The Economic Times – ET In The Classroom – Archives – 3 (Economics Concepts Explained)

The Economic Times newspaper now and then publishes articles on current economic issues in a question and answer format under the heading ‘ET In The Classroom’. They are simple to understand and remember.

Many tough concepts are beautifully explained by the ET team in these articles. All these articles are freely available on the net. They are the property of the Economic Times. I have just consolidated all of them here for the benefit of the readers.

For an IAS aspirant preparing for the UPSC civil service examination, ET in the Classroom is a one-stop solution for getting acquainted with many economic jargon and concepts.



The Prime Minister will soon hold a meeting of chief ministers to discuss the alarming food price situation and review the implementation of Essential Commodities Act (ECA). ET looks at the ECA and how it can help combat the rising prices of food articles.

What are essential commodities?

The government has powers under the Essential Commodities Act, 1955 (EC Act) to declare a commodity as an essential commodity to ensure its availability to people at fair price. The EC Act, 1955 allows the government to control the production, supply, and distribution of these commodities for maintaining or increasing supplies and securing their equitable distribution. Essentially, the act aims to ensure easy availability of important commodities to consumers and check exploitation by traders.

How many commodities are covered by the Essential Commodities Act?

There are seven broad categories of essential commodities covered by the Act. These are (1) Drugs; (2) Fertilizer, inorganic, organic or mixed; (3) Foodstuffs, including edible oilseeds and oils; (4) Hank yarn made wholly from cotton; (5) Petroleum and petroleum products; (6) Raw jute and jute textile; (7) (i) seeds of food-crops and seeds of fruits and vegetables; (ii) seeds of cattle fodder; and (iii) jute seeds. Recently cotton seed was also included in the list.

How does the Act help check price rise?

The Act is implemented by the state governments and union territories, leaving the central government to merely monitor the action taken by states in implementing the provisions of the Act. State and UT administrations use the powers of the Act to impose stock or turnover limits for various commodities and penalise those who hold them in excess of the limit. Stock limits have been imposed in several states for pulses, edible oil, edible oilseeds, rice, paddy and sugar.

How effective is the Act?

Over the three years 2006-2008 , state and union territory governments prosecuted 14,541 persons under the provisions of EC Act, 1955 and secured conviction in 2,310 cases. In 2009 as on 31 August 2533 persons had been prosecuted and 37 convicted. But, doubts have been raised about effectiveness of the Act time and again. Recently, Parliament’s estimates committee asked the government to come out expeditiously with a new legislation for controlling the retail prices of essential commodities such as rice, wheat, pulses, edible oils, sugar, milk and vegetables. –


ET in the classroom: What is underrecovery?


It is the gap between the local price of fuel and what would have been the price if the fuel were imported.

Is under-recovery the same as loss?

It is a notional loss in revenue to the extent the international price of the fuel is higher. It may or may not be a loss-making proposition to produce the fuel when there is an under-recovery.

In case of kerosene, oil companies suffer an under-recovery as well as a loss because the local retail price is much lower than the cost of crude oil. But sale of a product like petrol can still be very profitable at times, even if oil companies are reporting under-recovery of a few rupees a litre.

Does a rise in underrecovery make an oil co’s operation less profitable?

It may not. At times, international crude oil prices remain flat but petrol and diesel prices rise. In such a situation, an Indian refinery’s profitability will not change because crude oil costs have not gone up. But under-recovery would have risen because the cost of importing the fuel would have risen.

Has the concept of underrecovery exaggerated the problems of oil firms?

This year it did. Prices of oil products in Asia rose earlier this year, when a fire shut down a large refinery in Taiwan. This reduced the supply of refined oil products and the change in the demandsupply situation made petrol and diesel more costly.

The Tsunami in Japan and a recent fire at a refinery in Singapore had the same impact. The refining margin for diesel, called “crack spread” has been $20 a barrel most of this year. In April, diesel margins jumped to a three-year high of $24 per barrel. Last year, it was $10-15.

So, under-recovery on diesel looks higher this year. In other words, oil companies want a higher price for diesel partly because some refineries in other countries were shut down. Apart from this, oil companies also charge a customs duty and a marketing margin, in addition to marketing cost, to calculate underrecovery. These are profits, not costs.

Can oil companies be at a disadvantage by linking prices to under-recovery?

Yes. This may happen next year. In 2010, very little new refining capacity was added in Asia, while demand was strong. Next year, China and the Middle East will add about 1 million barrels per day of refining capacity. This is expected to increase supply of products and deflate refining margins. As a result under-recovery is expected to fall.


ET in the Classroom: Leave Travel Allowance


What is Leave Travel Allowance?

Leave Travel Allowance (LTA) is the part of the remuneration granted to employees by the employer to provide for personal travel expenses incurred during the year. Apart from the employee, it covers travelling expenses of spouse, children as well as dependent parents and siblings. Further, the exemption is restricted to two children born on or after October 1, 1998. There is no restriction on the number of children born before this date.

How does LTA save on tax outgo?

Under section 10 (5) of the Income-Tax Act, if an employee who is in receipt of LTA undertakes a journey within the country, s/he can claim the value of the allowance exempt from income tax. For the purpose, the individual should have been on leave for the period during which the journey was undertaken.

Can you claim it every year?

No. The exemption can be claimed only twice in a block of four calendar years. The current block has started from January 1, 2010, and will last until December 31, 2013. The previous one ended on December 31, 2009. If you do not avail of the concession in any particular block or undertake just one journey, you become entitled to carry forward one journey to the next block. However, this has to be utilised in the first year of the new block.

For instance, if you availed of the concession just once instead of twice between January 1, 2006 and December 31, 2009, then you are allowed to carry forward the unused one into the subsequent block (2010-2013), provided you undertake the journey in 2010 itself. A point to be noted here is that even if you don’t avail of the concession at all during a particular block, you can carry forward only one entitlement to the next block.

Can the entire amount be claimed as an exemption?

The exemption will depend on certain criteria specified. Firstly, it is the lower of the actual expenses incurred and the allowance granted by your employer. Let’s assume your LTA is Rs 10,000, but you end up spending Rs 15,000 on travelling. In such a case, the exemption will be allowed to the extent of Rs 10,000. Conversely, if your LTA stands at Rs 15,000 and your actual expenses amount to Rs 10,000, you will still be entitled to a deduction of only Rs 10,000.

Other parameters that decide the extent of exemption?

If you have opted to fly to the destination, an amount not exceeding the economy class airfare of the national carrier by the shortest route to that city would be admissible as deduction. In case you are travelling by road or rail, the cost of first class air-conditioned ticket to the destination by the shortest route would constitute the benchmark. Besides, if your travel plan entails visiting multiple places during the trip, the destination farthest from your place of residence would be taken into account for determining the exemption amount.

What if the travel bills are not submitted before the deadline?

If you fail to submit your travel bills pertaining to LTA claim with your employer within the time prescribed, your employer would consider the amount of LTA paid as taxable and deduct income tax at the rate applicable to you. However, you can claim LTA exemption at the time of filing your income tax return.


ET in the classroom: Non-tax sources of income for the government


Non-tax Revenues

Any loan given to state governments, public institutions and PSUs earn interests and this forms the most important item under this head. The government also receives dividends and profits received from PSUs. It also earns income for the various services it provides. Of this, the railways is a separate ministry, though all its receipts and expenditure are routed through the consolidated fund.

Capital Receipts

Receipts in the capital account of the consolidated fund are divided into three broad heads — public debt, recoveries of loans and advances, and miscellaneous receipts.

Public Debt

Since everything the government does is on behalf of the people, its borrowings eventually are the burden of the people. In budget parlance, the difference between borrowings (public debt receipts) and repayments (public debt disbursals) during the year is the net accretion to the public debt. Public debt can be split into two heads, internal debt (money borrowed within the country) and external debt. The internal debt comprises Treasury Bills, market stabilisation scheme, ways and means advances, and securities against small savings.

Treasury Bills (T-Bills)

These are bonds (debt securities) with maturity of less than a year. These are issued to meet short-term mismatches in receipts and expenditure. Bonds of longer maturities are called dated securities.

Market Stabilisation Scheme (MSS)

The scheme was launched in April 2004 to strengthen RBI’s ability to conduct exchange rate and monetary management. These securities issued under MSS are not to meet the government’s expenditure but to provide the RBI with a stock of securities with which it can intervene in the market to manage liquidity.

Ways & Means Advances (WMA)

RBI is the banker for both the central and state governments. Therefore, it provides funds to manage mismatches in the governments’ receipts and payments in the form of WMAs. Now, RBI wants the government to issue short-term securities to meet temporary needs.

Securities Against Small Savings

The government meets a small part of its loan needs by appropriating small savings collection by issuing securities to the funds that manage such schemes.



ET in the classroom: All about rate corridor


In the monetary policy on Wednesday, the RBI raised the repo rate by 25 basis points to 5.75% and the reverse repo rate by 50 basis points to 4.5%. This has narrowed the rate corridor from 150 basis points to 125 basis points. ET demystifies the concept of rate corridor.

What are repo and reverse repo rates?

Repo rate is the rate of interest charged by the central bank when banks borrow money from it. It is the tool through which the RBI in-fuses funds into the system by lending to banks against pledging of securities.

The reverse repo is the rate the RBI offers to banks when they deposit funds with it. The RBI drains out liquidity from the financial system through reverse repo by releasing bonds to the banks. This is a daily operation by the central bank to manage liquidity Over a longer time, the RBI can also manage liquidity through open market operations.

What is an interest rate corridor?

Interest rate corridor refers to the window between the repo rate and the reverse repo rate wherein the reverse repo rate acts as a floor and the repo as the ceiling. Ideally, rates in the overnight interbank call money market, where lending and borrowing is unsecured, should move within this corridor. However, when banks are short of funds and the overnight call money rates are high and above the repo rate, banks approach the RBI to borrow under the repo window.

Therefore, the repo rate becomes an effective policy tool as it would help bring down the rates in the overnight market . The reverse hap-pens when money market rates fall below the reverse repo rate. Banks then park surplus funds with the RBI through a reverse repo trans-action. As a result, when there is excess liquidity in the system, the reverse repo is more effective. When liquidity is tight and banks need short-term funds from the RBI to manage mismatches, then the repo rate emerges as the effective policy rate. But if liquidity returns to the system the reverse repo would become the operative policy rate as the RBI would be draining out funds from the system.

Why is a narrow rate corridor desirable?

A narrow rate corridor means that short-term interest rates in the call money market will move within that band. This band was earlier 150 basis points, which has now been lowered to 125 basis points. Effectively, the narrower rate corridor will mean there will be less volatility in short term rates.

Do other central banks also have rate corridors?

Many developing countries have the rate corridors but central banks in developed and deeper financial markets have a single rate. In the US, for instance, the Fed Fund rate is the key interest rate. Short term funds are available at this rate to the eligible borrowers.



ET In the Classroom: Making a Case of Financial Inclusion


What is a ‘business correspondent’ model?

In 2006, the Reserve Bank of India allowed banks to use non-bank intermediaries as business correspondents, or business facilitators, to extend banking and other financial services to areas where the banks did not have a brick and mortar branch present. The objective behind it was to aid the process of financial inclusion and consequently take banking to the remotest areas of the country and make them bankable.

What do these correspondents do?

The business correspondent is nothing but a bank-in-person, who is authorised to collect deposits and extend credit on behalf of the bank of small-ticket sizes. He also recovers principal interest of small value deposits, sale of micro insurance, mutual fund products, pension products, receipt and delivery of small value remittances/other payment instruments.

Who is eligible to be a banking correspondent?

RBI has allowed a host of entities to act as business correspondents (BCs) of banks. These include NGOs/MFIs set up under Societies/Trust Acts; societies registered under Mutually-Aided Co-operative Societies Acts, or the Co-operative Societies Acts of States; Section 25 companies, which are not-for-profit companies; companies in which NBFCs, banks, telecom companies and other corporate entities or their holding companies do not have equity holdings in excess of 10%; post offices and retired bank employees, ex-servicemen and retired government employees.

How is a business facilitator different from a business correspondent?

Very often the term ‘business correspondents’ is used interchangeably with the term ‘business facilitators’ (BFs). But RBI makes a clear distinction between the two. BFs are allowed to undertake only facilitation services like identification of borrowers, collection and preliminary processing of loan applications, including verification of primary information, creating awareness about savings and other products, processing and submission of applications to banks and promoting and nurturing SHGs and follow-up of recovery and debt counselling. However, facilitation of these services does not include conduct of banking business by BFs, which is the exclusive function of business correspondents.



ET in the classroom: Saving private airlines


Why are Indian airlines in the red despite rising passenger traffic?

Because of high taxes on fuel and rising operational costs. Moreover, cutthroat competition in the sector prevents airlines from raising ticket prices. Taxes constitute 40% of an airline’s total expenditure, far above the global average of 32%. Besides, revenues barely cover operational costs. For instance, operating margin for Kingfisher stands at 0.12 while it is negative for Jet Airways (-8.25%) and Spice Jet (-6.7%).

Why can’t airlines raise fares to cover these costs?

Fierce competition in the Indian skies prevents them from doing so. In the case of Jet, cost per available seat km (ASKM) rose to Rs 3.31 in the second quarter of this fiscal compared with Rs 2.74 in the previous quarter. In contrast, revenue passenger km (RPKM) has crawled up to Rs 3.63 from Rs 3.5.

So if an airline goes bust, should the government bail it out?

The tempting answer is that those responsible for corporate recklessness must bear the consequence, but in real world things are not so simple. Many experts argue that had Lehman Brothers not been allowed to go bust, the financial crisis could have been less damaging. But, a corporate bailout sends the wrong signal or creates a ‘moral hazard’ of encouraging more recklessness, the cost of which is borne by the taxpayer.

What is moral hazard?

In economic theory, the concept of moral hazard comes from the insurance industry where an individual or a company behaves differently when he is protected from a risk than when he is exposed to the risk. The guarantee of insurance can make the insured less risk averse, as he knows he is protected from the financial consequences of his actions.

How does the concept apply to bailouts?

If a company believes its existence is crucial for the economy or for public good, it may be tempted into taking reckless risks believing that the government will step in to bail it out if it were to land in trouble. Therefore, any rescue of troubled private sector firms makes others believe that they could also be similarly helped out if things went wrong.


ET IN THE CLASSROOM    What’s EPCG scheme?

The Export Promotion Capital Goods (EPCG) scheme was one of the several export-promotion initiatives launched by the government in the early ’90s.

The basic purpose of the scheme was to allow exporters to import machinery and equipment at affordable prices so that they can produce quality products for the export market.

The import duty on capital goods – like all other items – was high during that period, inflating the cost of capital goods nearly 50%, so the government allowed exporters to import capital goods at only 25% import duty.

For waiver of the remaining portion of import duty, exporters were supposed to undertake an ‘export obligation’ (a promise to export) which was worked out on the basis of the duty concession obtained.

Exporters were given eight years to carry out their commitment to export. Once the ‘export obligation’ was fulfilled, the owner of the capital goods concerned could sell them or transfer them to another facility.

Till the promised export materialised, the owners of the machinery or equipment were barred from even moving the goods concerned out of their manufacturing unit.

Did liberalisation of imports have an impact on EPCG?

Gradual reduction in import duties, particularly in the case of capital

goods, has been rendering EPCG scheme less attractive. However, till last

year, EPCG was preferred by many since the exemption also included 4%

special additional duty of customs (SAD) which has been abolished now.

Textile machinery, for example, attracted an import duty of only 5% but the

4% SAD resulted in the duty burden going up to nearly 10%. This led many

textile units to prefer the EPCG, but the scenario may change now in view of

the government’s decision to abolish SAD.

The government has been modifying the EPCG scheme over the years in line

with the demands of the domestic industry. The first change was the

introduction of two windows – the first one attracting 15% duty while the

second one attracted 25%. Those who preferred to pay higher duty under the

second window had a lower export obligation. In ’95, the government offered

duty-free imports under the first window while the duty under the second was

15%. This was the first time duty-free imports were made available under


Since the purpose of the scheme was to allow exporters compete

internationally, it was decided to allow them to buy machinery at

internationally-competitive rates. The pent-up demand for imported machinery

had peaked at this point and the domestic industry’s initial trouble with

competing imports had come to an end. Thereafter, the government even

reduced the import duty on capital goods under the second window to 10%

while the first remained duty-free. Subsequently, the policy was changed in

’00 to merge the two windows into one – import capital goods by paying 5%

and undertake uniform export commitment.

Who were the major beneficiaries of the EPCG?

The manufacturing industries, especially those who had to import their

capital goods, were the main beneficiaries over the years. The service

sector was nowhere in the picture till last year. Now service industries

like hotels can also avail of EPCG imports and fulfil the export obligation

through the foreign exchange earned by them.

This is a major concession for service providers who were ignored over the

years. Since services now account for nearly 50% of the country’s GDP, it is

fair to allow service providers to imports goods at

internationally-competitive rates.

The attraction of EPCG has, anyway, diminished over the years and it will be

a question of time before the scheme becomes redundant. Import duties will

come down over the years, especially in the case of capital goods.

It will be curtains for the EPCG scheme once the duty on capital goods comes

down to 5%.  Going by the pace at which India is signing free trade

agreements, this possibility seems nearer. Like other outdated instruments

like the cash compensatory scheme (CCS) for exporters and the quantitative

restrictions (QRs) on imports, the once-popular EPCG will also exist only on

records once the duty reduction materialises over a   period of time.


ET in the classroom: The anatomy of layoffs


What are layoffs?

When companies discharge employees either temporarily or permanently because they have no money to pay them or there is no work for them. The term is also known variously as downsizing, redundancy, right-sizing, workforce optimisation and redeployment.

Several companies, banks and financial institutions across the world resorted to layoffs during the slowdown after the collapse of Lehman Brothers in September 2008. In India, the term became more familiar during late 2008 and early 2009.

Are there any warning signs before jobs are shed?

Layoffs are a function of business sentiment. So job losses happen during slowdowns, which are usually preceded by phases of high inflation.

During a slowdown, job markets tighten up as entities go on austerity drives to lower their administrative and other costs. Generally, the next phase of critical action deals with rightsizing initiatives. Layoffs are imminent at this stage.

Is there a way to pre-empt and, thus, avoid job loss?

Sometimes organisations resort to layoffs as a natural reaction to slowdown. But instead of such knee-jerk measures, there are many other preventive steps they can take.

Proper work-force planning, continuous focus on cost control, multiskilling and creating a positively enabling work culture are some of the ways in which organisations can plan ahead of time so that they do not have to downsize and lay off people during a downturn.

How can one cope?

Craft a nice resume, circulate it in your professional network and approach headhunters which deal in your specialisation or in your target sectors. Do not hide the ‘pink-slip’ fact from your near family. Share it with them so that they can provide you emotional support.

How does one prepare for a new career?

Employees should reflect on their skillset and be clear about their competencies. Telecom and financial services sectors in India have experienced layoffs and ‘workforce deployment’ in recent months. If certain sectors are not doing well, look for similar options.

Those in financial services can explore small and medium enterprises and retail. Those from telecoms can look at anything that can connect B2C — social network, e-commerce, technology companies. Approach the principals and entities who would see close synergy with these profiles and start informal discussions with potential employers or interested parties.

Continuous skilling and learning is recommended. There is a need to be entrepreneurial so that in every change one finds newer opportunities and value propositions.



ET in the classroom: No-claim Bonus (NCB)


What is a `No-claim’ bonus?

No-claim bonus (NCB) is a discount in premium offered by insurance companies if a vehicle-owner has not made a single claim during the term of the motor insurance policy. The discount, which is on ‘own damage’ cover, ie, cover against damage to the vehicle, can go as high as 50% for both 2-wheelers as well as 4-wheelers.

How much NCB can you enjoy?

This discount in the premium is usually 20% for the second year, 25% for the third year, 35% for the fourth year, 45% for the fifth year and 50% for the sixth year. The value of the discount depends upon the insurance claims you have made in that particular year. NCB can be carried forward and will be only allowed provided the policy is renewed within 90 days of the expiry date of the previous policy.

What if you sell your car?

The no-claim bonus is a reward to the vehicle owner for prudent use of the vehicle. If you sell a 10-year old hatchback and purchase a C-segment car, the no-claim bonus will pass on to the new vehicle and you can save considerably on your insurance costs.

Can you get the NCB transferred to another insurance company?

Yes, subject to evidence in the form of a renewal notice or letter, confirming the NCB entitlement from the previous insurer.

What should you do if you renew the policy online?

You have to scan and send the cover note to the insurance company online and it will do the needful.

What if you hide your claim history and avail of a no-claim bonus from a new insurance company?

Initially, you might succeed in getting a no-claim bonus by hiding your claims history. But insurers are sharing their claims databases and any false declaration will surely be detected.



ET in the classroom: New rules treat GDRs/ADRs on par with shares


Do Global Depository Receipts (GDRs) and American Depositary Receipts (ADRs) currently have voting rights?

The GDRs and ADRs in themselves do not have voting rights, but the underlying equity shares do. These shares are held by a depository, which then issues the corresponding receipts (GDRs/ADRs) to investors looking to buy such instruments. So it is the depository that has the voting rights. Whether the holders of the GDRs/ADRs can vote or not depends on the depository agreement between the company issuing the GDRs/ADRs and the depository. During the initial years when GDRs and ADRs came into vogue, the agreement mandated depositories to vote on behalf of the management. But later, the depository agreements were changed so as to allow the GDR/ADR holders to instruct the depository to vote on their behalf.

How do ADRs/GDRs work?

ADRs/GDRs are issued by companies looking to raise funds overseas. These instruments may represent one, multiple or a fraction of the underlying shares. For instance, if an Indian company wants to issue ADRs, it will deliver the corresponding number of shares to the US depository bank. The depository will then issue receipts to investors who have subscribed to the issue. Depository receipts are transferable instruments, so they can be freely traded on the exchange on which they are listed. They are also fungible, which means the holder of ADRs can instruct the depository to convert them into underlying shares and offload them in the local market (in this case India).

What did Sebi say about GDRs/ADRs on Tuesday?

Till now, purchases made through GDRs/ADRs did not trigger an open offer by the acquirer even if the 15% threshold was crossed so long as the depository receipts had not been converted into underlying shares. But on Tuesday, the regulator amended this rule. Anyone now holding ADRs/GDRs with voting rights will have to make an open offer to minority shareholders if his holding touches the 15% limit.

Why did the regulator have to make this amendment?

Securities lawyers and merchant bankers say the Takeover Regulations relating to ADRs/GDRs were drafted at a time when the depositories always voted on behalf of the management. Now that depository receipt holders have the right to vote, it makes little sense to keep ADR/GDR holdings outside the purview of the Takeover Regulations.

How does this amendment affect the Bharti-MTN deal?

Bharti’s proposed takeover of MTN involved issuing GDRs to the South African telecom firm and its shareholders, which would add up to 27% of Bharti’s equity base. In an informal guidance to Bharti in July, the regulator had said that purchases through the GDR route would not trigger an open offer unless the GDRs were converted into shares. But under the new rule, MTN will have to make an open offer for an additional 20% in Bharti. This would make the deal expensive for MTN and also for Bharti, if it wants to get around the new rule.

Can Bharti still go ahead with its deal with MTN?

It can. For instance, the depository agreement can stipulate that the GDRs will not have any voting rights. This is the most inexpensive way of getting around the new rule. But the key question here is whether MTN shareholders will agree to such an arrangement. The other option for Bharti is to cut down the issuance of GDRs to below 15% and pay more cash to MTN. But that could increase the cost significantly for Bharti.



ET Classroom: Top-up premiums in ULIPs


A top-up premium is something that a policyholder can invest into his ULIP over and above his existing premium payment. If you want to take advantage of a well-performing ULIP, you can increase its investment component by paying an extra premium.

Will the sum assured increase in tandem with top-ups?

There is no compulsion to increase the insurance component of the ULIP.

But some ULIPs increase the sum assured in accordance with the top-up premium. For example, in ICICI Pru Life Time Maxima, a recently-launched ULIP, the sum assured would be increased by either 125% or 500% of the top-up premium as chosen by the customer. Hence, prepare your policy document carefully.

How can you top up a ULIP?

You can top up a ULIP anytime during the life of the policy until the total of top-up premiums does not exceed 25% of the total premium paid. Every company clearly defines the minimum top-up amount in the policy document itself. It is usually more than Rs 2,000. But this option is available only for disciplined customers who pay their premiums on time.

If your regular premium is due and you pay a top-up premium, the insurance company will direct the additional funds towards the regular premium amount. If the total of top-up premiums exceeds 25% of the total premiums paid, the sum assured of the policy can go up by as much as 125 times of the top-up, depending upon the underwriting requirements of the life insurance company.

What are the charges?

The premium allocation charge of a top-up plan is anywhere between 1% and 3% and varies from policy to policy.

How will I benefit from a top-up premium?

You can save on the premium allocation charge by opting for a top-up premium. For instance, you can opt for a low-value ULIP to test the waters. You can then step up your investment component in a staggered manner after monitoring its performance. Secondly, you can benefit from lower premium allocation charges by adopting this approach. For example, the lowest allocation charge of any regular premium of a ULIP available in the market today is 5%, which is still higher than the premium allocation charge of top-up premiums.

Ideally, you should avail yourself of the low base effect benefit in the initial years of the policy and top up the policy subsequently. But a word of caution: if your top-ups exceed a limit, the final sum may be subject to tax proceeds at maturity. This clause again varies from policy to policy.

Can you opt for partial withdrawal from top-up premiums?

Usually the lock-in-period for each top up premium is three years from the date of payment of that top-up premium for the purpose of partial withdrawals. In fact, some ULIPs do not permit partial withdrawals if top-up premiums are paid in the last three years before maturity date.



ET in the classroom: Mortality Charges


What are mortality charges?

Mortality charges are that part of life insurance premium that go towards providing a death benefit cover. In other words, these are the actual cost of insurance in a life policy. In most policies, the bulk of the premium goes towards investing in a savings fund which is returned to the policyholder when the policy matures or the policyholder dies.

How are they calculated?

Most companies use a table of charges prepared by the Life Insurance Corporation (LIC) since this is the only company which has five decades of experience and consequently has historical data on life expectancy. Since private insurers have been around for a decade, some have made alterations to the rates based on their own experience. Work is on progress on a new mortality table with data from all companies and prices are expected to fall as life expectancy has gone up.

Will the policyholder benefit from buying a policy at a young age?

Yes. For instance, the life expectancy of a 25-year-old will be higher than that of a 55-year-old, and hence, the former will stand to benefit in terms of lower charges while buying insurance.

How will the updated mortality table impact pension policies?

Since the life expectancy of the average Indian has gone up, it is likely that you will have to incur a higher cost when it comes to buying whole-life annuities. Those who invest in pension plans will have to use at least two-thirds of the accumulated sum to buy annuities — a product where the investor gets regular income for a specified period in return for a lumpsum payment. The savings under a pension plan have to be invested in annuities to avoid them being taxed. One-third of the pension fund value at maturity is made available to the insured for tax free. The balance has to be used for purchase of annuities from any insurer.

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