Life insurance policies that also promise guaranteed income entice people with claims such as: “Pay ₹1 lakh for 10 years and get ₹22 lakh lump sum after 20 years”, or “pay ₹1 lakh for 12 years and start getting ₹2 lakh from the 14th year onwards for the following 12 years”.
A potential buyer may think, “I pay ₹10 lakh but receive more than double that after the policy matures”, or “paying ₹12 lakh a year for 12 years will mean I receive ₹2 lakh a year for the next 12 years.”
However, this ‘doubling of investment’ is an illusion. People fail to factor in the time value of money – the concept that a certain sum of money has greater value now than it will in the future due to its earnings potential (and the effect of inflation). In other words, you can buy a lot more with ₹1 lakh today than in 10-15 years.
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This shows that returns from long-term life insurance policies should be calculated differently. Rather than the absolute return, you need to calculate the extended internal rate of return (XIRR). This is an advanced version of the internal rate of return (IRR) formula, which is used to calculate returns on a series of cash flows. IRR is used for cash flows that are of the same size and spaced out equally, while XIRR is used for cash flows that are of different sizes and occur at varying intervals.
Here’s the step-by-step process of calculating the XIRR on an insurance policy.
First, note down the following key numbers from the ‘benefit illustration table’ in the policy brochure: the base premium, premium with GST (add 4.5% in base premium in the first year and 2.25% from the second year onwards), premium paying term, policy term, age, sum assured, and guaranteed maturity.
This is how it should look:
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Now, create a table in Excel with three columns – age, date and premium payment/guaranteed income. In the first column, put in your age for the duration of the policy. In the second, write the dates on which you will pay the premium each year, and in the third, mention the premium including GST for the policy term. Using the ‘Function+F4’ keys make it simpler to extend the same figures across the column.
Once this is done, use the XIRR formula by entering =XIRR. The formula will be visible (values, date, guess). Now select the ‘cashflow amount’ and ‘cashflow date’ values (the ‘guess value’ is optional) and you’ll get the XIRR. It was 5.41% in our example.
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If instead of a one-time maturity, you receive regular guaranteed income for a certain period, you can enter this in Excel using the same process. First note down all the figures.
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In this example, you pay a premium for 12 years. The 13th year is a gap year and you receive ₹2 lakh a year from the 14th year onwards. Include this payout from years 14 to 25. So, the premium paying period and the payout period are 12 years each, excluding a gap year. Now calculate XIRR. It works out to 5.38% in our example.
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This shows that your investment has not really doubled. It has grown by about 5% a year. If inflation averages around 6% over this period, your investment will actually lose some value. For some policies, the XIRR could be as low as 3-4%.
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Abhishek Kumar, Sebi-registered investment advisor and founder & chief investment advisor of SahajMoney, said, “People suffer from an anchoring bias when they fall for the ‘double your money’ sales pitch. What they don’t realise is that time is an important factor when comparing returns. So, investing ₹1 lakh a year for 12 years to get ₹2 lakh a year for the next 12 years must be looked at in terms of XIRR, which gives the true picture of the returns over that period.”
Also, when comparing insurance policies with returns from other products, calculate the post-tax returns for a clearer picture. “An insurance policy with an XIRR of less than 6% should be compared with XIRR of, say, PPF to arrive at an investment decision. If the investor is fine with low returns as they come with certainty they can go ahead with it. But when one is investing for a long duration the aim should be to beat inflation on a post-tax basis.”
In conclusion, don’t buy a traditional life insurance policy without calculating the XIRR as explained above. No sales agent will do it for you.
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