Variable or unit-linked life insurance is subject to risks which the policyholder alone must bear. The performance of the investment funds is not guaranteed. It fluctuates. It may go up or down. It is subject to the volatility of the market. While the policyholder receives all the investment benefits there may be, he also must accept losses from the performance of his investment fund. The value of his insurance policy will fluctuate with the value of his underlying investment funds.
There are numerous risks that the investment fund of the unit-linked insurance policy is exposed to. These may be market risks, liquidity risks, credit and insolvency risks, foreign exchange risks, interest rate risks, and other risks. An individual averse to these risks would do well to just purchase traditional insurance. On the other hand, risks for guaranteed benefits are borne by the insurer. We take a look at two major risks.
Market risk
Market risk pertains to the performance of the investment funds. And the performance of the investment funds may be influenced by a host of other market factors such as pandemics, recession, political turmoil, changes in interest rates, natural disasters and terrorist attacks. There are other numerous market variables that can be considered. Basically, it is a bet on the economy and the financial markets. Thus, equities in a well performing economy could be expected to also perform well. While investment-linked policies are normally expected to yield better than traditional insurance policies, it is possible for investment-linked policies to perform worse than traditional policies. Market risk is a major concern for investors. But the skill of the fund manager is also an important factor.
Liquidity risk
Liquidity is the ability to meet expected and unexpected demands for cash. Variable insurance needs to be given time to grow its value. The yields will not come overnight. So there is a pre-determined period or a lifespan (investment period), usually five years, where the encashment charges will be very high. An early encashment exposes the investment to liquidity risks where the investment does not have enough liquidity yet. The charges involved in such early encashment should also be properly explained to the insured.
