A December 12, 2023, Insurance Regulatory and Development Authority of India (IRDAI) draft has caused a 3-6 per cent fall in the stock prices of major listed life insurance firms in past few we eks. The draft looks at reducing the currently exorbitant charges that policyholders pay if they exit earlier than policy maturity.

Early surrenders and lapsing of policies are linked to mis-selling since utility maximising investors will not willingly buy a policy that eats into the capital if terminated mid-way. Data suggests two things. One, complaints of mis-selling are highest against the banking channel. Two, private sector companies that have large bancassurance tie-ups see double the surrenders than government owned Life Insurance Corporation.

Considering LIC holds a 2.63 per cent share of premiums collected through banking for life insurance for individual new business (2021-22), while the private sector commands a significantly higher 54.57 per cent, it suggests that private sector insurers selling through the banking channel have a substantial presence in the mis-selling of life insurance policies in India. There is work to do for two regulators to stop this market failure — both IRDAI and RBI need to write regulation to fix this problem.

Product structure

Traditional life insurance policies, that have a 75.25 per cent market share in the life insurance industry, have a product structure that encourages mis-selling. The agent commissions for a 15-30-year product are front-loaded to the first year, resulting in almost a 100 per cent conversion of the first premium into agent commission. The commissions fall sharply subsequently to an industry average of 7.5 per cent, making utility maximising agents nudge investors into surrendering policies earlier than the maturity tenor. This might not have been a problem had the regulator disallowed the huge surrender costs that insurance firms can charge policyholders. Current regulations allow the insurance company to return nothing if the policyholder does not pay the second premium. After five regular premiums, if the 6th is not paid, the policyholder has a capital loss of 50 per cent.

How big is the problem? At an industry-wide level, the total surrender amount in 2021-22 was ₹1,58,284.94 crore, accounting for 34 per cent of the total benefits paid to all policyholders. Out of this, private sector insurers paid ₹63,166.90 crore in surrender value, representing 42.49 per cent of the total benefits paid by private insurers to policyholders. In contrast, LIC paid ₹95,118.04 crore as surrender value, comprising 26.91 per cent of the total benefits paid to policyholders.

This data indicates that the surrender value paid percentages of total benefits paid by private insurers were significantly higher than those of LIC. The higher percentages of benefits being paid as surrenders result in increased surrender costs that insurance firms can charge policyholders. As per existing surrender rules, the surrender cost could be 30-90 per cent of the total premiums paid by the policyholder 2nd year onwards.

IRDAI data reveal that private sector insurers have a large presence in the bancassurance distribution thread, with 54.57 per cent of their business coming from this distribution channel, while LIC has just a 2.63 per cent share of sales through bancassurance. Corporate agents-banks contributed 32.77 per cent to the overall individual new business. The highest number of mis-selling complaints is directed towards brokers, closely followed by banca-assurance (banks), when compared to other channels ( see chart).

According to IRDAI data, out of the 19 major intermediaries involved in mis-selling insurance, nine were banks. Furthermore, out of a total of 19,575 life insurance complaints, 14,785 were mis-selling complaints. This tells us that it is the private sector life insurance firms which have a significant presence in the bancassurance channel that face large mis-selling complaints by investors. IRDAI data also show that of the complaints on unfair business practices registered against life insurers, 54.66 per cent is accounted for by private insurer while its only 3.07 per cent for LIC.

The IRDAI’s recent draft proposal, aimed at reducing investor losses resulting from high surrender charges, has led to a decline in the stock prices of major life insurance companies over the past month. Shares prices of ICICI Prudential Life Insurance and HDFC Life Insurance fell by around 4.8 per cent and 6 per cent, respectively, during this period. Similarly, Max New York Financial Services saw its share price decline 6 per cent. In contrast, LIC’s stock price, with a significantly lower share of bancassurance and consequently fewer complaints related to mis-selling through this channel, jumped over 20 per cent during the same period. Notably, while LIC flourished, the broader market represented by the Sensex gained 7.84 per cent over the identical timeframe.

Therefore, the two regulators must work towards protecting investors’ money that is today being unfairly destroyed by mis-selling and high surrender costs. IRDAI must fully remove surrender costs on policyholders, and insurance agents must be incentivised to keep policyholders funding the investment till maturity by moving to a trail commission model. The RBI must regulate banks to stop the gross instances of mis-selling that have been mapped by the data.

A market failure is when individual incentives for rational behaviour do not lead to rational outcomes for the group. Given this definition, India faces a clear case of market failure in the life insurance space, with policyholders’ savings suffering a capital loss — paying for both commissions and profits of insurance firms. If the regulators are unable to address this, then the Finance Ministry must step in to protect retail investors.

Monika is the author of ‘Let’s Talk Money’ and Harsimran is a Professor of finance at IMT Ghaziabad

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