Question

An insurance company has issued $850,000,000 in short-term notes with a 4-year maturity to finance the purchase of $850,000,000 short-term investments with a 1-year maturity. The insurance company must pay 6.5% annual interest on the notes but earns 7.9% annual interest on the investments.

a. Calculate the insurance company's profit spread and dollar value of profit at the end of Year 1.
b. Calculate the insurance company's profit spread and dollar value of profit at the end of Year 2 if the bank must make short-term investments that earn 7.1% annual interest.
c. What type of interest rate risk is the insurance company facing due to the different maturities on its assets and liabilities? Why is this a concern to the insurance company?

Answer 1

a. The profit spread at the end of Year 1 is $11,900,000. b. The profit spread at the end of Year 2 is $5,100,000. c. The insurance company is facing interest rate risk due to the different maturities on its assets and liabilities.

Step-by-step explanation:

a. The insurance company's profit spread at the end of Year 1 can be calculated by finding the difference between the interest earned on the investments and the interest paid on the notes. The interest earned on the investments is $850,000,000 * 0.079 = $67,150,000. The interest paid on the notes is $850,000,000 * 0.065 = $55,250,000. So the profit spread is $67,150,000 - $55,250,000 = $11,900,000. The dollar value of profit at the end of Year 1 is the profit spread, which is $11,900,000.

b. The profit spread at the end of Year 2 can be calculated using the same method as in part a, but with the interest rate on the investments changed to 0.071. The interest earned on the investments is $850,000,000 * 0.071 = $60,350,000. The interest paid on the notes remains the same at $55,250,000. So the profit spread is $60,350,000 - $55,250,000 = $5,100,000. The dollar value of profit at the end of Year 2 is the profit spread, which is $5,100,000.

c. The insurance company is facing interest rate risk due to the different maturities on its assets and liabilities. This means that if interest rates were to increase, the insurance company may earn less interest on its investments while still having to pay the same amount of interest on its notes. This would result in a decrease in the profit spread and potentially lower profits for the insurance company.