Insurance is NOT investment; but this is how to calculate the returns

By MUNGAI KIHANYA

The Sunday Nation

Nairobi,

22 September 2024

Over the last 12 years, Lucy has been paying Sh50,000 annually to an insurance company for an education policy for her child. Finally, the policy has matured and the insurance company has informed her that she will be paid a total of Sh730,000. She writes: “I know I paid Sh600,000 and I am getting Sh730,000 so I am not losing money. But what is the percentage rate of my investment? I calculated the total rate [Sh130,000 divided by Sh600,000] and divided it by 12 years. I got 1.8 per cent which seems too small. What am I missing?”

Well, Lucy, you are missing two things. The first one is the fact that insurance is not investment. You should never buy insurance based on the rate of return you expect to get when the policy matures. Insurance is for financial protection against the unexpected. Indeed, you will notice that the extra money paid is called “bonus” and not “interest”. The reason is that the purpose of insurance is not to earn you money!

What would have happened if, after making your first payment of Sh50,000, you were in an accident where you suffered total disability? Your insurance policy would have taken over your premium payments. You would not have been required to pay anything else for the rest of the 12 years and you would still have been paid the Sh730,000 on maturity.

What would be the rate of return in that scenario? Over 110 per cent!

The second mistake is that you have assumed that the Sh600,000 was paid to the insurance company as a lumpsum 12 years ago. Clearly that’s not the case: you paid it slowly (Sh50,000 annually) over the period. Therefore, it is wrong to simply divide the Sh130,000 extra by Sh600,000.

A better way is to find out what was the average premium balance in the policy. Add all the annual balances and divide by 12. The answer is Sh325,000. So, in effect, you gave the insurance company Sh325,000, waited 12 years and they paid you Sh730,000. This is an increment of Sh405,000. Divide this increment by Sh325,000 and divide the result by 12. The answer is 10.4 per cent. A very good rate!

But that method over estimates the answer. The correct way to do it is to start by dividing Sh730,000 by Sh325,000 – the answer is 2.246. Then we ask: what number would be raised to the power of 12 to give 2.246? It is 1.0698. So, the correct answer is 6.98 per cent.