Deregulate the financial sector

-This article was originally published in The Himalayan Times on 27 March 2016 by Dinesh Karki.

Decades after the financial sector liberalisation began in Nepal, the present day financial sector still deviates from basic market principles. Financial institutions have to operate under strict regulations which render the regulatory regime anything but liberal. Consequently, the security and services that are available to consumers are limited. Last year’s devastating earthquake exposed a huge protection gap — the difference between insured and uninsured loss — for properties in Nepal. The pocketsized compensation from insurance companies for losses due to the earthquake indicates that Nepal’s insurance industry is still at a rudimentary stage. Interventionist and superfluous policies of regulators are the major impediments to the growth of insurance sector in Nepal.


In the second week of March, the Nepali stock market index peaked to a record high. One key driver of the soaring index was the transaction of securities of insurance companies. According to the Nepali print media, demand for securities of insurance companies rose owing to speculations among investors that the Insurance Board, the apex regulator of insurance business, is considering a new rule to raise the paid-up capital of insurers. Such a capital floor may or may not prove to be prudential in terms of strengthening the financial health of insurers, but it could potentially engender mergers when given a short time frame. When Nepal Rastra Bank raised the paid-up capital for banks last year, it impelled several banks to merge. A floor of capital requirement may obliterate smaller insurance companies that specialise in their niche market and don’t wish to expand. Such regulation ultimately breeds a consolidated financial market reducing competition.


The regulatory digression from market principles does not end there. The board’s investment and reinsurance portfolio requirements are worryingly didactical. The board directs insurers to invest certain percentage at minimum in particular asset classes while there is a cap for some other asset classes. Similarly, the percentage of reinsurance from a reinsurer that the insurers are allowed to maintain in their portfolio varies according to the credit rating of the reinsurers. These regulatory requirements have held back insurers from taking self-initiative in exploring profitable investment opportunities and appropriate reinsurance contracts.


What is even more worrying is that the regulation digresses from the fundamental principles of a market economy — the price system. The tariff advisory committee sets the tariff of the premium rates for fire insurance which also covers earthquake damage. Insurers are not allowed to charge prices different from the fixed price. One major problem with the fixed tariff rates is that they are uniform regardless of specific risk associated with the property being insured like the geographical seismic risk. The basic principle of insurance dictates that equal risks be treated equally while unequal risks should be treated differently. Such a uniform regulatory price ensue the problem of adverse selection — one of the most feared hazards in insurance business. When unequal risks are pooled together, high risk consumers will be more willing to buy insurance while it becomes less attractive to low-risk consumers. Insurers must be allowed to differentiate risks based on actuarial principles and accordingly differentiate premium prices. Further, tampering with the price system distorts the market mechanism precluding even the willing consumers from purchasing insurance. On the other hand, regulatory price fixing also distorts insurers’ incentive mechanism as they would not be able to charge different prices through product differentiation.


Let us think about what could materialise if there were a more liberal regulatory regime for insurance. First, there could’ve been more insurance companies, if the minimum paid-up capital and solvency regulation were not as rigid. If insurance companies were allowed to invest where they think is more profitable and keep a reinsurance portfolio that they think would hedge most of their risks, they would have incentive to develop their own risk management strategies. And, they could have maintained their solvency while increasing their profits themselves. Similarly, if they were allowed to charge prices guided by market forces, they would have more incentives to innovate. It is obvious that the financial liberalisation that began decades ago is still incomplete. There is an urgent need to deregulate the financial sector for the economic wellbeing of all other sectors. Had there been a deregulated insurance industry, the insurance companies could have come up with products that catered to a variety of customers, living anywhere. When insurer’s coverage grows by a fraction, the government has that fraction less to bear the entire responsibility of; the customer is secured against risks, the insurer’s business grows, the state’s role is curtailed and the burden on the taxpayer is lessened.