The fundamental problem with ULIPs

Posted By : Kushal Kothari

There's a good chance you already own a Unit Linked insurance plan (ULIP). Chances are that either your parents bought one in your name or the friendly bank manager showed up in the month of March to sell this policy for tax purposes. Only later you started to hear a lot of clamour about not mixing insurance and investments. You started to get a cringing feeling of having been ripped off. You try to understand the policy but you cant. Whose help do you take? And would you really want to admit to others of having made a bad investment decision? Besides you probably have paid 2 of the 5 instalments. You'd rather pay the rest than face surrender charges. What's done is done.


Sadly, that's the story of a vast majority of investors, including yours truly. Advisers much experienced and wiser than us have already written about the pros and cons of choosing a ULIP, the product. Though to understand the problem with the product, it's much more essential to understand ULIP, the business.

The Insurance Industry
Insurance of any kind is basically a protection against a perceived risk. In the case of Life insurance, it's the life of the policy holder. However, you'd probably be surprised to know, that the main business of life insurance companies is less about insurance and more about investments! Growth in any business comes from two things - Either increase the volumes or increase the margins. Unfortunately, the Life insurance business suffers from a lack of consumer awareness about the need for insurance. It is bloody difficult to make the consumer pay for benefits he will never see in his lifetime (with the good fortune of a healthy life). Hence even after decades of pushing and cajoling, the risk business of life insurance companies has not seen an uptake that their global peers have. Add to that the intense competition in a very commoditized business with a behemoth state owned entity (LIC), and you'll start to understand why there was a pressing need for an innovation in the product portfolio of the insurance industry. The thought process in the run up to creating ULIPs probably looked something like this


How do we sell more? (The product)
Bundling. Why sell just a risk product, when you can bundle it with an investment product and get more volumes? Those who are looking for insurance solutions can be sold investments, while those looking for investment solutions can be sold insurance.  


How do we earn more margins? (The evil genius)
By increasing the overall charges, the end user is going to get spooked sometime or the other about the total charges they are paying for their policy (which goes over 15% of the premium in many cases. Imagine paying 1 lakh of your hard earned money in premium and only 85000 gets invested). Hence, charge them by cancelling their units! It's true, read your policy. Some of the charges are actually collected by cancelling units allotted under the policy. It's the most deceitful way to charging the end user. These charges will never reflect in the NAV of the units, only your units will decline with time. 


How do we reach more consumers? (The distribution)
Do what every successful business does. Increase the commissions to the intermediaries. If a bank sold an ELSS mutual fund, it perhaps gets commissions up to 5%. With a ULIP, as high as, hold your breath, 35%! No wonder every single interaction with your banker starts with the possibility of selling a loan and ends with some new plan exclusively designed for you, a ULIP! The thing with financial products is - trust sells more than the product itself. And that's the tool that the entire insurance industry has deployed over decades. Onboard friendly bankers and neighbourhood uncles and aunts and have them sell, not the product, but the trust they have built with you over the years.


And thus was conceived a product that probably had some benign origins of providing a mix of insurance and investments. Though it eventually ended up being built on a platform of aggressive sales structure and obscenely high policy charges. Let's talk about the problems with the product itself. 


Cover - The cover provided by these policies is downright pathetic. With a plan in which you pay 1L of premium, you get life cover of around 10L! First of all, a life cover of that amount is hardly sufficient for today's investors. Secondly, the rule of thumb when it comes to life insurance is - For a 30yr non-smoker, the cover charges should be ~0.1% of the cover amount. So, for a 10L cover, that works out to Rs.1000. The rest should ideally get invested, but does it?


Charges - Have a look at any of the policies and you'd find charges such as policy administration, allocation, mortality and the fund management. To add to this, there's the innovation of surrender charges which make it practically useless to surrender your policy once you make your first instalment. 


Complexity - There's a better chance of you solving a rocket science problem than estimating the expected returns from a ULIP plan. With the multitudes of charges, conditionality and options, it's anyone guess what the returns will look like. And this is the biggest problem we personally have with ULIPS (or any investment plan from insurers for that matter). Eventually, every investor's money gets invested in Equity or Debt securities. However, with product structuring that would put most investment bankers to shame, the insurers seem sworn to design products that they can sell without making the customer understand the product in the first place.


Performance - Let's talk about an MF manager in an open ended mutual fund first. The NAV of the scheme is tracked daily. There is intense pressure to perform, not just in absolute terms, but relative to a passive benchmark as well as a peer group. The metric of an MF is the assets managed by it. Any sustained underperformance will guarantee that heads will roll at the fund house. Now let's talk about the manager of a ULIP fund. The investor is pretty much locked in the fund for 10 years, so AUM is only going to increase as premium payments are made. There is no urgency to beat a peer group on a daily, monthly, quarterly or even annual perspective. Just how motivated do you think is he going to be to deliver top performance?


There is one accidental benefit of a ULIP plan. Because of the complex structuring, an investor is pretty much stuck for 10 years with the product. This makes sure that fickle minded investors stay put with their investments. Though this benefits the fund more than it helps the investor. Inability to access your own money at your will is a far bigger drawback than the benefits of being forced to stay invested.

Why term insurance + Mutual funds beats ULIPS on all parameters? 
With term insurance, you have the ability to purchase affordable and customized risk cover of your choice from amongst 24 service providers. With Mutual funds, you have the ability to custom build your investment portfolio to your risk profile and investment horizon with high liquidity and transparency to rebalance it as and when required. Plus, there's the choice to choose from over 800 schemes. Finally, it's a whole lot cheaper! A lot of detailed studies have been done by other investment planners, such as here


Hope this helps. 


Happy Investing!