Regulatory mistakes on the treatment of investment products sold by insurance companies

by Ashish Aggarwal.

There are cost and commission differences in what are essentially investment products across insurance, mutual funds and pension. These tilt the market towards products with higher commissions. In insurance, the commissions are both high and front loaded. This causes serious problems, particularly in conjunction with poor persistency (high percentage of customers discontinuing their policies midway), which is often an outcome of mis-selling. Let us examine the evidence about these problems and the regulatory failures.

The large scale mis-selling in ULIPs was prompted by high front loaded commissions, helped by high costs and poor disclosures. Research shows that investors lost more than a trillion rupees on account of these mis-sales. Similar problems continue to plague the traditional insurance products, whose sales shot up after regulation of ULIPs was improved.

The Sumit Bose Committee on curbing mis-selling and rationalising distribution incentives had in August 2015, recommended:

1. Investment products and investment components of bundled products should have no upfront commissions.
   
   
2. All investment products and investment portions of bundled products should move to Asset Under Management (AUM) based trail fee.
   

Eight months later, IRDAI has not made progress in these directions. Even as SEBI has improved consumer protection, IRDAI has weakened consumer protection. Regulatory arbitrage between similar products is getting worse (Sebi tightens disclosure norms, versus IRDAI plans to increase commissions, and IRDAI removes persistency norms for distributors, specified in 2011).

High Costs

Life insurers are allowed to charge 90 percent of the first year and 15 percent of the renewal premium as cost for policies of over eleven years (Rule 17D prescribed by the Central Government under the Insurance Rules, 1939). Section 40B and 40C of the recently enacted Insurance laws (Amendment) Act, 2015 have made the above cost caps defunct and allowed IRDAI to regulate the same. Why did the government persist with such high cost structures for over 75 years? This continued even after IRDAI was established in 1999.

IRDAI's proposed reform as outlined in the draft on Expenses of management of Insurers transacting the business of life was released in December 2015. This suggests reducing the cap to 70 percent in the first year and 12 percent thereafter. The analysis that we present ahead shows that these numerical values are unjustifiable.

All insurance, other than protection (called term plans), are basically investment products with about 5 percent of the premium going towards protection. Consider a traditional plan with an annual premium of Rs 1 lakh and protection of Rs 10 lakhs. A standalone protection plan of same amount is priced between Rs 3,000-4,000 per annum (for 15 years, for a 40 year old). In other words, about Rs 96,000 of the premium is available for investment. No other product allows its manufacturer to charge upto 90/70 percent of this as cost in the first year.

High costs impact returns. This is amplified in case of traditional plans where the portfolio design is low risk. As shown by the table in Bose Committee report, the nominal returns on maturity can be very low. They can turn negative, even in nominal terms, if the policy is discontinued/ surrendered, after being held for many years!

Traditional Plan (Non Linked Participating)
This table shows the net yield on premiums (net of mortality costs) in case of premature exit for a 35 year tenure policy with an annual premium of Rs 2,881 and a sum assured of Rs 100,000. The customer age on joining is 30 years. For example, based on the above scenario, in case of surrender after 25 years, a customer would have earned a net negative yield of -0.1 percent on investment
Years	At 4% returns	At 8% returns
5	-27.2%	-23.5%
10	-9.7%	-6.3%
15	-4.8%	-2.6%
20	-2.5%	-0.9%
25	-1.3%	-0.1%
30	-0.4%	0.6%
35	2.4%	5.3%

 

High front loaded commissions

A life insurance product is usually for 15-25 years. In a 15 year traditional plan, the distributors could get 33 percent of the total commissions over 15 years in first year itself. In a ULIP, this could be 17 percent. On an NPV basis, they could earn 62 percent and 48 percent of the total commissions in the respective plans, in the initial three years. See:

UlIP/ Traditional Plans: Front loading of commissions
Particulars	Year 1	Year 2	Year 3	Year 15
Annual Premium	100,000	100,000	100,000	100,000
ULIP Commission	15%	7.5%	5%	5%
Yearly Commissions	15,000	7,500	5,000	5,000
Cumulative Commission (A)	15,000	22,500	27,500	87,500
Cumulative Commission on an NPV basis (discount rate of 10%) (B)	15,000	21,818	25,950	54,106
Cumulative Commission as a % of total commissions (A)/87,500	17.1%	25.7%	31.4%	100%
Cumulative Commission (NPV) as a % of total commissions (NPV) (B)/54,106	27.7%	40.3%	48%	100%
Traditional Plan Commission	35%	7.5%	5%	5%
Yearly Commissions	35,000	7,500	5,000	5,000
Cumulative Commission (A)	35,000	42,500	47,500	107,500
Cumulative Commission on an NPV basis (discount rate of 10%) (B)	35,000	41,818	45,950	74,106
Cumulative Commission as a % of total commissions (A)/107,500	32.6%	39.5%	44.2%	100%
Cumulative Commission (NPV) as a % of total commissions (NPV) (B)/74,106	47.2%	56.4%	62%	100%
Commissions: ULIPs - Y1 15%, Y2 7.5% and Y3 onwards 5%
Commissions: Traditional Plans - Y1 35%, Y2 7.5% and Y3 onwards 5%

While front loaded commissions drive sales, they leave distributors with little incentive to worry about investors staying put. For a long term product, this can be a recipe for mis-selling. In insurance, this usually means pushing low-return high-cost products. The front loading also incentivises churn, i.e. encourage customers to drop-off from the plan and then sell them a new policy, to make high commissions in the initial years, all over again.

Consumers interested in higher returns, could easily buy a term plan for protection, and mutual funds for investment. Clearly, most consumers do not understand this option. Even with online purchase removing the need for a distributor, the term segment constitutes less than 10 per cent of the insurance industry business. A pan India survey sponsored by IRDAI shows that only 38.23 percent of household replied felt that they were reducing risk by purchasing insurance products. The same survey reported that majority of insured perceived insurance as a bundle of savings and protection (see table).

Perception of Insurance
Perception	Insured Households			Uninsured Households
	Rural	Urban	Total	Rural	Urban	Total
Savings tool	10.5	9.3	9.9	10.0	10.0	10.0
Protection tool	20.5	20.8	20.7	15.6	17.6	16.8
Both	49.7	15.6	51.6	26.5	26.0	26.2
None	19.3	16.4	17.8	48.0	46.4	47.1
All	100.0	100.0	100.0	100.0	100.0	100.0
Total number of households	11,301	10,866	22,167	3,237	4,774	8,011
Source: IRDAI sponsored Pre-launch Survey Report of Insurance Awareness Campaign, NCAER, 2011

In a term plan, distributors earn about 25 percent commission in year one and five percent thereafter. In rupee value and in comparison to investment plans, this offers them no motivation. A Rs 10 lakh term plan, as described earlier, would earn Rs 750-1,000 in the first year. As against this, a traditional plan/ ULIP with an annual premium of Rs 1 lakh could earn Rs 35,000/ 15,000 in the first year.

The argument that customers make informed purchases does not tie up with the high discontinuance. The persistency is at just 65 percent at first year, meaning, 35 percent of the customers drop off within the first year. At the end of five years, 63 percent drop off. The Bose committee noted that, in the case of LIC, the 61st month persistency in 2013-14 was just 44 percent.

Source: McKinsey & Company, India Insurance Vision 2025, Prepared for Confederation of Indian Industry, 2015

Problem of partial fixes

IRDAI has since 2010, improved the regulation of ULIPs. These improvements include mandating charges to be evenly distributed during the lock-in, to reduce the high front end expenses. IRDAI also imposed cost cap as a percentage of the yield on the product. This resulted in the following trend in sales:

Shift in sales from ULIPS to traditional plans. Source:Bose Committee report

Sales of ULIP declined dramatically. The distributors shifted to sell the more toxic (expensive - no cap on reduction in yield; and opaque - customer is not explicitly disclosed costs or the the net return on investment) traditional products which were left out of the clean up. This phenomenon is also reflected through an audit study of insurance agents carried out by Anagol, Cole, and Sarkar (2012).

Problem of sectoral arbitrage

Mutual funds too faced similar problem, albiet on a smaller scale. Over the years, SEBI cleaned this up (removed initial issue expenses in 2008, banned upfront loads in 2009, required funds to offer direct plans in 2012). AMFI, the industry body, followed this up in 2015 and capped upfront commissions to one percent and banned payment of advance commissions. Anecdotal evidence suggests that some distributors are moving to an advisory or online sales model. The remainder have either exited the business or have shiftd to selling insurance plans. In less than four years of SEBI directions, retail investments in mutual funds from direct purchase (without any intermediary) have grown to 13 percent of the total.

However, with IRDAI not keeping keeping pace, the disclosure and product structure norms do not allow consumers to compare basic features like costs and returns with mutual funds and NPS. This further helps distributors to push insurance as the preferred long term investment instead of mutual funds (where the commissions are backloaded) or NPS (where the commissions are low and evenly spread).

Sectoral arbitrage: Front loading of commissions
First year commission as a percentage of total commissions payable (Nominal basis)
Tenure	Mutual Funds	ULIPS	Traditional Plans
30 yrs	0.35%	9%	19%
25 yrs	0.54%	11%	22%
20 yrs	0.91%	13%	26%
15 yrs	1.70%	17%	33%
The AUM based trail fee for mutual funds is assumed at one percent in the first year and 0.4 percent thereafter.

The point in the table above is not that the commissions in mutual funds are overall less than insurance. Since the commissions are back loaded, mutual funds would deliver higher commissions only if a consumer is persistent and the corpus grows over 20-25 years. When this happens, the incentive of the distributor are aligned with that of the consumer.

Conclusion

IRDAI needs to review the cost and commissions in investment oriented plans, specially the traditional plans, with the objective of making the products less expensive and more transparent. It needs to reduce the regulatory arbitrage by adopting SEBI's norms on costs and distribution incentives for investment portion of its bundled products.

The Bose Committee had representation from insurance and was a unanimous report. It is awaiting implementation.

We must ask deeper questions. IRDA is composed of intelligent people. Why has IRDA made mistakes in regulation of products sold by insurance companies, for decades? There are two factors at work. The first is the problem of the underlying legislations, which do not enshrine consumer protection as the central objective. The second is the problem of sectoral regulation, where persons in the organisation tend to get co-opted into the profit motive of the industry that they deal with. Both these problems are solved by the Indian Financial Code.


Ashish Aggarwal is a researcher at the National Institute for Public Finance and Policy.