Insurance Policy - Charges and Expenses

ULIPs work very similar to a mutual fund with an added benefit of life cover and tax deduction. They have a mandate to invest the premiums in varying proportions in gsecs (government securities), bonds, the money markets (call money) and equities. The primary difference between conventional savings-based insurance plans like endowment and ULIPs is the investment mandate- while ULIPs can invest up to 100% of the premium in equities, the percentage is much lower (usually not more than 15%) in case of conventional insurance plans. ULIPs are also available in multiple options like ‘aggressive’ ULIPs (which can invest upto 100% in equities), ‘balanced’ ULIPs (which invest 40-60% in equities) and ‘debt’ ULIPs (which invest only in debt and money market instruments). Broadly speaking, ULIP expenses are classified into three major categories:

1) Mortality charges

Mortality expenses are charged by life insurance companies for providing a life cover to the individual. The expenses vary with the age, sum assured and sum-at-risk for the individual. There is a direct relation between the mortality expenses and the above mentioned factors. In a ULIP, the sum-at-risk is an important reference point for the insurance company. The sum-at-risk is the difference between the sum assured and the investment value the individual’s corpus as on a specified date. Usually, the mortality charges are levied on the per thousand sum assured.

2) Sales and Fund Administration expenses

Insurance companies incur these expenses for operational purposes on a regular basis. The expenses are recovered from the premiums that individuals pay towards their insurance policies. Agent commissions, sales and marketing expenses and the overhead costs incurred to run the insurance business on a day-to-day basis are examples of such expenses.

3) Fund management charges (FMC)

These charges are levied by the insurance company to meet the expenses incurred on managing the ULIP investments. A portion of ULIP premiums are invested in equities, bonds, g-secs and money market instruments. Managing these investments incurs a fund management charge, similar to what mutual funds incur on their investments. FMCs differ across investment options like aggressive, balanced and debt ULIPs; usually a higher equity option translates into higher FMC.

Apart from the three expense categories mentioned above, individuals may also have to incur certain expenses, which are primarily ‘optional’ in nature- the expenses will be incurred if certain choices that are made available to individuals are exercised.

a) Switching charges

Individuals are allowed to switch their ULIP options. For example, an individual can switch his fund money from 100% equities to a balanced portfolio, which has say, 60% equities and 40% debt. However, the company may charge him a fee for ‘switching’. While most life insurance companies allow a certain number of free switches annually, a switch made over and above this number is charged.

b) Top-up charges

ULIPs allow individuals to invest a top-up amount. Top-up amount is paid in addition to the premium amount for a particular year. Insurance companies usually deduct a certain percentage from the top-up amount as charges. These charges are usually lower than the regular charges that are deducted from the annual premium.

c) Cancellation charges  

Life insurance companies levy cancellation charges if individuals decide to surrender their policies before the mandated lock-in period which is usually three years. These charges are levied as a percentage of the fund value on a particular date. The Compounded Annual Growth Rate (CAGR) of the fund goes up over a period of time. This is because the ULIP expenses even out over a period of time. The ‘evening out’ occurs because although the expenses are high in the initial years, they fall thereafter. And as the years roll by, the expenses tend to ‘spread themselves’ more evenly over the tenure of the ULIP. Another reason is also because the expenses are levied on the annual premium amount, which stays the same throughout the tenure. Therefore, the expenses do not have any impact on the returns generated by the corpus. Fund management charges also have an effect on the returns. FMC is levied on the corpus, which keeps fluctuating over the tenure.

The returns also depend to a large extent on how well the insurance company manages the investment. Individuals therefore, need to bear in mind that expenses are an important variable while evaluating ULIPs across life insurance companies. They have the potential to make a considerable difference to the returns generated over a period of time.