SEBI IRDA ULIP ISSUE

Ever since the SEBI order gagging sales by 14 Life Insurers there has been a spate of articles and commentary in the media. However I found that there was a fair deal of mis-information by various financial analysts especially those who think ULIPS are wrong instruments and they should be regulated by SEBI.  Here I present a defence that Life Insurers may wish to use.

As a disclaimer I do not work as a Insurance agent. I believe in buying term and investing the difference.  I mostly invest in Indexed ETF and not mutual funds. I cover why later .

Since Mutual Funds ( MF) are now no load funds ( As per SEBI directive) and ULIPS still provide front ended commission it is claimed that Agents are pushing ULIPS and this is a dis-service to Investors. IRDA is not regulating Insurers but acting as a trade body and SEBI is the guardian of Investors who should be allowed to regulate ULIPS.

ULIPS are mainly Investment

SEBI has pointed out that 98% of a typical ULIP premium is invested into the capital market and only 2 % is used for Insurance cover.  This is misleading argument. Take a 30 Year Endowment product. No one seems to call for this being regulated by SEBI. This is a classic Insurance product. Now more than 80% of this premium is an investment portion pooled in to the common fund of life company and allocated to policyholders via Dividends or Bonus . The asset share of the policy in the assets of the Insurance Company is opaque and calculated by the Actuary from time to time.

In ULIP the asset share is more transparent. However that is missing the point. Insurers are allowed to offer guarantees. A typical guarantee is death benefit. The Insurer will pay many times the premium in case of death. Even in ULIPS they would pay 120% or more then the premium received. This is very different then Mutual Funds which do not provide any guarantee and will never lose more than the principal.

Take a different example. A Fire policy may provide an earthquake cover. In normal years the Insurer only pays around 30% of these premiums as claims. In some year say 1 in 10 it may have a earthquake and pay 10,000% , In some markets like Japan Insurers build up a surplus for a certain number of years then pay a dividend to the long term policyholders. So by SEBI logic this is also an Investment product.

As a consumer we do need products with guarantees. GMxB product ( common in Developed markets in US , UK and Europe) now being introduced in India have two guarantee; A primary death benefit and a secondary guarantee on either interest / income credited or withdrawal amount.  The current version in India guarantees the withdrawal amount as the maximum of NAV achieved over a time frame. Another version that is very useful for retirees is Equity Indexed Annuity (EIA). This may provide a minimum annuity amount and a participation of say 60% in any change of the NIFTY Index with a floor of 5% loss in any one year and 15% gain in any year. For someone who expects to lead a active post retirement life of 20-25 years plain fixed annuity are very unattractive as the returns are very low making them expensive. This product provides a lot of jazz and makes it sing.

It is important to allow such innovation and guarantees to evolve in the Indian market. These are normally regulated by Insurance regulators in advanced markets and I assume IRDA has the necessary skills and checks on the Insurers introducing such products in India.

I think the correct measure for deciding if a product qualifies as Insurance is amount at risk and as long as IRDA requires a risk corridor then the policy is a Insurance policy. In ULIP a 125% corridor is accepted in most markets and these products will be regulated as Insurance products. So if I started a ULIP with 1 Lakh premium then the minimum death benefit must be 1.25 Lakh. I would opt for something more like 5 Lakh. IRDA should dis-allow any product which does not have this guarantee or risk corridor.

Agents sell ULIPS because they get 45% Commission

The front commission that a Insurer pays a Life agent for every rupee of premium paid into the policy is higher than other industries like mutual fund . However we may be comparing the wrong thing. Over the long term Insurers pay round 7-12% commission to the agent and their acquisition costs are around 15-20% overall.  These are comparable to Mutual Funds . A example may help.

Assume a 25 year ULIP Policy where we pay Rs 10,000 every year. In the first year 45% of the premium is paid the agent as (front) commission reducing to 25% in year 2, 15% in year 3 , 10% in year 3 and 7% in year 5 and zero afterwards. Then over 25 years the Life agent would get Rs 10,200 commission on 2,00,000 paid in or just 4.08%

Now assume a mutual fund where we again pay in Rs 10,000 every year. Assume this grows by 15% annually and at the end of the year we deduct 1% of the market value ( AUM) as Management charge as allowed by SEBI ( this will be Rs 115 in year 1, Rs 132 in year 2 Rs 200 in year 5 and Rs 1,000 in Year 17…) . The balance is carried forward to next year and augmented by new payment of Rs 10,000 each year. Now the mutual fund uses this management charge to pay trail commission to the agent or distributor. Say the trail commission is 0.75% of the fund value ( Asset under management  or AUM) . Then the trail commission will be Rs 86.25 in Year 1, Rs 99.06 in Year 2, Rs 150.07 in Year 5 and Rs 790.41 in Year 17…) The total trail commission over 25 years will be Rs 17,924.98 or 7.17% of the 2 Lakh paid in. See summary in Table below

Table 1 ULIP vs MF Commission

 

As you can see the mutual fund may not pay less commission. Obviously the numbers will vary by the growth in the funds under management and other variables but suffice to say we are comparing apples to oranges and jumping to misleading conclusions.

Some commentators have argued for harmonizing the commission across mutual funds and ULIPS. The Finance ministry is moving towards a regime of advisor fees and no commission. This is misguided. Retail financial services are expensive to provide without subsidy. Take the not for profit micro finance industry. They borrow from banks as a priority sector at 10-12% and then have to charge 22-24% as their administrative costs are around 12%.

It is difficult for agents or distributors to survive on selling retail financial services alone. The vast majority of life Agents do not make tonnes of money but have a hard time and many leave the industry.  A unintended consequence of a no commission regime will be the exclusion of small time retail consumer from any advice at all. In fact it may become very difficult for them to invest as they will have to interact with remote and faceless call centers and web portals and they will not be able to have their queries or complaints serviced by meeting a knowledgeable manager or adviser face to face.  I believe the regulators need to invest extensively in educating consumers, providing well researched comparisons of products and historical performance after costs and providing a lot more assistance for this regime to work.

A telling example is the low take up on the newly launched NPS or the index mutual funds or ETFS .  Attempts to cut the distributors have failed. In Singapore for example the Central Provident Fund reduced allowable expense ratios for mutual funds that CPF holders would invest in from 5% to 2%. The result has been that more then 50% of Mutual fund houses have withdrawn from the CPF scheme thus reducing choice for the investor; not the result the regulator wanted.  In another market life insurers started providing subsidized services like travel tickets or office rental to agents in lieu of commission. They claimed to be buying in bulk and passing the benefit to their agents. We should know by now from the history of socialist economies and black market that economic forces work their way laws not withstanding…

Regulators can help reduce the cost of retailing financial services by encouraging uses of shared infrastructure ( Like depository NSDL, CDSL) , educating consumers and reducing cost of doing business but must accept that distributors need to be subsidized if we want inclusive financial service.

I beleive it is the ill thought drive of SEBI to reduce commissions paid to distributors which is the root cause of the issue. SEBI should have coordinated with IRDA and others for a harmonized approach and it should also consider the viability of the business model if distributors are are not remenurated reasonably.  See  April 16 post in DNA by Satish Sadagopan

IRDA is a trade body and only SEBI can protect Investors…

I do believe IRDA should have done much more on the mis-selling  of ULIPS .A more intrusive system of audits and checks is needed. We as consumers also sign up all sorts of documents without reading  them. Hopefully IRDA will spend a lot more effort in educating consumers.

However I fail to see why SEBI would do a better job. There have been a number of scams on the stock market. Insider trading is probably far higher than we want to know and mutual funds have also many investor unfriendly practices. One reason why I stopped investing in MF was the fact they launch with a theme like small caps or power and after some time they merrily do what they want. I found my power MF held some large banks. They give loans you see… There are many other issues including some dubious trading, accounting ,  market timing and NAV calculation methods which are too technical for this audience. Suffice to say the total cost is much more then you are lead to believe.

SEBI also lacks skills in regulating for the cost of guarantees and would stifle innovation. SEBI off course wants to oversee commodities , money markets and Pensions as well. This is a policy issue . If the Government wanted a single regulator why create a new Pension Regulator?

Conflicts of Interest

Regulators learn to balance the three activities educating consumers, advocating their markets and regulating market conduct over time. IRDA is young and has done excellent job overall . ULIPS mis selling is the first serious blemish and I hope they will learn from this.

There are many areas where there is conflict of interest and we should aim to handle them by education, transparency or disclosure and competition rather than by more and more rules and regulators.

If my doctor prescribes a Rs 25,000 a shot injection for my medical condition I would have no idea that there is an alternative medicine worth only Rs 1,000 a shot and that there may be a pecuniary benefit to the doctor in prescribing such medicines. I trust him. May be we need to see more media coverage of these types of wrong advice where the consumer has little awareness and not much idea of options. As we become less naive and more discerning blatant conflicts will become more public and less harmful. ( I would also encourage my readers to keep in mind that quite often the media coverage may not be the OBJECTIVE-NO-AGENDA-TO-GRIND-KIND.  )

Competition should be the primary way to help consumers. So consumers may be allowed to negotiate commission and get rebates from the life agents. This is well accepted practice in some markets and works.