14 May 2013 0 Comments

IRR – The Finite Comparison Test

money exchangeIRR is short for Internal Rate of Return.  It can be used as a measure of either the death benefit or cash value of a life insurance policy.  Since the principal purpose of a life insurance policy is to produce a death benefit, that is what I will cover here.  IRR is stated as a percentage.  At the time of death the IRR is the amount of annual interest necessary to equal the death benefit paid in that year.

Here’s an actual example:  A married couple, both age 60 preferred non-tobacco users, are purchasing a $5,000,000 Second-to-die policy for estate tax liquidity.  The annual premium is $47,433.  Assume that the husband dies in 18 years and the wife dies in the 25th year, at age 85.  In year 25 the IRR of this policy is 9.84%.  That means that the $47,433 annual premium would have to earn 9.84% each year in order to equal $5,000,000.  Since the life insurance death benefit is not subject to income tax, the 9.84% is after-tax.

Still, having to pay the $47,433 premium forever concerns them so the agent shows them the same policy with an annual premium of $112,532 paid for only 10 years.  Is this a better way to go?  I doubt it.  Simple math tells you that cumulative premium for this 10 year payment exceeds the level payment policy through the 24th year.  Beyond that, the death benefit IRR doesn’t cross over until the 41st year at which time the 10 pay approach has an IRR of 4.15% against the continuous payment IRR of 4.06%.  Both of these premium payments guarantee the death benefit to age 121 of the wife.

When the policies being compared guarantee the same death benefit for the same duration of time, the IRR is an ideal way to determine which premium payment approach works best.  Remember, with a Universal Life policy you can also change premium payments at any time after the policy is issued.

When the true need for cash is at the time of death, it’s hard to compete with life insurance as the ideal delivery system.  Keep in mind that had the second death occurred in the 10th year the IRR would have been 41.35%!  When looking for a permanent policy always ask your agent to illustrate IRR for each year.

Isn’t using age 121 overkill (no pun intended) for measuring life expectancy?  That’s coming up next time. 

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