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Life Insurance

Why you should not invest in ULIPs?

Gone are the days when an insurance company focused solely on insuring your life, health and assets. Nowadays, insurance companies are more eager to manage your investments through unit-linked insurance plans (ULIPs). Indeed, almost 60% of new insurance sales are in ULIPs (the figure is even higher for some new private insurance companies), suggesting that things are topsy-turvy in the insurance world. So much so that a couple of insurance companies offer only ULIP plans, and no traditional insurance products.

Time was when insurance companies insured your life, health and assets, while mutual funds managed your investments. But today , insurance companies' profitability depends largely on attracting investments in the garb of life cover. It's a common complaint that insurance applications for health or vehicle protection are often rejected on flimsy grounds. If your application were accepted, chances are the premium would send you in a tizzy. It appears as if most insurance companies are strangely uninterested in the business of providing insurance these days.

Many retail investors believe insurance is a part of one's investment portfolio. Insurers capitalise on this common misconception and push investment products like ULIPs over traditional insurance products like a term policy or whole life policy. Insurance is primarily a product for protection, whereas mutual funds are ideal conduits for managing investments. So insurance should be used to insure and protect, and mutual funds should be used to create wealth over the long term. Mixing the two, as ULIPs do, can be injurious to your long-term wealth.

ULIPs bundle insurance cover with an investment benefit, in a single contract. They are similar to mutual funds in terms of structure and functioning. The insurer allots units to ULIP investors in the same way as a mutual fund, and the net asset value (NAV) is declared on a daily basis. So, of the total premium you pay on a ULIP, part goes into an investment portfolio, and the rest is used to offer life cover.

ULIPs are quite expensive, as most of the charges are recovered at the start of the tenure-usually in the first three years when your money is locked in. So very little is actually invested during those years. Most investors discontinue early, or sign up for five- to 10-year terms, thus suffering high costs and poor returns. ULIPs make sense only if investments are made for a long tenure-say , 15 or 20 years-thus defraying initial costs.

A better alternative to a ULIP is a combination of low-cost term insurance and a good equity mutual fund. Term insurance provides coverage for a specified period, and is amongst the cheapest insurance products. Its no-frills design only covers your life for a fixed period. Combining it with an equity, balanced or debt mutual fund gives you the benefits of a ULIP at a much lower cost. In the end, your long-term returns are higher. Let's analyse a few aspects of investing in ULIPs versus mutual funds.

Liquidity

ULIPs score low on liquidity. According to guidelines of the Insurance Regulatory and Development Authority (IRDA), ULIPs have a minimum term of five years and a minimum lockin of three years. You can make partial withdrawals after three years. The surrender value of a ULIP is low in the initial years, since the insurer deducts a large part of your premium as marketing and distribution costs. ULIPs are essentially long-term products that make sense only if your time horizon is 10 to 20 years.

Mutual fund investments, on the other hand, can be redeemed at any time, barring ELSS (equity-linked savings schemes). Exit loads, if applicable , are generally for six months to a year in equity funds. So mutual funds score substantially higher on liquidity.

Tax efficiency

ULIPs are often pitched as tax-efficient , because your investment is eligible for exemption under Section 80C of the Income Tax Act (subject to a limit of Rs 1 lakh). But investments in ELSS schemes of mutual funds are also eligible for exemption under the same section .Besides the premium, the maturity amount in ULIPs is also tax-free , irrespective of whether the investment was in a balanced or debt plan. So they do have an edge on mutual funds, as debt funds are taxed at 10% without indexation benefits, and 20% with indexation benefits. The point, though, is that if you invest in a debt plan through a ULIP, despite its tax-efficiency your post-tax returns will be low, because of high front-end costs. Debt mutual funds don't charge such costs.

Expenses

Insurance agents get high commissions for ULIPs, and they get them in the initial years, not staggered over the term. So the insurer recovers most charges from you in the initial years, as it risks a loss if the policy lapses. Typically , insurers levy enormous selling charges, averaging more than 20% of the first year's premium, and dropping to 10% and 7.5% in subsequent years. (And this is after investors balked when charges were as high as 65%!) Compare this with mutual funds' fees of 2.25% on entry, uniform for all schemes. Different ULIPs have varying charges, often not made clear to investors.

For instance, an agent who sells you a ULIP may get 25% of your first year's premium, 10% in the second year, 7.5% in the third and fourth year and 5% thereafter. If your annual premium is Rs 10,000 and the agent's commission in the first year is 25%, it means only Rs 7,500 of your money is invested in the first year. So even if the NAV of the fund rises, say 20%, that year, your portfolio would be worth only Rs 9,000-much lower than the Rs 10,000 you paid. On the other hand, if you invest Rs 10,000 in an equity scheme with a 2.25% entry load, Rs 225 is deducted , and the rest is invested. If the scheme's NAV rises 20%, your portfolio is worth Rs 11,730. This shows how ULIPs work out expensive for investors. Deduct the cost of a term policy from the mutual fund returns, and you're still left with a sizeable difference.

In case you need any further details, please send us an email at asktheexpert@Rupeewizard.com

  • Tip of the month!

    Tip of the month!

    When you take up a life insurance, the appropriate life cover(called the hlv or human life value) depends on your age, income and certain other factors.

    For example, a person earning 1 lakh per month will require more life cover than a person earning 40K per month, since the living standard is higher in the former case.

    Use a calculator(such as the one below) to arrive at this appropriate life cover. You can enter your details into the calculator below and estimate it.
    http://www.hdfcbank.com/personal/investments/HLV_calculator/hdfc.htm

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