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Fixed Income

Guest Blog: Insurance Funds Should Invest in All Classes of Bonds

This is a guest post by Karthik Shashidhar, who’s both a good friend and a great quant and data guy. He writes in on a recent IRDA directive.

Earlier today, I was going through some “Exposure drafts” that the IRDA has put out proposing some changes to the way Insurance and Pensions are regulated in India. The part that has got some people excited is that now insurance companies are going to be allowed to invest in corporate bonds that are rated AA (hitherto, they were only allowed to invest in AAA rated securities). An article in Monday’s Business Standard makes the usual noises about “gambling with people’s hard earned savings”.

Reading through the draft today, I realized that even this investment in AA rated securities is limited to 15% of the insurer’s assets, of which a whopping 50% needs to be invested in government and other “approved” securities. The question I ask, therefore is, “why only AA?”

As a class of investors, insurance and pension funds are unique in terms of the horizon over which they need to invest. They have cash inflows over the short term, but need to invest for large potential cash outflows over the long term. In that sense, they are among the most stable investors since they are able to tide over short-term blips due to the far-sightedness of their investments. Additionally, their massive corpuses also gives opportunity for significant diversification, and that allows them to make the odd risky investment.

The reason that corporate bond trading is next to dead in India is because insurers have hitherto only been able to invest in bonds rated AAA. With the regulator now permitting investments in AA bonds, there is a chance for that market to develop in a tiny fashion (though the 15% cap that the regulator has imposed, and this includes AAA securities, means it will only lead to minor development). However, unless insurance and pension funds are allowed to invest in bonds of lower grades, there is absolutely no chance of those markets developing, and that only means greater strain on the banking sector. Let me explain.

In another world where corporate bonds were widely traded, it would be extremely unlikely that Kingfisher Airlines would have raised as much bank debt as it has. It would have instead gone to the corporate debt market, and sold paper to the public. And the investors who had invested in Kingfisher’s debt would, as the company steadily declined, have been able to cut their losses and trade out of the company, and be replaced by a different set of investors with a greater risk appetite (you can notice that this has happened in the widely traded and liquid equity market. On the debt side, though, SBI and a few other banks are stuck with tonnes of bad loans).

The systemic risk in banks owning too much risk is that it encourages good money to go after bad. Knowing that the money it has lent to KFA is as good as gone should the airline go down, there is a perverse incentive for SBI to continue lending to KFA in the hope that it would somehow be kept afloat. Had it invested, instead, through the bond market, the bank could have steadily traded out of KFA’s debt and there wouldn’t be one player with perverse incentives saddled with the entire debt.

So where do insurance companies come in? As I explained earlier, they have a long-term horizon in investing and they are huge and hence diversified. Hence, they are the ideal catalysts for building a domestic corporate bond market. Due to their investment horizon, they won’t suddenly desert bonds as a class when the equity market jumps up. Due to their size, if one of the companies they have lent to (via the bond market) goes down, it is likely to be absorbed by some of their other investments that would have done well. World over, it has been seen that insurance and pension funds (and endowment funds of large universities) have played a critical role in creation of liquid markets for new asset classes (including Michael Milken’s junk bond market in the 1980s).

So what should be done? Insurance companies should be allowed to invest in whatever the hell they want to invest in, as long as they keep a certain risk-weighted score under control. The current mandate is for 50% to be in government and other “approved” securities. Instead, the risk-weight for these securities can simply be made to zero. AAA securities can have a higher risk weight, AA even higher and so forth with junk bonds having the highest risk weight. And the regulation can be of the form of an insurer’s weighted average risk being bounded from above by a certain number (this is similar to the Basel II norms for banks – something I’ve ranted about before, but I’ll save that for another day). What risk-weighted regulation does is to allow investors to choose their own investment profiles – for example, one investor might choose to invest all his money in AAA bonds, while another might invest 90% in government securities and the rest in junk.

Now what of the “playing with people’s life savings” argument? The answer is that people don’t keep all their life savings in insurance or pension schemes. They keep a significant proportion of their savings in banks also, and what the provisions I’ve proposed does is to reduce the stress from the banking system. If KFA goes down tomorrow, depositors in SBI and other banks (notwithstanding SBI’s de facto sovereign guarantee) stand to lose. The regulation I propose will simply diversify this risk between depositors of SBI and investors in SBI Life – thus taking one dimension out of the headache people might face in their investment decisions; and at the same time reduce the overall
risk in the financial sector.

The problem with current financial regulation in India is that it is siloed. We have one regulator for banks, another for capital markets and yet another for insurance and (maybe) another for pension funds (PFRDA). All this ensures is that each regulator tries to decrease the risk within his sector, without regard to risk to the financial sector as a whole. The sooner we recognize this, the safer the
life’s savings of our people will be.

Karthik Shashidhar runs Bespoke Data Insights  and blogs at Pertinent Observations. You can also reach him @karthiks. The post is available at

  • rrp says:

    If SBI as a company lent money that is their and shareholders problem. If they made a decision they have to pay for it. There are political angles there (and not exactly perverse incentive. They are not that dumb) . With investors direct money lying in insurance funds, the retail investors are either ignorant or have no choice (is there a tick mark which asks which grade of bond they can opt in ?). So Mr M will keep asking for loan .. more more more … KFA goes to zero and it is insurance investors who lose with junk bond in hand. So this is a really bad move playing with retail investors money.

  • subra says:

    theoretically true in a perfect market with perfect information flow. Where 80% of banking & Life insurance investing is controlled by EMPLOYEES and not by the shareholders, this is utopian. You want to develop the bond market? demat national savings certificates, force banks to invest in bonds/debentures instead of giving loans, and yes FORCE life insurance companies, mutual funds, etc. to buy ONLY rated instruments. Yes weightage can be used, but insur cos. SHOULD NOT BE ALLOWED TO give loans (mfs cannot). This will convert LIC’s loan books to bond markets. If nsc, kvp, post office products are in demat mode…imagine the size of the market – safely 10x the equity markets will be the size.

  • anon.coder says:

    “Had it invested, instead, through the bond market, the bank could have steadily traded out of KFA’s debt and there wouldn’t be one player with perverse incentives saddled with the entire debt.”
    Wasn’t ICICI bank able to exit and transfer its debt to some subsidiary of SREI Infra? What stops SBI from doing the same in chunks?
    Bond markets do need to be developed in India but just allowing participation from Insurance companies is not the right way. Bond markets are the most efficient of all markets. Everything is in the numbers. First we need good businesses run by honest people. Then everything will fall into place. They will never have trouble in raising money from the bond markets.

  • Guruprasad V says:

    Despite huge turbulence US is doing pretty decently compared to other developed countries. Main reason is their vibrant Bond Markets. If our government really has to bring reforms they should concentrate on creating a depth in Bond markets. US bond markets are highly liquid, has huge depth and are vibrant in the world. Only problem here in India is ” Corporate India” ‘s governance of their affairs. Very few are ethical and most of them breach corporate governance on continuous basis. Without corporate governance we won’t be able to find the reality of an issue (Use of issuance of bonds). Recently Religare Finvest came with NCDs. I could confidently say that this is one of the worst issue to subscribe because of lack of integrity of the issuer. As far as our state is concerned Religare Finvest doesn’t seems to do business to the closest of what they have said in their prospectus. In my city it has infact closed their operations and are not doing anything. Most of the companies in India are involved in cheating subscribers be it equity or bonds. Unless otherwise we see some real implementation of corporate governance and see transparency we couldn’t expect any prosperity in Bond markets.

  • Sanjay says:

    Read between the lines. What author is trying to say is:
    Hey, I am a corporate. I am not able to fool bankers. They are too smart. I am not able to fool retail investors in buying NCD.
    Let me try to fool pension funds where money of average investor is locked in for too long. Anyway, I don’t see profit margin of pension funds linked to their performance. 🙂 And investor’s money is not guaranteed anyway. 🙂
    And once bond market gets developed, I can once again try to fool retail investor just like I was fooling them in equity market.
    What I am saying is author’s thoughts might be noble but not practical. Recently Goldman Sachs was sued by a pension fund for lying on risk involved in bonds. In India, pension funds might be sleeping with corporate houses which need money.
    It will be great if you can come up counter examples.

  • Ritz says:

    Hue and cry of “playing with people’s life savings” is done by media to make everything sensational. As suggested, even pension funds should be allowed to invest.