Free markets and bad ULIPs

Over the years, life-insurance companies have indulged in a whole lot of mis-selling. They have mis-sold insurance policies like unit-linked insurance plans (ULIPs) and endowment plans, left, right and centre.

This despite the fact that there is massive competition, with nearly 20 companies operating in the life insurance sector. One would assume that with so much competition, mis-selling won't happen. But that is clearly not the way it is.

As Nobel Prize winning economists George Akerlof and Robert Shiller write in their new book Phishing for Phools: The Economics of Manipulation and Deception: "The competitive pressures of businessmen to practice deception and manipulation in free markets lead us to buy, and too pay too much for, products that we do not need; to work at jobs that give us little sense of purpose; and to wonder why our lives have gone amiss."

Many people end up paying too much for insurance products they did not need. One ULIP had a premium allocation charge of 100 per cent in the first year. ULIPs are essentially investment plans with a dash of insurance. They pay a high commission to insurance agents in comparison to mutual funds. A premium allocation charge of 100 per cent meant that the entire premium paid during the first year of the policy was taken up by the insurance company to meet its expenses, including paying the agent commission.

There was another ULIP that charged a 4 per cent policy administration charge per month during the first year of the policy. If you were to invest ₹1 lakh as a premium in this ULIP, ₹48,000 would go towards administering the policy. This meant that the company would charge ₹48,000 during the first year of the policy to buy envelopes for regular statements and the money it cost to courier those envelopes. If that is not a scam, I don't know what it is.

There are two points here: first, how did the regulator allow such policies to be launched? Second, why were almost all insurance companies behaving in the same way? Why didn't a single company view the entire mis-selling scam in the insurance sector as an opportunity to launch a low-cost and low-commission product?

Let me answer the second question first. Akerlof and Shiller explain mis-selling through the example of an avocado (a fruit) grower. If avocado is a little difficult to imagine, you might just consider an apple. The fruit in the example really doesn't matter.

This column appeared in the November 2015 Issue of Wealth Insight.

As Akerlof and Shiller write: "If I have a reputation for selling beautiful, ripe avocados, I have an opportunity. I can sell you a mediocre avocado at the price you would pay for the perfect ripe one. I have mined my reputation." This is one possible explanation for the mis-selling in the Indian case. Most insurance companies are either owned by banks or corporate groups which have been around for a long time. And they were just mining their reputations selling substandard products.

But this does not explain why no insurance company looked at the situation as an opportunity and launched a low-cost and low-commission product. Akerlof and Shiller explain this through the example of an avocado grower who has been growing good avocados and why he would be unable to compete in a scenario where everyone else is growing and selling mediocre avocados.

As they write: "A grower of delicious avocados would be unable to compete. He would have to sell his perfect avocados at the price of the overrated mediocre ones. If the costs for producing perfect ones were greater than the costs for producing mediocre ones, his orchard could be put to more profitable use. He could allow himself to be bought out by a mediocre-avocado producer; or he would go bankrupt."

In the Indian context, any company offering a low-cost policy would have to first ensure that it was paying a low commission on it. And in a scenario where other companies were offering a higher commission, that would have meant that it would have found it difficult to find insurance agents willing to sell its policy.

In fact, in a research paper titled 'Understanding the Advice of Commissions-Motivated Agents: Evidence from the Indian Life Insurance Market', Santosh Anagol, Shawn Cole and Shayak Sarkar point out: "We find strong evidence that commissions-motivated agents provide unsuitable advice. Depending on our treatment, agents recommend strictly dominated, expensive products, 60-90 per cent of the time."

This answers the second question and it brings us to the first question, i.e., how did the insurance regulator, Insurance Regulatory and Development Authority (IRDA) of India, allow these plans to be launched in the first place. In order to answer this question, we first need to understand the concept of perfect competition.

Perfect competition is essentially the opposite of monopoly. In a monopoly there is only one company or institution supplying a particular product or service. In a perfect competition there are many companies supplying the product or service, and none of them is dominant. All of them are small in size in comparison to the overall size of the market.

In the life insurance space in India, the government-owned Life Insurance Corporation (LIC) of India, continues to dominate. And when the largest player indulges in mis-selling through its agents, which LIC did, others really do not have much of an option but to follow the course.

Also, the insurance regulator IRDA has been batting for LIC and the insurance companies all this while, and not the consumers. The insurance advisory committee of the IRDA is constituted by people whose salaries depend on the insurance sector.

So who bats for the consumer then?

Vivek Kaul is the author of the Easy Money trilogy. He can be reached at [email protected].

This column appeared in the November 2015 Issue of Wealth Insight.

This article was originally published on November 27, 2015.