Thursday 25 March 2010

The trick behind - Guarantees in unit-linked plans (Ulips)!

Equity investments are risky. Then how do life insurance companies offer investment guarantees in unit-linked plans (Ulips)? You got it right. There is a catch in Ulip offers that guarantee the payment of highest NAV in the first seven years.

Mutual funds are not allowed by the market regulator Sebi to provide any kind of guarantee to investors either on capital or on investment returns.

But insurance regulator IRDA allows life insurance companies to offer guarantees on their products, even when these are market-linked.

Regulator trouble

So when Sebi asked some life insurance companies why they did not seek its approval before offering market-linked insurance plans, IRDA fielded the question for them. IRDA said life insurance companies were regulated by it and it had approved their insurance plans that had an investment component linked to the equity markets.

Moreover, last week IRDA came out with an aggressive media campaign — “Be wise, Ulip-wise”. This is unprecedented for a regulator because the campaign is for a particular product of entities that it regulates and the product itself is much debated and criticised even by IRDA for mis-selling by agents and high charges.

Insurance companies say they are already selling a kind of guaranteed product in the form of annuities. “At the time of buying an annuity, policyholders are assured of a fixed monthly, quarterly, half-yearly or annual income according to their choice. They get the fixed payment at regular intervals till their death,” said Mayank Bathwal, chief financial officer of Birla Sun Life Insurance Company.

But then, annuities are debt products.

Fine print

Before we understand how life insurance companies provide “the highest NAV guarantees”, we should take note that these Ulips promise payment based on “highest NAV” and not “highest return”. Besides, insurers deduct additional charges from the premium paid for such guarantees.

This guarantee of highest NAV, however, doesn’t offer you an option to choose among various investment funds, such as equity, balanced or money market fund.

Even the life cover and the tenure of such highest NAV guaranteed Ulips are not as beneficial to customers as in non-guaranteed insurance plans. The sum assured offered is generally five times the annual premium and the policy term is 10 years. So, these plans are not only giving you a smaller life insurance, they are covering a shorter span of your life.

What’s the plan?

The investment process followed in these “highest NAV guaranteed” Ulips is called Constant Proportion Portfolio Insurance — a trading strategy designed to ensure that a fixed minimum return is achieved at a set date in the future. This strategy involves a continuous re-balancing of the portfolio of investment between equity and debt — a mix of investment strategies followed by mutual funds in their dynamic asset allocation and fixed maturity plans.

Consider a Ulip guaranteeing payment of the highest NAV in the next seven years that starts today at a NAV of Rs 10. Let us assume that 100 per cent of the allocated premium is invested in equities.

Now, the market goes up and at the end of the first year the NAV increases to Rs 12. This is the highest NAV of the Ulip till now and the insurer has to make sure that the policyholder can be repaid at the end of the remaining six years on the basis of the Rs 12 NAV.

Game of shuffle

The insurer will shift a portion of the equity investment into debt instruments that ensure a return of Rs 12 after six years. If a debt paper maturing in six years is now available at a yield of, say, 8 per cent, the insurer can invest Rs 7.75 in that debt paper to ensure a return of Rs 12 after six years.

In the second year, the markets do down and the NAV declines to Rs 9 from Rs 12. However, the insurer doesn’t need to do anything as the return of highest NAV has been ensured by the debt investment of Rs 7.75.

While the insurer can take the risk of shifting investments from debt to equity to take advantage of the lower price levels in equity markets, he will not do so because the guarantee of “highest NAV” was given to the policyholder.

The investment process followed at the end of the first year will be followed in year three if markets go up and the NAV goes up to the previous highest level of Rs 12.

This reallocation of investment from equities to debt instruments keeps on and as the policy nears maturity, almost the entire investment goes to debt instruments.

Highest NAV guaranteed Ulips thus turn out to be primarily debt-oriented rather than equity-oriented plans — you can expect a gross return of between 8 per cent and 10 per cent on investment. But since there are various charges associated with a Ulip, your net return could be still lower at 5 to 7 per cent.

However, this return will be tax-free. Similarly, you can claim tax deduction on annual premium payments. So “highest NAV guaranteed” Ulips are suited for totally risk-averse people.

Given that the historical return of 12 to 15 per cent (annually compounded) from equity investments over a long enough period of 10 years assumes negligible risks, a non-guaranteed Ulip will give you a higher return.

Besides, guarantees come at a cost. The total cost of these guaranteed Ulips are higher than that in a non-guaranteed product. You get a lower return in a guaranteed Ulip and a higher return in a non-guaranteed Ulip given that both the categories yield the same gross return.

Hence must think about it before investing.

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