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ULIPs: Optimal to slice insurance-investment decision !
A declaration was issued by the Insurance Regulatory and Development Authority (IRDA) recently issued regarding a circular, capping insurance companies’ charges on ULIPs. Some in the industry claim that this measure will make ULIPs more attractive for the investors while some are of the view that this will impose a negative effect. The question here is: Are ULIPs optimal investments?
This article explains the structure of ULIP and then shows why ULIPs are not optimal within a core-satellite portfolio framework. Investors may then utilize ULIP structure to get a broader vision of things.
A ULIP is a life insurance policy, which provides a combination of risk cover and investment. There are typically two kinds of ULIPs — one that pays the higher of sum assured and the fund value to the nominee on the death of the insured and the other that pays both the sum assured and the fund value. ULIPs attract various charges. Insurance companies levy allocation charges for marketing and distribution costs, administration costs, fund management charges and mortality charges for insurance cover.
The allocation charges are front-loaded. This amount is deducted from the total premium and only the balance is invested. Mortality charges are typically deducted monthly by cancellation of the units as are the administration charges. The fund management fee is adjusted on the fund’s NAV. This means that sizable proportion is deducted from the total premium during the first two-three years.
Diversified funds take both beta and alpha exposure within a single portfolio. Typically, beta exposure comes from a largely passive portfolio of large caps, as consistently delivering alpha in this space is difficult. The alpha exposure (along with embedded beta) comes from a small active portfolio of mid-caps.
The problem, however, is that diversified funds charge active fees for the entire portfolio. Separating the passive (large-caps) core from the active satellite exposure (mid-caps) during the portfolio construction process helps investors’ custom-tailor their portfolios for a lower fee.
However there are a few points which impose a negative impact as Investment-insurance slicing in which an investor may find difficult to get the right insurance policy (term insurance with relevant riders) and optimal investment exposure at a reasonable price within a ULIP because Investors have index mutual funds to build their passive core and a choice of style-specific funds (mid-caps and sector funds) to construct their active satellite portfolio. ULIPs typically offer exposure similar to diversified equity funds and bond funds and, hence, do not provide investors the flexibility in constructing their core-satellite portfolio.
Some argue that ULIP’s structure is to cancel fund units to pay for the risk cover which is beneficial to investors. Even assuming that investors cannot replicate this structure, buying ULIPs for this purpose it is paying a huge price, as it sacrifices on the investment flexibility.
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