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The Trouble With Ulips

The real problem with ULIPs is that they are structured such that they offer very poor returns to investors

The row between the Insurance Regulatory and Development Authority (IRDA) and the Securities and Exchange Board of India (Sebi) is turning into an arm-wrestling match between two statutory bodies with huge clout. The chain of Sebi's argument goes like this. Life insurers offer unit-linked insurance plans (Ulips). Ulips invest in equity. Hence, Sebi wants Ulip schemes registered like mutual funds. IRDA has no intention of ceding control. Since both regulatory bodies have clout, they will eventually work out some compromise.

In my opinion, registration would serve no real purpose. Insurers would find some way to carry on raising money cheap and investing in the stock market. That, in itself, is not a problem - the stock market is an excellent investment avenue. What is a problem is that Ulips are structured such that they offer very poor returns to investors.

Ulips have been around for several years. The structures are known. Every financial newspaper and business magazine of repute has analysed Ulips and shown in detail why investors should avoid them.

In themselves, Ulips are not fraudulent; it's just that investors can get far better deals. So this is a classic case of “buyer beware”. If investors insist on buying Ulips, there isn't much more that can be done since there are already ample warning signs in the public space. It is also easy to understand why agents push Ulips - due to huge front-loaded commissions.

Ulips offer a combination of insurance and investment, paid for in an annual lump sum. The insurer combines a term cover, deducts the premium. Then it deducts commissions. It invests what's left in the policy-holder's choice of debt and equity. One good thing is that Ulip allocations are flexible. The same scheme will allow very large variations in the ratio of debt:equity investments.

The disadvantages
If the unit holder dies, the nominee gets a certain sum assured as in any term plan. Or else, units appreciate in value and therefore, a nest-egg is created. So far, so good. The devil lies in the details. The first couple of years have enormous commissions - usually 70 per cent or more. This huge outflow means that very little of the initial commitment is invested. A basic knowledge of compounding will show this is not an optimal way to grow money.

The second nasty detail is that most Ulips run on an “either/or” basis. If you die, you will get either the value of the term cover or the value of the units, whichever is higher. You won't get both. This means essentially that the insurer is always swallowing a large component of your annual payment.

The third major structural issue with most Ulips is that many investors are tempted by the agent telling them that they only have to pay a premium for the first three years or so. If you choose not to pay a premium after that mandatory period, the annual term cover charges are deducted from the standing unit-value. So the investment corpus evaporates.

Worse than the alternatives
Under almost all circumstances, Ulips yield lower returns than a combination of a simple term cover and a basket of equivalent mutual funds that together commits the same lump sum. If a Ulip-holder dies early, the estate receives a lower payout. If a Ulip holder survives, he receives a lower payout. If he dies later, his estate receives a lower payout.
Risk profile doesn't matter. A conservative person should take term cover and buy debt oriented funds with the surplus. An aggressive person should take term cover and buy diversified equity funds. Even an endowment insurance policy plus funds will generally produce better returns than a Ulip. (Endowment or “money-back” schemes charge higher premiums than term covers so less money goes into the fund portfolio.)

The reasons why a separate term cover plus a fund portfolio always outscores a Ulip are simple. Term covers have nominal commissions and so do mutuals. Much more money is therefore, actually invested. Second, there's no “either/or”. In the event of the death of the holder of a term cover who also holds a fund portfolio, the nominee receives both the policy payout and inherits the portfolio.

None of these Ulip details are concealed as such. It is written there in black and white on the agreements you sign. You can easily do the maths on the term cover (many insurers have calculators on their websites). However, it is not in salesmen's interest to point it out and they don't.

The mistake people make is to confuse insurance with investment. Insurance is a bet you want to lose. Investment is a bet you want to win. Two entirely separate intentions. Use two different instruments.