Saturday, January 30, 2016

Draft IRDAI regulations on insurance commissions: Going back to the beginning

by Ashish Aggarwal and Renuka Sane

On 13 January 2016, the Insurance Regulatory and Development Authority of India (IRDAI) released the draft (Payment of commission or remuneration to insurance agents and insurance intermediaries) Regulations, 2016 and invited public comments. The regulations propose a substantial increase in commissions for life insurance distributors starting April 2016.

In their present form, the proposals will be detrimental to consumer interest, increase the regulatory arbitrage in favour of products regulated by the IRDAI and undermine the recent attempts by the government towards curbing mis-selling and rationalisation of incentives for financial product distribution.

The regulations are intended to govern payments by an insurance company to individual agents or intermediaries (which include corporate agents, insurance brokers, web aggregators, insurance marketing firms, and any other entity as may be recognised by the IRDAI) for soliciting and procuring an insurance policy. Payments may be in the form of a commission (paid to agents), remuneration (paid to intermediaries) or a reward (any direct or indirect benefit over and above the commission). The Bill proposes that the Board of every insurance company will approve the commissions and reward policy. The draft Regulations propose two big changes.

Big change 1: Raise the overall commission rates

For bundled products, such as ULIPs and traditional plans, with a tenure of twelve years or more, an insurance company would be able to pay intermediaries 49% of the first year premium as commission and reward. This cap is proposed at 42% for insurance agents (See Table). The commissions for subsequent years has been increased to 7.5% of premium for year 2 to 6. Earlier, the cap from year 4 onwards was 5%. The 5% cap is now applicable from year 6 onwards.

Pure risk cover, or term plans, will have a maximum first year commission rate of 50% for policies of tenure 12 years or more. For those between 5 and 11 years, commission will be capped at 40%. Subsequent year commissions will be capped at 10%. The addition of rewards to these implies that the maximum cost cap for term policies of duration 5 to 11 years will become 48% for agents and 56% for intermediaries. For policies more than 12 years, the caps will be 60% for agents and 70% for intermediaries.

First Year Life Insurance Commissions and Rewards
Category Proposed Existing
Policies with premium paying term
of 5-11 year:
ULIP/ Traditional - 42% for intermediary and 36% for agent

Term - 56% for intermediary and 48% for agent [Note 1]
15% to 33% based on premium
paying tenure of the policy [Note
Policies with premium paying term of 12 years and
ULIP/ Traditional - 49% for intermediary and 42% for agent
Term - 70% for intermediary and 60% for agent [Note 3]
Note 1: Commission:- 30% of premium (ULIP/Traditional), 40% of premium (Term), Reward - 20% of Commission for agent and 40% for intermediary.
Note 2: Tenure and Commission:- 5 year - 15%, 6 years - 18%, 7 years - 21%, 8 years - 24%, 9 years - 27%, 10 years - 30% and 11 years 33%.
Note 3: Commission:- 35% of premium (ULIP/Traditional), 50% of premium (Term), Reward - (20% of Commission for agent and 40% for intermediary).

Big change 2: Bring in hereditary commissions

These are being reintroduced. Section 54 of the The Insurance Laws (Amendment Act), 2015 had removed section 44, according to which, if an insurance agent had served for more than 5 years, the commissions had to be paid to the heirs of the agent, even if the agent was no longer servicing the policy.

Problems with the draft regulations

Ignores all evidence on the perverse impact of high commissions
Research has shown that the incentive structure of agents has played a large part in the mis-sale of financial products. When agents get remunerated by the product provider, the incentive comes not from higher sales driven by customer satisfaction, but from commissions paid by the product provider. The product that pays the higher commission is the product that gets sold. This is not always in the interest of the customer. The world over, the response of regulators has been to ban conflicted remuneration structures, and/or impose requirements on ensuring the suitability of the product to the customer. Against such a background, the IRDAIs proposal to increase commissions, and also not impose any suitability requirements seems misplaced. This is particularly relevant as metrics of performance such as persistency and lapsation of policies have been steadily worsening.
Increases regulatory arbitrage
The same insurance distributor is likely to be selling other products like mutual funds and New Pension System which at their core are long term investment products. The commission structure for mutual funds is based on asset based trail fee. This results in relatively much lower commissions in initial years which could grow into substantial sums after say, 10-15 years, provided the customer stays into the scheme and invests regularly. The commission structure for NPS distributor provides for a nominal flat transaction fee and a 0.25% fee on amounts invested. A distributor is naturally incentivised to push insurance plans irrespective of suitability for the consumer. A consumer would be more likely sold a traditional insurance plan than a basket of NPS, mutual fund and term insurance. This makes selling difficult for the mutual funds and NPS. The proposed regulations are likely to further skew the markets.
Does not realign the pure term and bundled insurance products
It would be misleading to assume that the regulations incentivise sale of term insurance products by providing for higher commission rate as compared to ULIPs and traditional investment oriented plans. A term plan of Rs.1 crore for a 35 year old would cost Rs.13,000. At 70% of premium, Rs.9,100 should be a very attractive first year commission given that these products are apparently more difficult to sell as compared to investments. However, even if the initial commission rates on ULIPs and traditional plans were much lower, say 10%, these could still be more attractive for distributors to sell than term plans. For example, premium for ULIP/ traditional plan with a similar insurance cover would be about Rs 100,000 and even a 10% commission would fetch Rs.10,000. Of course, these are basically investment products with only a small portion of the premium going into insurance component. The raising of commissions on pure term along with that of bundled products does not alter the skew against the sale of pure term products.
Poor process
The draft regulations provide an approach which has gone into the formulation of the regulations. They do not, however, provide a rationale. How would these regulations benefit the consumers? In less than one year of the Insurance Laws (Amendment) Act omitting hereditary commissions, it is not evident why these are now proposed to be brought back through regulations? Regulators such as RBI, SEBI, have shown a poor track record in following regulation making processes. Regulations on fund management, and regulations on aggregators of the NPS, by the PFRDA have also raised similar concerns. The IRDAI draft regulations are yet another example of the failure of the attempts by the Government to encourage regulators to frame regulations as laid down in the Handbook on adoption of governance enhancing and non-legislative elements of the draft Indian Financial Code.

Another recent committee's recommendations on commissions

It would be useful to look at the recommendations on similar issues of another recent committee setup by the Government of India and headed by Sumit Bose, Former Union Finance Secretary. The report has recommended doing away with the practice of front loaded commissions. It noted that these created perverse incentives for distributors to push products with higher upfront/ first year commissions, increased regulatory arbitrage and proved expensive for the consumers. The committee's recommendations provided that:

  1. There should be no up-fronts for the investment part of the premium. The investment part should attract only AUM based trail commissions. The trail commission treatment should be decided with consultations with the lead regulator in the market-linked investment space. These should be level or declining.

  2. Upfront commissions should be allowed only on the mortality part of the premium.

  3. Distributors should not be paid advance commissions by dipping into future expenses, their own profit or capital.

  4. The illegal practice of rebating should be punished harshly by the regulator as it distorts the market.

In its present form, the IRDAI draft regulations ignore all the recommendations of the Bose Committee report.

Way forward

The disjointed approach as apparent in the draft IRDAI commission regulations is not in consumer interest. A useful approach would be to:
  1. Fix the commission structure for the distributors based on the  recommendations of the Bose Committee.

  2. Improve the regulation making process. Inviting public comments on draft regulations is a great step but mere existence of a public consultation process does not mean that the public will spend time and resources to comment and participate in the exercise. When the final regulations get released, the IRDAI should take care that these are accompanied with a proper explanation of (i) what exactly is being changed; (ii) evidence that has been relied upon to propose the changes and (iii) expected impact of the regulations on key stakeholders like consumers and sellers.

Ashish Aggarwal is a researcher at the National Institute for Public Finance. Renuka Sane is a researcher at the Indian Statistical Institute.

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