Traditional Plans or ULIPs – Which is a smarter choice?

29-Oct-2011
Source : Capitalmarket.com

The Indian insurance sector saw a proliferation of customer-centric insurance products after it was thrown open to the private sector in 2000. With the entry of numerous insurance companies and increasing competition in the sector, Unit Linked Insurance Plans (ULIPs), which combined insurance with savings, were introduced as an option to traditional insurance plans, which focused on protection with steady savings.
However, before making the decision whether to opt for a traditional insurance policy or a ULIP, an investor has to understand the principles and the way both these financial instruments operate.
ULIPs
ULIPs provide both protection and savings combined with flexibility to investors. These products are market-linked, and have the potential to deliver higher returns. A ULIP investor has the flexibility to switch funds, determine the amount of investment and withdraw funds partially or systematically. ULIPs also provide the convenience of pliable insurance coverage, which can be increased or decreased at any time. However, the ULIP policyholder needs to be more involved as the investment risk rests with him.
Traditional insurance plans
Traditional insurance plans, which include term, endowment and whole life policies, offer multiple benefits in terms of risk cover, return and safety. Traditional policies are considered risk-free, as they provide fixed returns in case of death or maturity of the term. Investment guidelines also ensure safety of funds with a cap on equity investment.
Traditional Participating plans are the most popular category of traditional life insurance products. Though it is popular in Indian market for many decades now, there is still lack of understanding about these products. Participating plans provides the policyholder 90% share of surplus whereas 10% is the share of life insurer. This sharing mechanism aligns the intent of both the policyholder and the life insurer as high investment surplus will drive higher returns for both parties. In participating plans as the investments are primarily in debt instruments, the returns do not have the volatility generally witnessed in market linked plans. Traditional participating plans are truly protection oriented financial instrument as it has a strong sum assured orientation along with consistent returns.
In a young economy like India, where a large share of population is in 20s and 30s, traditional plans are seen as slow and opaque. There are some myths around these plans.
It is often said that traditional participating policies give inferior returns. But what is not mentioned is that the investment risk is also lower. Therefore the money is invested in bond instruments, but companies may invest up to 35% of the funds in equities to provide positive real returns to customers over the long term.
Participating plans are also seen as less flexible. Empirical evidence suggests that only a very small percentage of customers use flexibilities like partial withdrawal or switch available within unit-linked products. On the other hand even traditional plans offer flexibilities like policy loans and automatic premium loan for short term cash needs and are much more used by policyholders.
Another myth around traditional participating plans is that these are less transparent as no NAV is declared every day. How many Policyholders check the NAV of their plan daily? The answer is none. What do policyholders want to know? The status of their investment periodically; returns on investment at the end of policy tenure, and safety of their capital. In traditional plans there is guaranteed return through pre-defined sum assured know at the time of buying the policy as well as bonus announced on yearly basis.
The biggest advantage is that the traditional plans are less prone to mis-selling because a large component of returns is guaranteed. Bonus history also gives ample clarity on the possibility of future returns. Unlike market linked products, which goes through cycles of volatility, returns are smoothened and hence mis-selling of these products is a lower possibility.
Which product to choose?
After understanding ULIPs and traditional plans it is important to understand the criteria for choosing between a traditional insurance plan and a ULIP. The choice requires considerable analysis, and largely depends on the profile and goal of the investor. The investor’s risk taking ability, which includes her age, income or return expectation is a crucial factor in determining the right choice for him. For instance, a young investor may be more aggressive and opt for ULIPs, whereas an older person within the same income bracket may choose an endowment policy for stability.
How to choose a product?
The selection of the type of insurance product greatly depends on the risk taking ability of the investor. This ability is ascertained through a number of factors, which include the following:
Income
An investor’s future income expectation determines whether to opt for a market linked product or a safe instrument. For instance, if a person expects her income to increase faster than inflation she would invest in ULIPs, which are market-linked compared to traditional insurance plans which assure guaranteed returns.
Age and number of dependents in the familyThe age of an individual and number of dependents is also directly proportional to her risk taking ability. Younger a person is, more time she has to remain invested to average out market fluctuation, hence her risk appetite increases. Similarly if she is the sole breadwinner in the family and has dependents relying on her income, she may not want to take any risk with her savings.
Investment value
The amount of returns one expects from investment is also one of the determinants of choice of product. In case an investor expects substantial returns, she will be willing to take the risk with ULIPs, whereas for moderate but assured returns, sticking to traditional insurance plans would be better.
Type of investor
ULIPs are ideal for an aggressive investor who wants higher returns and is prepared to withstand market volatilities, whereas a traditional insurance plan would suit the requirements of a conservative investor.
Volatility
The kind of volatility an investor is willing to handle also affects her investment decision. Investment in ULIPs may be more volatile than traditional insurance plans as they are directly linked to the market fluctuation.
In a nut shell
Deciding whether to invest in a traditional insurance plan or a ULIP is not easy and best left to the advice of experts such as agent advisors. Knowing one’s risk profile, financial condition, understanding the nitty-gritties of various financial instruments, planning with an objective in mind, goes a long way in making a wise decision.