Under The ULIP Umbrella

In the old days, insurance policies were representative of the time when high interest rates and the absence of a rational risk-return trade-off were the norm. The returns were so attractive that insurance products competed with investment products for a place in an investor’s portfolio. The subsequent fall of interest rates introduced the much-needed rationality to insurance products. Attractive returns at low risk became a thing of the past. This period coincided with an upturn in equity markets and the emergence of ULIPs, a new breed of equity-linked insurance products. As a result, the insurance-seeker who had never been exposed to this kind of flexibility in traditional insurance products was in turmoil because of the fundamental change in the mindset required to understand these products. 

For the uninitiated, understanding the functioning of ULIPs can be quite a handful. Higher expenses, rigidly defined insurance and investment components, and the impact of markets on the corpus - all these together makes ULIPs an extremely complex proposition. ULIPs are unlike traditional insurance products and remarkably like mutual funds in terms of their structure and functioning. Premium payments are converted into units and a net asset value (NAV) is declared for the same. Premium payments are the corner-stones of ULIPs and the savings component taking precedence over the insurance component. This is in sharp contrast to traditional policies where the sum assured is the key parameter around which the entire policy revolves.

ULIPs have a large number of variants which offer investors the opportunity to select a product that matches their risk profile. For example, an individual with a high-risk appetite can shun traditional endowment plans (predominantly debt-based) in favour of a ULIP, which invests its entire corpus in equities. Another characteristic of ULIPs is that they are extremely flexible, offering facilities such as enhancing insurance cover (top-ups), modifying premium payments and even opting for an asset allocation that is different from the one they originally opted for. All in all, ULIPs can indeed provide your insurance portfolio with a great deal of benefits. The same however, is not without a flipside. To avoid being caught on the wrong foot, here are some of the steps that need to be followed in the selection process:

1) Understand The Concept: Before investing your hard earned money in a ULIP, you need to ensure that you understand what you are getting into so that you are not faced with any unpleasant surprises at a later stage. Things like gathering information on ULIPs, the various schemes available and understanding their working is critical. Also, read ULIP-related information available on financial web-sites, newspapers and sales literature circulated by insurance companies. Another point to address is the misconception about ULIPs that they are linked only to equity markets. In reality, ULIPs give the flexibility of opting for equity, or debt products. You can choose one depending on your appetite for risk. 

2) Focus On Your Goals And Risk Profile: The first thing that you need to do before selecting a plan is to set a par-ticular financial goal/s — retirement, children’s education, or buying a house. Once this is defined, scan the plans that address your specific need and shortlist some. At this stage, it is important to ask a few questions. What is the period for which I will be saving? For example, if your child is 5 years old and you need money for her education when she is 20, you should be saving for 15 years. What will be the future cost of the thing I am saving for today? This can be calculated taking into account an assumed average rate of inflation. From here, you can work backwards to arrive at the premium you will be required to pay.[PAGE BREAK] 

How much risk am I willing to take? Your risk appetite should be the deciding criterion in choosing the plan. Thus, if you have a high-risk appetite, then an aggressive investment option with a higher equity component is what you should choose. Similarly, your existing investment portfolio and the equity-debt allocation therein also need to be given due importance before selecting a plan. Opting for a plan that is lopsided in favour of equities, only with the objective of gaining in the short term can prove to be a disaster if the market crashes and you are a risk-averse person. Risk appetite also changes with the customer’s life-stage — a person who has fewer financial liabilities is likely to take greater financial risk as compared to someone who is married with children or is paying off a housing loan. 

3) Hire A Trustworthy Insurance Advisor: Insurance advice at all times must be unbiased and independent. Also, rather than his job being restricted to filling forms and delivering receipts he should be conversant with the functioning of debt and equity markets and well equipped to inform you about the pros and cons of buying a particular plan. Before signing him up ask him for references of clients he has serviced earlier and cross-check his service standards. Also, put forth some product-related questions to test him and also ask him why the products from other insurers should not be considered. It is usually a good idea to meet advisors from more than one company before making a decision. Additionally, it is your right to ask the insurance company for product brochures and a printed benefit illustration. 

4) Compare Expenses: Expenses are a significant factor in ULIPs and hence one needs to evaluate these parameters closely before signing on the dotted line. Some of the expenses to keep a close watch on are: 

a) Premium Allocation Charge: This is a front-end charge deducted from the premium. The premium that is left after its deduction is invested in units of the funds chosen. The insurer uses this to meet most of its expenses. In some ULIPs, it is as high as 60 per cent and in others it is nil. A common misconception is that this charge is a crucial indi-cator of the overall costing of a ULIP because it is deducted from the premium. However, evaluation of costing should not be based solely on this charge.

b) Mortality Charges: This is the actual cost of the life cover-age opted for and is deducted from the fund value on a monthly basis. It depends on a number of factors, includ-ing the age of the buyer, the state of his health and the amount of coverage sought. The basis of this charge depends on the type of ULIP. In Type I ULIPS, this charge is initially deducted from the entire sum assured. It is later charged on the sum-at-risk, that is, the difference between the sum assured and the fund value. As a result, mortality expenses fluctuate as the fund value changes. In Type II ULIPS, the mortality charge is levied on the sum assured throughout the term.

c) Fund Management Charge: It is deducted as a fixed percentage of the fund value and is used to manage the investments of the funds. It is the most important charge in ULIPS, as gradual rise in fund value over the years keeps on making the impact larger.

d) Policy Administration Charge: This is deducted from the fund value every month. It can be a fixed amount through-out the policy term or vary at a pre-determined rate. Costs vary with products, the age and health of the investor, the tenure and sum assured chosen and the features and riders of the policy. Hence, experts suggest that the internal rate of return (IRR) is the best parameter to judge the total impact of costs for the policyholder, as it is the return left over after all the costs have taken their effect. To illustrate the point assume that you invest Rs 1 lakh a year in a ULIP for 15 years. At an annual rate of return of 10 per cent, you get back Rs 26.88 lakh after 15 years. With zero costs, you would have got back Rs 34.95 lakh. That means the cost factor has been to the value of Rs 8.07 lakh. The greater the gap between the IRR and the assumed rate of return, the higher the costs of the policy. Ask your insurance company for the IRR of the policy you already have or are planning to buy to assess the situation.[PAGE BREAK] 

5) Other Parameters: Information on premium payments will help you get a better picture of the minimum outlay since ULIPs work on premium payments as opposed to sum assured in the case of conventional insurance prod-ucts. Also, find out about the number of times you can make free switches (i.e. change the asset allocation of your ULIP account) from one investment plan to another. While some insurance companies offer multiple free switches every year, others do so only after the completion of a stipulated period. It also makes sense to compare the ULIPs’ performance i.e. find out how the debt, equity and balanced schemes are performing and also study the portfolios of various plans. Another parameter to consider is the top-up facility offered by ULIPs i.e. additional lump sum investments which can be made to enhance the policy’s savings portion. 

6) Minimum Guarantee Provision: Protecting the invest-ment’s downside in a market-linked product can be a huge advantage. Find out if the ULIP you are considering offers a minimum guarantee and the costs which have to be borne for the same. Make sure you read the fine print properly.

7) Set Your Insurance Target: A thumb-rule is that your insurance amount should be 7-10 times your annual salary. However, this does not take into account inflation, assets and liabilities. Filling out the life planner will help you understand your financial needs and help you decide on the right cover amount that your family will need in case of an unfortunate event. In the case of ULIPs the insurance cover is a multiple of the yearly premium and hence one needs to plan accordingly. 

8) Keep A Track: Once you have bought a ULIP, do not file it away and forget about it. Remember, a ULIP is a flexible financial product and, hence, you must periodically review how your savings are faring.