report - draft - risk management - poornima

8/2/2019 Report - Draft - Risk Management - Poornima

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Objective of the study:

To conduct a study on the various funds offered by the ULIP policies and analyse their riskand return characteristics, to calculate the effective risk and return of the entire portfolio and

optimize it using the sharpe ratio.

Methodology

The Research methodology used is the Descriptive Research Methodology, which enables the

researcher to describe a situation, problem, phenomenon, or service systematically and also

determines the results and solutions for such a problem. Here, the Descriptive Research

Methodology helps the researcher determine the amount of risk and return in each fund of the

ULIP product offered by HDFC Standard Life.


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Chapter 2

Evolution of Insurance

2.1 A Brief History

The origin of life insurance in India can be traced back to 1818 with the establishment of the Oriental

Life Insurance Company in Calcutta. It was conceived as a means to provide for English Widows. In

those days a higher premium was charged for Indian lives than the non-Indian lives as Indian lives

were considered riskier for coverage. Raja Ram Mohan Roy, the leader of the masses gave a call, in

the year 1822, for an Indian company to be formed. But, the first Indian insurance company was

formed only in 1870, by G A Summers of Bombay High Court and six others, and was named

Bombay Mutual Life Assurance Society.

This was followed by the Hindu Family Annuity Fund in 1872 by Pandit Iswarachandra Vidya

Sagar, and the Oriental Government Security Life Assurance Company in 1874 by D M Slater and Sir

Pheroze Shah Mehra. Shri Lala Hari Kishan Lal of Lahore started the Bharat Insurance Company in

1896. The formation of these and other companies like Bombay Life, Lakshmi, Indian Mutual, etc

necessitated the streamlining of their activities.

Some of the important milestones in the life insurance business in india have been:

Year Milestones in the life insurance business in India

1912 The Indian Life Assurance Companies Act (to regulate life insurance business)and Provident Insurance Societies Act were enacted. These legislations were notadequate to cover the fast changing situations. They also did not cover generalinsurance functions.

1928 The Indian Insurance Companies Act was enacted to enable the government tocollect statistical information about both life and non-life insurance businesses,but, it wasnt comprehensive.

1938 Earlier legislation consolidated and amended to by the Insurance Act with theobjective of protecting the interests of the insuring public.1956 170 life insurance companies and 75 provident societies taken over by the

central government and nationalised. LIC formed by an Act of Parliament, viz.LIC Act, 1956, with a capital contribution of Rs. 5 crore from the Governmentof India.

The expectation and the awareness of the insuring public were growing, but, the insurance business

still contributed in a very small measure to the growth of the GDP. Hence, in 1993, Malhotra

Committee headed by former Finance Secretary and RBI Governor R.N. Malhotra was formed to

evaluate the Indian insurance industry and recommend its future direction.


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The Malhotra committee was set up with the objective of complementing the reforms initiated in the

financial sector. The reforms were aimed at "creating a more efficient and competitive financial

system suitable for the requirements of the economy keeping in mind the structural changes currently

underway and recognizing insurance as an important part of the overall financial system.

In 1994, the committee submitted the report and some of the key recommendations included:

Structure:

Government stake in the insurance Companies to be brought down to 50%. Government should take over the holdings of GIC and its subsidiaries so that these

subsidiaries can act as independent corporations.

All the insurance companies should be given greater freedom to operate.Competition:

Private Companies with a minimum paid up capital of Rs.1 billion should be allowed to enterthe industry.

No Company should deal in both Life and General Insurance through a single entity. Foreign companies may be allowed to enter the industry in collaboration with the domestic

companies.

Postal Life Insurance should be allowed to operate in the rural market. Only One State Level Life Insurance Company should be allowed to operate in each state.

Regulatory Body:

The Insurance Act should be changed. An Insurance Regulatory body should be set up. Controller of Insurance (Currently a part from the Finance Ministry) should be made

independent.

Investments:

Mandatory Investments of LIC Life Fund in government securities to be reduced from 75% to50%.

GIC and its subsidiaries are not to hold more than 5% in any company (There currentholdings to be brought down to this level over a period of time).


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Customer Service:

LIC should pay interest on delays in payments beyond 30 days. Insurance companies must be encouraged to set up unit linked pension plans. Computerisation of operations and updating of technology to be carried out in the insurance

industry The committee emphasized that in order to improve the customer services and

increase the coverage of the insurance industry should be opened up to competition.

But at the same time, the committee felt the need to exercise caution as any failure on the part of new

players could ruin the public confidence in the industry. Hence, it was decided to allow competition in

a limited way by stipulating the minimum capital requirement of Rs.100 crores. The committee felt

the need to provide greater autonomy to insurance companies in order to improve their performance

and enable them to act as independent companies with economic motives. For this purpose, it hadproposed setting up an independent regulatory body.

2.2 IRDA (Insurance Regulatory and Development Authority)

As per the provisions of IRDA Act, 1999, Insurance Regulatory and Development Authority (IRDA)

was established on 19th April 2000 to protect the interests of holder of insurance policy and to

regulate, promote and ensure orderly growth of the insurance industry. IRDA Act 1999 paved the way

for the entry of private players into the insurance market which was hitherto the exclusive privilege of

public sector insurance companies/ corporations. Under the new dispensation Indian insurance

companies in private sector were permitted to operate in India with the following conditions:

Company is formed and registered under the Companies Act, 1956. The aggregate holdings of equity shares by a foreign company, either by itself or through its

subsidiary companies or its nominees, do not exceed 26%, paid up equity capital of such

Indian insurance company.

The company's sole purpose is to carry on life insurance business or general insurancebusiness or reinsurance business.

The minimum paid up equity capital for life or general insurance business is Rs.100 crores. The minimum paid up equity capital for carrying on reinsurance business has been prescribed

as Rs.200 crores.

Section 14 of IRDA Act, 1999 lays down the duties, powers and functions of IRDA as follows:

Issue to the applicant a certificate of registration, renew, modify, withdraw, suspend or cancelsuch registration;


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Protection of the interests of the policy holders in matters concerning assigning of policy,nomination by policy holders, insurable interest, settlement of insurance claim, surrender

value of policy and other terms and conditions of contracts of insurance;

Specifying requisite qualifications, code of conduct and practical training for intermediary orinsurance intermediaries and agents

Specifying the code of conduct for surveyors and loss assessors; Promoting efficiency in the conduct of insurance business; Promoting and regulating professional organisations connected with the insurance and re-

insurance business;

Levying fees and other charges for carrying out the purposes of this Act; Calling for information from, undertaking inspection of, conducting enquiries and

investigations including audit of the insurers, intermediaries, insurance intermediaries andother organisations connected with the insurance business;

Control and regulation of the rates, advantages, terms and conditions that may be offered byinsurers in respect of general insurance business not so controlled and regulated by the Tariff

Advisory Committee under section 64U of the Insurance Act, 1938 (4 of 1938);

Specifying the form and manner in which books of account shall be maintained and statementof accounts shall be rendered by insurers and other insurance intermediaries;

Regulating investment of funds by insurance companies; Regulating maintenance of margin of solvency; Adjudication of disputes between insurers and intermediaries or insurance intermediaries; Supervising the functioning of the Tariff Advisory Committee; Specifying the percentage of premium income of the insurer to finance schemes for

promoting and regulating professional organisations referred to in clause (f);

Specifying the percentage of life insurance business and general insurance business to beundertaken by the insurer in the rural or social sector; and

Exercising such other powers as may be prescribed

2.3 Industry Analysis

With a massive population base and huge untapped and under-penetrated market, the insurance

industry is home to tremendous opportunity in India as well as foreign investors.

India today is the fifth largest life insurance market amongst the emerging insuranceeconomies globally.


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It has grown at 25% CAGR since the market opened up in 2000. This impressive growth inthe market has been driven by fundamental factors like liberalization, global economic boom,

young population, growing middle class, rising income levels and customer awareness.

India successfully scores over China when it comes to demographic profile, premium growthrate, penetration level and as an investment destination.

In India, life insurance is a booming sector with huge possibilities for different globalcompanies, as life insurance premiums account to 2.5% of Indias GDP.

In 2010, the life insurance industry had reported a growth of 15% over the previous year. The industry grossed new business premium of Rs 1.26 lakh crores in FY10-11 over Rs 1.09

lakh crores in FY 09-10. However, most of this growth was accounted for by LIC which

recorded a 22% increase in premium to Rs 86,444 crores from an earlier 70,891 crores.

The private life insurance players, with a combined premium of Rs 39,381 crores and amarket share of 31.3%, reported only a 3% growth in new business premium in this financial

year

2.4 Proposals in the Union Budget 2011-2012 for Insurance

Budget proposes to move the following legislations in the financial sector:1. The Insurance Laws (Amendment) Bill, 2008;2. The Life Insurance Corporation (Amendment) Bill, 2009;3. The revised Pension Fund Regulatory and Development Authority Bill, first

introduced in 2005;

Services provided by life insurance companies in the area of investment are also proposed tobe brought into tax net on the same lines as ULIPs.

The insurance legislation would increase the FDI limit to 49 percent from the current 26percent.

The LIC bill would increase the share capital of Life Insurance Corporation (LIC) to Rs.100crore from its current Rs.5 crore.

Insurance bill will empower IRDA (Insurance Regulatory and Development Authority) tointroduce forward-looking regulations to promote sustainable growth of the industry. The bill

gives a lot of flexibility to the IRDA in framing regulations.

2.5 Challenges to the industry

Professionals and experts are in short supply. Man power requirement has increased manifold. High attrition rate of employees. Penetration is extremely low. Almost 3/4th of the population has not taken a life cover.


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Designing products suitable for the people of various economic strata.

2.6 Key Players in the Industry

Life Insurance corporation of India (LIC) ICICI Prudential Life Insurance SBI Life Insurance Company Ltd HDFC Standard Life Insurance Bajaj Alliance Life Insurance Reliance Life Insurance Company Ltd Birla Sun Life Insurance


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Chapter 3

ULIPS (unit linked insurance policy)

3.1 Definition

IRDA defines a ULIP asfollowsULIP is an abbreviation forUnit Linked Insurance Policy. A ULIP

is a life insurance policy which provides a combination of risk cover and investment. The dynamics of

the capital market have a direct bearing on the performance of the ULIPs. In a unit linked policy, the

risk in generally borne by the investor.

ULIPs are a category of goal-based financial solutions that combine the safety of insurance protectionwith wealth creation opportunities. In ULIPs, a part of the investment goes towards providing the life

cover. The residual portion is invested in a fund which in turn invests in stocks or bonds. The value of

investments alters with the performance of the underlying fund opted by investor.

Simply put, ULIPs are structured such that the protection element and the savings element can be

distinguished and hence managed according to the specific needs of the investor, offering

unprecedented flexibility and transparency.

3.2 Criteria

According to the December 2005 circular issued by the IRDA, Unit Linked products and business

should, at the minimum, satisfy the following features and criteria:

Reasonable insurance cover with a linkage to the premium payment during the term of thecontract;

Availability of greater part of a targeted sum at the longer end; Basic features oflife insurance contract including long term nature; Avoid technicaljargon; Remain simple for the public to understand. Complete transparency in all aspects of the product terms & conditions; Despite the investment risk being borne by the policyholder, the investment strategy is

aligned to long term nature of these contracts;


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Adequate disclosure of information pertaining to investment of funds and the elements ofrisk involved;

A standard method, across the industry, with regard to computation of NAV (Net AssetValue)

3.3 Working of ULIPs

ULIP is an investment+insurance plan. ULIPs basically work like a mutual fund with a life cover

involved in it. Once the amount of premium to be paid and the amount of life cover is decided, the

insurer deducts some portion of the premium upfront. This portion is known as the Premium

Allocation charge and this varies from product to product. The rest of the premium is invested in the

fund or mixture of funds chosen by the investor. Mortality charges and administration charges arethereafter deducted on a periodic (mostly monthly) basis whereas the fund management charges are

deducted on a daily basis

Since the fund of the investors choice has an underlying investment either in equity or debt or a

combination of the twothe fund value will reflect the performance of the underlying asset classes.

At the time of maturity of the plan, the investor is entitled to receive the fund value as at the time of

maturity.

In Simple words, ULIPs are structured in such a form that they can be managed according to the

specific needs of the consumers and the protection received is an added benefit.

3.4 Types of Funds

Most insurers offer a wide range of funds to suit ones investment objectives, risk profile and time

horizons. Different funds have different risk profiles. The potential for returns also varies from fund tofund.

The following are some of the common types of funds available along with an indication of their risk

characteristics.

General Description Nature of Investments Risk Category

Equity Funds Primarily invested in company stocks with the

general aim of capital appreciation

Medium to High


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Income, Fixed

Interest and Bond

Funds

Invested in corporate bonds, government

securities and other fixed income instruments

Medium

Cash Funds Sometimes known as Money Market Funds

invested in cash, bank deposits and money market

instruments

Low

Balanced Funds Combining equity investment with fixed interest

instruments

Medium

3.5 Investor Class for ULIPS

The following are the investor classes to whom the ULIPs are best suited for:

Those who wish to closely track their investments: Unit linked plans allow policy takers toclosely monitor their portfolios. They also offer the flexibility to switch your capital between

funds with varying risk-return profiles.

Individuals with a medium to long term investment horizon: Unit linked plans are idealfor individuals who are ready to stay invested for relatively long periods of time.

Those with varying risk profiles: Across the several funds offered, the equity componentvaries from zero to a maximum of 100 per cent. Thus there is a choice of funds available to all

types of investors - from risk-averse investor to those investors who have strong risk appetite.

Investors across all life stages: This plan category offers a variety of plans which can beopted for depending upon the life stage you are in and your needs and financial liabilities at

that point in time.

3.6 Advantages

ULIPs are dynamic plans and are flexible by nature and hence allow for changes and high degree of

customization in the plan as opposed to most of the financial plans which once purchased cannot be

modified. Opting for ULIPs allows for certain number of advantages to the investor. Some of them

are as follows:


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Market linked returns: Unit linked plans give you an opportunity to earn market-linkedreturns, as part of the premiums are invested in market linked funds which invest in different

market instruments including debt instruments and equity in varying proportions.

Life protection, Investment and Savings: Unit linked plans offer the twin benefits of lifeinsurance and savings at market-linked returns. Thus, the investor has the opportunity to

invest his/her money to earn higher returns, while taking care of his/her protection needs.

Investing in unit linked plans helps in inculcating a regular habit of saving and investment,

which is important for building wealth over a long term. ULIPs helps an investor cultivate a

disciplined savings pattern which ensures that the money being set aside will go towards the

fulfilment of the specific objective. In the absence of such a focused approach, there is a high

possibility of savings towards one objective getting utilized for an immediate short-term

requirement, thus jeopardizing the long-term goal. ULIPs are a potent safeguard against such

a tendency.

Flexibility: Unit Linked Plans offers one a wide range of flexible options such aso Flexibility to change the life cover: ULIPs provides the flexibility to choose a sum

assured (insurance cover) at the time of policy inception. Moreover, some ULIPs

allow one to increase the sum assured over the term of the plan. This is crucial as the

protection needs keep on changing with time .Typically, greater the financial

liabilities one has such as repayment of a home loan, greater will be the need for

protection.

o Flexibility to opt for a rider: ULIPs also enables one to customize the policy withoptional riders to enjoy additional protection. Riders are additional or supplementary

benefits that are bought along with the main insurance policy. Some of the commonly

offered riders by most insurance companies are critical illness benefit rider, accident

& disability benefit rider, waiver of premium rider etc. For ex. a critical illness rider

covers major critical illnesses like heart attack etc. In case of contracting any of the

above illness, the insurance company pays the insured amount.

oFlexibility to choose the fund option: Most of the ULIPs come with an in - builtrange of fund options to choose fromranging from aggressive funds to conservative

funds so that one can decide to invest the money in line with the investment

preferences and needs. Moreover, ULIPs also provides the option of switching

between different fund options so that one is able to reap maximum benefits from the

investments.

Liquidity: To cope with unforeseen circumstances, ULIPs offer the benefit of partialwithdrawal; wherein after 5 years one can withdraw funds from the Unit Linked account,

retaining only the stipulated minimum amount.


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Tax benefits : ULIPs are an efficient tax saving instrument too .The tax benefits that one canavail in case of investment in ULIPs are described below:

o Premium paid towards Life insurance plans and Pension plans are eligible fordeduction under Sec. 80C

o Premium paid towards a Health insurance plans and critical illness riders are eligiblefor deduction under Sec. 80D

o The maturity proceeds or withdrawals of life insurance policies are exempt under Sec10(10D), subject to norms prescribed in that section.

3.7 Comparison between Traditional Plans and ULIPs

Unit Linked Insurance Plans Conventional Plans

Description Unit Linked Insurance Plans offeredby insurance companies allow policyholders to direct part of theirpremiums into different types offunds (equity, debt, money market,hybrid etc.) Here the risk ofinvestment is borne by thepolicyholder.

Conventional Plans aretraditional insurance plans.They usually invest in lowrisk return options and offerguaranteed maturityproceeds along withdeclared bonuses.

Key Features

Flexibility of

Investment

Unit Linked Plans give you

flexibility to invest as per ones riskprofile, financial commitments andconvenience. One can choose toinvest either in equity, or in debt orin hybrid fund and even change theinvestment strategy.

These plans do not allow

one to choose investmentavenues. The funds areinvested as per the strategyand discretion of thecompany.

Transparency Most Unit Linked Plans allow one totrack the portfolio. They alsoregularly intimate regarding thepercentage of the premium that isinvested along with the charges

levied. Information regarding thevalue and number of fund units thatone holds are also provided.

The premiums are investedin a common 'with profits'fund and therefore onecannot track the individualportfolio.

Maturity benefits

payout

At the time of maturity, the unitscollected at the then prevailing unitprices can be redeemed. Some plansalso offer loyalty or additional unitsannually or at the time of maturity.

At the time of maturity thesum assured plus bonuses isgiven, if applicable in theplan.


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Partial

withdrawal

Unit Linked Plans allowswithdrawals from the fund, providedthe fund does not fall below theminimum fund value and subject toother conditions.

Conventional plans do notallow for withdrawal of partof the fund. Instead, somepolicies offer facilities totake a loan against theinvestment.

Switching options Available. One can change theinvestment fund decision byswitching between the funds as beingoffered by the policy.

Not available since theinvestment decision is takenby the insurance company.

Charges structure Unit Linked Plans specify thecharges under various heads.

These plans do not specifythe charges involved.

Single premium

top-up

Available. The single premium top-up facility allows for investment ofan extra amount over and above your

regular premiums in the unit linkedplan.

The top-up facility is notavailable.

Benefit

illustration

They allow one to track his/herportfolio.Unit Linked Plans offer the benefit ofa single premium top up whichallows one to invest ad hoc additionalamounts.Unit Linked Plans allow partialwithdrawals, subject to conditionsand switching between funds bypaying some charges, if necessary.

Unit Linked Plans gives one theoption of a premium vacation.

Conventional plans offerfixed premiums linked to thesum assured.The maturity benefits forthese plans include the sumassured plus bonuses, ifapplicable

3.7 Comparison between ULIPs and Mutual Funds

Unit Linked Insurance

Plans

Mutual Funds

Description Unit Linked Plans refer toUnit Linked Insurance Plans

offered by insurancecompanies. These plansallow investors to direct partof their premiums intodifferent types of funds(equity, debt, money market,hybrid etc.)

A mutual fund pools themoney from investors and

uses it to invest in varioussecurities according to a pre-specified investmentobjective.

Key features

Objective Unit Linked Plans are longterm plans offering a dualbenefit of insurance and

investment.

Mutual funds are idealinvestment tool for the shortto medium term.


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Tax benefit All Unit Linked Plans offertax benefits under section80C.

Only investments in taxsaving funds are eligible forsection 80C benefits.

Switching options Unit Linked Plans allowsone to switch investmentsbetween the funds linked tothe plan. This enables one tochange the risk-return.

No switching option isavailable. If the investor isnot satisfied with theperformance of the fundhe/she can exit completelyfrom the same by payingexit charges, if applicable.

Additional benefits Some of the Unit LinkedPlans give additional benefitor loyalty benefit by issuingextra fund units.

There are no additionalbenefits issued by mutualfunds.

Liquidity Unit Linked Plans have

limited liquidity. One needsto stay invested for aminimum period of time asspecified in the policybefore redeeming the units.

One can easily sell mutual

fund units (except for ELSSand funds that have aminimum lock-in period)

Charges structure Charges in a unit linked planinclude mortality charges forthe life insurance provided.In addition, premiumallocation charge, fundmanagement charge and

administration charges areapplicable.

Mutual fund charges includean entry load, the annualfund management chargeand an exit load, ifapplicable.

Benefit snapshot Dual benefit of investmentand insuranceSuitable for the long termOption to switch betweenthe funds is permitted.Offers tax benefits

Investment tool suitable forshort to medium term.Easy exit possible.Tax benefit available onlyon tax saving funds


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Chapter 4:

Risk Management in Insurance

4.1 Introduction

4.1.1 Risk

The term risk has a variety of meanings in business and everyday life. At its most general level, risk is

used to describe any situation where there is uncertainty about what outcome will occur. In

probability and statistics, financial management and investment management, risk is often used in a

more specific sense to indicate the chance that an investment's actual return will be different than

expected. Risk includes the possibility of losing some or all of the original investment. Technically,

this is measured in statistics by standard deviation.

4.1.2 Risk- Return trade-off

The risk-return spectrum is the relationship between the amount of return gained on an investment and

the amount ofrisk undertaken in that investment.

Low levels of uncertainty (low risk) are associated with low potential returns. High levels of

uncertainty (high risk) are associated with high potential returns. The risk/return trade-off is thebalance between the desire for the lowest possible risk and the highest possible return. This is

demonstrated graphically in the chart below. A higher standard deviation means a higher risk and

higher possible return.
http://www.investopedia.com/terms/i/investment.asphttp://www.investopedia.com/terms/r/return.asphttp://www.investopedia.com/terms/s/standarddeviation.asphttp://en.wikipedia.org/wiki/Investmenthttp://en.wikipedia.org/wiki/Riskhttp://www.investopedia.com/terms/r/riskreturntradeoff.asphttp://www.investopedia.com/terms/r/riskreturntradeoff.asphttp://en.wikipedia.org/wiki/Riskhttp://en.wikipedia.org/wiki/Investmenthttp://www.investopedia.com/terms/s/standarddeviation.asphttp://www.investopedia.com/terms/r/return.asphttp://www.investopedia.com/terms/i/investment.asp


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A common misconception is that higher risk equals greater return. The risk/return trade-off tells us

that the higher risk gives us the possibility of higher returns. There are no guarantees. Just as risk

means higher potential returns, it also means higher potential losses.

4.1.3 Risk Management and its Process

The process of identification, analysis and either acceptance or mitigation of uncertainty in investment

decision-making is called risk management. Essentially, risk management occurs anytime an investor

or fund manager analyzes and attempts to quantify the potential for losses in an investment and then

takes the appropriate action (or inaction) given their investment objectives and risk tolerance.

Inadequate risk management can result in severe consequences for companies as well as individuals.

For example, the recession that began in 2008 was largely caused by the loose credit risk managementof financial firms.

Simply put, risk management is a two-step process - determining what risks exist in an investment and

then handling those risks in a way best-suited to your investment objectives. Risk

management occurs everywhere in the financial world. It occurs when an investor buys low-risk

government bonds over more risky corporate debt, when a fund manager hedges their currency

exposure with currency derivatives and when a bank performs a credit check on an individual before

issuing them a personal line of credit.

Regardless of the type of risk being considered, the risk management process involves several key

steps:

1. Identify all significant risks that can reduce business value (cause loss).2. Evaluate the potential frequency and severity of losses.3. Develop and select methods for managing risk in order to increase business value to

shareholders.

4. Implement the risk management methods chosen.5. Monitor the performance and suitability of the firms risk management methods and

strategies on an ongoing basis.


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4.2 Identification of Risks faced by Insurance Companies

An Insurance company aids in reducing ones risk but it is extremely important to know the

risks that an insurance industry faces in general. There are various types of risks that an

insurance industry faces but they can be broadly classified under 4 categories:

1. Strategic Risk2. Operational Risk3. Market Risk4. Credit Risk

The first two risks i.e. strategic and operational risks are non- financial risks whereas market

risk and credit risks are financial risks. Along with these, an insurance company can faces

other risks like reputational risks (negative press comments), liquidity risk etc.

4.2.1 Strategic risk

Strategic risk is the risk to earnings or capital arising from adverse business decisions or

improper implementation of those decisions. This risk is a function of the compatibility

between an organizations strategic goals, the business strategies developed to achieve those

goals the resources deployed against these goals and the quality of implementation. Theresources needed to carry out business strategies are both tangible and intangible. They

include communication channels, operating systems, delivery networks and managerial

capacities and capabilities. The definition of strategic risk focuses on more than an analysis

of the written strategic plan. Its focus is on how plans, systems and implementation affect the

franchise value. It also incorporates how management analyzes external factors that impact

the strategic direction of the company.

The various types of strategic risks that may affect the insurance industry are as follows: Industry capital intensiveness, overcapacity, commoditization, deregulation, cycle

volatility. Insurance markets suffer from all these risks and hence its magnitude is

quite high.

Technologyshift, patents, obsolescence. The magnitude for such a risk is quite lowexcept for possible innovations in the distribution for the personal lines via internet.

One area of potential technological innovation is data management.

Brand erosion or collapse. Essentially, insurance products are claim checks.Therefore, it is difficult for insurers to differentiate based on product content. Either


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the check is good, or it isnt. Therefore, insurers often differentiate on price or

services. If one interprets the insurers brand promise as including a reputation for

fair claims handling, then loss of this reputation through adverse press or class action

suits could definitely destroy franchise value.

Competitor global rivals, gainers, unique competitors. Predatory pricing is asignificant risk, since market share can be grabbed fairly easily by carriers willing to

write the coverage at a discount to incumbent carriers.

Customerpriority shift, power, concentration. This risk is probably a bigger issuefor large commercial insurance business.

Projectfailure of R&D, IT, business development or M&A. Companies have a longtrack record of value-destroying mergers and acquisitions. They are also notoriously

small investors in R&D and IT, which is ironic given the nature of the intellectual

capital franchise.

Stagnationflat or declining volume, price decline, weak pipeline. This risk is highlycorrelated to cycle volatility management. Insurers have a difficult time redeploying

their assets, since they are essentially intellectual assets with a large degree of task

specificity and stickiness. Insurers also suffer from extensive reporting lags and

potentially mismatched revenue and expense. It could be argued that part of the

impetus driving insurers to continue to write business at inadequate prices is the need

to fund current-year fixed costs (plant expenses).

Entrance into new (or significant growth in existing) lines or territories withinadequate underwriting expertise, pricing systems, price monitoring capabilities,

policy servicing capabilities, understanding of regulatory requirements, claims

handling staff, etc.

Mergers or acquisitions entered into without contemplating integration costs ortimelines, cultural incompatibilities, reserve deficiencies, etc.

Destructive competition from multiple competitors simultaneously targeting the samemarket segment (unilateral planning, failure to anticipate strategic changes of

competitors).

Flawed organizational response plans to market price cycles, including maintainingpremium volume and market share during price declines and improper performance

incentives for underwriters.


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Planning (particularly plan loss ratio setting) process not fully integrated to internalfinancial indicators, external benchmarks, which fails to update, susceptible to

systematic optimism.

4.2.2 Operational risk

Operational risk is the risk of direct or indirect loss resulting form inadequate or failed processes,

people or systems or from external events. This definition includes legal risk, but excludes strategic

risk, reputational risk, and systemic risk. It is based on underlying causes of operational risk, which

are broken down into 4 categories: people, processes, systems and external factors.

Operational risk in an insurance industry could be caused by one or more of the following.

Internal Fraud: losses due to acts of a type intended to defraud, misappropriate property orcircumvent regulations, the law or company policy (excludingdiversity/discrimination events) which involves at least one internal party.

External Fraud: loss due to acts of a type intended to defraud, misappropriate propertyor circumvent the law, by a third party.

Damage to Physical Assets: losses due to loss or damage of physical assets fromnatural disaster or other events (manmade disasters are also included, i.e. fire,

explosion, terrorism, etc.).

Business Disruption and System Failures: loss arising from disruption of business orsystem failures including hardware and software failure, system development and

infrastructure issues6.

Execution, Delivery and Process Management: loss from failed transaction processingor process management, from relations with trade counterparties and vendors.

4.2.3 Market risk

The day-to-day potential for an investor to experience losses from fluctuations in securities prices is

known as market risk. This risk cannot be diversified away. It is also referred to as "systematic risk".

This is the risk that the value of a portfolio, either an investment portfolio or a trading portfolio, will

decrease due to the change in value of the market risk factors. The four standard market risk factors

are stock prices, interest rates, foreign exchange rates, and commodity prices:

Equity risk is the risk that one's investments will depreciate because of stock marketdynamics causing one to lose money. The measure of risk used in the equity markets

is typically the standard deviation of a security's price over a number of periods.
http://en.wikipedia.org/wiki/Portfolio_(finance)http://en.wikipedia.org/wiki/Equity_riskhttp://en.wikipedia.org/wiki/Investmentshttp://en.wikipedia.org/wiki/Stock_markethttp://en.wikipedia.org/wiki/Moneyhttp://en.wikipedia.org/wiki/Moneyhttp://en.wikipedia.org/wiki/Stock_markethttp://en.wikipedia.org/wiki/Investmentshttp://en.wikipedia.org/wiki/Equity_riskhttp://en.wikipedia.org/wiki/Portfolio_(finance)


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Interest rate risk is the risk (variability in value) borne by an interest-bearing asset,such as a loan or a bond, due to variability ofinterest rates. In general, as rates rise,

the price of a fixed rate bond will fall, and vice versa. Interest rate risk is commonly

measured by the bond's duration.

Currency risk or exchange rate risk is a form of financial risk that arises from thepotential change in the exchange rate of one currency in relation to another. Investors

or businesses face an exchange rate risk when they have assets or operations across

national borders or if they have loans or borrowings in a foreign currency.

Insurance and reinsurance companies are subject to market risk as investors, for the pool of insurance

assets on the balance sheet. They may need to match these against complex liabilities, such as

minimum guaranteed returns for life insurance and reinsurance companies.are subject to market riskas investors, for the pool of insurance a

4.2.4 Credit risk

Credit risk is the risk of loss of principal or loss of a financial reward stemming from a borrower's

failure to repay a loan or otherwise meet a contractual obligation. Credit risk arises whenever a

borrower is expecting to use future cash flows to pay a current debt. Investors are compensated for

assuming credit risk by way of interest payments from the borrower or issuer of a debt obligation.

Credit risk is closely tied to the potential return of an investment, the most notable being that the

yields on bonds correlate strongly to their perceived credit risk.

Simply put, the risk that a firms customers and the parties to which it has lent money will fail to

make promised payments is known as credit risk. Most firms face some credit risk for account

receivables. When firms borrow money, they in turn expose lenders to credit risk (i.e, the risk that the

firm will default on its promised payments). As a consequence, borrowing exposes the firms owners

to risk that the firm will be unable to pay its debts and thus force into bankruptcy, and the firm

generally will have to pay more to borrow money because of credit risk.

4.3 Measure and assess the Risk

4.3.1 Role of Actuarial and Underwriting in Risk Assessment

Actuaries are experts who perform actuarial analysis of insurance rates, rating procedures, rating

plans, and schedules of insurance companies. These are professionals who are experienced in
http://en.wikipedia.org/wiki/Bond_(finance)http://en.wikipedia.org/wiki/Interest_ratehttp://en.wikipedia.org/wiki/Fixed_rate_bondhttp://en.wikipedia.org/wiki/Bond_durationhttp://en.wikipedia.org/wiki/Financial_riskhttp://en.wikipedia.org/wiki/Exchange_ratehttp://en.wikipedia.org/wiki/Currencyhttp://en.wikipedia.org/wiki/Currencyhttp://en.wikipedia.org/wiki/Exchange_ratehttp://en.wikipedia.org/wiki/Financial_riskhttp://en.wikipedia.org/wiki/Bond_durationhttp://en.wikipedia.org/wiki/Fixed_rate_bondhttp://en.wikipedia.org/wiki/Interest_ratehttp://en.wikipedia.org/wiki/Bond_(finance)


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reviewing and analysing insurance operations, reserves and underwriting procedures and provide

technical assistance regarding actuarial matters to policy examiners and other technical staff. In other

words they are the people who ascertain in advance the uncertain events that could take place in future

and come to a financial conclusion.

The IRDA ensures that every insurance company has a team of actuaries headed by a chief actuary.

No life insurance company can carry on its business without an appointed actuary. The cost of

managing various risks is calculated by the actuaries. This is necessary for strategic management of

the companies.

The important duties and functions performed by an actuary are as follows:

1. Designing the products:Products refer to the plans of insurance the insurer launches for marketing. The products

should give details such as, persons to whom it can be sold, the age of entry, the age at

maturity, the maximum and the minimum sum assured allowed. Minimum and maximum

term allowed, whether bonus is available etc. The actuary has to recommend the product to

the IRDA for approval. Similarly, the actuary has to recommend the unviable products the

insurer proposes to withdraw from the market giving reasons for the same.

2. Pricing the products:The cost per unit sum assured of Rs. 1000 for a given term or age under the policy is known

as tabular premium. The actuary decides the tabular premiums for various ages and terms for

each class of insurance product; they also decide the rebates and extras for various modes

allowed under the plan and the extra premiums for any additional benefit, the extra premium

for extra risk, etc. This exercise is known as pricing the product.

3. Conducting mortality investigation:Mortality investigations mean that the deaths of the insured persons are to be recorded to

arrive at the rate of death. The table is called the mortality table. This process is known as

investigation. The investigations are conducted periodically by every insurer. The

investigations are continuous and the mortality tables are constructed frequently. The death

rates may vary from year to year, since they are based on socio-economic factors. The

mortality tables are different for average and substandard lives and different for male and

female lives.


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4. Constructing and comparing mortality tables:Mortality tables are constructed from the data taken for the study and investigation. The rate

of death may relate to age, term, type of policy, type of lives covered, types of risk etc. These

mortality tables are used for the purpose of granting individual insurance, group insurance,annuities etc.

The mortality tables constructed subsequently can be compared to the previous one to find out

whether the bases assumed for charging the premiums have changed appreciably and to

enable insurers to offer new products based on the mortality rates and the changing needs of

the customer.

5. Conducting annual actuarial valuation:The main purpose of conducting the valuation is to find out whether the insurance company is

having solvency of funds. Solvency means the capacity to pay out the claims as and when

they arise. Valuation is done prospectively or retrospectively. The process of prospective

valuation involves projection of the experience for the future. The possible financial surplus

also known as valuation surplus is not a profit but will prove that the insurance company is

working profitably. This is a proof that the insurance company is working on sound principles

and the policyholders interests are safe. On the other hand, if the valuation results in deficit,

it does not mean that the company is working on loss. It only means that the premiums

charged are inadequate or that the policies are to be conserved. It may also mean that the

products are yet to be popularized.

The Insurer ensures that every new entrant in to the pool of Policyholders has similar exposure to the

risks as the others. This process of verifying the risk extent of each new entrant is called

'Underwriting'.

Underwriting is an important process in life insurance since a wrongly assessed risk would charge

inappropriate premiums. Lower premiums would affect the solvency of funds, since the cost of

additional risk not recovered from the proposer will have to be shared by the rest of the Policyholders.

A larger premium charge on the other hand would be unfair to the proposer, and faith would be lost.

Underwriting has implications of fairness to both, the Insurer as well as the policyholders,

individually and collectively. If the life proposed to be insured has no adverse features affecting

mortality, then such a life is considered normal, standard, or first class life.


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Risks affecting the life of the insured or proposer are called hazards. Hazards are of three types, viz.

physical hazard, occupational hazard, and moral hazard.

Physical hazards:

1. Age - Underwriters look in to the factor of age because of its relationship with otherfactors. As age increases, the probability of death also increases. Further, certain

risks decrease with age, while some increase with age.

2. Sex - Mortality rates of female lives at a young age is much more as compared tomortality of the male child. This is particularly true amongst the poor and uneducated.

Insurer exercise caution in granting insurance on female lives. Particularly in remote

areas there are numerous cases of pregnancy related deaths.

3. Physical structure - Standard measurements with regards to a person's height, weight,chest and abdomen sizes are established and underwriters will view variations with

care. Careful observation may suggest a person's tendencies towards cardiac or other

ailments like tuberculosis and diabetes.

4. Physical condition - Medical examinations reveal data with regard to the functionalcondition of important systems of our body. These include reports on blood pressure,

pulse rates, sugar levels, reflexes, etc.

5. Physical impairments - Conditions such as blindness, deafness, and such others,which are not illnesses but affect the probability of death, are considered hazards.

6. Personal history - The lifestyle of an individual is an important pointer.7. Family history - Hereditary factors makes a person susceptible to certain illnesses. A

family with a history of early deaths, cardiac problems, diabetes, etc. could be

significant in analysing the hazards.

Occupational Hazards:

The nature of ones job and workplace ambience has a deep impact on the worker's physical andmental self. Contact with inhalation of fumes, excessive temperatures, hazardous materials, etc.

affects health and subsequently, the life span. Those jobs which involve flying, chemicals and

radiation emitting substances, high voltage electricity, physical heights, and high speed machines are

a few examples of higher risk jobs. Studies conducted have identified occupations with various

hazards and have tried to quantify the excess hazard, so that it helps the underwriters to determine the

appropriate extra premiums.

Moral Hazard:


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Moral hazard arises when the proposer is seeking undue advantage through insurance policy or

income, in the context of premium payment or reputation or integrity. Moral hazard is not measurable,

but is left to opinion. Thus no amount of extra premium will be appropriate. Underwriters normally

hesitate to accept proposals that show signs of moral hazards. Situations that may lead to suspecting

moral hazard can be:

Outstation party; High sum assured or advanced age; Sum insured disproportionate to income; First insurance at advanced age; Suppression of previous adverse insurance history; and Suppression of previous personal history.

The underwriter requires certain specific data in order to do a successful risk analysis of the proposer.

The data required usually is information about the person to be insured, family history, etc. given by

the proposer in the proposal form, which is assumed to be correct, medical examination report and

reports of agents and other officials.

After carefully examining the data available, the underwriter decides about the level of risk in each

particular case. The underwriter need not be an actuary, but has the capacity to assess the risk from

the data that is available to him. He may also avail the specialized service of doctors associated withlife insurance companies to know the effects of the medical condition on the mortality.

Personal habits, family history and medical history contribute to assessment of risk Hereditary ailments disclosed in Family History may suggest adverse situations Surgeries and hospitalizations will be looked into for possible recurrences or side effects Experienced underwriters will be able to make judgments on the strength of such information

and decide on the level of premium to be charged.

All care should be taken to see that relevant information is disclosed and correct facts are declared.

If this is not ensured the averages in the pool will be affected adversely. Any decision to insure a

person beyond his capacity or with income inconsistency may result in early discontinuance of the

policy. Even in case of over insurance, a person who is not healthy may not discontinue the policy but

may contribute for an early claim. These will result in Adverse Selection.


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4.3.2 Assess and Measure the market risk

The market risk in an insurance company can be measured by looking at the investments made by the

insurance company. To assess the risk and return for HDFC Standard Life, 3 sets of ULIP funds have

been considered which have different risk characteristics. The historical values of returns over aperiod of time have been calculated and these values have been used to arrive at a better portfolio

composition that increases the return and reduces the risk.

Sharpe ratio has been used to optimize the portfolio. This ratio was developed by Nobel

laureate William F. Sharpe to measure the risk-adjusted performance. The Sharpe ratio is calculated

by subtracting the risk-free rate from the rate of return for a portfolio and dividing the result by the

standard deviation of the portfolio returns. The Sharpe ratio formula is:

The Sharpe ratio tells us whether a portfolio's returns are due to smart investment decisions or a result

of excess risk. This measurement is very useful because although one portfolio or fund can reap

higher returns than its peers, it is only a good investment if those higher returns do not come with too

much additional risk. The greater a portfolio's Sharpe ratio, the better its risk-adjusted performance

has been. A negative Sharpe ratio indicates that a risk-less asset would perform better than the

security being analyzed. The ratio helps to make the performance of one portfolio comparable to that

of another portfolio by making an adjustment for risk.Some of the limitations of sharpe ratio are as follows:

All else equal, the portfolio sharpe ratio should decrease if we increase the risk (volatility).By looking at its formula, you can see that this is true only when the sharpe ratio is positive.

However, with a negative sharpe ratio, increasing risk results in a larger sharpe ratio.

Therefore, sharpe ratio should not be used as a measure to compare portfolios that have a

negative sharpe ratio value.

The Ratio formula assumes that the risk free rate is constant, but we all know this is false.Typically, we use the average risk free rate for the strategy period.

The Sharpe Ratio uses only the standard deviation as a measure of risk. This can beproblematic when calculating the Ratio for asymmetric returns because the Standard deviation


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is most appropriate as a measure of risk for strategies with approximately symmetric return

distributions.

The Ratio is based on historical data, and because past performance is not always an indicatorof future results, we should not rely only on this measure to assess trading strategies.

Analyzing and identifying the forces behind the strategy' returns is essential.

The following 3 ULIP funds have been discussed in detail:

1. Defensive Managed Fund2. Balanced Managed Fund3. Growth Fund

Assumptions

The portfolio composition has been assumed to be constant for the 3 year period. Since the information on the cap on the investments in various stocks was unavailable, it has

been assumed that there are no caps on the investment percentages on the various stocks

present in the portfolio.

The debentures and government securities have been assumed to have zero correlation withother securities.

The risk free rate has been assumed to be 7.25%.Measurement of the risk

A ULIP policy consists of various types of funds that an investor can invest in depending

upon his or her risk appetite. These funds range from having low to very high risks. Usually

these funds comprises of four kinds of securities: stocks, bonds, government securities and

money market.

For each of the fund considered i.e. defensive, balanced and growth fund, the returns and

risks were estimated using the Markowitz method also known as the mean variance method.

For estimating the returns for the equity, daily stock prices for the various stocks in the

portfolio were considered and the daily returns were calculated using the formula as shown

below

Daily returns =


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These returns were averaged to obtain the average yearly returns of the equity stocks. The

daily returns were then multiplied with the investment fraction to obtain the return of the

stock in the portfolio. These returns were summed to obtain the return on the equity.

The standard deviations for the various stocks in the equity were calculated using thefollowing formula:

Standard deviation =

where X is the daily return

is the average daily returnN is the number of observations

To calculate the effective standard deviation for the entire equity, the correlation between the various

stocks were estimated. For example to calculate the correlation between Stock A and Stock B the

following formula can be used

R =

Where R is the correlation

X is the return of Stock A

Y is the return of Stock B

N is the total number of observations

The standard deviation between two stocks in the equity can be calculated using the formula

The equation above is used to calculate the standard deviation of the equity.

For estimating the returns of the debentures/bonds and the government securities, the coupon rate is

assumed to be the yield and the return is then calculated by multiplying the yields with the investment

fraction. Repo rates (which can be used as an indicator for the debt market) have been used to

calculate the standard deviation of the debentures/bonds. The standard deviation for the governmentsecurities is assumed to be zero.


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Similar procedure is followed for the money markets as well. The standard deviation for the money

market is estimated using the MIBOR rates.

All the above returns and the standard deviations of the various securities (equity, debentures,

government securities and money market) are used for obtaining the effective average return and thestandard deviation of the portfolio in the same way as the return and standard deviation was calculated

for the equity using the formulas mentioned earlier.

To optimize the portfolio, sharpe ratio has been used to calculate the new investment fraction. By

optimizing the equity, new effective return and new standard deviation of the entire portfolio is re -

calculated.

An efficient frontier has been used to indicate the return and the risk of the original and the new

portfolio. An efficient frontier is a graphical representation of the combinations ofsecurities portfoliosthat maximize expected return for any level of expected risk, or that minimizes expected risk for any

level of expected return. It is a line created from the risk-reward graph, composed of optimal

portfolios that reflect various portfolio diversification strategies ranging from a most conservative all-

cash portfolio to a most aggressive all-equity portfolio.

DEFENSIVE MANAGED FUND

The defensive managed fund is a low risk fund as the percentage of allocation to equity instruments is

about 0-40% and the debt instruments have an allocation ranging between 40-100%.
http://financial-dictionary.thefreedictionary.com/bfgloss.htm#securityhttp://financial-dictionary.thefreedictionary.com/bfglosp.htm#portfoliohttp://financial-dictionary.thefreedictionary.com/bfglose.htm#expected_returnhttp://financial-dictionary.thefreedictionary.com/bfglosr.htm#riskhttp://financial-dictionary.thefreedictionary.com/bfglose.htm#expected_returnhttp://financial-dictionary.thefreedictionary.com/bfglose.htm#expected_returnhttp://financial-dictionary.thefreedictionary.com/bfglosr.htm#riskhttp://financial-dictionary.thefreedictionary.com/bfglose.htm#expected_returnhttp://financial-dictionary.thefreedictionary.com/bfglosp.htm#portfoliohttp://financial-dictionary.thefreedictionary.com/bfgloss.htm#security


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The asset allocation for the defensive managed fund of HDFC LIFE as on 30 th April 2011 is as

follows.

The table below shows the existing portfolio of the defensive managed fund.

EQUITY % TO FUND

Infosys Technologies 1.71%

Reliance Industries Ltd 1.59%

ITC Ltd 1.05%

ICICI Bank Ltd 0.77%

Bharat Heavy Electricals Ltd 0.77%

Others 14.35%

20.24%

DEBENTURES/BONDS % TO FUND

National Housing Bank NCD MAT 20/12/2012 2.83%

LIC Housing Finance Ltd MAT 28/09/2011 2.16%


IDFC NCD MAT 16/12/2013 1.66%

HDFC LTD DDB MAT 30/08/2013 1.62%

IRFC PTC series A12 MAT 15/10/2015 1.52%

United Phosphorous Ltd NCD 1.52%

LIC Housing Finance Ltd NCD MAT 26/02/2012 1.48%

Reliance Industries Ltd NCD 25/11/20131.39%

Asset Allocation

Equity

Debentures/bonds

Government Securities

Deposits, Money market

and other securities


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NABARD MAT 11/06/2014 1.38%

IRFC NCD MAT 11/09/2018 1.36%

Rural Elec Corp Ltd NCD MAT 26/11/2013 1.27%


HDFC LTD DDB MAT 24/08/2011 1.13%

Rural Elec Corp Ltd. NCD MAT 14/08/2013 1.10%

Infrastructure Dev Finance Corp NCD MAT 26/02/2012 1.08%

LIC Housing Finance Ltd. NCD MAT 8/01/2012 1.08%

HDFC LTD DDB MAT 27/01/2012 1.07%

State Bank of India NCD MAT 16/03/2026 1.07%

Others 18.68%

46.60%

GOVERNMENT SECURITIES % TO FUND

GOI MD 14/06/2015 4.72%

GOI MD 9/07/2017 4.33%

GOI MAT 3/11/2014 3.25%

GOI 28/08/2017 2.56%

GOI 15/02/2022 0.95%

Others 3.04%

18.85%

DEPOSITS, MONEY MARKETS, AND OTHER SECURITIES 14.33%

The table below shows the average return, standard deviation, and investment fraction of the

various equities of the current portfolio.

INSTRUMENT % INVESTMENT % RETURN STANDARD DEVIATION

EQUITY 20.24% 2.65% 0.004

DEBENTURES/BONDS 46.6% 3.17% 0.013

GOVERNMENT

SECURITIES

18.85%` 1.42% 0

DEPOSITS, MMIs 14.31% 1.67% 0.023


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AVERAGE RETURN ON THE PORTFOLIO 8.85%

STANDARD DEVIATION OF THE PORTFOLIO 0.0070

The new investment fraction using the sharpe ratio for the equity instrument is given below.

RETURN STANDARD

DEVIATION

%

INVESTMENT

SHARPE

RATIO

NEW %

INVESTMENT

INFOSYS 19.28% 0.022 1.71% 5.51 6.43%

RELIANCE 5.45% 0.033 1.59% -0.53 0.0%

ITC LTD 26.13% 0.027 1.05% 6.9 8.15%

ICICI 17.43% 0.036 0.77% 2.79 3.09%

BHEL 5.71% 0.025 0.77% -0.6 0.0%

OTHERS 12.09% 0.024 14.35% 2.37 2.57%

20.24%

(the return and the standard deviation is calculated using the sensex values)

The new portfolio of the defensive managed fund would be as follows

EQUITY % TO FUND


ITC Ltd 8.15%


Others 2.57%

20.24%





IDFC NCD MAT 16/12/2013 1.66%

HDFC LTD DDB MAT 30/08/2013 1.62%




Reliance Industries Ltd NCD 25/11/2013 1.39%

NABARD MAT 11/06/2014 1.38%

IRFC NCD MAT 11/09/2018 1.36%


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HDFC LTD DDB MAT 24/08/2011 1.13%

Rural Elec Corp Ltd. NCD MAT 14/08/2013 1.10%

Infrastructure Dev Finance Corp NCD MAT 26/02/2012 1.08%


HDFC LTD DDB MAT 27/01/2012 1.07%


Others 18.68%

46.60%


GOI MD 14/06/2015 4.72%

GOI MD 9/07/2017 4.33%

GOI MAT 3/11/2014 3.25%

GOI 28/08/2017 2.56%

GOI 15/02/2022 0.95%

Others 3.04%

18.85%


The table below shows the new average return, standard deviation, and investment fraction of

the various instruments of the new portfolio.


EQUITY 20.24% 4.22% 0.004


GOVERNMENT

SECURITIES

18.85%` 1.42% 0

DEPOSITS, MMIs 14.31% 1.67% 0.023




33/47

The graph below shows the efficient frontier of the defensive managed fund.

BALANCED MANAGED FUND

A balanced managed fund has a slightly higher risk profile than the defensive managed fund.

The asset allocation for the balanced managed fund of HDFC LIFE as on 30th April 2011 is as

follows.

The table below shows the existing portfolio of the balanced managed fund.

0.014 0.0145 0.015 0.0155 0.016 0.0165 0.017 0.0175 0.018 0.01850.04

0.042

0.044

0.046

0.048

0.05

0.052

0.054

Mean-Variance-Efficient Frontier

Risk (Standard Deviation)

ExpectedReturn

Asset Allocation

Equity

Debentures/bonds

Government Securities




34/47


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GOI MAT 3/11/2014 2.67%

GOI MD 14/06/2015 2.47%

GOI 2014 MAT 20/10/2014 1.33%

Oil Bonds MAT 7/03/2015 1.31%

GOI MD 9/07/2017 1.19%

Oil Bonds MAT 23/03/2012 1.14%

Others 2.47%

12.58%





EQUITY 39.79% 5.31% 0.007


GOVERNMENT

SECURITIES

12.58% 0.94% 0

DEPOSITS, MMIs 14.45% 0.61% 0.023




RETURN STANDARD

DEVIATION

%

INVESTMENT

SHARPE

RATIO

NEW %

INVESTMENT

RELIANCE 8.29% 0.033 3.12% 0.31 0.32%

INFOSYS 17.03% 0.022 3.08% 4.48 3.62%

ITC LTD -1.76% 0.027 2.24% -3.29 0.0%

ICICI 19.17% 0.036 1.45% 3.27 2.37%

BHEL 5.28% 0.025 1.34% -0.76 0.0%


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ZEE 35.95% 0.037 1.33% 7.73 6.96%

BHARTI 0.98% 0.032 1.18% -1.93 0.0%

JINDAL 29.08% 0.044 1.15% 4.87 4.02%

CROMPTON 6.88% 0.036 1.14% -0.10 0.0%

NESTLE 31.1% 0.016 1.13% 14.84 14.28%

SUN

PHARMA

18.42% 0.036 1.11% 3.07 2.17%

ONGC 17.64% 0.037 1.09% 2.82 1.91%

NTPC 2.03% 0.020 1.03% -2.55 0.0%

GSCH 16.36% 0.029 1.02% 3.13 2.23%

OTHERS 12.93% 0.024 18.38% 2.7 1.87%

39.79%

(the return and the standard deviation is calculated using the sensex values)

The new portfolio of the balanced managed fund would be as follows

EQUITY % TO FUND




Zee Entertainment Enterprises Ltd 6.96%

Jindal Steel and Power Ltd 4.02%

Nestle India Ltd 14.28%

Sun Pharmaceuticals Industries Ltd 2.17%

Oil and Natural Gas Corporation Ltd 1.91%

Glaxo Smithkline Consumers 2.23%

Others 1.87%

39.79%






IRFC NCD MAT 11/09/2018 1.25%





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HDFC NCD MAT 12/09/2011 1.07%

ICICI Securities Primary Dealership Ltd NCD MAT 21/02/2012 1.07%


HDFC Ltd NCD MAT 11/03/2014 1.02%

Power Finance Corp Limited NCD MAT 9/10/2011 1.01%

Others 16.08%

33.18%


GOI MAT 3/11/2014 2.67%

GOI MD 14/06/2015 2.47%

GOI 2014 MAT 20/10/2014 1.33%

Oil Bonds MAT 7/03/2015 1.31%

GOI MD 9/07/2017 1.19%

Oil Bonds MAT 23/03/2012 1.14%

Others 2.47%

12.58%





EQUITY 39.79% 10.56%% 0.006


GOVERNMENT

SECURITIES

12.58% 0.94% 0

DEPOSITS, MMIs 14.45% 0.61% 0.023




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The graph below shows the efficient frontier of the balanced managed fund.

GROWTH FUND

Growth fund has the highest risk among all the other funds because of the investment percentage of

about 20-100% in equity instruments and only about 0-20% in debt instruments.

The asset allocation for the growth fund of HDFC LIFE as on 30 th April 2011 is as follows.

The table below shows the existing portfolio of the balanced managed fund.

0.014 0.0145 0.015 0.0155 0.016 0.0165 0.017 0.0175 0.018 0.01850.04

0.042

0.044

0.046

0.048

0.05

0.052

0.054Mean-Variance-Efficient Frontier


ExpectedReturn

Asset Allocation

Equity




39/47

EQUITY % TO FUND



ITC Ltd 5.71%


Nestle India Ltd 3.28%

Zee Entertainment Enterprises Ltd 3.20%

National Thermal Power Corpoaration Ltd 3.14%

Bharat Heavy Electricals Ltd 3.07%

Crompton Greaves Ltd 3.05%

Rural Electrification Corporation Ltd 2.78%

Larsen and Toubro Ltd 2.39%

Glaxo Smithkline Consumers 2.35%

Bharti Airtel Ltd 2.34%

Union Bank of India 2.24%

Jindal Steel and Power Ltd 2.24%

Sun Pharmaceuticals Industries Ltd 2.01%

Mahindra and Mahindra Ltd 1.98%

United Phosphorous Ltd 1.91%

Exide Laboratories 1.87%

Divis Laboratories 1.87%Lupin Ltd 1.72%

Power Grid Corporation of India Ltd 1.71%

Power Finance Corporation Ltd 1.64%

Glaxo Smithkline Pharma Ltd 1.56%

Shree Cement Ltd 1.55%

Mphasis Ltd 1.50%

Bank of Baroda 1.41%

Kotak Mahindra Bank Ltd 1.27%

Sterlite Industries Ltd 1.25%

Punjab National Bank 1.20%

Oil and Natural Gas Corporation Ltd 1.07%

Blue Star Ltd 1.03%

IPCA Laboratories Ltd 1.03%

Others 12.61%

95.37%


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EQUITY 95.37% 5.05% 0.018

DEPOSITS, MMIs 4.63% 2.46% 0.023




RETURN STANDARD

DEVIATION

%

INVESTMENT

SHARPE

RATIO

NEW %

INVESTMENT

RELIANCE -7.4% 0.033 7.49% -4.36 0.0%

INFOSYS 20.15% 0.022 7.20% 5.90 2.93%

ITC LTD -5.23% 0.027 5.71% -4.55 0.0%ICICI 4.88% 0.036 4.70% -0.64 0.0%

NESTLE 30.6% 0.016 3.28% 14.53 12.65%

ZEE -15.72% 0.037 3.20% -6.18 0.0%

NTPC -3.73% 0.020 3.14% -5.3 0.0%

BHEL 0.88% 0.025 3.07% -2.49 0.0%

CROMPTON 1.91% 0.035 3.05% -1.48 0.0%

RURAL ELEC 24.53% 0.028 2.78% 6.08 6.34%

L&T -19.39% 0.033 2.39% -7.87 0.0%

GSCH 11.56% 0.018 2.35% 2.27 7.37%

BHARTI -6.66% 0.032 2.34% -4.28 0.0%

UBI 27.55% 0.026 2.24% 7.80 8.29%

JINDAL 12.3% 0.044 2.24% 1.12 0.41%

SUN

PHARMA

20.69% 0.036 2.01% 3.7 1.55%

M&M -1.52% 0.036 1.98% -2.38 0.0%

UPL -3.37% 0.037 1.91% -2.79 0.0%

EXIDE 29.20% 0.026 1.87% 8.33 1.18%


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EQUITY 95.37% 26.58% 0.012

DEPOSITS, MMIs 4.63% 2.46% 0.023



The graph below shows the efficient frontier of the growth fund.

0.014 0.0145 0.015 0.0155 0.016 0.0165 0.017 0.0175 0.018 0.01850.04

0.042

0.044

0.046

0.048

0.05

0.052

0.054Mean-Variance-Efficient Frontier


ExpectedReturn


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4.4 Limitations of the study

While conducting the study on the risk and return of the portfolio, the following limitations were

observed:

1. In real time situations, a fund manager does not keep the portfolio compositionconstant and hence the portfolio is dynamic. Since the investments made depend upon

the current market condition/situation, the fund manager keeps the portfolio in

tandem with the market to reap the best return out of the entire portfolio.

2. Since the period of study was 3 years, one of the years being 2008 (which was theyear of recession) there may have been possibilities that the fund manager changed

the asset allocation to concentrate more on the debt instruments than on the equity. In

order to ensure minimum returns on the portfolio. This hasnt been reflected in the

study conducted. The asset allocation was kept constant and no change to the

percentages allocated to the various instruments was made.

3. The study has made use of Sharpe ratio to help optimize or get a better portfolio. Butin reality, Sharpe ratio is not used in isolation. It is used along with other ratios like

Treynor ratio etc to give a wholistic view to the optimization.

4.5 Observations and Suggestions

The new investment fraction obtained is by making use of Sharpe ratio. Hence, the fundmanager should use the sharpe ratio and other similar ratios to get the best portfolio

composition depending on the market condition then. Hence, sharpe ratio could be used as a

benchmark to obtain a better portfolio.

The fund managers should conduct this exercise regularly in order to ensure that the stockswhich have negative sharpe ratio are eliminated from the portfolio and either a new stockwhich is performing better should be introduced or the investment fraction of the remaining

stocks should be proportionately increased.

The fund managers should strive to obtain a portfolio which lies on the efficient frontier. Aportfolio on the efficient frontier will give the best return for a given risk.


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Annexure I

About the organization

HDFC Life, one of India's leading private life insurance companies, offers a range of individual and

group insurance solutions. It is a joint venture between Housing Development Finance CorporationLimited (HDFC), India's leading housing finance institution and Standard Life plc, the leading

provider of financial services in the United Kingdom.

HDFC Ltd. holds 72.43% and Standard Life (Mauritius Holding) Ltd. holds 26.00% of equity in the

joint venture, while the rest is held by others.

HDFC Limited

HDFC Limited, India's premier housing finance institution has assisted more than 3.8 million

families own a home, since its inception in 1977 across 2400 cities and towns through its network of

over 289 offices. It has international offices in Dubai, London and Singapore with service associates

in Saudi Arabia, Qatar, Kuwait and Oman to assist NRI's and PIO's to own a home back in India. As

of March 2011, the total asset size has crossed more than Rs. 1,32,727crores including the

mortgage loan assets of more than Rs.1,17,126 crores. The corporation has a deposit base of over Rs.

24,625 crores, earning the trust of nearly one million depositors. Customer Service and satisfaction

has been the mainstay of the organization. HDFC has set benchmarks for the Indian housing finance

industry. Recognition for the service to the sector has come from several national and international

entities including the World Bank that has lauded HDFC as a model housing finance company for the

developing countries. HDFC has undertaken a lot of consultancies abroad assisting different countries

including Egypt, Maldives, Mauritius , Bangladesh in the setting up of housing finance companies.

Standard Life Plc.

Established in 1825, Standard Life Plc. is a leading provider of long term savings and investments to

around 6 million customers worldwide. Headquartered in Edinburgh, Standard Life has around 9,000employees across the UK, Canada, Ireland, Germany, Austria, India, USA, Hong Kong and mainland

China. The Standard Life group includes savings and investments businesses, which operate across its

UK, Canadian and European markets; corporate pensions and benefits businesses in the UK and

Canada; Standard Life Investments, a global investment manager, which manages assets of over

157bn globally; and its Chinese and Indian Joint Venture businesses. At the end of April 2011

the Group had total assets under administration of 198.4bn. Standard Life plc is listed on the

London Stock Exchange and has approximately 1.5 million individual shareholders in over 50

countries around the world.


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Vision

'The most successful and admired life insurance company, which means that we are the most trusted

company, the easiest to deal with, offer the best value for money, and set the standards in the

industry'.

'The most obvious choice for all'.

Values

Values that we observe while we work:

Integrity Innovation Customer centric People Care "One for all and all for one" Team work Joy and Simplicity

Associate Companies

HDFC Trustee Company Ltd. GRUH Finance Ltd. HDFC Developers Ltd. HDFC Property Ventures Ltd. HDFC Ventures Trustee Company Ltd. HDFC Investments Ltd. HDFC Holdings Ltd. Credit Information Bureau (India) Ltd HDFC Securities HDB Financial Services


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HDFC Milestones

Received the PCQuest Best IT Implementation Award 2008 for Consultant Corner, theapplications for its financial consultants, providing centralized control over a vast

geographical spread for key business units such as inventory, training, licensing, etc. Received the 2008 CIO Bold 100 Award for its mobile workforce portal and the Special 2008

CIO Security Award for a secure computing environment, including identity management

respectively.

Mr. Deepak M Satwalekar Awarded QIMPRO Gold Standard Award. HDFCSL expanded its reach in the Bancassurance channel by arrangements with co-operative

banks in the rural areas.

Continued to increase its focus on quality service, by putting in place a robust mechanism tocapture 'Voice of the Customer' through service audits across its offices. This was

complemented by use of technology that enabled capture of all interactions with customers

across all touch points

Sar Utha Ke Jiyo was honoured as 'Among India's 60 Glorious Advertising Moments. Theadvertisements of the company were ranked 6th amongst 'The 10 most effective

Advertisements' in September 2007.

Received the PCQuest Best IT Implementation Award 2007 for Wonders, its path-breakingimplementation of an enterprise-wide workflow system. In addition the company also bagged

the EMC storage award for being the most innovative users of storage and storage

management.

Pension Plan Tops Mint's Survey of Best TV Ads. HDFC Standard Life's advertising created high awareness for the brand and bagged 2 silver

and 1 bronze awards at the ADFEST 2007 National Awards organised by the Advertising

Agencies Association of India (AAAI). The 3 awards are the highest won by any single brand

in the financial services business (including banking, mutual fund, insurance and other

financial services). Ranked 29th most trusted Indian Brands amongst the Top 50 Service Brands of 2006

according to a study conducted by the Brand Equity Economic Times, the leading business

publication of India.

HDFC Life's product portfolio comprises solutions, which meet various customer needs such as

Protection, Pension, Savings, Investment and Health. Customers have the added advantage of

customizing the plans, by adding optional benefits called riders, at a nominal price. The company

currently has 29 retail and 5 group products in its portfolio, along with five optional rider benefitscatering to the savings, investment, protection and retirement needs of customers.


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References:

www.hdfclife.com

www.irda.gov.in

www.investopedia.com

www.wikipedia.com
http://www.hdfclife.com/http://www.hdfclife.com/http://www.irda.gov.in/http://www.irda.gov.in/http://www.investopedia.com/http://www.investopedia.com/http://www.wikipedia.com/http://www.wikipedia.com/http://www.wikipedia.com/http://www.investopedia.com/http://www.irda.gov.in/http://www.hdfclife.com/

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