Finance 101 dies each time a guaranteed plan is launched

Every time a new guaranteed return plan comes out of the ₹ 2.8 trillion life insurance factory, Finance 101 dies one more time. Remove all the bells and whistles and the core function of a financial system (this includes intermediaries and markets) is to reduce costs of moving money between borrowers and lenders. Banks are the best known intermediary between savers (you and me) and borrowers (companies with projects and also you and me as individual loan seekers). We need intermediaries and markets because the cost for me, with my monthly pot of savings, to find a company that needs the money for the time that I want to invest it for, is too large for me to make any return on my savings. Also, the borrower (think Flipkart in its early pre-billion phase, or even Kingfisher or any other company) has more information than me, the saver, at every point if we are in a one-to-one negotiation for my little pot of monthly savings.

As a saver, I am looking for the safety of my money. I do not want to take the risk of somebody running away with it. Next I want the preservation of my principal. Once this is done, I would like a return that keeps my money protected against the tax bite and inflation. And I would also like to invest in a product that matches my investment horizon or returns the money to me when I need it. A good financial system is able to do all of this for me and is able to fork across my funds and that of millions of others to those who can create value out of it from their business skills.

If the function of a financial system was to remove the information asymmetry between borrowers and lenders, the traditional life insurance products have failed miserably. To understand why, we need to do a quick recap on how we got here. The Indian insurance market was a monopoly of Life Insurance Corp. of India (LIC) till the turn of the century. LIC sold products called “traditional” plans that have opaque structures but gave guaranteed returns. Safety and corpus building investors in India had few options in the market and used this life insurance bundled product to save for the future. The opening up of the life insurance sector to private companies also allowed in a new product, called the unit-linked insurance plan (Ulip). The Ulip was a market-linked mutual fund with a crust of life insurance sitting on the product. Though the product structure was transparent, the then regulator could not foresee what the animal spirits of the market would turn this into. It finally became a trap that cost Indian investors trillions in losses. The launch of the Ulip coincided with the 2005-2008 bull-run in the market and the product that needed 10 years of funding was sold as a three-year money doubling product. So lucrative was this business that over 88% of private sector premiums in 2007-08 came from the sale of Ulips. A loud outcry against terrible cases of mis-selling prompted the government to nudge the Irda into cleaning up the Ulip product. From 1 September 2010 the Ulip has become a fairly transparent product (it needs some additional tweaks before I will recommend it, but it is getting there). But the traditional plans retained their opaque structure. Guess what the life insurance industry did? It moved to traditional plans—in 2012-13 over 65% of the first year premium by private sector companies was collected from traditional plans.

What is my problem with traditional plans in general and the current crop of guaranteed return plans in particular? They are the biggest value destroyers of an investor’s money. Savers would be better off putting the money in a fixed deposit rather than invest in products that give you an average annual return of between 2% and 4%. Why do investors bite? Because the quantum of return is never disclosed! The product benefits are constructed in a manner to obfuscate. Take this for example: “Vijay, aged 30 years, opts for XYZ Sure Return and selects premium payment term of 7 years, policy term of 20 years and pays an annual premium of ₹ 50,000 every year. Assuming that he is in good health, fixed regular additions (as a percentage of annualized premium) accrue within the policy immediately on premium payment. He gets 8% during the first policy year, 9% during the second policy year and 10% from the third policy year onwards. If he survives the start of the last policy year, Vijay will get the accrued fixed regular additions and at maturity, he gets the guaranteed sum assured which is equal to the annualized premium multiplied by the premium payment term and the fixed maturity addition that is equal to the maturity factor multiplied by the annualized premium.” Whew! There are nice diagrams on the brochure to show that your ₹ 50,000 will grow to a total benefit of over ₹ 6 lakh. Average investor looks at the big number sitting at the end of the product and thinks it is a wonderful product. A student of finance pulls out an Excel sheet. Struggles for five hours to decode the product and then finds that the internal rate of return is no more than 4%.

A simple disclosure of what the policy returns on average annual basis would be a base level regulatory action for these products that are destroying value for the average Indian middle class investor. And destroying the true meaning of “intermediation” in a financial 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, Yale World Fellow 2011 and on the board of FPSB India. She can be reached at expenseaccount@livemint.com