Home / Money / Calculators /  Hygiene rules for financial products

Why is a financial product mis-sold? Mainly because of badly constructed products, half-baked disclosures, uneven distribution incentives that tilt sales towards fat commission products and an uneven tax regime. It is these problems that the Sumit Bose committee seeks to address. The committee, chaired by Bose, former union finance secretary, was set up to recommend measures to curb misselling and rationalise distribution incentives in financial products. The full report is available on the Ministry of Finance website and you can read it here

Regulatory head

As a first step towards improving hygiene standards in financial products, the committee recommends that regulators should regulate financial products according to the function of the product. “In order to bring uniformity and proper oversight, the function should decide the regulatory framework. This means that, IRDAI (Insurance Regulatory and Development Authority of India) and PFRDA (Pension Fund Regulatory and Development Authority) should harmonise their investment regulatory function with that of the lead investment regulator SEBI (Securities and Exchange Board of India). IRDAI should take the lead on insurance and annuity function," said the report.

This would mean that the current situation of similar products coming under different regulators will cease. For instance, pension plans offered by insurers are regulated by Irdai, whereas the ones offered by mutual fund companies come under Sebi. Your Employees’ Provident Fund is overseen by the Employees’ Provident Fund Organisation (EPFO), whereas the relatively younger National Pension System (NPS) comes under PFRDA. The report’s recommendations mean that all of them will come under a single regulator, i.e., PFRDA. Bundled products such as non-term life insurance, function will decide the regulator. For instance, investment part of an insurance policy will be governed by rules set by Sebi.

Product design

The second focus of the report is on product design as a way to curb miselling ex ante rather than chase instances of mis-selling ex post. This is done by suggesting a product design that spells out investment benefits and costs clearly to the buyer in a manner that she will understand. Further, these costs need to sit in one place and be capped by the sector regulator. Similar functions across various products should have similar costs. “There are three basic functions that a financial product serves—protection, investment and annuity. In the investment function, the mark-to-market products must follow the cost structure decided by the capital market regulator. The non-mark-to-market products must follow the cost structures of other deposit-like products such as bank deposits," said the report.

For insurance policies this means that there should be a clear split of the premium into mortality cost and investment, at least for the new set of insurance policies. Mortality costs should be benchmarked to the mortality tables created by third-party actuarial firms and investment costs should be capped keeping in view the best practices in the rest of the market. “For example, for non-participating plans, costs should be benchmarked to best practices in banking or other small savings products that invest in similar products that give guaranteed returns. For participating plans, costs should be benchmarked to similar asset allocation products in the mutual fund space or the NPS," the report stated.

The aim of such measures is to standardize costs for financial products that have the same set of functions. So, products that invest in debt securities and guarantee returns should have similar costs irrespective of whether they are designed by a bank or an insurance company.

Further, the report suggests that the costs of surrender should be reasonable. In insurance, when a policyholder leaves midway, there is a penalty called the surrender charge or discontinuance charge. For unit-linked insurance plans (Ulips), these costs have been capped at a maximum of 6,000, but it continues to be exorbitant for traditional plans.

Open disclosures

The third focus is on making disclosures meaningful. The current format of disclosures in certain products hides more than it reveals. Therefore, it has been recommended that disclosures must be made in a manner that makes lay investors understand the impact of costs, early exit, ideal holding period and returns (which should be a function of the amount invested).

These disclosures should be machine readable to enable creation of web-based tools and mobile apps. The committee recommends that a one-page disclosure form should be made available at the point-of-sale, which both the customer and the seller can sign off on.

The report also said that the word “bonus" should not be used by insurance companies in lieu of “return".

For mutual funds, it recognizes the importance of the fund manager in shaping performance, and to that extent has recommended disclosure if there is a change in fund manager of a scheme. It also recommended adding the competence of the person as a risk factor.

Often, the difference in returns between similar products with the same benchmark can be explained due to the different management styles of portfolio managers.

“The report is a bit uneven when it comes to solutions. For example, disclosure of commissions at the time of sale is stipulated for mutual funds, but not for insurance products. It axiomatically states that selling risk products is difficult, but does not acknowledge the difficulty in selling market-linked products such as mutual funds or NPS. Also, the idea of a trial period for mutual funds is practically not feasible," said Srikanth Meenakshi, co-founder and chief operating officer,

Distributor commissions

The fourth focus area has been commissions. It recommends levelling commissions on the investment component of all financial products so that there is no cost arbitrage for the distributor due to which they gravitate towards the products with a higher incentive. Currently, products in the market do not have a uniform commission structure, as a result of which those with lower incentive structures are not preferred by distributors. For example, the distributor fee for NPS is currently 0.25% of the contribution (minimum being 20 and maximum 25,000). In insurance, the upfront commission or commission in the first year itself is as high as 35-40% of the premium paid by customers with a premium payment term of 12 years or more. Given this gap, distributors such as banks that sell both NPS and insurance policies may prefer to offer insurance plans to customers. But by levelling commissions, the distributors may be encouraged to do certain amount of need-analysis of the customer. “Upfront commissions in investment products and investment portion of bundled products skew seller behaviour and cause mis-selling and churning. These should be phased out completely," noted the report. It further added that upfront commissions for pure mortality should continue since selling a pure life insurance cover is relatively difficult.

Accordingly, the committee has suggested that commissions on the investment component should move to an assets under management (AUM)-based trail model. This means the distributor gets a commission as a percentage of the AUM. As a product becomes popular or if markets go up, AUM, and commission, will increase. When markets fall, commissions will come down.

For insurance policies, this means that commissions on the insurance component can be decided by Irdai. So, for example in a Ulip, the commission on the insurance component will be decided by Irdai whereas the investment component will be decided by Sebi. For mutual funds, the committee has recommended that costs within the total expense ratio should not be fungible.

Another recommendation made with the intention of aligning mutual fund distributors’ and investors’ interest is to remove upfronting of commissions. It has been suggested to put in place a declining trail commission model and to remove the additional commission for sales in beyond top 15 cities (B15).

Lastly, a reduction in cost caps as AUMs increase has been recommended. According to the chief executive officer of an asset management company, who did not want to be named, “Going for an all trail model is the best way forward and removal of fungibility of costs is also welcome as it will do away with any unaligned interests. Overall, if technology can be used to bring about changes, then this model can work. Getting an investor on board has to be made easier through the use of technology."

Other recommendations

The report said that insurers should not be allowed to book lapsed profits—a practice that encourages churn in life insurance policies. It also acknowledged that tax treatment of financial products is an important consideration for investors and said that there should be uniformity in how similar products are taxed. This is especially important for products such as NPS, which currently faces an EET (exempt-exempt-taxed) regime in which the withdrawable maturity corpus is taxed, whereas for products such as EPF, it is tax-free.

For mutual funds, the recommendations include periodic audit of the scheme benchmark, asset allocation and portfolios to ascertain that schemes have not strayed from original mandates. It also suggested that duplicate schemes should be merged. Doing so would be beneficial as long as innovative products aren’t curbed.

An end to misselling?

The main focus of the report is to standardise costs and uncomplicate investment benefits through proper disclosures. These changes are meant to empower the investor to take an informed decision by improving their understanding of costs and benefits of a financial product and enabling comparison.

“It brings sharp focus to the under-addressed issue of mis-selling. The fact that it seeks to address it not just for a particular product, but across products (under multiple regulators) is a welcome, and ambitious effort," said Srikanth.

For distributors, discontinuing upfront commissions would mean they are encouraged to serve you longer, and can build a stable livelihood through trail commissions. Uniform commissions across similar products means distributors can become commission agnostic when making a recommendation.

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