KNOCK KNOCK!

Me: Who is it?

“I am an Unit Linked Insurance Plan (ULIP)”

And thus began my conversation with a ULIP who came to my doorstep one day. I took the opportunity to ask him a few of my doubts. Here are excerpts from my conversation:

Me: Go away! I am told you are too expensive? I should not be investing into ULIPs ! I have learnt that term insurance + mutual funds is a better idea.ULIP (U): That may be right? But over a longer term I am better.

Me: How is that possible? I have to pay so much upfront i.e. in terms of my initial deductions. My breakeven will be a couple of years.

ULIP (U): Yes that’s right! You have to think of me as a helping hand for a period of about 20 years or so. The shorter the time frame you keep in mind the more expensive I can be.

Me: But the whole world tells me that I should just pay three premiums and that’s it.

ULIP (U): That may be technically correct but that is the way marketing agents are, who don’t tell you the real truth.

Me: So what is the real truth?

ULIP (U): It works like this. The premium you pay is broadly broken down into three parts viz., the expenses, mortality premium and the investment amount. The expenses are those of the life insurance company and a major portion of that is the commission paid to the agent. Hence, in the initial years you pay a huge amount. The mortality premium is the amount of money you will be paying for enjoying the life insurance cover. What remains is then invested as per your choice.

This means the larger the cover you take the more an amount will be allotted to the mortality premium thereby leaving less for investment.

Me: I see. So you are also telling me that I should opt for a lesser cover.

ULIP (U): Not only that. First assess your life insurance need. Then look at your age. The reason for this being the larger the life insurance you take and the older you are I will charge more mortality premium each year. The premium rate is different and higher each year unlike a term policy that remains steady all the way. You don’t realise this as you are not told of this fact and besides you are paying the same premium and you don’t really understand the break-up of this premium which is done internally. Hence, if you have an older age, large cover it will take you much longer to break even on your investment via premiums. This could be many years, even as much as 7-8 years. Further, if you just pay for 3 years and then if the markets keep crashing or going downwards I will deduct huge amounts as mortality premium. There are chances that all your premiums can get wiped off and you have nothing and the policy will also lapse for want of premium payment. Do not take a ULIP if you don’t plan to pay the premium for 20 years. Don’t get thrilled by the returns as those are just returns on net asset value (NAV)—your actual returns will depend on your age, life insurance cover and premium and they can be much much lesser. Agents are interested in their commission more than they are interested in giving you all the information. If you lose money they will say markets were bad and their advice would be for you to start another policy. Thus they will get more commission rather they should suggest to you to continue your policy and/or consider reducing the life insurance cover. Then take a term life cover to compensate for the reduction of cover from ULIP.

Me: Tell me more?

ULIP (U): If you are of age 40 or more generally avoid ULIP or reduce the life insurance cover substantially, and treat it like a pure investment product. But the breakeven will still be some years. Over a 20 years period I am better then a mutual fund investment. But then 20 years is too long a period. If you start doing direct investments and mutual funds reduce their management charge or make it flexible I will lose hands down. ULIP is a convenient product for someone who just wants to take no effort on investment management, just one product and both life insurance and investment is done with the choice of risk profile. You can also change your profile by making free switches but the cost comes to you in the form of higher mortality premium and initial expenses each time you make a payment.

Me: So I understand that I should not go by purely hearing what marketers have to say. I should be prudent. I understand that a high cover can be dangerous if I take an aggressive profile and during bad phases of the markets I can lose quite a bit.

ULIP (U): That’s a good summary and quite right too. Also don’t pay huge premiums—it only benefits agents as they get a larger commission at the cost of increasing your breakeven years. Go for the minimum required. This also reduces pressure to keep paying that each year. Take a term policy as well. Use the top option as the cost is normally much lesser and you get tax benefits on that too.

(Note to myself: Another good tip!)

Final word: If you are moving above 40-45 in age and you have a cover to fund ratio in excess of 3 that can be dangerous.  To explain this: If your life insurance cover is say Rs 15 lakh and your accumulated fund value is say Rs 5 lakh then the ratio of 15 divide by 5 is 3.

Me: ULIP seems to be ‘just ok’. No big deal. I should also explore other options.

TOP UPS

ULIPs are often sold as investments for the long run. While that is true, what is also true is that ULIPs are expensive, what with allocations charges ranging from 15-40 per cent in the first year. So here’s a little trick to make ULIPs work in the long term, while beating costs at the same time. Top-ups!

What is a top-up premium?
A top up premium is something that a policy holder can invest in his ULIP on top of his existing premium payment. For example, if your existing annual premium is Rs 7,000 and you choose to invest an extra Rs 7,000 over and above this premium, then it becomes a top up premium.

Will it benefit the policy holder?
The premium allocation charge (PAC) on a regular ULIP premium can be around 25 per cent in the first year, dropping down to less around 5 per cent in the third year. On the other hand the premium allocation charge for a top up premium is only around 1 per cent, irrespective of the year when you top up.

Number crunching
Let us compare two scenarios.

Scenario ONE: You pay an annual premium of Rs 20,000 for a 15 year term.

Assumptions: Charges and returns

First year allocation charge: 20 per cent

Second year allocation charge: 15 per cent

Third year allocation charge: 5 per cent

Fourth year onwards: 3 per cent

Administration charges: Rs 30 per month

Fund management charge: 1.5 per cent per annum

Rate of return: 10 per cent per annum

Outcome: At the end of 15 years, you would have a fund balance of Rs 5.6 lakh.

Scenario TWO: You pay an annual premium of Rs 10,000 and top up with Rs 10,000 every year for a 15 year term.

Assumptions: Charges and returns

Top up allocation charge: 1 per cent

Fund management charge on top up: 1.5 per cent per annum

Rate of return: 10 per cent per annum

Outcome: At the end of 15 years, you would have a fund balance of Rs 5.8 lakh.

Clearly, topping up is a beneficial option. While the benefit in this case is only Rs 20,000, the benefits are much higher for policies with larger premiums.

What are the points to remember?

a. You will be eligible to pay a top up premium only if you have been regular with your existing premiums. Defaults will prevent you from using the top up premium option.

b. The top-up premium comes with a minimum limit, which means you can only invest over and above a certain amount as a top up premium. If you exceed that limit, then your sum assured will also increase in proportion to the top up amount. This is in accordance with a directive from the Insurance Regulatory and Development Authority (IRDA) for insurance companies.

c. Even in the case of top up premium, do remember partial withdrawals are not possible until a time frame of 3 years post investing.

d. These top ups need not be invested at regular intervals. You can invest this top ups in a debt option even while your regular premiums are invested in an equity option and the reverse holds true as well.

e. The ongoing fund management cost will continue on top-ups as well.

f. Go through the fine print as is the case with every money related transaction. Do not be reckless with the limit on your top ups. If your total premium, including top up, for any year exceeds 20 per cent of the sum assured, you will lost the deduction benefit under section 80C.

Disclaimer: While we have made efforts to ensure the accuracy of our content (consisting of articles and information), neither this website nor the author shall be held responsible for any losses/ incidents suffered by people accessing, using or is supplied with the content.ULIPs De-Mystefied