Term insurance vs ULIPs: A reality check

In recent days it has become fashionable to discourage investors from buying unit linked insurance plans, ULIPs.

The reason: High administrative, mortality and fixed annual charges. Instead, term insurance plans offer better insurance to the life covered, so goes the argument.

While each and every insurance product has its advantages and disadvantages compared to other such similar products, insurance buyers must understand their need for insurance before buying any insurance product.

The current article dwells on the advantages that a ULIP has over term insurance plan. Or rather, it tries to remove some misconceptions about ULIPs.

To understand this better, let us go through a conversation between two friends.

Conversation One

Friend one: I am thinking of buying an insurance plan to cover my life. Not sure whether to go in for a term plan or a ULIP.

Friend two: Don't think twice. Go for a term insurance plan. They are the best way to cover a life

Friend one: But I have heard that in term plans no returns are available at the end of the plan period if I survive?

Friend Two: Yes. But why do you need returns from an insurance plan? You know my friend never mix investments with insurance. Keep them separate. You can always become rich by investing in mutual funds or equities. Take my word, go in for a term plan.

Friend One: You may be right. Hey, do you have any workings or illustrations, which I may go through before I decide on this?

Friend Two: Arrey yaar, why do you need workings? Don't you read newspapers? Don't you read the columns written by experts? All of them say that term plans are the best. If they are saying that term plans are good, they must be good. Anyways, who has the time to go through workings and all? I trust these free advices totally. I suggest you do the same too.

Friend One:  But I don't know anything about investing in mutual funds or equities. What do I do?

Friend Two:  Don't worry about that. There are financial planners who will plan everything for you. Just leave everything to them. They will help you out.

Conversation Two

Client: I need to plan my finances.  Can you suggest something good to me?

Consultant: Of course we can do it. Do you have any idea as to what your needs are?

Client: Yes I have. I am the only earning member of the family. Plus, I also have a housing loan liability. I need protection for my life. I am looking at a life cover of at least Rs 50 Lakhs. I am also looking for a reasonable return on my investments.

Consultant: Our suggestion to you would be to go in for a term plan and invest the remaining in mutual funds and equities. This will ensure that you get protection and returns from investments.

• Why ULIP is not the best insurance product

Client:  But my resources are limited, do you think it would be possible to take a term plan and invest at the same time?

Consultant:  Of course it is possible. The premium for a term plan with a life cover of Rs 100,000 is only Rs 400. Don't you think this is cheap?

Client:  But I need a life cover of Rs 50 lakhs. Also I have heard of this new thing called ULIP. Why can't we go in for that?

Consultant: Don't worry. Term plans are really cheap. Like I said for Rs 1 lakh, the premium is only Rs 400. And never mix insurance with investments. Also understand that these ULIPs are very expensive. They deduct a huge amount of money from the premium you have paid toward their charges and agents' commission. Only the balance is invested and the returns are no way comparable with that of mutual funds and equities.

Client:  But Sir, in case of a term plan, if I survive, nothing is paid back to me. This means that I will lose all the money that I have paid over the years towards the premium. Don't you think it is better to lose a part of the money in ULIPs than losing the entire money in a term plan?

Consultant:  Who is the expert here? If we are saying that term plans are best suited for protection, it is final. If you wish to continue as our client, please follow our advice.

A real life example

One of our clients, let us call him Amit, wanted to take a life insurance cover. He had taken a home loan of Rs 45,00,000. He wanted a matching life cover to ensure that in the event anything happens to him, the maturity proceeds from the insurance could be used to repay the housing loan. He had two options before him.

Either buy a term plan or go in for a ULIP. We looked around for a number of options for a term plan. Given below are the quotes from various insurance companies for a life cover of Rs 45,00,000 for a person aged 32 years. The term of the cover is 25 years.

The least cost premium, we found was Rs 15,496. This looked good. But he had to pay this premium for the next 25 years.The total premium payout would have been Rs 387,400.  This was not acceptable to him. Not because he could not afford the money. But for an entirely different set of reasons.

• Get right your insurance priority

Being a software engineer, his work required him to travel most of the times. Plus he also felt that keeping track of premium payment for 25 years would be too tedious. He wanted to buy a plan, which gave him a life cover of Rs 45,00,000 with a shorter premium payment period.

He was suggested to consider a ULIP with the following features:

• Premium per year would be Rs 30,000
• Minimum premium payment term of 3 years. Can continue the premium payment if he wished at a later stage
• Maximum life-cover availability. In this case the life cover was Rs 45,00,000
• Investments in ULIP to be in Maximiser, an option where the investments are into equity products like mutual funds and hence potential for higher returns

He agreed and took up the plan in December 2004. The policy got issued on 20th December 2004. He completed the mandatory premium payment for the first three years when he paid his last installment in December 2006.

Given below are the administration charges and the insurance charges deducted from the premium:

The total of the administration charges, mortality charges and fund management charges for all the three years put together works out to Rs 37,202. If one were to take the term plan premium into consideration, the total premium outflow would have been Rs 15,496*3 = Rs 46,488.

Premium as per term plan                     = Rs 46,488

Charges as per ULIP                            = Rs 37,202

Effective savings                                  = Rs 9,286

Now let us look at this from the investment angle too. If we have to understand whether the returns from the plan are reasonable, it is inevitable that we have to have a comparison. And so we compare the returns of this ULIP with two different mutual funds with two different objectives.

The following tables give a comparison of the same:

These net asset value, NAVs, are for Reliance Growth Fund, a fund rated number one in the last five-year returns category and number four in the last three-year returns category by Value Research Online. The NAVs are available for cross checking in www.reliancemutual.com. The date of investment is taken as 20th of December, on which date investment in ULIP was made.

For the sake of comparison an illustration of an equity linked saving scheme, ELSS, fund is also given here. The NAVs are for HDFC Tax Saver Fund, a fund rated 4th in the five-year returns category and 2nd in the three-year returns category. The NAVs are available for cross checking in www.hdfcfund.com.

What does this tell us?

The comparisons are made between COMPARABLE products. The investments in ULIP were in the maximiser option. Maximiser option allows investments predominantly in equities. The investment objectives of Reliance Growth Fund & HDFC Tax Saver Fund are to invest predominantly in equities.

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The difference between the fund values is very much evident. In the ULIP, after deducting all the applicable charges towards insurance, administration and fund management, the balance is Rs 75,225. The same investment in Reliance Growth Fund stands at Rs 69,801 and in HDFC Tax Saver Fund stands at Rs 79,173.51. While HDFC Tax Saver Fund has generated a higher return of Rs 3,948, this advantage would be nullified in the future years when the entire sum of Rs 30,000 is available for investments. This is more clearly explained in the next point.

In ULIPs, the obligation towards the premium payment is completed after the first three years of premium payment is made. This means for Amit, this obligation was over when the payment was made in Dec 2006. He completed his three years of payment. From December 2007, the whole of Rs 30,000 is available towards investment in mutual funds or equities.

Had Amit opted for a term plan, the situation would have been totally different. He would have paid the term premium charges of Rs 15,496 for the next 22 years. Consequently, the amount available for investments in each of the next 22 years would have been Rs 14,504. It is elementary mathematics that Rs 30,000 invested over a period of 22 years will compound itself much higher than Rs 14,504.

There is a near unanimous opinion amongst people that charges deducted for ULIP schemes are very high. The table below illustrates the charges more clearly:

Apart from the above-mentioned charges, ULIPs also charge fund management fees of 2.25 per cent per year. This has not been considered since mutual funds too levy almost the same charges. There might be a variation of 0.25 per cent to 0.5 per cent, but this is not very significant.

The table very clearly shows that the total charges levied in ULIP over a period of 25 years are Rs 27,450. If this were equated as an annual charge, per year charges would come to Rs 1,102. 

Now let us look at another misconception. Advisors become RICH by selling ULIPs. Is this true?

Commission structure -- ULIPs

After three years of premium payment, the net commission earned by an advisor in this scenario is a fabulous sum of Rs 5,700!

Compare this with the term premium commissions earned.

After 25 years of term premium payment, the net commission earned by an advisor is Rs 26,243. Also understand this: In case of a term plan, the revenue stream for an advisor will continue for the full 25 years whereas in ULIPs, after three years in case a customer decides to stop the premium payment, the revenue stream also stops.

The one drawback of ULIP is that in case of death, either the sum assured or the fund value, whichever is HIGHER is paid and not both.

To illustrate, if something were to happen to Amit today, his family would get back Rs 45,00,000 only. Had he opted for the term plan, then his family could have liquidated the mutual fund holdings for Rs 69,801 and they would also have got Rs 45,00,000 from the insurance company. From a long-term perspective, this may not affect the wealth creation for Amit since from the fourth year onwards the allocation towards mutual funds/equities is higher.

ULIPs today stand at the same position mutual funds stood in 1993, when private sector mutual funds entered the market. Returns from the fixed income bearing securities like EPF, PPF, NSCs & NSS were high.

• PPF vs NSC: What's the difference?  

Even the rate of interest on bank deposits was around 15-16 per cent during those days. Added to this was the fact that UTI was completely under Government control and people trusted UTI far more than other mutual funds.

The same sets of arguments we are hearing today against ULIPs were made against the mutual funds then. But as time has shown from Rs 47,000 crores in 1993, mutual fund industry today is managing assets worth Rs 231,862 crores (data as per AMFI website). UTI no longer enjoys the privileges it had under government patronage.

Mutual fund companies like Reliance, Franklin Templeton, Pru ICICI, HDFC, Birla Sunlife etc have emerged as dominant forces in the Indian financial market. Insurance industry too has witnessed a number of changes. From a single insurer just a decade back, today the industry has several private life insurance companies. Customers today have wider choices depending on their requirements and ability to invest money.

One last point before I conclude this article

Several comments are made against the insurance companies and advisors in general. Please understand that different products are structured to suit different individual needs of the customers. If endowment products have worked well since the last 50 years, it is not only due to the mis-selling by advisors.

Give credit to the product also which has enabled thousands of families to save regularly over a period of time and given them returns when they needed it the most.

Similarly if ULIPs are working well now it indicates the success of the product in tapping the latent demand existing in the market.

At the end of the day if you are convinced, for good or bad, buy what you want. But do take care to properly analyse the products and their pros and cons.

The author is Director, Fairsystems, an investment consulting firm. He can be reached at fairsystems@eth.net.