How do insurance companies make profits

By MUNGAI KIHANYA

The Sunday Nation

Nairobi,

27 May 2007

The mushrooming of dubious investment schemes (scams) has made many people very skeptical… and rightly so. One such individual is Omar Haji of Maua. He says that an insurance company has offered him an education policy for his daughter and, from the numbers presented, it is clear that he will get out with more money than what he puts in. So he cautiously asks, “What profit are they gaining from me?”

Omar asked for a “sum assured” of Sh50,000 over a period of 5 years. The figures were worked out as follows: He pays in Sh1,481 per month (total of Sh88,860 in five years). At the end of every year, he gets a bonus of 10 percent of sum assured (Sh5,000). Then on maturity, he get gets the full sum assured plus 7.5 percent interest per year. The total paid back is Sh93,750 – Sh4,890 higher than the invested amount.

Now Sh4,890 from an investment of Sh88,860 over the five years will not make you “an overnight millionaire”! Indeed, taking into account that the investment is done gradually over the period, the average rate of return comes to a paltry 2.5 percent per year.

But Omar is right to wonder where the insurance company gets the money to pay that “little” extra return. The answer is that when you put in the money, the company will invest it in interest-paying bank accounts, treasury bills, shares in companies, buildings etc. They are not making profits from you: They are getting it from your money

But still, as noted in these columns four weeks ago, the value of an insurance policy is not assessed by how much it pays on maturity but by what your dependants get if you die before the contract period is over.

I haven’t seen the details of Omar’s offer, but suppose he signs the contract, pays the first installment and then dies before the end of the month. The insurance company will probably pay only the Sh50,000 sum insured to his daughter. That is after investing only Sh1,481 – over 3,000 percent in less than 30 days! Where will all that money come from?

The insurance company has surveyed people of Omar’s age and social status to determine the average probability that he might die in the next 5 years. Suppose this is one percent. Assume further that there are 100 customers in Omar’s category.

In that first month, the company will collect Sh148,100 and then pay out Sh50,000 to Omar’s daughter. Now, according to the probabilities, none of the remaining 99 customers will die in the next 5 years. So the insurance company will continue receiving (and investing) the payments from these 99 “survivors”.

Now suppose the investments bring in 10 percent per year: At the end of the five years the insurance company will have made a profit of Sh2.65 million. From this it will pay a total of Sh484,110 to the 99 survivors (Sh4,890 each) leaving a gross profit of about Sh2.17 million…suddenly, the Sh50,000 paid to Omar’s daughter seems like peanuts!