Sep 27 at 1:23 PM
Report of the Committee
to recommend measures for curbing
mis-selling and rationalising distribution
incentives in financial products -Ministry of Finance
August 2015
Commissions and mis-selling in insurance
Until 2001, the life insurance industry in India was a state-owned monopoly enterprise,
the LIC. The original rationale for offering non-linked policies was that such investments
in addition to the pure life component could be used to fund any changes in the future
costs of the insurance product arising out of changes in mortality or fees for other
reasons. However, non-linked policies were popular with investors because they gave
investors some access to long-term investment opportunities unlike the annuities or the
term policies. Furthermore, there were no competing fund management avenues at the
time that offered guaranteed returns.
Investors funded the policy once or twice a year in the expectation of getting a lump
sum return in 15-20 years, or getting periodic returns after 10-15 years of funding the
policy. In addition, these insurance products had attractive tax benefits, both as being
eligible for tax benefits during investment, and after, with proceeds of the investment
and final withdrawals being tax exempt.
After 1999, when the insurance regulator, IRDAI was set up, and the insurance industry
was privatised in 2000, there were two significant changes in the market for insurance
customers. The first was the entry of the ULIP, an investment linked insurance policy,
where a large fraction of the premium was invested as in a mutual fund product with
a small insurance pay-out in the case of death. The second was that national level
corporate agents and banks, which were not regulated for their insurance services,
became important distributors of insurance products. The AUM attributable to ULIPs
grew at 534.82 percent between 2003 and 2004, and at 92 percent between 2009 and
2010. These were significantly higher growth rates when compared to growth rate in the
sales of the traditional insurance products, which grew at 16 percent.
Anecdotal evidence suggests that investors bought the equity-linked ULIP assuming
that they were buying a three-year guaranteed product that would double their money.
The regulation on a three-year lock in period which allowed companies to keep the
entire value of the policy if surrendered within three years, left very little incentive to
the insurance companies to promote follow-on premium payments from their customers.
The rule on front-loaded commissions, which were as high as 40 percent45 in the first
year, incentivised agents to sell products that earned them the highest pay-off. The tax
benefits made this product even more attractive. When the product did not provide the
(falsely) promised returns, a lot of customers stopped paying, and lost money as also
in other financial products. This was reflected in the spike in the lapsation in insurance
policies after the introduction of ULIPs in India. Halan, Sane, and Thomas (2014) find
that investors lost more than a trillion rupees from mis-selling over the 2005-2012 period
on account of these mis-sales.46
Though there were no court cases filed by the investors, the government and the regulator
took note of the media reports and letters written to the Ministry of Finance to change
45Maximum commission of 40 percent in the first year is for insurers in the first 10 years of business
and for the other insurers it is 35 percent.
46Monika Halan, Renuka Sane, and Susan Thomas, “The case of the missing billions: estimating losses
to customers due to mis-sold life insurance policies”, in: Journal of Economic Policy Reform 17.4 (2014).
the product and cost structure of the ULIP.
The June 28, 2010 IRDAI circular came
down harshly on the ULIP product and asked insurance companies to
reintroduce the
product with the following changes by September 1 2010, just two months
later48:
1. The three year lock in was moved to a five year lock in.
2. Insurers were required to distribute overall charges in an even
fashion during the
lock in period.
3. The minimum mortality was specified.
4. Surrender charges (through a July 1, 2010 notification) were capped
at a maximum
of Rs.6,000 for premiums above Rs.25,000. If discontinued within the
lock in
period, the paid up premium minus the maximum charge and mortality,
would
move to a fund (funds for discontinued policies) that would earn a
minimum return
and be returned to the policy holder once the lock in was over.
5. The costs, fixed vide a 2009 circular, were further explained. The
cost structure
applicable from September 1, 2010 was as follows:
• The net reduction in yield for a policy of a tenor of 10 years or less
can be
no more than 3 percent at maturity.
• The net reduction in yield for a policy of a tenor of above 10 years
can be no
more than 2.25 percent at maturity.
• To keep the industry to stay on the cost course, sub cost caps
according to
tenure of the policy were mandated. For example, a 15 year policy could
see
a reduction in yield of no more than 3.30 percent in the 8th year.
However, traditional plans were left out of this clean up in the
industry. These continue
with a first year commission of upto 35 percent.Insurance sales
immediately moved towards traditional plans that continued to pay
high commissions.This is reflected in Figure 2.3. This is also reflected
through
an audit study of insurance agents carried out by Anagol, Cole, and
Sarkar (2012).50
They find that insurance agents overwhelmingly recommend products which
provide
high commissions to the agent and are unsuitable for the customers. This
is greater for
customers who appear to be less financially literate.
A manifestation of this is the low persistency of policies in India.
Persistency tracks
the behaviour across time of policies sold in a year. The 13 month
persistency rate for
insurance companies ranged between 41 - 76 percent in 2013-14. In the
case of LIC for
example, the 61st month persistency in 2013-14 was just 44 percent. This
means that
less than half of the policies sold in FY 2009 were retained. The
persistency rate for
LIC dropped from 51 percent in 2011-12 to 43 percent in 2012-13, it saw a
marginal
increase in the latest numbers.51
India Insurance Vision 2025: McKinsey Report, Prepared for the
Confederation of
Indian Industry (CII), February 2015. (Page 58 of the report)
Figure 2.4: Persistency of life insurance in India
A recent McKinsey report (See Figure 2.4) also finds that overall, the 1
year persistency
ratio of Indian firms is 65 percent. This is much lower than countries
such as the US,
China, Malaysia and Korea, all of which have ratios more than 80
percent. The US
and China, in fact, have persistency rates greater than 90 percent.52
While there are
49It is possible that the market downturn also played a role in the
shift.
50Santosh Anagol, Shawn Cole, and Shayak Sarkar, Understanding the Incentives of Commissions
Motivated Agents: Theory and Evidence from the Indian Life
Insurance Market, Working Paper 12-055,
Harvard Business School, Jan. 2012.
51Source: Table 27: Persistency of Life Insurance Policies (based on
number of policies), Handbook of
Indian Insurance Statistics 2013-14, IRDAI.
52McKinsey & Company, India Insurance Vision 2025: Building a USD
250 billion customer centric
and value creating industry, Prepared for Confederation of Indian
Industry (CII), 2015.aspects such as income disruption for various
reasons including failure of monsoons, or
intermittent incomes which impact persistency, the report also says that
mis-selling and
poor service by agents accounts for the poor performance. Another reason
according to
the insurance industry for low persistency is the rural mandate on
insurance as well as
the high rate of inflation over the last decade.53
Commissions and low sales in ETFs and NPS
In a world of high incentives, similar products with low incentives end
up being at
a significant disadvantage. ETFs and index funds are relatively low cost
investment
products and offer returns comparable with their actively managed
counterparts in
the mutual fund space. In fact, ETFs have several advantages over
traditional mutual
funds, such as lower expense ratios, trading flexibility, tax
efficiency, transparency, and
exposure to diverse asset classes. While industry AUM data on index
funds is not readily
available the ETF AUM at Rs.14,705 crore, is a small fraction of the
total mutual fund
AUM at about less than 2 percent. Gold ETFs comprise half of the total
ETF assets.54
Similarly, it could be argued that one of the reasons that the private
sector NPS market
has failed to take off is that banks and other distributors find it
profitable to nudge the
customer towards insurance plans that pay higher front end commissions
or mutual fund
schemes which comes with asset based trail fees.
Changes in commissions
The first reform on distributor incentives was the ban on entry loads of
mutual funds
by SEBI in 2009. This was done with a view to empower the investors in
deciding the
commission paid to distributors in accordance with the level of service
received, and
to bring about more transparency in payment of commissions and to
incentivise long
term investment.57 This led to a huge furore with the industry claiming
that it would
lose out to other products, and the entry load would result in the death
of the industry.
However, this has not been the case. The industry has largely turned
itself around, and
re-organised to a trail-based model where the incentive of the
distributor gets aligned
with that of the customer. SEBI has required AMCs to provide direct
plans with lower
TER for investments not routed through intermediaries. A recent proposal
by AMFI has
suggested a commission of 1% upfront to be followed by all AMCs.
Similar rule change on ULIPs were brought about by the IRDAI in 2009.
The IRDAI
mandated that the cap on charges will be based on the difference between
gross and net
yields of any product. For insurance contracts which are of a tenor of
less than or equal
to 10 years duration, the difference between gross and net yields cannot
be more than
300 basis points. Of these, fund management charges cannot exceed 150
basis points.
For contracts whose tenor is more than 10 years, the difference between
gross and net
yields cannot exceed 225 basis points, of which the fund management
charges cannot
exceed 125 basis points.58 Further changes to the ULIP product structure
were made in
2011.59 resulting in a major clean up of the product.
The commissions structure of the traditional endowment product has not
undergone any
change. Today, this product earns the highest commission, and as
described in earlier
sections, has become popular once again. The Insurance Laws Amendment
Act, 2015
has led to the removal of the ceiling of 40 percent on the maximum
commission, fee or
remuneration. IRDAI now has the power to lay down the structure of
commission/brokerage
for intermediaries as well as the power to determine the expenses of
management
57SEBI, Mutual Funds- Empowering investors through transparency in
payment of commission and
load structure, SEBI/IMD/CIR No. 4/ 168230/09, June 2009.
58IRDA, Unit linked products - Cap on charges, Circular No:
20/IRDA/Actl/ULIP/09-10, July 2009.
59IRDA, Annual Report, 2010-11, 2011.
43
which can be incurred by insurers. This may leadwhich can be incurred by
insurers. This may lead the regulator to lower commissions on
these products in the near future.
Another recent policy response related to commissions pertains to using
claw backs as a
tool to curb mis-selling, mainly in open ended products. Claw backs
allow for upfront
commissions to be recouped from the agent in case the consumer exits
partially or fully
from the product before a predefined tenure. AMFI’s code of conduct
requires agents to
refund to mutual funds, incentives/ commissions which are subject to
claw back as per
SEBI regulations. With effect from January 1, 2013, all upfront
commissions paid to
distributors are liable to complete and/ or proportionate clawback in
case a consumer
switches from a Regular Plan (agent sold plan) to a Direct Plan (offered
directly by the
mutual fund). The concept of claw back has also been extended by SEBI to
additional
distribution expenses permitted on account of inflows from beyond the
top 15 cities.
These are subject to clawback if such investments are redeemed within
one year from
the date of investment.
Changes in agent responsibilities
In September 2011, SEBI released a concept paper for regulating investment advisers,
where it separated the role of an adviser from that of a distributor.60 SEBI’s proposal
included the formation of a Self Regulating Organisation (SRO) which will regulate
advisers who will charge clients for advise on various products. These advisers will
not be remunerated by product providers. The Securities and Exchange Board of India
(Investment Advisers) Regulations, 2013 were notified in January 2013.61
SEBI also put in place the Employee Unique Identification Number (EUIN), which is an
alphanumeric code assigned to each individual advising/selling to the customer. This
number stays with this individual as he moves jobs. This number can be used to track
each sale back to the person who was credited with the sale. This makes it possible to
hold agents responsible for their sales.
In 2011, the IRDAI issued guidelines to enhance the persistence of life insurance
policies.62 The new guidelines mandated a persistence of 50 percent for agency renewals
till the financial year 2014-15, and 75 percent persistence after that.63 By requiring
agents to achieve at least a 50 percent persistency rate, it was hoped that agents would
be more circumspect in how they sold the policy, and in following-up with consumers
about their premium payments. However, in February 2014, the IRDAI passed a new
guideline64 which allowed for renewal of agent licenses without regard to the persistency
60For more details, refer to SEBI, Concept Paper on Regulation of Investment Advisors, Concept Paper,
Securities and Exchange Board of India, 2011.
61SEBI, Securities and Exchange Board of India (Investment Advisers) Regulations, 2013, tech. rep.
No. LAD-NRO/GN/2012-13/31/1778, SEBI, 2013.
62Section 14(2) of the IRDA Act, 1999.
63IRDAI Journal, August 2011, Page 12.
64Guideline: IRDA/Life/GDL/057/02/2014, http://www.irda.gov.in/ADMINCMS/cms/
whatsNew_Layout.aspx?page=PageNo2207&flag=1
44 Poli
Insurance: Unit Linked Insurance Plans
The ULIP product came to limelight in India in 200198 as the first consequence of
private sector being allowed into insurance. New insurance companies with foreign
tie-ups wanted to bring the improved version of the old insurance policy – the traditional
endowment policy – as a transparent and market-linked investment vehicle bundled with
a crust of life cover. But the reform went only half way and a product was allowed into
the market that was linked to the market, but in all other manner of costs and product
structure was still using the traditional policy rules. This led to widespread mis-selling
of the ULIP and the regulator came down heavily on the product in 2010 putting in place
very strict cost caps and rules around what can be deducted from the investor’s money
on lapsation and surrender.
The post 2010 ULIP is a much better product as compared to the pre-2010 product. It
should be remembered that the endeavour of this Committee is to make the products
as useful and transparent for the consumer as possible so that the regulatory cost of
ensuring compliance is minimised. The following recommendations aim to take forward
the reform that IRDAI began in 2010 on the ULIP product in a manner that aligns similar
products across regulatory domains.
Product structure
1. Mortality and investment should be bifurcated. For the investor, this would mean
a clear understanding of what part of the premium goes to service the life cover
and what part of the premium goes to work as an investment.
Insurance: Traditional Life Insurance Policy
The traditional life insurance policy should be evaluated in its historical context. It was
manufactured in the post colonial era when the economy was in a nascent stage with
undeveloped capital and bond markets. As is experienced with a low income economy,
there was a need to make available a zero-risk saving vehicle that would preserve capital.
On the product side, fund management was unsophisticated by current standards with
limited access to multiple assets for allocation, hedging and other risk management
strategies. In such an environment, the traditional life insurance policy gave investors a
long-term capital preservation vehicle and a guaranteed return of sum assured on death
or maturity, that came with a small risk cover. The lack of alternate products made
this product the only vehicle for corpus targeting households. The product served its
mandate well enough.
However, over the years as markets have become sophisticated, financial products have
reflected the change in the economy with features like investments getting marked to
market to reflect the true value of the investment portfolio on a real time basis. However,
reform in the traditional life insurance policy has lagged the other parts of the markets.
It is in this context that the recommendations should be read. The aim is to bring this
Costs and commissions
1. All costs should be bifurcated into two parts - mortality and investment.
2. Mortality costs should be benchmarked to the mortality tables created by third
party actuarial firms.
3. Investment costs should be capped keeping in view the best practices in the rest of
the market. For example, for non-participating plans, costs should be benchmarked
to best practices in banking or other small savings products that invest in similar
products that give guaranteed returns. For participating plans, costs should be
benchmarked to similar asset allocation products in the mutual fund space or the
NPS.
4. The costs of surrender should be reasonable. After deduction of costs, the remaining
money should continue to belong to the exiting investors.
5. All charges should collapse into one single charge called the expense charge. This
charge should be deducted from the gross yield before crediting the net returns
to the customer’s investment account. This charge should be within an annual
expense ratio or expense limit specified by the regulator. No charges should be
deducted as premium allocation charge or any other charge before allocating the
69
annual premium to investment and mortality.
6. Upfront commissions should be allowed for the mortality part of the premium.
These can remain within the current limits fixed by the regulator. It is understood
that life insurance is a difficult concept and the sellers should be compensated for
the extra work done to sell a risk cover. In bundled products, upfront commissions
should be permitted for mortality part of the premium. There should be no upfront
commissions on the investment part of the premium.
7. Distribution commissions should not be front loaded. In a time-bound manner,
the distribution commission should be set at a (i) level percentage of the premium
over the tenure of the policy for non-participating products and at (ii) a percentage
of asset (as an AUM trail fee) for participating products.
8. Distributors should not be paid advance commissions by dipping into future
expenses, their own profit or capital.
9. The illegal practice of rebating should be punished harshly by the regulator as it
distorts the market.
10. The current structure of paying upfront commission (which is today pegged at 2
percent of premium) on single premium insurance policies may be continued for
the investment component of these policies, as these are closed-ended products
and do not mis-align the market towards churning, and there should be no trail
commission on this
