Why do ULIPs have such a high upfront charge?

Mumbai: Jignesh Mehta paid a premium of Rs 20,000 to invest in a unit-linked insurance plan (ULIP) in October 2005. At the end of one year, when he received the policy statement, he was surprised to see that the total value of his investment was just Rs 9,075. He wondered where the balance Rs 10,925 had gone.

ULIPs are insurance policies which club insurance and investment. Usually, an individual taking a ULIP has 4-6 choices, ranging from funds investing 100 per cent in equity to those investing 100 per cent in debt securities.

Other than this, the policy-holder gets an insurance cover as well, for which the insurance company levies a monthly charge.

What Mehta did not know is that the entire Rs 20,000 he had invested would not be invested.

There were expenses to be paid. In the first year of his ULIP policy, the insurance company had made an allocation charge of 25 per cent of the premium paid. What this meant was that of the Rs 20,000 he had paid, only Rs 15,000 was invested.

Other outgoes, like policy administration charge, and fund management charge, had ensured that instead of his money growing in value, it had shrunk.

The premium allocation charge in the first year of the policy varies from 15 per cent to 71 per cent of the premium paid, depending on the ULIPs chosen. So, why do ULIPs have such a high upfront charge?

“Historically, insurance commissions have always been high. The insurance industry tends to justify this practice, using the defence that selling insurance is tougher than selling other financial products.

While this itself is arguable, in any case, since these commissions are deducted from the investment, it is the investor who suffers,” says Sandeep Shanbhag, an investment consultant.

Financial planner Amar Pandit adds: “It’s a question of who bells the cat, and if an insurance company comes up with a low-cost product, they fear losing out on business.”

Investment experts complain it’s not easy to choose the best ULIP. “When I need to advise a client on which mutual fund to invest, I can check websites to know the best-performing schemes over three to five years.

But there is nothing like that available for ULIPs,” says a relationship manager with a private sector bank.

“Also, since the expense structure of each ULIP is different, any comparison between the performances of different Ulips is not possible,” says Shanbhag.

So, why do people invest in ULIPs? Last year more than Rs 31,000 crore came into ULIPs, which now account for around 56 per cent of the total new premia coming into insurance policies.

“The idea of a packaged product that offers both equity returns and insurance seduces investors,” says Shanbhag.

“The primary reason why people buy ULIPs is because of mis-selling. Agents tell people they have the option of paying a premium for only three years, when the actual term of most ULIPs is at least 10 years. It works as a good selling point,” says an investment advisor who did not wish to be identified.

Most ULIPs have a cover continuance option, which essentially ensures that even if the individual is not able to continue paying premia anytime after the first three years, the policy continues.

The insurance agents, though, have turned this into a selling point, giving an impression to investors that they have an option to stop paying premia after three years, which is really not the case.

An investor who decides to stop paying premia after three years hardly benefits; after three years, the expenses are less and more of the premium gets invested.

With a lower amount being invested, a lower initial corpus can have a huge impact on the corpus that the investor ultimately accumulates.

But there’s another reason why insurance agents tell their clients that they can stop paying premia after three years: they can sell another ULIP to them after three years and hope to make a greater commission.

If a client stays on with his/her ULIP, the agents make a much lower commission of around 5 per cent of the premium,” says an investment advisor.

“But companies are trying to curb mis-selling of this sort,” says R. Krishnamurthy, managing director of Watson Wyatt Insurance Consulting.

“One of the players has made it mandatory for the investor to sign a document, stating that he intends to invest for a longer term. However, this practice is not widely prevalent.”

Also, getting out of an ULIP, if it has not been performing well, can be a costly affair. If your tax- saving mutual fund is not performing, you can simply stop investing and move onto another scheme.

In case of ULIP, if you want to stop investing after three years and move onto another scheme, you will have to bear the high premium allocation charge of the new Ulip in the first three years.

To the detractors of ULIP, insurance companies keep pointing out that their expense structure over a longer period of 10-15 years works out to be much lower than that of a mutual fund. Hence over that period, ULIPs are more likely to perform better than mutual funds.

“In single premium products, which comprise 50 per cent of ULIPs sold, the commission is just 2 per cent. However, the cost is a little higher in regular premium products. But, it would even out in 8-10 years.

Investors need to understand that Ulips are for longer-term periods,” says SV Mony, secretary of the Life Insurance Council. But investment experts don’t seem to agree.

“Lower expenses have to match up with performance. The basic assumption that insurance companies make is that ULIPs and mutual funds will give similar returns. Actually, mutual funds have outperformed an average ULIP by a huge margin, and there is no way they can catch up in 10-15 years,” says Pandit.

“It is too early to compare the ULIP returns with mutual funds as Ulips have been launched only for 3-4 years now. Though we would not like to comment on the industry performance, our unit-linked funds have performed extremely well and are in-line with the performance of mutual funds, says Sanjay Tripathy, head marketing at HDFC Standard Life Insurance.

So what is the way out? It would be ideal to separate your insurance and investment decisions.

Investors desiring both insurance and investment should buy each product individually and avoid any combination thereof. Whenever insurance is combined with investment, it produces sub-opitmal results. So one should always buy term insurance and invest the rest of the funds in a pure investment product of choice," says Shanbhag.

Source: DNA Money