[Finance Wiz @Daniel] What is IRR (Internal Rate of Return)? Is it important to consider IRR when purchasing a savings insurance policy?
Finance2025-05-26
8 Mins Read
Many friends have asked me: ‘Daniel, I bought a certain savings insurance policy, and the returns seem quite good, but is it really worth buying?’ In fact, when evaluating whether a savings policy is worth it, simply looking at ‘how much you will get back in the end’ is not enough. This is because different savings policies have varying payment periods, and we must also consider the time value of money. At this point, an important indicator comes into play: IRR (Internal Rate of Return).
You may have heard of ROI (Return on Investment), but might be unfamiliar with IRR. Both are indicators used to calculate returns, but what is the basic concept of IRR? How does it differ from ROI? How is it calculated? Today, let me explore this indicator with you and help you understand the actual value of your insurance policy!
What is IRR? Understanding the basic concept of Internal Rate of Return!
To help everyone better understand the basic concept of IRR, let’s first look at a simple example. Below are two insurance savings products:
Product A: The policyholder pays a lump sum premium of HKD 50,000 and receives HKD 65,000 at the end of year 6.
Product B: The policyholder contributes HKD 10,000 annually for the first 5 years and receives HKD 65,000 at the end of year 6.
You might think that since both products offer the same return (HKD 15,000) and initial investment (HKD 50,000), there’s no difference between the two, so either product should be fine.
Of course, if we only consider the total return and the ratio to the initial investment, i.e., using ROI to calculate the return, the investment effectiveness of both products is the same. However, if you want to understand the actual effectiveness of the product by factoring in the length of the payment term and the impact of compound interest, calculating the IRR will reveal that Product B is actually more advantageous!
What is the difference between IRR and ROI?
Indicator | Definition | Suitable context |
IRR (Internal Rate of Return) | ||
IRR (Internal Rate of Return) | Measures the annualised return over the entire investment period, considering the time value of all cash flows | Suitable for long-term investments (e.g., savings insurance, real estate investments, business investments) |
ROI (Return on Investment) | ||
ROI (Return on Investment) | Calculates the ratio of total return to initial investment, without considering the time value | Suitable for short-term or one-time investments (e.g., individual stock transactions) |
The difference between IRR and ROI is that IRR takes the 'time value' into account when calculating investment returns, which can also be understood as the 'annualised return rate.' It represents the average annual return of the investment. For example, if your invested product has annual cash inflows and outflows, IRR can calculate the average rate of appreciation of these cash flows over a given period. This allows for a more accurate assessment of investment effectiveness. When comparing investment plans with different payment terms, IRR provides a standardised way to evaluate which plan generates the best profit opportunities from its cash flows.
IRR is commonly used to calculate the investment return of savings insurance, and it is also widely applied in investment decisions for businesses or individuals, stock or fund analysis, and even real estate investments, where IRR is used to assess whether the return is reasonable.
How is IRR calculated?
First, it is important to understand the formula for calculating IRR. IRR is based on the concept of discounting cash flows, which means finding the interest rate that makes the present value of all cash flows sum to zero. In simple terms, IRR is the discount rate that makes the cash inflows and outflows of the investment equal. This is similar to solving an equation where the total present value of the cash flows equals zero.
Where:
• Ct represents the cash inflow at time t (if it is an outflow, it is a negative value)
• t represents time, typically in years
• IRR is the Internal Rate of Return we need to calculate
Indeed, manually calculating IRR can be cumbersome and difficult to do precisely. However, with the help of online IRR calculators or using Excel’s formula functions, we can quickly calculate IRR!
How to calculate IRR using excel?
Using the IRR function:
In the example table*, in Excel, you need to prepare your cash flow data and enter the formula in a blank cell: =IRR(B2:B8). Here, B2:B8 is the range of cash flows, with the cash flow data going from B2 to B8. Press Enter, and Excel will display the calculated IRR.
*This is just sample data; actual data will vary based on your policy.
You must look at IRR when purchasing a savings insurance policy – here’s why
Why is IRR particularly important when it comes to savings insurance? Because savings insurance is typically a long-term investment, with returns that may only materialise after 20 years or even longer. These policies often come with different premium payment terms – for example, 2 years, 5 years, 10 years, 20 years or more. If you only look at the “final accumulated amount,” you may overlook the value of time. For instance, receiving HK$2 million after 20 years might sound impressive, but if the IRR is only 2%, it may not be as cost-effective as other investment options.
That’s why, when choosing a savings policy, it’s essential to consider the IRR – which takes into account the time value of money – so you can assess the true investment return of different policies on a like-for-like basis. This allows you to make the most informed decision, without being misled by surface-level figures.
Comparing the IRR of different insurance products
Since the structure of each savings insurance product, such as the premium payment term, investment approach, and return amount, varies, their IRRs will also differ. The IRR of a savings insurance policy can be divided into guaranteed IRR and expected IRR (which includes non-guaranteed returns). Generally speaking, conservative plans tend to have a better guaranteed IRR but lower potential returns, while more aggressive plans have higher expected returns but a relatively lower guaranteed IRR.
Does a higher IRR mean a better policy? You also need to consider risk and liquidity!
Although IRR can help us understand the return of a savings insurance policy, it cannot solely determine the policy’s value. IRR only reflects the expected return under certain assumptions, and the expected return is not the same as the actual return. Therefore, we also need to focus on the following two key factors:
1. Risk: Even if a policy has a high IRR, it does not necessarily mean it is a low-risk product. Especially for investment-linked insurance, the return is closely tied to market performance, and market fluctuations can significantly impact the final return of the policy. Therefore, when choosing a policy, it’s crucial to understand your own risk tolerance.
2. Liquidity and flexibility: Savings insurance typically has a longer holding period, so careful consideration and planning are needed for asset allocation. If you choose a savings insurance policy with flexibility, you can partially or fully withdraw funds as needed, according to the terms of the insurance contract.
Other factors affecting the choice of savings insurance
Although IRR is a very valuable indicator, it is not the only factor to consider when choosing a savings insurance policy. Other important factors include:
1. Fulfilment ratios
Bonuses are also a crucial factor in determining the actual return. Therefore, by referencing the past fulfilment ratios of insurance companies, you can choose an insurer with a stable fulfilment ratios, which helps ensure the steady growth of your funds, leading to the expected returns. AXA, for example, is committed to transparency in line with the requirements of the Insurance Authority in Hong Kong, providing clear insights into the actual performance of the non-guaranteed benefits through the fulfilment ratio. Therefore, choosing an insurance company with a strong financial background and a good reputation in the industry, like AXA, can provide a solid foundation for your future wealth accumulation.
2. Guaranteed return and life coverage
When selecting a savings insurance policy, in addition to focusing on attractive returns, it's important to pay attention to the life protection component. Life protection coverage acts as a safety net for your family, ensuring that if the policyholder unfortunately passes away during the term of the policy, the plan will provide a death benefit to their family.
Make smarter investment decisions with IRR
Different savings insurance policies come with varying payment terms, and using IRR to assess the performance of these products can help us understand their actual returns. However, IRR should not be the sole basis for decision-making. We should also consider other internal and external factors, such as risk, inflation, and the background of the insurance company, to make a well-rounded analysis. This way, we can make wiser and more informed investment decisions.
When planning the right savings plan, it is crucial to choose an insurance company with strong financial stability and a good reputation. AXA, a leading global insurer, has been offering a wide range of life, health, wealth management, and retirement solutions to protect the future of you and your family. As of December 31, 2024, AXA Group's revenue reached €110billion, with Underlying Earnings reached €8.1 billion, showcasing the group’s continuous and robust development strength, making it a trustworthy choice. If you are looking to explore savings tools with growth potential and greater flexibility in wealth management in the future, consider the wide range of savings solutions offered by AXA.
The above content is reviewed by Mr Daniel Lau - Head of Wealth Management Training of AXA Hong Kong and Macau.
No warranty or responsibility is assumed by AXA Hong Kong and our related or holding companies regarding non-infringement, security, accuracy, completeness, adequacy, reasonableness, fitness for a purpose or free from computer viruses in connection with the information and materials provided. AXA Hong Kong and our related companies and holding companies do not accept any liability for any loss, damage, cost or other expense, whether wholly or partially, directly or indirectly, arising from any error, inaccuracy or omission of the information and materials to the extent that such liability is not excluded by law.
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