Monday, February 08, 2016

Transforming the operational efficiency of tribunals and courts

by Pratik Datta.

Almost two decades ago in L. Chandra Kumar v. Union of India (1997), the Supreme Court had lamented that Indian tribunals function inefficiently since there is no authority in charge of supervising and fulfilling their administrative requirements. The Court had gone on to suggest that until a wholly independent agency for administration of all such tribunals is set up, it is desirable that all such tribunals should be under a single nodal Ministry. Finally, on January 18, 2016, a Constitution Bench of the Supreme Court in Madras Bar Association v. Union of India reportedly directed the Central Government to consider setting up a nodal body or agency for managing all tribunals across all Ministries.

In spite of pending tribunal reforms, Indian policy makers are heavily relying on tribunals to achieve the policy objective. For instance, the Insolvency and Bankruptcy Code, 2015 (IBC) recently introduced in the Lok Sabha envisages an efficient Adjudicating Authority which must dispose of matters within hard deadlines. The entire IBC is subject to this condition precedent. However, given the dismal performance of Indian tribunals, there are legitimate doubts as to how the DRTs and NCLTs will be able to achieve the ambition set out in IBC.

India needs to urgently reform its tribunal system. The Supreme Court's recent direction is a good starting point. This post explains the institutional reforms that would be needed to rachet up the performance of Indian tribunals.

Back-end institutions


Institutions are crucial to the development of a nation. Backward nations have poorer institutions. They may try to develop and yet consistently fail to improve their institutions. One usual reason for this is that these countries often try to adopt forms of other functional states and organizations which camouflages a persistent lack of function. This is the case with Indian judicial institutions. There is a general agreement in India on the desirable front-end features needed for tribunals (independence, efficiency, accessability, transparency, user-friendliness). These are visible features of any Western judicial institution and have been co-opted into the Indian context through legal transplant (by statute and case-laws). However, the back-end institutional systems supporting these front-end features in the West are neither readily visible to an outsider nor always possible to adopt by legal transplant (especially by case-laws). Therefore, there is an acute lack of awareness in India of what back-end institutional support systems are actually necessary to sustain these front-end features.

The key idea


Every judicial institution has judicial as well as administrative functions. In most advanced common law jurisdictions, the administrative functions are hived off into a separate agency with a corporate structure. This agency can take advantage of economies of scale and provide standardised administrative support services across courts and tribunals. Additionally, judges are freed from administrative burden and can fully focus on core judicial work. This simple yet critical institutional reform has enabled these countries to enhance the performance of their judiciary.

International best practice


UK has HMCTS which provides administrative support to its courts and tribunals. Canada has a similar agency set up under the Court Administration Service Act 2002; Australia has a similar agency set up under the Court Services Victoria Act 2014; US has a similar agency set up under the Administrative Office Act of 1939.

What are we doing in India?


In contrast, India does not have a similar agency for managing its courts and tribunals. Each tribunal has its own registry. They are administered by their respective sponsoring Ministries. Consequently, there is no standarisation of services across tribunals of different Ministries. Economies of scale are completely lost. In this overall flawed institutional design, blindly setting up more "fast-track" tribunals will not improve justice delivery. Instead, India should adopt the international best practice and set up a Tribunal Services Agency (TSA) to properly manage all the existing tribunals across different Ministries.

This idea is however not completely new in India. It has been discussed in rudimentary forms by the Law Commission in 1988 which suggested setting up of a National Judicial Centre. In 1997, the Supreme Court in L. Chandra Kumar (1997) suggested that until a wholly independent agency for administration of all such tribunals is set up, it is desirable that all such tribunals should be under a single nodal Ministry. Again in 2015, the FSAT Task Force led by Justice N.K. Sodhi (Chairman) and Mr. Darius Khambata (Vice-Chairman) also suggested incorporating a company to provide administrative services to tribunals in financial sector. And finally, on January 18, 2016, a Constitution Bench of the Supreme Court in Madras Bar Association v. Union of India reportedly directed the Central Government to consider the possibilities of setting up a nodal body or agency for managing all tribunals across all Ministries.

Recently, the Law Minister himself recognised concerns that tribunals are not working satisfatorily. However, the Central Government is yet to come up with a concrete plan on tribunal reforms.

Conclusion


In a recent Working Paper released by IGIDR, I argue that Indian policymakers should seriously consider setting up a TSA to support Indian tribunals including the ones under IBC. The detailed organisation design is also discussed along with board structure and financial arrangements.

The author is a researcher at the National Institute for Public Finance and Policy.

Acknowledgement


The author thanks Mehtab Hans and Mayank Mishra for useful discussions.

Interesting readings

Areas of weakness in the thinking of financial traders by Ajay Shah, Business Standard, 8 February.

As China's economy unravels, Beijing's attempts at damage control are growing increasingly desperate by Heather Timmons, qz.com, 4 February.

Stealing White: How a corporate spy swiped plans for DuPont’s billion-dollar color formula by Del Quentin Wilber in Bloomberg Businessweek, 4 February.

Is $3T in reserves enough? by Christopher Balding on Bloomberg.

Let the rupee slide by Ila Patnaik, Indian Express, 3 February.

How India Pierced Facebook's Free Internet Program by Lauren Smily, backchannel.com, 1 February.

Saturday, February 06, 2016

Lecture series on the Public Economics of Health Policy in Developing Countries

Jeff Hammer will deliver five lectures at NIPFP in the coming week. All are welcome.

Recessions uncover what auditors do not

On 14 December 2008, I was nervously looking around at the world and wrote a blog post Goodbye great moderation, hello financial fraud?  Almost on cue, we got the Satyam scandal: 21 December, 24 December, and then 7 January. We also got a few other problems in India which (I think) surfaced owing to the Great Recession : NSEL, a rash of ponzi schemes, Sahara, Saradha.

In China, unprecedented times are bringing forth revelations on an unprecedented scale [link, link]. Some of the rackets that are described in China appear quite familiar to us in India, but the magnitudes seen there are astonishingly large. We had such problems in developed markets also -- Madoff and MF Global.

Institutional reform: Consumer protection


One part of addressing this problem is the familiar machinery of the Indian Financial Code (IFC) version 1.1. As an example, see this analysis of ponzi schemes. As an IFC quality law is not found in either China or India, we have a rash of such problems in both countries.

Institutional reform: Criminal justice system


An important subset of financial crime is about plain criminal law. While the main track of financial policy has been along the Indian Financial Code, we need to develop a work program on improvements of the criminal justice system also. Put together, these will create an enforcement machinery that will generate deterrence against big financial scandals.

Procyclicality of trust?


Watching China unfold in recent weeks, I wonder if there's a general proposition of the following nature. Recessions will uncover what auditors could not, but under conditions of low institutional quality, this will happen on a bigger scale. Conversely, when institutional quality is low, business and finance will be hampered at all times by low trust. But in good times, when it's easier for the crooks to keep things under wraps, fewer scandals will burst into the public consciousness, and trust will go up. Procyclicality of trust may be heightened in places with low institutional quality.

Monday, February 01, 2016

Interesting readings

`The EU is on the verge of collapse' -- An interview with George Soros by Gregor Peter Schmitz in the New York Review of Books, 11 February.

"This Is Much Larger Than Subprime" - Here Are The Legendary Hedge Funds Fighting The Chinese Central Bank by Tyler Durden on ZeroHedge, 31 January 2016.

To really counter terrorism by Manvendra Singh in the Indian Express, 30 January.

Narendra Modi is losing India's market liberals by Sadanand Dhume in the Wall Street Journal, 28 January.

Pains of a young republic by Somasekhar Sundaresan in the Mumbai Mirror, 28 January.

Christopher Balding on proposals for capital controls in China, 28 January.

What a normal startup actually needs by Sumanth Raghavendra, Qz.com, 27 January.

The market's troubling message by Ashoka Mody, Bloomberg, 27 January.  Also see a video of his talk of 25 January.

China: Surviving the camps by Zha Jianying, the New York Review of Books, 26 January.

How will China influence us? by Ajay Shah, Business Standard, 25 January.

PBoC in a quandary over capital controls by Tom Mitchell, Financial Times, 25 January.

`My personal vendetta': An interview with Hong Kong publisher Bao Pu by Ian Johnson in the New York Review of Books, 22 January.

Highway for tigers by Padmaparna Ghosh, Mint, 19 January.

Be tight-fisted by Ila Patnaik, Indian Express, 18 January.

Cory Doctorow in the Guardian on India's net neutrality question, 15 January.

The dragnet by Russell Brandom, on TheVerge, 13 January. 

How Ukraine weaned itself off Russian gas by Leonid Bershidsky on the Bloomberg, 12 January.

The mother of all currency defences by Ajay Shah, Business Standard, 11 January.

A better bankruptcy regulator by Pratik Datta and Rajeswari Sengupta, Business Standard, 9 January.

Wilderness and economics by Thomas Power and George Wuerthner, Counterpunch, 8 January.

Hiring without signals, David Henderson, EconLog, 7 January.

The amazing maize by Surinder Sud, Business Standard, 4 January.

The big sleep by Julia Medew, the Sydney Morning Herald.

Sunday, January 31, 2016

Occam's razor of public policy

Occam's razor is the idea that when two rival theories explain a phenomenon, the simpler theory is to be preferred. Aristotle's epicycles fit the data as well as Kepler's ellipses, and a pure empiricist could have been agnostic between the two. Occam's razor guides us in preferring Kepler's ellipses on the grounds that this is a simpler explanation.

In the world of public policy, a useful principle is:

When two alternative tools yield the same outcome, we should prefer the one which uses the least coercion.

Example: Punishment


When we want to drive the incidence of a certain crime to the desired rate, we want to find out the lowest possible punishment that gets the job done. You can reduce theft to desired levels by promising to cut off the hand of the thief. We would much rather achieve the objective using a reduced use of the coercive power of the State, with mere imprisonment.

The purpose of punishment is deterrence, not vengeance. And, in the class of deterrents, we seek to find the smallest possible use of the coercive power of the State that gets the job done.

Suppose 4 years of imprisonment and 2 years of imprisonment are equally able to get the incidence of a particular crime down to the desired level. Suppose a person says: I am not a liberal; I am not squeamish about using the coercive power of the State; I hate the people who commit such crimes; I don't care whether they get 2 years or 4 years in jail. But an $\alpha$ fraction of all convictions are in error. In these cases, we are inflicting the punishment upon an innocent. The harm is minimised when we have deployed the lowest possible punishment.

Example: Spending on government programs


All government spending is grounded in taxation, present or future. All taxation is grounded in the coercive power of the State. If there are two different spending programs that get the job done, we should favour the one which spends less.

Example: Infrastructure bonds


When the market for infrastructure bonds in India does not work, too often, solutions are proposed which use extreme force. Some people propose tax breaks. Some people propose harsh interventions such as forcing every bank to buy infrastructure bonds or forcing every bidder to NHAI to issue infrastructure bonds. As an example, we in India force insurance companies to buy infrastructure bonds.

If, on the other hand, we trace the failures of financial sector policy which have held back the market for infrastructure bonds, this would show how to get the job done while actually reducing State coercion (i.e. getting the State out of inappropiate coercion).

Example: The journey to cashless


Cash is an abomination and we should have a thousand flowers of electronic payments blossoming. India is one of the most backward places in the world in the domination of cash.

Tax breaks for electronic payments or high taxes for cash transaction or outright bans of cash transactions: these are all ways that get the job done using a lot of force.

If, instead, we understand the failures of financial sector policy which have hobbled the sophistication of payments in India, we will get the job done while actually reducing the use of the coercive power of the State. We would have less cash in India if RBI did not use the coercive power of the State to block the clever Uber cashless transaction.

Example: Family welfare


A government which runs counselling services on family welfare is using less coercion when compared with forcible sterilisation or a one-child policy.

How to reduce the use of coercion: go to the root cause of a market failure


Market failures can be addressed in many ways. When we go to the source, with well understood causal claims about the source of the market failure, we will find ways to address the market failure using the smallest use of the coercive power of the State.

If we don't have a deep understanding of the sources of the market failure, we may often endup hitting a symptom rather than the disease. Getting the job done may then require the use of a lot of coercion.

As an example, for some market failures that are rooted in information asymmetry, if an intervention can be found which rearranges the structure of information, this can get the job done using the least coercion.

Why are big punishments often favoured in India?


A person who thinks of violating a law to obtain an ill gotten gain $G$ faces a probability $p$ of being caught and the fine imposed upon him will be $F$. Standard economic arguments suggest that we must set $F = G(1-p)/p$. In this case, the expected gain from violating the law is 0, and a risk averse person will favour the certainty of compliance over the lottery of breaking the law.

In India, too often, the executive works poorly and $p$ is quite low. This creates a bias in favour of driving up $F$. This is giving us very large penalties. This induces its own problems. We are inflicting terrible harm on the $\alpha$ fraction of innocents who are wrongly convicted. We are giving great power to front-line investigators and judges at a time when institutional capacity is low.

If we are able to build institutional capacity for enforcement, and $p$ goes up, we will then be able to come back to lower punishments that generate adequate deterrence.

Why does Occam's Razor of Public Policy make sense?


  1. It is consistent with the liberal philosophy that desires that humans should be free to pursue their own life with the minimum interference.

  2. At best, governments work badly. The information available to policy makers is limited, many wrong decisions are taken, many decisions are poorly implemented. Governments do not know the preferences of citizens. Politicians and officials are self-interested actors and work for themselves. The Lucas critique comes in the way: rational actors change their behaviour when policy changes take place in ways that confound the original policy analysis. Many government actions fail to achieve the desired outcome, but they always have unintended consequences.

    It's good to be humble, and swing the smallest stick that would get the job done.

Limitations


All this, of course, presupposes that all use of coercive power of the State is a purposive activity aimed towards achieving a certain well specified objective. This is not always the case. As an example, the objectives of exchange rate policy or capital controls are hard to decipher. Before we get to discussion of more coercion vs. less coercion, it would be a great step forward if all government intervention were fully articulated in terms of market failure, objective of the intervention, demonstration of the causal impact of the intervention upon the objective, and cost-benefit analysis.

The examples above have featured comparisons where more versus less coercion is easy to identify. Amputation of the hand $>$ imprisonment for 4 years $>$ imprisonment for 2 years. Forcing banks to give out 40% of their loans into priority sector lending is more coercion than information interventions which make the credit market work for poor people. Opening up to private and foreign telecom companies is a way to get phones to everyone with less use of State coercion when compared with forcing banks to open accounts for everyone.

In many situations, however, it is not easy to identify which of two alternative policy pathways involves more coercion. A government program which educated parents that their kids should get immunised seems to involve lower coercion when compared with a forced immunisation program, but this is perhaps not the case when we envision an education program that must generate eradication of polio. A government program to educate young people about saving for old age involves less coercion than forcible participation in the NPS.

Conclusion


The State has a monopoly on violence and is the only actor who can coerce citizens to do things against their will. All public policy initiatives involve the use of the coercive power of the State. In the field of public policy, we should be humble about our lack of knowledge, respectful of the freedom of others, and use this power as little as possible.

Acknowledgements


I am grateful to Jeff Hammer, Shubho Roy and Renuka Sane for useful conversations.

Land market reform is an important enabler of bankruptcy reform

By K.P. Krishnan, Venkatesh Panchapagesan and Madalasa Venkataraman

In India, it seems easy to lend money, but it is difficult to get it back. Just ask our banks. New law, and associated institutional infrastructure, for bankruptcy is in the pipeline, with the draft Insolvency and Bankruptcy Code by the T. K. Vishwanathan Committee. Will it work? What can the impediments be that could limit its effectiveness?

One of the key weapons in a lender's armoury is the collateral (or security) from the borrower. The quality of the collateral - how easy it is to collect, store, value and dispose of - determines the type and extent of credit that a lender is willing to provide. Land and associated real estate constitute a large part of collateral in India. More than 50 percent of corporate loans and 60 percent of retail loans have land and real estate as collateral. It is hence important to understand the complex nature of land markets to determine whether they would facilitate or undermine the effectiveness of these new laws. We examine this issue in a recent paper titled Distortions in Land Markets and Their Implications to Credit Generation in India.

The land market in India is not a homogenous national market but a heterogeneous collection of various State markets with variation in laws and regulations. This is because land related issues fall under the State and Concurrent List under our Constitution. This poses the first big problem: it is not easy to provide credit across state boundaries unless lenders have local presence or partners to count on. Even when land is accepted as collateral, several factors exist that could raise costs and risks for lenders. Let's run through the list of challenges faced by the lender.

Challenge 1: Does the land belong to the borrower?


It is hard to say because titles are not guaranteed by the State (like the Torrens system used in countries like Australia). Hence, all evidence of title is merely presumptive and can be challenged at any point by a person claiming to have better title to the land.

To mitigate the risk of future challenges to title, lenders spend considerable resources, including legal help, to conduct title searches, to protect themselves. A title search can be a fairly complex and expensive exercise in the Indian setting. This is because:

  1. Indian law does not mandate the registration of every single transaction that affects rights in or the enjoyment of, property. Hence, records of some transactions that affect title or enjoyment of property will not be found in any public office.

  2. Land records in India are spread across three offices - the Sub-Registrar's office, the revenue offices and the offices of the survey department. Time lags between these offices in updation of land records, often lead to inconsistencies in information obtained from these three offices.

  3. Title related disputes in courts require a search process in the courts, as the status of the dispute may not be reflected in the records in the Sub-Registrar's office or the revenue offices.

  4. A title search is necessarily a local exercise, as land records are maintained in local offices in local languages. The contents of land records across States are not standardised. Several State laws have restrictions on the transferability of land, depending on the land classification. For instance, in most States, agricultural land cannot be transferred to a non-agriculturist. The localisation of the title investigation process adds to transaction costs.

Lenders do not have recourse to a private title insurance industry in India. Interestingly, even in countries that follow Torrens system of state guaranteed titles, there is an increasing trend for lenders to seek private title insurance (Zasloff, 2011). Hence, lenders in India have to rely on title searches conducted by independent title investigators. This raises transactions costs and particularly hampers small loans.

Challenge 2: Has the land been already pledged with other lenders?


There is no single point of information on all the processes and transactions that can encumber land. Again, some transactions which create encumbrances on land (such as the mortgage by deposit of title deeds) are not required to be registered. Consequently, the records of such mortgages cannot be found in any public office.

The Central Registry of Securitisation Asset Reconstruction and Security Interest of India, or CERSAI, was set up to consolidate information about mortgages against property. However, its scope is limited: it does not include reconstruction loans outside the purview of the SARFAESI Act or loans given out by entities other than banks. Nor does it have information about all loans issued prior to 2011 when CERSAI was set up. Further, since the registry requires identification of land clearly, the importance of accurately mapping land boundaries becomes critical for its success. Accurate mapping of land boundaries has its own set of problems as described next.

Challenge 3: Is the land properly identifiable in classified records?


Land parcel identification is a challenge since cadastral maps are outdated and rarely reflect the reality on the ground. As mentioned above, record-keeping of various related aspects of land - titles and registrations, encumbrances, geographic information sources, revenue and taxation - is done in silos by various departments, often leading to conflicting information on the same land parcel. The problem is more acute in rural areas, where use of technology is still limited. The use of different units (acres, hectares etc.), terms (like Khata in Karnataka and Patta in Tamil Nadu) and bookkeeping standards across states present their own set of difficulties in identifying land across States, thus hampering the economies of scale of running a nationwide lending business.

Challenge 4: Do the constructions/settlements on the land adhere to local laws, and have all dues been properly paid?


Important attributes such as flood plain, seismic zone, lake encroachments, easements and rights of way etc. also cannot be conclusively established given the siloed nature of record keeping. If not properly accounted for through pricing, these attributes could pose significant risk to lenders. The recent announcement in Bengaluru that several lake beds have been encroached by entities including the Bangalore Development Authority - the agency obligated to protect lake beds - shows the extent of risk to lenders who have financed development activity on such land.

The problem is exacerbated where the collateral is built-up property. In the case of built-up collateral, the lender is also required to verify whether the building complies with city-level zoning regulations and has the requisite building permissions. This is to avoid the possibility of the future demolition of the collateralised property which is not compliant with the local laws. The value of the collateral may also change depending on issues such as the area on the land, if any, earmarked for municipal road widening, changes in town planning norms, etc. This requires searches in the local municipal offices.

Challenge 5: Is the value of land sufficient enough to cover the loan in case of distress?


Land valuation is done by lenders at the time of loan origination, and after the borrower has exhibited distress. Empanelled valuers use a combination of recent transactions and government estimates (called guidance values or circle rates) to derive land values that are used by lenders. Given the significant presence of black money in land transactions, getting true market values is more an art than science. Issues such as defective land title and illegal developments, mentioned above, impede land values but are hard to account for at the time of origination of the loan.

Challenge 6: If there is default, can the land be sold to recover dues owed easily?


The battle to recover the collateral really begins after default. The SARFAESI Act has shortened the recovery process for banks and financial institutions. However, it leaves out creditors who are not banks and financial institutions such as creditors of firms which have borrowed through secured bond issuances. For such creditors, a mortgage foreclosure suit will, under current law, have to go through the delays associated with civil courts. Moreover, the implementation and interpretation of the SARFAESI Act has not been free of problems. For instance, proceedings under the SARFAESI Act are often delayed through writ petitions or simultaneous proceedings which are pending in other fora (Ravi, 2015). Similarly, the SARFAESI Act does not resolve the problems of already encumbered collateral or collateral with no marketable title. For example, a bank or a financial institution cannot evict tenants of collateralised property under SARFAESI. This proposition was recently upheld by the Supreme Court in Vishal Kalsaria v. Bank of India and Others, January 2016.

Conclusion


Bankruptcy reform is important and valuable in and of itself. Land market reform is important and valuable in and of itself. Given the prominence of land as collateral in the working of the Indian credit market, improved working of the land market is an important enabler of a better functioning credit market and improved working of the bankruptcy code. Parallel and simultaneous progress on both fronts will yield a magnified impact upon the economy.

While the Bankruptcy Code is expected to improve recovery proceedings, it will not help where the title to the collateral itself is challenged at the time of recovery. Unlike movable collateral, the ability of a creditor to monetise immovable collateral quickly is fettered. Indian lenders have, so far, rationally responded to these issues by protecting themselves through credit rationing and through solutions like personal guarantees. Also, due to the difficult process of establishing title and related encumbrances, urban lands - where recovery time and cost are high - are subject to higher loan to value ratios.

One part of the reforms agenda is structural, and involves significant fiscal outlays, for cleaning up land titles, improving the quality of land registry through digitisation, overhauling the land litigation system and creating efficient stamp duty and registration processes. In addition, in the paper, we propose many modest, feasible and less expensive reforms. To begin with, we must standardise land-related data capture across states and create a repository of valuers' data that can be shared across lenders. Similarly, States need to focus their energies on building capacity in land record offices to enable smooth and efficient updation of land records. While creating conclusive titles with state guarantees is a laudable and ultimate goal, there are numerous opportunities for front-loading gains by streamlining existing land records using modern technology, and facilitating private title insurance to mitigate risk from lending against land.

Most of the challenges described above relate to the structure of information. Modern technology -- computers, telecom networks, GPS, Aadhaar, ubiquitous digital cameras -- has created a new opportunity to build improved institutional infrastructure for creating, storing and disseminating information that would transform the land market.

References


Aparna Ravi, The Indian insolvency regime in practice -- an analysis of insolvency and debt recovery proceedings, Economic and Political Weekly, 2015.

J. Zasloff, India's Land Title Crisis: The Unanswered Questions, Jindal Global Law Review, 2011.


K. P. Krishnan is at the Department of Land Resources, Government of India. Venkatesh Panchapagesan and Madalasa Venkataraman are researchers at the Indian Institute of Management, Bangalore.

Saturday, January 30, 2016

Draft IRDAI regulations on insurance commissions: Going back to the beginning

by Ashish Aggarwal and Renuka Sane

On 13 January 2016, the Insurance Regulatory and Development Authority of India (IRDAI) released the draft (Payment of commission or remuneration to insurance agents and insurance intermediaries) Regulations, 2016 and invited public comments. The regulations propose a substantial increase in commissions for life insurance distributors starting April 2016.

In their present form, the proposals will be detrimental to consumer interest, increase the regulatory arbitrage in favour of products regulated by the IRDAI and undermine the recent attempts by the government towards curbing mis-selling and rationalisation of incentives for financial product distribution.

The regulations are intended to govern payments by an insurance company to individual agents or intermediaries (which include corporate agents, insurance brokers, web aggregators, insurance marketing firms, and any other entity as may be recognised by the IRDAI) for soliciting and procuring an insurance policy. Payments may be in the form of a commission (paid to agents), remuneration (paid to intermediaries) or a reward (any direct or indirect benefit over and above the commission). The Bill proposes that the Board of every insurance company will approve the commissions and reward policy. The draft Regulations propose two big changes.

Big change 1: Raise the overall commission rates


For bundled products, such as ULIPs and traditional plans, with a tenure of twelve years or more, an insurance company would be able to pay intermediaries 49% of the first year premium as commission and reward. This cap is proposed at 42% for insurance agents (See Table). The commissions for subsequent years has been increased to 7.5% of premium for year 2 to 6. Earlier, the cap from year 4 onwards was 5%. The 5% cap is now applicable from year 6 onwards.

Pure risk cover, or term plans, will have a maximum first year commission rate of 50% for policies of tenure 12 years or more. For those between 5 and 11 years, commission will be capped at 40%. Subsequent year commissions will be capped at 10%. The addition of rewards to these implies that the maximum cost cap for term policies of duration 5 to 11 years will become 48% for agents and 56% for intermediaries. For policies more than 12 years, the caps will be 60% for agents and 70% for intermediaries.


First Year Life Insurance Commissions and Rewards
Category Proposed Existing
Policies with premium paying term
of 5-11 year:
ULIP/ Traditional - 42% for intermediary and 36% for agent

Term - 56% for intermediary and 48% for agent [Note 1]
15% to 33% based on premium
paying tenure of the policy [Note
2]
Policies with premium paying term of 12 years and
more:
ULIP/ Traditional - 49% for intermediary and 42% for agent
Term - 70% for intermediary and 60% for agent [Note 3]
35%
Note 1: Commission:- 30% of premium (ULIP/Traditional), 40% of premium (Term), Reward - 20% of Commission for agent and 40% for intermediary.
Note 2: Tenure and Commission:- 5 year - 15%, 6 years - 18%, 7 years - 21%, 8 years - 24%, 9 years - 27%, 10 years - 30% and 11 years 33%.
Note 3: Commission:- 35% of premium (ULIP/Traditional), 50% of premium (Term), Reward - (20% of Commission for agent and 40% for intermediary).

Big change 2: Bring in hereditary commissions


These are being reintroduced. Section 54 of the The Insurance Laws (Amendment Act), 2015 had removed section 44, according to which, if an insurance agent had served for more than 5 years, the commissions had to be paid to the heirs of the agent, even if the agent was no longer servicing the policy.

Problems with the draft regulations


Ignores all evidence on the perverse impact of high commissions
Research has shown that the incentive structure of agents has played a large part in the mis-sale of financial products. When agents get remunerated by the product provider, the incentive comes not from higher sales driven by customer satisfaction, but from commissions paid by the product provider. The product that pays the higher commission is the product that gets sold. This is not always in the interest of the customer. The world over, the response of regulators has been to ban conflicted remuneration structures, and/or impose requirements on ensuring the suitability of the product to the customer. Against such a background, the IRDAIs proposal to increase commissions, and also not impose any suitability requirements seems misplaced. This is particularly relevant as metrics of performance such as persistency and lapsation of policies have been steadily worsening.
Increases regulatory arbitrage
The same insurance distributor is likely to be selling other products like mutual funds and New Pension System which at their core are long term investment products. The commission structure for mutual funds is based on asset based trail fee. This results in relatively much lower commissions in initial years which could grow into substantial sums after say, 10-15 years, provided the customer stays into the scheme and invests regularly. The commission structure for NPS distributor provides for a nominal flat transaction fee and a 0.25% fee on amounts invested. A distributor is naturally incentivised to push insurance plans irrespective of suitability for the consumer. A consumer would be more likely sold a traditional insurance plan than a basket of NPS, mutual fund and term insurance. This makes selling difficult for the mutual funds and NPS. The proposed regulations are likely to further skew the markets.
Does not realign the pure term and bundled insurance products
It would be misleading to assume that the regulations incentivise sale of term insurance products by providing for higher commission rate as compared to ULIPs and traditional investment oriented plans. A term plan of Rs.1 crore for a 35 year old would cost Rs.13,000. At 70% of premium, Rs.9,100 should be a very attractive first year commission given that these products are apparently more difficult to sell as compared to investments. However, even if the initial commission rates on ULIPs and traditional plans were much lower, say 10%, these could still be more attractive for distributors to sell than term plans. For example, premium for ULIP/ traditional plan with a similar insurance cover would be about Rs 100,000 and even a 10% commission would fetch Rs.10,000. Of course, these are basically investment products with only a small portion of the premium going into insurance component. The raising of commissions on pure term along with that of bundled products does not alter the skew against the sale of pure term products.
Poor process
The draft regulations provide an approach which has gone into the formulation of the regulations. They do not, however, provide a rationale. How would these regulations benefit the consumers? In less than one year of the Insurance Laws (Amendment) Act omitting hereditary commissions, it is not evident why these are now proposed to be brought back through regulations? Regulators such as RBI, SEBI, have shown a poor track record in following regulation making processes. Regulations on fund management, and regulations on aggregators of the NPS, by the PFRDA have also raised similar concerns. The IRDAI draft regulations are yet another example of the failure of the attempts by the Government to encourage regulators to frame regulations as laid down in the Handbook on adoption of governance enhancing and non-legislative elements of the draft Indian Financial Code.

Another recent committee's recommendations on commissions


It would be useful to look at the recommendations on similar issues of another recent committee setup by the Government of India and headed by Sumit Bose, Former Union Finance Secretary. The report has recommended doing away with the practice of front loaded commissions. It noted that these created perverse incentives for distributors to push products with higher upfront/ first year commissions, increased regulatory arbitrage and proved expensive for the consumers. The committee's recommendations provided that:

  1. There should be no up-fronts for the investment part of the premium. The investment part should attract only AUM based trail commissions. The trail commission treatment should be decided with consultations with the lead regulator in the market-linked investment space. These should be level or declining.

  2. Upfront commissions should be allowed only on the mortality part of the premium.

  3. Distributors should not be paid advance commissions by dipping into future expenses, their own profit or capital.

  4. The illegal practice of rebating should be punished harshly by the regulator as it distorts the market.

In its present form, the IRDAI draft regulations ignore all the recommendations of the Bose Committee report.

Way forward


The disjointed approach as apparent in the draft IRDAI commission regulations is not in consumer interest. A useful approach would be to:
  1. Fix the commission structure for the distributors based on the  recommendations of the Bose Committee.

  2. Improve the regulation making process. Inviting public comments on draft regulations is a great step but mere existence of a public consultation process does not mean that the public will spend time and resources to comment and participate in the exercise. When the final regulations get released, the IRDAI should take care that these are accompanied with a proper explanation of (i) what exactly is being changed; (ii) evidence that has been relied upon to propose the changes and (iii) expected impact of the regulations on key stakeholders like consumers and sellers.


Ashish Aggarwal is a researcher at the National Institute for Public Finance. Renuka Sane is a researcher at the Indian Statistical Institute.

Thursday, January 28, 2016

Concerns about compliance with IRDAI regulations by insurance companies

by Sumant Prashant and Renuka Sane

Before choosing to buy any product, we want to know what the product is actually offering for the price, and how it suits our requirement and taste. For this comparison to work, we need information that a) describes truthfully all the features, or at least the material features, of the product and b) allows us to compare similar features across competing products. As the Bose Committee Report pointed out, when a financial, and especially an insurance product advertises its product features, it is not clear that the advertisement correctly represents the product. Sometimes advertisements are blatantly misleading. Sometimes, they are just hard to decipher. This environment of opaque disclosures has contributed to episodes of mis-selling, and losses to customers.

To address the problem of misleading advertisements, IRDAI issued a Master Circular on advertisements on 13th August 2015. The Master Circular aims to achieve two objectives - (a) make advertisements/sales material more accurate, comprehensive and reliable for the benefit of insuring public and; (b) set out minimum standards to be followed by all insurance companies for advertising and soliciting insurance business. In this article we summarise the Circular, and evaluate compliance by five randomly picked advertisements.

The IRDAI Master Circular on Advertisements


The Master Circular divides advertisements into two categories based on their intended purpose:

  • Institutional Advertisements are meant to promote the brand image of the insurer company.

  • Insurance Advertisements are meant to solicit insurance business and therefore provide more details about the product, such as name and benefits of the product and financial performance of the insurer company. Insurance Advertisements are further divided as

    • Invitation to Inquire advertisements, which only provide basic information about the product and advise the customer to refer to a more detailed brochure.

    • Invitation to contract advertisements, which contain detailed information about insurance products and induces prospective or existing consumers to purchase them.


Of these, Insurance Advertisements are critical in influencing the purchase decision of a customer. They also have the potential of being misused by insurance companies through projection of exaggerated benefits or non-disclosure of important terms and conditions of a product. The Master Circular, therefore, provides detailed do's and dont's for Insurance Advertisements. Some of the requirements for an advertisement are:

  1. The product should be identifiable as an insurance product, disclose risks, limitations and exclusions of the product.

  2. The benefits of a guarantee, when advertised, should also mention the cost and charges of the guarantee. If conditions of guarantee are elaborate, the advertisement should be accompanied by conditions applicable to the guarantee in specific font size.

  3. If promise, projection or past performance are mentioned, this should be accompanied by assumptions, sources of information and the statement that past performance is not an indication of future performance.

  4. If tax benefits are mentioned, this should be accompanied by statement that tax laws are subject to change.

  5. If a ranking or award is advertised, this should have been awarded by an agency independent of the insurance company which is advertising.

  6. Viewers of Internet advertisements should be able to view all the key features of the product.

  7. Insurer's website should flash a cautionary notice about spurious calls and fictitious offers.

  8. In case of ULIPs, the asset mix of various underlying funds, approved asset composition and pattern should be placed on website on half yearly basis.

  9. In promoting product combinations, all particulars of each product should be disclosed with an advice to refer to the sales brochure.

Evaluating Compliance


We examined 5 advertisements posted recently on the Facebook pages of leading insurance companies that fall into invitation to inquire category of advertisements, to ascertain the effectiveness of the Master Circular. Though these advertisements provide a weblink through which more details about the products can be accessed, they still have to comply with requirements of the invitation to inquire category of advertisements. The requirements placed by IRDA of these advertisements is less demanding, relative to the invitation to contract category of advertisements. We also focus on those aspects of the Master Circular that are clearly written and leave no ambiguity regarding their interpretation. The Table below shows how well the five advertisements we studied comply with the Master Circular. We find that:

  1. Some of the requirements which seem easy to implement, like mentioning the registration and UIN number have not been satisfied.

  2. Some advertisements did not mention that the product is an insurance product.

  3. Some advertisements did not publish an unique identifiable reference number.

  4. Some of advertisements did not follow the font and appearance requirement provided in the Master Circular.

  5. Some advertisements did not include the disclaimer mandatorily required by regulations.

Here is the summary of the analysis of five advertisements:

AD
1
AD
2
AD
3
AD
4
AD 5
Registration
number
NoNoNoNoYes
Product identified as insurance
product
YesYesNoYesYes
Unique Identifiable reference
number
YesNoNoNoYes
Mandatory
disclaimer
NoNoNoNoYes
FontN.A.N.A.N.A.NoYes

N.A. means "Not Applicable"

Conclusion


Many insurance companies appear to be violating the IRDAI Master Circular on Advertisements.

Monday, January 18, 2016

Assessing RBI's medium-term debt management strategy

by Radhika Pandey and Smriti Parsheera.

The international community has long highlighted the importance of a sound and transparent public debt management (DeM) strategy. Its objective being to set out the plan for achieving an optimal debt portfolio that minimises costs while accounting for associated risk factors. The Reserve Bank of India (RBI) has made a welcome move in this direction by publicly articulating the medium term debt management strategy for the three year period from 2015-18. Some key features of the strategy include adherence to a transparent debt issuance calender, elongating the maturity of the debt portfolio, undertaking buybacks and switches for effective liability management and taking steps to improve the liquidity of the government securities market.

The World Bank's Debt Management Performance Assessment Tool (DeMPA), which consists of a comprehensive set of indicators used to assess the strengths and weaknesses in government DeM practises, is a useful starting point in thinking about this issue. The DeMPA identifies the DeM strategy document as being an important component of the assessment toolkit and advocates that it should meet the following requirements:

  1. Description of the market risks being managed (currency, interest rate, and refinancing or rollover risks) and historical context for the debt portfolio;

  2. Description of the future environment for DeM, including fiscal and debt projections; assumptions about interest and exchange rates; and constraints on portfolio choice, including those relating to market development and the implementation of monetary policy;

  3. Description of the analysis undertaken to support the recommended DeM strategy, clarifying the assumptions used and limitations of the analysis;

  4. Recommended strategy and its rationale.


The RBI's strategy document also tries to base itself on these parameters. For instance, it begins with an assessment of the current debt profile of the government and then sets out the future strategy adopting the three broad pillars of low cost, risk mitigation and market development. The document however falls short of achieving a level of analysis that would meet the highest quality standards contemplated in the DeMPA. For this, the DeMPA requires that the strategy should ensure that the target ranges for the risk indicators are based on a comprehensive analysis of costs and risks - identifying the vulnerability of the debt portfolio to shocks in market rates - and these analyses are clearly described, clarifying the assumptions used and limitations of the analyses.

Analysed against this background we find that the strategy document in its current form suffers from certain flaws.


Scope limited to internal debt: The strategy is incomplete in that it has been prepared only for the country's internal debt and within that for the marketable debt of the Central Government. It is missing on two key components that are a part of the government's overall liability position: external debt and liabilities in the public account (i.e. National Small Saving Fund). The strategy also does not take into account contingent liabilities. There are close inter-connections between contingent liabilities and debt management. The government may guarantee a loan, but it will only be liable to make the payment if the recipient of the loan defaults. In such situations the government will have to assume the responsibility of paying the outstanding debt. Invoking of guarantees can therefore have an important bearing on the risk assessment of the debt portfolio of the government. This problem is, in turn, related to the lack of a unified Public Debt Management Agency, which would be able to take a full view of India's debt management problem.


Weak on forward looking analysis: A public debt management strategy must be set in a forward looking framework. The strategy document makes a point that external debt is being ignored on the ground that it forms a very small proportion of the total debt portfolio. This is a fallacious argument because if no analysis is made of the cost-risk trade-offs between external and domestic debt for the medium-long term then how can it be determined that the external debt will continue to remain "small". Similarly it has been stated that keeping currency risk low is a policy decision but the basis for this decision is not clear. It would have been desirable for such statements to be supported by an analysis of global interest rates versus domestic.


Inadequate description of underlying risks: The strategy falters in veering towards an over optimistic assessment of expected outcomes. For the baseline scenario it assumes that the "economy will record moderate to reasonable growth, a moderation in inflation as per the path projected by Reserve Bank and financial stability". It takes into account two alternate scenarios - a positive scenario in which the economy would grow at a higher pace than projected in the baseline and an adverse scenario where the reverse happens. However, the conclusion once again is that the stress tests "indicate a very low level of stress" and "the debt is stable, sustainable over medium to long run. Further, there are no short-term risks to the debt structure."

It assumes that the Government will follow its fiscal consolidation path i.e. a fiscal deficit of 3.9% by 2015-16, 3.5% by 2016-17 and 3.0% from 2017-18 onwards. It also assumes that the CPI inflation will follow the inflation targeting path adopted by the RBI. In the alternate scenario of fiscal slippage and high inflation it comes up with a higher debt-GDP and interest-GDP ratio. However, a clear analysis of the sources of fiscal and inflation shocks and the implication of deviation from the baseline scenario on the debt profile has not been demonstrated.

The strategy is weak in that it does not show a thorough analysis of the assumptions underlying its projections. For example: It says that the net market borrowing as a proportion of GDP is expected to fall from 33 per cent in 2014-15 to 31 per cent in 2017-18 reflecting fiscal consolidation. It does not explain how this will be impacted if there are deviations from the fiscal consolidation roadmap. The confidence of this statement also appears to be at odds with the Mid Year Economic Analysis which proposes a case for fiscal expansion to steer the economy on a higher growth path.


Mix of indicators for debt-sustainability and debt management: The strategy mixes debt sustainability and debt management indicators (See Table A3 of the strategy document). In a broader macroeconomic context there is merit in distinguishing between these two sets of indicators. The IMF's Guidelines for Public Debt Management emphasize that Governments should seek to ensure that both the level and rate of growth in their public debt is fundamentally sustainable, and can be serviced under a wide range of circumstances while meeting cost and risk objectives. Examples of debt sustainability indicators include debt service to revenue, debt service to exports, debt service to tax revenue in addition to what RBI has already calculated on debt to GDP and interest to GDP. In that same section the analysis of ATM (average time to maturity) is more of a debt management indicator, arising from the composition of the debt portfolio, and not of debt sustainability.


Time lag between the application of the strategy and its publication: The present strategy covers the period from 2015 to 2018 with a requirement of annual revisions. However, the RBI chose to publicly notify this strategy only on 31, December 2015, i.e. three quarters after its commencement. Going forward, if the objectives of transparency are to be met, it is essential that any revisions in the strategy for the coming period should be notified prior to its commencement.


The articulation of a medium term DeM strategy is a welcome step. The notified strategy has positive features like listing out measures to develop the domestic debt market and trying to conform with international best practices. However, it needs to be strengthened on its analytical foundations. In its present form the strategy is at best a description of the actions required to achieve a desired debt profile. Improving the analytical foundations will go a long way in improving the quality of the document to enable it to become a guidepost for achieving an optimal debt portfolio.



The authors are researchers at the National Institute for Public Finance and Policy.

Understanding heterogeneity in tax compliance

On 14 January 2016, we had a talk by Raymond Duch of the Nuffield Centre for Experimental Social Sciences (CESS). The title was Why we Cheat: Experimental Evidence on Tax Compliance [paper, video]. In an experimental setting, they find that high performance ("rich") experimental subjects are more likely to cheat on tax payments.

Understanding the results


I felt a key problem of the setup was the absence of coercion and punishment. Paying taxes is, at heart, about the coercive power of the State. Nobody wants to pay taxes; it is only the fear of punishment which makes you pay taxes.

I would interpret his results as saying: In a cooperative, high performance people are more likely to not pay in a fraction of their output to the common pool. The paper is about the behaviour of people in voluntary arrangements, and not tax compliance.

It perhaps suggests that a poll tax comes more naturally to humans as compared with a tax which is a fraction of the income. Imagine that you were in a cooperative: it's easier to think of everyone in the cooperative putting up Rs.X, rather than of everyone putting in x% of their income.

Heterogeneity in tax compliance


Turning to tax compliance, let's think of a simple setup where there is income $y_i$, a flat tax rate $\tau$, actual tax payment $T_i$, a $p$ probability of getting caught and a punishment $\lambda$ times larger than the tax shortfall $\tau y_i - T_i$. In this setup, the key parameter which will shape compliance is risk aversion. People who are more risk averse will comply more.

In countries where $p$ is high, the outcome will have high compliance. As $p$ becomes higher, the distribution of compliance will collapse into a point mass. When $p$ is low, and for certain kinds of distributions of risk aversion, we will get economically significant heterogeneity in tax compliance.

Low risk aversion is likely to be correlated with high performance. So we may endup with a simple correlation where high performance people are more likely to cheat on taxes. This is perhaps less spicy than meets the eye.

Tax compliance by firms in India


Consider the Indian operations of a multinational corporation versus an Indian family business. There is evidence that tax compliance by multinationals is superior. In my understanding, two things are going on.

The first is that $\lambda$ is not a constant; it is lower for Indian firms, as they are better able to manage the non-rule-of-law environment in the tax administration.

The second issue is risk aversion. MNCs tend to be very risk averse and look for safe interpretations of law. This may be related to multiple layers of bureaucracy and the principal-agent problems between the shareholder and the manager. Global compliance teams have a cover-your-ass attitude and force the local operations to play very safe. In contrast, Indian business houses tend to be take more aggressive interpretations of the law. They know this is risky and they walk into it with their eyes open.

There isn't much of a low-compliance-correlates-with-performance story here, as some of the best run companies in India (the MNCs) have the highest tax compliance. The empirical regularity actually runs in the reverse direction.