Risks Insurance Companies Face

As with any other business, the business of insurance has its own risks and if not planned and taken into account, those risks have potential to actually wipe off the whole company! Such is the business of Insurance and that’s why risk management is the most important part of Insurance.

Just to get an idea of the risks involved, imagine the smart guy and the burnt house example that was used in the earlier articles, where he had assessed that 1 out of 100 houses will actually catch a fire and based on that, calculated premiums and his profits. Now, what if 5 houses actually catch fire. He might have to pay from his own pockets and that would result in huge losses. Now, if lady luck is really angry with him and 15 houses catch the fire! Well, in this case, he will go bankrupt!

Or to say, a new and upcoming insurance company happens to insure a gang of bike riders who, in the process of doing stunts, actually break each and every part of their bike, say every fortnight! That poor company will straight away go into losses paying for all the parts and the repairs! Or even normal riders, who, after insuring the bike, actually start driving at higher speeds and in the process, files for repairing more often than he normally does, knowing that insurance company will pay for that! That would be disaster for that insurance company!  So, in the first case, the concerned company would actually have been better off doing business with the group of riders and in the second case, the behavior of the insured actually changed after insuring the bike! Some observation, this is! 

Actually, the above examples describe the two types of risks that insurance companies face! Easy Peasy!  The first one, where the insurance company should have avoided the group of bike riders but instead did business with them, is what we call as the problem of Adverse Selection. And the second one, where though the rider was actually a normal one, he became one to be avoided after he took the insurance, is what we call Moral Hazards in the language of risk management.

Now, going back to our example, the insurer did business with the group of riders because the insurers or the company were unaware of the fact that they are actually high risk group. Essentially, this means that there is a gap in the level of information between the two groups (The group of riders knew that they will be using the insurance a whole lot more than what the insurer believes!) and in the language of Risk Management and Insurance, we call that Asymmetry of Information. So, to be a bit more technical, adverse selection occurs when the seller values the good more highly than the buyer, because the seller has a better understanding of the value of the good. Due to this asymmetry of information, the seller is unwilling to part with the good for any price lower than the value the seller knows it has. On the other hand, the buyer, who is not sure of the value of good, is unwilling to pay more than the expected value of the good, which takes into account the possibility of getting a bad piece. So, in the simplest of terms,Adverse Selection is when you do business with people you would be better off avoiding.

Now, for the Moral Hazards, it simply means that people with insurance may take greater risks than they would do without it because they know they are protected, so the insurer may get more claims than it bargained for. And even that is a result of the asymmetry of information because the insurers didn't know that the behavior of the insured will change!  So, in short, we can say that the risks are because of asymmetry of information. Aha, the golden funda!
      

                      

To talk of hidden information and hidden characteristics! The damage they can do!

So, what does an insurance company do to mitigate these risks? This can be understood by the link between smoking status and mortality. Non-smokers, on average, are more likely to live longer, while smokers, on average, are more likely to die younger. If insurers do not vary prices for life insurance according to smoking status, life insurance will be a better buy for smokers than for non-smokers. So smokers may be more likely to buy insurance, or may tend to buy larger amounts, than non-smokers, thereby raising the average mortality of the combined policyholder group above that of the general population. From the insurer's viewpoint, the higher mortality of the group which selects to buy insurance is adverse. The insurer raises the price of insurance accordingly, and as a consequence, non-smokers may be less likely to buy insurance (or may buy smaller amounts) than they would buy at a lower price reflective of their lower risk.

But then, the reduction in insurance purchases by non-smokers is also adverse from the insurer's viewpoint, and perhaps also from a public policy viewpoint. Putting up the premium will not solve this problem, for as the premium rises the insurance policy will become unattractive to more of the people who know they have a lower risk of claiming. One way to reduce adverse selection is to make the purchase of insurance compulsory, so that those for whom insurance priced for average risk is unattractive are not able to opt out! Like Auto Insurance. Now, we know the reason why it’s compulsory! Blame the bad drivers on the road, the very few who files more claim individually than what a thousand others do!
In fact, to avoid adverse selection, firms need to try and identify different groups of people. This is why health insurance premiums are higher for smokers and obese people. In banking, banks check the previous credit history of people with debts.

Now, to focus more on Moral hazards, insurance companies mitigate the moral risks by building in incentives to stick to not being too extravagant. The insurance firms needs to provide incentives so that you still want to insure your bike. This is why they will not insure for the full amount. Usually you have to pay the first Rs. 1500 of an insurance claim. Insurance firms also make the process of getting money difficult. This means that you become more reluctant to make claims and so will try to avoid having your bike stolen in the first place. And they penalize bad behavior. You usually pay more if you have taken a claim the earlier year!

So this was about the risks that Insurance companies usually face. There are others such as fake claims and dishonest agents and all, but these two are the most fundamental of all. We will look at some other fundas in the upcoming articles. Keep Reading!

Petrol Subsidies: A BIG Lie.

So, with yet another hike in petrol prices, it’s becoming imperative that we understand the rationale behind the petrol pricing in India. And that too, when the case that all oil companies are actually the highest profit grosser of the country. Look through any oil company balance sheet or income statement and you will wonder why they cry so much over the supposed losses they are making! In fact, ONGC topped the list of highest profit earning company in the year 2012. You can see that all the oil companies actually figure in the list by googling the same.

So, before I go on with all my calculations and show you how we are being fooled by this country’s govt., let me tell  you what the Indian Govt. is doing in a very simple way. They say they are giving subsidies.  And hence the petrol price is lower than what it should have been. Now, if you just look into the break up of petrol pricing, 45% of it is taxes. So, if you are lucky and live in Delhi(Ask for raise if you are living somewhere else! Or at least a petrol allowance!), where the petrol price, for the sake of simpler calculations, is say, Rs, 71. So, Rs 32 of that is actually Taxes! So, they are charging Rs 32 above what they should charge! Today’s Brent crude oil price is $ 107 per barrel and India actually gets it at 5-7% discount a barrel since it buys in bulk. Now, a barrel produces about 150 liters of oil, so price per liter would be around Rs. 44.55, discount not being taken into account and rupees at 62 a dollar, which again is high since most of the prices are protected by price hikes with the use of futures. And even the petrol companies say the cost of refining, customs and transportation, on a per liter basis, is at most RS, 3. So, the real cost, taking the higher range of everything is Rs. 48 only! Where is the subsidy the govt. is talking about??? This is my big question!

And they say that Govt. cannot subsidize the rich! Really? Who is paying all these taxes? And I am not even talking about all those other taxes that the govt. is charging. This is the unkindest cut of all! As we saw just now, at the cost price of Rs. 48 per liter and a selling price of Rs. 71.0 per liter, (who is subsidizing whom? After the latest hike, the total taxes work out to whopping 43% to 60% (in Different States) on the basic price! How much more will this Govt add on the common man’s back? Till it breaks, I guess!

At this price, even diesel is NOT a subsidized product as the cost is exactly the same at Rs. 48 per liter for Diesel (the refining process yields all final products at almost same cost!), which is sold at Rs. 56-61 per liter! So, they should spare us these bullshits  on “Govt. subsidizing the rich for their cars and two wheelers!” an d if they do not want to subsidize, they should not! It’s simple. Why go through the convoluted path of shielding consumers from price hikes and falls (And that too, as we have seen, is a gross lie), absorb that loss from the oil marketing companies(Since they are, in reality, making huge, huge profits!) and ultimately put that back on India’s national budget which again is coming from the tax money? And in the process, taxing this heavily!

This is a big hypocrisy, one of the many by this Indian Govt. In fact, if we look at the petrol prices at Purchasing Power Parity, we are paying the highest! Talk of being subsidized!

    

                 

                                                                Source: Times of India

So, even TOI, which is usually a mouthpiece of Congress and their articles make me puke, acknowledges this loot!

In fact, the heaviest investors in OIL companies are Insurers like LIC. And this is a big, big area where their profits come from. In fact,  The Life Insurance Corporation picked up around 37.7 crore shares in the ONGC offer for sale held early this year, raising its total stake in the company to 9.48 per cent ! For sure, such a big company will not invest and hence be prone to these losses, if the companies they invested in is not a profit making one. In fact, huge profit making one!
The way forward would be let the oil companies make a profit, say 10%. And sell it at Rs 52. 8. They will make profits, still, but at least we will be spared the ‘We are helping you in the process’ thought.

Shitty Thought! For a shitty thing.

PS: In March 2012, the Chief Minister of Goa, Mr. Manohar Parrikar, has shown us all the way forward, by announcing a reduction of Rs. 11 per liter of petrol! I sincerely hope many other states follow this brilliant yet popular move and expose these popular myths going around about petroleum pricing!

How Insurance Companies Make Money

So, with articles on basic insurance and Risk Management, it’s time we dig deep and learn how insurance company actually works, how they manage risks and most importantly, how insurance companies make money! And that too, when LIC is posting profits of more than Rs 25,000 Crores!

So, if I have to get straight to the point, the combination of charging profitable premiums, plus making money on invested reserves, is how an insurance company makes money. And to talk about LIC, it has invested huge in OIL companies, Banks and other like equities.

So, as in the previous articles, when the smart guy in the burnt house example charged everyone Rs 110 and one house did burn, he still made a profit of Rs. 1000/-. And this is what all of us think how profits are made by insurance. Well, it is one of the ways to make money, but not the only one. And yes they do invest in equities (Hold shares in different companies) which give handsome returns. And in India, where the concept of insurance is generally linked with savings cum insurance, where you do get your money back along with some predefined rate of interest if the insured is still alive, to put it blatantly, the concept of earning money through premiums does become obsolete and the idea of earning money gains traction.

So, technically speaking, insurance companies make money in two ways: Underwriting and Investments. 

Investments, we have a bit of an idea how it works. Now, what is this underwriting?  Underwriting is the process of evaluating the risk to be insured. This is done by the insurer (I am sure we all are sure about Insurer and the Insured here!) when determining how likely it is that the loss will occur, how much the loss could be and then using this information to determine how much you should pay to insure against the risk.

Just remember the smart guy in the basics of Insurance article, where he decided to charge Rs 110/ to insure the houses against fire. What he did was what we call as underwriting!

Let's simplify it a bit more. Imagine a life insurance company is going to issue RS.100,000 policies to 1000 people for a one year period. They collect a pot of premiums from those 1000 people. During that one year, some number of the 1000 insureds will die and collect the Rs. 100,000. The rest won't. Underwriting is choosing whom to sell the policies too and figuring out how much premium to charge.

There are different approaches to this. You could take all comers and charge them all the same amount. Of course, going into it you have to have a prediction of how many people are going to die so that you'll have enough to cover and still make a profit. Say you think 10 people will die. So you'll have to collect 10 x 100,000 = 1,000,000 to cover plus a little more for profit, administrative expense and a safety margin. Let's say you decide you need 1,250,000. You charge each of your 1000 insureds Rs.1250.

Of course you could also charge the 25 year old healthy male non-smoker less than the 75 year old obese overweight heart patient who smokes like a chimney because the first guy is far less likely to die during the year. After centuries, the life insurance industry is very sophisticated about predicting how many and when people will die. But the whole idea is that you collect enough from the large pool of insureds to pay the benefits of the small number that die during the year. That's the underwriting side of it!

Easy enough!

Now, for the other way, that is, through investment. Go back to our example. Say you collect Rs 1,250,000 in premiums on January 1 for that one year insurance policy. During that year you invest the Rs.1,250,000 and make a return -- for ease of calculation sake, say 10%. 10% of Rs 1,250,000 is Rs.125,000 -- Profit!

So, simply speaking, as insurance company's reserves are not held in a savings account. Rather, the insurance company invests those reserves. If the insurance company makes a positive return on those investments, then that money would be a profit. So, if the company makes a 10 percent return as described  earlier, they will make a clean profit of Rs. 125,000, after accounting for the payments they have to make , which actually does incorporates all the expenses they have.

Now, to understand the investment process a bit more, I would say, clearly, we would have to understand the time value of money. In the simplest of terms, it means that a 100 rupees right now will be worth less tomorrow than what it is today. Let’s understand it in a better way. You were able to buy one kg of tomatoes for Rs. 30. Today they are at Rs. 60 a kg! So, the value of that Rs. 30 has decreased by a half!! That’s what we mean by Time Value of money.  Or to say it in a different way, the present Rs. 30 is worth half of its value in the future, say after one years! 

Or, to understand the business of Insurance better, we can say that if I borrow Rs. 30 from you today and then returning the same Rs 30 to you after one year, you are actually losing money! By the tomato analogy, you actually got half of what you  should have got! So, the value of money of same amount of money today is more than what it will be after an year! And if you follow what I have been trying to say, a Rs 30 in future, here, is actually as good as Rs. 15 today!! Eureka!

Now, to understand it better, let’s get back to our books. So, if you remember something called Compound interest, the equations for which looks something like:

The equation simply means that if you invest Rs. 80 at the rate of 25% per year, after plugging in the values , the value after one year would be:

FV= 80* (1.10)^1=100

So, 80 rupees right now becomes 100 after one year.Now, just juggle the equations a bit, we will have:

What this equation does is simply exchange the places for Present value and Future value. So, if in future, if we have 100 Rs, here, it’s present value would be Rs. 80 only!!

So, when insurance companies charges you premiums based on that Rs 80 and gives you back the pledged amount after , say, 10 years, they have effectively made money with this investment without moving a muscle! That’s the beauty of time value of money! And the power of compounding, which Einstein said was the eighth  wonder of the world!  Insurance companies, in effect, know they will be paying a lot less ten years or even two years down the line than what they charged premiums for and this is where the major parts of the profits are made.

I am sure you would have a good idea by now how Insurance companies make money. In the next article, I will talk a bit more about risk management and then follow it up with articles on different types of Insurance. Keep reading!

Risk Management and the Insurance link!

So, as promised, here’s an introduction to risk management!

As they say, life is full of risks - some are preventable or can at least be minimized, some are avoidable and some are completely unforeseeable. What's important to know about risk when thinking about insurance is the type of risk, the effect of that risk, the cost of the risk and what you can do to mitigate the risk?

Now, in simple terms, mitigating the risk means taking care of the risks. Or reducing it. So, when you play cricket and wear helmets and pads and all the accessories, you are mitigating your risk of getting injured! And taking that analogy, when you buy a motor insurance, you are insuring yourself against accidents and insuring your loss of vehicle. You are mitigating these risks.

Let's take the example of driving a bike.

                       

Type of risk: Injury, Complete Bike gone, having to fix your bike

The effect: Spending time in the hospital, having to rent a car and having to make EMI payments for the bike which no longer exists! 

The costs: Can range from small to very large. Think of just fixing the brakes to changing the whole Fuel tank, shockers, and wheels. All combined!

Mitigating risk: Not driving at all (risk avoidance), becoming a safe driver (you still have to contend with other drivers and especially those Truck Drivers on the NH 24), or transferring the risk to someone else (insurance).

So, as we have seen, Risk is a condition whereby there is a possibility of loss occurring. In insurance the subject matter insured is called the Risk( You having a bike crash or your house getting, in the previous  article!).

There are two main components in definition of risk:

i) Uncertainty: Uncertainty refers to a situation where an event may or may not happen.

For eg. a building may or may not have a fire accident.

ii) Undesired consequences: Undesired consequences refers to the negative results that may arise out of an event, such as a fire accident which may result in damage to a property as well as result in consequential loss of business due to stoppage of work.

Other two things that is important to note is that Risk is distinguished from peril and hazard. Peril is a cause of loss, eg. fire. Hazard is a condition that may create or increase the chance of a loss arising from a given peril.

So, risk is that you will get cancer; Peril is that your lungs will go haywire and smoking is the hazard! Simple enough!

Let's explore this concept of risk management (or mitigation) principles a little deeper and look at how you may apply them. The basic risk management tools indicate that risks that could bring financial losses and whose severity cannot be reduced should be transferred.

            

                                                         Risk Management!

So, the basic idea for Risk Management is that first of all, you have to identify the risks. Or what we call Asses the risks. So, when you realized that you might get into an accident or some other truck wala will run you over, you realized and identified the risk you are having.

That’s about Identification of the risk!

So, after identifying the risks, you will analyze what needs to be done to mitigate the risk! Will you be able to pay the amount involved if you get involved into accident, broke your bike or your bones or both! Say, everyone in your city is such a good driver that they have never been into an accident and the chances that you will get into an accident are so less or almost negligible that paying the premiums is actually a waste of money! Or if you live in a city like Delhi, where accidents are so common that you will not even think before signing that cheque for premiums!

So, what we did in the previous steps is what we call Analysis of Risk or Risk Assessment!

Next comes what we Risk Treatment, wherein we do risk planning.There are two ways that risks can be controlled. You can avoid the risk altogether, or you can choose to reduce your risk. So, based on the city you live, you will decide whether yo take the risk yourself or pass on the risk to some insurance companies. That is what we call Risk Financing! If you decide to transfer the risk, you can then transfer the risk to some insurance company. This is also where the concept of Risk Sharing comes in, where you pay the premiums and share the risk of a bike accident with fellow riders or share the risk if your house getting burnt!

For risks that involve a high severity of loss and a low frequency of loss, then risk transference (ie. insurance) is probably the most appropriate protection technique. Insurance is appropriate if the loss will cause you or your loved ones a significant financial loss or inconvenience. For risks that are of low loss severity but high loss frequency, the most suitable method is to keep the risk with yourself (say, you getting a cold!). In other words, some damages are so inexpensive that it's worth taking the risk of having to pay for them yourself, rather than forking extra money over to the insurance company each month. 

The last step is monitoring those risks, keeping a check on the finances so that cost of transferring the risk doesn't become greater than the risk itself!  And even if you have transferred the risk, it is better to avoid the realization of those risks than face them!

So, after an introduction to Risk Management, I will be taking up Risk Management from the point of view of Insurance Companies and how they actually make money!

An Introduction to Insurance

So, with all the talks about Uttarakhand disaster and LIC paying a record amount of money to the policy holders, insurance business has come into limelight like never before. And combine that with the talks of LIC holding stakes in some of the largest oil companies and others such companies, the whole business of insurance does become interesting!

So, what is Insurance?  Insurance is a form of risk management in which the insured transfers the cost of potential loss to another entity in exchange for monetary compensation known as the premium.  Now, what does that mean? Simply speaking,  insurance is risk management.

How?

Let me explain this through a very basic example. Say, you live in a village of 100 houses and it’s winter time. All of the families depend heavily on burning firewood to counter that. Now, as you might guess, fires will be a big concern  and somehow, you do calculate that there is one in a hundred chance of a house being burnt. Now, let’s say the price of reconstructing a house is Rs 10,000. So, a smart guy comes along and says that if everyone pays Rs. 110 rupees, he will pay the amount if any house burns! So, in effect, he gets RS 110*100=Rs 11000. Now, a house does get burnt and he does pay Rs. 10,000 to the family. So, in effect, the family whose house got burnt  got the amount he needed by just spending Rs 100 and the smart guy pockets Rs. 1000 as his profits. And all others who paid Rs 100 are actually happy seeing that an amount of Rs 100 secures his house, which would otherwise have cost them Rs 10,000!

       

The above story actually encompasses almost everything about insurance! Let’s see how!

The families were under pressure and if faced with the problem, here, their houses being burnt, would have suffered huge financial setbacks! So, they were under a risk! And what is a risk? Simply speaking, it is the probability of a loss occurring. And a smart guy saw that some people are under risk and sensed a business opportunity, wherein he could transfer their risks to himself and earn some money in the process! But then again, what if two houses caught fire. What if that number, in the highly unlikely case, goes to five? He will be broke! So, even he is under a risk that his calculations of the risk he is taking goes off chart (And this is where those FRM’s and Actuaries come into picture!)! Now, in pure business, even he can pass on those risks at some cost to some even smarter guy (In Technical terms, Insurers of the insurers).

And talking of technical terms, the families in the example are the insured and the smart guy is the insurer! And the amount of Rs 100 paid by every family is what we call a premium. An dthe amount of Rs.10,000 which will be given to the family whose house got burnt is what we call pledged amount or, sum assured! Simple enough, I believe!

Now, of course, there are various kinds of risks. Like a motor accident or a flood or your life or your shop getting looted or your house getting burnt! Fairly enough, there are various kinds of insurance. Broadly, it is divided into two parts: Life Insurance which insures life or in simple terms, promises a definite amount of money if someone (The insured dies) and Non-Life Insurance, such as theft insurance which promises to pay back the value of the goods stolen!

Insurance is appropriate when you want to protect against a significant monetary loss. Say, life insurance . If you are the primary breadwinner in your home, the loss of income that your family would experience as a result of our premature death is considered a significant loss and hardship that you should protect them against. It would be very difficult for your family to replace your income, so life insurance ensures that if you die, your income will be replaced by the insured amount. The same principle applies to many other forms of insurance. If the potential loss will have a detrimental effect on the person or entity, insurance makes sense. Now, you would not want to insure if you get a cold! That would not be worth the effort and the money involved!

Insurance works by pooling risk. What does this mean? It simply means that a large group of people who want to insure against a particular loss pay their premiums into what we will call the insurance bucket, or pool. Because the number of insured individuals is so large, insurance companies can use statistical analysis to project what their actual losses will be within the given class. They know that not all insured individuals will suffer losses at the same time or at all. This allows the insurance companies to operate profitably and at the same time pay for claims that may arise. For instance, most people have bike insurance but only a few actually get into an accident.

                      

                        Pooling Risks so that no one person has to pay the whole!

You pay for the probability of the loss and for the protection that you will be paid for losses in the event they occur!

So this was a general introduction to the business of Insurance. In the most basic sense, it is Risk Management! Though it is not easy and in fact, professionals are ther to manage risks for both the insured and the insurer! Let’s talk about Risk Management in the next article on the Insurance series!

Sovereign Bonds and Phorex Money!

So with all the newspapers and magazines going gaga over Sovereign bonds and the ability of India to raise capital through these (Some are saying to the tune of $8billion), the word has suddenly become the new hot and sexy word in the finance world.

So, what is a sovereign bond? And how will it help in stalling the fall of rupee and how  it will help the economy in general? Are there any risks involved? What are those risks? How will it be mitigated? Does Greece and Spain, with whom, the word Sovereign has so closely been mentioned all these months when they failed, have done something which India should be wary of?

These and other questions are cropping up and rightly so. These need to be addressed.   So, what is a sovereign bond? And what is sovereign?  Simply speaking, sovereign is government. Although the literal meaning does mean a ruler or king, for our purpose, govt. will suffice. And a bond is a paper issued by anybody which says that that the person (Or the organization) which issued the bond owes some amount of money, generally printed on the paper. Think of NSC papers or Kisan Vikas Patras! They are bonds! Simple no?

For that matter, say you want to open up a company and need money for that. You decide to raise money through public, but do not want to offer an IPO(Initial Public Offerings!). So, what you will do is you will announce to your friends that you want some money and you are willing to offer a fixed amount of interest on that. They give you the money. How would you assure them that they will receive the interest and the amount they lent you? Simple, you will offer them a legal paper which will state the amount borrowed, interest amount (maybe) and a promise to pay that back! So, in effect you have decided to issue bonds to raise money! Which is nothing but a promise made so that you can borrow money and would pay later! Or in economic terms, these papers called bonds are in effect a way to borrow money. Or what economists call as Debt Instruments! Easy Peasy!

Now, as you can guess, what will happen if your company fails? Or you run away with all the money without actually investing all that money anywhere? Or you die? Or you are notoriously known for not paying back and nobody is actually interested in lending you money?  Or the idea of your company is very shaky and even if you are a saint, the lenders doubt your company will do good enough to pay you back?

All these are risks associated when bonds are issued. Now, inflate the stakes, as we always do, and think of a country needing money and that too dollars? What will it do? It will try to issue bonds in dollars (which means bonds which are denominated in dollars and can be bought in dollars only and payable also, in dollars!), hoping to  strengthen its economy with all that money and then pay back with  all the more earned (And hopefully, strengthen own currency so that dollar cost can be lowered. Think of buying dollars at  60 a pieces, making money on that and in the process, bringing the dollar down to 50! So , a country will earn 10 Rs per dollar without moving a muscle! Awesome! )

So, now, let’s get a bit more involved. A sovereign bond is a debt security issued by a national government within a given country and denominated in a foreign currency. The foreign currency used will most likely be a hard currency, and may represent significantly more risk to the bondholder. The risk is, say if dollar weakens(In our case , Rupee Strengthens, so somebody who has bought the dollars by selling a rupee will actually lose out if, say interest earned is 10 Rs and dollar has weakened by more than that! Poor guy! ) And the debt so obtained is called sovereign debt! Again, elementary stuff!

A US bond looks something like the one given below:

        

Now, a few things to note are that the denomination that is printed on the bond is the amount that the person buying the bond will be getting at the maturity( i.e, after the time for which it was taken,has elapsed) . Then what is the profit that the bond holder will be getting? The funda here is that bonds are issued at what we call generally a discount . So, a 10% discount bond will mean that a bond of $ 1000 denomination will actually be available at $900, a 10% discount. These discounted bonds are also called as zero yield bond!

The other thing to talk and know about is related to the risk that we talked about. Remember you running away with the money?  In case of sovereign bonds, ratings are allocated to countries, as shown below: 

Countries with AAA ratings are those with least risk and hence will have to pay lower discount or lower interest rates since they are considered safe .In case of India, the figure above means we have to offer higher interest rates to attract investors, because of BBB- ratings. Generally, lower the ratings, the more riskier it is and hence higher rates. Compare that with the money lenders who lend at higher rates because no documentation is involved and the fact that the borrower could actually run with the money. If you have an idea about the Sub prime market, banks lends to those customers who have a bad credit history at higher rates to compensate for higher risks involved!

Now, in case of India,  latest data from the RBI shows forex reserves fell to a three-year low of $280.17 billion in the week ended July 5. A sovereign bond issue would infuse more dollars into the domestic financial system, the liquid dollar available will increase and have a bearing on the rupee. And hopefully, more dollars in the economy will strengthen rupee and also shore up economics into higher growth mode.

Risks are that India will come under sovereign pressure, though it will be a good thing if the pressure is taken positively and the money is used for manufacturing and real economic growth rather than funding some fancy Gandhi plans, which will only lead to increased risk of default! We have issued these bonds twice in past, once when we were broke in 1991 and another in 1998. We need to make sure we raise money by planning better rather than as a panic reaction, which is what even 2013 bond issues will be, if there is any!

Of course, there are countries which have defaulted on Sovereign bonds, such as Russia Rubel default in 1998 which sent the stock markets and bond market crashing and the current defaults by Greece and other EU countries, which are facing very high sovereign default risks (If in local currency, you can print money, but then hyperinflation lurks just around the corner and what to do if they are in dollars!) But then again, another article for that!