Wednesday, June 17, 2009

Keep your investments separate from insurance. Know why

To an average individual, an ‘insurance’ policy is something you get returns from, not something that insures your life. Returns generated, flexibility of investment options and plans are talked about as if they are the essence of insurance. Unfortunately this is far from the truth – insurance still is very much about, and only about, covering your life! In the long run, relying on an insurance product to give you returns could be fairly counterproductive and even value destroying.

Say you are a person who is very risk-averse. Naturally, you need to be satisfied with lower returns in this case. The best ‘investment’ products for you, though they may not sound sophisticated enough, are still the good old bank fixed deposits, the PPF, the NSC and debt mutual funds. These can easily earn you double the returns of an insurance policy like an endowment plan or a whole-life plan. And if some agent comes and recommends a ULIP in such a case, this is probably worth complaining to the authorities – ULIPs are equity linked products and are risky. They are not at all suitable for a risk-averse person like you.

But say you are the more adventurous investor. Possibly you have age on your side and hence feel confident of being able to take on more risk, in the expectation of higher returns. This is a perfectly valid position to take, but now comes the next step of comparing products.

ULIPs or Unit Linked Insurance Plans offered by a majority of insurance companies provide the benefit of capital appreciation by investments in various schemes in debt and equity markets. Although this sounds like a good idea, the high costs associated with such complex products bleed you dry immediately after you pay the first premium. Worse, since you have taken the maximum loss the moment the first premium is paid, it does not matter if you choose to discontinue later – the company and salesman have already made their money from you. “More complex the product, higher is the associated cost” – is a good axiom to always keep in mind in such matters. A simple mutual fund or even a few blue-chip stocks would get you much higher returns and keep your portfolio simple to understand.

A brief comparison

For the more mathematically inclined among investors, a brief comparison would be needed to convince you of the statements made above. Let us compare your corpus and insurance cover in two cases:

Where you opted for a ULIP
Where you invested in a mutual fund; and took a term cover on your life
We have taken actual ULIP and mutual fund schemes for the following comparison.

Assume amount paid yearly is Rs. 1 lakh. Age = 24 years. Life cover = Rs. 10 lakh

Thus, ULIPs carry almost a third of additional cost. There are several other disadvantages, as mentioned below

Highly illiquid: Switch over between ULIPs of different insurance companies is not possible in case their performances are below par. Worse, most ULIPs do not even disclose details about their fund management and their portfolio to the investors
Death benefit: In case of ULIPs, policy holders gets either the sum assured or the value of the units s/he holds, whichever greater in case of death. In case of mutual funds + term insurance, one avails the benefits of both; fund value and the sum assured in case of death. Some ULIPs offer both these benefits, but their costs are even higher than mentioned above
Costs knocked off straightaway: The moment you enrol for ULIP and pay the first premium, the worst is behind you. The structure ensures that the costs are heavily front-loaded and hence an investor who exits thereafter does so at his own loss
Poorer fund performance: ULIP fund performance has been far from satisfactory in general and has often lagged behind the market. It is not uncommon to see investors who put money in ULIPs over the last calendar year and find their portfolios down to 30% of their investment – thanks to a 30% cost loading, and a 50% knock in fund value in the recent market crash
Undoing the damage

Say you have already enrolled for a poorly thought-out insurance product. Let us examine the best options to optimise your future cash flow, without worrying about the losses of the past:

If you have entered an endowment or a whole-life scheme, you can typically salvage most of the premiums paid, and earn a basic return after five years of enrolment. Five years is the best time to exit such a policy if you have a long earning career ahead thereafter. In this case, you can invest the proceeds in more carefully chosen equity related instruments so that your upside potential is higher.
Is you have entered a ULIP, unfortunately the worst is behind you and you cannot do much. Unless you are an active investor in the markets, you would be better off continuing the ULIP for the rest of its life. Needless to say, the agent may approach you after the lock-in period recommending you switch to a ‘better’ ULIP, but now you should know better! There is one to-do however - track the fund performance of the ULIP closely. If it underperforms the market by more than 5% points, you should exit after the lock-in period and go for a good mutual fund.
- Ramganesh Iyer


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