Much like other statutory warnings that manufacturers of harmful products hope you won’t really listen to, ads for unit-linked insurance policies (Ulips) are followed by a jaded voice, chanting: “Please read the policy document before investing”. And, there is a very good reason for you to heed that voice. Insurance companies are removing costs that you recognize and are stuffing them in places that you don’t see yet. To understand the issue fully, we need to understand all the Ulip costs first.
An average Ulip comes with four cost heads. The first you encounter and, hence, recognize, is the premium allocation charge (PAC) or what the mutual funds call a “load”. This is a straight deduction from the premium cheque you write before even one rupee goes to work for either insurance or investment. In some policies you lose between Rs40,000 and Rs70,000 out of a premium of Rs1 lakh in the first year. This face of the enemy you already know. The second cost is called mortality charge, which is the cost of pure life insurance (what you would pay in a term policy that sells just a life cover without the bundled investment).
The third cost is fund management charge, which is now capped at 1.35% of the fund value. You pay this charge to your fund manager to invest your money well.
The fourth is the policy administration charge. Traditionally, this was as little as Rs50 a month or Rs600 a year, irrespective of the insurance amount or the premium you paid. It was a fixed cost that took care of expenses of an insurer such as paper work, stamp duty, welcome kit and policy brochures (note that mutual funds take care of all these costs plus fund management from the 2% annual charge).
Now, here is the rub. Some insurance companies are linking this administration cost to either the premium or the sum assured and using the cash to pay commissions, medical underwriting cost and marketing cost, while keeping the PAC either zero or less than 10%. Says Andrew Cartwright, chief actuary, Kotak Life Insurance: “At least 40% of the first-year premium is required to recover the cost of a Ulip. This cost was recovered through PAC. But now with PAC gaining visibility, this cost is recovered through the administration charge.” The agent, while selling the plan, usually forgets to point out the cost padding in the administration charge, but does highlight the 100% allocation feature quite well.
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How it hurts
But how do we know that the 100% allocation Ulips cost as much, if not more, than those that do not use administration costs in this manner? The only way to see what a policy will finally cost is to look at its return, net of costs, on an illustration (or example) of an assumed return of 10% per year. This means that if the policy returns 10% per year, post accounting for costs, it would return, say, 8%. The 2 percentage points gap is the cost that you pay each year. Our research shows that an efficient Ulip returns 8% or more net of costs (on an assumed 10% return).
We examined four Ulips with less than 10% PAC in the first year and looked at their net return (on a 10% illustration). We found that in all cases, the net return was below 8% (see chart).
But do note that the net returns are within the regulatory cost limit fixed by the regulator. But also note that in a competitive market, regulatory caps are ceilings and not floors. The insurers are themselves divided on the correctness of linking administration costs to the sum assured.
Says Paresh Parsnis, managing director, HDFC Standard Life Insurance: “We like to treat customers paying a higher premium differently by providing value-added services, especially in the case of high net-worth individuals. Hence, the administration charge is linked to the premiums. However, there is no argument to link this charge to the sum assured.” Agrees Pranav Mishra, senior vice-president and head (products), ICICI Prudential Life Insurance: “Differentiated service experience includes a basket of services such as welcome calling, separate queues at our call centre and a quarterly lifestyle magazine.”
Of course, it is debatable whether you will want to pay for, or even, get this preferential treatment. But since this cost is not negotiable, you end up paying for services which you may not want or even get. Our advice: don’t get taken in by the 100% allocation sales smart talk, ask for the net return (also called an internal rate of return) on a 10% illustration. If the return is less than 8%, avoid the plan.
Graphics by Ahmed Raza Khan / Mint