Traditional policies' tax benefits must go

The tax exemption encouraged retail investors to buy traditional policies, which, in turn, invested in G-Secs. But now there are many other buyers for G-Secs

The finance minister removed the tax exemption available on maturity proceeds of high premium Unit Linked Insurance Plans (ULIPs) on the ground that “high net worth individuals are claiming exemption under this clause by investing in ULIPs with huge premiums”, and that was not the legislative intent of this clause. The tax-free status for interest accrued on high-value Employee Provident Fund (EPF) contributions was also removed on similar grounds. Hence it is strange that the exemption on maturity values of high-premium traditional insurance policies has continued.
 
The earlier case for allowing this exemption was clear. As shown in the web series ‘Scam 1992’, investing in government securities was an arcane exercise meant for large institutional investors. The industry, represented by the Life Insurance Corporation, collected money from individual investors, provided a token amount of life insurance to justify its name, and invested the bulk of the money in government securities (G-Secs), thereby providing a ready source of financing for the government. The tax exemption incentivised this mode of saving by retail investors. The scenario has changed now with the government broad basing its investor base. The continued tax exemption on endowment policy maturity proceeds is an anachronism now.

 
An example will explain the cost of this exemption to taxpayers. If the government issues 12-year securities directly to the domestic HNW investors at the rate of 6 per cent per annum, it effectively pays out 4.13 per cent after accounting for the tax on interest at 31.2 per cent. However, when it issues the same securities through life insurers, its (and taxpayers’) cost stays at 6 per cent as neither life insurers nor policy holders pay tax on this interest. Thus, taxpayers lose 1.87 per cent per annum for securities issued to HNW investors through life insurers. 
 

The investors also end up getting a net post tax return of 3.50 per cent per annum only, instead of the 4.13 per cent they would have got had they invested directly in G-Secs, and thus lose approximately 0.63 per cent annually, due to the high operating expense and high commissions paid on such policies. 

 
The workings can be understood as follows: Annual premium for a 12-year maturity LIC new Endowment Plan for a 30-year-old male for sum insured of Rs 1 crore is Rs 8,52,000. Annual premium payable for the same Rs 1 crore for term insurance from LIC (LIC tech Term plan) is Rs 6,000. The net investment is Rs 8,46,000 per annum (Rs 8,52,000 less Rs 6,000). The total investment premium paid is Rs 1.02 crore approximately (Rs 8,46,000 into 12 years). The tax-exempt maturity value will be Rs 1.28 crore if LIC earns 6 per cent on the investment portion net of all expenses.

 
The investor’s post tax return on the investment portion of the premium works out to 3.5 per cent per annum on maturity value of Rs 1.28 crore. 
 
An extrapolation of these ratios on the total maturity proceeds of Rs 1,70,000 crore paid by the life insurance industry in 2019-20 translates to a loss of Rs 20,000 crore to taxpayers and Rs 8,000 crore to policyholders.
 
Can the government afford such large giveaways? If such tax exemptions are removed, the life insurance industry will refocus its efforts towards providing term insurance, which is critical for the country. 
 

The writer heads Fee Only Investment Advisers LLP, a Sebi-registered investment adviser