Global Outlook

The Insurance regulator’s new guidelines have re-established ULIPs as a long-term investment vehicle

Contributed by Nirmal Bang

By Nirmal Bang

The spat between the capital market regulator, Securities and Exchange Board of India (SEBI) and the insurance regulator, Insurance Regulatory and Development Authority (IRDA) that lasted for a good two months, ended in the fag end of June. The government of India’s ruling was in favour of the insurance regulator. The authorities have squashed SEBI’s plea and announced that IRDA will henceforth be the sole regulator of all insurance products. The tussle of the titans in the financial world, however, had a silver lining. After its victory over SEBI, IRDA decided that unit linked plans (ULIPs) that account for more than 50% of the insurance business sales and had caused the stir in the first place, should indeed be given a facelift. The insurance regulator has stipulated that ULIPs launching after 1st Sept ’10 will have lower charges, guarantee returns and be sold with larger insurance cover. The new norms are aimed at re-establishing ULIPs as a long-term investment vehicle, which has been the purpose all along.

The most notable change in the new guideline pertains to surrender charges, a five-year lock-in period (from the earlier three years) and a cap on the difference between gross yield to net yield for investment periods less than 10 years and a minimum guaranteed return on pension products. Although insurance industry experts are unanimous about the fact that the new guidelines are a step in the right direction, they also feel that the new guidelines for ULIPs are a mixed bag. We dig into some details.

INVESTOR-FRIENDLY MOVES

According to the new guidelines, the insurance cover for both the regular premium policy and single premium policy now have to be increased. For those below the age of 45 years, the cover will be ten times the annualized premium against that of five times earlier. For investors above 45 years, the cover will be seven times the annualized premium.

Also, the single premium policy cover now has to be based on the age of the policyholder rather than the tenure of the policy. The new guidelines explicitly mention the maximum limit of health insurance cover provided by insurers. Another beneficial development is hat no insurance cover (life or health) will be less than 105% of the total premiums paid by the policyholder.

Secondly, and perhaps the most significant change that will benefit investors, is the change in the load structure. The front loading or the commission structure that used to be heavily levied on such products over the first two years will now have to be spread evenly over the first five years of the tenure of the policy tenure.

IRDA also continues to manage the net yield to policyholders by fixing net yields for periods less than 10 years. The caps on costs that had been introduced by IRDA obviously did not do much to stop the mis-selling. In its earlier guideline, IRDA had prescribed the difference between gross yield (return) to net yield at 300 basis points (3%) for a policy maturity of 10 years and 225 basis points (2.25%) for maturity above 15 years.

However, as an investor the cost could still be very high during the course of the policy. So, if he surrenders in the 6th or 7th year, the impact on yield could be around 6-7%. To prevent this, IRDA has prescribed a difference of 400 bps (4%), which gradually reduces to 300 bps (3%) in the tenth year. Effectively, a cap has been put on the yearly charges, while maturity caps remain unchanged. However, finance industry experts note that the charges still appear higher in comparison to mutual funds that are allowed an annual expense of 2.25%.

MAKING AN IMPACT

Policyholders have further reason to smile with regards to the surrender charges. Surrender charges that punished policyholders for early discontinuance have undergone substantial changes. Surrender charges, which were as high as 100% in the first year, can no longer be charged on percentage terms, but on absolute terms. An investor will now have to shell out not more than Rs 6,000 in case the annualized premium is higher than Rs 25,000 and a maximum of Rs 3,000 in case of lower annualized premium. These charges go on decreasing as years go by and become nil in the 5th policy year.

The minimum three-year lock-in period in ULIPs, which was in a way responsible for triggering off this entire debate on ULIPs, has now been extended to five years. The biggest advantage of the change is that policyholders, instead of suffering a higher upfront charge, would henceforth pay the distribution charges evenly till the lock-in period, thus a higher amount of the premium will go towards investment. Insurance industry leaders, however, say that this is not necessarily an investorfriendly move as the minimum premium-paying term of limited premium policy has increased to five years, compelling investors to pay for a longer term.

However, IRDA has somewhat compensated the increase in the lock-in period of ULIPs by making a provision for loans in ULIPs. The loan margins will depend on the fund’s exposure to equity, says IRDA. In case the premium is invested in the investment option with more than 60% of equity exposure, the loan granted would be 40% of the fund value. Whereas, if the premium is invested in a high debt-oriented fund, the loan will increase to 50% of the fund value. Another feature that has been introduced under the new guidelines is the sum assured on the top-up or the extra premium paid by a policyholder for investment purposes.

Earlier, this extra premium would only get invested in the fund and earn market returns akin to a mutual fund investment. Now, IRDA has levied death benefit on these top-ups. To cite an example, if a 50-year-old policyholder makes a top-up of Rs 10,000 per year, his death benefit will increase by Rs 70,000. This will then be followed by an increase in mortality charges.

GUARANTY – A BLESSING OR A CURSE?

Another landmark move that is giving the insurance product makers reason to worry is that pension policies will now have to offer a minimum guaranteed return of 4.5% a year on maturity. Pension products constitute 20-25% of the total premium collected by the industry. For the last financial year, around Rs 65,000 crore came from the sale of pension products. The total premium collection went up by 18% during the last financial year to Rs 2,61,025 crore. This new move to provide guaranteed returns has come under considerable criticism.

Firstly from a policyholder’s perspective, though guaranteed returns may sound attractive, the percentage of the return being promised is very small. Any other fixedincome instrument provides much higher returns of 8%. Also, 4.5% guarantee would mean a decrease in the actual worth of the fund invested as the inflation rate is running at 11%.

Insurance makers are worried about the fact that in order to provide guaranteed returns, insurers will hold more in debt options. An insurance industry head pointed out that investors prefer equities over debt as equities outperform debt in the long run. Therefore, switching from investment in equity to debt only to ensure the guarantee would not be right for customers.

Insurance industry leaders also point out that due to the possibility of unfavourable interest rates that may prevail at the time of the maturity of the policy, they may spell further trouble as it would be difficult to match the assets and liabilities because of the fluctuation in interest rates, inflation and performance of the debt and equity markets.

IRDA, however, specifies that it retains the right to review this guaranteed rate according to macroeconomic developments. This means that the return can vary over the term of the policy and investors will not be sure of the maturity value. According to IRDA, on the vesting date policyholders can commute up to one-third of the accumulated value as lumpsum.

BETTER OPTIONS AVAILABLE

Financial planners, however, point out that pension plans from insurance makers are not that attractive. While a ULIP pension plan will allow only one-third of the corpus to be commuted, the rest will have to be used to purchase an annuity. Annuity plans have their own drawbacks. For example, if a person opts for a plan where the spouse will continue to get money after his demise, the payout will be lower.

In comparison, there are other pension products that offer better returns. For example, UTI Mutual Fund and Franklin Templeton Mutual Fund have one pension scheme each. Both have a debt-equity ratio of 60:40. Templeton India Pension has returned 13.85% annually since its launch 13 years ago. UTI Retirement Benefit Pension has given returns of 11.53% in over 15 years since its launch in December ’94. The Franklin Templeton Mutual Fund scheme allows withdrawal after three years. UTI Mutual Fund’s scheme offers two options - a three-year lock-in with tax benefit or no lock-in.

Then, there is the public provident fund (PPF) and the employee provident fund (EPF). These two work out to be better options because of their impressive returns of 8.5% (EPF) and 8% (PPF), respectively. The amount accumulated in EPF is paid at the time of retirement. When a person changes a job, he can either withdraw the entire amount or get the account transferred to the new organization. The tenure of a PPF account is 15 years and an employee can extend it by another five years. A PPF account holder can also make partial withdrawals.

Its not just pension plans but also regular ULIP products that financial advisors are not too optimistic about, at least at this stage. With the new set of guidelines by IRDA, while new products may appear more attractive than the older ones, investors who bought ULIPs in earlier years may be tempted to surrender their products in favour of the new ones.

Advisors say it may not be prudent to close the existing policy in favour of new products that are likely to be launched from September mainly on account of charges. Thus, it will be wise to hold on to your earlier products from the insurance space, rather than opting for the new ones till the product structure becomes clearer over the course of time, say experts.

Also from a stock market perspective, the new guidelines are not too favourable for insurance players. The new guidelines are expected to put pressure on ULIP sales and reduce the revenue of insurers. Insurance players will have to live with a reality where margins and profitability will be squeezed and, therefore, have a negative impact on valuations. This, in turn, could delay the initial public offerings of players planning to tap the market for capital requirements, market analysts feel.