It’s LIC IPO Time. Let me try to play devil’s advocate here and talk about why Insurance should be treated as an expense and not an Investment option.
LIC’s 652 Page DRHP, is full of interesting information and facts. Do check out the whole DRHP if you want to learn in detail about the Company and the Industry it operates in.
In this post, We will focus on one aspect which we as customers must have always wondered about when it comes to buying an insurance product.
Customer Acquisition Expenses allowed by IRDAI
In May 2016, the IRDAI issued regulations to control the expenses incurred by the life insurance company to acquire customers.
For insurance companies in operation for more than 10 years, the regulator capped the expense at 80% of first-year premium and 15% of renewal premium for players in respect of policies with premium payment terms of 10 years and above.
For players with less than 10 years of operations, the IRDAI provided a higher cap on expenses due to high costs involved in the first few years of operations. The expense was capped at 90% of first-year premium and 20% of renewal premium; The respective caps are higher for pure protection products.
| Particulars | Premium payment term | % of first-year premium | % of renewal premium |
|---|---|---|---|
| 5 -7 years | 70 | 18 | |
| Co. < 10 Years of Operations | 8-9 years | 80 | 19 |
| 10 and above | 90 | 20 | |
| 5 -7 years | 60 | 15 | |
| Co. > 10 Years of Operations | 8-9 years | 70 | 15 |
| 10 and above | 80 | 15 |
Source : IRDAI
What’s the Commission we pay for Mutual Funds?
In Sept 2018, SEBI Linked expense ratios with asset slabs and removed the upfront commission that is to be paid to mutual fund distributors. This helped lower the expense ratios.
The board of Sebi has cleared the proposal to cap the maximum total expense ratio (TER) – the fee that mutual funds collect from investors every year to manage their money – for closed-ended equity schemes to 1.25 percent and other than equity schemes to 1 percent.
The maximum TER for open-ended equity schemes will be 2.25 percent.
Let’s compare Insurance & MF Commissions taking a simple example to see how much these commissions make a difference to your returns
First, Let’s take the example of Mutual funds :
Table : with 1 lac as investment for 15 years @15% p.a
| Year | Return | Investment Every Year | Amount after the year end | @0.75% on AUM | @1% on AUM |
|---|---|---|---|---|---|
| 1 | 15.00% | 1,00,000.00 | 1,15,000.00 | 862.50 | 1,150.00 |
| 2 | 15.00% | 2,15,000.00 | 2,47,250.00 | 1,854.38 | 2,472.50 |
| 3 | 15.00% | 3,47,250.00 | 3,99,337.50 | 2,995.03 | 3,993.38 |
| 4 | 15.00% | 4,99,337.50 | 5,74,238.13 | 4,306.79 | 5,742.38 |
| 5 | 15.00% | 6,74,238.13 | 7,75,373.84 | 5,815.30 | 7,753.74 |
| 6 | 15.00% | 8,75,373.84 | 10,06,679.92 | 7,550.10 | 10,066.80 |
| 7 | 15.00% | 11,06,679.92 | 12,72,681.91 | 9,545.11 | 12,726.82 |
| 8 | 15.00% | 13,72,681.91 | 15,78,584.19 | 11,839.38 | 15,785.84 |
| 9 | 15.00% | 16,78,584.19 | 19,30,371.82 | 14,477.79 | 19,303.72 |
| 10 | 15.00% | 20,30,371.82 | 23,34,927.60 | 17,511.96 | 23,349.28 |
| 11 | 15.00% | 24,34,927.60 | 28,00,166.74 | 21,001.25 | 28,001.67 |
| 12 | 15.00% | 29,00,166.74 | 33,35,191.75 | 25,013.94 | 33,351.92 |
| 13 | 15.00% | 34,35,191.75 | 39,50,470.51 | 29,628.53 | 39,504.71 |
| 14 | 15.00% | 40,50,470.51 | 46,58,041.09 | 34,935.31 | 46,580.41 |
| 15 | 15.00% | 47,58,041.09 | 54,71,747.25 | 41,038.10 | 54,717.47 |
| 228375 | 304500 | ||||
| Cost of Commission : | 4.17% | 5.56% |
Lets check with the Insurance Policies
| Year | Premium | Amount | % of Commission |
|---|---|---|---|
| 1 | 100000 | 40000 | 35-40% in the first year |
| 2 | 100000 | 7500 | 7.00% |
| 3 | 100000 | 7500 | 7.00% |
| 4 | 100000 | 5000 | 5.00% |
| 5 | 100000 | 5000 | 5.00% |
| 6 | 100000 | 5000 | 5.00% |
| 7 | 100000 | 5000 | 5.00% |
| 8 | 100000 | 5000 | 5.00% |
| 9 | 100000 | 5000 | 5.00% |
| 10 | 100000 | 5000 | 5.00% |
| 11 | 100000 | 5000 | 5.00% |
| 12 | 100000 | 5000 | 5.00% |
| 13 | 100000 | 5000 | 5.00% |
| 14 | 100000 | 5000 | 5.00% |
| 15 | 100000 | 5000 | 5.00% |
| 110000 - 115000 | |||
| Cost of Commission | 11.97% |
Observation :
-
When it comes to regular mutual funds, even if we consider the trailing commission at an industry standard rate of 0.75% and keeping the calculation considering the final amount in an year, it amounts to 4.17% of the total AUM and diminishes the returns (264.78%) only by 5.75%
-
When it comes to some of the insurance products, If we even consider 50% of the IRDAI Mentioned rates and assume a 4% bonus rate and 4% final addition bonus, it amounts to of 4% of 15 lacs * 15 years = 9 Lacs and 60000 of Final Additional Bonus, Commissions therefore amount to 12% of your meager return of 960000.(hardly 64% in 15 years) It is like a double whammy. Abysmally low returns and extremely high commission charges. Considering the cost of living and Inflation, It can in fact yield negative real returns to us.
Parting Thoughts
Endowment & ULIP Policies which are extremely popular are often pretty horrible products. The reason is pretty simple - They mix up both investing and Insurance and neither provide adequate returns nor insurance (if we say good bye to the world early)
The best combination to cover both Insurance and Investments is to treat them separately first. The best way to approach it would be to buy a term insurance and treat it as an expense (this covers the insurance part) and then focus on Investment either using MF (Direct preferably or regular)
What are your views on the cost of acquisition undertaken by the Insurance Companies ? Do you think these are too high? With Insurance processes becoming fully online these days, It needs to be seen whether we can witness a decline in Insurance premium cost.