Planning your child's future

Though insurance is ideally seen only as a "protection tool", many investment-oriented products from insurance firms have caught the fancy of investors. Child insurance plans is one among them. These are promoted as ways that help parents fund their children's needs such as education and marriage. Usually under such plans, the parent is the insured person and the child is the beneficiary.

The two broad categories of Child Plans are:

Traditional plans such as endowment plans or money back plans: The proceeds from these may either be in lump sum (as in endowment) or as installments over a number of years (as in money back plans). Here, the proceeds will have two parts: (a) The basic sum assured which is payable to the beneficiary either on policy maturity or on the death of the insured. (b) The bonus component, which depends on the amount declared by the insurance company each year, is accumulated over the years and is paid out at in the final year. The premiums received under these plans are invested in debt instruments such as government bonds. Such policies are easy to understand. However, as they lack equity component, they do not really serve the purpose of creating wealth in the long term.

Unit linked plans (ULIPs): These policies became popular recently. The premiums received herein are invested in equity and/or debt markets, depending on the policyholder's preference. Here, there is usually no guaranteed bonus on the part of the insurance company and the entire investment risk is borne by the policy holder.

Benefits of ULIPs Vs traditional policies

There are two major benefits for ULIPs:

Charges and portfolio disclosures are transparent in the case of ULIPs.

A policyholder has greater flexibility in choosing the investment options compared with traditional policies. Switching between options is also possible.

ULIPs Vs diversified mutual funds

So how do these policies fare compare with mutual funds? After all, investing in these policies means that you are believing that they are an adequate substitute to mutual funds. This is what I found:

These policies are far more opaque compared with MFs. The Web sites of two of the leading insurance companies (HDFC and ICICI Prudential) contain data up to September 30, 2006, only and not beyond, as they only undertake quarterly declarations. Compared with this, most MFs declare performance data on a daily basis and their portfolios at least once a month.

The charge structure in insurance policies is complicated (as I have outlined above) compared with those of MFs where the maximum charges levied rarely exceed around 4.50-5 per cent. While some defenders of child plans may state that the charges reduce with time, it also means that the policyholder is compelled to stay with a poorly performing fund merely because he has already paid the lion's share of expenses at the outset of the policy.

Returns

On the returns front, a comparison is difficult as ULIPs have been functioning for only around the past three years, unlike most of the well managed diversified equity funds which have been around for much longer. However, certain stipulations on the part of the Insurance Regulatory and Development Authority(such as the seven-year dividend payout rule) constrain the investment universe for insurance companies. Hence they may not be able to exploit many investment opportunities, unlike mutual funds who can do so.

If one takes a couple of examples, HDFC Standard Life Growth Fund (ULIP) has given a return of 1100 basis points per annum over its benchmark (BSE-100) since January 2005 (as per their Web site) while Pru ICICI Maximiser has outperformed the benchmark by around 500 basis points since inception.

Compared with this, HDFC Growth Mutual Fund's returns stood at around 700 bps over the BSE Sensex while ICICI Growth Plan has given returns of around 1200 bps over the NSE Nifty Index. It will be interesting to see how the insurance companies perform during difficult times.

Traditional policies need not be considered as competition, as most, if not all, have given single-digit returns over time.

The final word

There is no conclusive evidence to show that Child Plans are superior for wealth creation. Till such evidence is obtained, I believe that it is preferable to unbundle the insurance and investment activities. Hence I will end by once again suggesting that a combination of a term policy plus a systematic investment plan (SIP) in a good diversified equity fund will serve our purpose in a superior way.

(The writer is vice-president, Parag Parikh Financial Advisory Services)