Ch 10: With-profits surplus (2)

Question 1

Revalorisation method description

Answer 1

• Bonuses under this approach are granted by increasing the reserves by say r%. Benefits and premiums of with-profits contracts are then increased by the same %.
• In determining this % it is common to divide surplus into “savings” (investment surplus) and “insurance” (surplus from other sources) profit.
• A high proportion of the savings profit is usually given to policyholders with the rest retained for shareholders. Investment profit distribution depends on the market.

Question 2

Advantages of revalorisation method (5)

Answer 2

• Simple to apply
• Method specifies exactly how a company should declare part of its profit as bonus to with-profits policyholders.
• Very little judgement is involved (except if PHs take a share of the insurance profit: then one-off profit or losses are usually spread over a period of time, judgement needed then)
• Should be relatively cheap to administer
• Specified method generally protects PHs from ungenerous life insurance companies
• By taking assets at book values including writing-up or down usually achieves a smooth emergence of investment profit.

Question 3

Disadvantages of revalorisation method (4)

Answer 3

• Company has no discretion in its profit distribution (except to the extent of spreading once-off costs where applicable)
• Method tends to discourage equity investment, since there is no deferral of profit distribution.
  * All investment losses will be borne by the company and could constitute an unacceptable insolvency risk.
  * Problem regarding the treatment of unrealised gains, whoch are not easy to distribute directly under current revalorisation systems.
• Versions that do not share insurance profits with PHs go against the principle of mutuality
• Not easy to explain to policyholders with “contsant premium” policies who see very small additions to their guaranteed benefits early in the policy term.

Question 4

Contribution method

Answer 4

• Principle is that each policy receives a share of distributable surplus in proportion to its contribution to surplus. For this purpose policies are classified into reasonably homogenous groups.
• The dividend given to a particular contract is calculated using a formula:
  * (Vo + P)x(i” - i)
  * (q - q”)x(S - V1)
  * [E(1+i) - E”(1+i”)]
• In practise the expense item is used as a balancing item to sweep up other sources of surplus such as withdrawal profits and profits from margins in the gross premium.
• The amount of distributable surplus will be determined by the company and the dividend formula will be applied with respect to this surplus
• Proportion of total surplus which is distributed will vary from year to year:
  * in order to obtain a more smoothed progression of dividends over time.
  * Some profit is retained for shareholders
  * Some surplus held against future contingencies
  * Or held for future distribution as a terminal dividend.

Question 5

Proportion of total surplus which is distributed will vary from year to year:

Answer 5

• in order to obtain a more smoothed progression of dividends over time.
• Some profit is retained for shareholders
• Some surplus held against future contingencies
• Or held for future distribution as a terminal dividend

Question 6

How the dividend could be paid out under the contribution method:

Answer 6

• Cash sum
• Reduce future premiums
• Converted into a paid-up addirion to benefit
• Part as a terminal bonus

Question 7

Remember summary table in solutions 10.7

Answer 7

Go look!!!

Question 8

How choosing a bonus distribution method could enable an insurer to manage various risks:

Answer 8

• Margins for future adverse experience:
  * Premium rates charged contain implicit or explicit margins so as to generate distributable profit.
  * These margins for profit could be looked at as margins against future adverse experience, as bonuses may be reduced to compensate the company if experience is much worse than expected. The extent to which this may be applied will depend on the expectations of policyholders
• Business objectives of the company
  * Likely to want to maximise profit distribution to policyholders to improve competitive position.
  * The decision on its distribution of profit should not aim to thwart this objective as it could lead to reduction in new business
• Policyholder expectations
• Provision of capital (relates to how much of the profit can be deferred under each option)

Question 9

The extent to which bonuses can be lowered to reflect poor experience will depend on:

Answer 9

• Policyholders’ reasonable expectations of payouts may make it difficult to reflect poor experience fully in bonuses they declare.
• Guarantees under with-profit contracts mean that there is some level of adverse experience beyond which any further losses cannot be recouped (cannot declare negative bonuses)
• Revalorisation method only distributes investment profit so any other sources of losses must be borne by the company.

Question 10

Policyholder expectations built upon:

Answer 10

• Documentation issued by company
• Company’s actual past practice
• General practice in the life insurance market

Question 11

Explain how bonuses are awarded to accumulating with-profit policies

Answer 11

• Bonuses are declared annually in relation to premiums paid to date and accrual of bonuses to date.
• May be an interem bonus on claim between bonus declarations
• May be guaranteed min bonus, this may be zero
• Terminal bonus may be added at maturity and possibly withdrawal
• Insurer may be able to apply MVR on withdrawal
• Regulation or market practise may dictate that MVR is zero
• Bonuses and MVR is at discretion of the company, subject to any policyholder expectations

Question 12

Why MVR is needed (Market value reduction) on surrender of unitised with-profits contracts

Answer 12

• Investment return is smoothed on a accumulating with-profits contract rather than linked directly to the underlying value of the assets.
• This means that at surrender, even with surrender penalty deducted, it may be possible that the value of the policy is higher than the value of the underlying asset share.
• In these circumstances the insurance company would be vulnerable to surrenders and switches and would be at risk of investment selection by policyholders.