ULIP’s —Type 1 Or Type 2?

Already deluged by complex insurance terminologies and obscure benefits, the last think Life Insurance buyers want is to contend with yet another piece of jargon! And yet - it's critical for ULIP buyers to know the difference between the two types of policies that exist in the market today, namely - Type 1 and Type 2. And more importantly, which one scores of the other?

Admittedly, ULIP's are a reformed lot today compared to their heydays of the early 2000's when buccaneering bankers originally made them a mega success. Their inbuilt costs are significantly lower, and their fund returns have been reasonably up to the mark in recent times too. Ironically, though, their market share within the overall premium pie has fallen off a cliff in recent years. In case you're interested, there's more on this baffling trend in this article:

Anyway, back to the point on Type 1 or Type 2 ULIP's. To understand their distinction a little better, we'll need to make a quick journey into the very structure of ULIP's themselves.

ULIP's ostensibly combine "insurance and investments" into a single product that solves both purposes (a debatable claim, mind you!). What this essentially means is that the premiums that you pay (post the deduction of commissions paid to your agent) are divvied up between the pool of money that serves to pay death claims, and the pool of money that is invested into securities such as stocks and bonds. Intuitively, the allocation to the former pool will be higher if the sum assured (read: the value at risk for the insurance company) is higher. For instance, the portion of your ULIP premium that goes towards covering risk will be a lot more if your sum assured is Rs. 50 lakhs than if your sum assured is Rs. 5 lakhs.

Here's where the difference between Type 1 and Type 2 ULIP's come in. Type 1 policies will pay your dependents the higher of the sum assured and your accumulated fund value, in case of your unfortunate death. Type 2 policies, on the other hand, will pay out the sum assured PLUS the accumulated fund value in such an event.

Mired in confusion? An example could prove handy at this stage. Let's say you've purchased a ULIP with an annual premium of Rs. 5 lakhs, which has an appended sum assured of Rs. 50 lakhs. If this is a Type 1 ULIP, the death benefit will remain constant at Rs. 50 lakhs till the point that your fund value overtakes the sum assured - at which stage, the death benefit becomes the fund value itself. For instance, if your fund value is Rs. 60 lakhs at the end of 8 years, the insurance company will be bearing no risk at all, since the payout will be equal to the funds that are already accumulated, paid up and held in your name.

For Type 1 ULIP's, the 'value at risk' for the insurance company drops a notch with each passing year and with each subsequent premium payment made by you. For instance, after the first premium payment (assuming a 10% deduction of charges), the value at risk for the insurance company will be Rs. 50 lakhs minus Rs. 4.6 lakhs, or Rs. 45.4 lakhs. After the second premium payment of Rs 5 lakhs, the value at risk will drop by another 5 lakhs, and so on.

As the value at risk for the insurer drops, so does the mortality cost, or the cost of transferring the financial risk of your loss of life to the insurer. Many hapless ULIP buyers aren't even aware that each year, this mortality cost is deducted from their fund value as cancelled units! Only when they scrutinize their statements do they realize this. (Check your last statement quickly if this is you)
Because the number of units getting deducted in lieu of mortality costs drops year on year in Type 1 ULIP's, the actual quantum of money that finds its way into the investment pool is higher - which is why they have a higher chance of providing you with a higher fund value at the end of the ULIP term.

For Type 2 ULIP's, on the other hand, the value at risk for the insurance company does not go down with time, as they will be paying your nominee the sum assured PLUS the accumulated fund value in the unfortunate event of your death. If anything, it goes up with each passing year, as the probability of dying goes up with every passing year (sorry to put it so crudely, but that's how insurance companies view it!).

Going back to our previous example, if your accumulated fund value is Rs. 60 lakhs at the end of 8 years, the death payout in case of a Type-2 ULIP will be Rs. 60 lakhs plus the sum assured of Rs 50 lakhs, or Rs. 1.10 crores (compared to 60 lakhs for a Type 2 ULIP). However - the final fund value will naturally be a lot lower, because the cost of providing the additional death benefit of Rs 50 lakhs will continue to get deducted from your kitty year on year.

End Note: As is the case ever so often with financial instruments, there's no 'one size fits all' answer to which variant, product or solution is best for you. Your decision must hinge on your unique financial priorities and money goals. For purely providing you a better death benefit (the actual purpose of insuring your life, which is so inconveniently forgotten by most), Type 2 policies score. For creating more wealth, Type 1 ULIP's work better. As a purist, I would opt for the Type 2 variant, since it makes for a better risk transfer tool. Some may beg to differ.