Has the Insurance Regulatory and Development Authority of India finally woken up to all the mis-selling that is happening? Well, it would like us to believe it has. But the truth of the matter is that it hasn't.
IRDA has thought of a new way to prevent the mis-selling of Unit Linked Insurance Plans (Ulips).
From now on, individuals investing in a Ulip, will have to sign a one-page document. This document will say that the individual is satisfied with what the agent has communicated and that buying the Ulip has been an informed choice.
This, the regulator feels will bring down the mis-selling which has been plaguing the industry. This is one of the most naïve arguments that one has heard in a long, long time.
What it is more likely to do is pass the buck. Instead of the agent being held responsible for mis-selling, now the individual will be blamed for buying the Ulip, without really understanding what he was getting into.
At the time of taking a Ulip, the individual needs to sign at a few places. This most individuals do without really bothering to read. Given this, agents can easily get individuals to sign this extra certificate as well. It shouldn't be a problem at all.
So what is really the solution to stop the mis-selling? The solution is simple. The economic incentive has to be structured correctly. Instead of giving the agent a huge commission in the first two years of the policy, the commission needs to be spread out over the period of the policy.
Right now the agent does not really work in the best interests of the individual taking the policy. As Steven D Levitt and Stephen J Dubner write in Freakonomics, A Rogue Economist Explores the Hidden Side of Everything: "But experts are human, and humans respond to incentives. How any given expert treats you, therefore, will depend on how that expert's incentives are set up."
Why does most mis-selling happen? The answer is because the incentive of the insurance agent is structured the wrong way. Typically most Ulips charge a premium allocation charge of 15% to 71% in the first year of the policy.
If the premium allocation charge in the first year is 40%, what this means -- in simple English -- is that if you were to give Rs 100 as a premium only Rs 60 would be invested.
The 40% premium allocation charge would be used to pay a very high commission to the agent in the first year of the policy. Even during the second year of the policy the premium allocation charge can be as high as 30%.
After the first two years these charges come down and are usually less than or equal to 5% of the premium paid. What this does is that the insurance agent makes the bulk of his commission in the first two years.
These high charges would typically put off most investors. So how do insurance agents get around this problem. They simply don't tell the individuals taking the policy about these charges. There is another impact that the front loading of commission has. Most insurance advisors, including big banks and corporate distributors, tell individuals that a Ulip is a three-year policy and that they can stop paying premiums after three years.
This is really not the case.
Why do insurance agents do this? For the simple reason that after three years their commissions really come down dramatically. And it makes more sense for them to sell a new Ulip so that they can make those high commissions again.
Insurance companies have been screaming from roof tops that Ulips are long-term products and there expenses work out to be much lesser than mutual funds in the long run. If that is the case, then why are they in such a haste to recover all the money in the first two to three years? Why not spread out the expenses over the period of the policy?
This will also ensure that distributors stop getting the high upfront commissions, and hopefully stop mis-selling. Other than that, IRDA needs to have standardised maximum charges that can be recovered from the premium being paid. If the insurance company wants to pay more commission, let it pay from its own pockets, rather than getting an investor to indirectly pay for it.
This will make Ulips comparable on the returns front, like mutual funds are. Currently there is no way the performance of various Ulips can be compared, because each one has its own expense structure in place.
This will help individuals make informed decisions and take Ulips of insurance companies which have the best performance, instead of just opting for what the agent sells it to them.
This will also give the investor the option of getting out of a Ulip, if it is not performing well. Currently what happens is that if the Ulip an investor gets into does not perform well after three years of compulsory holding period, getting out of the policy is a costly bet. The point is he has already paid a lot of premium allocation charge and the amount he will get, even if he cashes out at the end of three years, may not even match, the total premium he has already paid.
The high upfront charges make Ulip, a very inflexible way of investing. Taking them out, will be like killing two birds with one stone.
But IRDA seems to be sleeping.
It is more bothered about the well being of insurance companies rather than about the man on the street who is buying these costly Ulips. It is high time it woke up.