The world of ULIP is the most fascinating one for those who have a stronger risk appetite. It provides a means for individuals to participate directly in the prosperity of the country’s economy. Spreading the investment risk and tax advantage of insurance investments are the added advantages the ULIP investors enjoy. Before going into the details it is important to understand few of the basic concepts of ULIPs.
Savings versus Investment
Though savings and investment are the two facets of a single economic activity of a human being the concept of investment amongst them is comparatively of recent origin. And it is quite interesting to know that how a docile habit like savings gave rise to an instinctive activity like investment.
The transaction of money or money’s like (may be called the modern economic activity) started immediately after the beginning of civilization but the crude form of economic dealings were there with the human beings and the barter system was a visible sign of men’s economic activity in its rudimentary stage. Savings was a basic human instinct and it was there in the human race long before the modern man took birth.
It was in the form of cattle, land and other possessions to start with and the philosophy of “keeping something for the rainy day” is not specific to humans but a natural instinct in the living beings which is amply visible even in tiny ants! Probably men would have learnt it from the animals when he observed them keeping excess catch hidden in hollow of the tree trunk or the cave they were living in.
But when life became more complicated with commencement of money transactions and the ease with which the money could change hands made men think of a place where the money could be kept safely. During those days, getting back the money so kept was important to him than the additional amount he would get on such money. Safety of the wealth was of primary importance. This led people to think of safer heavens like land, gold and the like. Appreciation in the value of such wealth, though welcome, was not primary.
When institutions like banking started, it added a new angle to the concept of savings. From hoarding the money at home or burying wealth underground people started believing in outside agencies and started entrusting their wealth to others.
The bankers apart from keeping their money safely showed them that their money can earn them additional amount by way of interest. Though small was the amount, people were attracted to the banking system because of convenience of operation and the security attached to it.
Shift from Savings to Investment
Presence of an element of risk in investment distinguishes it from savings. The risk element in investment makes the quantum as well as the time of receipt of return uncertain whereas in savings the amount saved and the return – if any – on the same are fixed and known in advance. In spite of being aware of this deficiency people’s preference shifted from only savings to savings cum investment.
The concept of return of investment conjugated with that of return on investment. They showed interest in taking little more risk in return to higher returns. They got ready to barter safety for additional return. Risk and rewards combine has sunk into the psyche of the investing public and paved the way for revolutionary changes in product designing and decorating.
The advent of stock market provided additional spread to the canvas. Today, motivated by the risk appetite of the investing public, futures and options based not only on the prices of products and commodities but also on the stock market indexes are traded, virtually reducing the whole deal into gambling.
Whether the risk appetite of investing public are the reason for the advent of these kinds of products in the market or the provider’s over enthusiasm in bringing out innovative products motivated people to take risk is a million dollar question for which answer lies in obscurity.
All said and done there are good number of persons who are ready to take risk on their investment and equal number of product providers who are ready to cater to this greed with their innovative products.
Insurance – a Savings or an Investment?
Insurance in its pure form is neither an investment nor a savings. Term Insurance is just an indemnity and equal to the quantified loss. The other form is Pure Endowment where no indemnifying but pay back the amount (premium paid) on survival.
But men were not happy with these simple, basic products. Neither the providers were very comfortable in selling only risk products. This gave rise to the designing of hybrid products where pure insurance (term insurance) and pure endowment were blended in different proportions.
With this people started looking for some return on their money. Insurers while charging some amount for that started declaring bonus on policies. But soon policyholders found this meagre return to be insufficient. They started feeling that their money is worth little more.
And exactly at this point of time market was abuzz with several investment products like units of unit trusts and investment trusts (collective investment) stocks of different hues in the capital market (individual investment) and a hoard of debt instruments corporate bonds and government bonds). All these were promising higher rate of return, the debt instruments offering guaranteed returns.
Buy Term and Invest the Rest
When investment opportunities were aplenty people started looking forward for greener pastures where their money can grow faster. And this gave rise to a popular slogan called “Buy term and invest the rest” in the advanced countries during late sixties and early seventies. Insurance conscious people became crazy of Term Insurance and the rest of their disposable income started going to investment products thus making the Insurance Company’s kitty poorer.
The situation became so serious that insurance companies had to work out strategies to retain their customers and their money. At this stage the Insurers concept of hybridising the product took a further leap. The result is ULIP. In a ULIP minimum amount required to cover mortality cost and administrative expenses is taken out of the premium paid by the policyholder and the rest is invested in investment products, often choice being given to the investor to choose his portfolio.
Thus Insurance companies were partly successful in retaining the customers and their mind share, of course, their pocket share included. There was a scope for enormous growth but chance of losing investment also. But people accepted the fact that risk and reward go together.
By the turn of the century the fancy of the investing public had taken a full turn and people started looking for some safety for their investment and the accrued profits which was absolutely lacking in the traditional ULIPs. Usually in any ULIP the underlying value is determined by the NAV at any particular point of time irrespective of the value of investment on any earlier days.
Investors started looking for some guarantee for the growth their investment has earned. The trigger came from the Mexican fiasco. (In the mid eighties Mexican economy was booming. All the Fund Managers in Europe and America rushed with their huge funds to that country and one point of time the annual growth rate of the funds was more than 200% making everybody connected to that smile.
And suddenly, within a couple of years of the boom the economy busted and the investment not only lost all its growth but started showing negative growth thus posing the risk of losing even the original investment. The hit was so severe that investors started crying hoarse about this gambling by the providers.
This led the provider to think of hybridising the product again. They thought of designing a product where the guarantee of accruals on a traditional with profit endowment and the growth potential of a unit linked plan are combined. The result is Unitised With Profit policies. In simple terms this hybrid policies work like this.
The policies are issued in units but the value of the unit will be constant at say $ 1. Whenever the value of the fund increases, a comfortable portion of that is converted into number of units and added to the policy. Annual bonus addition also takes place in the same way. This ensures that the growth on the policy is protected to some extent.
ULIP – As a Product in the Modern Insurance Market.
ULIP as an Insurance product is comparatively of recent origin in the world market but as soon as it came in to the market it met with tremendous success in catching the attention of the buyers, market and the marketing men and it continues to do so even today. It is not a different story in India.
Though its entry was little late once it made an entry it took no time for the product to win over the Indian market too. It is true that it took long four and a half decades for the insurance monolith with whose name the life insurance in this country is intertwined to come out with a product.
Not that LIC as the only Life Insurer in this country during the second half of the last century was incapable of bringing out a ULIP product but the lack of investment opportunity for the huge funds it would have mobilised through those products and lack of matured stock market have frustrated earlier efforts of the Corporation and made the gigantic insurer to hold back its project and it had to wait till the opening up of the industry.
Once the insurance behemoth made up its mind and jumped into the fray the response it got from the investing public was overwhelming and success tremendous. It sent ripples in the market. Rest is history. It was the testimony for the Corporation’s organisational prudence, investment expertise, customer concern and efforts to do justice to the trust the public of this country has reposed in the corporation.
Product Construction
The construction of the product distinctly differentiates a ULIP from that of a traditional with profit policies. One of the very serious complaints against the traditional policies is its non – transparency. This is taken care in ULIP very well. People were calling the with profit endowment policies as` cheat policies’Â because at no stage the policy holder was informed about the expenses incurred under those policies and how the bonus is declared.
All these and many more deficiencies of the traditional policies are addressed in ULIPs. The expenses are deducted up front and made known to the policy holder in advance. The growth or otherwise of the money paid is made known to the policy holder then and there through daily declaration of NAV.
And the most redeeming feature of a ULIP is the freedom it offers to the policy holder as far as the investment choice is concerned. He can exercise the option of investment funds offered by the insurer depending on his own risk appetite.
NAV: Net Asset value is a concept specific to all unitised product. At any particular point of time the underlying value of the total fund (value of units put together) is found out as per the prevailing market value and that amount is divided by the number of units in that fund at that time.
The value so arrived is the value of each unit and is called Net Asset Value. For all practical purposes this is the money available for the policyholder on each unit he is holding. This is the rate at which units are allotted to the buyers of the units in the scheme. Bid Price and Offer Price: Bid price is the price at which units are encashed from the fund. Whenever the policyholder wants to take back the money in full or in part this is the value he gets per unit. Whereas the offer price is the one at which the units are purchased from the fund.
Usually there is a difference (maximum of 5%) between the bid and offer price, the later being higher. This margin is accounted for expenses by the fund manager. But currently in Indian scenario there is no bid offer spread meaning that the bid price and the offer price are same. The charges otherwise recovered through this are managed elsewhere (through higher allocation charges)
OFTEN THE NAV GROWTH IS PRESENTED AS THE GROWTH OF THEIR CONTRIBUTION TO THE CLIENT’S. IN REALITY THIS IS THE GROWTH OF THE CLIENTS CONTRIBUTION NET OF CHARGES. That means the real growth of clients money is lesser than the NAV growth. The charges play a major role here.
Allocation Rate: This is the percentage of the contribution which goes for investment. Higher the allocation rate higher is the amount available for investment and advantageous to the policy holder. This is at times indicative of the strength of the insurance company. Financially and structurally strong companies can manage with lesser margin for their expenses and give higher rate of allocation to the policy holders.
Charges: Out of the contribution the amount at the rate of allocation is invested and the rest is taken out to cover various expenses of the company including mortality charge (risk cover) wherever applicable and called allocation charge. ULIPs are front end loading policies and the charges are taken upfront and made known to the client beforehand. He will have an opportunity to compare it with other companies and make a considered decision. Lower the charges better will be the units allocation and indicative of the strength of the company.
Lock in period: This is a special condition attached to ULIPs. And it is imposed with an intention to prevent misuse of the provisions of premature withdrawal on the policy. In the beginning there was nothing like a lock in period. But, while exercising this freedom policyholders did everything to use, misuse and abuse the provision – at times – with the connivance of the provider.
Then regulators stepped into the scene and imposed a specified lock -in period. It was one year to start with and increased to two and it is three years now. During this period the policy holder cannot close his policy. Even if he decides to stop the premium payment in the middle, he has to wait till the lock in period is over to take the money.
Premature withdrawal: Unlike conventional policies there is no concept of surrendering in a ULIP and one need not wait till the date of maturity of the policy to take the proceeds. It is only withdrawal. After the lock in period policyholders are free to take away their money any time in any quantity. No penalty for early exit. Units are encashed at prevailing NAV and paid to the policyholder. The fund gets reduced to the extent of the units so encashed.
Provider
Solvency Margin: As far as the insurance providers are concerned an essential regulatory requirement is to provide for the solvency margin. This is the proportion of assets the insurer has to provide separately to bridge the gap between liability as per the risk they underwrite and the actual assets they own.
In the conventional type of insurance this margin is very huge and the amount they have to provide for causes strain on their operations. But on the other hand in a unit linked policy the margin to be provided thus is minimum and that makes the insurer comfortable.
Investment Risk: When the option is given to the ULIP policy holder to choose the fund in which his money shall be invested the insurer- theoretically – absolves himself of the investment risk. Thus the investment risk is passed on to the customer and Insurer need not bother much about the returns to the policy holder – at least technically.
Caveats: Though the solvency margin requirement is less, most of the fund raised by way of premium is not available with the insurer because the money so raised has to be invested immediately as per the wishes of the policyholder, in other than the funds on which the insurer has the absolute control. This in turn reduces the freedom of the insurer.
Though it is told that the investment risk is passed on to the policyholder the Insurer has an obligation to be prudent in investment and provide best possible return to the policy holders because this is how the company earns the customer confidence. For an insurance company customer confidence is of utmost importance to survive in the market.
Customers today are highly demanding and have high expectations. It is a business imperative for an insurer to meet those demands. Insurer should be very innovative and intuitive in investments so that in the otherwise competitive market he is able to satiate the never ending thirst of the investors. For this he should have the latest capabilities in technology as well. Then only he will be able to hold on to his market share.
The Distributors
Intermediaries in insurance selling play a vital role. Because of the technical nature of the product and its intangibility the presence of the intermediaries is indispensable. Buying public have realised this and hence there is minimal sales where the intermediaries role is not there.
That is why if there is any use, misuse or abuse of advisory process, insurance advisors are targeted and made responsible. And introduction of ULIPs added to the woes of the advisors. One, because of the nature of the product which – even now advisors feel – is alien and not very comfortable in explaining nay understanding it.
And two, the undue pressure from the provider to push the product in the market. The final outcome is misuse and abuse of the product which in industry parlance is called wrong sales. The first thing regarding the miss sale is about the exaggerated growth projection. In spite of regulatory restrictions the practice takes place with covert connivance of the insurer.
Knowing fully about the greed of his customer about instant realisation of riches the unscrupulous financial advisors play effectively on the emotions of these gullible customers and project the growth in the way in which it suits both of them.
Even in such kind of projection there is no uniformity. Different places same advisor may give different projection depending on the gullibility and ignorance of the customer. Even the projection stipulated by the regulators (5% and 10%) has no sanctity because they are only hypothetical situation indicative of the returns on the invested money and not guaranteed.
An advisor may ask “when even the projection given by the regulators is not guaranteed, what is wrong if we give a projection assuming a higher rate of return too with enough caveats to help the customer make an informed decision”(ultimately it is not impossible!).
This has led to a situation where the projection goes according to the advisors’ fancy and directly proportionate to the ignorance of the prospect. Rules and regulations are to be followed both in letter and spirit- true, but in a multi layered society it is very difficult to monitor at micro level.
But it goes without saying that our advisors should exercise constraints and be prudent while selling a highly risky plan like ULIP and conduct themselves in a dignified way as if they are rendering the advice to themselves.
Market
No sooner the product was launched whether in the world market or in Indian market, the ULIP caught the fancy of the public quickly. Though it is said that the customer decides about the shape of the product, in reality the provider shapes the fancy of the customer by innovative products and attractive features.
The same thing has happened in case of ULIPs. Added to that many a times the extensive advertisement and publicity too help creating hype in the market. To some extent the aggressive sales force also contributes its might (of course, at times by compulsion). Ultimately these hapless salesmen take the blame for the erratic and irrational reaction of the market to a specific product.
When ULIP products were introduced the market has reacted very erratically and irrationally. It is very difficult to say whether the kind of hype seen was a result of providers going overboard in pushing their products or the perceived possibility of high growth potential of the product. However either of them or both have driven the market crazy.
Flexibility
One of the unique features of ULIP is the flexibility it provides. Unlike the traditional policies the policy holder need not surrender his freedom once he takes the policy. Following are the freedom:
The freedom to choose the fund: The insurer offers several fund options each fund consisting of different risk profile. They constitute mainly Risk or Growth fund where major portion of the investment goes to equity and related products.
And as usual is risky. Next one is the Balanced Fund where the investment is distributed in equity and debt market related instruments in a balanced way. The third option is a Bond Fund where most of the investment is done in money market instruments and lesser portion in debt instruments with least or no part in equities.
The insurer may vary the proportion of the constituents and formulate any number of funds and offer it to the policy holders. While buying a policy the policy holder is given the option to choose any or all of the funds available under that plan and can opt for a specified percentage of his investment to go to a particular fund depending upon his risk appetite.
Switching: Once the policy is issued the policy holder can change his investment from one fund to the other and this is called switching. In a year a particular number of switches are allowed free of charges and beyond that the policy holder has to pay a cost for such switches.
Depending on the market conditions and scrupulously following the movement of NAV one can make prudent moves and make profit. But, in switches the value realised from the existing fund as per its NAV is used to buy the units in another fund at the prevailing NAV of that fund. In the process there is possibility of losing some number of units but not value.
One general principle about ULIP is, when the equity market is in the boom it is prudent to enter into ULIP through a Bond Fund and during weak market through equity oriented funds. And it is the same principle while switching funds. It works like this. Suppose you are investing Rs1000 net of all charges each in a Bond Fund and a Growth Fund.
Assume that the NAV of Bond Fund is Rs.10 and Growth Fund is Rs.20 you get 100 units in Bond Fund and 50 units in Growth Fund (Total of 150 units). After some time NAV of Bond Fund becomes 12 and that of Growth Fund Rs. 40. If you feel that there is an indication that the capital market is going to enter in to correction mode (which is reflected in the indicative reduction in the NAV) this is the right time to switch from Growth to Bond.
At the prevailing rate, for 50 units (50×40 =2000) in the Growth Fund you will get 167 (2000/12 = 167) units in Bond Fund. Total number of units you will have now is 267(all in bond fund). Wait for an opportune time till you feel that the equity market is about to start its rally, again switch from Bond Fund to Growth Fund.
It is likely that the NAV of Bond Fund at this time shall be more than that of your last switch (let us say – now it is Rs15.) This helps you to realise higher amount (267×15=4005) and this in turn will get you higher number of units in growth fund. (If the NAV of Growth Fund is Rs 25, you will get 4005/25=160) Compare it with the total of 150 units held in the beginning. (Example is worked out only to show how the switching works and may not reflect the real situation which could be quite different from this) You can repeat it any number of times.
It may be noted that the rally and the correction in the equity market and the corresponding movement in the NAV of the equity linked Units are cyclical and can be predicted with some amount of certainty.
It is the common knowledge that when equity market goes up the bond market goes down and vice versa. The NAVs of Growth Fund and the Bond Fund also react in the same way. A prudent investor uses the switching facility to his maximum advantage and increases the value of his policy.
Rupee Cost Averaging: When anyone buys a ULIP in a fluctuating market a concept called `rupee cost averaging’ should dictate his judgement. It means your contribution will buy fewer units when the NAV is more (during market rally) and more number of units when NAV is less (during market correction).
In effect it evens out the cost of acquiring units in the long tenure of the policy. But on the other hand if any one buys a policy when the NAV is the least (when the market is in low – a very difficult situation to identify) and one has reasonable ground to think that market may not slide further, it is prudent to go for single investment.
Apart from getting units at a lower NAV it is also a fact that the charge on the single investment is lesser. Both of these – the lower NAV and the lesser charge – enable one to get higher number of units as compared to regular investment.
Premature Closure: As already explained ULIPs provide an opportunity for the policyholder to close the policy anytime during the policy after the initial lock in period without any surrender penalty. This is the greatest boon to an ordinary policy holder because he can time the market and get best investment value out of his policy. Of course, by this act, the policyholder running the risk of losing the valuable life cover cannot be ignored.
Conclusion
In conclusion it can very well be said that properly used the ULIP is a good tool for the insurance companies to garner market share by offering flexible products with competitive returns, for the insuring public to get life cover at a cheaper rate and an opportunity to participate in the prosperity of the economy and for the advisors an easy sale.
But one thing to be remembered by constituent is that in their enthusiasm to excel they should not get in to the overdrive mode in their respective activity. Overdoing by any one of these stake holders will be detrimental to their own interest and dangerous to others.
The irreparable damage that may be caused can be so severe that the whole world will lose faith in the product, the provider and the market and the ultimate result will be the ULIP becoming literally the wonderland of the poor little girl Alice as in the famous epic `Alice in Wonderland’
By: P. P. Upadya, (Retired Senior Divisional Manager L.I.C), Bangalore, Published in Life Insurance Today, March, 2011
