Guaranteed return plus bonus

Someone asked me, "How is it possible for an insurance company to guarantee a return of 2% on its product, and give bonus on top of it"? Can it invest all of its funds to earn 8% of which 2% is guaranteed and the remainder is not guaranteed?

Can the Central Provident Fund operate on this model in paying its interest rate?

Here is my reply:

1. When the insurance company guarantee a return of 2%, it will invest 70% of its funds in government securities to earn 3.5% (the current rate). The remaining 30% will be invested in equities to earn an average of (say) 7% per annum. The average return on the fund is likely to be 4.5%.

2. After deducting about 1% to cover its expenses and profit, the insurance product can give a return of about 3.5%.

3. It is not possible for the insurance company to give a guarantee of 2% and invest all of its funds in equity to earn 7%.

Lesson: If you wish to get a good return, you have to take the risk and invest in an equity fund. If you invest for the long term, say 10 years or longer, you can average out the return over good and bad years.

If you wish to have a guaranteed return, you can get at best a return of between 2% to 4%. It may be better to invest in government bonds to earn close to 3.5%.