Is Moody's downgrade fair to LIC? :: Business Line,

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Limited foreign ownership should, in fact, not hurt LIC's credit ratings.

Recently, credit rating agency, Moody, downgraded Life Insurance Corporation's (LIC) rating from Baa2 to Baa3. What does this mean for LIC and its policy holders?

Let us begin with what credit rating means. Credit rating of an entity —be it individual companies, corporations or a government — reflects its capacity to repay its financial obligations. In other words, credit-rating represents an entity's risk of default in repaying its liabilities.

This assessment is typically based on the company's past history of borrowing and repayment, as well the future capacity to repay based on the available assets and liabilities position.

DOES CREDIT RATING HELP?

In general, credit assessment of companies by major rating agencies such as Moody's or Standard & Poor's influences the borrowing capacity of the companies, and provides valuable insights to potential lenders.

A high rating sends a positive signal, and installs confidence to potential lenders. This signal, in turn, helps the companies to borrow at better terms than otherwise.

The ratings also serve as a barometer for lenders to decide which companies to lend to and what rates to charge for the loan amount.

LIC'S DOWNGRADE

Moody's recent downgrade of the largest insurance company in India, LIC, has emerged when the agency reviewed all the institutions that have higher ratings than their domicile nation.

The major reasons cited for the downgrade can be summarised into two related points. First, LIC's operations are excessively focused on the domestic market and there is limited diversification in its operations. Second, LIC has inadequate foreign ownership and has significant exposure to domestic sovereign debts.

STRENGTH OR WEAKNESS

Much of these reasons, particularly lesser stake held by foreign investors, should favour LIC's credit ratings.

To explain, India was one of the very few countries to be less affected during the recent global recession in 2008. One of the reasons touted for such insulation is that India's exposure to global markets was not as high as it was for many other (deeply affected) countries.

India's domestic demand actually propelled the economy to shake off negative global sentiments.

Limited foreign ownership, in that regard, should analogously work in LIC's favour rather than being one of the reasons for the downgrade. The same argument holds good for being substantially driven by domestic demand.

With more than a billion people in the country, and only less than 20 per cent of them currently covered by LIC's policies, the Corporation has ample scope to tap the domestic market before looking outside of India.

IS LIC UNFORTUNATE?

The other reason for the downgrade, namely holding plethora of government securities is, perhaps, an unfair treatment extended to LIC exclusively. By law (Insurance Act), insurance companies that cover the general public on traditional insurance plans are mandated to hold 50 per cent of their portfolios in Central Government securities.

This was done to ensure that major portion of the investments is parked in relatively risk-free assets.

Should LIC be downgraded given that it was only following what is perceived as prudent practice by law? Then, shouldn't a similar downgrade be extended to all banks where the government holds more than 50 per cent stake?

IMPACT OF PREVIOUS DOWNGRADES

In June of 2010, Moody's downgraded British Petroleum three notches down (for the second time in the same month) from A2 to Aa2. But BP did post an 18 per cent increase in operating profits in the subsequent quarter.

This is not to suggest that credit ratings do not matter, but rather to give a heads-up that we could very well still find life as usual with LIC and its policy holders.