Are ULIPs really expensive?

A lot of ink has been spilled over how expenses on ULIPs (unit linked insurance plans) pan out over a period of time. Also, more often than not, the expense structure has not been clearly understood by most individuals who have taken a fancy to ULIPs. This article takes a closer look at the break-up of ULIP expenses and how they affect ULIP returns over a period of time.

Simply put, ULIPs work very similar to a mutual fund with a life cover thrown in. They have a mandate to invest the premiums in varying proportions in gsecs (government securities), bonds, the money markets (call money) and equities. The primary difference between conventional savings-based insurance plans like endowment and ULIPs is the investment mandate - while ULIPs can invest upto 100 per cent of the premium in equities, the percentage is much lower (usually not more than 15 per cent) in case of conventional insurance plans.

ULIPs are also available in multiple options like 'aggressive' ULIPs (which can invest upto 100 per cent in equities), 'balanced' ULIPs (which invest 40-60 per cent in equities) and 'debt' ULIPs (which invest only in debt and money market instruments).

The exact expense structure/ break-up for ULIPs is as transparent as one would have liked. While the expenses are displayed on companies' websites and in sales literature, the onus of dissecting the available information rests on individuals.

Broadly speaking, ULIP expenses are classified into three major categories:

Mortality charges
Mortality expenses are charged by life insurance companies for providing a life cover to the individual. The expenses vary with the age, sum assured and sum-at-risk for the individual. There is a direct relation between the mortality expenses and the abovementioned factors.

In a ULIP, the sum-at-risk is an important reference point for the insurance company. Put simply, the sum-at-risk is the difference between the sum assured and the investment value the individual's corpus as on a specified date.

Sales and administration expenses
Insurance companies incur these expenses for operational purposes on a regular basis. The expenses are recovered from the premiums that individuals pay towards their insurance policies. Agent commissions, sales and marketing expenses and the overhead costs incurred to run the insurance business on a day-to-day basis are examples of such expenses.

Fund management charges
These charges are levied by the insurance company to meet the expenses incurred on managing the ULIP investments. A portion of ULIP premiums are invested in equities, bonds, gsecs and money market instruments. Managing these investments incurs a fund management charge, similar to what mutual funds incur on their investments.

FMCs differ across investment options like aggressive, balanced and debt ULIPs; usually a higher equity option translates into higher FMC.

Apart from the three expense categories mentioned above, individuals may also have to incur certain expenses, which are primarily 'optional' in nature- the expenses will be incurred if certain choices that are made available to individuals are exercised.

Switching charges
Individuals are allowed to switch their ULIP options. For example, an individual can switch his fund money from 100% equities to a balanced portfolio, which has say, 60 per cent equities and 40 per cent debt.

However, the company may charge him a fee for 'switching'. While most life insurance companies allow a certain number of free switches annually, a switch made over and above this number is charged.

Top-up charges
ULIPs allow individuals to invest a top-up amount. Top-up amount is paid in addition to the premium amount for a particular year. Insurance companies deduct a certain percentage from the top-up amount as charges. These charges are usually lower than the regular charges that are deducted from the annual premium.

Cancellation charges
Life insurance companies levy cancellation charges if individuals decide to surrender their policies (usually) before three years. These charges are levied as a percentage of the fund value on a particular date.

Having defined ULIP expenses, an illustration will help in understanding how they pan out as well as their impact on returns over a period of time.

ULIP expenses table

Suppose an individual aged 30 years, wants to buy an 'aggressive' ULIP for a sum assured of Rs 500,000 for a 30-Yr tenure. The premium he pays for the same is Rs 25,000. The expenses for the initial 2 years is assumed to be 27% while for the remaining tenure, it is 3 per cent.

Fund management charges are assumed to be 1 per cent p.a. of the corpus for the entire tenure. We have also assumed that the individual stays aggressive throughout the tenure and does not shift his money between the various fund options.

We have assumed that the investments appreciate at 10 per cent compounded annualised growth rate. So the fund value at the end of 10 years is Rs 358,417 and the effective CAGR net of expenses is approximately 6.48 per cent.

However, it can be seen that as the years roll by, the CAGR keeps going up with a corresponding increase in the fund value. For example, the fund value at the end of the 20th year is Rs 1,232,827 while the CAGR has gone up to approximately 7.98 per cent. At the end of the 30th year, the CAGR has gone up to 8.36 per cent.

The reason why the CAGR goes up over a period of time is because the ULIP expenses even out over a period of time. The 'evening out' occurs because although the expenses are high in the initial years, they fall thereafter. And as the years roll by, the expenses tend to 'spread themselves' more evenly over the tenure of the ULIP.

Another reason is also because the expenses are levied on the annual premium amount, which stays the same throughout the tenure. Therefore, the expenses do not have any impact on the returns generated by the corpus.

Fund management charges also have an effect on the returns. FMC is levied on the corpus, which keeps fluctuating over the tenure. Therefore over a period of time, the lower the FMC, the higher the amount available for investments and in turn, the better will be the ULIP fund returns.

Of course, the returns shown in the illustration above will differ with a change in the sum assured, the annual premium amount, the percentage of expenses, the FMC and so on. The returns will also depend to a large extent on how well the insurance company has managed your money.

Individuals therefore, need to bear in mind that expenses are an important variable while evaluating ULIPs across life insurance companies. They have the potential to make a considerable difference to the returns generated over a period of time.

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