Insurance Business and Institutions

Insurance: The Discipline of managing risk.

Insurance defined

The dictionary defines insurance as “an arrangement by which a company or the state i.e., the insurer
undertakes to provide a guarantee of compensation for specified loss, damage, illness, or death of the
insured in return for payment of a specified premium.”

Definition from the finance perspective: A financial arrangement that involves the transfer of loss
exposures to an insurance pool, and the redistribution of losses among the members of the pool.

Definition from the legal perspective: A contractual arrangement whereby one party agrees to compensate
another party for losses.

From the practical perspective, insurance is a promise of compensation for specific potential future risk in
exchange for a periodic payment, known as premium.

A brief survey of insurance literature reveals differences of opinion among authors on how the term
insurance should be defined. However, there is consensus in the literature that insurance has to contain the
following two elements:
 risk pooling
 risk transfer.

The risk pooling creates a large sample of risk exposures and, as the sample gets larger, the possibility of
missing future loss predictions gets lower. This is called the law of large numbers, an important statistical
doctrine for the successful management of risk and the basic foundation for the existence of insurance in
society. Pooling the exposures together permits a more accurate statistical prediction of future losses. Loss
sharing is accomplished through premiums collected by the insurer from all insureds—from those who
may not suffer any loss to those who have. The losses are shared by all the risk exposures who are part of
the pool. This is the essence of pooling.

The law of large numbers allows an insurance company to predict the expected losses of a group. The
basic principle of this law is that the larger the number of separate risks of a like nature combined into
one group, the more predictable the number of future losses of that group within a given time period.

For example, a general insurance company may conduct a study to ascertain the number of accidents
caused by vehicle users in India. Based on the data collected, they will be able to predict the probability
of accidents in a given period in a given region. Knowing this, they partially can determine how much a
vehicle owner should pay for auto insurance (excluding other factors, such as the type of vehicle, region
where the driver resides, etc.) This is how the law of large numbers helps an insurance company determine
their rates, and why the rates vary from one region to another region.

Individuals and the firms transferring the risk are known as insureds. The institutions accepting the risks
transferred by insureds are known as the insurers, the professional risk-bearers. The insurer assumes risk
by promising to pay whatever loss may occur as long as it fits the description and or the events, given in
the policy and is not larger than the sum insured. The loss may be zero, or it may be in millions of rupees.
In return for accepting this variability in outcomes, the insurer receives a premium. Through the premium,
the policyholder has paid a certain expense in order to transfer the risk of a possible large loss. The
insurance contract stipulates what types of losses will be paid by the insurer and under what circumstances.

Most insurance contracts are expressed monetary terms, although some compensate insureds by providing
a service. A life insurance contract obligates the insurer to pay a specified sum of money upon the death
of the person whose life is insured. A liability insurance policy requires the insurer not only to pay money
on behalf of the insured to a third party, say when you damage/destroy someone’s property, vehicle, and/or
cause injury or death to their parties. Whether the insurer fulfills its obligations with money or with
services, the burden it assumes is financial in nature. The insurer does not guarantee that the event insured
against will not happen. Moreover, it cannot replace sentimental value or bear the psychological cost of a
loss. The death of a loved one can cause almost unbearable mental suffering that is in no way relieved by
receiving a sum of money from the insurer. Neither of these aspects of loss can be measured in terms of
money; therefore, such risks cannot be transferred to an insurer. Because these noneconomic risks create
uncertainty, it is apparent that insurance cannot completely eliminate the uncertainty.

Economics of the Insurance Contracts

Insurance intermediaries convert the uncertainty of an individual loss into a predictable expense.

Insurance Market is simply the buying and selling of insurance, and the companies that are involved in
it.

Structure of the insurance market

Primary segment Secondary segment
- Life insurers - Actuaries
- Non-life insurers - Loss adjusters
- (Property and casualty insurers) - Insurance brokers
- Reinsurers - Insurance agents

Status of insurance market

- Huge uninsured/underinsured population, low insurance penetration
- Low per capita income, inability to afford traditional insurance
- Myth that insurance is for the rich / the elitist class

Issues concerning the insurance markets

- Premium flight and rate cutting
- Rising claims cost
- Delay or non-payment of claims
- High cost of accessing reinsurance in international markets
- Dearth of skills/expertize
- Technology adoption/Role of fintech

Classification of insurance markets

Primary Insurance market: Market wherein the insurance companies/insurers write insurance policies.

Reinsurance Market: Market wherein an insurance company or the insurer transfer a part of risk, by
insuring it with another insurance company.

Classification from economic cycle perspective

The insurance industry cycles between periods of soft and hard markets. Soft markets are often thought of
as a buyer’s market and hard markets as a seller’s market.
Insurance Business

 Life-related risks insured by life insurers

 All risks other than life classified as general insurance
 Health insurance is typically a grey area. In India, stand-alone health insurance can only be sold
by non-life insurers whereas life insurers can sell health insurance as riders to other base products
 Classification in developed countries has moved to short-term risks versus long-term risks. Short-
term risks are underwritten by non-life insurers and long-term risks underwritten by life insurers
 Reinsurers sell insurance to insurance companies and are used by insurance companies to pass risks
they do not wish to retain on their own balance sheet

How Insurance Works

Insurance works through the following steps:
 Risk is transferred from an individual or entity (insured) to an insurer.
 The insurer pools all the risk exposures together to compute potential future losses with some level
of accuracy. The insurer uses various forecasting techniques, depending on the distribution of
losses.
 The pooling of the risk leads to an overall reduction of risk in society because insurers’ accuracy
of the prediction improves as the number of exposures increases.
 Insurers pool similar risk exposures together to compute their own risk of missing the prediction.
 Insurers discriminate via underwriting—the process of evaluating risk and classifying it with
similar risks

Insurance Products

Are in the nature of contingent promises, except life insurance. Why?

Death is certain, uncertainty is about the timing of the death.

Issue: How does a prospective buyer evaluate the value of contingent promises?

A prospective buyer evaluates the value of contingent promises on two counts

The content of the promise: The benefit structure of a protection or investment plan of insurance product

The credibility of the promise: The confidence that it would be fulfilled in a real rather than a literal sense.

Types of Insurance Plans

Life Insurance Plans:

- Term plan
- Endowment plan
- Money back plan
- Annuity plan
 - Unit linked insurance plan

General insurance or Casualty and Property insurance plans

- Motor insurance
- Fire insurance
- Home insurance
- Medical plan

Business model of an Insurance Company

 Insurance companies are in the discipline of managing risk. Accordingly, the business model of
insurance companies revolves around risk, more specifically pooling of risks.
 The premium is decided by pricing the risk using sophisticated algorithms and statistical tools
which vary across companies and types of insurance.
 Whenever an insurer offers a conditional payout of a seemingly huge sum, the likeliness of the
insured claiming for that payout is calculated and is stretched across the entire premium payment
duration.

How Insurers Make Money?

Primary sources of income of an insurance company

Underwriting income: The difference in the amount of money collected from the people as premiums and
the money paid when a claim is filed in the hour of need.

Investment income: Insurance is a cash business. Premium is collected in advance from the insured.
Premium received from insureds is invested further so that it accrues interest over time and that is further
used to cover the various expenses of the insurer. Most insurance companies have a well-diversified
portfolio and invest in both low-risk fixed-income securities and high-risk, high-return equity markets

Financial capacity of an insurance company

Financial capacity of an insurance company is a function of:
• Capital base
• Free reserve
• Reinsurance arrangement

Capital base + Free reserve + Reinsurance arrangement = Financial capacity of an insurance company.
Insurance Value Chain

Key functional departments of an Insurance Company

The principal functional departments of an insurance company include:

Actuarial, pricing, or rate-making department

Calculates rates, develops rating plans, and set reserves.
Rate-making is the process used to determine what prices, or rates, are charged by an insurance company.
The pricing is largely determined by information from underwriters, those who choose which risks or
determine the acceptability of those risks, and actuaries, those who compile and analyze statistics and use
that information to calculate insurance risks and premiums.

Four basic standards are used in rate-making:

(1) the structure of rates should allocate the burden of expenses and costs in a way that reflects as accurately
as possible the differences in risk—in other words, rates should be fair;
(2) a rate should produce a premium adequate to meet total losses but should not bring unreasonably large
profits;
(3) the rate should be revised often enough to reflect current costs; and
(4) the rate structure should tend to encourage loss prevention among those who are insured.
Objectives of rate-making
 Rates should be easy to understand
 Rates should be stable over short periods of time
 Rates should be responsive to changing loss exposures and changing economic conditions
 Rates should encourage loss prevention
 Ability to book new business
Pure premium: PV value of the expected cost of a claim. Pure premium or loss costs do not include the
overhead costs or profit loadings. Loss Loading — a factor applied to pure loss costs or expected losses to
produce a premium rate. The multiplier is applied to an account for insurer overhead, profit, and
contingencies that are in addition to anticipated loss amounts.
Factors determining the loss loadings
 Principle of adequacy: To cover total operating expenses; provide for a margin of safety; provide
for minimum bonus/dividend and contribute to profits of the company
 Principle of equity: Expenses must be equally apportioned among policies. Each class of policies
to pay own costs and rewarded in proportion to their contribution to the profits
 Competitiveness: enables the company in improving its’ position vis-à-vis other competitors and
competing products
 Expenses: acquisition costs (first year or new business expenses) and maintenance costs incurred
in servicing the business in force
 Expenses vary with premium (commission to agents); vary with amount of insurance, medical fees,
underwriting expenses; vary with the number of policies (overhead expenses)
Loss adjustment: The process of determining the amount of loss
Premium smoothing: The charging fixed premium overtime when the pure premium is changing
Insurance reserves: Policy holders’ funds' insurance companies are holding in anticipation of paying claims
(insurance company liabilities)

The Pricing Continuum

Start with internal Add required Company’s

profit margins price
cost estimates

Internal Cost Profit margins Market

pricing pricing

Set price to
Deduce internal Deduct internal benchmark
cost estimates profit margins market position

Examples of rate-making

1. Rate calculation of an automobile insurance policy covering a class of automobiles assuming an

expected loss frequency of 6 percent, an average loss of Rs.3 lakhs, insurer expenses at 30 percent of the
premium, and a profit of 6 percent.

The pure loss cost per unit is 6 percent of Rs.3 lakhs, or 18000.
 The formula for the gross premium =L/{1 - (E + P)}, in which L equals the loss cost per unit, E equals
the expense ratio, and P equals the profit ratio.
The gross premium would be Rs.18000/{1 - (0.30 + .06)}, or Rs.28125.

2.
Expected loss: Rs 95,000;
Related loss adjustment costs, Rs 5000;
Total cost: Rs 100,000;
Probability of loss :1/1000 (0.001)
The expected cost: 0.001x100,000 =Rs 100.

Average time difference between receipt of premium and payment of claim= 6 months;
interest rate: 10 % p.a.

The present value of the expected cost of claim: 100/(1.10)^(6/12)=95.35

Pure premium = Rs 95.35

Actual premium = pure premium + loss loading

Life Insurance Pricing Assumptions

 Premium rates derived using assumptions regarding the future

 Assumptions include items such as:
 Demographic factors: mortality, morbidity, surrenders
 Economic factors: interest rates, inflation
 Expenses – fixed and variable expenses
 Distributions costs – sales compensation typically variable and linked to different measures of how
the business performs
 Sensitivity analysis done to test impact of different assumptions

General Insurance Pricing Assumptions

General insurance products typically short-term in nature.

Basic principle of pricing same as life insurance
 Ability to vary rates as contracts typically one-year long
 Mechanism used to manage risks typically involves discount in case of a claim-free year – ‘no
claim discount’. This contrasts with participating life insurance where a bonus is given in case
experience is better than assumed.
 General insurance premium rates dependent on a lot more factors than life insurance. Examples
include general economic factors, individual preferences, lifestyle etc. Premium rating involves
heavy use of statistical techniques like generalized linear modeling to capture the interaction effect
of all the rating factors

Underwriting Department

The underwriting department of an insurance company decides which risks the company should accept,
how much amount of insurance the company will write on the acceptable risk, and at what rate. Insurance
companies are essentially in the business of taking calculated risks.

Underwriting Capacity refers to the risk assumption and/or retention ability of an insurer, or of the
insurance industry as a whole. It is determined by the amount of surplus- the amount by which an insurer's
assets exceed its liabilities. It is the equivalent of "owners' equity" in standard accounting terms. The ratio
of an insurer's premiums written to its surplus is one of the key measures of its solvency.
Life Insurance Underwriting Process at CanaraHSBC Life

Applying for a life insurance policy is easy, especially when applied for online, it may take only a few
minutes. Once you have given your basic details and provided necessary information, your insurance
application is then sent for the underwriting process. This process determines if you can get coverage,
how much coverage can be approved for you, and at what cost. The underwriter, the person who evaluates
your application, works on behalf of or for the life insurance company to look at your health and financial
information to figure out if you are eligible to receive the rate you were originally quoted.

Underwriters use underwriting guidelines based on mortality statistics that are calculated by actuaries. All
insurance products involve some degree of underwriting. For life insurance, the underwriter looks at data
like your health and medical history as well as lifestyle information like your hobbies and financial ability.

Two Parts of Life Insurance Underwriting

There are broadly two parts to underwriting:

1) Financial Underwriting
It helps the underwriter to make sure the amount you’re purchasing is in line with your family’s and your
needs.
2) Medical Underwriting
Here, the underwriters determine how much of a risk you are to insure by evaluating factors that may
affect your mortality.

What is Underwriting in Life Insurance?

Underwriting is a term used to describe the consideration given to a life insurance application, to
determine whether a policy applied for should be issued or there are changes to be made depending on
the person’s risk profile.

The process helps in the selection of risks for the insurance company involved in issuance of an insurance
policy to the person in question.

Underwriters are the risk managers of the organization. They help the organization to keep actual
experience within the mortality assumption used in calculating the premium rates, which helps the
company to offer insurance cover at competitive terms, maintain equity between policyholders, and offer
cover to as wide a group of lives as possible.

Life Insurance Underwriting Process

The most important underwriting tools include the Proposal Form, Age Proof, Income Documents,
Questionnaires Sales Report and a Client Confidential Report (CCR). These tools are used to implement
the following process:

Step 1: Application Quality Check

 Your application is first gone through to make sure the information provided is complete and correct.
Therefore, it is important you fill your proposal form carefully and completely. Unless the missing
information is related to your medical history, a minor change required in an application does not typically
slow down the underwriting process. After this, your application goes into the official underwriting
process. Each of the following checks can increase the turnaround time, but it is worth it to get you the
right premium price you will need to pay over the policy term.

Step2: Medical Examination

This step involves looking thoroughly at the results of your paramedical exam, conducted only if required
for health proof. This medical test is a simple check-up with the doctor recommended by the insurance
company. After the medical examination, the results are sent to the underwriter for evaluation. The
information used by the underwriter is mainly of three types – basic measurements, your blood test and
drug test. Basic measurements include regular metrics like height, weight, blood pressure. Blood test can
get a lot of information on potential health risks such as heart disease, stroke, diabetes, and blood-borne
illnesses, among others. Finally, a urine test for a full drug panel will alert the underwriter to the use of
drugs, smoking and alcohol consumption.

Step 3: Final Application Rating

Once the underwriting process is complete and all your medical and financial background have been
checked, you are either made a counter offer suggesting the changes basis your policy evaluation, or you
are proudly offered the life insurance policy. Depending upon your acceptance or rejection of the new
policy term, your policy is then issued. The whole process can take anywhere between three to eight
weeks. After this, all that’s left to be done is to confirm the premium rate, sign the policy to put it in force
to keep your family protected.

While not every applicant will require a detailed medical examination, underwriters may sometimes
request an inspection report, or independent information on the applicant's financial situation and lifestyle.
The premium that you have to pay for your life insurance policy depends majorly on this evaluation done
basis factors like your age, your medical history, gender, lifestyle, and job. However, you must remember
that a life insurance policy should not be bought on the basis of lower premiums. While term insurance
plans are usually known to have the lowest premiums, you can choose an insurance provider that offers a
relatively higher implied investment return, a high death benefit and relatively lower surrender charges,
along with a high claim settlement ratio.

Source: https://www.canarahsbclife.com/blog/life-insurance/what-is-life-insurance-underwriting-process.html

Production or marketing department

Activities of sales and marketing department of an insurance company.

This department communicates the insurer’s products, rates, premiums, and loss control assistance to
potential customers after doing market research, advertising, training, and setting sales goals. Broadly,
production department is responsible for the following activities:
 The development of a marketing philosophy
 The company’s perception of its role in the market place
 Identification of short-run and long-run production goals
 Marketing research
 Development of new products to meet changing needs of Consumers and business firms
 Development of new marketing strategies
 Advertising of the insurer’s products

Claims settlement department

Performs on the insurer’s obligations to insured’s to following losses. Overpayments result in non-
competitive rates. Underpayments result in fewer sales and more regulatory actions against the insurer.
Basic objectives in claim settlement
 Verification of a covered loss
 Fair and prompt payment of claims
 Personal assistance to the insured

Types of claim adjusters

 Agent
 Company adjuster
 Independent adjuster
 Adjustment bureau
 Public adjuster

Steps in settlement of a claim

 Notice of loss
 Investigation of the claim
 Filing of proof of loss
 Decision concerning payment

Investment department

Insurance investments is the process of deploying funds pending claim settlement.

Rationale for Insurance Investment

 Insurance is cash business
 Premium collected in advance and can be invested
 Until needed to pay claims and expenses

The investment department generates income to help lower rates. Investment risk should balance the
underwriting risk. Invest for time periods that balance policy payment periods (long for life, short for
general insurance. For example, auto and fire insurance). Broadly, the department is engaged in the
following activities:
 Earns income to help lower rates
 Investment risk should balance the underwriting risk.
 Invest for time periods that balance policy payment periods (long for life, short for general
insurance. for example, auto and fire insurance)

Reinsurance (Insurance of insurance companies) Department

Reinsurance is an arrangement by which an insurance company transfers all or a portion of its risk under
a contract (or contracts) of insurance to another company. The company transferring risk in a reinsurance
arrangement is called the ceding insurer. The company taking over the risk in a reinsurance arrangement
is the assuming reinsurer.

Reinsurance is effected through contracts called treaties, which specify how the premiums and losses will
be shared by participating insurers. Two main types of treaties exist—pro rata and excess-of-loss treaties.
In the former, all premiums and losses may be divided according to stated percentages. In the latter, the
originating insurer accepts the risk of loss up to a stated amount, and above this amount the reinsurers
divide any losses. Reinsurance is also frequently arranged on an individual basis, called facultative
reinsurance, under which an originating insurer contracts with another insurer to accept part or all of a
specific risk.
An example of excess-loss reinsurance
Original Policy Limit of Rs.200-crore, layered as multiples of primary retention
Rs. 25 crores Original insurer’s retention
Rs.100 crores First reinsurer’s limit
Rs.75 crores Second reinsurer’s coverage (remainder of the contract)

An example of proportional reinsurance

Total Premium Expenses Net premium* Loss
exposure (%) Rs in lakh Rs in lakh Rs in lakh Rs in Crore
Reinsurer 60 9 1.8 7.2 72
Ceding insurer 40 6 1.2 4.8 48
Total 100 15 3 12 120
Net premium*=Premium-Expenses

Assuming a 60:40 split of the premium, expenses, and a loss of Rs.150-crore, ignoring the ceding
commission
Insurance Ratios
By Yogita Khatri, ET Bureau

Persistency ratio
It gauges the trust customers have in the long-term products and services being offered by the insurer.

Persistency ratio = Number of policyholders paying the premium divided by net active policyholders,
multiplied by 100.

An indicator of customer satisfaction.

A high ratio indicates a large pool of satisfied customers; low persistency ratio indicates inability to
retain customers

Low persistency ratio indicates inability to retain customers

Data as on 31 March 2017; Source: Public disclosures by respective companies; Compiled by ComparePolicy.

Higher the persistency ratio, the better. “It implies that the associated policyholders are satisfied with the
product portfolio, customer service, post sales service, product utility, returns on their product, customer
loyalty, etc. and are renewing their policies as and when due,” says Harjot Narula, CEO, ComparePolicy.
According to the latest data available, Kotak Mahindra Old Mutual has the highest 61stmonth persistency
ratio, while Star Union has the lowest.

Solvency ratio
It defines how good or bad an insurance company’s financial situation is on defined solvency norms.
According to Irdai guidelines, all companies are required to maintain a solvency ratio of 150% to minimise
bankruptcy risk. “Solvency ratio helps identify whether the company has enough buffer to settle all claims
in extreme situations,”

An indicator of a company’s financial capacity to meet both short-term and long-term liabilities

High solvency ratio may not always mean good financial health, like in the case of Sahara.
Two state-owned insurance firms have among the lowest solvency ratios.

Data as of 31 Mar 2017; *Data available as of 31 Dec 2016; **Data as of 30 Sep 2016;
Source: Public disclosures by respective companies; Compiled by ComparePolicy.

Solvency ratio is calculated as the amount of Available Solvency Margin (ASM) in relation to the amount
of Required Solvency Margin (RSM). The ASM is the value of the company’s assets over liabilities, and
RSM is based on net premiums and defined as per Irdai guidelines.

Higher the solvency ratio, the greater the chances of your claims getting paid. There are unusual trends
insurance buyers should watch out for here. For instance, among all the 24 life insurance companies,
Sahara Life has the highest solvency ratio of 812%. However, this figure is misleading because the
company isn’t doing well financially. It has posted losses of Rs 4.57 crore for the third quarter ended 31
December, 2016. It had posted a profit of Rs 3.05 crore in the third quarter of the previous fiscal.

In fact, the insurance regulator has taken over the management of Sahara Life. In the general insurance
space, state owned Oriental Insurance and National Insurance have poor solvency ratios of 122% and 126%
respectively. Policy buyers should opt for companies that have maintained a good solvency ratio over the
last few years.

Combined ratio
This indicates a general insurance company’s total outflow in terms of operating expenses, commissions
paid, and incurred claims and losses on its net earned premium. Opt for companies with lower combined
ratio as it means that the expenses or losses of the company are lesser than its premium revenue for that
time period. “If the combined ratio is greater than 100%, it usually means the cash outflow of the insurance
company is more than its earned premium, which is not a healthy financial condition.

An indicator of operating expenses

A low ratio means expenses are less than premium revenue.

The higher combined ratio does not mean the company is running at a loss as the ratio does not include
earnings from investments or investment income.

Data as of 31 Mar 2017; *Data available as of 31 Dec 2016; Source: Public disclosures by respective companies; Compiled by ComparePolicy

According to the latest data available, Cigna TTK and Kotak Mahindra have one of the highest combined
ratios at 167% and 147%, respectively. However, do note that the higher combined ratio does not mean
the company is running at a loss as the ratio does not include earnings from investments or investment
income, say experts.

Incurred claims ratio

The ICR metric indicates a general insurer’s ability to pay claims. It is calculated as the total value of all
claims paid by the company divided by the total amount of premium collected in a financial year. For
instance, an ICR of 85% implies that the company has spent `85 on claims for every Rs 100 collected as
premium. An ideal ICR range should be between 75 and 90%, which indicates a healthy settlement of
claims by the insurer against the premium collection.

An indicator of insurer’s ability to pay claims. A high ratio is not always good news.
A healthy ratio is between 75 & 90%.

Data as of 2015-16; Source: Irdai; Compiled by ComparePolicy

An ICR greater than 100% may not be a good indicator. “It shows that a large part of the premium is used
to cover actual risk transfer,” says Verillaud. “But it is also a function of the company’s ability to avoid
fraud and select business,” he adds. A higher ICR can be seen in a new company which may not have
earned substantial premium in the initial years of operation and faced a high rate of claims. The ICR does
not reflect the company’s process of claim settlement. A company with a good ICR can have a long claim
settlement process.

5. Commission expense ratio

This ratio tells us what is the outflow towards commissions from the written premium during a particular
period. It is important to keep a tab on this ratio as it directly impacts the premium that you pay. After a
threshold, the higher the commission expense ratio, the lower the discount offered, leading to a higher
premium paid.

An indicator of expenses towards commissions. A low commission expense ratio will usually translate
to lower premiums
A high commission expense would translate to lower discounts offered.

Data as of 31 Mar 2017; *Data available as of 31 Dec 2016;

Source: Public disclosures by respective companies; Compiled by ComparePolicy

The lower the commission expense ratio, the better it is. Some companies may also have negative
commission ratios, like in the case of HDFC Ergo, ICICI Lombard and others. However, that doesn’t mean
it is always good. “Negative commission expense ratio could be due to various factors such businesses
where direct deals are done and no commission is paid like for crop insurance and mass health schemes
operated by the government in several states,” says Narula. In the life insurance space, Reliance Life
Insurance has the lowest commission expense ratio at 0.05%, while Max Life and Star Union have
commission ratio of about 9%.

6. Claims settlement ratio

This has to be looked at before you buy any insurance policy. Claim settlement ratio (CSR) indicates how
many claims a company has settled against the number of claims received. Higher the CSR, the greater are
the chances of settlement of a claim. It is also a measure of the insurer’s reputation. Among life insurers,
LIC has the highest claim settlement ratio of 98.33%.

An indicator of the number of claims settled. Always look for a high ratio

CSR is vital while buying term plans

Data as of 2015-16; Source: Irdai; Compiled by ComparePolicy

It means, out of every 100 claims received in a financial year, it has settled 98. “It is prudent to cumulatively
analyse the past few years’ claim settlement data to assess the trend for a particular insurer. You must not
ignore CSR especially before buying pure risk covers such as term plans.

“For other genres such as protection-cum-investment products, do look at other factors as well like returns,
guaranteed benefits, cost, tenure, portfolio, etc.,” says Narula. While all the ratios are important, none
should not be looked at in isolation. Along with these ratios, do consider all the parameters such as quality
of service, policy features, terms and conditions, etc, before making a purchase decision.
Source://economictimes.indiatimes.com/articleshow/59297010.cms?utm_source=contentofinterest&utm_medium=text&utmcampaign=cppst
Brief Note on Housing Finance Companies

HFCs extend housing finance to individuals, co-operative societies and corporate bodies and lease
commercial and residential premises to support housing activity in the country. The Finance (No.2) Act,
2019 (23 of 2019) has amended the National Housing Bank Act, 1987, conferring certain powers for
regulation of housing finance companies (HFCs) with the Reserve Bank of India. HFCs are henceforth
treated as a category of NBFIs for regulatory purposes. Non-banking financial institutions (NBFIs) are a
group of diverse financial intermediaries which, in a bank-dominated financial system like India, serve as
an alternative channel of credit flow to the commercial sector.

Salient features of revised framework of HFCs

Definition of Housing Finance Company

“Housing finance company” shall mean a company incorporated under the Companies Act, 2013 that
fulfils the following conditions:

(a) It is an NBFC whose financial assets, in the business of providing finance for housing, constitute
at least 60% of its total assets (netted off by intangible assets); and
(b) Out of the total assets (netted off by intangible assets), not less than 50% should be by way of
housing finance for individuals.

Definition of Housing Finance

“Housing Finance” shall mean financing, for purchase/ construction/ reconstruction/ renovation/ repairs of
residential dwelling units, which includes:
a. Loans to individuals or group of individuals including co-operative societies for construction/ purchase
of new dwelling units.
b. Loans to individuals or group of individuals for purchase of old dwelling units.
c. Loans to individuals or group of individuals for purchasing old/ new dwelling units by mortgaging
existing dwelling units.
d. Loans to individuals for purchase of plots for construction of residential dwelling units provided a
declaration is obtained from the borrower that he intends to construct a house on the plot within a period
of three years from the date of availing of the loan.
e. Loans to individuals or group of individuals for renovation/ reconstruction of existing dwelling units.
f. Lending to public agencies including state housing boards for construction of residential dwelling units.
g. Loans to corporates/ Government agencies for employee housing.
h. Loans for construction of educational, health, social, cultural or other institutions/ centres, which are
part of housing projects and which are necessary for the development of settlements or townships.
i. Loans for construction meant for improving the conditions in slum areas, for which credit may be
extended directly to the slum-dwellers on the guarantee of the Central Government, or indirectly to them
through the State Governments.
j. Loans given for slum improvement schemes to be implemented by Slum Clearance Boards and other
public agencies.
k. Lending to builders for construction of residential dwelling units.

Net Owned Fund (NOF) Requirement

In exercise of the powers conferred by clause (b) of sub-section (1) of Section 29A of the National Housing
Bank Act, 1987, and all powers enabling it in that behalf, the Reserve Bank hereby specifies Rupees
Twenty crore as the minimum net owned funds required for a company to commence housing finance as
its principal business or carry on the business of housing finance as its principal business. Provided that a
housing finance company holding a Certificate of Registration (CoR) and having net owned fund of less
than Rupees twenty crore, may continue to carry on the business of housing finance, if such company
achieves net owned fund of Rupees fifteen crore by March 31, 2022 and Rupees twenty crore by March
31, 2023.
Capital Requirement
Every housing finance company shall, maintain a minimum capital ratio on an ongoing basis consisting of
Tier-I and Tier-II capital which shall not be less than 13 per cent as on March 31, 2020; 14 per cent on or
before March 31, 2021; and 15 per cent on or before March 31, 2022 and thereafter of its aggregate risk
weighted assets and of risk adjusted value of off-balance sheet items. The Tier-I capital, at any point of
time, shall not be less than 10 per cent. The total of Tier-II capital, at any point of time, shall not exceed
100 per cent of Tier-I capita.

Degree of credit risk is expressed as percentage weightages assigned to balance sheet assets. Hence, the
value of each asset/ item requires to be multiplied by the relevant risk weights to arrive at risk adjusted
value of assets. The aggregate is taken into account for reckoning the minimum capital ratio.

Operations and Performance of HFCs

HFCs are specialised lending institutions which, along with Scheduled Commercial Banks (SCBs), are the
main providers of housing finance. HFCs’ credit to the housing sector accelerated in 2020-21, primarily
on account of low interest rates, availability of refinance as well as special refinance facilities and the
additional special refinance facility of the NHB (which amounted to ₹13,917 crore) backed by the Reserve
Bank under the Aatmanirbhar Bharat Abhiyaan. Bank credit to the housing sector, however, decelerated
in 2020-21 even though it remained higher than HFCs’ credit (Chart VI.43).

At the end of March 2021, there were 100 HFCs, of which only 16 were deposit taking entities. Five of the
latter need prior permission from NHB before accepting public deposits. Non-government public limited
companies dominate the segment, comprising 94.8 per cent of total assets. The combined balance sheet of
these entities experienced a growth in 2020-21 after a deceleration in 2019-20. The asset size of the lone
government HFC contracted in 2020-21 (Table VI.9).

Table VI.9: Ownership Pattern of HFCs

(At end-March-₹ crore)

2020 2021
Type
Number Asset Size Number Asset Size
1 2 4 5 7
A. Government Companies 1 79,535 1 76,959
B. Non-government Companies (1+2) 99 13,14,329 99 14,05,904
1. Public Ltd. Companies 75 13,09,762 78 14,01,522
2. Private Ltd. Companies 24 4,568 21 4,382
Total (A+B) 100 13,93,865 100 14,82,863
Note: Data are provisional;Source: NHB.
 Balance Sheet of HFCs
The consolidated balance sheet of HFCs grew in 2020-21 on account of steep growth in borrowings
from NHB, inter-corporate borrowing and reserves and surplus. On the asset side, loans and advances
registered a moderate growth while investments registered an impressive growth. On the other hand,
cash and bank balances, and other assets declined (Table VI.10).

Table VI.10: Consolidated Balance Sheet of HFCs

(At end-March-₹ crore)

Percentage variation
Items 2019 2020 2021
2020 2021
1 2 3 4 5 6
1 Share capital 34,048 36,858 37,696 8.3 2.3
2 Reserves and surplus 1,51,706 1,45,053 1,70,359 -4.4 17.4
3 Public deposits 1,05,895 1,19,795 1,26,691 13.1 5.8
4 Debentures 4,66,689 3,97,949 3,97,816 -14.7 0.0
5 Bank borrowings# 2,98,943 3,53,214 3,29,835 18.2 -6.6
6 Borrowings from NHB # 42,118 49,673 67,341 17.9 35.6
7 Inter-corporate borrowings 35,627 6,206 19,182 -82.6 209.1
8 Commercial papers 79,059 46,631 54,554 -41.0 17.0
9 Borrowings from Government*** 0 1,282 19,313 0 -
10 Subordinated debts 18,320 17,348 19,168 -5.3 10.5
11 Other borrowings 25,103 1,49,404 1,31,818 495.2 -11.8
12 Current liabilities 13,740 20,446 8,100 48.8 -60.4
13 Provisions^ 8,569 7,499 64,303 -12.5 757.5
14 Other* 40,021 42,508 36,686 6.2 -13.7
15 Total Liabilities/ Assets 13,19,840 13,93,865 14,82,863 5.6 6.4
16 Loans and advances 1,163,148 11,83,561 12,77,653 1.8 7.9
17 Hire purchase and lease assets 0 33 10 - -70.4
18 Investments 88,640 97,931 1,29,961 10.5 32.7
19 Cash and bank balances 33,166 56,955 36,864 71.7 -35.3
20 Other assets** 34,885 55,384 38,375 58.8 -30.7
^The sudden increase in provisions is due to high provision reported by one major HFC.
*includes deferred tax liabilities and other liabilities.
**includes tangible & intangible assets, other assets, and deferred tax asset.
*** includes borrowings from foreign government also.
# Figures have been revised.
Notes: Data are provisional.
Source: NHB.

Resource Profile of HFCs

HFCs primarily rely on debentures and bank borrowings for funds, which constitute around 66 per cent of
total resources (Chart VI.44). The dependence of HFCs on bank borrowings decelerated in 2020-21;
however, dependence on borrowings from NHB and public deposits increased, reflecting their reliance on
long term-resources amidst risk averse market conditions.

Public deposits, another important source of funding, decelerated in 2020-21 (Chart VI.45). Furthermore,
the share of deposits in total liabilities of HFCs has been steadily declining since 2015-16 till 2020-21 with
the exception of 2019-20.

The distribution of deposits with HFCs in 2020-21 shows that there is a concentration of deposits in the 6-
9 per cent interest rate bracket. A significant growth has been observed in deposits in the below 6 per cent
interest rate bracket due to the low interest rate environment (Chart VI.46). The maximum share of deposits
is in the maturity bracket of 24 to 48 months.
Financial Performance
The consolidated income of HFCs decelerated in 2020-21 on account of moderation of fee income
and stagnant fund income. Income as a proportion to total assets decreased on account of decrease
in fund income (Chart VI.47).

Furthermore, expenditure also decreased mainly on account of deceleration in both financial

expenditure and operating expenditure. As a result, there was a significant decrease in the cost to
income ratio in 2020-21. Meanwhile, the RoA reached zero (Table VI.11).

Table VI.11: Financial Ratios of HFCs

(As per cent of Total Assets)
(At end-March)
Particulars 2017 2018 2019 2020 2021
1 2 3 4 5 6
Total Income 10.0 9.0 9.9 10.2 8.7
1. Fund Income 9.8 8.8 9.7 10.1 8.6
2. Fee Income 0.2 0.2 0.2 0.1 0.1
Total Expenditure 7.4 6.6 7.9 8.8 6.7
1. Financial Expenditure 6.4 5.6 6.4 6.4 5.4
2. Operating Expenditure 0.9 1.0 1.5 2.4 1.3
Tax Provision 0.8 0.7 0.7 0.6 0.9
Cost to Income Ratio (Total Exp./Total Income) 73.6 73.6 79.3 86.2 76.4
Return on Assets (RoA) (PAT/Total Assets) 2.1 2.0 1.4 -0.2 0.0
Note: Data are provisional. Source: NHB.

Soundness Indicators
The GNPA ratio of HFCs increased in 2020-21. However, the NNPA ratio decreased in 2020-21
on account of significant increase in provisioning. Two major HFCs registered spikes in their
GNPA and NNPA ratios in 2020-21. Excluding these two major HFCs, GNPA and NNPA ratios
stood at 3.1 per cent and 1.7 per cent, respectively, in 2020-21 (Chart VI.48a and b).
To sum up, in 2020-21, HFCs have been able to sustain momentum with moderate growth in
credit demand. After the outbreak of COVID-19, several regulatory and liquidity measures were
announced by the Reserve Bank, along with the announcement of the Aatmanirbhar Bharat
Abhiyaan by the Government, which resulted in an improvement in the liquidity position of
HFCs. The recent uptick in sales of housing inventories on account of reopening of economy, the
benign interest rate environment and incentives in stamp duty reductions aided the sector.
Furthermore, HFCs took several proactive steps to counter the impact of the pandemic on their
business by adopting work-from-home processes which helped in ensuring continuity of business
even during the lockdown and made them digitally enabled for sourcing, processing, and
disbursing loans. Efforts towards digitisation also might have contributed towards reducing their
operating expenditure.

Risks Faced by Housing Finance Companies

Credit Risk: The risk of loss that may occur from the failure of any party to abide by the terms
and conditions of any contract, principally the failure to make required payments of amounts due
to the Corporation. In its lending operations, the Corporation is principally exposed to credit risk.
The credit risk is governed by various Product Policies. The Product Policy outlines the type of
products that can be offered, customer categories, the targeted customer profile and the credit
approval process and limits.
Funding Risk: The risk associated with lack of availability of funds to meet the projected planned
business targets.
Liquidity Risk: The risk that the entity will not have sufficient funds available to pay creditors
and other debts and meet day to day obligations under the normal course of business.
Interest Rate Risk: In view of the financial nature of the assets and liabilities of the housing
finance companies, changes in market interest rates can adversely affect its financial condition.
The fluctuations in interest rates can be due to internal and external factors. Internal factors
include the composition of assets and liabilities across maturities, existing rates and re-pricing of
various sources of borrowings. External factors include macroeconomic developments,
competitive pressures, regulatory developments and global factors. The rise or fall in interest rates
impact the Net Interest Income depending on whether the Balance sheet is asset sensitive or
liability sensitive.

Business or operating risk: Business or operating is the financial risk generally associated with
internal and external systems for the monitoring, negotiation and delivery of financial
transactions. The risks are wide-ranging and can include natural disasters, human error, and
breakdown of financial systems or failure of electronic systems
Forex Risk: Foreign exchange risk arises from future commercial transactions and recognised
assets and liabilities denominated in a currency that is not the company’s functional currency i.e.
INR.
Price Risk: This risk arises from investments held by the HFCs. To manage its price risk arising
from investments in equity/debt securities, HFCs usually diversify their portfolio. Diversification
of the portfolio is done in accordance with the limits set as per investment policy of the HFC.
Sources:
 Report on Trend and Progress of Banking in India, December 2021
 Master Direction – Non-Banking Financial Company – Housing Finance Company (Reserve Bank) Directions, 2021
 HDFC Annual Report 2019-2020
Comparison of Top 10 Housing Finance Companies

Quantitative Analysis of Housing Finance Sector

Introduction

Housing finance sector was growing at a healthy rate before the ILFS and DHFL crisis. Post that
due to liquidity crunch and the corona virus pandemic, the sector is impacted badly. This is
because of the de-growth of housing credit as well as worsening asset qualities due to lower
disposable income. Let us do a quantitative analysis of housing finance sector in India and find
out how the sector is treading through these difficult times.

Please note that we have done this analysis with the only purpose of screening good companies.
Analysis done is completely on quantitative basis. No suggestions are being made to directly go
and invest in the top scoring companies of this analysis. We suggest that one should perform a
qualitative analysis of top scoring companies in this analysis and take investment decision based
on risk profile.

Housing Finance Quantitative Analysis

Companies selected for analysis:

Housing Finance Companies Market Capitalization

 These 10 companies are analysed on following parameters and ranked and scored
accordingly. For example, if a company has higher PE ratio, it has a lower rank, hence
has scored lesser points. Similarly, if a company has higher RoE, it has higher rank and
has scored higher points.
 Here , 1 means that the company has scored lowest points and 10 means the company has
scored highest points.
 At the end, we have added all the points together and companies are ranked accordingly.
Valuation Ratios
1. PE

Housing Finance Companies PE

 PE is basically how much an investor pays for each rupee of profit earned. Here, we have
considered consolidated PE.
 Repco Home Finance is trading at cheapest valuations, whereas Avas Financiers has the
highest PE.
 HDFC is trading at a moderate PE of 14.5x
 Since PE ratio for DHFL is not available, it is ranked at last position.

2. PB

Housing Finance Companies PB

  PB is basically the price that an investor pays for book value of the company per share.
 It is also a valuation metric and it is more relevant in case of banks and other financial
institutions as most of their assets and liabilities listed at market price.
 Here, Indiabulls Housing Finance is trading at lowest PB whereas Avas Financiers is
trading at highest PB of 4.45 x.

3. Return on Equity (RoE)

Housing Finance Companies RoE

 One of return ratios that is used widely in fundamental analysis is Return on Equity (RoE)
which is Net Income/ Total Shareholder’s equity (Equity share capital +
Reserves/Surplus).
 For banks and financial institutions, RoCE is usually not that relevant. Hence we have not
considered RoCE in this analysis.
 Here, HDFC Ltd tops the list with RoE of 22%.
 PNB Housing Finance Ltd has the lowest RoE of 8.9% and hence it has lowest rank.
4. Return on Assets (RoA)

Housing Finance Companies RoA

 For housing finance companies, core assets are mainly the loans it has given to its
customers. Its core operating income is basically interest earned on these loans.
 Hence, it is important to look at how much income these assets are earning for these
companies.
 Return on Assets (RoA) is Net Income/Total Assets.
 Here, Avas Financiers has highest RoA, followed by HDFC Limited.
 PNB Housing Finance and Dewan Housing Finance have lowest RoA and hence are
ranked at lowest position.

5. Pledged Promoter Shares

Housing Finance Companies Pledged Promoter shares

  Pledged Promoter shares is also a parameter of corporate governance and ideally there
should not be any shares pledged by promoter.
 Here, except for DHFL, none of the companies have any pledged promoter shares.
 Hence DHFL is ranked and scored lowest.

6. Institutional Holding (FII + DII)

Housing Finance Companies Institutional Holding

 According to corporate governance parameters, more the institutional holding, the better
it is.
 Here, as seen HDFC has highest institutional holding, followed by Indiabulls Housing
Finance.
 Since HDFC is a part of NIFTY 50, it has passive funds inflow, resulting in higher
institutional holding.
 Here, HUDCO has lowest institutional holding and hence it is ranked at last position.
7. 5 Year Sales and Net Profit growth

Housing Finance Companies 5 Year Sales and Net Profit growth

 If we take a look at 5 Year Sales and Net Profit growth, Avas Financiers has stellar 5 Year
Sales and Profit growth.
 On the other hand, Indiabulls Housing Finance has lowest sales and net profit growth and
hence it is ranked at last position.

8. 3 – Year Sales and Net Profit growth

Housing Finance Companies 3-Year Sales and Net Profit growth

  If we take a look at 3 year sales and net profit growth, here also Avas Financiers leads the
list with highest growth.
 This shows that there is consistency in company’s sales and net profit growth.
 On the other hand, Indiabulls Housing Finance has lowest sales and net profit growth.
Hence, it is ranked at last position.

9. Net Interest Income (NII) as a % of Operating Income

Housing Finance Companies Net Interest Income as a % of Operating Income

 Net Interest Income (NII) is Interest Income – Interest Expended.

 This metric shows how much operating profit is earned from company’s core business.
 Here, GIC Housing Finance has the highest NII share in operating income, whereas
Indiabulls Housing Finance has lowest.
10. Average Loan to Value

Housing Finance Companies Average Loan to Value

 Loan to Value is the ratio of borrowed money divided by the appraised value of the
property.
 The lesser the Loan to Value ratio, the better it is. This means that the company is
conservative in providing finance and thus ensures the asset quality of the company.
 Here, Repco Home Finance has lowest loan to value ratio, hence it ranks first.
 On the other hand, GIC Housing Finance and DHFL have highest loan to value ratio and
hence they are ranked at last position.

11. Retail Housing Loans % of total loans

Housing Finance Companies Retail Loans %

  Retail Loans are usually considered safer as compared to wholesale loans. Hence, higher
proportion of retail loans is considered good during normal circumstances.
 Here, Can Fin Homes have highest proportion of retail loans in their loans and hence it
ranks at first position.
 HUDCO has lowest proportion of retail loans and hence it is ranked at last.

12. Salaried Individuals in Individual Loans

Housing Finance Companies Salaried %

 Probability of salaried individuals defaulting on loan is lesser than those of non-salaried

people. Hence, higher the % of salaried individuals in individual loans, the better as it
ensures to have stable asset quality.
 Here, LIC housing Finance has highest % of salaried individuals, followed by HDFC.
 Aavas Financiers has lowest salaried individuals in loan mix and hence it ranked at last
position.
13. Gross NPA

Housing Finance Companies Gross NPA

 NPAs stand for Non- Performing Assets. These are the loans which have turned into bad-
loans, thus affecting company’s profitability.
 Aavas Financiers have lowest Gross NPAs, thus indicating superior asset quality. Hence
it is ranked at first position.
 Here, DHFL has highest Gross NPAs and hence it is ranked lowest.

14. Moratorium as a % of total loans

Housing Finance Companies Moratorium as % of total loans

 Moratorium is the period in which borrower can skip EMIs. Once the moratorium is over,
borrower will start paying in EMIs. However, borrower has to pay interest on the period
of moratorium as well.
  Till 31st August ’20, RBI had mandated all financial institutions to provide moratorium to
the customers if required.
 However, since pandemic has affected salaried, self-employed personnel as well as
corporates, chances of loans under moratorium turning to bad loans is higher.
 Thus, lower the loans under moratorium, the better.
 Here, Can Fin Homes has lowest % of loans under moratorium and hence it ranks first.
PNB Housing Finance has highest % of loans under moratorium and hence it ranks
last.

15. Net Interest Margin

Housing Finance Companies NIM

 Net Interest Margin (NIM) is Net Interest Income/ Total income bearing assets. Higher
the NIM, the better it is.
 Here, Aavas Financiers again tops the list with NIM of 6.2%. On the other hand, Indiabulls
Housing Finance has lowest NIM of 0.85% and hence it is at lowest rank.
16. Cost to Income

Housing Finance Companies Cost to Income

 Cost to income is another efficiency ratio which affects the profitability. The lower the
cost to income ratio, better it is.
 HDFC Ltd has lowest cost to income, which also indicates that the company is managing
its costs quite efficiently.
 HUDCO has highest cost to income ratio and hence it is ranked at last position.
17. Capital Adequacy Ratio (CAR)

Housing Finance Companies CAR

 Capital Adequacy ratio is basically capital available as compared to company’s risk

weighted assets. Higher the CAR, the better it is as it indicates the capacity of the company
to sail through COVID pandemic and its after effects.
 Here, HUDCO has highest CAR of 57% as there is some capital infusion by government.
 Aavas Financiers also has a good CAR of ~56%. Overall except for DHFL, this sector
seems to be well capitalized.
 DHFL and LIC housing Finance have lowest CAR and hence they are ranked lowest.
18. Number of outlets

Housing Finance Companies Number of outlets

 Higher the number of branches, better the geographical diversification a company has.
 This also plays a part in keeping asset quality under check. However, it comes with the
cost of increased operating expenses.
 HDFC has a very good reach across the country with 585 outlets. Hence it is ranked at
first position.
 GIC Housing Finance has least number of outlets pan India and hence it is at lowest
position.

Final Points

Housing Finance Companies ranked as per Quantitative Analysis

https://blog.investyadnya.in/comparison-of-top-10-housing-finance-companies/
Rating of Housing Finance Companies

Housing Finance
Housing is a significant engine for growth and development of the economy. Housing and
housing finance activities in India have witnessed tremendous growth over the years. Some of
the factors that have led to this growth are - tax concessions to borrowers, increase in disposable
income levels, changing age profile of the borrowers, easy availability of loans, nuclear families
and urbanization, etc. The proportion of Mortgages to the Gross Domestic Product (GDP) ratio
for India is much lower than that for developed countries. As per 11thFive Year Plan (2007-2012)
the total number of houses that would be required cumulatively in the plan period is slated at 45
million units (7 million backlog plus 38 million additional units) which will require an investment
of around Rs.10 trillion between 2007-2012, i.e. Rs.2 trillion per year.
Methodology Process
The rating process takes about two to three weeks, depending on the complexity of the assignment
and the flow of information from the client. Ratings are assigned by the Rating Committee.
CARE’s ratings are an opinion on the relative ability and willingness of an issuer to make timely
payments on the specific debt obligations over the life of the instrument. CARE has developed a
comprehensive methodology for credit rating of debt instruments issued by HFCs.

Some of the factors considered in CARE’s analysis for rating HFCs are described below:
Quantitative Factors

The starting point of analysis is a detailed review of key measures of financial performance and
stability:

a) Capital Adequacy
Capital Adequacy ratio (CAR) is a measure of the degree to which the company’s capital is
available to absorb possible losses. High CAR indicates the ability of the company to undertake
additional business. Debt equity ratio is also examined as a measure of gearing. CARE examines
the conformity of the company to the regulatory guidelines on capital adequacy norms and further
examines the capital adequacy on the basis of expected erosion of capital arising as a result of
factors such as:

Additional provisioning for NPAs

Possible losses from other weak assets

CARE also examines the trends and pattern of growth in the last three years in both Tier I &Tier
II capital. Ability of the HFC to raise additional capital commensurate with the projected growth
in assets is critically evaluated.

b) Asset Quality
Asset Quality review begins with the examination of the company’s credit risk management
framework. Sound credit appraisal system & rigorous post sanction follow up mitigate credit risk.
CARE studies robustness of the HFC’s credit appraisal process by examining the quantitative and
qualitative parameters used in selecting the borrower. Loan portfolio is examined in terms of LTV
(Loan to Value) ratios, IIRs (Installment to Income ratios), age profile of the borrowers, tenure
of the loans and class of the borrowers like salaried, self -employed etc. CARE also considers
diversification of the portfolio into project financing, builder loans, reverse mortgages etc. The
historical collection efficiency and the company’s experience of loan losses and write-
offs/provisions are studied. The proportion of assets classified into standard, substandard,
doubtful or loss and the track record of recoveries of the company is examined closely.

c) Resources
Resource base of the company is analyzed in terms of cost and composition. Various options
available to HFCs to raise resources include borrowings from banks/Financial institutions, market
borrowings, refinance from NHB etc. Average as well as incremental cost of funds is examined
in the context of prevailing interest rate regime. Ability of the company to raise additional
resources at competitive rates is examined critically. Ability of the promoters to bring in funds
and access to equity/debt markets in India or abroad are also taken into account.

d) Liquidity
Lack of liquidity can lead an HFC towards failure, while, strong liquidity can help even an
otherwise weak company to remain adequately funded during difficult times. CARE evaluates
the internal and external sources of funds to meet the company’s requirements. Generally, HFCs
in India finance their loan advances that have longer maturity with borrowings of lower maturity.
The liquidity risk is evaluated by examining the assets liability maturity (ALM) profile, collection
efficiency and proportion of liquid assets to total assets. CARE also evaluates the steps taken by
HFCs such as securitization of mortgages to manage their ALM profile. Short term external
funding sources in the form of unutilized lines of credit available from banks etc. along with other
investments if any are important sources of reserve liquidity.

e) Earnings Quality
Profitable operations are essential for HFC to operate as a going concern. Each business area that
contributes to the core earnings is assessed for risks as well as for its earnings prospects and
growth rate. Yield on business assets and investments are viewed in conjunction with cost of
funds to arrive at the spreads earned by the company. Interest cover is also a useful indicator of
the extent of cover over the interest paid by the company. Operating efficiency is examined in
terms of expense ratios. Quality of company’s earnings is also influenced by the level of interest
rate and foreign exchange rate risks that the company is exposed to. Finally, the overall
profitability is examined in terms of, return on capital employed, return on assets and return on
shareholders’ funds.
Evaluation of quantitative factors is done, not only of the absolute numbers and ratios, but their
volatility and trends as well. The attempt is to determine core measures of performance. CARE
also compares the company’s performance on each of the above parameters, with its peers.
Detailed inter-company analysis is done to determine the relative strengths and weaknesses of
the company in its present operating environment and its prospects.

Qualitative Factors

Some of the qualitative factors that are deemed critical in the rating process are:

a) Ownership
Ownership pattern and track record of the promoters’/group companies is examined. Strong
promoters are more likely to provide support to the company in times of crisis.

b) Management quality
The composition of the Board, credentials of the CEO and the organisational structure of the
company are considered. The company’s strategic objectives and initiatives in the context of
resources available, its ability to identify opportunities and track record in managing stress
situations are taken as indicators of managerial competence. Adequacy of the information
systems used by the management is evaluated. CARE focuses on modern practices and systems,
degree of computerisation, capabilities of senior management, personnel policies and extent of
delegation of powers.
c) Risk Management
The management stance on risk and risk management framework is examined. Credit risk
management is evaluated by examining the appraisal, monitoring and recovery systems and
prudential lending norms of the company. The company’s policy and exposure to interest rate
and foreign currency risk is examined. Interest rate risk arises due to differing maturity of assets
and liabilities and mismatch between the floating and fixed rate assets and liabilities.
Pre-payments of fixed rate housing loans tend to rise when interest rates decline and increase the
interest rate risk of HFCs. Foreign currency risk arises due to difference in currency denomination
of assets and liabilities. The derivatives and other risk management products used in the past and
implication of these deals are also analysed.

d) Compliance with statutory requirements

CARE examines track record of the company in complying with regulatory requirements of NHB.

e) Accounting Quality
Rating relies heavily on audited data. Policies for income recognition, provisioning and valuation
of investments are examined. Suitable adjustments to reported figures are made for consistency
of evaluation and meaningful interpretation.

f) Size and Market Presence

The fund base and branch network of the company may have a bearing on the company’s
competitive position. While both large and small companies have successfully co-existed in India,
in the rapidly changing competitive environment, the niche strategy of smaller companies against
the scale advantages of larger players/banks would be carefully examined to understand the
business model of each company. All relevant quantitative and qualitative factors are considered
together, as relative weakness in one area of the company’s performance may be more than
adequately compensated for by strengths elsewhere. However, the weightage assigned to factors
are different for short term ratings and long term ratings. The intention of long term ratings is to
look over a business cycle and not adjust ratings frequently for what appear to be short term
performance aberrations. The quality of the management and the competitiveness of the company
are of greater importance in long term rating decisions.

The rating process is ultimately a search for the fundamentals and the probabilities for change in
the fundamentals. The assessment of management quality, the company’s operating environment
and its role in the nation’s financial system is used to interpret current data and to forecast how
well the company is positioned for the future. The final rating decision is made by the Rating
Committee after a thorough deliberation on the rating report on the company.

Disclaimer
CARE’s ratings are opinions on the likelihood of timely payment of the obligations under the
rated instrument and are not recommendations to sanction, renew, disburse or recall the concerned
bank facilities or to buy, sell or hold any security. CARE’s ratings do not convey suitability or
price for the investor. CARE’s ratings do not constitute an audit on the rated entity. CARE has
based its ratings/outlooks on information obtained from sources believed by it to be accurate and
reliable. CARE does not, however, guarantee the accuracy, adequacy or completeness of any
information and is not responsible for any errors or omissions or for the results obtained from the
use of such information. Most entities whose bank facilities/instruments are rated by CARE have
paid a credit rating fee, based on the amount and type of bank facilities/instruments. CARE or its
subsidiaries/associates may also have other commercial transactions with the entity. In case of
partnership/proprietary concerns, the rating /outlook assigned by CARE is, inter-alia, based on
the capital deployed by the partners/proprietor and the financial strength of the firm at present.
The rating/outlook may undergo change in case of withdrawal of capital or the unsecured loans
brought in by the partners/proprietor in addition to the financial performance and other relevant
factors. CARE is not responsible for any errors and states that it has no financial liability
whatsoever to the users of CARE’s rating.
Our ratings do not factor in any rating related trigger clauses as per the terms of the
facility/instrument, which may involve acceleration of payments in case of rating downgrades.
However, if any such clauses are introduced and if triggered, the ratings may see volatility and
sharp downgrades.
https://www.careratings.com/financial-housing-finance.aspx
COVID-19 Challenges and Economics of Bartering

Businesses and individuals are thinking beyond cash and embracing bartering.

16 May, 2020 by Vinay Dutta

The surge of COVID-19 cases from a relatively minute number of cases in China to a global
pandemic has transformed every sector and all aspects of our lives with alarming velocity.

As a result of the onslaught of the COVID-19 pandemic, many businesses are saddled with
inventories, excess capacities, and are short of cash or access to credit. Businesses are finding
it challenging to increase cash flow and reinforce its predictability. Likewise, the general public
too is facing an acute shortage of goods and services. So how are people responding? Experts
opine that by nature, humans always had a sort of quid-pro-quo exchange-based mentality.
Accordingly, businesses and individuals are thinking beyond cash and embracing bartering.

These are a few extracts from the “559 COVID-19 BARTER Public Group | Facebook”, which
shows how people are reaching each other for exchanging goods and services to overcome
Corona Virus pandemic.

 Nancy Tor22 March at 18:29

I have a 3 pack Huggies wipes I’d like to trade for some Lysol spray and some cleaning wipes.
 Stephanie Fields 22 March at 20:29
Does anyone have alcohol wipes? Asking for a friend who needs them for insulin shots. I have
food items to trade.

It is evident that bartering can play a vital role in situations like COVID-19 and recessionary
environments when the world yearns for a return to normal. 

But what is bartering and how can it benefits individuals and businesses, let's see:
Need to think of bartering again

Barter was the charter before the advent of the cash economy wherein individuals and businesses
use cash as a medium of exchange. Simply put, bartering is also referred to as reciprocal trade.
It is the method of payment in the form of products and services, not in cash. It is a trade where
parties try to exchange products or services of equivalent values. Obviously, the bartering
arrangement requires businesses to incur substantial search costs in terms of timing, and energy
to find a mutual coincidence of needs. Each party should have what the other wants, and
whatever is being bartered must be the identical value. Also, timing has to match and both parties
should agree on the value of each other’s products. Assigning value is essentially a big challenge
in barter deals. Apparently, such deals are not easy to come upon and make barter unrealistic.
Perhaps, for this reason, Adam Smith, the great economist, called a man a “bartering savage”, as
if each word was apt for the other.

Barter exchange- a substitute to cash transactions

Inferable to constraints of direct barter, a unique type of barter system, the barter exchange,
evolved. Barter exchange provides a creative multiparty and multilateral trading platform and is
a cashless business proposition. Unlike traditional one-to-one barter, the exchange maintains a
database of businesses willing to barter and allows for a great deal of barter flexibility. Here,
members can contact any other member on a database of the Exchange to buy or sell products
and services they require. Take, for example, B-School might want ad-space in a newspaper.
The newspaper needs gift hampers for running a promotional campaign. In turn, the gift supplier
is interested in training its executives in a financial management program floated by the B-
School. Using barter network, these parties can fulfil each other’s requirements without using
cash. 

In a way, bartering is taking business beyond the “money mentality” and placing value on human
resources and commodities instead of money. Bartering cannot substitute all cash transactions.
But it can definitely complement the cash business, amid the deadly COVID-19.

Multilateral barter system

A barter exchange is an association of businesses that agree to barter products and services
among themselves, without one-to-one restriction, using accounting units called trade credits,
equivalent to the rupee value of goods and services offered. Trade rupees are a unique currency
only accessible to reciprocal traders. The exchange operates the multi-party and multilateral
trading program, acts as a third-party record-keeper of trade transactions, develops member-
network, facilitate marketing of product and services, and provide support in deal structuring. It
manages and controls bartering among members. Moreover, it’s a combination of the ancient
practice of trading goods and services and modern accounting technology with the power of
networking. The arrival of online bartering sites and leveraging of technology has made
multilateral bartering more common. 

What does IRTA have to say?

US-based International Reciprocal Trade Association’s (IRTA), President and CEO Ron

Whitney says participation in a barter exchange can provide an important jumpstart for new
businesses. IRTA, a non-profit organization, pro-actively advocates preserving, protecting, and
enhancing the global barter industry. IRTA members exemplify the exchanges that have and
continue to positively outline the barter industry by successfully delivering the trade's values
throughout the world. As per IRTA, the key to the growth of the barter industry results from
the shift from one-on-one trading to third-party trading and the subsequent development of
sophisticated internet-based software. It not only maximizes trading opportunities but also
provides quality accounting and reporting functionality.

But why opt for bartering?

To overcome the Corona Virus Challenge-COVID-19, going back to the barter system can
offer a solution. The modern bartering process makes it possible for businesses to optimally
utilize production capacity and facilitate the disposal of non-performing and illiquid assets,
especially during adverse economic conditions, to regain lost revenues.

Barter is particularly recommended for companies dealing in time-sensitive inventories and

perishable assets with a limited shelf-life, such as media, airtime, ad-space, hotel room, etc. It
suits businesses with high margins, spare capacity, and those saddled with the slow-moving
inventory. Businesses can use barter to achieve specific business goals, including conserving
cash, increasing sales, moving inventory, seeking new distribution channels, utilizing excess
production capacity and thereby increasing profitability, and gaining a competitive edge.

In India, barter trade gained momentum following the credit crunch, recession, and
demonetization. Therefore, individuals and businesses can reconsider the possibility of
bartering to exchange goods and services during COVID-19 to help each
other. Acknowledging the importance of barter, Albert Einstein, said “If I had my life over
again, I would elect to be a trader of goods, rather than a student of science. I think barter is
a noble thing."

Disclaimer: The views expressed in the article above are those of the authors' and do not necessarily represent or
reflect the views of this publishing house

Source: http://bweducation.businessworld.in/article/COVID-19-Challenges-And-Economics-Of- Bartering-/16-05-

2020-192178/
Barter is Booming
Article 1: Businesses That Barter

The International Reciprocal Trade Association (IRTA) reports that there are approximately
500,000 existing retail trade members and corporate barter company trade members around the
world representing a $16 billion a year business. Experts estimate that 65 percent of Fortune
500 companies engage in barter to one degree or another, and the volume of barter trade is
expanding at 15 percent per year.
According to the U.S. Department of Commerce, barter accounts for 30 percent of the world’s
total business. In all likelihood that percentage will increase in the years ahead. And in all
likelihood, you as a small-business owner will find yourself playing the barter game sooner
rather than later.
In deciding whether or not to get involved in barter, the first question a small-business person
must ask is: Do I have something to barter? The answer is yes for most of the small businesses.
If you have excess inventory, you have goods to barter. If you’re a service provider with the
capacity to handle more clients, you have expertise to barter.
To make bartering payoff for your business, experts suggest that you have a 30-percent to 35-
percent profit margin on the products or services you offer in barter. This profit margin covers
the costs of barter and allows a small business to get the best out of a barter deal.
So, your small business has excess service capacity and has the required profit margin on the
goods it wants to offer in barter. The next question is: What are the benefits of barter?
Article 2: Barter Benefits: Cash and Inventory Control

In business, bartering helps you conserve cash and more effectively manage inventory.

“Barter has always been used by business as an efficient way of increasing sales and decreasing
cash expenditures,” said Richard L. Cravatts, CEO and founder of BarterItOnline.com.
Cash savings is cited as the number one benefit of barter. By bartering, a small business
acquires goods or services without spending cash. This is a definite plus for businesses that
suffer cash flow problems or for those trying to save cash. Barter can also help speed the
payment of receivables. Slow-paying or non-paying customers can relieve their debts by
bartering.
Bartering helps reduce cash outlays for overhead costs. Many of the services offered through
barter—such as accounting, cleaning, gifts, restaurant meals and travel—relate to overhead
costs. If you can obtain these overhead services through barter rather than writing out a check,
you’re saving cash.
“The reason I like barter is because it’s an effective way of retaining cash when you need to
buy something for your business,” says Trent DiGiulio, founder of Computer Animation
Technology and a member of the barter organization Tradaq. “People still need cash, and barter
is helpful in preserving cash as a resource. Plus, there are a lot of operational costs that are well
suited for trading.”
Barter can also provide businesses with an extended line of credit for little or no interest. When
you barter, you can owe people goods or services, not money. So you pay no interest on the
debt—a major cash savings.
Bartering also allows you to improve inventory management by converting excess products
into valuable goods and services. If you barter, you avoid having to liquidate excess inventory
through drastic discounting. If your small business experiences seasonal markets, barter
provides a profitable way to use the inventory on a regular basis.
Article 3: Barter Benefits: Marketing
Barter gives a small business access to new markets and customers. Through bartering, small
businesses use a new marketing channel to offer products. Bartering lets you interact with new
businesses and make new contacts. This helps develop new markets and expands your
marketing dollars.
Many companies involved in barter work in some aspect of the advertising business, whether
it’s graphic design, printing, layout, audio/visual production, newspaper ad sales or
broadcasting ad sales. In many cases, barter with these types of businesses can help improve
the quality of your company’s advertising campaign and marketing materials.
Bartering also helps generate referrals. As a small business barters, it extends its outreach and
contacts new customers. This in turn helps generate referrals that can bring cash-paying
customers to your door.
Barter gives a small business immediate access to a network of other businesses. In some cases,
these contacts may lead to cash sales outside the barter exchange, expanding the market for no
additional marketing cost.
“We use our Tradaq dollars for photography and other marketing projects,” says Gillian
Schultz, vice president of Metronet Safe and Sound. “We are able to use those items gained
through the Tradaq network for marketing to non-barter, cash customers.”
Metronet Safe and Sound also uses barter for customer and employee rewards. “We have
purchased gifts such as artwork, clothing, weekend stays, food and crystal through the Tradaq
network to show appreciation for clients and employees,” explains Schultz.
Article 4: One-on-One Barter
Okay. You have some excess inventory. You understand the benefits of barter. Now you want
to get started. How do you find someone to barter with? The beauty of barter is its simplicity.
You find a business that has something you need and you offer to barter something you have
in return.
When you begin to barter, keep it simple. Try to make a few one-on-one barter deals with folks
that you already do business with. Arranging a one-on-one barter is a matter of creative
thinking. Say you’re an accountant. Does a car detailing company owe you money? Why not
take payment in a free car wash? Are you a graphic artist who created menus for a restaurant
that now owes you money for the work? Take payment in meals and invite one of your cash-
paying clients out for a feast.
Small businesses regularly barter for advertising with radio and television stations, as well as
with local periodicals. Bartering for media placement gives you maximum exposure at
minimum cost. “During the 1990s, more than half of the mass media purchased was not
purchased at all, but bartered for,” writes Jay Conrad Levinson in his book Mastering Guerilla
Marketing (Mariner Books, 1999).
“I started my business by bartering with advertisers,” says chef Steve DeShazo, founder of
Gourmet on the Go in Texas and a member of Tradaq. “In the past, the problem was to match
two people who had exactly what the other one wanted. Now we have thousands of companies
to barter with. I absolutely perceive barter as a tool for growth.”
As DeShazo discovered, the more involved you become with bartering, the more you’ll find
that one-on-one barter deals can’t meet all of your needs. In that case, you’ll want to set up a
three-way barter deal. It goes something like this: You trade your goods or services to X
company. X company trades goods or services to Y company. You receive goods or services
from Y company.
Sound complicated? It is—or can get complicated fast. That’s why many business owners rely
on barter exchanges.
Article 5: Local Barter Exchanges
Local barter exchanges pave the way for three-way barter deals. A barter exchange is a business
organization engaged in the exchange of products and services without the use of cash.
Basically, the barter exchange arranges for a whole bunch of three-way barter deals. The
exchange finds businesses with goods or services to barter, arranges for different businesses to
trade for different services, and keeps track of everything for all the members of the exchange.
The barter exchange acts as a fiduciary agent in any barter arrangement. Typically, trades on
local barter exchanges range from $10 to $10,000. The fees that the exchanges charge usually
consist of membership dues ($300 - $600) and a small percentage of the transaction cost
(10percent to 15 percent).
The easiest way to select a local exchange is to look in the yellow pages under “barter services”
or “trade services.” The International Reciprocal Trade Association (IRTA), the industry’s
main interest group, estimates that there are more than 400 barter organizations in the United
States and that more than half of these barter exchanges are independent, locally-owned
businesses. The rest are local branches of national exchanges.
Well-established, locally-owned barter exchanges may have between 500 and 1,000 members,
although a high number of members is not the only indicator of an exchange’s stability or
effectiveness.
The benefits to joining a local barter exchange include:
 Greater possibilities for trade
 Reasonable fees
 Personalized customer service
 Flexibility
 Local management
Article 6: National Barter Exchanges

As you conduct research into local exchanges, you’ll come across some trade groups with
worldwide reach. The biggest benefit of national and international exchanges is the sheer
variety of goods and services available for barter.
For example, The International Trade Exchange (ITEX) represents more than 100,000 trading
partners worldwide and generates more than $200 million in trade transactions per year. Tradaq
boasts more than 10,000 member businesses and operates offices worldwide, including in the
United States, Canada, Europe and South America. It’s also expanding its presence in the Asia-
Pacific region. Tradaq generates trading volumes in excess $130 million annually and employs
more than 250 workers internationally. Its membership base includes such giants as Sheraton
Hotels, Holiday Inn and TGI Fridays.
You don’t have to be a corporate behemoth to become a member of these large trading groups.
And you don’t have to make barter deals worth millions to participate. For instance, in 2000,
the average business bartered $4,760 worth of goods and services through BarterNet, a network
with about 48,500 active members.
But, there are also several drawbacks to joining a national barter exchange. The quality of each
local branch can differ drastically, even though it’s a part of a national exchange. Some
branches may be more successful than others, depending on the knowledge and commitment
of the local staff. And the fees charged by national exchanges are generally higher than the fees
charged by local exchanges.
Article 7: Joining A Barter Exchange
Whether you’re considering joining a local exchange or the local branch of a national exchange,
it pays to do your homework. On average, one barter organization starts up every week and
one dies. With that rate of turnover, it only makes sense to do some research before you join a
barter exchange.
Before you join an exchange, get straight answers to these questions:

 Does the exchange belong to any larger barter groups? Most reputable exchanges
belong to the barter trade groups IRTA or the National Association of Trade Exchanges
(NATE). Also ask if the exchange has reciprocal relationships with any other barter
organizations.
 Develop a list of 10 items or services that you want. Ask the manager of the exchange
if those items are available through the exchange.
 What are the fee structures? Most exchanges earn their money by charging a
membership fee, monthly fees and trading fees, which are sometimes a percentage of
each transaction. Make sure you understand the entire fee structure before you sign up.
 How large is the exchange? Find out how many businesses are members of the
exchange. In general it takes a client base of roughly 300 active businesses for most
exchanges to be truly profitable. And profitability means stability.
  Will the exchange be able to trade your product or services? Ask it straight out, and
see if any other exchange members are offering similar products or services.
 How are prime items distributed? Some trade items like airfares, computers and hotel
rooms are more in demand than others. Ask how these items are distributed among
members, and make sure the system is fair.
 What are the rules concerning part-barter/part-cash trades?
 How many members are signing up a month? This figure will give you a good
indication of the strength of a barter exchange.
 How much advertising does the exchange do? Advertising is key in attracting new
members and getting your barter services out to the public. An active barter exchange
with an active advertising plan can help spread the word about your business and help
you create new markets.

 Are products and services going at fair market value or are people marking up
their services? Check certain items for which you know the appropriate price. You
want to make sure that exchange members aren’t inflating their barter prices to get a
better deal.
 How many businesses are on standby? On standby means that a member has more
credits than she can find items to spend those credits on. Look for exchanges that don’t
have many members on standby.
 Ask about the exchange’s total trade volume.
 Get a referral list that includes long-time exchange members. Call and ask them
about their best experiences and their worst experiences. When it comes to business,
horror stories are a lot more informative than fairy tales. You might also want to check
with the Better Business Bureau and the local chamber of commerce.
 Go to the barter exchange offices and meet the people in charge.

Article 8: Online Barter

It would seem that barter and the Internet would offer a near perfect blend of business and
technology. However, online barter is in its infancy. The volatility of the online universe is
reflected in the volatility of online barter companies.
For example, in the October 2000 issue of Inc magazine, a panel of experts reviewed six online
barter sites. Today, only one of the six sites still exists. Bigvine.com, the only site
recommended by the panel, was absorbed by Allbusiness.com, then transferred to yet another
Web site, Barternet.com, in December 2001.
The bottom line—proceed cautiously with online barter. If you’re not careful, you could end
up providing a large amount of goods and/or services to a barter company that may go out of
business. Even with that caution, there is undoubtedly a bright future for online barter. It’s just
a question of when that future will arrive.
With the tremendous volatility in the online barter marketplace, it’s important that you do your
research before you start bartering online. Things to check on the various sites include:
  Length of time in business
 Trade volume
 Fee structure
 Simplicity of application and enrollment process
 Available inventory
 Customer service (can you call a real person for help?)

You’ll find a list of online barter services and references in the Resources section at the end of
this article. Visit all of the sites and learn as much as you can about barter before making a
decision about which service is best for your business. And don’t be shy about contacting the
service to get referrals to existing members.

At some point in the future, online barter sites will be able to offer many of the same benefits
as national barter exchanges. At the present time, however, the online world is so volatile that
small businesses might be better served by sticking to bricks and mortar barter, especially when
first starting out in the trading game.
Article 9: Barter and Taxes
If and when you start bartering remember: There are no tax advantages to barter. The IRS treats
a barter transaction exactly as a cash transaction. All barter exchanges report transactions to
the IRS and prepare a 1099-B form for each member of the exchange. In addition, you have
the responsibility of issuing a 1099-B form for any direct trades in which you participate.
Article 10: Resources
Here are some online and offline resources to help you find more information about the practice
of bartering.
Online References
International Reciprocal Trade Association (IRTA)
http://www.irta.com
An informative Web site with information on the world of barter in general and about the
leading barter trade group in particular.
National Assocation of Trade Exchanges (NATE)
http://www.nate.org
Not very informative, but it does list information about this barter trade group and its upcoming
meetings.

Barter News
http://www.barternews.com
This is the leading barter business journal. At the site you’ll find information-packed articles
about the barter marketplace.
Mutual Fund Business
Introduction to Mutual Funds

Mutual Funds

A mutual fund is a collective investment vehicle that collects & pools money from a number
of investors and invests the same in equities, bonds, government securities, money market
instruments.

The money collected in mutual fund scheme is invested by professional fund managers in
stocks and bonds etc. in line with a scheme’s investment objective. The income / gains
generated from this collective investment scheme are distributed proportionately amongst the
investors, after deducting applicable expenses and levies, by calculating a scheme’s “Net Asset
Value” or NAV. In return, mutual fund charges a small fee.

In short, mutual fund is a collective pool of money contributed by several investors and
managed by a professional Fund Manager.

Mutual Funds in India are established in the form of a Trust under Indian Trust Act, 1882, in
accordance with SEBI (Mutual Funds) Regulations, 1996.

The fees and expenses charged by the mutual funds to manage a scheme are regulated and are
subject to the limits specified by SEBI.

History of Mutual Funds in India

A strong financial market with broad participation is essential for a developed economy. With
this broad objective India’s first mutual fund was establishment in 1963, namely, Unit Trust of
India (UTI), at the initiative of the Government of India and Reserve Bank of India ‘with a
view to encouraging saving and investment and participation in the income, profits and gains
accruing to the Corporation from the acquisition, holding, management and disposal of
securities’.

In the last few years the MF Industry has grown significantly. The history of Mutual Funds in
India can be broadly divided into five distinct phases as follows:

First Phase-1964-1987: The Mutual Fund industry in India started in 1963 with formation of
UTI in 1963 by an Act of Parliament and functioned under the Regulatory and administrative
control of the Reserve Bank of India (RBI). In 1978, UTI was de-linked from the RBI and the
Industrial Development Bank of India (IDBI) took over the regulatory and administrative
control in place of RBI. Unit Scheme 1964 (US ’64) was the first scheme launched by UTI. At
the end of 1988, UTI had ₹6,700 crores of Assets Under Management (AUM).

Second Phase-1987-1993-Entry of Public Sector Mutual Funds: The year 1987 marked the
entry of public sector mutual funds set up by Public Sector banks and Life Insurance
Corporation of India (LIC) and General Insurance Corporation of India (GIC). SBI Mutual
Fund was the first ‘non-UTI’ mutual fund established in June 1987, followed by Canbank
Mutual Fund (Dec. 1987), Punjab National Bank Mutual Fund (Aug. 1989), Indian Bank
Mutual Fund (Nov 1989), Bank of India (Jun 1990), Bank of Baroda Mutual Fund (Oct. 1992).
LIC established its mutual fund in June 1989, while GIC had set up its mutual fund in December
1990. At the end of 1993, the MF industry had assets under management of ₹47,004 crores.

Third Phase-1993-2003-Entry of Private Sector Mutual Funds: The Indian securities

market gained greater importance with the establishment of SEBI in April 1992 to protect the
interests of the investors in securities market and to promote the development of, and to
regulate, the securities market.

In the year 1993, the first set of SEBI Mutual Fund Regulations came into being for all mutual
funds, except UTI. The erstwhile Kothari Pioneer (now merged with Franklin Templeton MF)
was the first private sector MF registered in July 1993. With the entry of private sector funds
in 1993, a new era began in the Indian MF industry, giving the Indian investors a wider choice
of MF products. The initial SEBI MF Regulations were revised and replaced in 1996 with a
comprehensive set of regulations, viz., SEBI (Mutual Fund) Regulations, 1996 which is
currently applicable.

The number of MFs increased over the years, with many foreign sponsors setting up mutual
funds in India. Also the MF industry witnessed several mergers and acquisitions during this
phase. As at the end of January 2003, there were 33 MFs with total AUM of ₹1,21,805 crores,
out of which UTI alone had AUM of ₹44,541 crores.

Fourth Phase-Since February 2003-April 2014: In February 2003, following the repeal of
the Unit Trust of India Act 1963, UTI was bifurcated into two separate entities, viz., the
Specified Undertaking of the Unit Trust of India (SUUTI) and UTI Mutual Fund which
functions under the SEBI MF Regulations. With the bifurcation of the erstwhile UTI and
several mergers taking place among different private sector funds, the MF industry entered its
fourth phase of consolidation.

Following the global melt-down in the year 2009, securities markets all over the world had
tanked and so was the case in India. Most investors who had entered the capital market during
the peak, had lost money and their faith in MF products was shaken greatly. The abolition of
Entry Load by SEBI, coupled with the after-effects of the global financial crisis, deepened the
adverse impact on the Indian MF Industry, which struggled to recover and remodel itself for
over two years, in an attempt to maintain its economic viability which is evident from the
sluggish growth in MF Industry AUM between 2010 to 2013.

Fifth (Current) Phase-since May 2014: Taking cognisance of the lack of penetration of MFs,
especially in tier II and tier III cities, and the need for greater alignment of the interest of various
stakeholders, SEBI introduced several progressive measures in September 2012 to "re-
energize" the Indian Mutual Fund industry and increase MFs’ penetration.

In due course, the measures did succeed in reversing the negative trend that had set in after the
global melt-down and improved significantly after the new Government was formed at the
Center.

Since May 2014, the Industry has witnessed steady inflows and increase in the AUM as well
as the number of investor folios (accounts).

 The Industry’s AUM crossed the milestone of ₹10 Trillion (₹10 Lakh Crore) for the
first time as on 31st May 2014 and in a short span of about three years the AUM size
 had increased more than two folds and crossed ₹20 trillion (₹20 Lakh Crore) for the
first time in August 2017. The AUM size crossed ₹30 trillion (₹30 Lakh Crore) for the
first time in November 2020.
 The overall size of the Indian MF Industry has grown from ₹6.59 trillion as on 31st
January 2012 to ₹38.01 trillion as on 31st January 2022, more than 5½ fold increase in
a span of 10 years.
 The MF Industry’s AUM has grown from ₹17.37 trillion as on January 31, 2017 to
₹38.01 trillion as on January 31, 2022, more than 2-fold increase in a span of 5 years.
 The no. of investor folios has gone up from 5.38 crore folios as on 31-Jan-2017 to 12.21
crore as on 31-January-2022, more than 2-fold increase in a span of 5 years.
 On an average 11.55 lakh new folios are added every month in the last 5 years since
January 2017.

The growth in the size of the Industry has been possible due to the twin effects of the regulatory
measures taken by SEBI in re-energising the MF Industry in September 2012 and the support
from mutual fund distributors in expanding the retail base.

MF Distributors have been providing the much needed last mile connect with investors,
particularly in smaller towns and this is not limited to just enabling investors to invest in
appropriate schemes, but also in helping investors stay on course through bouts of market
volatility and thus experience the benefit of investing in mutual funds.

MF distributors have also had a major role in popularising Systematic Investment Plans (SIP)
over the years. In April 2016, the no. of SIP accounts has crossed 1 crore mark and as on 31st
January 2022 the total no. of SIP Accounts stands at 5.05 crore.

How a mutual fund works?

One should avoid the temptation to review the fund's performance each time the market falls
or jumps up significantly. For an actively-managed equity scheme, one must have patience and
allow reasonable time - between 18 and 24 months - for the fund to generate returns in the
portfolio.

When you invest in a mutual fund, you are pooling your money with many other investors.
Mutual fund issues “Units” against the amount invested at the prevailing NAV. Returns from
a mutual fund may include income distributions to investors out of dividends, interest, capital
gains or other income earned by the mutual fund. You can also have capital gains (or losses) if
you sell the mutual fund units for more (or less) than the amount you invested.

Mutual funds are ideal for investors who –

a. lack the knowledge or skill / experience of investing in stock markets directly.

b. want to grow their wealth, but do not have the inclination or time to research the stock
market.
c. wish to invest only small amounts.
Types of Mutual Fund Schemes

Mutual Fund Scheme classification

Mutual funds come in many varieties, designed to meet different investor goals. Mutual funds
can be broadly classified based on –

1. Organisation Structure – Open ended, Close ended, Interval

2. Management of Portfolio – Actively or Passively
3. Investment Objective – Growth, Income, Liquidity
4. Underlying Portfolio – Equity, Debt, Hybrid, Money market instruments, Multi Asset
5. Thematic / solution oriented – Tax saving, Retirement benefit, Child welfare, Arbitrage
6. Exchange Traded Funds
7. Overseas funds
8. Fund of funds

Scheme Classification by Organization Structure

• Open-ended schemes are perpetual, and open for subscription and repurchase on a
continuous basis on all business days at the current NAV.

• Close-ended schemes have a fixed maturity date. The units are issued at the time of the initial
offer and redeemed only on maturity. The units of close-ended schemes are mandatorily listed
to provide exit route before maturity and can be sold/traded on the stock exchanges.

• Interval schemes allow purchase and redemption during specified transaction periods
(intervals). The transaction period has to be for a minimum of 2 days and there should be at
least a 15-day gap between two transaction periods. The units of interval schemes are also
mandatorily listed on the stock exchanges.

Scheme Classification by Portfolio Management

Active Funds

In an Active Fund, the Fund Manager is ‘Active’ in deciding whether to Buy, Hold, or Sell the
underlying securities and in stock selection. Active funds adopt different strategies and styles
to create and manage the portfolio.

 The investment strategy and style are described upfront in the Scheme Information
document (offer document)
 Active funds expect to generate better returns (alpha) than the benchmark index.
 The risk and return in the fund will depend upon the strategy adopted.
 Active funds implement strategies to ‘select’ the stocks for the portfolio.

Passive Funds

Passive Funds hold a portfolio that replicates a stated Index or Benchmark e.g. –

 Index Funds
 Exchange Traded Funds (ETFs)
In a Passive Fund, the fund manager has a passive role, as the stock selection / Buy, Hold, Sell
decision is driven by the Benchmark Index and the fund manager / dealer merely needs to
replicate the same with minimal tracking error.

Active v/s Passive Funds

Active Fund –

 Rely on professional fund managers who manage investments.

 Aim to outperform Benchmark Index
 Suited for investors who wish to take advantage of fund managers' alpha generation
potential.

Passive Funds –

 Investment holdings mirror and closely track a benchmark index, e.g., Index Funds or
Exchange Traded Funds (ETFs)
 Suited for investors who want to allocate exactly as per market index.
 Lower Expense ratio hence lower costs to investors and better liquidity

Classification by Investment Objectives

Mutual funds offer products that cater to the different investment objectives of the investors
such as –

a. Capital Appreciation (Growth)

b. Capital Preservation
c. Regular Income
d. Liquidity
e. Tax-Saving

Mutual funds also offer investment plans, such as Growth and Dividend options, to help tailor
the investment to the investors’ needs.

Growth funds

 Growth Funds are schemes that are designed to provide capital appreciation.
 Primarily invest in growth oriented assets, such as equity
 Investment in growth-oriented funds require a medium to long-term investment
horizon.
 Historically, Equity as an asset class has outperformed most other kind of investments
held over the long term. However, returns from Growth funds tend to be volatile over
the short-term since the prices of the underlying equity shares may change.
 Hence investors must be able to take volatility in the returns in the short-term.

Income funds

 The objective of Income Funds is to provide regular and steady income to investors.
 Income funds invest in fixed income securities such as Corporate Bonds, Debentures
and Government securities.
  The fund’s return is from the interest income earned on these investments as well as
capital gains from any change in the value of the securities.
 The fund will distribute the income provided the portfolio generates the required
returns. There is no guarantee of income.
 The returns will depend upon the tenor and credit quality of the securities held.

Liquid / Overnight /Money Market Mutual Funds

 Liquid Schemes, Overnight Funds and Money market mutual fund are investment
options for investors seeking liquidity and principal protection, with commensurate
returns.
– The funds invest in money market instruments* with maturities not exceeding 91
days.
– The return from the funds will depend upon the short-term interest rate prevalent in
the market.
 These are ideal for investors who wish to park their surplus funds for short periods.
– Investors who use these funds for longer holding periods may be sacrificing better
returns possible from products suitable for a longer holding period.

* Money Market Instruments includes commercial papers, commercial bills, treasury

bills, Government securities having an unexpired maturity up to one year, call or notice
money, certificate of deposit, usance bills, and any other like instruments as specified
by the Reserve Bank of India from time to time.

Classification by Investment Portfolio

Mutual fund products can be classified based on their underlying portfolio composition

– The first level of categorization will be on the basis of the asset class the fund invests in, such
as equity / debt / money market instruments or gold.
– The second level of categorization is on the basis of strategies and styles used to create the
portfolio, such as, Income fund, Dynamic Bond Fund, Infrastructure fund, Large-cap/Mid-
cap/Small-cap Equity fund, Value fund, etc.
– The portfolio composition flows out of the investment objectives of the scheme.

Total Expense Ratio

Under SEBI (Mutual Funds) Regulations, 1996, Mutual Funds are permitted to charge certain
operating expenses for managing a mutual fund scheme – such as sales & marketing /
advertising expenses, administrative expenses, transaction costs, investment management fees,
registrar fees, custodian fees, audit fees – as a percentage of the fund’s daily net assets.

All such costs for running and managing a mutual fund scheme are collectively referred to as
‘Total Expense Ratio’ (TER)

The TER is calculated as a percentage of the Scheme’s average Net Asset Value (NAV). The
daily NAV of a mutual fund is disclosed after deducting the expenses.

Currently, in India, the expense ratio is fungible, i.e., there is no limit on any particular type of
allowed expense as long as the total expense ratio is within the prescribed limit. The regulatory
limits of TER that can be incurred/charged to the fund by a Mutual Fund AMC have been
specified under Regulation 52 of SEBI Mutual Fund Regulations.

Effective from April 1, 2020 the TER limit has been revised as follows.

Assets Under Management Maximum TER as a percentage of daily net assets

(AUM) TER for Equity funds TER for Debt funds

On the first Rs. 500 crores 2.25% 2.00%

On the next Rs. 250 crores 2.00% 1.75%

On the next Rs. 1,250 crores 1.75% 1.50%

On the next Rs. 3,000 crores 1.60% 1.35%

On the next Rs. 5,000 crores 1.50% 1.25%

Total expense ratio reduction Total expense ratio reduction

of 0.05% of 0.05%
On the next Rs. 40,000 crores for every increase of Rs.5,000 for every increase of Rs.5,000
crores of crores of
daily net assets or part thereof. daily net assets or part thereof.

Above Rs. 50,000 crores 1.05% 0.80%

In addition, mutual funds have been allowed to charge up to 30 bps more, if the new inflows
from retail investors from beyond top 30 cities (B30) cities are at least (a) 30% of gross new
inflows in the scheme or (b) 15% of the average assets under management (year to date) of the
scheme, whichever is higher. This is essentially to encourage inflows into mutual funds from
tier - 2 and tier - 3 cities.

TER has a direct bearing on a scheme’s NAV – the lower the expense ratio of a scheme,
the higher the NAV. Thus, TER is an important parameter while selecting a mutual fund
scheme.

As per the current SEBI Regulations, mutual funds are required to disclose the TER of all
schemes on a daily basis on their websites as well as AMFI’s website

SEBI Categorization of Mutual Fund Schemes

As per SEBI guidelines on Categorization and Rationalization of schemes issued in October

2017, mutual fund schemes are classified as –

1. Equity Schemes
2. Debt Schemes
3. Hybrid Schemes
4. Solution Oriented Schemes – For Retirement and Children
5. Other Schemes – Index Funds & ETFs and Fund of Funds
– Under Equity category, Large, Mid and Small cap stocks have now been defined.

– Naming convention of the schemes, especially debt schemes, as per the risk level of
underlying portfolio (e.g., the erstwhile ‘Credit Opportunity Fund’ is now called “Credit Risk
Fund”)

– Balanced / Hybrid funds are further categorised into conservative hybrid fund, balanced
hybrid fund and aggressive hybrid fund.

Equity Schemes

An equity Scheme is a fund that –

– Primarily invests in equities and equity related instruments.

– Seeks long term growth but could be volatile in the short term.

– Suitable for investors with higher risk appetite and longer investment horizon.

The objective of an equity fund is generally to seek long-term capital appreciation. Equity funds
may focus on certain sectors of the market or may have a specific investment style, such as
investing in value or growth stocks.

Equity Fund Categories as per SEBI guidelines on Categorization and Rationalization of

schemes

Multi Cap Fund* At least 65% investment in equity & equity related instruments

Large Cap Fund At least 80% investment in large cap stocks

Large & Mid Cap At least 35% investment in large cap stocks and 35% in mid cap
Fund stocks

Mid Cap Fund At least 65% investment in mid cap stocks

Small cap Fund At least 65% investment in small cap stocks

Dividend Yield Predominantly invest in dividend yielding stocks, with at least 65% in
Fund stocks

Value Fund Value investment strategy, with at least 65% in stocks

Contra Fund Scheme follows contrarian investment strategy with at least 65% in stocks

Focused on the number of stocks (maximum 30) with at least 65% in

Focused Fund
equity & equity related instruments
Sectoral/
At least 80% investment in stocks of a particular sector/ theme
Thematic Fund

At least 80% in stocks in accordance with Equity Linked Saving Scheme,

ELSS
2005, notified by Ministry of Finance

*Also referred to as Diversified Equity Funds – as they invest across stocks of different sectors
and segments of the market. Diversification minimizes the risk of high exposure to a few
stocks, sectors or segment.

Sector Specific Funds

Sectoral funds invest in a particular sector of the economy such as infrastructure, banking,
technology or pharmaceuticals etc.

– Since these funds focus on just one sector of the economy, they limit diversification, and are
thus riskier.

– Timing of investment into such funds are important, because the performance of the sectors
tend to be cyclical.

Examples of Sector Specific Funds - Equity Mutual Funds with an investment objective to
invest in

 Pharma & Healthcare Sector

 Banking & Finance Sector:
 FMCG (fast moving consumer goods) and related sectors.
 Technology and related sectors

Thematic funds

 Thematic funds select stocks of companies in industries that belong to a particular

theme - For example, Infrastructure, Service industries, PSUs or MNCs.
 They are more diversified than Sectoral Funds and hence have lower risk than Sectoral
funds.

Value Funds (Strategy and Style Based Funds)

 Equity funds may be categorized based on the valuation parameters adopted in stock
selection, such as

– Growth funds identify momentum stocks that are expected to perform better than the
market

– Value funds identify stocks that are currently undervalued but are expected to perform
well over time as the value is unlocked

 Equity funds may hold a concentrated portfolio to benefit from stock selection.
 – These funds will have a higher risk since the effect of a wrong selection can be
substantial on the portfolio’s return

Contra Funds

 Contra funds are equity mutual funds that take a contrarian view on the market.
 Underperforming stocks and sectors are picked at low price points with a view that they
will perform in the long run.
 The portfolios of contra funds have defensive and beaten down stocks that have given
negative returns during bear markets.
 These funds carry the risk of getting calls wrong as catching a trend before the herd is
not possible in every market cycle and these funds typically underperform in a bull
market.
 As per the SEBI guidelines on Scheme categorisation of mutual funds, a fund house
can either offer a Contra Fund or a Value Fund, not both.

Equity Linked Savings Scheme (ELSS)

ELSS invests at least 80% in stocks in accordance with Equity Linked Saving Scheme, 2005,
notified by Ministry of Finance.

 Has lock-in period of 3 years (which is shortest amongst all other tax saving options)
 Currently eligible for deduction under Sec 80C of the Income Tax Act upto ₹1,50,000

Debt Schemes

 A debt fund (also known as income fund) is a fund that invests primarily in bonds or
other debt securities.
 Debt funds invest in short and long-term securities issued by government, public
financial institutions, companies

– Treasury bills, Government Securities, Debentures, Commercial paper, Certificates

of Deposit and others

 Debt funds can be categorized based on the tenor of the securities held in the portfolio
and/or on the basis of the issuers of the securities or their fund management strategies,
such as

– Short-term funds, Medium-term funds, Long-term funds

– Gilt fund, Treasury fund, Corporate bond fund, Infrastructure debt fund

 Floating rate funds, Dynamic Bond funds, Fixed Maturity Plans

 Debt funds have potential for income generation and capital preservation.

Debt Fund Categories as per SEBI guidelines on Categorization and Rationalization of

schemes

Overnight Fund Overnight securities having maturity of 1 day

Liquid Fund Debt and money market securities with maturity of upto 91 days only

Ultra Short Duration Debt & Money Market instruments with Macaulay duration of the
Fund portfolio between 3 months - 6 months

Investment in Debt & Money Market instruments with Macaulay

Low Duration Fund
duration portfolio between 6 months- 12 months

Investment in Money Market instruments having maturity upto 1

Money Market Fund
Year

Investment in Debt & Money Market instruments with Macaulay

Short Duration Fund
duration of the portfolio between 1 year - 3 years

Investment in Debt & Money Market instruments with Macaulay

Medium Duration Fund
duration of portfolio between 3 years - 4 years

Medium to Long Investment in Debt & Money Market instruments with Macaulay
Duration Fund duration of the portfolio between 4 - 7 years

Investment in Debt & Money Market Instruments with Macaulay

Long Duration Fund
duration of the portfolio greater than 7 years

Dynamic Bond Investment across duration

Minimum 80% investment in corporate bonds only in AA+ and

Corporate Bond Fund
above rated corporate bonds

Minimum 65% investment in corporate bonds, only in AA and below

Credit Risk Fund
rated corporate bonds

Minimum 80% in Debt instruments of banks, Public Sector

Banking and PSU Fund
Undertakings, Public Financial Institutions and Municipal Bonds

Gilt Fund Minimum 80% in G-secs, across maturity

Gilt Fund with 10 year Minimum 80% in G-secs, such that the Macaulay duration of the
constant Duration portfolio is equal to 10 years

Minimum 65% in floating rate instruments (including fixed rate

Floater Fund instruments converted to floating rate exposures using swaps/
derivatives)

Dynamic Bond funds alter the tenor of the securities in the portfolio in line with expectation
on interest rates. The tenor is increased if interest rates are expected to go down and vice versa
Floating rate funds invest in bonds whose interest are reset periodically so that the fund earns
coupon income that is in line with current rates in the market, and eliminates interest rate risk
to a large extent

Short-Term Debt Funds

The primary focus of short-term debt funds is coupon income. Short term debt funds have to
also be evaluated for the credit risk they may take to earn higher coupon income. The tenor of
the securities will define the return and risk of the fund.

– Funds holding securities with lower tenors have lower risk and lower return.

 Liquid funds invest in securities with not more than 91 days to maturity.
 Ultra Short-Term Debt Funds hold a portfolio with a slightly higher tenor to earn higher
coupon income.

Short-Term Fund combine coupon income earned from a pre-dominantly short-term debt
portfolio with some exposure to longer term securities to benefit from appreciation in price.

Fixed Maturity Plans (FMPs)

– FMPs are closed-ended funds which eliminate interest rate risk and lock-in a yield by
investing only in securities whose maturity matches the maturity of the fund.

– FMPs create an investment portfolio whose maturity profile match that of the FMP tenor.

– Potential to provide better returns than liquid funds and Ultra Short Term Funds since
investments are locked in

– Low mark to market risk as investments are liquidated at maturity.

– Investors commit money for a fixed period.

– Investors cannot prematurely redeem the units from the fund

– FMPs, being closed-end schemes are mandatorily listed - investors can buy or sell units of
FMPs only on the stock exchange after the NFO.

– Only Units held in dematerialized mode can be traded; therefore, investors seeking liquidity
in such schemes need to have a demat account.

Capital Protection Oriented Funds

Capital Protection Oriented Funds are close-ended hybrid funds that create a portfolio of debt
instruments and equity derivatives

– The portfolio is structured to provide capital protection and is rated by a credit rating agency
on its ability to do so. The rating is reviewed every quarter.
– The debt component of the portfolio has to be invested in instruments with the highest
investment grade rating.

– A portion of the amount brought in by the investors is invested in debt instruments that is
expected to mature to the par value of the capital invested by investors into the fund. The capital
is thus protected.

– The remaining portion of the funds is used to invest in equity derivatives to generate higher
returns

Hybrid Funds

Hybrid funds Invest in a mix of equities and debt securities.

SEBI has classified Hybrid funds into 7 sub-categories as follows:

10% to 25% investment in equity & equity related

Conservative Hybrid Fund instruments; and
75% to 90% in Debt instruments

40% to 60% investment in equity & equity related

Balanced Hybrid Fund instruments; and
40% to 60% in Debt instruments

65% to 80% investment in equity & equity related

Aggressive Hybrid Fund instruments; and
20% to 35% in Debt instruments

Investment in equity/ debt that is managed dynamically

Dynamic Asset Allocation or
(0% to 100% in equity & equity related instruments; and
Balanced Advantage Fund
0% to 100% in Debt instruments)

Investment in at least 3 asset classes with a minimum

Multi Asset Allocation Fund
allocation of at least 10% in each asset class

Scheme following arbitrage strategy, with minimum 65%

Arbitrage Fund
investment in equity & equity related instruments

Equity and equity related instruments (min.65%);

Equity Savings debt instruments (min.10%) and
derivatives (min. for hedging to be specified in the SID)

Solution-oriented & Other funds

Lock-in for at least 5 years or till retirement age whichever is

Retirement Fund
earlier
 Lock-in for at least 5 years or till the child attains age of
Children’s Fund
majority whichever is earlier

Index Funds/ ETFs Minimum 95% investment in securities of a particular index

Fund of Funds (Overseas/

Minimum 95% investment in the underlying fund(s)
Domestic)

Hybrid funds

Invest in a mix of equities and debt securities. They seek to find a ‘balance’ between growth
and income by investing in both equity and debt.

– The regular income earned from the debt instruments provide greater stability to the returns
from such funds.

– The proportion of equity and debt that will be held in the portfolio is indicated in the Scheme
Information Document

– Equity oriented hybrid funds (Aggressive Hybrid Funds) are ideal for investors looking for
growth in their investment with some stability.

– Debt-oriented hybrid funds (Conservative Hybrid Fund) are suitable for conservative
investors looking for a boost in returns with a small exposure to equity.

– The risk and return of the fund will depend upon the equity exposure taken by the portfolio -
Higher the allocation to equity, greater is the risk

Multi Asset Funds

 A multi-asset fund offers exposure to a broad number of asset classes, often offering a
level of diversification typically associated with institutional investing.
 Multi-asset funds may invest in a number of traditional equity and fixed income
strategies, index-tracking funds, financial derivatives as well as commodity like gold.
 This diversity allows portfolio managers to potentially balance risk with reward and
deliver steady, long-term returns for investors, particularly in volatile markets.

Arbitrage Funds

“Arbitrage” is the simultaneous purchase and sale of an asset to take advantage of the price
differential in the two markets and profit from price difference of the asset on different markets
or in different forms.

 – Arbitrage fund buys a stock in the cash market and simultaneously sells it in the
Futures market at a higher price to generate returns from the difference in the price of
the security in the two markets.
 – The fund takes equal but opposite positions in both the markets, thereby locking in
the difference.
  – The positions have to be held until expiry of the derivative cycle and both positions
need to be closed at the same price to realize the difference.
 – The cash market price converges with the Futures market price at the end of the
contract period. Thus it delivers risk-free profit for the investor/trader.
 – Price movements do not affect initial price differential because the profit in one
market is set-off by the loss in the other market.
 – Since mutual funds invest own funds, the difference is fully the return.

Hence, Arbitrage funds are considered to be a good choice for cautious investors who want to
benefit from a volatile market without taking on too much risk.

Index Funds

Index funds create a portfolio that mirrors a market index.

 – The securities included in the portfolio and their weights are the same as that in the
index
 – The fund manager does not rebalance the portfolio based on their view of the market
or sector
 – Index funds are passively managed, which means that the fund manager makes only
minor, periodic adjustments to keep the fund in line with its index. Hence, Index fund
offers the same return and risk represented by the index it tracks.
 – The fees that an index fund can charge is capped at 1.5%

Investors have the comfort of knowing the stocks that will form part of the portfolio, since the
composition of the index is known.

Exchange Traded Funds (ETFs)

An ETF is a marketable security that tracks an index, a commodity, bonds, or a basket of assets
like an index fund.

 ETFs are listed on stock exchanges.

 Unlike regular mutual funds, an ETF trades like a common stock on a stock exchange.
The traded price of an ETF changes throughout the day like any other stock, as it is
bought and sold on the stock exchange.
 ETF Units are compulsorily held in Demat mode
 ETFs are passively managed, which means that the fund manager makes only minor,
periodic adjustments to keep the fund in line with its index
 Because an ETF tracks an index without trying to outperform it, it incurs lower
administrative costs than actively managed portfolios.
 Rather than investing in an ‘active’ fund managed by a fund manager, when one buy
units of an ETF one is harnessing the power of the market itself.
 Suitable for investors seeking returns similar to index and liquidity similar to stocks

Fund of Funds (FoF)

 Fund of funds are mutual fund schemes that invest in the units of other schemes of the
same mutual fund or other mutual funds.
  The schemes selected for investment will be based on the investment objective of the
FoF
 The FoF have two levels of expenses: that of the scheme whose units the FoF invests
in and the expense of the FoF itself. Regulations limit the total expenses that can be
charged across both levels as follows:

– TER in respect of FoF investing liquid schemes, index funds & ETFs has been capped
@ 1%

– TER of FoF investing in equity-oriented schemes has been capped @ 2.25%

– TER of FoF investing in other schemes than mentioned above has been capped @2%.

Gold Exchange Traded Funds (FoF)

 Gold ETFs are ETFs with gold as the underlying asset

– The scheme will issue units against gold held. Each unit will represent a defined
weight in gold, typically one gram.

– The scheme will hold gold in form of physical gold or gold related instruments
approved by SEBI.

– Schemes can invest up to 20% of net assets in Gold Deposit Scheme of banks

 The price of ETF units moves in line with the price of gold on metal exchange.
 After the NFO, units are issued to intermediaries called authorized participants against
gold or funds submitted. They can also redeem the units for the underlying gold

Benefits of Gold ETFs

 Convenience --> option of holding gold electronically instead of physical gold.

– Safer option to hold gold since there are no risks of theft or purity.

– Provides easy liquidity and ease of transaction.

 Gold ETFs are treated as non-equity oriented mutual funds for the purpose of taxation.

– Eligible for long-term capital gains benefits if held for three years.

– No wealth tax is applicable on Gold ETFs

International Funds

 International funds enable investments in markets outside India, by holding in their

portfolio one or more of the following:
 – Equity of companies listed abroad.
 – ADRs and GDRs of Indian companies.
 – Debt of companies listed abroad.
  – ETFs of other countries.
 – Units of passive index funds in other countries.
 – Units of actively managed mutual funds in other countries.
 International equity funds may also hold some of their portfolios in Indian equity or
debt.
 – They can hold some portion of the portfolio in money market instruments to manage
liquidity.
 International funds give the investor additional benefits of
 – Diversification, since global markets may have a low correlation with domestic
markets.
 – Investment options that may not be available domestically.
 – Access to companies that are global leaders in their field.
 There are risks associated with investing in such funds, such as –
 – Political events and macro-economic factors that are less familiar and therefore
difficult to interpret
 – Movements in foreign exchange rate may affect the return on redemption
 – Countries may change their investment policy towards global investors.
 For the purpose of taxation, these funds are considered as non-equity oriented mutual
fund schemes.

Net Asset Value (NAV)

NAV stands for Net Asset Value. The performance of a mutual fund scheme is denoted by its
NAV per unit.

NAV per unit is the market value of securities of a scheme divided by the total number of units
of the scheme on a given date. For example, if the market value of securities of a mutual fund
scheme is ₹200 lakh and the mutual fund has issued 10 lakh units of ₹10 each to the investors,
then the NAV per unit of the fund is ₹20 (i.e., ₹200 lakh/10 lakh).

Since market value of securities changes every day, NAV of a scheme also varies on day-to-
day basis.

NAVs of mutual fund schemes are published on respective mutual funds’ websites as well as
AMFI’s website daily.

Unlike stocks, where the price is driven by the stock market and changes from minute-to-
minute, NAVs of mutual fund schemes are declared at the end of each trading day after markets
are closed, in accordance with SEBI Mutual Fund Regulations. Further, Units of mutual fund
schemes under all scheme (except Liquid & Overnight funds) are allotted only at prospective
NAV, i.e., the NAV that would be declared at the end of the day, based on the closing market
value of the securities held in the respective schemes.

A mutual fund may accept applications even after the cut-off time, but you will get the NAV
of the next business day. Further, the cut-off time rules apply for redemptions too.
Determination of Applicable NAV

Liquid Funds/Overnight Funds All Other Schemes*

Subscription  Where the application is received
up to 1.30 p.m. on a day and the
 Where the application is
funds are available for utilization
received up to 3:00 p.m. and
before 1.30 p.m. without availing
funds are available for
any credit facility, the closing
utilization before 3:00 p.m.,
NAV of the day immediately
the closing NAV of the day
preceding the day of receipt of
on which the application is
application.
received.
 Where the application is received
 Where the application is
after 1.30 p.m. on a day and funds
received after 3:00 p.m. and
are available for utilization on the
the funds are available for
same day without availing any
utilization, closing NAV of
credit facility, the closing NAV of
the next business day.
the day immediately preceding the
 Irrespective of the time of
next business day; and
receipt of application (before
 Irrespective of the time of receipt
or after 3:00 p.m.), where the
of application (before or after 1.30
funds are not available for
p.m. on a day), where the funds are
utilization, the closing NAV
not available for utilization before
of the day on which the funds
1.30 p.m. without availing any
are available for utilization
credit facility, the closing NAV of
before cut-off time of 3.00
the day immediately preceding the
p.m.
day on which the funds are
available for utilization.

Redemption  Where the application is received  Where the application is

up to 3.00 pm received up to 3.00 pm –
– the closing NAV of day closing NAV of the day on
immediately preceding the next which the application is
business day; and received; and
 Where the application is received  Where the application is
after 3.00 pm received after 3.00 pm –
– the closing NAV of the next closing NAV of the next
business day. business day.

*other than Liquid Funds & Overnight Funds

Sale and Repurchase (Redemption) Price

Sale Price

 Sale Price is the price payable per unit by an investor for purchase of units
(subscription) and/or switch-in from other schemes of a mutual fund.
 SEBI vide circular no. SEBI / IMD / CIR No. 4 / 168230 / 09 dated June 30, 2009 has
abolished Entry Load for all mutual fund schemes.
  Hence, during the New Fund Offer (NFO), the Sale Price per unit is at Face Value per
unit specified in the respective Scheme Information Document (SID) and Key
Information Memorandum (KIM)
 During the ‘Ongoing Offer’ period (i.e., the date from which the scheme re-opens for
subscriptions/redemptions after the closure of the NFO period.), the units may be
purchased at NAV i.e., the Sale Price per unit is equivalent to applicable NAV on the
date of subscription

Repurchase/Redemption Price

 The Repurchase/Redemption Price is the price per Unit at which a Mutual Fund would
‘repurchase’ the units (i.e., buys back units from the investor) upon redemption of units
or switch-outs of units to other schemes/plans of the Mutual Fund by the investors, and
includes Exit Load, if / wherever applicable.
 Redemption price is calculated as follows:
 Redemption Price = Applicable NAV*(1- Exit Load, if any) For Example: If the
Applicable NAV is ₹10 and Exit Load is 2%, then the Redemption Price will be = ₹10*
(1-0.02) = ₹9.80

It may be noted that an AMC / Trustee has the right to modify existing Exit Load structure
and/or to introduce Exit Loads subject to a maximum limit prescribed under the Regulations.

Any change in Load structure will be effective on prospective basis and will not affect the
existing mutual fund units in any manner.

As per SEBI (Mutual Funds) Regulations, 1996, in respect of Open-Ended Schemes,

Repurchase Price (commonly referred to as Redemption price) shall not be lower than 95% of
NAV.

It may be noted that units of Closed Ended Schemes cannot be Repurchased prematurely.

Source: Association of Mutual Fund of India-Knowledge-Center

Understanding Returns from Mutual Funds

Measuring performance

While looking at a mutual fund scheme's performance, one must not be led by the scheme's
return in isolation. A scheme may have generated 10% annualised return in the last couple of
years. But then, even the market indices would have gone up in similar way during the same
period. Under-performance in a falling market, i.e. when the NAV of the scheme falls more
than its benchmark (or the market), is the time when you must review your investment.

One must compare the scheme's return as against its benchmark return. It is better to be rid of
investment in a scheme that consistently under-performs as compared to its benchmark over a
period of time, from one's portfolio. It is important to identify under-performers over the longer
time horizon (as also out-performers).

In addition, one may also consider evaluating the 'category average returns' as well. Even if a
scheme has outperformed its benchmark by a decent margin, there could be better performers
in the peer group. The category average returns will reveal how good (or bad) is one’s
investment is against its peers which help in deciding whether it is time shift the investment to
better performers.

One may be holding a too little or too much-diversified portfolio. Even the expense ratio of
some of the schemes that one could be holding may be high compared to others within the same
category.

Most importantly, the review helps an investor validate if the investments are aligned to his/her
goals.

How often should one review

One should avoid the temptation to review the fund's performance each time the market falls
or jumps up significantly. For an actively-managed equity scheme, one must have patience and
allow reasonable time - between 18 and 24 months - for the fund to generate returns in the
portfolio.

The review may become more pronounced in case of thematic or sectoral schemes as they are
more prone to the changing economic environment.

It is advisable for common investors to make a separate watch list of funds that are found to be
underperforming their benchmark or their comparable peers. From this list, one should look
for improvement in performance over the subsequent 2-3 quarters. A consistent under-
performance over 3-4 quarters may warrant shifting the investment to other better options. One
needs to even check the reason for the under-performance, which may be expressed in the fund
manager's commentary. The underlying stocks in the portfolio of an MF scheme keep changing
and along with it change the associated risks. An important factor is the risk metrics. If the risk
profile of the fund has skewed further towards "High" risk while the returns remain the same
or do down, it may be advisable to exit the fund.

Therefore, a review of the fund's risk-adjusted return, i.e., a measure to find how much return
an investment will generate given the level of risk associated with it, could be more helpful.
As an investor, high return at low risk is always preferable. Hence, MF schemes with high risk-
adjusted returns are most sought-after. Risk-adjusted returns are well captured by several rating
agencies.

The winners of today may not continue with the winning streak year after year. In other words,
reviewing the performance as mentioned above may not always be fruitful. Moreover, tracking
and reviewing of a scheme's portfolio is quite different from reviewing one's own portfolio. A
mutual fund investor should not worry themselves about the portfolio of a fund. That's the fund
manager's job.

Watch out

Be mindful not to disrupt your overall portfolio allocation, while redeeming units from equity
mutual fund schemes, as the redemption proceeds would have to be re-deployed in another
equity scheme which will require undergoing the entire process of choosing the right scheme
to invest in. Try to maintain the original levels of exposure to equities, unless your allocation
needs a change.

Frequent review and tracking of mutual fund returns may tempt you into taking unwarranted
impulsive decisions. Do not let an fall in NAVs tempt you to discontinue SIPs or redeeming
units from a fund. When there are market falls steeply, try to invest lump-sum amount. An
annual review comparing the fund with the benchmark as well as with the category peers will
certainly help and advisable.

Calculating returns on mutual fund units

There are many ways to calculate returns from mutual fund investments. Two of the most
popular methods are Absolute returns and Annualised returns.

Absolute returns

Absolute return is the simple increase (or decrease) in your investment in terms of percentage.
It does not take into account the time taken for this change.

So if an investment’s current market value is Rs. 5,25,000 and your invested amount was Rs.
2,75,000 then your absolute return will be: [(5,25,000-2,75,000)/2,75,000] = 90.9%

Notice how irrelevant the date of investment or date of redemption is. Ideally, you should use
the absolute returns method if the tenure of your investment is less than 1 year.

For periods of more than 1 year, you need to annualise returns; which means you need to find
out what the rate of return is per annum.

Annualised returns

A Compound Annual Growth Rate (CAGR) measures the rate of return over an investment
period. It is a smoothened rate because it measures the growth of an investment as if it had
grown at a steady rate, on an annually compounded basis.

CAGR = [(Current Value / Beginning Value) ^ (1/# of Years)]-1

How can I find the CAGR using the computer?

To calculate a CAGR, use the XIRR function in MS Excel.

8-Jan-06 1,00,000 Enter the date and the investment value

31-Dec-12 2,00,000 Enter the current value and the current date

XIRR formula 10.43%

Please remember to put a negative sign as the XIRR formula calculates the return on cash
flows. Thus to find returns there has to be a cash inflow and cash outflow, which should be
indicated with the use of positive and negative signs.

Actively Managed Funds and Passively Managed Funds

Actively managed funds are those where the fund manager actively manages these funds and
buys or sells stocks of companies as per the broad guidelines that have been enumerated in the
scheme information document sells stocks. These funds don’t mimic the index but buy and sell
on basis of the research of the fund manager.

Passive funds on the other hand look at offering returns by mimicking an index like a BSE or
Nifty. The whole point of Index fund is to follow a certain benchmark, and therefore they are
called passively managed funds.

Understanding Alpha. How does It measure the Fund Manager’s Contribution?

But how can I measure the fund manager's contribution to performance?

This brings us to the question, how exactly can you measure a fund manager’s contribution to
performance? Alpha measures the performance due to stock selection. It is the difference
between the return you would expect from a fund, given its beta and the return it actually
produced. If the fund returns more than its beta would predict, it has a positive alpha and if it
returns less than the amount predicted by the beta, that would mean that the fund has a negative
alpha.

A positive alpha is the extra return would be awarded to you for taking a risk, instead of
accepting the market return.

Understanding Beta

Beta measures the volatility of a security relative to something, usually a benchmark index. A
beta greater than one means the fund or stock is more volatile than the benchmark index, while
a beta of less than one means the security is less volatile than the index.

If the market goes up by 10%, a fund with a beta of 1.0 should go up 10% and vice versa. While
standard deviation determines the volatility of a fund according to the disparity of its returns
over a period of time, beta, determines the volatility, or risk, of a fund in comparison to that of
its index or benchmark.
Beta is based on the capital assets pricing model which states that there are two kinds of risk
in investing in equities- systematic risk and non-systematic risk. Systematic risk is integral to
investing in the market and cannot be avoided. For example, risk arising out of inflation and
interest rates. Non-systematic risk is unique to a company - can be mimimised by
diversification across companies. Since non-systematic risk can be diversified, investors need
to be compensated for systematic risk which is measured by Beta.

Understanding Standard Deviation

Usually denoted with the letter σ, Standard Deviation is defined as the square root of the
variance.

It basically serves as a measure of uncertainty. Volatile securities that have a higher standard
deviation are also considered a higher risk because their performance may change quickly, in
either direction and at any moment.

So the standard deviation of a fund measures this risk by measuring the degree to which the
fund fluctuates in relation to its mean return i.e. the average return of a fund over a period.

For example, a fund that has a consistent four year return of 3%, would have a mean, or average
of 3%. The standard deviation for this fund would then be zero because the fund's return in any
given year does not differ from its four year mean of 3%.

The standard deviation of a set of data measures how "spread out" the data set is. In other
words, it tells you whether all the data items bunch around close to the mean or if they are "all
over the place."

What you need to take out of this is that the fund with the lower standard deviation would
be more optimal because it is maximizing the return received, for risk acquired.

Imagine you have a choice between two stocks: Stock A historically returns 5% with a standard
deviation of 10%, while Stock B returns 6% and carries a standard deviation of 20%, which
one do you think is riskier.

Stock A has the potential to earn 10% more than the expected return, but is equally likely to
earn 10% less than the expected return. Likewise, Stock B can vary by up to 20%.

So on a risk and return perspective, Stock A is less risky than Stock B.

https://www.amfiindia.com/investor-corner/knowledge-center/understand-return.html
Mutual Fund Ratios

Given below are the key metrics used in evaluating a mutual fund.

Beta

Beta is a measure of mutual fund schemes volatility compared to its benchmark. This ratio
helps to judge how much a fund’s performance can move upside/downside compared to its
benchmark.

Formula

Beta = (Standard deviation of mutual fund scheme/Standard deviation of the Benchmark)

* R-Square

Significance:

A fund with a beta value of more than 1 would move more volatile than the market, i.e., if the
market moves up 100% a fund with a beta value of 1.5 would move up by 150% and if the
market comes down by 20%, the fund will come down by 30%.
If the beta value is less than 1 it means the fund will be less volatile than the market, i.e., if the
market moves up by 100% a fund with a beta value of 0.75 would move up by 75% and if the
market comes down by 20%, the fund will come down by 15%.
Alpha
Alpha is a measure of a mutual fund’s performance after adjusting the risk. This ratio helps to
measure the fund manager's performance.
Formula
Alpha = Mutual fund scheme return – (Risk-free rate of return + (beta*(Benchmark return –
Risk-free rate of return)

*Risk-free return is the return that would be obtained if invested in a government bond for the
same duration as a mutual fund.

Significance

The higher the alpha, it’s better for an investor. Positive alpha numbers indicate positive returns
compared to the benchmark and negative alpha value indicates negative returns to the
benchmark.

For example, if alpha is 8 it means the scheme would outperform the benchmark by 8% and if
alpha is minus 8 the scheme will underperform by 8% compared to the benchmark.

R-Squared

It’s a measure of co-relation between mutual fund schemes performance and its benchmark. It
ranges between 1 and 100.
Formula

R-Squared = (Covariance between the benchmark and mutual fund scheme/ (Standard
deviation of a mutual fund scheme* standard deviation of the benchmark))

Significance

A high R-Squared between 85% and 100%, indicates that the fund’s performance patterns have
been in line with the index. A fund with a low R-Squared, at 70% or less, indicates the fund
does not act much like the index.

Standard Deviation

Standard deviation (SD) measures the volatility of the fund’s return in relation to the average
returns. It tells you how much the fund’s return can deviate from the historical mean return of
the scheme. If a fund has 10% average rate of return and a standard deviation of 4%, its return
will range from 6%-14%.

Formula

When you take more than three-years data

Variance = (Sum of the squared difference between each monthly return and its mean/number
of monthly return data)
or

When you take less than three-years data

Variance = (Sum of the squared difference between each monthly return and its mean/number
of monthly return data-1)

Standard deviation = Square root of the variance

Significance

The higher the standard deviation, the more volatile is the fund’s returns. Prefer funds with
lower volatility.