Shyamal Banerjee/Mint
Shyamal Banerjee/Mint

Why the global insurance industry is wrong

Online term plans have grown 0.025% of the total number of policies in 2010-11 to 0.432% in 2013-14

Insurance is the transfer of risk of loss from one entity to another in exchange for a payment. An individual (usually the principal breadwinner) uses a life insurance policy as a means to compensate the loss of his income to his family in case he has an untimely death. Insurance in India is sold with the disclaimer: insurance is a subject matter of solicitation. This means that an insurance cover needs to be asked for by the customer and not sold. An individual feels the need for an insurance cover and then finds an agent to sell him a product. Not unlike a loaf of bread—you feel the need to buy, you buy from a convenient location and pay a small sales commission embedded in the price of bread towards the work done by the retailer to make the bread available.

Real life, however, is quite far away from this theoretical construct. Life insurance is not a product that people have traditionally sought out to buy. In fact, quite the opposite —life insurance agents are known globally for their pesky hard sales pitches. The difficulty of selling life insurance has encouraged the insurance industry to front load (collapse a large part of a lifetime of commissions into the first year) the first few premiums in order to incentivize the sales agent. Commissions on the first premium of life insurance policies were as high as 40% till 2010, when they were reduced for unit-linked insurance plans. But for traditional plans such as money-back, endowment and whole-life policies, these continue. Globally, there are models where the entire first premium is taken away as commission and value begins to build in the policy only from the second year. Such models have lock-ins and commission claw-backs to ensure that investors either stay the duration of the product or are compensated for the commissions that were pre-paid.

The front-loading of life insurance policies globally rests on two arguments. One, this is a product not bought but sold. Two, the difficult job of convincing people to buy life insurance (for their own good) makes high first-year commissions a basic need. However, the global growth of online insurance could be proving many of the traditionally held beliefs wrong, and could just be moving insurance to be true to its disclaimer—that it needs to be sought and not sold. Here’s why.

According to an IBIS World Report, US online sales grew 5% per year between 2007 and 2012 to reach revenues of $17 billion. An October 2000 paper by Jeffery Brown and Austan Goolsbee titled Does the Internet Make Markets More Competitive? Evidence from the Life Insurance Industry found that a 10% increase in the share of individuals in a group using the Internet reduces average insurance prices for the group by as much as 5%. It also said that growth of Internet has reduced term life prices by 8-15% and increased consumer surplus by $115-215 million per year, perhaps more.

The experience in India is similar, with online term plans growing from 0.025% of the total number of life policies in 2010-11 to 0.432% in 2013-14. Tiny numbers yet, but the growth is gathering steam. The average industry-wide growth of online term plans by number of policies was 165% and that for the industry as an average was 1% for 2011-12 to 2012-13 according to policybazaar.com data.

Although there is no study of consumer surplus behaviour in India, prices of online term plans are much lower than that of agent-sold policies and the sum assured is significantly higher. An online term policy is as much as 50% cheaper than an offline term plan for some companies. More importantly, the sum assured (money your family gets if you die) of online term plans is an average of 72 lakh as compared to 1.47 lakh for the insurance industry in India.

The primary job of a life cover is to compensate for the loss of the income stream due to the untimely death of the breadwinner. The global rule of thumb for such calculations is 7-10 times of annual income. An average of 1.42 lakh sum assured would mean an annual income of just 21,000 or a monthly income of just under 2,000. This points to the fact that the industry is not selling a life cover but an investment product with a crust of a life cover. The average sum assured of 72 lakh translates into an average income of 10 lakh—a more believable number for the middle-class India market.

The high commissions and tax breaks used to give sweeteners to both agents and buyers need to be seen in the context of rising self-bought term plans on the Internet—where a life insurance product is bought without a hard sales pitch, purely for income protection, and by people who have either been educated or have understood the importance of a life cover. This puts a question mark on the long history of life insurance industry demanding not just higher commissions but also tax breaks so that an unpalatable product like planning for your own death is sold. Maybe they’ve just done it the wrong way.

Monika Halan works in the area of financial literacy and financial intermediation policy and is a certified financial planner. She is editor Mint Money, and Yale World Fellow 2011 and is on the board of FPSB India. She can be reached at expenseaccount@livemint.com

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