Understanding ULIPs: Benefits, Risks, and How They Work

Search Fintrev

Search our guides, reviews and glossary.

A unit linked insurance plan (ULIP) is a life insurance policy in which part of each premium pays for life cover and the rest buys units in investment funds chosen by the policyholder. The policy’s value rises and falls with the net asset value (NAV) of those units, so a ULIP carries market risk that a traditional savings policy or a fixed deposit does not. ULIPs are mainly an Indian product, sold by life insurers and regulated by the Insurance Regulatory and Development Authority of India (IRDAI). Similar “investment linked” or “unit-linked” policies exist elsewhere, including unit-linked pensions in the UK and variable universal life policies in the US.

What a ULIP Is, and Where It Came From

India’s first ULIP was launched by the Unit Trust of India (UTI) in 1971. The product grew rapidly after private insurers entered the Indian market in the early 2000s. Heavy upfront charges and mis-selling led IRDAI to tighten ULIP rules in 2010, introducing the five-year lock-in and caps on charges, including a fund management charge ceiling of 1.35% of fund value per year.

Insurers use the plans for several goals: protecting a family while building savings, funding a child’s education, accumulating money for retirement, or leaving a benefit to descendants.

How a ULIP Works

Paying Premiums

The policyholder pays premiums as a single lump sum or regularly (monthly, semi-annually or annually) for a set paying term. Many plans also accept top-ups, which are extra lump sums added to the fund on top of the regular premium.

From Premium to Units

Each premium passes through a sequence:

1. Premium allocation charge is deducted first, usually as a percentage of the premium.
2. The remainder buys units in the selected fund or funds at that day’s NAV.
3. Policy administration charges and mortality charges (the cost of the life cover) are recovered each month by cancelling units.
4. Fund management charges are deducted within the fund itself, which is reflected in the NAV.

The core relationships are simple:

• Units allotted = (Premium − Allocation charge) ÷ NAV
• Fund value = Total units held × Current NAV

Choosing and Switching Funds

Insurers offer a menu of funds, typically equity, debt (bond), balanced and money market or liquid funds, and money can go into one fund or several. Most plans allow fund switching, moving existing units between funds without ending the policy, often with a set number of free switches per year. A common use is shifting from equity to debt as maturity approaches, to protect gains from a late market fall. Some insurers automate this through life-stage or systematic transfer options.

Death Benefit

If the policyholder dies during the term, the nominee receives a death benefit. ULIPs commonly use one of two designs:

• Higher of sum assured or fund value: cheaper cover, because the insurer’s risk shrinks as the fund grows.
• Sum assured plus fund value: higher mortality charges, because the insurer pays the full cover regardless of fund size.

Maturity

At the end of the term, the policyholder receives the fund value, meaning units held multiplied by the NAV on that date. Life cover ends at maturity. Some plans offer a settlement option that pays the maturity value in installments over a few years, which keeps the money invested (and exposed to the market) for longer. Any guaranteed additions or loyalty additions credited by the plan are added to the fund along the way.

Worked Example

These figures are hypothetical, not any insurer’s actual charges or returns.

Assume an annual premium of ₹1,00,000, a premium allocation charge of 2%, and an equity fund NAV of ₹20 on the purchase date.

• Allocation charge: 2% × ₹1,00,000 = ₹2,000
• Amount invested: ₹98,000
• Units allotted: ₹98,000 ÷ ₹20 = 4,900 units

Over the year, suppose combined mortality and administration charges total ₹4,000, collected monthly by cancelling units at the prevailing NAV. If the NAV averages ₹20 when those deductions are made, about 200 units are cancelled, leaving roughly 4,700.

If the NAV ends the year at ₹22, the fund value is 4,700 × ₹22 = ₹1,03,400. The fund itself rose 10%, but the policy’s value is only 3.4% above the premium paid, because of the allocation charge and the cost of insurance. If the NAV instead fell to ₹18, the fund value would be 4,700 × ₹18 = ₹84,600.

Two points follow from the arithmetic. Charges weigh most heavily in the early years, when the fund is small relative to the premiums being paid. Over a long term, the gains on surviving units compound on themselves, which is why ULIPs are designed and sold as long-term products, commonly with terms of 10 years or more, and are unsuitable for money needed within a few years.

Lock-In, Surrender and Partial Withdrawals

Under IRDAI rules, ULIPs have a five-year lock-in period. A policyholder can stop paying or surrender the policy within that time, but the money is not paid out. Instead, the fund value, minus a discontinuance charge capped by regulation, is moved to a discontinued policy fund, which earns a modest regulated minimum return. Life cover stops. The proceeds are paid out once the five-year period ends.

After the lock-in, the policyholder can:

• Surrender the policy and receive the fund value, with life cover ending.
• Make partial withdrawals while keeping the policy in force, subject to the plan’s limits on the amount and number of withdrawals.

Tax Treatment in India

ULIPs have historically been sold on their tax features under the Income Tax Act, 1961:

• Section 80C: premiums can qualify for a deduction under the old tax regime, within the overall 80C limit. This benefit is lost if the policy is surrendered within five years, and deductions already claimed are added back to income.
• Section 10(10D): maturity proceeds can be tax-exempt if the policy meets conditions on the ratio of life cover to premium.
• Budget 2021 change: for ULIPs issued on or after February 1, 2021, the 10(10D) exemption does not apply if total annual premiums exceed ₹2.5 lakh. Gains on such policies are taxed like capital gains on equity-oriented funds. Death benefits paid to nominees remain exempt.

Tax rules change with each budget, so the rules in force at purchase and maturity apply.

Benefits of ULIPs

• Insurance and investment in one contract. One premium funds both the death benefit and the investment.
• Choice of risk level. The fund mix can be matched to a goal and risk tolerance.
• Switching without tax events inside the policy. Unlike selling one mutual fund and buying another, a switch does not end the policy.
• Market-linked return potential. Equity exposure offers higher potential returns than traditional endowment plans, which credit bonuses at the insurer’s discretion.
• Discipline. Regular premiums and the lock-in discourage early withdrawal of long-term savings.
• Partial withdrawals after five years. Cash can be drawn for needs such as education costs without surrendering the whole policy.

Limitations and Risks

• Layered charges. Allocation, administration, mortality, fund management, switching and discontinuance charges all reduce returns, as the worked example shows.
• No guaranteed returns. The fund value can fall below the premiums paid.
• Limited liquidity. Nothing is paid out in the first five years, and stopping early moves the savings into a low-return fund.
• Cover may be too small. The sum assured is often a multiple of the annual premium, so a family needing large protection may need a separate term policy.
• Complexity. Comparing ULIPs means reading each plan’s charge schedule and fund options, which makes them harder to evaluate than a single mutual fund or deposit.

ULIPs Compared With Similar Products

ULIP vs. Mutual Fund

Both pool money into professionally managed funds priced by NAV. A mutual fund is a pure investment with no life cover, and open-ended funds can usually be redeemed at any time (equity-linked savings schemes carry a three-year lock-in). A ULIP adds life cover and deducts its cost, has a longer five-year lock-in, and allows switching within the policy. Investors who want liquidity and lower total costs often favor mutual funds; those who want cover and investment in one contract may prefer a ULIP.

ULIP vs. Term Insurance

A term plan provides only a death benefit, with no maturity value, for a much lower premium for the same cover. Pairing a term plan with a separate investment is the main alternative to a ULIP, and it separates protection from savings so each can be changed independently.

ULIP vs. Traditional Endowment Plan

Endowment and money-back plans also mix savings with cover, but the insurer invests the money and credits bonuses. The policyholder doesn’t pick funds or bear market risk directly. A ULIP gives fund choice and transparency of NAV, at the cost of market exposure.

ULIP vs. Fixed Deposit

A fixed deposit is a bank deposit with a stated interest rate that does not depend on markets, and it offers no life cover. Breaking an FD early usually brings a penalty on the interest rate rather than a lock-in. A ULIP’s value moves with markets and can lose capital, but it has higher growth potential over long periods.

FAQs

The Bottom Line

ULIPs suit Indian savers who want life cover and market-linked investing in one contract and can leave the money invested for 10 years or more. Layered charges weigh most in the early years, and the cover is often modest, so families needing large protection may need a separate term plan. Anyone wanting easy access to cash or lower total costs may find mutual funds or a term plan paired with investments a better fit.