You are regularly pitched an insurance product by your relationship manager or a sales agent.
And nothing confuses you more. You are clueless about how to evaluate the product.
There are fancy tables and illustrations. There are emotional “what-ifs.” The keywords like “bonuses” and “loyalty additions” give the impression that the insurance company is doing you a favour. There is no reason to say NO.
By the way, there is no need to say NO.
At the same time, there is no need to say YES either until you understand what you are buying.
And that’s the topic I will try to address in this post.
Two Types of Investment-cum-insurance plans
Traditional plans and Unit linked insurance plans (ULIPs).
Traditional plans have two variants: Participating and Non-participating.
Before we move further, let us look at a few terms.
Your money is invested in capital markets and your returns are linked to the performance of such investments. Just like mutual funds. ULIPs are linked products.
Non-linked means your returns are not linked to market performance. Traditional plans (both participating and non-participating) are non-linked.
Participating and Non-participating plans
Participating plans participate in the profits of the company. As the name suggests, the participating plans belong to this category.
Non-participating traditional plans and ULIPs are non-participating in nature.
How do you find which kind of plan is being sold?
Focus on these keywords.
- Non-Participating (traditional) plans: Non-linked, non-participating
- Participating (traditional) plans: Non-linked, Participating
- Unit Linked Insurance Plans: Linked, Non-participating
By searching for these terms in the brochure, you can figure out what kind of plan you are being sold. These terms are on the first or the second page of the product brochure.
Non-participating plans offer guaranteed returns
Non-participating traditional plans are both non-participating and non-linked. Hence, there is NO uncertainty about their returns. You can calculate the returns (XIRR) from the product upfront.
If the insurance company survives, you will get the promised returns.
So, you know upfront what you will get.
You just need to figure out if the return is high enough for a long-term investment. For that, you can use IRR or XIRR function in Microsoft Excel
However, there is just one aspect you must be careful about.
In investment and insurance combo products (traditional plans and ULIPs), the returns depend on your age (everything else being constant).
Everything else being the same (policy, annual premium, Sum Assured, policy term, premium payment term, variant), a younger person (at the time of entry) will earn higher returns than an older investor. That is why old investors must avoid ULIPs and traditional plans.
So, a 35-year-old investor will earn better returns than a 55-year-old investor. Both are entry ages.
If you are 55 years old and you are shown the illustration for a 35-year-old, you are being misled.
Sometimes, the brochures show the illustration for a specific age (say a 30-year-old). Nothing wrong with it. A brochure cannot possibly show you the cashflows for all the entry ages. Keep this in mind. You can generate an illustration for your age (from the insurer website).
Participating plans and ULIPs cannot guarantee returns
Therefore, it is misleading to give the impression of guaranteed returns in ULIPs and participating plans.
In participating plans, your final returns will depend on various kinds of bonuses (simple reversionary bonus, final additional bonus, loyalty additions, terminal bonuses, etc). Note that the nomenclature can vary across multiple plans. Now, these bonuses are NOT guaranteed. Your bonuses will depend on the company’s performance since you participate in the profits of the company. And a company’s performance is not guaranteed.
In ULIPs, your money gets invested in capital markets (just like mutual funds) and your returns will depend on the performance of those investments. The performance of the investments is not guaranteed
Hence, no one can give you a guarantee of returns in participating plans and ULIPs.
Since ULIPs are linked products, the returns from ULIPs can be very volatile.
ULIPs can be Type I or Type II
The difference is in the death benefit.
Under Type I ULIP, the nominee gets Higher of (Sum Assured, Fund Value) in the event of policyholder demise.
Under Type 2 ULIP, the nominee gets Sum Assured + Fund Value on policyholder demise.
You just have to look at the death benefit in the policy. You will know whether you are buying a Type-I or Type-II ULIP.
Now, since the death benefit is higher in Type 2 ULIP, the cost of insurance is higher, impacting returns.
Therefore, if you are buying a ULIP for investment, go with Type-1 ULIP.
If you are buying to bridge a serious investment gap, a Type 2 ULIP is a better choice.
What do I think?
If you are a regular reader, you already know that I do not like to mix investments and insurances. Thus, I advise investors to stay away from traditional plans and ULIPS. I stick with my advice. And there are reasons for such advice.
- High cost (especially if you buy through an intermediary)
- Low returns for a long-term investment (this is subjective)
- Lack of flexibility (premature exits are usually expensive)
Then, why do investors buy such products?
Again, many reasons. Lack of financial knowledge. Inability to calculate true returns from the product. Good salesmanship.
Still, I do not think that explains the popularity of such products.
Most investors seek comfort
Comfort that if I invest Rs 2 lacs per annum for the next 10 years, I will get Rs 2 lacs per annum for the next 30 years. A 50-year-old invests Rs 2 lacs per annum for the next 10 years (until the age of 60), he will get Rs 2 lacs per annum from the age of 60 until 90.
He is not bothered that the returns from this 40-year investment is only 6.3% p.a. Or he may not even know that the product will give 6.3% p.a.
Just the comfort of guaranteed post-retirement income is sufficient. He does not care about the returns. He does not have to track the markets or worry about the market noise. He just needs to pay the premium. Comfort.
For this peace of mind, he is willing to settle for sub-optimal returns. And I assume he knows the returns (most won’t know). You won’t find this information in product brochures.
In any case, low or high returns are subjective. 6% p.a. post-tax is high or low for a long-term product? What is the guarantee that the investor would earn better returns than this product?
Let us consider another example.
You want to invest Rs 1 lac per annum for your 6-month-old daughter. You want a product that ensures that this investment continues even if you were not around. Rs 1 lac gets invested for the next 18 years whether you are alive or not.
People like me will say, go buy a term plan. If you pass away, the proceeds from the term plan can be used to fund your daughter’s education. Fine advice. However, this advice does not give you comfort. You think, what is the guarantee that your family will manage such life insurance proceeds well? Or those proceeds will be used for your daughter’s education. Are there no products that meet such requirements?
Well, there are ULIPs and traditional life insurance plans that can give you such a product structure. Yes, these products will be expensive but how do you price comfort and peace of mind?
While I am not ok with this “comfort” approach to investments, I know that not everybody can or will afford a competent advisor. Therefore, I must respect the judgement of such investors. Many people/advisors mock the financial intelligence of such investors but I think this is petty and unjust. They should consider the investor perspective too.
However, it is still important that you understand what you are buying.
What should you do?
Do not mix investment and insurance.
However, if you must for the comfort and peace of mind, understand the product properly before buying. And buy what you think you are buying.
If you buy a participating plan (where the returns are NOT guaranteed) thinking you are buying a non-participating plan (where the returns are guaranteed), then we have a problem. And that is the intent of this post.
Similarly, while both participating plans and ULIPs do not guarantee returns, it does not mean their risk profiles are similar. A ULIP will be much more volatile.
Do must NOT buy a ULIP when you are looking for a traditional plan or vice-versa
Do NOT buy a participating plan or a ULIP when you are looking for a return guarantee. Buy a non-participating plan.
Do NOT buy a traditional plan when you have high return expectations. A ULIP is a better choice.
Do NOT buy a ULIP when you want a stable (albeit low) return and low volatility product. A participating plan might be a better choice.
Here is what you can do when you are pitched an insurance product.
- Figure out the type of insurance plan (Participating, Non-participating, Type II ULIP or Type II ULIP).
- Do the (Participating, Linked) check.
- In case of ULIP, look at how Death Benefit is defined to understand if it is Type I or Type II ULIP. Further in case of ULIPs, understand the cost structure.
- For a non-participating plan, calculate the promised return.
- Try to understand product structure. Decide accordingly.
- If confused, seeking professional help is a good idea. The cost of professional advice is lower than the cost of a poor financial product.