BEGINNER'S GUIDE TO INVESTING
Mis-selling of Insurance Products
This is going to be long. But you asked for details. And you may not be the only one, and some may be newbies. This is meant for absolute laymen. Fire away questions if necessary.
When you start off investing, unless you already have knowledge about various instruments, you are likely to get fooled. And you are more likely to be fooled by the people who already have knowledge about your purchasing power i.e. your bank.
In India, banks are allowed to act as distributors for various investment products, including insurance schemes and mutual funds. There are cases where investors register a loss of principal when exiting insurance schemes. A similar loss of principal from mutual funds through the same modus operandi is less probable. You can argue that people can be suckered into buying equities when they are at a high, but still this cannot be compared in scale to insurance products masquerading as investments. After all, with insurance products, you get a free look-in period of 15 days to return the policy and get your money back. The performance of the product won't be visible to you, until much later. For an investment that is not liquid (holding period is often 3 - 5 years at a minimum), you end up in a situation where you are trapped with the product. You are then left with a few choices:
  • discover how you got trapped, and whether you can complain to the company to recover your money. This was the subject of the article (more on this later).
  • eat up the cost of surrendering the policy, and get back a smaller portion of your principal
  • wait out the minimum period to surrender the policy at no cost.
Complaining doesn't work, since there are crafty ways to fool the gullible into purchasing such accounts leaving little or no trace behind that the buyer was suckered into it. Remember that most Indians don't have the required financial knowledge. The regulatory authority for these instruments is IRDA and not SEBI (unfortunately), even though investments are made by the insurance companies eventually in the capital markets regulated by the latter.
I'll cover the initiatives SEBI (and to a certain extent, the fund houses and AMFI) has brought forward in the recent past (5-10 years) to protect investor interests, because to understand how backward IRDA is, you need a reference point. SEBI has undertaken steps to ensure that the performance of the investments in the capital markets can be tracked in a transparent manner, and that distributors are not incentivized heavily to get investors to part with their money (except for closed ended MFs, but that too may change in the future). I'll call out certain features of MFs, some of which are notable in the Indian market because of SEBI -
  • the schemes are color coded to distinguish the amount of risk involved,
  • the brochures, KIM and SID contain sufficient information on where the investor's money goes.
  • the performance of the fund can be tracked daily. Fund houses are required to update the NAVs by 10 AM the next working day.
  • the holdings of funds are published in detail periodically (every month in some funds), so you know what the fund manager is doing with your money.
  • front-loads are banned, so practically all your money gets invested upfront in the fund, except for the expense paid to the distributor, the fees to the fund management team, and brokerage charges
  • the total expense ratios of funds are known are distributors are often required to disclose how much they collect in commissions when you invest in a fund.
  • funds must have a benchmark against which their performance can be tracked. With the current tax regimes, funds have to perform every year; often investors prefer that the funds meet or exceed the returns from the benchmark. With the current exit loads of most MFs, exiting a poor scheme doesn't penalize the investor a lot in favor of the fund; you don't see exit loads like 10% or so.
Now, when it come to IRDA and insurance products sold as investments, the story is quite different. IRDA resides in an era where the investors are expected to read and understand every item printed in fineprint in the brochure. It is down to the investor prepare a mental model of the investment and commit to the investment for a duration lasting several years, failing which the investor should be penalized. The insurance industry is beyond reproach. When you are presented with investor-facing documents on ULIPs, endowment plans, traditional policies, you'll notice the lack of transparency in these instruments:
  • comparing the performance of the insurance fund with a benchmark is downright difficult if not impossible. Usually the comparison is made between the benchmark and the money left for investment after deducting charges (aka a portion of your premium depending on how many years have passed). Coming back to MFs, you don't see funds even trying to pull this trick when it comes to disclosing fund performance.
  • then there is the problem with the charges themselves. You have a premium allocation charge which is deducted upfront (a portion is allocated for distributor commissions), mortality charge and policy administration charges for insurance, and finally fund management charges for managing the investment. Let's not forget service tax and cess. All of these work to reduce the principal invested in the markets. And then the surrender charges which hangs like the Damocles sword on the investor, forcing him to either forfeit a portion of his principal or have his money locked up for a period of time.
  • the projections on returns are made in a very simplistic model. Even though the underlying investments are made in capital markets, the projections themselves are drawn up assuming the markets will grow in a straight line graph (at 4% or 6%; the projections are capped at 10%). Ask yourself whether any financial instrument has behaved this way. Your first premium may give 5% in the first year (after deducting charges), your second premium may give -10% (after deducting charges), because the markets would have given 5% and -10% respectively.
  • who manages the fund, the analysts involved in the fund and their track record and the investment philosophy of the fund.
Now, where does it start to go wrong for investors?
  • Investors who start looking at new instruments after seeing miserable inflation-adjusted returns from the very simple savings bank accounts, FDs and RDs, are often pushed these instruments, on the premise that they are safe with no risk (hey, it's insurance).
  • Most are scared of equities, because of advertising. Insurance ads paint themselves as guaranteeing safety (hey, it's insurance). SEBI forces TV ads to report that "Mutual funds are subject to market risk. Please read the offer document carefully" (often blurted in a manner to plant suspicion XD). IRDA doesn't require them to mention market risks (what luck). The stage is set to push insurance as investment.
  • Distributors and agents can engage in variety of tricks in the selling phase. Products can be missold with agents/distributors stating that the investor can stay invested only for 5 years, when in fact the brochure itself mandates that payments be made for 10-20 years. The catch here is that the investor can surrender the product after 5 years, and thus can be misstated as "needing investment for only 5 years". There are several more tricks, but too long to list here. Basically, it is a free ride for anyone wanting upto 25% commission ^* ^(see ^reo_sam's ^comment ^below) on the first year's premium amount; the amounts reduce over subsequent years. There is a reason why they are loathe to sell pure insurance (term insurance) products to you - they don't get a lot of money out of it. When you pay a 1L premium, chances are 10-25k is paid to the distributor (the agent selling the plan to you employed by the distributor would get his cut). This is a very lucrative model. What could go wrong?
  • Premium allocation charges are very high in the initial years, ensuring that a smaller portion of your principal is invested. They are not satisfied with the returns, and end up attempting to withdraw their money. But then, they would be hit by a surrender charge as well, ensuring that the IRR (internal rate of return) of the investment is negligible or negative. A negative IRR may force investors to stay invested longer instead of getting out faster. And the industry washes this off as standard practice to get investors to stay invested in the long run; you don't see this conducted on an industry wide basis for MFs. Throwing good money after bad is apparently great behavior to some, but they don't practise the same - how often do you see the insurance product manager investing in his fund. You'll however see MF managers and employees investing in the same schemes run by them or the same fund house.
  • Recovering money locked in an investment is tough. The combination of surrender charges, and the onus of proving misselling that falls entirely on the investor means that he incurs a combination of principal loss and opportunity cost. This is why the article mentions that everything the agent or distributor says must be taken in writing (as proof). Otherwise the company can simply wash off its hands, until the matter goes to court.
Misselling in insurance is basically a case of complex products (insurance and investments packaged into one complex product), incentivized to be sold to investors who may not be able to distinguish it from the simple products that they are accustomed to, with insufficient opportunity to back out from the investment (high surrender charges and price shock in a period occurring much later in the product lifecycle).
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