By Hemanth Gorur
Many insurance products such as child plans and pension plans can take on the flavour of investments based on your objective of buying them. You may therefore want to compare the payouts to other investment products in the market, or even compare between insurance plans.
However, not only can the premiums vary, but also the amount, frequency, the start, and duration of payouts can all differ.
Let us see how we can compare insurance plans and their payouts.
What is the Internal Rate of Return (IRR)
The Internal Rate of Return (IRR) is a financial analysis tool to compare the returns from two different cash flow streams. The IRR involves the concept of Net Present Value (NPV), which is the present value of all cash flows in the present and future expected from an investment.
The present value of money is always higher than the same amount in future. This is due to uncertainty in the interim period and price inflation, which reduces your purchasing power. Any future value (FV) of money must be “discounted”, or reduced, at some discounting rate to arrive at its present value (PV). However, any amount in the present need not be discounted.
PV = FV / ( 1 + r )n where ‘r’ is the discounting rate and ‘n’ is the discounting period (usually years)
For example, if a present value of Rs 1,000 is invested at an interest rate of 10% per annum, the amount at maturity one year into the future will be Rs 1,100. Working backwards, Rs 1,100 one year from now is worth Rs 1,000 today—this is by discounting it at 10% to arrive at the present value.
PV of Rs 1,100 at a discounting rate of 10% = 1100 / (1 + 10%)1= Rs 1,000
How to calculate IRR of any cash flow stream
When you pay an amount or a premium, it represents a negative cash flow (outflow) while calculating the IRR. Similarly, when you receive an amount or a payout, it represents a positive cash flow (inflow). When you discount these cash flows at a particular rate and add them up, you get the Net Present Value of the cash flow stream.
The IRR is that discounting rate which sets the NPV of a cash flow stream to zero. In other words, the IRR represents the interest rate at which the amount(s) you invest will get compounded to fetch you the maturity amount(s).
NPV = 0 = PV of all negative cash flows + PV of all positive cash flows
Applying the IRR concept to evaluating insurance plans
In insurance plans, the premiums you pay become negative cash flows and the payouts you get become positive cash flows. Say, you pay a lumpsum premium of Rs 10,000 today and receive two payouts in the future: Rs 5,250 after one year and Rs 5,512 after two years. The Rs 10,000 becomes a negative cash flow since it is an outflow of cash, and is not discounted since it is in the present. The two payouts become positive cash flows since they are inflows of cash, and need to 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
Any future premiums to be paid can be included by discounting them at the IRR and with a negative sign. Usually, the IRR is obtained by trial and error. The IRR in the above example will turn out to be 5%. Microsoft Excel also provides functions like IRR() and XIRR() to calculate the IRR.
Applying similar reasoning, one can compare different insurance plans with different premium and payout amounts and frequencies to get their internal rates of return.