The new numbers say it clearly now: A mutual fund plus term insurance cover is a smarter strategy than buying a bundled product in the form of a unit-linked insurance plan (Ulip). The insurers’ argument for the Ulip is old—it gives you double benefit of investment and life insurance in one product. Buy a mutual fund for investment and a pure term policy to cover your life, say financial planners. And arguments fly thick and fast from both camps.
One of the arguments in favour of the Ulip was that if you kept the product alive for more than 10 years, it eventually did better than a mutual fund, if we looked at similar returns and built in costs of entry, fund management and mortality. But with both the capital market regulator and the insurance regulator hacking away at costs, the numbers need to be run again.
We ran the numbers taking an annual investment of Rs 1 lakh for a 35-year-old that would buy a life cover of Rs 50 lakh. We used an illustration of a type II Ulip (one that gives you the fund value as well as the sum assured on death. Type I gives you the higher of the fund value or the sum assured) growing at an annual return of 10%, and we took a mutual fund with an expense ratio of 1.75%—most diversified equity funds in Mint50 charge around 1.50-1.75% per annum. The MF-term cover combination won (see graph). The same numbers for a cover of Rs 10 lakh, too, make the combination the winner for most part of the tenor.
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In September 2010, the regulator capped the costs to 2.25% for Ulips with tenors above 10 years. So if the fund is growing at an assumed rate of 10%, the costs wouldn’t drag down the net return below 2.25%. In other words, the minimum mandated return becomes 7.75% in the example mentioned above. We put the numbers through a blender of Excel sheets factoring in this cost and got the older result: Ulips are long-term products and make sense if taken for a term above 10 years. But this is only in theory.
To calculate the real returns, you will need to look at the projected fund value in the illustration, which includes the costs that do not come under regulatory caps. And the minute you do that, your returns will come down. In the example we took, the game changer was the cost of insurance or mortality cost that has been kept outside the caps.
So while the published yield, which did not factor in the cost of insurance, conformed to the cost caps, a quick calculation of return on the basis of the fund value published in the same illustration told a different story.
In the illustration that we sampled to work our numbers in the example above, the published yield, on an assumed rate of return of 10%, was 8.51%. However, the maturity corpus came to around Rs 41.95 lakh, a return of 6.62%. It was the cost of insurance that dragged down the yield and the published return concealed the impact.
Why high mortality costs
So are the insurers padding up the cost of insurance because it doesn’t fall under the cost caps? It was difficult to elicit an on-the-record response from the industry but an actuary from the insurance industry, on condition of anonymity, confirmed. He said: “Mortality charges don’t come under the cost caps which gives an opportunity to the insurer to have a margin on the mortality cost.”
The cost of insurance has gone up also because of the recent changes—now Ulips are as much about insurance as about investment. The minimum sum assured has increased from five times multiple to 10 times multiple and is capped at 105% of the premiums paid. In other words, for a premium of Rs 1 lakh, the minimum sum assured can be Rs 10 lakh. But if a person dies in the 18th year of a 20-year term policy, his sum assured is not Rs 10 lakh but Rs 18.9 lakh which is 105% of all the premiums paid. Says Rituraj Bhattacharjee, head (product development), Bajaj Allianz Life Insurance Co. Ltd: “The primary reason why the total cost of insurance has gone up is that earlier the sum at risk would come down as the fund value went up. But as per the new guidelines, insurers need to maintain life cover of at least 105% of all the premiums paid. This means the sum at risk will never become zero during the entire policy period.”
Even structurally, Ulips have undergone a transformation. Commissions have come down and in order to incentivize sale of Ulips, insurers are easing underwriting norms. Says Andrew Cartwright, appointed actuary, Kotak Life Insurance Co. Ltd: “Mortality costs have risen slightly so that cover can be offered to most clients without going for medical examination. Most insurers have relaxed underwriting because at lower commission the intermediary is looking for greater ease of sale. The insurance companies have accepted higher risk in exchange for a slightly higher premium.”
The impact on returns
While, on the one hand, the cost of insurance in a Ulip has increased, on the other hand, term plans have slashed their premium rates since most plans are now offered online and are able to do away with distribution and administrative costs.
As a result, the MF-term combination has become a clear winner, especially if you are choosing higher cover. In the same example, for a premium of Rs 1 lakh and a sum assured of Rs 50 lakh, a 35-year-old would be richer by Rs 5.06 lakh at the end of 20 years if he buys a term plan and invests the difference in an MF. Even with a basic cover of Rs 10 lakh, the combination stays ahead for 19 out of 20 years; the Ulip outperformed only in the 20th year by Rs 83,375.
We even sampled three type 1 Ulips—the MF-term combination fared better for a higher cover in terms of returns. In one of the type I Ulips, for a premium of Rs 1 lakh and a sum assured of Rs 50 lakh, a 35-year-old would get Rs 44.96 lakh at the end of 20 years, assuming the fund grows at 10%. But with the same set of assumptions, in an MF-term combination, you would be richer by Rs 2.06 lakh. Adds Cartwright: “In the earlier Ulips, the minimum sum assured was five times the premium. This meant that the risk was normally only for the first five years because after the fifth year the fund would exceed the sum assured. But now the minimum sum assured is 10 times the premium paid and the risk is for close to 10 years. As a result of this, the total mortality costs in a type 1 Ulip has gone up by around four times.”
What to do
Despite the regulatory whip, Ulips have become expensive products and as a general rule, you would do better by keeping your insurance and investment needs separate. Says Sanket Kawatkar, practice leader (life insurance), Milliman, an actuarial and consulting firm: “If protection is your main motive, then Ulips defeat the purpose. Go for a term plan. That is the best product to have.”
But if you must buy a Ulip do your due diligence first. A quick calculation indicates that when the overall cost of a Ulip conforms to the cost cap of 2.25% for a term of more than 10 years, Ulips outperform mutual funds over a term above 10 years. But don’t look at the published rate of return, which will always conform to the cost caps since it excludes mortality costs, service tax and any cost of offering a guarantee. Go through the fine print to know what cost heads are excluded from the calculations. Some insurers following good practice will also publish the actual rate of return that includes all costs.
See the illustrations carefully and ask your agent to give you the net return on your policy factoring in all costs. To find out the return yourself, simply go to the insurer’s website and look for return calculators or browse for financial calculators.
Graphic by Yogesh Kumar/Mint