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.
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:
- How much death benefit you need. Insurance is priced in bands, and sometime more coverage costs less.
- The age and health of the insured. Insurers have different preferred client profiles and may view health issues differently, which affects the cost of insurance.
- When the death benefit is needed -- at the first death, second death, or both. In many cases, a survivorship policy that insures two lives has a lower premium and higher IRR than an individual policy.
- The financial stability of the insurer. The more stable the insurer, the lower the risk that it will be unable to pay its clients and their loved ones. There are several firms, such as A.M. Best, that assign a rating to an insurance company based on its financial statements, coverage in force, and ability to pay claims.
The next step is to request illustrations. To be consistent, all illustrations should:
- Have either a level premium or death benefit.
- Last until a specified age -- 90, 95, or 100.
- Have a consistent health class rating. Insurers use different names for similar ratings, so it's important to be consistent.
- Use the same premium payment mode -- monthly, quarterly, or annually.
- Have the same assumed gross rate of return on the growth of the cash value.
- Include policy fees for riders, such as a no-lapse guarantee or disability waiver of premium.
Then evaluate the illustrations:
- Decide on a guaranteed or non-guaranteed death benefit.
- Review the financial ratings of the insurer.
- Determine which policy offers the highest IRR at the lowest premium.
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.