Why has cost become so central to the insurance product? Nobody talked about costs for decades when we all bought endowment and money-back plans. Those of us who are old enough to have these in our portfolio remember how they were sold—the promise was of a certain sum that would come back, either periodically, or at the end of 10 to 15 to 20 years. That Rs20,000 a year would finally come back as Rs3.8 lakh after 15 years. If this meant a rate of return of just 3.5%, we were happy to buy into the product for the comfort of having the neighbour uncle push us into investing, the compounding and of course, the tax break. Nobody thought of cost because in a guaranteed return product, cost does not matter to the investor since he is looking at what he puts in and what he gets back. And if the return was just 3.5%, and he was fine with it, he invested.
Remember, the fixed deposit is a zero-load product—we all line up to offer our money for low rates of return only because there is certainty of the return. Costs became important when the traditional insurance product, which worked so well for small savers and zero-risk investors, became market-linked. Suddenly it was possible to sell a product, perceived to be guaranteed, offering abnormally high returns and play with the costs. I cannot forget a conversation in a TV studio four years back. It was a show that had a live audience in the studio who would ask questions. One person got into an argument on how he believed the unit-linked insurance plan (Ulip) was a guaranteed return product that delivered a 25% return each year. Others in the audience concurred. It was surreal to face a crowd of people, live, who believed in something that was so untrue!
The argument in the last few years with the insurance industry and regulator has been on getting this market-linked product to behave like one with a clean cost structure and without traps. After being in denial, the insurance regulator has hastened the pace of change, specially after the public outcry over Ulip mis-selling. The 28 June Insurance Regulatory and Development Authority (Irda) notice shows that finally progress is being made. It is yet another attempt to solve the skewed cost structure of the Ulip product where costs are front-loaded, leading to mis-selling, churning and lapsing. The Ulip will, from 1 September 2010, have a five-year lock-in and from the fifth year, the maximum cost chargeable to the investor will be around 4% of the corpus, and this will taper down to 2.25% from year 15. Also the earlier cost cap of 3% for policies of 10 years or less tenor and 2.25% of more than 10 years remains. How the two talk to each other is still a mystery only Irda can solve. For instance, what cost cap will apply at year 11—2.75% or 2.25%—is not clear.
With the information available, it seems that the maximum charge on a Ulip can be 4% (compared with 2.5% in a mutual fund) at the end of year five, which makes it difficult for the insurance company to load costs in the first few years as is done now. The pressure will be to get 4% compliant from very early on in the life of the product. Does this mean that high commissions are over for agents? We don’t know yet. The only way an insurance company can continue to give a higher commission will be by using its own capital—something that many companies do already.
The latest Irda move is a welcome step, even though it has taken an ugly fight and a very public expose of the Ulip scam to bring this about. But Irda needs to do more. The Ulip is a market-linked product and needs to face the market place on its own steam and not because some large operators have the muscle to twist regulation and the government. A market-linked product needs an independent benchmark so that investors can compare the returns with the index return. A market-linked product must be portable so that if the fund is not doing its job, the investor can switch at very low or no cost. These are reforms that will honestly make the Ulip a comparable product in the marketplace on its own merit and not because the agents have been bribed by a huge kickback to sell a lemon.
Endnote: There is growing discomfort with the way the government has put democracy aside to use an ordinance to amend four Acts of Parliament that govern financial markets: the Insurance Act, the Reserve Bank of India Act, the Securities and Exchange Board of India Act and the Securities Contract Regulation Act, with no debate, to vest the powers of decision-making with the bureaucracy rather than a judicial process. Worse, the sledgehammer of an ordinance was used when the option of a “direction” has been available with the government all along and could have been used at any point during the last few years as the issue boiled over. The fact that Irda is now quickly cleaning up shows that there was something wrong to start with. And to use the ordinance in favour of the laggard regulator points to all the wrong things in the system.
Monika Halan works in the area of financial literacy and financial intermediation policy and is a certified financial planner. She is editor, Mint Money.