The Insurance Regulatory and Development Authority of India, or IRDAI, has released a consultation paper, addressing the problems of mis-selling in the insurance sector. It offers a set of reform proposals. The most significant is a cap on commissions that insurance agents, brokers and banks can earn.
It is refreshing to see a regulator propose significant reforms in consumers’ interest. The proposals caused a stock market upheaval, demonstrating how much these commissions matter to the revenues of banks and insurers. That alone indicates the seriousness of the proposed reforms, and the pushback to seeing them through.
Why have insurance agents not behaved with our best interests in mind, given that good behaviour generates reputation, which can be good for business?
Why mis-selling persists
An agent typically earns two kinds of commission. Upfront commissions are paid as soon as a sale is made. Trail commissions are paid for every year the customer stays in the product. Commissions shape incentives. If an agent is paid more to sell you an expensive policy, he will sell it to you, whether or not it serves your interest, especially if you are not financially literate enough to ask the tough questions.
Research suggests that customers lost around $28 billion to mis-sold life insurance policies between 2004 and 2011. Agents have long favoured endowment policies, which mix insurance with investment, even though these offer less cover than a term policy and lower returns than even the Public Provident Fund.
Further, if upfront commissions are high relative to trail commissions, he has every reason to move you in and out of products, because each new sale earns him a fresh upfront payment. The higher the upfront commission relative to the trail, the stronger the incentive to churn. This has long been the industry’s modus operandi. As a result, the industry has seen low persistency for decades: many policyholders do not stay for the full term of their policy.
As the IRDAI consultation paper shows, these issues continue to persist even today. Between FY23 and FY25, commissions paid through the sampled corporate agents grew 2.25 times, while new business premium grew only 1.28 times. More than half of policymakers who have been sold policies by insurance agents discontinue their policies before completing five years.
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Tighter limit to hard cap to crackdown
For life insurance, the consultation paper makes three main recommendations.
The first is a tighter limit on insurers’ overall expenses. From FY2027-28, expenses would have to fall to 15 per cent of premium within two years and 12.5 per cent within five. Insurers already below these levels would have to reach 10 per cent. Since expenses are paid out of premiums, lower costs should translate into better returns on savings products, higher surrender values and cheaper cover.
The second is a hard cap on commissions, with all rewards and incentives counted towards them. On savings products, first-year commissions for distribution entities would be capped at 5 per cent for premium payment terms under five years, rising to 20 per cent for terms of ten years or more; for agents, the range would be 6.25 per cent to 25 per cent.
Renewal commissions would rise by 0.5 percentage points every three years from the sixth year, up to a maximum of 7 per cent. First-year commissions would be capped at 1-2 per cent for single-premium savings products, 0.5–0.75 per cent for annuities, and 25-30 per cent for pure term cover. Credit-linked cover sold by lenders would be capped at just 2-2.5 per cent. Reducing the imbalance between upfront and trail commissions should weaken the incentive to undertake policy churn.
The third is a crackdown on mis-selling. Banks and non-banking financial companies (NBFCs) would no longer be able to force borrowers to buy life insurance along with a loan, and sales incentives for their staff would be banned. Suitability checks would become mandatory for policies above a defined ticket size, and commissions on mis-sold policies could be clawed back.
These measures, if adopted, will hurt the fee income of distributors of insurance, especially banks, which rely on this income. It is not surprising that the stock market reacted negatively to the proposal.
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A 15-year-old problem
These are tough measures, and the industry will push back. The Bose Committee report had flagged these problems in 2015. The industry has always argued that customer acquisition is expensive because insurance is a push product and not a pull product, and requires deep capital, which India lacks. The warnings of job losses, shrinking sales and reduced reach will be back on the discussion table.
However, the experience in mutual funds shows that different compensation structures have worked for other push products such as mutual funds. Further, as the report also points out, acquisition is just part of the story. For long-term contracts such as insurance, post-sales assistance is equally important but gets neglected to the detriment of the customer. The 2023 reforms relating to the Expenses of Management framework were intended to provide insurers with greater flexibility while enhancing policyholder benefits and expanding insurance penetration. But no benefits have materialised.
A regulator’s job is to protect consumers, not share prices. IRDAI is not obliged to defend market valuations built on high commissions and poor sales practices extracted from uninformed customers. It is up to the industry to find ways to grow through better products, lower costs and honest advice. The story of commissions leading to mis-selling in insurance is not new. This discussion has been going on for more than a decade and a half at the very least. The IRDAI should not back down now.
Renuka Sane is managing director at TrustBridge, which works on improving the rule of law for better economic outcomes for India. She tweets @resanering.
(Edited by Saptak Datta)