Financial Services

Introduction: The principle of management by objectives rightly suits the financial services management. The basic objectives of management in financial services are cost effectiveness, efficiency in service quality and profitability. In this service sector quality counts more than the quantity. Management of financial services requires a combination of talents in marketing & area, finance area and in HRD capital market deals with raising of finance, arranging for loans, creating in capital and securities, etc. But being a service sector market management of a human component is vital for its operation. Capacity to take decisions and right decisions in time is essential part of capital market management. Corporate data and information is available, it is the manager's competency to pick up the correct information, analyse it and draw a correct conclusion market and investment analysis requires an expert financial manager. Meaning of Financial Services: The term "Financial Services" in a broad sense means "mobilizing and allocating savings". Thus, it includes all activities involved in the transformation of saving into investment. The financial service can also be called 'financial intermediation'. Financial intermediation is a process by which funds are mobilised from a large number of savers and make them available to all those who are in need of it and particularly corporate customers. Thus, financial services sector is a key area and it is very vital for industrial developments. Classifications of Financial Services Industry: The financial intermediaries are classified into two: (1) Capital market intermediaries, and (2) Money market intermediaries. (1) Capital market intermediaries: The capital market intermediaries consist of term lending Institutions and investing institutions which mainly provide long term funds. (2) Money market intermediaries: It consists of commercial banks, cooperative banks and other agencies which supply only short term funds. Scope of Financial Services: Financial services cover a wide range of activities. They can be broadly classified into two namely: (1) Traditional activities: Traditionally, the financial intermediaries have been rendering a wide range of services encompassing both capital and money market activities. They can be grouped under two heads: (a) Fund based activities: The fund based activities are as follows: (i) Dealing in foreign exchange market activities. (ii) Involving in equipment leasing, hire purchase, venture capital, seed capital, etc. (iii) Underwriting of or investment in shares, debentures, bonds, etc. of new issues (primary market activities). (iv) Dealing in secondary market activities. (v) Participating in money market instruments like commercial papers, certificate of deposits, treasury bills, discounting of bills, etc. (b) Non-fund based activities: Financial services provide services on the basis of non-fund activities. This can also be called" fee based" activity. Today customers whether individual or corporate are not satisfied with mere provision of finance. They expect more from financial service companies. Hence, a variety of services are being provided they are as follows: (i) Arrangement of funds from financial institutions for the clients project cost or his working capital requirements. (ii) Assisting in the process of getting all government and other clearances. (iii) Managing the capital issues - i.e., management of pre issue and post-issue activities relating to the capital issue in accordance with the SEBI guidelines and thus enabling the promoters to market their issues. (iv) Making arrangements for the placement of capital and debt instruments with investment institutions. Modern activities: Modern services are as follows: (a) Managing the portfolio of large public sector corporations. (b) Guiding corporate customers in capital restructuring. (c) Undertaking risk management services like insurance services, buy-back options, etc. (d) Rendering project advisory services right from the preparation of the project report till the raising of funds for starting the project with necessary government approval. (e) Acting as Trustees to the debenture holders.

(f) Structuring the financial collaboration/Joint Ventures by identifying suitable joint venture partner and preparing joint venture agreement. (g) Undertaking services relating to the capital market such as: (i) Clearing services. (ii) Safe custody of securities. (iii) Collection of income on securities. (iv) Registration and transfers. (h) Planning for mergers and acquisitions and assisting for their smooth carryout. (i) Promoting credit rating agencies for the purpose of rating companies which want to go public by the issues of debt instruments. (j) Hedging of risks due to exchange rate risk, interest rate risk, economic risk and political risk by using swaps and other derivative products. Causes for Financial Innovation: (1) Economic liberalization: Reform of the financial sector constitutes the most important component of India's programme towards economic liberalisation. The recent economic liberalization measures have opened the door to foreign competitors to enter into (2) Investor awareness: With a growing awareness amongst the investing public, there has been a distinct shift from investing the savings in physical assets like gold, silver, land, etc. to financial assets like shares, debentures, mutual funds etc. (3) Low profitability: The profitability of the major financial intermediary, namely the banks has been very much affected in recent times. There is a decline in the profitability of traditional banking products. (4) Customer service: Now-a-days the customer's expectations are very great. They want newer products at lower cost or at lower credit risk to replace the existing ones. (4) Keen competition: The entry of many financial intermediaries in the financial sector market has led to severe competition among themselves. This keen competition has paved the way for the entry of varied nature of innovative financial products so as to meet the varied requirements of the investors. (5) Improved communication technology: The communication technology has become so advanced that even the world's issuers can be linked with the investors in the global financial market without any difficulty by means of offering so many options and opportunities. (6) Global impact: Many of the providers and users of capital have changed their roles all over the world. Financial intermediaries have come out of their traditional approach and they are ready to assume more credit risks. (7) New Financial Products and Services: Today, the importance of financial services is gaining momentum all over the world. In these days of complex finance, people expect a financial service company to playa very dynamic role not only as a provider of finance but also a departmental store of finance. Sophistication and innovations have appeared in the arena of financial intermediaries. Some of them are briefly discussed below: (1) Merchant Banking: Definition: Merchant banking may be defined as, "an institution which covers a wide range of activities such as management of customer services, portfolio management, credit' syndication, acceptance credit, counseling, insurance, etc." The notification of the Ministry of Finance defines a merchant banker as, "any person who is engaged in the business of issue management either by making arrangements regarding selling, buying or subscribing to the securities as managers consultant, adviser or rendering corporate advisory service in relation to such issue management. Services of Merchant Banks: (1) Project Counseling: Project counseling includes preparation of project reports, deciding upon the financing pattern to finance the cost of the project and appraising project report with the financial institutions or banks. Protect reports are prepared to obtain government approval, get financial assistance from institutions and plan for the public issue. Project counseling also includes filling up of application forms with relevant information for obtaining funds from financial institutions. (2) Issue Management: Management of issue involves marketing of corporate securities viz. equity share, preference shares and debentures or bonds by offering them to public. Merchant banks act as intermediary whose ma i. I job is to transfer capital from those who own it to those who need it. (a) Marketing: After dispatch to SEBI, the merchant bankers arrange a meeting with company representatives and advertising agents to finalise arrangements relating to date of opening and closing of issue, registration of prospectus, launching publicity campaign and fixing date of board meeting to approve and sign prospectus and pass

the necessary resolutions. Publicity campaign covers the preparation of all publicity material and brochures, prospectus, announcement, advertisement in the press, radio, TV, investors' conference, etc. The merchant bankers help choosing the media, determining the size and publications in which the advertisement should appear. (b) Pricing of Issues: The SEBI guidelines 1992 for capital issues have opened the capital market to free pricing of issues. Pricing of issues is done by companies themselves in consultation with the merchant bankers. Pricing of issue is part of pre-issue management. (3) Post-issue Management: The post-issue management consists of collection of application forms and statement of amount received from bankers, screening applications, deciding allotment procedure, mailing of allotment letters, share certificates and refund orders. Registrars to the issue playa major role in post-issue management. They receive the applications, verify them and submit the basis of allotment to the stock exchange. Registrars have to ensure that the applications are processed and allotment/refund orders are sent within 70 days of the close of the issue. (4) Underwriting of Public Issue: Underwriting is a guarantee given by the underwriter that in the event of under subscription the amount underwritten, would be subscribed by him. It is an insurance to the company which proposes to make public offer against risk of under subscription. Lead managers have to underwrite mandatory 5% of the issue or Rs. 2.5 lakh whichever is less. Banks/Merchant banking subsidiaries cannot underwrite more than 15% of any issue. (5) Managers, Consultants or Advisers to the Issue: The managers to the issue assist in the drafting of prospectus, application forms and completion of formalities under the Companies Act, appointment of Registrar for dealing with share applications and transfer and listing of shares of the company on the stock exchange. Companies are free to appoint one or more agencies as managers to the issue. Ordinarily, not more than two merchant bankers should be associated as lead managers, advisers and consultants to a public issue. In issue of over Rs. 100 crores up to a maximum, of four merchant bankers could be associated as managers. (6) Portfolio Management: Portfolio refers to investment in different kinds of securities such as shares, debentures or bonds issued by different companies and securities issued by the government. Portfolio management refers to maintaining proper combinations of securities in a manner that they give maximum return with minimum risk. (7) Advisory Service Relating to Mergers and Takeovers: A merger is a combination of two or more companies into a single company where one survives and others lose their corporate existence. A takeover is the purchase by one company acquiring controlling interest in the share capital of another existing company. Merchant bankers are the middlemen in setting negotiation between the offeree and offeror. (8) Off Shore Finance: The merchant bankers help their clients in the following areas involving foreign Currency. (a) Long term foreign currency loans. (b) Joint Ventures aboard. (c) Financing exports and imports and (d) Foreign collaboration arrangements. (9) Non-resident investment: The services of merchant bankers include investment advisory services to NRI in terms of identification of investment opportunities, selection of securities, investment management, etc. They also take care of the operational details like purchase and sale of securities, securing necessary clearance from RBI for repatriation of interest and dividend. (1) Loan Syndication: loan syndication refers to assistance rendered by merchant banks to get mainly term loans for projects. Such loans may be obtained from a single development finance institution or a syndicate or consortium. Merchant bankers help corporate clients to raise syndicated loans from commercial banks. Merchant banks help clients approach financial institutions for term loans. (2) Corporate Counseling: Corporate counseling covers the entire field of merchant banking activities viz. project counseling, capital restructuring, project management public issue management, loan syndication, working capital, fixed deposit, lease financing, acceptance credit, etc. The scope of corporate counseling is limited to giving suggestions and opinions to the client and help taking actions to solve their problems. Scope for Merchant Banking In India: In the present day capital market scenario, the merchant banks play the role of an encouraging and. supporting force to the entrepreneurs, corporate sectors and the investors. (1) Growth of new issues market: The growth of new issue market is unprecedented since 1990-91. The amount of annual average of capital issues by non-government public companies was only about 90 crores in the 70s, the same rose to over Rs. 1,000 crores in the 80s and further to Rs. 12,700 crores in the 1st four years of 19905. This figure could be well beyond Rs. 40,000 crores. (2) Development of debt market: The concept of debt market has set to work through National Stock Exchange and the over the Counter Exchange of India. Experts feel that a good portion may be raised through debt instruments.

(3) Innovations in financial instruments: The Indian capital market has witnessed innovations in the introduction of financial instruments such as non-convertible debentures with detachable warrants, cumulative convertible preference shares, zero coupon bonds, deep discount bonds, triple option bonds, secured premium notes, floating rate bonds, auction rated debentures, etc. (4) Entry of foreign investors: Within two years to March 1994, the total inflow of foreign capital through the routes reached to about $ 5 billion. It is estimated that this figure may go up to $ 35-40 billion by the turn of century.. Further, foreign direct investment as also investment by NRIs have risen considerably due to number of incentives offered to them. (5) Disinvestment: The government raised Rs. 2000 crores through disinvestment of equity shares of selected public sector undertakings. The government proposes to shift the present method of periodic sale of public sector shares to round the year offloading of shares directly on the stock exchange. The government will sell the shares of identified public sector at any time during the year when they get a good price above minimum stipulated level. (6) Changing policy of financial institutions: With the changing emphasis in the lending policies of financial institutions from security orientation to project orientation, corporate enterprises would require the expert services of merchant bankers for project appraisal, financial management, etc. The policy of decentralization and encouragement of small and medium industries will further increase the demand for technical and financial services which can be provided by merchant bankers. (7) Corporate restructuring: As a result of liberalisation and globalisation, the competition in the corporate sector is becoming intense. To survive in the competition, companies are reviewing their strategies, structure and functioning. This has led to corporate restructuring including mergers, acquisitions, splits, disinvestment and financial restructuring. (2) Loan Syndication: This is more or less similar to 'consortium financing'. But, this work is taken up by the merchant bankers as a lead manager. It refers to a loan arranged by a bank called lead manager for a borrower who is usually a large corporate customer or a Government Department. (3) Mutual Funds: Definition: The Securities and Exchange of Board of India Regulations, 1993 defines a Mutual fund as "a fund established in the form of a trust by a sponsor, to raise monies by the trustees through the sale of units to the public, under one or more schemes, for investing in securities in accordance with these regulations". According to Weston J. Fred and Brigham, Eugene F Unit Trusts are "corporations which accept dollars from savers and then use these dollars to buy stocks, long term bonds, short term debt instruments issued by business or government units; these corporations pool funds and thus reduce risk by diversification. Types/Classification of Funds:
Mutual fund

On the basis of execution & Operation

On the basis of yield & investment pattern

Close ended

Open ended

Income Fund

Growth fund

Balance fund Specialised Fund

Money Taxation Market fund

Mutual fund schemes can broadly be classified into many types as given below: On the Basis of Execution and Operation: (A) Close-ended Funds: Under this scheme, the corpus of the fund and its duration are prefixed. In other words, the corpus of the fund and the number of units are determined in advance. Once the subscription reaches the predetermined level, the entry of investors is closed. After the expiry of the fixed period, the entire corpus is disinvested and the proceeds are distributed to the various unit holders in proportion to their holding. Thus, the fund ceases to be a fund, after the final distribution. Features of Close-Ended Funds: (1) The main objective of this fund is capital appreciation. (2) From the investors' point of view, it may attract more tax since the entire capital appreciation is realised into at one stage itself. (3) The period and/or the target amount of the fund is definite and fixed beforehand. . (4) Generally, the prices of closed-end-scheme units are quoted at a discount of upto 40 per cent below their NAV. (5) Once the period is over and/or the target is reached, the door is closed for the investors. They cannot purchase any more units. 6) If the market condition is not favourable, it may also affect the investor since he may not get the full benefit of capital appreciation in the value of the investment. (7) At the time of redemption, the entire investment pertaining to a closed-end scheme is liquidated and the proceeds are distributed among the unit holders. (8) These units are publicly traded through stock exchange and generally, there is no repurchase facility by the fund. (9) The whole fund is available for the entire duration of the scheme and there will not be any redemption demands before its maturity. Hence, the fund manager can manage the investments efficiently and profitably without the necessity of maintaining any liquidity. (B) Open-ended Funds: It is just the opposite of close ended funds. Under this scheme, the size of the fund and the period of the fund is not pre-determined. The investors are free to buy and sell any number of units at any point of time. For instance, the Unit Scheme (1964) of the Unit Trust of India is an open-ended one, both in terms of period and target amount. Anybody can buy this unit at any time and sell it also at any time at his discretion. Features of Open-Ended Fund: (1) The main objective of this fund is income generation. The investors get dividend, rights or bonuses as rewards for their investment. (2) The fund manager has to be very careful in managing the investments because he has to meet the redemption demands at any time made during the life of the scheme. (3) There is complete flexibility with regard to one's investments or disinvestment. In other words there is free entry and exit of investors in an open-ended fund. There is no time limit. (4) Since the units are not listed on the stock market, their prices are linked to the Net Asset Value (NAV) of the units. The NAV is determined by the fund and it varies from time to time. (5) These units are not publicly traded but, the fund is ready to repurchase them and resell them at any time. (6) The investor is offered instant liquidity in the sense that the units can be sold on any working day to the fund. In fact, the fund operator just like a bank account wherein one can get cash across the counter for any number of units sold. (7) Generally, the listed prices are very close to their Net Asset Value. The fund fixes a different price for their purchases and sales. On the Basis of Yield and Investment Pattern: (A) Income Funds: As the very name suggests, this Fund aims at generating and distributing regular income to the members on a periodical basis. It concentrates more on the distribution of regular income and it also sees that the average return is higher than that of the income from bank deposits. (B) Pure Growth Funds (Growth Oriented Funds): Unlike the income funds, growth funds concentrate mainly on long run gains i.e. capital appreciation. They do net offer regular income and they aim at capital appreciation in the long run. Hence, they have been described as "Nest Eggs" investments.

(C) Balanced Funds: This is otherwise called "income-cum-growth" fund. It is nothing but a combination of both income and growth funds. It aims at distributing regular income as well as capital appreciation. This is achieved by balancing the investments between the high growth equity shares and also the fixed income earning securities. (D) Specialised Funds: Besides the above, a large number of specialised funds are in existence abroad. They offer special schemes so as to meet the specific needs of specific categories of people like pensioners, widows, etc. There are also funds for investments in securities of specified area. For instance Japan fund, South Korea fund, etc. Again, certain funds may be confined to one particular sector or industry like fertiliser, automobiles, petroleum, etc. These funds carry heavy risks since the entire investment is in one industry. But, there are high risk taking investors who prefer this type of fund, of course, in such cases, the rewards may commensurate with the risk taken. The best example of this type is the Petroleum Industry Funds in the USA. (E) Money-Market Mutual Funds (MMMFs): These funds are basically open ended mutual funds as such they have all the feature" of the open ended fund. But, they invest in highly liquid and safe securities like commercial paper, bankers acceptances, certificates of deposits, treasury bills, etc. These instruments are call money market instruments. They take place of shares, debentures and bonds in a capital market. They pay money market rates of interest. These funds are called 'money funds' in the USA and they have been functioning since 1972. Investors generally use it as a "Parking Place" or stop gap arrangements for their cash resources till they final1y decide about the proper avenue for their investment i.e., long term financial assets like bonds and stocks. Since MMMFs are a new concept in India the RBI has laid down certain stringent regulations. For instance, the entry to MMMFs is restricted only to scheduled commercial banks and their subsidiaries. (F) Taxation Funds: A taxation fund is basically a growth-oriented fund. But, it offers tax rebates to the investors either in the domestic or foreign capital market. It is suitable to salaried people who want to enjoy tax rebates particularly during the month of February and March. In India at present the law relating to tax rebates is covered under Sec. 88 of the Income Tax Act, 1961. An investor is entitled to get 20% rebate in Income Tax for investments made under this fund subject to a maximum investment of Rs. 10,000/- per annum. The tax saving Magnum of SBI capital market limited is the best example for the domestic type. UTI's US $ 60 million Indian fund, based in the USA, is an example for the foreign type. Other Classification: (G) Leveraged Funds: These funds are also called borrowed funds since they are used primarily to increase the size of the value of portfolio of a mutual fund. When the value increases, the earning capacity of the fund also increases. The gains are distributed to the unit holders. (H) Index Funds: Index funds refers to those funds where the portfolios are designed in such a way that they reflect the composition of some broad based market index, (I) Offshore Mutual Funds: Offshore mutual funds are those funds which are meant for nonresidential investors. In other words, the forces of investments for these funds are from abroad so they are regulated by the provisions of the foreign countries where those funds are registered. (J) Dual Funds: This is a special kind of closed end fund. It provides a single investment opportunity for two different types of investors. For this purpose, it sells two types or investment stocks viz. income shares and capital shares. Those investors who seek current investment income can purchase income shares. (K) Bond Funds: These funds have portfolio consisting mainly of fixed income securities like bonds. The main thrust of these funds is mostly on income rather than capital gains. (L) Aggressive Growth Funds: These funds are just the opposite of bond funds. These funds are capital gains oriented and thus the thrust area of these funds is 'capital gains'. Hence, these funds are generally invested in speculative stocks. Importance/Advantages of Mutual Funds:

(1) Offering wide portfolio investment: Small and medium investors used to burn their fingers in stock exchange operations with a relatively modest outlay. If they invest in a select few shares, some may even sink without a trace never to rise again. Now, these investors can enjoy the wide portfolio of the investment held by the mutual fund. (2) Offering tax benefits: Certain funds offer tax benefits to its customers. Thus, apart from dividend, interest and capital appreciation, investors also stand to get the benefit of tax concession. For instance, under section 80L of the Income Tax Act a sum of Rs. 10,000 received as dividend (Rs. 13,000 to UTI) from a MF is deductible from the gross total income. Some funds operate 88A funds where 20% of the amount invested (subject to a maximum of Rs. 25,000) is allowed to be deducted from the tax payable under the Wealth Tax Act, investments in MF are exempted upto Rs. 5 lakh. (3) Supporting capital market: Mutual funds playa vital role in supporting the development of capital markets. 'The mutual funds make the capital market active by means of providing a sustainable domestic source of demand for capital market instruments. In other words, the savings of the people are directed towards investments in capital markets through these mutual funds. (4) Channelising savings for investment: Mutual funds act as a vehicle in galvanising the'savings of the people by offering various schemes suitable to the various classes of customers for the development of the economy as a whole. A number of schemes are being offered by MFs so as to meet the varied requirements of the masses, and thus, savings are directed towards capital investments directly. (5) Providing better yields: The pooling of funds from a large number of customers enables the fund to have large funds at its disposal. Due to these large funds, mutual funds are able to buy cheaper and sell dearer than the small and medium investors. Thus they are able to command better market rates and lower rates of brokerage. So, they provide better yields to their customers. They also enjoy ~he economies of large scale and can reduce the cost of capital market participation. Promoting industrial development: The economic development of any nation depends upon its industrial advancement and agricultural development. All industrial units have to raise their funds by resorting to the capital market by the issue of shares and debentures. (7) Rendering expertised investment service at low cost: The management of the fund is generally assigned to professionals who are well trained and have adequate experience in the field of investment. The investment decisions of these professionals are always backed by informed judgement and experience. Thus, investors are assured of quality services in their best interest. (8) Providing research service: A mutual fund is able to command vast resources and hence it is possible for it to have an in-depth study and carry out research on corporate securities. Each fund maintains a large research team which constantly analyses the companies and the industries, recommends the fund to buy or sell a particular share. (9) Introducing flexible investment schedule: Some mutual funds have permitted the investors to exchange their units from one scheme to another and this flexibility is a great boon to investors. Income units can be exchanged for growth units depending upon the performance of the funds. (10) Reducing the marketing cost of new issues: Moreover the mutual funds help to reduce the marketing cost of the new issues. The promoters used to allot a major share of the Initial Public Offering to the mutual funds and thus they are saved from the marketing cost of such issues, (11) Simplified record keeping: An investor with just an investment in 500 shares or so in 3 or 4 companies has to keep proper records of dividend payments, bonus issues, price movements, purchase or sale instruction, brokerage and other related items. It is very tedious and consumes a lot of time. One may even forget to record the rights issue and may have to forfeit the same. Thus, record keeping is the biggest problem for small and medium investors. (12) Acting as substitute for initial public offerings (IPOs): In most cases investors are not able to get allotment in IPOs of companies because they are often oversubscribed many times. Moreover, they have to apply for a minimum of 500 shares which is very difficult particularly for small investors. But, in mutual funds, allotment is more or less guaranteed. (13) Keeping the money market active: An individual investor cannot have any access to money market instruments since the minimum amount of investment is out of his reach. On the other hand, mutual funds keep the money market active by investing money on the money market instruments. The Indian Mutual fund is perhaps the best. example of the customer focussed, well-managed and regulated financial industry in India and may be in the world. The professionals in the industry are uniformly of a high caliber and bring great dedication and drive to their task. Changed Environment: While the spread and penetration of mutual funds has been relatively low in the past, things are changing at a rapid pace now.

One of the important drivers of this change has been the change in demographic profile of the country where greater sophistication has meant some shift away from a saving culture to an investment culture. This shift in turn is being aided by benefits including taxation benefits given to the investors. Decline in the yield on alternative investment instruments such as bonds and government sponsored savings products and the overall decline in interest rates have also aided the focus on ownership of assets. To serve this changing trend, the financial distribution and the financial advisory infrastructure has been evolving at a rapid pace. The recently witnessed uptrend in the equities market and the consequent value creation for investors in equity. Mutual funds have also led to improvements in sentiments towards these products. Mutual funds have also attempted to innovate and position products appropriate to investors needs and requirements. Over the past five years the basket; of products available to investors has increased significantly. (4) Leasing: Definition:
,

"Lease is a form of contract transferring the use or occupancy of land, space, structure or equipment, in consideration of a payment, usually in the form of a rent." - Dictionary of Business and Management
"Lease is a contract whereby the owner of an asset (lessor) grants to another party (lessee) the exclusive right to use the asset usually for an agreed period of time in return for the payment of rent. - James C. Van Horne "A contract between lessor and lessee for the hire of a specific asset selected from a manufacturer or vendor of such assets by the lessee. The lessor retains the ownership of the asset. The lessee has possession and use of the asset on payment of specified retain over the period.
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- Equipment Leasing Association of UK Types of Lease: (1) Financial Lease: A financial lease is also known as capital lease, long term lease, net lease and close lease. In a financial lease, the lessee selects the equipments, settle the rights and terms of sale and. arranges with a leasing company to buy it. He enters into a irrevocable and non-cancellable contractual agreement with the leasing company. The lessee uses the equipment exclusively maintains it, insures and avails of the after sales service and warranty backing it. He also bears the risk of obsolescence as it stands committed to pay the rental for the entire lease period. The financial lease may also contain a non-cancellable clause which means that the lessor transfers the title to the lessee at the end of the lease period. The financial lease is very popular in India as in other countries like USA, UK and Japan. On all India basis, at present, approximately a lease worth Rs. 75 to 100 crores is transacted as tax planning device. (2) Operating Lease: An operating lease is also known as service lease, short term lease or true lease. In this lease, the contractual period between lessor and lessee is less than the full expected economic life of equipment. This means that the lease is for a limited period, may be a month, six months, a year or few years. The lease is terminable by giving stipulated notice as per the agreement. The leaser does the services like handling warranty claims, paying taxes, scheduling and performing maintenance and keeping complete record. Lease is suitable for; (a) Computers, copy machines and other office equipments, vehicles, materials handling equipments, etc. which are sensitive to obsolence, and (b) Where the lessee is interested in tiding over temporary problem (3) Sale and Lease Back: Under this type of lease, a firm which has an asset sells it to the leasing company and gets it back on lease. The asset is generally sold at its market value. The firm receives the sale price in cash and gets the right to use the asset during the lease period. The firm makes periodical rental payment to the lessor. The title to the asset vests with the lessor. (4) Leverage Lease: A leverage lease is used for financing those assets which require huge capital outlay. The outlay for purchase cost of the asset generally varies from Rs. 50 lakhs to Rs. 2 crore and has economic life of 10 years or more. The leverage lease agreement involves three parties, the lessee, the lessor and the lender. The lessor acquires the assets as per the terms of the lease agreement but finances only a part of the total investment, say 20% to 50%. The balance is provided by a person or a group of persons in the form of loan to the lessor. The loan is generally secured by mortgage of the asset besides assignment of the leased rental payments. The position of the lessee under a leverage leasing agreement is the same as is the case of any other type of lease. In leveraged lease, a wide range of equipments such as rail, road, rolling stock, coal mining, electricity generating plants, pipe lines, ships, etc are acquired. (5) Cross Border Lease: Cross border lease is international leasing and is known as transnational leasing. It relates to a lease transaction between a lessor and lessee domiciled in different countries and includes exports leasing. In other words, the lessor may be of one country and the lessee may be of another country. To illustrate, if a leasing company in USA makes available an Air bus on lease to Air India, there would be a cross border lease.

Advantages of Leasing: (1) Alternative use of funds permitted. (2) Availability of faster and cheaper credit. (3) Facilitates additional borrowings. (4) Protection against obsolescence. (5) Hundred percent financing available. (6) Boon to small firms. Disadvantages of Leasing: (1) Lease is not suitable mode of project finance. (2) Certain tax benefits/incentives such as subsidy may not be available on leased equipments. (3) The cost of financing is generally higher than that of debt financing. (4) If the rentals are not paid regularly the lessor would suffer a loss particularly in case of sophisticated asset. (5) A manufacturer who wants to discontinue a particular line of business will not be able to do so except by paying heavy penalties. (5) Hire Purchase: Under hire purchase system the buyer takes the possession of goods immediately and agrees to pay the total hire purchase amount in Installments. Each installment is treated as hire charges. The ownership of the goods passes from the seller to the buyer on payment of all the installments. If the buyer makes any default in the payment of any installment the seller has the right to reposses the goods from the buyer and forfeit the amount already received treating it as hire charges. Banks and Hire Purchase Business: The following guidelines should be made applicable to banks so far as hire-purchase business is concerned: (1) Banks shall not themselves undertake directly the business of hire purchase. (2) Those banks which have set-up subsidiaries for the business of equipment leasing, merchant banking etc. may undertake the hire purchase business either through such a subsidiary or through a separate subsidiary. (3) Investment of a bank in the shares of the subsidiary set-up for undertaking equipment leasing and/or hire purchase business together with investment of the bank in the shares of other companies carrying on equipment leasing and/or hire purchase business shall not in the aggregate exceed 10 per cent of the paid-up, capital and reserves of the bank. (4) Banks may invest in the shares of other hire-purchase companies within the limits specified in Section 19(2) of the banking Regulation Act, 1949 with the RBI's prior approval but they shall not act as promoters of such companies. (5) Those banks setting up a subsidiary for carrying out hire purchase business or through existing subsidiaries should furnish such information in such form and at such time as the RBI may require from time to time. (6) Factoring: Meaning: The word 'factor' has been derived from the Latin word 'Facere' which means 'to make or to do'. In other words, it means 'to get things done'. According to the Webster Dictionary 'Factor' is an agent, as a banking or insurance compapy, engaged in financing the operations of certain companies or in financing wholesale or retail trade sales, through the purchase of account receivables. Definition: Robert W. Johnson in his book "Financial Management" states "factoring is a service involving the purchase by a financial organization called a factor, of receivables owned to manufacturers and distributors by their customers with the factor assuming full credit and collection responsibilities." According to V. A. Avadhani, "Factoring is a service of financial nature involving the conversion of credit bills into cash". In other words of Kohak "Factoring is an asset based means of financing by which the factor buys up the book debts of a company on a regular basis, paying cash down against receivables, and then collects the amounts from the customers to whom the company has supplied goods". Prof. S. P. Singh, a member of the study group appointed by the RBI to examine the feasibility of introducing factoring services in India feels that "factoring - which traditionally meant buying of book debts for cash - is not merely invoice discounting or credit insurance". Types of Factoring: (1) Maturity factoring: Under this type, the factor does not provide immediate cash payment to the client at the time of assignment of debts. He undertakes to pay cash as and when collections are made from the debtors. The entire amount collected less factoring fees is paid to the client immediately.

(2) Invoice factoring: Under this type, the factor simply provides finance against invoices without undertaking any other functions. All works connected with sales administration, collection of dues, etc. have to be done by the client himself. The debtors are not at all notified and hence they are not aware of the financing arrangement. (3) Full service factoring: Under this type, a factor provides all kinds of services discussed above. Thus, a factor provides finance, administers the sales ledger, collects the debts at his risk and renders consultancy service. This type of factoring is a standard one. If the debtor fails to repay the debts, the entire responsibility falls on the shoulder of the factor since he assumes the credit risk also. (4) International factoring: Under this type, the services of a factor in a domestic business are simply extended to international business. Factoring is done purely on the basis of the invoice prepared by the exporter. Thus the exporter is able to get immediate cash to the extent of 30% of the export invoice under international factoriing. (5) Limited factoring: Under this type, the factor does not take up all the invoices of a client. He discounts only selected invoices on merit basis and converts credit bills into cash in respect of those bills only. (6) With resources factoring: As the very name suggests, under this type, the factor does not assume the credit risk. In other words, if the debtors do not repay their dues in time and if their debts are outstanding beyond a fixed period, say 60 to 90 days from the due date, such debts are automatically assigned back to the client. (7) Bulk factoring: Under this type, the factor provides finance after disclosing the fact of assignment of debts to the debtors concerned. This type of factoring is resorted to when the factor is not fully satisfied with the financial condition of the client. (8) Suppliers guarantee factoring: This type of factoring is suitable for business establishments which sell goods through middlemen. Generally, goods are sold through wholesalers, retailers or through middlemen. In such cases, the factor guarantees the supplier of goods against invoices raised by the supplier upon another suppliers. (9) Agency factoring: The word agency has no meaning as far as factoring is concerned. Under this type, the factor and the client share the work between themselves as follows: (a) The client has to look after the sales ledger administration and collection work, and (b) The factor has to provide finance and assume the credit risk. (10) Buyer based factoring: In most cases, the factor is acting as an agent of the seller. But under this type, the buyer approaches factor to discount his bills. Thus, the initiative for factoring comes from the buyer's end. (11) Seller based factoring: Under this type, the seller, instead of discounting his bills, sells all his accounts receivables to the factor, after invoicing the customers. The seller's job is over as soon as he prepares the invoices. (7) Forfeiting: Definition: Forfeiting has been defined as "the non-resources purchase by a bank or any other financial institution of receivables arising from an export of goods and services". Distinguish between Factoring and Forfeiting: (1) Factoring is always used as a tool for short term financing whereas forfeiting is used for medium term financing at a fixed rate of interest. (2) Factoring is generally employed to finance both the domestic and export business. But forfeiting is invariably employed in export business only. (3) The central theme of factoring is the purchase of invoice of the client whereas it is only the purchase of the export bill under forfeiting. (4) Under factoring, the client is able to get only 80% of the total invoice as 'credit facility' whereas the 100% of the value of the export bill (of course deducting service charges) is given as credit under forfeiting. (5) Forfeiting is a specific one in the sense that it is based on a single export bill arising out of an individual transaction only. But factoring is based on the "whole turnover" i.e., a bulk finance is provided against a number of unpaid invoices. (6) Forfeiting is done without resource to the client whereas it mayor may not be so under factoring. (7) The bills under forfeiting may be held by the forfeitor till the due date or they can be sold in the secondary market or to any investor for cash. Such a possibility does not exist under factoring. Benefits of Forfaiting: (1) Profitable and liquid. (2) Flexible and simple. (3) Avoids export credit risks. (4) Fixed rate finance. (5) 100% finance. (6) Suitable to all kinds of Export deals. (7) Speedy and confidential.

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(8) Avoids export-credit insurance. Drawbacks: (1) Non-availability for financially weak countries. (2) Non-availability for short and long period. (3) Dominance of western currencies. (4) Procuring International Bank's guarantee is difficult. VENTURE CAPITAL: Meaning: Venture capital is long term risk capital to finance high technology projects which involve risk but at the same time has strong potential for growth. Venture capitalist pool their resources including managerial abilities to assist new entrepreneurs in the early years of the project. Definition: A venture capital company is defined as "a financing institution which joins an entrepreneur as a co-promoter in a project and shares the risks and rewards of the enterprise". Importance/Advantages of Venture Capital: (1) Advantages to Investing Public: (a) The investing public will be able to reduce risk significantly against unscrupulous management, if the public invest in venture fund who in turn will invest in equity of new business. (b) Investor have no means to vouch for the reasonableness of the claims made by the promoters about profitability of the business. The venture funds equipped with necessary skills will be able to analyse the prospects of the business. (c) The investors do not have any means to ensure that the affairs of the business are conducted prudently. (2) Advantages to promoters: (a) Public issue of equity shares has to be preceded by a lot of efforts viz. necessary statutory sanctions, underwriting and brokers arrangement, publicity of issues, etc. The new entrepreneurs find it very difficult to make underwriting arrangement which requires a great deal of effort. (b) The entrepreneur for the success of public issue is required to convince tens of underwriters, brokers and thousands of investors but to obtain venture capital assistance, he will be required to sell his idea to justify the officials of the venture fund. (c) Cost of public issues of equity share often range between 10% to 15% of nominal value of issue of moderate size, which is often even higher for small issues. {3) General: (a) Venture capital acts as a cushion to support business borrowings, as bankers and investors will not lend money with inadequate margin of equity capital. (b) A venture capital firm serves as an intermediary between investors looking for high returns for their money and entrepreneurs in search of needed capital for their start ups. (c) A developed venture capital institutional set up reduces the time lag between a teleological innovations and its commercial exploitation. (d) It also paves the way for private sector to share the responsibility with public sector. (e) Once venture capital funds start earning profits, it will be very easy for them to raise resources from primary capital market in the form of equity and debts. (f) It helps in developing new processes/products in conducive atmosphere, free from the dead weight of corporate bureaucracy which helps in exploiting full potential. Innovative Financial Instruments: (1) Treasury bill: A treasury bill is also a money market instrument issued by the central government. It is also issued at a discount and redeemed at par. (2) Zero interest convertible debenture/bonds: As the very name suggests, these instruments carry no interest till the time of conversion. These instruments are converted into equity shares after a period of time. (3) Convertible bonds: A convertible bond is one which can be converted into equity shares at a per-determined timing eitl1er fully of partially. There are compulsory convertible bonds which provide for conversion within 18 months of their issue. There are optionally convertible bonds which provide for conversion within 3h months. Example: In June 1989, the Tata Iron and Steel company issued 30 lakhs partly convertible debentures of R.e;.1200 each for cash at par with the following terms: (a) Conversion of Rs. 600 par value into one equity share of Rs. 100 at a premium of Rs. 500 on Feb 1, 1990. (b) Interest rate of 12% p.a. and (c) Redemption of the non-convertible portion at the end of 8 years.

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(4) Commercial paper: A commercial paper is a short-term negotiable money market instrument. It has the character of an unsecured promissory note with a fixed maturity of 3 to 6 months. Banking and non-banking companies can issue this for raising their short term debt. (5) Deep discount bonds: There will be no interest payments in the case of deep discount bonds also. Hence, they are sold at a large discount to their nominal value. (6) Index linked guilt bonds: These are instruments having a fixed maturity. Their maturity value is linked to the index prevailing as on the date of maturity. (7) Variable rate debentures: They are debt instruments. They carry a compound rate of interest, but this rate of interest is not a fixed one. It varies from time to time in accordance with some pre-determined formula as we adopt in case of dearness allowance calculations. (8) Certificates of deposits: The scheduled commercial banks have been permitted to issue certificate of deposit without any regulation on interest rate. (9) Inter-Bank Participations (IBPs): The scheme of inter-bank participation is confined to scheduled banks only for a period ranging between 51 days and 180 days. This may be 'with risk' participation or 'without risk' participation. (10) Medium term debentures: Generally, debentures are repayable only after a long period. But, these debentures have a medium term maturity. (11) Option bonds: TI1ese bond may be cumulative or non-cumulative as per the option of the holder of the bonds. (12) Security with 100% safety net: Some companies make "100'% safety net" offer to the public. It means that they give a guarantee to the issue price. Suppose, the issue price is I{s. 40 per share (nominal value of Rs. 10 per share) the company is ready to get it back at Rs. 40/- at any time, irrespective of the market price. (13) Secured premium notes: These are instruments which carry no interest for three years. (14) Easy exit bond: As the name indicates, this bond enables the small investors to encash the bond at any time after 18 months of its issue and thereby paving a way for an easy exit. (15) Cumulative convertible preference shares: These instruments along with capital and accumulated dividend must be compulsorily converted into equity shares in a period of 3 to 5 years from the date of their issue, according to the discretion of the issuing company. (16) Infrastructure bond: It is a kind of debt instrument issued with a view to giving tax shelter to investors. The resources raised through this bond will be used for promoting investment in the field of certain infrastructure industries. (17) Convertible bonds with a premium put: These are bonds issued at face value with a put, which means that the bond holder can redeem the bonds for more than their face value. (18) Dual currency bonds: Bonds that are denominated and pay interest' in one currency and are redeemable in another currency come under this category. (19) Debt with equity warranty: Sometimes bonds are issued with warrants for the purchase of shares. These warrants are separately tradable. (20) Yankee Bonds: If bonds are raised in USA, they are called Yankee Bonds and if they are raised in Japan they are called Samurai Bonds. (21) Flip-Flop notes: It is a kind of debt instrument which permits investors to switch between two types of securities. Example, to switch over from a long-term bond to a short term fixed rate note. (22) Floating Rate Notes (FRNs): These are debt instruments which facilitate periodic interest rate adjustments. (23) Loyalty coupons: These are entitlements to the holder of debt for two to three years to exchange into equity shares at discount prices. (24) Global Depository Receipt (GDR): A global depository receipt is a dollar denominated instrument h'aded on a stock exchange in Europe or the USA or both. It represents a certain number of underlying equity shares. (25) Carrot and stick bonds: Carrot bonds have a 'low conversion premium to encourage early conversion and sticks allow the issuer to call the bond at a specified premium if the common stock is trading at a specified % above the strike price. Emerging Opportunities: Investment activities in India are on the increase. The positive outlook towards private placements with established private equity firms by companies can be attributed to the following reasons: (i) Venture capital allows companies time to build value without being subject to overall market sentiments. (ii) Remaining unlisted allows the management to focus on the long-term development of the business rather than short term share price movement and investor reactions. It also allows the company to establish a strong competitive position within its market without being required to reveal market sensitive information.

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(Hi) There are strong long-term prospects for knowledge-based sectors in India given the large talent pool and labour cost advantage, thus heading to unique growth financial opportunities. Also, there are high growth prospects due to the deregulation in retail, telecom, and pharma sector. Challenges Facing the Financing Services Sector: Some of the important challenges are briefly reported here under: (1) Lack of qualified personnel: The financial services sector is fully geared to the task of 'financial creativity'. However, this sector has to face many challenges, (2) Lack of specialisation: in the Indian scene, each financial intermediary seems to deal in different financial service lines without specialising in one or two areas. In other countries, financial intermediaries like Newton's, Solomon Brothers, etc. specialise in one or two areas only. (3) Lack of investor awareness: The introduction of new financial products and instruments will be of no use unless the investor is aware of the advantages and uses of the new and innovative products and instruments. (4) Lack of recent data: Most of the intermediaries do not spend more on research. It is very vital that one should build up a proper data base on the basis of which one could embark upon 'financial creativity', (5) Lack of transparency: The whole financial system is undergoing a phenomenal change in accordance with the requirements of the national and global environments. It is high time that this, sector gave up their orthodox attitude of keeping accounts in a highly secret manner. Lack of efficient risk management system: With the opening of the economy to multinationals and the exposure of Indian companies to international competition, much importance is given to foreign portfolio flows. It involves the utilisation of multi currency transactions which exposes the client to exchange rate risk, interest risk and
rate

economic and political risk.

Chapter 5 Derivatives
Introduction: Financial derivatives are fundamentally contingent contracts whose values are derived from some underlying financial instruments like currency, bonds, stock indices, interest rates, commodities and so on. Generally, derivatives can be devised upon any underlying asset whose future price movements are uncertain. The limit to the number of instrument on which derivatives can be built is left to the imagination of the human mind. In fact, we have derivatives on whether traded in Chicago Mercantile Exchange. Often derivatives are deemed to be risky and their mechanism is not understood. The succession of financial disasters on account of unscrupulous trading in derivative products witnessed in the last decade leads one to easily conclude that derivatives are unnecessary. If we look into the root cause of each and every instance, it will be easily observed that products by themselves are not responsible for the disasters, but the lack of control over derivatives, transactions and the lack of understanding were the reasons. Derivatives have the Characteristic of Leverage or Gearing. With a small outlay of fund (a small percentage of the entire contract value) One can deal in big volumes. Pricing and trading in derivatives are complex and a thorough understanding of the price behaviour and product structure is an essential pre-requisite before one can venture into dealing in these products. Derivatives by themselves have no independent value. Their value is derived out of the underlying instruments. Derivatives shift the risk from the buyer of the derivative product to the seller and as such are very effective risk management tools. They improve the liquidity of the underlying instruments. They provide avenues for raising money and contribute substantially to increase the depth of the market. Meaning of Derivatives:

Derivatives involve payment receipt of income generated by the underlying asset on a notional principle. They are a special type of off-. balance sheet instruments in which no principal is ever paid. They are
instruments which make payments calculated using price of interest rates derived from the balance sheet or cash instruments, but do not actually employ those cash instruments to fund payments. Kinds of Financial Derivatives: (1) Forwards (2) Futures (3) Options (4) Swaps.

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(1) Forwards: It is also known as forwards rate agreements. It is an interest rate derivative. A forwards rate agreement is a contract between two parties by which they agree to settle between them the interest differential on a notional principal on a future settlement date for a specified future period. The promised asset may be currency, cornmodities, and instruments For example, on July 1 Raju enters into an agreement to buy hundred bales of cotton on December 1 at Rs 2000 per bale from Peter, a cotton dealer. It is a case of forward contract where Raju has to pay Rs 1 lac on, December 1 to Peter and Peter has to supply hundred bales of cotton. ' In a forward contract, a user who promises to buy the specified asset at an agreed price at a fixed future date is said to be in the long position and on the other hand, the user (holder) who promises to sell at an agreed price at a future date is said to be in short position. Thus, long position or short position take the form of buy and sell in a forward contract. Features of Forward Contracts: (a) These contracts are purely privately arranged agreements and hence, they are not at all standardised ones. They are traded over the- counter and not in exchanges. (b) There must be a promise to supply or receive a specified asset at an agreed price at the future date. The contracting parties need not pay any down payment at the time of agreement. (c) The important feature of a forward contract is that no money or commodity changes hands when the contract is signed. It takes place on the date of maturity only as given in the contract. (d) A forward contract cannot be traded in an organised stock exchange and therefore there is no secondary market for it. (e) There is a need for an intermediary to enable the parties to enter into a forward rate contracts. This intermediary may be any financial institution like bank or any other third-party. (f) The delivery of the asset which is the subject matter of the contract is essential on the date of maturity of the contract. (2) Futures: A futures contract is very similar to a forward contract in all respects excepting the fact that it is completely a standardised one. Clark has defined future trading, as a special type of futures contract bought and sold under the rules of organised exchanges. The term future trading includes both speculative transactions where futures are bought and sold with the objective of making profit from the price changes and also the hedging or protective transactions where futures are bought and sold with a view to avoid unforeseen losses resulting from price fluctuations. To trade in future contracts, one has to become a member of the exchange by paying the initial margin and maintain a variable margin account too with the future exchange. The maturity and the size of the contract are standardised. Features of Futures: (a) Futures are highly standardised and legally enforceable and hence they are traded only in organised future exchanges. It is also difficult to modify the agreement according to the needs of the contracting parties. (b) Settlement is on a daily basis of all the outstanding contracts. (c) Future contracts are highly liquid and can be closed out easily. (d) Hardly 2% of the total contracts are delivered and taken delivery of. (e) The main feature of futures contract' is to hedge against price fluctuations. The buyers of a futures contract hope to protect themselves from future spot price increase and the seller from future spot price decrease. Types of Futures: Futures may be broadly divided into two types: (a) Commodity Futures (b) Financial Futures. (a) Commodity Futures: A commodity future is a future contract in commodities like agricultural products, metals and minerals. In organised commodity future markets, contracts are standardised with standard quantities. This standard varies from commodity to commodity. They also have fixed delivery dates in each month in the year. In India, commodity futures in agricultural products are popular. Some of the well-established commodity exchanges are as follows: (i) International Petroleum Exchange of London which deals in crude oil. (ii) Commodity Exchange in New York which deals in agricultural products. (iii) Chicago Board of Trade which deals in soyabean oil. (iv) London Metal Exchange which deals in gold.

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(b) Financial Futures: Financial futures refers to a future contract in foreign exchange or financial instruments like Treasury bill, commercial paper, stock market index or interest rate. It is an area where financial service companies can play a very dynamic role. Financial futures are more popular in Western countries as hedging instruments which are used to protect against exchange rate/interest rate fluctuations and for ensuring future interest rates on loans. We also have futures contracts on currency and interest rates just like forward rate currency contracts and forward rate contracts on interest rates. But, the primary objective of futures market is to enable individuals and companies to hedge against price fluctuations. For an example, risk due to interest rate fluctuations and exchQ.nge rate fluctuations are very common. These risks cannot be eliminated but transferred to a counterparty. This counterparty may have a hedging motive with opposite requirements. Some of the well-established financial futures exchanges are: (a) New York Futures Exchange which deals in sterling, Eurodollar deposits etc. (b) International Monetary Fund which deals in US Treasury bills, Eurodollar deposits, Sterling and so on. (c) London International Financial Future Exchange that deals in Eurodollar deposit. Advantages of Forward and Futures Contracts: (i) Parties to these contracts can protect themselves against the risk of adverse fluctuations against the price of the assets. For an example, the buyer of a forward rate currency contracts can avoid the risk of a possible adverse hike in the exchange rate in futures. In the same way the buyer of commodity future contract can avoid the risk of a possible price escalation in future. In this way one can overcome the risk. (ii) The buyer of this contract avoids paying the carrying costs on the assets bought in advance, as he need not take the delivery of the asset. (iii) Such contracts enable the parties to buy or sell assets at the time when they are most required. This prevents the need to purchase or sell the assets in advance of future requirements. In this way they facilitate proper planning for buying and selling. (iv) Efficient cash management is made possible with the help of these contracts. (v) These contract facilitate bulk purchases and sales of assets m short notice in advance of delivery and even in advance of production. (vi) They are highly flexible and even the parties to the contract prefer to close out their positions, they can do so by exchanging the net difference between the positions. Assets need not be exchanged physically. (vii) It is a boon to financial intermediaries as these contracts give a good scope for financial companies to playa dynamic role. They can diversify their activities by innovating new instruments in this field and take up new lines of financial activities in the best interest of their customers. (3) Options: An option contract is essentially a contract between two parties wherein one-party buys the right to sell or buy a given underlying at a future date at the pre-agreed price and the other sells this right. Obviously, this means options are basically forward contracts on rights. In other words they are simply insurance products against adverse movement in the market prices. For example, when we insure our motor vehicles by paying a certain premium on an annual basis, we have the right to claim damages in case something happens to our vehicle from the insurance company which is obliged to pay us. If nothing happens, we do not claim anything from the company and our premium is lost. Similarly, in an option contract, the buyer of the right enjoys all benefits by paying of the premium on the price of the option up front and the seller of the option is under obligation to honour its commitment in case he is asked to do so. The seller is also known as the writer of the option. Hence, if I write an option in your favour, it means that I have sold an option to you and you are the buyer of the option. The right to buy an underlying is called a call option and the right to sell the underlying is called the put option. The option which can be exercised by the buyer only on the date of maturity is called an European option and the option which can be exercised on any working day before the maturity or on the maturity date is called an American option. Features of Option Contract: (a) Option contracts are highly t1exible. (b) The option holder has to pay a certain amount called premium for holding the right of exercising the option. This is considered to be the consideration for the contract. If the option holder does not exercise an option, he has to forego this premium. (c) Settlement is made only when the option holder exercise his option. Suppose option is not-exercised till maturity, then the agreement automatically lapses and no settlement is required.

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(d) In all option contracts, the option holder has a right to buy or sell an underlying asset. He can exercise this right at any time during the currency of the contract but, in no case, he is under an obligation to buy or sell if it is not buy or sell, the contract will be simply lapse. Options Trading in Shares and Stocks: When an option contract is entered into with an option to buy or sell shares or stocks, it is known as share option. Share option transactions are generally index-based. All calculations are based on change in index value. For example, the present value of an index is 600. Mr. Raju buys a three-month call option for an index value of Rs 650 by paying 10 per cent of the present index value in points at the rate of this 10 per point. Now, the option price is taken as proper 600 and the strike price or exercise price is Rs 650. So long as the index remains below 650 the option holder will not exercise his option since he will be incurring losses. Now the loss will be limited to the premium paid at the rate of 10 per point. As the spot price increases beyond the strike price level, exercise of the option becomes profitable. Suppose the spot rate reaches Rs 660, option may be exercised. The option holder gets a profit of Rs10Q/-- (10 points multiply 10). A person with more money can create the index at a higher price of Rs 100 or 200 per index point. However, only speculators play this type of game plan. Genuine portfolio managers can use the instrument to hedge the risk due to heavy fluctuations in the prices of shares in stocks. Benefit: Option trading is beneficial to the parties. For example, index-based options help the investment managers to insure the whole portfolio against fall in the prices rather than hedging each and every security individually. Option writing is a source of additional income for the portfolio managers with a large portfolio securities. In fact, large portfolio managers can guess the future moment of stock prices accurately and enter into option trading. Generally, the option writers are the most sophisticated participants in the option market and the option premiums are simply an additional source of income. Option trading is also quite simple and flexible. For example, option transactions are index based and so all the calculations are made on change in index value. The rate at which the index points are contracted forms the basis for the calculation of profit or loss, fixing of the option price etc. In an option contract the loss is carried to the minimum of the amount i.e. to the extent of the option premiums alone. Hence, the players in the option market know that their losses can be quantified and limited to the amount of premium paid. This may also lead to high speculation and therefore it is very essential that options trading must be encouraged for the purpose of hedging risks and not for speculation. (4) Swap: Swap is yet another trading instrument. It is a combination of forwards by two counterparties. It is arranged in order to reap the benefits arising from the fluctuations in the market. It may be either currency market or interest rate market or any other market. Features of Swap: The following are some of the important features of swap: (a.) A swap is nothing but a combination of forwards, so it has all the properties of a forward contract. (b) Swap requires that two parties with equal and opposite needs must come into contact with each other. It is a combination of forwards by two counterparties with opposite but matching needs. (c) Though a specified principal amount is mentioned in the swap agreement, there is no exchange of principal. On the other hand, a stream of fixed-rate interest is exchanged for floating rate of interest, and thus, the streams of cash flows rather than single payment. (d) Generally forward are arranged against short period only. Long dated forward rate contracts are not preferred because they involve more risks like risk of default, risk of interest rate fluctuations and so on. But, swaps are in the nature of long-term agreement and they are just like long dated forward rate contracts. Salient features of RBI guidelines on forward rate agreements and interest rate swaps. (a) Scheduled commercial banks (excluding regional rural banks), primary dealers and all India financial institutions are free to undertake forward rate agreements and interest rate swaps as a product for their own balance sheet management for market making. (b) They may also offer thes2 products to corporate for hedging their own balance sheet exposures. (c) Participants should ensure, adequate infrastructure and risk management systems before venturing into marketmaking activities (d) The benchmark rate should necessarily evolved on its own in the market and require market acceptance. (e) The parties are free to use any domestic money or debt market rate as benchmark rate provided the methodology of computing the rate is objective, transparent & mutually acceptable.

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(f) There are no restrictions on the minimum or maximum size of notional principal amount. Size norms too emerge in the market with the development of the market. (g) There are no restrictions on the tenor as well. (h) Banks, financial institutions and primary dealers are required to maintain capital for forward rate agreements and interest rate swaps. (i) Transactions for hedging and market making purposes should be recorded separately. Positions on account of market-making activities should be marked to market at least at fortnightly intervals. Transactions entered into for hedging purposes should be accounted for on accrual basis. (j) Participants could consider using ISDA standard documentation with suitable modifications for transactions in forward rate agreements and interest rate swaps. (k) Participants are required to report their operations in forward rate agreements and interest rates swaps on a fortnightly basis to Monetary Policy Department of RBI. (l) Capital adequacy for banks and financial institutions for undertaking for rate agreements and interest rate swaps transactions shall be calculated as under; The notional principal multiplied by a conversion factor as per the table given below; for original maturities less than one year - 0.5 per cent, for original maturities one year and less than two years 1%, for each additional year 1%. The product thus obtained shall be assigned risk weightage at 20% for banks and financial institutions and at 100% for others (except Governments).

Chapter 6 Credit

Risk

Introduction: Credit risk is the oldest and perhaps the most important of all risks in terms of size of potential losses. Credit risk is measured on a long several lines i.e. risk for portfolios of loans, risk for market instruments, Value At Risk (VAR) for credit risk, and envisaging loan portfolio management. In fact, Credit risk is growing and needs special attention. Credit Risk: Credit risk is defined by the losses in the event of default of the borrower to repay his obligations or in the event deterioration of the borrower's credit quality. This simple definition hides a couple of underlying risks. The quantity of risk is the outstanding balance loaned to the borrower and the quality of risk reflects both the chances that the default occurs and from the guarantees that reduce the loss in the event of default. The amount of risk represented by the outstanding balance and the date of default may differ from the ultimate loss in the event of default because of potential recoveries. Recoveries would depend upon any credit risk mitigators, such as guarantees, either collateral or third party guarantees, the capabilities of negotiating with the borrower and of funds available, if any, to repay the debt after repayment of other who lenders who may have a priority claim over the borrower's asset/funds either by virtue of legal rights, superior bargaining position, efficient debt collection strategies etc. Default: There are many possible definitions of default, like missing repayment obligations (payment of periodical interest on repayment of principal), breaking a covenant, entering a legal procedure, or economic default. Payment default is declared when a schedule payment has not been made even after minimum period, say three months, after the due date. Breaking a covenant, such as a financial ratio subject to upper or lower bounds, is a technical default. The default can also be purely economic without being associated with any specific event. Economic Default: An economic default occurs when the economic value of the assets goes below the value of outstanding debts. The economic value of assets is the value of future expected cash flows discounted to present. Such value constantly gets influenced by and changes with the market conditions. If the market value of the asset drops below that of the liabilities, it means that the current expectations of future cash flows are such that the debt cannot be repaid. Such economic default obviously needs to attract attention, even though it may not trigger any corrective action unless events takes place which creates serious doubts about the ability of the borrower to generate further cash flows as anticipated. Default Probability: Default risk is measured by the probability of default occurring during a given period of time. Default risk depends upon the credit standing of a borrower. Such credit standing would depend upon factors such as market outlook for the borrowing company, the size of. The company, its competitive f~!Ors, the quality of management, and the strength and reputation of its promoters/major shareholders.

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Different Types of Credit Ratings: It can be debt issue ratings, issuer ratings and Industrial ratings. In some cases, agencies rate the quality of risk of a debt issue. The quality of risk is defined as the "severity of losses" which depends upon both default probability and recoveries in the event of default. Exposure Risk: Exposure risk is generated by the uncertainty associated with future amount at risk. For some facilities, there is almost no exposure risk. Amortized credit is repaid on the basis of a contractual schedule, so that future outstanding balances are known in advance, except in case of prepayment for which an option is often provided in the credit arrangement. For all credit lines for which there is a repayment schedule, the exposure risk can be considered as small or negligible. Exposure risk may arise also with the derivatives. In this case, the source of uncertainty is not the client's behaviour but the market movements. The liquidation value of derivatives depends upon such movements and changes constantly. Whenever the liquidation value is positive, there is a credit risk for the bank since it loses money if the counter party defaults. This credit risk continues during the whole life of over-the-counter instruments. Recovery in Risk: The recoveries in the event of default are not predictable. They depend upon the type of default and numerous factors such as whether guarantees have been received from the borrower, the type of such guarantees, which can be collateral or third-party guarantees, and circumstances surrounding the default. Collateral Risk: The existence of collateral minimizes credit risk if the collateral can be easily taken possession of and sold at some significant value. Collateralisation is an increasingly common way to mitigate credit risk. There are many types of collaterals; cash, other financial assets, or any fixed assets such as real estate, planes, ships or fixed equipments. The value of the collateral depends upon its nature and the market conditions. Fixed equipments offer has a low resale value. On the other hand, the value of cash collateral is certain. When collateral is used, the risk becomes two folds. Firstly, there is an uncertainty with respect to the ability to access the collateral, to dispose of it and to the cost required to sell it. Secondly, there is an uncertainty with respect to its value, which depends upon the secondary market and the nature of the collateral, which can be easy or difficult to sell. The collateral risk is in fact zero with cash. It is influenced by market risk when the collateralised assets are financial assets traded over a market. It depends upon the nature of assets in the case of non-financial assets. In brief, the use of collaterals to mitigate credit risk transforms the credit risk into a recovery risk plus an asset value risk. Third-party Guarantee Risk: Guarantees are contingencies given by third parties to the bank at the request of the borrower. The head of a group can commit to pay on behalf of one of its subsidiaries if the latter defaults. When third-party guarantees is readily enforceable, it transforms the credit risk on the borrower into a credit risk on the guarantor. This is, however, not a simple transfer of risk. There is a risk that both the borrower and the guarantor default at the same time; the corresponding probability is a joint probability of default. Thus, third-party guarantees transform the default risk of the borrower into a joint default risk of the borrower plus the guarantor. There is also associated legal risk of not being able to enforce the guarantee. Operational Risk: Operational risk is the potential risk of loss arising from inadequate or failed internal processes, people and systems from external events. It also includes potential legal risk involving claims, penalties and damages resulting from supervisory decisions. Banks have guidelines and instructions either developed internally or by way of directives from RBI. When operational risk arises? Operational risk arises in the following situations leading to substantial losses: (1) Internal Fraud: Internal frauds occur in remittances, letters of credit transactions, operating the inoperative accounts, operating the non-resident accounts by unscrupulous insiders, creating fictitious entries in the inter-branch/ inter-bank transactions involving potential fraud. There has been a recent case of a substantial fraud in one of the private sector banks wherein bogus bill discounting transactions was processed. External Fraud: It is caused on account of robbery, forgery, kite flying cheque operations and computer hacking. Unfair employment practices: Like violation of employee health and safety rules and discriminating claims. Clients and Business practices: Sometimes misuse of confidential customer information, w1fair practices, improper trading activities on the banks own account, money law1dering and undertaking activities that are not authorised.

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Damages: Damages to fixed assets caused through natural disasters, hardware and software failures, telecom problems, data entry errors, collateral management failures, incomplete legal documentation are some of the potential factors for operational risk. Lack of Control: Lack of control leading to managements in attention, insufficient guidance and lack of clear cut management accountability. In adequate recognition and assessment of the risk of certain banking functions. In adequate communication. In effective audit function. It is incumbent that the banks put, in place a operational risk management policy, processes communicated to the field level staff. Identification of Operational Risk: Before formulating a clear-cut policy, banks are expected to identify and assess the operational risks in all the existing products and services and systems. Such identification is a must before a new product, process or system is introduced and a full-proof system should be in place, in order to avoid the damages that may be caused on acq)unt of human or system failures. Operational risk should take into account the human element especially on placement, competency, work environment and turnover. Process risk arising out of transaction processing, errors in execution of transaction, complexity of procedures etc., need to be addressed while formulating the policy. Sometimes violations of controls and internal control procedures, exceeding of limits, money laundering activities, systems risk also arise on account of the technology, systems and securities failure, programming error and communications failure. In addition to this reputational risk that may arise out of customer claim, staff-claim and regulators claim may have to be addressed. Measurement: It is for the individual banks to develop a model according to its scale of operations and the past experience. Some banks follow the Matrix approach in which losses are categorized according to the type or event and business line in which the event occurred. In other words, the bank's past history of loss could be a guiding factor in addressing the operational risk.. In order to assess the potential loss events, banks are required to construct database on the number of failed transactions over a period of time and the frequency of staff turnover within a division. Every risk event in the risk matrix is then classified according to its frequency and severity. Potential losses can be categorized as arising from high frequency / low severity event or low frequency /high severity events. While the latter needs closer attention and monitoring, efforts should be made to completely eliminate such events. Legal Risk: Recovery risk depends upon the type of default. A payment default does not mean that the borrower will never pay, but it triggers various types of actions, such as renegotiation up to the obligation to repay all outstanding balances. If no corrective action can be considered, legal procedures takeover. In such a case, all commitments given to the borrower will be suspended until some legal conclusion is reached. In the best of the situations, recoveries may be delayed until the end of the procedure. In the worst-case, there may be no recoveries at all because the company is resold or liquidated, and no excess funds may be available to repay an unsecured debt. Credit Risk - Derivatives: Derivatives include currency and interest swaps, options, and any combination of these building blocks. Swaps exchange interest flows based on different rates or flows in different currencies. Options allow buying or selling of an asset at a given price. All derivatives have a liquidation value. The value of swaps is obtained through the familiar discounted cash flow model. The streams of flows include those which are fixed and those indexed on the market rates or current exchange rates. Options have a liquidation value which combines the value of the right to exercise plus the gain obtained if exercise is immediate. All derivative transactions have a notional amount that measures the size of the transaction. The notional amount is the base which, combined with market parameters, determines the interest flows, the currency flows or the size of the transaction when an option is exercised. Banks hold such instruments until maturity, which ranges from a few months up to 10 to 15 years, or beyond in advance forex markets. The basic issue for measuring the credit exposure is to find out which value can be lost in the event of default. If the default occurs immediately, this value is identical to the liquidation value of the derivative. Swaps can have both positive and negative values, since these are the differences between the values of the fixed leg and of the floating leg. Credit risk exists only if the value is positive for swaps. Options always have a positive value. However, the

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credit risk exists only for the buyers of the option. The seller runs no risk since he has to pay rather than receive money in the event of exercise of option by the holder. Since the credit risk of derivatives has increased greatly with the development of those instruments, an adequate methodology is required to capture the actual potential risk. Credit Risk Management of Derivatives: Financial institutions have to comply with strict rules so as to limit their risk. For their internal management they also need better measures of risk. For instance, the limits system is adequate only if the risk measures are correct. For derivatives, the usage of risk limit is difficult to measure. The notional does not represent actual exposure. The current exposure is measured by the liquidation values. But the potential exposure arising from future increase in liquidation values should also be considered. If the measure of potential exposure overestimate the actual risk, the usage of credit limits hits the limit too early, which constrains the volume of business. If the measures understates the actual risk, the limit system becomes insufficient because it does not actually limit the credit risk of transactions. RBI Guidelines in Risk Management Systems: While managing credit risk, the guidelines issued by RBI to Banks in India are clearly defined and exhaustive. They are as under: (1) Credit policies that define target markets, risk acceptance criteria, credit approval authority, credit organisation and maintenance procedures, and guidelines for portfolio management and remedial management. (2) Establish proactive credit risk management practices like annual/half yearly industry studies and individual obligor reviews, periodic credit calls that are documented, periodic plant visits and at least quarterly management review of troubled exposures/weak credits. (3) Business managers in Banks to be accountable for managing risk and maintaining appropriate risk limit and risk management procedures for their businesses. Banks to have a system of checks and balances in place around the extension of credit viz.: (a) an independent credit risk management function, (b) multiple credit approvers, and (c) an independent audit and risk of review function. Banks to have a consistent approach towards early problem recognition, the classification of problems, exposures and the remedial action. Banks to maintain diversified portfolio or risk assets in line wi.th the capital desired to such q portfolio. In order to ensure transparency of risk taken, it is necessary for the banks to accurately, completely and in timely fashion, report the comprehensive set of credit risk data into the independent risk system.

Chapter 8 Definitions, Nature and Functions of Insurance

Introduction: Risk is there at every walk of life, risk also endangers life itself. In the same way all financial deals, as well as possession of money and property goods etc. are fraught with the element of risk. For an example, money may be stolen, or goods robbed or destroyed or an employee may misappropriate. A man may be killed in an accident or may die of a fatal disease. The loss arising out of these risks may be quite substantial and in extreme cases, it may be so heavy that business may be crippled. However, the businessmen and owners of the property discovered that if they got together and contributed a relatively small amount to a common pool, the total amount so contributed would be sufficient to compensate any of them for the loss arising due to such causes. All risks do not actually occur at all times and hence it is possible to calculate probable chances of any particular risk materializing. It is quite clear that all the people do not face risks at the same time. Thus the transfer of risk to another i.e. the insurer is in fact a pooling of risks. If Insurance did not exist, each individual would have to bear the losses on his Own Insurance, in effect means that each one in the pool undertakes to bear a portion of the loss. Such an agreement has proved to be advantageous to everyone as it is uncertain as to who will suffer the loss. Thus in course of time, the idea developed that such a common pool of resources should be managed by experts who would calculate the quantity of the contribution to be levied on each individual. In this way the Idea of insurance developed. In the modern times, insurance has come to be a highly commercial undertaking however, the principle is still the same viz., the insurer collects premia for a large number of persons and covers them against a large variety of risks.

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Nature of Insurance: The insurance has the following Characteristics that are generally observed in case of Life, Marine, Fire and General Insurances. (a) Sharing of 'Risk: Insurance is a device to share the financial losses which may befall on an individual or his family, on the happening of a specific event. The event may be death of a bread-winner to the family in case of Life Insurance, Marine-perils in Marine insurance, Fire in case of Fire insurance and other certain events in general insurance. The loss arising from these events if insured are shared by all the insured in the form of premium. (b) Co-operative Device: The important feature of most of the insurance plans is the co-operation of large number of persons who, in effect agree to share the financial loss arising out of a particular risk that is insured. Such a group of persons may be brought together voluntarily or through publicity or through the solicitation of agents. Like all Cooperative devices, there is no compulsion on anybody to purchase the Insurance Policy. (c) Value of Risk: The risk is evaluated before insuring and only then the premium is decided. There are several methods of evaluation of risks. The probability of loss is calculated at the time of insurance. (d) Amount of Payment: The amount of payment depends upon the value of loss occurred provided that the insurance is atleast upto the value of loss incurred. In case of life insurance, the purpose is not to make good the financial loss suffered. The insurer promises to pay the fixed sum on the happening of an event. If the event or the contingency does, not take place, then the payment falls due after the payment of the last premium of the policy. It is immaterial in case of life insurance what was the amount of loss at the time of contingency, but in case of -property and general insurances, the amount of loss, as well as the material loss are required to be proved. (e) Payment at Contingency: The payment of loss is made at a certain contingency. If the contingency occurs the payment is made. Life insurance contract is a contract of certainty as the contingency i.e. death ot the expiry of the term will certainly occur and hence the payment is certain. In case of other insurance contracts the contingency is the fire or the marine perils etc. that mayor may not occur. So if the contingency occurs, payment is made, otherwise 1).0payment is made to the policyholder. Large Number of Insured Persons: In order to spread the loss immediately, smoothly and sheaply, a large number of persons should be insured, so that the cost of insurance to each member may be lower. In the past years, tariff associations or mutual fire insurance associations were found to share the loss at a cheaper rate. In order to function successfully, the insurance should be taken by a large number of persons.
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(g) Insurance is Not Gambling: Insurance indirectly serves to increase the productivity of the community by eliminating the worries and increasing initiative. The uncertainty is changed into certainty by insuring property and life because the insurer promises to pay a definite sum at damage or death. Failure of insurance amounts to gambling because the uncertainty of loss is always looming. In fact, insurance is just the opposite of gambling. In gambling, by bidding, the person exposes himself to risk of losing, in insurance the insured is always exposed to risk, and will suffer loss if he is not insured. (h) Insurance is Not Charity: When we talk about charity it is given without consideration but insurance is not possible without premium. It provides security and safety to the individual and also to the society although it is a kind of business in consideration of premium that guarantees the payment of loss. Insurance: Definition: The Dictionary of Business and Finance has defined insurance as a "form of contract or agreement under which one party agrees in return for a consideration to pay an agreed amount of money to another party to make good a loss, damage, or injury to something of value, as a result of some uncertain event in which the insured has pecuniary interest." The documents which contains the contract is called the "Insurance Policy". The person who is insured is called the "Insured" and the firm which insures is called as the "insurer". Essentials of Contract of Insurance: Like other contracts, the contract of insurance must have the following essentials: (a) There must be an agreement between two parties who are competent to enter into a contract. (b) The agreement must be in writing and the parties must give free consent to terms and conditions. (c) The event must be subject to risk or otherwise it will amount to betting. (d) The event must also involve some element of uncertainty either as regards in time or with respect to its occurrence. (e) The risks should not be very small. (f) The cost of insurance should not be prohibitive. Low cost can be achieved if the number of risks insured is larger. (g) The risk must be capable of approximate mathematical estimation on the basis of the past records so that premium can be fixed.

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Role of Insurance: On the basis of the following advantages of insurance the importance of insurance and its role is made clear. (a) Insurance protects and safeguards the interest of the individuals and businessmen in their business operations. It gives them safety and creates confidence in their minds. Indirectly this brings expansion of business activities. (b) It results in diversification of risk among specialised professional agencies called insurance companies. (c) It promotes rate of savings and investment and leads to capital formation in the economy. (d) Insurance creates a sense of security and confidence among all sections of the society. (e) It provides better security for loans and advances offered by banks. Risk in granting loans is limited if the property is properly insured by the borrower. (f) It brings safety in storage and transportation and leads to expansion of commercial activities. (g) Insurance companies act as underwriters, guarantor, subscriber and financier of industrial concerns. They help and support their clients in different ways and in different areas. (h) It gives proper investment advice to businessmen and creates proper investment climate in the country. (i) It accelerates the process of industrialisation by rendering various services. This suggest the role of insurance in the society as well as in the development of national economy. Principles of Insurance: An insurance contract made without due consideration to these principles is treated as void, not enforceable by law. These principles are as follows: (1) Principle of Utmost Good Faith: One 'of the basic and primary principle of insurance is utmost good faith. It states that insurance contract must be made in absolute good faith on the part of both the parties. The insured must give to the insurer complete, true and correct information about the subject matter of the insurance. Material fact should not be hidden on any ground. This principle is applicable to all types of insurance contracts. It is implied condition of all the insurance contracts that each party must disclose every material fact known to him. Insurance is for protection and not for profit and hence correct information must be given to the insurance company. (2) Principle of Insurable Interest: This principle suggest that the insured must have insurable interest in the object of insurance. A person is said to have such interest when the physical existence of the object of insurance gives him some gain but which he is likely to loose by its non-existence. In other words, the insured must suffer some kind of financial loss by the damage to the subject matter of insurance. Ownership is the most important test of Insurable interest. Every individual has insurable interest in his own life. Insurance contracts without insurable interest is void. Insurable interest is not a sentimental concept but a pecuniary interest. Insurance contract without insurable interest is nothing but a wagering contract. We all have h'1surable interest in our life. A trader has insurable interest in his business and a creditor has insurable interest in his debtor. Similarly, an exporter has insurable interest in the goods which is exporting. In addition, the owner of a shop or building has Insurable interest in his shop or building. (3) Principle of Indemnity: This is one important principle of insurance. This principle suggests that insurance contract is a contract for affording protection and not for profit making. The purpose of insurance is to secure compensation in case of loss Or damage. Indemnity means security against loss. The compensation will be paid in proportion to the loss actually occurred. The amount of compensation. in the insurance contract is limited to the amount assured or the actual loss whichever is less. The compensation will not be more or less than the actual loss. Compensation will not be paid if the specified loss does not occur during a particular period due to a Farticular reason. Thus insurance is simply for giving protection and certainly not for profit- making. Indemnity and insurance interest are linked together. It is the insured's financial interest in the subject matter of the insurance that is insured. Therefore, the account of compensation on the claim cannot be more than the extent of the insurable interest. '(4) Principle of Subrogation: This principle is an extension and a corollary of the principle of indemnity. It is applicable to all the contracts of indemnity. It states that once the full compensation is paid by the insurance company, it acquires all rights and remedies which the assured would have enjoyed regarding the said loss. When the compensation is paid for the total loss, all the rights of the insured in respect of the subject matter of insurance are transferred to the insurer. The assured will not be able to keep the damaged property because in that case he will realise more than the actual, loss suffered. This principle prevents the insured from making profit out of loss. When partial compensation is paid, such rights cannot be exercised by the insurance company. The principle is applicable to fire, marine and accident policies. In such policies the insured has to give a letter of subrogation to the insurance company. The insurance company protects its interest with the help of such letter of subrogation. .

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(5) Principle of Contribution: There is no restriction as to the number of times the property can be insured. But on the occurrence of the loss only the amount of actual loss can be realised from one insurer or all the insurers together. This principle is, however, takes out a marine policy for the goods being shipped from Goa to Mumbai and if the storm takes place due to which there might be risk of ship sinking. According to this principle, the ship can be saved by throwing away some of the goods in order to reduce the weight on the ship. (7) Risk must Attach: The subject matter should be exposed to risk. e.g. for goods placed in god own marine insurance policy cannot be taken. However, goods may be insured against fire or theft. (8) Causa Proxima: The principle of Causa Proxima means that when a loss has been caused by the series of causes, the proximate or the nearest cause should be taken into consideration to determine the liability of the insurer. The principle states that to ascertain whether the insurer is liable for the loss or not, the proximate and not the remote cause must be looked into. For an example, a cargo ship got a hole, due to negligence of the master and as a result sea-water entered and cargo was damaged. Here there are two causes of damage of the cargo - the hole in the ship and sea-water. The risk of sea-water is insured but the first cause is not. The nearest cause of damage is sea-water which is insured and therefore the insurer is liable.

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Evolution of Insurance
Introduction: The beginning of insurance is traced to the city of London. It started with the Marine business. Marine traders, who used to gather at Lloyd's Coffee House in London, agreed to share losses to goods during transportation by ship. Marine related losses included: Loss of ship by sinking due to bad weather in high seas. Goods in transit by ship robbed by sea pirates. Loss of or damage to the goods in transit by ship due to bad weather in high seas. The first insurance policy was issued in England in 1583. The earliest trace of insurance in the ancient world are found in the form of marine trade loans or carrier's contracts that included an element of insurance. In Rigveda, the most sacred book of India, references were made to the concept of 'Yogakshema' more or less akin to the well-being and security of the people. The Insurance sector in India dates back to 1818 when the first insurance company was established, i.e. the Oriental Insurance Company at Calcutta. This was followed by the establishment of Bombay Life Assurance Company in 1823 and Madras Equitable Life Insurance Society in 1829. The first attempt to regulate the insurance business in India was through the Indian Life Assurance Companies Act in 1912. Different forms of insurance can be discussed as under: (1) Marine Insurance: Insurance was introduced to the world by the concept of Marine Insurance. In the earlier centuries the seafarers were exposed to the worst kind of dangers and unknown risks such as sea conditions, pirates, war, weather, disease, perils of sea etc. The marine policies of the present form were sold in the beginning of the fourteenth century by the 'BRUGIANS' but in a different form. On the demand of the inhabitants of Burges, the court of 'FLANDERS' permitted in the year 1310, the establishment in the town. 'A CHARTER OF ASSURANCE' by means of,which the merchants could insure their goods, exposed to the risks of the sea. The development of insurance was not only confined LOMBARDS and to the 'HANSA MERCHANTS', but it throughout Spain, Portugal, Holland, France and England. The lending prominence of the LOMBARD MERCHANTS got them a prominent position in the London city. They built their homes there and took the name of Lombard Street. Later on these streets became famous in INSURANCE HISTORY and the establishment of the 'LLOYD'S COFFEE-HOUSE' gave an impetus to the development of marine insurance. (2) Fire Insurance: Fire insurance is one of the oldest forms of insurance as far back as Marine Insurance. It had been observed in Anglo-Section Guild form for the first time where the victims of the fire hazards were given personal assistance by providing them the necessities of life. It originated in Germany in the beginning of the sixteenth century. In the year 1666, a great fire broke out in England, the losses were tremendous, about 85 per cent were burnt to ashes and property worth ten crores sterling were completely burnt off. It is here that the Fire Insurance got momentum and Fire Insurance office was established in 1681 in England. With the 'COLONIAL' development in England, the fire insurance spread all over the world, the 'SUN FIRE OFFICE' was one of the successful Fire Insurance Institution. (3) Life Insurance: Life insurance appeared first in England in the 16th century when a policy on the Life of William Gybbous was issued on 18th June, 1653. The Life insurance developed at 'EXCHANGE ALLEY' and the first registered office was established in England in 1696. The famous 'AMICABLE SOCIETY FOR A PERPETUAL ASSURANCE OFFICE' started in operation since 1706. During the 18th century Life Insurance did not prosper due to the serious fluctuation in the death-rate. But soon after 1800 because of the application of lower premium plan some active interest began. In India, some Europeans started the first Life Insurance Company in Bengal Presidency viz: the ORIENT LIFE ASSURANCE COMPANY in 1818. The year 1870 was a landmark in the history of Indian Insurance separating the life insurance. The Bombay Mutual Life Assurance Society was established in 1871 and the next was the 'ORIENTAL GOVERNMENT SECURITY LIFE ASSURANCE CO. Ltd., which started its operation since 1874. Since then life insurance gained momentum and many offices developed in India. (4) Miscellaneous Insurance:

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In the later half of the 19th century with the Industrial revolution in England miscellaneous insurance gained momentum. Accident insurance, fidelity insurance, liability insurance and theft .insurance were the important forms of insurance at that time. 'LLOYD'S ASSOCIATION' was the main functioning institution. With the growing needs of the people and risk involved insurances such as cattle insurance, crop insurance, liability insurance etc. are now taking place. With the advancement of the society the scope of general insurance is increasing. Kinds of Insurance: Insurance can be viewed from two different angles. Firstly from the business point of view and secondly from the risk point of view. Business Point of View: From the business point of view insurance can be categorised as under: (a) Life Insurance (b) General Insurance, and (c) Social Insurance. (a) Life Insurance: Life insurance is a very popular form of insurance. It ensures the life of an individual and gives financial protection to the members of the family of the policyholder. It is different from other types of insurance in various ways. It not only gives protection but it is a method of compulsory saving. It is an exception to- the principle of indemnity. This insurance provides protection to the family at the premature death or gives adequate amount at the old age when the earning capacities are reduced. (b) General Insurance: The genera} insurance includes property insurance, liability insurance and other forms of insurance. Marine and fire insurances are called property insurance whereas motor, theft, fidelity and machine insurances are included in liability insurance to a certain extent. Fidelity insurance is the strictest form of liability insurance whereby the insurer compensates the loss to the insured when he is under the liability of payment to the third party. In India, the general insurance started working since 1850 with the establishment of the Triton Insurance, Calcutta. The General Insurance could not progress much due to the slow growth of Joint stock Enterprises and Mechanized Production. (c) Social Insurance: Social insurance is issued in order to provide protection to the weaker section of the society who is not able to pay the premium for adequate insurance. The various forms of social insurance are pension plans, disability benefits, unemployment benefits, sickness insurance and industrial insurance. With the increase of the socialistic idea it is obligatory for the government to provide social insurance to the masses. Risk Point of View: From the risk point of view (a) Property Insurance. (b) Liability Insurance. (c) Other Forms. (a) Property Insurance: Under the property insurance a person/persons may be insured against a certain specified risk. The following are the different types of insurances under property Insurance.
(i) Marine Insurance. (ii) Fire Insurance, and (iii) Miscellaneous Insurance.

(b) Liability Insurance: The general insurance also includes liability insurance where the insured is liable to pay the damage of property or to compensate the loss of personal injury or death. This insurance may be in the form of fidelity insurance automobile insurance, machine insurance etc. (c) Other Forms: Besides the property and liability insurances, there are certain other insurances which are included under the general insurance whereby the insurer guarantees to pay certain amount at the happening of a certain event. E.g. Export-Credit Insurances, Employees State Insurance etc. Types of Insurance Organisations: With the advancement of Insurance Practices, different forms of Insurance Organisations were developed. The following are the different forms of insurance: (1) Self- Insurance. (2) Individual Insurer. (3) Partnership. (4) Joint Stock Companies. (5) Mutual Companies. (6) Co-operative Insurance Organisations. (7) Lloyd's Association.

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(8) State Insurance. (1) Self- Insurance: It is a plan by which an individual or concern sets up a "PRIVATE FUND" out of which he pays the claims. The persons lay aside periodically certain sum to meet the losses of a contemplated risk. "SELF INSURANCE" as a matter of fact is not insurance at all because there is no hedge, no shifting or distribution of the burden of risk among larger persons. The self-insurance will be successfully operated under the following conditions: (i) The properties or units are widely distributed. (ii) There are several properties such as machine, motor vehicles, house, factories etc. (iii) All the above mentioned properties are under the influence of varied risks. (iv) The risks are greater at one place and lesser at another place. The self-insurance cannot be effectively utilised by those concerns where the losses cannot be easily estimated; no proper management of the accumulated funds can be practised and the funds so accumulated sometimes prove to be inadequate at the contingency. (2) Individual Insurer: Individual Insurance Organisation has been very rare in the field of insurance. An individual can perform the business of insurer provided he has sufficient resources and talent of insurance. (3) Partnership: A partnership firm can also carryon the business of insurance for earning profit. In the early period before the advent of Joint Stock companies many insurance undertakings were partnership or unincorporated companies. They were constituted by the partnership deed which regulated the business. With the advent of joint stock companies the partnership form completely disappeared. (4) Joint Stock Companies: According to the Indian Companies Act, 1956 a Joint Stock Company is an artificial person created by law having a perpetual succession and a common seal. The share holders are the owners of the company but the day to day management and administration is entrusted in the hands of Board of Directors who are the elected representatives of the shareholders. The, company can operate insurance business and the policyholders have nothing to do with the management of the concern. But, in life insurance it is the practice to share certain portion of profits among certain policyholders. Profit is shared in the form of bonus. According to the Indian Insurance Act 1938, before the Nationalisation the policyholders had a right to elect their representatives to the Board of Directors to the extent of one fourth of the total number of directors of the company. They used to distribute only 5 percent of the divisible profit to the shareholders and more than 95 percent of the divisible profit was distributed among the policyholders. This was discontinued after Nationalisation. (5) Mutual Companies: The mutual companies were a Cooperative association formed for the purpose of type of effecting insurance an the propriety of its members. The shareholders of the company were the policyholders themselves. . Each member was an insurer as well as insured. They participated in the management of the company. (6) Co-operative Insurance Organisation: These organizations are incorporated and registered under the Indian Ca operative Societies Act. They are also, called as 'Co-operative Insurance Societies' These societies like mutual companies are nonprofit organizations. Their main objective is to provide insurance protection to its members at the lowest reasonable cast. The Indian Insurance Act, 1938 had made special provisions for the Co-operative Insurance Societies but after nationalization the societies have been ceased. (7) Lloyd's Association: Lloyds Association is one of the greatest Insurance Institution in the world. In 1871, Lloyds Act was passed incorporating the members of the association into, a single corporate body with a perpetual succession and a corporate seal. The powers of Lloyds Corporation were extended from the business of marine insurance to, another insurances and guarantees business. They are also, termed as 'SYNDICATES' or NAMES. The business of the association is effected by the insurers called Underwriters or Syndicator. The underwriter assumes liability for himself and not far another. . Lloyds as a corporation is never liable on a policy. It does supervise the conditions under which its members may issue policies. It undertakes to, provide collective protection for the commercial and maritime interest of its members. (8) State Insurance: State Insurance is defined as that insurance which is undertaken by public sector or when the government has taken over the life insurance business. In 1946, France nationalized larger Insurance Companies. In Brazil, Japan and Mexico" the insurance sector is largely nationalized. In India, the Life Insurance business was nationalized in 1956 and General Assurance was nationalized in 1971. Today in India, the Life Insurance business is

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under the control and ownership of the Central Government. Privatization and reform in the insurance sectar is a big challenge. Insurance Organisations in India: In India the following different kinds of Insurance Organizations exist: (i) Departmental Organization. (ii) Corporation. (iii) Employees State Insurance Corporation. (iv) Deposit Insurance Corporation. (i) Departmental Organization: The Central and the State Government have insurance facilities in their different departments. The postal department has its own system of insurance under which the employees of the post office are insured. The State Government of different states have provided life insurance to, their respective employees. Apart from this the State Government have also, provided sickness, maternity, disability, medical and pension insurances to their employees. (ii) Corporations: In India in order to, deal with the insurance business two corporations are established under separate Acts. (a) The LIC Act 1956: This Act has provided far life insurance legislations far life insurance business. It started its functions since September 1956 and awns all the life insurance business in India. (b) Under General Insurance Corporation of India Act 1972, the General Insurance Corporation of India was established. It formed into, four distinct companies viz. (i) National insurance Companies Ltd. (ii) New India Insurance Companies Ltd. (iii) Oriental and General Insurance Companies Ltd. and (iv) United India Fire General Insurance Companies Ltd. These companies would work separately maintaining their distinct features but they are enrolled and guided by General Insurance Corporation of India. These companies are the subsidiary of GIC. (iii) Employees State Insurance Corporation: This Corporation was established in 1948 in order to, provide social insurance to laborers working in the factories earning less than Rs. 400 per month. They are provided assistance in sickness, maternity, disability, medical expenses etc. (iv) Deposit Insurance Corporation: This Corporation was established in 1962 in order to provide protection to the depositors of a bank. In case if the bank fails to return the deposit, the depositors can get a refund of their deposits upto Rs. 10,000. (v) Government Companies: The government established their companies according 1;0the provisions of the Indian Companies Act. In order to secure export risks, 'THE EXPORT RISKS INSURANCE CORPORATION' was established in 1957. In 1964 it was renamed as Export Credit Guarantee Corporation (ECGC).

Chapter 10 Life Insurance

Introduction: Life Insurance is a very popular form of Insurance. It insures the life of an individual and gives financial protection to the members of the family of the policyholder. It is popular among all sections of the society. In western countries, life insurance is a normal feature of individual's personal life and this business is carried on by private companies too. In India, this business has been nationalized since 1956. Life Insurance is different from other types of insurance in various ways. It not only gives protection but it is a compulsory method of savings. It promotes savings as well as investment. Protection is given to family members in case of premature death of the policyholder and in case of survival of the policyholder; he is given a lump sum after a fixed period. Besides there are other concerns about taking care of children and their future and about creating wealth that most individuals cherish. Life Insurance products are generally designed to address such needs. Definition: Life Insurance may be defined as a type of Insurance Contract whereby the insurer, in consideration of the premium paid in periodical installments, undertakes to pay an annuity or a certain sum of money either on the death of the insured or on the expiry of a certain number of years. The definition of the Life Insurance Contract is enlarged by section 2(1)of the Insurance Act, 1938 by including

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" ANNUITY BUSINESS". Benefits of Life Insurance: (1) Life Insurance gives monetary protection to the policyholder and his family members in case of premature death. (2) It reduces tensions and provides peaceful life to policyholders. (3) Life Insurance acts as a social security measure. (4) It serves as a provision for old age. (5) Life Insurance is useful as an ideal method of compulsory saving for old age. (6) It is useful for meeting certain expenses like marriage and education of children. (7) The benefits of profitable investment are available in life insurance as LIC gives attractive bonus to policyholders. (8) Life Insurance policy is useful for securing temporary loan for meeting unexpected expenses. (9) It also gives protection and safety to policyholders, raises the rate of capital formation and contributes for economic development. Features of Life Insurance Contract: (1) Nature of general contract. (2) Insurable interest. (3) Utmost good faith. (4) Warranties. (5) Proximate cause. (6) Assignment and nomination. (7) Return of premium. (8) Other features. (1) General Contract: Since life insurance contract is a sort of contract it is governed by the Indian Contract Act. According to section 10 of Indian Contract Act, 1872 a valid contract must have the following essentialities: (a) Offer and acceptance. (b) Legal consideration. (c) Competent to make contract. (d) Free consent. (e) Legal object. 2) Insurable Interest: The insured must have an insurable interest in the life to be insured for a valid contract. Insurable interest arises out of the pecuniary relationship that exists between the policyholder and the life assured. Insurable interest in life insurance may be divided into two categories: (a) Insurable interest in own life, and (b) Insurable interest in other's life. The latter can be sub-divided into two classes: (i) Where proof is not required, and (ii) Where proof is required. Again this insurable interest, can be divided into two classes (a) Insurable interest arising due to business relationship, and (b) Insurable interest in family relation. (3) Utmost Good Faith: The life insurance requires that the principle of utmost good faith should be preserved by both the parties. The principle of utmost good faith says that both the parties, proposer (insured) and insurer must be of the same mind at the, time of contract because only then the risk may be correctly ascertained. They must make full and true disclosure of the facts material to risk. (4) Warranties: Warranties are integral part of contract i.e. they form the bases of the contract between the proposer and the insurer and if any statement whether material or non-material, is untrue the contract shall be null and void and the premium paid by him may be forfeited by the insurer. The policy issued will contain that the proposal and the personal statement shall form part of the policy and be the basis of the contract. (5) Proximate Cause: The efficient or effective cause that causes loss is called 'PROXIMATE CAUSE'. It is the real and actual cause of loss. If the cause of loss is insured, the insurer will pay. In 'LIFE INSURANCE' the doctrine of CAUSA F.ROXIMA is not applied because the insurer is bound to pay the amount of Insurance whatever may be the reason of death. It may be natural or unnatural. Hence this principle is not of much practical Importance with life insurance.

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(6) Assignment and Nomination: Life insurance policy can be assigned freely for a legal consideration or love and affection. Notice of assignment must be given to the insurer who will acknowledge the assignment. The holder of life insurance policy on his own, may either at the time of affecting the policy or at any subsequent time before the policy matures, nominate person or persons to whom the money secured by the policy shall be paid in event of his death. Nomination can be cancelled before the maturity, but a notice should be served to this effect. (7) Return of Premium: In the ordinary course premium once paid cannot be refunded. But in the following cases the premium paid are returnable: On account of misrepresentation or breach of warranty, the insured, in the absence of any express condition to the contrary, can claim the return of premium paid. But where the insured is guilty of fraud in obtaining a policy, he will fail in his claim to the sum assured. He cannot ask for a return of the premium because he will have to allege his own fraud to succeed in his claim. (8) Other Features: Life Insurance policies have the following additional features: (i) It is an Aleatory Contract. (ii) A Unilateral Contract. (Hi) A Conditional Contract. (iv) A Contract of Adhesion and (v) Not a Contract of Indemnity. Life Insurance Products: The life insurance products are in the form of life insurance policies. The following are the different kinds of life insurance policies and their uses: (1) Whole-Life Policy: Under the whole life policy the sum' insured becomes payable to the beneficiary only after the death of the insured. The policy remains in force throughout the life of the assured and he has to pay premium regularly till his death. This policy does not give protection to him but only to his family members. Whole life policies are issued with lower rate of insurance premium. The whole life policies may be limited payment whole life policies or convertible whole-life policy. (2) Endowment Policy: Under this policy, the sum assured becomes payable after the expiry of a specified period or after the death of the assured whichever is earlier. The premium is to be paid till the maturity of the policy. Endowment policy is convenient when an individual desires to enjoy the fruits of his savings during his life time. This policy is useful for the policyholder as well as his dependents. All the usual benefits of life insurance are available to this policy. There are several types of endowment policies, they are: (a) Pure Endowment Policy. (b) Ordinary Endowment Policy. (d ) Joint Life Endowment Policy. (d) Double Endowment Policy. (e) Fixed Term (Marriage) Endowment Policy. (f) Educational Annuity Policy. (g) Triple Benefit Policy. (h) Anticipated Endowment Policy. (1) The Money Back Policy with Profits. (j) Progressive Protection Policy with Profits. (k) Anticipative Whole Life with Profits. (l) New Jan Raksha Policy. (m) Mortgage Redemption Assurance Policy. (n) Children's Deferred Endowment Assurance. (0) Children's Anticipated Policy with Profits. (3) With or Without Profit Policy: Under the with profit policy the Policyholder is paid the sum assured plus a share in the profits earned by the insurance company every year. In case of without profit policy, the share in the profits is not given but the rate of premium is less in case of without profit polices. LIC gives handsome bonus to its policyholders by way of profits. (4) Joint Life Policy: This policy is taken on the life of two persons. The amount becomes payable to the survivor after the death of the other party. Such policy can be taken for any amount. It is useful for both partners and gives them safety and security. Joint life policy is suitable when both partners are employed and have the capacity to pay premium regularly.

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(5) Double Accident Policy: This policy gives special protection in case of death of a policyholder due to accident. In this case if the insured expires by accident, the survivor get double amount of the policy. In case of such policies the premium rate is higher but the extent of protection against risk is also more. People who travel extensively may prefer this policy. (6) Annuity Policy: Under this policy the amount of policy is paid in the form of annuities for a specified number of years or till the death of the assured. It is like pension payment arrangement through life insurance. Such policy is useful to those who prefer regular income in their old age. They are relieved from, the botheration of keeping money safely. Those who are not able to control their regular expenditure may prefer this policy in order to limit their expenditure. (7) Group Insurance Policy: Group insurance policy can be taken on the lives of the members of a family or of the employees of a business concern. Joint stock companies prefer such type' of policies for their employees. The companies pay premium. If any insured employee dies while in service, the insured amount becomes payable to the relatives of the employees. (8) Convertible Whole Life Policy: In the beginning, a whole life policy is taken but a provision is made in the policy itself to convert the same into an endowment policy after a fixed period. The period is usually 5 years. For a whole life policy the rate of premium is much less but it increases when it is converted into an endowment policy. This policy is beneficial to newly employed people as in the beginning they can take a whole life policy as their salary is less. Later on when the salary increases the policy can be converted into all endowment policy. (9) Janta Policy: LIC introduced this policy with a view to popularize the message of insurance among the poor section of society. Under this scheme only endowment policy can be taken. This policy is issued for such a period that it should not mature after the age of 60 years. (10) Jeevan Sathi Policy: This policy can be taken by married couple only. Under this husband and wife can insure their lives by a single policy. The unique feature of this policy is that it matures twice i.e. if one of them dies before the expiry of the policy period the sum insured is payable to the survival. The policy continues even after that till the date of maturity. The same sum is again payable to the survival or the nominee. (11) Jeevan-Mitra Policy: It is taken up by a single person. If he dies before maturity then the sum assured is paid to nominee. However, if he survives till maturity a single sum assured is paid to him. Non-Conventional Policies: The LIC of India has introduced several non-conventional policies in order to meet the requirement of the population. The conventional policies have the main attributes of protection at early death or living too long, but majority of the population is mainly interested in investment. LIC has designed several new policies to meet these requirements. Some of the important policies are: (1) Policy under LIC mutual fund. (2) Jeevan Akshay. (3) Jeevan Dhara. (4) Jeevan Kishor and (5) Jeevan Chaya. Procedure of Taking out a Life Insurance Policy: (1) Submission of Proposal Form: The first step in the procedure of taking out a life policy is to submit a proposal form to the LIC authorities. A person who desires to take life insurance policy has to submit a completed proposal form for the consideration of LIC. A proposal is a written request made to the insurance company for Insurance Cover or benefit. For this, printed proposal forms are available. Information must be given correctly, clearly and in good faith in the proposal form. The agent of corporation also makes his remarks on this form. The insured is required to give two references in proposal form. All details regarding occupation, family background, age, health, etc. are required to be given properly in the proposal form. The life policy may be voidable if full and correct information is not supplied in the proposal form. The proposal form acts as the base of insurance contract. Information given in proposal form is used in the policy document prepared by the company in due course. (2) Submission of Proof of Age: The assured has to state his date of birth in proposal form. He has also to give an authentic proof of his age. For this, birth certificate, school leaving certificate or horoscope is adequate. The claim on the policy will not be accepted unless the age is verified and approved by the insurance company. Information about the age is also necessary for fixing the rate of premium and for fixing the maturity date of the policy. Premium rate increases along with the age and amount of policy. Thus, in the case of life insurance, proof of age must be submitted to the insurance company. It is better to submit this proof of age along with the proposal form so as to avoid complications at a later stage. Proof of age is not necessary in case of fire and marine insurance.

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(3) Medical Examination: For life insurance, the proposer has to get himself examined medically from the approved doctor of the insurance company. LIC arranges for medical examination if necessary in order to decide the premium and final acceptance of the proposal. Medical examination is taken after the receipt of the proposal form. Medical examination must be conducted by the doctor, who is on the panel of LIC In India, for a policy upto Rs. 15,000 medical examination is not required. (4) Scrutiny of Proposal: The proposal form and the medical report are examined by the officers of the LIC This is necessary before the final approval of proposal. The decision as regards the acceptance of the proposal and the rate of premium is taken on the basis of the proposal form, the report of the agent and the medical report of the applicant. (5) Acceptance of Proposal: If the medical report is favourable, the proposal is generally accepted and the decision is communicated to concerned party. He is also asked to pay the first premium immediately. The risk is accepted by the insurance company from the date of the receipt of the first premium. (6) Payment of First Premium and Issue of Policy: The insured will pay the first premium after the receipt of communication from the LIC office. In many cases, the proposer has to pay in advance the amount equal to first premium along with the proposal form. The amount is kept as a deposit by the LIC and adjusted after tl1e proposal is accepted. The policy comes in force with the payment of first premium. The regular policy document is sent to the policy holder in due course. This policy contains insurance contract and all details of the policyholder including his name, age, address, occupation, the amount of the policy, the name of nominee, manner of payment of premium and terms and conditions of insurance contract. The policyholder has to keep this insurance policy under his custody. It is an important document required in due course for claiming compensation or for payment after maturity. In addition, the policyholder has to pay insurance premium regularly till the maturity of the policy. The premium may be paid on monthly, quarterly, half yearly or on yearly basis. If the insured fails to make payment of premium, the policy may be discontinued by the

LIC
However, it can be received as per the rules and regulations laid down by the corporation. Settlement of Claims: Settlement of claim is necessary in the case of each and every life policy. To settle the claim means to demand insurance amount and to collect this amount from the insurance company. The problem of claim in life insurance arises in the case of death of policyholder or when the period specified in policy expires. Such claim will be made by the members of the families or by the policyholder himself (in case of his survival).The important steps in the procedure of making a claim are as follows: (1) Submission of Claim Form Along with Proof of Death: When the Policy becomes mature for payment, the claim for payment must be made either by the assured himself or by his family members in case of the death. Along with the claim, a satisfactory proof of the death of the policyholder is required to be submitted. Such death certificate has to be obtained from the medical practitioner who had treated policyholder before his death. This type of certificate can be obtained from municipal authorities on the basis of information available in the death register. Death certificate is not required in the case of maturity of policy during lifetime of policyholder. (2) Proof of Title: The person claiming the amount has to furnish the proof of his title to the amount of the policyholder. Thus he has to submit succession certificate. If the nominee is mentioned in the policy, he can claim the amount easily. However, if such Information is not given in policy, the person making the claim has to prove his legal title to the policy. (3) Proof of Age: This proof of age is necessary if the age of the assured was not admitted earlier i.e. at the time of taking out an insurance policy. Such certificate can be obtained from the municipal authorities easily. However, if such information is not given, the person making the claim has to prove his legal title to the policy. For this, the probate from the court must be taken and submitted. (4) Making Payment: Once the claim along with all necessary certificates is submitted, the LIC examines the claim as well as the documents and make the final payment to concerned party. If the policyholder is alive, the claim is settled quickly as limited formalities are required to be completed. The policy amount is generally paid by cheque in lumpsum. At present, LIC informs the policyholder that the policy is due for payment with a request to complete the formalities and collect the amount. This procedure is generally completed within one month. Surrender Value and Paid up Value of Life Policy: Surrender Value: If the policyholder is unable to pay the premium regularly, he may surrender his policy to the company with a request to pay back whatever amount due as per rules. The surrender value of the policy is the amount which the insurance company is willing to pay to policyholder in total settlement of insurance policy. The surrender value

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depends upon the total amount of premium paid by the policyholder. However, surrender value is less as compared to the total premium paid. A policy acquires surrender value only if the premiums are paid for a period of at least three years. A policyholder suffers financial loss when he surrenders his life policy to LIC.

Paid-up Value:
The policyholder has an option to make his policy paid-up one. Here the policyholder decides to discontinue the policy and is not interested in the payment of premium. Here, the policy will be converted into paid-up policy. The policyholder is entitled to have paid-up value of his policy which will be equal to the total premium amount already paid. However, this paid-up amount will be paid on maturity or death of policyholder whichever is earlier. It may be noted that surrender value and paid-up value are two different terms and concept. Assignment and Nomination of Life Policy: (1) Assignment of the policy means the transfer of the rights and liabilities of the assured to a third party. Such third party may be a creditor, a bank or even the insured himself. Such assignment is necessary for taking loan or financial help from other party. The assignment is usually made by endorsement on the back side of the policy itself. The assignment must be intimated to the insurance company for suitable noting and registration. (2) Nomination of the life policy means, to note the name of the person to whom the benefit of the policy is to be given or transferred. The nominee' has a right to claim compensation after the death of policyholder. Nomination can be made even after the issue of policy. Nomination can be cancelled or changed at any time before the maturity of the policy. Nomination of life policy is desirable for the convenience of the relatives. They will get compensation easily and quickly due to such nomination. LIC, in India has made liberal rules regarding the nomination. Nomination or change in nomination has to be communicated by proper notice to the corporation.

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Fire Insurance
Introduction: Fire Insurance is one of the oldest forms of insurance and goes as far as Marine Insurance. Its origin is in the age-old fear of fire and human failing to control fire. In the early development of Industrial Society, fire was the main source of energy. No industrial activity or commerce was possible without fire and the need to insure the risk of uncontrolled fire became an integral part of society. Fire Insurance is designed to provide for financial loss to property due to fire and a few other related hazard. Fire Insurance is governed by a Tariff, under the Tariff Advisory Committee (TAC). The following are some of the examples of insurable property under the Fire Insurance Policy: (1) Buildings. (2) Electrical installation in buildings. (3) Contents of building such as machinery, plant and equipments, accessories etc. (4) Goods, raw materials, semi-finished goods, packing material etc. stored in factories and godowns. (5) Goods in the open. (6) Dwellings and contents of dwellings. (7) Furniture, fixture and fittings. (8) Pipelines located inside and outside buildings, dwellings and compounds. Definitions of Fire Insurance: (1) Section 2(6A) of Insurance Act, 1968 defines "Fire Insurance Business" as "the business of effecting, otherwise than incidentally, to some other class of insurance business, contracts of insurance against loss incidental to fire or other occurrences customarily included among the risks insured against in Fire Insurance Policies." (2) "A Contract of Fire Insurance is a Contract of Indemnity against the loss or damage to property arising from fire during an agreed period of time. Here the insurer undertakes to indemnify the insured against financial loss
caused directly or as a result of fire. "

(3) "A Contract of Fire Insurance is a contract by which the insurer undertakes, for a money consideration, to indemnify the insured against the consequences of afire during an agreed period upto the amount stated in the policy." (4) "A Fire Insurance Contract is a contract whereby the insurer in consideration of the premium paid undertakes to compensate the insured for any loss that may result due to occurrence of fire. " The term "FIRE" in a contract of Fire Insurance means the production of light and heat by combustion. Combustion occurs only at the actual ignition point. Hence, there is no fire without ignition. Loss or damage which occurs as a result of putting out the fire would also be covered by the fire risks. Fire policies are not covered through fire caused by earthquakes, riots, civil commotion, foreign enemy, rebellion etc. Fundamental Principles of Fire Insurance: The following are the Fundamental Principles essential for a valid contract of fire insurance. (1) Contract of Indemnity: This principle suggests that Insurance Contract is a contract for affording protection and not for profit making. The purpose of insurance is to secure compensation in case of loss or damage. The insured can recover only the amount of actual loss subject to the sum assured. (2) Insurable Interest: This principle suggests that the insured must have insurable interest in the object of insurance. In case of fire insurance the insurable interest must exist at the time of affecting the insurance as well as at the time of the loss. The interest however may be legal or equitable or may arise under a contract of purchase or sale. (3) Contract of Good Faith: Utmost good faith is one basic and primary principle of Insurance. It states that Insurance Contract must be made in absolute good faith on the part of both the parties. The insured must make full and detailed disclosure of all material facts likely to affect the judgment of the fire officials in determining the rates of premium or deciding whether the proposal should be accepted. (4) Loss Through Fire: The principle of Causa Proxima means that when a loss has been caused by series of causes, the proximate or the nearest cause should be taken into consideration to determine the liability of the insurer.

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Loss resulting from fire or some other cause is the proximate cause of risk covered under a Fire Insurance Contract. But where the fire is caused by insured himself or with his connivance or by the operation of a peril specifically excluded under the policy like earthquake, the loss will not be covered. (5) A Contract from Year to Year: A fire insurance policy is usually for one year and can be renewed thereafter. (6) Principles of Subrogation and Contribution: This principle is applicable to fire, marine and accident policies. It states that once the full compensation is paid by the Insurance Company it acquires all the rights and remedies which the assured would have enjoyed regarding the said terms. Fire Insurance's Coverage: Standard Fire Policy: In India, the Fire Insurance business is governed by the All India Fire Tariff that lays down the terms of coverage, the premium rates and the conditions of the fire policy. Fire insurance policy is suitable for the owner of the property, one who holds property in trust or in commission, individuals/financial institutions, who have financial interest in the property. The fire insurance policy has been renamed as Standard Fire and Special Perils Policy. The Standard Fire Policy covers the following hazards: (1) Fire: This usually excludes: (a) Destruction or damage to the property caused by its own fermentation, natural heating, or spontaneous combustion, or (b) It is undergoing any heating or dying process, or (c) Burning of any property insured by order of any public authority. (2) Explosion/Implosion: Explosion is defined as a sudden, violent burst with a loud report. An implosion means bursting inside or inward or collapse. Such explosion as may happen to boilers, economizers or other vessels in which steam is generated would be excluded from fire insurance but can be covered by Boiler Explosion Policy under Engineering Insurance. (3) Lightning: It may result in the fire damage or other type of damage such as roof broken by a falling chimney struck by lightning, or cracks in the building due to lightning strike. Both fire and other types of damages caused by lightning are covered by the policy. (4) Impact Damage: Impact by any rail/road vehicle or animal by direct contact with the insured property is covered. However, such vehicles or animals should not be occupied or belong to the insured owner or their employees while acting in the course of their employment. (5) Storms, cyclone, typhoons, tempest, hurricane, tornado, flood and inundation. (6) Subsidence and landslide including rock slides. (7) Riots, strike, malicious and terrorism damage. (8) Missile testing operation. (9) Bush fire, excluding fire caused by forest fires. (10) Leakage from automatic sprinkler installations. (11) Aircraft damage. Special Coverage: Apart from standard coverage, Fire policy may also be issued in order to meet the specific requirements of the clients. Some of these are: (1) Reinstatement value policies. (2) Stock policies. (3) Consequential policies. (1) Reinstatement Value Policies: This is a fire policy that specifies that in event of loss, the policy will pay an amount required for reinstatement of the property insured. Usually the insurer issues policies of reinstatement only for such properties that are relatively new. TAC does not permit such policies for stocks and goods. In this type of policy it is not only possible to recover the depreciation value of the property lost but also the cost of replacing the damaged property by new property of the same kind.

(2) Stock Policies: There are three types of policies for stock:
(a) Floater Policies. (b) Declaration Policies. (c) Floater Declaration Policies. (a) Floater Policies: Under the floater policies stocks at various locations can be insured and covered under one sum as these policies take care of the frequent changes in the sum insured. The floating policies are not issued in respect of immovable property nor they are issued to transport contractors and cleaning and forwarding agents.

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The total sum insured in respect of all locations should not be less than Rs. 3 crores and the maximum sum insured at any one location should not be more than 10% of the total sum insured. The insured should have a good internal audit and accounting procedure to establish total amount of risk and location at particular time. The pro-rata conditions of average are applied to the limit of sum insured at each location and also to the total sum insured under the policy. (b) Declaration Policies: These policies are useful to businesses which face frequent fluctuations in stock quantity or value. The Insurance Companies can issue these policies subject to the following conditions: (i) that the minimum sum insured is Rs. 1 crore. (ii) reduction in sum insured is not allowed under the policy. (iii) the insured has to submit monthly declarations based on the average of the highest value of risk on each day or highest value on any day of the month to the insurer. (iv) The insured cannot claim refund of premium 011 adjustment based .on the declarations in excess of 50 percent of the total premium. (v) The basis of value for declaration shall be the market value prior to the loss or otherwise agreed upon. Declaration policies are not issued to: (i) Transport contractors and forwarding and clearing agents. (ii) in respect of stock-in-process.

(iii) insurance for short period.

(d )Floater Declaration Policies: These policies combine the features of the floater and declaration policies. All the rules relating to both the policies shall apply except: (i) Minimum sum insured is Rs. 2 crores. (ii) The minimum premium retention of the insurance company shall be 80 per cent of the annual premium. (3) Consequential Loss Policy: This policy is suitable for business establishments and corporate for whom business interruption would mean heavy monetary loss in view of fixed costs. Fire Consequential Loss Policy provides cover for expenses and increased cost of working as a result of business interruption following a loss covered by the fire policy. It also covers reduction in gross profit due to the business interruption. The additional expenditure incurred for avoiding or reducing the fall in the turnover during the interruption period is too covered under this policy. The premium chargeable depends on the type of industry / business, the anticipated gross profit, indemnity period chosen and additional covers required. Refund of premium not exceeding 50% can be claimed based on the actual gross profit figures as per the audited balance sheet after the expiry of the policy. General Exclusions: A typical fire policy does not cover: (1) 5% of each and every claim resulting from the operation of lightning/STFI/Subsidence and landslide including rockslide covered under the policy. (2) Loss, destruction or damage caused to the insured property by pollution or contamination excluding: (a) Pollution or contamination which itself results from the hazard insured against.
(b) Any insured hazard which itself results in pollution or contamination. (3) Loss, destruction or damage directly or indirectly caused to the property due to nuclear hazard. (4) Loss, destruction or damage caused by war, arid perils arising/ kindred to it.

(5) Loss, destruction or damage to any electrical and/or electronic machine, apparatus, fixture or fitting (Excluding fans and electrical wiring in dwellings) arising from or occasioned by over running, excessive pressure, short circuit, arcing, self heating or leakage of electricity from whatever cause. (6) Loss, destruction or damage to the stocks in cold storage premises caused by change in temperature. (7) Loss, destruction or damage to bullion or unset precious stones, curious or works of art for an amount exceeding Rs.10,000, manuscripts, plans, drawings, securities, obligations or documents of any kind, stamps, coins or paper money, cheques, books of account or other business books, computer system records, explosives unless otherwise expressly stated in the policy. (8) Expenses incurred on (a) architects, surveyors and consulting engineer's fees and (b) debris removal necessarily incurred by the insured following a loss, destruction or damage to the property by an insured hazard in excess of 3% and 1% of the claim amount respectively. General Conditions: Fire policies, as per the Tariff, carry fifteen general conditions.

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(1) The policy will become void in the event of non-disclosure of material facts, misrepresentation by the insured. This is to make sure that the principle of utmost good faith is complied with. (2) Under any of the following circumstances the insurance ceases to exist as regards the property insured if before the occurrence of any loss or damage the insured does not obtain the sanction of, or an endorsement of the insurer: (a) If the trade or manufacture carried out in the property is altered, or if the nature of the occupation of the property, of other circumstances affecting the building insured or containing the insured property are changed in such a way that the risk of loss or damage is increased. (b) If the building insured or containing the insured property becomes unoccupied and remains so continuously for 30 days or more. (c) If the interest in the property passes from insured to someone else, except by succession, will or such similar operation of law. (d) All of the above changes in the risk and nature of the hazard have to be notified to the insurer prior to the occurrence of any loss or damage. However, in the event of the death of the insured his legal heirs automatically become the insured. (3) All insurance under such policies will automatically cause if the building or structure covered by the policy falls, or is displaced in full or in part, unless the insurer is given a notice within 7 days of the event of such a fall or displacement on receiving such notice the insurer may agree to continue the insurance subject to revised rates, terms and conditions as may be decided by it and confirmed in writing. Such exclusion will not apply if the fall or displacement is caused by the hazard that is under the policy. (4) Cancellation of the policy' is possible by either party. If the cancellation is issued by the insured then the premium is retained by the company on short period basis. The insurance company can also cancel the policy by giving 15 days notice to the insured and in such a case the premium will be refunded on a pro-rata basis, depending on the remaining period of coverage. (5) If there is a marine policy covering the property and the loss, the fire policy will only pay the excess over the amount payable under the marine policy. This is a necessary condition because the marine policy also covers risk of fire e.g. if goods stored in the hold of the ship are destroyed by fire on the ship, then the marine policy will pay for the loss. If there is any balance loss that the marine policy could not pay, the same will be covered by the fire policy. (6) Rights of insurers in respect of the occurrence of loss or damage are: (a) Enter and take possession of the building or premises where the loss has occurred. (b) Take a possession of the insured property that was in the building during the loss/ damage. (c) Remove, sort, arrange or salvage the insured property. (d) Sell, dispose off the damaged property as they deem fit, for account of whom it may concern. (e) The insurer can exercise the above rights until the claim is closed or withdrawn by the insured in writing. Further, the insured will not incur any liability whatsoever on account of this action for payment of the claim, which will depend upon the terms and conditions of the policy. (f) If the insured or any person on his behalf does not CO-operate or hinders the process in any way then all benefits under the policy could be forfeited. (g) The insured does not have the right to abandon the damaged property whether the insurer take possession of it or not. (7) The duties of the insured on the happening of the loss are: (a) Notice of loss/damage should be given to the insurer immediately. (b) Within 15 days or further time as allowed by the insurer, submit a claim statement giving item-wise detail of amount of loss not including profit of any kind. (c) Particulars of other insurance applicable to the loss/ damage to be submitted. (d) Non-compliance of these conditions could make the claim untenable. (e) The insurer is not liable for any loss after the expiry of 12 months from the date of loss unless the claim is the subject of pending action, arbitration or litigation. (f) If the liability is disclaimed by the insurer and the insured has not filed a suit in court for recovery, within 12 months of the date of the disclaim, the claim is deemed to have been abandoned by the insured. It is not recoverable thereafter. (8) The insurer has the right to replace or re-instate the property that is lost/ damaged instead of paying for the loss or damage. This condition is invoked usually when the insured is claiming a disproportionately large quantum of loss than what the insurer is willing to admit. (9) If the claim is fraudulent or any false evidence is produced by the insured to avail of a benefit under the policy then the insured loses all the benefits under the policy. Similarly, if the loss or damage is caused willfully by the insured or with his connivance, then all the benefits under the policy will be forfeited.

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(10) An insured is expected to insure his property to the fullest extent of its value. In the event of the claim if it is found that he has not covered the property to its full value, then he has to bear a portion of the loss. The loss borne by the insured will be calculated in the same proportion as the insured amount bears to the actual value of the property. An example Value of property Rs. 3,00,000 Sum assured Loss The amount payable Rs. 1,00,000 Rs. 60,000

1, 00,000 _________ 3,00,000 x 60,000 = Rs. 20,000. (11) Any dispute regarding the amount of claim payable shall be referred to arbitration as per the provisions of the Arbitration and Conciliation, 1996. Arbitration is a private method of dispute resolution rather than going to court and is usually faster and cheaper. (12) If the loss/damage is caused by a third party the insured is required to help and assist the insurer to enable it to recover the loss from the third party responsible for the loss/damage. The insured's right to recover against a third party is subrogated to the insurer, and this transfer of rights takes place even before the insurer pays for the loss/ damage. (13) In the event of one or more policies covering the same property for the same hazard, all policies will contribute towards the claim in the same proportion as they bear individually to the sum assured. (14) Upon the settlement of any loss under the fire policy, pro-rata premium for the un-expired period from the date of the loss to the expiry of the policy for the amount equivalent to the loss is payable by the insured to the insurer. The amount of premium payable under this policy is deducted from the net claim payable under the policy. However, the sum assured stands reduced by the amount of loss in case the insured immediately on occurrence of the loss exercises his option not to re-instate the sum assured as above. (15) All notices under this policy are required to be given in writing. Procedure for Taking out a Fire Policy: (1) Selection of Insurance Company: There are many insurance companies engaged in insurance business. The owner of the goods Interested in taking out an insurance policy has to select the Company which is suitable and convenient to him. The insurance company which is popular and which offers efficient service should be selected. (2) Submission of the Proposal Form: In order to take out a insurance policy, the interested party i.e., the owner of the property, has to submit a completed proposal form to the insurance company. It is general practice with insurance company to supply printed proposal forms for this purpose. The intending party has to obtain such printed proposal form from the office of the insurance company or from its agent. The completed proposal form with the necessary details is to be submitted to the insurance company by the interested party. The basic principle of insurance like utmost good faith, insurable interest, etc. must be followed properly while submitting the proposal form. The proposal form should be accompanied by the necessary documents required by the insurance company for inspection. (3) Scrutiny of the Proposal: Immediately after the receipt of the proposal, the company examines the proposal with the help of experts. The scrutiny is made in order to find out the nature and the extent of risk involved in the proposal. The insurance company has to make an on the spot survey of the property through qualified surveyors. The purpose is to estimate the extent of risk involved and also to fix the premium accordingly. (4) Acceptance of the Proposal: After detailed scrutiny of the proposal and the survey of the property, the insurance company takes final decision regarding the proposal. It may accept or reject the proposal. The company has to inform its decision regarding the proposal as early as possible. The information of acceptance of proposal is accompanied by a premium notice. This enables the intending party to pay the premium amount. The acceptance of proposal is always subject to the payment of premium. (5) Payment of Premium: Once the proposal is accepted, the company informs the party accordingly with a request to pay the premium. The intending party has to pay this premium immediately. The insurance policy or insurance cover starts immediately after the payment of premium. The policyholder is entitled to claim the compensation if the loss occurs after the payment of premium. The policyholder is given necessary stamped receipt as regards the premium paid. Policy document is also sent in due course. In the meantime, the insurance company issues a cover

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note which serves as an interim insurance policy. The cover note is adequate to claim compensation if the need arises and the company is also under the obligation to pay compensation. (6) Despatch of Insurance Policy: .Once all this formalities are completed, the insurance company issues a legal document containing the contract of insurance. It is known as duly stamped fire insurance policy. It contains the terms and condition of the insurance contract. It is a legal document and must be preserved properly. The cover note is not necessary after the issue of insurance policy by the company. The policy contains various details like the name of the insurance company, name of the insured, particulars of property insured, the amount insured, premium amount, period of policy and signature and seal of the insurance company. Settlement of Fire Insurance Claim: (1) Intimation about Loss: Immediately after the loss of property due to fire, the insured has to inform the insurance company about the occurrence of fire. He has to take reasonable steps to extinguish the fire so as to reduce the loss to minimum. Compensation may not be paid for unreasonable delay in giving intimation of loss to the company. (2) Assessment of Loss: The next step is the insured has to make an assessment of the actual loss which he has suffer- The correct estimation in this behalf is very necessary as this details are to be filled in the claim form. (3) Submission of Claim Form: Within 15 days of the loss due to fire, the insured has to submit his claim in the prescribed claim form. Full details about the actual loss or damage must be stated in this form. Printed form should be used for this purpose. The claim form should be lodged with the insurance company within the stipulated period. (4) Evidence for Claim: Along with the claim, the insured must send documents which may help the company in determining the actual loss occurred. This will make the settlement' of claim easy and quick. If possible eye witnesses should be produced before surveyors. (5) Verification of Form: As soon as the claim form is received, the insurance company makes the preliminary verification of the form. In this verification the supporting documents and relevant papers are thoroughly checked. Hereafter, insurance company appoints surveyors for the assessment of the actual loss. (6) Survey of Loss by the Insurance Company: After the receipt of the claim form, the company sends its surveyors to determine the actual amount of loss or damages to the property for which insurance cover is taken. The surveyors conduct investigations. They calculate the actual loss and also dispose off the salvage at the best price. The surveyors submit their report to the insurance company for information. (7) Settlement of the Claim: On the basis of the claim made by the insured and the actual loss as calculated by the surveyors, the company decides how much amount should be paid to the policyholder as compensation. Accordingly, necessary arrangements are made to pay the account and to settle the claim. (8) Appointment of Arbitrator, if necessary: Sometimes, dispute may arise between the insurance company and the policyholder as regards the amount of compensation. In order to settle such a dispute, the company refers the matter to an arbitrator who gives his decision after hearing both the sides. The decision of the arbitrator is binding on both parties. Rights of Insurer: (1) Right to Avoid Policy: Where the subject matter is not specified honestly or willful fire is caused by the insured or with his connivance then an insurer has a right to avoid the policy. (2) Rights of Entry Control over Property: Where any loss or damage of property insured arises due to outbreak of fire, the insurance company has the right to enter in the premises and take possession of the building or property. It is essential for the insurer to ascertain the cause of loss or damage or minimise the loss and to protect the salvage. (3) Right of Reinstatement: An insurer has a right of reinstatement or replacement of the damaged property instead of paying the amount of loss or damage in money. (4) Right of Subrogation: This right states that once the full compensation is paid by the insurance company it acquires all the rights and remedies which the assured would have enjoyed regarding the said loss. When the compensation is paid for the total loss, all the rights of the insured in respect of the subject matter of insurance are transferred to the insurer. (5) Right to Contribution: According to this principle, in case a person has taken out more than one policy against the same risks, the insurer is to share the loss in proportion to the amount assured by each. (6) Right to Salvage: In case of any loss due to fire, it is the duty of the assured to hand over the salvage to the insurance company. The insurer has the right to ascertain the claim to be made for the exact value of goods damaged or destroyed at the date of fire.

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