ULIP

It turns out(*) that the new guidelines for ULIPs in 2010 have claimed another victim: Cover Continuance.

The concept, prior to September 2010: if you bought a ULIP and stopped paying premiums after say 5 years, you could choose to continue to have

• Insurance cover continued
• in which case, Mortality charges and policy admin charges would get deducted from fund value.

Now, with the new regulations this is no longer allowed. If you stop paying premiums, you have to take back your money. Subramoney also mentions this in his blog.

What this means now is: there is no way to stop payments and still continue cover. Let's look deeper.

Why did this rule come into place?

ULIPs had horrendous surrender charges, upto 100% of fund value. IRDA said boss, you can't charge more than Rs. 6,000.  And you have to pay back the fund value to the customer, or if five years are not completed, leave it in at 3.5% interest and then give it back. That prompted the question: what, exactly, is a "surrender"? If you stop paying premium, that is equivalent to a surrender.

Now, ULIPs must return the money or move it over to a low grade investment area if you stop paying premiums. What is required, perhaps, is a tweak to the regulation that allows users to continue (at their own behest) the risk cover. The specific wording of the current regulation is:

A policyholder shall be entitled to exercise one of the following options upon discontinuance of the policy:

    (i) Revival of the policy, or

    (ii) Complete withdrawal from the policy without any risk cover.

This could be augmented with (iii) Continue with the risk cover, with mortality charges being reduced from the fund value from time to time, and the option to withdraw completely from the policy under (ii) above at any time.

Is the cover continuance practical?

Most ULIPs had absolutely crappy insurance limits, and in practice, almost everyone took 5x of annual premiums as cover. Many ULIPs provided the sum assured OR the fund value, whichever was higher. For them, the continuance meant very little insurance - probably 3x-4x annual premiums - practically, if you paid Rs. 50,000 you would have cover for about 2 lakhs, which, one must admit was unreasonably small.

Some others offered risk cover of sum assured PLUS fund value, which is where the continuance option may be useful, so let's explore some more.

What happens if risk cover continues?

Let's say you were paying Rs. 100,000 for a sum assured of Rs. 10 lakhs, and after year 5 you decide to stop premiums.

In a cover continuance scenario, you would get the Rs. 10 lakh cover to continue. With age, your mortality charge increases - that's how ULIPs work - and eats into your fund value. From the Rs. 3,000 a  year if you were 35, it will go to Rs. 10,000 a year if you're 55. Even at that, the cost is reasonable.

But think about it - for someone who can afford Rs. 100,000 a year: is a 10 lakh cover worth it? You obviously need more - if you can save 1 lakh a year for insurance, chances are that you spend more than 5 lakhs a year (15% saving) and therefore, the 10 lakh insurance is utterly useless. In current ULIPS, though, you may be allowed to take on a larger insurance cover, and to that extent, there is likely to be a practical need.

By the way, policy administration charges nowadays can be substantial (sometimes, 3% a year, of the premium amount!).

The cover continuance option could be useful for those who are younger, and gives them the ability to stop paying premiums; and I would definitely recommend that it be made available as an option.

With the caveats : This should not be the default option. It should not be allowed less than 5 years from the policy date. It should also let you exit fully at any time.

Other Options

Till then of course, your options are:

• Take the money, buy a term plan and put the rest into an investment like a mutual fund or stocks.
• Invest in a single premium plan if you still like insurance. I don't recommend this but there are those that swear by insurance, or can't get rid of annoying agents.

Overall, the current regulation must be augmented, to allow cover continuance if you stop paying premiums after 5 years.

* I got this information from a survey being conducted by Money Life.

(This is an article I wrote recently, so here you go!)

The new ULIP regime is here, and insurers must be balking in fear. The changes? Spread commissions over the lock-in period of the scheme, the minimum of which is now five years from the earlier three; a cap on surrender charges to a maximum of 6% (or Rs. 6,000); a guaranteed 4.5% on pension products and forcing investors to buy annuities on exit; and higher minimum sums-assured on ULIPs.

The one aspect that must trouble insurance companies the most is the cap on surrender charges. For many insurers, this has been a significant source of revenue, since these fees directly line insurer pockets. Prior to September 1, a significant number of ULIPs would charge huge amounts as surrender charges – from 100% of your fund value if you exited in year 1, grading down to 5% in year 5 and so on. The idea was something like:

Phase 1: Entrapment

“Sir, you should invest in this ULIP. All you have to do is pay for three years, and you’ll get a tax-saving, and a fantastic deal! Just 20,000 a month.”

Phase 2: Realization

“Mr. Agent. It’s been a year now, and I’ve paid Rs. 240,000 in premiums. The Sensex has gone up 20% in the last year. So why does my account balance show just 120,000?”

“Well, there was 60% first year premium allocation charges, which meant only 96,000 was left; that grew to 120,000 which is pretty good growth!”

“Good? What good? I pay 240K and am left with 120K and that’s good?”

Phase 3: Exit!

“Get me out of this plan now.”

“Sir, if you stop paying your premium you will lose another 50% of whatever is left, as surrender charges”.

“Oh. Wait. I don’t care. I’ve been cheated!”

People still surrender their policies, sometimes choosing to pay two or three more years of premiums before doing so – and primarily because they had been sold a “three-year” policy, which turned out to be a much longer, 20 year product instead. The surrender charges they paid after three years may be small – of the order of 5% or so - or massive, in some cases losing whatever little was left after commissions. When you’ve lost 90% of your money, you’re unlikely to pay more for a few more years just to recover what’s left (and pay even more commissions).

Insurance companies are seeing tremendous amounts of money leave through surrendered policies. Look at the L-7 (“Benefits Paid Schedule”) of most insurers (eg. ICICI, Birla Sun Life) and you will find that more than 90% of money going out is on account of surrenders. A further look at L-22 (Analytical ratios, Persistency) shows that only about 1/3^rd of customers choose to continue policies after the 36^th month.

We don’t know what the average surrender charge is – but for most policies before September 1, these charges were pretty hefty – let’s say the average is around 10-20% when you consider all surrenders. When this drops to a maximum of 6% (or Rs. 6,000) for policies above Rs. 25,000 premium, this will impact all insurers. The three insurers I checked – HDFC, Birla Sun Life and ICICI – had surrenders of 430 cr, 330cr and  2,400 cr. respectively; the surrender fees are likely to be above 50 crores for each insurer, just for the last quarter.

Consider now that the high salaries in the sector have largely been justified by the high fees. Salaries are sticky – no one likes to take a pay cut – so the obvious impact will be to retrench; and going by the grapevine, that retrenching is already happening. The impact of the Direct Tax Code is also negative, starting 2012, with the loss of tax-saving status of most existing policies (the DTC provides tax-saving coverage to policies with a premium of less than 5% of sum assured – most ULIPs don’t qualify). Plus there’s a tax deduction at source for insurance maturity payments, making them less attractive.

What about agents? They complain that commissions are now sub-10% which is very less. Well, the point is this – no other financial product offers even half the “lower” insurance commissions. So there is really nowhere to run anymore – insurance still provides a multiple of what they would get otherwise.

Why is this relevant to you?

What is important to understand is how the dynamics of the industry changes – and therefore what new spiel you’re going to receive, and how to decode it.

Endowments: We’ll get to hear about traditional endowments – non-unit-linked – as a great way to invest. I wouldn’t even bother – endowments are opaque products with very high but hidden charges. Additionally, surrendering the policy early costs a very large amount – usually you would be happy to see even 1/3^rd of what you’ve paid should you want a premature exit. Endowments might have their uses (for example, a “waiver of premium” rider helps continue a policy in case of disability, or a cheap way to transfer wealth when you die) – but for the purpose of investment, it is a fairly useless product.

Why sell them, you ask? Agents continue to get great commissions and the non-transparency of the product and high fees ensure you get stiffed without your realizing it.

The sales pitch of the ULIP might change – to force you to pay higher premiums, or to disguise the product as something it is not. With bankers who would gleefully sell you a ULIP when you ask for a fixed deposit, you have to be careful! So here’s a set of steps

First, don’t sign a document if it contains the word “insurance” unless you receive the complete detailed brochure for the investment.

Second, check for phrases that steal your money away from you: Premium allocation charge means they’ll take that much away. Policy Administration Charge is another premium stealing measure; earlier it used to be miniscule but now they have “tweaked” the policies around. “Administration” charges can add up to 5% of your fund value per year and what you will see is 0.4% per month, another dirty way to hide theft. Fund management charges apply at about 1.5% per year, which is okay – this is charged even by mutual funds. Mortality Charges are, again, okay because this is what the real charge of insurance is – what they take to give you the sum assured in case you die.

Lastly, add up the charges (other than mortality). Most policy charges will add up to 10-15% in the first year. Then, throw all these documents away.

I would invest in a long-running, diversified mutual fund instead; because paying 10-15% for investing your money is financially stupid, when you’ll pay only management fees in a mutual fund. (For funds like HDFC Top 200 or HDFC Equity, the total recurring fees, including trustee, registrar and other fees, adds up to 1.8%)

Yes, you will ask me about insurance – for that, I would buy a term plan; online term plans are available from ICICI Prudential and Aegon Religare for extremely low premiums. (A policy of 1 crore for a 35 year old will cost less than Rs. 25,000 per year) More insurers will offer low cost term plans, and as our life expectancy grows with better medical care, we will find premiums coming down over the next few years. I don’t like ICICI and Religare Claim payout ratios are horrible so I’ll wait.

My method does not help the profitability of insurers either, especially those who wanted to make money stealing it from us. The good old method of making profits from the practice of insurance must take center stage; the method of making money without killing us in the process.

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