Two basic questions that you ask when buying any product are: what does it cost and what does my money buy me. Ask the same questions when buying a financial product and you get different answers depending on which product you are buying. A market-linked investment product, like a mutual fund or a unit-linked insurance plan (Ulip), will give indicative returns or will rely on past returns to answer the ‘what does it return’ question. A fixed deposit will simply indicate the returns the product gives. A traditional life insurance plan will never answer this question directly but will obfuscate cleverly. Ask ‘what it costs’, and you see that an equity mutual fund in India charges an annual fee of 2.5%. A Ulip costs 4% a year if held till year 5 and costs drop to 2.25% if held for more than 10 years. But ask the question for traditional insurance plans and you draw a blank. Insurers and regulators have both expressed helplessness in getting an industry average handle on these costs because of the nature of the product. Each policy is different and there are more than 40 million policies issued each year; whose cost should we give you? When put like this, of course, there is no answer possible. It is a difficult problem to solve because, unlike a Ulip, traditional plans do not segregate funds according to the two functions of risk cover and investment, but put the entire money into one pool. There is no segregation of the pool across time—the older money and new money all goes into the same pool.

But it is important to answer the return and cost question on a traditional plan simply because of its size and the quantum of Indian household money that it manages. The life insurance industry is a giant money gathering machine with its tentacles spread across the country. In financial year 2014, it sucked in a total premium of Rs.3.14 trillion. In the same year, some 40 million new policies were issued. With an 88% market share, traditional policies would be a bulk of this business. The total assets under management in the life fund (where the money collected from individual traditional policies goes) stood at Rs.12.88 trillion at the end of FY14. Any which way you look at it, the traditional life insurance policy is a giant money machine. It is important for the household to know what it costs and returns so that household savings can choose between products and buy the ones that give them the maximum positive real return at least cost and risk.

We know from decoding traditional insurance plans that the average annual return is no more than 3% if held for 10-15 years. However, what it costs at an industry level is still an unanswered question. We could look for an insight on costs by using the service tax rate levied on traditional insurance plans.

Service tax is levied on the cost of the service provided. An insurance premium in a pure risk policy will buy the customer a risk cover. In a bundled insurance product such as a Ulip, cost segregation is part of the product structure and, therefore, the service tax incidence is broken up according to function. From 1 June 2015, a service tax of 14% is payable on Ulip charges such as fund management charges, mortality and morbidity charges, premium allocation charges, policy administration fees, switch fees and reinstatement fees. But because a traditional policy does not segregate its risk premium from its investment premium, the tax department, in consultation with the insurance regulator, has fixed a service tax rate of 3.5% on the entire first-year premium and 1.75% on subsequent premiums. Remember Ulips are paying 14% of cost, which is capped at 2.25% for a 10-year product. Using the same insight, a 3.5% tax on the entire premium would translate into a 25% cost in the first year and a 12.5% cost in subsequent years. These are huge costs to buy essentially a portfolio of government securities. But the problem is not that. It is that even this 25% number understates the costs.

I ran these numbers off some former and current life insurance heads. This is what one had to say: “Prima facie, the costs in traditional plans in the first year are much higher, say, a minimum 40% of premium. If we take 14% of 40%, service tax should be 5.6% of the first-year premium paid. The government fixed it at 3.5% for the first year, more as a concession towards traditional plans and not on any fair estimate of actual costs embedded in the first-year premium. If they apply the 14% tax rate to the actual costs, it will have several effects. First, companies would be forced to separate costs from savings amount in the first and renewal life premiums. Second, all traditional policy holders will have to pay higher taxes. Third, as a consequence, customers would start asking inconvenient questions and may not buy traditional plans.”

What does the government lose by understating traditional policy costs? About Rs.2,000 crore a year on first-year premiums of traditional policies. What do you lose by not knowing these costs? You end up paying a very high cost for a sub-standard return that is dressed up as ‘bonus’ and uses large numbers to trap you into the deal.