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The Geek’s Guide to Calculating the Real Returns on Your Life Insurance

It’s widely understood that life insurance protects against financial losses in the case of death, or total permanent disability (TPD). Where it begins to get murky, however, is when technical terms and industry jargon come into the picture — especially for the different types of life insurance.

We get it. It’s easy to get confused. But we’re here to help you make sense of it all, particularly understanding what insurance returns with cash value is. More specifically, we’ll show you how to calculate the real returns on policies.

That knowledge, in turn, will be helpful in determining what form of insurance better suits your needs and choices.

The first thing you should know about life insurance is that there are two categories: one with cash value, also known as whole life insurance, and one without cash value, also known as term policy.

Cash value or no cash value: How do they differ?

An individual pays a sum of money, known as an insurance premium, in return for coverage.

Life insurance with cash value is more expensive. For the higher premium you pay, the insurance company uses a portion of it to do some low to medium risk investments, yielding returns for the policyholder over time. This leads to the cash returns the insurer gives to the policyholder at the end of the policy, a sum often known as the surrender value, and comes on top of the risk coverage the policyholder was provided.

On the other hand, life insurance without cash value is cheaper as it serves a sole purpose of insuring you for the duration of the policy. You get no cash return when the policy is surrendered.

How to calculate your real returns?

Now that you know the difference between the two types of insurance policies, it brings us to the next question: What are the annual returns on them like, and how can you make a more informed choice on which one is more suitable according to your needs and objectives? ?

Returns are generally not shown in the policy illustration of the insurance product, but we can compare and calculate returns easily using an Excel template.

Let’s look at this example:

Mr Yang is 30 years old this year. He goes through an needs analysis, which helps him determine an appropriate amount of coverage an individual should get. He understands that he needs a $200,000 coverage for critical illness insurance until he turns 65.

If Mr Yang buys an insurance policy without cash value, he will pay an annual premium of $1,000 until he’s 65.

On the other hand, if he decides to purchase an insurance policy with cash value, he will pay an annual premium of $3,000 for 20 years. When his coverage ends at 65, Mr Yang will receive a cash value of $60,000.

Using this data, we can fill up an Excel spreadsheet as shown below:

In Column A, we can insert Mr Yang’s age, starting from 30 when the policy starts, to 65 when his coverage ends.In Column B, we insert the cash flow of the insurance with cash value. Positive numbers illustrate the premium paid by the policyholder, while negative numbers illustrate the amount of cashback he will receive.

In Column C, we insert the cash flow of the insurance without cash value. Using the “minus” operation in Excel, we can calculate the difference between Column B and Column C. The second and third columns. This then results in Column D,which gives us the cash flow difference.

With all of that calculated, we can now determine the internal rate of return (IRR), a metric that helps us estimate something’s profitability.

We can derive this by using the IRR function in Excel; that is, =IRR(D2:D37). Based on the date range of this example, the result of this IRR formula is 2.692%. In other words, both the insurance policies with and without cash value provided the same coverage for the policyholder, but the former had an additional net investment rate of return of 2.692% per annum. Of course, the comparison is not as simplistic as this. There is also opportunity cost to consider here. An individual can choose to purchase a policy without cash value — a term policy — and invest what he would save in the hopes of yielding a better rate of return.

In this case, you will need to calculate your investments and make sure they earn at least 2.692% per annum for this strategy to make sense. Otherwise, you are probably better off getting the insurance policy with cash value.

It should also be noted that for this comparison to be fair, both policies should be from the same insurance company, and also provide identical risk coverage.

 

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