What is a Unit Linked Insurance Plan (ULIP)?

What is a unit-linked insurance plan? A Unit Linked Insurance Plan (ULIP) is a life insurance product where premiums are split into two components: one for life cover and another for investment in funds like equity, debt, or hybrid. The returns depend on the fund’s performance, so if the fund grows, your investment increases. However, ULIPs come with multiple fees, such as premium allocation charges and fund management charges. Moreover, ULIPs have a 5-year lock-in period, meaning you can't withdraw early without facing penalties.

When it comes to life insurance, many people are tempted by products that offer “double benefits” of both protection and investment. That’s precisely what a Unit Linked Insurance Plan (ULIP) promises. 

The catch? ULIPs come with multiple charges, a mandatory 5-year lock-in, and returns that depend entirely on market performance. In this guide, we’ll simplify how ULIPs work, break down their costs, and weigh whether they’re truly worth it compared to simpler alternatives like term insurance plus mutual funds.

Looking for cost-effective life cover and smarter investments? Compare ULIPs with Term Insurance + Mutual Funds with Ditto and choose what’s best for you.

Unit-Linked Insurance Plan (ULIP): Quick Overview

According to the IRDAI Regulations, 2024, a ULIP is defined as:

“Unit-linked insurance products shall operate by offering one or more segregated funds, wherein each segregated fund shall have well-defined asset categorization along with its risk profile.”

In simple terms, when you buy a ULIP, your premium gets split. One part goes towards securing life insurance, and the other part is used to invest in different funds, like equity (stocks), debt (bonds), or hybrid (a mix of both). 

So, in essence, you’re betting that your investments will grow enough to make the life insurance worth it, with the promise of higher returns and some risk thrown into the mix.

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Still figuring out if ULIPs are worth it? Book a free call with a Ditto advisor and we’ll help you understand the fine print and compare smarter alternatives.

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Now, how exactly does this whole system work?

How Does A Unit Linked Insurance Plan Work?

Let’s break it down with the help of an example.

Let’s say you invest ₹1,00,000 in a ULIP. As discussed above, the premium is allocated in two parts:

• ₹20,000 goes into providing you with life insurance.
• ₹80,000 is invested in funds (like equity, debt, or hybrid funds) of your choosing.

If the equity fund you chose grows at 10% annually, the ₹80,000 invested could grow over time. But if the fund doesn’t perform well and loses 5%, your investment value will decrease.

This is where the "unit" concept comes in. You buy units of the fund(s), and their value (known as Net Asset Value or NAV) fluctuates based on how the fund performs. If the fund is doing well, the value of your investment (i.e., units) grows. If the fund underperforms, the value of your units can drop.

What are the Costs Associated with ULIPs?

Understanding the various charges is crucial for you to evaluate the overall cost-effectiveness of a ULIP. Over the years, the IRDAI has worked to standardize and cap these charges to ensure transparency, fairness, and consumer protection.

1) Premium Allocation Charges (PAC)

Premium Allocation Charges (PAC) are deducted from the premium paid by the policyholder before the amount is allocated to the investment fund. This charge is typically a percentage of the premium and is levied upfront.

IRDAI Guidelines: The premium allocation charges cannot exceed 12.5% of the premium in any year.

2) Policy Administration Charges

Policy Administration Charges are charged by the insurer for maintaining the policy over its term. These fees are levied at the beginning of each policy month from the unit fund by cancelling units for an equivalent amount. They cover administrative expenses, including issuing documents, keeping records, and providing customer service.

IRDAI Guidelines: This charge could be flat throughout the policy term or vary at a predetermined rate of change not exceeding 5% per annum, and the maximum policy administration charge that can be levied shall be ₹500 per month.

3) Fund Management Charges (FMC)

The Fund Management Charge (FMC) is levied by the insurer for managing the investment portion of the ULIP. This includes the cost of managing the assets, including portfolio management, research, and compliance.

The FMC is applied as a percentage of the total value of assets under management (AUM) and is deducted by adjusting the Net Asset Value (NAV) of the fund. This deduction is made daily during the NAV computation.

IRDAI Guidelines: The cap on fund management charge in respect of each of the segregated and funds other than the discontinued policy fund shall be 135 basis points per annum.

For the discontinued policy fund, the cap on fund management charge shall be 50 basis points per annum. In short, IRDAI caps FMC at 1.35% per annum for all funds.

4) Mortality Charges 

Mortality charges are levied for providing life coverage under the ULIP. The charges are typically deducted monthly and depend on factors like the policyholder's age, health, and sum assured.

IRDAI Guidelines: The mortality charges are not capped by the IRDAI, but they must be disclosed to the policyholder upfront, and they should be based on standard mortality tables. These can also be expressed as per a ₹1,000 sum at risk for each age.

In ULIPs, as the person's age increases, the mortality charges levied also increase, but only until the sum assured at death exceeds the investment fund value. If the fund value exceeds a certain threshold, then these charges are not levied anymore. 

5) Surrender/Discontinuation Charges

Surrender charges apply when a policyholder decides to surrender the ULIP before the completion of the lock-in period (typically 5 years). These charges are meant to discourage early withdrawals, ensuring that the insurer has enough time to recover costs and generate reasonable returns.

IRDAI Guidelines: Surrender charges are high in the initial years and gradually decrease as the policy matures. The exact percentage depends on the insurer and the terms of the policy.

6) Switching Charges

Policyholders are typically allowed to switch between different investment funds (e.g., from equity to debt) depending on their risk profile and market conditions.

IRDAI Guidelines: IRDAI leaves it up to the insurer to define the number of free switches available in a policy year. However, the maximum switching charge is capped at ₹500 per switch. 

Note: There are other minor charges in ULIPs as well. For more details, you can read pages 29 to 31 of the official IRDAI circular here.

Ditto’s Verdict on Costs Associated with ULIPs

• In the early years, PACs are high, meaning a large portion of your premium goes towards fees. This reduces the amount that’s actually invested in funds, limiting your potential growth.
• On top of that, FMCs reduce the growth of your investments, shrinking your returns with regular cuts, even if the market performs well. The IRDAI has capped these fees, but even the capped rates can still add up over the years and affect your overall wealth-building strategy.
• Mortality charges and policy administration fees are regular deductions that can feel like a constant drain, especially as you get older. These charges are designed to cover the insurance portion, but when combined with all the other fees, they make a noticeable dent in your returns.
• Let’s not forget about surrender charges, which can be hefty if you decide to exit early. For those who might need liquidity, these charges act as a deterrent, forcing you to hold on to the policy even when the charges outweigh the benefits.

Fortunately, there are benefits that offset the impact of the charges. 

• Loyalty Additions: Some ULIPs offer extra units added to your fund value after you’ve stayed invested for a certain number of years (5-10). These help partially offset the charges incurred.
• Fund Boosters: Certain plans (like ICICI Prudential’s Signature plan and Aditya Birla Sun Life’s Wealth Infinia) offer these or maturity additions at predefined intervals (or on maturity). These are meant to increase your corpus and compensate for FMC and other ongoing charges. However, these are often conditional on paying premiums regularly and staying invested for the full term. 
• Return of Mortality Charges (RoMC): Some modern ULIPs, such as Bajaj Allianz Goal Assure IV, now offer to return the mortality charges deducted over the policy term, either on maturity or at certain milestones. This can be a significant value-add, primarily for investors focused more on long-term investment than insurance.

ULIPs have definitely improved in recent years, and the above benefits can mitigate some of the drag caused by charges, especially for long-term investors. 

However, the fact remains. ULIPs are complex, multi-layered products with multiple charges and conditions. Even with added benefits, the net returns can still lag behind simpler, lower-cost investment options like FDs, PPFs, or Mutual Funds (paired with term insurance for protection). 

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Did these ULIP charges confuse you? Don’t worry, we’ve got your back. Book a free call with a Ditto advisor to understand if a ULIP aligns with your goals or if a more cost-effective plan makes better sense. 

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What are the Minimum Sum Assured and Death Benefit Guidelines for ULIPs? Minimum Sum Assured (ULIPs) For Single Premium ULIPs: 1) Age < 50 years → Minimum 1.25 × Single Premium 2) Age ≥ 50 years → Minimum 1.10 × Single Premium For Regular Premium / Limited Premium ULIPs: 1) Age < 50 years → Minimum 7 × Annualized Premium 2) Age ≥ 50 years → Minimum 5 × Annualized Premium These multiples are the minimum regulatory requirements. Insurers are encouraged to offer higher multiples depending on their underwriting policy and the customer’s risk profile. Death Benefit Floor For all ULIPs, other than single premium options, the minimum death benefit must be at least 105% of total premiums paid up to the date of death. This ensures that the nominee always receives more than the premiums paid, even if fund performance is poor.

What is the Lock-in Period of a ULIP?

In a ULIP (linked life insurance product), there is a mandatory lock-in of 5 years. During this lock-in, the fund value cannot be paid out (except in case of death benefit). If a policyholder stops paying premiums or chooses to discontinue the policy within the lock-in period, the policy is treated as “discontinued.” The money is then moved to a Discontinued Policy Fund until the lock-in ends.

After the lock-in period is over, the surrender value/fund value (minus applicable charges) is payable to the policyholder. These charges are higher in the early years and reduce with policy duration, eventually becoming zero after the 5th policy year.

What is the purpose of the lock-in period in ULIPs?

• To discourage premature withdrawals.
• To allow the insurer to recover high initial expenses (distribution, underwriting, policy issuance) over a reasonable period.
• To protect the long-term investment discipline that ULIPs are designed for. 

These charges typically decrease over time but can be significant in the early years, as discussed in the above section. 

What are the tax benefits associated with a ULIP?

ULIPs offer attractive tax benefits under the Income Tax Act:

• Tax Deduction on Premiums: Under Section 80C (old regime), premiums paid for a ULIP are eligible for tax deductions, up to ₹1.5 lakh per year.
• Tax-Free Proceeds: Both death benefits and maturity benefits from a ULIP are tax-free under Section 10(10D), as long as the sum assured is at least 10 times the annual premium.

Important Update: From February 2021, if the annual premium exceeds ₹2.5 lakh across all your ULIPs, the investment returns are subject to capital gains tax.

Having looked at the foundational facets of ULIPs, it is now time to ask a more pressing question: are there better life insurance offerings in the market? 

Why Term Insurance + Mutual Funds is a Better Option? 

While ULIPs offer both life insurance and investment in one product, Term Insurance combined with Mutual Funds often proves to be a more efficient and cost-effective solution for most investors. Here's why:

1) Lower Premiums for Higher Coverage

Term insurance offers pure life cover at a significantly lower cost than ULIPs, enabling you to secure higher coverage for a lower premium. For example, a ₹1 crore sum assured in a term plan could cost you only ₹12-14 thousand annually.

2) Better Investment Flexibility

With Term Insurance + Mutual Funds, you have the flexibility to choose your investments. You can allocate your money across different mutual funds based on your risk tolerance and goals, without being tied to the insurer’s fund options. ULIPs restrict you to a limited set of funds, often with higher management fees.

3) No Market Risk in Insurance

In term insurance, the life cover is guaranteed regardless of market conditions. In contrast, ULIPs link your returns to market performance, introducing market risk. If the market performs poorly, your returns in a ULIP can be significantly affected.

4) Lower Charges

Term insurance has no hidden charges or administrative fees like those associated with ULIPs. You simply pay your premium for life coverage. In contrast, ULIPs come with premium allocation charges, fund management fees, and administration charges, which can significantly eat into your returns over time.

5) Tax Benefits

Both Term Insurance and ULIPs offer tax benefits under Section 80C. However, there are key differences. Term Insurance provides tax deductions under Section 80C for the premiums paid, and the death benefit is tax-free under Section 10(10D), making it an efficient option for life coverage.

ULIPs also offer tax benefits under Section 80C, but with one key distinction: while the premiums you pay are tax-deductible, the returns from ULIPs are subject to market performance. If you surrender or withdraw before 5 years, you might also incur taxes on the capital gains.

Bottom line? For those focused on affordable life coverage and better investment returns, Term Insurance plus Mutual Funds is a superior choice. It offers higher coverage, lower costs, more investment flexibility, and no market risk on the insurance side, while allowing you to invest your money in a more transparent and controlled manner compared to ULIPs.

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Conclusion: Is a ULIP Right for You?

A Unit-Linked Insurance Plan (ULIP) might seem appealing to many. However, the numerous fees, the 5-year lock-in period, and the dependence on market performance can impact the overall return on investment.

While ULIPs offer tax benefits and flexibility in switching funds, they may not always be the most cost-effective solution, especially if you’re looking for high insurance coverage or low fees. For those seeking more flexibility, lower premiums, and better control over their investments, term insurance combined with mutual funds could be a more suitable alternative.

Ultimately, whether a ULIP is the right choice depends on your long-term financial goals and risk tolerance. Always weigh the costs against the potential benefits before committing.

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