The Insurance Regulatory Development Authority (Irda) issued a circular to the life insurance industry on July 22, capping overall charges in Unit Linked Insurance Plans (popularly known as Ulips).

Most insurance companies today have several Ulips, each one having a different cost structure and various types of charges, such as Premium Allocation Charge (PAC), Product Administration Charge, Mortality Rate and Fund Management Charge. These are recovered from the initial contribution (PAC) or from the fund value.

Hence, there is a lot of confusion on the actual charges one has paid. To clear this confusion and enable policy buyers to have a clear understanding of the product costs, Irda has prescribed one cap on all charges put together.

Lets see if this cap really helps people understand the charges or if a better framework is needed. Irda's cap is expressed in terms of the difference between the gross and net yield to the customer. The net yield is the gross yield adjusted for all charges. For insurance contracts of a tenure less than or equal to 10 years duration, the difference between gross and net yields shall not exceed 300 basis points, of which fund management charges shall not exceed 150 basis points.

For contracts above 10 years, the difference between gross and net yields shall not exceed 225 basis points, of which the fund management charges shall not exceed 125 basis points. Additionally, the following should be observed:

Extra premium due to underwriting emanating from extraordinary health conditions, cost of all rider benefits, service tax on charges and any explicit cost of investment guarantee shall be excluded in the calculation of net yield.

At the time of sale, for benefit illustration purposes, the insurer may assume a growth rate of 10 percent per annum of the investment as a model, as suggested by the Life Council.

At the time of maturity, the insurer must issue the policyholder a certificate showing year-wise contributions, charges deducted, fund value and final payment made to the policyholder, taking into account partial withdrawals, if any. This certificate must also show the actual gross yield and net yield, taking into account the actual charges deducted.

The circular will be effective from October 1, so all products approved by Irda on or after October 1 will be governed by the provisions of this circular. All existing products that do not meet the requirements of this circular should be withdrawn or modified by December 31, 2009.

Let's review a couple of illustrations to see the various charges. As seen in illustration A, where the initial charge is 54 percent in the first year, the gross yield of 10 percent gross yield translates into a net yield is around 5.55 percent. In illustration B, where the initial charge is 14 percent in the first year, the gross yield of 10 percent yield, leads to a net yield is around 7.56 percent.

Even in terms of total charges, policy B that follows Irda guidelines (because the differential between the gross and net yield is less than 3 percent) is less. That is, in illustration A, a policyholder pays Rs 212,105 as total charges whereas, in illustration B, the numbers add up to Rs 160,189 - a difference of Rs 51,916.

Obviously, the initial cost of 54 percent in illustration will have to come down substantially.

The complaint, though, is this - most people will not understand the concept of gross yield and net yield as applicable to life insurance products and will think that 3 percent is the charge for a 10-year product, whereas in reality this is not true. The PAC in the first year is the highest and often causes big damage to the returns, as this varies from 15 percent to 81 percent across life insurance companies. There is no doubt this move could reduce first-year PAC dramatically to below 30 percent in the first year for Illustration A, but the PAC will continue to be as high as 20 percent or more in the first year.

Additionally, Premium Allocation and Product Administration charges, which are the main charges, will continue to be different and this will continue the confusion among policy buyers. A better structure would have been to cap the PAC and Premium Administration charge to not more than 5-10 percent in the first as most these charges do not vary substantially across insurance companies. This would at least standardise the costs across insurance companies and a policyholder would understand that whatever policy he buys, costs would remain the same.