Jul 30, 2009

Investor’s Reform in 2009 (# 3) - Cap on ULIP Charges by IRDA

Photo by Mutasim Billah Pritam

This post is a thorough review of IRDA circular putting a cap on ULIP charges. I’ve divided the post into three parts for ease of reading:

Part 1: Highlights of the IRDA circular capping ULIP expenses

Part 2: Impact on Investor’s, Insurance Agents and Life Insurance Industry

Part3: My opinion

The year 2009 has potential to become watershed in the history of investor’s reforms if the pace of financial reforms continues.

Of late, financial regulators have started taking their job seriously and thinking with a focus on customer benefit rather than working under pressure from various industry lobbies. Perhaps, taking a cue from SEBI, IRDA also wants to come out of the undue influence of insurance industry and work for the benefit of customers / investors.

The much anticipated and long over-due reform in the life insurance industry is a step in the right direction, though it has left many questions unanswered.

Currently, various ULIP charges such as mortality charges, premium allocation charges, administration charges and fund management fees are recovered from the policy holder, but there is no maximum limit imposed. To know more about the charges,
click here.

To ensure that ULIP charges are reasonable, IRDA has issued a circular (No: 20/IRDA/Act/ULIP/09-10) dated 22 July, 2009 to all life insurance companies capping overall ULIP charges but leaving various individual charges at the discretion of insurers.

Highlights of the IRDA Circular Capping ULIP Charges:
Here are the major points of the IRDA circular dated July 22, 2009 capping ULIP expenses:

1. Effective Date:
New ULIP Products --> October 1, 2009
Existing ULIP Products --> December 31, 2009

2. Maximum Cap on ULIP Expenses:
IRDA has defined the overall cap on charges in terms of difference between gross yield and net yield which is nothing but ‘expense ratio’ or ‘reduction-in-yield’.

For the purpose of maximum limit on expenses, IRDA has classified ULIPs in two parts based on the tenure. Besides, total cap on expenses, it has also put a sub-limit on fund management charges (FMC).

i). ULIPs having tenure of up to 10 years: the difference between gross and net yield can’t exceed 3 per cent (300 basis points) of which FMC can’t exceed 1.5 per cent (150 basis points). Put simply, the overall charges are capped at 3% and the fund management charges (FMC) not to exceed 1.5 per cent.

ii). ULIPs with tenure of more than 10 years: Overall ceiling is 2.25% of which FMC shall not exceed 1.25%

3. Exclusions from Cap:
However, certain charges / expenses have been excluded from the ceiling. Put simply, insurance companies can recover the following charges in addition to maximum allowed limits of 3 per cent / 2.25 per cent mentioned above:

a). Extra mortality premium charged from policyholder due to poor health.
b). Cost of all rider benefits such as accident & disability benefit rider, waiver of premium rider, critical-illness rider and income benefit rider.
c). Service tax on all charges.
d). Explicit cost of investment guarantee. In other words, guaranteed Ulips are allowed to charge extra for providing capital guarantee / NAV guarantee.

4. Certificate:
In addition to putting a cap on the maximum limit, IRDA has also made it mandatory for all insurers to issue a certificate at the time of ULIP maturity showing year-wise premiums paid, charges levied, fund values, actual gross yield and net yield.

Impact of the IRDA Circular Capping ULIP Charges:

1. Impact on Insurance Agents
Reduced commission for insurance agents. But reduction is not going to be significant and won’t stop mis-selling of ULIPs.

2. Impact on Customers / Investors
i). Policyholders can expect higher return on investments in ULIPs due to reduced costs.

ii). Investors will be encouraged to go for longer term ULIPs.

iii). The flip side is that there is every possibility of reduced insurance cover and short term ULIPs.

Anyhow, let’s make an attempt to quantify the actual impact of the reduction in costs / increase in ULIP returns due to capping of charges. The only reliable way to measure the impact in terms of difference between present expense ratio and the maximum expense ratio to be allowed in future is to use the ULIP rankings done by OUTLOOK MONEY in December 2008.

A total of 32 Type I Ulips and 10 Type II Ulips were ranked assuming 10 per cent rate of return (Gross Yield). The comparison was for a 15 year ULIP with a sum assured of Rs 5 lakh and annual premium of Rs 50,000 purchased by a 35 year old male.

Out of 32 Type I ULIPs, the best one has a ‘net yield’ (also called IRR) of 8.07 per cent and the last one has an IRR of 6.09 per cent. Leaving aside the top 3 ULIPs, all others have “expense ratio” or “reduction in yield” which is exceeding the maximum limit of 2.25% by a margin in the range of .06% to 1.66%.

Besides, all the 10 ULIPs under Type II have expense ratio / reduction-in-yield exceeding the maximum limit by a margin ranging from 0.20% to 1.62%.

But, how much difference does it make in the maturity value of an ULIP? Let’s see with the help of an example. Suppose, you’re investing Rs 50,000 every year for 15 years in a ULIP which is currently having an ‘expense ratio’ of 3.50% (IRR of 6.50%) against the maximum allowed 2.25% based on assumed Gross Yield of 10%.

a. Maturity value at 10% CAGR (Gross Yield) --------------> Rs 17,47,486

b. Maturity Value at 7.75% CAGR (Minimum Net Yield) -> Rs 14,34,668

c. Maturity Value at 6.50% CAGR (Current Net Yield) ---> Rs 12,87,700

d. Maximum allowed expenses (a-b) --------------------------> Rs 3,12,818

e. Impact on Returns / reduction in expenses (b-c) ---------> Rs 1,46,968

Please note that the amount of expenses allowed will keep on varying with the change in gross yield. Suppose that in the above example ULIP is able to generate actual gross yield of 12%, then the maximum allowed expenses will be Rs 3,78,330 (minimum ‘net yield’ for investor to be 9.75%) and if the actual gross yield falls to 4%, then the maximum charges to the extent of Rs. 1,77,143 can be recovered.

3. Impact on Insurance Industry
This significant move from IRDA is expected to have far reaching consequences on the way life insurance industry works. It should rein in the excesses of life insurance industry, put some semblance of order in the way life insurance industry works and check the mis-selling of ULIPs.

Let’s wait and watch whether life insurance industry actually put their house in order and control the expenses or find some innovative ways to bypass the IRDA ruling.

Following is the list of immediate fall out of the IRDA circular capping ULIP charges on the life insurance industry:

i). We can expect some kind of level playing field between life insurance industry and mutual fund industry.

Due to abolishment of entry load in mutual funds, the gap between the commission structure of mutual funds and life insurance policies widened too much and hence the ULIPS were expected to have an undue edge over their mutual fund counterparts. Now, to some extent, this concern will be taken care of.

ii). It should result in more focus towards protection oriented policies (which is the real essence of life insurance industry) rather than just fund management business. However, it seems doubtful.

iii). From the point of view of insurer’s, short term ULIPs (with a duration of up to 10 years) are going to more profitable.

Although customer will prefer buying longer term ULIPs ; however, it is quite probable that insurance companies will hesitate is selling long term ULIP plans and give more push to shorter term policies.

iv). Insurance companies are caught in a catch-22 situation, due to inclusion of mortality charges in the over-all cap. A mortality charge depends on ‘sum-at-risk’ (SAR) which varies with the sum assured and age of the insured. Either it can lead to cross-subsidization or affect the profitability of the insurance companies adversely.

However, there is third possibility (reducing life coverage) also and in all likelihood insurers will go for it. Put another way, it is quite possible that instead of controlling other expenses such as allocation charges and administration charges insurers will start restricting or reducing the level of maximum sum assured to remain within the maximum limit imposed on the charges. As a result, whatever meager life cover the ULIPs currently offer will get reduced further and it will become more of a pure investment product.

In a similar vein, life insurance companies will prefer to issue Type I ULIPs over Type II because of higher mortality charges in the latter.

Furthermore, debt funds will have an edge over equity funds as there is no distinction between debt and equity funds for the purpose of cap on expenses. As you must be aware that FMC of debt funds is lower (almost half in case of pure debt funds) than equity funds, so an ULIP with only debt fund option or majority of debt funds would have more leeway in recovering higher other charges.

My Opinion:
First, Mortality charges should be excluded from the overall cap and accordingly the cap on overall charges should also be revised downwards, so that finally there are two different caps, one for the FMC and other one for the other charges such as allocation charges, administration charges and other miscellaneous charges (mortality charge to be added in the exclusion list).

Alternatively, remove the mortality charges from the cap and also remove the sub-cap on FMC so that there is only one cap for all expenses except mortality (in addition to the exclusions already mentioned).

Second, manner of calculation of gross yield (the actual returns generated by the ULIP) has not been defined. At the time of sale, ‘benefit illustration’ will be based on assumed gross yield of 10%. But, you would have to wait till the expiry of your policy to know the actual gross yield. As per the circular, insurers are going to show you the actual yield only at the time of maturity of ULIP. And how they are going to calculate it has been left entirely at their discretion. Why not show the cumulative gross yield & expense ratio’s every year? This disclosure is very essential to bring in more transparency.

Third, to avoid any confusion and mis-interpretation it should be specifically mentioned that the ‘gross yield’ is to be based on premium paid (i.e., premium allocation charges are also part of the overall cap).

Fourth, put a blanket ban on issuance of Ulips with less than 10 years duration.

But my worry is that instead of taking the above steps, IRDA might dilute the effect of circular before its implementation date due to pressure from insurance lobby.

Anyhow, still this is not enough and won’t stop life insurance industry from making fool of people.

In my view, ultimately the simple & best way to regulate life insurance industry is to separate investment from insurance which can be done if our finance minister becomes wise enough to abolish all kind of tax incentives on life insurance policies except pure term plans. Rest everything will follow.

The need of the hour is provide affordable & real life insurance to the masses and the solution is very simple enough. Any takers??

What do you feel about it? Do you agree or do you have any other opinion regarding capping of ULIP charges or the working of life insurance industry? Please feel free to air your views by writing in the comment box.
UPDATE: To know the details of revision made by IRDA in the original circular capping ULIP charges, see: Revised Cap on ULIP Charges - What a Sham!


  1. Thank you so much for the detailed review sir. Please may i know , if the cap on charges will be applicable for Existing ulip insurance contracts too? (from dec or from oct?) thankU

  2. Dear Sir,
    Kindly advise me on the following:
    I am a Unit Linked Insurance policy holder of TATA AIG from April 18th, 2005 (Policy No.u330001274).

    As per Circular No.20/IRDA/Actl./ULIP/09-10 dated 22 nd July, 2009,No surrender charge can be levied by an insurer for policies surrendered from the 5 th policy year and thereafter and consequently the policyholder will be entitled to receive the full fund value on such surrender.
    Kindly clarify whether the above mentioned clause is applicable for this existing policy ?

    I am advised by one of the insurance agent that this clause is not applicable for existing policies. Hence this question put up for clarification.
    Best regards

  3. Sundararjan,

    It is applicable on existing policies also.


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