Why India’s reliance on state insurance giant LIC to bailout troubled lenders is worrying

• Insurance regulator IRDAI warns insurance firms to make “prudent” decisions when investing in companies whose credit ratings have been downgraded.
  
• IRDAI had recently allowed LIC to vastly exceed the maximum of 15% stake an insurer can hold in any one company.
  
• Policyholders’ funds potentially at risk with large exposure to the investments.

Amid an escalating bad loans crisis, India appears to be relying heavily on the capital of state insurance giant Life Insurance Corporation (LIC) to bail out some of its troubled lenders, leading to experts worrying about a dangerous precedent being set by the insurer.

The country’s bad debt crisis involving its state-owned banks had largely been believed to have had manageable systemic risk with fairly low liquidity concerns –- until now.

India is in the midst of its worst liquidity crisis in two years triggered by the potential bankruptcy of infrastructure finance company Infrastructure Leasing and Financial Services Ltd (IL&FS), which has defaulted on a series of loan repayments, raising alarm in the country’s shadow banking sector and spooking financial markets.

LIC, the largest shareholder in IL&FS with a 25.3% stake, is reportedly investing close to ₹40 billion ($550 million) into IL&FS non-convertible debentures and also expected to subscribe to a ₹45 billion rights issue later this year. It is reportedly in the process of requesting India’s insolvency court National Company Law Tribunal to allow it time to resolve its current situation through its capital raising efforts and hold off on admitting a bankruptcy suit. The news of IL&FS comes weeks after LIC stepped in to also bailout state-owned IDBI Bank by increasing its stake from 8% to 51% for upto ₹130 billion.

Regulatory exceptionalism

India’s regulators restrict investments by insurance organisations to a maximum of 15% stake in any one company.

In the IDBI case, LIC sought special clearance from India’s insurance regulator Insurance Regulatory and Development Authority of India (IRDA), which reportedly waived the threshold “based on market conditions and the larger interest of the market and shareholders,” Mint reported in June.

Additionally, out of the investment LIC made in IDBI, less than 1% or only about ₹1 billion has come from LIC’s shareholders with the remaining being policyholders’ money, according to the Mint report. That shows the extent of how risky the move can be.

While LIC has indicated it will pare down its stake in IDBI in the coming years, no timeframe has been set by the insurer. LIC had earlier made an investment in Corporation Bank exceeding the threshold limit of 15% to buy a 27% stake, which took about 16 years for LIC to pare down, experts point out.

A case of throwing good money after bad?

Following the news of LIC investing in IL&FS, a subtle warning has come from the Insurance Regulatory and Development Authority of India (Irdai), which has asked insurance firms to make “prudent” decisions when investing in companies whose credit ratings have been downgraded.

Subhash C Khuntia, chairman of IRDAI, has said, “Normally, when there is a downgrade, insurers should withdraw their investment and place it somewhere else,” Khuntia said, adding it is up to the insurer to derive maximum value from its investments.

The National Organisation of Insurance Workers (NOIW), has also opposed LIC’s move to invest in IL&FS, with NOIW organising secretary Milind Ballal stating “thousands of crores of rupees collected by the LIC from ordinary Indians as premium is at stake.”

Joydeep K. Roy, partner and leader, insurance sector, PwC, had termed LIC’s investment in IDBI an “extraordinary event” that “should not be allowed as a precedent.”

“Insurers holding a larger share of any one company for policyholders’ funds can increase the entire risk profile of the portfolio. However, this is ultimately an equity transaction for policyholder funds and can result in profits or losses,” Roy said.

While Sanket Kawatkar, Principal and Consulting Actuary, Life Insurance, Milliman India, has warned LIC policyholders’ benefits would be adversely impacted if LIC incurs a loss on its investment.

Elsewhere, insurers’ exposure to bad debt has led to dire consequences. In the 2008 credit crisis in the US, for instance, insurance giant American Insurance Group (AIG) had a near collapse because of the insurer’s exposure to soured loans through its investment in risky credit default swaps. That led to the US Federal Reserve bailing out AIG by giving a crucial loan of $85 billion that kept it from going under.