More on ULIPs - esp NAV Guarantee

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In this entry, I had done a round-up on the ULIP SBI vs IRDA controversy, quoting a few experts. One of those experts, Jayant Thakur, commented on one aspect of my entry on which entity takes up the downside of the NAV guarantee, and what is its capital adequacy. He pointed out this article to me.  Inter alia, this article points out that the way the guarantee is managed is that if the NAV spikes on any day, enough of the portfolio is transferred to debt to cover the guaranteed NAV on maturity. This struck me as very unfair to the investor.

 Most ULIP brochures (here is an example) include words to this effect:

There will be an additional charge for the cost of investment guarantee of 0.10% per annum. These will be made by adjustment to the NAV.

This actually is the opposite of what advertisements make out implicitly -- that the risk and cost of the guarantee is being borne by the insurance company, whereas they are charging the investor every year. This sentence was what made me think in the first place that perhaps there would be a third party backing up or taking the downside for the guarantee, in return for a fixed charge, similar to bond insurance premia charged by monoline insurers in the US. Till I saw this sentence in the above-referred example ULIP brochure:

If the NAV of Pinnacle Fund falls below allowable limits, assets will be completely reallocated to debt.

If the guarantee is to be implemented by shifting from equity to debt as the article suggests, (and also what the above example brochure suggests) then it is insult added to injury added to dishonesty. Why so?
(a) It means they are charging the investor for what the fund managers already have the right to do, viz. invest any part of the portfolio in debt. That is Insult.
(b) It means that when the going gets tough, switching to debt to contain the fallout of the guarantee is a "poison pill" that the fund manager forcibly makes the investor swallow, because it lowers the expected rate of return dramatically and reduces NAV fluctuation dramatically too. It also means that the fund managers have virtually abdicated their fund management function. That is Injury.
(c) Switching to debt predominantly to de-risk and cap NAV guarantee liability means hardly any equity exposure left. Why should the investor pay a higher fund management charge on the now specious argument that investing in equity being riskier justifies a higher risk management charge? Worse, the fund reserves the right to increase the fund management charge to 2.5% per annum [being almost double of what they are charging today (1.35% in the example)]. All this when the investment risk is borne by the investor! That is Dishonesty. It is also Unfairness.
If, on the other hand, the guarantee is being implemented by passing on most or all of the guarantee cost to a third party, then the questions raised in my earlier blog entry remain relevant.
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Regulatory Turf Wars: SEBI v IRDA

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Generally, turf wars are a bad thing. However, in this case, I am totally on SEBI's side. 

See the SEBI order here.

I have examined ULIP scheme after ULIP scheme, only to find in the fine print that the fees and charges levied by the insurance companies are so high as to be unconscionable. For example, at the end of a three-year lock-in period, even if I assume an average return of 20% per annum on money invested, I find that the NAV of the units the investor is entitled to will be barely equal to what the investor has paid in. In other words, for 3 years, the insurance company effectively confiscates all returns on investments to the extent of the first 20% per annum at least. If the return is lower than that, the investor swallows the loss, even though he has parted with a fat fund management charge every year.  

I was also sure that the commissions paid on these schemes must be very high, because none of the agents I contacted offered me a tax-saving MF scheme (ELSS) instead (mostly, insurance agents also double up as agents for MF schemes) when I expressed my dissatisfaction. Hence, I eventually preferred a bank deposit with a 5-year lock-in at 7.25% per annum compounded assured return, that also gave me the tax benefit I sought. The hook in the ULIPs is that the highest NAV over 7 years is guaranteed. The fine print here is that you have to be locked in for that whole period (at least 7 years) and the premium paid every year to insure the risk of paying out amounts exceeding the NAV on the redemption date are paid for by the investor. No skin off the fund manager's or insurance company's nose! I would like to be enlightened on which entity insures this risk., and what their capital adequacy to cover this risk is.

If MFs can make do with much lower asset management fees, with a better governed (chinese walls between AMC and Trust, separate Boards for both, etc) investment management structure, with more sensible incentive structures (no front-end commission, agency commission paid over the life of the MF deposit) I cannot see why insurance companies should be an exception to this. Especially because the insurance risk is kept to a very low figure -- for example, the insured sum does not exceed, in single payment schemes, twice the premium. In other schemes where premia are paid over several years, the insured sum cannot exceed 5 times the annual premium. In any case, linking it to the premium paid is mere semantics -- because what is being paid is nothing but an instalment of an SIP, with a minuscule proportion of the payment being diverted for insurance cost, the fig-leaf that enabled insurance companies to market ULIPs on flagrantly different terms than an MF is allowed to do. 

The biggest factor helping the insurance companies is the huge size of the market, and the sheer number of investors who would lose money if the ULIPs were banned with immediate effect -- a lot of what they have paid would just disappear, having been paid to cover sales and marketing costs, various upfront and recurring fees and charges, and the costs of unwinding if it becomes necessary. The unfairness of this would have to be balanced against allowing continuance of such hopelessly one-sided schemes. Fait accompli should not be allowed to be a defence or a consideration in the decision arrived at.

Several experts have lauded this order from SEBI. 

• Jayant Thakur, for example, asks why the ban should not be extended to endowment schemes too, because obviously nearly 90% of the premium paid goes towards the investment corpus, if we compare it with term insurance schemes.  
• Sandeep Parekh expresses a similar sentiment as I have expressed in an earlier paragraph.  
• Ajay Shah has acclaimed SEBI's order for breaking the silo-like thinking of regulatory verticals -- where the IRDA regulates insurance companies, though ULIPs are predominantly investment products, and not insurance products. He also writes in today's Financial Express, exposing 3 common fallacious arguments against SEBI's intervention.
• Vivek Kaul writing in DNA, exposes how less the proportion of insurance really is in different ULIP schemes -- approximately 1.1% of multiple premium schemes, and 0.6% of single premium schemes, if equivalent term insurance policy rates were applied to the amount of insurance cover extended.
• Suniti Ahuja Kohli, writing in the Indian Express, points out that whatever the decision maybe, at the end of the day, it is the policyholder who stands to gain the most. She also goes on to trace the chequered history of ULIPs.

Keep your eyes peeled on this turf war. While we should regret regulatory turf wars, this kind of a war is far preferable to the kind of war seen a few years back in the US -- where both, the SEC and the CFTC eagerly disowned jurisdiction over derivative instruments like CMOs and CDOs, and the nvestment bankers made merry till the economy and the risk bubble they built up imploded.

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