Chapter 16: Surplus distribution policy

Question 1

1. BONUS STRUCTURES

Question 2

Bonus structures:

In South Africa, with-profits business can generally be divided into: (2)

Answer 2

1. “Traditional” with-profits business (also called “conventional” or reversionary bonus business).
2. Smoothed bonus business (also known as with-profits universal life business, accumulating with-profits business or unitised with-profits business in the UK).

Question 3

Bonus structures:

Reversionary bonus:

Answer 3

• This method of bonus distribution applies to conventional with-profits business.
• They take the form of an addition to benefits (“sum assured”) payable on maturity or death.
• Once declared, the reversionary bonus becomes a guaranteed addition to benefits, and cannot be removed.
• Regular reversionary bonuses are declared periodically, usually annually.

Question 4

Bonus structures:

Smoothed bonus:

Answer 4

• This method is used to distribute surplus to smoothed bonus policies.
• This method of bonus declaration bears more resemblance to a “savings” account, in the sense that bonuses are not added directly to the ultimate maturity benefit but to the current value of the policy.
• Policyholders may find smoothed bonuses easier to understand than reversionary bonuses.
• Smoothed bonuses often fluctuate more than reversionary bonuses
• When a bonus declaration is made, the bonus is normally split into a vesting and non-vesting component.

Question 5

Bonus structures:

Terminal bonus:

Answer 5

• Terminal bonus is commonly used to fairly distribute residual surplus.
• A terminal bonus is normally only paid when the policy becomes a claim.

Question 6

Interim bonus:

Answer 6

Because bonus rates on with-profits contracts are typically declared annually in arrears, an interim rate is normally utilised to determine the value of benefits between bonus declarations.

Question 7

2. FACTORS TO TAKE INTO ACCOUNT IN BONUS DECLARATIONS

Question 8

Factors to take into account in bonus declarations: (13)

Answer 8

1. The insurance company balance sheet
2. Bonus stabilisation reserve (BSR)
3. Free assets
4. Returns on the assets underlying the with-profits fund
5. Investment strategy
6. Competition
7. Policyholders’ reasonable benefit expectations (RBEs)
8. Shareholders versus policyholders
9. Sources of surplus
10. Asset shares
11. Smoothing
12. Equity between classes and generations of policyholders
13. The level of vesting versus terminal bonus

Question 9

The bonus stabilisation reserve (BSR): (3)

Answer 9

• The BSR essentially represents the past accumulation of over- and under-declarations of bonuses relative to the actual earned investment returns.
• The BSR, although not contractually constrained, is considered part of the actuarial liabilities.
• The BSR is a measure of the financial soundness of a with-profits portfolio.

Question 10

The BSR in the regulatory basis:

Answer 10

In the regulatory basis, the BSR is incorporated into the technical provisions by setting future bonuses at a level supported by the BSR.

Question 11

Condition for holding a negative BSR:

Answer 11

Normally, a company may only hold a negative BSR if it is relatively certain that it can recoup the deficit over the subsequent 3 years, as per SAP 104.

Question 12

Free assets:

Answer 12

Excess of assets over liabilities, where the liabilities include the BSR.

Question 13

A company with a high level of free assets would be able to: (2)

Answer 13

1. Would be able to maintain bonus levels and still remain solvent even following a long period of poor returns.
2. Would be able to follow a more aggressive investment strategy while still maintaining a stable bonus rate over time.

Question 14

The degree to which declared bonus rates would follow returns actually achieved depends on a number of factors, including: (4)

Answer 14

1. The office’s bonus declaration philosophy
2. The amount of BSR and to some extent the amount of free assets
3. Underlying guarantees
4. The investment mandate of the smooth bonus fund

Question 15

Various methods exist to allocate surplus between shareholders and policyholders in a proprietary life office. Among the most common are: (3)

Answer 15

1. The 90/10 method: Policyholders receive 90% of all distributed surplus and shareholders get 10%.
2. Explicit charges: Shareholders charge explicit fees to cover expenses and profit, while the policyholders receive all remaining surplus.
3. Investment surplus only: Policyholder receive all investment and bonus loading surplus, while shareholders get the surplus from all other sources, such as mortality, terminations etc.

Question 16

Surplus for distribution to with-profits policyholders might arise from some or all the following sources: (6)

Answer 16

1. Investment surplus
2. Expense surplus
3. Mortality and other risk benefit surplus
4. Withdrawal (termination) surplus
5. Surplus from other contracts (for example, without-profits contracts)
6. Mismatching surplus

Question 17

Expense surplus for smoothed bonus policies:

Answer 17

For smoothed bonus policies, the expense surplus arising over the term of the contract would be a function of the difference in the margin (defined as the difference between policyholder charges and expenses) actually achieved and that assumed in the valuation basis underlying the negative rand reserve.

Question 18

Expense surplus for reversionary bonus policies:

Answer 18

• For reversionary bonus policies, the expense surplus would be a function of the expense assumption in the premium basis and actual expenses.
• The valuation basis would determine when this surplus is recognised.

Question 19

Mismatching surplus:

Answer 19

• Mismatching surplus is a special type of investment surplus, which is volatile.
• It is effectively funded by accrued terminal bonuses, and is therefore best distributed as an addition to terminal bonuses.

Question 20

The nature of Mortality and other risk benefit surplus:

Answer 20

• This source of surplus will usually be relatively small and for most participating endowment type contracts it will reduce over the term of the contract.
• The pattern of emergence is not suited to a reversionary bonus or smooth bonus system.

Question 21

How would “mortality and other risk benefit surplus” arise under smoothed bonus policies and reversionary bonus policies.

Answer 21

• Mortality and other risk benefit surplus would normally arise under smoothed bonus policies with guaranteed minimum benefits, as a result of differences between risk benefit charges and actual risk benefit payments.
• Under reversionary bonus policies, it would be a function of differences in the pricing basis and actual experience.

Question 22

Factors affecting the degree of smoothing include:

Answer 22

1. Policyholder RBEs
2. Method of distributing surplus
3. Asset mix backing the contracts
4. Size of the BSR (and related, the free assets)

Question 23

Uses of asset shares:

Answer 23

1. as a benchmark for determining the level of pay outs to with-profits policyholders
2. as a tool for the consideration and quantification of treating customers fairly (TCF)
3. as a guide for determining maturity values and in setting surrender values, including market value reductions on unitised with-profits business.
4. Used in the calculation of the value of investment guarantees under APN110

Question 24

A typical definition of Asset share:

Answer 24

A typical definition would be that an asset share is the premiums paid, less deductions, plus allocation of miscellaneous profits, all accumulated at suitable rates of investment return, with allowance for any tax payable.

Question 25

For conventional with-profits asset share calculations, allocations of miscellaneous profits may include some or all of the following items: (4)

Answer 25

1. Surrender profits on with-profits business
2. Profits from without-profits business
3. Allocations from the free assets (transfers from shareholders)
4. Windfall profits, such as unexpected tax gains.

Question 26

For conventional with-profits asset share calculations, typical deductions would be: (5)

Answer 26

1. Commissions and expenses, net of tax if applicable.
2. The cost of providing life cover and any other benefits and options.
3. Tax on income, taxable realised and unrealised gains, and profits, if appropriate.

4, Shareholders’ transfers

5. Capital charges, includeing charges for smoothing and/or guarantees.

Question 27

For conventional with-profits asset share calculations, typical deductions would be: (5)

Answer 27

1. Commissions and expenses, net of tax if applicable.
2. The cost of providing life cover and any other benefits and options.
3. Tax on income, taxable realised and unrealised gains, and profits, if appropriate.

4, Shareholders’ transfers

5. Capital charges, includeing charges for smoothing and/or guarantees.

Question 28

There is no universal approach to determining the rates of investment return at which the premiums, deductions and allocations are accumulated, and a company’s approach may depend on the quality of its historical data. Possible methods would include: (3)

Answer 28

1. The return on assets notionally allocated to with-profits business or to specific product lines within the with-profits portfolio.
2. Notional returns calculated using a notional asset mix and returns on indices.
3. The overall return on the on the non-linked assets in the fund.

Question 29

Two main methods have been used by companies for allocation of surrender profits: (2)

Answer 29

1. asset share would be accumulated allowing for actual surrender profits arising each year so that, broadly, the profits arising from a particular cohort of business are allocated to the remaining policies in that cohort.
2. the alternative would be to allocate the surrender profits by an increase in the investment return.

Question 30

Capital charges:

Answer 30

Capital charges refers:

• to the costs of providing guarantees and carrying out the smoothing process,
• to the cost of providing an appropriate return on capital employed in writing the contract,
• or to the cost of building up the capital base of the company.

Question 31

There are three distinct methods for calculating asset shares for smoothed bonus with-profits business:

Answer 31

1. Retrospective accumulation using actual expenses - deducting actual expenses from asset shares rather than the charges loaded into the premiums.
2. Retrospective accumulation using product charges - deducting product charges rather than actual expenses.
3. Shadow fund - in a shadow fund, asset shares for smoothed bonus with-profits business are calculated in a similar way as for the bid value of units within the unitised fund.

Question 32

The requirements of treating customers fairly include the following aspects, which may affect company’s philosophy and calculation method of asset shares:

Question 33

Modelling considerations: (4)

Answer 33

1. The relevant experience
2. Supportability of projected bonus rates
3. Split between reversionary/terminal bonuses or vested/non-vested bonuses
4. Terminal bonuses
5. Guarantees and options
6. Dynamic interaction between projection assumptions.

Question 34

The modelling exercise may indicate an inability to support the same level of bonus on new and existing business, which may lead to: (3)

Answer 34

1. A revision of the premium rates
2. A change to a new bonus series for new business.
3. A decision to gradually adjust rates over a period of years so that they run into the rates supportable by new business.

Question 35

It is important to consider the effect the proposed bonus distribution - and its continuation - will have on the level of the BSR and free assets. In particular, the following questions need to be answered: (3)

Answer 35

1. Cant the company continue with its proposed distribution policy and still satisfy supervisory requirements in future?
2. Will the company’s free asset stay at an adequate level to allow it to continue its desired new business strategy?
3. Will continuation of its current bonus distribution policy lead to constraints on its investment policy?

Question 36

The same principles for individual life business are applicable to group or employee benefits contracts. Some (perhaps subtle) differences that are worth pointing out include: (6)

Answer 36

1. MVAs normally do not apply when individual members withdraw from a group scheme (but an MVA would apply if the whole scheme terminates).
2. Bonus rates tend to more closely follow the investment experience of the fund.
3. Bonus rates on large group schemes normally relate only to the investment experience of the scheme itself. Smoothing from one year to the next is applied, but subsides between schemes are limited.
4. The reversionary bonus system is rare with new group contracts. Most new with-profits group schemes employ the smoothed bonus approach.
5. Explicit charges are normally made by the life office for administering the fund. Because of bulk administration, costs per member tend to be less than under individual contracts.
6. Hedged investment strategies are more common than under individual policies.