Oct 5, 2009

New Tax Code - Impact on Life Insurance Policies

Photo by biphop

Currently more than 80% savings under section 80C goes towards life insurance. A consumer behavior survey (in January 2009) by IMRB for ICICI Prudential Life had revealed that 79% of people prefer life insurance vis-à-vis other tax saving instruments.

As already mentioned in my previous posts, the main reason behind mis-selling of life insurance policies is tax concessions and not the high commission rates (which is the secondary reason).

Let’s review how the Direct Taxes Code Bill, 2009 (New Tax Code) changes the life insurance current scenario. First, investment in life insurance policies is also covered under EET regime. Following are the relevant sections of the new tax code impacting life insurance:

New Direct Tax Code on Life Insurance Policies: Relevant Provisions
According to section 56(2)(r) of the new tax code, the scope of residuary income includes

“any amount received, or withdrawn, under any circumstances, from any account maintained with any permitted savings intermediaries, referred to in sub-section(2) of section 66, representing,-

(i) the principal amount of the savings; or

(ii) interest, dividend, bonus, capital appreciation or any other form of return on the investment, by whatever name called;”

This income u/s 56(2)(r) can be reduced by deductions allowed under section 57. As per section 57 of the new tax code following deduction is allowed while calculating income u/s 56(2)(r):

“any sum received under a life insurance policy, including the sum allocated by way of bonus on such policy, if –

(i)the premium payable for any of the years during the term of the policy does not exceed five per cent of the actual capital sum assured; and

(ii) the sum is received only upon completion of the original period of contract of the insurance or upon the death of the insured;”

Further, following two paragraphs of Chapter XI (Income from Residuary Sources) of Discussion Paper on Direct Taxes Code, 2009 are also relevant:

Para 11.3: The scope of gross residuary income include, inter alia, the redemption or withdrawal of the principal amount from any investment that is eligible for deduction in computing the total income. However, withdrawals/ redemptions from provident funds and pure life insurance policies will not be included under this head.

Para 11.5: Any sum received under Life Insurance Policy, including any bonus, shall be exempt from income tax, provided it is a pure life insurance policy. In order to achieve this objective, the Code provides that deduction will be allowed in respect of any sum received under a Life Insurance Policy, including any bonus, only if the premium payable for any of the years during the term of the policy does not exceed 5 percent of the capital sum assured. Consequently, in all other cases, the sum received under the policy, including any bonus, will be included under this head and taxed accordingly.

Review / Analysis: Impact of New Direct Tax Code on mis-selling of Life Insurance
Apparently, Mr. Draftsman thought that by making it mandatory to have insurance coverage of at least 20 times the premium paid, only pure term policies will be covered under tax exemption.

I think the Draftsman are blissfully ignorant of the working of the life insurance business. Why? Because the new tax code contains so many flaws:

1. First, there is neither any maturity value nor any bonus in case of a pure life insurance policy. Let me inform the draftsman that amount spent on buying a pure life insurance cover is an expense (just like tuition fees) and not an investment. The amount of life cover is payable only to the nominee in case of unfortunate death of the insured during the policy term.

2. By paying premium equivalent to 5 per cent of sum assured, one can get a life policy with a sum assured which is 20 times the premium paid. But what’s wrong with this? It means that the life insurance coverage is too low and major portion of premium is going towards investment. For buying a pure life insurance cover, you don’t need to pay such a high premium. For example, a 40 year old male can buy a Rs. 10 lakh level term plan from SBI Life Insurance (SBI Life Shield) for a period of 25 years by paying an annual premium of Rs 6,648 which means that insurance cover is 150 times the premium paid or, in other words, premium is just 0.66% of the sum assured.

So, by keeping low coverage / high premium, Mr. Draftsman is trying to ensure that even most of the ULIPs also get the tax exemption under the new tax code.

3. Furthermore, there is no such condition under section 66 of the new tax code(which replaces existing section 80C of the IT Act, 1961) which implies that at the time of making savings one is free to invest Rs 3 lakh in all kinds of life insurance policies (including Ulips, money back and endowment plans) and avail tax deduction irrespective of the extent of insurance coverage provided under the plan.

If you take a second look and dig a little deeper, you’ll find that this new tax code is only going to increase the mis-selling of life insurance policies. How?

1. If you invest in life insurance policies such as ULIPs, money back and endowment plans with a sum assured less than 20 times, you’re going to get tax deduction u/s 66. However, all the withdrawals would be taxable (irrespective of whether amount withdrawn before or after the maturity). In effect, it means that the tax status of such life insurance policies will be equivalent to PF, PPF and NPS under the new tax code.

2. If you invest in ULIPs or traditional life insurance plans, with a sum assured greater than 20 times the premium, the tax concessions will go a step further and even the maturity amount would become tax exempt. In effect, such life policies will enjoy a better tax status than NPS, PPF and PF under the new tax code.

So it’s a win-win situation for life insurance companies. Heads they win and tails you lose.

My contention is that:

If the intention of the legislature is to really provide tax benefits only on the premium paid on pure life insurance policies, the wordings of the section 57 of the new tax code can simply state “ term plans without return of premiums” instead of stating it in terms of premium paid as percentage of sum assured.

Furthermore, if the legislative intent is, in fact, to encourage life insurance companies to sell and people to buy pure life insurance plans, why treat insurance policies as a saving avenue under section 66 of Direct Taxes Code Bill, 2009.

By offering tax incentives on life insurance, legislature is causing great harm to the society and the Nation. What is the sole purpose of insurance? Is it the instrument meant for protection or savings? Combining both the elements increases complexity and opens the door for mis-selling. Besides, the customer (who is already too busy watching cricket, discussing politics, buying latest models of car/gadgets, or gossiping about someone) loses focus and it becomes a preferred instrument to invest and save tax. In the process, the core purpose of insurance gets neglected.

If the government keeps on encouraging the people (via the medium of tax incentives) to save money by investing in insurance products, then providing real life insurance to masses will remain a pipe dream.

Does anybody know that providing affordable life insurance to Indian masses is even more important than providing them with an affordable car (Is Mr. Tata listening?) or an affordable house? Just go and ask any family whose breadwinner has met an untimely death without an adequate insurance cover.

Any Comments?

Also see:

1. Most Amazing Fact about Life Insurance
Understanding Life Insurance

Revised IRDA Circular on ULIPs: What a Sham?

New Direct Tax Code: Income Tax Slabs


  1. Fisher,
    Well said. Only hope is public awareness. We need to awaken the government.


  2. Madan: Public interest is secondary to that of the LIC.


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