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The burden of reconstruction

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 providers of no medical exam life insurance 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.

This article was originally published on Setopati on the 8th of January, 2016. The article was authored by Dinesh Karki. For the original version of the article, please click here

Dinesh Karki

About Dinesh Karki

Dinesh Karki is an independent researcher. He has Economics degree from Xi'an Jiaotong-Liverpool University, Suzhou, China.

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Limited Government and Maximum Governance

The development activities were carried out relatively rapidly during the three-decade Panchayat although the country was ruled under single party system. A lot of infrastructural developments took place then. The roads of Nepal, Mahendra Highway, Arniko Highway (that connects Nepal with China), Tribhuvan Highway, Kulekhani Hydropower Project (the only one storage type project in Nepal), were built during the same period. Institutions such as Nepal Electricity Authority (NEA), Nepal Telecommunication Corporation, Nepal Drinking Water Corporation, and Nepal Airline Corporation (NAC) which were very essential for providing electricity, communication, water and air services to the people were created during the direct regime of the King which lasted till 1990. The development process is similar in other countries as economic development is initiated with the involvement of government intervention.

However, the involvement of government is not a sufficient condition for bringing prosperity at every nook and corner of the country because it monopolizes resources available and, hence, looses the incentive to utilize these resources efficiently in the absence of active participation of private sectors, which is quick in decision-making and following innovative practices. This is very true in case of Nepal as well as evinced by several examples in service and production sectors.

The generation of electricity has increased after deregulating energy sector by bringing Electricity Act in 1992. Private initiatives have already contributed to adding more than 237 MW of electricity to the national grid. Currently, around 44 projects, with a total capacity of 338 MW are under different stages of construction, and 76 hydroelectric projects that can contribute 711 MW to the national grid have already concluded Power Purchasing Agreements (PPAs) with the NEA. The output of electricity is expected to increase after complete deregulation in distribution as well transmission system as it solves one of the critical constraints – the construction of transmission lines by acquiring private land – of this sector. The government has recently decided to form a Transmission Company by including all the stakeholders such as Ministry of Finance (MoF), Ministry of Forest and Soil Conservation, Ministry of Environment, Science and Technology, Ministry of Land Reforms and Management, Ministry of Information and Communications, Ministry of Defense and Ministry of Home Affairs, and general public in order to solve the problems being faced by 18 different projects (worth over 650 MW) – continuous delay in construction of transmission system being the major one.

Access to mobile as well as landline phone has also risen after involvement of Ncell, United Telecom Limited (UTL), Nepal Telecom Satellite Private Limited (Hello Nepal), and through structural change of Nepal Telecommunication Corporation by disinvesting government’s share to its staff and general public and rebranding the same company as Nepal Telecom. These are just a few examples of sectorial development that Nepalese people have observed in the recent past. The easy access on phone has helped in overall development of the country as the farmers living in remote parts of the country can access necessary information such as the price, demand, supply and stock of their product, and initiate new ventures with the support of internet facility that is available in the mobile phones.

Liberalization, followed by privatisation is needed in an economy to mobilize human resources effectively and efficiently, reduce unnecessary expenditure, and manage other available resources more wisely. Furthermore, the involvement of private sector is very helpful for avoiding additional costs associated with insurance, pension and so on. Every year, Nepalese government has to allocate a large chunk of budget for such expenditure which increases with increase in number of employees.

On top of this, it is not necessary for private sector to follow lengthy recruitment processes that requires an examinee to go through a series of exams that lasts for more than a year. They do not have to worry about being unable to fire any staff unless they are legally declared unsound. It is widely accepted fact that without the presence of vibrant private sector, there is possibility of monopolization of the resources that reduces the chance of innovation – which actually results in fewer jobs in the country.

While the private sector helps in achieving high growth trajectory by judicious use of all forms of resources in the country, the government too can aid by maintaining rule of law, providing free and fair justice, and protecting private property. Only a decade ago, nobody wanted to establish any new enterprises in the Indian State of Bihar. This was also before Nitish Kumar came into power as the Chief Minister at a time when entrepreneurs were mugged, extorted and threatened by criminals. There was no security of life and property.

Today, many domestic and foreign entrepreneurs who want to invest in Nepal are not ready to do so due to lack of security of their property and absence of proper patient rights. Therefore, the government should make every effort to create an enabling environment for doing business by formulating necessary policies that bring efficiency to the economy, incentivize investments, and promote the culture of entrepreneurship.

Pramod Rijal

About Pramod Rijal

Pramod Rijal is a Research Associate at Samriddhi, The Prosperity Foundation. He is also a lecturer of Economics at Mega National and Unique College of Management and has contributed a number of articles in various national dailies.

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