ULIPs: Optimal to slice insurance-investment decision

ULIPs: Optimal to slice insurance-investment decision



The Insurance Regulatory and Development Authority (IRDA) recently issued a circular, capping insurance companies’ charges on ULIPs.

Some in the industry claim that this measure will make ULIPs more attractive for the investors. The question is: Are ULIPs optimal investments?

This article explains the structure of ULIPs. It then shows why ULIPs are not optimal within a core-satellite portfolio framework. Investors may, hence, be better off slicing their insurance and the investment decisions.
ULIP structure

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.

IRDA’s recent circular caps these charges. The question is not whether this decision makes ULIPs attractive. Rather, the question is whether the structure itself is optimal.

And for this, we move to the alpha-beta separation in portfolio management. The investment management industry has matured so much in the last decade that portfolios are increasingly being split between beta and alpha exposure.

The beta exposure is constructed to deliver benchmark returns.

The alpha exposure is structured to deliver excess returns over the benchmark.

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.

The argument against ULIPs rests on this structure.
Investment-insurance slicing

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. Here is why.

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.

Consider next the costs. ULIPs typically carry front-load charges. It is argued that such high front-end charges even out if an investor stays with the ULIP for a long term. But what if the market performs well in the first few years? A policyholder cannot take advantage of the market uptrend, as the benefit of compounding when more money is invested in early years is lost.

Some argue that ULIP’s structure to cancel fund units to pay for the risk cover is beneficial to investors. Even assuming that investors cannot replicate this structure, buying ULIPs for this purpose is paying a huge price, as it sacrifices on the investment flexibility.
Conclusion

Insurance is a hedge for mortality risk. Separating the insurance decision from the investment portfolio could lead to optimal choices. Insurance companies have to offer meaningful choices for ULIPs to be considered optimal investments. The current structure certainly does not fit well within the core-satellite framework.