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On Yahoo: The ULIP War

My latest at Yahoo!: The ULIP war on the topic of the week, ULIPs.

The turf war between the Insurance Regulator (IRDA) and the Securities Regulator (SEBI) is finally over. The government, on June 19th, passed an ordinance that granted full regulatory control of the Unit Linked Insurance Product (ULIP) market to IRDA, foxing many financial commentators. To an outsider, the brouhaha seems strange, but there’s a history to it. (Isn’t there always?)

Insurance has meant that you pay a certain amount of money so that if there is damage or a demise, there is a cash payout to compensate. If nothing happens, you lose the ‘premium’ paid.

In India, life insurance, in particular, has seen a different twist. People are sold products that return money even if they survive. So you pay Rs. 100,000 per year for 20 years, and you can get Rs. 50 lakhs back if you survive, and should you die, you have ‘insurance’ of 5 lakhs during this period. A part of your premium goes to cover the ‘risk’ of the 5 lakhs of insurance. Another part goes to cover fees and charges. What is left goes into an investment fund that will be invested and will grow over time.

Such products mix investment and insurance, and traditional ‘endowment’ products have been opaque offerings. An insurance company would only take the premium from you, and not tell you how much of that was fees or risk premium or investments-they would announce a ‘bonus’ every year, which would range from 4% to 9%, and you knew that was how much your total premium had grown that year.

Unit Linked Endowment products came in, promising more transparency, segregating and revealing costs, insurance and investment pieces. Additionally, you could choose the broad categories in which your money was invested-from risky avenues like stock markets, to very safe avenues.

This should have been good, compared to the traditional endowment market. But not the way it was implemented. ULIPs started confusing customers with complex products, where the costs weren’t obvious. For example, some brochures mention ‘Premium Allocation Charges’ of 30% – meaning, they charge you 30% of your premium as this particular charge, and after taking out all other charges, the remaining is invested. Another product would mention a ‘Premium Allocation Rate’ of 30% – meaning only 30% of your premium was invested. And sometimes they would move the costs into a Policy Administration Charge, as the IRDA, the insurance regulator, looked the other way.

Other strange charges were surrender charges-after charging you through the roof for the act of investing, insurers decided it was correct to penalize you for an attempt to take your money back-charges range from 5% to 100% in the first five years. The standard reply: ULIPs are long-term products, and this is the way we make them so. Yet, they charge the highest in the first few years of a policy and reduce the charges later-meaning, they’re not thinking longer term themselves; if they were, they would spread the charges evenly over the entire term. And the practice defeats the compounding concept: your first investments make the maximum rupee gains in the long term, but when they extract the maximum flesh from the initial premiums, your eventual gains are crippled.

The muddled and high cost structure negated any transparency benefits. It didn’t matter that some of these quirks were unearthed by financial journalists. Indeed, if you search for ULIP-related articles, nearly every single mainstream financial publication has carried articles against such practices; yet, people continued to buy them, even those with continuous access to the internet.

The reason: agents, who got a good chunk of those high initial charges as commissions, chose to highlight products as god-like offerings tailor-made just for those people who didn’t have time to decode a complex brochure or, seemingly, search the internet. They would lie, oversell, under-insure, or generally ignore their fiduciary duty as ‘advisors’. Again, IRDA chose not to cap the incentive commissions that promoted such behavior, arguing that any cap would hurt the industry.

In comparison, mutual funds have been much better products to invest in. With their regulator, SEBI, actively clamping down on mis-selling, charges have been reduced to just one-the ‘fund management charge, capped at 2.5% per year. There is no entry load, and any advisory fees must be paid directly to the advisor, not embedded in the products. SEBI’s actions made mutual fund agents poorer-the milking through entry loads was no longer possible-so agents moved substantial amounts of assets from the mutual-fund industry to higher -commission-paying ULIPs.

As a response, SEBI unearthed a technicality: since most ULIPs have a negligible insurance component, they are really collective investment products, which SEBI has the right to regulate. IRDA, noting that nearly 50% of the insurance business was ULIPs , decided to fight it out.

The rules were ambiguous, so the government had to take a stand. Admitting to SEBI oversight would unearth an uncompetitive product that gathered investment of nearly 1% of GDP, and perhaps even hurt investors in the short term as the concept was overhauled. IRDA would be embarrassingly compromised as a regulator. Insurers who made money milking investors would see immediate cash-flow problems. In hindsight, SEBI didn’t have too much of a case; there are many products that qualify under SEBI’s criteria of collective investment, but aren’t regulated by SEBI. Plus, the main issue was the mis-selling, which most commentators thought the IRDA wasn’t capable of curing.

A political decision was taken- in a process that some say did not include SEBI -to make IRDA the regulator for ULIPs. Some say insurers rescued certain government public issues, and this was just quid-pro-quo. What happened doesn’t matter anymore-what matters are consequences.

It may just be that investors have been thrown to the wolves, to decide which financial product to take, all by themselves. Which, shamefully, is a bad thing because we suspect our collective ability to decide for ourselves; but until we demonstrate lack of stupidity by actually not buying these products, we will continue to hear calls for stronger regulation, reduced incentives and fiduciary responsibility.

At one level, it’s a free market; people should be able to buy what they want, even if they choose to overpay, especially when such information is available to them. On the other hand, we have seen a worldwide financial crisis built on the back of information asymmetry; you must decide based on what you know, and you can’t possibly know enough. The answer: regulate, de-incentivise, litigate. There has to be a little of each, because in the end we are not rational beings. But it looks like the government decision seems to have just favoured the unregulated market.

Buyer beware. If you ask me, I would tell you to blindly refuse any ULIP offered to you, for which you will undoubtedly receive a large number of unsolicited enquiries in the coming months. But maybe there is a way to benefit: I suggest you demand Rs. 500 per phone call, payable in advance. For this advice, I demand no commissions.

Read my < a href="">other articles on ULIPs. Comments are deeply appreciated.

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