POSTGRADUATEDIPLOMAINMANAGEMENT

ReadingMaterial

INDEX
1 FinancialMarkets,Products&Institutions 1
2 MutualFundsinPerspective 5
3 InvestmentsbyMutualFundSchemes. 11
4 NovelPortfolioStructuresinMutualFundSchemes 21
5 SchemeSelection 29
6 SelectingtheRightInvestmentProductsforInvestors 53
7 HelpingInvestorswithFinancialPlanning 66
8 RecommendingModelPortfolios&FinancialPlans 84
9 IntroductiontoInsurance 93
10 FundamentalsofRiskmanagement 107
11 InsuranceContract,Terminology,Elements&Principles 115
12 GeneralInsurance 121
13 Personal&LiabilityInsurance 137
14 TypeofLifeInsurancePolicies 148
15 FinancialPlanning&LifeInsurance 158
16 InsuranceIntermediaries 164
17 IntroductiontoBanking 176
18 BankDeposits,NominationandDepositInsurance 186
19 OtherBankingServices 193
20 BankCustomerRelationship 200
21 SecurityCreation 203
22 NPA&Securitization 211
23 BASELFramework 221
24 RegulatoryFramework 225

Chapter 1 : Financial Markets, Products &

Institutions
1.1 Financial Markets
Financial markets are an important constituent of any economy. They include money
market viz. the market for short term debt funds of upto 1 year; and capital market viz.
the market for equity and long term debt funds for more than a year.
Financial markets meet various needs of different entities:
o Government
Financial markets help governments meet their borrowing requirements.
Taxes collected from the enhanced economic activity promoted by markets help
boost the hnances of the government.
Financial markets can force companies to operate under transparent corporate
governance standards.
o Issuing companies
Financial markets make it possible for companies to mobilise money for the
projects they want to implement.
The yield curve in the debt market sets the tone for the borrowing cost of issuing
companies.
The markets give companies a benchmark for their valuation and top management
to assess their performance.
The hnancial markets provide companies a currency with which they can reward
employees
The valuation effect of hnancial markets helps companies to acquire other
businesses without having to pay from the bank account.
The stock exchange gives companies visibility and raises their prohle with
investors, customers, government and general public.
o Investors
The market helps investors beneht from the performance of the economy and
companies.
Price discovery in the markets provide messages to investors on where various
companies stand.
Markets provide a platform for investors to punish poor management.
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o Economy
Financial markets are a barometer of the economy.
Financial markets help in channelling resources from those who have them to
those who need them.
New projects and higher activity promoted by hnancial markets boost the growth
of the economy.
1.2 Financial Products and Market Entities
Governments issue treasury bills and government securities in the debt market. They
also offer shares of public sector undertakings in the equity market.
Financial products issued by companies include equity shares, preference shares,
convertible debentures, non-convertible debentures, commercial paper, certihcates of
deposit etc.
Companies can either mobilise moneys from retail investors through a public issue,
or target institutional investors through a private placement. Venture Capital Funds,
Private Equity Funds, Foreign Institutional investors and high net worth individuals are
leading investors in the private placement market.
Investment bankers help companies to mobilise the resources from investors. They also
help businesses acquire other businesses and re-structure themselves.
Broking houses have research teams that cover different sectors and companies.
Their research reports are an important source of information about companies for
investors.
Credit rating agencies rate the debt instruments issued to the public. They also provide
a rating for public issues of equity.
Investors can take exposure to companies, either directly or through mutual funds or
other funds. Brokers, distributers and investment advisers are in touch with investors
and part of the chain of distribution of hnancial products.
The registrar and transfer agent maintains records of investors in companies.
Financial products issued by governments and companies in the primary market are
traded in the secondary market. An active and liquid secondary market is important for
investors to be interested in the primary market.
Futures and options are popular derivative instruments. A convertible debenture, where
the conversion is not compulsory, is like a debenture with an attached option. The
exchange too creates derivatives on underlying hnancial instruments. A liquid cash
market for the underlying is important for an efhcient market for derivatives on that
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underlying. Trading in derivatives and their underlying provide vibrancy to the hnancial
markets.
1.3 Market Infrastructure Institutions
Stock exchanges provide the platform for secondary market trades. They also perform
certain regulatory functions over companies whose shares are listed in the exchange.
Transactions executed in the stock market are settled through the clearing corporations.
Through a process of novation, they become counter parties for all trades executed in
the exchange. Thus, they give conhdence to various parties to trade in the exchange.
The depositories make it possible for the market to trade securities in dematerialised
form. The elimination of physical securities has made it possible for large volumes of
trades to be executed and settled through the exchange.
Depositories appoint Depository Participants (DPs) to enable investors to dematerialise
and rematerialize their securities.
Stock exchanges, depositories and clearing corporations are collectively referred to as
securities Market Infrastructure Institutions (MIIs).
1.4 ConHicts of Interest
Specialist organisations perform various roles in the hnancial markets. However, there
are several potential conficts of interest in the market. For example:
o Issuers have an interest in issuing complex hnancial products that are difhcult to
assess for many investors. This can lead to gullible investors investing in products
they should not invest in.
o Broking companies come out with research reports on companies. Issue of capital
by a company may be managed by an investment bank that is part of the same
group as the broking company. In such a situation, the independence of the research
report can get compromised by a desire to help the investment bank make a success
of the issue.
o Asset management companies earn fees that are linked to assets under management.
They have an interest in maximising the assets under management by presenting a
bullish view of the market and holding back bearish views. This can hurt the interest
of investors who take investment decisions based on biased information.
o Credit rating companies issue ratings to protect investors. However, they earn
rating fees from the companies whose instruments they are expected to rate. In the
competitive context in which rating companies operate, the desire to boost income
can affect the objectivity of the rating.
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o Investment advisers position themselves as protecters of investor interest. But they
may earn a commission from the manufacturer of the hnancial product (mutual fund
or insurance company). The manufacturers commission can incentivise the adviser
to suggest a product to investors for whom it is not suitable.
The securities market regulater, SEBI has introduced various regulations to ensure
transparency and protect investors interests.
Markets are dynamic, market structures evolve and accordingly, SEBI keeps rehning its
regulations. The emerging paradigm of regulation is detailed in Chapter 10.
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Chapter 2 : Mutual Funds in Perspective
1.1 Mutual Funds
Mutual Funds are a vehicle for retail and institutional investors to beneft from the capital
markets. They offer different kinds of schemes to cater to various types of investors, retail,
companies and institutions. Mutual fund schemes are offered to investors for the frst
time through a New Fund Offering (NFO). Thereafter, close-ended schemes stop receiving
money from investors, though these can be bought on the stock exchange(s) where they
are listed. Open-ended schemes sell and re-purchase their units on an ongoing basis.
Know Your Client (KYC) process is centralised in the mutual fund industry. Therefore, the
investor needs to complete the formalities only once with the designated KYC service
provider. The KYC confrmation thus obtained is valid for investment with any mutual
fund.
A feature of mutual fund schemes is the low minimum investment amount as low as Rs.
1,000 for some schemes. This makes it possible for small investors to invest. The expense
ratio (which is not more than 2.5% in many schemes, especially liquid and index funds
and goes below 0.05% in some schemes)being low also helps in making mutual funds a
good instrument for building wealth over the long term.
Mutual funds are closely regulated by the Securities & Exchange Board of India (SEBI).
The applicable regulation is the SEBI (Mutual Fund) Regulations, 1996.
Under the regulations, the Board of Trustees perform an important role in protecting the
interests of investors in mutual fund schemes. Another protective feature is the checks
and balances in the mutual fund system. For instance, while the Asset Management
Company (AMC) handles the investment management activity, the actual custody of the
investments is with an independent custodian. Investor records are mostly maintained
by the registrar and transfer agents (RTAs), who offer their services to multiple mutual
funds. In some cases, the AMC itself maintains the investor records.
SEBI also regulates the investments that mutual fund schemes can make. For instance,
commodities other than gold are not permitted. Even within the permissible investments,
SEBI has prescribed limits for different kinds of schemes.
Rigorous standards of disclosure and transparency make sure that investors get a
complete view of their investments on a regular basis. Consolidated Account Statements,
mandated by SEBI, ensure that the investors investments across various mutual funds in
the industry are consolidated into a single monthly statement. Even those investors who
do not transact, receive their statement of accounts every 6 months.
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1.2 Portfolio Management Schemes (PMS)
PMS is an investment facility offered by fnancial intermediaries generally to high networth
investors. There is no concept of a NFO. The PMS provider keeps receiving money from
investors. Unlike mutual funds, which maintain their investment portfolio at the scheme
level, the PMS provider maintains a separate portfolio for each investor.
An investor who chooses to operate multiple PMS accounts will need to go through a
separate KYC process with each intermediary. Each will provide a separate statement of
the investors account in their own format. The facility of Consolidated Account Statement
is not available.
SEBI has set the minimum investment limits under PMS (Rs. 5 lakh presently). Many PMS
providers operate with much higher minimum investment requirements.
The cost structure for PMS, which is left to the PMS provider, can be quite high. Besides a
percentage on the assets under management, the investor may also have to share a part
of the gains on the PMS portfolio; the losses are however borne entirely by the investor.
PMS have an unconstrained range of investments to choose from. The limits, if any, would
be as mentioned in the PMS agreement executed between the provider and the client.
PMS are regulated by SEBI, under the SEBI (Portfolio Managers) Regulations, 1993.
However, since this investment avenue is meant only for the high networth investors, the
mutual fund type of rigorous standards of disclosure and transparency are not applicable.
The protective structures of board of trustees, custodian etc. is also not available. Investors
therefore have to take up a major share of the responsibility to protect their interests.
1.3 Hedge Funds
These are a more risky variant of mutual funds which have become quite popular
internationally. Like PMS, hedge funds too are aimed at high networth investors. They
operate with high fee structures and are less closely monitored by the regulatory
authorities.
From a fund management perspective, the risk in hedge funds is higher on account of the
following features:
Borrowings
Normal mutual funds accept money from unit-holders to fund their investments.
Hedge funds invest a mix of unit-holders funds (which are in the nature of capital)
and borrowed funds (loans).
Unlike capital, borrowed funds have a fxed capital servicing requirement. Even if
the investments are at a loss, loan has to be serviced. However, if investments earn
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a return better than the cost of borrowed funds, the excess helps in boosting the
returns for the unit-holders. The following example illustrates how borrowing can be
a double-edged sword for the fund.
Scenarios-> A B C
a. Unit-holders Funds (Rs. Cr.) 1,000 100 100
b. Borrowings (Rs. Cr.) 0 900 900
c. Total Investment (Rs. Cr.) [a+b] 1,000 1,000 1,000
d. Return on Investment (%) 15% 15% 5%
e. Return on Invt. (Rs. Cr.) [c X d] 150 150 50
f. Interest on loan (%) 7% 7%
g. Interest on Loan (Rs. Cr.) [b X f] 0 63 63
h. Unit-holders Profts (Rs.Cr.) [e-g] 150 87 -13
i. Proft for Unit-holders (%) [h a] 15% 87% -13%
The 15% return in the market was boosted through leverage of 9 times to 87% return
for unit holders in a good market; in a bad market the same leverage dragged the
unit-holders return down to -13%.
The borrowing is often in a currency that is different from the currency in which the
investments are denominated. If the borrowing currency becomes stronger, then that
adds to the losses in the fund.
Risky investment styles
Hedge funds take extreme positions in the market, including short-selling of
investments.
In a normal long position, the investor buys a share at say, Rs. 15. The worst case is
that the investor loses the entire amount invested. The maximum loss is Rs. 15 per
share.
Suppose that the investor has short-sold a share at Rs. 15. There is a proft if the
share price goes down. However, if the share price goes up, to say, Rs. 20, the loss
would be Rs. 5 per share. A higher share price of say, Rs. 50 would entail a higher loss
of Rs. 35 per share. Thus, higher the share price more would be the loss. Since there
is no limit to how high a share price can go, the losses in a short selling transaction
are unlimited.
Under SEBIs mutual fund regulations, mutual funds are not permitted to borrow to invest.
Borrowing is permitted only for investor servicing (dividend or re-purchases). Further, the
borrowing is limited to 20% of the net assets, and cannot be for more than 6 months at
a time. Similarly, mutual funds are not permitted to indulge in short-selling transactions.
Such stringent provisions have ensured that retail investors are protected from this risky
investment vehicle.
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1.4 Venture Capital Funds & Private Equity Funds
These funds largely invest in unlisted companies. Venture capital funds invest at an earlier
stage in the investee companies life than the private equity funds. Thus, they take a
higher level of project risk and have a longer investment horizon (3 5 years).
Venture Capital Funds are governed by the SEBI (Venture Capital) Regulations, 1996.
Under these regulations, they can mobilise money only through a private placement.
Investors can be Indians, NRIs or foreigners. Every investor has to invest a minimum of
Rs. 5 lakh in the fund.
Unlike mutual funds, which accept money from investors upfront, venture capital funds
and private equity funds only accept frm commitments (a commitment to invest) initially.
A part of the frm commitment may be accepted in money. The balance moneys are called
from the investors, as and when the fund sees investment opportunities.
Firm commitments worth Rs. 5 crore have to be arranged from investors, before the
venture capital fund commences operations. At least two-thirds of the investible funds
should be invested in unlisted equity and equity related instruments. Not more than one-
thirds can be invested in the following forms:
Subscription to Initial Public Offer (IPO) of a company whose shares are to be listed
Debt of a company where the fund has already invested in equity
Preferential allotment of a listed company, subject to lock in period of 1 year
Special Purpose Vehicles (SPV) created by a fund for facilitating or promoting
investments
Equity shares or equity-linked instruments of fnancially weak or sick companies.
Venture capital funds may invest in India or abroad. However, not more than 25% of the
corpus can be invested in a single undertaking.
Venture capital funds are not permitted to invest in Non-banking Financial Services,
Gold Financing (other than for jewellery) and any other industry not permitted under the
industrial policy of the country. They can also not invest in companies where the owners
or managers of the fund have more than 15% stake.
Just as investors bring money into the fund in stages, the fund returns money to investors
in stages, as and when some investments are sold. On maturity of the fund, the unsold
investments may be distributed to the investors in the proportion of their stake in the
fund.
Private equity funds typically have a shorter investment horizon of 1 3 years. While their
focus is on unlisted companies, they do invest in listed companies too. Such deals, called
in Private Investment in Public Equity (PIPE) are increasing in India.
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Points to remember
Mutual Funds are a vehicle for retail investors to beneft from the capital market. They
offer different kinds of schemes to cater to various types of investors.
Mutual fund schemes are offered to investors, for the frst time, through a New Fund
Offering (NFO). Thereafter, close-ended schemes stop receiving money from investors.
Open-ended schemes offer to sell and re-purchase their units on an ongoing basis.
Know Your Client (KYC) process is centralised in the mutual fund industry.
Mutual funds are closely regulated by the Securities & Exchange Board of India (SEBI).
The applicable regulation is SEBI (Mutual Fund) Regulations, 1996.
A protective feature of mutual funds are the checks and balances in the system :
o Trustees are responsible for protecting the interests of investors in mutual fund
schemes.
o Asset Management Company (AMC) handles the investment management activity.
o Custody of the investments is with an independent custodian.
o Investor records are mostly maintained by registrar and transfer agents (RTAs). In
some cases, the AMC itself maintains the investor records.
Portfolio Management Scheme (PMS) is an investment facility offered by fnancial
intermediaries generally to high networth investors.
Unlike mutual funds, which maintain their investment portfolio at the scheme level, the
PMS provider maintains a separate portfolio for each investor.
SEBI has set the minimum investment limit under PMS at Rs. 5 lakh presently. Many PMS
providers operate with much higher minimum investment requirements.
The cost structure for PMS, which is left to the PMS provider, can be quite high. Besides a
percentage on the assets under management, the investor may also have to share a part
of the gains on the PMS portfolio; the losses are however borne entirely by the investor.
PMS have an unconstrained range of investments to choose from.
PMS are regulated by SEBI, under the SEBI (Portfolio Managers) Regulations, 1993.
Hedge funds are a more risky variant of mutual funds which have become quite popular
internationally.
Like PMS, hedge funds too are aimed at high networth investors. They operate with high
fee structures and are less closely monitored by the regulatory authorities.
Risk in a hedge fund is built through borrowings or risky investment styles, including
short-selling of securities.
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Under SEBIs mutual fund regulations, mutual funds are not permitted to borrow to invest.
Borrowing is permitted only for investor servicing (dividend or re-purchases). Further, the
borrowing is limited to 20% of the net assets and cannot be for more than 6 months at a
time. Similarly, mutual funds are not permitted to indulge in short-selling transactions.
Venture Capital Funds (VCF) and Private Equity (PE) Funds largely invest in unlisted
companies. VCFs invest at an earlier stage in the investee companies life than the PE
funds. Thus, they take a higher level of project risk and have a longer investment horizon
(3 5 years).
VCF are governed by the SEBI (Venture Capital) Regulations, 1996. Under these regulations,
they can mobilise money only through a private placement.
Investors in VCF can be Indians, NRIs or foreigners. Every investor has to invest a minimum
of Rs. 5 lakh in the fund.
Unlike mutual funds, which accept money from investors upfront, VCF and PE funds only
accept frm commitments (a commitment to invest) initially.
Firm commitments worth Rs. 5 crore have to be arranged from investors, before the
venture capital fund commences operations.
At least two-thirds of the investible funds in a VCF should be invested in unlisted equity
and equity related instruments.
Not more than one-thirds of the investible funds in a VCF can be invested as subscription
to Initial Public Offer (IPO) of a company whose shares are to be listed; debt of a company
where the fund has already invested in equity; preferential allotment of a listed company,
subject to lock in period of 1 year; Special Purpose Vehicles (SPV) created by a fund for
facilitating or promoting investments; and equity shares or equity-linked instruments of
fnancially weak or sick companies.
VCF may invest in India or abroad. However, not more than 25% of the corpus can be
invested in a single undertaking.
VCF are not permitted to invest in Non-banking Financial Services, Gold Financing (other
than for jewellery) and any other industry not permitted under the industrial policy of the
country.
VCF can also not invest in companies where the owners or managers of the fund have
more than 15% stake.
Private equity funds typically have a shorter investment horizon of 1 3 years.
While PE Funds focus on unlisted companies, they do invest in listed companies too. Such
deals, called in Private Investment in Public Equity (PIPE) are increasing in India.
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Chapter 3 : Investments by Mutual Fund Schemes
SEBI (Mutual Funds) Regulations, 1996 has laid down the limits to investment by mutual fund
schemes. Some of these are discussed below.
2.1 Equity
A scheme cannot invest more than 10% of its assets in a single companys shares or
share-related instruments. However, sector funds can have a higher investment in a
single company, as provided in their Scheme Information Document.
Index funds invest as per the index they track. In the index construction, a single
company may have a weightage higher than 10%. In such cases, the higher single
company investment limit would be applicable.
The 10% limit is applicable when the scheme invests. Breach of the limit on account
of subsequent market movements is permitted. For example, a scheme with net
assets of Rs. 100 crores may have invested Rs. 10 crores in a single company, XYZ.
Later, on account of market movements, the net assets of the scheme increase to
Rs. 102 crores, while the value of the investment in XYZ company goes up to Rs. 11
crores. XYZ company now represents Rs. 11crores Rs. 102 crores i.e. 10.78%. The
scheme is not obliged to sell any shares of XYZ company to fall within the 10% limit.
However, fresh purchases of XYZ companys shares would need to be suspended, until
the investment value goes below 10% of the schemes net assets.
Mutual funds are meant to invest, primarily in listed securities. Therefore, investment
in unlisted shares is restricted as follows:
o Open-ended schemes: 5% of Net Assets
o Close-ended schemes: 10% of Net Assets
Unlisted securities or securities issued through private placement by an associate or
a group company of the sponsor are not a permissible investment.
Mutual fund schemes cannot invest more than 25% of their net assets in listed
securities of group companies of the sponsor of the Asset Management Company.
All the schemes of a mutual fund put together cannot control more than 10% of the
voting rights of any company.
Mutual fund schemes cannot charge management fees on their investment in other
mutual fund schemes (of the same asset management company or other asset
management companies). Such investment is also subject to a cap of 5% of the net
assets of the fund. This is not applicable to fund of funds schemes.
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Inter-scheme transfers of investments can only be at market value.
If any scheme of a mutual fund has invested in a company or its associates, which
together hold more than 5% of the net assets of any mutual fund scheme of that asset
management company, then that needs to be disclosed.
Investments and disinvestments are to be contracted directly in the name of the
concerned scheme. Transactions cannot be contracted in a general account and
distributed across schemes later.
Carry forward transactions are not permitted. But mutual funds can trade in
derivatives.
Mutual funds are permitted to lend securities in accordance with SEBIs Stock Lending
Scheme.
2.2 Debt
Mutual fund schemes can invest in debt securities, but they cannot give loans.
A scheme cannot invest more than 15% of its net assets in debt instruments issued
by a single issuer. If prior approval of the boards of the Asset Management Company
and the Trustees is taken, then the limit can go up to 20%. If the paper is unrated,
or rated below investment grade, then a lower limit of 10% is applicable.
These limits are exempted for money market securities and government securities.
However, the exemption is not available for debt securities that are issued by public
bodies / institutions such as electricity boards, municipal corporations, state transport
corporations, etc. guaranteed by either state or central government.
Investment in unrated paper and paper below investment grade is subject to an
overall cap of 25% of net assets of the scheme.
Liquid funds can only invest in money market securities of upto 91 days maturity.
The following regulations are applicable for investment in short term deposits:
o Short term means not more than 91 days
o The deposits can only be placed in scheduled banks
o The deposits are to be held in the name of the specifc scheme
o Not more than 15% of the net assets of the scheme can be placed in such short
term deposits. With the permission of trustees, the limit can go up to 20%
o Short term deposits with associate and sponsor scheduled commercial banks
together cannot exceed 20% of the total short term deposits placed the mutual
fund
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o Not more than 10% of the net assets are to be placed in short term deposits of
any one scheduled bank including its subsidiaries
o The funds are not to be placed with a bank that has invested in that scheme
o The Asset Management Company cannot charge investment management and
advisory fee on such deposits placed by liquid and debt funds
Transactions in government securities are to be settled in demat form only
Inter-scheme transfers are to be effected at market value only
Unlisted securities or securities issued through private placement by an associate or
a group company of the sponsor are not a permissible investment.
Mutual fund schemes cannot invest more than 25% of their net assets in listed
securities of group companies of the sponsor of the Asset Management Company.
2.3 Derivatives
Mutual Funds are permitted to invest in fnancial derivatives traded in the stock exchange,
subject to disclosures in the Scheme Information Document. The permitted derivatives
include stock futures, stock options, index futures, index options and interest rate
futures.
They can also enter into forward rate agreements and interest rate swaps (for hedging)
with banks, primary dealers (PDs) and fnancial institutions (FIs). Exposure to a single
counter-party cannot however exceed 10% of net assets of the scheme.
Mutual funds can also invest in derivatives traded on exchanges abroad, for hedging and
portfolio balancing with the underlying as securities.
The following limits have been stipulated by SEBI:
Gross exposure through debt, equity and derivatives cannot exceed 100% of the net
assets of the scheme.
The exposure in derivative transactions is calculated as follows:
o Long Futures - Futures Price x Lot Size x Number of Contracts
o Short Futures - Futures Price x Lot Size x Number of Contracts
o Option Bought - Option Premium Paid x Lot Size x Number of Contracts
Mutual funds are not permitted to sell options or buy securities with embedded written
options.
In the exposure calculations, positions that are in the nature of a hedge are
excluded.
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o Hedging positions are the derivative positions that reduce possible losses on an
existing position in securities. These are excluded from the limits till the existing
position remains.
o Hedging positions taken for existing derivative positions are not excluded from
the limits.
o Any derivative instrument used to hedge should have the same underlying security
as the existing position being hedged.
o The quantity of underlying associated with the derivative position taken for hedging
purposes should not exceed the quantity of the existing position against which the
hedge has been taken.
The total exposure related to option premium paid cannot exceed 20% of the net
assets of the scheme.
Within the SEBI limits, the Board of Trustees can stipulate limits. The limits on investment
in derivatives need to be disclosed in the Scheme Information Document.
The AMC has to put in place, adequate risk containment measures, as may be stipulated
by the Trustees.
2.4 Gold
Gold ETFs invest primarily in gold and gold-related instruments. Gold-related instruments
are defned to mean instruments that have gold as the underlying, and specifed by
SEBI.
If the gold acquired by the gold exchange traded fund scheme is not in the form of
standard bars, it is to be assayed and converted into standard bars which comply with the
good delivery norms of the London Bullion Market Association (LBMA).
Until the funds are deployed in gold, the fund may invest in short term deposits with
scheduled commercial banks.
The fund may also maintain liquidity, as disclosed in the offer document, to meet re-
purchase / redemption requirements.
2.5 Real Estate
Real estate mutual funds are permitted to invest in direct real estate assets, as well as
real estate securities.
Direct investment in real estate has to be in cities with population over a million.
Construction has to be complete and the asset should be usable. Project under construction
is not a permitted investment. Similarly, investment cannot be made in vacant land,
agricultural land, deserted property or land reserved or attached by the government or
any authority.
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The real estate asset should have valid title deeds, be legally transferable and free from
encumbrances, and not be the subject matter of any litigation.
The following SEBI limits are applicable:
At least 75% of the net assets is to be invested in direct real estate, mortgage backed
securities and equity shares or debentures of companies engaged in dealing in real
estate assets or in undertaking real estate development projects.
At least 35% has to be invested in direct real estate.
The combined investment of all the schemes of a mutual fund:
o In a single city cannot exceed 30% of the net assets
o In a single real estate project cannot exceed 15% of the net assets
o Cannot exceed 25% of the issued capital of any unlisted company.
No real estate mutual fund scheme can invest more than 15% of its net assets in
equity shares or debentures of any unlisted company.
A real estate mutual fund scheme is not permitted to invest more than 25% of its net
assets in listed securities of its sponsor or associate or group company.
Real estate mutual funds are not permitted to invest in:
o Unlisted security of its sponsor or associate or group company.
o Listed security by way of private placement by its sponsor or associate or group
company.
Real estate mutual funds are not permitted to engage in lending or housing fnance
activity.
Real estate mutual funds cannot invest in real estate which was owned by its sponsor
or AMC or associates during last 5 years, or in which any of these parties enjoy
tenancy or lease rights.
The lease or rental arrangement on the real estate assets cannot go beyond the
maturity of the scheme.
Not more than 25% of the rental of a scheme can come from real estate assets let out
to its sponsor, or associates or group. The lease would need to be at market rates.
Real estate assets cannot be transferred between schemes.
2.6 International Investments
Indian mutual fund schemes are permitted to take exposure to the following international
investments:
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American Depository Receipts (ADRs) and Global Depository Receipts (GDRs) issued
by Indian or foreign companies
Equity of overseas companies listed on recognized stock exchanges overseas
Initial and follow on public offerings for listing at recognized stock exchanges
overseas
Government securities issued by countries that are rated not below investment
grade
Foreign debt securities (short term as well as long term with rating not below investment
grade by accredited/ registered credit rating agencies) in countries whose currencies
are fully convertible
Money Market Instruments rated not below investment grade
Repos in form of investment, where the counterparty is rated investment grade or
above. However, borrowing of funds through repos is not allowed
Derivatives traded on recognized stock exchanges overseas only for hedging and
portfolio balancing with securities as the underlying
Short term deposits with banks overseas where the issuer is rated not below investment
grade
Units / securities issued by overseas mutual funds or unit trusts, registered with
overseas regulators, that invest in:
o The above securities; or
o Real estate investment trusts (REITs) listed on recognized stock exchanges
overseas
o Unlisted overseas securities not more than 10% of the schemes net assets.
The mutual fund needs to appoint a dedicated Fund Manager for overseas investments
(other than for investment in units / mutual funds / unit trusts).
The mutual fund industry is permitted to invest up to USD 1bn, in overseas ETFs that
invest in securities. A single mutual fund cannot invest more than USD 50mn.
Points to remember
A scheme cannot invest more than 10% of its assets in a single companys shares or
share-related instruments. Exceptions are sector funds and index funds. The 10% limit
is applicable when the scheme invests.
Investment in unlisted shares is restricted as follows:
o Open-end schemes: 5% of Net Assets
o Close-ended schemes: 10% of Net Assets
16
Unlisted securities or securities issued through private placement by an associate or a
group company of the sponsor are not a permissible investment.
Mutual fund schemes cannot invest more than 25% of their net assets in listed securities
of group companies of the sponsor of the Asset Management Company.
All the schemes of a mutual fund put together cannot control more than 10% of the voting
power of any company.
Mutual fund schemes cannot charge management fees on their investment in other mutual
fund schemes (of the same asset management company or other asset management
companies). Such investment is also subject to a cap of 5% of net assets of the fund.
This is not applicable to fund of funds schemes.
Inter-scheme transfers of investments can only be at market value.
If any scheme of a mutual fund has invested in a company or its associates, which
together hold more than 5% of the net assets of any mutual fund scheme of that asset
management company, then that needs to be disclosed.
Investment and disinvestment are to be contracted directly in the name of the concerned
scheme. Transaction cannot be contracted in a general account and distributed across
schemes later.
Carry forward transactions are not permitted. But mutual funds can buy derivatives.
Writing of options is not permitted, though the fund can buy options.
Mutual funds are permitted to lend securities in accordance with SEBIs Stock Lending
Scheme.
Mutual fund schemes can invest in debt securities, but they cannot give loans.
A scheme cannot invest more than 15% of its net assets in debt instruments issued by a
single issuer. If prior approval of the boards of the Asset Management Company and the
Trustees is taken, then the limit can go up to 20%. If the paper is unrated, or rated below
investment grade, then a lower limit of 10% is applicable.
These limits are exempted for money market securities and government securities.
However, the exemption is not available for debt securities that are issued by public
bodies / institutions such as electricity boards, municipal corporations, state transport
corporations, etc. guaranteed by either state or central government.
Investment in unrated paper and paper below investment grade is subject to an overall
cap of 25% of net assets of the scheme.
Liquid funds can only invest in money market securities of upto 91 days maturity.
17
Short term deposits by mutual funds are governed by the following conditions:
o Not more than 15% of the net assets of the scheme can be placed in short term
deposits. With the permission of trustees, the limit can go up to 20%
o Short term deposits with associate and sponsor scheduled commercial banks together
cannot exceed 20% of the total short term deposits placed the mutual fund
o Not more than 10% of the net assets are to be placed in short term deposits of any
one scheduled bank including its subsidiaries
o The funds are not to be placed with a bank that has invested in that scheme
o The Asset Management Company cannot charge investment management and advisory
fee on such deposits placed by liquid and debt funds
Transactions in government securities are to be settled in demat form only
Inter-scheme transfers are to be effected at market value only
Unlisted securities or securities issued through private placement by an associate or a
group company of the sponsor are not a permissible investment.
Mutual fund schemes cannot invest more than 25% of their net assets in listed securities
of group companies of the sponsor of the Asset Management Company.
Mutual Funds are permitted to invest in fnancial derivatives traded in the stock exchange,
subject to disclosures in the Scheme Information Document. The following limits have
been stipulated by SEBI:
o Gross exposure through debt, equity and derivatives cannot exceed 100% of the
net assets of the scheme. The exposure in derivative transactions is calculated as
follows:
Long Future - Futures Price x Lot Size x Number of Contracts
Short Future - Futures Price x Lot Size x Number of Contracts
Option Bought - Option Premium Paid x Lot Size x Number of Contracts
In the exposure calculations, positions that are in the nature of a hedge are excluded.
o Mutual funds are not permitted to sell options or buy securities with embedded written
options.
The total exposure related to option premium paid cannot exceed 20% of the net assets
of the scheme.
Gold ETFs invest primarily in gold and gold-related instruments. Gold-related instruments
are defned to mean instruments that have gold as the underlying, and specifed by
SEBI.
18
Gold acquired by the gold exchange traded fund scheme that is not in the form of standard
bars, is to be assayed and converted into standard bars, which comply with the good
delivery norms of the London Bullion Market Association (LBMA).
Until the funds are deployed in gold, the fund may invest in short term deposits with
scheduled commercial banks.
The fund may also maintain liquidity, as disclosed in the offer document, to meet re-
purchase / redemption requirements.
Real estate mutual funds are permitted to invest in direct real estate assets, as well as
real estate securities.
Direct investment in real estate has to be in cities with population over a million.
Construction has to be complete and the asset should be usable. Project under construction
is not a permitted investment.
Similarly, investment cannot be made in vacant land, agricultural land, deserted property
or land reserved or attached by the government or any authority.
At least 75% of the net assets is to be invested in direct real estate, mortgage backed
securities and equity shares or debentures of companies engaged in dealing in real estate
assets or in undertaking real estate development projects.
At least 35% has to be invested in direct real estate.
The combined investment of all the schemes of a mutual fund:
o In a single city cannot exceed 30% of the net assets
o In a single real estate project cannot exceed 15% of the net assets
o Cannot exceed 25% of the issued capital of any unlisted company.
No real estate mutual fund scheme can invest more than 15% of its net assets in equity
shares or debentures of any unlisted company.
A real estate mutual fund scheme is not permitted to invest more than 25% of its net
assets in listed securities of its sponsor or associate or group company.
Real estate mutual funds are not permitted to invest in:
o Unlisted security of its sponsor or associate or group company.
o Listed security by way of private placement by its sponsor or associate or group
company.
Real estate mutual funds are not permitted to engage in lending or housing fnance
activity.
19
Real estate mutual funds cannot invest in real estate which was owned by its sponsor or
AMC or associates during last 5 years, or in which any of these parties enjoy tenancy or
lease rights.
The lease or rental arrangement on the real estate assets cannot go beyond the maturity
of the scheme.
Not more than 25% of the rental of a scheme can come from real estate assets let out to
its sponsor, or associates or group. The lease would need to be at market rates.
Real estate assets cannot be transferred between schemes.
Indian mutual funds are permitted to invest in ADRs, GDRs and Government securities
issued by countries that are rated not below investment grade.
They can also invest in foreign debt securities (short term as well as long term with rating
not below investment grade by accredited/ registered credit rating agencies) in countries
whose currencies are fully convertible, and in international mutual funds and REITs.
The mutual fund industry is permitted to invest up to USD 1bn, in overseas ETFs that
invest in securities. A single mutual fund cannot invest more than USD 50mn.
20
Chapter 4 : Novel Portfolio Structures in
Mutual Fund Schemes
The investor in any mutual fund scheme is buying into a portfolio of securities. The upsides
and downsides on that portfolio, and the expenses of running the scheme belong to the
investors.
In general, the fund manager has unfettered right to select securities for the scheme, subject
to limits that have been set in the scheme information document, and certain prudential limits
on holding of securities. These limits were discussed in Chapter [2].
Mutual funds come out with variations from the normal portfolio structure, to cater to unique
customer needs. Some of these are discussed below.
5.1 Index Funds
Every mutual fund scheme has to disclose its benchmark a standard against which the
schemes performance can be compared. For instance, diversifed equity funds use S&P
CNX Nifty as a benchmark. Equity schemes that propose to go beyond large cap companies
can opt for S&P CNX 500. CNX Midcap 100 can be considered for equity schemes that
invest mainly in mid cap companies. Similarly, there are sectoral indices for sector funds
and debt indices for debt funds.
Fund managers who operate on the mandate of beating the benchmark are said to run
active schemes or managed schemes. They seek to perform better than the benchmark.
Comparision of mutual performance with that of its benchmark is called relative performance
of schemes. Parameters for such quantitative evaluation of schemes are discussed in
Chapter [6].
The danger with active management is that the fund manager can also get beaten by
the benchmark. The fund manager seeks to beat the benchmark through superior stock
selection. But if the investment portfolio fares poorly, as compared to the benchmark,
then the relative performance suffers.
Active management also calls for higher investment in stock analysis. This is passed on to
the actively managed schemes through higher investment advisory fees.
Some investors are satisfed with the benchmark returns. However, buying all the shares
that go into the benchmark, in the same proportion as in the benchmark, requires large
investment. Retail investors may not be able to do this.
Alternatively, the investor can buy futures contracts on the benchmark. For instance, Nifty
Futures. But here again, the investment requirement is high. Further, futures are typically
21
short term products of upto 3 months maturity. A long term investor will need to keep
rolling over (close out the near month contract and buy the next month contract) the
futures contract at the end of its expiry.
Index schemes make it convenient for investors to take the benchmark exposure by
investing small amounts. For instance, the minimum investment amount is as low as Rs.
1,000 in some schemes. With such a low investment outlay, the investor is effectively
getting exposure to a basket of 50 stocks that represent the S&P CNX Nifty.
The index scheme maintains a portfolio that mirrors the index. That is how they ensure
that the performance of the index gets translated into the scheme. As will be seen in the
next chapter, index schemes have a Beta of 1.
Index schemes are also called passive schemes, because the fund manager does not do
stock selection. The stocks and their weightage in the scheme, depend on the composition
of the index that the scheme is replicating. This kind of investment behaviour is cheaper
for the mutual fund scheme to administer. Therefore, the investor in the passive scheme
also benefts through lower investment advisory fees.
5.2 Exchange Traded Funds (ETFs)
Despite its best efforts, the index scheme performance may not be perfectly in line with
the index. The gap in the performance between the index scheme and the index is called
tracking error. This is caused by several factors:
Timing differences
As discussed in NCFMs Workbook titled Securities Market (Advanced) Module, the
NAV at which investors are allotted units, depends on the time stamp on the investors
application and timing of receipt of funds. For example, an investor whose application
is received before 3 p.m. is allotted units at the closing NAV of the application date.
Although the units would have been allotted on the basis of the same days NAV, the
scheme itself will receive funds only after a couple of days. By the time the scheme
receives funds and invests, the market may have changed. If the market goes higher
at the time of investment, then the scheme performance suffers.
Liquidity
The S&P CNX Nifty only comprises 50 stocks. The scheme however invests in the
50 stocks, plus money in the bank. The liquidity needs of the scheme determine the
money it keeps in the bank. This portfolio difference from the Nifty causes a gap
between the scheme performance and index performance.
22
Costs
The index fund will charge investment advisory fees, albeit lower than in actively
managed schemes. Similarly, there are other costs like registrar fees, trustee fees,
brokerage etc.
Even if the mutual fund scheme somehow managed a perfect mirroring of the index,
its performance will be lower than the index on account of the cost and fees.
Another weakness of index schemes is that all the investors investing up to the cut-off
time will get units at the same NAV. There is no difference between a 10 am investor, a 12
noon investor or a 2 pm investor. The market however changes every micro second.
An investor, who is buying index schemes that are close-ended, may fnd its price in the
exchange changing in line with the market. But then, investors cannot be sure that they
will be able to trade. Liquidity is better for open-ended schemes, where investors can offer
their units for re-purchase or buy new units, any day, at NAV-based prices.
Exchange Traded Funds started as passive funds (investing as per an index), though
active ETFs have been launched abroad. In India, we only have passive ETFs. When the
scheme is launched, its connection with the index is announced. For instance, 500 ETF
units = 1 unit of S&P CNX Nifty.
ETFs are open-ended funds that can be bought at prices, which vary during the day, and
operate with low tracking error. They achieve this combination of features through their
unique structure as follows:
ETFs receive funds from investors only during the NFO. These are invested by the
date the scheme goes opens and declares its NAV. Post-NFO, the scheme does not
receive funds from investors, thus avoiding the investment timing problems normally
associated with index funds.
Being open-ended, they need to sell new units on a daily basis. Post-NFO, the ETF
only sells units against securities. Therefore, an investor who wants to buy ETF units
after the NFO needs to offer the requisite Nifty securities, in the same proportion as
the index.
Similarly, the scheme fulfls the need of daily re-purchase of its units, by releasing
the requisite Nifty securities. An investor who offers his units for re-purchase will
receive Nifty securities in the same proportion as the index - not funds. Therefore, the
scheme does not need to maintain liquid funds. This eliminates another reason for the
tracking error found in index schemes.
Smaller investors do not have the transaction size to receive and give the requisite
Nifty securities. The mutual fund lists the ETF units in the stock exchange, and appoints
identifed brokers as market makers to facilitate the transactions of small investors.
23
The market maker gives a two-way quote for the ETF units. Thus, investors know at what
price they can buy or sell the ETF units. As with any securities transaction in the stock
exchange, the ETF units are bought and sold by the market maker against funds. The
broker will also charge a brokerage for the transaction.
Such the market makers transactions with the investors do not go through the books of
the scheme, the scheme does not run into the timing differences and liquidity needs that
normal open-ended index funds face.
In order to trade in the above manner, the investor needs to have a demat account and
trading account with the broker.
Since the ratio between each unit and the index is frozen, the units are expected to trade
in the exchange on the basis of that intrinsic value. There are however occasions when,
on account of ignorance or lack of liquidity, ETFs are traded at prices that are signifcantly
different from their intrinsic value. Buying ETF units at higher than their intrinsic worth is
not advisable.
5.3 Arbitrage Funds
In an arbitrage, the investor takes opposite positions in two transactions. The net effect is
that no new position is created, but a spread is earned on the difference between the two
transactions.
For instance, shares of a company may be bought in the cash market, and futures (with
underlying as the same number of shares on the same company) are sold. The cash and
futures positions balance each other.
Normally, the futures price would be higher than the cash price. The difference in prices
is the riskless proft earned from the arbitrage. The difference tends to capture the cost
of funds for the period of the contract, though at times it may be higher or lower than the
funding cost. In periods of extreme volatility, the futures price can be much higher than
the cash price for the same underlying.
Arbitrage funds focus on such arbitrage transactions. The returns are closer to liquid
funds, which capture the short term funding cost in the market. It can be higher in volatile
market conditions.
As will be seen in Chapter 11, equity funds are more tax effcient than debt funds. The
interesting aspect of arbitrage funds is that the return profle is closer to a debt fund.
On account of the compensating positions taken, the market risk is negligible lesser
than in a normal debt fund. Yet, they offer the tax effciency of equity funds, because the
positions taken are in the equity market.
24
5.4 Monthly Income Plans (MIP)
Monthly Income Plans maintain a portfolio that is debt-oriented. Equity component is as
low as 15-20%. The high debt component, with its daily interest accrual, balances the
volatility risks on the low equity component. The nature of equity and debt investments
made is also safer in MIP. With such a portfolio structure, the MIP hopes to pay a monthly
income to investors.
Mutual fund schemes offer income to investors through declaration of dividend. As discussed
in the previous chapter, dividend can only be declared if the scheme has distributable
reserves. There are occasions where on account of signifcant decreases in MTM valuation,
the scheme will not have the distributable reserves to distribute a dividend. Portfolio
losses may be higher than the income accrual. In such cases, the scheme cannot declare
a dividend. Therefore, investor needs to be clear that there is no guarantee regarding the
monthly income.
The MIP portfolio, with low allocation to equity, is appropriate for most risk averse investors.
They need to take exposure to equity to protect themselves against infation. The MIP
portfolio with its relatively low NAV volatility is appropriate for such investors.
However, MIP is not appropriate for investors who depend on the monthly income to
meet their regular expenses. Such investors should rely on safer investments (like Post
Offce Monthly Income Scheme) that assure a monthly income to meet their monthly
expenses.
5.5 Fixed Maturity Plans (FMP)
A major risk in debt investments is the price risk arising out of changes in yields in
the market. As discussed in the next chapter, Weighted Average Maturity and Modifed
Duration are measures of this risk.
This price risk is a market phenomenon. Until maturity, debt securities trade in the market
at prices that fuctuate with interest rates. However, on maturity, the issuer redeems the
instrument at the agreed value. The redemption amount, which is paid by the issuer, is
not a function of the market. The only uncertainty is the one created by credit risk. Will
the issuer be able to pay the redemption amount?
Thus, on maturity of a debt instrument, the market risk is no longer a factor. A scheme
that invests all its moneys for the same maturity as the schemes own maturity will thus
be able to eliminate the market risk on maturity. FMPs are structured in this manner.
FMPs are close-ended scheme. Their Scheme Information Document will not only mention
the maturity of the scheme, but also the credit rating of the instruments it will invest in.
Suppose, an FMP is offered for 3 years, and it proposes to invest in only AAA securities. If
25
AAA companies are paying 9% on 3-year securities, and the expense ratio of the scheme
is indicated to be 0.5%, then the investor can expect a return of 9% minus 0.5% i.e.
8.5% from the 3-year FMP. This is not a guaranteed return, but an indicative return that
the investor can expect.
The point to note is that until maturity, the scheme has a market risk. Therefore its NAV
can fuctuate. An FMP investor selling the units before maturity can earn a return higher
or lower than the indicative return.
5.6 Capital Protection Oriented Schemes
Like MIPs and other hybrid funds, Capital Protection Oriented Schemes too, invest in a mix
of debt and equity securities. However, the investment philosophy here is different. The
portfolio of capital protection oriented schemes is structured to ensure that the investor
at least gets back the capital invested.
These schemes are offered as close-ended schemes. Suppose a capital protection oriented
scheme of 7 years is offered to investors. If yields on government securities of the same
maturity are 8%, then Rs. 58.35 invested today in government securities will grow to Rs.
100 in 7 years.
The mutual fund scheme will therefore allocate 58.35% of the amount collected from
investors, to government securities. Sovereign securities do not have a credit risk and
market risk too is eliminated by matching the schemes maturity with its investment
maturity. Thus, the scheme is in a position to assure investors that they will at least get
their capital back at the end of 7 years.
The remaining 41.65% of the investors moneys is invested in risky investments like
equity. In the worst case, these investments lose their entire value. In such an eventuality,
the investor will get only the capital back (through redemption of underlying government
securities).
Realistically, the risky investments too will have some realisable value. Thus, the investor
gets the capital back, with some additional return.
Such schemes are suitable for investors who want to take some exposure to equity, but
without any risk of losing the principal invested.
Points to remember
Every mutual fund scheme has to disclose its benchmark a standard against which the
schemes performance can be compared.
Fund managers who operate on the mandate of beating the benchmark are said to run
active schemes or managed schemes. They seek to perform better than the benchmark.
26
Comparision of mutual performance with that of its benchmark is called relative performance
of schemes.
The index scheme maintains a portfolio that mirrors the index. Index schemes have a
Beta of 1.
Index schemes are also called passive schemes, because the fund manager does not
do stock selection. The investor in a passive scheme benefts through lower investment
advisory fees.
The gap in the performance between the index scheme and the index is called tracking
error. It is caused by
o Timing differences
o Liquidity
o Cost
Exchange Traded Funds started as passive funds (investing as per an index), though
active ETFs have been launched abroad. In India, we only have passive ETFs.
When the scheme is launched, its connection with the index is announced. For instance,
500 ETF units = 1 unit of S&P CNX Nifty.
ETFs are open-ended funds that can be bought at prices, which vary during the day, and
operate with low tracking error.
ETFs receive funds from investors only during the NFO. Post-NFO, the scheme does not
receive funds from investors, thus avoiding the investment timing problems normally
associated with index funds.
Post-NFO, the ETF only sells units against securities. Therefore, an investor who wants
to buy ETF units after the NFO needs to offer the requisite Nifty securities, in the same
proportion as the index.
Similarly, the scheme fulfls the need of daily re-purchase of its units, by releasing the
requisite Nifty securities. An investor who offers his units for re-purchase will receive Nifty
securities in the same proportion as the index - not funds. Therefore, the scheme does not
need to maintain liquid funds. This eliminates another reason for the tracking error found
in index schemes.
The mutual fund lists the ETF units in the stock exchange, and appoints identifed brokers
as market makers to facilitate the transactions of small investors. The market maker
gives a two-way quote for the ETF units.
Such the market makers transactions with the investors do not go through the books of
the scheme, the scheme does not run into the timing differences and liquidity needs that
27
normal open-ended index funds face. In order to trade in this manner, the investor needs
to have a demat account and trading account with the broker.
The returns in a arbitrage fund are closer to liquid funds, which capture the short term
funding cost in the market. It can be higher in volatile market conditions.
Although arbitrage funds have the returns profle of a debt fund, and are low in risk, they
are taxed as equity funds.
Monthly Income Plans maintain a portfolio that is debt-oriented. Equity component is as
low as 15-20%.
There are occasions where on account of signifcant decreases in MTM valuation, the
scheme will not have the distributable reserves to distribute a dividend. Therefore, investor
needs to be clear that there is no guarantee regarding the monthly income.
FMP invests all its moneys for the same maturity as the schemes own maturity. Thus,
price risk is eliminated on maturity.
FMP is a close-ended scheme. Return is not guaranteed, but investor can operate with an
indicative yield based on yields in the market and the expense ratio of the scheme.
An FMP investor selling the units before maturity can earn a return higher or lower than
the indicative return.
Capital Protection Oriented Schemes invest in a mix of debt and equity securities. They
are offered as close-ended schemes.
28
9. Scheme Selection
Learning Points
You are reading this Workbook because you would like to
choose between the hundreds of schemes available in the
market. This unit will help you do this. It also informs you about
the sources where you can easily access data related to mutual
fund schemes.
It is considered a good practice to first understand the risk
exposure that is appropriate for an investor (through a risk profiler,
which is discussed in Unit 12). Based on that, decide how the
investors investments should be distributed between different
asset classes (asset allocation, which is discussed in Unit 12).
Mutual funds are a vehicle that helps an investor take exposure to
asset classes, such as equity, debt, gold and real estate. The
benefits of mutual funds and various kinds of schemes were
discussed in Unit 1. How does an investor select between the
various schemes? Broadly, this flows from the asset allocation.
Equity funds will help in equity exposure; gold funds will help in
gold exposure etc.

29
As a structured approach, the sequence of decision making is as
follows:
Step 1 Deciding on the scheme category
Step 2 Selecting a scheme within the category
Step 3 Selecting the right option within the scheme
9.1 How to choose between Scheme Categories?
The risk and return drivers for various categories of schemes was
discussed in the previous unit. Risk levels, especially across
categories, are subjective.
Yet, as a learning-aid, a pictorial representation of the risk
hierarchy of different schemes follows:

30
Risk Level Debt Funds Hybrid Funds Equity Funds
High
Sector Funds
Bal anced Funds
based on Fl exi bl e
Asset Al l ocati on
Growth Funds
Hi gh Yi el d Debt
Funds
Di versfi ed Equi ty
Funds
Index Funds
Val ue Funds
Equi ty Income
Funds / Di vi dend
Yi el d Funds
Bal anced Funds
based on Fi xed
Asset Al l ocati on
Monthl y Income
Pl ans
Capi tal Protecti on
Ori ented Funds
Di versi fi ed Debt
Funds
Gi l t Funds
Low
Money Market
Funds / Li qui d
Schemes
31
While deciding between schemes to invest in, a few principles to
keep in mind:
9.1.1 Equity Funds
While investing in equity funds, a principle to internalize is that
markets are more predictable in the long term, than in the short
term. So, it is better to consider equity funds, when the investment
horizon is adequately long.
How long is long? Investing in equities with a horizon below 2
years can be dangerous. Ideally, the investor should look at 3
years. With an investment horizon of 5 years and above, the
probability of losing money in equities is negligible. Chances are
that within this 5 year horizon, the investor will have at least one
window of opportunity, to sell the equity investments for an
attractive return.
The role of various broad equity scheme categories in an
investors portfolio is as follows:
Active or Passive
As seen in Unit 1, index funds are passive funds. They are
expected to offer a return in line with the market. An investor in an
active fund is bearing a higher cost for the fund management, and
a higher risk. Therefore, the returns ought to be higher i.e. the
scheme should beat the benchmark, to make the investor believe
that choice of active scheme was right. This, in no way, means
that the higher return that ought to happen, will happen. Hence,
the risk in such investments.

32
Investors who are more interested in the more modest objective of
having an equity growth component in their portfolio, rather than
the more aggressive objective of beating the equity market
benchmark, would be better off investing in an index fund. This
again does not mean that the NAV of an index fund will not decline
in value. If the bench mark index goes down, then the NAV of the
index fund too will go down. However, as suggested earlier, if the
investor has a long enough horizon, then his investment will do
well, in line with the overall market.
Several pension funds are limited by their charter, to take equity
exposures only through index funds.
Open-ended or Close-ended
The significant benefit that open-ended funds offer is liquidity viz.
the option of getting back the current value of the unit-holding from
the scheme.
A close-ended scheme offers liquidity through a listing in a stock
exchange. Unfortunately, mutual fund units are not that actively
traded in the market. A holder of units in a close-ended scheme
will need a counter-party in the stock exchange in order to be able
to sell his units and recover its value.
The price of units of a closed-end scheme in the stock exchange
tends to be lower than the NAV. There is no limit to this discount.
Only towards the maturity of the scheme, the market price
converges towards the NAV.
33
In the case of an open-ended scheme, the unit will be bought back
by the scheme at the NAV less Exit Load. SEBI legislations
prescribe a maximum exit load of 7%; in practice, it was rarely
above 5%, which too was applicable only if investors exited from
the scheme within a year of investment. Whatever the exit load
percentage, it is known when the investor makes his investment in
the scheme.
In order to provide this liquidity facility to investors, open-ended
schemes maintain a part of their portfolio in liquid assets. The
liquid assets component in the portfolio of an equity fund can dilute
the returns that would otherwise have been earned in the equity
market.
Open-end schemes are also subject to the risk of large fluctuations
in net assets, on account of heavy sales or re-purchases. This can
put pressure on the fund manager in maintaining the investment
portfolio.
Diversified, Sector or Thematic
The critical difference between the two is that the multi-sector
exposure in a diversified fund makes it less risky. Further, in an
actively managed diversified fund, the fund manager performs the
role of ensuring higher exposure to the better performing sectors.
An investor, investing or taking money out of a sector fund has
effectively taken up the role of making the sector choices.
Diversified funds should be part of the core portfolio of every
investor. Investors who are comfortable with risk can invest in

34
sector funds. Further, an investor should have the skill to make
the right sector choices, before venturing into sector funds.
Some investors are more comfortable identifying promising
investment themes (for example, infrastructure), rather than
specific sectors (like cement, steel etc.). Such investors can
decide on investment themes they would like to buy.
At any point of time, an investor in sector funds should have
exposure to not more than 3 - 5 different sectors. Investing in
more sectors than that, would amount to having a diversified
portfolio of sector funds. The investor can save a lot of time by
investing in a diversified fund instead!
Large-cap v/s Mid-cap / Small Cap Funds
When industry scenario is difficult, the resource strengths of large-
cap front-line stocks help them survive; many mid-cap / small cap
companies fall by the way side during economic turmoil, because
they lack the resources to survive. It can therefore be risky to
invest in mid-cap / small cap funds during periods of economic
turmoil.
As the economy recovers, and investors start investing in the
market, the valuations in front-line stocks turn expensive. At this
stage, the mid-cap / small cap funds offer attractive investment
opportunities.
Over a long period of time, some of the mid-cap and small-cap
companies will become large companies, whose stocks get re-
rated in the market. The healthy returns on such stocks can boost
the returns on mid-cap and small-cap portfolios.
35
Growth or Value funds
As seen in the previous unit, in the initial phases of a bull run,
growth funds tend to offer good returns. Over a period of time, as
the growth stocks get fully valued, value funds tend to perform
better. Investments in value funds yield benefits over longer
holding periods.
In a market correction, the Growth funds can decline much more
than value funds.
Fund Size
The size of funds needs to be seen in the context of the proposed
investment universe. Thus, a sector fund with net assets of Rs
1,000 crore, is likely to find investment challenging if the all the
companies in the sector together are worth only about Rs 10,000
crore. On the other hand, too small a fund size means that the
scheme will not benefit from economies of scale.
Portfolio Turnover
Purchase and sale of securities entails broking costs for the
scheme. Frequent churning of the portfolio would not only add to
the broking costs, but also be indicative of unsteady investment
management.
Portfolio Turnover Ratio is calculated as Value of Purchase and
Sale of Securities during a period divided by the average size of
net assets of the scheme during the period. Thus, if the sale and
purchase transactions amounted to Rs 10,000 crore, and the

36
average size of net assets is Rs 5,000 crore, then the portfolio
turnover ratio is Rs 10,000 cr Rs 5,000 cr i.e. 200%. This means
that investments are held in the portfolio, on an average for 12
months 2 i.e. 6 months.
The portfolio turnover needs to be viewed in the light of the
investment style. 6 month holding period may be too short for a
value investment style, but perfectly acceptable for a scheme that
wants to benefit from shifts in momentum in pivotal.
Arbitrage funds
These are not meant for equity risk exposure, but to lock into a
better risk-return relationship than liquid funds and ride on the
tax benefits that equity schemes offer.
Domestic Equity v/s International Equity funds
When an Indian investor invests in equities abroad, he is
essentially taking two exposures:
An exposure on the international equity market
An exposure to the exchange rate of the rupee. If the investor
invests in the US, and the US Dollar becomes stronger during
the period of his investment, he benefits; if the US Dollar
weakens (i.e. Rupee becomes stronger), he loses.
Investors might consider investing abroad, for any of the following
reasons:

37
He feels that the overall returns (international equity +
exchange rate movement)will be attractive
He is taking an asset allocation call of diversifying his
investments to reduce the risk.
9.1.2 Debt Funds
Debts funds are less risky than equity funds for the reasons
discussed in the previous unit.
These can be structured in various ways to meet useful investor
needs. Some of these structures, and their benefits to investors
were discussed in Unit 1. The risks in these structures, as
discussed in the previous unit, need to be understood.
Regular Debt Funds v/s MIPs
MIP has an element of equity in its portfolio. Investors who do not
wish to take any equity exposure, should opt for a regular debt
fund.
Open-end Funds v/s FMP
FMP is ideal when the investors investment horizon is in synch
with the maturity of the scheme, and the investor is looking for a
predictable return that is superior to what is available in a fixed
deposit. The portfolio risk discussed in the previous unit needs to
be considered too.
An investor who is likely to require the funds anytime, would be
better off investing in a normal open-ended debt fund.

38
Gilt Funds v/s Diversified Debt Funds
Diversified debt funds invest in a mix of government securities
(which are safer) and non-government securities (which offer
higher yields, but are subject to credit risk). A diversified mutual
fund scheme that manages its credit risk well can generate
superior returns, as compared to a Gilt Fund.
Long-Term Debt Fund v/s Short Term Debt Fund
As discussed in the previous unit, longer term debt securities
fluctuate more than shorter term debt securities. Therefore, NAVs
of long-term debt funds tend to be more volatile than those of
short-term debt funds.
It was also seen that as yields in the market goes down, debt
securities gain in value. Therefore, long term debt funds would be
sensible in declining interest rate scenarios. However, if it is
expected that interest rates in the market would go up, it would be
safer to go with Short Term Debt Funds.
Money Market Funds / Liquid Schemes
An investor seeking the lowest risk ought to go for a liquid scheme.
However, the returns in such instruments are lower. The
comparable for a liquid scheme in the case of retail investors is a
savings bank account. Switching some of the savings bank
deposits into liquid schemes can improve the returns for him.
Businesses, which in any case do not earn a return on their current
account, can transfer some of the surpluses to liquid schemes.

39
Just as it is not advisable to keep all of ones moneys in a savings
bank account some money needs to go into fixed deposits in
order to improve returns similarly, all of ones mutual fund
investments should not be in liquid schemes. Hence there is a
need to invest in other debt schemes and also equity schemes.
Schemes that are named liquid plus are not more liquid. These
are like the Short Term Funds discussed earlier. They try to earn a
higher return by investing in securities of a longer tenor than the
regular liquid schemes. As the tenor increases, risk too increases.
In order to prevent potential mis-selling, SEBI has now disallowed
the use of the term liquid plus as a fund type.
Regular Debt Funds v/s Floaters
Regular debt funds are subject to the risk of fluctuations in NAV.
Since floating rate debt securities tend to hold their values, even if
interest rates fluctuate, the NAV of floaters tend to be steady.
When the interest rate scenario is unclear, then floaters are a safer
option. Similarly, in rising interest rate environments, floaters can
be considered as an alternative to short term debt funds and liquid
funds.
9.1.3 Balanced Schemes
The discussion on asset allocation brought out the benefit of
diversifying the investment portfolio across asset classes. An
investor desirous of having a mix of debt and equity exposures has
two options
He can invest in a mix of equity schemes and debt schemes

40
He can invest in a balanced scheme, which in turn invests in a
mix of equity and debt securities.
The first option obviously implies more decisions on scheme
selection that the investor would need to take. But the benefit is
that the investor has a wide array of scheme options, within both
equity and debt scheme categories. Further, the investor would be
in a position to work towards a mix of debt and equity that is most
appropriate for him.
Investing in a balanced scheme makes things simpler for the
investor, because fewer scheme selection decisions need to be
taken. However, the investor would need to go by the debt-equity
mix in the investment portfolio of the schemes.
Investors need to be cautious of the high risk potential of a variant
of balanced schemes that are structured as flexible asset
allocation schemes.
Further, balanced schemes may be taxed as a debt scheme or an
equity scheme depending on the schemes investment portfolio.
The two categories of schemes have completely different tax
implications, as was discussed in Unit 6.
9.1.4 Gold Funds
Investors need to differentiate between Gold ETF and Gold Sector
Funds. The latter are schemes that invest in shares of gold mining
and other gold processing companies. The performance of these
gold sector funds is linked to the profitability and gold reserves of
these gold companies unlike Gold ETFs whose performance

41
would track the price of gold. When gold metal prices go up, gold
mining companies with large reserves of gold can appreciate a lot
more than the gold metal. Conversely, they can also fall more
when gold metal prices decline.
Investors therefore need to understand the structure of the gold
schemes more closely, before investing.
9.1.5 Other Funds
As per mutual fund regulations, debt, equity, gold and real estate
are the only asset classes permitted for investment. More
categories might come up in future. Or some foreign schemes
with other asset class exposures might be permitted. The
discussion in the previous unit on risks in gold and real estate
funds are a useful primer on the kinds of issues to explore in any
new category of mutual fund schemes.
9.2 How to select a Scheme within a Scheme Category?
All the 35+ AMCs that are permitted to do business in India, meet
the minimum eligibility criteria set by law. Different AMCs have
different approaches, styles and value systems in doing business.
An investor has to be comfortable with the AMC, before investing
in any of its schemes.
An investor buying into a scheme is essentially buying into its
portfolio. Most AMCs share the portfolio of all their schemes in
their website on a monthly basis.

42
Equity investors would like to convince themselves that the sectors
and companies where the scheme has taken higher exposure, are
sectors / companies that are indeed promising.
Long-term watchers of mutual fund performance also develop
views on AMCs/ Fund Managers that are more prescient in
identifying changes in market trends.
Experienced researchers can also identify how true the fund
manager is, to the promised investment style. A large proportion
of fully-valued front-line stocks in the portfolio of a value fund is
indicative of the fund manager not being true to the promised
investment style. Debt investors would ensure that the weighted
average maturity of the portfolio is in line with their view on interest
rates viz. Higher weighted average maturity during periods of
declining interest rates; lower weighted average maturity, and
higher exposure to floating rate instruments during periods of rising
interest rates.
Investors in non-gilt debt schemes will keep an eye on credit
quality of the portfolio and watch out for sector concentration in
the portfolio, even if the securities have a high credit rating.
Some other parameters that are considered while selecting
schemes within a category, are as follows:
Fund Age
A fund with a long history has a track record that can be studied.
A new fund managed by a portfolio manager with a lackluster
track-record is definitely avoidable.

43
Fund age is especially important for equity schemes, where there
are more investment options, and divergence in performance of
schemes within the same category tends to be more.
Scheme running expenses
Any cost is a drag on investors returns. Investors need to be
particularly careful about the cost structure of debt schemes,
because in the normal course, debt returns can be much lower
than equity schemes. Similarly, since index funds follow a passive
investment strategy, a high cost structure is questionable in such
schemes.
Tracking Error
Amongst index schemes, tracking error is a basis to select the
better scheme. Lower the tracking error, the better it is. Similarly,
Gold ETFs need to be selected based on how well they track gold
prices.
Regular Income Yield in Portfolio
Schemes income comes out of regular income (dividend income
in equity portfolio, interest income in debt portfolio) and capital
gains. Regular incomes are seen as a more stable source of
income than capital gains. Therefore, a high regular income yield
is a strong positive for a scheme.
Risk, return and risk-adjusted returns as parameters to evaluate
schemes were discussed in the previous unit. These form the
basis for mutual fund research agencies to assign a rank to the
performance of each scheme within a scheme category (ranking).

44
Some of these analyses cluster the schemes within a category into
groups, based on well-defined performance traits (rating).
Every agency has its distinctive methodology for ranking / rating,
which are detailed in their websites. Investors should understand
the broad parameters, before taking decisions based on the
ranking / rating of any agency.
Some research agencies follow a star system for the rating. Thus,
a 5-star scheme is better than a 4-star scheme; 4-star scheme is
better than 3-star, and so on and so forth.
Quarterly performance ranking of schemes over a period of time
shows that the best ranking fund in a quarter is not necessarily the
best ranking fund in the next quarter. Therefore, seeking to be
invested in the best fund in every category in every quarter is
neither an ideal objective, nor a feasible target proposition.
Indeed, the costs associated with switching between schemes are
likely to severely impact the investors returns.
The investor should therefore aim to stay invested in schemes that
are in the top few in their category on a consistent basis. The
few could mean 3 to 5, in categories that have few schemes; or
the top 10-15%, in categories where there are more schemes.
Investors need to bear in mind that these rankings and categories
are based on historical performance, which may or may not be
repeated in future.
The investor also needs to remember that beyond performance of
the scheme, loads make a difference to the investors return.

45
9.3 Which is the Better Option within a Scheme?
The underlying returns in a scheme, arising out of its portfolio and
cost economics, is what is available for investors in its various
options viz. Dividend payout, dividend re-investment and growth
options.
Dividend payout option has the benefit of money flow to the
investor; growth option has the benefit of letting the money grow in
the fund on gross basis (i.e. without annual taxation). Dividend re-
investment option neither gives the cash flows nor allows the
money to grow in the fund on gross basis.
Re-purchase transactions are treated as a sale of units by the
investor. Therefore, there can be an element of capital gain (or
capital loss), if the re-purchase price is higher (or lower) than the
cost of acquiring those units. Some investors may like to book
such a capital gain (or capital loss) to set it off against some other
capital loss (or capital gain), where such set off is permitted. The
broad set off rules, including the differential treatment of long term
and short term, were discussed in Unit 6.
Re-purchase transactions in equity schemes are subject to STT.
Further, there is no dividend distribution tax on equity schemes.
Therefore, subject to the set-off benefit that some investors might
seek, it is better to receive moneys in an equity scheme in the form
of dividend, rather than re-purchase of units.
The dividend payout option seems attractive for investors wanting
a regular income. It should however be kept in mind that even in a

46
Monthly Income Plan, dividend declaration is a function of
distributable surplus. If there is no surplus to distribute, dividend
cannot be declared. Therefore, the need for regular income is
better met through a SWP for the requisite amount. {Sale of units
under an SWP may have STT implication (equity schemes) and
capital gains tax implication (equity and debt schemes)}.
Dividend flows in a debt scheme come with the associated
dividend distribution tax, which reduces the NAV. Thus, the
investor is effectively bearing the cost of the dividend distribution
tax, although it might be paid by the scheme to the income tax
authorities. This cost might be fine for an investor in the high tax
bracket, because the impact of the distribution tax would be lower
than his marginal rate of taxation (which comes into play for
taxation, if the investment is held for less than a year). But for a
pensioner with no taxable income, or whose marginal rate of
taxation is lower, it is meaningless to bear the cost of distribution
tax. As seen earlier, SWP can take care of any need for a regular
income and there is no dividend distribution tax on the
repurchase proceeds. The capital gains tax impact however,
would need to be checked.
Thus, taxation and liquidity needs are a factor in deciding between
the options. The advisor needs to understand the investors
situation before advising.

47
9.4 Sources of Data to track Mutual Fund Performance
It would now be evident to the reader, that mutual fund
performance reviews are data intensive. An investor seeking to do
the research by collecting daily NAV and dividend declaration
information from the newspapers can find it frustratingly time
consuming.
Fortunately, ready-made solutions are available in the market.
Many AMCs, distribution houses and mutual fund research houses
offer free tools in their website. Using these, the performance of
schemes, their ranking, rating etc. and comparison of performance
between specific schemes, is easy to ascertain.
Investors, who wish to access the raw data of NAVs, dividends etc.
in a systematic manner and distributors who wish to integrate
such information into their investor-management systems and
processes can subscribe to the data from these vendors. Based
on the subscription, data updates can be easily downloaded every
day through the internet.
The mix of free and paid content is subject to change. The
following are some of the agencies that are active in this field:
Credence Analytics (www.credenceanalytics.com)
CRISIL (www.crisil.com)
Lipper (www.lipperweb.com)

48
Morning Star (www.morningstar.com)
Value Research (www.valueresearchonline.com)
The listing of websites is only a piece of information for the reader.
Users need to convince themselves before subscribing to, or using
any of this information. Neither SEBI nor NISM nor the author
certifies the data or information or tools that these agencies offer.
49
Checklist of Learning Points
Asset allocation is the approach of spreading ones investments
between multiple asset classes to diversify the underlying risk.
The sequence of decision making in selecting a scheme is: Step 1
Deciding on the scheme category (based on asset allocation);
Step 2 Selecting a scheme within the category; Step 3
Selecting the right option within the scheme.
While investing in equity funds, a principle to internalize is that
markets are more predictable in the long term, than in the short
term. So, it is better to consider equity funds, when the investment
horizon is adequately long.
In an actively managed diversified fund, the fund manager
performs the role of ensuring higher exposure to the better
performing sectors or stocks. An investor, investing or taking
money out of a sector fund has effectively taken up the role of
making the sector choices.
It can be risky to invest in mid-cap / small cap funds during periods
of economic turmoil. As the economy recovers, and investors start
investing in the market, the valuations in front-line stocks turn
expensive. At this stage, the mid-cap / small cap funds offer
attractive investment opportunities. Over longer periods, some of
the mid/small cap companies have the potential to become large-
cap companies thus rewarding investors.
Arbitrage funds are not meant for equity risk exposure, but to lock
into a better risk-return relationship than liquid funds and ride on
the tax benefits that equity schemes offer.
The comparable for a liquid scheme in the case of retail investors
is a savings bank account. Switching some of the savings bank
deposits into liquid schemes can improve the returns for him.
Businesses, which in any case do not earn a return on their current
account, can transfer some of the surpluses to liquid schemes.

50
Balanced schemes offer the benefit of diversity of asset classes
within the scheme. A single investment gives exposure to both
debt and equity.
Investors need to understand the structure of the gold schemes
more closely, before investing.
Equity investors would like to convince themselves that the sectors
and companies where the scheme has taken higher exposure, are
sectors / companies that are indeed promising.
Debt investors would ensure that the weighted average maturity of
the portfolio is in line with their view on interest rates.
Investors in non-gilt debt schemes will keep an eye on credit
quality of the portfolio and watch out for sector concentration in
the portfolio, even if the securities have a high credit rating.
Any cost is a drag on investors returns. Investors need to be
particularly careful about the cost structure of debt schemes.
Amongst index schemes, tracking error is a basis to select the
better scheme. Lower the tracking error, the better it is. Similarly,
Gold ETFs need to be selected based on how well they track gold
prices.
Mutual fund research agencies assign a rank to the performance
of each scheme within a scheme category (ranking). Some of
these analyses cluster the schemes within a category into groups,
based on well-defined performance traits (rating).
Seeking to be invested in the best fund in every category in every
quarter is neither an ideal objective, nor a feasible target
proposition. Indeed, the costs associated with switching between
schemes are likely to severely impact the investors returns.
The underlying returns in a scheme, arising out of its portfolio and
cost economics, is what is available for investors in its various
options viz. Dividend payout, dividend re-investment and growth
options.
Dividend payout option has the benefit of money flow to the
investor; growth option has the benefit of letting the money grow in
the fund on gross basis (i.e. without annual taxation). Dividend re-

51
investment option neither gives the cash flows nor allows the
money to grow in the fund on gross basis. Taxation and liquidity
needs are a factor in deciding between the options. The advisor
needs to understand the investors situation before advising.
Many AMCs, distribution houses and mutual fund research houses
offer free tools in their website to help understand performance of
schemes.
52
10. Selecting the Right Investment Products for Investors
Learning Objectives
Investors tend to block their money in physical assets. This unit
compares physical assets with financial assets.
Distributors and financial advisors perform an invaluable role in
helping investors decide on investment products. Mutual fund
schemes are just one of the various alternatives that investors
consider for investment. This unit discusses some of these
alternatives in the context of mutual fund schemes.
Since the focus of this Workbook is on mutual funds, the
discussion on other investment products is illustrative, not
exhaustive.
10.1 Financial and Physical Assets
10.1.1 The Concept
An investor who buys land, building, a painting or gold can touch
and feel them. The investor can choose to build a house in the
land, stay in the building, display the painting and make jewellery
out of the gold. Such assets are called physical assets. Similarly,
a company buying plant and machinery is buying physical assets.
Physical assets have value and can be touched, felt and used.

53
An investor who buys shares in a company is entitled to the
benefits of the shareholding but this entitlement cannot be
touched or felt. The paper on which the share certificate is printed
can be touched and felt, but that paper is only evidence supporting
the benefit that the investor is entitled to. The benefit itself is
intangible. Such assets are called financial assets. Financial
assets have value, but cannot be touched, felt or used as part of
their core value.
Shares, debentures, fixed deposits, bank accounts and mutual
fund schemes are all examples of financial assets that investors
normally invest in. Their value is not in the paper or receipt on
which they are printed, but in what they are entitled to viz. a share
in the fortunes of the company (share), an amount repayable on a
future date (debenture or fixed deposit), an amount that you can
withdraw any time (bank account) or a share in the fortunes of a
portfolio (mutual fund scheme).
10.1.2 The Implication
Comfort
The investor in a physical asset draws psychological comfort from
the fact that the asset is in the investors possession, or under the
investors control in a locker. Whatever may happen in the outside
world, the investor can still use the physical asset.
The value encashment in a financial asset, on the other hand, can
depend on the investee company. What if the company closes
down? What if the bank or mutual fund scheme goes bust? These
are issues that bother investors.

54
The difference in comfort is perhaps a reason why nearly half the
wealth of Indians is locked in physical assets.
Mutual fund schemes can offer a lot of comfort, in this regard, as
was discussed in Unit 3.
Unforeseen Events
The comfort of investors in physical assets is tempered by an
understanding of consequences of unforeseen events. A physical
asset is completely gone, or loses substantial value, when stolen,
or if there is a fire, flood or such other hazard. It is for this reason
that some owners of physical assets insure them against such
hazards.
Theft or fire or flood, have no impact on the entitlement of the
investor to a financial asset. The investor can always go the
investee organization i.e. company or bank or mutual fund where
the money is invested, and claim the entitlement, based on records
of the investee company and other documentary evidence.
Dematerialisation makes these processes a lot simpler.
Economic Context
Investors money in land, or gold does not benefit the economy.
On the other hand, money invested in financial assets can be
productive for the economy.
The money that the government mobilizes through issue of
government securities can go towards various productive
purposes.

55
The company, whose shares are bought, can invest the money in
a project, which can boost production, jobs and national income.
The bank where the bank account or fixed deposit is maintained
can lend the money to such productive activities, and thus help the
economy.
Similarly, mutual fund schemes that invest in securities issued by
companies are effectively assisting in building the nation and the
economy.
This explains the interest of the government in converting more
and more of the physical assets held by investors, into financial
assets. Recognising that comfort is a key factor that can boost the
conversion, a lot of importance is given to the regulation of the
banks and financial markets. Independent regulators like RBI and
SEBI therefore focus on creating the requisite policy framework,
and ensuring that participants in the market adhere to the policy.
Gold and real estate are two physical assets, where a significant
portion of investor wealth is blocked. The risk and return drivers
for these asset classes was discussed in Unit 8. Let us now
understand them in the context of format of holding - physical or
financial.

56
10.2 Gold Physical or Financial?
Gold suffers one of the highest risks of loss through theft. Storage
in bank lockers too costs money. The exposure to gold as a
financial asset can be taken in different forms:
Gold ETF was discussed in Units 1 and 8.
Gold Sector Fund was discussed in Units 1 and 8.
Gold futures contracts are traded in commodity exchanges like
the National Commodities Exchange (NCDEX) and Multi-
Commodity Exchange (MCX). The value of these contracts
goes up or down in line with increases or decreases in gold
prices.
When an investor buys a gold futures contract, the entire value of
the contract does not need to be paid. Only a percentage of the
contract value (margin) is to be paid immediately. Investors can
therefore take positions that are a multiple of what is otherwise
possible with the money at hand. This practice of taking larger
positions based on margin payments is called leveraging.
Let us consider an example.
Suppose gold can be bought at Rs 1,500 per gram. Purchase of
10 grams would cost Rs 15,000.
If it were possible to buy a gold futures contract at Rs 15,000 for
10 grams, the exchange would ask for a margin of, say, 5%. Initial
margin payable would be Rs 15,000 X 5% i.e. Rs 750.
57
Thus, with an initial outlay of merely Rs 750, the investor is able to
take a position worth Rs 15,000 in gold. Extending the logic
further, if the investor had Rs 15,000 to invest in gold futures, he
can take a position worth Rs 15,000 5% i.e. Rs 300,000.
(It may be noted that exchanges have their contract specifications
which set the minimum contract size).
Investors need to be cautious of the risks associated with
leveraging. In the above example, the investor took a position of
Rs 300,000, based on investment of Rs 15,000 in gold futures. A
10% decline in gold price would translate into a loss of Rs 30,000.
The investor needs to look at his ability to bear that loss not
merely consider how much exposure can be taken with the initial
investment.
Further, gold futures contracts have a limited contract period.
Thus, a 3-month gold futures contract will expire at the end of 3
months. An investor who wishes to continue his exposure will
therefore need to roll over the position effectively, enter into a
fresh contract. Every contract purchase has its associated costs.
Gold ETF on the other hand is an open-ended scheme with no
fixed maturity. It is very rare for an open-ended scheme to
liquidate itself early. Therefore, an investor who buys into a gold
ETF can hold the position indefinitely.
Gold deposit schemes are offered by some banks. This is like a
fixed deposit in gold. An investor depositing gold into a Gold
deposit scheme is given a receipt promising to pay back the same
quantity of gold (or its equivalent value) on maturity. During the
58
period of deposit, interest is paid at regular intervals, as in the case
of a regular fixed deposit, but calculated as a pre-specified
percentage on the value of the gold deposited.
An investor contemplating whether to invest in gold in physical
form or financial, needs to note that:
Wealth Tax is applicable on gold holding (beyond the jewellery
meant for personal use). However, mutual fund schemes (gold
linked or otherwise) and gold deposit schemes are exempted from
Wealth Tax.
Mutual fund schemes and deposit schemes offer the facility of
appointing nominees who will be entitled to the proceeds in the
event of death of the depositor / investor. Gold in physical form
does not offer this facility.
10.3 Real Estate Physical or Financial?
Besides the risk of loss on account of fire and other hazards, real
estate in physical form is prone to a few more disadvantages:
The ticket size i.e. the minimum amount required for investing
in real estate is high. The investment would run into lakhs of
rupees, even to buy agricultural land.
Unless the budget is very high, and the value of properties
bought are very low, investors would find it difficult to maintain

59
a diverse portfolio of real estate. Thus, they end up with
concentration risk.
Once purchased, vacant land can be encroached upon by
others. Therefore, unless properly guarded and secured, one
can lose control and ownership of real estate, especially vacant
land.
Real estate is an illiquid market. Investment in financial assets
as well as gold can be converted into money quickly and
conveniently within a few days at a transparent price. Since
real estate is not a standardized product, there is no
transparent price and deals can take a long time to execute.
Once a deal is executed, the transaction costs, such as stamp
duty and registration charges, are also high. At times, these
regulatory processes are also non-transparent and
cumbersome.
When property is let out, there is a risk that the lessee may lay
his own claim to the property (ownership risk) or be unable to
pay the rent (credit risk).
It is for these reasons that real estate investors prefer to invest
through Real estate mutual funds. The ticket sizes are flexible;
further professional managers of the real estate portfolio are in a
better position to manage the other risks and issues associated
with real estate investment.

60
10.4 Fixed Deposit or Debt Scheme
Several investors are comfortable only in placing money in bank
deposits; they do not invest in debt schemes, partly because of
lack of awareness. The following are features where bank
deposits clearly score over mutual funds:
In the event that a bank fails, the deposit insurance scheme of
the government comes to the rescue of small depositors. Upto
Rs 1 lakh per depositor in a bank (across branches) will be
paid by the insurer. This limit is inclusive of principal and
interest. Mutual fund schemes do not offer any such insurance.
The depositor can also prematurely close the deposit at any
time. However, a penalty needs to be borne for such
premature closure.
Mutual fund debt schemes are superior to bank deposits in the
following respects:
With a bank deposit, the depositor can never earn a return
higher than the interest rate promised. In a mutual fund
scheme, no return is guaranteed however it is possible to
earn returns that are much higher than in a bank deposit.
There have been occasions, where investors even in lower risk
government securities funds, have earned in excess of 20%
p.a.
Given the way debt securities are priced in the market, such
abnormally high returns become possible when interest rates in
the economy decline. In such a scenario, the NAV of the debt

61
fund would go up, thus boosting the value of the investment of
the investor this is precisely the scenario when fixed
depositors in a bank worry about the lower interest rates that
banks offer on their deposits.
Interest earned in a bank deposit is taxable each year.
However, if a unit holder allows the investment to grow in a
mutual fund scheme (which in turn is exempt from tax), then no
income tax is payable on year to year accretions. In the
absence of the drag of annual taxation, the money can grow
much faster in a mutual fund scheme.
Mutual funds offer various facilities to make it easy for investors
to move their money between different kinds of mutual fund
schemes. These are not available with a bank deposit.
10.5 New Pension Scheme
Pension Funds Regulatory and Development Authority (PFRDA) is
the regulator for the New Pension Scheme. Two kinds of pension
accounts are envisaged:
Tier I (Pension account), is non-withdrawable.
Tier II (Savings account) is withdrawable to meet financial
contingencies. An active Tier I account is a pre-requisite for
opening a Tier II account.

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Investors can invest through Points of Presence (POP). They
can allocate their investment between 3 kinds of portfolios:
Asset Class E: Investment in predominantly equity market
instruments
Asset Class C: Investment in Debt securities other than
Government Securities
Asset Class G: Investments in Government Securities.
Investors can also opt for life-cycle fund. With this option, the
system will decide on a mix of investments between the 3 asset
classes, based on age of the investor.
The 3 asset class options are managed by 6 Pension Fund
Managers (PFMs). The investors moneys can thus be distributed
between 3 portfolios X 6 PFMs = 18 alternatives.
The NPS offers fewer portfolio choices than mutual funds.
However, NPS offers the convenience of a single Personal
Retirement Account Number (PRAN), which is applicable across
all the PFMs where the investors money is invested. Further, the
POPs offer services related to moneys invested with any of the
PFMs.

63
10.6 Other Financial Products
The inherent risk and return characteristics vary between financial
products. The discussions in this and the previous units give a
good perspective on the key parameters on which various financial
products need to be compared, before investment decisions are
taken.

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Checklist of Learning Points
Physical assets like land, building and gold have value and can be
touched, felt and used. Financial assets have value, but cannot be
touched, felt or used as part of their core value. Shares,
debentures, fixed deposits, bank accounts and mutual fund
schemes are all examples of financial assets that investors
normally invest in.
The difference in comfort is perhaps a reason why nearly half the
wealth of Indians is locked in physical assets.
There are four financial asset alternatives to holding gold in
physical form ETF Gold, Gold Sector Fund, Gold Futures & Gold
Deposits.
Wealth Tax is applicable on gold holding (beyond the jewellery
meant for personal use). However, mutual fund schemes (gold
linked or otherwise) and gold deposit schemes are exempted from
Wealth Tax.
Real estate in physical form has several disadvantages.
Therefore, investors worldwide prefer financial assets as a form of
real estate investment.
Bank deposits and mutual fund debt schemes have their
respective merits and demerits.
Pension Funds Regulatory and Development Authority (PFRDA) is
the regulator for the New Pension Scheme. Two kinds of pension
accounts are envisaged: Tier I (Pension account), is non-
withdrawable. Tier II (Savings account) is withdrawable to meet
financial contingencies. An active Tier I account is a pre-requisite
for opening a Tier II account.
The NPS offers fewer portfolio choices than mutual funds.
However, NPS offers the convenience of a single Personal
Retirement Account Number (PRAN), which is applicable across
all the PFMs where the investors money is invested. Further, the
POPs offer services related to moneys invested with any of the
PFMs.

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11. Helping Investors with Financial Planning
Learning Objective
Financial Planning is an approach to building long term
relationships with clients. It is also a need for large sections of
investors. This unit introduces the concept of financial planning.
11.1 Introduction to Financial Planning
11.1.1 What is Financial Planning?
Everyone has needs and aspirations. Most needs and aspirations
call for a financial commitment. Providing for this commitment
becomes a financial goal. Fulfilling the financial goal sets people
on the path towards realizing their needs and aspirations. People
experience happiness, when their needs and aspirations are
realized within an identified time frame.
For example, a father wants his son, who has just passed his 10
th
standard Board examinations, to become a doctor. This is an
aspiration. In order to realize this, formal education expenses,
coaching class expenses, hostel expenses and various other
expenses need to be incurred over a number of years. The
estimated financial commitments towards these expenses become
financial goals. These financial goals need to be met, so that the
son can become a doctor.

66
Financial planning is a planned and systematic approach to
provide for the financial goals that will help people realise their
needs and aspirations, and be happy.
11.1.2 Assessment of Financial Goals
The financial goals related to making the son a doctor, call for
commitments over a period of about 6 years 2 years of under-
graduate studies, coaching class expenses for preparing for the
medical entrance exams, followed by the medical education and
hostel expenses.
An estimate of these future expenses (the financial goals) requires
the following inputs:
Year Current Cost
(Rs)
Likely
Inflation
(% p.a.)
Likely
Exchange
Rate impact
(% p.a.)
1 100,000 7% N.A.
2 120,000 7% N.A.
3 1,000,000 7% N.A.
4 500,000 7% N.A.
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5 500,000 7% N.A.
6 500,000 7% 2%
How much would be the expense, if it were incurred today?
How many years down the line, the expense will be incurred?
During this period, how much will the expense rise on account
of inflation?
If any of these expenses are to be incurred in foreign currency,
then how would changes in exchange rate affect the financial
commitment?
Suppose the inputs are as follows:
The costs mentioned above, in todays terms, need to be
translated into the rupee requirement in future. This is done using
the formula A = P X (1 + i)
n
, where,
A = Rupee requirement in future
P = Cost in todays terms
i = inflation
n = Number of years into the future, when the expense will be
incurred.
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1
2
3
4
5
6
The below-mentioned calculations can be done on calculator.
However, the calculations are easier, using MS Excel formulae.
For instance, the Rs 120,000 money requirement of 2 years down
the line, calculated at todays prices, translates into a future rupee
requirement of =120,000 X (1 + 7%) ^ 2 (as entered in MS
Excel). The answer is Rs 137,388.
The same exercise done for the other years expenses gives a
year-wise future rupee requirement as follows:
Year MS Excel Formula Future Rupee
Requirement
(Rs)
=100,000 X (1 + 7%) ^ 1 107,000
=120,000 X (1 + 7%) ^ 2 137,388
=1,000,000 X (1 + 7%) ^ 3 1,225,043
=500,000 X (1 + 7%) ^ 4 655,398
=500,000 X (1 + 7%) ^ 5 701,276
=500,000 X (1 + 7% + 2%) ^ 6 838,550
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These are the financial goals that need to be met, in order to
realize the aspiration of seeing the son become a doctor.
11.1.3 Investment Horizon
The year-wise financial goals statement throws up the investment
horizon. It would be risky to expect the first three years expenses
to be met out of equity investments being made today. But equity
is a viable investment option for expenses starting from Year 4.
In most cases, the investor would have some regular income out of
which part of the expenses can be met. So the investments being
considered now need to fund only the balance of the financial
goals.
11.1.4 Assessing the Fund Requirement
Suppose the investor is comfortable about meeting Rs 100,000 of
the expense each year. The balance would need to be provided
out of investments being made today. How much is that
investment requirement? This can be calculated using a variation
of the formula used earlier i.e. P = A (1 + r)
n
, where:
P, A and n have the same meaning as in the earlier formula.
r represents the return expected out of the investment portfolio.
Suppose requirements of Years 1 to 3 are met out of debt
investments that would yield a return of 6% p.a. The requirements
of Year 4 onwards are met out of equity investments that are

70
estimated to yield a return of 9% p.a.. The amount that would
need to be invested today is as follows:
Year Required
(Rs)
Regular
Savings
(Rs)
Balance
Required
(Rs)
MS
Excel
Formula
Investment
Required
Today
(Rs)
1 107,000 100,000 7,000 =7000/
(1+6%)^1
6,604
2 137,388 100,000 37,388 =37388/
(1+6%)^2
33,275
3 1,225,043 100,000 1,125,043 =112504
3/
(1+6%)^3
944,608
4 655,398 100,000 555,398 =555398/
(1+9%)^4
393,458
5 701,276 100,000 601,276 =601276/
(1+9%)^5
390,788
6 838,550 100,000 738,550 =7000/
(1+9%)^1
440,373
Total 22,09,106
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Thus, a total amount of Rs 22,09,106 needs to be invested right
now Rs 984,487 in debt with a 3-year horizon, and Rs 12,24,619
in equity with a 4 6 year horizon to meet the financial goals that
would help the investor realize the aspiration of seeing his son
become a doctor.
Many AMCs and websites offer calculators that help with the
above calculations.
11.1.5 Financial Planning Objectives and Benefits
The objective of financial planning is to ensure that the right
amount of money is available at the right time to meet the various
financial goals of the investor. This would help the investor realize
his aspirations and experience happiness.
An objective of financial planning is also to let the investor know in
advance, if some financial goal is not likely to be fulfilled. In the
above case, the investor knows that if he cannot make the
requisite combined investment of Rs 21,33,238 in debt and equity
today, then financial constraints may affect the realization of his
aspiration.
Thanks to advance information available through financial
planning, timely corrective actions can be taken, such as:
Reviewing what is a need and what is a desire that can be
postponed for the more desirable objective of realizing the
aspiration of son becoming a doctor.
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Moving to a smaller house, or a house in a less expensive
locality, to release more capital.
Improving the future annual savings by economizing on
expense, or taking up an extra part-time job, or influencing the
spouse to take up employment for some time.
The financial planner may also suggest a loan to meet the heavy
expense of Year 3. Financial planning thus helps investors realize
their aspirations and feel happy. It also helps the financial planner,
because the process of financial planning helps in understanding
the investor better, and cementing the relationship with the
investors family. This becomes the basis for a long term
relationship between the investor and the financial planner.
11.1.6 Need for Financial Planners
Most investors are either not organized, or lack the ability to make
the calculations described above. A financial planners service is
therefore invaluable in helping people realize their needs and
aspirations.
Even if the investor knows the calculations, the knowledge of how
and where to invest may be lacking. The financial planner thus
steps in to help the investor select appropriate financial products
and invest in them.
Transactions such as purchase of house or car, or even education,
necessitate a borrowing. The financial planner can help the
investor decide on the optimal source of borrowing and structure
the loan arrangement with the lender.

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Taxation is another area that most investors are unclear about.
Financial planners who are comfortable with the tax laws can
therefore help the investor with tax planning, so as to optimize the
tax outflows.
Financial planners can also help investors in planning for
contingencies. This could be through advice on insurance
products, inheritance issues etc.
The financial planner thus is in a position to advise investors on all
the financial aspects of their life.
11.2 Alternate Financial Planning Approaches
The financial plan detailed above is a goal-oriented financial plan
a financial plan for a specific goal related to the aspiration to
make the son a doctor.
An alternate approach is a comprehensive financial plan where
all the financial goals of a person are taken together, and the
investment strategies worked out on that basis. The steps in
creating a comprehensive financial plan, as proposed by the
Certified Financial Planner Board of Standards (USA) are as
follows:
Establish and Define the Client-Planner Relationship
Gather Client Data, Define Client Goals
Analyse and Evaluate Clients Financial Status
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Develop and Present Financial Planning Recommendations
and / or Options
Implement the Financial Planning Recommendations
Monitor the Financial Planning Recommendations
The comprehensive financial plan captures the estimated inflows
from various sources, and estimated outflows for various financial
goals, including post-retirement living expenses. The plan can go
several decades into the future.
A comprehensive financial plan calls for significantly more time
commitment on the part of both the investor and the financial
planner. However, the time commitment needs to be viewed as an
investment in a long term relationship.
11.3 Life Cycle and Wealth Cycle in Financial Planning
While working on a comprehensive financial plan, it is useful to
have a perspective on the Life Cycle and Wealth Cycle of the
investor.
11.3.1 Life Cycle
These are the normal stages that people go through, viz.:
Childhood
During this stage, focus is on education in most cases. Children
are dependents, rather than earning members. Pocket money,

75
cash gifts and scholarships are potential sources of income during
this phase. Parents and seniors need to groom children to imbibe
the virtues of savings, balance and prudence. Values imbibed
during this phase set the foundation of their life in future.
Young Unmarried
The earning years start here. A few get on to high-paying salaries
early in their career. Others toil their way upwards. Either way,
the person needs to get into the habit of saving. The fortunate few
who start off well have to avoid falling into the trap of
unsustainable life styles.
Equity SIPs and Whole-life insurance plans are great ways to force
the young unmarried into the habit of regular savings, rather than
lavish the money away.
This is the right age to start investing in equity. Personal plans on
marriage, transportation and residence determine the liquidity
needs. People for whom marriage is on the anvil, and those who
wish to buy a car / two-wheeler or house may prefer to invest more
in relatively liquid investment avenues. Others have the luxury of
not having to provide much for liquidity needs. Accordingly, the
size of the equity portfolio is determined.
Young Married
A cushion of assets created during the early earning years can be
a huge confidence booster while taking up the responsibilities
associated with marriage.
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Where both spouses have decent jobs, life can be financially
comfortable. They can plan where to stay in / buy a house, based
on job imperatives, life style aspirations and personal comfort.
Insurance is required, but not so critical.
Where only one spouse is working, life insurance to provide for
contingencies associated with the earning spouse are absolutely
critical. In case the earning spouse is not so well placed, ability to
pay insurance premia can be an issue, competing with other basic
needs of food, clothing and shelter. Term insurance (where
premium is lower) possibilities have to be seriously explored and
locked into.
Depending on the medical coverage provided by the employer/s,
health insurance policy cover too should be planned. Even where
the employer provides medical coverage, it would be useful to start
a low value health insurance policy, to provide for situations when
an earning member may quit a job and take up another after a
break. Further, starting a health insurance policy earlier and not
having to make a claim against it for a few years, is the best
antidote to the possibility of insurance companies rejecting future
insurance claims / coverage on account of what they call pre-
existing illness.
While buying an insurance policy, there has to be clarity on
whether it is a cashless policy i.e. a policy where the insurance
company directly pays for any hospitalization expenses. In other
policies, the policy-holder has to bear the expense first and then
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claim re-imbursement from the insurer. This increases the liquidity
provisions that need to be made for contingencies.
All family members need to know what is covered and what is not
covered in the policy, any approved or black listed health services
provider, and the documentation and processes that need to be
followed to recover money from the insurer. Many insurance
companies have outsourced the claim settlement process. In such
cases, the outsourced service provider, and not the insurer, would
be the touch point for processing claims.
Married with Young Children
Insurance needs both life and health - increase with every child.
The financial planner is well placed to advise on a level of
insurance cover, and mix of policies that would help the family
maintain their life style in the event of any contingency.
Expenses for education right from pre-school to normal schooling
to higher education is growing much faster than regular inflation.
Adequate investments are required to cover this.
Married with Older Children
The costs associated with helping the children settle i.e. cost of
housing, marriage etc are shooting up. If investments in growth
assets like shares and real estate, are started early in life, and
maintained, it would help ensure that the children enjoy the same
life style, when they set up their independent families.
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Pre-Retirement
By this stage, the children should have started earning and
contributing to the family expenses. Further, any loans taken for
purchase of house or car, or education of children should have
been extinguished. The family ought to plan for their retirement
what kind of lifestyle to lead, and how those regular expenses will
be met.
Retirement
At this stage, the family should have adequate corpus, the interest
on which should help meet regular expenses. The need to dip into
capital should come up only for contingencies not to meet
regular expenses.
The availability of any pension income and its coverage (only for
the pensioner or extension to family in the event of death of
pensioner) will determine the corpus requirement.
Besides the corpus of debt assets to cover regular expenses, there
should also be some growth assets like shares, to protect the
family from inflation during the retirement years.
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11.3.2 Wealth Cycle
This is an alternate approach to profile the investor. The stages in
the Wealth Cycle are:
Accumulation
This is the stage when the investor gets to build his wealth. It
covers the earning years of the investor i.e. the phases of the life
cycle from Young Unmarried to Pre-Retirement.
Transition
Transition is a phase when financial goals are in the horizon. E.g.
house to be purchased, childrens higher education / marriage
approaching etc. Given the impending requirement of funds,
investors tend to increase the proportion of their portfolio in liquid
assets viz. money in bank, liquid schemes etc.
Inter-Generational Transfer
During this phase, the investor starts thinking about orderly
transfer of wealth to the next generation, in the event of death.
The financial planner can help the investor understand various
inheritance and tax issues, and help in preparing Will and
validating various documents and structures related to assets and
liabilities of the investor.
It is never too early to plan for all this. Given the consequences of
stress faced by most investors, it should ideally not be postponed
beyond the age of 50.

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Reaping / Distribution
This is the stage when the investor needs regular money. It is the
parallel of retirement phase in the Life Cycle.
Sudden Wealth
Winning lotteries, unexpected inheritance of wealth, unusually high
capital gains earned all these are occasions of sudden wealth,
that need to be celebrated. However, given the human nature of
frittering away such sudden wealth, the financial planner can
channelize the wealth into investments, for the long term benefit of
the investors family.
In such situations, it is advisable to initially block the money by
investing in a liquid scheme. An STP from the liquid schemes into
equity schemes will help the long term wealth creation process, if
advisable, considering the unique situation of the investor.
Given the change of context, and likely enhancement of life style
expectations, a review of the comprehensive financial plan is also
advisable in such situations.
Understanding of both life cycle and wealth cycle is helpful for a
financial planner. However, one must keep in mind that each
investor may have different needs and unique situations; the
recommendations may be different for different investors even
within the same life cycle or wealth cycle stages.
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11.3.3 Financial Planning Tools
The financial plan preparation becomes simpler with the aid of
packaged software. These help not only in estimating the cash
flow requirements and preparing the financial plan, but also
ongoing monitoring of the portfolio.
A few mutual funds and securities companies provide limited
financial planning tools in their websites. A serious financial
planner might like to invest in off-the-shelf software that will enable
storing of relevant client information confidentially, and offer
ongoing support to the clients.
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Checklist of Learning Points
Financial planning is a planned and systematic approach to
provide for the financial goals that will help people realise their
aspirations, and feel happy.
The costs related to financial goals, in todays terms, need to be
translated into the rupee requirement in future. This is done using
the formula A = P X (1 + i)
n
The objective of financial planning is to ensure that the right
amount of money is available at the right time to meet the various
financial goals of the investor.
An objective of financial planning is also to let the investor know in
advance, if some financial goal is not likely to be fulfilled.
The process of financial planning helps in understanding the
investor better, and cementing the relationship with the investors
family. This becomes the basis for a long term relationship
between the investor and the financial planner.
A goal-oriented financial plan is a financial plan for a specific
goal. An alternate approach is a comprehensive financial plan
where all the financial goals of a person are taken together, and
the investment strategies worked out on that basis
The Certified Financial Planner Board of Standards (USA)
proposes the following sequence of steps for a comprehensive
financial plan:
Establish and Define the Client-Planner Relationship
Gather Client Data, Define Client Goals
Analyse and Evaluate Clients Financial Status
Develop and Present Financial Planning
Recommendations and / or Options
Implement the Financial Planning Recommendations
Monitor the Financial Planning Recommendations
Life Cycle and Wealth cycle approaches help understand the
investor better.
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12. Recommending Model Portfolios and Financial Plans
Learning Objective
This concluding Unit discusses three key aspects of financial
planning how to understand the risk profile of investors, how to
decide on an asset allocation mix for the investor, and an
approach to deciding on model portfolios.
12.1 Risk Profiling
12.1.1 Need for Risk Profiling
As seen earlier, various schemes have different levels of risk.
Similarly, there are differences between investors with respect to
the levels of risk they are comfortable with (risk appetite). At times
there are also differences between the level of risk the investors
think they are comfortable with, and the level of risk they ought to
be comfortable with.
Risk profiling is an approach to understand the risk appetite of
investors - an essential pre-requisite to advise investors on their
investments.

84
The investment advice is dependent on understanding both
aspects of risk:
Risk appetite of the investor
Risk level of the investment options being considered.
12.1.2 Factors that Influence the Investors Risk Profile
Some of the factors and their influence on risk appetite are as
follows:
Factor Influence on Risk Appetite
Family Information
Earning Members Risk appetite increases as
the number of earning
members increases
Dependent Members Risk appetite decreases as
the number of dependent
members increases
Life expectancy Risk appetite is higher when
life expectancy is longer
Personal Information
Age Lower the age, higher the
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risk that can be taken
Employability Well qualified and multi-
skilled professionals can
afford to take more risk
Nature of Job Those with steady jobs are
better positioned to take risk
Psyche Daring and adventurous
people are better positioned
mentally, to accept the
downsides that come with
risk
Financial Information
Capital base Higher the capital base,
better the ability to financially
take the downsides that
come with risk
Regularity of Income People earning regular
income can take more risk
than those with
unpredictable income
streams

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More such factors can be added. The financial planner needs to
judge the investor based on such factors, rather than just ask a
question How much risk are you prepared to take?
12.1.3 Risk Profiling Tools
Some AMCs and securities research houses provide risk profiling
tools in their website. Some banks and other distributors have
proprietary risk profilers. These typically revolve around investors
answering a few questions, based on which the risk appetite score
gets generated.
Some of these risk profile surveys suffer from the investor trying to
guess the right answer, when in fact there is no right answer.
Risk profiling is a tool that can help the investor; it loses meaning if
the investor is not truthful in his answers.
Some advanced risk profilers are built on the responses to
different scenarios that are presented before the investor. Service
providers can assess risk profile based on actual transaction
record of their regular clients.
While such tools are useful pointers, it is important to understand
the robustness of such tools before using them in the practical
world. Some of the tools featured in websites have their
limitations. The financial planner needs to use them judiciously.

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12.2 Asset Allocation
12.2.1 The Role of Asset Allocation
Dont put all your eggs in one basket is an old proverb. It equally
applies to investments.
The discussion on risk in Unit 8, highlighted how the risk and
return in various asset classes (equity, debt, gold, real estate etc.)
are driven by different factors. For example, during the
recessionary situation in 2007-09, equity markets in many
countries fared poorly, but gold prices went up. Thus, an investor
who had invested in both gold and equity, earned better returns
than an investor who invested in only equities. The distribution of
an investors portfolio between different asset classes is called
asset allocation.
Economic environments and markets are dynamic. Predictions
about markets can go wrong. With a prudent asset allocation,
the investor does not end up in the unfortunate situation of having
all the investments in an asset class that performs poorly.
Some international researches suggest that asset allocation and
investment policy can better explain portfolio performance, as
compared to selection of securities within an asset class (stock
selection) and investment timing.
12.2.2 Asset Allocation Types
In the discussion on risk in balanced schemes in Unit 8, the
concept of flexible asset allocation was introduced. It was

88
reasoned that these are more risky than balanced funds with more
stable asset allocation policies. Balanced funds that adopt such
stable asset allocation policies are said to be operating within a
fixed asset allocation framework.
At an individual level, difference is made between Strategic and
Tactical Asset Allocation.
Strategic Asset Allocation is the ideal that comes out of the risk
profile of the individual. Risk profiling is key to deciding on the
strategic asset allocation. The most simplistic risk profiling thumb
rule is to have as much debt in the portfolio, as the number of
years of age. As the person grows older, the debt component of
the portfolio keeps increasing. This is an example of strategic
asset allocation.
As part of the financial planning process, it is essential to decide
on the strategic asset allocation that is advisable for the investor.
Tactical Asset Allocation is the decision that comes out of calls
on the likely behaviour of the market. An investor who decides to
go overweight on equities i.e. take higher exposure to equities,
because of expectations of buoyancy in industry and share
markets, is taking a tactical asset allocation call.
Tactical asset allocation is suitable only for seasoned investors
operating with large investible surpluses. Even such investors
might like to set a limit to the size of the portfolio on which they
would take frequent tactical asset allocation calls.

89
12.3 Model Portfolios
Since investors risk appetites vary, a single portfolio cannot be
suggested for all. Financial planners often work with model
portfolios the asset allocation mix that is most appropriate for
different risk appetite levels. The list of model portfolios, for
example, might read something like this:
Young call centre / BPO employee with no dependents
50% diversified equity schemes (preferably through SIP); 20%
sector funds; 10% gold ETF, 10% diversified debt fund, 10% liquid
schemes.
Young married single income family with two school going kids
35% diversified equity schemes; 10% sector funds; 15% gold ETF,
30% diversified debt fund, 10% liquid schemes.
Single income family with grown up children who are yet to settle
down
35% diversified equity schemes; 15% gold ETF, 15% gilt fund,
15% diversified debt fund, 20% liquid schemes.
Couple in their seventies, with no immediate family support
15% diversified equity index scheme; 10% gold ETF, 30% gilt
fund, 30% diversified debt fund, 15% liquid schemes.
As the reader would appreciate, these percentages are illustrative
and subjective. The critical point is that the financial planner should
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have a model portfolio for every distinct client profile. This is then
tweaked around based on specific investor information. Thus, a
couple in their seventies, with no immediate family support but
very sound physically and mentally, and a large investible
corpus might be advised the following portfolio, as compared with
the previous model portfolio.
20% diversified equity scheme; 10% diversified equity index
scheme; 10% gold ETF, 25% gilt fund, 25% diversified debt fund,
10% liquid schemes.
Within each of these scheme categories, specific schemes and
options can be identified, based on the approach described in Unit
10.

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Checklist of Learning Points
There are differences between investors with respect to the levels
of risk they are comfortable with (risk appetite).
Risk profiling is an approach to understand the risk appetite of
investors - an essential pre-requisite to advise investors on their
investments. Risk profilers have their limitations.
Risk profile is influenced by personal information, family
information and financial information.
Spreading ones exposure across different asset classes (equity,
debt, gold, real estate etc.) balances the risk.
Some international researches suggest that asset allocation and
investment policy can better explain portfolio performance, as
compared to being exposed to the right asset classes (asset
allocation) is a more critical driver of portfolio profitability than
selection of securities within an asset class (stock selection) and
investment timing.
Strategic Asset Allocation is the ideal that comes out of the risk
profile of the individual. Tactical Asset Allocation is the decision
that comes out of calls on the likely behaviour of the market.
Financial planners often work with model portfolios the asset
allocation mix that is most appropriate for different risk appetite
levels. The financial planner would have a model portfolio for
every distinct client profile.
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Chapter 9: Introduction to Insurance
1.1 Definition of Insurance
Insurance has been defined in many ways; Willet defines insurance as the social device for
making accumulations to meet uncertain losses of capital which is carried out through the
transfer of risks of many individuals to one person or to a group of persons.
Dr. Pfeffer defined Insurance as a device for the reduction of the uncertainty of one party
called the insured, through the transfer of particular risks to another party called the insurer,
who offers, a restoration at least in part of economic losses suffered by the insured.
Another definition of insurance is a promise of compensation for specific potential future
losses in exchange for a periodic payment. Insurance is designed to protect the financial
well-being of an individual, company or other entity in the case of unexpected loss. Some
forms of insurance are required by law, while others are optional. Agreeing to the terms of
an insurance policy creates a contract between the insured and the insurer. In exchange for
payments from the insured (called premiums), the insurer agrees to pay the policy holder a
sum of money upon the occurrence of a specific event. In most cases, the policy holder pays
part of the loss (called the deductible) and the insurer pays the rest. Examples include car
insurance, health insurance, disability insurance, life insurance, etc.
Insurance therefore is a contract between two parties whereby one party agrees to undertake
the risk of another in exchange for consideration known as premium and promises to pay a
fixed sum of money to the other party on happening of an uncertain event (death) or after
the expiry of a certain period (in case of life insurance) or to indemnify the other party on
happening of an uncertain event (in case of general insurance).
The party bearing the risk is known as the insurer or assurer and the party whose risk is
covered is known as the insured or assured.
1.2 How Insurance Works
The underlying concept behind insurance is sharing of risks by pooling of funds. Groups of people
sharing similar risk come together and make contribution towards a pool and the money so
collected is used towards compensating for any losses suffered by members of the pool. When
the pool is managed by the individuals it is called mutual insurance and when it is managed
by a company it is called life/general insurance.
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1.2.1 We will understand the concept with an example:
Example 1
(What happens if 2 houses are burnt?)
Example 2
(What happens if 25 persons dies?)
Assumptions
Houses in a village = 500
Value of 1 House = Rs.1,00,000
Houses burning in a year = 2
Total annual loss due to fire
= Rs. 2,00,000/-
Contribution of each house owner
= Rs. 500/-
Assumptions
Number of Persons = 5000
Age and Physical condition = 60 years
and Healthy
Number of persons dying in a yr
= 25
Economic value of loss suffered by
family of each dying person
= Rs. 2,00,000/-
Total annual loss due to deaths
= Rs. 50,00,000/-
Contribution per person
= Rs. 1,200/-
UNDERLYING ASSUMPTION
All 500 house owners are exposed to a
common risk, i.e. fire
UNDERLYING ASSUMPTION
All 5000 persons are exposed to common
risk, i.e. death
PROCEDURE
All owners contribute Rs. 500/- each as
premium to the pool of funds
Total value of the fund = Rs. 2,50,000
(i.e. 500 houses * Rs. 500)
2 houses get burnt during the year
Insurance company pays Rs. 1,00,000/- out
of the pool to 2 house owners whose house
got burnt
PROCEDURE
Everybody contributes Rs. 1200/- each as
premium to the pool of funds
Total value of the fund = Rs. 60,00,000
(i.e. 5000 persons * Rs. 1,200)
25 persons die in a year on an average
Insurance company pays Rs. 2,00,000/- out
of the pool to the family members of each of
the 25 persons dying in a year
EFFECT OF INSURANCE
Risk of 2 house owners is spread over 500
house owners in the village, thus reducing
the burden on any one of the owners
EFFECT OF INSURANCE
Risk of 25 persons is spread over 5000
people
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1.3 We can see from above that two concepts emerge out of this
Criteria for insurable Risk
Underwriting
1.3.1 Can Insurance insure all kinds of risks?
For a risk to be considered for insurance, the following criteria should be satisfied.
1. Law of large numbers: Mathematical premise stating that the greater the number of
exposures (1) the more accurate the prediction; (2) the less the deviation of the actual losses
from the expected losses (X - x approaches zero); and (3) the greater the credibility of the
prediction (credibility approaches one). This law forms the basis for the statistical expectation
of loss upon which premium rates for insurance policies are calculated.
Insurance is based on probabilities of loss occurrence. The insurers estimate the premium
payable based on the relevant statistics and probabilities. For the actual outcome of loss
exposure to be reflective of the statistics, there must be a large number of homogenous
units. The larger the number of homogenous (similar) exposure units the more likely the loss
experience will conform to the probability statistics.
2. The loss must be accidental or fortuitous: For a risk to be insurable, it should be accidental
or of fortuitous nature because insurance is based on chance. We cannot insure an event which
is bound to happen. There should be an element of uncertainty. For e.g. in fire insurance,
the property is insured against the perils of fire, flood etc. on the assumption that loss may
or may not happen. If we are sure there is bound to be floods in the next 15 days and take
insurance, the policy will not be valid. However, in life insurance though death is certain, this
principle is still applicable as we are not sure when death would actually arise, some may die
at 20 some at 60 and so on.
i) Here we need to distinguish between Speculative risk and Pure risk:
Speculative risks are not insurable. The difference between pure risk and speculative risk
is that in speculative risk there is a possibility of loss or profit. These risks are willingly taken
by people with an aim to make profit. The typical example is a day trader in the stock market
who buys shares in the morning hoping that the price will go up before the market closes and
he can sell the shares at a profit. However, the share prices may come down in which case
the day trader incurs a loss.
Pure risks are those risks in which there is only a possibility of loss or no loss, there is no
probability of making profits. Pure risks are categorized into Personal, Property and Liability
or legal risks. Personal risks affect people directly such as illness, death, injury etc. Property
risk affects property such as building, machinery, car etc. Legal risks or Liability risks involves,
as the name suggest, the risk of being sued due to negligence or causing injury to another
person or loss/damage to property of another person.
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Pure risk is insurable, because the law of large numbers can be applied to forecast future
losses and thus insurance companies can calculate what premium to charge based on expected
losses. On the other hand, speculative risks have more varied conditions that make estimating
future losses difficult or impossible. Also, speculative risk will generally involve a greater
frequency of loss than a pure risk.
ii) Risk can also be classified as to whether it affects many people or only a single individual.
Fundamental risk is a risk, such as an earthquake or terrorism, that can affect many people at
once. Economic risks, such as unemployment, are also fundamental risks because they affect
many people. Particular risk is a risk that affects particular individuals, such as robbery or
vandalism. Insurance companies generally insure some fundamental risks, such as hurricane
or wind damage and most particular risks.
In the case of fundamental risks that are insured, insurance companies help to reduce the
risk of great financial loss by limiting coverage in a specific geographic area and by the use
of reinsurance, which is the purchase of insurance by insurer from another insurer called
reinsurer.
Fundamental risks are risks that affect many members of society, but fundamental risks can
also affect organizations. For instance, enterprise risk is the set of all risks that affects a
business enterprise. Speculative risks that can affect an organization are usually subdivided
into strategic risk, operational risk, and financial risk.
Strategic risk results from goal-oriented behavior. A business may want to try to improve
efficiency by buying new equipment or trying a new technique, but may result in more losses
than gains. Operational risks arise from the operation of the enterprise, such as the risk of
injury to employees or the risk that customers data can be leaked to the public because of
insufficient security. Financial risk is the risk that an investment will result in losses. Because
most enterprise risk is speculative risk and because the enterprise itself can do much to lower
its own risk, many companies are learning to manage their risk by creating departments and
hiring people with the express purpose of reducing enterprise risksalso called as enterprise
risk management. Many larger firms may have a chief risk officer (CRO) with the primary
responsibility of reducing risk throughout the enterprise.
iii) Peril and Hazard
Peril is an immediate, specific event, causing a loss and giving rise to risk. An accident or
illness is a peril. If a house burns down, then fire is the peril.
A hazard is a condition that gives rise to a peril. Smoking is a physical hazard that increases
the likelihood of a house fire and illness.
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Three types of hazards :
i) Physical hazards are characteristics of the individual that increase or reduce
the chance of peril. Examples are body structure (height related to weight), blood
pressure, sugar levels, cholesterol levels etc.
ii) Moral Hazards are habits or activities that increase risk, such as drug or alcohol
use. These have social as well as personal effects.
iii) Morale Hazards are individual activities that arise from a state of mind, such
as the casual indifference toward ones body as exhibited by individuals with
hazardous hobbies, such as ski-diving or flying ultra-light aircraft.
3. Loss must be definite and measurable: The insurer should be able to measure the
loss in financial terms and there should be no ambiguity as to whether loss has occurred or
not. That is, there should not be any doubt on whether the payment is due under the policy
or not. For example, under health insurance, the cost of medical treatment is obtained by way
of hospital and medical bills and enables the insurer to check on the extent of loss suffered by
the insured.
4. The loss must not be catastrophic: Catastrophic losses refers to devastating losses
arising out of a single event such as an earthquake. While insurance companies do cover
catastrophic losses, they may agree to cover these losses for the insured, not as a standalone
loss but combined along with other types of losses and provided the catastrophic losses are
such that their occurrence would be rare. Most of the insurance companies protect themselves
against catastrophic losses by taking out sufficient reinsurance. We have discussed above the
criteria which should exist for a risk to be insurable. Another important aspect of insurance is
related to underwriting.
1.3.2 Underwriting:
In insurance parlance the term underwriting refers to the insurers decision as to whether to :
a) Accept a risk
b) Rate, terms and condition subject to which the risk is to be accepted.
For an insurer to be able to underwrite, he has to evaluate the risk as well as the exposure.
Based on the evaluation, it decides on the extent of coverage to be granted, the premium to
be charged in consideration of transfer of risk. If the nature of risk does not fit in with the
underwriting philosophy of the company, the insurer (underwriter) may decide to decline
acceptance of the risk.
While underwriting a risk, various factors are taken into account; for example, while granting
motor insurance, the past driving record of the insured, age of the insured, type of vehicle
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etc. are of great relevance. Similarly, while underwriting health insurance, the past health
history of the assured, nature of pre-existing diseases, family history of chronic ailment are
taken into account.
The underwriters, based on information gathered, past experience on similar lines as well as
using the underwriting guidelines of the company may decide :
i) To accept the risk
ii) To accept the risk subject to special terms and conditions
iii) To reject the risk
1.4 Insurance Act, 1938
This Act came into force on 1st July 1939 and is applicable to the whole of India, except
Jammu and Kashmir. This law is applicable to all the insurance companies and other entities
participating in the insurance industry in India .
The purpose of enactment of this law is:
1. To supervise all the organisations operating in insurance business in India. This is
ensured by making registration compulsory.
2. To increase deposit of insurance companies to ensure that they are adequately
financed and conform to minimum capital requirements.
3. Full disclosure of information is enforced to ensure soundness and transparency in
management.
4. Submission of accounts and inspection of insurance companies by authorities.
5. Guidelines are laid for investment of funds by insurance companies.
6. Regulations to govern the assignment and transfer of life insurance policies besides
including the possibility of making nominations.
The Insurance Act, 1938 was amended in 1950, again in 1956 when life insurance business
was nationalized and again in 1972 when general insurance was nationalised.
1.5 Insurance Regulatory and Development Authority (IRDA)
IRDA is the regulator of the insurance industry in India and was constituted by an Act of
Parliament in 1997. It has the following mission:
To protect the interests of the policy holders. To regulate, promote and ensure orderly growth
of the insurance industry.
It is constituted by a 10 member team consisting of :
Chairman
Five whole time members
Four part time members
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1.5.1 Duties, Powers and Functions of IRDA
Section 14 of the IRDA Act, 1999 lays down the duties, powers and functions of IRDA which
are :
1. issuance of certificate of registration, renewal, modification, withdraw, suspend or
cancel such registration;
2. Protection of the policyholders interest;
3. Laying down qualifications, training and code of conduct for intermediaries;
4. Laying down code of conduct for Surveyors;
5. Promote efficiency in the conduct of insurance business;
6. Promoting and regulating professional organisations connected with the insurance
and re-insurance business;
7. Levying fees and other charges for carrying out the purposes of this Act;
8. Calling for information, conduct of inspection, audit of all organizations associated
with the insurance business;
9. Control of the rates, terms etc. offered by general insurers in respect of business not
controlled by Tariff Advisory Committee (TAC);
10. Specifying the manner in which accounts should be maintained by insurers and
intermediaries;
11. Regulation of investment of funds by insurers ;
12. Regulation of maintenance of solvency margins;
13. Act as a dispute settlement authority between insurers and intermediaries;
14. Supervise TAC;
15. Specify the percentage of premium income to be utilised for promoting organizations
mentioned in clause 6 ;
16. Specify the rural sector obligation of insurers;
17. Exercise any other powers as prescribed.
1.6 Insurance Advertisements and Disclosure Regulations, 2000
This regulation has been formulated with a view to prevent mis-selling and misleading
information about the insurance products being sent to the potential clients. Some important
points to be kept in mind are:
Every advertisement for insurance shall:
1. State clearly and unequivocally that insurance is the subject matter of solicitation;
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2. State the full registered name of the insurer/ intermediary/ insurance agent;
3. Every insurance company shall be required to prominently disclose in the
advertisement, the full particulars of the insurance company and not merely any
trade name or monogram or logo;
4. Every insurer or intermediary or insurance agent shall have a compliance officer,
whose name and official position in the organisation shall be communicated to the
IRDA and he shall be responsible to oversee the advertising programme;
5. Every advertisement by an insurance agent that affects an insurer must be approved
by the insurer in writing prior to its issue. It shall be the responsibility of the insurer
while granting such approval to ensure that all advertisements that pertain to the
company or its products or performance comply with these regulations and are not
deceptive or misleading.
6. Every insurer or intermediary shall follow recognised standards of professional
conduct as prescribed by the Advertisement Standards Council of India (ASCI) and
discharge its functions in the interest of the policyholders.
1.7 Protection of Policy holders Interest Regulations, 2002
With a view to protect the end consumer, IRDA has laid down regulations which cover the
following:
1.7.1 Matters to be stated in life insurance policy
1. A life insurance policy shall clearly state:
i. the name of the plan governing the policy, its terms and conditions;
ii. whether it is participating in profits or not;
iii. the basis of participation in profits such as cash bonus, deferred bonus, simple or
compound reversionary bonus;
iv. the benefits payable and the contingencies upon which these are payable and the
other terms and conditions of the insurance contract;
v. the details of the riders attached to the main policy;
vi. the date of commencement of risk and the date of maturity or date(s) on which the
benefits are payable;
vii. the premiums payable, periodicity of payment, grace period allowed for payment
of the premium, the date for the last installment of premium, the implication of
discontinuing the payment of an instalment(s) of premium and also the provisions
of a guaranteed surrender value;
viii. the age at entry and whether the same has been admitted;
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ix. the policy requirements for (a) conversion of the policy into paid up policy (b)
surrender (c) non-forfeiture and (d) revival of lapsed policies;
x. contingencies excluded from the scope of the cover, both in respect of the main
policy and the riders;
xi. the provisions for nomination, assignment and loans on security of the policy and
a statement that the rate of interest payable on such loan amount shall be as
prescribed by the insurer at the time of taking the loan;
xii. any special clauses or conditions, such as, first pregnancy clause, suicide clause
etc.;
xiii. the address of the insurer to which all communications in respect of the policy shall
be sent;
xiv. the documents that are normally required to be submitted by a claimant in support
of a claim under the policy.
2. While forwarding the policy to the insured, the insurer shall inform through the letter
forwarding the policy, that the insured has a period of 15 days from the date of receipt of
the policy document to review the terms and conditions of the policy and where the insured
disagrees to any of those terms or conditions, he has the option to return the policy stating
the reasons for his objection, whereby he shall be entitled to a refund of the premium paid,
subject only to a deduction of a proportionate risk premium for the period on cover (15 days)
and the expenses incurred by the insurer on medical examination of the proposer and stamp
duty charges.
3. In respect of a unit linked policy, in addition to the deductions given under (2) above,
the insurer shall also be entitled to repurchase the unit at the price of the units on the date of
cancellation.
4. In respect of a cover, where premium charged is dependent on age, the insurer shall
ensure that the age is verified, as far as possible, before issuance of the policy document. In
case where age has not been admitted by the time the policy is issued, the insurer shall make
efforts to obtain proof of age and admit the same as soon as possible.
1.7.2 Matters to be stated in general insurance policy
1. A general insurance policy shall clearly state:
i. the name(s) and address(es) of the insured and of any bank(s) or any other person
having financial interest in the subject matter of insurance;
ii. full description of the property or interest insured;
iii. the location or locations of the property or interest insured under the policy and
where appropriate, with respective insured values;
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iv. period of insurance;
v. sums insured;
vi. perils covered and not covered;
vii. any franchise or deductible applicable;
viii. premium payable and where the premium is provisional subject to adjustment, the
basis of adjustment of premium be stated;
ix. policy terms, conditions and warranties;
x. action to be taken by the insured upon occurrence of a contingency likely to give rise
to a claim under the policy;
xi. the obligations of the insured in relation to the subject matter of insurance upon
occurrence of an event giving rise to a claim and the rights of the insurer in the
circumstances;
xii. any special conditions attached to the policy;
xiii. provision for cancellation of the policy on grounds of mis-representation, fraud, non-
disclosure of material facts or non-cooperation of the insured;
xiv. the address of the insurer to which all communications in respect of the insurance
contract should be sent;
xv. the details of the riders attached to the main policy;
xvi. proforma of any communication the insurer may seek from the policyholders to
service the policy.
2. Every insurer shall inform and keep informed periodically the insured on the requirements
to be fulfilled by the insured regarding lodging of a claim arising in terms of the policy and the
procedures to be followed by him to enable the insurer to settle a claim early.
1.7.3 Claims procedure in respect of a life insurance policy
1. A life insurance policy shall state the primary documents which are normally required to
be submitted by a claimant in support of a claim.
2. A life insurance company, upon receiving a claim, shall process the claim without delay.
Any queries or requirement of additional documents, to the extent possible, shall be raised
all at once and not in a piece-meal manner, within a period of 15 days of the receipt of the
claim.
3. A claim under a life policy shall be paid or be disputed giving all the relevant reasons,
within 30 days from the date of receipt of all relevant papers and clarifications required.
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However, where the circumstances of a claim warrant an investigation in the opinion of the
insurance company, it shall initiate and complete such investigation at the earliest. Where in
the opinion of the insurance company the circumstances of a claim warrants an investigation,
it shall initiate and complete such investigation at the earliest, in any case not later than 6
months from the time of lodging the claim.
4. Subject to the provisions of section 47 of the Act, where a claim is ready for payment but
the payment cannot be made due to any reasons of a proper identification of the payee, the
life insurer shall hold the amount for the benefit of the payee and such an amount shall earn
interest at the rate applicable to a savings bank account with a scheduled bank (effective from
30 days following the submission of all papers and information).
5. Where there is a delay on the part of the insurer in processing a claim for a reason other
than the one covered by sub-regulation (4), the life insurance company shall pay interest on
the claim amount at a rate which is 2% above the bank rate prevalent at the beginning of the
financial year in which the claim is reviewed by it.
1.7.4 Claim procedure in respect of a general insurance policy
1. An insured or the claimant shall give notice to the insurer of any loss arising under
contract of insurance at the earliest or within such extended time as may be allowed by the
insurer. On receipt of such a communication, a general insurer shall respond immediately and
give clear indication to the insured on the procedures that he should follow. In cases where a
surveyor has to be appointed for assessing a loss/ claim, it shall be so done within 72 hours
of the receipt of intimation from the insured.
2. Where the insured is unable to furnish all the particulars required by the surveyor or
where the surveyor does not receive the full cooperation of the insured, the insurer or the
surveyor as the case may be, shall inform in writing the insured about the delay that may
result in the assessment of the claim. The surveyor shall be subjected to the code of conduct
laid down by the IRDA while assessing the loss and shall communicate his findings to the
insurer within 30 days of his appointment with a copy of the report being furnished to the
insured, if he so desires. In certain circumstances either due to special or complicated nature
of the case, the surveyor may, under intimation to the insured, seek an extension from the
insurer for submission of his report. In no case shall a surveyor take more than six months
from the date of his appointment to furnish his report.
3. If an insurer, on the receipt of a survey report, finds that it is incomplete in any respect,
he shall require the surveyor under intimation to the insured, to furnish an additional report
on certain specific issues as may be required by the insurer. Such a request may be made by
the insurer within 15 days of the receipt of the original survey report. Provided that the facility
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of calling for an additional report by the insurer shall not be resorted to more than once in the
case of a claim.
4. The surveyor on receipt of this communication shall furnish an additional report within
three weeks of the date of receipt of communication from the insurer.
5. On receipt of the survey report or the additional survey report, as the case may be, an
insurer shall within a period of 30 days offer a settlement of the claim to the insured. If the
insurer, for any reasons to be recorded in writing and communicated to the insured, decides
to reject a claim under the policy, it shall do so within a period of 30 days from the receipt of
the survey report or the additional survey report, as the case may be.
6. Upon acceptance of an offer of settlement as stated in sub-regulation (5) by the insured,
the payment of the amount due shall be made within 7 days from the date of acceptance of
the offer by the insured. In the cases of delay in the payment, the insurer shall be liable to pay
interest at a rate which is 2% above the bank rate prevalent at the beginning of the financial
year in which the claim is reviewed by it.
1.7.5 Policyholders Servicing
1. An insurer carrying on life or general business, as the case may be, shall at all times,
respond within 10 days of the receipt of any communication from its policyholders in all
matters, such as:
1. recording change of address;
2. noting a new nomination or change of nomination under a policy;
3. noting an assignment on the policy;
4. providing information on the current status of a policy indicating matters, such as,
accrued bonus, surrender value and entitlement to a loan;
5. processing papers and disbursal of a loan on security of policy;
6. issuance of duplicate policy;
7. issuance of an endorsement under the policy; noting a change of interest or sum
assured or perils insured, financial interest of a bank and other interests; and
8. guidance on the procedure for registering a claim and early settlement
1.8 Third Party Administrators (TPA) - Health Insurance
TPAs are licensed by IRDA and are engaged for a fee or remuneration for the provision of
health services. Health services means all the services rendered by a TPA as per the terms
of agreement entered into with an insurance company in connection with health insurance
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business, however the services rendered will not include either insurance business or soliciting
of insurance business either directly or through an intermediary. They are normally contracted
by a health insurer to administer services, including claims administration, premium collection,
enrollment and other administrative activities.
The license to act as TPA is granted by IRDA only to companies which have a share capital
and are registered under Companies Act, 1956. As per the memorandum of the company, the
primary objective should be to carry on business in India as TPA in the health services and
they are not permitted to transact any other business. The minimum capital prescribed is Rs.
1,00,00,000 .
As per the act at least one of the directors should be a qualified medical doctor registered with
Medical Council of India. The Chief Executive Officer (CEO) of the company has to under go
training as prescribed by the IRDA.
The TPA can enter into agreement with more than one insurance company and the insurance
companies can also deal with more than one TPA.
1.8.1 Code of conduct for TPA
The code of conduct for TPA has been prescribed by the Act.
TPA licensed under these regulations shall as far as possible act in the best professional
manner.
In particular and without prejudice to the generality of the provisions contained above, it shall
be the duty of every TPA, its Chief Administrative Officer or Chief Executive Officer and its
employees or representatives to :-
1. establish its or his or their identity to the public and the insured/policyholder and
that of the insurance company with which it has entered into an agreement.
2. disclose its licence to the insured/policyholder/prospect.
3. disclose the details of the services it is authorised to render in respect of health
insurance products under an agreement with an insurance company;
4. bring to the notice of the insurance company with whom it has an agreement,
any adverse report or inconsistencies or any material fact that is relevant for the
insurance companys business;
5. obtain all the requisite documents pertaining to the examination of an insurance
claim arising out of insurance contract concluded by the insurance company with the
insured/policyholder;
6. render necessary assistance specified under the agreement and advice to policyholders
or claimants or beneficiaries in complying with the requirements for settlement of
claims with the insurance company;
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7. conduct itself /himself in a courteous and professional manner;
8. refrain from acting in a manner, which may influence directly or indirectly insured/
policyholder of a particular insurance company to shift the insurance portfolio from
the existing insurance company to another insurance company;
9. refrain from trading on information and the records of its business;
10. maintain the confidentiality of the data collected by it in the course of its
agreement;
11. refrain from resorting to advertisements of its business or the services carried out
by it on behalf of a particular insurance company, without the prior written approval
by the insurance company;
12. refrain from inducing an insured/policyholder to omit any material information, or
submit wrong information;
13. refrain from demanding or receiving a share of the proceeds or indemnity from the
claimant under an insurance contract;
14. follow the guidelines/directions that may be issued down by the IRDA from time to
time.
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Chapter 10 : Fundamentals of Risk
Management
2.1. Definition of Risk
Risk is a condition whereby there is a possibility of loss occurring. In insurance the subject
matter insured is called the Risk.
There are two main components in definition of risk:
i) Uncertainty: Uncertainty refers to a situation where an event may or may not happen.
For eg. a building may or may not have a fire accident.
ii) Undesired consequences: Undesired consequences refers to the negative results
that may arise out of an event, such as a fire accident which may result in damage to a
property as well as result in consequential loss of business due to stoppage of work.
Risk is distinguished from peril and hazard.
Peril is a cause of loss, eg. fire.
Hazard is a condition that may create or increase the chance of a loss arising from a given
peril.
Physical hazard refers to the hazards / features associated with a risk, such as storage of
cotton near chemicals in a factory (chemicals increase chances of igniting the cotton).
Moral hazard refers to the moral risk of the insured. For instance if the insured has a history
of making fictitious claim in the past, insurers would not like to insure him.
2.1.1 Subjective Risk and Acceptable Risk
Subjective risk is the extent to which a person feels threatened by a particular risk.
Uncertainty of an event, as seen by an individual, varies from person to person based on the
quality of data available of past events.
Acceptable risk is the level of subjective risk which an individual or company feels comfortable
in facing and the size of loss that could be absorbed. Acceptable risk will always be influenced
by financial considerations.
2.2 Classification of Risks
i. Pure Risks and Speculative Risks
Pure risks are those which present the possibility of a loss or no loss but not a profit.
The person who buys a car immediately faces the possibility that something may
happen which could damage or destroy the car. The possible outcomes are loss or
no loss.
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Speculative risks may produce a profit or loss. Most typical example is day trading,
i.e. buying a share expecting to make profit which may not be the case always.
It is possible a risk may be both pure and speculative, e.g. loss of property by fire is
a pure risk for owner. But speculative for the insurer who underwrites large number
of risks hoping to achieve an overall profit on his portfolio.
ii. Dynamic and Static Risk
Dynamic risks are those resulting from changes in the economy, changes in price
level, consumer tastes, income and output, technology and may cause financial loss
to members of the society.
Static risk involves those losses that would occur even if there were no changes in
the economy. These losses arise from causes other than changes in economy eg.
fire, flood.
iii. Fundamental and Particular Risks
Fundamental risks are those which affect the whole or significant part of the society
- wars, major natural calamities etc.
Particular risks involve losses that arise out of individual events and affect an
individual or a single firm and arise from factors over which he or it may exert some
control.
2.3 Definition of Risk Management
Most definitions stress two points:
i. Risk management is concerned primarily with pure risk and
ii. Managing pure risks
Risk managers job is:
i. Identification of the problem.
ii. Evaluation / measurement of its potential effects.
iii. Identification and analysis of possible solutions.
iv. Adoption of-the most appropriate solution.
v. Monitoring the results.
2.4 Stages of Risk Management - Two Stages
i. Risk identification - until a risk is identified as a threat, it cannot be managed.
ii. Risk measurement / evaluation - is essential to decide on the appropriate method of
dealing with the risk.
The process of risk identification and evaluation/ measurement is called Risk Analysis.
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2.4.1 Risk Identification
Consists of -
Risk perception - ability to perceive that there is an exposure to risk.
Identification of causes which can lead to a loss and its effect.
Whether the risk is actually a threat? How it might be caused? What perils would be involved?
What are the likely consequences?
Tools of risk identification :
i. Exposure check list - this is simply a listing of common exposures. It is good to
prepare a list of exposures, that is the peril to which the business is exposed to.
ii. Event analysis is a technique for considering likely events which could cause problems
and then investigating the causes and effects. This technique uses as its starting
point a particular loss producing event such as fire. Use of Hazard Logic Trees which
is a method in which the various hazards which can increase the risk and increase
the chance of operation of a peril is drawn, so that it is possible to identify the cause
of and event which would produce a loss.
iii. Fault Tree Analysis - It highlights situations which may present no risk on themselves
but which could endanger the organization if they were to exist together. Eg. if
flammable vapours are produced in a chemical factory, this might not be a hazard in
itself. However, if it is exposed to electrical spark or ignited cigarettes, the hazard is
enhanced.
iv. Hazards and Operability Studies - this technique is used at the planning stage of
process plants in order to identify and eliminate potential causes of failure. It consists
of posing of the repeated question what would happen if . at every stage.
v. Dow Index - Dow Chemicals in the USA developed a system for identification and
evaluation of fire and explosion hazard potential based on the study of many plant
accidents. The technique is to:
List all materials in the operation
Identify the dominant substance in terms of quality and hazard
Quantify the hazards according to heats of combustion, decomposition or
reaction
Apply DOW rating factors.
For eg. in a factory manufacturing chemicals, as a first step, all the materials used in
the plant are listed, once the listing is done, the chemicals which are most hazardous
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are identified. The next step is to evaluate each chemical in terms of its various
attributes to understand the risks to which it is most susceptible to. Once these are
done, the rating which has been developed by DOW is applied. In this way the risk
is identified and classified.
vi. Safety Audit fire plus explosion safety, accident precaution, products safety, statistical
analysis of experience, contingency plan, final report with recommendation and time
bound implementations. To be done internally or by an outsider consultant.
vii. Flow charts - A flow chart of the entire process is drawn and risks the process is
exposed to is identified.
viii. Site visits - standard of maintenance and housekeeping which have a bearing on
exposure to losses arising out of fire, explosion etc. are analysed.
2.4.2 Risk measurement / evaluation
Once the risks are identified, the risk manager must evaluate them. Evaluation implies
some ranking in terms of importance. In the case of loss exposures, two facts must be
considered:
1. possible frequency or probability of loss
2. possible severity of loss
Measuring probability is difficult due to
Risks facing a company are not of a kind where the number of possible outcomes
are known for certain.
Therefore, statistical probability cannot be exactly calculated.
What can be done is to calculate a probability of future occurrences based on
information about the past.
The probability arrived at will never be more than an estimate.
Two important conclusions :
i. Better the record keeping of past occurrences of a similar kind, better the measurement
of a particular risk is likely to be.
ii. Catastrophic events happen so infrequently compared to small losses. The
measurement of the probability of such events is likely to be least exact.
While measuring probability, severity must not be ignored as the effect of a risk is most
important to risk manager. The most accurate determination of the probability of a fire
occurring is of little use if the prediction does not distinguish between a trivial fire and one
which destroys the factory.
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Measuring Severity
Purpose is to locate a risk in the scale of risks facing an organization.
Risks facing any organization can be categorised as :
Trivial - effects can be borne by organization as part of normal operations.
Minor - effects can be born within a single accounting period.
Major - effects would be too great for the organization to bear in a single accounting
period, but which could be acceptable if spread over a period of time.
Catastrophe - effects would destroy the organization.
The divisions between these categories can be expressed in financial terms and there tends
to be an inverse ratio between size of a risk and its frequency.
Risk Occurence
Catastrophe Rare
Major Infrequent
Minor Fairly Frequent
Trivial Frequent
2.4.3 Risk Avoidance
Risk avoidance is the most drastic method of dealing with risks. Whereas other methods
are aimed at reducing the potential impact of risks, either by reducing loss probabilities or
reducing financial consequences, risk avoidance results in total elimination of exposure to
loss due to specific risk. But it is most limited in practical application because it involves
abandoning some activity and so losing the benefits that may accompany it. It is a negative
rather than a positive approach.
Depending on the type of risk involved risk avoidance can be achieved by :
Changing the activity which brings about risk.
Changing materials used in the activity.
Changing the method by which the activity is done.
Plan for risk avoidance at planning stages - saves expenses, disruption of business etc.
Risk Reduction
Risk avoidance is limited in scope. A more common approach is risk reduction.
Risk reduction may relate either to the probability or severity and may take effect before,
during or after a loss.
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STAGE TECHNIQUE AIM
Pre Loss Preventive - eliminate cause of loss Reduce Probability
During Loss Protection - salvaging to preserve as much as possible
of the value of damaged property or ability of injured
person
Reduce severity
Post Loss 1. Protecting things or persons exposed to damage or
injury.
2. To limit loss to as small a compass as possible.
Reduce severity
All forms of risk and loss reduction will involve the following:
1. Physical Devices
i) Active devices which continually operate to reduce the probability of a loss producing
event occurring - e.g. thermostats on boilers and refrigerating equipment, overload
switches on electrical equipment.
ii) Passive devices like security and fire alarm, sprinklers, automatic fire door etc.
2. Organisational measures - structure and responsibility geared towards risk control
goals.
3. Education and training of employees.
4. Management education and training - to create awareness of the risk to which the
organization is exposed and of the ways in which they may be controlled.
5. Contingency planning - prepares the organization for 3 phases:
i) Pre-loss - emphasis on ways of preventing the risk from producing its effects and
ensuring that those effects are minimized if loss occurs.
ii) At the time of loss - main concern is to save life and salvage property and to bring
the disaster to end as quickly and as safely as possible, so as to limit its effects.
iii) Post loss - a recovery plan to be implemented to bring the organization back to its
normal pre-loss level of operations as quickly as possible.
2.4.4 Risk Transfer
1. Transfer of the activity that creates the risk.
2. Transfer of financial losses arising from the occurrence of the risk e.g. subcontracting
hazardous activities - transfer of liability to contractor etc.
Transfer of liability risks by contract, is by exclusion clause, hold harmless clause or indemnity
clause.
This contract for transfer of risks is entered into by the parties to the contract whereby
one party is relieved of his responsibility for loss/damage for which he is responsible under
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common law. For eg. an owner of a building is responsible for any damages to the building
and has to incur expense to rectify it. He may enter into a contract with the tenant whereby
the tenant takes over the responsibility for damages to the property.
Exclusion clause - clauses that relieves one party of the liabilities that he may otherwise incur
towards the other.
Hold Harmless clause - a contract usually written such that one party assumes legal liability
on behalf of another party.
Indemnity clause contract to indemnify one party for losses sustained in lieu of consideration
received.
2.4.5 Risk Financing
After risk is identified, measured and treated appropriately, the question of financing the risk
arises:
Options
1. Pay for losses as they arise out of operating budgets with no specific financial
provision being made.
2. Set up internal contingency fund to meet loss.
3. Borrow to meet cost of losses - from subsidiaries.
4. Risk transfer by insurance.
2.4.6 Risk Retention
Factors influencing risk retention decision:
1. Risk Appetite of the organization - management philosophy, size of company etc.
2. Nature and size of risk
3. External incentives and disincentives - this refers to the incentive which a company
derives for retaining risk or disincentive for transferring risk. For eg. some of the
rating agencies from Japan do not confer quality rating to a company if the company
avails loss of profit insurance. Loss of profit insurance is an insurance where losses
in revenue sustained due to stoppage of business due to an insured peril is covered.
If such coverage is taken, it implies (as per the rating agencies) that the insured
does not have an alternative plan to continue with production and cannot commence
operations within a short period of time from an unforeseen event.
2.4.7 Construction of a plan
Once the risk exposure is identified and analysed, the next step is to take a decision on the
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combination of measures which an enterprise wishes to adopt to minimize or eliminate the
risk. This is done by putting up an appropriate risk management plan. The plan should clearly
state the various techniques of risk management adopted with regard to various risks. The
plan for a shop may state that:
a) The measures for risk reduction such as putting up fire extinguishers, warning boards
etc.
b) Risk avoidance measures such as undertaking not to sell crackers, cigarettes etc.
c) Risk transfer measures such as availing Fire, Burglary, Money Insurance
d) Risks retained; such as, since the employees are highly trusted, the insured decides
not to avail of fidelity polices
2.4.8 Implementation of a plan
Once the risk management plan is adopted, the next step is to implement it. The plan so
adopted should be economical, efficient and should be constantly updated.
2.4.9 Monitoring the Plan
The risk management program does not end with the implementation of a plan. The success
of the plan has to be constantly monitored, the outcome should be reviewed. This would
enable the risk manager to detect risks which might have escaped his attention earlier and
plug holes in the plan to ensure that the optimal program is formulated.
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Chapter 11: Insurance Contract,
Terminology, Elements and
Principles
3.1 Introduction
All insurance purchases involve contracts. In fact, insurance is a distinct branch of contract law.
It would be easier to understand insurance, if general knowledge of contract law is available
with a person. It is important to understand the term contract as it is used in general and
the distinguishing feature of insurance contract.
A contract is an agreement between two or more parties which, if it contains the elements of
a valid legal agreement, is enforceable by law or in other words a contract involves exchange
of promise and in case of breach the parties to the contract can avail of legal remedy. The law
of contract in India is governed by the Indian Contract Act, 1872.
3.2 Contract Terminology
Contracts are legally binding agreements which mean that the parties to the contract have
legal recourse in the event of one of the parties not adhering to the terms of the contract. The
court can either ask the party to the contract to honour the commitment and perform an act
as laid down in the contract or it can instruct the offender to compensate the affected party
financially.
Depending on the nature of breach, a contract may either become :
i) Void, or
ii) Voidable
A contract becomes void if the purpose of the contract is illegal for e.g. an insurance policy
taken to cover a smuggled item becomes void and cannot be enforced. Similarly, if a person
not competent to enter into a contract, such as a person of unsound mind is party to a
contract, the contract becomes void ab initio (which means the contract is void from the very
beginning of the contract). The courts cannot enforce such a contract as the contract, in strict
terms, never existed.
A contract becomes voidable when one of the parties to the contract can exercise the option
of breaking the contract when the other party commits a breach of any of the terms of the
contract. For instance, in an insurance policy, if the insured changes the nature of business,
from that of an office to a shop, then, in the event of a claim, the insurer can refuse to admit
a claim and can consider the contract as voidable as the insured has failed to inform them
about change in the nature of risk.
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3.3 Elements of a Valid Contract
All valid contracts must have the following four elements: offer and acceptance, consideration,
capacity and legal purpose.
3.3.1 Offer and Acceptance
In any valid contract, there should be an offer and acceptance. If we take the insurance policy
as an example, the insured makes an offer by way of filling up a proposal and the insurer
accepts the offer by quoting rates and terms under which he is willing to accept the offer to
insure. It is of absolute importance in a contract that both the offer and acceptance should be
expressed in terms which are unambiguous and clear.
It is also important that the acceptance should be on the same terms on which the offer is
made. For instance, if an insured makes an offer to cover his house in Karol Bagh, Delhi, then
the acceptance should be for coverage of the same house and not a different property. If the
second party to whom the offer is made wishes to make a counteroffer, he may do so and the
contract is valid only when the first party agrees to the terms proposed by the second party.
This is called consensus ad idem.
The acceptance of an offer should be unconditional. If any conditions are imposed then those
conditions have to be agreed to by both the parties for the contract to come into existence.
While it is good for the offer and acceptance to be in writing, both oral and written offer and
acceptance are recognised by law.
3.3.2 Consideration
Consideration is the price paid by both the parties for the promise and is a key requirement
for a valid contract. The logic for this is that each part to the contract should confer some
benefit on the other. In insurance, the consideration on the part of the insured is the money
he pays as premium and the insurer makes a promise to indemnify the insured in the event
of the happening of the contingency insured against.
3.3.3 Capacity
The third requirement for a valid contract is the capacity of the parties to enter into a contract.
The reason being a person entering into the agreement should have the ability to honour
the commitment made under the contract. Minors, a person of unsound mind, those in an
intoxicated state etc. cannot enter into a legally binding agreement. The purpose is to ensure
that people who are not in a fit state should not be taken advantage of.
Similarly the insurer should possess the necessary qualification to enter into a contract. In
India only those insurers who have been licensed by IRDA to carry on the business of insurance
can issue insurance policies.
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3.3.4 Legal Purpose
The purpose of the agreement/contract should be legal. If two parties enter into an agreement
the purpose of which is not legal, the same cannot be enforced in a court of law and hence the
contract would not be valid. For example, if an insurance policy is issued to cover the results
of a race, the contract would become invalid.
3.4 Distinguishing Characteristics of Insurance Contracts
While all the contracts should have the abovementioned four features to be legally binding,
an insurance contract has some special characteristics while at the same time adhering to the
above mentioned features.
The special features of an insurance contract are :
1. Principle of indemnity
2. Rules of insurable interest
3. Subrogation in insurance
4. Doctrine of utmost good faith
5. Aleatory contract concept
3.4.1 Principle of indemnity
Insurance contracts are generally based on the principle of indemnity. As per this principle,
the insured should be in the same financial position after the settlement of claim as he was
immediately prior to the loss. The rationale being that the insured should not benefit from an
insured loss.
However there are some insurance policies which are an exception to the above rule, such as:
1. Life Insurance
Since the value of human life cannot be assessed, life insurance policies are not strict policies
of indemnity. These are more of a benefit policy. However, this does not mean that one can
take insurance policy for any value, as this would create a moral hazard. Most of the insurers
determine the sum assured based on some benchmark, such as the earning capacity of the
assured.
2. Replacement cost insurance
This policy offers new for old and came into vogue during the second world war. Due to high
inflation in those days, the claim amount received on market value basis was found to be
inadequate to carry on businesses. Such type of policies are issued under Fire and Engineering
branch of insurance and they are granted for relatively new property, project insurance etc.
In such policies no depreciation is deducted and the claim settlement is made on replacement
value of the property on the date of loss.
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3. Valued insurance policies
A valued insurance policy is another exception to the rule of indemnity. Valued policies pay
the full face value of the policy whenever an insureds loss occurs. The value of the insured
property is agreed to before the policy is written. Marine insurance contracts are issued on
a valued basis. Under marine insurance, the policies are generally issued for Invoice cost +
Freight + Insurance + 10% being margin for profit.
For eg. marine insurance is taken for 100 cartons of readymade garments which has an
invoice value of Rs 1,00,000, the freight payable for transporting it is Rs. 2,000, marine
insurance payable for covering the transportation risk is Rs. 1,500. Insurance can be taken for
Rs. 1,00,000 + Rs. 2,000 + Rs. 1,500 = Rs. 1,03,500 . Additional 10% can be added for the
profit which the seller may make on the transaction, as the profit would be lost in case of any
loss or damage while the consignment is in transit. Hence, the value for which insurance can
be taken is Rs 1,03,500 + 10% (of Rs. 1,03,500) = Rs. 1,13,850. This is the amount that will
be paid by the insured to the insurer in case of loss, damage to the cartons.
Claim settlements are also based on the valuation agreed upon.
Similarly while insuring obsolete machinery, antiques, works of art which does not have a
regular market, the valuation is agreed prior to the commencement of the policy to avoid
disputes in the event of claims.
3.4.2 Insurable Interest
For an insurance contract to be valid, the proposer should have insurable interest in the subject
matter of insurance. Insurable interest implies that the proposer should benefit financially by
the continued existence of the insured property/life or should be put into financial loss by the
loss/damage/death of the subject matter insured.
i) Property Insurance
In all types of property insurance other than marine, the insurable interest should
exist at the time of inception of the risk as well as at the time of claim. Marine
insurance, by its nature, is taken to cover trade related activities wherein the rights
to the goods is passed on from one party another. Hence, insurable interest under
marine insurance should exist at the time of claim. The person with insurable interest
is the person in whom the ownership of the property vests at the time of loss.
ii) Life Insurance
In life insurance, insurable interest should exist at the time of entering into the
contract. Further, in life insurance it is the owner of the policy and not the beneficiary
who should possess insurable interest. However, it is quite possible that owner and
the beneficiary are the same though it is not mandatory.
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3.4.3 Subrogation
Subrogation is the legal substitution of one person in anothers place. Subrogation means
stepping into the shoes of another person. In insurance it implies if the insured has any
rights against third parties, the insurer on payment of the claim takes over these rights. This
is a corollary to the principle of indemnity and enforcing the principle of subrogation ensures
that the principle of indemnity is upheld. In insurance, subrogation gives the insurer the right
to collect from a third party, any rights which the insured has against such a third party, after
paying the insureds claim(s). A typical case of subrogation arises in automobile insurance
claims. Suppose Satish is responsible for the collision of his car with Rahuls car. Rahul may
sue Satish for damages or he may collect money from his own automobile insurance. If he
chooses to collect money from his own insurance, his insurance company will be subrogated
to his right to sue Satish (insurance company replaces Rahul). Rahul cannot collect money for
his loss both from his insurer and from Satish.
Subrogation does not exist in life insurance because life insurance is not a contract of
indemnity. Thus, if Mr. Rahul Kumar is killed by his neighbors negligence, Mrs. Kumar may
collect whatever damages a court will award for her husbands wrongful death. She may also
collect the life insurance proceeds. The life insurer is not subrogated to the liability claim and
cannot sue the negligent party.
3.4.4 Utmost good faith (Uberrimae Fidei)
In all legal contracts, it is essential that the parties to the contract exercise good faith.
However, in insurance the emphasis is on utmost good faith which should be exercised by
the insured. As the insured alone has complete information about the subject of insurance,
he should reveal all the facts to the insurer. In case of breach of this condition the contract
becomes void abinitio.
3.4.5 Aleatory contract
Aleatory contract is a contract wherein the performance of one or both the parties is based
on the occurrence of an event. Such insurance contracts may be a boon to one party but
create a major loss for the other, as more in benefits may be paid out than actual premiums
received, or vice versa (a large amount is paid by way of claim where as the amount received
as premium is very small, or when there is no claim, the entire premium is retained without
any outflow to the insured).
3.4.6 Contract of adhesion
The wordings of the insurance policy is written by the insurer and the insured either accepts
the contract in full or rejects it but cannot modify it. Because of the one sided nature of the
contract, the courts interpret the policy wordings and clauses, in case of any ambiguity, in
favour of the insured.
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3.4.7 Unilateral contract
Insurance contracts are unilateral in nature as only the insurer can be held accountable in a
court of law.
3.5 Common clauses and sections in a insurance contract :
The insurance contract contains the following sections and clauses :
1. Declaration section where in the insured declares that the information provided by
him is true to the best of his knowledge.
2. The operative clause which describes the insured and the extent of coverage.
3. Exclusions under the policy.
4. Conditions which need to be fulfilled for the cover to be valid.
5. Riders and endorsements which are not standard part of the policy but can be
covered subject to extra premium. The term rider is used in Life policies. A common
rider is accidental death also called double indemnity, whereby if death occurs due
to an accident, the claim amount payable is double the face value of the policy.
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Chapter 12: General Insurance
4.1 Insurance can be broadly classified as:
A) Life Insurance
B) Non- Life Insurance
As the name denotes, Life Insurance deals with insurance of human life and Non life deals
with all insurance other than life.
4.2 Non-Life insurance can be further classified into:
A) Property Insurance
B) Personal Insurance
C) Liability Insurance
In this chapter we will deal with various types of Property Insurances.
4.3 Types of Property Insurance :
A) Fire Insurance
B) Various types of Engineering Insurance
C) Marine Insurance, etc.
4.3.1 Fire Insurance
4.3.1.1 Suitability
Fire insurance policy is suitable for the owner of a property, one who holds property in trust or
in commission, individuals/financial institutions who have financial interest in the property. All
immovable and movable property located at a particular premises such as buildings, plant and
machinery, furniture, fixtures, fittings and other contents, stocks and stock in process along
with goods held in trust or in commission including stocks at suppliers/ customers premises,
machinery temporarily removed from the premises for repairs can be insured.
4.3.1.2 Salient Features
Along with the basic coverage against loss or damage by occasional fire, the standard fire and
special perils policy provides protection from a host of other perils such as:
1. Lightning
2. Explosion/implosion
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3. Aircraft and articles dropped therefrom, i.e. any damage to the insured property
caused either due to an aircraft falling on the property or any object dropped from
the aircraft damaging the insureds property.
4. Impact damage due to rail/road or animal; other than insureds own vehicle
5. Riots, strike, malicious and terrorism damage
6. Subsidence (motion of a surface as it shifts downward) and landslides (including
rockslide)
7. Storm, cyclone, typhoon, tempest, hurricane, tornado, flood and inundation, damage
caused by sprinkler leakage, overflow, leakage of water tanks, pipes etc.
4.3.1.3 Extra covers
The policy may be extended to cover earth quake, fire and shock; deterioration of stock in
the cold storages following power failure as a result of insured peril, additional expenditure
involved in removal of debris, architect / consulting engineers fee over and above the amount
covered by the policy, forest fire, spontaneous combustion and impact damage due to own
vehicles.
4.3.1.4 Benefits
In case of a partial loss, the insurance company effects payment for repairs and replacement.
In case of policy with reinstatement value clause, cost of reinstatement will be paid on
completion of reinstatement subject to overall limit of the sum insured. The insurance company
may at its option, also repair or replace the affected property instead of paying for the cost
of restoration.
4.3.1.5 Premium
Premium rating depends on the type of occupancy-whether industrial or otherwise.
All properties located in an industrial complex will be charged one rate depending on
the product(s) made.
Facilities outside industrial complexes will be rated depending on the nature of
occupancy at individual location.
Storage areas will be rated based on the hazardous nature of goods held.
Additional premium is charged to include Add on covers.
Discount in premium is given based on past claims history and - fire protection
facilities provided at the premises.
The insured has the option not to avail riot, strike, malicious and terrorism damage
cover. Similarly the insured can decide not to take coverage against the risks of
flood, storm, typhoon and inundation in which case the insured may be entitled to
some discounts.
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4.3.2 Various types of Engineering Insurance
4.3.2.1 Machinery insurance policy
Machinery Insurance Policy was developed to grant industry effective insurance cover for plant
and machinery and mechanical equipment at work, at rest or during maintenance operations.
Normally financial institutions insist on insurance cover against fire, riot and strike and Acts
of God perils. With the advancement of technology, the machines used in the industry are
becoming increasingly complicated. Now machines are manufactured with increased capacities,
higher speeds of operation, reduced energy consumption, reduced maintenance time, reduced
life, cheaper substitutes for reducing costs etc.
The machineries are getting more and more sophisticated and delicate. The guarantees given
by the manufacturers are very vague. It is very difficult to prove whether a loss was due to
manufacturing defect or not.
Since a modern machine replaces a number of small machines, the cost of replacement is high.
The cost of repairs of most of the machinery would be rather high due to the expertise required
to carry out the repairs as well as frequent changes in technology making the earlier machines
redundant or making it difficult to get spare parts etc. A major breakdown in the machinery
may have a severe affect and wipe out a large portion of profit for a businessman.
4.3.2.2 Machinery covered under the policy
Under machinery insurance, it is possible to insure practically all stationary and mobile
machinery, mechanical and electrical equipments, machineries and apparatus used in industry.
Fertilizer plants have many critical types of equipments. The vital equipments such as main
compressors, turbine, turbo alternator sets, process and their motors blowers, transformers
and boiler feed water pumps, ID fan, FD fan, etc. can be insured.
4.3.2.3 Basis of sum insured
The sum insured to be declared under this policy should be its new replacement value including
freight, customs duty if any, handling and erection charges.
4.3.2.4 Deductible / excess under the policy
Every item in this policy is subject to a deductible excess. This is the amount which the
insured has to bear in each and every loss or damage that occurs to the item. Over and above
this amount only the insurers are liable under this policy. Thus in case of a claim, the insurers
deduct this excess from the claim amount and pay the rest of the amount.
4.3.2.5 Basis of claim settlement
The basis of claim settlement is as follows :
1. Partial loss : Cost of replacement of parts in full without depreciation plus the labour
charges, cost of dismantling, re-erection, freight to and from repair shop, customs
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duty, if any. In case of items with limited life, appropriate depreciation is taken into
consideration.
2. Total loss : Total loss is destruction of an asset or property to the extent that nothing
of value is left and the item cannot be repaired or rebuilt to its pre-destruction state.
In case of total loss the settlement is based on the actual value of item immediately
before the occurrence, taking into account appropriate depreciation.
4.3.3 Contractors All Risk Insurance
4.3.3.1 Introduction
Contractors All Risks (CAR) Insurance is a relatively modern branch of engineering insurance.
The basic concept of CAR Insurance is to offer comprehensive and adequate protection against
loss or damage in respect of the contract works, as well as for third party claims in respect of
property damage or bodily injury arising in connection with the execution of a civil engineering
project.
4.3.3.2 Insured
CAR insurance may be availed by :
- the principal
- the contractors engaged in the project, including all subcontractors.
In order to prevent overlaps or gaps in the cover provided, the insured under CAR insurance
can be all parties concerned, such as the Principal, the contractor and sub contractor (where
applicable) so that the interests of all the parties are protected.
4.3.3.3 Subject matter insured
CAR insurance can be taken out for all buildings and civil engineering projects, such as:
- office buildings, hospitals, schools and theaters
- factories, power plants
- roads and railway facilities, airports
- bridges, dams, tunnels, water supply and drainage systems, canals and harbours
etc.
The cover relates to the following:
Bantras Works :
This denotes the property being erected including preparatory work on the site, such as
excavation, grading and leveling work, the execution of temporary structures like diversion
and protective dams etc.
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Temporary Structures and Equipments :
This includes workers temporary accommodations, storage sheds, scaffolding, construction
utilities for temporary electricity, water supply etc.
Construction Machinery :
This includes earthmoving equipments cranes and the like as well as site vehicles not licensed
for use on public roads, no matter whether such machinery is owned or hired by the contractors.
These are to be covered under separate Contrators Plant and Machinery (CPM) policy.
Costs at Clearance of Debris :
This term implies the expenses incurred for the removal of debris from the site in the event
of a loss indemnifiable under the policy.
Third Party Liability :
This refers to legal liability arising out of property damage or bodily injury suffered by third
parties and occurring in connection with the contract work on or near the building site.
However, the cover does not extend to indemnify insured against any claims from the insureds
employees or workmen who are connected with the construction project.
Surrounding Property :
The term implies property located on the site as well as property surrounding the site.
A distinction is made however, between :
Property belonging to or held in care, custody or control of persons named in the policy as the
insured (in this case cover is only granted by way of an endorsement) and property belonging
to or held in care, custody or control of persons, who may be regarded as third parties for the
purposes of the policy, (in this case indemnity is payable according to the principles of third
party liability cover of the CAR policy).
4.3.3.4 Scope of cover
CAR insurance provides an all risk cover whereby every hazard is covered which is not
specifically excluded. This means that almost any sudden and unforeseen loss or damage
occurring during the period of insurance to the property insured on the building site is
indemnified. The most important causes of loss indemnification under CAR insurance are:
- Fire, lightning and explosion
- flood, inundation, rain, snow avalanche, wind storm
- earthquake, subsidence, landslide, rockslide
- theft, burglary
- bad workmanship, lack of skill, negligence, malicious act or human error
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CAR insurance also covers loss of or damage to building material; on site, while being
transported, while in intermediate storage or during assembly or disassembly.
The cover provided for CAR insurance is only subject to a few exclusions which the international
insurance markets usually apply. These are normally what are termed as uninsurable risks.
These exclusions are named in the policy and essentially comprise:
i. loss or damage due to war or warlike operations, strike, riot, civil commotion,
cessation of work, requisition by order of any public authority (it is possible to
include the risks of strikes and riot in special cases but such an inclusion is subject
to careful prior examination)
ii. loss or damage due to wilful act or wilful negligence of the insured or of his
representatives.
iii. loss or damage due to nuclear reaction, nuclear radiation or radioactive
contamination
iv. consequential loss of any kind or description whatsoever such as claims from penalty
losses due to delay, loss of contract
v. loss or damage due to mechanical and/or electrical breakdown or derangement of
construction machinery, plant and equipment
vi. loss or damage due to faulty design
vii. the cost of replacement; repair or rectification of any deficiencies in the contract
works (i.e. use of defective or inadequate material). While the cost of rectification
of a defective material/work is excluded, if this defective material/workmanship
causes any other damage, such losses are payable. For eg. if a part of the building
develops cracks and falls down due to defective workmanship, which in turns falls on
a machinery and damages the machinery, loss to such machinery is payable though
damage to the part of the building which developed cracks is not payable.
4.3.3.5 Period of cover
The cover attaches as from the commencement of Work or after the items entered in the
schedule of the policy have been unloaded at the site and terminates when the completed
structure or any completed part thereof is taken over or put into service. In addition, it is
possible to extend the period of cover to include maintenance period.
4.3.3.6 Calculation of sum insured and premium
a. Sum insured
The sum insured must be equal to the amount stated in the building contract, plus the value
of any construction material supplied and/or additional work performed by the principal. Any
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increase in the contract sum must be notified immediately to the insurers in order to avoid
under insurance.
Usually, separate sums insured are fixed for:
- construction machinery and construction plant and equipment (the relevant sum
insured must be equal to the replacement value applicable when the contract is
concluded, including freight, erection costs and customs duties) ;
- existing buildings and clearance of debris (in this connection it is essential that the
respective sums insured are adequate)
Third party liability cover is likewise subject to a separate limit of indemnity for any one
accident or series of accidents arising out of an event.
b. Premiums
The premium rates for CAR insurance is based on the nature of the project and period of
contract taking into account peculiarities of each individual project. Basically, the following
factors are considered for proper risk assessment:
i. experience and ability of the contractor
ii. conditions on and exposure of the site e.g. the probability of earthquakes, flood,
inundation etc.
iii. design features and building material
iv. construction techniques
v. safety factors considered in the construction; time schedule measures provided to
ensure safe execution of the project
To be able to arrive at premium rate which are reasonable and commensurate with
the risk involved, the insurers must be given an opportunity of checking the building
contract, drawings and specifications, construction time schedule as well as other
relevant information. The more complete the information given to the insurers, the
more accurate the assessment of the risk will be and the more appropriate and fair
the premium for the insured.
If it is not possible to complete a project within the policy period, the insurance may
be extended, subject to the payment of an additional premium.
4.3.3.7 Indemnification
While the CAR policy undertakes to indemnify the insured against loss or damage specified in
the policy, it is customary to make the insured responsible for a small portion of the loss. This
is achieved by stipulating a deductible:
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A deductible is stipulated for each CAR insurance. This is the share in each and every
loss which the insured has to bear from his own account and which is thus deducted
from the amount of indemnity of indemnity. The deductible varies according to the
type and size of a building project and the hazards involved in each individual case.
The purpose of each deductible is to stimulate the insureds interest in loss prevention
and to relieve the insurers as also the insured from dealing with the many minor
losses where the administrative expenses incurred would be excessive compared
with the indemnity. Usually, separate deductibles are applied for the contract works,
the temporary structures for normal losses and losses due to Act of God perils such
as flood, storm, earthquake etc. The limit of indemnity over all is the sum insured.
4.3.4 Marine Cargo Insurance
4.4.4.1 Brief History :
Marine insurance is as old as civilization. This system of marine insurance owes its origin and
evolution to mankinds fear of future uncertainty and consequent search for security. It began
probably in the cities of Northern Italy by the Lombardy merchants around the end of the
12
th
century. Marine insurance became a full-fledged and specialised activity some centuries
later. The humble coffee house of the Lloyds opened by Edward Lloyd around 1680 AD saw
the beginning of marine insurance. From these humble beginnings it has now grown into a
business of vast proportions.
4.3.4.2 What is marine insurance?
It is a system of financial protection against the happenings of accidental or fortuitous events,
such as;
a) During sea transportation the goods may be lost due to sinking of the vessel.
b) Damaged due to incursion of seawater into the holds of the ship during rough
weather.
c) During land transit, the goods may be lost damaged by the derailment of railway
wagons or collision of motor goods vehicle.
d) During transit and whilst in storage incidental to transit, the goods may catch fire or
may be stolen.
These hazards or causes of loss are referred to as perils or risks in insurance terminology
And may result in the following types of losses:
a) Total loss - e.g. an entire shipment is lost due to the sinking of the vessel or due to
outbreak of fire
b) Partial loss - cargo is damaged by seawater during heavy weather or cargo is
jettisoned (thrown away) to save the marine voyage threatened by heavy weather.
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c) Expenses - The insured may incur certain expenses to prevent aggravation of loss or
damage - e.g. hides (animal skin before it is converted to leather) / leather slightly
damaged by seawater may be - re-conditioned at an intermediate port to reduce the
loss or prevent the total loss.
The purpose of marine insurance is to indemnify such losses. The types of losses paid for
and the extent of payment depends upon the terms and conditions of the marine insurance
policy. Marine insurance covers cargo when it is in transit not only over the sea but also when
in transit by air, overland, inland, waterways, costal seas and also when being sent by post
(registered or otherwise) etc. In fact anything in transit under a valid contract can be covered
under a marine policy.
4.3.4.3 What is the need for marine insurance?
Marine cargo insurance and banking are considered to be the life blood of commerce. Domestic
and international trade is financed by the banking system and this financing is dependent on
collateral security against loss, which is provided by the marine insurance policy. The cargo
might constitute the physical security for the bank finance, but if the goods are lost or
damaged by transportation hazards, this physical security is of no use to the banks. Hence,
the marine cargo insurance provides the supportive security.
4.3.4.4 Limited liability of the carrier (shipper):
At times shipping and trading circles argue that the carriers liability can take the place of an
insurance policy. The Carriage of Goods by Sea Act, 1925, statutorily determines the carriers
liability and responsibility. Unless it can be proved that the carrier did not perform his duties
as provided for in the statute, he cannot be held liable. The undertaking to make good the loss
under insurance policy is wider in scope than under the various statutes governing carriers.
The per package limitation and provisions relating to excluded articles also act as limitations
to recovery of the full value of the goods from the carriers.
4.3.4.5 What are the special features of marine insurance?
a) Marine cargo policies are freely assignable because the interest in the goods passes
through various hands till the ultimate consignee takes final delivery. A cargo policy
may be assigned either before or after a loss.
Since the policies are freely assignable the existence of the insurance interest of the
claimant should exist at the time of loss. There is no need of insurable interest to
exist at the time of taking up the policy. However, the insured should have reasonable
expectation of acquiring such interest at a later date.
b) The sum insured indicated in the policy is the value agreed between the insured
and the insurer. Hence the policies are on agreed value basis. The value so agreed
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upon cannot be reopened i.e. the value once agreed upon cannot be changed unless
fraud is suspected. In addition to cost, insurance and freight a percentage loading is
included to arrive at the agreed value. An element of anticipated profit can also be
added to arrive at such an agreed value. The indemnity provided by the policy is of
course subject to the actual amount of the loss or damage and is also subject to the
overall limit i.e. the sum insured.
c) The duration of cover in a marine policy is subject to the transit clause of the
respected cargo clause. This differs from one mode of transit to another (sea, rail,
road and air). While the duration of cover in other clauses of insurance is fixed at
the time of the issue of the policy itself - in marine insurance it is governed by the
nature of transit, time of discharge, time of arrival at destination.
d) The interpretation and applicability of various Statutes, the legislation of various
countries, port conditions, customs procedures, and the legal systems in various
parts of the world, govern the operation and interpretation of a marine insurance
policy.
4.3.4.6 Scope of cover
A marine insurance policy undertakes to indemnify the insured in the event of a loss caused
by an insured peril during the currency of the policy. The cargo is exposed to various perils
from the time it leaves the suppliers warehouse till received at the final warehouse of the
consignee. The policy should offer cover against these various types of losses. The minimum
extent of cover is against the total loss or damage of the cargo. This can be caused by fire,
sinking, stranding, washing over-board etc. Cargo remaining undelivered is also a loss to the
insured. The total loss may be of the entire cargo or a part thereof may be totally lost. The
scope of cover afforded under different types of policies is determined by the clauses attached
to them.
4.3.5 Features of motor insurance
4.3.5.1 Types of covers
We shall now see how motor insurers meet the insurance requirements of their clients- both
compulsory and optional.
Irrespective of the type of vehicle involved, motor insurers usually will grant one of four main
types of policy cover, namely:
Statutory Third Party Liability Only
Extended Third Party Liability only
Third party, fire and or theft
Comprehensive
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In many countries the third party liability cover is broken in two parts, viz; third party bodily
injury and third party property damage. The conditions of the policies issued may vary in
many respects according to the class of vehicle insured.
4.3.5.2 Classification of motor insurance business
For proper and equitable rating of any insurance portfolio the insurable population has to be
divided into homogeneous groups, more popularly known as classifications, such that the
constituents of each class present more or less the same degree of risk for the insurer. If a
group consists of constituents having diverse risk levels, the pricing of insurance for such a
group would be very difficult and may expose the insurer to the risk of adverse selection.
Motor insurance business is commonly divided as follows:
a) Private cars (not used for carrying passengers for hire or reward)
b) Motor cycles
c) Commercial vehicles (including private cars carrying passengers for hire or reward)
d) Motor trade road risk
e) Motor trade internal risk
Private Cars
This category comprises cars of private type including station wagons used for social, domestic
and pleasure purposes and business or professional purposes (excluding the carriage of goods
other than samples).
Motor Cycles
Motorcycles with or without sidecars, pedal cycles or mechanically assisted pedal cycles and
motor scooters with or without sidecars come under this category.
Commercial vehicles
All vehicles other than Private Cars or Motor Cycles excluding vehicles running on rails come
under this category.
Motor trade road risk
Essentially this classification is a sub class of commercial vehicles and the road risks of vehicles
belonging to motor traders, before being sold to the ultimate customers, are covered under
this class.
Motor trade internal risk
This class covers the risk that the motor trader is exposed to while the vehicles are either
brand new or belong to customers and are on premises of the motor traded for servicing or
repair.
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Besides this broad classification, each class is further divided into sub classes of homogeneous
risks. The broad classification will usually be same in most of the countries. However the
sub-classifications may vary slightly from country to country.
4.3.5.3 Motor Insurance Coverage
The motor insurance usually covers three kinds of financial losses:
1. Loss or damage to the vehicle
2. Liability to third parties
3. Loss of use of vehicle
Loss of use of vehicle cover is available in most of the developed insurance markets. For eg.
due to an accident, the insured vehicle cannot be used for may be a week in which case an
alternate vehicle is given by the insurer for the period when his vehicle is under repairs. This
cover is currently not available in India.
4.3.5.4 The Perils (please check this once again)
The most common perils covered by motor insurance policies are:
i. Fire, explosion, self ignition or lightning;
ii. Burglary, housebreaking or theft;
iii. Riot and strike;
iv. Earthquake (fire and shock damage);
iv. Flood, typhoon, hurricane, storm, tempest, inundation, cyclone, hailstorm, frost;
vi. Accidental external means (all accidents are covered under this);
vii. Malicious act;
viii. Terrorist activity;
ix. Transit by road, rail, inland-waterway, lift, elevator or air;
x. Landslide or rockslide.
xi. Legal liability of the insured to third parties for death, bodily injury or damage to
property arising out of the use of the vehicle. The legal cost and expenses incurred
by the insurance with the insurers consent are also payable.
xii. Personal accident to owner driver
4.3.5.5 Additional Benefits
Apart from the standard coverage as discussed above some extra benefits are also
available:
i. Wider legal liability to drivers
ii. Legal liability to employees travelling in the vehicle
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iii. Personal accident cover for unnamed passengers of vehicle
iv. Coverage for trailers
v. Coverage for rallies, reliability trials, motor racing etc.
4.3.6 Burglary Insurance
4.3.6.1 Scope
The Burglary policy covers theft of property after forcible violent entry or theft followed
by actual violent forcible exit. The policy is issued to cover the stocks, furniture, fixtures,
calculators etc. as well as damage to the building caused by burglary. Cash in safe can also
be covered provided the cash is kept in burglar proof safe and the burglary happens following
violent and forcible methods to obtain the key or in opening the safe. The policy can be
extended to cover the risk of riots, strike and terrorism.
4.3.6.2 Exclusions
Loss or damage caused by the family members or employee of the insured.
Committed by any person lawfully present in the premises.
Bills, promissory notes, cheques etc. unless specifically covered.
War and nuclear perils
4.3.6.3 Conditions
i) Each and every item is separately subject to the condition of average.
If the insured value of the property is less than the value of the property immediately
prior to the loss, the insurance company will pay only proportionate amount towards
the claim and the balance has to be borne by the insured. Each and every item is
separately subject to the condition of average.
For eg.
Insured Items
Insured value
(In Rs.)
Value at the time of
loss (In Rs.)
Loss
(In Rs.)
Stock in process 2,50,000 3,00,000 Nil
Raw material 1,00,000 1,00,000 Nil
Finished Goods 1,50,000 1,00,000 75,000
Total 5,00,000 5,00,000 75,000
In this case even though total value insured is equal to the value at risk on the date
of loss, since principle of average is applicable to each item, the claim payable for
finished goods would be =75,000*1,00,000/1,50,000= Rs. 50,000.
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ii) Notice of loss: Immediate notice of loss should be given to the insurer. Within 7 days
of loss, completed information of lost items, their estimate should be submitted.
iii) Prevention and minimization of loss: The insured should act as though he is uninsured
and take all steps to prevent and minimize the loss.
iv) The indemnity may be by way of replacement, repair or reinstatement at the option
of the insurer. The principle of contribution shall apply which means that if the
insured has taken insurance for the same property with more than one insurer,
each insurer shall pay proportionate amount towards the claim. For eg. stock of Rs.
3,00,000 is insured both with Insurer A and with insurer B for Rs. 3,00,000 each.
Due to burglary, stocks worth Rs. 50,000 is stolen. Both Insurer A and Insurer B
would pay Rs. 25,000 towards the loss.
v) Unless notice is given to the insurer and approved by them, any transfer of property
other than by will, shall render the policy void.
vi) If liability is admitted, any dispute on quantum shall be referred to arbitration.
4.3.7 Money Insurance
4.3.7.1 Scope
Money in transit covers :
i. wages in transit form bank to the insureds premises.
ii. cash in transit from the insureds premises to post office for purchase of stamps,
money order etc.
iii. postal order, money order, postage etc. in transit from post office to the insureds
premises.
iv. wages in transit from the insureds main office to branch office.
v. cash other than wages, in transit from the bank to the insureds premises, from the
insureds premises to the bank and between offices of the insured.
vi. Cheques, bills of exchange, money order etc. in transit form the insureds premises
to the bank.
vii. Cash collected by employees from the time of collection until delivery at the insureds
premises or bank. Money retained in safe at the insureds premises upto 48 hours
from the time of collection.
4.3.7.2 Extensions
i. Infidelity of the employees the normal policy does not cover infidelity of employees
unless discovered within 48 hours. However, on payment of additional premium, the
policy can be extended to cover the act of dishonesty by an employee.
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ii. Disbursement risk : the normal policy does not cover loss of money while the wages
are being disbursed. However, this risk can be covered by charging additional
premium.
iii. Riots, strike : These risks too can be covered on payment of extra premium.
iv. Over 48 hours : Money retained in safe in the insureds premises is ordinarily covered
only for 48 hours. This means that if the money is kept in the premises for over 48
hours and not deposited in the bank, the policy will not cover the money in safe
beyond 48 hours. Cover in excess of this period can be agreed at an additional
premium.
v. In till / counter : Money in counter during the insureds office hours can also be
covered at additional premium. The theft should be accompanied by violence by any
person other than the employee of the insured.
4.3.7.3 Exclusions
i. Shortages due to errors or omissions.
ii. Loss of cash entrusted to any person other than an employee.
iii. Loss where the insured or employee is involved, unless loss is caused by fraud by a
cash carrying employee and discovered within 48 hours.
iv. Losses which are covered by other policies.
v. Loss arising from war and allied war perils.
vi. Losses arising from riot, strike and civil commotion and acts of terrorism.
vii. Loss of cash from the safe by the use of key to the safe unless the key has been
obtained by force.
viii. Loss after business hours, unless the money is locked in a safe or strong room.
4.3.7.4 Sum Insured
Under money insurance, two sums are relevant:
i. The maximum amount carried in any one single transit.
ii. The total estimated amount of money in transit during the policy period.
The premium is charged on (ii) above i.e. on the total estimated amount of money in transit
during the entire policy period which is considered as provisional premium. On expiry of the
policy, the insured has to declare the actual value of money in transit. The premium is then
calculated again on this amount. This premium is called the earned premium. The difference
between the estimated premium and the earned premium is refunded /charged to the insured.
The limit mentioned in (i) above is the maximum liability of the insurer in a single loss.
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4.3.7.5 Underwriting considerations
The insurer needs some information based on which he can decide whether he wishes to offer
coverage to the inured. The information elicited to underwrite money insurance are:
i. Maximum amount carried in a single transit.
ii. No. of employees carrying cash, the no. of years of service with the company, any
history of previous default.
iii. Mode of carrying money, i.e. by bus, taxi etc.
iv. Manner of carrying cash.
v. Whether there are any armed guards accompanying the cash carrying employees.
vi. Nature of location of office, the distance between office and the bank etc.
vii. Distance over which money is carried.
viii. General condition of law and order in the area in which money is being carried.
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Chapter 13: Personal and Liability Insurance
5.1 Personal Insurance
Though general insurance does not insure the life of a person, as in the case of life insurance
policies, there are certain personal insurance policies which are issued under the non-life
section. The major amongst these are the Mediclaim and Personal Accident policies.
5.2 Mediclaim Policies
Mediclaim policy was introduced in India 1981 and later on modified in 1996. These policies
offer health insurance and can be issued either as individual policies or as a group policy.
5.2.1 Individual Mediclaim
This policy seeks to reimburse the expenses incurred by the insured for hospitalization/
domiciliary (residence) hospitalisation arising out of an illness/accident.
Hospitalisation
The following expenses are reimbursed under this policy provided the illness /accident is
sustained during the policy period:
1. Room and Boarding charges in hospital/nursing home.
2. Nursing expenses.
3. Surgeon, anaesthesia and other specialist doctor fees.
4. Operation theatre, diagnostic materials, blood, pacemaker requirements etc.
5. The treatment should be taken in a nursing home/hospital which is -
i. registered
ii. has at least 15 inpatient beds ( 10 for C class cities )
iii. has an operation theatre which is fully equipped
iv. fully qualified nursing staff round the clock.
6. It is a requirement that patient should be admitted for at least 24 hrs. However
this is not applicable for dialysis, chemotherapy, dental surgery etc., that is those
ailments where the treatment is given and the patient is discharged on the same
day.
7. Medical expenses incurred 30 days prior to and 60 days after hospitalization are
also paid provided it is incurred for the same ailment for which the patient has been
hospitalised.
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Domiciliary Hospitalisation
Means treatment given for an ailment, for a period of more than 3 days, which normally needs
hospitalization but the treatment has to be given at home because the patients condition is
such that he cannot be physically moved or lack of accommodation in the hospital. However,
certain diseases which are chronic in nature such asthma, bronchitis, diabetes, hypertension,
arthritis and fever for less than 10 day etc. are not considered for domiciliary hospitalization
benefit.
5.2.2 Exclusions
Claims made for the following will not be considered for payment as they are excluded from
the scope of the policy:
1. Pre-existing diseases.
2. 30 days exclusion certain ailments are excluded for the first 30 days from the
time of inception of the policy, as it is felt that these could not have been contracted
within such a short period and they were probably pre-existing.
3. Some ailments are excluded in the first year of the policy, as again, these are of such
a nature that they take time to manifest for eg. cataract, hysterectomy, hernia, piles
etc.
4. War and nuclear perils.
5. Circumcision is not paid for unless necessary for treatment of a disease.
6. Spectacle, hearing aids etc.
7. Dental treatment, unless requiring hospitalization.
8. General weakness, venereal diseases (VD), rest cure etc.
9. AIDS
10. Hospitalisation merely for diagnostic purpose.
11. Vitamins, tonics.
12. Treatment related to childbirth. Voluntary abortion.
13. Naturopathy.
5.2.3 Age Limit
Mediclaim policies are issued to those in the age group of 5 to 80 years. However, children can
be covered from 3 months to 5 years provided either of the parents have taken a mediclaim
policy.
5.2.4 Policy conditions :
Some of the policy conditions which are common and incorporated by most of the insurers
are:
i. All notices to the insurance company should be in writing.
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ii. Premium to be paid before commencement of the policy.
iii. Claim intimation should be given within 7 days with details about the hospital,
illness, doctor etc.
iv. Final claim with bills and required documents should be given to the insurer within
30 days from the date of completion of treatment.
v. All bills in original should be submitted.
vi. Fraudulent claims will not be paid.
vii. Principle of contribution shall apply.
viii. Policy can be cancelled by 30 days notice. If cancelled by insurer, refund is made on
prorate basis. If done by insured refund is on short period basis. Most of the general
insurance policies are issued for one year. It is not advisable to issue shorter period
policies. However, all insurers provide for short period rates which are much higher
than annual rates. These rates are mentioned in the policy. Hence, if the insured
wishes to cancel the policy midterm the insurer will not refund the entire premium
for the balance period. He will retain the premium for the period for which the policy
has been in existence on short period rates.
For eg. let us say the short period rate for a policy of 3 months is 40% and the
premium paid is Rs. 10,000. If the insured wishes to cancel the policy after 3 months
the refund will be Rs. 10,000 - ( 40% of Rs. 10,000)= Rs. 6,000/-
Whereas if the insurer cancels the policy the refund will be on prorate, i.e. on
proportionate basis. In the example above, if the insurer cancels the policy, the
refund amount would be Rs. 10,000 - (10000 * 3/12) = Rs. 7,500/-
ix. If liability is denied, the insured should file a case within 12 months from the date of
denial. If quantum is in dispute it should be referred to arbitration.
5.3 Group Mediclaim policy
Group policy is issued to a homogenous group such as employees of a company, members
of credit card etc. For eg. Citibank can take a Group policy for all the credit card holders of
Citibank.
The benefits are the same as for an individual policy with some variations, which are;
a) Cumulative bonus and health check up are not allowed.
b) Group discount based on size is allowed.
c) Renewal is subject to bonus/ malus clause
d) Maternity benefit extension is available.
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5.3.1 Bonus/Malus
Depending on the claims ratios for the preceding 3 policies, bonus or low claim discount is
allowed. Similarly, if the claims ratio is adverse, malus or claim loading is charged.
For eg. for a policy, the sum insured is Rs. 1,00,000 and the claims ratio for the past three
years is 120% and the premium paid is Rs. 10,000. If the insurance company wishes to apply
malus of say 20%, the renewal premium would be Rs 12,000/-.
Coversely, if the claims ratio is 50% and the insurer gives a low claim discount of 20%, then
the renewal premium payable would be Rs. 8,000/-.
5.3.2 Maternity Extension
The policy can be extended to cover expenses incurred towards child birth; this extension
is granted by charging 10% loading on the total basic premium. The maximum sum insured
allowed is Rs. 50,000 or sum insured under the policy, whichever is lower. The maternity
benefit is available only if incurred in a hospital.
For childbirth the waiting period is 9 months; this can be relaxed in case of a
miscarriage.
The claim is payable only for 2 children; if someone has 2 children already they will
not be eligible.
Voluntary medical termination of pregnancy within 12 weeks is not payable.
Pre natal and post natal expenses not payable unless hospitalized.
5.4 Personal Accident Insurance (PA)
5.4.1 Coverage
If during the currency of the policy the insured sustains any bodily injury directly and solely
from accident caused by external violent means, the insurance company shall pay to the
insured or his legal personal representative, the sum indicated in the policy if the accident
results in death or disability.
5.4.2 Definition of some of the terms used in PA policy
i. Bodily injury While this excludes any disease from natural causes, however
any disease proximately caused by accident is payable. While shock or grief is not
covered, disablement arising out of shock is payable.
ii. Solely and Directly - This means that the bodily injury should be a direct and sole
cause of the accident. An accident may cause a disease, which in turn may result in
death. The proximate cause is accident, hence the claim will be paid. For eg. a man
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is thrown off a horse and is so injured he cannot walk. While lying in bed as a result
of the injury, he contacts pneumonia and dies. The proximate cause is the accident
and there is no break in the chain of events, hence a claim under PA policy would be
considered.
iii. Accident An accident is an unexpected, unintended act. However, sometimes even
voluntary acts are considered as accidents. For eg. a man jumping from a burning
building sustaining injuries, murder, snakebite, frostbite etc. are also considered as
accidents.
iv. External, violent and visible means Cause of accident should be external but
injuries can be internal.
v. Disablement Disability refers to the inability of the insured to attend to occupation/
work.
5.4.3 Types of coverage :
i. Permanent Total Disablement (PTD) Disablement is permanent, irrevocable
and total. Loss of eye sight, loss of limbs etc. are examples.
ii. Permanent Partial Disablement (PPD) Here the disablement is permanent and
partial. For eg. the loss of finger(s). The policy carries a table of compensation for
different disabilities which is expressed as a percentage of capital sum inured.
iii. Temporary Total Disablement (TTD) The disability is total but temporary. For
instance a fracture in the leg due to which the insured is unable to attend to work.
Benefit chart to give an idea as to the benefits available in a PA policy
Contingency Compensation payable
Death 100% of capital sum insured
Loss of 2 limbs, 2 eyes, one
limb and one eye
100% of capital sum insured
Loss of one limb or one eye 50% of capital sum insured
PTD other than above 100% of capital sum insured
PPD As per table attached to the policy
TTD Weekly 1% of capital sum insured subject to
maximum of Rs. 3,000
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Additional Benefits
Nature of benefit coverage Amount payable
Carriage of dead body Expense incurred in
carrying dead body to
residence
2% of capital sum insured or
Rs. 2500, whichever is less
Education Fund Education benefits to
insureds dependent
children
If one dependent child,
10% of capital sum insured
subject to a maximum of Rs.
5000
If more than one dependent
child, 10% of capital sum
insured, subject to a
maximum of Rs. 10,000
5.4.4 Exclusions under PA policy
Common exclusions :
i. Suicide, intentional self injury.
ii. While under the influence of liquor or drugs.
iii. While engaged in aviation, ballooning etc.
iv. Venereal diseases, Insanity.
v. Breach of law with criminal intent.
vi. Service in armed forces.
vii. Child birth/pregnancy.
viii. War and similar perils.
5.4.5 Policy conditions
The conditions applicable to a personal accident policy are:
1. Claims intimation should be given in writing.
2. In case of death, notice to be given before cremation and in any case, latest, within
a month.
3. In case of any permanent total disablement, notice to be given within a month.
4. Proof of claim to be given.
5. In case of any disability, the company can exercise the right to examine the
insured.
6. In case of death, post mortem should be done and report submitted within 14
days.
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7. The insurer may ask the insured to undergo any operation at insureds expense in
case of loss of sight.
8. In case of death/PTD/PPD, the claim shall be settled on submission of policy for
cancellation.
9. No interest shall be payable.
10. Claims will not be settled if the claim made is fraudulent
5.5 Liability Insurance
The third type of general insurance is liability insurance, this form of insurance is gaining
popularity of late with the society getting more and more litigious. Liability insurance provides
indemnity for financial consequences arising from legal liability. The indemnity payable under
this insurance covers compensation awarded against the insured, legal costs awarded against
the insured and the defence costs. This insurance is concerned with the civil liability and not
the criminal liability.
Civil liability arises under :
a) The law of tort - tort in French means wrong. Tort laws deals with wrong doing. If
an act of a person caused injury to another person or damages his property, the
wrongdoer will be held responsible for the losses caused by such damage/injury.
b) Statutory law the liability arising under the statutory law. For eg. an employer
is responsible to compensate a workman for injuries sustained at work under the
Workmans Compensation Act, 1923.
c) Law of contract Liabilities arising out of breach of a contract.
5.6 Employers Liability Insurance
If an employee, during the course of employment, sustains injury or contacts any disease
which can be considered as an occupational disease, the employer is liable under the law to
pay compensation as laid down in the Act. In India this type of liability is governed by the
Workmans Compensation Act, 1923. The act clearly lays down the compensation for death,
permanent and temporary disablement. The amount of compensation payable depends on the
age of the employee and the wages drawn at the time of death/injury, the lower the age the
higher would be the compensation payable. Similarly, higher the wages drawn higher would
be the compensation payable.
5.6.1 Coverage under the policy
This policy provides coverage against legal liability arising under the -
i) Workmens Compensation Act, 1923
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ii) The Fatal Accidents Act, 1855
iii) Common law
Personal injury or disease should have occurred during the course of the policy
period.
Legal expenses incurred by the insured to defend their liability, provided the same
is incurred with the consent of the insurer.
5.6.2 Exclusions
The policy will not be liable for claims arising due to -
1) Any disease or injury arising out of nuclear risks.
2) Liability of the insured to its contractors employees, unless agreed to by payment
of extra premium.
3) Contractual liabilities.
5.7 Public Liability Insurance
To indemnify the insured, in respect of all sums which they become legally liable to pay to
third parties, as compensation for damages in respect of :
i. Death, personal injury, bodily injury or illness of any person.
ii. Loss of or damage to property as a result of an occurrence happening in the territorial
limits (all liability policies specify the territorial limit covered) in connection with and
during the course of the business activities or caused by any of its (the insureds)
products.
5.7.1 Compulsory Public Liability (Act Policy)
In India, under Public Liability Insurance Act, 1991, certain guidelines have been laid down
about the liability of industries dealing in certain types of commodities.
Under Public Liability Insurance Act 1991, the liability of the enterprise dealing in
hazardous substance is defined. If death/injury or damage to property is caused by
an accident the owner shall be liable.
If it is a no fault liability, the claimant need not establish that the death/injury etc.
was caused by the default/negligence of the insured.
The compensation payable is Rs. 25,000 for death and permanent total disablement,
a percentage of Rs. 25,000 for partial total disablement as certified by a physician
and Rs. 1,000 per month for temporary total disablement. Medical expense upto Rs.
12,500 can be paid and Rs. 6,000 is the maximum limit for property damage.
The liability of the owner has to be compulsorily insured.
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The sum insured is equal to the paid up capital of the company. If the owner is not
a company, the sum assured should be equal to all assets of the undertaking.
The insurers liability is restricted to Rs. 5 crores per accident and Rs. 15 crores
during the entire policy period.
An amount equal to premium is collected towards Environment Relief Fund by the
insurer and remitted to the goverment.
If the award for an accident exceeds the limit of insurer, the amount shall be paid
from the above fund and the amount in excess of this has to be borne by the
insured.
While this is a compulsory insurance, the Central Goverment may exempt some
goverment undertakings from this insurance, provided, a fund for Rs. 5 crores or an
amount equal to the paid up capital is maintained is maintained by these government
entities.
Accident is defined as fortuitous, sudden occurrence such as handling any hazardous
material resulting in exposure to death or injury.
Handling means processing, storage, transportation etc. of hazardous substance.
Hazardous substances are listed and grouped in the Act.
Owner is refered to a partner in the case of a firm; directors, managers etc. in the
case of a company.
Turnover means the entire gross sales turnover for manufacturing units and total
annual receipt for godowns/warehouses. For transport operators it would be annual
freight receipts.
The policy has an operative clause which essentially details the following:
The first part of the clause spells out
a) the parties to the contract
b) business carried out
c) payment of premium
d) contribution to environment relief fund etc.
While the second part states that the insured will be indemnified against statutory liability
arising out of handling hazardous substances.
5.7.2 Policy Exclusions:
Liability arising out of -
Wilful non-compliance with statutory provisions.
Fines, Penalties.
Any other legislations other than the Act.
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While Act policy provides coverage as per the Public Liability act, the insurer may be legally
held liable to pay compensation much in excess of what is covered under the Act Policy, in
which case the Public Liability Act Policy would compensate to the extent specified in the
operative clause and the balance has to be paid by the insured himself or he should take
additional liability policy to cover such legal liability.
5.7.3 Conditions
i. Written notice of claim and of any claims received against the insured should be
given to the insurance company.
ii. No liability should be admitted without the written consent of the insurer.
iii. The liability under the policy is invoked for claims made within 5 years from the date
of accident.
iv. Written records of annual turnover should be maintained by the insured.
v. Condition of contribution shall be applicable.
vi. Policy can be cancelled by either party by giving 30 days notice. Refund is made on
prorata basis if cancelled by the insurer and on short period basis if cancelled by the
insured.
vii. If claim is disputed, the insured should file a suit within 12 months.
viii. Fraudulent claims will not be paid as, the principle of utmost good faith for disclosure
of material facts, is applicable.
ix. In case of any dispute about the meaning of any word, the definition given by the
Act is applicable.
5.8 Professional Indemnity Insurance
This policy provides indemnification to the policyholder against loss incurred only as a result of
their negligent act, error or omission in carrying out their business. This policy is also known
as Errors and Omissions Insurance as well as malpractice insurance. The liability under this
policy primarily arises due to the negligence of the insured in performance of their professional
duties.
5.8.1 Coverage
To indemnify the insured against all sums for which they shall become legally liable to pay as
compensation to third parties for bodily injury or for loss or damage to third party property
arising out of or from any negligent act, error or omission committed or omitted or alleged to
have been done during the course of the conduct or performance of the professional services
and duties, including all legal costs and expenses. Professional Indemnity policy is usually
availed by Accountants, Doctors, Architects etc.
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5.9 Product Liability Insurance :
The liability under this section arises as per the terms of the Sale of Goods Act, 1930 (date of
the Act). As per this provision, only those who have purchased the goods can file a claim and
secondly the claimant need not prove negligence on the part of the seller. The policy aims at
making good the losses incurred by the claimant in terms of -
i. personal injury/death sustained as a result of use of the product.
ii. Loss/damage to property sustained as a result of the use of the product.
5.9.1 Exclusions
i. Mere defect in the product for which the claimant incurs cost for reconditioning,
repairing etc. does not fall within the scope of coverage.
ii. Liability arising out of product guarantee.
iii. Liability arising for products which have left the control of the insured prior to
retroactive date.
iv. Costs incurred for product recall, unless specifically covered.
5.9.2 Conditions
The conditions applicable to public liability (given earlier) shall apply for product liability,
except condition no. viii as this is not applicable for this policy.
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Chapter 14: Types of Life Insurance Policies
7.1 Term Insurance :
As the name implies, these policies are issued for a term or a period of time and if the death
of the assured occurs during the term of the policy, the policy pays the sum assured. If the
insured lives beyond the period stated in the policy, no payment under the policy is envisaged.
The term insurance provides pure death protection and does not have any savings element
as some other insurance policies do. The premium under the term policies are lower as the
policies are issued for a fixed period. However, this type of policy is not a great option as a
saving instrument as the assured does not get any amount from the policy should he survive
the policy period i.e. if the policy is issued for a period of 20 years expiring on 31
st
December
2012 and the insured is still alive on that date, he will not be entitled to receive any money
under the policy.
7.2 Types of Term Life Insurance
7.2.1 Yearly renewable term insurance :
This policy is issued for one year period and if the insured dies during the policy period, the
insurer settles the claim. This might be issued with a renewable term, for 5 years, 10 years
and so on. Instead of a time period, the policies are also issued offering coverage upto a
specified age such as 60 years etc. The insurer settles the claim if the assured dies before the
specified age.
7.2.2 Level term life insurance :
Under this policy, the premium amount stays the same for a given period of years (10, 15,
20 years etc.). The policy is generally issued for a period of 10, 15, 20, or 30 years. The
longer the term, the higher is the annual premium (the premium payable remains the same,
however if the policy has been taken for a longer period, say 30 years, the premium rate
would be higher (than say a 10 year policy) as the policy covers the insured at a older age
when the chances of death are higher). For eg , if a policy is taken for a sum assured of Rs.
10,00,000 at an annual premium of Rs. 25,000 per year for 10 years, the insured continues
to pay Rs. 25,000 every year and for the same sum assured if the policy is for 20 years, the
premium may be Rs. 40,000 per year.
Most level term policy have a renewal option and allow the insured to renew and extend the
period if they so desire. The renewal is not guaranteed. However, as long as the insured is of
normal health it is permitted.
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7.2.3 Decreasing term life insurance:
This type of contract factors in payment of lesser benefits each year the policy is in force. For
eg. should the assured die in the very first year of availing the policy, the beneficiary receives
the face value of the policy, say for eg. Rs. 50,00,000. If death occurs in year two, the
proceeds would come down (would be less than Rs. 50,00,000) and in year 20 the proceeds
may be a mere Rs. 15,00,000. The premium during the years remains constant while the
benefit comes down as the probability of death goes up with age.
7.2.4 Increasing term life insurance:
Under this contract, the benefit goes up with passing year and the premium under this policy
also goes up every year.
The term life insurance policies are useful as they provide maximum coverage to people
whose resources may be limited. The premium for term insurance is lower than Whole Life
insurance.
7.3 Whole Life Insurance :
The oldest and the purest form of life assurance is Whole Life insurance. The premium is
paid by the assured throughout the life time of the assured and the sum assured is paid to
the beneficiary on the death of the assured. This policy satisfies the original intention of life
insurance which is to provide security to dependants on the death of the assured, Under this
type of policy the beneficiary named in the policy is paid the benefits under the policy on the
death of the assured. The payment under the policy is assured and this policy does not have
an end date.
As these policies provide for payment only in the event of death, the premium under this policy
is lower than other policies. The assured can insure himself or herself for higher amounts (at
comparatively low premiums) so that his dependants are well provided for in the event of his
or her death.
However, these policies are not very popular as it does not meet the expectations and changing
needs of many investors, who look at insurance as an investment option besides being a
means to provide for the survivors in the event of the insureds death. Further, this type of
policy requires premium payment to be made indefinitely and the policy holder may find it
difficult to continue the premium payment during his old age. This type of policy is ideally
suited to take care of estate duty liability. Duties or property tax is payable on the death of
the assured by the legal heirs for transfer of property in their name. This duty at times can be
very steep. The proceeds of the policy is useful for paying up these taxes.
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7.3.1 Limited payment whole life insurance:
Under this policy while the policy continues to provide coverage to the assured till his death,
the premium payments are for a fixed period of time. The last premium, depending on the
policy, may be paid at the age of 60 years.
It is needless to mention that the amount of premium paid is a function of the duration for
which the premium is paid, hence in limited payment policies, the premium payable shall be
higher for the same sum assured as compared to Whole Life Insurance.
7.3.2 Types of Whole Life Insurance
1) Single Premium : This policy envisages one single payment of premium regardless of
when the death would occur. It involves front ending premium payment i.e. payment
of the entire premium in one lumpsum payment at the inception of the cover.
2) Continuous Premium : The insured continues to pay the same premium as long
as he or she lives. These are also called level premium whole life insurance. The
amount of premium to be paid is calculated taking into account the probability of
insureds death and compound interest.
3) Modified whole life insurance : The premium payable is staggered so that the insured
pays a lower level of premium in the initial years and much higher amount in the
later years as the earning capacity of the insured goes up.
Whole Life insurance provides permanent protection by way of payment of sum
assured on the death of the assured to his family.
7.4 Endowment policy :
The sum assured is payable on the death of the assured or after a fixed period of years
whichever occurs first. This type of policy combines the advantage of security or protection
for the family in the event of the assureds premature death and /or facilitates retirement by
paying out a lumpsum amount at an age agreed upon, should the assured continue to live upto
that age. Generally, people try to coincide this with their retirement age of say 60 years.
Endowment policies are popular in India as it combines life assurance with investment option
and appeals to the security conscious people. However, the premium under this policy is
higher as the insurer has to definitely pay out a claim either to the beneficiary in the event of
the death of the assured or to the insured if he lives upto a certain age.
7.4.1 Joint Life Endowment Policy:
This is a variation of the endowment policy and is generally issued to cover the husband
and wife together. The sum insured is payable under this policy either on expiry of a stated
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number of years or on death of one of the assured whichever is earlier. With this payment
the policy comes to an end and does not continue to cover the second assured. This policy is
jointly taken by a husband and wife.
7.4.2 Double Endowment Policy:
The amount of sum assured, which is paid by the insurer on survival of the insured, is double
the amount payable in the event of the insureds death (within policy period). For eg. if under
the policy the sum assured payable on death might be Rs. 5,00,000, whereas the amount
payable on survival would be Rs. 10,00,000/-.
Under term insurance, the policy proceeds are paid in the event of the death of the insured
during the specified term. Whereas, under endowment policy, insured may either avail an
endowment policy for a specified period at the end of which, if he or she is alive, collects the
proceeds of the policy or alternately, the insured may choose an age at which he or she would
like to be paid the policy benefits.
7.5 Childrens policies
1. Fixed Term (Marriage) endowment : Policy is taken by the parent or guardian
and for the purpose of this insurance, they are regarded as the assured. A particular term is
selected and on expiry of the term the sum assured is paid to the assured. During this term,
premium is paid but payment of premium ceases in case of death of the assured. The sum
assured is payable on the death of the assured or on completing the period fixed for insurance
whichever should occur first. The logic behind this policy is to create a capital for any major
expense such as marriage of the child or higher education of the child.
2. Educational Annuity Assurance : It is similar to the above policy except that
instead of lump sum payment of the sum assured, the benefit is disbursed in half yearly
installments for 5 years. This is ideal for higher education needs as it helps in the payment of
semester fees.
These types of policies are taken when parents are aware that after a lapse of say 10 years,
the education of the child or marriage of the child has to be provided for.
3. Childrens deferred assurance :
The purpose is to provide for life assurance to a child. The parents propose the life of the child
as assured. As the name suggests the insurance is deferred :
a) The life assurance for the child commences when he or she reaches the age of 18
to 22 (i.e. any age between 18 and 22 can be chosen for the commencement of life
assurance) No claims are paid during the deferment period, i.e. the period between
commencement of premium payment and the chosen age when the life assurance
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begins. For eg. if a parent starts a policy for his child when the child is 10 and wishes
to commence life assurance from the age of 22, then the deferment period would be
12 years from the time the child is 10 years old till he reaches the age of 22.
b) In case of death of the child before the agreed age when the risk commences, the
premium is returned.
c) In case the parent (the premium payer) dies, the premium must be continued to be
paid by someone else till the deferred date.
d) Once the child reaches the vesting age, i.e. the age when the life assurance
commences, he or she can claim cash option i.e. he can opt to receive the premium
amount paid so far under the policy in case the policy is discontinued.
e) On reaching majority i.e. the age of 18, irrespective of the vesting age chosen under
the policy, the life assured signs an agreement with the insurer and from that date
the contract is between the insurer and the life assured.
f) Health proof is not asked for once the assured attains the vesting age.
7.6 Annuities
Annuity: Annuity is the periodical payment made by the insurer to the assured, in consideration
for the capital payment or lumpsum payment received by them. For capital payment received,
the insurer agrees to pay the annuitant an agreed amount of money periodically throughout
life. The purpose is the opposite of life insurance, where the payment is made on the death of
the assured. In the case of annuity the payments are made as long as the annuitant is alive.
There are two phases of an annuity; they are :
1) The accumulation phase is the phase during which the annuitant pays premium to
the insurer.
2) The distribution phase / liquidation period is when the insurer makes annuity payment
to the annuitant till his death.
7.6.1 Types of Annuity
1) Immediate Annuity : This type of annuity should be purchased with a single
premium. The benefit payment i.e. the payment made by the insurer to the insured,
is made within a short period of taking the policy. The annuitant receives annuity
either till his death or for a fixed period of time such as 10 years, 20 years etc.
depending on the type of contract entered into. The payment is made as long as the
annuitant is alive .
2) Deferred Annuity : Under this type of policy, the annuitant starts receiving the
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annuity payment after lapse of fixed number of years as agreed upon at the inception
of the policy. The premium may be paid either as one lumpsum payment or it
could be monthly, quarterly, half yearly or yearly payments during the deferment
period (i.e. the period intervening between the commencement of the policy and the
commencement of benefit payment by the insurer to the annuitant). In case of the
death of the annuitant during the deferment period, the premium will be returned
without interest.
3) Guaranteed Annuity : The insurer is required to make annuity payments for
at least a certain number of years, which is called period certain, irrespective of
whether the annuitant is alive or dead. If the annuitant survives this period, the
annuity payments then continue until the annuitants death and if the annuitant
dies before the expiry of the period certain, the beneficiary is entitled to collect the
remaining payments certain i.e. the amount to which the annuitant would have
been eligible had he been alive till period certain. For e.g. a policy commences on 1
st
January 2005, the period certain is upto 31
st
December 2010 and the annuitant was
to receive Rs. 10,000 every year. However, the annuitant dies on 30
th
June 2009.
The annuitant would have received the payment for 2009 and thereafter his heirs
would receive an amount of Rs. 10,000 in 2010 being the amount they are entitled
for the year 2010 as the period certain lapses on 31-12-2010.
7.6.2 Method of Premium payment
1) Single premium annuity : The annuity is purchased by remitting a single premium.
2) Annual Premium annuity : When annuity is purchased by payment of annual
premiums for a fixed period of time.
7.7 Group Insurance
While most of the individuals avail life insurance policy for the purpose of security as well as
for investment purposes, group insurance policies are becoming increasingly popular as many
employers are seeking to provide benefits to the employees, by way of taking a life policy in
the employers name. The group has to be homogeneous, i.e. all the members of the group
should either be employed by the same employer or should belong to the same association
etc. for the group policy to be issued.
A master policy, in the name of the employer or any association which takes the policy, is
issued. Unlike individual policies here the risk assessment is done for the group as a whole.
It is important that the group should not have been formed for the sole purpose of availing
insurance. There should be a steady flow of members into the group to ensure that the risk
profile is maintained and the policy does not end up servicing only aging members.
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In case of group policies, the premium rates are periodically reviewed based on the claims
experience of the group. This is known as experience rating. Most of the policies offer sharing
of profits based on actual claims experience. If the overall claims experience of the group
over a period of years is favourable, the excess of premium paid over claims and other
administrative expenses of the insurer, is shared with the assured by way of bonus etc.
7.7.1 Types of groups
which avail group insurance are :
1) Employer-Employee groups : The employer takes a master policy for all his
employees. The premium payment may be made either by the employer fully or it
might be shared with the employees in agreed ratios. However, it is insisted that the
share of the employer should be atleast 25% and also that all the employees in the
company should be insured and there should be no adverse selection against the
insurance company. That is, if given as an option to the employees, it is likely that
the younger employees may not wish to take life insurance and the company may
take the group insurance only for the senior members (in terms of age). This would
lead to increase in the average age of the group insured, as life insurance is based
on calculation of life expectancy. A group consisting of senior, aged employees,
from the point of view of the insurer, is an adverse risk and deemed as an adverse
selection against the insurer.
2) Creditor-Debtor Groups : The creditor takes out a master policy is favour of all
its debtors. This is most common where a housing loan has been sanctioned. The
housing financier may take out a policy in favour of all those who have availed
housing loan from the housing financier and the claim amount can be used to repay
the balance amount of the housing loan, in the event of the unfortunate death of a
debtor.
3) Government schemes : Either the central or state government often take out a group
policy for the lives of a section of the people as a welfare measure. For instance
some of the state governments take a life policy for fishermen, policemen etc.
7.7.2 Experience Rating :
Experience rating as the name implies means that the rating of premium based on the experience.
In individual policy, the premium rates are arrived at based on the age and occupation of the
assured and once the premium is stated, there would be no further adjustment made during
the policy period.
Whereas, under group policies, the rate for premium are quoted on the basis of the overall
experience of the insurer for similar groups. Once the policy has been in force, the insurer
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may realize that the experience of the group in question is vastly different from the insurers
original assumptions. If the experience of the group is favourable i.e. if the claims ratio are
attractive, then the insurer offers a share in the surplus or profit.
However for the concept to work, the size of the group has to be fairly large; the insurers
insist on a group size of atleast 200. Experience rating does not mean that after every year the
excess of premium over claims is shared with the policy holder, rather the insurer deducts from
the gross premium, the amount of claims paid, administrative expenses etc. and out of the
amount so arrived at, a percentage of the balance is used for experience rating adjustment. For
eg., let us assume the premium received from a group in a year is Rs. 10,00,000. The amount
of claims and administrative expenses comes to Rs. 6,00,000. The insurer wishes to distribute
60% of the surplus. Then the amount available for profit sharing is Rs. 2,40,000. This profit
is shared with the group either by way of reduction in future premium(s) or enhancement in
sum assured or payment of bonus.
In case of negative balance in a year, the amount is carried forward and adjusted against
profits made in the later years and till the net balance becomes positive, no adjustment would
be made.
Year Profit/loss under
the policy (in
Rs.)
(A)
Profit /loss
brought for
adjustment
(B)
Adjustment
(B-A)
Profit/loss
under the policy
available for
sharing (in Rs.)
2007 (-) 5,00,000 0 0 0
2008 3,00,000 (-) 5,00,000 (-) 2,00,000 0
2009 5,0,0000 (-) 2,00,000 3,00,000 3,00,000
7.8 Industrial Life Assurance
Industrial Life assurance originated in the United Kingdom. The policy was issued for the
benefit of low income workers. The agents collected premium on a weekly basis as the workers
were paid weekly wages and the purpose of the insurance was to provide for a burial fund.
These policies are high cost policies for insurance companies mainly because the target
clientele was the low income workers whose life expectancy is low and secondly due to high
administrative cost involved in collecting premiums from large number of workers. These
policies are almost extinct now.
7.9 Life insurance premium and tax benefits
In India, life insurance has been popularized by offering a number of tax incentives. The
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Income Tax act provides tax relief for investing in life insurance and investors use this form of
investment for tax planning as well.
Any amount that you pay towards life insurance premium for yourself, your spouse or your
children can be included under section 80C deduction. Please note that life insurance premium
paid by you for your parents (father / mother / both) or your in-laws is not eligible for
deduction under section 80C. If you are paying premium for more than one insurance policy,
all the premiums can be included. It is not necessary to have the insurance policy from Life
Insurance Corporation (LIC) even insurance bought from private players are eligible.
Deductions allowable from income for payment of life insurance premium :
Under Section 80C
a. Life insurance premium paid in order to effect or to keep in force an insurance on
the life of the assessee (tax payer) or on the life of the spouse or any child of the
assessee and in the case of Hindu Undivided Family (HUF), premium paid on the life
of any member thereof, provided premium paid is not in excess of 20% of capital
sum assured. For eg. if the capital sum assured under the policy is Rs. 5,00,000, the
premium paid under the policy should be less than Rs. 1,00,000 for it to be eligible
for deduction.
b. Contribution to deferred annuity plans in order to effect or to keep in force a contract
for deferred annuity on his own life or the life of his spouse or any child of such
individual, provided such contract does not contain a provision to exercise an option
by the insured to receive a cash payment in lieu of the payment of annuity.
Under Section 80CCC
A deduction is allowed, to an individual assessee, for any amount paid or deposited by
him from his taxable income in the annuity plans for receiving pension (from the fund set
up under the Pension Scheme).
NOTE: The premium can be paid upto Rs. 1,00,000 to avail deduction u/s. 80C,
80CCC and 80CCD. However, there is no sectoral cap i.e. the limit of Rs. 1,00,000
can be exhausted by paying premium under any one of the said sections.
Under Section 80D
Deduction allowable upto Rs.15,000/- if an amount is paid to keep in force an insurance
on health of assessee or his family (i.e. spouse and children)
Additional deduction upto Rs.15,000/- if an amount is paid to keep in force an insurance
on health of parents.
In case of Hindu Undivided Family (HUF), deduction allowable upto Rs.15,000/- if an
amount is paid to keep in force an insurance on health of any member of that HUF
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Note: If the sum specified in (a) or (b) or (c) is paid to effect or keep in force an insurance
on the health of any person specified therein who is a senior citizen, then the deduction
available will be upto Rs.20,000/-, provided that such insurance is in accordance with the
scheme framed by
a) the General Insurance Corporation of India (GIC) as approved by the Central
Government in this behalf or;
b) Any other insurer approved by the Insurance Regulatory and Development
Authority.
Jeevan Aadhar Plan (Sec.80DD):
Deduction from total income upto Rs. 50,000/- allowable on amount deposited with LIC
under Jeevan Aadhar Plan for maintenance of an handicapped dependent (Rs.1,00,000/-
where handicapped dependent is suffering from severe disability)
Exemption in respect of commutation of pension
Under Section 10 (10A) (iii) of the Income Tax Act, any payment received by way of
commutations of pension (commutation of pension means payment of lump sum amount
in lieu of a portion of pension surrendered voluntarily by the pensioner based on duration
of period in relation to the age). For eg. if a person retiring at 60 is expected to live
upto 80, he may surrender a portion of his pension say Rs 5,000 per month and receive
lumpsum amount of perhaps Rs. 8,00,000 which would be equivalent to Rs. 60,000 for
20 years discounted for interest factor out of the Annuity plans is exempt from tax.
Income tax exemption on maturity/death claims proceeds under Section 10 (10D)
Any sum received from Life insurance policy as maturity proceeds, death benefits is
exempt from tax.
However, the proceeds of the following policies are taxable :
a) Key man insurance is taxable. (It is a type of policy where key executives of a company
are insured by the company as their sudden demise may lead to a management
crisis for the company.)
b) Single premium policies will be taxed as income in the year benefits under the policy
are received assuming the premium exceeds 20% of the sum assured.
c) An insurance policy in respect of which the premium payable for any of the years
during the term of the policy exceeds 20 % of the actual capital sum assured. This
will not be applicable for any sum received on the death of a person.
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Chapter 15: : Financial Planning and Life
Insurance
6.1 Financial Planning
A financial plan is a process, which helps an individual to achieve his or her financial objectives.
It involves careful and well thought out spending, savings and investment planning.
The need for financial planning has become essential more so with economic uncertainty,
erratic job situation, longer life span etc. In financial planning, the first and foremost is to set
the investment objectives. This could vary from person to person. Some typical objectives
are :
Building a home
Childrens education
Marriage - own/childrens
Retirement provision
In addition there might be some emergency funding required which could be caused
by :
o Illness
o Accident
o Job loss etc.
Financial planning provides security in times of uncertainity. Let us understand in a little more
detail the need for financial planning :
6.1.1 Emergency funding:
An emergency fund may be needed for meeting sudden contingencies such as, major illness in
the family requiring medical expenses, property losses, loss of job etc. Any prudent individual
would set aside an amount to meet such contingencies. This can be achieved through the help
of insurance. The amount of the fund required depends upon the level of insurance coverage
the individual or household can get, attitude of the individual and the family towards risks
etc. Generally the emergency fund is expressed as x number of months of a familys income
depending on the financial capacity of the family.
6.1.2 Education Fund:
Unlike the earlier days, the education of children has become prohibitively high in many fields
and most of the families aim to set aside a part of their earnings to provide for the higher
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education of their children. Again insurance products which provide funding for educational
purposes are available. The size of fund to be insured for would depend upon the number of
children, their educational aspirations etc. Further, the educational institution in which the
children plan to go for their higher education also makes a substantial impact on the size of
funds required.
6.1.3 Unemployment :
In times of recession, economic downturns etc., there is a possibility of a person being out job
and hence every family needs to have some money set aside to take care of possible periods
of unemployment. Insurance comes useful in such cases.
6.1.4 Premature Death :
The earning member(s) of the family are worried about the possibility of premature death,
which would result in the drop in the standard of living of the family left behind. Hence, one
of the key objectives of people while carrying out financial planning is to effectively provide
for this contingency.
6.1.5 Property loss :
One of the major objectives of most families is to build a house. The house faces certain
threats such as fire, floods etc. If such an event happens and the house had been bought on a
loan, not only the loan needs to be repaid but also an additional burden of having to pay rent
to live in a rented premises till the house is repaired. This is another contingency any family
should take into account while carrying out the financial planning.
6.1.6 Retirement Planning :
Most people would like to ensure that in their post retirement life they can live with the same
comforts they are accustomed to during their working life. However, after retirement, the
monthly salary a person earns stops while expenses, particularly medical expenses, stays the
same or increases.
Most individuals plan for the above contingencies by setting aside a part of their income and
investing them in various investment options / insurance products available.
However, one crucial component of financial planning is to take care of uncertainty of life.
What would happen if the earning member of the family dies an untimely death? Who would
pay for the housing loan, childrens education, medical expenses etc. Life is uncertain and
therefore we have life insurance to take care of this uncertainty.
Life insurance policies are very innovative. Besides taking care of the survivors in the event
of the death of the earning member, various options are available by which one can plan for
pension, education for the children, marriage of the children etc.
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6.2 Ratios as a tool for financial analysis
Ratios can be very effective tools for financial analysis for individuals as well as companies.
Discussed below are some of the ratios which can help in providing benchmarks to help in
personal financial planning -
i) Basic Liquidity ratio (BLR)
BLR = Liquid assets/monthly expenses.
BLR helps in working out the number of months one can live with the available cash
assets should you lose your job or for whatever reason the source of income of a
person dries up. While there is no ideal ratio, if it is anywhere between 3 and 6 it
means that one has adequate cash to support monthly expenses for a period of 3 to
6 months which could be considered as adequate.
ii) Savings Ratio (SR)
SR = Savings/gross income.
This ratio indicates the percentage of income that is saved. The higher the savings,
higher would be the funds available for future financial requirements.
iii) Debt to Asset ratio = Debt (total liabilities )/total assets
This ratio gives a clear picture of how much of the assets have been financed by
debt, a very high ratio indicates low networth.
iv) Debt service ratio = Total amount of debt repayment/ annual take home income
This ratio indicates the proportion of income which is used up towards loan repayments.
While granting loans, most of the companies take this ratio into account to satisfy
themselves that the borrower can service further borrowings.
6.3 Definition of Life Insurance
6.3.1 Life Insurance is a contract between two parties, the insured and the insurer, wherein
the insurer agrees to pay a specified sum of money upon the occurrence of insureds death or
any other event specified in the policy. The consideration from the insured is that he or she
agrees to pay an agreed amount (premium) at specified time periods to the insurer.
6.3.2 Like all contracts, this contract has offer and acceptance. The insured by of completing
the proposal form makes an offer and the insurer accepts the offer by way of quoting the terms
and conditions. The consideration from the insureds end is payment of premium and from the
insurer it is promise to compensate in the event of occurrence of the insured event.
6.3.3 The purpose of the contract is legal and both the parties should be competent to
enter into a contract, i.e. the insurer should have the license to carry on the business of
insurance and the insured should be of stable mind and not a minor.
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6.4 Law of large numbers
The law of large numbers is the foundation of all Insurance and was discovered 300 years
ago by a Swiss mathematician, Jacob Bernoulli. When an event based on chance is observed,
the larger the number of observations, the more likely the actual result will coincide with the
expected result.
This principle also demonstrates that an event with a low probability of occurrence in a small
number of trials has a high probability of occurrence in a large number of trials. The actual
outcome of a statistical process converges towards the expected value as the number of
observation increases.
When a coin is flipped once, the expected value of the number of heads is equal to one half.
Therefore, according to the law of large numbers, the proportion of heads in a large number
of coin flips should be roughly one half. In particular, the proportion of heads after n flips will
surely converge to one half as n approaches infinity .
In insurance premium calculations are done on the basis of the probability of occurrence
of an event such as death, fire etc. The costing which is done on the basis of using the
probability theory works more accurately when the number of people insured is large and the
geographical spread is greater.
6.5 Factors affecting rating under Life insurance
i) In life insurance we take into account the life expectancy or the rate of mortality
for the purpose of premium calculation. Insurance is spreading the loss of few to
many. It is primarily aimed at sharing the losses. Premium amount is collected from
a number of people and claims paid to a few people. For eg. if the policy is issued
for Rs. 1,00,000 and a group of 100 are part of the insurance scheme, the amount
to be charged from each person would depend upon the estimation of loss ratio. If
one out of 100 is expected to die then the premium for each person in the group
would be Rs. 1,000 so that an amount of Rs. 1,00,000 can be paid on the death
of one person. However, if 2 out 100 are expected to die, then the premium would
be Rs. 2,000 to create the pool of Rs. 2,00,000. The estimation of losses is done
by way of mortality tables. These tables depict age wise probability of death and
survival. Mortality tables are used as a basis for calculating the cost of insurance by
all insurance companies.
ii) Actuaries take into account the time value of money i.e. the interest that can be
earned on the premium. The assumption in the earlier example was very simplistic.
We assumed collecting premium in such a manner that it became equivalent to the
value of the claim. In actual practice it is not so because the premium collected from
various insured persons is invested in certain forms of investments. Such investments
yield returns which helps in subsidizing (reducing) the premium amount.
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Some of the factors which should be taken into account while calculating the time
value of money is whether the premium is collected in one lumpsum from the insured
or is it annual payments. If single premium is received, the returns on it would be
higher as the entire amount is available for investment over a longer period of
time as against annual premiums. In insurance, a single payment is a lumpsum
payment made once during the entire policy period, whereas annual premium refers
to premium paid annually.
Similarly, the rate of return on investments is also of great importance. Correct
estimation of the rate of return is critical. If erroneously, a higher rate of return on
an investment is taken for calculating the premium payable, the insurance company
stands to incur losses as it might collect lower premium and pay out higher sums.
iii) The terms and conditions of the policy and the benefits accruing under it are critical.
The premium rate to be charged would depend on the type of policy issued. There
are many different types of Life insurance policies available in the market. Under
some policies, the benefits are payable either on death or on expiry of a fixed period
of time, whereas other policies provide for payment of fixed amount of money in
periodic intervals. Similarly, there is difference in the mode of payment of premium
too. It could be single premium or annual premium. Hence, the premium charged
would depend upon the benefits of the policy to a great extend.
iv) In the example given in (i) above no consideration has been given to administrative
expenses that would be incurred by the insurer. Any insurance company has to incur
lot of costs while administrating the policy. Further, at the inception of the policy
high amount of expenses are incurred. However, premium to be charged has to be
uniform and cant be high in year one compared to the rest of the policy period.
The insurance companies also have to incur expenses such as rent, electricity,
salaries, the insured has to bear these expenses too, hence the pure premium
calculated in example given in A above is loaded for all the expenses and the gross
premium is arrived at, the insurers charge the gross premium from the insured and
not the pure premium.
6.6 Principles of Insurance and Life Insurance
We will see below how the principles of Insurance are applicable for Life Insurance
contracts:
6.6.1 Utmost good faith :
When insured decides to insure himself he has access to all the information about the insurance
company. However the insurer does not have adequate information about the insured. Hence,
it becomes imperative for the proposer to disclose to the insurer all material facts regarding
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the proposed insurance. This duty is not limited to facts known to him but also to facts which
he is expected to know.
Material fact is a fact which affects the decision of a prudent underwriter in deciding the terms
of acceptance of the risk as well as whether to accept or reject the risk. If a material fact is
not disclosed to the insurer, the contract becomes voidable at the option of the insurer.
6.6.2 Insurable Interest:
The proposer should have insurable interest in the life of the assured. Insurable interest exists
when the proposer derives financial benefit from the continuous existence of the assured or
suffers financial loss by the death of the assured. Every person has insurable interest in his
own life as he can protect his estate from loss of future earnings by insuring his life. Spouse
has insurance interest in the life of his wife/ husband.
Others who are said to have insurable interest are
Employer in the name of the employee
Creditor in the name of the debtor
Partner in the life of his partner etc
6.6.3 Indemnity
As per this principle, the insured should neither be better off nor worse after the claim is
settled. This principle requires that the financial loss is measurable. The insured should neither
profit nor suffer a loss.
Life insurance is not a strict insurance of indemnity as the value of a human life cannot be
calculated, however the insurers are careful while insuring the life of an individual and take
into account his earning capacity while deciding on the value for which insurance is granted.
The sum assured is fixed in such a way that the proceeds of the policy help the insureds
family to maintain the same standard of living.
6.6.4 Subrogation
Subrogation involves transfer of rights of the insured to the insurer who indemnifies the
insured on the happening of the loss. This principle is a corollary of the principle of Indemnity
and is imposed to ensure that the insured does not profit by insurance. Since the value of life
cannot be determined this principle is not applicable for life insurance .
6.6.5 Contribution
This means sharing of losses between multiple insurers for the same risk. This is not possible
in Life insurance for the same reason as mentioned for subrogation.
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Chapter 16: Insurance Intermediaries
8.1 Introduction
Insurance products can be either sold directly by the licensed insurance companies or it can
be marketed through intermediaries holding authorised sanction from IRDA. With a view to
ensure that the insurance policies are marketed only by licensed agents and brokers, the
regulator has laid down stringent regulations for granting of license to the intermediaries.
While agents play a key role in marketing insurance products, the role played in life insurance
and personal insurance by the agents is far greater than in commercial, property and liability
insurance which is by and large availed by corporates.
8.2 Individual agent :
As per the Licensing of Insured Agents Regulations, 2000, the agents are required to hold
a license issued by IRDA/ authorised office of the insurance company (usually the corporate
office is designated as the authorised office by the insurer). The license once issued is valid for
a period of three years and a license fee is applicable. On expiry of three years the license has
to be renewed. The applications for renewable should reach the insurance company atleast 30
days prior to the expiry of the license.
To qualify as an agent, the agent should :
1. At least have passed 12
th
standard where he resides in a place with population of
5000 or more / or should have atleast passed 10
th
standard when a applicant resides
in any other place.
2. Have completed from an approved institution certain number hours of training in life
or general insurance business when he is seeking license for the first time to act as
an insurance agent.
3. Have completed from an approved institution certain number of hours of training in
life and general insurance business when he is seeking license for the first time to
act as a composite agent (an agent who works for both life and general insurance
business)
4. Should be a major.
5. Should not be of unsound mind.
8.2.1 Corporate agent :
The following entities can apply to become a corporate agent :
i. A firm
ii. Company formed under the Companys Act, 1956
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iii. Banking company
iv. Regional Rural Bank (RRBs)
v. Co-operative societies, Co-operative Banks
vi. Panchayat/ Local Authority
vii. NGO as approved by the IRDA
8.2.2 Code of Conduct.
Every person holding a licence, shall adhere to the code of conduct specified below :-
1. Every insurance agent shall :
i. identify himself (through an identity card issued by the insurance company) and the
insurance company of whom he is an insurance agent;
ii. disclose his licence to the prospect on demand;
iii. disseminate the requisite information in respect of insurance products offered for
sale by his insurer (insurance company) and take into account the needs of the
prospect while recommending a specific insurance plan;
iv. disclose the scales of commission in respect of the insurance products offered for
sale, if asked by the prospect;
v. indicate the premium to be charged by the insurer for the insurance products offered
for sale;
vi. explain to the prospect the nature of information required in the proposal form by
the insurer and also the importance of disclosure of material information in the
purchase of an insurance contract;
vii. bring to the notice of the insurer any adverse habits or income inconsistency of the
prospect, in the form of a report (called Insurance Agents Confidential Report)
along with every proposal submitted to the insurer and any material fact that may
adversely affect the underwriting decision of the insurer as regards acceptance of
the proposal, by making all reasonable enquiries about the prospect;
viii. inform promptly the prospect about the acceptance or rejection of the proposal by
the insurer;
ix. obtain the requisite documents at the time of filing the proposal form with the
insurer and other documents subsequently asked for by the insurer for completion
of the proposal;
x. render necessary assistance to the policyholders or claimants or beneficiaries in
complying with the requirements for settlement of claims by the insurer;
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xi. advise every individual policyholder to effect nomination or assignment or change of
address or exercise of options, as the case may be and offer necessary assistance in
this behalf, wherever necessary;
xii. with a view to conserve the insurance business already procured through him, make
every attempt to ensure remittance of the premiums by the policyholders within the
stipulated time, by giving notice to the policyholder orally and in writing.
2. No insurance agent shall :
i. solicit or procure insurance business without holding a valid licence;
ii. induce the prospect to omit any material information in the proposal form;
iii. induce the prospect to submit wrong information in the proposal form or documents
submitted to the insurer for acceptance of the proposal;
iv. behave in a discourteous manner with the prospect;
v. interfere with any proposal introduced by any other insurance agent;
vi. offer different rates, advantages, terms and conditions other than those offered by
his insurer;
vii. demand or receive a share of proceeds from the beneficiary under an insurance
contract;
viii. force a policyholder to terminate the existing policy and to effect a new proposal
from him within three years from the date of such termination;
ix. have, in case of a corporate agent, a portfolio of insurance business under which
the premium is in excess of fifty percent of total premium procured, in any year,
from one person (who is not an individual) or one organisation or one group of
organisations;
x. apply for fresh licence to act as an insurance agent, if his licence was earlier cancelled
by the designated person and a period of five years has not elapsed from the date
of such cancellation;
xi. become or remain a director of any insurance company;
8.3 Broking regulations
IRDA regulations classify brokers into three categories :
i. Direct brokers
ii. Reinsurance Brokers
iii. Composite Brokers
Brokers represent a client while agents represents an insurer. The direct brokers are authorised
to represent clients and arrange insurance policies for them in life as well as in general
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insurance and can place business with any of the insurance companies. Reinsurance brokers
represent direct insurers and arrange reinsurance (when an insurance company insures a part
of the business underwritten by them with another insurance, it is called reinsurance) with
Reinsurance companies. Composite brokers are licensed to place direct as well as reinsurance
business with insurers.
The broker can be an individual, partnership firm, company or a society. The principal officer
of the broker should possess the minimum qualifications prescribed in the IRDA Act, he has
to undergo 100 hours of practical training and pass the exams conducted by the National
Insurance Academy (NIA) or any other body recognised by the IRDA.
The brokers have to comply with minimum capital requirements specified by IRDA.
8.3.1 Functions of a direct broker :
The functions of a direct broker includes any one or more of the following:
a. obtaining detailed information of the clients business and risk management
philosophy;
b. familiarising himself with the clients business and underwriting information so that
this can be explained to an insurer and others;
c. rendering advice on appropriate insurance cover and terms;
d. maintaining detailed knowledge of available insurance markets, as may be
applicable;
e. submitting quotation received from insurer/s for consideration of a client;
f. providing requisite underwriting information as required by an insurer in assessing
the risk to decide pricing terms and conditions for cover;
g. acting promptly on instructions from a client and providing him written
acknowledgements and progress reports;
h. assisting clients in paying premium under section 64VB of Insurance Act, 1938 (4 of
1938);
i. providing services related to insurance consultancy and risk management;
j. assisting in the negotiation of the claims; and
k. maintaining proper records of claims;
8.3.2 Functions of a re-insurance broker:
The functions of a re-insurance broker includes any one or more of the following:
a. familiarising himself with the clients business and risk retention philosophy;
b. maintaining clear records of the insurers business to assist the reinsurer(s) or
others;
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c. rendering advice based on technical data on the reinsurance covers available in the
international insurance and the reinsurance markets;
d. maintaining a database of available reinsurance markets, including solvency ratings
of individual reinsurers;
e. rendering consultancy and risk management services for reinsurance;
f. selecting and recommending a reinsurer or a group of reinsurers;
g. negotiating with a reinsurer on the clients behalf;
h. assisting in case of commutation of reinsurance contracts placed with them;
i. acting promptly on instructions from a client and providing it written acknowledgements
and progress reports;
j. collecting and remitting premiums and claims within such time as agreed upon;
k. assisting in the negotiation and settlement of claims;
l. maintaining proper records of claims; and
m. exercising due care and diligence at the time of selection of reinsurers and international
insurance brokers having regard to their respective security rating and establishing
respective responsibilities at the time of engaging their services.
8.3.3 Functions of composite broker:
A composite broker carries out any one or more of the functions mentioned in 8.3.1 and 8.3.2
above.
8.8.4 Procedure for licensing
The IRDA on being satisfied that the applicant fulfills all the conditions specified for the
grant of licence, grants a licence in Form B and sends an intimation thereof to the applicant
mentioning the category for which the IRDA has granted the licence. The licence shall be
issued subject to the insurance broker adhering to the conditions and the code of conduct as
specified by the IRDA from time to time.
8.3.5 Validity of licence
A licence once issued shall be valid for a period of three years from the date of its issue, unless
the same is suspended or cancelled pursuant to these regulations.
8.4.6 Renewal of licence
1. An insurance broker may, within thirty days before the expiry of the licence, make an
application in Form A to the IRDA for renewal of licence.
Provided however that if the application reaches the IRDA later than that period but before
the actual expiry of the current licence, an additional fee of rupees one hundred only shall
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be payable by the applicant to the IRDA. Provided further that the IRDA may for sufficient
reasons offered in writing by the applicant for a delay not covered by the previous proviso,
accept an application for renewal after the date of the expiry of the licence on a payment of
an additional fee of seven hundred and fifty rupees only by the applicant.
2. An insurance broker before seeking a renewal of licence, shall have completed, atleast
twenty five hours of theoretical and practical training, imparted by an institution recognized
by the IRDA from time to time.
3. The IRDA, on being satisfied that the applicant fulfills all the conditions specified for a
renewal of the licence, shall renew the licence in Form B for a period of three years and send
an intimation to that effect to the applicant.
4. An insurance broker licensed under these regulations for a specified category may also
apply for the grant of a licence by the IRDA for any other category by fulfilling the requirements
of these regulations. However, such application shall be made only after a lapse of one year
from the grant of a licence in the first instance.
8.3.7 Remuneration
No insurance broker shall be paid or contracted to be paid by way of remuneration (including
royalty or licence fees or administration charges or such other compensation), an amount
exceeding:
1. on direct general insurance business -
i. on tariff products:
a. 10 percent of the premium on that part of the business which is compulsory
under any statute or any law in force;
b. 12 percent of the premium on others.
ii. on non- tariff products:
17 percent of the premium on direct business.
2. on direct life insurance business -
i. individual insurance
a. 30 percent of first years premium
b. 5 per cent of each renewal premium
ii. annuity
a. immediate annuity or a deferred annuity in consideration of a single premium, or
where only one premium is payable on the policy, 2 percent of the premium
b. deferred annuity in consideration of more than one premium:
i. 7 percent of first years premium
ii. 2 percent of each renewal premium
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3. group insurance and pension schemes:
i. one year renewable group term insurance, gratuity, superannuation, group savings
linked insurance 7 percent of risk premium
Note: Under group insurance schemes there will be no remuneration for the savings
component.
ii. single premium - 2 percent of risk premium
iii. annual contributions, at new business procurement stage - 5 percent of non risk
premium with a ceiling of Rupees three lakhs per scheme.
iv. single premium new business procurement stage - 0.5 percent with a ceiling of
Rupees five lakhs per scheme.
v. remuneration for subsequent servicing - one year renewable group term assurance
- 2 percent of risk premium with a ceiling of rupees 50, 000/- per scheme.
4. on reinsurance business
i. as per market practices prevalent from time to time.
8.3.8 Professional indemnity insurance
1. Every insurance broker shall take out and maintain and continue to maintain a professional
indemnity insurance cover throughout the validity of the period of the licence granted to him
by the IRDA, provided that the IRDA shall in suitable cases allow a newly licensed insurance
broker to produce such a guarantee within fifteen months from the date of issue of original
licence.
2. The insurance cover must indemnify an insurance broker against
ii. any error or omission or negligence on his part or on the part of his employees and
directors;
iii. any loss of money or other property for which the broker is legally liable in consequence
of any financial or fraudulent act or omission;
iv. any loss of documents and costs and expenses incurred in replacing or restoring
such documents;
v. dishonest or fraudulent acts or omissions by brokers employees or former
employees.
3. The indemnity cover
i. shall be on a yearly basis for the entire period of licence;
ii. shall not contain any terms to the effect that payments of claims depend upon the
insurance broker having first met the liability;
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iii. shall indemnify in respect of all claims made during the period of the insurance
regardless of the time at which the event giving rise to the claim may have occurred,
provided that an indemnity insurance cover not fully conforming to the above
requirements shall be permitted by the IRDA in special cases for reasons to be
recorded by it in writing.
4. Limit of indemnity for any one claim and in the aggregate for the year in the case of
insurance brokers are as follows :
Category of insurance
broker
Limit of indemnity
(i) Direct broker three times of the remuneration received at the end of every
financial year subject to a minimum limit of rupees fifty
lakhs.
(ii) Reinsurance broker three times of the remuneration received at the end of every
financial year subject to a minimum limit of rupees two crores
and fifty lakhs.
(iii) Composite broker three times of the remuneration received at the end of every
financial year subject to a minimum limit of rupees five
crores
5. The un-insured excess in respect of each claim shall not exceed five percent of the capital
employed by the insurance broker in the business.
6. The insurance policy shall be obtained from any registered insurer in India who has
agreed to
i. provide the insurance broker with an annual certificate containing the name, address,
licence number of the insurance broker, the policy number, the limit of indemnity,
the excess (i.e. the balance amount, which as per policy, has to be borne by the
insured in the event of a claim) and the name of the insurer, as evidence that the
cover meets the requirements of the IRDA;
ii. send a duplicate certificate to the IRDA at the time the certificate is issued to the
insurance broker; and
iii. inform the insurer immediately of any case of voidance, non-renewal or cancellation
of cover mid-term.
7. Every insurance broker shall
i. inform immediately the IRDA should any cover be cancelled or voided or if any policy
is not renewed;
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ii. inform immediately the insurer in writing of any claim made by or against it;
iii. advise immediately the insurer of all circumstances or occurrences that may give
rise to a claim under the policy ; and
iv. advise the IRDA as soon as an insurer has notified that it intends to decline indemnity
in respect of a claim under the policy.
8.4 Indian Insurance Market
8.4.1 Life Insurance
The first Life Insurance Company which came into existence in India was The Oriental
Life Insurance Company, established in 1818. This was a British company. The first Indian
insurance company subsequently came into being in 1871 called the Bombay Mutual Life
Assurance Society.
8.4.2 Nationalisation of Life insurance in India
Life insurance in India was nationalized on January 19, 1956, through the Life Insurance
Corporation Act. At the time of nationalisation of life insurance in India, there were 154 domestic
insurers, 16 foreign insurers and 75 provident funds operating under the Insurance Act of 1938.
All the 245 Indian and foreign insurers and provident societies were taken over by the central
government as a result of their nationalisation. Life Insurance Corporation of India (LIC), which
is the largest insurance company in India, was formed by an act of Parliament, viz. the LIC Act,
1956. LIC was promoted with a capital of Rs. 5 crore by the Government of India.
8.4.3 Privatisation Of Life insurance in India
Following the recommendations of the Malhotra Committee report in 1999, the Insurance
Regulatory and Development Authority (IRDA) was constituted as an autonomous body to
regulate and develop the insurance industry. The IRDA was incorporated as a statutory body
in April, 2000. The key objectives of the IRDA includes promotion of competition so as to
enhance customer satisfaction through increased consumer choice and lower premiums, while
ensuring the financial security of the insurance market.
The IRDA opened up the insurance market in August 2000 with the invitation for application
for registrations. Foreign companies were allowed ownership of up to 26%. The Authority has
the power to frame regulations under Section 114A of the Insurance Act, 1938 and has from
2000 onwards framed various regulations ranging from registration of companies for carrying
on insurance business to protection of policyholders interests.
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8.4.4 Life Insurance Players
Some licensed life insurers operating in India* :
1. Bajaj Allianz Life Insurance Company Ltd.
2. Birla Sun Life Insurance Co. Ltd.
3. HDFC Standard Life Insurance Co. Ltd.
4. ICICI Prudential Life Insurance Co. Ltd.
5. ING Vysya Life Insurance Company Ltd.
6. Life Insurance Corporation of India
7. Max New York Life Insurance Co. Ltd.
8. Met Life India Insurance Company Ltd.
9. Kotak Mahindra Old Mutual Life Insurance Ltd.
10. SBI Life Insurance Co. Ltd.
11. Tata AIG Life Insurance Company Ltd.
12. Reliance Life Insurance Company Ltd.
13. Aviva Life Insurance Company India Ltd.
14. Sahara India Life Insurance Co, Ltd.
15. Shriram Life Insurance Co, Ltd.
16. Bharti AXA Life Insurance Company Ltd.
17. Future Generali India Life Insurance Company Ltd.
18. IDBI Fortis Life Insurance Company Ltd.,
19. Canara HSBC Oriental Bank of Commerce Life Insurance Company Ltd.
20. AEGON Religare Life Insurance Company Ltd.
21. DLF Pramerica Life Insurance Co. Ltd.
22. Star Union Dai-ichi Life Insurance Co. Ltd.
23. India First Life Insurance Company Ltd.
*Please check IRDAs website for latest details
8.4.5 Non-Life Insurance
Triton Insurance Company Ltd. (the first general insurance company) was formed in the
year 1850 in Kolkata by the British. The first Indian general insurer to commence operations
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was the Indian Mercantile Insurance Company in the year 1907. The New India Assurance
Company Ltd. a leading public sector non-life insurance company was incorporated in 1919.
8.4.6 Nationalisation of general insurance In India
In 1972, the non-life insurance business was nationalized and General Insurance Corporation
of India (GIC) was formed with four subsidiaries:
The National Insurance Co. Ltd.
Oriental Insurance Co. Ltd.
United India Insurance Co. Ltd.
New India Assurance Co. Ltd.
All the 107 Indian and Foreign insurers operating at the time of nationalisation were integrated
and grouped into the above mentioned four companies and operated as subsidiaries of GIC.
8.4.7 Privitisation of Non-Life Insurance :
The general insurance market was opened for competition in December 2000 and the four
public sector companies have been made autonomous and no longer function as a subsidiary
of the GIC. They have been de-linked from the parent company and made as independent
insurance companies, though they continue to operate as government owned entities. Private
sector general insurance companies have also been allowed to open up business in India.
Licensed non-life insurers operating in India* :
1. Bajaj Allianz General Insurance Co. Ltd.
2. ICICI Lombard General Insurance Co. Ltd.
3. IIFFCO Tokio General Insurance Co. Ltd.
4. National Insurance Co.Ltd.
5. The New India Assurance Co. Ltd.
6. The Oriental Insurance Co. Ltd.
7. Reliance General Insurance Co. Ltd.
8. Royal Sundaram Alliance Insurance Co. Ltd
9. Tata AIG General insurance Co. Ltd
10. United India Insurance Co. Ltd.
11. Cholamandalam MS General Insurance Co. Ltd.
12. HDFC ERGO General Insurance Co. Ltd.
13. Export Credit Guarantee Corporation of India Ltd.
14. Agriculture Insurance Co. of India Ltd.
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15. Star Health and Allied Insurance Company Ltd.
16. Apollo Munich Health Insurance Company Ltd.
17. Future Generali India Insurance Company Ltd.
18. Universal Sompo General Insurance Co. Ltd.
19. Shriram General Insurance Company Ltd.
20. Bharti AXA General Insurance Company Ltd.
21. Raheja QBE General Insurance Company Ltd.
22. SBI General Insurance Company Ltd.
23. Max Bupa Health Insurance Company Ltd.
24. L&T General Insurance Company Ltd.
*Please check IRDAs website for latest details
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Chapter 17 : Introduction to Banking
1.1 Fundamental Role and Evolution
1.1.1 India
The banking sector is meant to meet the financial needs of the economy. Too much of money
can cause inflation too little can stifle economic growth and create problems of unemployment
and lost opportunity. Accordingly the apex banking institution, the Reserve Bank of India
(RBI) has a basic function "...to regulate the issue of Bank Notes and keeping of reserves with
a view to securing monetary stability in India and generally to operate the currency and credit
system of the country to its advantage."
1
The RBI, which commenced operations on April 1, 1935, is at the centre of Indias financial
system. Hence it is called the Central Bank. It has a fundamental commitment to maintaining
the nations monetary and financial stability. It started as a private share-holders bank but
was nationalized in 1949, under the Reserve Bank (Transfer of Public Ownership) Act, 1948.
RBI is banker to the Central Government, State Governments and Banks. Key functions of
RBI Include:
Monetary policy
Supervision of Banking companies, Non-banking Finance companies and Financial Sector,
Primary Dealers and Credit Information Bureaus
Regulation of money market, government securities market, foreign exchange market
and derivatives linked to these markets.
Management of foreign currency reserves of the country and its current and capital
account.
Issue and management of currency
Oversight of payment and settlement systems
Development of banking sector
Research and statistics.
While RBI performs these functions, the actual banking needs of individuals, companies and
other establishments are met by banking institutions (called commercial banks) and non-
banking finance companies that are regulated by RBI.
RBI exercises its supervisory powers over banks under the Banking Companies Act, 1949,
which later became Banking Regulation Act, 1949.
1 Preamble to the Reserve Bank of India Act, 1934
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The largest commercial bank in the country is State Bank of India (SBI). Its origins can be
traced back to 1806, when Bank of Calcutta was constituted. It was re-named Bank of Bengal
in 1809. Bank of Bombay (created in 1840), Bank of Madras (created in 1843) and Bank of
Bengal were amalgamated in 1921 to form Imperial Bank of India. Until 1935 (when RBI
commenced operations), the Imperial Bank of India performed the functions of Central Bank
as well as Commercial Bank.
In 1955, State Bank of India was constituted to take over the Imperial Bank of India. Later, 8
state associated banks (State Bank of Jaipur, State Bank of Bikaner, State Bank of Patiala, State
Bank of Hyderabad, State Bank of Indore, State Bank of Mysore, State Bank of Travancore
and State Bank of Saurashtra) were brought under SBI. Subsequently, State Bank of Jaipur
and State Bank of Bikaner merged to form State Bank of Bikaner and Jaipur. In course of time,
State Bank of Saurashtra and State Bank of Indore were merged into SBI. In order to benefit
from economies of scale and technology, SBI has a grand vision to merge the other associate
banks too, into itself.
RBI earlier owned the entire share capital of SBI. Later, when SBI went public, other investors
too became shareholders. A few years ago, the shares of SBI that were owned by RBI were
transferred to the Government of India.
The reach of the banking network is a key determinant of banking services available for the
economy. In order to ensure that banks focus on building that reach irrespective of profitability
considerations, the Government of India went through two rounds of nationalization of
banks:
In 1969, 14 major Indian commercial banks (like Central Bank of India and Punjab
National Bank) were nationalized (SBI, as seen earlier, was already under the control of
RBI).
6 more banks (like Vijaya Bank and Corporation Bank) were nationalized in 1980.
SBI, its subsidiaries, and the 20 nationalised banks are generally referred to as public sector
banks.
Other private sector banks (essentially the smaller ones of Indian origin) were allowed to
continue as private entities under RBI supervision. These are commonly referred to as old
private banks. Foreign banks that were operating in the country were similarly allowed to
continue as private entities.
In order to enhance banking services for the rural sector, a framework of Regional Rural Banks
came up in 1975. Ownership of these banks is split between three stake-holders viz. Central
Government (50%), concerned State Government (15%) and the bank which sponsors the
RRB (35%). The sponsoring bank is expected to assist the RRB in its operations. The smaller
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RRBs are in the process of being merged with each other so that they have the critical mass
for meaningful banking operations.
Another vehicle for local reach is the Co-operative Banks, which have been in existence for
over a century. They are registered under the Co-operative Societies Act, 1960 and regulated
under the Banking Regulations Act, 1949 and Banking Laws (Co-operative Societies) Act,
1956. Several states have their own regulations. Urban co-operative banks finance small-
scale units and self-employment businesses, besides home finance, consumer finance and
personal finance. Rural co-operative banks are active in areas like farming, cattle, hatcheries
and milk.
In some cases, the co-operative banks have become tools for politics, thus endangering the
money of depositers. RBI has been working towards a mechanism for better regulation and
control over the co-operative banks.
In line with the liberalization in the 1990s, private sector was permitted to promote new
banks, subject to obtaining banking license from RBI. These are commonly referred to as new
private banks.
The RBI recently announced a draft policy framework for issue of new banking licenses to the
private sector.
At a socio-economic level, the test of a countrys banking system is how well it meets the
needs of the weaker and disadvantaged sections of society. Accordingly, RBI is giving a thrust
to financial inclusion and financial literacy.
1.1.2 United States
After the stock market crash of 1929 and the banking crisis in the 1930s, the US brought in
the Glass-Stegall Act, 1933. The intention was to prohibit commercial banks from investment
banking activities and taking equity positions in borrowing firms.
Many of the restrictions of the Glass-Stegall Act were reversed through the Gramm-Leach-
Bliley Act, 1999 (GLB Act, also called Financial Services Modernisation Act, 1999). The act
permitted commercial banks, investment banks, securities firms and insurance companies to
consolidate. This paved the way for Universal Banking, where all kinds of banking services
would be offered under a single umbrella institution.
Leading economists like Paul Krugman and Joseph Stigilitz believe that the GLB Act was
responsible for the sub-prime mortgage crisis which hit the world in 2007. It also created
huge institutions that were risky to the financial system and too big to fail.
President Obamas administration is moving to correct some of the anomalies. Former Federal
Reserve Governor, Paul Volcker has made proposals which have come to be called the Volcker
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Rule. It specifically prohibits a bank, or an institution that owns a bank, from engaging in
proprietary trading that isn't at the behest of its clients, and from owning or investing in a
hedge fund or private equity fund. It also limits the liabilities that the largest banks could
hold.
An important recent development is the DoddFrank Wall Street Reform and Consumer
Protection Act, 2010. The Act, which was passed as a response to the late-2000s recession,
is the most sweeping change to financial regulation in the United States since the Great
Depression. It changes significantly, the American financial regulatory environment affecting
all Federal financial regulatory agencies and affecting almost every aspect of the financial
services industry in the United States. The highlights of the Act are as follows:
Consumer Protection with Authority and Independence
The Ac creates a new independent watchdog, The Consumer Financial Protection Bureau,
housed at the Federal Reserve. Its role is to ensure American consumers get the clear,
accurate information they need to shop for mortgages, credit cards, and other financial
products, and protect them from hidden fees, abusive terms, and deceptive practices.
Ends Too Big to Fail Bailouts
The Act seeks to end the possibility that taxpayers will be asked to write a cheque to bail
out financial firms that threaten the economy. It does this by:
o Creating a safe way to liquidate failed financial firms;
o Imposing tough new capital and leverage requirements that make it undesirable to
get too big;
o Updating the Feds authority to allow system-wide support but no longer prop up
individual firms; and
o Establishing rigorous standards and supervision to protect the economy and American
consumers, investors and businesses.
Advance Warning System
Creates a council, The Financial Stability Oversight Council, to identify and address
systemic risks posed by large, complex companies, products, and activities before they
threaten the stability of the economy.
Transparency and Accountability for Exotic Instruments
o Eliminates loopholes that allow risky and abusive practices to go on unnoticed and
unregulated - including loopholes for over-the-counter derivatives, asset-backed
securities, hedge funds, mortgage brokers and pay day lenders.
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o Requires companies that sell products like mortgage-backed securities to retain at
least 5% of the credit risk, unless the underlying loans meet standards that reduce
riskiness.
Executive Compensation and Corporate Governance
Provides shareholders with a say on pay and corporate affairs with a non-binding vote on
executive compensation and golden parachutes.
Protects Investors
o Provides tough new rules for transparency and accountability for credit rating agencies
to protect investors and businesses.
o Creates an Office of Credit Ratings at the Securities Exchange Commission (SEC)
with expertise and its own compliance staff and the authority to fine agencies.
o Creates the first ever office in the Federal government focused on insurance. The
Office, as established in the Treasury, will gather information about the insurance
industry, including access to affordable insurance products by minorities, low- and
moderate- income persons and underserved communities. The Office will also monitor
the insurance industry for systemic risk purposes.
o Gives SEC the authority to impose a fiduciary duty on brokers who give investment
advice - the advice must be in the best interest of their customers.
Enforces Regulations on the Books
Strengthens oversight and empowers regulators to aggressively pursue financial fraud,
conflicts of interest and manipulation of the system that benefits special interests at the
expense of American families and businesses.
Card Transactions
Requires Federal Reserve to issue rules to ensure that fees charged to merchants by
credit card companies / debit card transactions are reasonable and proportional to the
cost of processing those transactions.
Since many of the large global banks are incorporated in the US, developments on this
front will influence the global banking architecture in the next few years.
1.2 Banking Structure in India
Problems in the banking sector can seriously affect the real economy, as has been experienced
globally in the last few years. Therefore, a well-regulated banking system is a key comfort for
local and foreign stake-holders in any country. Prudent banking regulation is recognized as
one of the reasons why India was less affected by the global financial crisis.
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The Banking Regulation Act, 1949 defines a banking company as a company which transacts
the business of banking in India. Banking is defined as accepting, for the purpose of lending
or investment, of deposits of money from the public, repayable on demand or otherwise and
withdrawable by cheque, draft, order or otherwise.
Section 49A of the Act prohibits any institution other than a banking company to accept
deposits from the public withdrawable by cheque.
RBI is the apex regulater for banks.
Banks can be broadly categorized as Commercial Banks or Co-operative Banks.
Commercial Banks include:
Public Sector Banks (SBI, SBI Associates and Nationalised Banks)
Private Sector Banks (Old, New and Foreign)
Regional Rural Banks
Co-operative Banks include:
Urban co-operative banks
Rural / Agricultural co-operative banks.
Banks which meet specific criteria are included in the second schedule of the RBI Act, 1934.
These are called scheduled banks. They may be commercial banks or co-operative banks.
Scheduled banks are considered to be safer, and are entitled to special facilities like re-finance
from RBI. Inclusion in the schedule also comes with its responsibilities of reporting to RBI and
maintaining a percentage of its demand and time liabilities as Cash Reserve Ratio (CRR) with
RBI.
Non-banking finance companies (NBFC) become a source of incremental finance. At times,
they finance businesses which do not meet strict banking norms. NBFCs do not have access
to cheap bank deposits from the public (in the form of savings account, current account etc.,
which are discussed in the next Chapter), although they can accept fixed deposits. Their cost
of funds being higher than banks, their lending too tends to be at a higher rate. Yet borrowers
access these funds, either because they are unable to mobilise funds from banks, or to fund
their requirements beyond what they can mobilise from banks. NBFCs are particularly active
in consumer finance and personal finance.
1.3 Licensing of Banks in India
Before anyone can carry on the business of banking in India, a license from RBI is required.
RBI has the discretion to decide on the conditions to be complied with, before grating a
license. Some of the points considered by RBI are as follows:
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Whether the company is or will be in a position to pay its present and future depositors
in full as their claims accrue;
Whether the affairs of the company are being conducted or likely to be conducted in a
manner detrimental to the interests of its present or future depositors;
Whether the general character of proposed management of the company will not be
prejudicial to public interest or the interest of depositers;
Whether the company has an adequate capital structure and earning prospects;
Whether public interest will be served by grant of license to the company;
Whether considering the banking facilities available in the proposed area of operation,
the potential scope for expansion of business by banks already in existence in that area
and other relevant factors, the grant of license would be prejudicial to the operation and
consolidation of the banking system, consistent with monetary stability and economic
growth;
The fulfillment of any other condition which the Reserve Bank considers relevant in public
interest or in the interest of depositors.
When it comes to foreign banks, RBI also considers the following:
Whether the government or the law of the country, in which the company is incorporated,
discriminates in any way against banking companies registered in India.
Whether the company complies with the provisions of the Banking Regulation Act, as
applicable to foreign companies.
RBI also has the right to cancel the bank license if the company stops its banking business
in India or does not follow any directions issued by RBI.
1.4 Branch Licensing
Besides the banking license, banks have to obtain prior permission of RBI for opening a new
place of business or changing the location of the existing place of business. Place of business
includes any place at which deposits are received, cheques are cashed or moneys lent.
The requirement of permission is however not applicable in the following cases:
Changing the location of an existing place of business within the same city, town or
village.
Opening a temporary place of business upto one month for the purpose of affordable
banking facilities for any exhibition, mela, conference or like occasion. The temporary
place should however be within the limits of the city, town or village where there is an
existing branch.
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Banks earlier had to obtain permission separately for each ATM location. Now, they can obtain
permission once a year for opening new branches, administrative offices of ATM locations.
RRBs need to route their request for permission through NABARD, alongwith comments of the
sponsor bank.
1.5 Foreign Banks
Foreign banks in India mostly operate as branches of the international entity. Recently, RBI
has come out with a discussion paper on the subject, which incorporates the learning from the
recent global financial crisis. Key points mentioned in the report are as follows:
There are currently 34 foreign banks operating in India as branches.
o Their balance sheet assets, accounted for about 7.65 percent of the total assets of
the scheduled commercial banks as on March 31, 2010 as against 9.03 per cent as
on March 31, 2009.
o In case, the credit equivalent of off balance sheet assets are included, the share of
foreign banks was 10.52 per cent of the total assets of the scheduled commercial
banks as on March 31, 2010, out of this, the share of top five foreign banks alone
was 7.12 per cent.
The policy on presence of foreign banks in India has followed two cardinal
principles of (i) Reciprocity and (ii) Single Mode of Presence. These principles are
independent of the form of presence of foreign banks. Therefore, these principles should
continue to guide the framework of the future policy on presence of foreign banks in
India.
Prima facie the branch mode of presence of foreign banks in India provides a ring-fenced
structure as there is a requirement of locally assigned capital and capital adequacy
requirement as per Basel Standards.
It may not be possible to mandate conversion of existing branches into subsidiaries.
However, the regulatory expectation would be that those foreign banks which meet the
conditions and thresholds mandated for subsidiary presence for new entrants or which
become systemically important by virtue of their balance sheet size would voluntarily
opt for converting their branches into Wholly Owned Subsidiaries (WOS) in view of the
incentives proposed to be made available to WOS.
The following category of banks may be mandated entry in India only by way of setting
up a WOS:
o Banks incorporated in a jurisdiction that has legislation which gives deposits made/
credit conferred, in that jurisdiction a preferential claim in a winding up.
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o Banks which do not provide adequate disclosure in the home jurisdiction.
o Banks with complex structures,
o Banks which are not widely held, and
o Banks other than those listed above may also be required to incorporate locally, if
the Reserve Bank of India is not satisfied that supervisory arrangements (including
disclosure arrangements) and market discipline in the country of their incorporation
are adequate or for any other reason that the Reserve Bank of India considers that
subsidiary form of presence of the bank would be desirable on financial stability
considerations.
The minimum capital requirements for WOS may generally be in line with those prescribed
for the new private sector banks. The WOS shall be required to maintain a minimum
capital adequacy ratio of 10 per cent of the risk weighted assets or as may be prescribed
from time to time on a continuous basis from the commencement of operations.
In order to ensure that the board of directors of the WOS of foreign bank set up in India
acts in the best interest of the local institution, RBI may, in line with the best practices in
other countries, mandate that
o Not less than 50 percent of the directors should be Indian nationals resident in
India,
o Not less than 50 percent of the directors should be non-executive directors,
o A minimum of one-third of the directors should be totally independent of the
management of the subsidiary in India, its parent or associates and
o The directors shall conform to the Fit and Proper criteria.
With a view to incentivise setting up of WOS/conversion of foreign bank branches into
WOS, it is proposed that the branch expansion policy as applicable to domestic banks as
on January 1, 2010, may be extended to WOS of foreign banks also.
The expansion of the branch network of foreign banks in India both existing and new
entrants who are present in branch mode would be strictly under the WTO commitments
of 12 branches or as may be modified from time to time.
At present under the WTO commitments, there is a limit that when the assets (on balance
sheet as well as off-balance sheet) of the foreign bank branches in India exceed 15% of
the assets of the banking system, licences may be denied to new foreign banks.
Building on this to address the issue of market dominance, it is proposed that when the capital
and reserves of the foreign banks in India including WOS and branches exceed 25% of the
capital of the banking system, restrictions would be placed on
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o further entry of new foreign banks,
o branch expansion in Tier I and Tier II centres of WOS and
o capital infusion into the WOS
This will require RBIs prior approval.
1.6 Private Banks Capital and Voting Rights
The minimum capital requirement for a new private bank is Rs300crore.
No shareholder can exercise voting rights in respect of the shares held by him in excess
of 10% of the total voting rights of all shareholders in the bank. Banks have to take RBIs
acknowledgement before transferring shares in favour of a party beyond this threshold limit.
1.7 Dividend
RBI has also laid down conditions regarding declaration of dividends.
Capitalized expenses will have to be written off, before dividend is declared.
It can be paid only out of current years profits only.
The dividend payout can be a maximum of 40%. The ceiling is linked to net NPA level.
Minimum capital adequacy ratio of 9% has to be maintained.
Net NPAs should not exceed 7%.
1.8 Corporate Governance
At least 51% of the total number of directors have to be persons with special knowledge or
practical experience of accounting, agriculture and rural economy, banking, co-operatives,
economics, finance, law, small scale industry or any other aspect, the special knowledge or
practical experience of which is useful to the banking company.
At least two directors should have special knowledge or practical experience in agriculture and
rural economy or co-operative or small scale industry.
Directors other than the Chairman and whole-time directors shall hold office for not more than
a period of 8 years, continuously.
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Chapter 18 : Bank Deposits, Nomination and
Deposit Insurance
Deposits are a key source of low cost funds for banks. The bank is profitable, when it is able
to lend or invest these funds and earn a higher return.
The deposit accounts serve various purposes of the account holders:
A safe avenue to park surplus funds
Earn a return on surplus funds
Receive payments from others, and make payments to others.
3.1 Kinds of Deposits
3.1.1 Demand Deposits
These are deposits which the customer can get back on demand or which are placed for very
short time periods. For example:
Savings account deposits
This is the normal bank account that individuals and Hindu Undivided Families (HUFs)
maintain. The account can be opened by individuals who are majors (above 18 years of
age), parents / guardians on behalf of minors and Karta of HUFs. Clubs, associations and
trusts too can open savings accounts as provided for in their charter.
Banks insist on a minimum balance, which may be higher if the account holder wants
cheque book facility. The minimum balance requirement tends to be lowest in the case
of co-operative banks, followed by public sector banks, private sector Indian banks and
foreign banks, in that order.
Banks do impose limits on the number of withdrawals every month / quarter. Further,
overdraft facility is not offered on savings account.
Traditionally, banks paid an interest on the lowest balance in the bank account between
the 10
th
and the end of the month. Suppose the balance in the depositers account in a
particular month was as follows:
1
st
to 10
th
Rs. 50,000
11
th
Rs. 10,000
12
th
to 31
st
Rs. 50,000
Although Rs. 50,000 was maintained for all but one day in the month, the depositer
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would receive interest as if only Rs. 10,000 (the lowest balance between 10
th
and the end
of the month) was maintained in the account during the month. The bank thus got free
money of Rs. 50,000 less Rs. 10,000 i.e. Rs. 40,000 for all but one day in the month.
Since April 1, 2010, scheduled commercial banks have been directed to pay interest on
the daily balances. Thus, banks have lost on the free money, and their cost of funds has
gone up.
Interest is paid on a half-yearly basis, every September and March.
Current account deposits
This is maintained by businesses for their banking needs. It can be opened by anyone,
including sole-proprietorships, partnership firms, private limited companies and public
limited companies.
The current account comes with a cheque book facility. Normally, there are no restrictions
on the number of withdrawals. Subject to credit-worthiness, the bank may provide an
overdraft facility i.e. the account holder can withdraw more than the amount available in
the current account.
Current accounts do not earn an interest. Therefore, it is prudent to leave enough funds
in current account to meet the day-to-day business needs, and transfer the rest to a term
deposit.
CASA is a term that is often used to denote Current Account and Savings Account. Thus,
a bank or a branch may have a CASA promotion week. This means that during the week,
the bank would take extra efforts to open new Current Accounts and Savings Accounts.
3.1.2 Term Deposits
These are deposits that are maintained for a fixed term. The time period can be anything from
7 days to 10 years. This is not like a normal operating bank account. Therefore, cheque book
facility is not offered.
Benefit of term deposits is that the interest rate would be higher. Weakness is that if the
investor needs the money earlier, he bears a penalty. He will earn 1% less than what the
deposit would otherwise have earned, if it had been placed for the time period for which the
money was left with the bank.
Suppose the bank offers 6% for deposits of 1 year, and 7% for deposits of 2 years. The
depositer placed money in a 2-year deposit (at 7%), but did a premature withdrawal after 1
year. The interest earning would be limited to 6% (the rate applicable for the time period for
which the money was placed with the bank) less 1% i.e. 5%.
Banks may also offer the facility of loan against fixed deposit. Under this arrangement, a
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certain percentage of the fixed deposit amount may be made available as a loan, at an
interest rate, which would be higher than the term deposit rate. This is an alternative to
premature withdrawal.
Unlike interest rate on savings account, the interest in term deposits is de-regulated. Therefore,
every bank decides its own interest rate structure. Further, it is normal to offer 0.50% extra
interest to senior citizens.
For large deposits of above Rs. 1 crore, the bank may be prepared to work out special
terms.
The term deposits may also be structured as recurring i.e. the depositer would invest a
constant amount every month / quarter, for anything from 12 months to 10 years. Benefit
of such an account is that the interest rate on the future deposits is frozen at the time the
recurring account is opened. Thus, even if interest rates on fixed deposits, in general, were
to go down, the recurring deposits would continue to earn the committed rate of interest.
Interest rate in a recurring deposit may be marginally lower than the rate in a non-recurring
term deposit for the same time period.
3.1.3 Hybrid Deposits / Flexi Deposits
These are value added facilities offered by some banks. For instance, a sweep facility may
be offered in their CASA accounts. Under the facility, at the end of every day, surplus funds
beyond the minimum balance required, is automatically swept into an interest earning term
deposit account. When more money is required for the regular operations, it is automatically
swept from the interest earning term deposit account. Benefit for depositers are:
Superior interest earnings, as compared to normal CASA
Less paperwork no need to sign papers etc. for each sweep in or sweep out.
Sweep out of money from the interest earning term deposit account does not attract
premature withdrawal charges.
However, unlike in a normal term deposit, interest rate is liable to be changed by the bank at
any time.
3.1.4 Non-Resident Accounts
These can be opened by Non-Resident Indians and Overseas Corporate Bodies with any bank
in India that has an Authorised Dealer license.
Foreign Currency Non-Resident Account (FCNR)
These are maintained in the form of fixed deposits for 1 year to 3 years. Since the
account is designated in foreign currency (Pounds, Sterling, US Dollars, Japanese Yen
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and Euro), the account holder does not incur exchange losses in first converting foreign
currency into rupees (while depositing the money) and then re-converting the rupees
into foreign currency (when he wants to take the money back).
The depositer will have to bring in money into the account through a remittance from
abroad or through a transfer from another FCNR / NRE account. If the money is not in
the designated foreign currency, then he will have to bear the cost of conversion into
the designated currency. On maturity, he can freely repatriate the principal and interest
(which he will receive in the designated currency that he can convert into any other
currency, at his cost).
Interest earned on these deposits is exempt from tax in India.
Non-Resident External Rupee Account (NRE)
As in the case of FCNR,
o The money has to come through a remittance from abroad, or a transfer from another
FCNR / NRE account.
o The principal and interest are freely repatriable.
o Interest earned is exempt from tax in India.
The differences are:
o It can be operated with a cheque, as in the case of any savings bank account.
o It is maintained in rupees. Therefore, a depositer bringing money in another currency
will have to first convert them into rupees; and then re-convert them to the currency
in which he wants to take the money out.
If during the deposit period, the rupee becomes weaker, then that loss is to the
account of the depositer.
Non-Resident Ordinary Account (NRO)
As with a NRE account,
o It can be operated with a cheque, as in the case of any savings bank account.
o It is maintained in rupees with the resulting implications in terms of currency
conversion losses for the depositer.
The differences from NRE are:
o The money can come from local sources not necessarily a foreign remittance or
FCNR / NRE account.
o The principal amount is not repatriable, though the interest can be repatriated.
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o The bank will deduct tax at source, on the interest earned in the deposit.
o A non-resident can open an NRO account jointly with a resident.
3.2 Joint Accounts
Two or more individuals may open a joint account. Various options exist for operating the
account:
Jointly by A and B Both A and B will have to sign for withdrawals and other operations.
For example, high value transactions in a partnership firm may require the joint signature
of two or more partners.
Either or Survivor Either of them can operate the account individually. After the demise of
one, the other can operate it as survivor. This is the normal option selected by families.
Former or Survivor The first person mentioned as account-holder will operate it during
his / her lifetime. Thereafter, the other can operate. This option is often selected by a
parent while opening an account with the son / daughter.
Latter or Survivor - The second person mentioned as account-holder will operate it during
his / her lifetime. Thereafter, the other can operate.
While opening the account, the operating option needs to be clearly specified.
3.3 Nomination
The bank account opening form provides for the account holder to select a nominee. In the
event of demise of the account holder, the bank will pay the deposit amount to the nominee,
without any legal formalities. The salient provisions regarding nomination facility in bank
accounts are as follows:
Nomination facility is available for all kinds of bank accounts savings, current and fixed
deposit.
Nomination can be made only in respect of a deposit which is held in the individual
capacity of the depositor and not in any representative capacity such as the holder of an
office like Director of a Company, Secretary of an Association, partner of a firm and Karta
of an HUF.
In the case of a deposit made in the name of a minor, nomination shall be made by a
person lawfully entitled to act on behalf of the minor.
Nomination can be made in favour of one person only.
Nomination favouring the minor is permitted on the condition that the account holder,
while making the nomination, appoints another individual not being a minor, to receive
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the amount of the deposit on behalf of the nominee in the event of the death of the
depositor during the minority of the nominee.
Cancellation of, or variation in, the nomination can be made at any time as long as
the account is in force. While making nomination, cancellation or variation, witness is
required and the request should be signed by all account holders.
When the nominee makes a claim to the bank account, two documents are normally
asked for:
o Proof of death of depositer
o Identity proof of nominee
Payment to nominee only releases the bank from its obligation on the account. The
nominee would receive the money, in trust, for the benefit of the heirs. The legal heirs of
the deceased person can claim their share of the deposit proceeds from the nominee.
3.4 Closure of Deposit Accounts
This might occur in different ways:
Account-holder can request closure of the account, and give instructions on how the
balance in the deposit should be settled.
On death of the sole account holder, the account would be closed and balance paid to the
nominee. If nominee is not appointed, then bank would pay the legal representative of
the account holder.
On receipt of notice of insanity or insolvency of the sole account holder, the bank will stop
operations in the account.
On receipt of notice of assignment of the bank account, the bank would pay the amount
lying in the account to the assignee.
On receipt of a court order or garnishee order from Income Tax authorities, the bank
would stop the transactions in the bank account during the pendency of the order.
3.5 Deposit Insurance
Deposit Insurance and Credit Guarantee Corporation (DICGC) was set up by RBI with the
intention of insuring the deposits of individuals. The deposit insurance scheme covers:
All commercial banks, including branches of foreign banks operating in India, and Regional
Rural Banks
Eligible co-operative banks.
The insurance scheme covers savings account, current account, term deposits and
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recurring accounts. However, the following deposits are not covered by the scheme:
Deposit of Central / State Government
Deposit of foreign governments
Inter-bank deposits
Deposits received outside India
In order for depositers in a bank to benefit from the insurance scheme, the bank should
have paid DICGC the specified insurance premium (10 paise per annum per Rs. 100 of
deposit).
Under the Scheme, in the event of liquidation, reconstruction or amalgamation of an
insured bank, every depositor of that bank is entitled to repayment of the deposits
held by him in the same right and same capacity in all branches of that bank upto an
aggregate monetary ceiling of Rs. 1,00,000/- (Rupees one lakh). Both principal and
interest are covered, upto the prescribed ceiling.
A few points to note:
Suppose Mr. X has one account in his individual capacity, another account jointly with
wife, a third account jointly with wife and son/daughter, and a fourth account as partner
of a firm. Each of these would be treated as being in a different right and capacity.
Therefore, for each of these accounts, insurance cover of Rs. 1,00,000 is available i.e.
the insurance cover could go upto Rs. 4,00,000
Since the monetary ceiling is applicable for all branches of a bank put together, splitting
the deposit between different branches of the same bank does not help.
If Mr. X maintains an account in his individual capacity in different banks (not different
branches of the same bank), then insurance cover of Rs. 1,00,000 will be available in
each such bank.
Some other aspects of opening and operating bank accounts including Know Your Customer
(KYC) requirements are discussed in Chapter 10.
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Chapter 19 : Other Banking Services
Accepting deposits is only one activity of a bank. Banks offer various other services to customers.
In the context of universal banking, the services offered by a bank can be extremely wide.
Some of these are listed below:
4.1 Fund-based Services
Banks accept deposits and raise other debt and equity funds with the intention of deploying
the money for a profit.
The income that a bank earns, as a percentage of its loans and investments, is its Gross
Yield.
The interest it pays as a percentage of the resources mobilised is its cost of funding.
Gross Yield less the Cost of Funding represents its Gross Spread.
Gross Spread less Administrative and Other Costs is its Net Spread.
Fund-based services are thus a key determinant of the banks spreads. The lending takes
several forms.
4.1.1 For Business
Bank Overdraft a facility where the account holder is permitted to draw more funds that
the amount in his current account.
Cash Credit an arrangement where the working capital requirements of a business are
assessed based on financial projections of the company, and various norms regarding
debtors, inventory and creditors. Accordingly, a total limit is sanctioned. At regular
intervals, the actual drawing power of the business is assessed based on its holding of
debtors and inventory. Accordingly, funds are made available, subject to adherence to
specified limits of Current Ratio, Liquid Ratio etc.
Funding could come from a consortium of bankers, where one bank performs the role of
lead banker. Alternatively, the company may make multiple banking arrangements.
Bill Purchase / Discount When Party A supplies goods to Party B, the payment terms
may provide for a Bill of Exchange (traditionally called hundi).
A bill of exchange is an unconditional written order from one person (the supplier of the
goods) to another (the buyer of the goods), signed by the person giving it (supplier),
requiring the person to whom it is addressed (buyer) to pay on demand or at some fixed
future date, a certain sum of money, to either the person identified as payee in the bill of
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exchange, or to any person presenting the bill of exchange.
o When payable on demand, it is a Demand Bill
o When payable at some fixed future date, it is a Usance Bill.
The supplier of the goods can receive his money even before the buyer makes the
payment, through a Bill Purchase / Discount facility with his banker. It would operate
as follows:
o The supplier will submit the Bill of Exchange, along with Transportation Receipt to his
bank.
o The suppliers bank will purchase the bill (if it is a demand bill) or discount the bill (if
it is a usance bill) and pay the supplier.
o The suppliers bank will send the Bill of Exchange along with Transportation Receipt
to the buyers bank, who is expected to present it to the buyer:
For payment, if it is a demand bill
For acceptance, if it is a usance bill.
o The buyer will receive the Transportation Receipt only on payment or acceptance, as
the case may be.
Term Loan / Project Finance Banks largely perform the role of working capital financing.
With the onset of universal banking, some banks are also active in funding projects. This
would entail assessing the viability of the project, arriving at a viable capital structure,
and working out suitable debt financing facilities. At times, the main banker for the
business syndicates part of the financing requirement with other banks.
4.1.2 For Individuals
Bank credit for individuals could take several forms, such as:
Credit Card The customer swipes the credit card to make his purchase. His seller will
then submit the details to the card issuing bank to collect the payment. The bank will
deduct its margin and pay the seller. The bank will recover the full amount from the
customer (buyer). The margin deducted from the sellers payment thus becomes a profit
for the card issuer.
So long as the customer pays the entire amount on the due date, he does not bear any
financing cost. He may choose to pay only the minimum amount specified by the bank. In
that case, the balance is like a credit availed of by him. The bank will charge him interest
on the credit.
Such a mechanism of availing of credit from the credit card is called revolving credit.
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It is one of the costliest sources of finance upwards of 3% p.m. Besides, even for a few
days of delay in payment, the bank charges penalties. Similarly, penalties are charged if
the credit card outstanding crosses the limit specified by the bank.
Owners of many unorganized businesses (who find it difficult to avail of normal bank
credit) end up using the credit card to fund their business in this manner undesirable,
but at times, inevitable.
Personal Loan This is a form of unsecured finance given by a bank to its customer based
on past relationship. The finance is given for 1 to 3 years. Cheaper than credit card, but
costly. It is not uncommon to come across interest rates of 1.5% p.m. plus 2-3% upfront
for making the facility available plus 3-5% foreclosure charges for amounts pre-paid on
the loan.
At times, banks convert the revolving credit in a credit card account to personal loan.
Such a conversion helps the customer reduce his interest cost and repay the money
faster. This is however a double edged sword. Once the credit card limit is released,
customers tend to spend more on the card and get on to a new revolving credit cycle.
Vehicle Finance This is finance which is made available for the specific purpose of buying
a car or a two-wheeler or other automobile. The finance is secured through hypothecation
(discussed in next Chapter) of the vehicle financed. The interest rate for used cards can
go close to the personal loan rates. However, often automobile manufacturers work out
special arrangements with the financiers to promote the sale of the automobile. This
makes it possible for vehicle-buyers to get attractive financing terms for buying new
vehicles.
Home Finance This is finance which is made available against the security of real
estate. The purpose may be to buy a new house or to repair an existing house or some
other purpose. The finance is secured through a mortgage (discussed in next Chapter) of
the property.
The finance is cheaper than vehicle finance. As with vehicle finance, real estate developers
do work out special arrangements with financiers, based on which purchasers of new
property can get attractive financing terms.
4.2 Non-Fund-based Services
These are services, where there is no outlay of funds by the bank when the commitment is
made. At a later stage however, the bank may have to make funds available.
Since there is no fund outflow initially, it is not reflected in the balance sheet. However, the
bank may have to pay. Therefore, it is reflected as a contingent liability in the Notes to the
Balance Sheet. Therefore, such exposures are called Off Balance Sheet Exposures.
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When the commitment is made, the bank charges a fee to the customer. Therefore, it is also
called fee-based business.
4.2.1 For Business
Letter of Credit - When Party A supplies goods to Party B, the payment terms may
provide for a Letter of Credit.
In such a case, Party B (buyer, or opener of L/C) will approach his bank (L/C Issuing
Bank) to pay the beneficiary (seller) the value of the goods, by a specified date, against
presentment of specified documents. The bank will charge the buyer a commission, for
opening the L/C.
The L/C thus allows the Part A to supply goods to Party B, without having to worry about
Party Bs credit-worthiness. It only needs to trust the bank that has issued the L/C. It
is for the L/C issuing bank to assess the credit-worthiness of Party B. Normally, the L/C
opener has a finance facility with the L/C issuing bank.
The L/C may be inland (for domestic trade) or cross border (for international trade).
Guarantee In business, parties make commitments. How can the beneficiary of the
commitment be sure that the party making the commitment (obliger) will live up to the
commitment? This comfort is given by a guarantor, whom the beneficiary trusts.
Banks issue various guarantees in this manner, and recover a guarantee commission
from the obliger. The guarantees can be of different kinds, such as Financial Guarantee,
Deferred Payment Guarantee and Performance Guarantee, depending on how they are
structured.
Loan Syndication This investment banking role is performed by a number of universal
banks.
4.2.2 For Individuals
Sale of Financial Products such as mutual funds and insurance is another major service
offered by universal banks.
Financial Planning and Wealth Management, again, are offered by universal banks.
Executors and Trustees a department within banks help customers in managing
succession of assets to the survivors or the next generation.
Lockers a facility that most Indian households seek to store ornaments and other
valuables.
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4.3 Money Remittance Services
4.3.1 Demand Draft / Bankers Cheque / Pay Order
Suppose A needs to make a payment to B. In the normal course, A would sign a cheque for
the requisite amount and give it to B.
If it is a bearer cheque, B can go to As bank and withdraw the money.
If it is a crossed cheque, A will deposit the cheque in his bank account.
B wants to be sure that the money would be received i.e. the cheque would not be bounced
for any reason. In such a situation, B will insist on a Demand Draft / Bankers Cheque. If both
A and B are in the same city, then the bank would issue a Pay Order.
A will have to buy the instrument from a bank, bearing the prescribed charges. A will then
send it to B, who will deposit it in his bank account.
4.3.2 National Electronic Funds Transfer (NEFT)
National Electronic Funds Transfer (NEFT) is a nation-wide system that facilitates individuals,
firms and corporates to electronically transfer funds from any bank branch to any individual,
firm or corporate having an account with any other bank branch in the country.
In order to issue the instruction, the transferor should know not only the beneficiarys bank
account no. but also the the IFSC (Indian Financial System Code) of the concerned bank.
IFSC is an alpha-numeric code that uniquely identifies a bank-branch participating in the NEFT
system. This is a 11 digit code with the first 4 alpha characters representing the bank, and the
last 6 numeric characters representing the branch. The 5th character is 0 (zero). IFSC is used
by the NEFT system to route the messages to the destination banks / branches.
Once the NEFT instruction has been issued, it will be effected between the concerned banks in
the next settlement. During weekdays, between 9am and 7 pm, there are 11 settlements i.e.
every hour. On Saturdays, there are 5 hourly settlements between 9am and 1 pm.
The beneficiary can expect to get credit on the same day, for the first nine batches on week
days (i.e., transactions from 9 am to 5 pm) and the first four batches on Saturdays (i.e.,
transactions from 9 am to 12 noon). For transactions settled in the last two batches on week
days (i.e., transactions settled in the 6 and 7 pm batches) and the last batch on Saturdays
(i.e., transactions handled in the 1 pm batch) beneficiaries can expect to get credit either on
the same day or on the next working day morning (depending on the type of facility enjoyed
by the beneficiary with his bank).
There is no limit to the amount that can be transferred under NEFT. However, for transfers
above Rs1lakhs, RTGS (discussion follows) is a superior form of funds transfer.
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4.3.3 Real Time Gross Settlement (RTGS)
RTGS transfers are instantaneous unlike National Electronic Funds Transfer (NEFT) where
the transfers are batched together and effected at hourly intervals.
As with NEFT, the transferor needs to know the IFSC Code and the beneficiarys bank account
no.
RBI allows the RTGS facility for transfers above Rs1lakhs. The RBI window is open on weekdays
from 9 am to 4.30 pm; on Saturdays from 9 am to 12.30 pm.
4.3.4 Society for Worldwide Interbank Financial Telecommunications (SWIFT)
SWIFT is solely a carrier of messages. It does not hold funds nor does it manage accounts on
behalf of customers, nor does it store financial information on an on-going basis.
As a data carrier, SWIFT transports messages between two financial institutions. This activity
involves the secure exchange of proprietary data while ensuring its confidentiality and
integrity.
SWIFT, which has its headquarters in Belgium, has developed an 8-alphabet Bank Identifier
Code (BIC). For instance HDFCINBB stands for:
HDFC = HDFC Bank
IN = India
BB = Mumbai
Thus, the BIC helps identify the bank. A typical SWIFT instruction would read as follows:
Please remit [amount in US$] by wire transfer
To HDFC Bank Mumbai Account Number V801-890-0330-937
with Bank of New York, New York [Swift code IRVTUS3N]
for further credit to account number XXXXXXXXXXXXXX of Advantage-India Consulting Pvt.
Ltd
with HDFC Bank, Ghatkopar East Branch, Mumbai 400077, India
HDFC Banks Swift code is HDFCINBBXXX
Internationally, funds are remitted through such SWIFT instructions.
4.4 Banking Channels
Initially, all banking services were offered from the bank branches. Automated Teller Machines
(ATMs) made it possible for customers to handle their transactions at multiple ATM locations
across the country. Tele-banking, supported by call centers and automated messaging made
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it convenient for customers to handle many services from their home. E-banking (through
the internet) and M-banking (through mobile phones) have added another chapter of banking
convenience.
Thus, with the aid of technology, the service offering of banks and convenience of customers
is continuously increasing.
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Chapter 20 : Bank - Customer Relationship
5.1 Roles of Banks
The relationship with the bank gets defined by the nature of the product / service availed by
the customer. Some of these are described below:
5.1.1 Bank as Debtor
This is the normal relationship of a person who has an account with the bank. The moment he
deposits money in the account, he becomes a creditor of the bank; the bank will be his debtor
for the amount lying in his account. The following are the legal implications:
The banker is required to return the money only when the customer asks for it.
The customer will have to ask for the money in the branch where he has an account.
These days, of course banks offer the facility of anywhere banking including withdrawing
money from the ATM.
The demand for money should be made in the proper form. Example cheque / withdrawal
slip
Depending on the nature of the deposit, the bank may impose restrictions, which were
discussed in Chapter [3].
Once the bank has the money, it can use the money the way it chooses. The depositer
cannot direct the bank to use it in any specific manner. Similarly, the depositer cannot
ask for return of the same currency notes / coins that he deposited.
5.1.2 Bank as Creditor
When a customer takes a loan from the bank, he becomes the borrower. The bank will be
his creditor. The terms for the loan will be as incorporated in the loan agreement executed
between the parties.
Various forms of creating the security are discussed in Chapter [6].
5.1.3 Bank as Bailee
When the customer deposits valuables or documents with the bank, the bank becomes a
bailee of those items. The customer is the bailer. As provided in the Indian Contract Act,
1872, the bailer is responsible to the bailee for any losses that arise on account of the bailers
negligence.
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5.1.4 Bank as Agent
When a customer deposits a cheque into his account, the bank will send it for clearing. The
bank, in this role, is an agent of the customer. The customer is the principal. Similarly, the
bank becomes an agent when the customer leaves various standing instructions for payments
with the bank.
It is the duty of the agent to follow the instructions given by the principal. The relationship
terminates either when the principal gives notice of such termination, or in the event of death,
insolvency or lunacy of the principal.
5.1.5 Bank as Lessor
When a customer opts for a safe deposit locker with a bank, he is effectively leasing the
locker. He is a lessee, the bank is the lessor. The relationship lasts so long as the lessee keeps
paying the prescribed charges.
The lessor is responsible for ensuring minimum standards of security to ensure the safety of
the items deposited in the locker. However, it will be liable for loss only if it is negligent in any
manner. It can also insist on the procedures to be followed for using the locker.
5.1.6 Bank as Executor / Trustee
Banks have their Executor and Trustee department, who can be appointed for handling the
estate of the customer, after the customers death. The person, in his Will, would mention the
bank as Executor of the Will. So long as the bank has accepted the prescribed charges from
the customer, it cannot refuse to act as such. While performing this role, it has to act as a
trustee of the customers affairs, and exercise reasonable diligence and care.
Companies often appoint bankers as Trustees for their debenture-holders. In such situations,
the bank has a role to protect the interest of the debenture-holders. This would normally take
the form of ensuring that the security is created, payments are made as promised etc. The
company may appoint different trustees for different series of debentures.
5.2 Bankers Obligation of Secrecy
The banker has an obligation to maintain secrecy of the details of the account-holder, not only
when he has a relationship with the bank, but also after the account is closed. This right of
the customer to expect secrecy is limited in the following situations:
5.2.1 Disclosure under Law
Various legislations impose an obligation on the bank to disclose details of the customer.
These legislations prevail over the customers right to secrecy. The legislations include:
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Income Tax Act, 1961
Companies Act, 1956
Reserve Bank of India Act, 1934
Foreign Exchange Management Act, 1999
The anti-money laundering legislations have increased the responsibility on the banks to
disclose information about their customer, even without informing the customer about the
information being shared.
5.2.2 Disclosure based on customers consent
The customer may authorize the bank to share its view on the customers banking affairs with
the customers customer. He may also authorize the bank to issue a certificate on the balance
held in his account on a particular day or during a period. The consent of the customer to
disclosure of his information may be express, or implied by the circumstances.
5.2.3 Disclosure with Credit Information Bureaus
Banks routinely share with Credit Information Bureaus, details of defaults by their borrowers.
The loan agreement with the borrower typically has a clause that provides for such sharing
of information.
5.2.4 Disclosure with Business Correspondent / Business Facilitater (BC/BF)
The role of BC / BF is discussed in Chapter 12. The nature of their role makes it necessary to
share customer information. Here again, banks take the precaution of getting a sign off from
the customer for the sharing of information, in their standard documentation.
5.2.5 Disclosure in Bankers Interest
There are situations when the banker has to disclose information in order to protect the banks
own interest. For example, sharing information with a lawyer in order to fight a case; or with
a guarantor in order to invoke a guarantee, where the customer has defaulted.
Even when the information is shared on the above grounds, bankers take certain
precautions.
They restrict the sharing information to facts. Opinions are subjective and can expose the
bank to huge damages.
They mention the obligation of secrecy and the grounds on which the information is being
made available to the other person and re-iterate that the receiver of the information
needs to respect the customers right to secrecy.
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Chapter 21 : Security Creation
Financing provided by a bank may be backed by some asset as security (also called collateral).
Loans that are backed by such security are called secured loans. The benefit of security is
that if the borrower does not re-pay, the bank can sell the asset to recover the dues. If the
asset sale does not cover the entire dues, then the bank can still recover the balance from the
borrower; any excess recovered on the sale of asset belongs to the borrower. Loans that are
not backed by the security of an asset are called unsecured loans.
Different kinds of assets are offered as security land and buildings, plant and machinery,
inventory, receivables, shares, debentures, fixed deposit receipts, insurance policies, licenses,
brands etc. The banker working on a security structure needs to keep the following in mind:
The borrower should have clear title to the asset being offered as security. If the asset
belongs to someone who is not the borrower (for example, entrepreneurs house being
mortgaged for loan to the entrepreneurs business), there has to be clear documentation
regarding the same. Even otherwise, documentation is key.
The security has to be readily encashable. This, for instance, becomes the problem when
a telecom license is offered as security. Realising the license to recover moneys gets
quite complicated because of the government permissions required.
Encashment of the asset should not impose significant additional costs on the bank.
The security has to adequately cover the financing provided. Bankers typically ask for
a higher security value than the financing provided. The difference is the margin to
take care of potential decline in value of the asset or expenses involved in realizing the
security. Where the value of the asset is subject to fluctuations (for example, in the case
of shares) a higher margin is insisted on. In market parlance, the margin is also called
hair-cut. Greater the uncertainty, higher the hair-cut.
With most intangible assets (like brands), the valuation of the asset is highly subjective.
Extra precaution has to be taken in such cases.
The rights of the banker also depend on how the security is created. The following are the
typical forms of security creation:
6.1 Pledge
As per the Contract Act, 1872, pledge means bailment of goods for the purpose of providing
security for payment of a debt or performance of a promise.
Bailment is nothing but delivery of goods to the financier. The person offering the goods as
security is the bailer, pawner or pledger. The person to whom the goods are given is the
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bailee, pawnee or pledgee.
At times, the delivery of goods may not be actual, but constructive. For instance, goods in
a warehouse may be pledged by handing over the warehouse receipt. This constructively
implies delivery of goods of the pledgee.
There is no legal necessity for a pledge agreement; pledge can be implied. However, it is
always preferable for the banker to insist on a pledge agreement.
The pledger is bound to inform the pledgee about any defects in the goods pledged, or any
risks that go with possession of the goods. He is also bound to bear any incidental expenses
that arise on account of such possession.
Pledge becomes onerous for the pledger, because he has to part with possession. For the
same reason, the pledgee is generally comfortable with a pledge arrangement. He does not
need to take any extra effort or incur any cost for realizing the security. He is however bound
to take reasonable care of the goods.
The pledgee has a general lien on the goods i.e. he is not bound to release the goods unless
his dues are fully repaid.
A point to note is that the bankers lien is limited to the recovery of the debt for which the
pledge is created not to other amounts that maybe due from the borrower. This is the
reason that banks often provide a protective clause in their pledge agreement that the pledge
extends to all dues from the borrower.
In the event of default by the borrower, the pledgee can sell the assets to recover his dues.
The dues may be towards the original principal lent, or interest thereon or expenses incurred
in maintaining the goods during the pledge.
6.2 Hypothecation
Hypothecation is defined under the SARFAESI Act, 2002, (which will be discussed in the next
chapter) as follows:
Hypothecation means a charge in or upon any movable property, existing or future, created
by a borrower in favour of a secured creditor, without delivery of possession of the moveable
property to such creditor, as a security for financial assistance, and includes floating charge
and crystallization of such charge into fixed charge on moveable property.
As with pledge, hypothecation is again adopted for movable goods. But, unlike pledge, the
possession of the asset is not given to the bank. Thus, the borrower continues to use the
asset, in the normal course.
A good example is vehicle financing, where the borrower uses the vehicle, but it is hypothecated
to the bank. The bank protects itself by registering the hypothecation in the records of the
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Regional Transport Officer (RTO). Therefore, ownership cannot be changed without a NOC
from the bank. Further, to prevent any unauthorized transfers, the bank takes possession of
the vehicle (re-possession) in the event of default by the borrower.
In the business context, it is normal to obtain working capital facilities against hypothecation
of stocks and debtors. Since these are inherent to the business, the stocks and debtors keep
changing form (some debtors clear their dues; new debtors are created based on credit
sales by the borrower) and value. The bank only insists on a minimum asset cover. If the
hypothecated assets are worth Rs. 40lakhss and the outstanding to the bank is Rs. 25 lakhss,
the asset cover is Rs. 40 lakhss Rs. 25 lakhss i.e. 1.6 times.
Since the form and value of the assets charged keep changing (the outstanding amount also
keeps changing), this kind of a charge is therefore referred to as floating charge. In the event
of default by the borrower, the bank will seek possession of the assets charged. That is when
it becomes a fixed charge viz. the assets charged as well as the borrowers dues against those
assets get crystallised.
Since possession is with the borrower, there is a risk that non-recoverable debts are included
in debtors, or non-moving or obsolete goods are included in inventory. Further, an unethical
borrower, despite all provisions in the hypothecation deed, may hypothecate the same stock
to multiple lenders. Therefore, banks go for hypothecation in the case of reputed borrowers,
with whom they have comfort.
Companies have a requirement of registering the charge with the Registrar of Companies
(ROC). Under the Companies Act, if the charge is not registered with ROC within 30 days, (or
a further period of 30 days on payment of fine), then such charge cannot be invoked in the
event of liquidation of the company. This is a protection against multiple charges created on
the same property, in case a company is a borrower. This is also a reason, why banks pursue
borrowers until they register the charge with the ROC.
At times, when the asset cover is high, banks may permit other bankers to have a charge on
the same property. Such a charge in favour of multiple lenders, all having the same priority
of repayment in the event of default, is called pari passu charge.
Not all banks are comfortable with pari passu charge. There are situations, where the first
lender insists on priority in repayment. Subject to such priority, it may not object to the
creation of an additional charge in favour of a second lender. The first lender is said to have
a first charge on the property; the second lender has second charge. Similarly, third charge,
fourth charge etc are possible, but not common.
Let us consider a situation where in the event of default by a borrower, the following charges
get fixed:
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Value of assets charged Rs. 50 lakhs
Dues to first charge-holder Rs. 40 lakhs
Dues to second charge-holder Rs. 35 lakhs
In such a situation, the first charge-holder will be fully paid. After that only Rs. 50 lakhs less
Rs. 40 lakhs i.e. Rs. 10 lakhs worth of charged asset is left. This will be paid to the second
charge-holder.
The second charge holder now has due of Rs. 35 lakhs less Rs. 10 lakhs i.e. Rs. 25 lakhs. He
can still recover the money from the borrower, but he will rank with other unsecured creditors
for the payment.
If other unsecured creditors are Rs. 5 lakhs, and other assets of the borrower are Rs. 15
lakhs, then the following is the borrowers position:
Assets Rs. 15 lakhs
Dues to second charge-holder Rs. 25 lakhs
Other unsecured creditors Rs. 5 lakhs
Total dues Rs. 30 lakhs
The second charge-holder will receive 50% of Rs. 25 lakhs i.e. Rs. 12.5 lakhs
Other unsecured creditors will receive 50% of Rs. 5 lakhs i.e. Rs. 2.5 lakhs.
Since the company has no further assets left, the lenders will have to write-off their remaining
dues as bad debts. The following will be the bad debts position of the two lenders:
Second charge-holder
Total dues of Rs. 35.0 lakhs
Less Recovered from charged asset Rs. 10.0 lakhs
Less Recovered from other assets Rs. 12.5 lakhs
Bad Debts Rs. 12.5 lakhs
Other unsecured creditors
Total dues of Rs. 5.0 lakhs
Less Recovered from other assets Rs. 2.5 lakhs
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Bad Debts Rs. 2.5 lakhs
If however, the first two lenders had pari passu charge, the position would be as follows:
Value of assets charged Rs. 50 lakhs
Dues to pari passu charge-holders Rs. 75 lakhs
(Rs. 40 lakhs plus Rs. 35 lakhs)
Therefore, the first two lenders will receive (Rs. 50 lakhs Rs. 75 lakhs i.e.) 2/3
rd
of their
dues viz.
Lender 1 2/3 of Rs. 40 lakhs i.e.Rs. 26,66,667
Lender 2 2/3 of Rs. 35 lakhs i.e. Rs. 23,33,333
With this, the asset charged is fully used up. For the balance amount, the 2 lenders will be
like unsecured creditors:
Lender 1 1/3 of Rs. 40 lakhs i.e. Rs.13,33,333
Lender 2 1/3 of Rs.35 lakhs i.e. Rs.11,66,667
Unsecured creditors Rs. 5,00,000
Total Rs. 30,00,000
Since assets available is only Rs. 15 lakhs, every lender will receive only 50% of their dues.
Lender 1 will receive Rs. 6,66,667
Lender 2 will receive Rs. 5,83,333
Unsecured creditors will receive Rs. 2,50,000
Thus, all of them will have bad debts as follows:
Lender 1 Rs. 6,66,667
Lender 2 Rs. 5,83,333
Unsecured creditors Rs. 2,50,000
Lender 1 ends up with bad debts in the pari passu charge situation, which he could have
avoided with a first charge. That is the reason banks tend to insist on first charge.
The unsecured creditors bad debts are the same, irrespective of whether any of the secured
creditors have first charge or pari passu charge.
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6.3 Mortgage
The term mortgage is defined in the Transfer of Property Act, 1882 as follows:
A mortgage is the transfer of interest in specific immoveable property for the purpose of
securing the payment of money advanced or to be advanced by way of loan, on existing
or future debt or the performance of an engagement which may give rise to a pecuniary
liability.
The person transferring the property is the mortgager; the transferee is the mortgagee.
The mortgage is generally created through a mortgage deed. However, there are exceptions
as will clear from the following discussion on different kinds of mortgages. These kinds of
mortgages are again defined in the Transfer of Property Act, 1882.
6.3.1 Simple Mortgage
The mortgage is simple because possession of the mortgaged property is not handed over to
the mortgagee. However, the mortgager accepts personal liability to pay the mortgage money
(principal plus interest).
If the mortgager does not pay the dues, the mortgagee has the right to approach court for
a decree to sell the mortgage property. This right of the mortgagee may be expressed in the
mortgage deed or implied.
As is logical, the mortgagee does not have the right to receive rent or any other proceeds from
the property. These would belong to the mortgager.
Registration is mandatory if the principal amount secured is Rs100 or above.
6.3.2 Mortgage through Conditional Sale
Here, the mortgager sells the mortgage property, but subject to conditions:
The sale becomes absolute only if the mortgager defaults on paying the dues by a
specified date; or
The sale becomes void if the mortgager pays the dues by the specified dates. In that
case, the mortgagee will transfer the property back to the mortgager.
A legal technicality is that the mortgagee cannot sue to sell the property, but he can sue to
forclose the mortgage deed. Once court grants the foreclosure, the mortgager loses the right
to claim the property. Thereafter, the mortgagee can sell the property to recover his dues.
In a standard form of such a mortgage, there is no personal liability on the mortgager to pay
the dues [he only (presumably) has an interest in paying it, so that he will get the property
back]. If he does not pay, and the asset sale does not fully cover the mortgagees dues, he
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cannot claim the balance from the mortgager. Therefore, bankers typically are not comfortable
with such a mortgage.
6.3.3 Usufructuary Mortgage
This is a mortgage where the mortgagee has the right to recover rent and other incomes from
the mortgaged property, until the dues are cleared. Thus, repayments come from the property
rather than from the mortgager.
The transfer of possession from the mortgager to the mortgagee may be express or implied.
Thus, legal possession is more important than physical possession. For example, physical
possession may be with a tenant who pays the rent.
As with Conditional Sale, there is no personal obligation on the mortgager to pay. The banker
has to keep holding the property for an indeterminate period of time, until the dues are
cleared. Therefore, bankers are not comfortable with such mortgages.
6.3.4 English Mortgage
In this form of mortgage, the mortgager transfers the property to the mortgagee absolutely.
However, the mortgagee will have to re-transfer the mortgaged property to the mortgager, if
the dues are paid off.
Since the mortgager assumes personal liability to repay, the mortgagee can sue the mortgager
for recovery of dues or seek a court decree to sell the property. This gives comfort to the
banker.
6.3.5 Equitable Mortgage / Mortgage by Deposit of Title Deeds
As is clear from the name, the mortgager merely deposits the title deeds to immoveable
property with the mortgagee, with the intention of creating a security.
Such mortgages can only be created in Mumbai, Chennai or Kolkatta. The mortgaged property
may be located anywhere, but the mortgage creation has to be in any of these three cities.
Benefit of this kind of mortgage is that stamp duty is saved. Further, it is less time consuming
to create.
The risk is that a fraudulent mortgager may obtain multiple title deeds, and create multiple
mortgages, thus adding to the complexity of the banker when it comes to recovering money.
6.3.6 Anomalous Mortgage
A mortgage which does not fall strictly into any of the above mortgages is an anomalous
mortgage. For instance, in a usufructuary mortgage, the mortgager may take personal
obligation to pay the dues.
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The mortgage creation format is one of the key conditions in the sanction letter of the lender
/ term sheet that the lender and borrower sign to freeze the terms of their arrangement.
6.4 Assignment
The Banker may provide finance against the security of an actionable claim. Under the Transfer
of Property Act, an actionable claim is a claim to any debt other than a debt secured by
mortgage of immovable property or by hypothecation or pledge of movable property.
Since security depends on the quality of the debt, bankers are comfortable if the dues to the
borrower are from the Government. With such a structure, the bank can earn a return that is
higher than what is normal for taking a sovereign risk.
In housing loans, where repayment depends on the earning cycle of the borrower, financiers
tend to ask for assignment of life insurance policy that covers the life of the borrower. This can
be done by mentioning the same in the reverse of the insurance policy document, along with
signature of the assigner. Alternatively, a separate deed of assignment can be signed. Either
way, the insurance company needs to be informed about the assignment.
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Chapter 22 : NPA and Securitisation
7.1 Non-Performing Assets
In the normal course, borrowers repay their dues to the bank by their respective due dates.
Some debts, however, turn sticky. The borrower is unable or unwilling to pay. If such debt
is shown as a regular debt, and interest is accrued on such debt as a regular income, then
the financial statements would give an incorrect picture of the financial status of the bank.
Therefore, RBI has laid down strict requirements regarding recognition of Non-Performing
Assets (NPA).
An NPA is a loan or advance where:
Term Loan interest and / or instalment of principal remains overdue for more than 90
days.
Overdraft / Cash credit - account is out of order i.e.
o Outstanding balance remains continuously in excess of the sanctioned limit / drawing
power; or
o Outstanding balance is within the sanctioned limit / drawing power, but there are no
credits continuously for 90 days as on the date of balance sheet, or the credits are
not enough to cover the interest debited during the same period.
Bills purchased and discounted bill remains overdue for more than 90 days.
Short duration crops (crop season is upto a year) instalment of principal or the interest
thereon remains overdue for two crop seasons.
Long duration crops - instalment of principal or the interest thereon remains overdue for
one crop season.
A few more relevant points
Banks are supposed to classify an account as NPA only if the interest charged during any
quarter is not serviced fully within 90 days from the end of the quarter.
If an advance is covered by term deposits, National Savings Certificates eligible for
surrender, Indira Vikas Patras, Kisan Vikas Patras and Life policies, then it need not be
treated as NPA. This exemption however does not extend to government securities and
gold ornaments.
Drawing power should be determined based on stocks statements that are not older than
3 months. Else, it would be treated as irregular.
If irregular drawings are permitted in the working capital account for a continuous period
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of ninety days, it will become an NPA (even if the financial status of the borrower is
stable).
Regular and ad hoc credit limits are to be reviewed / regularized within 3 months from
the due date / date of ad hoc sanction. If this is not done within 180 days of the due date
/ date of ad hoc sanction, the asset would be treated as NPA.
Once arrears of interest and principal are paid by the borrower, the NPA becomes a
standard asset.
If even one facility to a borrower or investment in securities issued by a borrower becomes
NPA, all the facilities granted by the bank to the borrower and investment in all the
securities issued by the borrower will have to be treated as NPA.
7.2 NPA Categories
7.2.1 Sub-Standard Assets
An asset that has remained NPA for upto 12 months.
7.2.2 Doubtful Assets
An asset that has remained sub-standard for upto 12 months.
7.2.3 Loss Assets
An asset that the bank or its auditors or the RBI has identified as a loss, but the amount has
not been written off entirely.
In exceptional cases, such as fraud by the borrower, the above mentioned stages of NPA can
be skipped. The asset can directly be treated as a doubtful asset or loss asset.
If the realizable value of the security is less than 50% of the value assessed by the bank or
accepted by RBI at the time of last inspection, then the asset will be treated as doubtful.
If the realizable value of the security, as assessed by the bank or valuers or RBI is less than
10% of the amount outstanding, then the existence of the security is to be ignored. The NPA
asset will be immediately treated as a loss asset.
Where a sub-standard asset is re-structured, then it would be treated as standard asset only
1 year after the first payment (interest or principal) is due. This too is subject to satisfactory
performance during the one-year period.
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7.3 NPA Provisioning Norms
7.3.1 Loss Assets
Should be entirely written off. If this is not done, provisioning should be made for 100% of the
amount shown as outstanding.
7.3.2 Doubtful Assets
Realisable value of the security, if any should be estimated. The excess of the outstanding
over the security value should be entirely provided for.
Provisioning requirement for the secured portion is as follows:
20%, if the advance has been doubtful for up to 1 year
30%, if the advance has been doubtful for 1 to 3 years
100%, if the advance has been doubtful for more than 3 years.
7.3.3 Sub-standard Assets
Provision of 10% of the total outstanding should be made, without any allowance for security
available or ECGC guarantee available.
Unsecured exposures i.e. where the security value is less than 10% of the outstanding
exposure, need to be provided for to the extent of a further 10% (i.e. total 20%).
7.3.4 Standard Assets
Provision is required, even for such assets, as follows:
Direct advances to agricultural and SME sectors 0.25%
Personal loans, loans in the nature of capital market exposures, residential housing loans
beyond Rs20lakhs and commercial real estate loans 1%
Other advances 0.40%
7.4 SARFAESI Act
Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest,
2002 (SARFAESI Act, 2002) was enacted to provide banks and financial institutions with a
more effective framework to enforce the security structure underlying loans and advances
given by them, and recover their dues expeditiously. As is evident from the name, it addresses
the regulation of three distinct areas:
Securitisation
Reconstruction of Financial Assets
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Enforcement of Security Interest
Banks and Financial Institutions can benefit from SARFAESI. The term bank includes all
banking companies, including co-operative banks. However, regional rural banks have been
kept out. Financial institution means:
A public financial institution within the meaning of the Companies Act, 1956
Any institution specified by the Central Government under the Recovery of Debts due to
Bank and Financial Institutions Act, 1993
The International Finance Corporation, established under the International Finance
Corporation (Status, Immunitis and Privileges) Act, 1958
Any other institution or non-banking financial company as defined in the Reserve Bank of
India Act, 1934, which the Central Government may specify as a financial institution for
the purposes of the Act.
The bank or financial institution which has lent money to a borrower is also called originator
in the context of securitization.
The person who has an obligation to the bank or financial institution is an obligor. Under the
Act, obligor includes a borrower and means a person liable:
To pay to the originator, whether under a contract or otherwise; or
To discharge any obligation in respect of a financial asset, whether existing, future,
conditional or contingent.
What does financial asset mean? Under the Act, financial asset means debt or receivables,
and includes:
A claim to any debt or receivables, or part thereof, whether secured or not; or
Any debt or receivable secured by mortgage of or charge in immoveable property; or
A mortgage charge, hypothecation or pledge of moveable property; or
Any right or interest in the security, whether full or part, securing debt; or
Any beneficial interest in any moveable or immoveable property or in debt, receivables,
whether such an interest is existing, future, accruing, conditional or contingent; or
Any financial assistance.
Property means:
Immoveable property
Moveable property
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Any debt or any right to receive payment of money, whether secured or unsecured
Receivables, whether existing or future
Intangible assets such as know-how, copyrights, trademarks, license, franchise or ay
other business or commercial right of a similar nature.
The Act uses the term asset re-construction for the acquisition of any right or interest, of
any bank or financial institution, in any financial assistance, by any securitization company or
re-construction company, for the purpose of realization of such financial assistance.
An entity holding more than 10% of the equity capital of a securitization company or re-
construction company is its sponsor.
RBI is the regulater for securitization companies and re-construction companies, which are
companies created for the purpose, under the Companies Act, 1956. Such companies need
to be registered with RBI. At the time of registration, they need to have net owned funds of
at least Rs2crore. RBI can set a higher requirement, upto 15% of the total financial assets
acquired or to be acquired.
The capital adequacy requirement is Rs100crore or 15% of the total assets acquired whichever
is less.
A point to note is that a company that is not registered with RBI too can handle the securitization
and re-construction business. However, such an unregistered company cannot benefit from
the provisions of SARFAESI.
7.4.1 Securitisation
This is a process where financial assets (say, dues from a borrower) are converted into
marketable securities (security receipts) that can be sold to investors.
In the first stage of a securitization transaction, an originater sells the financial asset to the
securitization company. This can be done as follows:
The securitization company / asset re-construction company issues a debenture or bond
or any other security in the nature of a debenture, for the agreed consideration, and as
per the agreed terms and conditions, to the originator; or
Entering into an agreement for transfer of the financial asset as per the agreed terms and
conditions.
On acquisition of the financial asset, the securitization or reconstruction company becomes
the owner of the financial asset. In rights, it steps into the shoes of the lending bank or
financial institution. It is to be noted that only the assets get transferred any related liability
remains with the bank or financial institution (originator). However, any pending suit, appeal
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or proceeding against the originator can be continued against the securitization company or
asset reconstruction company.
In the second stage, against the security of the financial asset, the securitization company can
mobilise money by issuing security receipts to QIB investors.
Thus, securitization makes it possible to transfer loans secured by mortgage or other
charges.
The term security receipt is defined as a receipt or any other security issued by a securitization
company or reconstruction company to any qualified institutional buyer (QIB) pursuant to a
scheme, evidencing the purchase or acquisition by the holder thereof of an undivided right,
title or interest in the financial asset underlying the securitization.
Qualified institutional buyer (QIB) means a financial institution or an insurance company
or a bank or a state financial corporation or a state industrial development corporation or
trustee or any asset management company making an investment on behalf of a mutual fund
or provident fund or gratuity fund or pension fund or SEBI-registered foreign institutional
investor (FII) or any other body corporate specified by SEBI. Any other company will have to
register itself with SEBI, if it wants to be treated as QIB.
The securitization company can create separate trusts for each scheme, and act as trustee
for the schemes.
It is not compulsory to give notice of the transfer to the obliger; or to register the charge with
the Registrar of Companies, if the obliger is a company.
In the absence of notice, payments by the obliger to the bank or financial institution
shall be treated as a valid discharge of obligation. The bank or financial institution shall
receive the proceeds, in trust, for the benefit of the securitization company / asset re-
construction company.
If notice is given to the obliger, then the obliger will have to make payments to the
securitization company / asset re-construction company. Further, if the obliger is a
company, then the charge is to be registered with the Registrar of Companies.
7.4.2 Asset Re-construction
Here, the right or interest of any bank or financial institution in any financial asset is acquired
by the asset re-construction company for the purpose of realization of dues.
Asset re-construction might entail taking several measures such as:
Takeover the management of the business of the borrower or bring about any such
change.
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On realization of the secured debt in full, the management of the business is to be restored
back to the borrower.
To sell or lease a part or whole of the business of the borrower.
Reschedule debts of the borrower.
Take possession of secured asset
Enforce security interest
Settle dues payable by the borrower
The grounds on which these actions may be taken would be as per the loan agreement
between the borrower and the lender. Default is not a necessary pre-condition.
Although the Act does not provide for notice to the borrower before these measures are taken,
court rulings in similar cases indicate that it is better that the notice be given.
Within 12 months of acquiring a NPA, the securitization company or the re-construction
company has to formulate a plan for its realization. During this period, it can classify the
asset as a standard asset.
SARFAESI does not cover pledge and enforcement of pledge. Therefore, if the loan is backed
by pledge of owners stake in the company, then the enforcement of power to sell the owners
stake in case of default, would be as per the loan agreement, SEBI requirements (if it is a
listed entity) and the Indian Contract Act not as provided for in SARFAESI.
7.4.3 Enforcement of Security Interest
In the normal course, court intervention is required for sale of property and realization of
money due from a defaulter. This is equally applicable to mortgage of immoveable property,
as well as charge created on moveable property. Only realization of money from pledged
security is outside the requirement of court intervention.
SARFAESI gives another window for banks and financial institutions to enforce their security
interest without the intervention of Civil Court or the Debt Recovery Tribunal (DRT).
If the lender also holds security through a pledge of any moveable assets, or the guarantee
of any person, then it can sell the pledged goods or proceed against the guarantor without
initiating any action against the secured assets.
Under SARFAESI, the bank or financial institution needs to give 60-day notice to the defaulter,
giving details of the amount payable and the secured asset intended to be enforced by the
secured creditor, in the event of non-payment of the secured debt. The effect of this notice is
that the borrower is barred from transferring the property mentioned in the notice.
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If the borrower responds to the notice, then the secured creditor needs to consider the
representation or objections fairly. If these are not acceptable, then the reasons for non-
acceptance need to be conveyed to the borrower within 7 days. Such non-acceptance however
does not confer a right on the borrower to approach the DRT or any Civil Court
If the dues are not paid during the notice period, then the secured creditor gets the following
rights:
Take possession of the secured assets, and transfer it by lease, assignment or sale for
realization of money.
Appoint a manager to manage the secured assets that have been re-possessed.
Takeover management of the secured assets, and transfer it by lease, assignment or sale
for realization of money.
Give notice to any person who has acquired the secured asset from the borrower, and
from whom any money is due or may become due to the borrower, to pay the moneys
to the secured creditor. Such payment to the secured creditor will be a valid discharge of
the persons dues to the borrower.
When the secured creditor transfers the secured asset under SARFAESI, the transferee gets all
the rights in, or in relation to the asset, as if the owner of the asset executed the transfer.
In order to take possession or control of the secured asset, or sell or otherwise transfer it,
the secured creditor can make a request in writing to the Chief Metropolitan Magistrate or the
District Magistrate. On receiving such a request, the judicial authority is bound to take the
requisite steps.
Amounts realized from the secured asset are to be applied in the following sequence:
Costs, charges and expenses incidental towards preservation and protection of securities,
insurance premium etc. that are recoverable from the borrower.
Dues of the secured creditor
Any surplus will be paid to the person entitled to it in accordance with the rights and
interests.
Thus, dues to the secured creditor have precedence over the preferential payments to the
government or labour or other creditors.
At any time before the date fixed for sale or transfer, the borrower can pay the entire dues,
costs, charges and expenses incurred by the creditor. In that case, the secured creditor will
not sell or transfer the asset. Only in the event the borrower company is being wound up,
dues to workmen will rank pari passu with secured creditors, as provided in the Companies
Act, 1956.
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If the financing facility is offered by a consortium of lenders, then no secured creditor can
take possession of the secured asset unless agreed upon by the creditors representing not
less than three-fourths in value of the outstanding dues (principal, interest and other dues).
If at least three-fourths by value agree to the action, then it is binding on the rest of the
creditors.
If the sale of secured assets does not fully cover the dues, then for the balance, the bank or
financial institution can approach the DRT or Civil Court.
The rights under SARFAESI need to be executed a person of appropriate seniority. The
authorized person should be of the level equivalent to a Chief Manager of a public sector bank
or equivalent or any other person exercising the powers of superintendence, direction and
control of the business or affairs of the creditors.
7.4.4 Central Registry
SARFAESI also provides for a Central Registry to register transactions that are in the nature
of securitization and reconstruction of financial assets or creation of security interest under
the Act.
The securitization company or reconstruction company or secured creditor is required to
file the details with the central registrar within 30 days of the transaction or the creation of
security. A further time period of 30 days is available for the registration, provided penalty is
paid.
Registration under this Act is in addition to registration requirements under other acts, like the
Companies Act, 1956, Registration Act, 1908 and Motor Vehicles Act, 1988.
When payment is made in full, details of the satisfaction of charge are to be filed by the
securitization company or the reconstruction company or the secured creditor within 30
days.
If, otherwise, the central registrar receives notice of satisfaction of charge, then it has to issue
a notice to the securitization company or the reconstruction company or the secured creditor,
to respond within 15 days on why the satisfaction of charge should not be recorded in the
central registry. If no response is received, then the satisfaction of charge will be recorded in
the registry. If a response is received, the borrower will be informed about it.
7.4.5 Resolution of Disputes
Disputes between the securitization or re-construction company and the bank or financial
institution or QIB relating to securitization or re-construction or non-payment of any dues or
interest, have to be settled by conciliation or arbitration under the Arbitration and Conciliation
Act, 1996. The obliger / borrower is however not covered by this requirement.
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7.4.6 Debt Recovery Tribunal (DRT)
Any person, including the borrower, aggrieved by any of the measures taken by the secured
creditor or his authorized officer for taking possession of the security may apply to the DRT
within 45 days. The DRT has to dispose the application within 60 days. If not done within
this time frame, the DRT has to record the reasons for the delay in writing. In any case, the
application has to be disposed within 4 months from the date it is filed.
The Recovery of Debts due to Banks and Financial Institutions Act, 1993, has set the jurisdiction
of DRT at Rs10lakhs and above. However, since the SARFAESI Act does not provide for a limit,
appeals to the DRT are possible even if the amount entailed is lower.
7.4.7 Appellate Tribunal
Any person aggrieved by an order of the DRT can appeal to the Appellate Tribunal within
30 days of date of receipt of the order. The borrower has to deposit 50% of the amount
claimed by the secured creditor, before filing an appeal. The Appellate Tribunal can reduce
the deposit requirement to 25% of the amount claimed, after recording the reasons for such
a concession.
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Chapter 23 : BASEL Framework
9.1 Bank for International Settlements (BIS)
Established on 17 May 1930, the BIS is the world's oldest international financial organisation.
It has its head office in Basel, Switzerland and two representative offices: in the Hong Kong
Special Administrative Region of the People's Republic of China and in Mexico City.
BIS fosters co-operation among central banks and other agencies in pursuit of monetary and
financial stability. It fulfills this mandate by acting as:
a forum to promote discussion and policy analysis among central banks and within the
international financial community
a centre for economic and monetary research
a prime counterparty for central banks in their financial transactions
agent or trustee in connection with international financial operations
Every two months, the BIS hosts in Basel, meetings of Governors and senior officials of
member central banks. The meetings provide an opportunity for participants to discuss the
world economy and financial markets, and to exchange views on topical issues of central bank
interest or concern. The Basel Committee on Banking Supervision comprises representatives
from Argentina, Australia, Belgium, Brazil, Canada, China, France, Germany, Hong Kong SAR,
India, Indonesia, Italy, Japan, Korea, Luxembourg, Mexico, the Netherlands, Russia, Saudi
Arabia, Singapore, South Africa, Spain, Sweden, Switzerland, Turkey, the United Kingdom and
the United States.
BIS also organises frequent meetings of experts on monetary and financial stability issues,
as well as on more technical issues such as legal matters, reserve management, IT systems,
internal audit and technical cooperation.
BIS is a hub for sharing statistical information among central banks. It publishes statistics on
global banking, securities, foreign exchange and derivatives markets.
Through seminars and workshops organised by its Financial Stability Institute (FSI), the BIS
disseminates knowledge among its various stake-holders.
The role of BIS has been changing in line with the times. Initially, it handled the payments that
Germany had to make consequent to the First World War. Following the Second World War and
until the early 1970s, it focused on implementing and defending the Bretton Woods system.
In the 1970s and 1980s, it had to manage the cross-border capital flows following the oil crises
and the international debt crisis. The economic problems highlighted the need for effective
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supervision of internationally active banks. This culminated in the Basel Capital Accord on
international convergence of capital measurement and capital standards, in 1988.
9.2 Basel Accords
The Basel Accord of 1988 (Basel I) focused almost entirely on credit risk. It defined capital,
and a structure of risk weights for banks. Minimum requirement of capital was fixed at 8%
of risk-weighted assets. The G-10 countries agreed to apply the common minimum capital
standards to their banking industries by end of 1992. The standards have evolved over time.
In 1996, market risk was incorporated in the framework.
In June 2004, a revised international capital framework was introduced through Basel II.
The following year, an important extension was made through a paper on the application
of Basel II to trading activities and the treatment of double default effects. In July 2006, a
comprehensive document was brought out, which integrated all applicable provisions from the
1988 Accord, Basel II and the various applicable amendments.
The Basel II framework is based on three pillars:
The first Pillar Minimum Capital Requirements
Three tiers of capital have been defined:
o Tier 1 Capital includes only permanent shareholders equity (issued and fully paid
ordinary shares and perpetual non-cumulative preference shares) and disclosed
reserves (share premium, retained earnings, general reserves, legal reserves)
o Tier 2 Capital includes undisclosed reserves, revaluation reserves, general provisions
and loan-loss reserves, hybrid (debt / equity) capital instruments and subordinated
term debt. A limit of 50% of Tier 1 is applicable for subordinated term debt.
o Tier 3 Capital is represented by short-term subordinated debt covering market risk.
This is limited to 250% of Tier 1 capital that is required to support market risk.
The second Pillar Supervisory Review Process
Four key principles have been enunciated:
o Principle 1: Banks should have a process for assessing their overall capital adequacy
in relation to their risk profile and a strategy for maintaining their capital levels.
o Principle 2: Supervisors should review and evaluate the banks internal capital
adequacy assessments and strategies, as well as their ability to monitor and ensure
their compliance with regulatory capital ratios. Appropriate corrective action is to be
taken, if required.
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o Principle 3: Supervisors should expect banks to operate above the minimum regulatory
capital ratios and should have the ability to require banks to hold capital in excess of
the minimum.
o Principle 4: Supervisors should seek to intervene at an early stage to prevent capital
from falling below the minimum levels required to support the risk characteristics of
a particular bank and should require rapid remedial action if capital is not maintained
or restored.
The third Pillar Market Discipline
This is meant to complement the other two pillars. Market discipline is to be encouraged
by developing a set of disclosure requirements that will allow market participants to
assess key pieces of information on the scope of application, capital, risk exposures,
risk assessment processes and overall capital adequacy of the institution. The banks
disclosures need to be consistent with how senior management and the Board of Directors
assess and manage the risks of the bank.
The capital adequacy requirement was maintained at 8%. However, the whole approach
is considered to be more nuanced than Basel I.
The stresses caused to institutions and the markets during the economic upheaval in
the last couple of years, created a need for further strengthening of the framework. At
its 12 September 2010 meeting, the Group of Governors and Heads of Supervision, the
oversight body of the Basel Committee on Banking Supervision, announced a substantial
strengthening of existing capital requirements. These capital reforms, together with the
introduction of a global liquidity standard, deliver on the core of the global financial
reform agenda (Basel III).
Basel III is a comprehensive set of reform measures to strengthen the regulation,
supervision and risk management of the banking sector. These measures aim to:
improve the banking sector's ability to absorb shocks arising from financial and economic
stress, whatever the source
improve risk management and governance
strengthen banks' transparency and disclosures.
The reforms target:
bank-level, or micro-prudential regulation, which will help raise the resilience of individual
banking institutions to periods of stress.
macro-prudential, system wide risks that can build up across the banking sector as well
as the pro-cyclical amplification of these risks over time.
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These two approaches to supervision are complementary as greater resilience at the individual
bank level reduces the risk of system wide shocks.
The Committee's package of reforms will increase the minimum common equity requirement
from 2% to 4.5%. In addition, banks will be required to hold a capital conservation buffer of
2.5% to withstand future periods of stress bringing the total common equity requirements
to 7%. This reinforces the stronger definition of capital agreed by Governors and Heads of
Supervision in July and the higher capital requirements for trading, derivative and securitisation
activities to be introduced at the end of 2011.
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Chapter 24 : Regulatory Framework
10.1 Anti-Money Laundering and Know Your Customer
The G-7 summit in 1989 established the Financial Action Task Force (FATF) in 1989. Membership
of the FATF has been expanded subsequently. India has a status of observer in FATF.
In 1990, FATF came out with 40 recommendations to fight money laundering. These covered
customer due diligence and record keeping, reporting of suspicious transactions, measures to
deter money laundering and handling of countries that do not adopt these practices.
9 recommendations to combat terrorism financing were added in 2001. These were meant
to get countries to criminalise terrorism financing, adopt UN resolutions on terrorism and
freeze and confiscate terrorism assets. The UN, from time to time, issues lists of people
and organisations associated with terrorism. Member countries are expected to freeze their
assets.
The Wolfsberg Group consisting of 12 leading international financial institutions formulated
AML Principles, specially intended for combating increased money laundering risk in case of
private banking and correspondent banking.
In June 2007, the FATF adopted high level principles and procedures in risk-based approach
in combating money laundering and terrorist financing.
In India, The Prevention of Money Laundering Act, 2002 (PMLA) came into effect on July
1, 2005. On the same day, the Financial Intelligence Unit-India (FIU-IND) constituted by
Government of India on 18th November 2004 as a nodal agency for AML measures got
statutory recognition.
Reserve Bank of India (RBI), Securities and Exchange Board of India (SEBI), Insurance
Regulatory and Development Authority (IRDA) and FIU-IND are the bodies mainly responsible
for the anti-money laundering efforts for financial institutions in India.
FIU-IND is an independent body reporting directly to the Economic Intelligence Council
(EIC) headed by the Finance Minister of India and is responsible for receiving, processing,
analyzing and disseminating information relating to suspicious financial transactions. FIU-IND
is also responsible for coordinating and strengthening efforts of national and international
intelligence, investigation and enforcement agencies in pursuing the global efforts against
money laundering and related crimes.
RBI, SEBI and IRDA too have issued guidelines for their regulated entities.
The requirements are being continuously strengthened. For instance, lately, market participants
have been asked to be cautious of money flows from Iran. Even earlier, RBI had bought out
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a watch-list of six countries viz. Sao Tome and Principe, Turkmenistan, Iran, Northern Part of
Uzbekistan and Pakistan.
10.1.1 Money Laundering
Money laundering is the approach that criminals take to camouflage their money flows from
criminal activities (like drug trafficking, child pornography etc.) and pass it off as regular legal
money flows.
According to PMLA, whosoever, directly or indirectly attempts to indulge, or knowingly assists,
or knowingly is a party or is actually involved in any process or activity, connected with the
proceeds of crime and projecting it as untainted property shall be guilty of offence of money-
laundering.
"Proceeds of crime" means any property derived or obtained, directly or indirectly, by any
person as a result of criminal activity relating to a scheduled offence or the value of any such
property.
10.1.2 Terrorist Financing
Terrorists adopt the same approach as money launderers, to manage their finances. Since
the contributions to terrorist financing may come from normal legal sources and often the
contributions are of small value terrorist financing is a lot more difficult to track.
10.1.3 Know Your Customer (KYC)
'Customer' has been defined as:
o a person or entity that maintains an account and/or has a business relationship with the
bank;
o one on whose behalf the account is maintained (i.e. the beneficial owner);
o beneficiaries of transactions conducted by professional intermediaries, such as Stock
Brokers, Chartered Accountants, Solicitors etc. as permitted under the law, and
o any person or entity connected with a financial transaction which can pose significant
reputation or other risks to the bank, say, a wire transfer or issue of a high value demand
draft as a single transaction.
RBI has issued guidelines to banks to prevent money laundering through:
KYC policies and procedures specifying the objective of KYC framework, i.e. appropriate
customer identification. The KYC policies should incorporate the following four key
elements:
o Customer Acceptance Policy
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o Customer identification procedures
o Monitoring of transactions
o Risk Management
Monitoring transactions of a suspicious nature;
Risk management and monitoring procedures, i.e. staff awareness, identification and
reporting of suspicious transactions, record keeping of transactions;
Treating the information collected from the customer for the purpose of opening of
account as confidential and not divulge any details thereof for cross selling or any other
purposes;
Ensuring that any remittance of funds by way of demand draft, mail/ telegraphic transfer
or any other mode and issue of travelers' cheques for value of INR 50,000 and above
is effected by debit to the customer's account or against cheques and not against cash
payment;
Ensuring that the provisions of Foreign Contribution and Regulation Act, 1976 wherever
applicable, are adhered to strictly.
The RBI regulations are applicable to all the branches of subsidiaries of Indian banks
functioning in other countries. For these institutions, where the host country regulations are
more rigorous; the host country regulation prevails.
The following transactions need to be reported to FIU-IND:
All cash transactions of the value of more than INR 1,000,000 or its equivalent in foreign
currency;
All series of cash transactions integrally connected to each other which have been valued
below INR 1,000,000 or its equivalent in foreign currency where such series of transactions
have taken place within a month, however, aggregating to more than INR 1,000,000;
All cash transactions where forged or counterfeit currency notes or bank notes have been
used as genuine or where any forgery of a valuable security or a document has taken
place facilitating the transactions; and
All suspicious transactions whether or not made in cash.
Staff is expected to ensure that the customers are not informed (i.e. tipped off) that his/
her accounts are under monitoring for suspicious activities and/or that a disclosure has been
made to the FIU-IND.
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10.1.4 Customer Risk Categorisation (CRC)
RBI has directed banks to categorise customers into low, medium, and high risk categories
and have differential due diligence and monitoring standards based on the risk assessment.
The guidelines mention some of the parameters, which may be considered for categorising a
customer's risk.
Customer constitution: Individual, proprietorship, partnership, private limited, etc
Business segment: Retail, Corporate, etc
Country of residence/ Nationality: Whether India or any overseas location/ Indian or
foreign national.
Product subscription: Salary account, NRI products, etc.
Economic profile: High Net Worth Individuals (HNI), public limited company, etc.
Account status: Active, inoperative, dormant.
Account vintage: less than six months old, etc.
Presence in regulatory negative/ Politically Exposed Persons (PEP) /defaulter/fraudster
lists.
Suspicious Transaction Report (STR) filed for the customer.
AML Alerts
Other parameters like source of funds, occupation, purpose of account opening, nature of
business, mode of operation, credit rating, etc. can also be used in addition to the above
parameters. Banks may adopt all or some of these parameters based on availability of data.
Examples of some high risk categories are also given, which include Non Resident Indians
(NRIs), High Net worth Individuals (HNIs), Trusts, Charities, Non Governmental Organisations
(NGOs), companies having closed shareholding structure, firms with sleeping partners, Politically
Exposed Persons (PEPs), non-face-to-face customers, persons with dubious reputation, etc.
The guidelines further require the banks to carry out a review of risk categorization of
customers at a periodicity of not less than once in six months. It is therefore, now mandatory
for banks in India to introduce a system of CRC for their customers.
10.1.5 Customer Identity and Due Diligence
Identity generally means a set of attributes which together uniquely identify a natural or
legal person. The attributes, which help establishing the unique identity of a natural or legal
person, are called 'identifiers'.
Name (in full), Father' Name, Date of birth, Passport number, Election Card number (EC
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number), PAN number, Driving License number, etc are unique identifiers available which help
establishing the identity of a natural or legal person. These are termed as 'primary identifiers'
as they help in uniquely establishing the identity of a natural or legal person.
Addresses / location and nationality and other such identifiers may serve as secondary
identifiers' as they help further refine the identity though they may not directly help uniquely
identify a natural or legal person.
The following are the typical document requirements for opening an account:
For individuals
o Identity Passport / PAN Card / Voter Identity Card / Driving License / Identity
card (subject to bank satisfaction) / Letter from recognized public authority or
public servant verifying the identity and residence of the customer (subject to bank
satisfaction)
o Permanent address Telephone bill / Bank account statement / Letter from recognized
public authority / Electricity bill / Ration card / Letter from employer (subject to bank
satisfaction).
For companies
o Certificate of Incorporation, Memorandum of Association, Articles of Association
o Resolution of the Board of Directors to open the account and identification of the
authorities who will operate the account.
o Power of Attorney granted to its managers, officers or employees to transact business
on behalf of the company
o PAN allotment letter for company
o Officially valid document identifying the signing authorities (Passport copy / PAN
Card)
For partnership firms
o Registration Certificate, if registered
o Partnership Deed including names and addresses of each partner
o Power of attorney granted to a partner or employee to transact business on behalf of
the firm.
o Officially valid document identifying the signing authorities (Passport copy / PAN
Card)
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For trusts and foundations
o Registration Certificate, if registered
o Trust Deed including names and addresses of each trustee
o Resolution of the board of trustees to open the account
o Power of attorney granted to a trustee or employee to transact business on behalf of
the trust.
o Officially valid document identifying the signing authorities (Passport copy / PAN
Card)
Customer Due Diligence (CDD) has been defined as any measure undertaken by a financial
institution to collect and verify information and positively establish the identity of a customer.
A bank should apply Customer Due Diligence measures when it:
establishes a business relationship;
carries out an occasional transaction;
suspects money laundering or terrorist financing; or
doubts the veracity of documents, data or information previously obtained for the purpose
of identification or verification
When a bank is unable to apply CDD, it
must not establish a business relationship or carry out an occasional transaction with the
customer;
should not carry out a transaction with or for the customer through a bank account;
should terminate all existing business relationship with the customer;
should consider whether it ought to report to FIU-IND/ Regulators, in accordance with
extant guidelines.
Depending on the CRC, CDD may be basic (normal), simplified (low income group for financial
inclusion) or enhanced (high risk category).
10.1.6 Wire Transfers
Money is transferred between accounts through wire transfers. These may be domestic (within
the country) or cross-border (across countries).
For domestic wire transfers, RBI has stipulated the following:
Information accompanying all domestic wire transfers of Rs.50000/- (Rupees Fifty
Thousand) and above must include complete originator information i.e. name, address
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and account number etc., unless full originator information can be made available to the
beneficiary bank by other means.
If a bank has reason to believe that a customer is intentionally structuring wire transfer
to below Rs.50000/- (Rupees Fifty Thousand) to several beneficiaries in order to avoid
reporting or monitoring, the bank must insist on complete customer identification before
effecting the transfer. In case of no cooperation from the customer, efforts should be
made to establish his identity and Suspicious Transaction Report (STR) should be made
to FIU-IND.
When a credit or debit card is used to effect money transfer, necessary information as (a)
above should be included in the message.
For cross-border wire transfers, the requirements are:
All cross-border wire transfers must be accompanied by accurate and meaningful
originator information.
Information accompanying cross-border wire transfers must contain the name and
address of the originator and where an account exists, the number of that account.
In the absence of an account, a unique reference number, as prevalent in the country
concerned, must be included.
Where several individual transfers from a single originator are bundled in a batch file for
transmission to beneficiaries in another country, they may be exempted from including
full originator information, provided they include the originator's account number or
unique reference number as at (b) above.
10.2 Banking Ombudsman Scheme, 2006
The scheme was introduced with the following objectives:
To resolve complaints relating to banking services and to facilitate the satisfaction or
settlement of such complaints.
Resolve disputes between a bank and its constituents as well as amongst banks, through
the process of conciliation, mediation and arbitration.
All banks are covered by the scheme, including Regional Rural Banks and scheduled primary
co-operative banks.
The scheme provides for Reserve Bank to appoint one or more of its officers in the rank
of Chief General Manager or General Manager to be known as the banking ombudsmen to
carry out the functions entrusted to them within the identified territorial limits. As on date,
fifteen Banking Ombudsmen have been appointed, with their offices located mostly in state
capitals.
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The Banking Ombudsman can receive and consider any complaint relating to the following
deficiency in banking services (including internet banking):
non-payment or inordinate delay in the payment or collection of cheques, drafts, bills
etc.;
non-acceptance, without sufficient cause, of small denomination notes tendered for any
purpose, and for charging of commission in respect thereof;
non-acceptance, without sufficient cause, of coins tendered and for charging of commission
in respect thereof;
non-payment or delay in payment of inward remittances ;
failure to issue or delay in issue of drafts, pay orders or bankers cheques;
non-adherence to prescribed working hours ;
failure to provide or delay in providing a banking facility (other than loans and advances)
promised in writing by a bank or its direct selling agents;
delays, non-credit of proceeds to parties accounts, non-payment of deposit or non-
observance of the Reserve Bank directives, if any, applicable to rate of interest on deposits
in any savings, current or other account maintained with a bank ;
complaints from Non-Resident Indians having accounts in India in relation to their
remittances from abroad, deposits and other bank-related matters;
refusal to open deposit accounts without any valid reason for refusal;
levying of charges without adequate prior notice to the customer;
non-adherence by the bank or its subsidiaries to the instructions of Reserve Bank on
ATM/Debit card operations or credit card operations;
non-disbursement or delay in disbursement of pension (to the extent the grievance can
be attributed to the action on the part of the bank concerned, but not with regard to its
employees);
refusal to accept or delay in accepting payment towards taxes, as required by Reserve
Bank/Government;
refusal to issue or delay in issuing, or failure to service or delay in servicing or redemption
of Government securities;
forced closure of deposit accounts without due notice or without sufficient reason;
refusal to close or delay in closing the accounts;
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non-adherence to the fair practices code as adopted by the bank or non-adherence to the
provisions of the Code of Banks Commitments to Customers issued by Banking Codes
and Standards Board of India and as adopted by the bank ;
non-observance of Reserve Bank guidelines on engagement of recovery agents by banks;
and
any other matter relating to the violation of the directives issued by the Reserve Bank in
relation to banking or other services.
Further, a customer can also lodge a complaint on the following grounds of deficiency in
service with respect to loans and advances
non-observance of Reserve Bank Directives on interest rates;
delays in sanction, disbursement or non-observance of prescribed time schedule for
disposal of loan applications;
non-acceptance of application for loans without furnishing valid reasons to the applicant;
and
non-adherence to the provisions of the fair practices code for lenders as adopted by the
bank or Code of Banks Commitment to Customers, as the case may be;
non-observance of any other direction or instruction of the Reserve Bank as may be
specified by the Reserve Bank for this purpose from time to time.
The Banking Ombudsman may also deal with such other matter as may be specified by the
Reserve Bank from time to time.
Complaint can be filed before the Banking Ombudsman if the reply is not received from the
bank within a period of one month after the bank concerned has received ones representation,
or the bank rejects the complaint, or if the complainant is not satisfied with the reply given
by the bank.
Although RBI, in its website, has made available a form for filing the complaint, it is not
mandatory to use the form. Complaint can be filed in plain paper, or even electronically.
The complaint should have the name and address of the complainant, the name and address
of the branch or office of the bank against which the complaint is made, facts giving rise to
the complaint supported by documents, if any, the nature and extent of the loss caused to
the complainant, the relief sought from the Banking Ombudsman and a declaration about the
compliance of conditions which are required to be complied with by the complainant.
Complaint is to be filed at the office of the Banking Ombudsman under whose jurisdiction,
the bank branch complained against is situated. For complaints relating to credit cards
and other types of services with centralized operations, complaints may be filed before the
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Banking Ombudsman within whose territorial jurisdiction the billing address of the customer
is located.
Complaint can be filed personally, or through an authorized representative (but not an
advocate).
There is no filing fee.
Complaint will not be considered if:
One has not approached his bank for redressal of his grievance first.
One has not made the complaint within one year from the date one has received the
reply of the bank or if no reply is received if it is more than one year and one month from
the date of representation to the bank.
The subject matter of the complaint is pending for disposal / has already been dealt with
at any other forum like court of law, consumer court etc.
Frivolous or vexatious.
The institution complained against is not covered under the scheme.
The subject matter of the complaint is not within the ambit of the Banking
Ombudsman.
If the complaint is for the same subject matter that was settled through the office of the
Banking Ombudsman in any previous proceedings.
The Banking Ombudsman endeavours to promote, through conciliation or mediation, a
settlement of the complaint by agreement between the complaint and the bank named in the
complaint.
If the terms of settlement (offered by the bank) are acceptable to the complainant in full and
final settlement of his complaint, the Banking Ombudsman will pass an order as per the terms
of settlement which becomes binding on the bank and the complainant.
If a complaint is not settled by an agreement within a period of one month, the Banking
Ombudsman proceeds further to pass an award. Before passing an award, the Banking
Ombudsman provides reasonable opportunity to the complainant and the bank, to present
their case.
Compensation for any loss suffered by the complainant is limited to the amount arising directly
out of the act or omission of the bank or Rs 10 lakhss, whichever is lower.
The Banking Ombudsman may award compensation not exceeding Rs 1 lakhs to the
complainant only in the case of complaints relating to credit card operations for mental agony
and harassment. The Banking Ombudsman will take into account the loss of the complainants
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time, expenses incurred by the complainant, harassment and mental anguish suffered by the
complainant while passing such award.
It is up to the complainant to accept the award in full and final settlement of the complaint or
to reject it.
If the complainant is not satisfied with the decision passed by the Banking Ombudsman, he
can approach the appellate authority against the Banking Ombudsmens decision. Appellate
Authority is vested with a Deputy Governor of the RBI.
The appellate authority will have to be approached within 30 days of the award. In exceptional
cases, the appellate authority may grant a further period of 30 days to file the application.
The complainant can also explore any other recourse and/or remedies available to him/her
as per the law.
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