Bajaj has opened a Pandora's box in the insurance industry. In the insurance sector foreign partners can invest only up to 26% through indirect stake holdings. CNBC-TV 18 reports how and why the insurance industry is flirting with danger!

The Bajaj Auto demerger has driven a new controversy into the insurance industry. Rahul Bajaj announced last week that Bajaj has given its German insurance partner a call option on Bajaj's stake in the venture.

Allianz has the option to acquire an additional 48% in the life insurance business at Rs 5.42, a share plus 16% interest per annum. But that is possible only if the government changes the FDI regulations.

But why has Bajaj offered to sell its stake so cheap and not priced it at a fair market value.

Sanjiv Bajaj, the Executive Director at Bajaj Auto says, “We did the deal with Allianz during the initial years when the business was expected to rake up losses and needed a lot of capital. That is why we preferred a fixed return formula. And after 2016, it is related to market price.”

The option is not surprising, considering that Allianz has contributed a major chunk of the insurance companies' capital – Rs 900 crore versus Rs 70 crore from Bajaj.

And therein lies the rub - many Indian insurance partners simply do not have the cash to constantly reinvest in the business. Many of them are manufacturing companies and would rather use the money for their core activities. So, foreign partners pump in the cash on the promise of enhanced equity stakes.

The Insurance Regulatory and Development Authority, or Irda, may not know it, but many insurance joint ventures are said to have taken various indirect routes to fund their operations; routes that do not violate the letter of the FDI law, but do test in spirit. Sources say there are four or five popular methods.

Pledging shares is the most common one, where

(a) the Indian company pledges its joint venture shares to the foreign partner.

(b) the Indian company uses the money raised as its share of capital contribution. When the FDI limit is raised, all the Indian company has to do is default on the loan. Its shares then become the property of the foreign company, at a many year old value.

The same default ploy is used in the case of the Line of Credit method wherein, the foreign partner offers the Indian partner an overseas line of credit for some unrelated international business. In return, the Indian company agrees to invest more money in the insurance business at home. Here again, the unspoken premise is that when FDI limits are raised, the Indian company would default on the line of credit and thereby have to part with its stake in the insurance company.

And then there is the Side Letters, in which the Indian company promises to sell its stake to the foreign partner at a discounted price. Since the FDI limits do not permit such a deal in India, the side letter is drawn up and stored in an offshore tax haven.

And finally, there are complicated structures using holding companies. The Indian and foreign partners create an over arching holding company. The Indian partner subscribes to a majority portion of its equity at par and the foreign partner buys a minority stake through convertible instruments priced at a premium. The Indian partner then uses the holding company’s money as its capital contribution to the insurance joint venture. The structure is designed in such a way that when the FDI limit is raised, the holding company can be merged with the insurance venture.

Six years since the insurance sector opened up, the foreign insurance companies have been waiting for the FDI limit to be raised.

For many, these convoluted ways of funding the business are the only available options.