Icing on the cake

Abhinav Jain has decided to break the vow he took three years ago. In 2007, two years after he bought an insurance-cum-investment plan, the Jaipur-based production manager realised that the features of his Unit Linked Insurance Plan (Ulip) were loaded against him. "The charges in the first two years were so high that barely 30-40 per cent of the premium was invested," says Jain. He felt cheated by the insurance company and the broker and swore never to invest in a market-linked insurance product again.

However, Jain has gone back on his word and is shopping for a Ulip once again. This is because the recent regulatory changes in Ulips and those expected in the future promise to reduce or remove some of the drawbacks of the hottest-selling insurance product. For instance, Ulips have been widely castigated for the high premium allocation (includes agency commission) and other charges (like policy administration) that leave very little of the premium for investment.

In some plans, these charges gobble up 60-80 per cent of the premium in the first year, a fact that has irked many Ulip investors, including Jain. But in August 2009, the Insurance Regulatory and Development Authority (IRDA) imposed a limit on the charges by capping the difference between the gross yield and net yield of a Ulip to 2.25-3 per cent. The gross yield is what a Ulip would earn if no charges are deducted, while the net yield is what it would earn after all charges are deducted.

If the difference between the two yields is capped at three per cent, it means insurance companies will have to reduce the charges on Ulips or distribute them evenly over the term of the plan. To do this, they would also have to launch longer duration plans. Right now, 10-15 years is the norm, but the change might lead to the launch of 25-30-year plans. The regulation on capping of charges while good, is not enough.

Manish Chauhan, personal finance advisor who founded Jagoinvestor. com says: "The insured has to be with the ULIP throughout its tenure to get the benefit." ULIPS today have a poor track record of policy retention, which is not likely to change in the near future.

The revised draft of the Direct Taxes Code (DTC) released on June 15 clarifies that investments (including life insurance policies) made before April 1, 2011, will continue to be governed by the existing tax rules till maturity. This means that income from all Ulips bought before the DTC comes into effect will continue to be tax-free (see box on next page). The other major investor-friendly proposal is the cap on surrender charges.

Till now, besides the heavy deductions in the initial years, Ulips also levied fat surrender charges. These acted as a strong deterrent for anyone attempting to surrender in the first three years. So, instead of surrendering their policies, most customers just allowed their Ulips to lapse and waited for the lock-in period of three years before withdrawing the balance. The quantum of the charge and the method of computation also varied across insurers. Surrender charges were either levied as a percentage of the paid-up premium or as a percentage of the fund value.

Now, IRDA proposes to standardise the surrender charges and impose a limit (see table). This helps because the investor gets a clear picture at a glance and comparing plans becomes easier. However, there is no reason for elation. Ulips are a long-term investment and surrendering them early is not a good idea. Moreover, most Ulips still have high upfront charges and would probably give negative returns in the first three years.

Add to this the surrender charges and the disincentive to surrender is almost as strong as before. However, if an investor's circumstances don't allow him to pay the premium any more, the regulator has ensured that he recoups at least some of his money. "In exceptional circumstances, if the customer chooses to surrender, he will benefit since he will receive a higher fund value," says V. Srinivasan, CFO, Bharti AXA Life Insurance.

In another investor-friendly move, IRDA has proposed that if a policy lapses because of non-payment of premium, the corpus will earn a nominal interest of 3.5 per cent per annum till it is withdrawn by the policyholder. While 3.5 per cent per annum may seem low, given the high number of policies that lapse (according to IRDA, 91 lakh policies lapsed in 2008-09), the gains for investors work out to a gargantuan amount. IRDA also wants the minimum lock-in period of three years for Ulips to be increased to five years.

On the face of it, this seems an unfriendly move for the investor as it curbs the liquidity for the policyholder. But this actually helps investors by cutting down on chances of mis-selling. The lure of high commissions often motivates unscrupulous agents to push Ulip investors to stop paying premiums and withdraw the amount after three years. This is a costly strategy for the investor because he has already suffered high charges levied in the initial years.

By increasing the minimum lock-in period to five years, IRDA has aligned Ulips with a long-term horizon. "Distributors will no longer be able to push Ulips as three-year plans," says personal finance consultant Raag Vamdatt, Founder of the advisory service RagVamdatt.com. Insurance companies are also happy with the change. "Exiting prematurely from Ulips is not beneficial for investors. Increasing the minimum lock-in period to five years will promote the long-term investment and financial protection characteristic of Ulips," says Srinivasan.

That's not all. Distributors may also have to clearly state how much commission they will pocket for selling the policy. IRDA plans to make it mandatory for insurance agents to state this in the benefit calculation they give to potential investors. This is expected to bring in greater transparency but there are doubts whether the average investor understands the calculations at all.

Besides, insurance agents brazenly violate IRDA guidelines on the maximum returns to be assumed in such calculations. While IRDA has stipulated six per cent and 10 per cent, agents generally use a higher rate of 15-18 per cent in their calculations, thus making the result more attractive for potential buyers. In many of the changes proposed by IRDA, the underlying objective is to emphasise the insurance cover.

For instance, top-up contributions in Ulips, which do not attract any charges because they are pure investments, will also be used to buy a life insurance cover for the policyholder. What this also means is that a small proportion of the top-up investment will go into mortality charges. This will, though, make top-ups more complicated, while providing only a small insurance cover to the policyholder.

"Though every top-up will give additional insurance to the insured, the amount will be too insignificant to matter. While the effort is not worth it, additional medical tests may still be required from the insured person; while for us factoring the top-up will become an underwriting challenge," says G.L.N. Sharma, an actuary and currently Managing Director, Hannover Reinsurance."

In its zeal to expand insurance coverage, IRDA also proposes to make it compulsory for unit-linked pension plans to offer life or health cover. This is bad news for investors. A compulsory mortality charge in the pension plan will reduce the amount of investment flowing into retirement savings. Till now, pension plans were cheaper than Ulips because they didn't have an insurance component. If the proposal goes through, pension plans will become just as costly.

HOW THE CAP ON CHARGES HELPS

• Suppose Rs 10,000 is invested in a Ulip every year for 10 years.
• Invested amount reduces due to 45 per cent charges in fi rst year, 40 per cent in second year, 30 per cent in third year and 2 per cent per year thereafter.
• If fund grows at 10 per cent, the fund value would be Rs 1.46 lakh after 10 years.
• The net yield for the investor works out to 6.74 per cent, while the gross yield is 10 per cent.
• The difference between gross and net yield is capped at 3 per cent for 10-year plans.
• To comply with this rule, the charges will have to be reduced to 30 per cent in the fi rst year, 20 per cent in the second year, 5 per cent in the third year and 2 per cent per year thereafter. Then the net yield will be 7.23 per cent.

Courtesy: Money Today