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
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 thisCosts 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