PSI Ohio Insurance Practice Exam

What type of interest is typically used by insurers to calculate dividends?

1. Compounded interest

2. Semi-annual interest

3. Simple interest

4. Fixed interest

The correct answer is: Compounded interest

In the context of insurance and the calculation of dividends, compounded interest is commonly utilized. Insurance companies often invest the premiums collected from policyholders to generate returns. The returns earned on these investments accumulate over time, and since compounded interest allows interest to be earned not only on the initial principal but also on the interest that has been added to it, it results in a greater overall return. When insurers calculate dividends for policyholders, they consider the growth of these investments, which is effectively compounded over the period. This means that the dividends reflect the earnings generated by reinvesting the returns, leading to a higher payout than would be possible with other types of interest calculation methods. While semi-annual interest and simple interest may appear relevant, they do not provide the same potential for growth over time as compounded interest does. Fixed interest refers to a consistent rate without fluctuations, but it lacks the dynamic accumulation seen with compounding, making it less favorable for insurers aiming to maximize returns for policyholder dividends.