Insurance Funds Should Invest in All Classes of Bonds

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.

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