What is it, and what should your clients know? IRR is your greatest financial measurement: translate “analyst speak” into terms your clients appreciate.
Most financial advisors are familiar with the concept of Internal Rate of Return (IRR), which evaluates a stream of cash flows over time and determines the implied rate of return that would have to be earned to equalize the cash inflows and outflows over time (i.e., the return that would have to be earned on deposits over time to support the payouts at the end).
Another way of describing it: the internal rate of return (IRR) is a metric used to estimate the return on an investment. The higher the IRR, the better the return on an investment. As the same calculation applies to varying investments, it can be used to rank all investments to help determine which is the best.
How IRR Works
- Cash Flows: An investment typically involves an initial outflow (the cost of the investment) followed by a series of inflows (returns or revenues generated by the investment).
- NPV Calculation: The Net Present Value (NPV) of an investment is the sum of all future cash flows, discounted back to the present using a specific rate (the discount rate).
- IRR Calculation: IRR is the discount rate at which the NPV of these cash flows equals zero. That discount rate is the Internal Rate of Return for the cash flows.
Internal Rate of Return Formula:
The internal rate of return formula can be written as,
0=∑Nn=1CFn(1+IRR)n
Where,
- N = Total number of time periods
- n = Time period
- CFn = Net cash flow at time period
- IRR = Internal rate of return
Why is IRR important?
- Decision-Making: IRR is a critical tool in capital budgeting. If the IRR of a project or investment exceeds the required rate of return (or hurdle rate), it is considered a good investment. If the IRR is lower, the investment may be deemed less attractive.
- Comparing Investments: IRR allows investors to compare the profitability of different investments or projects by providing a single percentage figure for each.
What are some ways IRR can be used in Life Insurance?
Comparing Different Policies
Whole Life vs. Universal Life: When evaluating life insurance products like whole life and universal life policies, IRR can be used to compare the rate of return on the cash value accumulation within each policy. For example, you can calculate the IRR on the cash value of both policies over a specific period to see which one offers a higher return.
Evaluating Policy Performance
IRR of Premium Payments: You can calculate the IRR on the premiums paid into a life insurance policy versus the death benefit or cash value payout. This can help you assess how efficiently your premiums are converted into cash value or death benefits over time.
Determining the Break-Even Point
IRR on Cash Value: For policies that build cash value, calculating the IRR can help determine how long it will take for the policy's cash value to grow to a certain level. This is useful for understanding when the policy will start providing positive returns relative to the premiums paid.
Assessing Policy Loans:
Cost of Borrowing vs. Policy IRR: If you’re considering taking a loan against your policy’s cash value, comparing the loan interest rate with the policy's IRR can help you decide if borrowing is a cost-effective option.
.svg){kind=small}
