T_Glossary 4

Question 1

What is the IRR

Answer 1

The internal rate of return is the interest rate that gives a project a net present value of zero

Question 2

Advantages of IRR

Answer 2

Higher IRR means a greater return from the project, therefore a sensible method of project appraisal.

IRR is relatively easy to calculate

No need to determine a suitable discount rate therefore it is less subjective.

Useful for comparing similar and less complex projects

Question 3

Disadvantages of IRR

Answer 3

IRR does not allow for the inherent risks in the project

IRR could lead to a higher return but may also lead to higher risk projects being taken on. (Riskier projects should offer higher returns, but IRR doesn’t tell you about the risk.

IRR may lead o more than one solution. This is a problem when there are negative cash flows involved e.g. termination expenses.

IRR takes no account of the size of the profit. A small profitable project may be chosen rather than a larger project offering a larger profit but slightly lower IRR

To calculate IRR, cash flow estimates needed for:
- capital expenditure
- running costs
- revenues and termination costs
These are difficult to estimate for some projects

Question 4

Additional disadvantages of IRR

Answer 4

Assumes single interest rate suitable for the whole term of the project

Assumes income is invested at the IRR, which may be unrealistic

The risk profile over the lifetime of the project needs to be considered along with the cash flow profile

Timing of profits is not obvious from IRR

Question 5

with profits / participating

Answer 5

A life insurance contract is with profits if the policyholder is entitled to receive part of the surplus of the company. The extent of the entitlement is usually at the discretion of the company.

Question 6

without profits / non participating

Answer 6

A life insurance contract is without profits if the life insurance company has no discretion over the amount of the benefit payable, i.e. the policy document will specify, at outset, either the amount of the benefits under the contract or how they will be calculated.

Question 7

Waiting period

Answer 7

This is a feature adopted by insurers under which benefits will not be paid for a specific period after the policyholder first takes out the insurance policy.

This waiting period may also be applied to any additional benefit from the date that the member buys the additional units of cover. It might also be called a no claim period.

Question 8

valuation

Answer 8

This is the process by which a life insurance company will place a value on its assets and/or its liabilities.

Question 9

unit reserve

Answer 9

This is part of the reserve that a life insurance company needs to set up in respect of its unitised contracts. The unit reserve represents its liability in terms of the units held under the contracts.

Question 10

Standalone critical illness

Answer 10

These are policies that only provide cover against critical illness and do not provide (or accelerate in the case of a standalone rider) any benefit in the event of death. Following payment of the critical illness benefit , the policy terminates.

Occasionally such policies may offer a nominal sum in the event of death before a critical illness is suffered.