Equity markets have done very well over the last year. A lot of retail investors who had deserted the markets post the financial crisis in 2008 have come back or are looking to invest markets. To cater to such investment demand, unit linked insurance plans (ULIPs) have also made a comeback in the insurance market.
ULIPs are much maligned insurance products of the last decade. A number of investors lost a lot of money in ULIPs in mid 2000s, partly due to high cost structure of ULIPs and partly due to poor stock market returns. There was rampant mis-selling too. IRDA, the insurance regulator, took note of the investor grievances and modified the ULIP guidelines in 2010 to streamline the cost structure
We will not go into the changes made by IRDA or whether ULIPs have become attractive investment avenue post the change in guidelines. We have already discussed this in one of your earlier posts. You may go through our post ULIPs vs MF + Term Insurance to understand the changes. In this post, we will discuss the two types of ULIPs available. ULIPs can be broadly classified into Type I and Type II ULIPs. The only difference between the two types of ULIPs is in the death benefit. The death benefit defines the amount that the beneficiary (under the policy) gets in the event of death of the policy holder. However, this difference in death benefits also impacts the returns of the two types of ULIPs.
How ULIPs work?
Unit linked insurance plans (ULIPs) are insurance products that provide the dual benefit of insurance and investment. A part of your premium goes towards providing the life cover (mortality charges). Sum assured is the minimum amount that one gets in the event of the policy holder. The remaining premium amount (net of mortality charge, fund management, distribution and administration charges etc) is invested. Investors/policy holders are offered various investment options (equity, debt, balanced etc). You can choose the investment fund as per your requirement. The value of your investments (“fund value”) grows over a period of time through regular premium payments and return on your investments.
ULIPs can be broadly classified into two types: Type-I and Type II ULIPs.
Death benefit under the two types of ULIPs
In the event of death of the policy holder, the insurance company pays the higher of fund value or sum assured to the nominee/beneficiary. Suppose a person has paid premium for 8 years, the fund value has grown to 30 lacs. In the event of death of the policy holder, the beneficiary will be paid Rs 50 lacs (higher of 30 lacs, 50 lacs).
Type II ULIPs
In the event of death of the policy holder, the insurance company pays the sum of fund value or sum assured to the nominee/beneficiary. Considering the same scenario, the beneficiary would have received Rs 80 lacs (Rs 30 lacs + Rs 50 lacs)
How does it impact the return?
Among other charges, an insurance company charges mortality charge on sum-at-risk for insurance company. The sum-at-risk is the amount insurance company will have to pay from its own pocket in the event of death of policy holder. Expectedly, higher the sum-at-risk, higher the mortality charge. Additionally, mortality charge increases with the age of the policy holder.
Under type I ULIP, since the insurance company only needs to pay the higher of fund value and sum assured, the sum-at-risk goes down as the fund value grows. Considering the above example, if the fund value after 5 years is Rs 20 lacs, the sum-at-risk will be Rs 30 lacs (Rs 50 lacs – Rs 30 lacs). This is because in event of death of policy holder, the insurer needs to pay only Rs 30 lacs from its pocket. Rs 20 lacs is already there with the company in the form of fund value.
If the insured event (death of the policy holder) occurs after the fund value has grown to Rs 30 lacs, the sum-at-risk for the insurance company will go down to Rs 20 lacs. If the fund value grows to Rs 80 lacs, there is zero sum-at-risk for the insurance company. This is because as its entire liability (Rs 80 lacs) can now be met through fund value only. Therefore, under Type I ULIP, sum-at-risk keeps decreasing as the fund value grows and eventually becomes zero. As sum-at-risk keeps decreasing, mortality charge also goes down and eventually goes to zero.
On the other hand, in case of a type II ULIP, sum-at-risk is constant (sum assured) during the term of the policy. Therefore, mortality charge does not go down and in fact increases every year as the policyholder ages.
Thus, the investor/policy holder pays much lower mortality charges in a type-I ULIP. Since the amount invested is net of all the charges including mortality charges, the amount of premium that gets invested is much higher in a Type-I ULIP. Under Type-II ULIPs, sum-at-risk remains the same and hence mortality charges are higher. This impacts the returns negatively. Thus, type-I ULIPs offer better returns than type-II ULIPs.
Type-I ULIPs offer far superior returns than Type-II ULIPs if the policy holder survives the policy term. However, Type-II ULIPs perform far better if the policy holder passes away during the policy term. You can go through our ULIPs vs MF + Term Insurance to illustrative results. So, which one is better? One provides better maturity benefits (policy holder survives the policy term) while the other provides better death benefits. To answer the question, you have to look at why you purchase insurance products. Don’t you purchase insurance products so that your family is taken care off if something were to happen to you? Hence, in an insurance product, death benefits should be given far greater importance than maturity (survival) benefits. Type-II ULIPs are better insurance products than type-I ULIPs.
Type-I ULIP are primarily investment products. To be fair to insurance companies, that’s how type I ULIPs are being marketed. However, when you approach an insurance company, you must be looking for an insurance product and not investment product.
Please note we are not recommending that you must purchase Type-II ULIPs. We are just saying that these are better than type I ULIPs. In fact, we have always maintained that you must never mix insurance and investment. A combination of mutual funds and term insurance is much better both type-I and type-II ULIPs.
Deepesh is a fee-only financial planner and Founder, PersonalFinancePlan.in