Report of the Committee

on
Investment Pattern
for Insurance and Pension Sector










Government of India
Ministry of Finance
Department of Financial Services
3
rd
Floor, Jeevan Deep Building
Parliament Street, New Delhi

2013

F.No.11/19/2012-PR
Government of India
Ministry of Finance
Department of Financial Services

3
rd
Floor, Jeevan Deep Building,
Parliament Street, New Delhi,
Dated, the 29
th
May, 2012

OFFICE ORDER

Subject: Committee on Investment Pattern for Insurance and Pension Sector

A committee has been constituted in the Department of Financial Services
with a view to review the Investment pattern of Insurance and Pension sectors. The
Committee will examine the existing investment pattern being followed in Banking, Capital
Market, Pensions and Insurance Sector and will suggest an investment pattern, keeping, inter-
alia, in view the existing investment patterns and claims time cycle in Insurance Sector.

The constitution of the Committee is as under:

1. Sh. G.N. Bajpai, Ex-Chairman, LIC Chairman
2. Sh. K.N. Bhandari, Ex. CMD, NIACL Member
3. Sh. M.S. Sahoo, Ex-Member, SEBI Member
4. Sh. Vinay Baijal, Ex-CGM, RBI Member
5. Sh. Biswajit Mohanty, MD & CEO, SBI Pension Fund Ltd. Member
6. Prof. Jayant Verma, IIM, Ahmedabad Member
7. Dr. Shashank Saksena, Director (PR & BO-II) Member
8. Sh. Lalit Kumar, Director (Insurance) Member
9. Ms. Mamta Rohit, CGM, PFRDA Member
10. Sh. S.N. Jayasimhan, JD, IRDA Member
11. Sh. Gautam Bhardwaj, MD, IIEF Member
12. Sh. P.C. James, Chair Professor (Non-Life), NIA Member


(Dr. Shashank Saksena)
Director (BO-II & PR)
Tele No. 23742100
Email [email protected]
1. Sh. G.N. Bajpai, Ex-Chairman, Life Insurance Corporation
2. Sh. K.N. Bhandari, Ex. CMD, NIACL, to represent non-life sector
3. Sh. M.S. Sahoo, Ex-Member, SEBI
4. Sh. Vinay Baijal, Ex-CGM, Reserve Bank of India
5. Sh. Biswajit Mohanty, MD & CEO, SBI Pension Fund Ltd.
6. Prof. Jayant Verma, IIM, Ahmedabad
7. Dr. Shashank Saksena, Director (PR & BO-II), Deptt. Of Financial Services
8. Sh. Lalit Kumar, Director (Insurance), Deptt. Of Financial Services
9. Ms. Mamta Rohit, CGM, PFRDA
10. Sh. S. N. Jayasimhan, JD, IRDA
11. Sh. Gautam Bhardwaj, MD, IIEF, will be the coordinator and will provide necessary
arrangements for compilation of report.
12. Sh. P.C. James, Chair Professor (Non-Life), NIA

F.No.11/19/2012-PR
Government of India
Ministry of Finance
Department of Financial Services

3
rd
Floor, Jeevan Deep Building
Parliament Street, New Delhi
Dated, the 10 May, 2013

OFFICE ORDER

Subject: Committee on Investment Pattern for Insurance and Pension Sector

A committee has been constituted in the Department of Financial Services with a
view to review the Investment pattern of Insurance and Pension sectors. The committee will examine
the existing investment pattern being followed in Banking, Capital Market, Pensions and Insurance
Sector and will suggest an investment pattern, keeping, inter-alia, in view the existing investment
patterns and claims time cycle in Insurance Sector.

The constitution of the Committee is as under:

1. Sh. G.N. Bajpai, Ex-Chairman, LIC Chairman
2. Sh. K.N. Bhandari, Ex. CMD, NIACL Member
3. Sh. M.S. Sahoo, Ex-Member, SEBI Member
4. Sh. Vinay Baijal, Ex-CGM, RBI Member
5. Sh. Biswajit Mohanty, MD & CEO, SBI Pension Funds Ltd. Member
6. Prof. Jayant Verma, IIM, Ahmedabad Member
7. Dr. Shashank Saksena, Director (PR & BO-II) Member
8. Sh. Lalit Kumar, Director (Insurance) Member
9. Ms. Mamta Rohit, CGM, PFRDA Member
10. Sh. S.N. Jayasimhan, JD, IRDA Member
11. Sh. Gautam Bhardwaj, MD, IIEF Member
12. Sh. P.C. James, Chair Professor (Non-Life), NIA Member
13. Shri Rajrishi Singhal Member



(Dr. Shashank Saksena)
Director (BO-II&PR)
Tele No. 23742100
Email [email protected]


New Delhi, , 2013


The Secretary,
Department of Financial Services
Ministry of Finance
3
rd
Floor, Jeevan Deep Building
Parliament Street
New Delhi

Dear Sir,

We submit herewith a Report of The Committee to Review the Investment Pattern of Insurance and
Pension Sectors.

Yours sincerely,
..
Shri G. N. Bajpai
Former Chairman, LIC
(Chairman)

.. ..
Shri K.N. Bhandari Shri M.S. Sahoo
Ex. CMD, NIACL Ex-Member, SEBI
(Member) (Member)

.. ..
Shri Vinay Baijal Shri Biswajit Mohanty
Ex-CGM, RBI MD&CEO, SBI Pension Fund Ltd.
(Member) (Member)

.. ..
Prof. Jayant Verma Dr. Shashank Saksena
IIM, Ahmedabad Director (PR & BO-II)
(Member) (Member)

.. ..
Shri Lalit Kumar Ms. Mamta Rohit
Director (Insurance) CGM, PFRDA
(Member) (Member)

.. ..
Shri S.N. Jayasimhan Shri Gautam Bhardwaj
JD, IRDA MD, IIEF
(Member) (Member)

.. ..
Shri P.C. James Shri Rajrishi Singhal
Chair Professor (Non-Life) NIA (Member)
(Member)
CONTENTS
LIST OF ABBREVATIONS..05
FOREWORD..07

CHAPTERS
I. EXECUTIVE SUMMARY......08
II. THE ECONOMIC BACKDROP: TWO MORAL DILEMMAS........13
III. INVESTMENT NORMS & THEIR RATIONALE ....21
IV. INTERNATIONAL EXPERIENCE WITH INVESTMENT NORMS...43
V. WHY CHANGE NOW? ..61
VI. MOVING TO PRUDENT INVESTOR RULE....67
VII. MOVING TO PRUDENT INVESTORS REGIME: THE ROAD-
MAP.71
VIII. FINANCIALISATION OF PHYSICAL ASSETS ..81
IX. RECOMMENDATIONS .....83
X. RECOMMENDATIONS: APPROACH & SUMMARY....95

REFERENCES...96

List of Abbreviations

AUM Assets Under Management
BSE Bombay Stock Exchange
CAGR Compounded Annual Growth Rate
CDO Collateralised Debt Obligation
CDS Credit Default Swap
CG Central Government
CIRC Chinese Insurance Regulatory Corporation
DB Defined Benefit
DC Defined Contribution
DEA Department of Economic Affairs
DFS Department of Financial Services
EEE Exempt-Exempt-Exempt Tax Status
EPF&MP ACT Employees Provident Fund & Miscellaneous Provisions
Act, 1952
EPFO Employees Provident Fund Organisation
ETF Exchange Traded Fund
FDI Foreign Direct Investment
FII Foreign Institutional Investor
GDP Gross Domestic Product
GOI Government of India
G-SEC Government Security
GST Goods and Services Tax
IDR Indian Depository Receipt
IIFCL Indian Infrastructure Finance Corporation Ltd
IPF Insurance and Pension Fund
IPFM Insurance and Pension Fund Manager
IRDA Insurance Regulatory and Development Authority
IIT Infrastructure Investment Trust
KYC Know Your Customer
KYP Know Your Product (or Provider)
LIC Life Insurance Corporation of India Ltd


MF Mutual Fund
NAV Net Asset Value
NPS National Pension System
NSAP National Social Assistance Programme
NSE National Stock Exchange
OECD Organisation for Economic Cooperation &
Development
P&GA Pension and Group Annuity
PE Private Equity
PFM Pension Fund Manager
PFRDA Pension Funds Regulatory and Development Authority
PIR Prudent Investor Regime
PSU Public Sector Unit
RBI Reserve Bank of India
REIT Real Estate Investment Trust
SBI State Bank of India
SDS Special Deposit Scheme
SEBI Securities and Exchange Board of India
SG State Government
SLR Statutory Liquidity Ratio
SPV Special Purpose Vehicle
UK United Kingdom
ULIP Unit Linked Insurance Plan
USA United States of America
UTI Unit Trust of India
VCF Venture Capital Fund
YTM Yield To Maturity



FOREWORD

I, on behalf of my colleagues in the Committee, take great pleasure in presenting the Report
of this Committee. The Committee was constituted by the Government of India, Ministry of
Finance on May 15, 2012 to review the Investment Pattern of Insurance and Pension Sectors.
The Committee was expected to examine the existing investment patterns being followed in
Banking, Capital Markets, Pensions and Insurance Sectors and to suggest an investment
pattern, keeping, inter alia, in mind the existing investment patterns and claims time cycle in
Insurance Sector. The Government of India, which has been redesigning and restrengthening
the sector for reinforcing retirement benefits of the investing public and stepping up the
economic development of the country, felt that the time had come to revisit the current
investment guidelines so that the industry is able to serve better the twin purposes of its
existence.
It is our belief that the analysis of the Committee and recommendations made in the Report
would help the policy-makers initiate steps to address some mission-critical issues, dismantle
the obstacles that hinder the growth of Insurance and Pension Sectors and improve the
economic efficiency of savings pooled by the sector for the economic growth of India.
I take this opportunity to thank The Secretary, Department of Financial Services for having
reposed his faith in the Committee and also for having been patient. I take this opportunity to
thank the cross-section of individuals and organizations that met with the Committee to share
their views and suggestions in order to make Insurance and Pension products a more viable
proposition. I thank Dr. Achintan Bhattacharya, JS (Banking) and then Interim Director of
NIA, Pune for his valuable suggestions and assistance in hosting the meetings for the
Committee, taking care of all travel and other arrangements. Our special thanks are due to
Mr. Arvind Kumar, Joint Secretary (Pension & Insurance) who rendered invaluable
assistance and support to the Committee. I also take this opportunity to thank Mr. Rajrishi
Singhal, Dr. Shashank Saksena, and Dr. M .S. Sahoo for the extensive help in researching
and assimilating the material to be put in the cogent form of the report. Last but not the least,
thanks are also due to Ms. Surinder Kaur, Under Secretary (Pension Reforms), and Ms.
Connie Franco, Executive Assistant of Intuit Consulting for providing valuable assistance and
support during several meetings of the Committee.

CHAPTER I
EXECUTIVE SUMMARY

ndia is firmly on the path of reforms since 1991. The reforms broadly have three
components, namely, liberalisation, regulation and development. Economic agents are
being liberalised to take decisions in a developed and regulated environment and take
responsibility for their decisions. However, it was a gradual process and liberalisation,
regulation and development fed on one another in a virtuous circle. The time has come when
we need to provide similar freedom to insurance and pension fund managers to invest their
funds in asset classes they consider appropriate, keeping in view the interests of their clients
and the opportunities available in the environment. However, the environment needs to be
well developed and regulated so that a professional fund manager enjoys investing.
Otherwise, the Insurance and Pension Sector would soon find their investment options
limited and the available options would not provide them an opportunity to build a safe and
balanced portfolio. Incidentally, such freedom would help the economy by promoting savings
of households by providing them risk-adjusted adequate returns and channelising investments
to socially productive and useful projects. However, this freedom needs to be carefully
calibrated to avoid any untoward occurrences and make the reforms sustainable.
2. A committee was constituted in the Department of Financial Services, Ministry of
Finance under the Chairmanship of Shri G. N. Bajpai, Ex-Chairman of Life Insurance
Corporation of India and Ex-Chairman of Securities and Exchange Board of India
with a view to examine the existing investment pattern being followed in the Capital
Market, Pensions and Insurance Sector and to suggest an investment pattern, keeping,
inter-alia, in view the existing investment patterns and claims time cycle in Insurance
Sector.
3. The composition of the Committee is annexed at Annex 1. The terms of reference for
the Committee on investment pattern are as under:
1) To analyse the:
investment of funds under Insurance Sector and Pension Sector and
review the existing Investment patterns and exposure limits laid
down by the Regulator and the Government.
market mechanisms and review the potential of Insurance and
Pension funds in contributing to the development and deepening of
markets as well as re-energise investment management.
2) To review the scope for modification of investment patterns and exposure
limits in order to provide recommendations as guidance to the Government
and the Regulators.
I
3) To study international best practices and experiences on Insurance and
Pension fund management as well as investment patterns to learn from the best
practices of OECD and emerging economies.
4) To examine and provide recommendations to help:
understand and capture the potential of Insurance and Pension
sectors in contributing to meeting the long term financing needs of
the nation while maintaining the safety of the policyholder as the
topmost priority.
bridge the regulatory gaps in investment pattern of Insurance and
Pension funds across funds of similar nature and risk profile.
5) To suggest a road map for the gradual easing of investment exposure patterns
with the aim of eventual alignment of Indian Insurance and Pension Fund
management to a global investment framework.
4. The Committee examined and reviewed all the factors responsible for the growth
slowdown experienced in the Indian economy in the past few quarters, including the
ripple effects of the global financial meltdown and the attendant Euro-crisis, a few
domestic reasons also contributed to slowing investment demand. Insurance and
pension companies need to focus on twin objectives of improving real rate of returns
and making more financing available for infrastructure and other long term projects,
since they need assets that match the maturity profile of their liabilities, which
requires introduction of some new products and expansion of some existing ones,
such as credit enhancement and credit derivatives.
On the basis of discussion with various stakeholders of the industry, the recommendations of
the committee are summarised as under:
i. The investment philosophy pertaining to both the insurance and the pension
sectors has to leapfrog to the prudent investor regime.
ii. The move to a prudent investor regime cannot, and must not, take place
abruptly without giving the extant systems an opportunity to upgrade, re-learn and
re-tool. Since there is not enough supply of fixed income paper in categories other
than government securities, the move needs to be phased out. The Committee
recommends a five-year phase-out plan to move to the prudent investor regime.
During the first two years, the current boundaries of directed investment should be
shrunk and more play allowed to individual fund managers. In the next three
years, the Committee recommends that strings of directed investment norms must
be substantially loosened, including as a preparatory to paradigm shift to Prudent
Investor regime. While doing so the regulator must allow for the introduction of
some new ideas and new products, such as Real Estate Investment Trusts,
commodity futures, Infrastructure Investment Trusts - units, etc. It is only after
five years that the Insurance and Pension sectors should move to Prudent
Investor regime completely.
iii. As a measure of abundant precaution, the regulator should lay down guidelines
and rules regarding fit and proper persons that can be appointed to the
Investment Committee and provide detailed guidelines on Board-led governance
processes, including risk management and risk mitigation.
iv. Budget 2013-14 has announced the launch of inflation-indexed bonds or inflation-
indexed national security certificates. For an understanding of how these bonds
work, the Reserve Bank published a technical paper titled Inflation Indexed
Bonds.
(http://www.rbi.org.in/scripts/PublicationReportDetails.aspx?UrlPage=&ID=598).
v. Allow pension fund managers and insurance companies to pool their investments
together in a company, like it is done in the case of bank consortia. This will allow
sharing of risk.
vi. Implement financialisation of products, which are popularly perceived to be risky
and volatile, such as bullion or real estate. Financialisation allows for exchange-
traded instruments and provides liquidity. Exchange trading also provides
guarantees against counter-party risk.
vii. The commodity market, especially the futures market, also needs to be developed.
This will be only possible when the commodity exchanges are brought under an
autonomous and statutory regulator.
viii. Most insurance companies and pension funds are barred from investing below a
certain credit rating which needs to be relaxed a bit more. Credit enhancement can
be of immense help here.
ix. Re-focus on Indian Depository Receipts. The product already exists but suffers
from poor marketing. In fact, there is also enormous scope for extending the rupee
bonds market to wider range of overseas issuers. Such rupee bonds and IDRs not
only provide a unique opportunity for insurance and pension companies it also
gives them an opportunity to invest in select foreign companies without having to
go cross the borders and also insulates them from currency risks.
x. It might also be apposite for the government to revisit the report submitted by the
High Powered Expert Committee on Making Mumbai an International Financial
Centre, and re-examine the various proposals.
xi. Existing rules and guidelines prohibit insurance companies and pension funds
from investing in private limited companies, which needs to be scrapped or
modified.
xii. Wide-ranging capacity building has to take place across the categories (insurance
and pension) and sectors (public versus private) to enable fund managers,
compliance officers, dealers, marketing experts, sales agents, board members, risk
officers to improve their skills and help deliver improved returns to investors.
xiii. The Government should look at launching some more infrastructure finance
companies, in addition to the ones existing today such as, Rural Electrification
Corporation, Power Finance Corporation. This will automatically increase the
supply of paper to the market.
xiv. The Government could examine the possibility of exempting income - arising out
of investments in infrastructure made by insurance companies or pension funds --
from tax.
xv. Government should examine the possibility of infrastructure bonds carrying some
sort of an explicit guarantee. This will immediately improve the rating of the
projects and allow investment by insurance companies and pension funds.
xvi. The regulators should examine the possibility of allowing insurance companies
and pension funds to access the credit default swap markets to hedge their
exposure to paper floated by the infrastructure projects.
xvii. Greater regulatory clarity on whether investments made by insurance companies
and pension funds in infrastructure funds should be classified as an investment in
a mutual fund as this will allow greater flexibility in portfolio construction.
xviii. Insurance companies and pension funds should be allowed to invest in derivatives,
in both equities and bonds. This is essential for hedging their exposure in the cash
market. Each of the regulators should evolve a roadmap with a definite time-frame
and clearly enunciated milestones that include capacity building, improved
governance and regulatory structures, higher disclosure norms -- to move the
industry towards a greater level of sophistication, one that reduces risk but
increases the returns. In addition, it goes without saying that use of derivatives
should be restricted to only hedging the investment position in the cash markets.
xix. Insurance companies can currently invest only up to 3% in a single banks fixed
deposits. The regulator concerned should reconsider raising this upper limit.
While it will improve the liquidity position in banks, it will also provide a cash
buffer for fund managers to meet unforeseen redemption calls or withdrawals.
xx. It is recommended that the minimum rating standard for infrastructure projects be
relaxed substantially. Project investors should get a wider choice of credit
enhancement facilities.
xxi. It is recommended that exposure of insurance companies should be linked to 15-
20% total project cost.
5. The Committee had five Meetings from 18
th
April, 2012 to 28
th
January, 2013. The
Committee also assigned the responsibility of drafting Chapters to its Members and
the following 3 Sub-Groups were constituted with dedicated jobs:
1. Financial Markets Sub-Group to analyse the market mechanisms and consider the
nations requirements in terms of development and deepening of financial markets.
The Group was also requested to explore the market mechanisms and the potential of
Insurance and Pension funds in contributing to the development of markets.
2. Insurance Investment Sub-Group to analyse the funds under management of Life
and Nonlife Insurers.
3. Pension Investment Sub-Group to analyse the funds under management of the
National Pension System (NPS) as well as other retirement savings funds.
The subgroups on Insurance and Pension also examined the International experience on
Investment patterns to learn from the best practices of the US, UK, Japan and other nations
that have gone through turbulent changes in Investment of Insurance and Pension funds.
6. The Committee would like to thank the National Insurance Academy, Pune, for
providing the logistic and administrative support for organising meetings of the
Committee. The Committee would also like to thank the Pension Division and
Insurance Division, Department of Financial Services, Ministry of Finance,
Government of India for providing administrative and technical support to the
Committee.
7. It is expected that the recommendations of the Committee would be taken into
consideration to revise the investment patterns for the Non-Government provident
funds, Superannuation Funds and Gratuity Funds and for insurance companies. It is
also hoped that, at a later date, the practice of prescribing and investment pattern
would be abandoned provided the enabling environment is created and the
institutional mechanism is put in place.










CHAPTER II
THE ECONOMIC BACKDROP: TWO MORAL DILEMMAS

he Indian economy has been experiencing a growth slowdown over the past few
quarters. This has caused concern all around, coming as it does on the back of strong
growth registered over the past few years. The growth rate of the Indian economy has
faltered during 2012-13 after many years of strong and impressive growth. According to
quick estimates of Indias GDP, the Indian economys gross domestic product (GDP)
managed to post a growth rate of 5% during FY13, which is the lowest in past 10 years,
against 6.2% in the previous year.
The overall growth rate was also pulled down by the low 4.8% Y-o-Y growth posted for the
January-March 2013 quarter. Unfortunately, the low growth rate now seems to have sunk its
roots. GDP growth rate for the first quarter of 2013-14 (April-June) at 4.4% has also not been
very encouraging.
The year 2012-13 also saw the investment rate of the economy dipping due to supply
bottlenecks and weak demand, leading to a knock-on effect on consumption as well, and
thereby depressing the twin drivers of the growth engine -- investment demand and
consumption demand. The slowing investment demand also was reflected in the decelerating
industrial production data being released every month.
While there are multiple factors behind the slowdown, including the ripple effects of the
global financial meltdown and the attendant Euro-crisis, a few domestic reasons also
contributed to slowing investment demand. In the aftermath of the Lehman Brothers collapse
and the global financial crisis, the Indian government and the central bank Reserve Bank of
India (RBI) focused their attention on stimulating consumption demand (through a
combination of fiscal measures and entitlement schemes) and pursuing an easy money policy,
respectively, to ensure continuing economic growth. While this did help the economy stave
off an egregious slowdown, this strategy was not without its inherent drawbacks.
While the consumption driven growth was able to shield overall economic growth from the
global economic freeze on a temporary basis, it soon gave birth to inflationary impulses in the
economy in the absence of adequate capacity to meet this increasing demand for goods and
services. Inflation and inflationary expectations forced RBI to reverse its easy money policy
and pursue a path of increasing interest rates and tight monetary policy to squeeze out
inflationary expectations. While monetary policy does have a role to play in combating
inflation, its efficacy is limited if the fiscal side is out of alignment.
In addition, the inflation construct in India has certain structural infirmities which are outside
the pale of monetary policy. For example, the wage increase in the rural areas as a
consequence of the enhanced entitlement programmes -- has a direct correlation with the
increase in demand for essential, including high protein, food items. Given the lack of
investment in building either capacity to meet enhanced consumption levels, or lack of
T
investment in building infrastructure that is capable of delivering goods and services from
producers to consumers efficiently, friction builds up in the system and creates inflationary
pressures.
Therefore, while lack of investment demand and slowing investment activity directly impact
economic growth, it also results in a heightened inflationary state. Whats worse, a
combination of slow growth and inflation has a crushing effect on the poor more than
anybody else. This is particularly relevant to India, since past periods of high growth were
directly a fall-out of increasing levels of investment activity. With GDP growth now close to
the lower band of the tolerance limit, there is an urgent need to rekindle the economys
animal spirits and focus on reviving investment demand.
Specifically, investment activity in infrastructure needs to be stepped up urgently since lack
of infrastructure acts as a dampener on overall investment demand for manufacturing.
Investment activity in both infrastructure and manufacturing also needs to be increased for
another urgent reason: to absorb the large armies of youth that will be added to the labour
force every year. According to various studies and reports, it is estimated that over 10 million
employable people are expected to join the workforce every year. Therefore, the
manufacturing sector (including infrastructure) has to create job opportunities that will absorb
at least substantial number of these millions of people every year. India has been the
beneficiary of a propitious economic event known as the demographic dividend. However,
this gain may turn out to be not only illusory but can also become a severe drag on the
economy if investment demand is not catalysed in time; some initial signs of the impending
crisis are already visible in some parts of the country.
The Approach Paper for the Twelfth Five Year Plan, drafted by the Planning Commission,
has this to say: India has a younger population not only in comparison to advanced
economies but also in relation to the large developing countries. As a result, the labour force
in India is expected to increase by 32 per cent over the next 20 years, while it will decline by
4 per cent in industrialised countries and by nearly 5 per cent in China. This demographic
dividend can add to growth potential, provided two conditions are fulfilled. First, higher
levels of health, education and skill development must be achieved. Second, an environment
must be created in which the economy not only grows rapidly, but also enhances good quality
employment/livelihood opportunities to meet the needs and aspirations of the youth.
The Economic Survey for 2012-13 has a chapter devoted to the issue and is titled Seizing
The Demographic Dividend. The introduction to the chapter states: The central long-run
question facing India is where will good jobs come from? Productive jobs are vital for
growth. And a good job is the best form of inclusion. More than half our population depends
on agriculture, but the experience of other countries suggests that the number of people
dependent on agriculture will have to shrink if per capita incomes in agriculture are to go up
substantially. While industry is creating jobs, too many such jobs are low productivity non-
contractual jobs in the unorganized sector, offering low incomes, little protection, and no
benefits. Service jobs are relatively high productivity, but employment growth in services has
been slow in recent years. India's challenge is to create the conditions for faster growth of
productive jobs outside of agriculture, especially in organized manufacturing and in services,
even while improving productivity in agriculture. The benefit of rising to the challenge is
decades of strong inclusive growth.
The repercussions of not building adequate capacity for absorbing/employing 10 million
employable persons every year can be devastating on society and the social fabric. It is a
chilling thought and that makes the task of improving investment demand that much more
pressing.
So, What Is To Be Done?
So, in a nutshell, improving investment demand seems to constitute the central pillar of the
suite of solutions needed by the economy. However, improving investment demand is a
multi-pronged task involving changes that need to be introduced in the political matrix, the
skill development capacities, policies for use of natural resources, the entire approval chain
stretching from central to state to local authorities, consolidation of the regulatory structure in
each sector, the move from multi-point, multi-levy taxation regime to GST, availability of
proper infrastructure and, finally, an efficient financial system.
However, since this committees remit is limited, this report will focus on improving the
delivery mechanism in the financial system and examine specific areas within the financial
system that need policy, regulatory and legislative changes to facilitate efficient capital
allocation to both infrastructure as well as manufacturing projects. The two sectors
(infrastructure and manufacturing) have been mentioned separately because both have varied
needs in terms of the capital blend, the maturity profile, the investor class, the mix of assets,
the markets approach strategy, the regulatory and legislative structure.
Within the two needs mentioned above, this paper will focus largely on infrastructure
financing since the financial infrastructure for meeting the needs of manufacturing sector are
already well developed, barring a few noticeable gaps (such as the lack of a decent corporate
bond market). However, financing of infrastructure projects requires special attention since
there are many mission-critical gaps that need to be resolved urgently.
So, the central question then boils down to this: what level of investment in manufacturing
and infrastructure is required over the next five years to not only help deliver 9% annual
growth on an average, but also create capacity to bring down the average annual rate of
inflation to 4-5% and employ large armies of people every year?
During the 11
th
Five year plan, which just got over, the Planning Commission had envisaged
a total investment of $500 billion in infrastructure. Going by the preliminary reports
available, total investment has fallen short of the target, though the performance varies across
sectors. This is also evident from the slowing down of the economy and the concomitant
shocks from the growing infrastructure deficit. However, when seen from a GDP point of
view, investment in infrastructure increased from 5% of GDP during the Tenth Plan (2002-
07) to 8.9% of GDP now. While the growth looks impressive, it should be seen in perspective
of other countries. For example, Chinas annual spend on infrastructure is close to 20% of
GDP.
To achieve an average annual growth of 9%, the Working Group constituted by the Planning
Commission
1
to ascertain the financing needs of infrastructure during the Twelfth Five Year
Plan (2012-17), has envisaged an investment of Rs 41,00,000 crore at 2006-07 prices if
resource mobilisation in the sector is to reach 10% of GDP. Assuming an average annual
inflation of 5%, the working group has estimated that infrastructure will require an
investment of Rs 65,80,000 crore at current prices.
The Department for Industrial Policy and Promotion, under the Ministry of Commerce and
Industry, has also released a discussion paper on financing requirements of infrastructure and
industry
2
. In that paper, it is estimated that the manufacturing sector will require Rs 51,80,000
crore during the same period, on the basis of investment in manufacturing during 2004-10
and the governments avowed target of raising the share of manufacturing in GDP from the
current 16% to 25%.
Assuming an average annual inflation rate of 5%, manufacturing will require an investment
of Rs 83,20,000 crore at current prices. However, even if we stick with the estimates based on
the 2006-07 prices, the total requirement for both infrastructure and industry works out to
24.2% of GDP in the terminal year (2016-17) of the Twelfth Plan, compared with 19.4% of
GDP in 2010-11. Therefore, on an average, the total investment in infrastructure and
manufacturing works out to about 22.5% of GDP every year.
Investments in Infrastructure and Manufacturing sector at 2006-07 prices (Rs crore)
Years

GDP Investment In
Infrastructure
(Rs in Crore)
Investment in
Manufacturing
(Rs in Crore)
Total
Investment
to GDP (In
% )
Net
Requirement
from Market
Net
Requirement
to GDP (In
%)
2011-12 6,314,265 528,316 694,569 19.4 541,986 8.6
2012-13 6,882,549 619,429 791,493 20.5 626,312 9.1
2013-14 7,501,978 712,688 900,237 21.5 716,439 9.6
2014-15 8,177,156 809,538 1,022,145 22.4 813,627 9.9
2015-16 8,913,100 918,049 1,158,703 23.3 922,506 10.3
2016-17 9,715,279 1,039,535 1,311,563 24.2 1,044,393 10.8
2012-17 41,190,063 4,099,239 5,184,141 22.5 4,123,276 10.0
Base Year = 2011-12; Total Investment = Investment in Infrastructure + Investment in Manufacturing; * Note: GDP
numbers are as per the Report of the Working Group on Investment in Infrastructure
While the Planning Commissions Working Group assumes that almost half the estimated
investment amounts for infrastructure will be met by the government through budgetary
support, the DIPP discussion paper assumes 60% of the estimated outlay in manufacturing
will emanate from internal accruals (based on the track record for 2004-09). If we accept this

1
Draft Report of the Sub group on Infrastructure funding requirements and sources for the 12th Plan
2
http://dipp.nic.in/English/Discuss_paper/Feedback.aspx
assumption (though the intervening years have not been too kind for manufacturing and
internal accruals would have reduced somewhat during 2009-12), then the balance Rs
41,23,276 crore will have to be accessed from the market. Assuming further a debt-equity
ratio of 70:30, the debt markets will have to provide Rs 28,86,293 crore and the balance Rs
12,36,983 crore will have to come from the equity markets.
Seen from a historic perspective, the volumes alone suggest that all the existing and known
sources of financing for infrastructure the Indian banking system, the Indian capital
markets, foreign direct investment, external commercial borrowing, alternative investment
platforms (private equity and venture capital) combined will not be able to provide the
staggering amount of Rs 41,23,276 crore. For instance, the banking system, has been
providing a large proportion of financing for infrastructure during the first three years of the
Eleventh Five Year Plan, banks provided 56% of the total funding to infrastructure projects.
Infrastructure projects accounted for 11.7% of total bank credit during FY10 compared with
1.7% during FY00. Banks now face two key challenges in expanding their exposure to the
sector an asset-liability mismatch (banks typically access short term liabilities while
infrastructure assets are usually long term in nature) and hitting the existing regulatory
sectoral caps.
These two problems could be surmounted partially by introducing certain products (such as,
take-out financing) but it would still not address the problem of finding the required amount
of financing. There are other visible gaps in the existing financial systems that need to be
sorted out too such as, increasing depth and liquidity of the Indian capital markets,
providing increased financing options (such as mezzanine equity), lack of a deep forward
market inhibiting long term currency loans, an underdeveloped debt market, and so on. These
are issues that will definitely improve the efficiency of the capital markets and are likely to
result in improving the flow of finance to projects. However, sorting out these issues alone
might not be capable of bringing about the huge spike in funding requirements that is needed.
This would then require tapping newer sources of financing. This will require a policy
strategy envisaging a higher level of intermediation of household savings in the economy.
The two sectors that corner a large proportion of the household sectors savings and are yet to
contribute meaningfully to the available pool of investible funds in the capital markets are
insurance and pension. These two have the potential to substantially increase the flow of
funds into both infrastructure and manufacturing.
Insurance and pension combined account for close to 32% of household savings in financial
assets, second to bank deposits (which corners close to 49% of gross financial assets).
However, because of certain mandated investment norms followed by insurance companies
and various pension funds, very little of this money finds its way to the capital market to fund
growth of either infrastructure projects or manufacturing assets. At a time when the economy,
and the nation, need long term funds to lay the foundation for future growth, insurance and
pension sector provide the right balance in terms of volume as well in terms of tenor.
This then presents Moral Dilemma I: at a time when the country needs long term capital, can
the Insurance and Pension sectors be governed by policies that are inimical to this national
objective?
Are Institutions Serving The Customer?
One of the over-riding concerns of the insurance and pension sector custodians have been to
shield the savings of beneficiaries from volatility and risk, and protect it from capital erosion.
These anxieties are justified and are essential for the healthy growth of long term savings
culture in the economy. However, it might be worthwhile examining whether the walls built
around the insurance and pension sectors have outlived their utility and whether the
custodians of these funds need to rethink their defence strategy in the light of changed times
and developments.
There is another larger moral dilemma that now confronts the insurance and pension sectors.
As the overall savings pattern in the economy has been showing for a while now, savers are
preferring to move their investments out of financial assets into physical assets, such as gold
and property. This trend has accelerated over the past few years when the perceived rate of
inflation and expectations of future inflation rates have exceeded the returns provided by
most classes of financial assets, especially fixed income assets. Household savings committed
to equities and mutual funds have also decelerated after the 2008 global financial meltdown.
According to data from the RBIs Annual Report for 2012-13, the household sectors savings
show a marked preference for physical assets over financial assets. Data from the report
(which is available only up to 2011-12) shows that the gap between financial investments and
physical investments has been growing almost every year from 1.2% of GDP in 2009-10,
the wedge widened to 6.3% during 2011-12.
Therefore, while the proposition in both insurance and pension is substantially different from
the other categories of fixed income assets (in that the saver does not have easy access to his
funds for a prolonged period), it is quite likely that the overall propensity towards physical
assets is hurting the insurance and pension sectors. In fact, data clearly shows that accruals to
the head Pension and Provident Funds have been progressively declining with each passing
year. Growth of life insurance sector is also declining. It is a common practice to measure
insurance penetration through the ratio of insurance premium to GDP. In India, not only is it
abysmally low but it has even dropped from these low rates. Sure, there are other legislative
and regulatory issues that are retarding the growth rate of funds accruals to pension and life
insurance sectors, but negative real returns might over time also result in large-scale flight to
physical savings. For example: inflation, as measured by the consumer price index, averaged
around 9.3% during the 12-month period January-December 2012 (as per Economic Survey
2012-13, http://indiabudget.nic.in/es2012-13/echap-04.pdf). The RBIs Annual Report for
2012-13 lists the weighted average yield of government securities for 2011-12 at 8,52% and
at 8.36% for 2012-13 (http://rbidocs.rbi.org.in/rdocs/AnnualReport/PDFs/P2_07PDM220813.pdf).
Therefore, clearly, government securities (as well as a host of other fixed income investment
opportunities) were yielding negative returns.
This then brings up Moral Dilemma II can the insurance and pension sectors seek safe
harbour under policies that are denying investors positive rates of return, in the name of
safety and risk mitigation? Today, a large percentage of investible funds from the insurance
and pension sectors gets invested in government bonds, which are perceived as the safest,
risk-free investment in the economy. While that might be substantially true, there have been
periods in the recent past when the rate of inflation in the economy exceeded the yield on
government bonds, thereby yielding a negative real return on investment.
In the classic trade-off between risk and return, the design of the mandated investment
norms in vogue today whether its insurance or pension has no tolerance for risk, but
a high tolerance level for low returns. This is, in the opinion of this Committee, unfair
for the investors who need a combination of both low risk as well as moderate returns.
There might even be some investors who do not mind taking slightly higher risks with a
proportion of their long term savings in the pursuit of higher returns, especially those in
the early stages of their saving curve.
It is not the contention of this Committee that risk mitigation measures, regulatory
overview or compliance standards be compromised or that the investment norms be
redesigned to give free rein to cavalier, injudicious or imprudent investment styles. But,
there can be no denying that in the pursuit of risk-free investment, investors are getting
the short shrift and therefore revealing a preference for physical assets. Finally, as
recent events in Europe have shown, there are today no assets which are completely
risk-free.
Summing Up
It is by now quite evident that both the insurance and pension sectors are somewhat remiss in
their duty as financial intermediaries. On the one hand, they are unable to provide funds to
industry and infrastructure, which provide the ideal investment opportunity for the nature of
funds parked with the institutions. On the other, as financial agents, they are unable to
provide investors with the right returns. And, the root cause for these slippages seems to be
the mandated investment regulations that are preventing funds from finding the right
investment opportunities as well as hobbling returns.
Apart from the moral dilemma, the continuation of these investment norms are likely to erect
potential future roadblocks for the economy and are probably carrying the seeds of future
fiscal disequilibrium as well. And, these issues are related to the demographic dividend that
have so propitiously positioned India in an economic sweet spot. As mentioned earlier in this
chapter, the demographic problems start with finding suitably employment for the large
number of young people who are expected to join the working force every year. But, the
problems do not end with only finding suitable employment. There are other consequences
for the Indian economy, which will start kicking in 10-15 years from now but need remedial
measures to be implemented here and now. Here are the reasons.
The Indian economy is currently enjoying the collateral benefits from the demographic
dividend a crucial ratio called the dependency ratio, or the number of people in the
country not working/earning to the working/earning population. In India, till about 2005, the
dependency ratio was 0.6. In other words, the measure calculates exactly what it says: the
number of non-earning people in the economy who are dependent on the people who are
earning. This is expected to decline over the next 20-30 years as the demographic dividend
takes effect. With fertility rates dropping over the years, especially in the past 20 years, from
3.8 in 1990 to 2.9 in 2007 and expected to fall further, the number of new-borns will
decrease. This will further bring down the number of people not working/earning to a
situation where the bulk of the population will be working/earning.
A lower dependency ratio has many economic benefits: with a larger percentage of the
population working, savings and consumption levels in the economy go up, providing vector
forces for higher economic growth. But, unfortunately, this dividend is not permanent. Over
time, this huge bulge in the working force which is being considered as an economic
windfall currently -- is expected to retire. At the same time, the lower dependency ratio will
see fewer younger people joining the workforce, resulting in a greying of the economy or the
number of older people not working increasing. Consequently, if the economy fails to
implement a proper pension system today, the economy will have fewer people in the
working age group to support the old. And, if the retired do not have access to regular income
streams by then, for which they need to save today, the burden on the economy is likely to be
crippling in nature.
A larger number of older and retired people, in the absence of a dependable pension system,
will pose a danger to the old age income security in the country and put enormous pressure
on the government of the day to re-route expenditure earmarked for public goods and services
towards providing for health and pension spending. This will inevitably cause a drain on the
state of the fiscal and, subsequently, on the economy.
It is therefore imperative that the pension programme be strengthened and all inherent
weaknesses tackled forthwith. It is absolutely necessary that a larger proportion of the current
working force whether in the formal or the informal sector be moved over to a robust and
dependable pension system predicated on the defined contribution philosophy. The challenge
lies in making the pension sector attractive enough to draw in the large percentage of the
working force that is currently outside its pale. And, there is a necessary and sufficient
conditions required to make this happen --- ensure that the pension sector is in a position to
provide returns that are stable and competitive in nature.
------------------------------------------
CHAPTER III
INVESTMENT NORMS & THEIR RATIONALE

t is imperative that an urgent resolution be found for the two moral dilemmas described
in detail in the previous chapter. This will be needed for removing a key irritant that
bedevils financing of long-term projects, especially infrastructure ventures. But, more
importantly, it is also required to provide a positive net real return to the millions of investors
and savers. We owe it to the people of this country.
However, before we recommend any changes in the way pension and insurance sectors invest
their funds, it might be necessary to examine the rules governing current investment activity
and to chart their evolution to get a better understanding of the thought process behind the
existing framework.
The history of investment norms is quite old in India. But, first, what is investment? It is the
commitment of money or capital to purchase financial instruments or other assets in order to
gain profitable returns in the form of interest, income, or appreciation of the value of the
instrument. An investment involves the choice by an individual or an organization such as a
pension fund, after some analysis or thought, to place or lend money in a vehicle, instrument
or asset -- such as, property, commodity, stock, bond, financial derivatives (e.g. futures or
options), or a foreign asset denominated in foreign currency -- that has certain level of risk
and provides the possibility of generating returns over a period of time.
Long-term investment can be bifurcated into two basic categories: pension and insurance.
Ideally, any directed investment advisory should be available in two versions one for
insurance and one for pension. However, as with all things Indian, there are four sets of
guidelines which govern how insurance companies or pension funds should invest their
accretions one issued by the department of economic affairs in the finance ministry, one
issued by the Insurance Regulatory and Development Authority (IRDA), one from the labour
ministry for guiding the investment activities of employees provident funds, and finally,
another one authored by the Pension Fund Regulatory and Development Authority (PFRDA)
to guide the National Pension System (NPS). Actually, there are two sets of guidelines within
NPS one for government employees (who constitute the majority of subscribers) and the
non-government employees. Similarly, there are four sets of guidelines issued by IRDA for
its constituents one for life insurance, one for ULIPs, one for general insurance and one for
pension and general annuity funds.
Given the diversity of opinions and directives, it is only natural that methodologies will get
mangled and objectives will get obfuscated in the ensuing melee. This committee actively
wishes for some realignment of objectives and harmonisation of processes, which will
eventually allow for efficient allocation of capital and maximisation of returns.
The following section looks at the history of mandated investment norms in the pension
sector.
I
PENSION SECTOR
A report published by the City of London Corporation (Insurance Companies & Pension
Funds As Institutional Investors: Global Investment Patterns) has broadly classified Indian
pension system into four segments:
The National Social Assistance Programme (NSAP). A limited first pillar, the
central government has launched poverty alleviation programmes aimed at the aged
under this umbrella scheme. Its a pay-as-you-go plan (an unfunded scheme, with
current revenue receipts used for paying out retirement benefits). Under the scheme,
the government pays out Rs 200-1,000 every month to 15.7 million poor citizens aged
65 and above. Some state governments make a matching contribution. Obviously, this
falls short of the optimal universal, old-age, income security plan.
The Employees Provident Fund Organisation (EPFO). The Employees Provident
Fund, Indias largest defined contribution and publicly managed plan, is an example
of the typical PillarII arrangement. Employees in the organised sector are required to
participate in provident funds and pension plans administered by EPFO. According to
the City report: These include a defined-contribution provident fund and a defined-
benefit pension plan that cover only 14% of the workforce (59 million workers as of
March 2010). Included in this ambit are about 2,750 private trusts approved by the
EPFO that offer similar programmes in private companies with 4.9 million members
and assets of Rs 100,500 crore ($20.4 billion).
Private pensions and annuities. Regulated by the insurance regulator (IRDA), these
are various schemes administered by life insurance companies. In 2010, IRDA
directed all insurance companies, which had launched unit-linked pension plans, to
provide a guaranteed return indexed to interest rates. The order was reversed in 2011
but sales in this segment have remained sluggish.
The National Pension System (NPS). All government employees have to enrol under
this new, mandatory, defined contribution plan. However, it is optional for private
sector workers. The product has not found much popularity among non-government
individual investors. The scheme has a unique architecture it allows investors
portability and the ability to select the fund manager as well as the investment
strategy.
In terms of assets under management, EPFO funds hold two-thirds of the market and private
pensions and annuities one-third. NPS is still very small but is expected to gain in importance
as product awareness grows. As of now, though, NPS seems to be providing a higher return
than all the other options available. Pension funds are expected to grow vigorously as the
population grows richer and seeks to secure sufficient old-age provisions.


Investment Norms for Provident, Superannuation & Gratuity Funds: A History
Till 1969-70, the history of investment norms was quite simple. The entire investment by
provident funds was required to be made in central and state government securities only. This
represented the classic text-book definition of financial repression, providing captive
financing of government debt. It also resulted in hindering the development and emergence of
a deep and liquid financial market in the country.
A provision in the Income Tax Act, 1961, was made for investment of provident funds and
pension funds according to the investment pattern prescribed by the government from time to
time. In the beginning, a major part of investible funds was required to be invested in
securities issued by state/central governments or in the securities where payment of principle
and interest was guaranteed by the central/state governments.
In 1974, post office time deposits were added to the list of eligible investments for provident
funds, superannuation funds and gratuity funds. With the passage of time and changes in the
economic environment, the list started adding a larger number of eligible investments.
In 1975, investment in Special Deposit Scheme (SDS) up to a maximum of 20% -- was
introduced. SDS was introduced in the mandated investment pattern mainly to provide a
secure financial instrument and better returns for provident funds. There was a sweetener
attached to the investment -- interest income accruing from deposits under the scheme was
exempt from income tax. Initially, the scheme was supposed to run only for 10 years.
However, it was extended for another 10 years in 1985, three years in 1995 and for a further
five years in 1998. The scheme was finally wound up in May 2003.
The rate of interest in SDS was administratively determined and it varied from year to year.
At launch, the rate of interest offered was 10% per annum. Subsequently, on April 1, 1983
this was raised by one percentage point to 11%, and by another percentage point to 12% on
April 1, 1986. It remained unchanged for almost 15 years after that.
As a consequence of the balance of payments crisis and the precarious fiscal health during
1990-91, the government undertook a fiscal consolidation programme. SDS came under the
scanner for its high administered interest rate and the consequent repayment burden. As a
result, the government decided to gradually reduce the interest rate offered by the scheme. It
was also in keeping with the governments policy to reduce administered interest rates on
other instruments. The first reduction to 11% -- came about in April 2000. Subsequently,
the rate was reduced to 9.5% on April 2001 and to 9% on April 2002. In 2003, the rate was
further lowered to 8%.
Given the high interest rates and tax allure of the scheme, the minimum investment
prescription under the scheme also changed. From an initial limit of a maximum of 20% of
net accretions, the limit was increased to 70% in January 1993. Thereafter, the limit was
reduced to 55% in May 1994, 30% in May 1995 and 20% in September 1996. And from
March 1997, no fresh deposits were allowed under the scheme. However, the interest
received on the deposits could be reinvested.
The design of the scheme and the interest rate scenario point to an inherent risk in investing
long term liabilities in assets with mismatched tenors: reinvestment risk. As the administered
rate on SDS kept declining, the fund administrators faced declining yields from reinvestment
options.
The investments in National Savings Certificates or Post Office Time Deposits continued till
1985 only. The investment pattern has been progressively liberalised over the years. During
the period 1993-94, the pattern allowed investment in bonds issued by the public sector
undertakings (PSUs) up to a limit of 15% initially, which was subsequently increased to 40%.
At the same time, investment in public sector financial institutions and public sector banks
were also prescribed, which like PSU bonds, generally carried higher rates of return. Keeping
in mind the requirements of the private sector, investment in corporate bonds (bonds issued
by private sector) were allowed in 1998 for the first time, with an option to invest up to 10%.
The mutual fund industry in India started in 1963 with the formation of Unit Trust of India, at
the behest of the government and Reserve Bank of India. But the mutual fund units could be
included as an eligible asset in the investment pattern for pension funds only in 1999 with an
option of investing 40% at the initial stage. In fact, by then, the mutual fund industry had
been substantially liberalised and a number of financial institutions both in the public and
private sectors had set up their mutual funds.
With the introduction of pension reforms in India, it was found desirable to leave the choice
of investment decision to various pension funds, irrespective of their provenance -- whether
they were in the government or private sector. Going by the type of problems coming to the
notice of the government -- such as, theft of government securities, default in repayment by
public financial institutions -- it was felt that the government should stop prescribing any
investment pattern to avoid any explicit or implicit guarantee or liability. Consequently, the
onus of due diligence rested with the trustees of the fund. This allowed the government to
maintain a distance from the investment decisions of a provident fund, while at the same time
provide guidance for safe and reasonable returns.
The investment pattern of 2008 saw the introduction of three new instruments -- money
market instruments, term deposits of private scheduled commercial banks and rupee bonds.
Money market instruments are debt instruments with residual maturity of up to one year
such as, commercial paper, certificates of deposits, treasury bills, etc. These instruments are
safe, less volatile and provide safe avenues for temporary parking of incremental accretions.
Thus, a part of accretion to the funds was earmarked for investment in money market
instruments including mutual fund schemes.
The permission for rupee bonds stems from the interest displayed by multilateral funding
agencies such as, World Bank or Asian Development Bank -- in borrowing and lending in
the Indian currency by leveraging their international credit rating, which translates into fine
pricing of rupee bonds. The logic was: since these institutions were using resources raised
overseas to lend to Indian projects in rupees, their exposure suffered from a currency risk.
The rupee bonds were made eligible instruments as funds raised through these bonds would
also be used for infrastructure projects, thereby providing an opportunity to lock in long-term
liabilities into secure, long-term assets.
To encourage long term investments and promote the equity culture, equity shares as a class
of investments were introduced in 2005 as an option with a limit of 5%. In August 2008, the
limit on investment in equity was increased to 15%. However, again this was an option given
to the provident funds etc. Government, in 2008, also permitted slightly active portfolio
management, by including the option of trading in securities.
Central government securities and state government securities were also merged into a single
category in the 2008 revision. It permits direct investment up to 15% of the investible funds
in shares of companies on which derivatives are available in Bombay Stock Exchange or
National Stock Exchange or indirect investment in stock market through equity linked
schemes of mutual funds. Pension funds were given the freedom to trade in securities subject
to the turnover ratio (defined as the total value of shares traded divided by the average market
capitalisation for that period) not exceeding two. The investment pattern of 2008 also
permitted flexibility in choosing investment instruments by introducing the concept of
flexible ceiling against the fixed investment ceiling in the past investment patterns. The
changes in the investment pattern for provident funds are summarised below.
Table: Changes in the Provident Fund Investment pattern (1975 2008)
Investment
Categories
S.D.S (
A ) ( % )
G.O.I./
Gilt MF
@
( B ) (%)
State
Guaranteed
/ Gilt MF @
( C ) ( % )
PSU bonds
/ Term
Deposits/
Money
Market
MFs ( D )
(% )
Any of
A,B,C
& D ( %
)
Pvt
Sector
( % )
Equity
Shares (
% )
Total ( % )
Before 1975 - 100 - - - - - 100
1975-85 30 70 - - - - - 100
1986-92 Not more
than 85
Not less
than 15
- - - - - 100
1993-94 70 15 15 - - - - 100
1994-95 55 15 30 - - - - 100
1995-96 30 25 15 30 - - - 100
1996-97 20 25 15 40 - - - 100
1997-98 - 25 15 40 20 - - 100
1998 - 25 15 40 20 10 - 100
1999-2002 - 25 15 40 20 10 - 100
2003-04 - 25 15 30 30 10 - 100
2005-08 - 25 15 25 30 10 5 100

Legal and Regulatory Framework Governing Investment Norms
The prescription of an investment pattern by the Department of Economic Affairs (DEA), in
the Ministry of Finance, is done under the Government of India (Allocation of Business)
Rules, 1961. The rules have been framed by the cabinet secretariat in exercise of the powers
conferred by clause (3) of Article 77 of the Constitution. The Second Schedule to these rules
lists the distribution of subjects among the departments of the government, which includes
investment pattern for Employees Provident Fund and other like provident funds as part of
the DEAs oversight. The Central Board of Direct Taxes, Department of Revenue also
notifies the same investment pattern for the recognised provident funds etc. under the Income
Tax Rules, 1962.
After the work relating to pension reforms was transferred to the Department of Financial
Services (DFS), the work related to investment norms was also transferred to DFS. The
pattern notified by DEA is suitably adopted by the Ministry of Labour and notified in terms
of the powers given under the Employees Provident Fund and Miscellaneous Provisions Act,
1952. The pattern was last modified by DEA in August 2008 and was made effective from
April 1, 2009. This investment norm is being used for the central government and state
government employees covered under the National Pension System (NPS). The investment
pattern of 2008 was adopted by Department of Revenue and notified under the Income Tax
Rules, 1962, but it has not been adopted for the employees covered under the Employees
Provident Fund and Miscellaneous Provisions Act, 1952 by the Ministry of Labour.
Therefore, while the investment pattern for Employees Provident Fund notified in July 2003
continues even today, there is now a divergence between the investment philosophies
followed by different parts of the pension industry. This is another aberration in the strategy
for the deployment of long term investments in the country. This is over and above the
difference mandated in NPS between funds managing accretions from central government
employees and those from the state governments.
Game-Changer: The National Pension System (NPS)
Source: PFRDA
As of April 7, 2013, the total NPS corpus was Rs 30,274 crore, contributed by 48.62 lakh
NPS subscribers. The break-up of the corpus and the subscribers is as under:
For managing the contributions of government employees, PFRDA appointed three pension
fund managers (PFMs) in April 2012 namely, LIC Pension Fund Ltd, SBI Pension Funds
Private Ltd, and, UTI Retirement Solutions Ltd. The applicable annual investment
management fee is only 0.0102%.
Particulars Corpus (Rs in crores) No. of Subscribers (in lakhs)
Central Government Employees 17,672 11.42
State Government Employees 10,760 16.29
Private 1,385 2.16
NPS Lite 457 18.75
Total 30,274 48.62
In a recent move, the Ministry of Finance has given PFRDA the dispensation to allow
government employees to make investment choices in the same manner as that applicable to
voluntary NPS for private citizens. The modalities are still being worked out.
For managing the contributions of the non-government private sector, PFRDA issued
guidelines for registration of PFMs in July 2012, which has done away with the earlier
bidding process. Under the old process, PFMs bid for a pre-determined number of slots, and
the fees charged by them for managing the pension funds had to be uniform for all players.
The earlier process has now been replaced by a system which lays down the eligibility
criteria for registration as PFMs, and all interested players desiring to enter the pension
industry, can register as PFMs subject to their fulfilling the eligibility criteria. There is no
restriction on the number of PFMs.
Further, the PFMs were allowed to prescribe their own fee charges, subject to an overall
annual ceiling of 0.25%, laid down by PFRDA. The changes are as per the recommendations
of the Committee to Review Implementation of Informal Sector Pension, set up by
PFRDA to go into the reasons for the slow progress of NPS in the private sector. Currently,
five PFMs manage the contributions of the non-government private sector subscribers -- SBI
Pension Funds, UTI Retirement Solutions, Reliance Capital Pension Fund, ICICI Prudential
Pension Fund, and, Kotak Mahindra Pension Fund.
The revised guidelines, available on PFRDAs website (www.pfrda.org.in), have done away
with the earlier bidding process, which was constrained by a pre-determined number of slots
and fixed fees. The earlier process has now been replaced by a system which lays down an
eligibility criteria and all those interested in acting as PFMs can register with PFRDA, subject
to their fulfilling the eligibility criteria. There is no limit on the number of PFMs. Further,
PFMs are now allowed to prescribe their own fee charges, subject to an overall ceiling to be
laid down by PFRDA. It is expected that this would provide for an economically viable
business model for the PFMs attracting a fresh set of entrants into the pension industry, and
the resultant competition would ensure a market-driven fee structure, which would work to
the advantage of the pension subscribers.
The non-government private sector subscribers have the option of three schemes -- E or
equity market instruments, C or credit risk bearing fixed income instruments and G or
government securities. Subscribers are free to switch across schemes as well as PFMs once in
a year free of charges, in case they so desire.
There is a separate scheme for the underprivileged NPS Lite -- which is also supported by
the government through Swavalamban scheme under which the government contributes Rs
1,000 annually per account, subject to fulfillment of conditions of eligibility by the
subscribers.
The investment guidelines for the non-government private sector were revised to facilitate
active fund management by PFMs and utilisation of their investment skills for generating
optimum returns to subscribers. Broadly, the instruments approved for investments by PFMs

are as under:
i. Central Government Bonds and State Government Bonds
ii. Equity shares listed in BSE or NSE on which derivatives are available or are part
of BSE Sensex or Nifty Fifty Index
iii. Fixed Deposits of scheduled commercial banks
iv. Debt securities issued by Bodies Corporate including scheduled commercial banks
and public financial institutions
v. Credit Rated Public Financial Institutions/PSU Bonds
vi. Credit Rated Municipal Bonds/Infrastructure Bonds / Infrastructure Debt Funds
vii. Money Market instruments including liquid schemes of mutual funds.
The above investments contribute to economic growth by directing investments to
infrastructure (through bonds and equity) and participating in Government borrowings. The
above schemes have enabled indirect participation of subscribers from all sectors, in the
financial markets, who would have otherwise remained unexposed and also bereft of its
benefits. Incentives in the form of tax benefits are given to subscribers. The exit is allowed
from the age of 60 years and has been kept flexible keeping the interests of the subscribers in
mind, albeit with 40% compulsory annuitisation of the accumulated corpus.
PFMs are active participants in the markets as they have to constantly monitor and conserve
the scheme portfolio. PFMs have to be proactive as the scheme portfolio is marked to market
and subscribers are allotted units based on the NAV of the portfolio. Generation of
reasonable returns by PFMs on the scheme portfolio is a reflection of their market
competence and has a direct bearing on subscriber acquisition.
As contributions to NPS are considered long term investments, the selection of instruments in
each scheme is based on the PFMs risk-return perception, subject to the objectives of the
scheme. While building the scheme portfolio, PFMs are broadly guided by credit quality of
investments, tenor/ maturity of instruments, yields and returns. Risks related to investments
are mitigated through stringent internal procedures and controls by PFMs and through regular
monitoring by PFRDA/NPS Trust.
Investment pattern under NPS for Private Citizens
One of the criticisms often levelled against NPS has been its failure in propagating its
product. There is also an apprehension that, given the poor standard of financial literacy in
India, whether the ordinary investor will have the required financial knowledge to understand
the nature of NPS. However, the design of NPS includes a provision for such a contingency.
The investment guidelines for NPS for private citizens allow investment in government
securities (asset class G), corporate bonds (asset class C) and equities (asset class E) in
various proportions (subject to condition that investment in equity cannot exceed 50% of the
investible funds). For subscribers not exercising any choice, their funds are invested under
the auto choice, which is based on life-cycle investment choice.
Allocation of funds across asset class for Auto choice
Age ( In Years )

Asset Class E (% ) Asset Class C ( % ) Asset Class G ( % )
Up to 35 50 30 20
36 48 29 23
37 46 28 26
38 44 27 29
39 42 26 32
40 40 25 35
41 38 24 38
42 36 23 41
43 34 22 44
44 32 21 47
45 30 20 50
46 28 19 53
47 26 18 56
48 24 17 59
49 22 16 62
50 20 15 65
51 18 14 68
52 16 13 71
53 14 12 74
54 12 11 77
55 10 10 80

The following table shows the existing exposure of government schemes under NPS.
Exposure to various financial instruments under NPS (as on February 28, 2013)
Investment
Category
Minimum Limit Maximum Limit
( % )
Existing
Exposure ( %)
Existing
Exposure ( % )
NPS CG NPS SG
Government
Securities : G
Not Specified 55 49.63 49.83
Fixed Income :
C-Debt
Corporate Debt
Not Specified 40 38.87 35.92
Fixed Income :
C-MM
Money Market
Not Specified 5 4.26 7.29
Fixed Income
Total : C
Not Specified 45 43.13 43.21
Equity : E Not Specified 15 7.24 6.96
Source: PFRDA
The table throws up two important findings. One, the total exposure to fixed income category
of investments is reaching the maximum limit of 45%, with corporate debt close to the upper
limit of 40%. Two, investment in government securities and equities are well within the
prescribed upper limits. It can be inferred from the above that while pension funds seem to
have an appetite for fixed income securities yielding higher returns than government bonds,
they are yet to fully embrace the equities culture. However, it also must be remembered that
this data pertains to the post-crisis period when funds across the world trimmed down their
equity exposure.
This becomes all the more evident when we compare the performance of the NPS private
sector schemes which, unlike the government schemes, are invested separately in each
investment category. The table below shows that Scheme C (fixed income) has outperformed
scheme G (government securities) as shown in data from pension fund managers (PFM).
Pension Fund Mangers Performance for Scheme C and Scheme G since inception (as
on March 31, 2013)
PFM Return since Inception
CAGR ( % )
Scheme C ( Tier I)
Return since
Inception CAGR (%)
Scheme G ( Tier I)
Yield Spread
( C over G ) (% )
SBI Pension Funds
Pvt Ltd
12.52 10.49 1.76
UTI Retirement
Solutions Ltd
9.36 7.97 1.39
Kotak Mahindra
Pension Fund Ltd
11.76 8.21 3.54
Reliance Capital
Pension Fund Ltd
8.74 7.51 1.23
ICICI Prudential
Pension Funds
Management Co Ltd
11.51 8.15 3.36
Source: PFRDA
It is clear that corporate fixed income securities are more attractive investment options when
compared with government securities, which yield a very low real rate of return due to high
inflation in India. While equities have performed poorly during 2010-12, this is on account of
underperforming equity markets in the aftermath of the global financial crisis. It is common
knowledge that corporate debt yields are necessarily higher than that offered by government
securities, given the risk differential. Therefore, given the persistence of inflationary
pressures in the economy and the near-negative real yields available on gilts, there is an
urgent need to shift asset allocation from government securities to corporate bonds.
It may be mentioned that the corporate debt (fixed income) category of investments includes
(i) corporate debt securities of not less than 3 years tenure, (ii) term deposits of not less than 1
year duration, and, (iii) rupee bonds having outstanding maturity of at least 3 years.
Corporate debt (category i) requires at least 75% of investments to be made in securities with
an investment grade rating (BBB and above). The remaining 25% can be invested in
securities below investment grade. It is to be noted that corporate long-term infrastructure
debt would qualify under category (i) due to the 3-year tenure requirement.
Considering that (a) infrastructure represents the most urgent, long-term financing need of the
nation, and, (b) pension funds are a long term source of financing, which are typically
invested by the fund managers over a longer horizon, there is an alignment of supply and
demand financing. With appropriate credit enhancement mechanisms for infrastructure debt,
a substantial part of the annual flow of pension funds could potentially be invested in
infrastructure debt, subject to the normal risk provisions.
The long term nature of pension funds, the robustness of equity markets and the existence of
equity risk premium in stock markets over the longer horizon present a strong case for greater
investment in equities. Studies have shown that equity risk premium -- the excess return of
stock markets over the risk-free rate -- exists in many developed countries as is evident from
historical stock returns data. The equity risk premium in India from 1981 to 2006 has been
estimated on a geometric mean basis at 8.74%. Similar experience of existence of equity risk
premium has been documented for many OECD countries for which the data of more than
100 years is now available.
EPFO vs NPS
The rate of return provided by the Employees Provident Fund are declared rates and not net
market returns on investments, which are arrived at after incorporating penalties and damages
and the use of some reserves. Even if we look at the nominal returns on the Employees
Provident Fund against the rate of inflation, it would appear that the real rate of returns has
been negative. This could be directly related to the pattern of investment adopted, which has
not been revised since July 2003.
There has been high tolerance to the negative real returns but a low level of acceptance to
taking risk in equity investment as the investment pattern of the finance ministry, which
allows a small proportion of investible funds in equity, has not been adopted by the labour
ministry. On the other hand, the higher returns (compared to the returns on the Employees
Provident Fund) delivered by NPS even though its been around for only a short period --
are essentially due to a relaxed and flexible investment pattern. The objectives of long-term
savings cannot be met if there are shortfalls in the return performance. As mentioned
elsewhere, a 1%. shortfall in investment return would reduce the terminal pension wealth
over a 40-year period by 20-30%. Therefore, the interests of the subscribers to a pension fund
are not being served by an investment pattern which has high tolerance for low or negative
real returns.
Deficiency in Laws/Regulations
Although there is no legal restriction in revision of the investment patterns and the review of
investment pattern is mostly policy based, which can be done through a notification under the
Employees Provident Funds and Miscellaneous Provisions Act, 1952 or the Income-tax
Rules, 1962, a piquant situation has emerged creating regulatory anomaly and compliance
nightmare for the provident funds.
After the enactment of Finance Act, 2006, even establishments which were uncovered under
the Employees Provident Fund and Miscellaneous Provident Fund Act, 1952 (EPF & MP
Act) have been asked to get registration under sub-section (4) of section 1 and exemption
under section 17 of the EPF & MP Act before they approach the income tax authorities for
grant of status of Recognised Provident Fund under Schedule IV of the Income Tax Act,
1961 (rule 4 (ea) of Part A of the Fourth Schedule of the Income-tax Act, 1961). The status
of a Recognised Provident Fund is required to get income tax benefits for provident funds.
This has resulted in a situation where even the establishments which are not covered under
EPF and MP Act are forced to go to the Ministry of Labour for seeking exemption under
Section 17 of the EPF and MP Act.
Further, there is a provision in paragraphs 27 and 27A of the EPF Scheme to exempt from all
or any of the provisions of the Scheme any class of employees to whom the scheme applies,
subject to such condition as may be specified in the order of exemption.
It is, therefore, clear that the uncovered provident funds are required to be specifically
exempted under the provisions of the EPF and MP Act before these funds acquire the status
of a Recognised Provident Fund which gets EEE tax status, meaning thereby that the
contributions to the provident fund, its returns and even payments from the fund are tax
exempt.
However, this has created an anomalous situation for these funds as one of the conditions of
the exemption from EPF and MP Act is that these provident funds are required to follow the
investment pattern specified by Ministry of Labour. But, on the other hand, the condition to
qualify as a Recognised Provident Fund under Income Tax Act, 1961 is that these funds
should follow the investment pattern set down by the Ministry of Finance. Earlier, the labour
ministry adopted the investment pattern laid down by Ministry of Finance. This trend was
broken in 2005 after which the Ministry of Labour has not adopted the new investment
notifications announced by the Ministry of Finance, first in January, 2005 and the subsequent
notification of August 2008. Therefore, the Ministry of Labours investment pattern has not
been revised since July 2003. As a result, under the current conditions, a private Recognised
Provident Fund is forced to violate one of the investment patterns.
Lack of Opportunities and Lack of Competency
The investment pattern for provident funds assigns the trustees of provident fund trusts with
the responsibility of maintaining a balance between the risk-return trade-off. This is a fairly
onerous burden considering that we are still far away from creating a robust framework for
selecting fit and proper provident fund trustees. The investment guidelines for NPS for all
citizens which lets them chose the blend of their portfolio has also created space for
inclusion of financially illiterate subscribers through the use of index fund investment in
equities and also through an auto choice which is based on life-cycle investment strategy.
This has two implications one, relating to cost minimisation of asset management thorough
the passive fund management and, two, it has created an intelligent option for default
investment behaviour for financially illiterate subscribers.
Needs/Concerns of Clients
A defined contribution (DC) scheme, such as the NPS which maintains individual retirement
accounts of pensioners who bear the investment risk, must not only maximise pension wealth,
but also ensure that the return of pensioners reported, as net asset value of units, are relatively
smoothened. This means special care should be taken to ensure that the volatility of returns,
which is also an important parameter, is monitored regularly. It is, therefore, essential that
while increasing the awareness and literacy of the individual subscribers under NPS is
important, it is equally vital to appoint fit and proper trustees on provident funds which
work on pooled investment principle. It is, therefore, clear that no liberalisation of investment
pattern is complete without simultaneously increasing the administrative and governance
capacity of the trustees of the provident funds. This in-house capacity creation is required for
monitoring external fund managers -- so that not only investment objectives are satisfied but
also volatility of investment returns is minimised.
Needs/Concerns of Fund Managers
The concept of auction of pension fund managers has been gradually accepted for all the
major provident and pension systems (including Employees Provident Funds, Seamens
Provident Fund and National Pension System). The pension fund managers (PFMs) had bid
aggressively to manage NPS assets and eventually ended up with a low fee of 0.0009 basis
points in the open auction process. This gave rise to the concern about whether PFMs would
be able to provide quality asset management services at such a low fee. However, there has
been a change in the strategy and PFRDA has now decided to appoint PFMs on fit and
proper criteria and the fee of the PFMs has also been increased with the expectation that this
would also spur the PFMs to promote NPS as a long-term savings product.
Needs/Concerns of Economy/Market
There is a symbiotic relationship between the pension market and the financial markets.
While the long-term saving instruments require long-term financial assets for investment, the
economy needs these investors to provide resilience and depth to the financial markets. In
many developed markets, pension assets add up to a large percentage of the countrys GDP
and influence financial market development. In turn, these funds benefit from efficient
execution of investment strategies in deep and liquid financial markets. In many small
economies, their small domestic financial markets are unable to provide scale, volume and
depth to pension funds. India, however, does not face that challenge as our financial markets
can provide safe and sound avenues for pension assets.
Need for review of investment pattern based on NPS performance
To summarise, there is a case to reduce exposure to government securities and allow greater
investment in corporate debt (fixed income) and equities, because:
Government securities yield a low real rate of return in persistently high inflationary
environment.
Corporate debt yields are considerably higher than government yields as observed
from the performance data of the PFMs under NPS.
Corporate debt includes investment in infrastructure debt which is an urgent financing
need that is in alignment with the long-term nature of pension fund liabilities.
Equities provide a risk premium that can be captured over a longer time horizon by
pension funds.

The relatively large mandated portfolio allocation in government bonds creates an
undesirable concentration in the sovereign, yielding a low real rate of return. Allowing an
opportunity for greater investment in corporate debt would not only provide better real
returns but also help deepen the debt markets and contribute to infrastructure financing. Due
to the presence of equity premium, greater investment in equities over the longer horizon
would help maximise pensioners terminal pension wealth.
Let us now look at the history of investment norms in the insurance sector.

INSURANCE SECTOR
The Indian Life Assurance Companies Act, 1912 was the first statutory measure to regulate
life business. In 1928, the Indian Insurance Companies Act was enacted to enable the
Government to collect statistical information about both life and non-life business transacted
in India by Indian and foreign insurers including provident insurance societies. In 1938, with
a view to protecting the interest of the insuring public, the earlier legislation was consolidated
and amended by the Insurance Act, 1938 with comprehensive provisions for effective control
over the activities of insurers. The Insurance Amendment Act of 1950 abolished Principal
Agencies. However, there were a large number of insurance companies and the level of
competition was high. There were also allegations of unfair trade practices. The Government
of India, therefore, decided to nationalise insurance business. An Ordinance was issued
on January 19, 1956, nationalising the life insurance sector and Life Insurance Corporation
came into existence in the same year. The LIC absorbed 154 Indian, 16 non-Indian insurers
as well as 75 provident societies 245 Indian and foreign insurers in all. The LIC had
monopoly till the late 90s when the insurance sector was reopened to the private sector.

The history of general insurance dates back to the Industrial Revolution in the west and the
consequent growth of sea-faring trade and commerce in the 17th century. It came to India as
a legacy of British occupation. In 1907, the Indian Mercantile Insurance Ltd was set up. This
was the first company to transact all classes of general insurance business. The General
Insurance Council, a wing of the Insurance Association of India, was formed in 1957. The
General Insurance Council framed a code of conduct for ensuring fair conduct and sound
business practices. In 1968, the Insurance Act was amended to regulate investments and set
minimum solvency margins. The Tariff Advisory Committee was also set up around that
time. In 1972, with the passing of the General Insurance Business (Nationalisation) Act,
general insurance business was nationalised with effect from January 1, 1973. A total of 107
insurers were amalgamated and grouped into four companies namely, National Insurance
Company Ltd, the New India Assurance Company Ltd, the Oriental Insurance Company Ltd
and the United India Insurance Company Ltd. The General Insurance Corporation of India
was incorporated as a company in 1971 and it commenced business on January 1, 1973.

This millennium has seen insurance come a full circle in a journey extending to nearly 200
years. The process of re-opening of the sector had begun in the early 1990s and the last
decade and more has seen it been opened up substantially. In 1993, the Government set up a
committee under the chairmanship of R.N.Malhotra, former Governor of RBI, to propose
recommendations for reforms in the insurance sector. The objective was to complement the
reforms initiated in the financial sector. The committee submitted its report in 1994 wherein,
among other things, it recommended that the private sector be permitted to enter the
insurance industry. They committee suggested that foreign companies be allowed to enter by
floating Indian companies, preferably a joint venture with Indian partners.

Following the recommendations of the Malhotra Committee report, the Insurance Regulatory
and Development Authority (IRDA) was constituted in 1999 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 include 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 market in
August 2000 with by inviting applications 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. In December, 2000, the subsidiaries of the General Insurance
Corporation of India were restructured as independent companies and at the same time GIC
was converted into a national re-insurer. Parliament passed a bill de-linking the four
subsidiaries from GIC in July, 2002.

Today there are 27 general insurance companies (including the Export Credit Guarantee
Corporation and Agriculture Insurance Corporation of India) and 24 life insurance companies
operating in the country. The insurance sector is a colossal one and is growing at a healthy
rate of 15-20%. Together with banking services, insurance services add about 7% to the
countrys GDP. Since the passage in 1999 of the Insurance Regulatory and Development
Authority Act, which permitted the entry of private and foreign firms into the insurance
sector, the market share of the state-run firms has decreased to 71% (2012-13) for life
insurance and to 56% (2012-13) for non-life insurance. A well-developed and evolved
insurance sector is a boon for economic development as it provides long-term funds for
infrastructure development while simultaneously strengthening the countrys risk-taking
ability.

Chart 1: Insurance company assets as share of GDP*, 2001-10


Source: IRDA, Ministry of Statistics

The nature of the industry requires insurers to generate reserves for claims that might arise
any time in the future; as a result, over time, a large corpus of funds is built up. Thus, it is
important that insurance companies invest these funds judiciously with the combined
objectives of liquidity, maximisation of yield and safety. The returns on investments of life
funds influence the premium rates and bonuses of life insurance business and, eventually, the
buying behaviour of customers. Thus, the rate of return offered by insurance companies has a
direct bearing on the growth rate of insurance industry, especially in a country like India
where persistently high inflationary trends have skewed expectations of yields. Hence, this
endeavour in reforming the investment norms is directly related to the growth and
development of the insurance sector in our country.
Prevailing Investments Norms
The Insurance Industry in India is subject to a complicated set of rules and regulations.
Companies are required to invest minimum amounts in government securities; and
restrictions are put on the amount to be invested in approved investments and other
investments, as per a detailed list that includes specific equities and corporate bonds as well
as bank deposits. Approved investments are in companies that have a strong, multi-year
dividend payment record. Investments that do not fit these criteria are called Other
Investments.
The Insurance Act of 1938 required that the life insurers should hold 55% of their assets in
government securities or other approved securities (Section 27A). In the 1940s, many
insurers were part of financial conglomerates. With a 45% balance to play with, some
insurers used these funds for financing their other enterprises or even for speculation. Based
on the reading of Section 27A of the Insurance Act, 1938, together with the exposure norms
issued by IRDA from time to time, the following can be the summary of the currently
prevailing rules and regulations pertaining to investment norms for insurance companies.
Life insurance. A minimum 25% is to be invested in Central Government securities.
A minimum 50% is to be invested in Central Government and state government
securities (and in securities guaranteed by those entities), and equity investments
cannot exceed 35%. Housing and infrastructure require a minimum 15% investment.
Pension and annuity plans offered by life insurance firms. A minimum of 20% is to
be invested in Central Government securities and a minimum of 40% in Central and
State Government securities (and in securities guaranteed by those entities). Equities
have a cap of 60%.
General insurance. A minimum of 20% is to be invested in Central Government
securities. A minimum of 30% is to be invested in Central Government and State
government securities (and in securities guaranteed by those governments), and equity
investments cannot exceed 55%. Housing and loans to State Governments for housing
and fire-fighting equipment require a minimum of 5% investment and infrastructure
requires a minimum of 10% investment.
ULIPs face fewer restrictions. At least 75% should go to approved investments,
which tend to be liquid stocks with a strong dividend payment record, and not more
than 25% to other investments. Unit-linked policies may be offered only where the
units are linked to categories of asset that are both marketable and easily realisable.

In 1958, the central government issued a notification under Section 43 of the LIC Act, vide
which Section 27A of the Insurance Act, 1938 was made applicable to LIC in terms of: at
least 25% in central govt securities; at least 50% in Central govt. and State govt. securities;
further 25% in social sector (including housing and infrastructure). Further, LIC is allowed to
invest 15% of the life fund in other than approved investments. For the P&GA fund, it is: at
least 20% in central government securities; at least 40% in central government and state
government securities; Balance in approved investments. No investment is permitted in
other than approved investments.
Insurance companies can invest in corporate bonds, including infrastructure bonds, within the
overall cap specified by the regulator. At least 75% of the debt held by life insurance and
general insurance plans must have a sovereign rating or be rated AAA (for long-term
securities) or P1 (for short-term securities). They also cannot own more than 10% of the
equity or debt of a single firm, group of firms or sector. Insurance companies are increasing
their investments in equities, albeit at a glacial pace. Insurance companies have shifted their
equity allocation from 22% of assets in FY06 to 34% in FY11. The rest of their assets are
invested almost entirely in debt instruments, mostly in government bonds. In case of LIC,
which accounts for 71% of the market, there has been a shift into corporate bonds, which
accounted for nearly 20% of assets in FY10 up from 10% in FY06.
Total Investments of the Insurance sector
As on March 31, 2013, the accumulated total investments of the insurance sector stood at Rs
18,60,500 crore, showing a 10.70% increase over the Rs. 16,80,527 crore AUM recorded
during 2011-12. Life insurers continue to contribute a major share of total investments held
by the industry with a share of 93.58% (previous year 94%). Similarly, public sector
companies continue to contribute a major share (79.74%) in total investments, although the
share of AUM held by private sector insurers has also been growing fairly in recent years,
particularly in the backdrop of increase in sales of Unit Linked Insurance Products (ULIPs).
INVESTMENT OF INSURERS
Sector 2000-01 2011-12 2012-13
Life 1,94,009 15,81,259 (11%) 17,41,175 (10.11%)
General 24,462 99,268 (20%) 1,19,325 (20.20%)
Total 2,18,471 16,80,527 (11%) 18,60,500 (10.70%)
Source: IRDA
Investments of Life Insurers
The various sources of funds available for investment by life insurers are classified as (i)
funds from traditional products, and, (ii) funds from ULIP products. The total funds invested
by life insurers as on March 31, 2013, amounted to Rs 17,41,175 crore, compared with
Rs15,81,259 crore in the previous year. Of this, Rs 3,42,507 crore or 19.67% of the total
funds (Rs. 3,69,972 crore or 23.4% in the previous year) were contributed by ULIP funds.
The remaining Rs 13,98,668 crore or 80.33% (Rs. 12,11,287 crore, or 76.60% in previous
year) was contributed by traditional products. The share of ULIP funds in total investments
has decreased in the last year. Thus, during the year the increase in total investments was
contributed entirely by traditional funds as there was a reduction in funds contributed by
ULIP funds.
The pattern of investments made by life insurers as on March 31, 2012, followed the trend of
the previous year. According to IRDAs 2011-12 annual report: Central government
securities and approved investments continued to be the two major avenues of investments by
life insurers. Segregated on the basis of funds, life funds contributed Rs 974,620 crore or
61.64% of the total funds (Rs.8,41,075 crore, 58.81%, in the previous year), pension and
general annuity & group funds Rs 2,36,667 crore at 14.97% (Rs.1,89,927 crore, 13.28%) and
ULIP funds Rs 3,69,972 crore at 23.4% (Rs.3,99,116 crore, 27.91%). Two interesting trends
emerge one, during 2011-12, share of pension/annuity funds increased to 14.97% from
13.28% in the previous year, and two, share of ULIP funds decreased from 27.91% to 23.4%.
TOTAL INVESTMENTS BY LIFE INSURERS: INSTRUMENT WISE
(As on 31
st
March ) ( Rs in Crore )

Pattern Of Investments

2010 2011 2012
Amount Percentage Amount Percentage Amount Percentage
Traditional Products
1. Central Govt
Securities
360447 41.20 420952 40.83 468082 38.64
2. State govt and
other approved
securities
137236 15.69 173733 16.85 214515 17.71
3. Housing &
Infrastructure
85675 9.79 89181 8.65 97320 8.03
4. Approved
Investments
257084 29.38 304977 29.58 385107 31.79
5. Other
Investments
34477 3.94 42159 4.09 46262 3.82
A. Total
(1+2+3+4+5 )
874918 100.00 1031002 100.00 1211287 100.00

ULIP Funds

6. Approved
Investments
311669 92.34 371899 93.18 346340 93.61
7. Other
Investments
25871 7.66 27217 6.82 23632 6.39
B. Total ( 6+7) 337540 100.00 399116 100.00 369972 100.00
Grand Total (A+B) 1212458 1430118 1581259
Source: IRDA
GROWTH OF INVESTMENTS : FUND WISE
( As on 31
st
March ) ( Rs in Crore)
Fund 2010 2011 2012
Total Growth in
%
Total Growth in
%
Total Growth in
%
Life 731291 16.14 841075 15.01 974620 15.88
Pension &
General
Annuity &
Group Fund
143627 26.04 189927 32.24 236667 24.61
Traditional (
A)
874918 17.66 1031002 17.84 1211287 17.49
Unit Linked
Funds ( B)
337540 95.38 399116 18.24 369972 -7.30
Total ( A+B) 1212458 32.31 1430118 17.95 1581259 10.57
Source: IRDA
Investments of Non Life Insurers
Non-life insurers contributed to the extent of only 6.41% (6% in the previous year) of total
investments held by the insurance industry. The total investments of the non-life sector, as on
March 31, 2013, stood at Rs 1,19,325 crore, compared with Rs.99,268 crore in the previous
year, showing a growth of 20.20% growth. The pattern of investments remained the same as
in the previous year. As on March 31, 2012, non-life insurers held Rs 24,241 crore in central
government securities, representing 24.42% of total investments (Rs 19,865 crore, 24.07%, in
the previous year) and Rs 38,563 crore, representing 38.84% of total investments (Rs.31,769
crore, 38.50%) in approved investments.
TOTAL INVESTMENTS OF NON-LIFE INSURERS : INSTRUMENT WISE
(As on 31
st
March )
( Rs in Crore )
Pattern of
Investments
2010 2011 2012
Total % Total % Total %
Central Govt
Securities
16038 24.16 19865 24.07 24241 24.42
State Govt and
other approved
securities
6971 10.50 8191 9.93 9339 9.41
Housing and Loans
to State Govt for
Housing & FFE
4790 7.22 6973 8.45 8179 8.24
Infrastructure
Investments
10373 15.63 12216 14.80 15198 15.31
Approved
Investments
24256 36.55 31769 38.50 38563 38.85
Other Investments 3944 5.94 3506 4.25 3749 3.78
Total 66372 100.00 82520 100.00 99268 100.00
Source: IRDA
Based on the above mentioned prevailing state of affairs in terms of the complicated set of
regulations and the consequent impact they have on the overall growth of the industry we can
now look at the specific key constraints being faced by the life and the general insurance
sector relating to the investment pattern.
What are the issues:
The Life Insurance Sector is very close to the cap of 35% for approved plus other
investment and feels restricted by rules on corporate bonds. A trend analysis of NCDs/bond
issuances during FY12 shows that many large investors such as state-owned LIC -- may
have already touched/breached the IRDA specified cap of 10% of the capital employed in the
case of some issuers. But, more important is the lack of supply (a chicken-and-egg problem).
The corporate bond market is less than 6% of GDP, compared to 140% of GDP in the US.
There is a shortage of long-tenor securities, as most insurance companies would like to invest
in securities with a tenor of 10 years or more but corporate debt currently available are of a
maturity of 2-5 years. Moreover , issue sizes in AA, AA- and A+ categories are fairly
small compared to the overall size of the Indian bond market (together 7.67%) whereas a
large insurer like LIC requires much larger headroom for investment than what is available in
A+ to AA categories. Hence, the space available for investments in Indian bond market
in the context of IRDAs current regulatory framework may not be enough for the larger
players like the Life Insurance Corporation of India. SEBI, RBI and the government need to
resolve the outstanding issues to develop the market and also lower the cost of issuance and
to add liquidity to the market. The imminent entry of foreign pension funds into rupee-
denominated corporate bonds and focus on innovations (such as takeout financing,
securitisation and infrastructure debt funds) is expected to stimulate its development.
In the General Insurance Sector, PSUs as well as private sector non-life companies do not
have a large corpus of funds such as LIC and their business is typically short term, which at
the moment depends a great deal on investment income to overcome underwriting losses.
Such a short term focus -- that too with a predominance of bank fixed deposits -- indicates
risk aversion on their part together with the paucity of adequate human capital to effectively
gauge market sentiments and accordingly invest in riskier but higher return bearing equity
capital. To resolve this predicament, there is a need to ensure that, on one hand, the
infrastructure debt market takes off (due to the credit enhancement schemes of IIFCL, tax
incentives from the Government and encouragement to FII as well as greater clarity in
investment classification by the regulator ) so that the limits can be eased or modified as and
when required while, on the other, necessary human capital is developed in terms of
equipping the sector with the necessary technical skills of financial management in order to
survive and thrive in the riskier environment.
What is required:
Given this state of affairs, there is an urgent need to have reforms on the lines of:
i. Making available sufficient head-room for making investments into AAA and
AA+ sector on a regular basis.
ii. Promoting diversification by having enough fresh institutional borrowers with good,
long-term financial standing. Also, permission to use derivatives (including futures,
options and credit default swaps) to hedge investment risk needs to be provided.
iii. Making available greater avenues for investing in infrastructure projects (which are
long term in nature). For instance, equity investments in infrastructure to be eligible
for the approved investments category, the investee companies need to have a
strong, multi-year dividend payment record. Since infrastructure projects in their
early years tend to have poor credit ratings and are unlikely to have a strong dividend
payment record, these strict conditions eliminate a number of potential investments
opportunities from consideration. There is thus an imminent need for their relaxation.

iv. Regulatory uncertainty has also slowed down sales of pensions and annuities
products, especially after IRDA prescribed a guaranteed return for pension plans,
which was subsequently withdrawn in August 2011. Given the fact that the potential
for growth for such products in India is huge, especially because Indias household
savings rate is high and social security net is almost non-existent, there is an urgent
need to ensure regulatory consistency and cohesiveness.
Thus we can state that, investment by insurance companies and approved pension funds in
India is currently subject to a prescriptive model with a substantial chunk of funds being
channelled into government related investments. This invariably raises questions about the
underlying risk aversion and the consequential ability of funds to earn adequate returns given
their over-dependence on low-yielding government securities.
If we look at Indias high-growth, high-inflation environment, ideally it would be equities
which make more sense than fixed income securities given the higher yield that they
traditionally generate. The optimal investment strategy should therefore be one more similar
to that of the UK where equity has been favoured by institutional investors because
inflation has historically been high than that of, for example, Germany, where inflation has
been low. However for this to happen, there is a need for two opposing forces to balance each
other out a tendency by insurance companies to misinform investors about the cost structure
and a regulatory propensity to micro-manage.
In conclusion it can thus be said that, the time has probably come to re-examine the
prescriptions, as well as the model itself, and see whether greater investment latitude can be
created for new and existing insurers. Such a step would result in an improved rate of return
and the consequential improvement in the low penetration levels and greater flow of funding
to large scale infrastructure projects, many of which are now being undertaken by private
sector. However, simultaneously, funds and fund managers should be required to hone their
skills in portfolio management and stock selection techniques before participating in
corporate debt and equity markets in order to develop the necessary human capital for having
a sustainable growth of the sector.

CHAPTER IV
INTERNATIONAL EXPERIENCE WITH INVESTMENT NORMS

INSURANCE
hereas the activities of the insurance industry are undoubtedly of great benefit to people
and the economy at large, the consequences of insurance companies failing to meet their
contractual obligations are extremely serious and far-reaching. In the 19
th
century, fraud and
mismanagement led to frequent failures of insurance companies with serious consequences for
policyholders and adverse effects on the reputation of the industry. Even so, it was not until the
middle of the 20
th
century that the need for regulations to protect policyholders was recognised
across geographies. The Insurance Companies Act (1982) of UK (which consolidated the
earlier 1974 Act) brought in minimum solvency margins and defined eligibility for an insurer to
be licensed to transact business in the UK. The guiding principle of the legislations was to
ensure that only fit and proper persons be allowed to undertake insurance business so that
eventually a strong insurance market can be developed and built.

The history of economic development indicates that there is a direct co-relation between the
national prosperity and the degree of development in the insurance and pension sectors. The
City of London Corporation report outlines that, insurance assets in the UK grew
exponentially from 20 per cent of GDP in 1980 up to 100 per cent of GDP and have since
stabilised at that level in the past one decade. The trend of growing insurance and pension
sectors seems universal, but there are numer ous factors that influence its size. In the US,
the insurance sector seems to have stabilised at around 40 per cent of GDP and in Germany
at 60 per cent. Even though insurance penetration is relatively low in southern European
countries, it is expected to grow as greater fissures appear on the versatile social safety net.

In line with the trend, Indian insurance sector has also grown rapidly during the past decade
post liberalisation. Assets of life insurance companies, as a share of GDP, increased from
9.6 per cent in 2001 to 16.1 per cent in 2010. However, the Indian insurance sector is still
W
S.
No
Parameter U.K U.S Comments
Insurance
Company
Pension
Fund
Insurance
Company
Pension
Fund
1 Regulations Relaxation with respect
to investment abroad
and derivatives
Relaxation led to shift
in equities
Risk control via
Hedging -- Riskier
assets become
attractive
2 Asset-
Liability
matching
Bonds -- inappropriate match for liabilities due to
exposure to inflation risk
Equities -- move in line with nominal wages thus
better
Equities help
counter inflation
risk
3 Assets
Supply
Development of Corporate Bond Market requires-
greater demand and supply
Role for
institutional
investors &
Companies
4 Macro
Economic
conditions
[High inflation: Equity preferred over fixed income
product] + [ Large Govt. deficit: Govt. bonds give
higher returns]
State of economy
also determines
attractiveness of
investment choice
5 Competition Greater Competition - need to have greater returns
by investing in riskier assets

small in comparison to that of most developed economies, notwithstanding absence of a
meaningful social safety net. The potential for growth in India is therefore huge, especially
because of declining dependency ratio and growth potential of household savings.

Further, according to the report prepared by the City of London, investment patterns are
driven by certain country-specific factors, of which five are most relevant namely,
regulations, asset-liability matching, supply of assets, macro economic conditions and
competition. According to this report, the relatively liberal position of the countries (that of
U.K and U.S is summarised below) on these 5 factors determines the extent to which the
insurance and pension Sector succeed in their role as institutional investors.

The report concludes that, driven by the liberal position on the above mentioned 5 key
elements, much of the financial wealth of UK and US households was in insurance
companies and pension funds and these institutions have invested actively in equities and
corporate bonds, which in turn helped to develop and establish liquid and sophisticated
financial markets with reduced volatility. It can thus be surmised that investment norms
cannot be visualised in a vacuum, rather a holistic view of the prevailing macroeconomic
scenario in the country as well as the world has to be taken into account; in addition, a freer
approach to investing helps develop the financial markets.

A similar analysis on China shows that insurance companies there have diversified their
investment mandates over time to include bonds, mutual funds, equities and
infrastructure. Bank deposits have gradually declined from 53 per cent of total invested assets
in 2001 to 30 per cent in 2010. Bonds have become a much more important asset class, and
comprised half of total investment in 2010. But conservative investment norms are still
predominant. Equity investment has stabilised at around 11 per cent of total investment after
shooting up to 18 per cent in the bull market of 2007 and subsequently collapsing in 2008
owing to the global financial crisis. Investment in securities investment funds has remained
flat at around 6-7 per cent. The various limits as existing currently in China are as follows:

S. No Investment Head Insurance
1 Guaranteed Corp. Bonds (A or above rating) No limit
2 Non guaranteed Corp. bonds (AA or above) Not more than 20%
3 Stocks and Securities Investment Funds (SIFs) Not more than 25%
4 Overseas stock markets Not more than 15%
5 Private equity Not more than 5%
6 Real estate, excluding residential properties Not more than 10%
7 Infrastructure Not More than 10%

The Chinese market also highlights a risk averse investment style by way of a conservative
investment pattern and the consequent lower returns. This risk aversion is not purely
cultural, but also related to the short history of liberal regulation, the lack of investment
management skills, as well as the indelible shadow of past investment failures. Many life
insurance companies lobbied the China Insurance Regulatory Commission (CIRC) in 2007
to relax its controls over stock market investment and aggressively bought shares during the
bull market, but they took a massive hit in the 2008 collapse. This experience helps to
explain why no insurance company dramatically increased its equity position when
regulations were loosened in 2010.

How does this compare with India?
Indias current position on the above mentioned five key parameters shows that insurance
companies have increased their involvement in both equities and corporate bonds in recent
times. They currently hold the equivalent of 11 per cent of free-float market
capitalization, but compared with the US and the UK, their participation is still low. The
reason is Indias regulations are still quite restrictive, in comparison with most developed
countries where either no limits exist or investment limits for equity and corporate bonds are
quite high. The following table provides a snapshot of the Indian limits:

S. No Investment Head Life Insurance General Insurance
1 C.G. Security Min 25% Min 20%
2 C.G + S.G Security Min 50% Min 30%
3 Equity Max 35% Max 55%
4 Housing & Infrastructure Min 15% Min 5% + Min 10%
5 Derivatives/foreign assets Not Permitted to Invest
6 Corporate Bonds(infra bonds also)
Only AA or higher(Min 75% Debt be
AAA/Sovereign rated)
7
Equity/Debt of single
firm/group/sector Not More than 10%


The move to ULIPs however, creates a more liberal investment climate and is a step in the
right direction. For ULIPs at least 75 per cent should go to approved investments, which
tend to be very liquid stocks with a strong dividend payment record, and not more
than 25 per cent to other investments.

The holdings of government securities by life insurance funds have been consistently
higher than the minimum 50 per cent threshold set by the regulator. This demonstrates two
obvious trends: one, life insurance companies are risk averse and, two, low availability of
good-quality corporate bonds. The life insurance sector is very close to the cap of 35 per
cent for approved plus other investment and feels restricted by rules on corporate bonds,
but more important is the lack of supply (a chicken-and-egg problem). Permission to use
derivatives (including futures, options and credit default swaps) to hedge investment risk is
also required. Further, for equity investments in infrastructure to be eligible for the
approved investments category, investee companies need to have a strong, multi-year
dividend payment record. Since infrastructure projects in their early years tend to have poor
credit ratings and are unlikely to have a strong dividend payment record, these strict
conditions eliminate a number of potential investments from consideration.

Inadequate supply of non-governmental debt instruments is the principal constraint on
the bond investment strategies of insurance companies. The corporate bond market is less
than 6 per cent of GDP, compared to 140 per cent of GDP in the US. There is also a
shortage of long-tenor securities, as most insurance companies would like to invest in
securities with a tenor of 10 years or more but corporate debt currently available are of a
maturity of 2-5 years. SEBI, RBI and the government need to resolve the outstanding issues
to develop the market and also lower the cost of issuance and to add liquidity to the market.
The imminent entry of foreign pension funds into rupee-denominated corporate bonds and
focus on innovations (such as takeout financing, securitisation and infrastructure debt
funds) is expected stimulate its development.

Indias high-growth, high-inflation environment makes equities more attractive than fixed
income securities. The optimal investment strategy would therefore be one more similar to
that of the UK where equity has been favoured by institutional investors because
inflation has historically been high than that of, for example, Germany, where inflation
has been low. In fact, regulatory intent in the mature economies to liberate insurance and
pension fund managers from a directed investment regime has helped them deliver positive
real rate returns, something that has eluded Indian investors.

This explains the enormous popularity of ULIPs and points to continued growth of demand
for such instruments, provided two opposing forces can manage to balance each other out
a tendency by insurance companies to misinform investors about the cost structure and a
regulatory propensity to micro-manage. The yield on 10-year government bonds is
currently 8.3 per cent, lower than the current inflation rate of 9.2 per cent. If
insurance companies and pension funds want to offer a decent real return to savers, they
will have to venture into higher-yielding securities. For instance, the below mentioned
analysis depicts that as we move from AAA rated corporate securities to the consequent
lower rated securities the average yield to maturity (YTM) goes on increasing at an
exponential rate and is also higher than the YTM on G-Sec for similar maturity profiles.



Presence of Equity Risk Premium in India
In the equity risk premium study by Varma and Barua
3
, the equity risk premium, defined as
the excess return of the stock markets over the risk free rate, has been estimated for the Indian
capital markets. BSE Sensex was used to derive the stock market index by narrowing the
stock universe to highly traded stocks, adjustment for self-selection bias, removal of the
outliers, incorporation of dividend and a weighted adjustment for revision of the Sensex in
1996. During the pre-reform period, the risk-free rate was determined based on estimates of
financial repression using the call market rate, real interest rates pre and post-deregulation
and a comparison of the US and Indian interest rates. From 1995 onwards, the risk-free rate
was estimated as the yield on the 1 year T-Bill. Linear interpolation was used to determine
the risk free rate from 1992 to 1995.
The risk premium in India from 1981 to 2006 has been estimated on a geometric mean basis
at 8.74% (Varma and Barua). The study has found that there has not been a significant
difference in the equity risk premium between the pre-reform (8.96% from 1981-1991) and
post-reform period (8.58% from 1991-2006). However, the volatility in returns has been
found to increase from 20% to 25% between the pre-reform and post-reform periods.
In a different study
4
, the equity risk premium has been estimated for various countries for
long historical periods. In the US, the risk premium (excess of the real market return over the
risk free rate) has been estimated at 7% for the period of 1947 to 2000. Similarly in other
countries, the equity risk premium has been estimated using the similar methodology -- stock
market return over the risk free rate (treasury bill rate).

Country Time Period
Equity Risk
Premium
United States (1947-2000) 7.00%
United Kingdom (1947-1999) 4.60%
Japan (1970-1999) 3.30%
Germany (1978-1997) 6.60%
France (1973-1998) 6.30%
Sweden (1919-2003) 5.50%
Australia (1900-2000) 8.70%

It is noteworthy that taken together, the United States, the United Kingdom, Japan, Germany,
and France accounted for more than 85% of capitalised global equity value at the time of the
study in 2006. In the same study, the question of why there exists such as a large equity risk
premium has been examined. While modern portfolio theory and the standard model for
estimating the value of marginal utility to the investor of the excess stock returns during good
and bad states of the economy do not seem to fully explain why such a large equity premium

3
A First Cut Estimate of the Equity Risk Premium in India: Jayanth R Varma & Samir K Barua; IIM Working
Paper Number 2006-06-04, June 2006, http://www.iimahd.ernet.in/~jrvarma/papers/WP2006-06-04.pdf
4
The Equity Premium: A Puzzle; Rajnish Mehra & Edward C Prescott;
http://www.artsci.wustl.edu/~cedec/azariadis/teaching/e589Sp08/papers/MehraPrescott_jme85.pdf
exists, it is widely held by most economists that the equity premium that has been discovered
in the historical data across countries is statistically significant.

Similarly the following two tables highlight the favourable impact that any reduction in the
mandated investment in government securities and the consequent increase in
equity/corporate bonds can have on the return from a portfolio of, say, Rs 1000 crore.


If the exposure limits are relaxed the returns may show significant improvement. This is
illustrated in the following table.

PENSIONS
Performance of the National Pension System
or NPS, computing the weighted average of returns of each scheme under different fund
managers would be necessary in order to keep track of the overall performance of the
funds under management. The NPS corpus is broken up based on source of funds of
pensioners Central Government (CG), State Government (SG), Private Sector (Tier I and
II) and NPS Lite (unorganised sector via aggregators).
NPS CG, SG and NPS Lite corpus funds are invested under Ministry of Finance guidelines.
Overall, the NPS CG corpus has witnessed a healthy return (CAGR since inception in April
2008) of 9.95% (average return of the three PFMs) in spite of global economic downturns
which adversely affected capital markets. The reasons commonly adduced for the
comparatively improved returns so far have been: (i) Ministry of Finance guidelines which
permit low exposure to equity and higher exposure to G-secs and domestic fixed income
securities, and, (ii) steady cash flows received from Central Government employees.
The NPS SG corpus has a return (CAGR since inception in June 2009) of 9.62% (average
return of the three PFMs) which is relatively low compared to the NPS CG corpus in spite of
its management by the same PFMs and coming under the same guidelines of the Ministry of
Finance. This could possibly be due to (i) investments in different instruments within each
category due to size of corpus (ii) lack of a steady source of fund inflow from state
government employees. It might, therefore, be necessary to investigate the reason behind
unsteady cash flows and how to streamline them. Also, by pooling funds with similar cash
flow streams, NPS fund managers can extract greater bargaining power and cooperative
bidding for instruments, or achieving economies of scale in investments where possible.
Despite relatively unsteady cash flows of the unorganised sector, NPS Lite has performed
well with a healthy return of 11.61% (CAGR since inception in October 2010, average return
of the same three PFMs) due to the Ministry of Finance guidelines. A closer look and attempt
to stabilise the cash flows received from aggregators, especially those serving the
unorganised sector with more predictable sources of income, could possibly help contribute
to improving investment returns for the vulnerable sector of the society participating in the
co-contributory Swavalamban Scheme.
NPS Private has a segregated fund allocation strategy for private sector C (Fixed Income
and Money Market), G (Government Securities) and E (Equity). While an individuals return
depends on his asset allocation preference, the performance of the entire corpus under the
Private Sector can be computed based on a weighted average. A computation of weighted
average return of funds under NPS Private (Tier I and Tier II) vis--vis the return on NPS
funds of the Central and State Government employees as well as NPS Lite would help
measure and compare the performance of funds with and without investment limits.
The movement towards greater efficiency and sophistication in markets calls for a greater
adoption of the modern portfolio theory which is based on the efficient market hypothesis.
While some of the assumptions of the efficient market hypothesis -- such as normally
distributed asset returns, fixed correlation between assets, rational and risk-averse investors,
symmetry of information, lack of transaction costs and taxes -- do not exactly hold true even
in sophisticated and well-developed financial markets, the degree to which the modern
F
portfolio theory is applicable is dependent on the degree to which these assumptions can be
approximated as true.
As per the European Journal of Economic and Finance, several factors may be
contributing to inefficiency in Indian markets (Mishra et al). Inflationary pressures in India
are bound to lead to periods of high interest rate regimes. During such periods, while the
coupon rates on debt securities both corporate and government are expected to be higher,
the high inflationary environment would imply a low real rate of return on the debt securities.
However, three facts remain that are applicable and should be considered for investment of
pension funds:
(i) The contributions to the NPS pension funds (except in the case of NPS Tier II) are all
long- term.
(ii) The equity markets in India are robust and well-developed.
(i) There exists an equity risk premium in the Indian stock markets over the longer
horizon.
Basis and rationale for regulation of pension portfolios
Financial sector customers in countries which have introduced mandatory, funded, defined
contribution based pension systems often had little experience of investing in the financial
market. Besides this, financial services industries were rarely well developed. There is an
apprehension in the minds of the pension sector regulators and governments that the lack of
experience of investment and risk management might lead to poor portfolio choices. The
risks of investing in emerging economies can take many forms -- capital markets can be
weak, lacking both liquidity and transparency.
Countries with more developed financial markets, where the population has more investment
experience, may require only a light regulatory regime. The preponderance of individual and
voluntary retirement savings also put a less onerous responsibility on the government and
pension regulators than mandatory pensions, again suggesting less need for strict regulation
of pension fund investments.
International Experience of Portfolio Limits
Prudent person rules are more common for pension fund members in most OECD countries
(2011 Survey of Investment Regulations of Pension Funds, Organisation for Economic
Cooperation and Development) except in some countries. Governments and pension
regulators in OECD impose few rules on pension funds asset allocation (beyond some basic
prudential restrictions, such as concentration of holdings or prohibition of related party
transactions).
The second type of restriction imposed on pension fund managers is the embargo on
investing in foreign assets. The economic logic is that the pension fund liabilities are
domestic and so, by investing at home, assets and liabilities are denominated in the same
currency. Investing overseas, in contrast, involves exchange rate risk. Although hedging
against currency movements is possible and the products to achieve this are available in the
market, there is a cost element involved; further, the complex financial instruments that
hedging involves have been known to adversely affect even sophisticated investors.
Relationship between asset allocation and pension fund returns
The main concern about allowing portfolios with small equity holdings is that while equity
has historically generated a higher rate of return than bonds, these returns are more volatile
than bond yields. But pension and insurance funds are long-term investors and there is a
possibility that much of volatility is smoothened out over a long investment period. Further,
any shortfall in funds returns is very important for the value of the terminal wealth.
The impact of investment restrictions on returns is that pension funds in countries with
relatively liberal investment regimes earn more compared to the countries that restrict asset
allocations. Or, in other words, returns in countries where pension funds have sizeable
investments in equity have been higher than countries where bonds dominate portfolios.
Portfolio limits could, therefore, have a high cost in terms of reduced benefits for subscribers
of pension and insurance funds.
One objective of transition towards a funded pension system is to increase an individuals
responsibility for his or her own retirement income planning, based on self-effort. The ability
to choose a pension fund manager is an important factor for increasing competition between
funds in both service and performance. Stipulation of portfolio limits, along with regulation
of industry structure and fund returns, significantly reduces individual choice. These rules
interacted to produce almost identical pension fund portfolios and performance in Latin
America (the so-called herding behaviour). The trends are evident in the investment
patterns of insurance companies and pension funds.
Portfolio Limits Are these important in India?
A pension scheme may be funded that is, there exists a savings corpus from which pension
is paid. Alternatively, it may be a pay-as-you-go scheme, where taxes of current generation of
workers pay for the pension of current pensioners and there is no stock of savings to invest.
The goal of any funded pension scheme should be to maximise return on investment of
pension funds under management in order to provide adequate pension to the pensioners. A
1% increase in annual returns increases the terminal pension wealth for a full 40-year lifetime
of contributions by 20-30%.
For a funded defined benefit (DB) pension scheme, the pension outgo is a defined formula,
dependent on factors such as average wage and number of years of service. There does exist a
corpus of savings which must be invested with the goal of maximising return. The specific
investment objectives would have to be defined based on the existing size of the corpus fund
as well as the pension obligations of the fund. Reducing the volatility of returns may not be
the priority. Also, any shortfall in the returns of the fund would have to be borne by the
employer providing the pension benefit.
On the other hand, a defined contribution (DC) scheme (such as, the NPS), which maintains
individual retirement accounts of pensioners who bear the investment risk, must not only
maximise pension wealth, but also ensure that returns are relatively smoothened, or the
volatility of returns is minimised. It is, therefore, not surprising to notice that several
countries, developed and emerging, which run both DB and DC schemes as separate pillars of
social security, have different investment pattern requirements for their schemes.
The above international experiences indicate the following:
A defined contribution scheme in which a pensioner bears the investment risk requires
more prudent investment regulations as the goal is to maximise pension wealth as
well as smoothen returns by reducing volatility to assuage any concerns about the
NAV reported.
A voluntary defined contribution scheme would have to provide greater freedom to
the pensioner to decide his investment exposure based on risk appetite. A mandatory
DC scheme could, on the other hand, be more prescriptive in terms of investment
norms.
The above observations also hold true for the investment limits of the NPS. The NPS for
central government employees and state government employees, both mandatory schemes,
prescribe investment limits for the pension funds under management. Since they are co-
contributory schemes, there is an alignment of interest between the pensioner and the
government to maximise terminal pension wealth. NPS for the private sector, a voluntary
scheme, provides flexibility to the investor to decide his investment portfolio based on risk
appetite. However, for those employed in the unorganised sector, without sufficient
awareness of financial investments, there is a default investment portfolio balancing
mechanism which incorporates the goal of maximising terminal pension wealth while
mitigating the risk of dispersion in returns.
An important reason for the existence of investment limits for mandatory pension schemes is
the information asymmetry between the various stakeholdersthis is most obvious, for
example, in the case between fund managers and subscribers to NPS Lite scheme for the
unorganised sector. It could also be the case that there exists a knowledge gap between the
pension fund managers and the board of trustees of other pension and provident fund
schemes. The above are examples of the principal-agent problem, which serves as a
deterrent to applying the prudent person rule in the current Indian framework.
Rationale for Stipulating Investment Limits:
Pensions
Investment rules in mandatory funded schemes are globally structured such that most
countries, which follow mandatorily provided defined contribution pension schemes usually
impose explicit investment limits. Such limits can take several forms including asset class
limits, issuer limits and concentration limits. While in many OECD countries pension funds
are required to follow the prudent man rule -- that is, assets should be invested in a manner
that would be approved by a prudent investor -- there are some quantitative restrictions based
on minimum diversification requirement (in terms of investment instruments), self
investment/conflict of interests, other quantitative rules and ownership concentration limits
(which seeks to minimise exposure risk by restricting a funds investment to each company
beyond a certain limit). On the other hand, while no emerging market economy follows the
prudent person rule, but instead follows directed investment approach, some countries do
allow a high proportion of their portfolio in stocks.
The asset limits are usually justified from three public policy objectives:
(i) There is an unstated desire to limit the dispersion of outcomes (in terms of terminal
pension wealth) for equivalent workers. In some jurisdictions, this is reflected into a
policy response of a relative return guarantee;
(ii) There is a desire to limit the downside risk even if it compromises average return;
(iii) There may be a moral hazard when a minimum pension guarantee exists and the
absence of investment limits would encourage an investor to choose a riskier
portfolio.
The prudent person approach does not address these issues and in any case its effective
application requires a robust legal system and well-developed institutional capacity at the
level of trustees of the pension funds. In most emerging market countries, that seems to be
absent. On the other hand, placing limits on the overall risk level of the portfolio would
address the three concerns.
The risk-return trade off that underlies the entire financial management is at work here as
well. For, as we move from predominantly risk-free government securities to risk-prone
securities like equity, the return is seen to be increasing but commensurate with the risk.
However, shift to prudent person approach warrants ability of the capital markets to facilitate
investing. Let us look at the state of the Indian capital market. According to the Financial
Development Report 2011 of the World Economic Forum, the characteristics of capital
markets in India in 2011 were still at a nascent stage in certain categories, such as corporate
bonds.
Market State Global Rank
(on 60)
Metric Vis--vis
Foreign
Exchange
Markets
Robust 14 (spot)

% share of global
foreign exchange spot
turnover*:
India: 0.74 (spot)
UK: 38.5 (spot)
US: 26.1 (spot)
Foreign
Exchange
Derivatives
Robust 14 (outward
forward)
13 (options)
% share of global
foreign exchange
derivatives turnover*:
0.89 (outward
forward)
0.54 (options)
UK: 41.3 (outward
forward)
US: 21 (outward
forward)
UK: 55.3(options)
US: 16.14 (options)
Government
Securities (G-
Sec) Market
Robust, large
share of the
debt market
19

G-Secs as % of GDP:
Domestic: 37.3%
International: ~0%
(No external holders of
Government Debt)
Domestic
US: 70% of GDP
UK: 56% of GDP
International:
US: 0.08% of GDP
UK: 3.3% of GDP
Private
(Corporate Debt)
Market
Underdevelop
ed
32 Financial Institution
(FI) /Corporate Debt as
% of GDP:
Domestic: 5.6%
International: 3.15%
Domestic
US: 101% of GDP
UK: 15% of GDP
International
US: 47% of GDP
UK: 137% of GDP
Interest Rate
Derivatives
Robust 13 (Options)
21(Swaps)
% share of OTC
turnover
0.51 (Options)
0.14 (Swaps)
UK: 45.3 (swaps)
US: 18.9 (swaps)
UK: 50.4(options)
US: 28.4 (options)
Equities Market Well
Developed
4 (Market cap)
16 (Trading
value/GDP)
Value of listed shares
(market cap) as % of
GDP: 278%
Value traded as % of
GDP: 170%
US
Stock market cap:
152% of GDP
Value traded: 350%
of GDP
* turnover = trading volume as % of market cap Source: Financial Development Report, 2011

Thus, although at an overall level the Indian financial markets are robust and well-developed.
The development is non-uniform and skewed across various segments, with a very well
developed equity market (market cap at 278% of GDP), a robust G-sec market (market cap at
37.3% of GDP) and an underdeveloped corporate debt market (market cap at 5.6% of GDP).
This skewed development of capital markets, combined with weaknesses in institutional and
business environment and low financial access, implies the need for prudent regulation of
investment assets under management in general.
Thus a movement towards liberalisation, beneficial from returns point of view, has to be
embedded in the overall framework of the prevailing state of economy (for instance the fiscal
deficit and its impact on driving out private investment); availability of expertise to
effectively manage funds; corporate governance and also things like creativity and innovation
of the MSME sector to use funds for generating disproportionate gains for the nation. Thus
the word Prudent has to be the guiding mantra for an investor in India and such a
movement should also be in phases accompanied by capacity building.
The asset constraints do have important effects on the funds asset allocations and hence on
the development of local securities market. A comparison of the mature and emerging
markets indicates that because of these asset restrictions the mature markets hold a
predominant proportion of pension assets in equities, whereas emerging market pension funds
hold smaller shares of their portfolio in stocks. In short, emerging markets pension funds
have relatively larger holding of domestic bonds and smaller allocation in equities and
foreign securities than most mature market pension funds. Thus, an important policy issue is
whether the emerging market economy should gradually liberalise some of the investment
restrictions and how much weight should be given to the development of local securities
market in formulating pension fund regulations.
The portfolio regulations on equity holdings in most countries undertaking pension reforms
appear not to be too restrictive and the relatively large portfolio allocation in government
bonds could be construed to be a natural outcome of the early stages of such a reform
process. However, it creates an undesirable concentration of assets in one category of
financial instruments. There is a case for not only increasing investment limits for corporate
bonds in the investment guidelines for pension funds, but also relaxing the credit rating
eligibility norms for such bonds in the mandated guidelines. However, stringent requirements
on minimum acceptable ratings for corporate bonds could also be relaxed gradually and
prudently, if only to allow for investment in infrastructure projects. This relaxation should
happen concurrently with the creation of adequate support systems providing credit
guarantees and credit enhancement.
Pension fund assets under management (AUM) have been growing at a rapid pace in the
mature markets as well as in the emerging markets that have implemented pension reforms.
There could be an imbalance between the demand (from pension funds) and supply in the
local securities market which may cause significant distortions in asset pricing, concentration
of exposures and price bubbles. This calls for constant and coordinated efforts to improve the
regulatory frameworks for both pension funds and securities market. Considering the
diversification argument, the limits on equity holdings and corporate bonds could be
gradually relaxed as the local asset managers become used to risk management techniques.
The gradual relaxation of portfolio limits to investment in bonds and shares (both domestic
and offshore), perhaps through diversified mutual funds, is likely to improve pension fund
diversification opportunities and financial market stability. In case of offshore investments,
since it amounts to relaxation of control over capital outflows, the macro-economic
consequences of such measures have to be carefully considered. However, for the time being,
in view of the prohibition on offshore investments by pension funds in the Pension Fund
Regulatory and Development Authority Bill, 2011, the offshore investments are not being
considered. In view of this, the gradual liberalisation of investment instruments attempted in
January 2005 by the Ministry of Finance (which permitted equity investment for the first
time) needs to be continued.
Finally, it has already been discussed that the skewed development of financial markets in
India would put some inherent restrictions for liberalised investment framework. To sum up,
the pension funds in India, especially the defined contribution scheme of the NPS, would
require prudent investment limits with the intention of maximising shareholder wealth while
reducing the volatility of returns. Also, the presence of individual retirement accounts
requires consistency of investment performance without large dispersion between returns of
individual pensioners.
Why exposure limits are necessary for Insurance and Pension Funds in India
The efficient market hypothesis, which states that markets carry information of prices, can be
expected to hold to a certain extent in uniform, transparent and well-developed financial
markets. In India, however, empirical studies have provided evidence of growing market size
and liquidity but also greater volatility and inefficient capital markets. As discussed above,
the non-uniform development of capital markets, weaknesses in institutional and business
environment and low financial access leaves room for inefficiencies across markets. The
disaggregated structure of supervision of financial services and markets also leaves room for
regulatory arbitrage.
The combined effect of the abovementioned factors could have two implications (i) the
risk-return trade-off may not always hold true, and (ii) there could be existence of alpha or
excess returns due to mispricing of financial instruments. Stock markets in emerging
economies, such as, India are therefore characterised by higher returns coupled with higher
volatility, but their Sharpe ratios (excess return over the risk free rate/volatility) need not be
higher compared to developed economies.
Correlation between funds tenor/nature of cash flows and existence of investment limits
Insurance and pension funds are characterised by longer term funds with more stable and
predictable cash flows. They represent large pools of long-term household savings and
therefore require a more predictable rate of return for policyholders and pension savers. In
Indian markets, with risk-return mispricing and existence of alpha or excess returns,
insurance and pension funds would require prudent investment limits to ensure there is a
predictable rate of return on investments. The exposure limits for long term investors can be
tweaked and eventually relaxed as the markets evolve with short term investors acting as
drivers of market efficiency. The beneficial impact of declining interest rates as anticipated
in the future -- on fixed income securities is likely to increase the gap in the rate of returns
between equity and bonds.
G-Secs are stable and low risk but provide a low real rate of return
While Government securities are low risk and safe instruments, there could be a case for
lowering the minimum requirement limits of G-Sec investments for the following reasons:
Persistent inflationary pressures in India translate into a low real rate of return on G-
sec investments.
High minimum exposure investment limits in G-secs may be contributing to the
chicken-and-egg problem of the underdeveloped domestic debt market.
Lowering investment limit requirements on G-secs may also serve as an indication of
the governments intention to rein in fiscal deficit by reducing borrowing.
Chicken-and-Egg Problem of the Corporate Debt Market
The second point above can also be observed by a comparison of the debt funds raised on the
primary market and turnover on the secondary market.

Amt raised (Rs mn)
(%)
Turnover (Volume traded)
(%)
Primary Market Secondary Market
2009-10 2010-11 2009-10 2010-11
Government
6,236,190
(76%)
5,835,210
(75%)
84,337,567
(98%)
70,682,541
(97.8%)
Corporate/Non-Government
1,919,902
(24%)
2,016,763
(25%)
1,442,484
(2%)
1,591,623
(2.2%)

Total 8,156,092 7,851,973 85,780,050 72,274,164
Source: NSE Indian Securities Market Review 2011

Funds raised in the primary bond market during 2012 were split in the ratio of 3:1 for G-secs
and corporate bonds, respectively. The turnover (volume traded) in the secondary market is
almost entirely from G-secs. This implies that there is lack of sufficient depth and liquidity
for corporate bonds when compared with G-secs. Depth in the corporate bond market could
be achieved by means of more product innovation and securitisation under an appropriate risk
mitigation framework. Liquidity in the corporate debt market can be improved by an increase
in trading across the yield curve. However, trading may not pick up under low liquidity
conditions leading to a typical chicken-and-egg problem. Tweaking limits to improve the
liquidity can be done by either (i) reducing the minimum investment limits of G-secs and
increasing the minimum limits of corporate debt securities or (ii) increasing maximum limits
of corporate debt securities where applicable keeping the limits on G-secs unchanged.
Equity Markets
Emerging economies such as India are characterised by equity markets with high returns and
high volatility. Since insurance and pension fund managers seek to maximise long-term
returns and are less concerned about short-term volatility, the Indian equity markets are good
avenues for investment. Having said that, there is a strong case for risk mitigation via equity
derivatives even for long term funds to smoothen out returns and avoid excess loss of NAV
during economic downturns.
Case for more Dynamic Asset Allocation strategies for Insurance and Pension Funds
Typically, long term investors use fundamental analysis of securities for more tactical and
passive asset allocation strategies. This may be expected to work in efficient markets.
However, greater inefficiencies imply that long term investors who do not dynamically
balance their portfolios may be (i) foregoing opportunities of alpha and leaving excess
returns on the table, or, (ii) booking excess losses due to economic downturns, market
sentiments or inefficiencies. Therefore, while broad investment limits are necessary for long
term funds, there is no reason why certain investment categories with high volatility, such as
equity, should not adopt a more dynamic portfolio allocation strategy by utilising derivatives
to hedge risk. More dynamic strategies for interest-rate hedging can be used in the fixed
income markets as well. Active hedging combined with tactical asset allocation based on
fundamental analysis would allow long-term fund managers to mitigate risk during market
downturns and maximise the wealth of pensioners within each investment category while
adhering to the overall investment exposure limits.
Role of Pension Fund and Insurance Companies in the Development of Financial
Markets:
mpirical research suggests that pension funds and insurance companies have over time
helped the development of the financial markets in matures economies. Their large size
investments in debt of various maturities along with hedging of interest rate risk with fixed
income derivatives have helped in building robust debt markets. Huge allocations of
investible resources to equities coupled with their initiatives of minimising the risks of the
investment and its return via equity derivatives have helped in improving the micro-structure
of also the equity markets. Arguably, its their sheer size and their capacity to hold securities
over a long period, along with their active portfolio management, that provided size, depth
and liquidity to the financial markets. The directed investment regime in India has provided
very little space for the insurance companies and provident funds to help develop the
financial market, especially the debt market.

Meeting nations financing requirements provided there is an alignment of interests
Developing countries may have certain financing requirements in sectors such as
infrastructure that can be met by long term institutional investors, such as insurance and
pension funds due to the matching of supply and demand for long term funds. The Twelfth
Five Year Plan has identified infrastructure as a crucial driver of sustainable economic
growth. India has huge financing needs as $1 trillion of infrastructure projects are planned
during the period 2012-17.
As has happened in developed markets, a more mature insurance and pension system could
help in meeting these needs by channelling more savings into productive investments
through the stock and corporate bond markets. The greater involvement of insurance
companies and pension funds will also contribute to reducing the volatility of the stock
market, as they bring stable pools of capital interested in long-term positions instead of
speculative trades. They provide the much needed heterogeneity to the markets which have
otherwise usually been characterised by players with the similar time horizons.

Thus, regulations should be liberalised to encourage greater participation of pension funds
and insurance companies in capital markets. Further, restrictions on corporate bond issuance
should be removed in order to boost supply and promote the growth of the market.

The Government has taken several initiatives to encourage investment in the sector by
increasing the limit on purchase of tax-free infrastructure bonds, setting up infrastructure
E
debt funds to tap overseas insurance and pension markets, raising the FII limit on long term
infrastructure bonds, extending the scope of the viability gap funding scheme to include
agricultural infrastructure, oil and gas storage and fixed network telecommunication sectors
as well as establishing a harmonised master list of infrastructure sectors.

However, the lack of adequate opportunities for infrastructure investment, other than directly
acquiring equity stake, poses a problem. One of the reasons for the lack of development of
infrastructure financing debt markets has been the credit rating of the debt raised for
infrastructure projects. Typically, the infrastructure project developer creates a special
purpose vehicle (SPV) which serves as a mechanism to raise debt. Since infrastructure
projects are capital intensive and have a long gestation period requiring several years for
cash inflows to stabilise, credit rating agencies assign BBB rating to the infrastructure debt
raised via the SPV. However, debt rated below AA is generally not picked up by insurance
and pension funds in India or foreign investors.

To summarise, while there is a need to further relax the investment pattern. However, abrupt
abandonment of prescriptive investment pattern may not be desirable. Hence a sequenced
approach may be pursued.





CHAPTER V
WHY CHANGE NOW?

This chapter reviews the ground conditions and the reasons that are forcing the need to
think about changing the investment norms now.
he investment norms currently in force seem to have stood the system in good stead.
They have, unarguably, managed to meet their primary objective of shielding long
term savings from the menacing shadow of risk, especially in the realm of insurance
and pension. So, what has changed that requires us to even contemplate overhauling the
extant system? This chapter will examine some of the reasons why there seems to be a
compelling need now to re-examine the entire framework and identify where the tectonic
plates have shifted.
As mentioned in Chapter-I, one of the pressing needs for reviewing the investment norms are
the diminishing real returns earned by investors in these sectors. Given the excessive risk-
T
protection measures adopted by the sector regulators, the flexibility to diversify investments
and earn higher real returns a fundamental concept enshrined in modern portfolio
management theory seems to have been repeatedly overlooked.
This spells trouble for both the insurance and pension sectors because this might force
investors to turn their backs on these savings channels. The trend is already discernable,
though its still in its nascent stages. Both pension and insurance sectors do not seem to be the
preferred choices for incremental flows into financial instruments.
The current investment philosophy in both the sectors presumes that, fundamentally, over the
long term investors might be willing to sacrifice higher returns for capital protection.
Although this might seem to be intuitively true, there is no academic study to back this
hypothesis. Also empirical data seems to be suggesting otherwise with the incremental
inflows into both insurance and pension narrowing down. This committee would like to
reiterate that while it is not in favour of throwing caution to the wind -- nor does it believe in
advocating investment norms that are bereft of any safeguards it nevertheless feels strongly
that the investment norms definitely need a launch-pad that will not only allow beneficiaries
gain positive real rates of returns but also shelter them from capital erosion. In fact, the reality
is extreme the mandated investment norms do not allow even for a balanced portfolio, one
that hedges its risk between equities and bonds. This is an extremely outdated concept, as the
next Chapter shows.
The economy is facing a crisis today: the savings rate, especially the household savings rate,
seems to be stalling. According to the report submitted by the Sub-Group on Household
Sector Savings During Twelfth Five Year Plan, commissioned by the Planning Commissions
Working Group on Savings, the household savings rate has levelled off at around 23% after
2003-04.
Therefore, this sounds a bit contra-indicative: post-2004, while the economy experienced an
annual average growth rate of over 9%, the household savings rate remained more or less
stagnant. Numerous empirical studies have shown a direct, causal relationship between
economic growth and savings rate growth.
5

6
While the jury is still out on the exact nature of
relationship between economic growth and household savings, especially in the context of a
developing economy like Indias, there is little doubt that three consecutive years of 9%-plus
growth should have had some impact on the rate of household savings.
This is an ominous trend and would require further research, especially if the trend is at odds
with the pattern seen globally and with the average Indian template observed so far.
Let us look at some numbers here.
YEAR GDP Growth (%) Household Sector Savings*
2000-01 4.3 21.4

5
Mohan, Ramesh: Causal Relationship Between Savings and Economic Growth in Countries with Different Income Levels
(2006), Economics Bulletin. http://www.economicsbulletin.com/2006/volume5/EB05E20002A.pdf
6
Salz, I S: An Examination of the Causal Relationship between Savings and Growth in the Third World (1999),
Journal of Economics and Finance
2001-02 5.5 23.2
2002-03 4 22.3
2003-04 8.1 23.2
2004-05 7 23.6
2005-06 9.5 23.5
2006-07 9.6 23.2
2007-08 9.3 22.4
2008-09 6.7 23.6
2009-10 8.4 25.4
2010-11 8.4 22.8
* As percentage of GDP at current market prices
According to both the Sub-Group and the Working Group, During the second half of the
decade, even though the gross financial savings (assets) and gross financial liabilities of the
households increased sharply, the increase in net financial savings rate remained modest. At
the same time, the rate of physical savings declined partly in response to the tightening in
credit norms, offsetting the increase in the financial savings rate. Consequently, the
households overall savings rate remained largely unchanged (at around 23 per cent) since
mid-2000s.
According to the Reserve Bank of Indias Annual Report for 2011-12: Preliminary estimates
show that the net nancial saving of the household sector declined further to 7.8% of GDP at
current market prices in 2011-12 from 9.3% in the previous year and 12.2% in 2009-10...The
moderation in the net nancial saving rate of the household sector during the year mainly
reected an absolute decline in small savings and slower growth in households holdings of
bank deposits, currency as well as life funds. At the same time, the persistence of ination at
a high average rate of about 9% during 2011-12 further atrophied financial saving, as
households attempted to stave off the downward pressure on their real
consumption/lifestyle.
However, it is widely believed that the recent and prolonged episode of high inflation (ignited
by the failure of monsoons in 2009) and inflationary expectations might have rekindled the
propensity for physical savings, especially constructed property and bullion. Therefore, the
decline in financial savings might have been compensated to an extent by an increase in
physical savings and/or a spike in consumption levels. The Reserve Banks Macroeconomic
and Monetary Development Report for 2011-12, in fact, shows the physical savings rate
increasing to 12.8% during 2010-11, after briefly dipping 12.4% in 2009-10, even though its
still lower than the 13.5% recorded in 2008-09.
Gross Domestic Savings: A Break-Up
(Percentage of GDP at current market prices)

2008-09 2009-10 2010-11*
Gross Domestic Savings 32 33.8 32.3
1.Household savings 23.6 25.4 22.8
Of which,
a. Financial Savings (Gross) 10.1 12.9 10
b. Savings in Physical Assets 13.5 12.4 12.8
2. Private Corporate Sector 7.4 8.2 7.9
3. Public Sector 1 0.2 1.7
Source: Reserve Bank of India *Quick Estimate
But, to return to the broader question: why has the household savings rate stagnated? Among
the many reasons, one stands out -- contributions under the heading Provident and Pension
Fund have declined steeply from 15.1% of gross financial assets during the period 2000-05
to 9.7% during 2005-10. Contrast this with the 19.6% provided by the same head during the
1970s.
One of the reasons for the dwindling interest is the archaic policy design. The sub-groups
report mentions: The EPF and MP Act, 1952 covers only those employees of organised
sector whose salary is below Rs 6500 per month. This statutory limit is stagnant since 2002
while there has been a phenomenal growth in wage structure in industry over the years.
Resultantly, in new coverage of the establishments, very few categories of employees are
eligible for coverage under the Act...While the new enrolment of members has become
difficult as mentioned above, the exit of members by way of retirement, retrenchment and
death are keeping normal pace.
However, it is this committees observation that one of the reasons, as yet unstated in the
working group report on savings, could probably be the declining yield from such savings.
Given the low inflation-adjusted yield on savings from existing provident and pension funds,
especially those in the public sector, the income that could have been saved is flowing into
other avenues particularly physical assets in search of higher yields.
An exception needs to be made here. Funds invested under the National Pension Scheme,
which was launched in 2004 and allows investors to chose their fund managers as well as
their investment plans, have been consistently providing higher inflation-adjusted returns
than other similar investment channels.
7

8
However, the NPS has a long way to go before it
attains the level of popularity enjoyed by some of the other alternative instruments (such as
Public Provident Fund or EPF) despite delivering higher returns. According to PFRDA
trustees, as on May 7, 2013, NPS had 49,90,988 subscribers with Rs 32,567 crore of assets
under management. Therefore, the daunting task before the pension regulator Pension Fund
Regulatory and Development Authority is to fulfil its development role by increasing
awareness and literacy about pension products.
The story of declining yields could well be repeated in the case of insurance because the
return from insurance products has also been somewhat tardy, In addition, it has been

7
NPS scores on charges, returns over PPF, Business Standard (August 16, 2012), http://www.business-
standard.com/india/news/nps-scorescharges-returns-over-ppf/483367/
8
Why new NPS could be the best way to save for retirement, The Economic Times (August6, 2012),
http://articles.economictimes.indiatimes.com/2012-08-06/news/33065696_1_nps-schemes-fund-managers-pension-fund

believed so far that life insurance sales in India is driven primarily by tax considerations. An
initial examination of the data seems to prove otherwise. Life insurance funds accounted for
20.1% of gross financial assets during 2005-10, compared with 14.7% during 2000-05. The
working group had this to say: The share of life insurance funds continued to increase
during 2000s, in line with higher insurance penetration and robust economic growth.
However, this committee feels that the life insurance numbers could probably have been
inflated somewhat by the phenomenon of single-premium products, which witnessed a
tremendous spike primarily due to the lopsided agency commission structure. It is only in
2010 that the insurance regulator Insurance Regulatory and Development Authority
tightened the rules surrounding the commission structure and, it is believed, this seems to
have impacted the sales of single premium life insurance policies severely. It will be
interesting to see the extent of life insurance contribution to gross financial assets post 2010.
Data from the website of the insurance regulator (Insurance Regulation and Development
Authority, IRDA) is illustrative. For instance, individual single premium collected by all life
insurance companies in India during the 12-month period ending March 2012 amounted to Rs
18,401.75 crore, against Rs 35,873.52 crore in the previous comparable period. Further, the
life insurance penetration ratio of premium to GDP-fell for second consecutive year and has
declined from a peak of 4.6% in 2009-10 to 3.4% in 2011-12. It must be noted here that life
insurance penetration in India is lowest even compared to some of the emerging economies
including China.
According to preliminary data published by the Reserve Bank of India, life insurance funds
as a percentage of gross financial savings of the household sector, have dropped from 26.2%
in 2009-10, to 22.3% during 2010-11, to a provisional estimate of 23.1% during 2011-12.
There is another inescapable fact: despite the lopsided commission structure of single
premium products, and the associated mis-selling that resulted in the sharp spike in sales,
investors found the product remunerative because it managed to side-step the asphyxiating
investment norms prescribed for all the other insurance premium and deliver comparatively
higher returns than other competing financial instruments. This is indeed, in some ways, an
eloquent commentary on investors disappointment with the returns provided by the pension
and insurance sectors.
The story of insurance and pension sectors, as well as the overall level of household savings
in the country, is definitely a cause for concern. Any plans to boost investment in the
economy will need to be matched with a domestic savings rate, especially in financial
instruments, that can supply the required funds. Only a small balance can be met from
external sources (such as, external commercial borrowings). Therefore, given the economys
ambitious investment plans, the savings rate today is far from what would be necessary. One
of the tasks before the government today is to ensure that household savings flow back into
financial instruments and for that to happen the inflation-adjusted returns from these
instruments have to be more attractive than physical savings, without forfeiting any of the
risk-containment measures. This will be necessary not only for the continuing relevance of
the pension and insurance sectors but also in the national interest.
The insurance and pension sectors help the growth and development of financial markets.
Unfortunately, the directed investment norms have left very little room for the sector to
contribute to this important aspect of the development of Indian economy. Further, if
investing by these sectors is liberalised it can contribute very significantly to financialisation
of savings described in a separate chapter devoted to this.
As we outlined in Chapter-II, India needs large sums of money, especially funds of a long-
term nature, for building infrastructure in the country. This includes both physical as well as
social infrastructure. In addition, funds of medium-to-long-term nature will also be required
for enhancing the capacity in the manufacturing sector. As the current inflationary episode
has so eloquently highlighted, capacity shortage in various industries has provided the
necessary ignition to runaway inflation and inflationary expectations. Needless to say, the
sums required are large and, seemingly, beyond the capacity of the current sources combined.
Therefore, newer fund sources have to be tapped. Especially sources which have at their
command funds with a maturity profile matching the long-gestation nature of the projects. At
this point, the only such source seems to be the insurance and pension fund industry.
Its worthwhile to pause for a moment and survey the supply sources of long maturity funds
in the economy. Till the mid-90s, the Indian economy had three large institutions tasked with
the supply of long-term funds. These institutions were called development finance institutions
namely, Industrial Development Bank of India, Industrial Credit and Investment
Corporation of India and Industrial Finance Corporation of India.
Given their development status, the state allowed these institutions to raise cheap, long-term
finances by issuing bonds that were accorded the status of SLR bonds therefore, these
bonds found ready subscribers in the commercial banks. Apart from being an inexpensive
source, SLR-eligible bonds also gave these institutions access to 10-15 year funds, which is
an ideal maturity profile for project financing.
However, by virtue of being SLR bonds, the bonds carried an explicit government guarantee
against defaults. Therefore, as part of the governments fiscal adjustment programme, which
began in 1992, these institutions had to cede the privilege of issuing SLR-eligible bonds. As a
result, they had to resort to market borrowings to finance their lending operations. Market
financing led to escalating interest costs and thinning margins; in addition, some other
project-related issues made them unviable. Consequently, two of these institutions were
forced to convert themselves into commercial banks IDBI Bank and ICICI Bank.
As a result of this conversion, two things have happened. One, while commercial banking
operations gave them access to household savings, these typically had a shorter maturity
profile. At the same time, the regular flow of long-term funds required for project finance,
either dwindled or dried up. Second, and more importantly, the competence built up by these
two institutions over years for evaluating long term projects also evaporated. Inadequacy of
these skills will be felt much more as the wheels of economy move to greater growth and size
in years ahead.
However, one institution which had also provided long-term funds in the past and continues
to do so is Life Insurance Corporation of India. It has both access to long-term funds as well
as the inherent appraisal skills intact within the organisation, but that is not enough. But,
unfortunately, LICs hands are somewhat tied by the investment norms in vogue. There are
numerous other insurance companies that have emerged in the economy over the past few
years both in the private and the public space (with shareholding from a state-owned bank)
which have garnered long maturity funds from investors. But, unfortunately, a bulk of these
investment funds cannot find assets that are matching in terms of either maturity or the
returns. It has, therefore, become necessary to take a fresh look at the availability of long-
term funds in the system.
Therefore, given the urgent nature of the twin problems confronting the economy at this stage
along with the attendant benefit of development of financial market eventually aiding and
assisting financialisation of physical savings, it has become imperative to revisit the existing
investment norms governing the pension and insurance sectors, examine the possibility of
updating them without sacrificing any safety and risk mitigation measures. Further delay will
cause serious damage to the long term prospects of the growth of Indian economy.
----------------------------------------------------------

CHAPTER VI
MOVING TO PRUDENT INVESTOR RULE

t has become increasingly evident that the existing rules governing investment of funds
in the insurance and pension industries has clearly lost their raison detre they have
failed to serve the investors by not providing adequate inflation-adjusted real returns,
and, failed to match the nature of funds with appropriate investment destinations as well.
Therefore, there is a need to migrate to another regime, without sacrificing any of the risk
mitigation principles. One of the legal templates that seems to be adequate for our endeavour
is the prudent-investor rule.
Before we begin this chapter on introducing prudent investor rule in the country, it might be
necessary to dwell upon the changes in this global set of rules. The governments
involvement in investment decisions was prompted by the bursting of the South Sea bubble in
Britain in 1720. As a consequence of the wide-spread financial ruin that followed the crisis,
the English Court of Chancery drew up a list of permissible investments primarily
government securities for trustees. This list, by default, became the gold standard and was
adopted even in the United States, which was a fledgling union at that point. This list
prohibited investments in equity.
A paper
9
authored by John H. Langbein (Yale Law School) provides a brief historical
background: English law got off to a bad start on trust investing. In 1719 Parliament
authorized trustees to invest in shares of the South Sea Company. A number of them did, and
when the South Sea "Bubble" burst the next year, share prices declined by 90%. The
Chancellors took fright and developed a restricted list of presumptively proper trust
investments, initially government bonds, later well-secured first mortgages. Lord St.
Leonard's Act in 1859 added East India stock, and across the decades, some dribbles of
legislation approved various other issues. Only in 1961 was the English statute amended to
allow trustees to invest in equities more generally, and even then the investment was subject
to a ceiling of half the trust funds.
This rule came in for a massive shake-up in 1830 as a consequence of a landmark US trusts
law case Harvard College v Amory under which the Supreme Judicial Court of
Massachusetts rejected the earlier prescription and formulated the now-famous prudent-man
rule or the prudent person rule. The events leading up to the historic judgement will help
understand the import of the prudent person rule.
According to the facts listed in Wikipedia, in 1823 a certain John McLean died after drawing
up a detailed will. In it, he left his wife $35,000 a house and some personal property. He also
left $50,000 to Jonathan and Francis Amory to manage the funds in trust to lend or invest,

9
Langbein, John H: The Uniform Prudent Investor Act and the Future of Trust Investing (1996). Faculty Scholarship Series. Yale Law
School. Paper 486. http://digitalcommons.law.yale.edu/fss_papers/486
I
as quoted in Wikipedia, in safe and productive stock, either in the public funds, bank shares,
or other stock, according to their best judgment and discretion". The proceeds of the
investment were to go to his wife. On her death, half the value of the fund was to go to
Harvard College for funding a professor of ancient and modern history, and the other half to
Massachusetts General Hospital. However, Harvard College went to court after it learnt that
the investments had made losses.
This prompted the judge to remark, and this formed the bedrock on which the principle of
prudent persons rule was based, before exonerating Francis Amory: All that can be
required of a trustee is, that he shall conduct himself faithfully and exercise a sound
discretion. He is to observe how men of prudence, discretion and intelligence manage their
own affairs, not in regard to speculation, but in regard to the permanent disposition of their
funds, considering the probable income as well as the probable safety of the capital to be
investedDo what you will, the capital is at hazard.
What this meant was that trustees had to exercise discretion and prudence while managing
somebody elses money, similar to what they would have applied had they been managing
their own funds. This also tantamount to creating a legal precedent restricting a trustees
discretion to investments that a prudent person would ideally commit for his or her own
portfolio. At the same time, the ruling also relaxed the strait-jacket imposed in the aftermath
of the South Sea Bubble. While this did loosen the earlier restrictions somewhat, it created a
new template for fiduciary investments, which imposed new constraints. The Harvard v
Amory judgement exhorted trustees to eschew speculation and to treat the probable safety of
the capital as central. This led to various including some ludicrous interpretations on
what constituted speculation and how safety of capital could be ensured. The default
investment portfolio then largely constituted government bonds, with mortgages and selective
equity investments being minor contributors. In addition, regulators (or law courts, as the
case might have been) assessed the prudence of each individual investment rather than the
composition of the portfolio or the risk-return profile of the portfolio.
Then came WWII and with it an intense inflationary episode. The war-induced, and shortage
fuelled, price rise of the war years showed how bonds were no less riskier than equities. This
led fiduciaries over the second half the Twentieth Century to focus on improving the mix of
investments in their portfolios and reducing the risk emanating from being overweight on
government or corporate bonds.
In their well known paper
10
on the subject, authors Max M. Schanzenbach and Robert H.
Sitkoff have written: How do you make a small fortune? Give a bank a large one to manage
in trust (Dukeminier and Krier 2003, p. 1335). So goes an old saw about the banking industry
that reflects long experience with risk-averse, conservative trust investing by institutional
trustees operating under the prudent-man rule of trust investment law. The prudent-man rule
favored safe investments such as government bonds and disfavored speculation in stock, and
under the rule the courts assessed the prudence of each investment in isolation rather than in
the context of the portfolio as a whole. In the last 20 years, however, all states have replaced

10
Schanzenbach, Max M & Sitkoff, Robert H: Did Reform of Prudent Trust Investment Laws Change Trust Portfolio Allocation (2008),
Discussion Paper No 580, John M Olin Center for Law, Economics, and Business, Harvard Law School
the old prudent-man rule with the new prudent-investor rule. Drawing on the teachings of
modern portfolio theory, the new prudent-investor rule directs the trustee to invest on the
basis of risk and return objectives reasonably suited to the trust and instructs courts to review
the prudence of individual investments not in isolation but in the context of the trust portfolio
as a whole. The new prudent investor rule thus abolishes all categorical restrictions on
permissible types of investments and clearly rejects the old laws hostility to investment in
stock.
In effect, over the past fifty years or so, the prudent-man rule morphed or evolved into the
prudent-investor rule. Among all the changes that were forged, three important ones stand
out. The first is the trustees duty to diversify investments to minimise risk. Second, while the
old order emphasised the need to avoid speculation, the new set of rules requires trustees to
assess the risk-tolerance of a particular trust and to invest for risk and return objectives
reasonably suited to the trust. Finally, the new rules reverse the earlier accent on non-
delegation and encourage trustees to delegate the investment responsibility to professionals.
However, the prudent-investor rule is by no means the end-point or the final destination in
the journey of investing philosophies. The rule has been subject to refinements and fine-
tuning, especially in the aftermath of the 2008 financial crisis and the resultant global
economic slowdown. Some of the assumptions are under scrutiny while some others are
being reinforced.
At the centre of this flux is the philosophical debate over the differences between
reasonable behaviour and rational behaviour.
11
In fact, there is even a debate whether the
prudent-investor rule should stay solely focused on the modern portfolio theory and
whether there is a need to also include the efficient capital markets hypothesis.
12

For our purpose, it is abundantly clear that we are still stuck in the era of legal lists -- when
the government or courts of law dictated how much should be invested, and into what and it
is high time we moved on. In fact, it is suggested that we move to the prudent-investor rule
straight away, albeit with some modifications and special features suited to the Indian
environment.
There will be some course corrections necessary before sweeping changes can be made in the
environment. Before adopting the prudent-investor rule, there is a need to make a
systematic assessment of the human resource capabilities within the institutional framework,
map their competence and skill levels and match them with the competence needs of a
prudent-investor framework. Wherever gaps exist, as surely they do across the industry, the
regulator should provide a time-frame to allow insurance companies and pension funds to
bring their managers up to the mark, through adequate training and capacity building.

11
Lydenberg, Steve: Reason, Rationality and Fiduciary Duty, Investor Responsibility Research Centre Institute,
http://www.irrcinstitute.org/pdf/FINAL-Lydenberg-Reason-Rationality-2012-Winner.pdf
12
Schanzenbach, Max M & Sitkoff, Robert H: The Prudent Investor Rule: A Theoretical and Empirical Reassessment,
https://www.utexas.edu/law/academics/centers/clbe/wp/wp-content/uploads/centers/clbe/schazenback-
the-prudent-investor-rule.pdf

The market also needs to improve, modernise and open up before the investment norms can
be revamped. The next chapter deals with that issue.
There will indeed be some critics who will rush to point to the 2008 financial crisis and use
that to justify their opposition to the changes being proposed by this committee. But, as all
references and the empirical data so far suggest, nothing is bereft of risk. Recent global
experience has shown us how even government securities can teeter on the brink of default.
Therefore, given the low-growth-high-inflationary phase that the Indian economy is currently
passing through, there is a dire necessity to overhaul the current legal and regulatory
framework in the interest of the funds, the investors and the economy.


CHAPTER VII
MOVING TO PRUDENT INVESTORS REGIME: THE ROAD-MAP

ndia is now unarguably settled that India is committed to economic reforms which,
among other things, entails allowing economic agents the liberty to take decisions in a
developed and regulated environment and to take responsibility for their decisions.
While entities wishing to raise resources have the freedom to do so in any manner they like,
subject to complying with existing regulations, all entities wishing to invest their resources do
not enjoy a similar freedom. For example, the insurance and pension funds/fund managers
(IPFs / IPFMs) do not have full freedom, as detailed in earlier chapters, to invest their funds
in asset classes they consider appropriate keeping in view the interests of their clients and the
opportunities afforded by the environment. This approach prevents IPFs from exercising
skills in the most prudent and efficient manner and dilutes their accountability. It also
contradicts with the principle of consumer protection as it prevents generation of optimum
returns for the clients. For these reasons, legal frameworks governing institutional investors
globally have moved towards the prudent investors approach, which allows such investors
the freedom to invest their funds in the manner that appears most prudent taking into account
the needs and interests of their consumers.
Such freedom is absolutely necessary for the growth and survival of insurance and pension
industry as argued in the previous chapters, as IPFs would soon find their investment options
limited and the available options would not provide them an opportunity to build a safe,
balanced portfolio and thereby deliver appropriate returns to their clients. Incidentally, such
freedom would help the economy higher returns would promote higher household savings,
allowing insurance companies and pensions funds to channel such savings to most productive
investments, including infrastructure projects. However, all markets need to be well
developed and regulated to ensure that a professional fund manager enjoys the freedom of
investing within the rigours of a proper governance framework. The freedom of professional
fund managers will have to be calibrated, probably in step with the development of markets,
to avoid any untoward occurrences and to make the reforms sustainable. This essentially
entails moving gradually to prudent investors regime (PIR) along with appropriate
safeguards.
The success of PIR hinges on three pillars, namely,
I. Freedom To Invest In A Broader Range Of Asset Classes, Domestic & Overseas:
i. Government Securities,
ii. Corporate Securities (Equities, Debentures and any other),
iii. Units issued by Investment Funds (CISs, MFs, VCFs, PEs, etc.)
iv. Paper/Demat Commodities, including Metals,
v. Derivatives of Securities/Commodities, including interest rate futures
vi. Real Estate Projects, and,
vii. Infrastructure Projects.

I
This has a direct and proportionate relationship with expansion of financial market.
II. Institutionalisation of Capacity Building:
The move to the new investment regime and philosophy will warrant
institutionalisation of capacity building in the areas of:
i. Regulatory oversight
ii. Corporate governance structure and processes
iii. Policy formulation
iv. Risk management
v. Pool of Investment Managers and Trustees, with a deep reservoir of
skill sets, including project appraisal skills

III. Regulatory Oversight:

The IPFMs can have such freedom only if the markets for the wider range of asset
classes are appropriate in terms of:
i. Regulated Market: (a) Empowered, capable and motivated regulator,
and, (b) Robust Regulation
ii. Developed Market: (a) Range of Products, (b) Depth, Liquidity, Costs,
Safety, Efficiency, and (c) Transparency, Research, Databases.
iii. Protected Market: (a) Market Stability, (b) Market Surveillance, (c)
Investor Protection, (d) Indemnity against Loss, (e) Governance of
Investee, and, (f) Bankruptcy Laws.

While it might be difficult to deal with this subject comprehensively in this report, it might be
desirable to broadly outline the approach to regulatory oversight and very briefly touch upon
other areas listed above.
Accountability of IPFMs: The new regime envisages that IPFMs have a fiduciary
responsibility towards their clients and beneficiaries. They must discharge their duties with
the care, skill and diligence that a prudent investor of similar character and objectives
would do in a similar environment. Thus, the prudent investor regime focuses on the
approach rather than outcomes. It concentrates on how diligently a fiduciary discharges its
obligations, including how investment decisions are made. It believes that every investment
option and every investment strategy is benign. Accordingly, the most aggressive and
unconventional investment would be good, if preceded by a sound process; at the same time,
the most conservative and traditional investment strategy may fail the test if a due process is
not followed.
As the moniker itself suggests, prudence will be required in developing, executing, and
monitoring the investment strategies, subject to the options available in the market and the
objectives of the fund. What is material, therefore, is the manner of taking investment
decisions, which necessarily have to be principle based rather than rule based. It assesses
the fiduciaries, not on the basis whether its investment decisions were successful, but whether
it applied reasonable principles and processes in arriving at its decisions. The accountability
must, therefore, focus on how the fund managers acted in the selection of the investment, and
not whether the investments succeeded or failed.
The Prudent Investor Act, which was adopted in 1990 by the American Law Institute's Third
Restatement of the Law of Trusts, reflects a "modern portfolio theory" and "total return"
approach to the exercise of fiduciary investment discretion. This approach allows fiduciaries
to utilise modern portfolio theory to guide investment decisions and requires risk versus
return analysis. Therefore, a fiduciary's performance is measured on the performance of the
entire portfolio, rather than individual investments. In a complete departure from historical
practices, the prudent investor rule now measures a trustee's liability by comparing the
portfolio's total return, whether positive or negative, with what the portfolio reasonably could
expect to earn under an "appropriate" investment programme. This makes the governance as
one of the most significant elements in the approach to prudent investor principle.
Governance of Funds: A fund manager must invest only in assets whose risks it can
properly identify, measure, monitor, manage, control and report. Investments must balance
the security, quality, liquidity and profitability of the portfolio as a whole, commensurate
with the disclosed policy objectives, as well as in line with the nature and duration of the
funds and in the best interest of all clients and beneficiaries. The adoption of the regime,
therefore, requires that the fund managers must have sufficient resources and systems of
governance in place. Existence, implementation and constant upgradation of such systems
would be the initial steps towards the adoption of a prudent investor regime.
A fund manager must at all times fulfil the fit and proper requirements that is, his
professional qualifications, knowledge and experience should be adequate to enable sound
and prudent investment management. Also, he should have impeccable integrity and a rock-
solid reputation. The fund must have in place effective governance systems that include an
adequate and transparent organisational structure with a clear allocation and appropriate
segregation of responsibilities, and an effective system for ensuring transmission of
information. It should have in place an effective risk-management system comprising
strategies, processes and reporting procedures necessary to identify, measure, monitor,
manage and report -- on a continuous basis -- risks, at an individual and at an aggregated
level, to which it is or could be exposed. The risk-management system must be effective and
well integrated into the organisational structure and in the decision-making processes of the
fund.
In particular, the following must be ensured:
a. Every fund must have an Investment Committee empowered to administer the fund
and take ultimate responsibility for ensuring that fund managers adhere scrupulously
to the terms of the arrangement and are protecting the best interests of clients and
beneficiaries. The governing body should retain ultimate responsibility for the fund,
even when delegating certain functions to downstream decision makers and those
executing these decisions and /or external service providers. It should be accountable
to the clients and beneficiaries, and the competent authorities. Membership in the
governing body should be subject to minimum suitability standards in order to ensure
a high level of integrity, competence, experience and professionalism in the
governance of the fund.
b. The governing body must draft an overall investment policy that is actively observed.
This investment policy should establish clear investment goals for the fund that are
consistent with the objectives of the fund. The approach for achieving those
objectives should satisfy the prudent investor regime, taking into account the need for
proper diversification and risk management, the maturity of the obligations and the
liquidity needs of the fund, and any specific legal limitations on portfolio allocation.
The investment policy has to be dynamic and should identify the strategic asset
allocation strategy for the fund (the long-term asset mix over the main investment
categories), the overall performance objectives for the fund, and the means of
monitoring and, when necessary, modifying allocations and performance objectives in
the light of changing liabilities and market conditions. It should also include any
broad decisions regarding tactical asset allocation, security selection and trade
execution. There should be procedures and criteria by which the governing body
periodically reviews the effectiveness of the investment policy and determines
whether there is a need to change the policy, its implementation procedures, the
decision-making structure, as well as the responsibilities linked to its design,
implementation, and review.
c. The governing body must establish adequate internal controls in place to ensure that
all persons and entities with operational and oversight responsibilities act in
accordance with the objectives of the fund. There should also be appropriate controls
to promote the independence and impartiality of the decisions taken by the governing
body, to ensure the confidentiality of sensitive information pertaining to the fund and
to prevent the improper use of privileged or confidential information. Reporting
channels between all the persons and entities involved in the governance of the fund
should be established in order to ensure the effective and timely transmission of
relevant and accurate information.
d. The governing body should engage persons of repute who have appropriate
professional qualifications and experience. Persons responsible for the overall
implementation of the investment policy should be identified together with any other
significant persons who will be part of the investment management process.
e. There should be clear a outline on how any conflict of interests in the investment
function, as and when it arises, will be managed.
f. The governing body must establish a sound risk management process to measure and
appropriately control portfolio risks and to manage the assets and liabilities in a
coherent and integrated manner.
g. The governing body must appoint an auditor, independent of itself, the fund, the fund
manager, and the sponsor to carry out a periodic audit consistent with the needs of the
arrangement.
h. The IPFM must draw up annual accounts and annual reports which reflect a true and
fair view of the assets, liabilities and financial position of each fund. Such reports
must also reflect the governance processes followed.
i. The IPFM must disseminate proper information to clients and beneficiaries, including
information regarding rights and obligations of the parties involved, the financial and
other risks involved, and the nature and distribution of those risks, in a clear, accurate,
and timely fashion. It must provide any other relevant information as may be sought
by the clients and beneficiaries and/or may be relevant to understanding/appreciating
the decision making processes.
j. The IPFM must provide relevant, material and updated information to competent
authorities, on a regular basis.
In short, the quality of meeting room practices of the governing body become very significant
and have necessary to be ensured at a very high pedestal in terms of objectivity, engagement
and support systems.
Markets for Asset Classes
Governance of Markets: The fund manager is like an investor. An investor needs a
developed and regulated market where he is protected in case he loses money for no fault of
his. This means that the system must ensure that (i) the investor learns investing, obtains and
uses information required for investing, and takes adequate precautions; (ii) the market
participants reveal relevant details about themselves, the products, the market and the
regulations so that the investor has full knowledge about the market; (iii) the market has
systems and practices which make transactions safe, only the fit and proper persons are
allowed to operate in the market, every participant has incentive to comply with the
prescribed standards, and there is assurance that the miscreant will be meted out exemplary
punishment; and, (iv) the investor is fully compensated, if he happens to lose money due to
failure of any system or participant, malafide or otherwise.
In short, the investor needs an empowered and accountable regulator to regulate and develop
the market for the assets and protect the investors in those assets before the investor ventures
to invest in those assets. A fund manager may invest in securities because there is an
empowered and accountable regulator called SEBI, which is responsible for protecting the
interests of investors in securities and for promoting the development of and regulating the
securities market. If a fund manager is to consider investing in real estate projects, for
example, we need to establish a regulator to promote the development of and regulate the
market for real estates and protect the interests of investors in real estates. We should allow a
fund manager to invest in the assets in those markets, which operate under the oversight of an
empowered and accountable regulator.
Conducive Legal Framework: Dynamic and inter-connected markets are now witness to
rapid changes something that would earlier take centuries to transform now happens in
some years, and sometimes even in months. The governance response to this has been
establishment of regulators empowered by almost incomplete form of law. This form
believes that it is not possible to visualise all the possible future circumstances and provide
for all of them the legislation. Here, the legislations tend to be skeletal, but have the potential
to deal with all the possible circumstances. The separation of powers is blurred -- the same
entity is vested with the quasi-legislative, executive and quasi-judicial functions so that it can
enforce the laws proactively and preferably before any harm has been done either to the
efficacy of the market or the interests of the participants.
An example is the Securities and Exchange Board of India Act, 1992. It empowers SEBI to
register and regulate not only the intermediaries listed in the Act, but also such other
intermediaries who may be associated with the securities market in any manner. This allows
SEBI to regulate the intermediaries who are not listed in the Act, should the need arise in
future and also the new intermediaries that may emerge in future, without an amendment to
the law. At the time of enactment, the legislature could not possibly visualise all
intermediaries who would need to be regulated in future. Similarly, the Act mandates SEBI to
take such measures as it considers fit to protect the interests of investors with an illustrative
list, as at the time of enactment, it could not visualise all possible measures that might
prospectively become necessary. This enables SEBI to undertake innovative measures to
respond appropriately to the circumstances at hand. For example, SEBI recently sought
disgorgement of illegal gains from fraudsters and disbursed the proceeds among the victims,
though disgorgement is not explicitly mentioned in the illustrative list.
The Act also confers on SEBI substantial powers of delegated legislation (quasi-legislative)
to make subordinate legislation (regulations) to fill the gaps in laws and to deal with the
matters of detail, which rapidly change with time. While the SEBI Act is about ten pages,
SEBI has framed regulations running into thousands of pages and changes from time to time.
This enables it to strike the moving targets at the right time and at the same time, keep the
laws relevant. The Act further confers on SEBI the enforcement, including quasi-judicial,
powers, to enforce the laws made by the legislature and also by itself. In particular, it can by
regulations cast obligations on participants and dispense civil penalties for failure to
discharge the said obligations.
Consequently, if SEBI considers a particular conduct undesirable, it can immediately outlaw
it through regulations and enforce such regulations. It does not have to wait for the legislature
to outlaw any conduct or create an offence through legislations. Nor does it need to seek
judicial concurrence for levying a variety of penalties (except prosecution) on the accused.
This form of law is eminently suitable for markets, which evolve very fast and the authority
needs to respond faster with preventive and remedial measures.
The regulator has to keep pace with moving targets. This is possible only if the law evolves
continuously, in tandem with the environment to meet the emerging deficiencies,
accommodate new products and market designs, deal with innovative transactions by the
market participants and improve the safety and efficiency of operations in the market by
overcoming the legislative lags. The law should enable the regulator to expeditiously issue a
variety of innovative (administrative and quasi-judicial) preventive, remedial and penal
measures matching the conduct of the participants. This requires an incomplete legal regime
where the regulator, which has a better understanding of the environment, has adequate
powers of promulgating subordinate legislation within the basic frame of the statute and also
the powers to enforce the laws proactively and promptly.
Protection of Investors: What worries an investor are regulatory overlaps, gaps and
overlapping jurisdictions of various regulatory agencies. A plethora of laws and agencies
seemingly created to protect the interests of investors has created this confusion. There must
be a single window, where an investor can seek redressal of his grievances. While the
banking and insurance regulators have created separate Ombudsmen offices, there is a need
to institute a common Ombudsman for the markets of all asset classes in the country to
reduce duplication of efforts and costs and dispense justice from one source. A specialised
ombudsman must be created who can award compensation by following a summary
procedure to investors (across markets/products) who have lost money for whatever reason,
except for market loss or their own negligence. The compensation must be paid by the
negligent or defrauding party.
Depositors in banks are protected to the extent of Rs 1lakh against liquidation or bankruptcy
of the bank. This protects innocent depositors and thereby contributes to the stability of the
financial system. A similar mechanism may be instituted to compensate an investor. A group
insurance policy may be considered under which investors can be insured. An investor, losing
any money for whatever reason except for market loss or his own negligence and not
compensated by the negligent or defrauding party, will be compensated up to a specified
amount. A national non-profit organization is needed which will espouse the cause of
investors and take up their case before the authorities such as regulators, arbitrators, courts,
ombudsmen etc. An enabling environment needs to be created for emergence of such an
organization.
Investment Advice: A fund manager may be competent to take appropriate investment
decisions on its own. How does a client choose a fund manager? The authorities find great
solace in KYC, or know your client, norms. The clients, however, find solace in KYP, know
your product and know your participant.
There is an elaborate arrangement to enforce KYC while there is not even talk of KYP. The
retail client struggles to undertake KYP, while products and participants get increasingly
complex. The modern markets attempt to address the issue, inter alia, by making available a
cadre of competent, responsible professionals who help clients undertake effective KYP.
Given the role of such professionals, who are generally referred to as investment advisers, in
the financial well-being of retail clients, the SEBI Act, 1992 mandates SEBI to register and
regulate them. It has recently notified regulations to regulate the investment advisers in
securities.
A fund manager invests in markets some of which are regulated. However, clients entrust
their resources to a fund manager. While the regulators of markets are bound by the limits of
their respective jurisdictions, the business is not. The economies of scale and scope together
with deregulations have blurred the legal boundaries. Consequently, a person simultaneously
engages in activities that come under the purview of multiple regulators. An investment
adviser, for example, renders advice on assets across jurisdictions and even outside regulatory
jurisdictions. He holistically assesses the needs of a client and the suitability of all assets
classes for him before recommending an asset or a combination of assets. If he limits his
assessment to the assets in the jurisdiction of A, the client may miss out a better asset which
is in the jurisdiction of B. It is, therefore, not possible to render and regulate jurisdiction-wise
investment advice. It is difficult for a regulator to lay down standards for investment advice
across jurisdictions. It is not practical for all regulators to simultaneously register and regulate
the same person as investment adviser. The resolution lies in unified regulation of investment
advisers by a statutory authority.
Distribution and advice are generally offered together as a composite service. There is hardly
a person who only distributes assets/financial products and does not advise clients on those
products and vice versa. Multiple conflicts of interest are inherent in this model. First, as
distributor, he is an agent of the product provider, and as adviser, he is an agent of the client.
Thus, he serves simultaneously two principals who generally have conflicting objectives. The
interests of one principal may take precedence over that of another depending on the
importance of the principal to his business and/or reward. Second, while advice is totally
unregulated, distribution is not. There are rules from respective regulators in respect of
origination, including distribution, of products and product distributors. As a result, while an
adviser is theoretically capable of advising on all products, he can distribute only those
products which he is authorised to. This obviously prompts the adviser to recommend those
products which are available with him even if those are not most suitable for the client. Third,
it is not uncommon for a person to deal simultaneously in many competing products. In such
a case, he would naturally recommend those products which maximise his incentives. He
may even exploit regulatory arbitrage and push those products where regulatory compliance
is minimal. This calls for segregation of distribution from investment advice. While
regulation of distribution is left to the respective product regulators, investment advice needs
unified regulation.
All kinds of persons, irrespective of their competence, advise retail clients on various assets.
This adds to confusion and insecurity among clients. There are generally two requirements to
ensure that an investment adviser works in the best interest of clients. First is the requirement
of registration and oversight. The investment advisers need to be registered and regulated by
an appropriate regulator. They should be held accountable for their investment advice and
obliged to redress grievances of their clients. There should be a code of conduct for them and
enforcement actions should follow in appropriate circumstances. Second is the capability.
There should be arrangement to equip investment advisers to render competent investment
advice. The appropriate regulator should develop a comprehensive specialized course
covering all kinds of assets and prescribe the same as one of the eligibility requirements for
registration as investment adviser. There should also be continuing professional education to
ensure that the investment adviser remains abreast with the developments (products and
participants) in the market. This would ensure effective investment advice from qualified and
responsible people.
Given the twin responsibilities of developing and regulating financial advisers, it is necessary
to establish a statutory body which will have two broad activities, namely, (a) development of
appropriate courses which a person must complete to be eligible for registration as
investment adviser, and, (b) registration and regulation of investment advisers. The institute
can be called Institute of Investment Advisers of India (IIAI). The institute shall also
provide continuing professional education to update knowledge of investment advisers and
exercise oversight over them to ensure orderly growth of a responsible profession. After a
particular cut-off date, no person shall act as a investment adviser unless he has a certificate
of registration from the IIAI.
Governance of Investee: A fund manager would have comfort if the investee, such as
company, collective investment scheme, venture capital fund, infrastructure project, etc.
abides by certain best practices and governance norms. For example, an IPF should invest in
securities issued by a listed company which is subject to corporate governance norms
prescribed under the Companies Act, 1956 and Listing agreement. In fact, the operations of a
company are governed under the Companies Act. The operations of a mutual fund are
governed by the SEBI (Mutual Funds) Regulations. The operations of Government are
governed by the Constitution. An IPF may invest in the assets issued by the investee who is
subject to certain regulations and governance norms. The gaps, which do exists must be filled
up fast.
IV. CORPORATE GOVERNANCE STRUCTURE & PROCESSES
The dynamism of the market rapidity and profundity of changes have to be
matched by the concurrently evolving corporate governance structure and
processes. This will involve institutional capacity into knowledge management,
research and recommendations for reengineering of the structure and processes.
Acceptance and quick adjustment will warrant opinion building. This cannot be
left to one off exercise to be undertaken periodically and hence, will necessacitate
creation of institutions/wings to engage in this exclusively with stakeholders,
which may incidentally help the policy formulation too.
V. POLICY FORMULATION:
Public policy has to keep pace with dynamism of the market and environment.
Hence, it will have to be reoriented to the emerging demands so that the
legislature and judiciary collaborate in the process of tectonic shift and are on
board to changing philosophies. It is the inadequacy of changing face of public
policy, which is withholding investment of EPF moneys in capital market
instruments directly.
VI. RISK MANAGEMENT:
Risk management is going to be the key to the success PIR. Hence, significant
investment both in academics and operations in designing, operationalising and
refurbishing will be called for eventually enabling optimal risk management and
risk mitigation.

VII. CADRE OF INVESTMENT MANAGERS & TRUSTEES:
Switch over to new regime will demand different skills sets for investment
management. And, as the market expands and undergoes transformation, the
needs will grow both quantitatively and qualitatively.
This will require academic institutional capacities and cadre building capabilities
within the organisation.

Conclusion: The above are some of the building blocks before the PIR is adopted and IPFM
is granted freedom to invest in various asset classes. However, a comprehensive governance
framework will have to worked out, while the nation prepares to move to prudent investor
rule.



CHAPTER VIII
FINANCIALISATION OF PHYSICAL ASSETS

he disposable surplus income minus expenses -- of individuals culminates into
physical and financial savings. As the economy of a country matures and the financial
markets acquire depth and width, the proportion of financial savings grows and that
of physical savings contracts. This process is, among other things, also enabled by the ability
of the markets to financialise physical assets.
The mature economies of US, Europe are marked by a higher proportion of financial savings
over physical savings; the contrary holds true for emerging economies, especially India.
The preference for physical savings accelerates if the financial instruments deliver
negative/marginal real returns, as by and large physical assets act as a natural hedge against
inflation. In India, as mentioned in one of earlier chapters, in the past 3 years, the proportion
of financial savings has declined by nearly four per cent. Investment in physical assets, if not
financialised, becomes a locked asset and does not benefit the economy.
Developed financial markets facilitate financialisation of physical assets and help the
economy to grow even with these investments. Hence, financialisation of physical assets have
found increasing favour across many economies as a means of capturing value that might be
otherwise get lost. Wikipedia has a simple definition for the process: Financialisation is a
term that describes an economic system or process that attempts to reduce all value that is
exchanged (whether tangible, intangible, future or present promises, etc.) either into a
financial instrument or a derivative of a financial instrument. The original intent of
financialisation is to be able to reduce any work-product or service to an exchangeable
financial instrument, like currency, and thus make it easier for people to trade these financial
instruments.
The concept, in its most basic form, involves taking ownership of the physical assets out of
the equation and providing financiers with financial paper that not only promises fractional
ownership of a physical asset but also allows for liquidity through an exchange-traded
mechanism. In India, the endeavour should be to increasingly seek financialisation of
investment in bullion and real estate. There are pitfalls associated with fiancialisation, as the
recent global financial crisis has shown. Numerous academic papers have highlighted how
increasing financialisation of commodity markets in the developed markets led to inflationary
tendencies in some commodity categories.
However, that should not detract from our task at hand. There is already enough academic
work that will help Indian markets going down the same path. This will require necessary
legal and regulatory changes. An UNCTAD policy brief, which is titled Dont Blame the
Physical Markets: Financialization Is The Root Cause Of Oil And Commodity Price
T
Volatility, has provided a checklist of regulations that might be a necessary accompaniment
to financialisation of physical assets.
13

This economic re-engineering can be facilitated by addition of some of missing links in the
creation and marketing of financial products, like:
1. Real Estate Investment Trusts (REITS):
Globally, REITS are used to channelise and formalise investment in property, using
capital market platform and all the risk-mitigation systems that comes with exchange
traded mechanism (such as novation). Unfortunately, SEBI is yet to notify
regulations governing the activities of REITS. It is a pity that this opportunity has
been exported and investors in overseas markets (such as Singapore) are benefitting
from the opportunity of investing in the Indian property market. However, in addition
to action by SEBI, this would also require setting up of an empowered and active
housing regulator and formulation of a House Pricing Index.
2. Infrastructure Investment Trusts (IITs):
On similar lines, ISITs can be floated for financing roads, ports, airports, railways,
power projects. With adequate credit enhancements, it should be possible to attract
private individual and institutional -- investments into the sector and fill up the gaps
of equity that constrains financial closures.
3. Gold and Commodity ETF:
Even though gold ETF have since been introduced in the market, commodity ETF are
yet to find their place.
However, products like gold ETF will remain a non-starter or under-penetrated if the
size and liquidity do not shape up. This can be achieved only if the insurance and
pension funds are allowed to invest in these products. Expansion of investment
basket into these products for insurance and pension industries would have the
following benefits:
1) Primary Benefits: Insurance and pension funds will find an avenue to notch
up a real rate of return, which today is largely missing in fixed income
securities, particularly government bonds.
2) Secondary Benefits: (a) This will help develop and broaden the financial
markets, (b) It will provide liquidity and depth to the market of these
instruments and discourage individuals from investing into locked assets of the
underlying products, (c) This will help financialise the existing investments in
property and gold in particular thus help mitigating at least partly concern of
the nation.


13
http://unctad.org/en/PublicationsLibrary/presspb2012d1_en.pdf
CHAPTER IX
RECOMMENDATIONS

t is this committees firm view that the era of directed investments is now an antiquity
which must be discarded and replaced. However, as we have repeatedly stressed
elsewhere in this report, it is not the intention of this committee to suggest that
precautions should be thrown to winds, or to completely dispense with regulation, or even
slacken the governance norms. As economies, markets and systems evolve, so must
regulation. What worked in the 1960s or the 1980s may not necessarily be relevant for the
current environment.
For example, the regulatory structure has to take into account the changing nature of risk,
especially risk that emanates elsewhere and sweeps across porous global financial
boundaries. Comprehensive work has been done in risk-predictive and risk-mitigation
models. Regulation has to evolve in such a manner that it takes into account extensive
changes being fashioned in corporate governance theory and practice and other related areas.
Dynamic markets, like moving targets, cannot be regulated through static policies. It has to
evolve concurrently with the development of markets.
It is also time that regulators moved away from micro-management of companies and their
business practices. In fact, the regulators should leave micro-management of investment to
the investment committees of individual companies. The regulator currently requires every
company to draw up an investment policy, which needs to be ratified by the Board every six
months. If that be the case, why still insist on a set of directed investments all over again?
This indicates two things. One, probably the regulators do not have adequate trust in the
companies, the board members and their governance structures or practices. Two, by
indulging in such micro-management, the regulators run the risk of losing sight of the big
picture and the way risks seem to be morphing across the world. It also forces regulators to
become reactive to changes rather than anticipating them well in advance and putting
adequate and alternate macro-prudential and micro-prudential measures in place.
Unfortunately, regulation in India is, by and large, a post factum occurrence. Rules and
guidelines are typically fashioned after an isolated incidence of misdemeanour by one or two
players. A situation, thus, arises when everybody else in the industry has to suffer on account
of mis-steps by one or two members of the industry. The entire regulatory structure needs to
evolve, build credible monitoring processes, design transparent communication processes,
involve stakeholders in structuring the regulatory direction, create just and swift arbitration
mechanisms, among other things.
It may be instructive to point out here that many developed countries have not abolished their
existing prudent investor regime despite the debilitating blow dealt by the 2008 global
financial crisis. At best the regulatory structures have been reviewed and
restructured/reoriented.
I
This chapter consolidating the committees recommendations strewn across the report --
rests primarily on the twin pillars of introducing the prudent investor concept and on
suggesting for an accelerated pace of financialisation of various physical assets.
One of the primary reasons behind the falling savings rate in the Indian economy is the high
inflation rate and the absence of financial instruments that can offer a positive real rate of
return. As a result, investments in physical assets such as gold or real estate have emerged
as popular alternatives for individual investors. While investments in physical assets do
manage to shield capital from the corrosive effects of sticky inflation, it also takes away
investible resources from the economy.
The paragraphs below provide the committees recommendations on what needs to be done
to resolve the two moral dilemmas that this report outlines in its initial chapters.
RECOMMENDATIONS:
1. It is evident that the era of directed investments is over and it is time to search for new
paradigms. This committee feels that the investment philosophy pertaining to both the
insurance and the pension sectors has to leapfrog to the prudent investor regime.
However, it must be kept in mind that such a tectonic shift cannot happen without its
attendant risks and due care has to be taken while moving to this new investment
regime.
The reason for this shift is simple. This committee, after speaking to various
stakeholders, feels that the concern for preserving the investors capital should remain
paramount but, perhaps, not at the cost of eroding her corpus and/or real returns.
Indians parting with their savings for extended periods, as is the case with insurance
and pension, should get back an enhanced corpus, thereby yielding a positive real rate
of return. The principle is simple: people save during their working years so that a
corpus is available to finance consumption during their golden years, or years spent
in retirement. Receiving a marginal or incremental addition to the original corpus,
where the delta is lower than the rate of inflation, is doing injustice to the investor.
This committee also felt that moving to an interim regime of prudent man doesnt
make much sense in the current economic and financial environment. Indian financial
systems, finance professionals and regulators have acquired enough sophistication to
enable to leap frog to the prudent investor regime.
2. This committee believes that multiplicity of investment mandates across pension and
insurance domains is self-defeating in nature and dissipates the original objectives of
pension and insurance industries. The Employees Provident Fund Organisation, for
example, steadfastly refuses to follow the investment philosophy laid down by the
Ministry of Finance and is sticking to an outdated mandate. This committee,
therefore, recommends that the existing investment norms across all verticals be
harmonised, at least till such time as the move to a prudent investor regime is
complete. This creation of a uniform regime will usher in transparency and allow
investors to compare their returns across product platforms.

3. Flowing from the above recommendation, it is quite clear that customers should have
adequate, reliable information available in the public domain which they can then use
to compare and take an educated decision before choosing any pension scheme or
insurance fund. Therefore, a framework for benchmarking performance of pension
and insurance funds is necessary for generating healthy competition and for meeting
the standards of transparency. Therefore, the Committee feels that intra-fund
comparison, as well as internal assessment of the performance of each fund, is a
desirable practice. It will, therefore, become necessary for the regulator to develop
and define a benchmark that can be used by every pension scheme and insurance fund
to assess its performance. Currently, no such benchmark exists.
In addition, every fund house must conduct an internal benchmarking exercise to
assess the performance of each fund. There are many ways to achieve this. The
committee recommends that each fund may allocate a small portion of the funds under
its management to an external fund manager with clearly defined investment
benchmark. For a fair comparison, it would be desirable that the benchmark followed
for internal fund investment should be the benchmark for the external fund manager
also.
This committee is consciously not recommending any specific percentage of the funds
that may be allocated to the external fund managers. The Boards of the respective
pension or insurance companies may be left free to decide the portion that they would
like to allocate to the external fund manager, but the amount should not exceed 15%
of the total funds under management. The management can benchmark its
performance on fund management to the external manager and take corrective
measures, if required. This practice of allocating a part of the funds to external fund
manager would also provide a fair opportunity to the pension and insurance
companies to update their investment skills.
4. This committee would also like to address an issue of natural justice that eludes all
investors investing in pension and insurance products. All citizens must get an
opportunity to maximise their retirement income, regardless of where they work. In
the interest of equity and natural justice, all citizens must be allowed freedom of
individual choice to invest in whichever long-term retirement fund they want. Today,
citizens covered by the mandatory Employees Provident Fund Organisation are
locked in by the existing rules and are denied mobility. As a consequence, they are
deprived of the higher returns available to other retirement products, such as the
National Pension System (NPS) administered by the Pension Fund Regulatory and
Development Authority. This is patently unfair.
The NPS architecture already allows investors portability within the system any
investor is free to move his retirement corpus from one fund manager to another. The
architecture is also not restricted by geography or by place of work. This is to allow
all investors freedom of choice and an opportunity to maximise their retirement
incomes. This committee recommends that all pension and insurance investors be
granted their right of portability; they should be able to take their investments to
whichever fund manager is providing their higher returns. This is a fundamental right
and should be granted forthwith.
Importantly, if all long-term savings are managed by funds which are regulated by
either PFRDA or SEBI, it will be possible to get a better handle on setting suitable
and uniform investment regulations and on obtaining investment compliance.
5. It goes without saying that the move to a prudent investor regime cannot, and must
not, take place abruptly and overnight without giving the extant systems an
opportunity to upgrade, re-learn and re-tool. In other words, the move needs to be
phased out. The committee recommends the following phase-out:
a. First Two Years: The current boundaries of directed investment should be
diminished to allow for more play to individual fund managers. As a beginning,
the regulator can start tweaking the ratios in the overall menu of directed
investments. This committee feels that, following up on its recommendation of a
uniform investment mandate, the immediate requirement is to allow for a higher
investment limit into equities. Room should also be made for investment in
exchange traded funds, debt mutual funds and asset-backed securities, as
highlighted by Finance Minister Shri P Chidambaram in his budget
announcement for 2013-14. The new investment mandate should look like this:
Nature of Investment %age to be
Invested
1. Government Securities 30%
a. Including a maximum of 10% in other securities
where principal and interest payment are
guaranteed by the Central or State governments

2. Equities and Equity-related Mutual Funds 15%
3. Corporate Bonds 40%
a. Including a maximum of 15% in bonds which are
floated by infrastructure companies as defined by
the Reserve Bank of India

4. ETFs, Debt Mutual Funds, Asset-Backed Securities,
Derivatives
15%

As is evident from the table above, the time is indeed ripe for allowing greater
limits in equity, corporate bonds (especially with a slightly higher risk profile),
paper from infrastructure sector, derivatives (within reasonable limits). Apart
from allowing higher investment limits in equity, the regulators might even
examine the possibility of allowing insurance and pension companies to trade in
derivatives so that they can hedge their cash positions. The move should be
marginal and must suggest a change in approach.
Insurance and pension companies need to focus on twin objectives of improving
real rate of returns and making more financing available for infrastructure and
other long term projects, since they need assets that match the maturity profile
of their liabilities. This would require introduction of some new products and
expansion of some existing ones, such as credit enhancement and credit
derivatives.
b. Next Three Years: During this period, strings of directed investment norms must
be substantially loosened to prepare for a complete shift to product investor
regime. The committee feels that the regulators must jettison the mandated
investment edict at this stage and move to a structure of prudential guidelines,
which seek to achieve substantive and qualitative risk diminution within the
framework of modern portfolio theory. For instance, the regulator must at this
stage specify which assets should be out of bounds or how much of its AUM a
fund can invest in the equity of any one company or sector. For fixed income
securities, the regulator can prescribe a dynamic and comprehensive asset-
liability management module which could include, among others, duration gap
limits, prudential limits for interest rate sensitivity and a structural liquidity
framework. While doing so the regulator must allow for the introduction of
some new ideas and new products, such as Real Estate Investment Trusts,
commodity futures, Infrastructure Investment Trusts units, etc. It must be kept
in mind that only such financial products be allowed which are exchange-traded,
so that counter-party risk is eliminated, liquidity is enhanced and exchange-level
regulation keeps a check on excess volatility. Progress can be reviewed after
three years. This should be the phase when financial markets get ready to offer
full basket of products for IPFM to choose from.
c. After Five Years: Move to Prudent Investor regime completely.
6. As a measure of abundant precaution, the regulator should lay down guidelines and
rules regarding fit and proper persons that can be appointed to the Investment
Committee and provide detailed guidelines on the broad principles of the governance
processes, including risk management and risk mitigation. This will take into account
the knowledge, skills and experience of the professionals being appointed to the
Committee.
a. Their term being limited to 3-5 years with a second term only possible after a gap
of another three years. All members should have a maximum of only two terms.
b. It is also not necessary that only Board members be seconded to the Investment
Committee. The Board should also be given the freedom to invite experts in the
fields of finance and investment analysis.
7. In addition to the above recommendations, some of the measures briefly outlined in
one of the earlier chapters must be implemented -- during the interim 5-year transition
to prudent investor regime -- to allow for capacity building within the related
institutional architecture, primarily to smoothen the journey to prudent investor
regime. This will include the following:
i. Regulatory oversight
ii. Corporate governance structure and processes
iii. Policy formulation
iv. Risk management
v. Building up a pool of Trustees and Investment Managers
8. In this committees various meetings with stakeholders, one misgiving kept cropping
up: while it might be desirable to move to a prudent investor regime, this might not
be possible immediately since there is not enough supply of fixed income paper in
categories other than government securities. As our research has shown, and as has
been covered in this report in the earlier chapters, there is indeed a shortage of paper
supply.
There is, therefore, a dire need to increase the supply of paper across the maturity
curve and across risk profiles. This will only be possible when there is fully
functioning corporate bond market, which has an equally diverse mix of issuers and
investors. Today, the debt market is characterised by the presence of homogenous
players with analogous horizons.
Numerous reports such as the R.H. Patil Committee Report -- have outlined what
needs to be done to get a proper, deep and liquid corporate bond market. It is time that
such a market was put in place, not only for increasing the pipeline of paper for
insurance companies and pension funds, but to also provide an alternative and
necessary platform for projects seeking a proper blend of funds. Today, for most
companies which are not rated AAA, bank funds are the only source of non-equity
financing. This not only leads to inefficient allocation of capital but also ends up
putting an enormous strain on bank balance sheets.
Substantial groundwork has already been undertaken by all the agencies concerned.
However, progress still eludes us. The development of a proper corporate bond
market will require the removal of the remaining tax and regulatory constraints. The
government might want to also examine if some introductory incentives can be built
into the overall structure say, exempting bond trading from securities trading tax as
a run-up to incentivising the growth and development of the markets. It is our belief
that the pay-off arising from a vibrant debt market will be in multiples and will more
than compensate for the temporary loss in revenue.
9. It might, also, not be such a bad idea to entrust the Securities and Exchange Board of
India with all forms of exchange trading, including for corporate bonds and other
fixed income products, as has been suggested on numerous occasions. Alternatively, a
system like the Negotiated Dealing System an electronic trading system operated by
RBI for G-sec trade confirmation and settlement under novation from the Clearing
Corporation could be made available for corporate bonds as well.

10. Separately, regulators should allow insurance companies and pension funds to invest a
higher limit of their investible funds in securities rated below AAA. Insurance
companies have the ability to stay invested in long dated bonds, even if they are
below the desired AAA-rating. The credit enhancement through CDO (Collateralised
Debt Obligations) and CDS (Credit Default Swaps) etc. can help risk mitigation.
There is another related issue. Today insurance companies cannot invest more than
10% in any single issuer. The regulators should re-examine the validity of this limit in
the current circumstances, particularly when the current shallow market does not
provide adequate space to invest elsewhere profitably for large investors like LIC.
11. There is no denying the fact that government bonds will continue to play a vital role
in the investment portfolios of both insurance companies and pension funds.
Government bonds play a stabilising role in any portfolio, especially for smoothening
out volatility. However, recent experience shows that yield on government bonds has
been lagging the rate of inflation, thereby providing investors with a negative real rate
of return.
Given that a large portion of investment portfolios in insurance companies and
pension funds will continue to comprise government securities, it might become
necessary for them to seek a hedge against their real returns turning negative. A
partial solution has already been offered. After Budget 2013-14 announced the launch
of inflation-indexed bonds or inflation-indexed national security certificates, the
central bank launched its first tranche of inflation-indexed bonds (Rs 1,000 crore) on
June 4, 2013. These bonds were indexed to the wholesale price index of January, as
per RBIs policy of using the final inflation with a lag of four months. The RBI is also
now promising to issue inflation-indexed securities indexed to the consumer price
inflation.
Pension funds and insurance companies need a special dispensation. Given that they
absorb subscriptions and premium inflows on a continuous basis, the central bank will
have to provide them with inflation-indexed bonds on tap, at pre-determined intervals.
The other regulators concerned should take this up with RBI immediately to develop a
protocol and issuance calendar.
For an understanding of how these bonds work, the Reserve Bank published a
technical paper titled Inflation Indexed Bonds
(http://www.rbi.org.in/scripts/PublicationReportDetails.aspx?UrlPage=&ID=598).
12. Allow pension fund managers and insurance companies to pool their investments
together in a company, like it is done in the case of bank consortia. This will allow
sharing of risk.

Alternatively, given the limited scope for banks to keep participating in infrastructure,
allow insurance and pension funds to participate in the consortia. This allows
insurance and pension access to the appraisal skills present in banks till these
institutions build their own.
13. Implement financialisation of physical assets, which are popularly perceived to be
risky and volatile, such as bullion or real estate. Financialisation allows for exchange-
traded instruments and provides liquidity. Exchange trading also provides guarantees
against counter-party risk. This committee would also request regulators to examine
how infrastructure projects can be made appealing to retail investors, without
weakening any of the safety issues. Introduction of Infrastructure Investment Trust
units, traded on the exchange platform could be one of the methods to do.
This has another collateral benefit. Many gold buyers in India with the exception of
those purchasing it for traditional reasons, such as weddings invest in the yellow
metal as a hedge against inflation. Once they realise that buying a gold unit, which
can also be traded on the exchanges, is almost similar to buying the real thing, and in
a crunch can actually be exchanged for the real thing, it might bring down the
widespread propensity to hoard bullion. However, this market will develop -- with
depth and liquidity -- only if the insurance and pension funds are allowed to invest in
such instruments.
14. As a logical corollary to the recommendations of financialising physical assets, this
committee also sees some opportunity in reviving the reverse mortgage market. Given
the rapidly transforming demographic, sociological and economic dynamics of Indian
society, particularly in relation to those in 60-80-years age group, it makes sense to
revive the reverse mortgage market for those willing to leverage their investment in
property to finance their old age consumption. This committee is aware that reverse
mortgages will, at best, enjoy marginal acceptance as is evident from its low
popularity after its introduction but it does provide an opportunity to add another
product to deepen and diversify the market.
15. The commodity market especially the futures market -- also needs to be developed.
This will be only possible when the commodity exchanges are brought under a single
regulator responsible for all futures trading. Today, equity futures trading is regulated
by Sebi, while all commodity futures trading exchanges come under the regulatory
jurisdiction of the Forward Markets Commission, which is an arm of the Agriculture
Ministry. It might be pointed out here that SEBI has already gained expertise on
regulating futures market for over a decade now, including building a robust
framework around it. Therefore, this committee suggests that all futures trading be
brought under SEBI which already has the necessary capability.
16. One of the main hurdles hindering the financing of infrastructure projects is the
absence of a vibrant credit enhancement culture. Most insurance companies and
pension funds are barred from investing below a certain credit rating. While that floor
needs to be relaxed a bit more, it may still not be sufficient to include paper issued by
infrastructure companies. Credit enhancement can be of immense help here.
Today the system has only one proper credit enhancement agency India
Infrastructure Finance Corporation Ltd. However, given the volume and scope of
financing needed during the Twelfth Five year Plan, multiple platforms are required
for credit enhancement. Many more institutions offering credit enhancement products
have to be developed. The need is urgent and will demand for the instrument will
grow with growth and expansion of the economy.
17. Re-focus on Indian Depository Receipts. The product already exists but suffers from
poor marketing. In fact, there is also enormous scope for extending the rupee bonds
market to wider range of overseas issuers. Currently, barring Standard Chartered
Bank, only multilateral lending agencies have used that window, and that too
sparingly. Such rupee bonds and IDRs provide a unique investment opportunity for
insurance and pension companies. It not only gives them an opportunity to invest in
select foreign companies without having to cross the national borders (currently they
are prohibited from investing in overseas assets), it also insulates them from currency
risks. There is another bonus: it provides them with the opportunity to upgrade their
appraisal skills and benefit from an ability to invest in profitable overseas
opportunities. Insurance and pension funds should be allowed to invest in such
instruments.
18. It might also be apposite for the government to revisit the report submitted by the
High Powered Expert Committee on Making Mumbai an International Financial
Centre, and re-examine its various proposals. An International Financial Centre will
be useful in product development, increasing the depth and liquidity of markets, and
improving financialisation of physical assets. In fact, this will greatly help in reaping
greater benefits of prudent investor regime. The attendant benefits accruing from
such a development would be accelerated innovation in the product lines of the
financial markets.
19. Existing rules and guidelines prohibit insurance companies and pension funds from
investing in private limited companies. However, while this rule might have had some
logic in the past, in the current scenario it seems to be having unintended
consequences. For instance, most infrastructure projects are housed in private limited
companies, termed as Special Purpose Vehicles, or SPVs. As a result, these remain
out of the investment purview of insurance companies and pension funds. This rule,
therefore, needs to be scrapped or modified.
20. Focus on skill development. Wide-ranging capacity building has to take place across
the categories (insurance and pension) and sectors (public versus private) to enable
fund managers, compliance officers, dealers, marketing experts, sales agents, board
members, risk officers to improve their skills and help deliver improved returns to
investors.

a. As part of this exercise, companies and funds might need to tie up with various
management institutions and law schools. The regulators help might be
necessary for drafting the course structure and the pedagogy for the new
regime.
21. The government should look at launching some more infrastructure finance
companies, in addition to the ones existing today such as, Rural Electrification
Corporation, Power Finance Corporation. This will automatically increase the supply
of paper to the market.
22. The government should examine the possibility of exempting income -- arising out of
investments in infrastructure made by insurance companies or pension funds -- from
tax. This income can be in the form of dividends, interest income or capital gains. The
benefit of tax exemptions can create a virtuous circle apart from improving the
returns, it will also help infrastructure companies bring down their cost of capital
raising. A sunset clause can be built into the proposal to accelerate funds flows into
infrastructure projects in the initial stages of market development.
23. Government should examine the possibility of infrastructure bonds carrying some sort
of an explicit guarantee. We are not suggesting that the government provide the
guarantee on its own account since that would directly impact the fiscal balance.
Instead, the government could examine the possibility of allowing some of the
infrastructure finance companies such as IIFCL or Infrastructure Development
Finance Corporation -- to provide capital guarantee for a fee. In addition, the overall
design of the projects should include a partial recourse to the sponsors. This will
immediately improve the rating of the projects and allow investment by insurance
companies and pension funds.
24. The regulators should examine the possibility of allowing insurance companies and
pension funds to access the credit default swap markets to hedge their exposure to
paper floated by the infrastructure projects. However, the regulator will not only have
to ensure that the exposure to CDS is backed by an investment in fixed income paper
but also draw up a regulatory structure to minimise exposure risk in this market. It is
quite likely that the example of AIG (or other related incidents) would be used to beat
down the proposition. The only difference is this: while the CDS related blow-outs in
the western financial markets were a case of unfettered speculation and regulatory
failure, this committee is recommending facilitation of risk management. And this is a
great financial innovation, which is being used across geographies and sectors,
notwithstanding incidents of market failures and mishaps. When operated within a
proper regulatory framework, CDS can be used as an effective hedging tool.
25. Greater regulatory clarity is required on whether investments made by insurance
companies and pension funds in infrastructure funds should be classified as an
investment in a mutual fund which are currently allowed only as short-term
investments or in infrastructure. This will allow greater flexibility in portfolio
construction.
26. Insurance companies and pension funds should be allowed to invest in derivatives, in
both equities and bonds. This is essential for hedging their exposure in the cash
market.
a. Regulators may have valid concerns about the risks emanating from excessive
speculation in derivatives, especially since the eco-system prevailing in the
insurance and pension sectors has limited domain knowledge in the field. This
committee, however, is not suggesting or recommending that the floodgates to
be opened immediately. But, the regulators must evolve a roadmap with a
definite time-frame and clearly enunciated milestones that include capacity
building, improved governance and regulatory structures, higher disclosure
norms -- to move the industry towards a greater level of sophistication, one
that reduces risk but increases the returns. In addition, it goes without saying
that use of derivatives should be restricted to only hedging the investment
position in the cash markets.
27. Regulators should examine the possibility of allowing long-term fixed income
derivatives or interest rate swaps. Today, the insurance companies are allowed to
cover only one years cash flows. The time horizon should be elongated suitably,
given the liability profile of the insurance companies and pension funds. This will also
benefit the interest rate futures market.
28. We have already spoken about equity derivatives. Volatility is a given in any market,
the only difference being the degree of turbulence. Institutions investing the long term
savings of a large number of policy-holders should be provided the opportunity to
shield these investments from volatility through the instrumentality of derivatives. For
instance, a high beta portfolio can easily be brought down to a lower beta through
selling index futures.
29. Insurance companies can currently invest only up to 3% in a single banks fixed
deposits. The regulator concerned should reconsider raising this upper limit. While it
will improve the liquidity position in banks, it will also provide a cash buffer for fund
managers to meet unforeseen redemption calls or withdrawals.
30. Current IRDA investment guidelines allow investments in infrastructure only if such
assets/instruments have a minimum credit rating of AA, or A+ in exceptional cases
with the approval of the investment committee. Given the nature of structuring and
financing of infrastructure projects in the country, there is neither any revenue stream
in the initial years nor any recourse to the sponsor. This results in a low rating in the
initial years. It is recommended that the minimum rating standard for infrastructure
projects be relaxed substantially. Alternatively, as suggested earlier, project investors
should get a wider choice of credit enhancement facilities. Today, the number of
projects that can avail of credit enhancement is limited, directly proportional to the
limited number of players offering the service.
31. These guidelines further stipulate that not less than 75% of debt instruments,
excluding government and other approved securities, shall have a AAA or equivalent
rating. Given this condition, most of the insurance sectors infrastructure exposure
gets restricted to only AAA paper, most of which are issued by public sector
companies. Therefore, there is a crowding out of such investments for infrastructure
projects promoted by the private sector or even in the public-private participation
space. This 75% limit should, hence, be relaxed.
32. Under the IRDA Investment Regulations and Clarifications, insurance companies can
invest in debt of infrastructure companies up to a maximum of 25% of the project
equity or capital employed. In real terms, this works out to only 5-8.75% of the total
project cost, depending on the equity brought in by the promoters. It should also be
remembered that not all equity is brought in at the same time. It is recommended that
exposure of insurance companies should be linked to 15-20% total project cost.

















CHAPTER X
RECOMMENDATIONS: APPROACH & SUMMARY

The recommendations of the Committee attempt to achieve twin objectives of:
a) Facilitating the journey of insurance companies and pension funds to delivering
positive real rate returns
b) Facilitating financing of infrastructure and other financing needs of the economy in
greater measure.
In the process, the attendant benefits will hopefully be the following:
a) Broadening and deepening of the financial markets
b) Building capacities for credit enhancement
c) Growth and development of insurance and pension sectors with the delivery of
positive real rate returns
d) Growth of financial savings (which are low even from emerging market standards and
are declining) and thus helping higher GDP growth
These are sought to be achieved by moving to:
a) Prudent Investor regime from the current directed investment
b) Financialisation of investment in physical assets
c) Capacity building across the institutional framework to handle the challenges of the
new prudent investor regime sagaciously.
d) Clearing the bottlenecks on the path of new prudent investor regime
e) Transitional arrangements for a smooth roll-over from the current regime to new
regime.
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