 33%.
Note 3: Commission:- 35% of premium (ULIP/Traditional), 50% of premium (Term), Reward - (20% of Commission for agent and 40% for intermediary).

Big change 2: Bring in hereditary commissions

These are being reintroduced. Section 54 of the The Insurance Laws (Amendment Act), 2015 had removed section 44, according to which, if an insurance agent had served for more than 5 years, the commissions had to be paid to the heirs of the agent, even if the agent was no longer servicing the policy.

Problems with the draft regulations

Ignores all evidence on the perverse impact of high commissions

Research has shown that the incentive structure of agents has played a large part in the mis-sale of financial products. When agents get remunerated by the product provider, the incentive comes not from higher sales driven by customer satisfaction, but from commissions paid by the product provider. The product that pays the higher commission is the product that gets sold. This is not always in the interest of the customer. The world over, the response of regulators has been to ban conflicted remuneration structures, and/or impose requirements on ensuring the suitability of the product to the customer. Against such a background, the IRDAIs proposal to increase commissions, and also not impose any suitability requirements seems misplaced. This is particularly relevant as metrics of performance such as persistency and lapsation of policies have been steadily worsening.

Increases regulatory arbitrage

The same insurance distributor is likely to be selling other products like mutual funds and New Pension System which at their core are long term investment products. The commission structure for mutual funds is based on asset based trail fee. This results in relatively much lower commissions in initial years which could grow into substantial sums after say, 10-15 years, provided the customer stays into the scheme and invests regularly. The commission structure for NPS distributor provides for a nominal flat transaction fee and a 0.25% fee on amounts invested. A distributor is naturally incentivised to push insurance plans irrespective of suitability for the consumer. A consumer would be more likely sold a traditional insurance plan than a basket of NPS, mutual fund and term insurance. This makes selling difficult for the mutual funds and NPS. The proposed regulations are likely to further skew the markets.

Does not realign the pure term and bundled insurance products

It would be misleading to assume that the regulations incentivise sale of term insurance products by providing for higher commission rate as compared to ULIPs and traditional investment oriented plans. A term plan of Rs.1 crore for a 35 year old would cost Rs.13,000. At 70% of premium, Rs.9,100 should be a very attractive first year commission given that these products are apparently more difficult to sell as compared to investments. However, even if the initial commission rates on ULIPs and traditional plans were much lower, say 10%, these could still be more attractive for distributors to sell than term plans. For example, premium for ULIP/ traditional plan with a similar insurance cover would be about Rs 100,000 and even a 10% commission would fetch Rs.10,000. Of course, these are basically investment products with only a small portion of the premium going into insurance component. The raising of commissions on pure term along with that of bundled products does not alter the skew against the sale of pure term products.

Poor process

The draft regulations provide an approach which has gone into the formulation of the regulations. They do not, however, provide a rationale. How would these regulations benefit the consumers? In less than one year of the Insurance Laws (Amendment) Act omitting hereditary commissions, it is not evident why these are now proposed to be brought back through regulations? Regulators such as RBI, SEBI, have shown a poor track record in following regulation making processes. Regulations on fund management, and regulations on aggregators of the NPS, by the PFRDA have also raised similar concerns. The IRDAI draft regulations are yet another example of the failure of the attempts by the Government to encourage regulators to frame regulations as laid down in the Handbook on adoption of governance enhancing and non-legislative elements of the draft Indian Financial Code.

Another recent committee's recommendations on commissions

It would be useful to look at the recommendations on similar issues of another recent committee setup by the Government of India and headed by Sumit Bose, Former Union Finance Secretary. The report has recommended doing away with the practice of front loaded commissions. It noted that these created perverse incentives for distributors to push products with higher upfront/ first year commissions, increased regulatory arbitrage and proved expensive for the consumers. The committee's recommendations provided that:

1. There should be no up-fronts for the investment part of the premium. The investment part should attract only AUM based trail commissions. The trail commission treatment should be decided with consultations with the lead regulator in the market-linked investment space. These should be level or declining.
   
   
2. Upfront commissions should be allowed only on the mortality part of the premium.
   
   
3. Distributors should not be paid advance commissions by dipping into future expenses, their own profit or capital.
   
   
4. The illegal practice of rebating should be punished harshly by the regulator as it distorts the market.
   
   

In its present form, the IRDAI draft regulations ignore all the recommendations of the Bose Committee report.

Way forward

The disjointed approach as apparent in the draft IRDAI commission regulations is not in consumer interest. A useful approach would be to:

1. Fix the commission structure for the distributors based on the  recommendations of the Bose Committee.
   
   
2. Improve the regulation making process. Inviting public comments on draft regulations is a great step but mere existence of a public consultation process does not mean that the public will spend time and resources to comment and participate in the exercise. When the final regulations get released, the IRDAI should take care that these are accompanied with a proper explanation of (i) what exactly is being changed; (ii) evidence that has been relied upon to propose the changes and (iii) expected impact of the regulations on key stakeholders like consumers and sellers.

Ashish Aggarwal is a researcher at the National Institute for Public Finance. Renuka Sane is a researcher at the Indian Statistical Institute.

Concerns about fundamental changes in the New Pension System

by Ashish Aggarwal.

The recent report¹ of the PFRDA constituted Committee headed by former SEBI chairman GN Bajpai to review investment guidelines for NPS schemes has re-opened three important questions. Its recommendations on these appear to be misplaced. From 1999 onwards, a consensus came together about the wisdom of the design of the NPS. PFRDA is now set to jettison the core design concepts of the NPS, without having adequately argued the case for the change. PFRDA needs a much more rigorous approach to the financial regulatory process, than it has demonstrated in the recent years.

Investment management approach: Active or passive?

The NPS has traditionally followed a passive approach to equity investment where Pension Fund Managers (PFMs) replicate the portfolio of a chosen market index. To illustrate, if a fund had tracked BSE Sensex since its inception 36 years ago, it would have delivered annualised returns close to 15.79 per cent. For an example, see the remarkable returns on Nifty and Nifty junior in history. The Bajpai Committee has advocated a shift to active investment management. In this approach, PFMs create a portfolio of stocks and decide the timing of their purchase and sale with an aim to beat passive investment returns.

From 1999 onwards, the policy thinking that led up to the NPS has emphasised passive investment, for good reason. Passive management costs much less than active management. For example, the expense ratio of Nifty BeES, an Exchange Traded Fund (ETF) tracking Nifty, is 0.49 per cent. Globally, index funds and ETFs like Vanguard 500 charge expense ratios of 0.05 to 0.17 per cent. Passive funds costs less as their task is relatively simple and can be largely mechanised. In contrast, actively managed funds have to spend a lot more on human-intensive procedures, and routinely charge expenses of around 2 to 2.5 per cent. A one per cent increase in cost can reduce the pension corpus by 24 per cent over 40 years^a.

Second, global wisdom suggests that while active management can generate higher returns, these are mostly offset by the higher costs. Importantly, active funds that consistently outperform their benchmarks are a rare breed. Here is one recent report² which finds that actively managed funds have generally underperformed their passive counterparts and experienced high mortality rates (i.e. many are merged or closed). Here is another report³ which shows that over a 10 year period, 82 per cent of large cap managers underperformed their benchmark. Mid and small cap managers have fared worse. The data on Indian mutual fund managers shows that about 50 per cent of them have underperformed^b their benchmark.

The GN Bajpai report does not show the rationale in favour of this major change in policy direction. There is a discussion in the report about moving to a `prudent man' regime^c. While the up-side from the change is not obvious, the upward pressure on fund management costs is.

Following the report, PFRDA has gone ahead and changed the investment guidelines⁴ to permit active fund management. The Government sector scheme^d already permits investing in individual
stocks. As a result, there is no scheme now which offers passive management in the NPS. This is a fundamental shift from the concepts of the NPS which had been articulated from 1999 onwards.

Role of fund managers: Should they market the schemes or only manage them?

The Committee recommends that the PFMs should market and sell the NPS, ostensibly in order to grow the customer base. This is a bad idea. Push sales strategies have worked where they are backed by high commissions, opaque products (where costs and benefits are not transparent) or both. NPS is an unbundled design where PFMs focus exclusively on managing investments. POPs (Points of Presence) comprising banks and other distributors are responsible for sales. The Chinese wall between POPs and PFMs ensures that they do not collude to push a particular scheme. This restricts mis-selling.

The issue of mis-selling is often associated with insurance and mutual funds who take a lead in marketing and selling their schemes. The Committee suggests that with the notification of the PFRDA Act, the consequent empowerment of PFRDA through various provisions on investigations, enquiry, penalty, and other enforcement actions besides customer protection measures envisaged in the various regulations under the Act, the issue of mis-selling will be addressed. While the logic of the committee on this count cannot be faulted, a similarly empowered IRDAI and SEBI have been battling this challenge for about two decades. The very design of the NPS was motivated by the problems of the conventional approach seen at SEBI and IRDA.

Allowing PFMs to do marketing is contrary to the basic design of NPS. The committee wants to change this design. To remain within the precincts of the Act, it recommends that, the PFs (PFMs) may canvass the product while the actual on-boarding may be done through the PoPs.

Another Committee, headed by former union finance secretary, Sumit Bose, set up to examine the issue of mis-selling and distributor incentives recently recommended⁵ that the POPs in NPS should be paid an AUM based trail fee. This would provide them the needed incentive and align their interest with the consumer over long term without increasing the risk of mis-selling. This would also leave the Chinese wall between the PFMs and POPs intact. PFRDA should examine these aspects before setting off on solutions to convert the NPS into a conventional SEBI/IRDA style system.

Fund management fees: auction based or fixed?

The Bajpai Committee recommends that the regulator should introduce a fixed and variable component in the fee. The variable fee should depend upon other performance indicators like relative returns generated. It has recommended that PFRDA examine this without compromising on the cost.

It is not apparent how increasing fees will not compromise costs. The Bose committee, has taken a contrary view and specifically recommended against any change of fees for the PFMs as they are
discovered through an auction process. The NPS auction is an transparent and efficient means to achieve lowest pricing in fund management. The remaining contestants have to match this lowest
fee. The consumers get the benefit of lowest cost and can also choose their PFM based on performance. Once the rules of the auction are transparent and apply equally, PFRDA should not have to worry about how to pay PFMs more.

Case for a rigorous approach

PFRDA has been grappling with the above questions over the last few years. It had in 2013⁶ and 2014⁷ re-affirmed passive investment management as the norm. In about a year, it has changed direction towards active management without adequate evidence or rationale. The approach to the issue of PFMs role with regard to marketing and sale of NPS has similarly lacked rigour. In 2013⁸, PFRDA brought in a change and permitted PFMs to market the NPS. Within a few months, in November 2013, this was reversed. This left the PFMs stranded as is evident from the feedback PFRDA received from a PFM:

"Following the new guidelines of 2012 that expanded the permissible activities that can be undertaken by PFs, many PFs made significant investments towards setting up promotion and distribution infrastructure. Clarity about role along with the incentives / revenues available to fulfil this role is a prerequisite to enable the PFs to plan their operations and business plan over a medium to long term."

Clarity on the policy direction on PFM fees is missing. The auction based system was dumped in 2012⁹ in  favour of a fixed fee of 0.25 per cent of assets, a significant increase over the earlier fee of 0.0009 per cent discovered through auction. Since 2014¹⁰, PFRDA has reverted to an auction which again resulted in a low fee of 0.01 per cent. As PFRDA heads for another round of selection for fund managers, it might need to examine the approach to this issue more closely.

On these questions, we should be concerned about the extent to which PFRDA has failed to bring knowledge about pensions into its thinking. The problem runs deeper. If the processes at PFRDA do not produce sound answers on the questions outlined above, they could similarly come up with unsound answers on other issues in the future. As an example, PFRDA might feel like responding to the clamour of assured returns in the NPS.

Rigorous analysis is required before setting sail on such matters. Poor policy decisions are very expensive. Decisions need to be grounded in evidence, be well documented and disclosed transparently.

In the past, sub optimum processes have resulted in sub optimum outcomes in case of PFRDA's regulations¹¹. RBI and SEBI also lag on this¹² count. The government has prepared a Handbook¹³ which lays down sound practices on regulatory governance and lists the procedures that Indian regulators should follow to achieve better governance in regulation making. All financial sector regulators have agreed to comply with the Handbook procedures on framing regulations for: (a) all regulations from 31st October, 2013, and (b) all subordinate legislation -- which includes circulars, notices, guidelines, letters -- from 31st December 2014.

Going by the Handbook, the draft investment circulars/guidelines should have been published by PFRDA with a statement of objectives, the problem that is to be solved, and a cost-benefit analysis (using best practices). Thereafter, comments should have been invited from the public and all comments should have been published on the web site of the regulator.

Conclusion: Undo, rewire and reboot

NPS is over a decade old. It would be useful to close the discussion on fundamental design questions, and bring predictability to the scheme on multi-decade horizons that are required in pension planning. This would increase confidence among consumers, PFMs and POPs. Rapid progress on implementing the best practices laid down in the Handbook would help achieve outcomes in the best interest of consumers. PFRDA could start by applying these to review the questions at hand. Till such time:

• NPS schemes should emphasise passive investment management.
• PFMs should continue to focus only on fund management, while the selling is done by arms length POPs who are neutral between all PFMs.
• The fee for PFMs should continue to be auction based.

Footnotes

1. An annual investment of Rs. 100,000 over 40 years with net annual returns of 11 per cent would result in a corpus of Rs. 64.58 million. An additional one per cent cost would reduce the
   net returns to 10 per cent and the corpus by 24.62 per cent to Rs. 48.68 million. back
2. Over last 10 years, out of 19 mutual funds tracking CNX Nifty, 10 outperformed the benchmark and 9 underperformed. Of the 16 tracking the BSE Sensex, the number of out-performers and under performers were equal. During this period, the category average
   returns by large cap equity mutual funds in India stood at 13.43 per cent per annum. As against this, the reference index, BSE 100 delivered an annualised return of 12.16 per cent. The top performer in the above fund category delivered 18.29 per cent while the bottom performer delivered 7.76 per cent. Flexicap category had similar results. (Category Average: 14.49 per cent, Top Performer: 19.34 per cent, Bottom Performer: 5.53 per cent). Data from Morningstar database. back
3. Under the prudent man rule, if the process followed for taking investment decisions in prudent, then the decisions are prudent. For example, it is imprudent to invest in lottery. The relative prudence does not get affected even if one wins the lottery. back
4. In the government sector scheme, PFMs can invest in individual stocks. Here, NPS follows the pattern notified by the government which permit a maximum of 15 per cent exposure to equity as against 50 per cent in the private sector scheme. The Bajpai Committee has rightly recommended that government employees should have the same scheme option as private sector. This has prompted PFRDA to review the status quo with the government. PFRDA has tied the NPS lite/ Atal Pension Yojana (APY) to the same norms that apply to the government scheme. This should also be reviewed as customers of these schemes too have no scheme choices. back

References

1. PFRDA, Report of the committee to review investment guidelines for NPS schemes in private sector, April 7 2015. back
2. Morningstar,  Active/Passive Barometer, June 2015. In addition to analysing active funds, the report finds that failure tended to be positively correlated with fees (i.e. higher cost funds were more likely to underperform or be shuttered or merged away and lower-cost funds were likelier to survive and enjoyed greater odds of success). back
3. S&P Dow Jones Indices, SPIVA US Scorecard, 2014. back
4. PFRDA, Investment guidelines for NPS schemes (Private Sector), September 10, 2015. The eligible stocks should have a market capitalisation at least Rs. 50 billion and should have derivatives trading in either BSE or NSE. The criteria for being considered for derivatives trading includes being in top 500 stocks in terms of average daily market capitalisation and average daily traded value in previous six months in a rolling basis. NSE currently has 163 eligible stocks for trading in derivative segment. back
5. Ministry of Finance, Report of the Committee to recommend measures for curbing mis-selling and rationalising distribution incentives in financial products, August 7, 2015. back
6. PFRDA, Clarifications on investment guidelines for private sector NPS, April 17, 2013. Prior to 2013 also PFMs were not permitted stock picking. Passive investment management was required to be done through in-house replication of Index funds or ETFs that tracked BSE Sensex or NSE Nifty Index. Investing in ETFs or Index funds of AMCs which charged a management fee was not permitted. Further, investment in equity mutual funds was not permitted. The PFMs were required to choose which index they intended to track in advance on a yearly basis. back
7. PFRDA, Revision of investment guidelines for NPS Schemes, January 29, 2014. back
8. PFRDA (Registration of Pension Fund Managers) 2012 Guidelines, July 12, 2012. back
9. PFRDA, Circular No. PFRDA/CIR/1/PFM/1, August 31, 2012. back
10. PFRDA, Revision of investment management fee for private sector NPS, August 1,
    2014. back
11. Arjun Rajagopal and Renuka Sane, Difficulties with PFRDA's Draft Aggregator Regulations 2014, July 2, 2014.  back
12. Arpita Pattanaik and Anjali Sharma, Regulatory governance problems in the legislative function at RBI and SEBI, September 23, 2015. back
13. Ministry of Finance, Handbook on adoption of governance enhancing and non-legislative elements of the draft Indian Financial Code, December 26, 2013. back