How would you react if you were told that you could lose your money if you exited a product before its term expired or that if you stuck on, the returns may be nothing to write home about? This straight talk, in all likelihood, will prevent many from buying traditional insurance-cum-investment plans. But, in reality, the agents’ smooth talk and smart product packaging get many to line up for them—these bundled plans are sold as guaranteed products, with an element of insurance and tax benefits. Lack of proper disclosures makes matters worse. On top of all that, these plans come with heavy surrender penalties that can eat up the entire investment in the first year. The two areas of costs and disclosures are crying for attention. Here are the details.

Product construct

These are opaque plans that can broadly be classified as participating and non-participating plans. Participating plans guarantee a certain minimum amount, typically the sum assured, and promise periodic additions, which are pegged to the performance of the underlying fund (also known as par fund) and that, once declared, are guaranteed. In the case of non-participating plans, the returns are guaranteed, and the benefits are declared upfront.

As investment products, their USP is the fact that they come with an added layer of insurance, but so far these products have not impressed financial planners due to poor returns. “These plans enjoy superior tax treatment compared to a normal fixed deposit due to the insurance wrapper. Despite this, the returns are not very competitive," said Shyam Sunder, managing director and co-founder, PeakAlpha Investment Services Pvt. Ltd.

Returns from participating plans are in the range of 4-6%, according to experts, while the many non-participating or guaranteed plans that Mint’s personal finance team has decoded in the past give returns of around 4%.

Surrender value in a Ulip vs a traditional saving plan
Surrender value in a Ulip vs a traditional saving plan

Moreover, traditional plans come with huge surrender penalties, despite the new guidelines—likely to be enforced in December—that have reduced them.

Due to the high penalties, early exit from traditional plans means loss of the principal invested. Currently, the rules discourage early surrender by not returning any money if you exit before paying three premiums for a policy with a term of more than 10 years. For policies with a tenure less than 10 years, you need to pay at least two annual premiums to get some money back in case of surrender. The new rules, once implemented, will bring down the period to two years for all policy terms. Even after paying two premiums, the surrender value you will get is 30% of your investment. This surrender value increases to a minimum of 50% between the fourth and seventh years.

What is disturbing is that the industry has moved towards selling more traditional plans. For the private sector, according to data provided by the Insurance Regulatory and Development Authority of India (Irdai) for FY18, nearly 55% of the premiums come from the non-linked or traditional portfolio, whereas for the overall industry, including Life Insurance Corp. of India, this figure is 86%.

At the same time, the industry has been witnessing poor persistency ratio, which shows the continuity of a policy by measuring the number of premiums paid. According to Irdai figures, the average 13th month persistency was at 69% and 61st month persistency at 35% for FY18.

Since traditional plans form a huge chunk of insurance sold, they also have a larger share of discontinued policies. It’s not difficult to imagine then how big an amount customers are paying for surrender.

One of the reasons why the industry has moved to traditional plans is high commission structure. “After costs on Ulips (unit-linked insurance plans) were streamlined, we find that many distribution channels have migrated to selling traditional plans due to better remuneration. However, this results in higher costs for customers, eating into the returns," added Sunder.

A compliance officer at an insurance company told Mint, on condition of anonymity, that the commission ratio in a traditional plan is around 25% compared to 6% for Ulips.

The cost factor

Unlike traditional plans, which have high embedded costs and, therefore, exorbitant surrender penalties, in Ulips, the costs are defined by the regulator.

Ulips come with four main cost heads: premium allocation, policy administration, fund management and mortality charges. While premium allocation is a straight deduction from the premium, the other three are deducted from the invested corpus. The current rules define cost caps by a cap on the reduction in yield (the difference between gross yield and net yield is capped). However, the new rules, once implemented, will also cap individual cost heads, barring the mortality cost since that would depend on the policyholder’s age. “Costs in Ulips provide a basis for how costs can be set,"said Kapil Mehta, co-founder, Securenow.in.

A rough back-of-the-envelope calculation shows that if you surrender a Ulip in the first year, assuming no fund growth, you would get back around 70% of the corpus. In comparison, traditional plans return no money (see graph). In fact, as mentioned earlier, in traditional plans, even by the seventh year, the minimum guaranteed surrender value is 50% of the premiums paid.

“Even when a person puts money in a recurring deposit, she gets her principal back if she decides to liquidate. In traditional plans, the cost of liquidating the investment before the term is very high and this is unfair especially because other bundled insurance products like Ulips give much more in case of early surrender," said a senior industry official, who didn’t want to be named.

To remove this inequity, the commission structure will need change. “Commissions are much higher in traditional plans compared to Ulips. Commissions are front-loaded so in the first year it can be as high as 35% and then it comes down, but in the first five years, an agent gets about 60%. If the quantum can’t come down then there is definitely a case to evenly distribute the commission that will also encourage persistency," said the official.

Poor disclosure

Another problem area is poor disclosure. For instance, agents need to show customers a benefit illustration that shows policy benefits for each policy year. The illustration is made assuming returns of 4% and 8%. But what this benefit illustration lacks is the net return that takes the costs into account. So if a fund grows at, say, 8% and the net return is 7%, the costs would have shaved 1 percentage point off the gross return. Given that these plans don’t disclose costs, mentioning the net return becomes important.

In fact, mentioning the surrender value at the end of each year—to drive home the point that early exits can be costly—followed by a column that explains the net return for early exit at different points in time is also important. The market conduct guidelines have made it mandatory for insurers to mention the surrender value and that’s a step in the right direction, but the mention of net return is still missing.

The second layer of disclosure happens when policyholders get the periodic statement on the bonuses accrued in the plan. “The method of expressing bonuses is important. The current default is as a percentage of the sum assured. This could also be expressed on premium as a base to be better understood and more relatable. The annual statement could include a net return on investment for policyholders and some form of a benchmark," said Mehta. Even non-participating plans that declare returns upfront don’t give the net return.

A product overhaul that transforms the market from “buyer beware" to “seller beware" is needed, and so is a relook at commissions. Adding more disclosures so that investors are able to assess their returns is equally essential.

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