Guaranteed Universal Life Insurance Internal Rate of Return
If you look up the definition of internal rate of return (IRR), you will see something like this: the IRR is the discount rate at which the net present value of all cash flows from a project or investment is equal to zero. This definition is pretty straightforward, but there are a few subtle nuances to address, especially in the context of life insurance.
IRR and Life Insurance
Although IRR is typically associated with evaluating potential investments and projects, it is often used in the life insurance industry to measure the return on premium dollars (both for cash values and death benefits). In this article we are only going to focus on death benefits, for guaranteed universal life insurance in particular.
The first thing to be aware of is that the cash flows in an IRR calculation are expected cash flows, although many definitions seem to leave this word out. This means that the variability is in the cash flows, not the IRR, and the variability is accounted for by using the expected cash flows. So the concept of an “expected IRR” doesn’t really make sense (more on this later). The IRR is a single value, not a distribution of values from which an expectation is calculated.
Second, the IRR is a forward-looking or prospective measure. It is calculated for a potential project as one way of determining whether or not to go ahead with the project. It is not a backward-looking or retrospective measure. After a project is completed, the cash flows are no longer expected, but realized. So, you can calculate the actual annualized rate of return for a project, and call it an IRR. In practice this caveat is more of a technicality, and we even do this in the IRR section of our Guide to Universal Life Insurance.
Guaranteed Universal Life Insurance Death Benefit IRR Calculations
There are many life insurance IRR calculators, many of which calculate an “expected” IRR. Basically, it calculates this IRR by figuring out your life expectancy and then determines what the IRR would be if you died at that age. From the first caveat, this is completely wrong, since we noted that there is not a distribution of IRRs. You should be calculating expected cash flows and then determining the IRR from those. (Also, imagine trying to use this method on term insurance. You could buy a 10-year term insurance policy but have a remaining life expectancy of 50 years. What would the IRR be then? If the method doesn’t work for all types of insurance, maybe something isn’t quite right. Hmm…).
If this seems confusing, an example should help to illustrate the difference.
Let’s use a 60-year-old man in great health who wants to purchase a $250,000 guarantee universal life insurance policy. He’ll pay premiums for 20 years, after which no additional premiums will be required, and coverage will last for his entire life. Let’s assume that this policy costs $425 per month and that the insured has a life expectancy of 81 years. If he pays premiums for 20 years and dies in exactly 21 years (his remaining life expectancy), his IRR would be about 7.9%. And this is how many online life insurance IRR calculators would do it.
But to be more accurate, you need to use expected premiums and expected death benefits to get the expected cash flows. You’ll need to use mortality rates to do this. (Ideally you would also factor in lapse rates, but that’s beyond the scope of this article). I won’t go through the exercise in this article, but If you want to see how to get expected premiums and death benefits year by year, you can read an article on how life insurance premiums are determined.
If you look at expected premium payments and expected death benefits, the IRR is about 5.2%. This is the correct way to do it because cash flows are weighted by their probabilities to find expected cash flows. There is a huge difference (2.7%) between the two methods.
Let’s re-do the example, except assume that the insured is 65 years old (everything else remains the same, except the premium will go up to about $545 per month). His life expectancy is 82 years, and if he dies at that age, the IRR is about 8.5%. He only paid premiums for 17 years in this case.
If we do it the correct way, the IRR is about 5%. Note that performing calculations the correct way gives more consistent IRRs. (And this makes sense, since companies pricing policies wouldn’t have wildly different investment/return assumptions for insureds who are five years apart). Second, insurance companies invest mostly in bonds and other fixed-income securities. So does 5% or 8% sound more reasonable to you, especially since there are items in addition to interest rates factored into the premium, such as profits and expenses?
For a product like guaranteed universal life, the internal rate of return is something that many people will look at. If you are going to use this metric, you want to make sure that you are calculating it correctly. Many calculators out there don’t give an accurate IRR, not because someone is trying to lie to you (hopefully), but more likely because they just don’t know how to calculate it properly.