When you purchase a life insurance policy, you are given a benefit illustration which shows the amounts of money you are paying (premiums) and the amount of money you get (return). Since the return you get is a function of the underlying market which is under nobody’s control, it is calculated at two assumed rates of return (ARR) of 8% and 4%.
It may sound very basic, but for those who are not aware, the ARR of 8% or 4% is not the return you get. The ARR is the assumed return from the underlying market whereas the return you get is net of various charges like premium allocation, admin, fund management, mortality, etc. There isa cap on the expenses in the form of reduction in yield (RIY) e.g. 3% for a 10-year policy or 4% for a 5-year policy. So if 8% or 4% is not the return you would get, even if the market gives that much, then what is your return?
Understanding the calculations
The way to calculate your return is to plot the cash flows in excel, one below the other, in the order of dates, i.e., the first cash flow in the first row, second one in next row and so on. The premium payment dates are given, you have to type the dates and the amounts of premium next to it with a minus sign, as it is an outflow for you.
At the end of the premium outflows, on a certain date, there is a fund value. Type that amount in the last row of excel worksheet, next to the relevant date, as positive amount as it is an inflow for you. Having typed all the cash flows, select the excel function XIRR. In XIRR function, select the cash flows and the dates, and press enter. Convert the output number to percentage. This XIRR percentage is your net return.
As an example, the benefit illustration is given at an ARR of 8% and your return, taking the cash flows given in the illustration, is say 5%. Then 3% is the RIY on account of all the charges given earlier.
Need for doing the calculations
The seller of a product will highlight the brighter aspects. The fact that the benefit illustration is computed at 8% and 4% is due to rules framed by Irdai, otherwise sellers would show a brighter picture. It is not in the interest of the seller to tell you that your return is less than the ARR of 8% or 4%. In legal terminology, there is a term caveat emptor, which means buyer beware. Since you are buying into it, you should know what you are getting into. Most customers of insurance policies are at the stage where it has to be explained that 8% or 4% is just an assumed rate and not guaranteed (apart from certain guaranteed policies).
We depend on the seller of financial products for clarity. While that is fair and that is how it has always been, it is better to go a little extra mile. Self-earned clarity is the best clarity. While regulators are there like SEBI for mutual funds or Irdai for insurance, they can curb rampant mis-selling if that is happening. In the current context, the seller of the insurance product has to take signature of the customer on the benefit illustration while selling the policy, showing the assumed (non-guaranteed) rates of return. Beyond that, it is up to you.