ULIPs: Does the marriage work?

Unit-linked insurance plans (ULIPs) have become something of a rage with their 'promise' of market-linked returns combined with the dual benefit of insuring your life from eventualities.

To put it simply, ULIPs attempt to fulfill investment needs of an investor with protection/insurance needs of an insurance seeker. ULIPs work on the premise that there is a class of investors which regularly invests its savings in products like fixed deposits, coupon-bearing bonds, debt funds, diversified equity funds and stocks.

Some individuals take insurance to provide for their family in case of an eventuality. So both these categories of individuals (which also overlap to a large extent) have a portfolio of investments as well as life insurance.

ULIP as a product combines both these products (investments and life insurance) into a single product. This saves the investor/insurance-seeker the hassles of managing and tracking a portfolio of products.

Novel and noble as it appears, investor/insurance-seekers rarely understand the cost implications of the marriage between investments and life insurance. To be sure, it is intricate and not everyone is able to unravel it.

Abhishek Bhatia, Head (Marketing), ICICI Prudential Life Insurance, explains, "Unit-linked products are designed to put control in the hands of the customer. While some customers are comfortable with this, there are others who require some more explanation about the features. This is provided by the insurance agent. All the charges are clearly disclosed in the product brochures that are given to customers. Moreover, customers get a benefit illustration, which clearly illustrates the up-front, investment and mortality charges that are levied on the premium, and shows how the monies will grow over time, under a certain set of assumptions."

In this backdrop let's understand the costs of owning a ULIP. For illustration purpose, we have taken ULIPs of ICICI Prudential and HDFC Standard Life, two leading private insurers.

Investors need to understand that this should only give them an indicative idea about the costs associated with a ULIP as different insurers have varying cost structures.

We will start with the investment costs. Since ULIPs manage a portfolio of investments for clients, they incur a cost known as the fund management cost. This is similar to a mutual fund that incurs costs on managing the equity and debt portfolio for investors. In this regard, ICICI Prudential ULIP has a three-tier cost structure.

PruICICI's fund management costs

Compare this to Prudential ICICI's Growth Plan's expense ratio (2.3 per cent as on March 31, 2003). The expense ratio typically includes fund management fees, brokerage and custodial fees, marketing/advertising fees.

ICICI Pru's fund management costs

Likewise PruICICI Balanced Fund's expense ratio is also 2.30 per cent. If one had to isolate fund management costs it would be in the region of 1.00 per cent plus about 0.30 per cent in terms of the share brokerage and custodial fees, which adds up to 1.30 per cent (the balance 1.00 per cent is accounted for by marketing, administration costs).

This is how it would work for a fund house as large as PruICICI. So ICICI Pru's ULIP (equity plan) is more expensive than PruICICI Growth Plan while ICICI Pru's ULIP (balanced plan) is more economical than the PruICICI Balanced Plan.

Unlike ICICI Pru's ULIP which has a graded fund management fee structure, HDFC Standard Life's ULIP has a flat fund management fee of 0.80 per cent of net assets regardless of the plan one chooses (there are five of them).

Let us see how HDFC Standard Life's ULIP compares with HDFC Mutual Fund schemes in terms of fund management costs.

The flagship equity fund -- HDFC Equity Fund's fund management expenses (indicative) works out to 1.30 per cent given the size of HDFC Mutual Fund -- likewise for HDFC Prudence Fund (the flagship balanced fund). So HDFC Standard Life's ULIP (0.80 per cent) stands cheaper than both HDFC Equity Fund and HDFC Prudence Fund.

However, investors need to note that while ULIPs are more economical on fund management costs, this can be attributed to the fact we have not factored in the marketing costs of ULIPs.

Remember we have isolated the fund management costs of a mutual fund to segregate it from the marketing costs. With a ULIP, the costs are significantly higher because there is a life insurance component in it as well, in addition to the investment component.

For instance, with HDFC Standard Life ULIP, in the first and second years, 27 per cent of the premium constitutes ULIP charges. So if you have taken a Rs 10,000 ULIP from HDFC Standard Life (which is the minimum amount to start with), Rs 2,700 in the first and second years each will be set aside to meet ULIP charges.

Only Rs 7,300 will be invested in the first and second years each. From the third year onwards, only 1 per cent of the premium will be charged to the ULIP, which means Rs 9,900 will be the amount invested.

So should investors opt for ULIPs?

First and foremost, investors need to understand that a ULIP is a bundled product of their investments and their insurance proceeds. So if you have a ULIP invested in equities, you are exposing your life insurance monies as well as your investible surplus to the vagaries of equity markets.

While it is fine and even sensible to let your investible assets get an equity flavour, the same cannot be said about your life insurance monies, which to a large extent should be sacred.

The volatility in equity markets can disturb the calmest of minds and the last thing you want to see is your nest egg being eroded by the latest slide in equity markets.

Abhishek Bhatia elaborates, 'A ULIP policyholder has the option to invest in a variety of funds, depending on his risk profile. If one does not have the appetite to invest in equity, they can choose a debt or balanced fund.'

However, the structure of a ULIP takes care of quite a bit of the uncertainty in the markets. Insurance companies understand the need to give insurance-seekers the flexibility to rethink their investment strategy in view of market histrionics.

There is an option for the insurance-seeker to switch to another plan with a lower or zero equity component to stem the loss in a falling equity market. Abhishek points out, 'The switch option allows customers to switch between fund options, thereby making adjustments to any perceived risks.'

ICICI Pru allows policyholders to make this switch four times a year at no cost, with Rs 100 at every additional switch after that. HDFC Standard Life allows policyholders to make as many switches as they like.

However, for investors to make the right switch they need to track markets actively and be well informed, which is actually the job of the investment advisor/consultant.

ULIPs are suitable for individuals who are already adequately insured and are reasonably well-informed and savvy to take active investment decisions by using the 'switch option' that is provided to a ULIP policyholder.

Also policyholders with regular endowment plans who are not satisfied with the 4-6 per cent returns can consider taking a ULIP with a lower equity component. It is best if insurance-seekers tread the middle path and choose balanced plans (with about 50-60 per cent equity component).

Ideally they need to avoid taking the aggressive 100 per cent equity ULIP, which could needlessly expose their assets to market volatility. So if insurances-seekers/investors play their cards right, they can make this marriage work.

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