Should I buy a ULIP

ULIPs or Unit Linked policies are a variety of life insurance where a part of the premiums you pay are invested in stock market instruments. To get a more detailed description of ULIPs please refer to our earlier blog .  The stock markets are rising and the SENSEX and Nifty are at never seen before highs. ULIPs are back with a bang and every insurer has more than one offering.

So should you buy a ULIP?

The simplest life insurance product one can buy is a term plan. However as everyone is aware if you survive the duration of the policy, nothing is returned to you. Because of the fact that ULIPs have a savings element attached to them, ULIPs can help a purchaser maintain a periodic savings habit. The risk attached to the savings portion is equal to the risk of investing in mutual funds. This being said there are several important caveats before you buy such a policy.

Caveat 1: The investment risk in the investment portfolio is borne by the policyholder. 

What this means is that while the chances of an upside in your portfolio exists because of a general rise in the stock market, or the savviness of the insurance fund manager, you stand an equal chance of not meeting your investment goals and ending up with less money than what you invested. This is unlike an endowment policy where bonuses are generally declared, though the rates may be meagre.

Caveat 2: The policyholder will not be able to surrender / withdraw the monies invested in linked insurance products completely or partially till the end of the fifth year.

It is important to be aware that there is no liquidity in the first 5 years, and though your obligations to pay premiums continue, you cannot withdraw any of your funds.

Caveat 3: The entire premium is never invested. 

There are several deductions that apply on your premium before it is invested. The first is allocation charge. This charge is primarily used to pay commission to the distributor and to defray some part of the initial expenses in issuing a policy. These can range from zero to a total of 15% in the first 3 years. Then there is a policy administration charge which is a fee deducted to manage your policy year on year. These can range from zero to a total of Rs. 100 per month. Each of the funds will carry a fund management charge (maximum of 1.35% of the investment amount). In all cases a mortality charge which is the amount of premium required to cover death risk is also deducted.

Caveat 4: Servicing is not free. 

Unlike other policies any transaction that you effect within your policy is chargeable. Such servicing includes switching between funds, partial withdrawals, premium redirections and so on.

Caveat 5: Fund performance can vary widely even within the Company for different funds.  

It is necessary for you to study fund performance before you buy such a policy. Average CAGR (Compound Annual Growth Rates) of funds can vary. Most policyholders are inactive fund managers, preferring to forget about any insurance policy once purchased. Lack of vigilance can give a nasty shock after 20 or so years at maturity.

This being said, ULIPs have been cleaned up considerably after Regulatory intervention. Charges are now reasonable and policy brochures are less complex. Earlier if a policyholder had lapsed his policy, hardly any amounts were returned to him. Currently if a policyholder is unable to pay premiums for the full 5 years, amounts are not lost, because companies have to mandatorily operate a Discontinued Policy Fund that provides a guarantee of 4% return. These amounts are paid the moment the policy completes 5 years.

Our view therefore is to buy a ULIP only if you are able to keep track of your funds, because you are responsible for your investment decisions and the company has already disclaimed responsibility for investment performance. If you decide to go ahead, you will find all the key information on www.policylitmus.com to help you choose the best policy for you.

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ULIPs: An Introduction

ULIPs are an acronym for Unit Linked Insurance Policies. As the name suggests these are life insurance policies. A life insurance policy covers the risk of death, by paying a pre-decided sum of money to the policyholder who has purchased the policy by paying a premium. This simple transaction is called a term insurance policy. In its simplest version if the policyholder dies, the insurance company pays the claim but if the policy holder survives, he gets nothing back.

Perceiving that this “get-nothing-back” is not appealing to a vast majority of people, insurance companies introduced a savings element, in such a way that while the policyholder’s family would get the claim amount on his death, if he survived he would still get some amount back. There are 3 versions of this theme:

Term Return of Premium Policies:  Varying proportions of the premium are returned to the policyholder on survival. Amounts can range from half of the total premiums paid to twice the total premiums paid.

Endowment Policies: 

A portion of the premiums paid by the policyholder is invested by the company in various interest bearing instruments like government bonds. A minor portion is also invested in stock markets. Investment policies are tightly governed by IRDA (the Regulator). The policyholder has little control over the kind/type of investment made. Since safety is a primary concern, companies sacrifice risk for returns. Thus earnings are fairly low. These earnings (net of company expenses) are returned to policyholders in the form of bonuses. The upshot of this control and rigidity is that while earnings are almost certain, they are quite meagre in comparison to most investment instruments.

ULIPs: 

Here too a portion of the premium is set aside for investment. The difference is that the policyholder has greater control of the type and kind of investment she can make.  Investments are made in the stock market through designated funds by purchasing units at the current price.

Let us say a company has created 2 Funds called Fund A (High Risk) and Fund B (Low Risk). Each Fund’s objective is to purchase shares and stocks and trade in them for a profit. (The technical difference is that High Risk Funds are more Equity oriented and Low Risk Funds are more Debt oriented. The higher the risk the higher are the chances of making a good profit, but you stand an equal chance of making a loss, and vice versa for a low risk proposition – but let us move on). Initially the company seeds both funds by putting in some money. A policyholder can participate in the trading actions of the funds thereby participating in the loss or profit that may occur. He participates by purchasing portions of the fund arbitrarily designated as “units”.

By convention when a fund starts all units are available at a price of Rs 10/unit. This is called the Net Asset Value (NAV) of each unit. After several sessions of trading (over weeks/months/years) the NAV can be higher (say Rs 15.60/unit) or lower (say Rs 9.65/unit) based on whether the fund manager has been wise and made profits or been unlucky/incompetent and made losses. Let us say a policyholder purchases a ULIP and pays a premium of Rs 1000. The insurance company will keep Rs 100 for death risk, which leaves Rs 900 for investment. Say the policyholder divides this equally between Fund A and Fund B. This means he invests 450 in Fund A and 450 in Fund B. If he invests at Rs 10/unit, he will get 45 units of Fund A and 45 units of Fund B.

Total Investment/NAV of 1 unit, i.e. 450/10 =45 units.

Let us say after a year NAV of Fund A is 15.60 and Fund B is 9.65. The value of the units with the policyholder is:

Value of Units in Fund A: No. of Units X NAV, i.e. 45X15.60 = 702

Value of Units in Fund B: No. of Units X NAV, i.e. 45X9.65 = 434.25

Thus:

Original Investment: Rs (450 + 450) = 900

Value after 1 year: Rs (702 + 434.25) = 1136.25

If another policyholder buys a similar policy today and follows a similar investment pattern as the earlier policyholder, this is what will happen.

Premium - Cost of Death Risk = Premium available for Investment.

1000-100 = 900

He wishes to invest half in Fund A and half in Fund B, i.e. 450 in Fund A and 450 in Fund B.

He will now get:

Total Investment/Current NAV of 1 unit, i.e. 450/15.60 =28.846 units of Fund A

Total Investment/Current NAV of 1 unit, i.e. 450/9.65 =46.632 units of Fund B

The new policyholder has to buy units at current cost.

It is important to note that a policyholder can buy either or both funds and in any proportion that she chooses. Thus, for example, she may choose to invest 100% in Fund B and nothing in Fund A, or 20% in Fund A and 80% in Fund B. It is important to read the objectives of the fund and see if they match your risk profile. If you are close to retirement it may make better sense to invest in a debt oriented fund. If you have just embarked on your career, equity oriented funds may be your choice. Companies have anywhere between 2 and 13 funds, each with differing objectives – hence choice is usually not an issue. Companies also allow you to move your money between funds if you perceive an advantage in such movement. We do not recommend active management unless you are proficient to make such movements. Many companies also have options that restrict such active management in the interest of more stable returns. If you have questions talk to our experts at www.policylitmus.com.

As a general rule ULIPS provide a better investment return than endowment policies. But this is not guaranteed. All the rules and caveats that apply to stock market investments in general, apply to ULIPs. Thus, if units were purchased in a rising stock market and if the market goes down for a prolonged period, unit values will drop. There are 2 factors that may be considered.

Maintaining a steady investment pattern by paying regular premiums does help in getting fair returns.

Insurance fund managers are instinctively conservative. While this may depress earnings somewhat, the losses too will not be dramatic.

Note: The insurance company deducts some charges from the policyholder for managing these investments.

All figures are illustrative and not in relation to exact values or proportion.

This is how ULIPs work. In my next post we shall debate on whether one should buy a ULIP and if so what needs to be the basis for such purchase.