Type-1 and Type-2 ULIPs: An Essential Difference You Must Understand

The maturity and death benefit proceeds of a life insurance policy is a crucial aspect to consider when buying a new policy. In the financial budget for FY-2023, the Hon. Finance Minister Mrs. Nirmala Sitharaman announced that for life insurance policies bought after 1st April 2023, with total premiums exceeding ₹5 lacs, the maturity proceeds will be taxable. The good news is that this notification excludes ULIPs. This is because the taxation of ULIPs was recently modified.

The Finance Act of 2021 prohibited tax exemption to investments in Unit Linked Insurance Plans ('ULIP') purchased after February 2021, with yearly aggregate premiums exceeding INR 2.5 lakhs. If the premium exceeds this amount, then the returns would be taxable as Long-Term Capital Gains.

Despite this change, ULIPs are one of the most popular investment plans today, that serve as a favoured financial tool for both investment as well as insurance. Furthermore, they provide a variety of tax benefits under Section 80C and Section 10 (10D), as well as flexibility in ULIP investments based on your unique financial goals and priorities. But are you aware that ULIP plans are classified into two types: Type-1 and Type-2?

Before choosing the best insurance policy depending on your needs, you should understand these two types of ULIPs. While both have distinct advantages, it is critical to first understand how they work and how they can specifically assist your financial objectives. Here's a closer look at Type-1 and Type-2 ULIPs, their differences, and their advantages and disadvantages.

How Your ULIP Investment Works?

How does ULIP insurance work? What are the main features of ULIPs? If all these questions have been buzzing in your mind, here are some core points that will help you get a better picture.

• ULIPs combine insurance and investments, where a part of the premium is invested into market-linked instruments, and you get life coverage for the entire policy term.
• You can choose fund options based on their future goals and risk appetite, allocating investments towards equity, debt, or a mixture of both.
• Professional fund managers take care of these investments, with periodic options for switching funds to combat market volatility or earn higher returns.

These are some of the features of ULIPs that contribute to their popularity as preferred investment options for several consumers today. However, what would be the best ULIP plan for you? Here is a guide to better understanding Type-1 and Type-2 plans.

Understanding Type-1 and Type-2 ULIPs

Both ULIP types function similarly except for the death benefit payout. Let us understand how:

• Type 1- For these ULIPs, the insurance companies pay out either the fund value or the sum assured to your nominees (whichever is higher) in case of your unfortunate demise during the policy term. Suppose you have a Type-1 ULIP with a sum assured of Rs. 40 lakh. At the same time, your ULIP has generated a fund value of Rs. 60 lakh. In this case, your nominee will get Rs. 60 lakh as the death benefit. Conversely, if the sum assured is Rs. 40 lakh and the fund value is Rs. 20 lakh, then your nominee will get Rs. 40 lakh as the death benefit.
• Type 2- In this ULIP, the sum assured of the policy is paid to your nominee upon your demise during the policy term. Hence, the death benefit is just the sum assured as outlined in the policy document. Suppose you purchase a ULIP with a sum assured of Rs. 40 lakh. In this case, the death benefit to your nominees will be Rs. 40 lakh based on the guiding principles of these policies. In some cases, the company pays out both: the sum assured and the fund value to your nominee.

How Type-1 and Type-2 ULIPs Differ?

A mortality fee is levied by the insurer on the 'sum-at-risk' for the insurance company. The sum-at-risk is the amount the insurance company would have to pay out of its pocket if the insured died. The bigger the sum-at-risk, the higher the mortality charge. Because the insurance company only has to pay the greater of the fund value and the sum assured under Type-1 ULIP, the sum-at-risk decreases as the fund value increases.

Why is this so? It is because every year, with the increase in the fund value, the risks will come down since the payout involves either the sum assured or the fund value. For Type-2 ULIPs, however, the sum-at-risk remains constant during the policy period. As a result, the mortality charge remains unchanged.

As a result, you would have to pay considerably smaller mortality charges in a Type-1 ULIP, and the amount of premium invested would be much greater. Under Type-2 ULIPs, the sum-at-risk remains constant, resulting in increased mortality expenses. This would have an influence on the returns. As a result, Type-1 ULIPs would provide comparatively higher returns than Type-2 ULIPs.

What should be your choice?

Which ULIP plan should you choose? At first glance, it is difficult to determine which type of ULIP is better. The first offers higher maturity benefits (if the policyholder survives the policy period), whereas the second provides better death benefits. To answer this question, you must first consider why you are buying the insurance policy in the first place. For example, if you are getting insurance to make sure your family is taken care of if something were to happen to you, death benefits will take precedence over maturity (survival) benefits. In this case, Type-2 ULIPs would be more suitable for you. In case you want to have higher maturity benefits, going with a Type-1 ULIP would be better.

When it comes to selecting financial instruments, however, there is no "one size fits all" solution. You need to take your financial goals, budget, and risk tolerance into consideration when you are making a ULIP investment. No matter what your need is, modern ULIPs can provide financial support for its fulfilment. Make sure you start your ULIP journey early, as the longer you stay invested, the better the returns will be. 

 

Aastha Mestry - Portfolio Manager

An Author and a Full-Time Portfolio Manager, Aastha has 6 years of experience working in the Insurance Industry with businesses globally. With a profound interest in traveling, Aastha also loves to blog in her free time.