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Permanent life insurance is a complicated and confusing product. Unlike term life insurance, permanent policies build cash value. However, every company's policy has different fees and expenses. So it can be difficult to directly compare the policies each company offers when you're shopping for coverage.
Internal rate of return
Fortunately, there is a way to cut through the confusion: using a measure called the internal rate of return. IRR is widely used to evaluate the expected return over time of a lump-sum investment or series of payments. In a life insurance policy, IRR measures the potential return of the death benefit and cash value, based on the amount and frequency of premium payments.
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The IRR of the death benefit is very high in the early years -- often more than 1,000% -- and it decreases over time to around 4%-6%. The IRR is so high in the first few years because very little premium has been paid in exchange for a large death benefit. As more and more premium payments are made, the IRR on the death benefit declines. Term life insurance policies, which have a lower premium, have the highest IRR. However, unlike permanent insurance, most term policies lapse, and the insurance company never pays a death benefit.
The IRR on the cash value in a permanent policy has an inverse relationship with the death benefit. Because of policy fees and surrender charges, the IRR of the cash value is minimal in the early years. But over 10, 20, or 30 years, the IRR gradually increases depending on the assumed rate of return. In whole and universal life policies that pay a dividend or have a fixed rate of return, the long-term IRR can be similar to that of an investment-grade bond.
How to use IRR
As you shop for life insurance, agents or brokers will provide an "illustration package" that explains how the policy works and includes several ledgers that show, year by year, how the policy will perform. Although it's not part of the standard illustration package, you can request an optional report that shows a policy's IRR. This can help you decide whether permanent life insurance is a good investment or whether you should allocate your money elsewhere.
First, decide on the kind of coverage you want. It may help to work with an independent broker who can offer guidance about policy design and underwriting. Here are some issues to consider when making a selection:
The next step is to request illustrations. To be consistent, all illustrations should:
Then evaluate the illustrations:
Once you've evaluated these various factors, policies with the highest IRR, offered by insurers with solid financial ratings, will usually be the best choice. Once you've selected an insurer and contract, you will need to submit an application and go through underwriting. In some situations, the offer from the insurer may have a different rating that's better or worse. If this happens, your broker can help you shop the case to other companies to see if a more favorable offer is available.