The life insurance sector's trouble with taxation on high-value policies

The imposition of a tax on high-value policies could hurt the growth rates of life insurers in the next fiscal year

At a time when life insurers reckon that the industry is in a policy sweet spot because of the steps taken by the regulator to enhance the ease of doing business, the imposition of a tax on high-value policies in the latest Budget comes as a dampener.

Analysts and experts say that the government’s proposal to tax income from traditional insurance policies, other than unit-linked insurance products (ULIPs), having a premium of more than Rs 5 lakh a year, is likely to impact the growth and margins of life insurance companies, at least in the next year.

The rationale behind the government move is to plug the arbitrage which high-net-worth individuals use to earn tax-free returns on their high-value insurance policies through Section 10 (10D) of the Income Tax Act, 1961.

Under Section 10 (10D), individuals can avail themselves of tax exemption on the sum assured and accrued bonus (if any) received through their life insurance policy claim (maturity or death benefit). This exemption is also applicable to returns earned from a ULIP and available on all forms of life insurance policy claims.

ULIPs already have a limit of Rs 2.5 lakh for the maturity and surrender proceeds to be tax-free. However, any ULIP above this limit is taxed as per the capital-gains taxation provision and, hence, entails a lower tax rate in the case of equity-oriented ULIPs and the benefit of indexation in the case of debt-oriented ULIPs.

The finance minister has clarified that taxing income from high-value, savings-oriented life insurance policies would not impact insurance penetration.

In a post-budget press interaction, T V Somanathan, finance secretary, said that the proposal does not target pure insurance products. Rather, it targets investments which are made in the garb of insurance to obtain high tax-free incomes.

The government has, however, said that if the income accrues due to the death of the insured person, it will be exempt from tax.

Analysts say the proposal does not entail any indexation benefit, and hence the entire gains will be taxed at the marginal tax rate, irrespective of policy tenure, which typically is around 15 years. Consequently, this could reduce the attractiveness of non-par policies and, with the proposed tax treatment, they would broadly come on a par with bank term deposits.

The life insurance industry has requested the Union government that gains be taxed as debt mutual funds rather than at the marginal tax rate. It has also sought an increase in the current Rs 5-lakh threshold of premium income to Rs 10 lakh.

Whether these demands will be met remains unclear. But the market has already factored in the downside of the government decision on the major life insurance companies listed on the bourses, as almost all the companies’ scrips lost some shine following the Budget announcement. A couple of stocks have since seen marginal recovery from the lows witnessed on Budget day (February 1).

As per disclosures, ICICI Prudential Life Insurance’s share of business of non-unit linked policies with annual premium of above Rs 5 lakh is about 6 per cent of the total annualised premium equivalent (APE) for the first nine months of the current fiscal year (FY23). For Max Life, the ratio is 9 per cent, and for HDFC Life it is over 10 per cent. For SBI Life the impact could be as low as 1 per cent.

Explaining the impact of this decision, Vibha Padalkar, managing director and chief executive officer, HDFC Life, in a call with Macquarie Research, said that assuming there are no tweaks to products or the sales process, the impact is 10-12 per cent on APE and 5 per cent on the value of new business (VNB). However, this doesn’t include the possibility of their policyholders breaching the Rs 5-lakh mark on account of having policies with other life insurance companies.

The VNB impact is lower because some of these high-ticket policy variants actually have lower margins owing to the products’ shorter tenure. Also, there are some par products which inherently have much lower margins than the company’s reported margins of 26-27 per cent, Padalkar explained.

That said, the management is confident that it can tweak product structures and change the selling process to manage both growth and margins. The company can carry out some tweaks to ULIPs to improve margins. It can launch lower-sum-assured products (less than 10x cover), as a 10x cover is the minimum required for claiming tax benefits, and if they stand withdrawn, then customers will be happy buying lower-sum-assured products, if required. The company is also taking a family view for selling products, so that they can split the product across various family members, Padalkar was quoted as saying in the report.

Industry experts reckon that if life insurance is looked at through the prism of term insurance only, then insurance penetration (which is measured as the ratio of premium to gross domestic product), in the country will hardly see any improvement, because very few people buy pure term products. Hence, insurance will continue to be an instrument of saving and investment.

Further, while the government has not explicitly spelt this out, there is broad consensus in the market and among analysts tracking the sector that, perhaps, the government is nudging insurance players to increase the pie of protection products as well as broaden the customer base.

The other view is that it may be a way of luring tax-paying citizens towards the new tax regime, which does not have provisions for any deductions. This may impact the insurance sector negatively, because generally it is believed that customers look to buy life insurance to claim deductions under various provisions of the Income Tax Act, so that their tax outgo is minimised.

However, over the years’ the dependence of life insurers on the exemption provided under 80C of the Income Tax Act has declined to some extent owing to shifts in customer segments. The dependence of the Life Insurance Corporation has remained fairly high. Private life insurers too continue to have a positive relationship with exemption-driven investments.

For now, the indications are that growth rates of life insurers could slow down a bit in the next fiscal year.