Unit-linked insurance Product (ULIPs) always remains a major product in any insurer’s portfolio but after the crash in stock market in 2008-09 it started losing its charm. People had seen reduction in their fund value and suffered losses as the major portion of the investments were in equity market. Since people burnt their fingers in the equity market they wanted to invest more in the safer products such as bond or other low risk instruments.
Insurance companies didn’t want to lose their valuable customers just because of market crash so they decided to come up with new a product; a new scheme of ULIP which guarantees maturity payout with the highest Net Asset Value (NAV) that the ULIP reaches in the given tenure and marketed it as highest NAV guaranteed plans. This term usually has a period of 7-8 years. The plan appeared good at its face and soon became popular.
This highest NAV guarantee plan, works on the concept of Constant Proportion Portfolio Insurance (CPPI). This concept is borrowed from the dynamic portfolio hedging strategy; it works on the basis of ex-anti specified minimum portfolio value.
The concept of CPPI was originated in 1980s; this concept was initiated by the work of Black and Perold in 1982 and work of Black and Jones in 1987.
The long term fall of stocks market in 1980s led to the development of this concept but when in 1990s stock market started gaining continuously this concept of CPPI took the back seat.
The concept of CPPI where on the one hand limits the down side in the event of falling stock markets also limits down the growth from the participation in rising markets.
CPPI invests in risky instruments such as equities on one hand and slowly allocate it to low-risk fixed income instrument on the other hand such as money market and bonds to limit the losses from any unfortunate event.
The concept of CPPI works on the following assumptions
- The market trades at low dividend shares
- Borrowing is not allowed
- Short selling is not allowed
- It is possible to buy any number of securities
This strategy of CPPI takes effect during the entire period under the permanent restructuring of the portfolio between risky and non-risky instruments; its permanent adjustments are influenced by multiple factors such as volatility of stock markets and interest rates.
This strategy has some advantages especially in falling stock markets but on the other hand this strategy has many disadvantages such as adjustments can cause permanent portfolios shifts due to high transaction costs and in rising market CPPI underperform the equities.
This concept was originally meant for derivatives to hedge the positions but then insurance companies innovated and adapted this concept in ULIPs in the form of highest NAV guaranteed plans.
This concept in the highest NAV guaranteed plans works in the following way:
Take for instance if a ULIP is launched with the NAV of Rs 10 the fund manager invest 100% of fund in the equities and when its NAV goes, say, up to Rs 16 than he withdraw around Rs 10 from equity and invest it in debt instruments for 6 years with the return of 8% so that the debt investment will accumulate to Rs 16 at the end of the tenure i.e. after 6 years, and he invests rest Rs 6 in the equities; and if in the next year if NAV goes to any amount higher than Rs 16 he invests invest more fund in debt instruments eventually it will become a debt product.
In the long term equities will give you the return of at least 12-15% while debt instruments will give you the return of 6-8%. So this highest NAV plan being invested in equity and majorly in bonds it can fetch you return somewhere around 8-10%. These plans will also limit the fund manager to diversify the portfolio and hence limit any upside movement from rising stock market. So this plan gives you better returns but not best return.
This plans even have higher transaction cost as there is additional guarantee charge of 20-30bps.
The caveat with this plan is that it guarantee the highest NAV only if the insured survive till the end of the tenure otherwise if he/she dies or surrenders the policy during the tenure then the payout will be based on prevailing NAV.
Overall this is not a very good product to buy because you are not availing the full benefit of equity market. And if you want to take the benefit of equity market then you should invest in normal ULIP or in a combination of Mutual Fund with Term Insurance products.