Archive / Investment Adviser (Level 2) / Life Insurance Products

nism-series-xb-bose-endowment-policy-irr-calculation[ INVESTMENT ADVISER (LEVEL 2) ]

Bose evaluates an insurance cum investment policy with an annual premium of Rs. 6,000 for a sum assured of Rs. 1,00,000, a term of 20 years, and a maturity payout of Rs. 2,00,000. A pure term policy for Rs. 1 Lakh cover costs Rs. 150 p.a. What is the approximate internal rate of return (IRR) earned on the pure investment portion of this policy?

[ A ]1.7%

[ B ]5.3%[ CORRECT ]

[ C ]3.6%

[ D ]6.1%

Takeaway

Isolating the pure investment portion of Bose's endowment policy (net of the term insurance cost) and solving for the rate that grows it to the Rs. 2 Lakh maturity value gives an IRR of approximately 5.3%, so option B is correct.

Derivation

Net annual investment portion = total premium (Rs. 6,000) - pure risk/term cost (Rs. 150) = Rs. 5,850 per year for 20 years. Using Excel's RATE function: RATE(Nper=20, PMT=-5,850, PV=0, FV=2,00,000) returns approximately 5.3% p.a. This question tests the core insight behind 'unbundling' an endowment policy — stripping out the pure mortality cost to reveal the actual return earned on the savings component — which is almost always far lower than investors assume because a large share of the premium pays for insurance and distribution costs, not investment growth.

Why the others fail

A — 1.7%

Obtained if the maturity value is mistakenly entered as Rs. 1,00,000 (the sum assured) rather than the actual Rs. 2,00,000 maturity payout in the RATE calculation.

C — 3.6%

Obtained by running the RATE calculation on the full unadjusted Rs. 6,000 premium without subtracting the Rs. 150 term insurance component, understating the true investment IRR.

D — 6.1%

Assumes payments occur at the end of the year with a compounding convention mismatch, producing a rate different from the correct annuity-due-consistent 5.3% figure.