Wider service tax net gives term plans an extra edge over Ulips

Wider service tax net gives term plans an extra edge over Ulips

The new service tax rules will make your life insurance policy more expensive once the Finance Bill, 2011, gets enacted. While for a term plan it would mean business as usual, for investment products it would also mean a hit on the returns.

Also See Who Gains, Who Loses (PDF)

Budget 2011 announced two major insurance-related proposals: first, that the scope of life insurance service be widened to cover all services provided to a policyholder and that service tax be levied on the portion of the premium other than what is allocated for investment where the charge break up is given; and two, that the composition rate be increased from 1% to 1.5%.

We look at how these proposals will make your insurance policy more expensive.

If you have a Ulip

If you have an unit-linked insurance policy (Ulip), the first proposal is of consequence. The service tax proposal is to increase the scope of service tax to cover all services provided to a policyholder and to levy a service tax on the portion of the premium that is not invested. In other words, you will now have to pay a service tax on all the charges of the policy as against a service tax on only the fund management charge and mortality charge as is the case currently.

Ulips are made of typically four cost heads: policy allocation charge, policy administration charge, fund management charge and mortality charge. As the name suggests, mortality charge deducts the cost of insuring you and fund management charge deducts a cost for managing your investments. The other two are costs that get deducted to service the policy.

Currently the service tax is only applicable on the mortality charge and fund management charge. The rate of service tax is 10.3% including cess. However, moving forward, it will be applicable on all cost heads and considering you would typically end up bearing that cost, it means more payout in the form of service tax for you.

Impact on returns: In other words, your payout is more while the returns from that payout stays constant. Say, you have an Ulip where you pay an annual premium of 1 lakh. This policy deducts 4%, or 4,000, as policy or premium allocation charge annually, charges 1,309 as fund management charge and charges 3,000 as the policy administration charge and 2,853 as mortality or risk charge in the first year.

Under the current system you would be paying 429 as service tax since you pay a service tax only on the mortality charge and the fund management charge. However, once the new rule kicks in, you will be paying about 721 extra. Says V. Srinivasan, chief financial officer, Bharti AXA Life Insurance Co. Ltd: “The service tax is not under the regulatory cap of charges. It is likely to impact the returns. For instance, for a 15-year policy the returns will come down by about 30 basis points."

One basis point is one-hundredth of a percentage point.

If you have a traditional policy

In case of a term plan, that only charges you for the insurance cover and does not invest your money, there is no impact as the service tax continues to be levied on the entire premium. The rate of service tax continues to be 10.3% and hence your term plan does not become more expensive.

However, for traditional plans that also invests your money but don’t explicitly disclose costs as done by Ulips, the composite rate is 1% or 1.03% including the cess currently. This will increase to 1.5% or 1.545% as per the Budget proposal. So you will pay 50% extra on service tax for the same sum assured. Insurance policies that double up as investments products are increasingly getting expensive—increase in service tax and the proposed direct taxes code which brings insurance-cum-investment products under EET (exempt-exempt-tax) category—despite the recent clean up.

Says Rajesh Relan, managing director, MetLife India Insurance Co. Ltd: “There has to be encouragement for long-term savings and the recent move does not encourage long-term savings. Also life insurance industry needs to be seen in the light of the services it is providing. While managing funds and policy administration are services, a mortality charge is a cost that we deduct for providing insurance. This is not really a service."

The new service tax rules have once again lent prominence to term plans. It will be a good idea to keep your insurance and investment needs separate. For insurance needs, look at terms plans and with many insurers now offering term plans online, buying a term plan has become much simpler.