If a newbie enters a finance forum like AIFW and starts posting gungaan of his endowment policy, ULIP, he is definitely going to be ridiculed and mocked. This ridicule is due to expert’s knowledge of concept called discounted cash flow and items permeating the world of valuation. It’s knowledge of these things the core reason why experts touch only term insurance policy and won’t even go near others.  This post is just a guide on how to be on the same song sheet as that of expert’s. Since an endowment is predominantly taken with intention of savings, knowing the valuation of it helps in comparing it with other instruments.

The fundamental principle governing the finances is that money is worth more today than it is in future. If you go back in time you see petrol available at the mind-bogglingly cheaper price of 10 Rs. Which can be said alternatively – money back then had so much worth in it that it could by a litre of petrol back then. Compared to today its worth has diminished so much that cannot even afford even half of that. For sake of comparison, the future money will be valued at today’s prices. This post is about it only, valuing things in today’s terms for sake of comparison.

collecting the required information:

When we go about valuing a cash flow in future, the things needed to calculate its present worth are the discount rate, time and amount to discount. So to calculate  Present value the Cash Outflows from us i.e. Premiums, the Cash Inflows upon maturity, the discount rate at which the present value will be calculated is required. In the case of the period of discounting the variable sets the maximum period of insurance policy. The Net Present Value Formula is difference Between Present Values of Cash Outflows and Cash Inflows. The present value concept hinges on the fact that a rupee today is worth more than rupee tomorrow. 

The most important thing in this calculation will be the rate of discount to be used. In the case of companies, the discount rate used for calculation will be either Opportunity cost or cost of capital. Since our intention is to compare an endowment policy with an FD or ULIP with Equity Mutual Fund, the natural choice will be the rate of return given by the latter.

calculations:

\displaystyle NPV = \sum_{t=1}^T \frac{Cash Inflow}{(1+r)^t} - \sum_{p=1}^P \frac{Initial Investments}{(1+r)^p}

r = Discount Rate
T,P = Time period

This formula can be alternatively viewed asNPV = PV of Maturity Proceeds - PV of Premiums. This calculation has been made easy in excel. The excel function PV can be given with Discount Rate, Total Period, and Premiums. (Note: If the discount rate is yearly then period and premium too should be yearly, if you want to mention monthly premium then discount rate and total periods should also be mentioned in monthly format i.e. discount rate divided by 12 and period multiplied by 12)

The  PV function:

The PV function needs the discount rate i.e. rate of interest offered by the instrument with which you are comparing it. In the case of endowment kind of policies, it’s the FD rates being offered. In the case of ULIPs, its the rate of return offered by broad market indexes like Sensex or Nifty 50. Since the rate of return in the case of index varies constantly, it’s better to take 10yr returns (which you can get from  Index Dashboards available on the Exchange’s Site or from sites like Value Research, etc…).

The number of periods of payments can be either in months or years. It includes periods where the continuous payment was done. If there was a break in payments, then each continuous payment cycle should be considered and present value should be calculated for each of the chunks of continuous payments. Also, the number of periods has an impact on discount rates too. Normally the rate of return is mentioned in per annum format, If the period is in months then the rate of return should be divided by 12 and that result is considered for calculations.

The most important input in this calculation will be premiums and benefits. If the present value of lump sum payment is being considered then that lump sum amount will be entered in the Future Value (FV) field. If the present value of a series of payments starting from today is being calculated then such payments are entered in PMT field of the formula. If there are breaks in payments and it appears in chunks then PV of that chunk’s starting date be calculated and then the PV output should be FV input(not PMT) for base date discounting.

(Note: The Excel PV and FV function always output the result in the opposite sign. If you enter PMT or FV as a positive number then the result outputted will be negative. Hence its necessary to neutralise the sign when doing calculations.)

The Jumlas used for selling:

The industry which is firmly footed on mis-selling has lots of tricks up their sleeve to fool the gullible. The industry very well knows the calculation of Present Value, which common folks don’t.  It’s this disparity that enables them to mis-sell. Essentially the antidote for this mis-selling is same, know the present value complexities.

If you are master of present value calculations then its impossible to mis-sell insurnance to you.

(See AlsoUncertainty & Risk)

Coming to jumlas, the first thing they do is to derail your present value calculations by being non-committal of total benefits that will be available at the end. This has 2 pronged advantages for them, the IRR calculation will get derailed if Future Value is not available. NPV calculations are also not possible as you can only calculate PV of premiums. In insurance, the Sum Assured is always lesser than total premiums paid over policy duration. ( This is with non-term policies) Hence earnings for policyholder is the bonus which gets declared from time to time. Since this bonus is based on Sum Assured which is fixed for the entire duration of the policy, a policyholder will get a false sense of mindblowing earnings in initial years of the policy, even though it’s of a fixed rate.  The normal counter can be what if I did RD of the same amount, for the same duration as that of policy. For example, an RD for 33 years, 7.2% as the rate of interest, and 1053 monthly payment yield 17 l. The monthly payment amount is the exact premium amount of 4l Sum Assured Policy that was quoted to me.

The other jumla is spreading of benefits over a longer duration. Its more like pay premiums till 25 years and get a lump sum at end of policy term of 30 years and yearly payments for 10/20/30 years. This is sophisticated con intended to derail IRR calculations. Most will add all the benefits and input the figures into Excel’s Rate function, which will throw out eye-popping rate of returns. The way to handle is to calculate Present Value of yearly payments as on policy’s end term date i.e. 30 years from now. Then add this present value to lumpsum benefits. Then use this sum as future value and calculate the present value of benefits. After this calculate Present Value of premiums. When you subtract the present values of premium from the present value of the benefits, you get NPV of that policy. If its negative then it means that the rate of return of that policy is lower than the rate you have used for calculations. If the result is positive then redo calculation with a slightly higher rate at which calculation is -ve, so that you can get bounds of rates between which the actual one falls.

The other counter-argument by them to avoid comparison to FD, RD, MFs is “this has insurance component attached”.  Hence you get benefits of both worlds kind of emotional argument. This is golden opportunity to tear into them on the basis of sum assured. Insurance is always taken with intention of giving financial support in case of accidental death of the breadwinner. To give proper financial support the sum assured of that policy too should also be higher. The thumb rule of min insurance amount is 15 times current annual income. According to this rule, a person with 2l yearly earnings needs a minimum of 30l as sum assured. Such a high sum assured of 30l with affordable premiums are available only in Term Insurance Plans.

Conclusion:
  • Net Present Value is the right way to compare Insurance with other Saving Mediums.
  • Insurance selling is sophisticated con art, hence mastery over present value calculations is right antidote.
  • Simplest financial instruments are the best. Insurance with investment by the name itself a complex, why bother entering it.
  • The PV function in excel is the tool that needs to be used to counter the overzealous insurance agent.
  • Using rational arguments in dealing with an agent is a sure shot way to raise the temperatures. Be ready for it.
  • Present Value and Discounting are non-intuitive concepts, don’t bother using it at water chiller discussions.
  • Use spreadsheets, not calculators when dealing with insurance topics.
  • The present value concept is the bedrock of the human monetary and financial system.
  • Your Insurance Cover from day 1 should be 15x of your yearly salary. If it is less than 10x, it considered as worse coverage ratio.
  • If you want to invest in a market-linked product, that product should be governed by the Securities Contract (Regulations) Act, 1956 and SEBI. ULIPs are not governed by this.
  • If you want to save in banking product, that should be governed by RBI and RBI should have regulatory powers given to it under FEMA, 1999, or Banking Regulations Act, 1949 or RBI Act 1936. Savings instruments by insurance companies do not come under the purview of RBI.
  • If the intention is to invest in Real Estate Project then that should be governed by RERA, and agency lending for such should be governed by NHB or RBI.
  • In an insurance policy, you should die to get the currently shown bonus. Whereas, you need to just redeem in case of FD’s and Mutual Funds.
  • Insurance Savings makes accounting hard. If you are a stickler to accounting like me, don’t touch anything other than Term Insurance Policies.