The last few weeks have been very perplexing for the insurance industry. For investors in unit-linked insurance plans (Ulips), it has been equally confusing, if not more. How the turf war between the Securities and Exchange Board of India and the Insurance Regulatory and Development Authority (Irda) unfolds remains to be seen, but, in the meanwhile, let’s understand the bone of contention—Ulips, which are marred with inherent problems.
Herein lies the main problem. The way Ulips are structured, the agents stand to make huge gains in the first few years. In subsequent years, their remuneration goes down and so does the attraction to remain loyal to the policy or the policyholder. In fact, Ulips are long-term products and need to be held for at least 10 years to give convincing returns. But agents have no incentive to sell them as long-term products or ensure that the customer sticks to them for the long term.
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Though Irda stepped in last year asking agents to stick with one company for at least three years, the move would be of little help. While the industry professes sound training and advisory strengths to make commissions as high as 40% look legitimate, the ground reality is quite different. Ulips are still sold as mutual funds (MFs), giving additional benefits of insurance and tax saving. It is because of this approach that lapsation in the industry runs high. And the earlier you close your policy, the less likely it is that you would get adequate returns .
Agents are allowed to get 40% in commissions, but typically get about 18% of the premium you pay. And it doesn’t stop at just 18%, every year the agent gets a portion of the premium you pay. Typically, it tapers off to 5% in the second year and to 2% in subsequent years, becoming nil in some cases towards the end of the tenure. But till the time you keep paying premiums, the agent keeps making money. His incentive doesn’t stop even if he mis-sold the policy to you.
While the agents have nothing to lose if you opt out, you stand to lose money and your insurance cover if you do so.
Ulips deduct a substantial portion of the total costs in the initial years. The industry’s rationale: The cost of procuring a customer is huge in year one. This they recover from policy allocation charge, which includes commissions and other costs. Some Ulips that have low or nil policy allocation charge hide this cost in policy administration charge.
Because the costs are front-loaded, in the initial years, your money pays mostly for the charges and there’s hardly anything left to be invested. Look at it as moving into a new place: you pay the brokerage and spend capital in logistics and setting up the house. If you realize after a month that your house is not what you were looking for and decide to shift, you would have to spend a huge sum once again, while losing out on what you have already spent. In Ulips, too, if you switch to another, you would pay the same costs twice.
Ulips are investment-cum-insurance products, but at the practical level, they give none of the benefits. Unlike MFs, where benchmarks and comparison are readily available, Ulips still work in isolation.
Having benchmarks, which give you a reference point to compare your returns, is not mandatory for Ulips. In the MF industry, there are several independent entities tracking and tabulating performance in reader-friendly formats, there is no such thing happening for Ulips.
Unlike their traditional peers that come with other pitfalls, Ulips don’t even provide adequate insurance. The industry average is to give 10 times your premium as the sum assured and many policies don’t give beyond 25 times. In fact, some policies only give you up to five times your premium as sum assured.
Also, Ulips that give you the benefit of either the fund value or death benefit on death of the policyholder expose you to serious risk—the risk of investing too much but leaving behind too little for your family in case the market tanks at the time you die.
As a rule of thumb, financial planners suggest 10 times your annual salary as a must-have cover. If your need is insurance, buy a term plan, the simplest and cheapest form of insurance. If you still want to buy a Ulip, keep a goal in mind like your child’s education or marriage and keep funding that policy till you hit maturity. But if you want to invest in equity and have a short-term horizon or are uncertain about when you need the money, go with an MF instead.
Graphics by Yogesh Kumar / Mint