A government committee has made a set of recommendations that would effectively shut down much of the insurance industry--and force its reinvention in a customer friendly form
07-Sep-2015 •Dhirendra Kumar
Last week, a government committee set up to examine the misselling of financial products submitted its report. The committee made 16 broad recommendations under which there are almost a hundred specific ones. These are all well-reasoned and sensible measures that would severely reduce--or maybe even eliminate--sharp sales practices. Actually, if these recommendations are all actually implemented, the impact would be much greater. India's insurance industry, as it exists now--would effectively shut down and would have to be reinvented.
That's not hyperbole, it would actually happen. And of course, it would be a very good thing. Among the recommendations that the committee makes, the highest impact ones are those that would bring transparency and fairness to mixed insurance+investment products like ULIPs and traditional policies. Potential customers would be clearly able to see what the insurance part costs and what the investment part costs; they would be able to evaluate the investment track record in a way that would be easy to understand and comparable across products and product categories; they would be able to see how much of their money goes into commissions--and compare that to other types of investments; and the commissions and reporting structure would be distinct for the investment and the insurance parts.
What the report obviously leaves unstated is that if potential customers actually had all this information and understood it, then they would simply not buy these products. A customer with even minimal financial literacy would instantly be able to see that going for a separate life cover (term insurance) and any other investment--even a recurring deposit in the post office or a bank--would be a better option than endowment plans and other such horrors that our insurance industry runs.
The key to the committee's recommendations is that regulations should follow function, not form. It recommends that there should be no difference--in costs, commissions, or transparency--between an investment product like a mutual fund and the investment component of any product from an insurance company. Moreover, as the report recommends, "The lead regulator, according to function, should fix the rules of the game. In bundled products, the lead regulator for the function of the sub-part must fix rules of the game." This would effectively mean that in insurance products like ULIPs and endowment plans, the investment portion will have to follow the rules that SEBI has set for mutual funds.
Interestingly enough, this was exactly the view that SEBI took a few years ago and made an attempt to regulate ULIPs. At the time, there were many ULIPs that had negligible insurance components. They were basically mutual funds with ultra-high commissions and costs, that had a tiny component of insurance so that they could operate under IRDA's lax regulatory regime. The brouhaha resulting from that episode eventually led to the 'new ULIP' which had lower total commissions if held over the entire term. As this report notes, given the higher upfront commissions and the low persistence rate, the lower commissions are largely a mirage. Moreover, insurance sales push across the country shifted to the traditional plans which still have high commissions and low transparency.
The report also makes a set of recommendations on mutual funds of which the most impactful one is that there should be no upfront commissions at all and the advisors' remuneration should entirely come from a trail commission that continues at a low rate while the investor holds the product. This is a much needed change and would perfectly align the advisor's interests with those of the investor.
Is there any chance that these recommendations would actually be implemented? Well, I'm not waiting with bated breath. The problems on which these solutions are based--as well as the solutions themselves--have been widely known and understood for a long time. Formalisation as recommendations in a report by a government committee is a step forward but only one a small one. The key recommendations would require a complete overhaul of the financial regulatory structure, something which is already supposed to be underway through the Indian Financial Code.
However, the worst case would be if some of these are implemented and others are not. The main issue here is one of regulatory arbitrage, whereby IRDA's regulation of investments is utterly lax compared to SEBI. Hypothetically, if it were to happen that the mutual fund recommendations were implemented and the insurance ones ignored, then that would actually increase the regulatory arbitrage! I wouldn't rule this out because historically, we've seen that the insurance industry's lobbying muscle has been much stronger.