Many insurance products, such as child and pension plans, can take on the flavour of investments depending on why you purchase them. As a result, you may want to compare the payouts to other investment products on the market or even between insurance plans.
However, not only can premiums vary, but so can the amount, frequency, start date, and duration of payouts.
Let's look at how we can compare insurance plans and
payouts.
How much does the internal rate of return cost? (IRR)
The Internal Rate of Return (IRR) is a financial analysis tool that compares the returns from two different cash flow streams.
The IRR incorporates the concept of Net Present Value (NPV), which is the present value
of all cash flows expected from an investment in the present and future.
The present value of money is always more significant than the future value of the same amount. This is because of the uncertainty in the interim period and price inflation, which reduces your purchasing power.
To arrive at its present value, any future value (FV) of money must be "discounted" or decreased at some discounting rate (PV). Any amount in the present, on the other hand, does not need to be discounted.
PV = FV / (1 + r) n, where 'r' is the discounting rate, and 'n' is the period of discounting (usually years) For example, if a present value of Rs 1,000 is invested at a ten per cent annual interest rate, the amount at maturity one year later will be Rs 1,100. Working backwards, Rs 1,100 one year from now is worth Rs 1,000 today (after a 10% discount to arrive at the present value).
PV of Rs 1,100 at a 10% discount rate = 1100 / (1 + 10%)
1 = Rs1000.
How to Calculate the Internal Rate of Return on Any Cash
Flow Stream
When you pay a sum or a premium, it represents a negative cash flow (outflow) in the IRR calculation. Similarly, receiving a sum or a payout represents a positive cash flow (inflow).
When these cash flows are discounted at a specific rate and added together, the Present Net Value of the cash flow stream is obtained.
The IRR is the discount rate that causes the NPV of a cash flow stream to be zero. In other words, the IRR represents the interest rate at which your investment(s) will be compounded to yield the maturity amount (s).
PV of all negative cash flows + PV of all positive cash flows = NPV = 0.
Using the IRR concept to evaluate insurance policies
The premiums you pay become negative cash flows in insurance plans, while your payouts become positive. Assume you pay a Rs 10,000 lump-sum premium today and receive two payments in the future: Rs 5,250 after one year and Rs 5,512 after two years.
Because it is an outflow of cash, the Rs 10,000 becomes a negative cash flow and is not discounted because it is in the present. Because the two payouts are cash inflows, they become positive cash flows and must be discounted at the IRR so that:
NPV = 0 = — PV of Rs 10,000 + PV of Rs 5,250 + PV of Rs 5,512 = — 10000 + 5250 / (1 + IRR) 1+ 5512 / (1 + IRR) 2
Future premiums can be accounted for by discounting them at the IRR and with a negative sign. Typically, the IRR is calculated through trial and error. In the preceding example, the IRR will be 5%. Microsoft Excel includes IRR() and XIRR() to calculate the IRR.
Using the same logic, one can compare different insurance plans with different premium and payout amounts and frequencies to determine their internal rates of return.
0 Comments