The Indian Government has been on a fast track as far as reforms are concerned in the past couple of weeks. This has not only brought back investor confidence but has also made the rating agencies to think again about downgrading Sovereign Credit rating of the country. Till now the reforms have touched various sectors in the country right from retailing to civil aviation. All of these reforms have a common objective of bringing India on its high growth trajectory.

Similarly, even in the insurance sector the Finance Ministry has proposed Foreign Direct Investment (FDI) upto 49%. Furthermore, to ease investment norms for the insurance companies, the IRDA may consider relaxing minimum requirement of 75% in AAA-rated instruments. At present, there is a stipulation that 75% of investments must be in AAA-rated debt instruments, excluding investments in Government Securities (G-Secs). The regulator has decided to include G-Secs in the minimum stipulation. This is expected to release about 12.5% for investments in less than AAA rated debt instruments.

At present, insurance companies only invest in AAA-rated securities which restrict their choice to government bonds and debt instruments of top government-owned companies and a handful of the country’s largest private sector firms. The AA-rated universe is several times bigger and various kinds of companies are its members. This diversity, however, can cause policyholders to sweat as the balance sheet of a typical AA-rated company is more leveraged and it has lower earnings cushion to service debt than AAA-rated peers.

Moreover, the choice of assets which rests with the insurance companies (for investing the corpus) is also fraught with danger given the number and diversity of the AA-club in India. While the AAA club has just 35 non-bank and non-government members, about 200 companies (nearly 10% of the corporate universe) enjoy an AA credit rating. That includes companies whose balance sheets and valuations are as good as those of top rated companies and also those with highly leveraged balance sheets and poor valuations. Thus, although, this proposal to allow insurance companies to invest in AA-rated securities will broaden investment options for insurance companies but at the same time it is also likely to expose their policyholders to higher risk.

We are of the view that, reforms in many sectors will benefit India’s growth prospects. However, growth at the cost of high risks may not be the right idea. In case of the insurance sector wherein the investment norms are proposed to be relaxed in order to generate higher returns needs word of caution. Investment in insurance (though insurance should be poles apart from investment) is undertaken from a long term point of view by the policyholders with an aim to generate corpus for their retirement. Such a long term corpus of funds requires investment in high quality debt instruments and there need not be a compromise on the asset quality in the quest to generate higher returns.

And even if insurers are allowed to investment in AA-rated securities, care should be taken to select financially sound companies for investment which in turn requires an active fund management exercise.
 

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