eading the Irdai (Insurance Regulatory Development Authority of India) draft on updating regulations for unit-linked insurance plans and traditional policies, you get the impression that somebody gave an aspirin when what was needed was a heart surgery. Product structures in finance are taking on a new importance globally because mis-selling and unsuitable sales can be reduced by taking the tricks and traps out of these products. This simply means that the costs and benefits are better defined and marked so that investors are able to understand the features of the products properly. Product structure rules also deal with early exits and their costs so that investors are not trapped in products they buy.
A recent story reports on mis-selling and fraud by a bank in rural Rajasthan where they allegedly made bank deposit customers put their signatures on life insurance products of a group firm. While the story of people of small means being cheated out of their money is worrying enough, what is of greater concern is that this problem is not limited to one insurance company or bank, or location. Life insurance mis-selling and fraud by bank branches is systemic in the country. The evidence to this statement comes from three sources. The first is anecdotal: almost everybody who has a bank account has a mis-selling or fraud story to tell about life insurance. For those who superciliously turn away from anecdotes, there are three academic papers that nail the problem. In 2014, two economists and I, wrote a paper estimating that policyholders lost over Rs 1.5 trillion from mis-sold life insurance plans between 2007 and 2012. In 2017, I published another paper that mystery shopped bank branches to catch mis-selling. I found that bank officials lied most of the time on features around costs and costs of early redemptions to potential customers. A 2015 paper by Anagol et al find that agents overwhelmingly recommend life insurance products that are unsuitable to the customer but get the agent high commissions. Three, two government committees, Swarup and Bose, have found life insurance to have very high front incentives that cause sharp sales and fraud. (Disclosure, I have served on both the committees).
Most of you who read this column are now investing in the right way, using a systematic investment plan (SIP). But did you know that your dull, boring SIP is the result of more than 10 years of regulatory change? Most of you have also discarded the low-return endowment plans and now purchase a pure term plan to look after your life insurance needs. But did you know that you got to the right solution not because of regulatory change but despite it. I’ve been mapping the Indian personal finance industry for over 15 years and the behaviour of two regulators in industries that both manage household money has been fascinating. We now have the data to show the impact of regulatory change in the mutual fund and the life insurance industries on firms, sellers and households. I will relate the story through four tables.
Two basic questions that you ask when buying any product are: what does it cost and what does my money buy me. Ask the same questions when buying a financial product and you get different answers depending on which product you are buying. A market-linked investment product, like a mutual fund or a unit-linked insurance plan (Ulip), will give indicative returns or will rely on past returns to answer the ‘what does it return’ question. A fixed deposit will simply indicate the returns the product gives. A traditional life insurance plan will never answer this question directly but will obfuscate cleverly. Ask ‘what it costs’, and you see that an equity mutual fund in India charges an annual fee of 2.5%. A Ulip costs 4% a year if held till year 5 and costs drop to 2.25% if held for more than 10 years. But ask the question for traditional insurance plans and you draw a blank. Insurers and regulators have both expressed helplessness in getting an industry average handle on these costs because of the nature of the product. Each policy is different and there are more than 40 million policies issued each year; whose cost should we give you? When put like this, of course, there is no answer possible. It is a difficult problem to solve because, unlike a Ulip, traditional plans do not segregate funds according to the two functions of risk cover and investment, but put the entire money into one pool. There is no segregation of the pool across time—the older money and new money all goes into the same pool.
Imagine that there is a very crowded city, bursting at the seams. A state-of-the-art satellite city comes up and is ready for settlement, but remains largely empty. All the shiny new infrastructure is wasted because the citizens seem to want to stay in the polluted, congested space they currently occupy. The local authority wants people to crossover and keeps thinking of new ways to incentivize this. Tax breaks, cheaper medical facilities, better schools…. But no go. The citizens are blamed for being foolish. But the truth is that the only thing the local authority is unable to resolve is the extremely high crime rate in the new city area. Roads have no rules, gangs of criminals roam around, plunder and kill at will. The authorities turn a blind eye saying that this tribe of criminals has traditionally robbed and killed for livelihood and, therefore, they must be left alone since their livelihood is at stake. The local authority does not tell the real reason—that it gets a cut from the criminals. Perversely it uses some of this money to give further incentives to people to move! The new city remains empty, and every year during the annual budget, experts pontificate on how to incentivize the silly citizens to move. But the smart guys don’t. They prefer the safety of the known problems.
A committee set up by the insurance regulator earlier this month is all set to look into a host of issues, the chief being product structures in traditional life insurance products. There is arbitrage in the market as the unit-linked insurance plan (Ulip) got a cleaner structure in 2010, but the traditional plans (whole life, money back, endowment) continue to be opaque products. The Committee on Design of Life Insurance Products will look into some 17-18 areas including pension products and the highest net asset value (NAV) Ulip plans. On the committee are the chief executive officers of Birla Sun Life, HDFC Standard Life and SBI Life, actuaries of Aegon Religare and Life Insurance Corp. of India and representatives of the Life Insurance Council and Insurance Regulatory and Development Authority (Irda). The first meeting is on 22 May and the report is due in 15 days.