LIC of India : Of Notional Losses and Profits

The real guarantee with LIC is its scale and size that makes it too big to fail.

Last week, there was this news item in a number of newspapers about the Life Insurance Corporation discovering (or admitting to, it wasn't clear which), a Rs 14,000-crore shortfall in three guaranteed return annuity schemes that it runs. This shortfall has come to happen because these schemes were launched with guaranteed returns of around 12% during the 80s and 90s.

Now, the fixed income returns that are realizable in the Indian economy are sharply lower and so there's a gap between what the assets in these schemes should be worth if they are to meet future liabilities and what they are actually worth.

In its defense, LIC has offered two mitigating factors - one, that these losses are notional. And two, the shortfall will be compensated by other plans - there are always some plans which have a surplus and some in deficit. This is encouraging to hear but nonetheless a little problematic.

Firstly, I think the experience of the 2008 economic crisis has made all of us a little skeptical of the actual nationality of notional losses. I often wonder why companies dismiss notional losses in such an off-handed manner while never managing to do the same for notional profits.

After all, if some schemes are always in deficit and in some in surplus, then the surpluses must, correspondingly, be precisely as notional as the losses. Why don't we ever hear a company management say, "Listen, don't pay any attention to all these gains we have on our investments - they are mere notional profits. They are irrelevant." Why this step-motherly treatment for notional losses alone?

In any case, the root cause of this gap doesn't sound notional to me. A gap between the returns that are guaranteed is not only real but more alarmingly is very likely to grow at an exponentially higher rate. Fixed income returns in India are likely to be lower than the 12% the schemes need in the foreseeable future. Quite possibly, the annual gap will be at least three to four per cent on a sustained basis. This means that the shortfall, whatever it is, will grow at a compounding rate. The guaranteed schemes yet have a few decades more to run. A three per cent p.a. gap will compound to 80% in twenty years and to 165% at 5% a year over the same period. It's very likely that the gap will always be a manageable proportion of LIC's total asset base, but it certainly will be a far from trivial amount.

Still, as an LIC customer, you needn't ever worry. If there's an organization in India that really is too big to fail, then that's LIC. No matter how much it mismanages its products or its investments, the Government of India will step up to the plate. Whatever be the shortfall, the taxpayer will fill it. And that's the real guarantee