Nov 4, 2008

Unravelling the ULIPs: 5 Secrets You Should Know About

Since there introduction in the Indian market a few years back, unit-linked insurance policies (Ulips) have become a lot popular, but for all the wrong reasons. Here, I am not commenting on whether Ulips are good or bad as an insurance/investment product but trying to highlight the fact that among all the financial products Ulips are the most mis-sold (hawked as short term investment and tax saving product). Why? Because we are too pre-occupied either with earning more money or blowing away our hard earned money -- buying that newly introduced iPhone -- that there is hardly any time left for managing the money already earned (which is left at the mercy of the insurance agents or so called financial advisors).

In addition to rampant mis-selling, unit-linked plans are the most complex financial product. So lets make an attempt to understand some of the unique but little known facts associated with them.

But, first the basics. Ulips are similar to traditional insurance products like money back and endowment policies because they also offer insurance-cum-investment but with one major difference. Ulips offer you market linked investing as opposed to assured returns offered by traditional policies. Put simply, in case of money back and endowment plans, investment risk lies with insurance company whereas in case of Ulips, insured have to bear the investment risk. There are lot many other aspects also (like transparency, liquidity, complexity and control) where Ulips differ from conventional insurance products. Besides, there are many hidden features which are unique to Ulips.

Here is a list of five such closely guarded secrets of ULIPs:

1. Minimum Premium
If you pay more than the minimum premium for a particular sum assured, it costs you more. Why? Because the allocation charges -- similar to entry loads in case of mutual funds -- applicable to regular premium are front-loaded -- mainly go towards agent commission -- and thus quite steep in the initial years.

If you want to invest more than the minimum premium required for a particular sum assured, go for top-ups (additional investment over and above the regular premium) where the allocation charges are usually 1-2 per cent and thus work out to be cost-effective. Furthermore, unlike regular premium, there is no commitment on your part to pay it on regular basis.

For example, if the maximum coverage allowed is 50 times the premium paid, then to get coverage of Rs 10 lakh, you need to pay a minimum premium of Rs 20,000. Now, if the allocation charges applicable to first and second year premiums is 40% and you pay the minimum premium of Rs 20,000, Rs 8,000 will be deducted in each of the first two years and only the balance sum of Rs 12,000 will be invested. If instead of Rs 20,000 you pay a regular premium of say Rs 45,000, then Rs 18,000 will be deducted in each of the first two years i.e., you straightaway lose extra Rs 20,000 in the first two years itself. Alternatively, you can pay the minimum premium of Rs 20,000 and invest the balance amount of Rs 25,000 as top-up. If the allocation charges applicable on top ups is say 1% then there is straight saving of Rs 19,500 (39% of Rs 25,000 * 2) in the first two years itself.

But the above ideal scenario, unfortunately, is not feasible practically because of the conditions imposed by the insurance regulator (IRDA). As per IRDA regulations effective July 1, ’06, any top-up amount over and above 25 per cent of the regular premium (Rs 5,000 in the above example) will require additional insurance cover of 1.25 times the top-up amount. For instance, in case of a 20 year policy with a regular premium of Rs 20,000 you can invest maximum amount of Rs 1 lakh (25% of Rs 20,000 * 20) as top-up over the entire duration of the policy without requiring any additional insurance. Besides top-ups also have lock-in period of 3 years.

So, what’s the way out? You should still go for the minimum premium only and if you would like to invest more, put up to 25% of your regular premium in Ulip as top-up and go for mutual funds for any amount over and above that.

Believe me, it can make a huge difference to your insurance costs and consequently to your returns and no insurance advisor is ever going to tell you about this well kept secret because your loss is a direct gain to the agent and the insurance company.


2. Asset Reallocation Tool
ULIPs not only offer you to choose your equity exposure (from 0% to 100%) but through the option of fund switches also provide you the flexibility to shift between various fund options as per your convenience.

Thus, it is an ideal instrument to manage your asset allocation between debt and equity. Unlike mutual funds Ulips allow you to do asset reallocation at a click of button with no hassles, minimal/no cost and without any tax implications. Having selected an investment option, say 100% equity, you always have an option to shift to various other plans, say with 50% equity or 100% debt or any other combination.

In my opinion, this flexibility in altering the asset allocation is the best benefit ULIPs offer over mutual funds. Therefore, make the most of this tool but be wary of timing the markets.


3. Expense Ratio/IRR
The best way to compare ULIPs is to look at their expense ratio
. It is arrived at by deducting IRR (also called net yield) from gross returns.


Gross Yield/Returns -------------10%
Less Actual returns / IRR ---------7%
Expense Ratio ---------------------3%

For example, assuming a gross return of 10 per cent (the maximum allowed by IRDA for illustration purposes) if the IRR comes out to be 7% for a 10 year period, it means that during the 10 year period, every year 3% returns would go towards meeting various expenses (like administration, fund management and mortality charges) and you would receive a net yield of 7 percent.

In initial years, expense ratio is quite steep (because of front loading of charges) but decreases over a period of time.

Besides, expense ratio you should also consider the fund performance (i.e., change in NAV of the fund) while making a decision because after costs, returns the funds earn are the most important criteria for selecting a fund. For further details, please see Best ULIPs Based on IRR and Expense Ratios


4. Type I vs Type II ULIPs
There are basically two types of ULIP plans. Type-I plans pays the higher of the sum assured and fund value to the nominees upon the death of life assured whereas in case of Type II plans both the sum assured and fund value are paid.

It is always preferable to opt for Type 2 policies which are more protection (the core aim of insurance) oriented -- although a bit expensive then Type-I policies due to high mortality charges -- because in case of Type-I policies risk exposure/sum at risk (sum assured minus fund value) keeps on decreasing in the later years as your fund value increases which amounts to having inadequate insurance coverage.


5. Termination/Surrender before 5 years
Like all insurance products, ULIPs are long term instruments and therefore it is better not to make an early exit.

As stated earlier, expense ratio is too high (in other words, IRR/net yield is too low) in the initial years. Furthermore, exit costs called surrender charges are applicable in case of early exits. Thus, you should let the ULIPs run their full term unless you are in financial crises.

Although most ULIPs allow full fund value if you surrender it any time after five or six years, it is better not to exit even after the 5 years and to let them run for at least 10 years because longer the policy runs, better the returns.

Furthermore, most ULIPs allow partial withdrawal anytime after 3 to 5 years. But it is better not to opt for it unless you are hard pressed for funds. Why? Because if you make a partial withdrawal your insurance coverage gets reduced proportionately resulting in dilution of death benefits (in case your policy is issued before 1st July 2006). However, nothing to worry about for policies issued after that date because new IRDA guidelines for ULIPs which came into effect from 1st July, 2006 barred insurance companies from reducing the partial withdrawals from the sum assured except in few specified cases.


For tax consequences of Ulip surrender, please read 10 Common Income Tax Fallacies and if you would also like to know some known and unknown things about Ulips, please read "10 Top Most Factors to Know About ULIPs".

Also see:

1. SBI Life - SMART ULIP: A Review

2. 10 FAQs about ULIPs

3. Most Amazing Fact about Life Insurance

8 comments:

  1. Hi,

    Really liked the post and with the information provided in the article. I am very much impressed with the information. Normally these secrets will not be revealed by the Agents. Appreciate for the effort , information and for sharing.




    I advise all the people who plan to go for ULIP'S Pl. do research on net for basic terms to understand, fine prints and fund ratings. I had taken two ULIP'S for tax purpose at the last minute in March month ( 3 years back) and was the victim of the allocation & fund charges.

    Bajaj has charged 70% of total amt as the first allocation charges. I feel cheated. It was too late when I checked it. Request everyone to read and know everything before to sign on the dotted line.


    Request the author if possible to show some simple calculations for comparsions.

    ReplyDelete
  2. AnonymousMay 24, 2009

    tanhks a lot for such a vital information . the content is really helpful & lucid.

    ReplyDelete
  3. i want to invest 300000 anually in jeevan lakshya (tata aig) for 15 year ?
    can you suggest me am i right to take this decision
    Sanjay Verma
    Vasant EnclAVE
    New Delhi

    ReplyDelete
  4. Dinesh/Sanjay: It is always better to keep a safe distance from power lines and energized electric circuits. For more details, read the blog thoroughly.

    ReplyDelete
  5. how would i know the best time to switch between funds (eqity to debt)or vice versa..

    ReplyDelete
  6. If you can’t decide, then please keep a safe distance.

    ReplyDelete
  7. Dear Sir,

    This is in terms to Circular No.20/IRDA/Actl./ULIP/09-10 dated 22 nd July, 2009 issued by IRDA. As regards to surrender charges levied by Insurers are now waived after completion of 5 years. This is an absolutely welcome move, but I would like to ask you to please clarify that :

    1) Whether this changes are effective on old policies also issued prior to the date of this circular?
    2) If it is not, then a big question arises. That is ;

    If any cap is imposed by the IRDA to insurers taking into consideration the mischievous/falsification of statements made by insurers/agents of companies earlier, then why it is not imposed by retrospective date to cover all because of whom IRDA compelled to regulate the things later on?

    I would like to draw your kind attention to the matter that since inception to the date of this circular all insurers were issuing policies for more than 20 years and agents were selling this ULIP products saying customers to pay premium for first three premium only. In such cases surrender charges is calculated at {1-(1/1.05)}^n multiplied by capital unit value where 'n' stands for remaining premium paying years. By this formula surrender charges are 59% to 10% from third year to twenty years. This means that an insured will never gat his principal money back in his life and to get hsi fund back he would have to die. Is it acceptable at all? If all new customers are getting benefits of no surrender charges after five years, then why old customers should not? Due to late regulation/framework by IRDA why they should suffer for longer period?

    Please clarify because as per the language of circular no insurer can charge surrender charge after five years (if it is written to charge in the policy document) as there is no effective date is mentioned in the circular and it carries the all policies legally, but if it is applicable to new policies only then take up the matter to resolve the issue as this is unfair that decisions are taken when a lot of people are tricked, but not applicable to them, because of whom concerns are expressed and need is felt to impose the regulation later on.

    Awaiting your reply.

    Thanks N Regards

    Rajnish Jain

    ReplyDelete
  8. Rajnish,

    The circular is also applicable to old policies.

    ReplyDelete

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