This article was originally published in Setopati on 8 Jan 2016.
The legislative parliament has passed the Reconstruction Authority Bill for executing the rebuilding program by disseminating the targeted $2 billion reconstruction fund plus $ 4.4 billion pledged by foreign governments and donors as grants and soft loans. The National Planning Commission (NPC) estimates the cost of reconstruction to be as high as $ 6.7 billion. The obvious question to ask now is ‘Who is going to bear all this cost?’ The obvious answer is us – the taxpayers. And if so, why is there a need for such huge government assistance in the first place? One plausible answer is that protective measures like buying insurance could have lowered the fund needed for reconstruction. However, such voluntary adoption of protective measures as buying insurance is very low in Nepal. In fact, some serious regulatory hurdles have constrained the growth of insurance industry!
Insurance penetration is very low in Nepal – a mere 1.42% of the GDP as per the Insurance Board of Nepal (IBN) data. The same for emerging markets averages 1.75% of the GDP. The compensation amount post-earthquake from insurers stands at Rs. 3.519 billion, a mere fraction of the required reconstruction costs. Apparently, there would be no need for such costly reconstruction assistance from the government had there been more structures been insured against earthquake-induced damages.
Rigid Solvency and Investment Requirements
In the name of prudential regulation for protecting consumers in case of insolvency, the IBN heavily regulates the insurance companies. There are strict solvency requirements and rigid investment requirements that limit the insurance companies from devising their own risk-management strategies.
The board has laid out solvency ratios and their consequent corrective actions. These solvency controls are uniform rule-based quantitative requirements without incorporating the risks undertaken by the insurers. It leads to a restrictive atmosphere where insurers are forced to meet inappropriate capital requirements even when the riskiness of their portfolio is low. Swiss Solvency Test (SST) in Switzerland and Solvency II Directive in the EU, for instance, align capital requirements with their specific risk profile.
The IBN has also laid out quantitative (mandatory minimum) requirements for investment in limited asset classes (for example, government securities, treasury bills, fixed or short term deposits of commercial banks, etc.) in the name of minimizing risks from uncertain losses. As per the recent IBN data, only 16.4% of the actual investments made by non-life insurers are under unregulated category which further proves how restrictive the requirements are. Such highly restrictive solvency and investment requirements are detrimental to the insurance industry as they stifle product development, innovation and competition.
Price-setting and Confidentiality of Premiums
The premiums charged for different categories of houses are set by the Insurance Tariff Advisory Committee (ITAC). The tariff and the premium rates are rendered confidential and are not available to consumers even when demanded. Such provision of price setting and confidentiality creates a problem of asymmetric information and further distorts the coordination of the insurance market through prices. Further, such price setting could lead to ‘cartel-type market arrangement’ imposing higher costs to insurers as well as consumers. Another problem is that they are not based on any actuarial methodologies; meaning, they are not based on specific risks of the policyholder. The basic principle of insurance dictates that equal risks must be treated equally while unequal risks must be treated differently. When unequal risks are pooled together and levied a uniform premium rate, this gives rise to the classic problem of ‘adverse selection’. In other words, such policies become more attractive to high risk consumers and unattractive to low risk consumers.
Disincentives for Purchasing Insurance: Earthquake Deductible and Low Claim Settlement
As far as the purchase-decisions are concerned, one clear disincentive for people while buying insurance is not being eligible for compensation. According to the latest IBN data, about 20% of the claims (i.e. 3499 out of 17,400 claims are ‘no claim’) related to earthquake are either ineligible or withdrawn by the homeowners. One of the reasons for the case of ‘no claim’ is because the claims are either equal or lower than the amount that insurers are allowed to deduct while settling claims. When we compare this to Japan’s case for instance, insurers are required to reimburse 100% of the insured amount. Another constraint for purchase and post-purchase decision can be attributed to the ineffective claim settlement process. The probability that an insurance claim will receive some compensation after being evaluated by a supervisor stands at just 3.28%.
The Reconstruction Bill and the Moral Hazard Problem
Even before people decide to purchase an insurance policy, they should recognize the need for it and evaluate other alternatives. When there is a strong assumption that the government will provide grants and soft-loans in case of an earthquake, there would be no financial incentive for people to purchase insurance. Inference from history suggests that post-disaster government responses play the role of the substitute to disaster preparedness. For example, loans provided during the reconstruction and rehabilitation program after the earthquake of 1988 were later converted into grants. Further, lobbying for total loan forgiveness in the past is a testimony for rent-seeking and vote-bank-securing behavior from politicians and interest groups. Though meeting immediate needs of the earthquake victims can be justified from the humanitarian aspect, outright grants and low-interest loans would only make things worse in the present and the future.
Tying It All Together
Removing these regulatory supply constraints will create room for the disaster insurance market to expand and thus cover more properties. This expansion will shift the risks of disasters like earthquakes to the homeowners themselves. The government will not have to redirect huge amounts of taxpayers’ funds to rebuilding efforts. Removing these constraints should in no way be viewed as a magic-wand; insurers will not magically cover all nooks and crannies of the country right away. Like all market processes, this will be a continuous process and will see scores of adjustments along the way. Having said that, this is in every way, a move in the right direction – letting the market thrive, giving choices to the people, and most importantly, reducing the burden to the government – the government that has not been very efficient in handling the relief and reconstruction activities to say the absolute least.