What is your advice to the people who buy insurance in order to save tax?
The decision to buy insurance shouldn't be driven by tax considerations alone. The first step to investing in insurance is to have an asset allocation strategy. The amount of insurance you take depends on how much you save. Usually, early in their careers, people take several loans such as auto and home loans. For them, the first priority is to pay off the debt as quickly as they can, followed by the building of a corpus for their child's education, etc. It is prudent to save at least 25 per cent of your salary from the beginning. When you are planning for retirement, you should put aside 40 per cent towards it. If your employer offers a pension fund or you contribute to superannuation, your decision on how much to invest in insurance will change completely.
Insurance has various advantages over other products, including the flexibility to switch investments and realise gains without tax implications. Unit-linked insurance policies offer a transparent approach along with several investment choices. Unlike traditional endowment plans, most Ulips do not offer guaranteed returns, but they score in terms of tax advantages and net yield.
There is a lot of ambiguity about the 100 per cent allocation claimed by Ulips. What is the fine print that investors need to look out for and how can they make cost comparisons?
All insurance companies have adequate disclosures in place, but a 100 per cent allocation plan is a myth. Typically, the insurer will invest the entire amount in the first year and, thereafter, recover charges on a monthly basis by cancelling units. This could be approximately 0.5 per cent of the premium per month, that is, 6 per cent annually.
Although all costs are stated upfront, it is not easy to compare policies based on cost as it can be expressed in many ways. For instance, the sales and distribution cost of an insurance company ranges from 7 per cent of the first-year premium to as high as 70 per cent. With the new cap on charges, most insurers have restricted it to below 50 per cent of the actual costs. This charge can be frontloaded or recovered later. Insurance companies usually have a three-year window for recovering costs from a policyholder. Then there is the administration cost, which ranges from Rs 1,000 to Rs 2,000. This can be recovered as servicing cost by charging a percentage of the premium every year for 10 years, or as part of the initial allocation charge. So the best way to decide on a policy is by ascertaining the reduction in yield—your net gain from the policy. A 10 per cent IRR (internal rate of return) may equate to a net yield of 7.8 per cent after the impact of various charges, which means that the reduction in yield is 2.2 per cent.
The insurance regulator has capped the Ulip charges to 3 per cent for policies up to 10 years, and 2.25 per cent for plans with longer terms. How will this affect investors and insurers?
Some products had to be amended to comply with the cap of 3 per cent. So, ultimately, investors will get a better return. However, this has negatively impacted small policyholders because every policy has a fixed cost for servicing and the cap may not render it viable for insurers to offer plans with low premiums. An investor cannot buy a policy by paying a premium of Rs 15,000 any longer. He may be pushed by an insurance adviser to buy an endowment plan with a premium of Rs 15,000, which could have a lower net yield than a Ulip. Typically, endowment plans have a higher reduction in yield compared to Ulips due to the taxes levied on them.
How will the Direct Taxes Code impact insurance?
The code will reduce the advantages of investments in general, but there is no indication that it will happen retrospectively. So if you buy an insurance policy today, you could continue with your contributions. Currently, capital gains from Ulips are tax-exempt at the time of withdrawal if the sum assured is five times the annual premium. In the new proposal, they will be exempt from tax only if the cover is more than 20 times the premium.
How does life insurance in India compare with the trends in other developing countries?
In India, investment in insurance is mainly driven by tax savings. Earlier, investments were predominantly in endowment plans, but with the introduction of Ulips and the interest in equities, many people are investing in this category too. Unlike the international trend, where much of the investment is in pension products, in India it is limited as the taxation of these products is not so conducive. Two-thirds of the maturity proceeds are taxed irrespective of how they are withdrawn, and contributions are exempt from tax only up to Rs 1 lakh.
What are the factors that investors should consider before they select a Ulip?
The most important factor is the reduction in yield, which has been regulated after the new cap on charges. Secondly, investors must buy the Ulip that is most suitable for their objective. One should also consider the surrender value of the policy after five years. Many insurers give bonuses on maturity by way of loyalty additions, etc, which can account for almost 5 per cent of the policy proceeds on maturity. If you want to give up the policy after five years, the surrender value should be acceptable relative to the premiums paid; at least 90 per cent of the value is good but 60 per cent is questionable, unless you are sure to stay invested till the plan matures.
Finally, you must consider the level of cover that you need. If you want the policy to provide protection for your family, make sure that the life insurance cover is adequate. In many cases, the client just needs a minimum cover to enjoy the full tax advantages.
Andrew Cartwright is Chief Actuary of Kotak Life Insurance