Mathematics of Compound Interest

Fall 2012
Kamaruddin, I.K.
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Summary
SIGMA - Facing The Interest Rate Challenge

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On the whole, this Sigma Study explains the effects of interest rates fluctuations on
insurers. In essence, insurers suffer greatly from low interest rates. It also suggests some
resolutions that insurer can take in order to counter this interest rate challenge.

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This paper also briefly describes several types of interest rates. It defines interest rate as
the market price that keeps savings and investment in a state of equilibrium. It is also
important to note that most of the data are based on the real interest rate. Real interest rates as
defined in this paper as the nominal interest rates minus inflation expectations. In fact, this is a
simplified version of real interest rates derived from the formula below
1 + real interest rates = 1 + nominal interest rates
1 + inflation rates

Nominal interest rates are the rates observed without taking inflation into account in the
market. Thus, as analogous to the formula above, all investment calculation should be computed
at the real interest rates when the data are not adjusted to reflect the inflation rates.

This paper also indicates that interest rates differ according to maturity periods. This
difference is congruent with the Expectations Theory that used to explain the normal yield curve.
The expectation states that a higher percentage of individuals and business firms have an
expectation that interest rates will rise in the future than the percentage which expect them to
fall.1

Besides, several suggestions on how insurers could better adapt and mitigate the interest
rate risk are pointed out throughout this paper. For example, insurers could manage interest rate
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1. Kellison, S.G. (2009). The Theory of Interest. 276.

risk using the Modern Portfolio Theory, hedge policyholder risk, mitigate policyholder risk
through product design, and balance the cost and benefits of insurance options and guarantees.

After all, perhaps, the existence of interest itself, could be the leading obstacles in
promoting business. With the emergence of many interest-free financial products, it is not
impossible that greater economy stability could be accomplished someday. Last but not least, this
rationalization is substantiated by the great philosopher, Aristotle as he thought that interest is
the price of time and time belongs to God2.

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2. Shajari, H., & Kamalzadeh, M., (December, 1995). The Interest Rate and the Islamic Banking. Islamic
Economic Studies 3. 115-112.