Announcements

CUTS 5th Biennial Competition, Regulation & Development Conference 09-11 November, 2017 Jaipur, India

CALL FOR PAPERS

I. Introduction

CUTS and CIRC invite papers for the 5th Biennial Competition, Regulation & Development Conference to be held on 09-11 November, 2017 in Jaipur (India). Interested scholars and practitioners are invited to submit a 500 word abstract for a chance to participate in this Conference and present their paper.

The abstract should be based on any one of the four plenaries of the Conference (below) and should be submitted to the undersigned, along with a brief CV (not more than 2 pages) of the author. Authors are requested to mention the specific ‘Plenary’ their paper is based on while submitting the abstract.

Authors of selected abstracts would be invited to submit full conference papers (3,000 to 4,000 words) for a chance to participate in this conference. On successful selection, the organisers will provide support to the author (air travel, accommodation and meals) to participate in the conference, and present the paper.

II. Plenary Sessions

The abstract/paper should target any one of the following four plenaries of the conference.

1. Plenary 1: Revisiting IPR and Competition
2. Plenary 2: Disruptive Technologies and Economic Regulations
3. Plenary 3: Building Organisational capacities for tackling policy and regulatory uncertainty
4. Plenary 4: Challenges and Opportunities of Development Financing for Fostering an Innovation based Ecosystem

For more information, please visit:
Call for Papers https://goo.gl/1yMK3L
Background Note https://goo.gl/pFfby9

III. Important Dates and Deadlines

The following dates/deadlines need to be noted:

• Last date for submission of Abstract (500 words) is 15th April 2017
• Selection of successful Abstract will be done by 30th April 2017
• Last date of submission of Full paper (3,000 to 4,000 words) is 30th June 2017
• Selection of successful papers will be done by 31st August 2017

IV. Further Information and Contacts

All submission and further queries should be directed to Mr. Ashutosh Soni (ash@cuts.org) and Mr. Parveer Ghuman (psg@cuts.org)

Competition issues in India's online economy

Smriti Parsheera, Ajay Shah and Avirup Bose.

The world of high technology companies is seen as a dynamic area with a rapid pace of creative destruction. There is, however, a class of industries where there are strong network effects, where the market tends to collapse into a narrow set of players. After one burst of innovation where a new online business is born, there is the possibility of entrenched market power with the extraction of consumer surplus.

Many firms, global and Indian, have resorted to the strategy of making large losses by subsidising users, as a way to obtain those network effects. This has created a new class of concerns about predatory pricing, with unprecedented negative profit margins on a sustained basis, being supported by equity capital infusions. In the short run, discounts are popular, but recoupment is inevitable and market power will adversely affect consumers in the future.

In a recent Paper, we argue that the existing competition law regime in India needs to be fine tuned, for technology-enabled markets with significant network effects, to address the possibility of new kinds of abusive conduct. We offer a series of tangible proposals through which the Competition Commission of India can better handle these emerging situations. We also look into the role and responsibilities of the investors who back these online businesses and the impact of their conduct on competition in the underlying markets.

Entry barriers in the new economy

Innovation is the foundation of economic progress. While we normally revere technology companies for their disruptive innovations and the efficiencies that they create, we must recognise that some technology-driven businesses are susceptible to the acquisition and abuse of market power. The Indian competition regime is an evolving one, and has only recently started facing some of these concerns. Our paper brings new evidence and arguments to the table, on these questions.

Internet-based businesses, along with several other high-technology sectors, form part of the 'new economy', characterised by high rates of innovation; low marginal cost; increasing returns of scale; and, in many cases, network effects. Direct `network effects' arise where a user's benefit from a product or service increases with the number of other users on that network. The benefit of being on Facebook or WhatsApp, for instance, corresponds with the number of friends and family who use that service. Contrast this with the benefit of having an email address, where the benefits are not limited to closed proprietary networks. This became possible due to the early adoption of interoperability standards in email protocols.

Network effects are particularly important in two-sided markets where users on each side of the market derive a positive effect from the expansion of users on the other side. Commuters who use taxi aggregation platforms like Ola and Uber will logically be attracted to a service that has a large number of drivers on its network, which yields a lower waiting time. The same is true for the drivers working with these platforms. Similarly, in case of payments wallets, in the absence of interoperability regulation, merchants and customers will both prefer a service that has the most addressable users.

With the use of modern technology, the cost of running the marketplace itself has dropped to near zero levels. As an example, the online classifieds site Craigslist reports that it has about 40 employees who manage a network that sees over 80 million classified ads per month. The marginal cost of a transaction has gone to near-zero levels. This gives a unique class of problems where technological innovation that yields cost reductions cannot be a mechanism to take on an incumbent.

Brain versus brawn

How can market power be established, in this new world? One mechanism through which one player can obtain a competitive advantage is to attract users through technological innovation, and thus get a network effect started. This is an attractive strategy for firms which have deep human capital. Another mechanism is by using financial capital to pay subsidies that entice users. This is an attractive strategy for firms which have superior access to financial capital. Many online businesses have resorted to practices like deep discounting, cash-back offers and other schemes designed to attract new users and establish the network effect. Sometimes, heavy losses have been sustained for years on end.

As an example, the global taxi company 'Uber' made worldwide losses in the first half of 2016 of US\$1.27 billion (approximately Rs.86.5 billion). Uber's behaviour impacts upon the Indian economy as it has applied the strategy of using financial capital as a competitive lever in India also. On a similar note, the Indian taxi company 'Ola' reported a net loss of Rs.7.96 billion in March, 2015. The company's financial records for the periods after that are not yet available although it is reasonable to expect that the losses will be significantly higher due to the higher driver incentives. In the last two years, it is estimated that the two taxi companies, Uber and Ola, burned cash adding up to about Rs. 130 billion in India.

Such behaviour is found in other industries also. In the field of payments, where regulations have blocked interoperability and thus created the opportunity to kick off a network effect, the firm One97 Communications, which owns 'PayTM', reported a loss of Rs.15.49 billion in March, 2016.

The scale of these discounting practices, and the sustained periods for which they are continued, has created new barriers to competition. It is difficult to rationalise these sustained losses as being an introductory offer by a new player. Rather, these practices appear to be a systematic competitive strategy. Capital has become a competitive weapon. This gives rise to concerns that the market may eventually tip in favour of the player that may not necessarily have the most innovative product or service, but one that succeeds in obtaining more capital and enticing more users in the early days, using subsidies. While seeming beneficial for consumers in the short run, such practices raise concerns about competition on account of the creation of market power, and elevated prices for consumers in the following years when losses are recouped.

The FDI guidelines issued by the government in March, 2016 turned the spotlight on pricing practices of e-commerce firms. It clarified that the automatic route of foreign investment would be available only to those e-commerce marketplaces that avoided such subsidies.

These issues have also come to the attention of the CCI in a few recent cases. In April 2015, the CCI passed a prima facie order recommending a detailed investigation into the allegation that, armed with substantial funding received from various investors, Ola had indulged in abusive market practices to garner greater market power in the city of Bengaluru. More recently, the COMPAT directed the Director General of the CCI to initiate a similar investigation to assess Uber's dominance in the market for radio taxi services in the National Capital Region (NCR) of Delhi after the CCI had refused such an investigation. Uber has now challenged this decision before the Supreme Court, citing a 'jurisdictional flaw' in the Tribunal's ability to order such an investigation. Alongside these developments, CCI is also reported to have set up an in-house panel to understand the cash-back incentives being offered by various online companies from the perspective of predatory pricing provisions under the Act.

Our paper explores the recent developments in India in this area, in the light of foundations of economics and competition law. It argues that there are grounds for concern about the harm to competitive dynamics from these new business strategies. At the same time, it is important to avoid intrusive interventions that bring the State into excessive involvement in the world of business.

New economy requires new thinking

There is a need to take into account the distinct economic features of certain high-technology businesses when looking into allegations of anti-competitive conduct by them. Practices like deep discounting and cash back offers may be aimed at building sufficient scale in today's market to ensure that the business is able to fully capture tomorrow's market, to the exclusion of other competitors. A robust economic analysis of the impact of increasing returns to scale, and network effects, is required for understanding the present and future impact of these practices on competition and consumer interests. A novel dimension, which is addressed in the paper, concerns collaboration between the investors in the multiple firms that they invest in.

Transient gains to consumers

We examine the question about gains to consumers from discounting. We suggest that the gains in the short term need to be seen in a larger context. The recoupment test examines the extent to which market power can be achieved in the future, after which prices can be raised. If the CCI were to adopt this test in investigations relating to predatory pricing by online firms it would see that in certain areas, there are network effects, and once a small cartel of firms has acquired market power, it would be difficult for entrants to compete with them in the future. In that future scenario, it would be possible for incumbents to raise prices, and recoup earlier losses.

Interoperability as a tool for competition policy

In some situations, the CCI could rely on the essential facilities doctrine to mandate interoperability between a dominant player that is found to be indulging in the abuse of its position and other operators in the market. For instance, imposing interoperability requirements on a dominant payments network can help extend the network effects of digital payments to the economy as a whole, rather than being limited
to a closed network. The imposition of any such requirements will, however, need to be balanced against factors such as the payment of fair and reasonable access fees, the complexity of institutional arrangements required to monitor such arrangements and assessment of the impact on future innovation. More generally, open standards are an important element of interoperability, and various arms of the regulatory State need to push in favour of competitive markets through interoperable open standards.

Acting within Internet time

Given the fast-changing nature of online businesses, there are concerns about the elapsed time between a full-fledged investigation and the determination of a violation. We suggest a two-pronged approach to address this issue. On one hand, the CCI needs to work towards adopting stricter time frames for the disposal of cases, particularly those relating to new economy firms. On the other, we propose a voluntary settlement process that will allow a business that is under investigation to voluntarily alter its market behaviour, with the concurrence of the authority but without the need for a conclusive finding of violation by the CCI.

Conclusion

In India, technology companies are generally revered as the source of technological progress. However, the problems of competition policy are universal and cut across all industries. The basic principles do not change. The purpose of competition policy is to stave off situations where a narrow set of firms have market power, and new players are not able to enter. Society gains when firms obtain profits and valuation through innovation, not through the crafty use of financial capital to kick off network effects.

These issues were not faced in thinking about Indian competition policy as recently as five years ago. They are, however, likely to become increasingly important in the future. We argue that this calls for fresh think about the legal framework also. There is a case for competition authorities to look into the unilateral abusive conduct of a firm, which, although not dominant at the given point of time, is engaging in anti-competitive practices that create a strong and imminent possibility of its dominance. We highlight some pros and cons of this approach and leave this question open for further research.

Smriti Parsheera and Ajay Shah are researchers at NIPFP, and Avirup Bose is a researcher at Jindal Global Law School.

Drafting hall of shame: A mistake in the Reserve Bank of India Act, 1934

Aditya Singh Rajput and Shubho Roy.

In the last two years, we have had a debate about monetary policy reform. On June 27, 2016, the Government, through the Finance Act, 2016, amended the Reserve Bank of India Act, 1934 and created a statutory Monetary Policy Committee (MPC). This is an 'executive MPC', which will control monetary policy. Section 222 of the Finance Act, 2016 introduced Chapter IIIF in the RBI Act titled Monetary Policy. In this Chapter, section 45ZL has a drafting error.

Section 45ZL requires RBI to publish the proceedings of meetings of the MPC. RBI is obliged to publish MPC meeting minutes, with three documents: The resolution of the meeting, The votes of individual members, and the statement of each member explaining their vote. Here is the text of S.45ZL:

The Bank shall publish, on the fourteenth day after every meeting of the Monetary Policy Committee, the minutes of the proceedings of the
meeting which shall include the following, namely:-

(a) the resolution adopted at the meeting of the Monetary Policy Committee;

(b) the vote of each member of the Monetary Policy Committee, ascribed to such member, on resolutions adopted in the said meeting; and 

(c) the statement of each member of the Monetary Policy Committee under sub-section (11) of section 45ZL on the resolutions adopted in the said meeting.

(Emphasis added)

This has an error. There is no subsection (11) in Section 45ZL. The correct cross-reference should have been to subsection (11) of Section 45ZI which reads:

Each Member of the Monetary Policy Committee shall write a statement specifying the reasons for voting in favour of, or against the proposed resolution.

In this case, this drafting error is minor and is unlikely to have substantial legal effects. However, it reveals weaknesses of the process through which laws are drafted, which could easily have major legal effects in other cases. This is not an isolated problem. As an example, the recent Insolvency and Bankruptcy Code has numerous cross-referencing mistakes.

Solution

Such errors can be minimised by the use of appropriate document processing software which automates cross-referencing. The files managed by human authors should have labels, cross-references should point to labels, and the software should map logical labels to physical section numbers.


The authors are researchers at the National Institute of Public Finance and policy, New Delhi. The authors thank Pratik Datta for valuable inputs.

Policy puzzles about UIDAI

A great debate is taking place about UIDAI. We have worked on many aspects of the policy puzzles about UIDAI.

-- Is UIDAI worth building, in the sense of comparing the financial costs and the financial benefits? In November 2012, we did a cost benefit analysis, and the answer seems to be Yes.

-- How should UIDAI think about the user charges for the infrastructure services that it provides? We were part of the UIDAI thought process on these questions in December 2013.

-- The public administration side: What were the ingredients that led up to the successful launch? A good paper is UIDAI's public policy innovations, by Ram Sewak Sharma, September 2016.  Building on this paper, Praveen Chakravarty has an article Building forts, not empires, 9 September 2016.

-- There are grave problems associated with privacy in India. How do we avoid the China model? An early paper on privacy in India is Towards a privacy framework for India in the age of the Internet, by Vrinda Bhandari and Renuka Sane, October 2016. This paper includes one section analysing the Aadhaar Act from the viewpoint of this proposed privacy framework.

-- Can the judiciary review the Speaker's decision on classifying the Aadhaar Bill as a money bill? Pratik Datta, Shefali Malhotra and Shivangi Tyagi have a paper from March 2017, in which they feel the answer is Yes.

-- If a country had to build an Aadhaar like system, what kind of law and regulations would be required?  Is the Aadhaar Act and the associated regulations (both of which were issued in 2016) an adequate legal foundation? Vrinda Bhandari and Renuka Sane feel this is not the case.

-- As Aadhaar becomes the core around which the citizen's relationship with the state revolves, we need to ask if citizens have access to an adequate grievance redressal mechanism? Vrinda Bhandari and Renuka Sane think the answer to this question is a resounding no.

-- Why do we need a fundamental right to privacy? Smriti Parsheera argues that the potential ramifications of not recognising this right run much deeper than the Aadhaar issues of today.

-- UIDAI is an important new organisation, and it should emerge as a high performance agency. Vrinda Bhandari, Renuka Sane and Bhargavi Zaveri argue that under the present law, UIDAI is neither performance oriented nor is there accountability for failure. They propose that the UIDAI should be held to appropriate accountability standards, so as to create an environment where it will perform well.

Is Aadhaar grounded in adequate law and regulations?

by Vrinda Bhandari and Renuka Sane.

The Aadhaar (Targeted Delivery of Financial and Other Subsidies, Benefits and Services) Act, 2016 ["the Aadhaar Act"], as the name suggests, aims at targeted delivery of subsidies, benefits and services by providing unique identity numbers based on an individual's demographic and biometric information. Enrollment into Aadhaar is, in principle, voluntary - both as per the Central Government's own stand and repeated orders of the Supreme Court since 2013. The Government has, however, slowly been linking government (and other services) to the Aadhaar card. Since January 2017, the Government has issued 22 notifications making Aadhaar mandatory for receipt of a range of services, ranging from the Mid-Day Meal scheme to maternity benefits. The Aadhaar number is likely to become a pre-requisite for filing income tax returns and applying for a PAN card.

As of March 2017, more than 1.1 billion individuals have been enrolled in the system and 4.9 billion authentication transactions have taken place. In the process, the Government has expanded the scope and coverage of Aadhaar while the Supreme Court has yet to decisively settle questions about constitutional challenge.

In this article, we ask if the legal foundations on which the Aadhaar operates match up to the requirements of a program that is likely to touch the lives of all citizens of India. Can we, as citizens of India, be satisfied that there are enough checks and balances in the functioning of Aadhaar?

This is important as we have already started seeing implementation problems in the form of failure of biometric authentication, server and connectivity problems, cryptic error messages, and the irrevocability of the biometric, all of which have left the Aadhaar number holder and intended recipient of a subsidy without any remedy. As well, in the absence of an over-arching privacy law, our regulatory surveillance architecture is heavily weighted in favour of the State leading to the very real possibility of strengthening mass surveillance with little regard for the effect on individuals' rights to privacy.

What should the legal framework provide?

A program such as Aadhaar, should be built on sound legal foundations. At the very least, the Aadhaar scheme should be able to guarantee first, good governance by the Unique Identification Authority of India ["UIDAI"], the statutory body responsible for the functioning of the Aadhaar system; second, privacy protection from the State and the private sector against the misuse of the Aadhaar number; third, security protection against data breaches; and fourth, an effective grievance redress mechanism against mistakes, deception, and abusive practices.

We evaluate the Aadhaar Act and the subsequent regulations on two issues namely their scope and ambit, and security standards. In a follow up article, we will focus on the privacy, accountability, and enforcement concerns that arise in the current legal framework.

Concerns about the Aadhaar Act

In a recent paper, Towards a privacy framework for India in the age of the internet, we proposed a privacy framework that incorporated universally accepted privacy principles and analysed the Aadhaar Act against these benchmarks. Our critique of the Aadhaar Act focused on the lack of clarity surrounding the scope and ambit of the Act; the absence of any meaningful provisions on consent; the omission of privacy considerations; the role of private companies; and inadequate redress mechanisms.

The Act leaves too much to be specified by the Regulations. For instance, the definition of biometric information [Section 2(g)], the procedure for sharing [Section 23(2)(k)], and publication [Section 29(4)] of an Aadhaar number holder's information are left to be specified by regulations. This causes uncertainty about the scope and ambit of the Aadhaar Act, apart from concerns about the lack of Parliamentary scrutiny over any subsequent Regulations. In fact, the constitutionality of the Act can be challenged on the ground that it delegates essential legislative functions, including important decisions on policy, to the Executive, and lacks sufficient control over its exercise (See Re Delhi Laws Act, AIR 1951 SC 332; Avinder Singh v State of Punjab, AIR 1979 SC 321; and Ajoy Kumar Banerjee v UOI on excessive delegated legislation).

Concerns with the Aadhaar Regulations

In an attempt to address some of these criticisms, the Government, through the UIDAI, released detailed Regulations on enrollment, authentication, data security, and sharing of information in September 2016. These Regulations are also incomplete for two reasons.

Lack of clarity on the scope and ambit of the Regulations

As with the Act, the UIDAI, which was expressly tasked with notifying the Regulations under the Aadhaar Act, has failed to exercise such power delegated to it, causing further uncertainty about the working of the Act and the Aadhaar Scheme. The UIDAI, while notifying various regulations in September 2016, left multiple aspects of the functioning of the Aadhaar Scheme to be ``specified by the Authority'', i.e. to be specified by itself at a future undetermined date.

For instance, the UIDAI was empowered under Section 23(2)(a) of the Act to "specify, by regulations, demographic information and biometric information required for enrollment and the processes for collection and verification thereof." However, Regulations 3(2) and 4(5) of the Enrollment Regulations leave the ``standards'' for collecting biometric and demographic information, required for enrollment, to be specified by the Authority for this purpose. Thus, despite being tasked with laying down the regulations to govern the enrollment and collection of demographic and biometric information, the UIDAI's own Enrollment Regulations leave the specification of such standards to be notified by itself at some point in the future.

Similarly, Regulation 13(2) of the Enrollment Regulations on the generation of Aadhaar numbers states The Authority shall process the enrollment data received from the Registrar, and after deduplication and other checks as specified by the Authority, generate the Aadhaar number. There is no guidance to the UIDAI on what kind of checks should be laid down, and principles that have to be followed in the interim, before further regulations are notified.

Through the four substantive regulations, the phrase specified by the Authority has been used 51 times (See Regulations 3(2), 4(5), 7(2), 8(2), 8(4), 11(2), 11(5), 13(2), 14(2), 17, 19(c), 20, 22(2), 23(5), 25(1), 29(2), 31(2), 32(1), 32(2), 32(3), 34 and Rules 17, 19, 22, 23, 24, 25, and 26 of the Code of Conduct in Aadhaar (Enrollment and Update) Regulations 2016; Regulations 6(2), 7(3), 12(1), 12(2), 12(4), 13(1), 14(1)(d), 16(8), 18(1)(c), 18(1)(d), 18(2), 19(1)(a), 19(1)(h), 22(2), 22(3), 23(2)(a), 28(3), and 28(4)(a) of the Aadhaar (Authentication Regulations); Regulations 4(2), 5(a), and 6(1) of the Aadhaar (Data Security) Regulations; and Regulations 4(1) and 4(2) of the Aadhaar (Sharing of Information) Regulations, 2016).

In some cases this may be justified because the standards relate to technical aspects such as the collection of information, the mode of updating residents' information, convenience fees, and certification processes; which may require a separate set of rules outside the regulations. However, important issues surrounding the enrollment, storing, and sharing of data -- issues that determine how our sensitive, personal information is collected, authenticated, stored, used, and shared with third parties -- have been left unspecified. This does not seem to have deterred the Government from pushing forward with the Aadhaar project.

The incompleteness of the various Regulations notified by the UIDAI underscores the lack of specificity in the working of the Act and the Regulations. The powers delegated to the UIDAI have in a sense been 'delegated' to its future self, to be notified when the UIDAI deems it appropriate. There is thus complete uncertainty about when, and whether, any future regulations will be notified by the UIDAI or whether the enrollment process will continue in this legal vacuum.

Lack of specification of security standards

The incompleteness of the Aadhaar Regulations is not limited to the Aadhaar (Enrollment and Update) Regulation. It extends to other Regulations as well, such as the Aadhaar (Data Security) Regulations. Notably, Section 23(2)(m) of the Aadhaar Act empowers the UIDAI to specify, by regulations, "various processes relating to data management, security protocols and other technology safeguards under this Act." Given the vast quantities of sensitive, personal data that is being stored in one centralised repository, one would imagine that the UIDAI would be quick in clarifying all the security protocols and technology safeguards. However, through Regulation 3(1) of the Data Security Regulation, the UIDAI does not lay out any specific measures for ensuring information security, instead only stating that: The Authority may specify an information security policy setting out inter alia the technical and organisational measures to be adopted by the Authority and its personnel, and also security measures to be adopted by agencies, advisors, consultants and other service providers engaged by the Authority, registrar, enrolling agency, requesting entities, and Authentication Service Agencies.

Regulation 5(a) then further requires service providers engaged by the UIDAI to ensure compliance with such information security policy ``specified by the Authority''. Such a policy, to the best of our knowledge, has not yet been notified.

Thus, despite the enactment of the Aadhaar Act and the notification of the Aadhaar (Data Security) Regulations 2016, the failure to notify/specify an information security policy has meant that the fear of identity theft remains. In fact, is only exacerbated in a country such as India, which does not have an adequate data protection regime, both in terms of the relevant legal provisions and effective enforcement mechanisms.

Conclusion

The Aadhaar regulations raise an important question on the consequences of a regulator's (UIDAI) failure to exercise the power that has been delegated to it, and to instead, postpone the specification of important standards/procedures to a future, undetermined time. In the meanwhile, the UIDAI is carrying on, and in fact, hastening, the process of enrollment, without any of these guidelines and processes having been notified. Thus, the various processes under the Act are happening in some sort of legal vacuum. This is a cause for worry.



Vrinda Bhandari is a practicing advocate in Delhi. Renuka Sane is a researcher at the Indian Statistical Institute, Delhi. We thank Anirudh Burman, Pratik Datta, Shubho Roy and Bhargavi Zaveri for useful discussions.

Interesting readings

Trump's benevolence by Ajay Shah in Business Standard, March 20, 2017.

Escape to another world by Ryan Avent in The Economist, April/May 2017.

Improving NCD outcomes: How to reduce the evidence-policy gap by Brian Oldenburg in NIPFP YouTube Channel, March 16, 2017.

'People are scared': Paranoia seizes Trump's White House by Alex Isenstadt and Kenneth P. Vogel in Politico, March 15, 2017.

Humans Made the Banana Perfect-But Soon, It'll Be Gone by Rob Dunn in Wired, March 14, 2017.

Media and the rise of the right wing by Vanita Kohli Khandekar in Business Standard, March 14, 2017.

Protest and persist: why giving up hope is not an option by Rebecca Solnit in The Guardian, March 13, 2017.

Big bang reforms are done; time to fix the nuts & bolts by Shrimi Choudhary in Business Standard, March 5, 2017.

What do Uber, Volkswagen and Zenefits have in common? They all used hidden code to break the law by Quincy Larson on FreeCodeCamp, March 3, 2017.

No End in Sight to India's Slow-Motion Bank Crisis by Mihir Sharma on Bloomberg, March 1, 2017.

The Enlightenment Project by David Brooks in The New York Times, February 28, 2017.

When Evidence Says No, but Doctors Say Yes by David Epstein and Propublica in The Atlantic, February 22, 2017.

Surveillance in India: Policy and Practice by Pranesh Prakash in NIPFP YouTube Channel, February 9, 2017.

IRDAI’s commission notification hikes total compensation for insurance intermediaries

by Monika Halan.

On 14 December 2016 the insurance regulator, the Insurance Regulatory and Development Authority of India (IRDAI), notified revised commission rules for both life and general insurance. Titled ‘IRDAI (Payment of Commission or Remuneration or Reward to Insurance Agents and Insurance Intermediaries) Regulations, 2016’, the new rules have raised overall payments in the insurance industry to agents and intermediaries. The notification has come 11 months after an exposure draft that proposed changes in existing rules. The draft was open to public comments. The author helped the team at NIPFP to draft a response to the insurance regulator that argued against raising upfront commissions and payments as it encourages mis-selling, churning and causes losses to investors. A blog on the draft can be read here. The final regulations have been notified after consultation with the Insurance Advisory Committee and will come into effect from 1 April 2017. IRDAI has not given a reason why it needed to rethink the payment structure in the insurance industry. Nor has it given a reason for the change in the manner of payment and the quantum of payment. It has mandated a board-approved written policy for payments of intermediary compensation.

I will examine the changes in payouts in the life insurance industry and not the general insurance industry in this blog. Examining high upfront costs in India’s life insurance industry is important because these have been identified in two government committee reports (Swarup Committee and Bose Committee) as one of the reasons for mis-selling of insurance products in India. Several papers (this, this and this) have documented mis-selling of such products in the Indian market and the money lost by investors. The IRDAI regulation is important to analyse because it has increased the total payouts in the first year of the product at a time when other regulators are reducing upfront costs. The capital market regulator had made the mutual fund product zero front commission in August 2009 and in 2015 had capped upfronting of trail commissions (that come out of the annual expense ratio) at 1% of the investment. The National Pension System (NPS) already has low front costs that are more in the nature of a transaction cost.

The Regulations

There are four changes in the new regulations.

1. Change in intermediary categories. Currently, there are five categories of intermediaries: agents, corporate agents, insurance brokers, web aggregators and insurance marketing firms. The notified regulations break up the market into three categories of distributors of life insurance products. Agents, intermediaries with more than half their income coming from insurance, and intermediaries with less than half their income coming from insurance. Agents represent one insurance company and are individuals. Intermediaries include corporate agents, insurance brokers, web aggregators and insurance marketing firms.
2. Change in nomenclature of intermediary payments. Currently, all intermediary payments are called ‘commissions’. The new rules mandate that agent payments will be called ‘commission’, while intermediaries’ sales commissions will be called ‘remuneration’.
3. Addition of a payment category. A new payment category has been introduced to compensate agents and intermediaries called ‘rewards’. A reward is an amount paid, directly or indirectly, as an incentive by the insurer to agents and intermediaries. Rewards seek to formalise informal (which were illegal thus far) payments made by insurance firms to agents and intermediaries. IRDAI believes that agents need to be rewarded to account for benefits such as gratuity, term insurance cover, various group insurance covers, telephone charges, office allowance, sales promotion, gift items, competition prizes and such other items. Intermediaries need rewards to compensate for services such a risk analysis, gap analysis, plan design, predictive modelling, data management, infrastructure, advertisement and such other items, including any additional incentives by whatever name called. All agents are eligible for rewards that are fixed at a maximum of 20% of the first year commission that the agent collects. Not all intermediaries are eligible for rewards. Only those who earn more than half their income from the insurance business are eligible for rewards, which are the same as that for agents. Others are not. In effect, IRDAI has legalised what were illegal payments in the industry.
4. Change in the compensation structure. The new rules have changed the existing commission structure in three ways.
1. Higher commissions for pure risk products. IRDAI has hiked commissions for pure risk policies as compared to policies that bundle investment and insurance across both single premium and regular premium products. Pure risk policies insure just the life of the policyholder. If the policyholder does not die, no money returns to him. Bundled policies combine life insurance cover with investment. These come in two variants. One, unit linked insurance plans (ULIPS) that are transparent, marked to market products that work like mutual funds with a crust of life cover. Two, traditional plans that are opaque products, do not disclose a net asset value but give either an assured investment return or an indicative payout number. These products invest largely in government securities of both the centre and the states. Further, there are two kinds of policies according to periodicity of premium payment. Single premium policies, which need funding once and stay alive for the duration of the policy tenure. And regular premium policies, which need to be funded each year till the premium paying term ends and can have tenures of between five and 100 years. The changes are in Table1 and Table 2.

Table 1: Pure risk gets more commission

Table 1a: 1st year commission on regular premium policies

	Existing 1st year commission for agents1	New 1st year commission for agents and intermediaries
	(%)	(%)
Pure risk	35/402	40
Bundled 3	35/402	35/40
1 For brokers the numbers are 30% in year one for all policies with premium paying term of 10 years or more
2 35% for firms more than 10 years old and 40% for firms less than 10 years old. Today, more than 90% of the market is made of firms that are over 10 years old, therefore the 35% commission number is effective
3 For a premium paying term of 12 years or more. Commissions range from 15% to 33% for premium tenures between 5 and 11 years

Table 1b: 1st year commission on single premium policies

	Existing commission for agents 1	New commission for agents and intermediaries
	(%)	(%)
Pure risk	2	7.5
Bundled	2	2
1 For brokers the numbers are 2% of the premium

2. Higher renewal commission on regular premium policies. On each renewal the intermediary gets a ‘renewal commission’. These rates are now higher than before for both pure risk and bundled plans, though pure risk gets more than bundled plans.

Table2: Renewal commission on regular premium policies rise

For agents and brokers	Existing commission	New commission
	(%)	(%)
Pure risk	51	10
Bundled	51	7.5
1 Currently, 3rd year and subsequent premiums get 7.5% commission. Year 4 onwards it is 5% commission on renewal.

3. Introduction of ‘rewards’. The impact of adding rewards to the commissions in the first year are captured in Table 3a, 3b, 3c and 3d.

Table 3: Total payouts on life insurance policies from 1 April 2017

Table 3a: Maximum first year payments on regular premium pure risk life insurance policies

For pure risk cover policies	Maximum commission on 1st year premium	Reward as % of first year commission	Total 1st year payment of Commissions + Reward
	(%)	(%)	(%)
Agent	40	20	481
Intermediary > half income from insurance	40	20	482
Intermediary < half income from insurance	40	0	402
1 Total first year commission currently is 35/40% depending on age of insurance firm
2 Total first year commission currently is 30% for a premium paying term of 10 years or more

Table3b: Maximum first year payments on regular premium bundled life insurance policies

For bundled policies (insurance + investment)	Maximum commission on 1st year premium	Reward as % of first year commission	Total 1st year payment of Commissions + Reward
	(%)	(%)	(%)
Agent	35	20	421
Intermediary > half income from insurance	35	20	422
Intermediary < half income from insurance	35	0	352
1 Total first year commission currently is 35/40% depending on age of insurance firm
2 Total first year commission currently is 30% for a premium paying term of 10 years or more

Table 3c: Maximum payments on single premium pure risk life insurance policies

For pure risk cover policies	Maximum commission on 1st year premium	Reward as % of first year commission	Total 1st year payment of Commissions + Reward
	(%)	(%)	(%)
Agent	7.5	20	91
Intermediary > half income from insurance	7.5	20	91
Intermediary < half income from insurance	7.5	0	7.51
1 Total commission currently is 2%

Table3d: Maximum payments on single premium bundled life insurance policies

For bundled policies (insurance + investment)	Maximum commission on 1st year premium	Reward as % of first year commission	Total 1st year payment of Commissions + Reward
	(%)	(%)	(%)
Agent	2	20	2.41
Intermediary > half income from insurance	2	20	2.41
Intermediary < half income from insurance	2	0	21
1 Total commission currently is 2%

What do these changes mean?

Post these changes, from 1 April 2017, the peak rates of payouts to agents and intermediaries will go up to as high as 48% in the first year, from the current levels of 35% or 40% depending on the age of the insurance firm. IRDAI has not given a reason for making changes to the compensation structure of the intermediation industry in insurance. Section 52(2) of the draft Indian Financial Code (Volume Two) of the Financial Sector Legislative Reforms Commission Report requires that all regulators should first publish a draft of the regulations to be made. This draft should be accompanied by a statement of objectives. The statement of objectives lists out the need for new regulation and the cost and benefit analysis of the proposed changes. The financial sector regulators, including IRDAI, have agreed to implement some of the recommendations that do not require legislative action. These actions can be read in the Handbook on Adoption of Governance Enhancing and non-legislative Elements of the Draft Indian Financial Code. Carrying out a cost benefit analysis for a new regulation and making it public is one of such actions. IRDAI did bring out a draft regulation on 13 January 2016 that was mentioned earlier, but there was no cost-benefit analysis or rationale for increasing commissions. Read the analysis of what IRDAI had proposed.

What’s good and what’s not

The new rules are good in parts, but IRDAI has let go of an opportunity to reduce mis-selling in the life insurance market in India. Some parts of the regulation are in the right direction but fail to address the larger malpractice issues; one rule is outright harmful.

1. Raising commissions for pure risk policies. Life insurance is a difficult concept to understand and the sales effort to sell life insurance needs a higher incentive than selling an investment product where a return is expected. India is a poorly insured country because life insurance is sold as an investment product with a thin covering of a life cover. Agents prefer to sell the bundled products because they generate a higher commission value than a pure risk plan. Therefore, giving a higher commission to a pure risk plan as compared to a bundled plan is a good step, but these remain still too high at 40% of the first year premium. To transition the market to pure risk plans, IRDAI could have reduced commissions on bundled products instead of keeping them at 35% of the first year premium. Two government committees have recommended that investment products go zero upfront commission and move to a full trail model (links to the reports are above in para two). The capital market regulator has already implemented these recommendations in mutual funds.
2. Raising renewal commissions. A long term financial product needs to be funded each year. When faced with very high first year commissions and significantly lower subsequent commissions, the incentive structure for agents gets skewed towards stopping old policies and selling new ones. Keeping policies alive is a big problem in the life insurance industry that sees very high rates of lapsation – or discontinuation of a long term plan in the first five years. The persistency (the number of policies that stay in business after the first year) rates in life insurance are very poor, with the industry average of 61st month (5-year) persistency of just 44% in FY15 for Life Insurance Corporation that accounts for over 70% of the industry. The private sector numbers are worse. Two largest private sector firms saw poor persistency levels, with ICICI Prudential Life’s 61st month persistency in FY2015 at just 16.7% and HDFC Standard Life’s at 31.78%. These numbers are from IRDAI’s Handbook of Statistics 2014-15 that can be seen here on page 211. One way to deal with this issue is to reduce front commissions and move to a trail heavy compensation model. The capital market regulator has successfully implanted this with no harm to the market. In 2009, the capital market regulator banned upfront commissions that go from investor’s money. In 2015, it banned even ‘upfronting’ of trail commissions beyond 1% of the investment. In fact, the move to a trail based model has raised investor confidence reading to a systematic investment pipeline of Rs 4,000 crore a month into mutual funds. IRDAI is right when it raised renewal commissions in the industry, but wrong because it has kept the upfronts high.
3. Introducing of ‘rewards’. Introducing a new head for payments in the first year that essentially formalises informal payments that breached the commission caps of IRDAI is a surprising regulatory action. It is common knowledge in the insurance industry that the exiting commission caps are regularly breached. A look at IRDAI orders corroborates this where the regulator finds many companies paying out commissions to agents and brokers under many heads, including skill building, promotions, office expenses. An 8 January 2017 Final Order from IRDAI fined HDFC Standard Life for hiding foreign junket costs as ‘skill building’. It does look like the regulator has attempted to formalise what were earlier informal (and therefore illegal) payouts by the industry to the intermediaries. Post the introduction of ‘rewards’ in the first year, the peak payout rate will hit 48%. IRDAI says that intermediaries must be paid these rewards for the benefits they need to be given, including sales promotion, gift items, office expenses, competitions, for data management, infrastructure, advertising and so on. But it is worth asking the question: aren’t the commissions paid meant to take care of such costs? Why does it need an extra head to reward agents and intermediaries for getting the first year business? It is very surprising that a regulator, instead of curbing illegal payments has actually gone ahead and legalised them.

What could IRDAI have done?

IRDAI could have implemented the recommendations of the two committees and reduced upfront commissions, moving to a full trail model. The problem with raising compensation in year one of a long term product has been flagged by multiple research papers and regulators. High front commissions and payouts are go against regulatory learning across the world where high front commissions are linked to investor churning, mis-selling and sharp sales practices. To raise intermediary payouts in the first year in an overall market that has seen reduction in costs is surprising. Had IRDAI hiked the upfront payouts with tighter rules on persistency and claw backs, there could have been an argument for raising compensation. Perversely, in a 2014 Guideline to all CEOs of inurance companies, IRDAI diluted its earlier guideline for stricter persistency targets. It said:

1. Renewal of Individual Agency License and Corporate Agency License will not be subject to meeting the Persistency Rates as stated in the above referred Guidelines/Circulars.

2. All Life Insurers are required to have their own company specific persistency criterion for renewal of Individual and Corporate Agency from 1st July 2014.

With no regulatory cost on poorer persistency, the economic signal of raising first year commissions and payouts is to continue with the hit-and-run sales process. Claw back of front commissions is another way that globally insurance companies ensure a minimum persistency rate, but IRDAI is silent on this. By pushing policy holder interest onto Boards of companies, while raising overall payout rates, the regulator has let the fox into the chicken coop and told the fox to be a good boy now.

 

The author works in the area of consumer protection in finance. She is Consulting Editor Mint, Consultant NIPFP, and on the Board of FPSB India.