Many clients I have spoken to have Unit Linked Policies (ULIP) in their portfolio of investments. Clients are either unaware of Term Life policies or believe that they are more expensive than ULIPs. Is this really true? How do we make an apple-to-apple comparison between the two?

A Term Life Policy is a life insurance policy in which the entire premium that is paid by the investor simply goes towards insuring her life and nothing else. In other words the investor will get no money back and is paying purely for insuring her life. To illustrate, the premium paid by a 40 year old man would amount to ~20,000 Rs per annum to generate a cover of 1 cr Rs. over a term of 25 years. i.e. The investor will pay Rs 20,000 every year to the insurer for 25 years and in return will be insured for 1 cr Rs over the 25 year period and will get no money back at the end of the 25 year term.

On the other hand a ULIP is an insurance scheme where in a small portion of the premium paid by the investor goes towards a premium allocation charge (~2% commission expenses for the agent and renewal expense), another portion goes towards a mortality charge(0.1% to 3.5% per annum depending on the age of the insured) to cover the life of the insured, another portion goes towards administrative charges (~600 Rs per annum increasing at 5% per annum), and another ~1% per annum towards fund management charges. After all these charges are deducted, the rest of the money is invested in a fund that is aligned with investors risk appetite and the investor is assigned units in the fund (that is why the term “units” in ULIPs). Typically an investor can generate insurance cover of ~1.25X the premium paid. To generate a cover of 1 cr Rs, an investor will need to pay a premium of 80 lakh Rs. At any point in time if death happens, there will be a payout equivalent to the sum assured (1 cr Rs) plus the money managed under the fund. If death does not occur, then when the policy lapses the investor will be paid only the fund value of the units available under the investor’s account.

In other words the term life policy is a pure life insurance product while the ULIP is an investment linked insurance product. Typically investors believe that a ULIP is better than a term life policy since at the end of the policy term there is no money flowing back to the investor. On the other hand in the ULIP the investor typically gets back all of his money and more (depending on the performance of the fund in which his money is invested). This is typical loss aversion behavior. The investor is averse to “losing” money as he feels that nothing is being returned. Is this an accurate assessment?

To make an apple-to-apple comparison, the opportunity cost of the money being invested in the ULIP fund and the drag of allocation, mortality and administrative charges in the ULIP scheme must be considered. First if we assume the ULIP is a single premium policy. To generate a 1 cr Rs cover, the investor would need to pay a premium of ~80 lakh Rs. We then assume that under the term plan, the investor would need to have first paid off the premium of 20,000 Rs and then invested the rest of the funds (79.80 lakh Rs) into a fund that generates similar return to the fund that the ULIP invests in. Surprisingly if one were to do this analysis, it shows that a strategy of taking a term plan and investing separately works out to be more profitable than a ULIP. In my simulations it shows that for a 40 year old man today, at the end of a 25 year term, the funds invested separately under the term plan (79.80 lakh Rs) would compound to 20.07 cr Rs - this is after taking into account the 20,000 Rs annual premium that will need to be paid to keep the term policy alive. On the other hand the ULIP funds would have compounded to 19.73 cr Rs. In both cases I have taken the invested funds return 15% per annum and have a 1% management fees.

Why this seemingly anomalous difference between the term + separate investment vs. ULIP inspite of “losing” money under the term plan? The devil is in the increasing mortality charges of the ULIP. For a 40 year old man and a sum assured of 1 cr. Rs, the mortality charges are just 0.19%, which is 19,000 Rs in year 1. These charges balloon up to ~1.4% of the sum assured in year 25 (which is 1.4 lakh Rs). In the term plan however the investor pays a flat amount of 20,000 Rs through the 25-year term.

I admit the difference between the two options is not much. However not only are the results opposite of what a normal investor would expect, but also the difference can be magnified if under the term + separate investment option, the investor invests through a DIRECT plan in a mutual fund which can have lower management expenses by as much as 0.5%. In this case the difference in outcomes becomes stark. The term + separate investment option returns 22.78 cr Rs while the ULIP option will continue to return 19.73 cr Rs. I have included an excel file for you to work with and understand how I came to the above conclusions.

Another salient point to note is that for those who are young and do not have a large enough corpus to create a single premium ULIP will be unable to undertake a large enough life cover - since life cover in ULIPS is normally about 1.25X the premium paid. On the other hand for a very small upfront charge, term insurance enables large covers with small premiums. This is very important when young working individuals have dependents and need to cover their lives for the discounted value of their future earnings.

There is no doubt that ULIPs do serve their purpose. ULIPs have benefits when the client wishes to switch between debt and equity funds without any short-term capital gains tax consequences. This acquires even more significance in today’s context wherein the time period over which capital gains in debt mutual funds would be exempt from tax has been extended from 1 year to 3 years. Furthermore ULIPs provide a more disciplined way of investing. Nevertheless from a rational inspection of the two modes of investing, the term policy + separate investment option proves to be cheaper.

It is possible I have made errors in assumptions or calculations. If that is so please feel free to email me and I will have the same corrected.