Insurance cover has never been the top priority among policyholders. Instead it has been synonymous with investment-linked endowment plans. They come with guaranteed maturity benefit along with insurance cover. The popularity of these plans stemmed from the fact that they were back by the government (LIC of India) and offered income tax benefits. Of course, the guaranteed return was another attraction.
The remain popular even after the sector was opened up to the private player, which introduced array of products such as unit-linked insurance plans (Ulips) and cheaper term plans. For some time between 2003 and 2010, Ulip sales seemed to march ahead of the endowment. However, the latter's dominance was restored after the crash in the equity markets and changes in the Ulips commission structure.
There was a time when the Ulip commission structure was highly front-loaded, giving insurance agents and distributors as high as 50 per cent to 100 per cent of the first year premium as commission. Though the insurance regulator reined in this, for some inexplicable reasons endowment plans were left untouched. They continue to offer as high as 35-40 per cent of the first year premium as commission.
Insurance agents continue to push endowment plans and insurance companies defend this by saying that demand for these products are high as investors don't want to put money in stock markets.
Endowment plans have two basic problems - they neither offer a high life cover nor do they provide good returns. Usually, the sum assured - the money paid on death of the insured - is 10-20 times the annual premium. That is, if the annual premium is Rs 50,000, the sum assured is Rs 5 lakh - Rs 10 lakh. In case of a term plan, a healthy non-smoking male in the 30-35 years age group can get a Rs 1 crore life insurance cover at Rs 12,000-15,000.
A 20-year regular traditional plan would barely double money over the full policy term. Even after adjusting for the tax benefit for a policyholder in the 30 per cent tax bracket, one cannot expect more than 8.5 per cent annual return. For those in the lower tax bracket, the return can be even lower at 6-7 per cent.
Some of these are sold in the garb of guaranteed return plans, and promise to offer 9-10 per cent return every year from the end of the premium paying term until the end of the policy term. However, the guaranteed addition is on the sum assured and not the fund value of the plan. The sum assured remain same throughout the policy term, but fund value keeps increasing. For example, a 24-year plan with 12 years premium paying term promises to pay 10 per cent guaranteed addition every year. The sum assured of the plan is 10 times the annual premium. If the annual premium is Rs 1 lakh, then the sum assured is Rs 10 lakh. Now, after paying premium for 12 years, the fund value is Rs 12 lakh. However, the guaranteed addition would be Rs 1 lakh (10 per cent of Rs 10 lakh). So, for the next 12 years, the insurer would pay the policyholder Rs 2 lakh every year.
That is, by investing 12 lakh over the 12 years, you get Rs 24 lakh in 24 years. The tax-adjusted return for a person in the 30 per cent tax bracket is 9.25 per cent, for a person in 20 per cent tax bracket is 8 per cent and for someone one in the 10 per cent, it's 7 per cent.
To compare this return with that of Public Provident fund (PPF), let us assume that a person invested Rs 1 lakh every year for 15 years, and kept the money in the account for 10 more years. Considering it continues to pay 8.7 per cent interest over the 25 years, the tax-adjusted return would be between 9.3 per cent and 10.75 per cent.
The average commission that an agent gets selling an endowment plan is around 6-6.5 per cent over the 20-year period. A high upfront commission on endowment plans skews the balance in favour of agents. That's why they push these products whether they are suitable for the policyholder or not.
ULIPs have 6-8 per cent of the first year premium as an upfront commission and 4-5 per cent of the premium for the next four years. From the sixth year onwards, the commission is 2-3 per cent. In contrast, mutual funds usually have no upfront commission and the industry is pushing for a complete trail commission model, where the agent gets 0.5 per cent of the total fund value of the investment every year.
Due to frontloading of commission and the resultant mis-selling, insurance in India often suffers from poor persistency levels. A McKinsey report released in February 2015 says that the one-year persistency ratio of Indian insurance companies is just 65 per cent compared to 92 per cent in China, 90 per cent in Taiwan and 87 per cent in Malaysia. This means, only 65 of 100 policyholders continue their policy after a year. The three-year persistency ratio, according to the report, is 52 per cent. Almost half of the policyholders would have surrendered their products by the third year. Only around one-third continue their policies after five years.
According to the Sumit Bose Committee, upfront commissions in such product skew seller behaviour, and cause mis-selling and churn. It therefore recommends that upfront commissions should be phased out.
The committee further recommends key structural changes in the endowment plans to keep pace with the changing financial requirements of individuals and investment landscape. It remains to be seen if the endowment plans would make way for better products that suit the policyholder's requirement.
The writer is CEO, BankBazaar