Thursday, June 24, 2010

SEBI, IRDA & ULIPs: Hurried solutions lead to poor law

by Bikku Kuruvila and Shubho Roy.

On 18th June, the President signed an ordinance that would settle the recent spat between SEBI and IRDA over unit linked insurance plans ("ULIPs"). The ordinance makes it clear that ULIPs cannot be regulated by SEBI and places them within the jurisdiction of IRDA. The ordinance also tries to prevent further disputes by setting up a joint committee to address future conflicts. But this is not all there is to the matter. The ordinance also amends 4 major acts of parliament governing financial markets in the country (the RBI Act, the Insurance Act, the Securities Contract Regulation Act and the SEBI Act) with minimal consultation. The language of the ordinance also raises a wide range of questions about regulatory arbitrage, misselling, what issues the joint committee would actually consider, the very effectiveness of the proposed solutions, good governance and the structure of financial sector regulation. This is not a small list.

Looking at these matters in turn, the ordinance raises serious concerns about regulatory arbitrage. Today, ULIPs act as 'endowment policies' where the premium paid by the insured on a what is nominally a life insurance contract is invested in the stock market. Under these contracts, if the insured dies before the maturity of the policy, there is an insurance payout. After a fixed period or maturity, the investments in the stock market are liquidated and returned to the insured minus charges. Under these conditions, insurance companies cover the risk of premature death for only a short period of time (between entering into a contract and maturity). As such, the insurance component of these policies (the money which the insurance company must keep with itself to meet its contingent liability) is very low. The rest of the money can easily be invested and payouts depend upon the stock market.

Mutual funds are similar in all aspects to ULIPs except for the small component of insurance that an ULIP carries. However, mutual funds must comply with tough regulations imposed by SEBI and are severely limited in the forms of fees they can charge. Financial firms faced with the choice of registering as a mutual fund and complying with SEBIs regulatory framework or providing a small component of insurance in their product structures, registering as a ULIP, and charging open-ended fees, will rationally choose the latter.

Second, as many others have commented, the ordinance does not address misselling. (See recent articles by Monika Halan, Deepak Shenoy and Jayant Thakur). The ordinance does not include any provisions to deal with misselling. The ordinance also does not address IRDAs lack of enforcement capabilities vis a vis SEBI. The ordinance does active harm and removes provisions that previously protected investors. By amending the Securities Contract Regulation Act, insurance instruments are now not considered securities for the purposes of the Act. Section 27 A and B were one of the few statutes in the country addressing misselling. These two sections gave investors in collective investment schemes and mutual funds limited investment protection, namely rights to income under collective investment scheme. These small provisions will now not apply to insurance products, weakening investor protection for the time being.

Third, the provisions of the ordinance raise concerns about what matters the joint committee would actually consider. The dispute settlement mechanism in the ordinance specifies the securities which can be referred to the joint committee. We wonder: could the ULIP controversy have been the first matter submitted to the joint committee? In any case, since new types of securities are constantly being developed by financial firms, the joint committee would need frequent legislative interventions to be operable. For example, the joint committee in its current form, does not include the Forwards Markets Commission (FMC). If a product were to be launched which consisted of a hybrid of steel futures and steel companies futures (not an absurd proposition to the extent that steel prices play a significant role in the profits of the steel industry), the FMC would not be allowed to approach the joint committee as the Commission is not a recognised regulator under the ordinance.

To take up a different example, the joint committee is also limited in its jurisdiction to ``hybrid" or ``composite" instruments. Certainly many disputes could arise between regulators that do not involve an underlying hybrid or composite instrument. An instrument governed by one regulator that has a negative effect on the market regulated by another regulator, as with the regulatory arbitrage hypothesis suggested above, could not be referred to the joint committee. Neither could issues which bring instability to multiple markets, unless, of course the underlying instrument is hybrid or composite.

Fourth, the structure of the joint committee points to problems of institutional design. The ordinance is largely silent about the procedures the joint committee would follow. This is not simply a technical matter. How would differences of opinion in the board be settled? By majority vote? Consensus? Would there be staffing? Who would be responsible for expenses? No doubt, to a significant extent disputes would be settled by reference to soft norms and existing hierarchies in government. The culture of deference by IAS officers to other IAS officers of a senior class provides one example. The unlikely possibility of agency regulators going against the deeply held preferences of a strong finance minister provide another. Yet these are not simply mundane questions and impact, materially, how extensively the committee could study and resolve matters before it.

Fifth, the process by which the ordinance was passed is worrisome. As suggested by the Economic Times, regulators were not consulted on a ordinance that amends 4 major acts of parliament. What does this say for consultativeness and democratic process? What does this say for the legitimacy of the proposed solution? Is the failure to consult and rush to promulgate this solution reflected in the drafting and policy flaws of the instrument suggested above?

Sixth, the ULIP dispute has been presented as a contest between SEBI and IRDA. Implicitly, one regulator had to win, and the other, lose. This is misleading. One scenario would have each regulator govern the portion of ULIPs which fall within their domain. IRDA would govern the insurance component of these instruments and SEBI would govern the investment component. Some might suggest that this would lead to too much complexity. Yet, we are more used to dealing with complexity than we realize. A person driving a vehicle who causes damage to property could be liable for damages under rules of the Motor Vehicle Act, tort law and possibly the Indian Penal Code. That the net zone of freedom of action in driving a car would be limited to the conjunction of the areas prescribed by these laws seems hardly remarkable. The government would never declare that all motor vehicle drivers are immune from civil or criminal laws. The more complex the transaction, the more regulation might apply. Financial firms are as well-equipped as any actor in society to handle this complexity.

Another scenario would involve crafting a mechanism for joint regulation of ULIPs. As Monika Halan suggests, this proposal has precedent in the arrangements between the banking and capital markets regulators and could lead to the harmonisation of regulation to the benefit of investors and the marketplace.

Yet another scenario would involve actively fostering or allowing some measure of regulatory competition. The heightened regulation of ULIPs as a result of this controversy is itself a salutary case in point. We do not suggest that the government allow this issue to fester but feel confident that serious scholars and practitioners of administrative law and institutional design could develop interesting ways of promoting regulatory competition given time and a mandate.

Hurried solutions lead to poor law with implications that will be felt by investors and markets down the line. Ordinances are intended for use when Parliament is out of session and the President perceives a need for immediate legislation. Ordinances may be amended. The conflict between SEBI and IRDA is also only one small piece of a larger problem of financial sector legislation that is fragmented, at times duplicative and at times inadequate. We can only hope that Parliament revisits this matter in a more thorough fashion, either independently or through the efforts of the Financial Sector Legislative Reforms Commission (FSLRC) proposed in the Finance Ministers budget speech of 2010-11.

5 comments:

  1. Yes. It is absolutely correct. The Govt. should not act in haste.

    ReplyDelete
  2. sir,
    dear all !
    WELLCOME,
    let us know about lowering huge front loaded charges upto 60 % in the
    first year and 20 % in 2/3 policy years.
    Even after 10 years why all pvt . life insurance co. are still in huge LOSSES ?
    how banks sell life insurance polices as pay only 3 years investements?

    ReplyDelete
  3. IRDA is not a regulatory body but an industry body I think. They have forgotten their original role.

    ReplyDelete

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