The life insurance policyholders will have to shell out 10.2 per cent service tax when they pay their next round of premium.

With the Finance Bill 2004 coming into effect from September 10, life insurance premiums now come under the service tax net. Existing policyholders are also liable to cough up the 10 per cent service tax plus the two per cent education cess.

While insurance companies will start paying tax on premium collected from September 10 onwards, "as the necessary software is not in place, we will not be in a position to recover the same from existing policyholders immediately," said Shikha Sharma, chief executive officer, ICICI Prudential Life Insurance Company.

Insurance companies expect that there will be some portion, which may not be recovered at all should policyholders decide against paying the service tax.

Other CEOs of insurance firms even expect to be taken to court by existing policyholders forming consumer societies, as the tax imposed could be seen as a breach of the contract signed between the insurer and the insured.

"Recovery from policyholders will pose a problem," said S Krishnamurthy, CEO, SBI Life Insurance Company.

The service tax is to be levied only on risk premium. The finance ministry has come out with two options for insurance companies for levying the tax.

They can levy 1 per cent tax on the gross premium or 10.2 per cent on the risk premium. The thumb rule of 1 per cent is based on the general belief that 10 per cent of premium is the risk premium and 10 per cent of that works out to be the service tax.

As there is no demarcation of premium amount under the head of risk premium in traditional insurance plans, imposing a flat rate on the entire premium payable will facilitate computation of the tax amount.

This 1 per cent rule will not be applicable for pure term insurance policies, where the entire premium collected is risk premium. Nor would it apply to unit-linked products, as these have a clear demarcation in terms of risk and investment portion.

"When a flat rate is imposed, this means the younger generation will end up subsidising the older generation, whose risk premium amount is generally higher," pointed out Deepak Satwalekar, managing director, HDFC Standard Life Insurance Company.

The collection of the service tax will pose problems for the entire industry when it comes to renewal premiums.