Impact & possible changes for the life insurance industry if surrender values in non-linked products go up (Draft IRDAI Regulation)?

Insurance regulator IRDAI has released new draft product regulations for life insurers last week. One clause in the proposed regulations has raised many eyebrows within the life insurance industry and observers alike – the clause of surrender value in non-linked life insurance products.

What is surrender value, why is it important?

Most life insurance policies sold in India have a significant savings element and are longer term in nature. Non-market linked products, in particular, have long term savings benefits, some payable periodically and some as lump sum at the end of the policy term. The benefits could be fully guaranteed at the time of purchasing the policy or have minimum guarantee with a potential upside. Surrender value is the cash value of these policies from a customer’s PoV.

And these cash values are “very low”!?

For instance, if you purchase a policy where you have to pay Rs. 1 lac per year for 5 years and stop paying premiums beyond 1 year, the cash value is typically zero (Yes, 100% surrender charge). In case you paid 2 premiums (Rs. 2 lac total) in this policy and then surrendered, the surrender value could be as low as Rs. 60,000.

The reason for low cash values is linked to the fundamentals of the life insurance Industry, in India and beyond. 1) Disincentivizing short term exits by policyholders, 2) Lop sided distributor payout structure, 3) Risk control from shareholder perspective

1. Disincentivizing short term exits: Life insurance savings products are designed to serve long term needs such as retirement planning. To discourage early exits, it can be argued that the surrender values should be set low.
2. Distributor Payout structure: Life insurance products have relatively high distributor commission on the 1st premium, which comes down drastically from 2nd premium onwards. To make the product design financially viable, with attractive benefits to customer over the long term and supporting these high distributor commision,? the surrender value in the initial years is required to be low. In case the customer surrenders early, the insurer anyway has very little kitty left from the first few premiums, after parting with high upfront commissions, to pay to the customer as cash value.
3. Risk control: Well, these policies have a life insurance element as well. Death benefit will always be higher than surrender value. If surrenders are not disincentivized, healthier customers would be more likely to surrender than those with ailments. This could lead to higher death claims from a given customer cohort than the insurer assumed.

How is surrender value decided?

The minimum surrender values are governed by IRDA product regulations (last changed in 2019), known as Guaranteed Surrender Value (GSV). This is dependent on the year of surrender and is represented in terms of %’s (<100%) of premiums paid as illustrated above.

Please note that till now the regulatory lower bound did not differentiate between different premium levels (where different customer segments would lie)!

Additionally, Insurers are also required to offer a discretionary surrender value, called the Special Surrender Value (SSV), which reflects the underlying asset share/proxy asset share for a par/non-par policy respectively. Policyholders are paid the higher of GSV/SSV at the time of surrender.

Principally, IRDA requires a smooth progression of surrender values over the policy lifetime and the same moving towards the maturity value.

What does the new product regulations draft say (and don’t say) about surrender value calculation in non-linked products ?

While the principles for arriving at surrender value remain the same, the draft product regulation proposes to? differentiate between different levels by introducing the concept of a? ‘Threshold Premium’ in non-linked products for the purpose of surrender value calculation. The discounts or deductions applied to premiums paid for the purpose of surrender value calculations is to be allowed only to the extent of the Threshold Premium and the amount above is to be returned in full to customers in case of surrender.

Using similar examples as above, let’s assume a Threshold Premium of Rs. 40,000 for an insurance product. Annual Premium of Rs. 100,00 is to be paid for 5 years and the customer surrendered after paying only 1 year of premium. In this case, the? minimum surrender value shall be Rs. 60,000 (100% surrender charge only up to the Threshold Premium). If the policy is surrendered in the 2nd policy year after paying 2 premiums, the minimum surrender value shall be Rs. 144,000 (30% X 2 X 40,000 + 2 X 60,000). Though the factors used for discounting (0%, 30% etc.) may not change, there is a substantial jump in the GSVs that are proposed to be offered.

The draft regulations, however, do not specify an absolute value for Threshold Premium and whether the same will vary across insurers/products. It is also not clear what principles would be followed for SSV and how the % of asset share needs to be computed given the front-loaded cost structure of life insurers.

Life insurance customer proposition becomes much better

In a nutshell, the draft regulations make cash value in non-linked savings products much better and customers who may have emergency liquidity needs over the term of the contract can benefit immensely from the increase in surrender value. This could be viewed in the wider context of the regulator trying to make insurance as a financial products consumer friendly like simple retail banking products or mutual funds.

Even without surrendering, the customers can now take larger amounts of policy loans from insurers or external lenders, against their policies. Emerging areas of policy buyout for better liquidity options on surrender may see a dent due to reduced incentives for investors buying out existing in-force policies.

New customer segments could also open up for insurers who stayed away from life insurance as a savings vehicle due to inferior liquidity options.

One down-side we see though is that Insurers might bring down the benefits/IRR for customers who stay till the end/at maturity to compensate for lower margins from surrendering customers.

For insurers and/or distributors, we see some adverse impact in the short-term, however it may be beneficial for the long-term health of the industry:

Likely impact on insurers

First, let us look at the key reasons for lower cash value in insurance products that we discussed above:

1. Lower disincentive for short term exits: The disincentive will become much lower as per the draft regulation. Customers who are aware of the loss they face on surrendering non-linked insurance policies avoid surrendering. It is unlikely that significantly more customers will start surrendering just because surrender values are going to be less penal, because for most cases the values will still be below the premiums paid.

1. Supporting high cost of acquisition difficult: Insurers are left with very little from the first few premiums, after parting with high upfront payouts, to be able to pay high cash values to customers. If the minimum required cash values go up, insurers may have to spread commission payouts more evenly over the policy term or take a hit on their margins due to expected higher surrenders.

1. Risk control: Given that the death benefit in non-linked savings products is not very high compared to the premiums paid, unlike in pure term plans, the increase in surrender values are unlikely to cause any selective withdrawals (i.e. surrendering customers on an average being healthier than those who continue).?

Other key impact areas could be…

The capital requirements for insurers could increase as additional capital/reserves might have to be set aside to meet liquidity requirements in case of higher surrenders. The new business strain would also be relatively higher leading to overall higher capital requirements for writing non-linked business.

Investment returns on non-linked portfolio could be lower as a higher proportion of assets need to be allocated to low yielding money market instruments/cash than is done currently. This would be necessary to provide for the increased risk of surrenders. This will impact customer proposition and/or shareholder margins vis-a-vis currently available product offerings.

The impact across insurers is expected to vary in case the draft regulations are interpreted to apply a product level Threshold Premium. High Threshold Premium in a product would lead to minimum surrender value being close to where it is in the current regime. However, a low Threshold Premium would significantly increase surrender values for high ticket policies (this may have limited impact as surrender rates are often lower for high premium non-linked policies).

How are insurers likely to respond?

LIC is likely to be least affected by the regulation change as the average annual premium size is low (~Rs.20,000) compared to private life insurers (~Rs. 70,000). If IRDAI specifies a standard Threshold Premium (say Rs. 25,000) for the industry, LIC would be barely impacted while private life insurers would face significant impact. This is despite the fact that almost 95% of LIC’s retail premiums come from non-linked savings policies.

Most private insurers have significant non-linked savings in their product mix and are likely to be wary of the draft regulations. Here is how we expect such insurers to respond.

1. Justify a high Threshold Premium for each product to IRDAI in the product filing and approval process. For instance, a Threshold Premium equal to the expected average or median premium would lead to surrender values (and related product design constraints) getting impacted? only for higher premium policies.The product level justification across insurers might lead to large variances across insurers and some insurers could demand a level playing field and ask for standardization of the Threshold Premium.
2. Make distributor commission structures less skewed towards first year. Typical non-linked savings products have high initial commissions (30-40% of the first year premium) followed by low single digit commissions for future premiums. The higher minimum surrender value requirements can be efficiently met for insurers if the industry moves to a more levelized commission payout structure. Insurers could look at a commission payout similar to AUM based payment structures followed by AMCs.?However, this would dissuade most distributors selling non-linked insurance products where upfront commissions are much higher than unit linked insurance plans and other financial products.One scenario might play out in case upfront distributor payouts are reduced across industry, distributors may become indifferent to selling unit linked vs. non-linked products. Please note that there is no surrender charge in unit linked plans post their 5 year lock-in period and customers get surrender value equal to their fund value. The charges on discontinuing premiums during the lock-in period are also very low.
3. Have stringent commission clawback arrangements with distributors. Commission clawback is a typical arrangement by insurers with most banks and brokers selling insurance. All or part of the first year commission is clawed back in case the distributor fails to meet a certain level of renewal collection. This can be applied to surrenders in early policy years.While this reduces financial risks for insurers on surrenders and aligns interests of distributor and insurer, it is difficult to implement, especially for individual agents.?
4. Higher focus on customer retention metrics i.e. persistency and surrender retention rate to realize more of the profits embedded in the life insurance contracts. Though customer retention metrices have been in focus in recent years and traditional products enjoy a relatively higher persistency, the draft regulation is expected to give further push to these important retention metrics, which would be a step in the right direction. Co-ownership of these metrics by Distributors is also expected to get further prominence.
5. Reduce benefits/IRR for non-surrendering/maturing policies while offering higher surrender values. This is a likely response for some insurers who may not be able to offer the same long term benefits to customers who do not surrender, due to the increased outgo on surrenders. This balancing of benefits would make non-linked savings products unattractive as a long term savings vehicle, especially for high premium customers.For participating plans (basic guaranteed benefits with upside via bonuses), insurers have the ability to change bonuses in future years based on future investment returns, death and surrender payout experience. Hence, the minimum guaranteed benefits in these policies may not need to change as much compared to fully guaranteed non-participating policies.
6. Swallow the bitter pill and take a hit on profitability. Competitive forces may force some insurers to keep distributor commissions and? long term customer proposition unchanged. This will directly impact the insurer’s profitability and increase capital requirements.In all likelihood, we will see a mix of 4, 5 and 6 in action.
7. Change product strategy with high ticket focus with ULIPs and lower ticket with non-linked products. Given that the minimum surrender value will increase most for high ticket size non-linked products, it is possible that insurers address affluent customers with unit linked products while less affluent segments are addressed by non-linked savings products.This was the reality for most private insurers till about 5 years back. Non-linked savings plans with guarantees and no market linkages typically appealed to only lower premium segments while unit linked plans appealed to more affluent customers.

There is a risk that some insurers/ distributors resort to policy splitting wherein instead of selling a high ticket policy, multiple lower ticket policies are sold to the same individual at the same time. In this way, the insurer could avoid giving higher surrender value to a high ticket non-linked policy. While policy splitting is not allowed as per extant regulations, creative practices have always been at play.

We must note that the regulation is still in the draft stage and the final manifestation could be in a form where insurers have sufficient leg room and escape any financial impact. The ambiguous bit in the draft regulation is the Threshold Premium which will determine how large an impact this regulation might have on the life insurance industry.