January 30 , 2013
We have often heard about insurance products (especially Life Insurance products) getting mis-sold. Indeed, in such products, mis-selling is often more prevalent than selling! Let us examine how this happens, so that we as aware investors can avoid falling victim to this in future. We will focus on Unit Linked Plans known by various names – ULIPs, pension plans, child plans, retirement plans, highest NAV plans, and so on.
Chasing the wrong goose
The problem starts with measurements and incentives. Assume you were told to study, and given a target of 10 hours of reading – rather than passing an exam - as the target. You would most likely sit with the book in front, but your mind would be everywhere except the book. You would do lip service to the mandatory 10 hours, without actually learning anything. In the process, the entire exercise would be reduced to a farce.
One would think that life insurance industry measures life cover given. But no, it measures premiums collected. The two are very different things – depending on the policy, the ratio of life cover to premium collected could be as low as 5, to as high as 1000! Agents are given commissions based on premiums, and sales persons in the industry have premium collection targets. Thus, the whole industry works in a lopsided fashion, trying to collect premiums without bothering about life cover. If the regulator allows premiums without life cover, they would be too happy to sell on such plans. ULIPs come closest to their ideal, since premiums are high and life covers low (typically 5 times, which is the mandated minimum).
For you as an investor, the logic is exactly the opposite. You want to part with a small premium, but would need a high life cover. The natural product for this is the Term Plan, which gives a cover of 500 to 1000 times annual premium. But try approaching an agent with such a requirement, and he will likely divert you to the nearest ULIP. All excuses, such as 'ULIP is a better product', 'we don't have Term Plan', 'you need a medical test in a Term Plan', and so on will be offered.
Cost upfront, benefits later
The next serious problem is the cost structure. All charges and costs in the product, which you would normally think should be spread over the life of the product, are loaded upfront. Most of it is cut from your first year premium itself, and the remaining in the second and third years.
Think about a 3% annual charge over 20 years – sounds reasonable. But assume 40% is cut straight from your first year premium and handed over to the agent. 10% is then cut in second and third years, with no costs thereafter. In such a case, since the agent earns no further commission on your subsequent payments, he comes back to you after three years to recommend a new 'better' product. The 40%, 10%, 10% cost repeats all over again. This ensures that while he fattens his pocket, any returns your plans may have earned are effectively wiped out by charges alone.
Such charges are variously known as Premium Allocation Charges, Policy Administration Charges, Fund Management Charges, etc. But they are really 'Commissions for Agent'. Some product brochures really insult your intelligence by quoting these as monthly charges. A 3% charge per month doesn't sound too bad, till you realize it is actually a 36% annual charge!
Negatives masquerading as benefits, and vice versa
'No medical test needed' is advertised as selling point for some ULIPs. This is not because it is a great positive of the product. It is in fact because the life cover offered is so low; the Company doesn't think it worthwhile spending on a medical test! So it is actually a disadvantage that you have got a low life cover – one that is grossly insufficient for your family in case of an eventuality.
A customer who had undergone an angioplasty (and hence who was often refused life insurance) was approached by an agent saying he could still get this particular policy. A closer reading revealed that the policy had no life cover at all. No wonder the agent was being very 'generous' with the customer!
Longer lock-in is actually a benefit. One, it controls your urge to withdraw and spend the money. Second, it ensures the benefits of equity investing really kick in. Third, given the high costs upfront that we have seen earlier, it actually allows time for the returns to catch up with costs. Yet, agents tom-tom that after three years, you can stop paying premiums or even withdraw the policy. Indeed, many agents come up with new policies after every three years, so that they can earn the huge upfront commissions all over again. This is a classic case of a benefit being made to sound like a cost.
Illustrations: more misleading than leading
It is a regulatory requirement today to show illustrations with 6% and 10% annual returns. Agents used to (and still do) make informal claims of much higher annual returns, to lure investors. Even if they stick to the mandated 6% and 10%, the results are still misleading. For instance, 10% doesn't sound like a huge return, but shown over a 20-year period, it can look spectacular. It would show your investment grow to nearly eight times your initial contribution.
What this illustration hides is that, on one hand, a sustained 10% over a 20 year time frame is very difficult to achieve. Second, if indeed the market returns these numbers, you would get 8-times return in any fund or index you invest in, not just this ULIP. Third, given the high charges of the ULIP, it is unlikely the return will be anywhere near the projection. After all, after three years, the same agent will be back with a different product, as we mentioned before.
In summary, ULIPs in their current form are more prone to mis-selling than genuine selling. As intelligent and aware investors, you should stay at more than arm's length from them and prefer the simpler Term Plans and mutual funds instead.