Buying ULIPs? Read this first

The past couple of years have seen ULIPs (Unit-Linked Insurance Plans) emerge as overwhelming favourites with individuals wanting to buy life cover complemented by a flavour of equities.

The Indian bourses too have played a part in fuelling the demand for ULIPs. However, there is one important aspect, which we feel individuals should consider before they commit their money to ULIPs from any life insurance company.

Simply put, ULIPs are life insurance plans, which can invest a portion of their corpus in equities. The percentage of investments in equities though differs across insurance companies.

While some companies have a mandate to invest up to 100% of their corpus in the 'aggressive' option, other insurance companies have a cap (like 35% of corpus for instance) on the 'aggressive' option.

Given the edge equities can provide to your portfolio, the percentage of equities in a ULIP can make a significant impact on the returns over the long term.

An illustration will help in understanding this better.

Let us take an example of an individual wanting to invest a sum of Rs 100 (as premium) each year in ULIPs. His investment tenure is 30 years. He has two options to consider- one which offers him a maximum of 35% exposure to equities and the remaining 65% in debt instruments.

The other option offers him 100% exposure to equities. Let us also assume that he is expecting a 10% growth year-on-year CAGR (compounded annual growth rate) from the equity component and a 7% growth CAGR from the debt component.

The individual is assumed to have a high-risk appetite and hence, he decides to invest his entire corpus in the aggressive option throughout the tenure.

The power of equities

As can be seen from the table, if a sum of Rs 35 is invested each year (out of the Rs 100 paid as premium) in equities for a period of 30 years and the rate of returns is assumed to be 10% CAGR, then the individual stands to gain Rs 6,333 on maturity.

Also assuming that the remaining Rs 65 is invested in debt instruments for the same period and this yields 7% CAGR, the maturity amount works out to Rs 6,570. The total amount that the individual stands to receive on maturity is Rs 12,903.

As opposed to this, if the individual were to invest the entire amount of Rs 100 in equities, other variables remaining the same, the returns amount to Rs 18,094. Which is approximately 40% higher than the returns that the individual would have received had his investments been 'limited' to a 35% equity exposure!

So what does this mean for an individual who wants to invest in ULIPs? To begin with, several studies have shown that equities tend to outperform other asset classes like bonds and G-Secs over the long term. It therefore makes sense for the risk-taking individual to invest a sizable portion of his corpus in equities.

Therefore it also follows that a 'maximum 35%' equity exposure will not be able to power the individual's portfolio returns like a 100% equity exposure would, other parameters (tenure, expected returns, premium amount) remaining the same. Add to this the fact that the 100% equity ULIP option also allows the individual to shift his money to debt in varying proportions (which range from 0%-100%), and one has a potent combination.

Of course, the return figures will change with a change in the assumptions considered above. For example, had we assumed a 15% return on equity without changing the other parameters, then the difference in returns between the 35% equity option and 100% equity option would be 107%!

Conversely, if we compare a 35:65 (equity: debt) portfolio versus a 70:30 (equity: debt) portfolio without changing the other parameters, then the difference in returns would have been approximately 22%.

Of course, it goes without saying that many factors other than the equity exposure affect ULIP returns. For example, expenses and the quality of fund management are two very important factors that need to be evaluated before taking the plunge into ULIPs.

Individuals therefore need to bear in mind that a ULIP needs to be evaluated on various parameters before zeroing in on a particular life insurance company.

The illustrations given above are for existing life insurance companies. They could differ across companies.