Question

- Example: An insurance company issues a guaranteed investment contract (GIC) for $10,000. If the GIC has a five-year maturity and a guaranteed interest rate of 8%, i t promises to pay $10,000 x 1.085= $14,693.28 • The company can choose to fund its obligation with $10,000 of 8% annual coupon bonds, selling at par value, with six years to maturity. As long as the market interest rate stays at 8%, the company has fully funded the obligation. Why? • What if the interest rate fluctuates?

Answer 1

Ans - The guaranteed investment contract is an obligation on insurance company to pay fixed rate of interest to the holder of this contract until maturity. Increase an interest rate will increase the burden on the company

For example : If company has taken 10000 at 8% for 5 years then an insurance company will pay i.e 10000 * (1.08)^5 = 14693.28. Suppose the market interest rate increases to 10%, the investors will sell these contracts and company have to repay their debt. So to keep their investor they also increase their interest rate to 10% i.e 10000 * (1.10)^5= 16105

This will increase the debt burden. And there is a possibility that company is unable to pay its obligation. So if market rate stays at 8% then company is able to fulfill its obligation.

If the interest rate fluctuates, then company could either get benefitted or get disadvantage from that. Suppose the interest rate decreases, the obligation of company reduces because now an insurance company is paying less than previous amount.

Suppose the market interest rate falls to 6% i.e 10000 * (1.06)^5= 13382.22. The obligation has reduced from 14693.28 to 13382.22. On the other hand if interest rate increases to 10% i.e 10000 * (1.10)^5= 16105.

Increase in time period also increase the obligation. Because now company is paying interest more than pervious no of years.