--By Ujjwal Chand & Suraj Bansal

 

Currently, there are 25 insurance companies in Nepal -16 of them provide non-life insurance services and  eight  provide life insurance services while one provides both of these services. Insurance companies use their funds consisting of capital, reserves, premiums and loans to finance claim payments and other expenses. The remaining fund is invested as per the Investment Directives from the regulatory body, i.e. Insurance Board (Beema Samiti). As of FY 2011-12, these companies had investments to the tune of Rs. 60 billion out of which Rs. 52 billion was from life insurance companies and the rest was from non-life insurance companies.

 

The insurance companies can put their investment funds in the sectors specified  in the investment guidelines which specify that Life insurance companies must invest a minimum of 75% and non-life insurance companies minimum of 65% of their investment funds in combination of government securities, fixed deposits of commercial banks and development banks, and mutual fund/Citizen Investment Trust Schemes. They can put a maximum of 5% of their total investment fund in ordinary shares of public limited companies. Other areas for investment are secured debentures of Banks and Financial Institutions (BFI)s and Fixed Deposits (FDs) in finance companies. Non-life insurance companies can additionally invest in shares of real estate development or public limited housing company. 

 

Importance of Returns from Investment 

The operations of life and non-life insurance companies are different. Non-life insurance companies generate profit through both returns from investment and from regular insurance business. Life insurance companies, however, are suffering loss in the regular insurance business. Therefore, it is only due to the returns from investment that they are able to report positive bottom lines. Ganesh Dahal, deputy manager of Sagarmatha Insurance puts that “the contribution of investment returns to the company’s bottom line is at 40%”and in similar vein Suraj Rajbahak, CA of Shikhar Insurance, shared that “about 30% of the company’s returns are from investment returns”. Life insurance companies are far heavily reliant on the investment returns. Dip Bahadur BC, chief financial officer at Prime Life Insurance says, “Investment returns not only sustain the company’s expenses but also contribute to the bottom line”. Bigyan Shrestha, finance chief at National Life Insurance, seconds this and states that “the investment returns have been sufficient to sustain normal operations” for the company. 

 

 

Investment returns of insurance companies 

Of the twenty-five insurance companies, only twenty had published their annual report for FY 2011-12 by September 2013. An analysis of the same shows that 15 of the 20 companies posted returns from 8.5% to 10.5% from investments. This was primarily due to the high interest rates on the fixed deposits of the BFIs. 

 

But, the returns from their investment in ordinary share was relatively weak during this period  - ranging from 0% to 5.42%. However, during the same period, Nepse increased by 14.7%. This shows that the insurance companies underperformed Nepse in terms of returns from ordinary shares investments.

 

Issues with current ordinary shares investment 

There are few internal issues of the insurance companies themselves behind poor  returns from ordinary shares investment.  Additionally, there are some issues with the current ordinary shares investment practices that could damage these returns in the long run of the insurance companies. These internal issues are:

 

Passive investment – Over-reliance on dividends 

Of the 20 insurance companies analyzed, four hadn’t invested in ordinary shares at all in FY 2011-12. In the remaining sixteen insurance companies, dividends contributed about 99.97% of the overall return from this avenue in 2011-12. This means only 0.03% of the returns came from capital gains. Thus passive investing, thereby over reliance on dividends for income from ordinary shares investments remained as the most important reason for poor performance in ordinary shares investments by insurance companies.

 

Lack of experts, research-based decision making

Further, the insurance companies did not follow research based decision making approach while selecting ordinary shares for investment. This is despite the fact that the insurance companies accept the high importance of investment decisions to the bottom-line. Moreover, investment team in these companies is made of up of generalists, i.e. overseeing all aspects of finance in the company, rather than specialists with specific field expertise. 

 

Lack of Diversification

Investment gurus advocating diversification of fund always caution that “putting all your eggs in one basket is very dangerous”. These insurance companies lack proper diversification in ordinary shares investments, which could damage the returns from this avenue in the long term. The ordinary shares investments were heavily concentrated in stocks of major BFIs, constituting 96% of total ordinary shares investments. In terms of diversification at company level, they fare even worse. Although they had invested in 67 securities, they heavily concentrated on six companies, constituting 67% of the total ordinary shares investments. 

 

Issues with overall current investments 

High interest rate exposure is found to be triggering volatility on the overall investment returns. This exposure was also due to the conservative guidelines that made it mandatory for the insurance companies to park their fund in interest-rate volatile investment avenues like fixed deposits. The conservative investment guidelines are curtailing the diversification of investments, and thereby introducing concentration risk on the investments.

 

High interest risk exposure

Due to regulatory constraints, large portion of the investment fund is parked in BFIs as fixed deposit. This brings about high interest rate risk in the investments returns of the insurance companies. Sushil Kumar Luniya, manager at Gurans Life Insurance, sees “the decrease in interest rates of fixed deposits hampering insurance company returns for the current fiscal year”. Manoj Shrestha, head of finance department at NLG Insurance, too regards “the volatile bank interest rates as major factor deciding the investment returns”.  

 

Due to high interest rates prevalent during the sample period (average of 8.125% for commercial banks in FY 2011-12 as per the central bank’s Monetary Policy document), most of the insurance companies had fair returns on the investments. Imagine the effect of decrease in the rates to 5.2%, as predicted by NRB Monetary Policy for 2013-14, on the investment returns ! 

 

Now lets simulate this Simulating such scenario by decreasing the FY 2011-12 returns from fixed deposits of BFIs by the same proportion as the decrease in interest rate, i.e. from 8.125% to 5.2%. In FY 2011-12, it was found that only one insurance company was making loss. If the interest rates during this period were only 5.2, four insurance companies would have been at loss. 

 

Lack of diversification options

The conservative investment guidelines put by the regulatory board give little room for diversification to insurance companies. Majority of the fund is to be parked in government bonds, and fixed deposit of commercial and development banks. Even in ordinary shares investments, insurance companies are finding hard to diversify from a stock market with over 76% concentration in BFIs. Thus there is huge concentration risk.  If one bank or finance institution goes bust, the whole insurance industry would suffocate. One such event in Gurkha Development Bank has already occurred. Few insurance companies are still provisioning the losses from this bank’s tragedy.

 

But, investment guideline isn’t the only sore finger. There is also lack of innovativeness among insurance companies in terms of diversifying their investments. As Dr. Fatta Bahadur KC, chairman of Insurance Board, claims, “The investment guidelines clearly indicate flexibility of alternative investment avenues for the insurance companies”. Upon request by insurance companies, the Board is ready to look into alternative investment proposals. But as this includes some hassles and would put the insurance company management under scrutiny if the innovation backfires, the insurance companies are reluctant to tread on this way.

 

Asset-liability mismatch

Asset-Liability mismatch is a major issue with life insurance companies. Safer investment assets with longer maturity are hard to find in Nepali market, where bonds and debentures have minimal presence. Debentures of commercial banks bring concentration risk with them for the insurance companies, which already have major portion of their investment fund in the banks as fixed deposits and their ordinary shares. Dr. KC, sees “Asset-Liability mismatch for life insurance companies as they issue policy for long term whereas they can invest for short term only”. Dip Bahadur BC, CFO of Prime Life, also considers “asset-liability maturity mismatch as a prevalent issue in all life insurance companies”.

 

The Way Ahead

 

Resolving Internal Issues

Internal issues - lack of research based decision making, diversification and active investing - can be resolved through robust internal research systems. To boost their ordinary shares investment performance through research backed investments, the insurance companies could build their own internal system and processes but at a huge cost. It would also mean taking two diverse businesses in parallel, i.e. insurance business and investment business. Outsourcing of ordinary shares investment management by availing the customized portfolio management service given by several financial intermediaries like Kriti Capital, Nabil Invest and Beed Management, seems more beneficial. Such outsourcing  will not only enable insurance companies to focus on their core business, but also get better returns from their investments via expert handling of their funds at a relatively lower cost.

 

 

Resolving external issues

There are limitations faced by insurance companies while investing their fund as per current investment guidelines. Fixed deposits have inbuilt interest rate risks. The life insurance companies face an additional issue of asset-liability maturity mismatch, with investments maturing in about 1-1.5 years and liabilities remaining active for about 10-13 years. There is need for long term investment alternative. 

 

Further, diversification of fund is hard in a secondary market with heavy concentration of BFI stocks. With the investment fund increasing rapidly (CAGR of 21.35% from 2004-05 to 2011-12), there is a need to look for additional investment avenue to resolve these issues. This is not just voiced by the insurance company professionals but also by the insurance regulatory board.

 

Dr. KC feels that “although the investment guidelines give flexibility to insurance companies to come up with alternative investment proposals, the time has come to review the overall investment guidelines”.

 

A suitable avenue to be added in the investment guidelines could be private placements in infrastructure companies. This will not just help the insurance companies to resolve the issues of diversification and the infrastructure companies in getting easier financing, but also help the overall economy of the nation. Dr. KC says that the Board is “positive on investment made by insurance companies in hydropower and other infrastructure companies, and these avenues could be opened for investments”. Most of the insurance companies also state that they are willing to invest in hydropower and other infrastructure companies, if allowed by investment board.

 

Insurance Board should allow investments by the insurance companies via private placements, as the secondary market doesn’t have appropriate diversification opportunities. Further, the insurance companies would be able to invest at a bargain in the infrastructure companies due to their sheer investment fund size. Also, if SEBON comes up with more liberal rules on the issuance of shares at premium, the infrastructure companies could benefit hugely from private placements. Even if the insurance companies decide on being risk averse and just invest in debentures, they could do so in infrastructure debentures. As there isn’t presence of these instruments in secondary market, private placement would be ideal way for diversification of  by insurance companies. On the other hand, the infrastructure companies would have lower issue costs and lesser regulatory hassles than going public for raising finance. Also, in case of debentures, these companies would be avoiding interest rate exposure. Similarly, the promoters of infrastructure companies would be able to delay issuing the shares to public, thereby being in position with better financial statements before going public. This would help get better response on public issuance of shares at premium. 

 

Thus the insurance companies should initiate this by coming up with effective proposal and lobbying with the Insurance Board for liberal investment guidelines.

 

But, investment in private placements of the infrastructure companies (if allowed by the Board) requires expert knowledge on these companies and regular monitoring. Also, the entry and exit strategies must be taken into account as these investments are relatively less liquid as compared to secondary market investments. There will be need of diversification as well as policy and strategy development for the insurance companies vying to invest via private placements. So, to benefit from this additional investment avenue, insurance companies will have to develop in-house expertise or outsource private placements management services for financial intermediaries.

 

(The article is based on a joint research conducted by Ujjwal Chand and Suraj Bansal as part of their academic requirement at KUSOM. The researchers can be contacted at: chandujjwal@gmail.com)