IRDAI’s commission notification hikes total compensation for insurance intermediaries

by Monika Halan.

On 14 December 2016 the insurance regulator, the Insurance Regulatory and Development Authority of India (IRDAI), notified revised commission rules for both life and general insurance. Titled ‘IRDAI (Payment of Commission or Remuneration or Reward to Insurance Agents and Insurance Intermediaries) Regulations, 2016’, the new rules have raised overall payments in the insurance industry to agents and intermediaries. The notification has come 11 months after an exposure draft that proposed changes in existing rules. The draft was open to public comments. The author helped the team at NIPFP to draft a response to the insurance regulator that argued against raising upfront commissions and payments as it encourages mis-selling, churning and causes losses to investors. A blog on the draft can be read here. The final regulations have been notified after consultation with the Insurance Advisory Committee and will come into effect from 1 April 2017. IRDAI has not given a reason why it needed to rethink the payment structure in the insurance industry. Nor has it given a reason for the change in the manner of payment and the quantum of payment. It has mandated a board-approved written policy for payments of intermediary compensation.

I will examine the changes in payouts in the life insurance industry and not the general insurance industry in this blog. Examining high upfront costs in India’s life insurance industry is important because these have been identified in two government committee reports (Swarup Committee and Bose Committee) as one of the reasons for mis-selling of insurance products in India. Several papers (this, this and this) have documented mis-selling of such products in the Indian market and the money lost by investors. The IRDAI regulation is important to analyse because it has increased the total payouts in the first year of the product at a time when other regulators are reducing upfront costs. The capital market regulator had made the mutual fund product zero front commission in August 2009 and in 2015 had capped upfronting of trail commissions (that come out of the annual expense ratio) at 1% of the investment. The National Pension System (NPS) already has low front costs that are more in the nature of a transaction cost.

The Regulations

There are four changes in the new regulations.

1. Change in intermediary categories. Currently, there are five categories of intermediaries: agents, corporate agents, insurance brokers, web aggregators and insurance marketing firms. The notified regulations break up the market into three categories of distributors of life insurance products. Agents, intermediaries with more than half their income coming from insurance, and intermediaries with less than half their income coming from insurance. Agents represent one insurance company and are individuals. Intermediaries include corporate agents, insurance brokers, web aggregators and insurance marketing firms.
2. Change in nomenclature of intermediary payments. Currently, all intermediary payments are called ‘commissions’. The new rules mandate that agent payments will be called ‘commission’, while intermediaries’ sales commissions will be called ‘remuneration’.
3. Addition of a payment category. A new payment category has been introduced to compensate agents and intermediaries called ‘rewards’. A reward is an amount paid, directly or indirectly, as an incentive by the insurer to agents and intermediaries. Rewards seek to formalise informal (which were illegal thus far) payments made by insurance firms to agents and intermediaries. IRDAI believes that agents need to be rewarded to account for benefits such as gratuity, term insurance cover, various group insurance covers, telephone charges, office allowance, sales promotion, gift items, competition prizes and such other items. Intermediaries need rewards to compensate for services such a risk analysis, gap analysis, plan design, predictive modelling, data management, infrastructure, advertisement and such other items, including any additional incentives by whatever name called. All agents are eligible for rewards that are fixed at a maximum of 20% of the first year commission that the agent collects. Not all intermediaries are eligible for rewards. Only those who earn more than half their income from the insurance business are eligible for rewards, which are the same as that for agents. Others are not. In effect, IRDAI has legalised what were illegal payments in the industry.
4. Change in the compensation structure. The new rules have changed the existing commission structure in three ways.
1. Higher commissions for pure risk products. IRDAI has hiked commissions for pure risk policies as compared to policies that bundle investment and insurance across both single premium and regular premium products. Pure risk policies insure just the life of the policyholder. If the policyholder does not die, no money returns to him. Bundled policies combine life insurance cover with investment. These come in two variants. One, unit linked insurance plans (ULIPS) that are transparent, marked to market products that work like mutual funds with a crust of life cover. Two, traditional plans that are opaque products, do not disclose a net asset value but give either an assured investment return or an indicative payout number. These products invest largely in government securities of both the centre and the states. Further, there are two kinds of policies according to periodicity of premium payment. Single premium policies, which need funding once and stay alive for the duration of the policy tenure. And regular premium policies, which need to be funded each year till the premium paying term ends and can have tenures of between five and 100 years. The changes are in Table1 and Table 2.

Table 1: Pure risk gets more commission

Table 1a: 1st year commission on regular premium policies

	Existing 1st year commission for agents1	New 1st year commission for agents and intermediaries
	(%)	(%)
Pure risk	35/402	40
Bundled 3	35/402	35/40
1 For brokers the numbers are 30% in year one for all policies with premium paying term of 10 years or more
2 35% for firms more than 10 years old and 40% for firms less than 10 years old. Today, more than 90% of the market is made of firms that are over 10 years old, therefore the 35% commission number is effective
3 For a premium paying term of 12 years or more. Commissions range from 15% to 33% for premium tenures between 5 and 11 years

Table 1b: 1st year commission on single premium policies

	Existing commission for agents 1	New commission for agents and intermediaries
	(%)	(%)
Pure risk	2	7.5
Bundled	2	2
1 For brokers the numbers are 2% of the premium

2. Higher renewal commission on regular premium policies. On each renewal the intermediary gets a ‘renewal commission’. These rates are now higher than before for both pure risk and bundled plans, though pure risk gets more than bundled plans.

Table2: Renewal commission on regular premium policies rise

For agents and brokers	Existing commission	New commission
	(%)	(%)
Pure risk	51	10
Bundled	51	7.5
1 Currently, 3rd year and subsequent premiums get 7.5% commission. Year 4 onwards it is 5% commission on renewal.

3. Introduction of ‘rewards’. The impact of adding rewards to the commissions in the first year are captured in Table 3a, 3b, 3c and 3d.

Table 3: Total payouts on life insurance policies from 1 April 2017

Table 3a: Maximum first year payments on regular premium pure risk life insurance policies

For pure risk cover policies	Maximum commission on 1st year premium	Reward as % of first year commission	Total 1st year payment of Commissions + Reward
	(%)	(%)	(%)
Agent	40	20	481
Intermediary > half income from insurance	40	20	482
Intermediary < half income from insurance	40	0	402
1 Total first year commission currently is 35/40% depending on age of insurance firm
2 Total first year commission currently is 30% for a premium paying term of 10 years or more

Table3b: Maximum first year payments on regular premium bundled life insurance policies

For bundled policies (insurance + investment)	Maximum commission on 1st year premium	Reward as % of first year commission	Total 1st year payment of Commissions + Reward
	(%)	(%)	(%)
Agent	35	20	421
Intermediary > half income from insurance	35	20	422
Intermediary < half income from insurance	35	0	352
1 Total first year commission currently is 35/40% depending on age of insurance firm
2 Total first year commission currently is 30% for a premium paying term of 10 years or more

Table 3c: Maximum payments on single premium pure risk life insurance policies

For pure risk cover policies	Maximum commission on 1st year premium	Reward as % of first year commission	Total 1st year payment of Commissions + Reward
	(%)	(%)	(%)
Agent	7.5	20	91
Intermediary > half income from insurance	7.5	20	91
Intermediary < half income from insurance	7.5	0	7.51
1 Total commission currently is 2%

Table3d: Maximum payments on single premium bundled life insurance policies

For bundled policies (insurance + investment)	Maximum commission on 1st year premium	Reward as % of first year commission	Total 1st year payment of Commissions + Reward
	(%)	(%)	(%)
Agent	2	20	2.41
Intermediary > half income from insurance	2	20	2.41
Intermediary < half income from insurance	2	0	21
1 Total commission currently is 2%

What do these changes mean?

Post these changes, from 1 April 2017, the peak rates of payouts to agents and intermediaries will go up to as high as 48% in the first year, from the current levels of 35% or 40% depending on the age of the insurance firm. IRDAI has not given a reason for making changes to the compensation structure of the intermediation industry in insurance. Section 52(2) of the draft Indian Financial Code (Volume Two) of the Financial Sector Legislative Reforms Commission Report requires that all regulators should first publish a draft of the regulations to be made. This draft should be accompanied by a statement of objectives. The statement of objectives lists out the need for new regulation and the cost and benefit analysis of the proposed changes. The financial sector regulators, including IRDAI, have agreed to implement some of the recommendations that do not require legislative action. These actions can be read in the Handbook on Adoption of Governance Enhancing and non-legislative Elements of the Draft Indian Financial Code. Carrying out a cost benefit analysis for a new regulation and making it public is one of such actions. IRDAI did bring out a draft regulation on 13 January 2016 that was mentioned earlier, but there was no cost-benefit analysis or rationale for increasing commissions. Read the analysis of what IRDAI had proposed.

What’s good and what’s not

The new rules are good in parts, but IRDAI has let go of an opportunity to reduce mis-selling in the life insurance market in India. Some parts of the regulation are in the right direction but fail to address the larger malpractice issues; one rule is outright harmful.

1. Raising commissions for pure risk policies. Life insurance is a difficult concept to understand and the sales effort to sell life insurance needs a higher incentive than selling an investment product where a return is expected. India is a poorly insured country because life insurance is sold as an investment product with a thin covering of a life cover. Agents prefer to sell the bundled products because they generate a higher commission value than a pure risk plan. Therefore, giving a higher commission to a pure risk plan as compared to a bundled plan is a good step, but these remain still too high at 40% of the first year premium. To transition the market to pure risk plans, IRDAI could have reduced commissions on bundled products instead of keeping them at 35% of the first year premium. Two government committees have recommended that investment products go zero upfront commission and move to a full trail model (links to the reports are above in para two). The capital market regulator has already implemented these recommendations in mutual funds.
2. Raising renewal commissions. A long term financial product needs to be funded each year. When faced with very high first year commissions and significantly lower subsequent commissions, the incentive structure for agents gets skewed towards stopping old policies and selling new ones. Keeping policies alive is a big problem in the life insurance industry that sees very high rates of lapsation – or discontinuation of a long term plan in the first five years. The persistency (the number of policies that stay in business after the first year) rates in life insurance are very poor, with the industry average of 61st month (5-year) persistency of just 44% in FY15 for Life Insurance Corporation that accounts for over 70% of the industry. The private sector numbers are worse. Two largest private sector firms saw poor persistency levels, with ICICI Prudential Life’s 61st month persistency in FY2015 at just 16.7% and HDFC Standard Life’s at 31.78%. These numbers are from IRDAI’s Handbook of Statistics 2014-15 that can be seen here on page 211. One way to deal with this issue is to reduce front commissions and move to a trail heavy compensation model. The capital market regulator has successfully implanted this with no harm to the market. In 2009, the capital market regulator banned upfront commissions that go from investor’s money. In 2015, it banned even ‘upfronting’ of trail commissions beyond 1% of the investment. In fact, the move to a trail based model has raised investor confidence reading to a systematic investment pipeline of Rs 4,000 crore a month into mutual funds. IRDAI is right when it raised renewal commissions in the industry, but wrong because it has kept the upfronts high.
3. Introducing of ‘rewards’. Introducing a new head for payments in the first year that essentially formalises informal payments that breached the commission caps of IRDAI is a surprising regulatory action. It is common knowledge in the insurance industry that the exiting commission caps are regularly breached. A look at IRDAI orders corroborates this where the regulator finds many companies paying out commissions to agents and brokers under many heads, including skill building, promotions, office expenses. An 8 January 2017 Final Order from IRDAI fined HDFC Standard Life for hiding foreign junket costs as ‘skill building’. It does look like the regulator has attempted to formalise what were earlier informal (and therefore illegal) payouts by the industry to the intermediaries. Post the introduction of ‘rewards’ in the first year, the peak payout rate will hit 48%. IRDAI says that intermediaries must be paid these rewards for the benefits they need to be given, including sales promotion, gift items, office expenses, competitions, for data management, infrastructure, advertising and so on. But it is worth asking the question: aren’t the commissions paid meant to take care of such costs? Why does it need an extra head to reward agents and intermediaries for getting the first year business? It is very surprising that a regulator, instead of curbing illegal payments has actually gone ahead and legalised them.

What could IRDAI have done?

IRDAI could have implemented the recommendations of the two committees and reduced upfront commissions, moving to a full trail model. The problem with raising compensation in year one of a long term product has been flagged by multiple research papers and regulators. High front commissions and payouts are go against regulatory learning across the world where high front commissions are linked to investor churning, mis-selling and sharp sales practices. To raise intermediary payouts in the first year in an overall market that has seen reduction in costs is surprising. Had IRDAI hiked the upfront payouts with tighter rules on persistency and claw backs, there could have been an argument for raising compensation. Perversely, in a 2014 Guideline to all CEOs of inurance companies, IRDAI diluted its earlier guideline for stricter persistency targets. It said:

1. Renewal of Individual Agency License and Corporate Agency License will not be subject to meeting the Persistency Rates as stated in the above referred Guidelines/Circulars.

2. All Life Insurers are required to have their own company specific persistency criterion for renewal of Individual and Corporate Agency from 1st July 2014.

With no regulatory cost on poorer persistency, the economic signal of raising first year commissions and payouts is to continue with the hit-and-run sales process. Claw back of front commissions is another way that globally insurance companies ensure a minimum persistency rate, but IRDAI is silent on this. By pushing policy holder interest onto Boards of companies, while raising overall payout rates, the regulator has let the fox into the chicken coop and told the fox to be a good boy now.

 

The author works in the area of consumer protection in finance. She is Consulting Editor Mint, Consultant NIPFP, and on the Board of FPSB India.