Chapter 16- Surplus Distribution Policy

Question 1

outline the high level structure of this chapter? (6)

Answer 1

• Different ways of adding to policyholders benefits (“bonus structures”)
• Factors to take into account in bonus declarations
• More on asset share
• Modelling considerations
• Management of bonus stabilisation reserve and free assets
• Related concepts

Question 2

outline the features of a reversionary bonus structure? (5)

Answer 2

• This method of surplus distribution is associated with conventional with-profit business
• Once declared the reversionary bonus becomes guaranteed addition to benefits and cannot be removed i.e. the bonus vests in the sense that guarantee benefit increases
• Life office tend not to let the reversionary bonus levels fluctuate from year to another and therefore set a conservative or sustainable level
• The policyholders expectation that bonus rates will not cut significantly places financial strain on the life office which need to reserve for bonuses declared and bonuses expected to be added in the future
• Sometime life offices also distribute surplus by way of a “special” reversionary bonus which is a once off payment that cannot be taken away

Question 3

outline the features of a smooth bonus structure? (7)

Answer 3

• The method bears more of a resemblance with a “savings” account in the sense that bonuses are added to the current value of the policy rather than final maturity amount
• Smoothed bonus polices also tend to follow more closely the actual investment returns rather than as opposed to reversionary bonuses which tend to be more stable
• Given that smoothed bonuses fluctuate more than reversionary bonuses they create less of an expectation that needs to be maintained
• The bonus declaration is usually split into vesting and non-vesting components

• The vesting portion is guaranteed
and non-vesting portion can be removed at the discretion of the company

• However the removal of non-vesting bonuses is considered a very extreme event
• Normally the investment mandate of a smooth bonus portfolio is conservative such that a extreme event is unlikely to occur

Question 4

outline the features of a terminal bonus? (7)

Answer 4

• Given that reversionary bonuses are set at conservative levels they do not normally distribute the entire surplus generated by the polices
• Therefore another type of bonus called the terminal bonus is used to distribute the residual surplus
• The terminal bonus is normally paid when the policy becomes a claim
• Paying part of the benefit in the form of a terminal bonus means greater volatility in the size of the claims
• Terminal bonuses do not vest which means that they can be reduced or removed
• It is common practice for terminal bonuses to be reduced on surrender
• If the terminal bonus is expected to be maintained (given the investment return assumption), a corresponding reserve must be set up
• The company retains more investment freedom so both shareholders and policyholders have the prospect of higher potential benefits
• Terminal bonuses that are based on asset share can take care of equity between different generations and types of contracts

Question 5

outline interim bonuses? (3)

Answer 5

• Bonus rates on with-profit contracts are typically declared annually
• Interim bonus rate applies to contracts that becomes claims before the next declaration
• They represent distribution earned since the last bonus declaration

Question 6

Outline what is included in the principles and practices of financial management? (5)

Answer 6

o This includes the nature and extent of discretion

o Factors considered in bonus declarations

o The investmentt strategy for the underlying assets

o When will decisions be taken to remove non-vested bonuses

o The board must approve the document

Question 7

list the factors that will be considered in bonus declarations? (15)

Answer 7

• BSR
• Free assets
• Return on underlying assets
• Investment strategy / IGR
• Competition
• Expectation of bonuses

• SH vs PH allocations
o Delay distribution of profits  delay SH allocations

• Sources of surplus (AoS)
• Asset share
• Smoothing
• Equity between classes and generations of policyholders

• Vesting vs non-vesting vs TB
o Vested increase guaranteed Ls  surrenders & increased SCR

• PPFM (i.e. includes company’s bonus philosophy)
• TCF
• Solvency

Question 8

outline BSR and how it may influence the distribution of surplus?(6)

Answer 8

• Measure of financial soundness of a with-profit portfolio
• If assets underlying the with-profits fund exceed liabilities then the fund has effectively declared a lower bonus rate supported by distributable surplus that arose over the period
• This insurer can hold back the surplus for latter distribution by setting up a BSR
• The BSR collectively belongs to policyholders sharing in the fund and any positive BSR will be distributed through future bonus declarations
• Similarly if assets underlying the with-profit fund are less than the liabilities the fund would have declared a higher bonus than that supportable by the surplus
• A negative BSR can only be included in valuation of liabilities if the insurer is expecting to recover the deficit through under distribution in the next 3 years (according to SAP 104)

Question 9

outline free surplus and how it may influence the distribution of surplus? (5)

Answer 9

• Higher free asset level  greater ability to:
o Smooth by deviating from market returns
o Invest aggressively (while maintaining a stable bonus rate)

• Low free asset level 
o Constrained investment freedom
o Constrained ability to write new business
o Endangered solvency position

Question 10

outline the influence of return on underlying assets in declaring a surplus? (4)

Answer 10

• The offices bonus declaration philosophy (e.g. volatility of regular bonus distributions)
• The amount of BSR available
• The level of underlying guarantees influences prudence in bonuses
• The investment mandate will influence the volatility of returns which may influence the degree of smoothing

Question 11

outline the influence of investment strategy in declaring a surplus? (3)

Answer 11

• Investment mandate in marketing literature  clearly communicate any deviation from this

• Typical mix: 60% equity, 20% bonds, 20% money market
• Not too conservative - higher returns than money market
• Not too aggressive – require long-term stable returns

• More conservative  smoother pattern of bonuses

Question 12

outline the influence of competition in declaring a surplus? (2)

Answer 12

• Competitive bonus rates are important in attracting new business and retaining inforce business
• Although the insurer should not endanger its solvency by declaring higher bonus rates

Question 13

outline the influence of PRE in declaring a surplus? (5)

Answer 13

• If policyholder expectations are not met this could result in bad publicity and have a reputational impact on the insurer
• Policyholder usually expect reversionary bonuses to be stable over time
• There is usually less expectations regarding the terminal bonus rate
• However for smooth bonus polices there is not usually a terminal bonus to ensure equity over time therefore regular bonuses vary more the RB
• Some actuaries argue that gradual change is acceptable as long as it is communicated to the policyholder

Question 14

outline the influence of allocations between shareholders and policyholders in declaring a surplus? (3)

Answer 14

• 90/10 method (Policyholders get 90% of all distributed surplus and shareholders get 10%
• Shareholders charge explicit fees to cover expenses and profit while policyholders receive all the remaining surplus
• Investment surplus only (policyholders receive all investment and bonus loading surplus while shareholders get the surplus from all other sources)

Question 15

outline the influence of sources of surplus in declaring a bonus? (6)

Answer 15

In South Africa bonuses on with-profit contracts are designed primarily for the distribution of investment surplus. However there are other sources of surplus which could influence the levels and patterns of bonuses distributed:

• Investment surplus
• Expense surplus
• Mortality and other risk benefit surplus
• Withdrawal surplus
• Surplus from other contracts (non-profit contracts)
• Mismatching surplus

Surplus will arise if the actual experience is more favourable than the pricing basis and the emergence of the surplus will depend on the valuation basis

Question 16

outline the distribution of investment surplus? (7)

Answer 16

• Smooth bonus product design most of the surplus emerging is investment surplus due to product design
• Depending on bonus distribution philosophy and profit sharing agreement between shareholders and policyholders most of surplus in period will be declared as bonuses
• The extent to which bonuses match actual returns over the period depend on smoothing policy
• Guaranteed benefits under the reversionary bonus policy is priced to allow investment return to be earned over time of policy
• Only the excess of achieved returns over those assumed in the valuation basis are declared as bonuses

• Various methods of distributing surplus via regular bonuses exist such as
o Uniform bonus (same bonus regardless of duration)
o Compound bonus (distributes more towards the end of the policy term)

• The release of bonus loading in the premium basis is a subset of investment surplus arising from deliberate underestimation in premium basis

Question 17

outline the distribution of expense surplus? (2)

Answer 17

• Strains or renewal surplus is usually small initial and then depend on difference between actual expense inflation and that assumed
• It is common for expense surplus to accrue to shareholders as pattern of emergence is not suitable for distribution

Question 18

outline the distribution of withdrawal surplus? (5)

Answer 18

• The high a volatile lapse and withdrawal rates in South Africa means that strains and surpluses can be significant in the first few policy years
• Most products have surrender penalties however strains arise in early durations where penalties are not sufficient to recoup initial expenses
• The extent and pattern of emergence will depend on the surrender value basis
• Any surplus accruing might be allowed for in a terminal bonus
• It is also common for surplus to accrue to shareholders

Question 19

outline the distribution of mismatching surplus? (2)

Answer 19

• Surplus is likely to be larger if a more risky investment strategy is adopted
• Mismatching surplus is therefore a special type of investment surplus which is more volatile

Question 20

outline the incorporation of asset share in distributing surplus? (3)

Answer 20

• The insurers will usually ensure that maturity benefits do not significantly deviate from earned asset share
• However given that with-profit benefits are determined indirectly from a pooled fund the proceeds will not necessarily equal asset share
• Some polices will earn benefits in excess of the asset share while other will earned benefits less than the asset share

Question 21

outline how smoothing influences the distributing surplus? (5)

Answer 21

• The smoothing philosophy will influence the bonus distribution philosophy as it provide protection from volatility of the underlying assets
• In addition the fund may offer a guaranteed annual return or overall return over the lifetime of the policy

• Factors that affect the degree of smoothing include:
o Policyholder reasonable benefit expectations
o Method of distributing surplus (TB vs RB)
o Asset mix underlying contracts (bonuses will be more smooth depending in volatility of underlying assets)
o Size of BSR

• Ideally an insurer should decide on the level of smoothing and then insure that the method of distribution, asset mix and free assets are set accordingly
• It is common for asset shares to be built up using graduated mortality tables, expense allocations and smoothed investment return

Question 22

outline the influence of equitable treatments of policyholders in surplus distribution? (4)

Answer 22

• While it is accepted that with-profits are subject to a degree of smoothing consideration of equitable treatment between generations are required
• Example following a period of poor investment returns the deficit may need to be recouped through lower future bonus declarations
• In such a case the policyholder fund may be closed to new business to avoid prejudicing new policyholders
• Equity dictates that a policyholder should receive benefits close to their asset share which is in conflict with smoothing

Question 23

outline the level of vesting vs. terminal bonus on surplus distribution? (4)

Answer 23

• Life insurance companies will want to grow in size if there business is sufficient profitable and they have the required administrative and financial resources
• The deferral of surplus all the company to conserve capital to finance new business
• Furthermore the has given less of a guarantee therefore they can invest is more risky investments such as equity
• Terminal bonuses represent the ultimate deferment of surplus to policyholders
• On the other hand a company will want to maximise its shareholder transfers which would be linked to vested bonuses under the 90/10 structure
• If shareholder are not liquidly constrained and reserves are funded by policyholders then deferral of surplus will be beneficial to both parties

Question 24

outline the uses of asset shares? (5)

Answer 24

• Benchmark for determining the payout to with-profit policyholders and a tool for consideration and quantification of treating customers fairly
• Most companies use asset shares for determining the maturity and surrender values (including market value adjustments for smoothed bonus products)
• Policy asset shares are also used to help smoothing process for maturity values
• They could also be used a guide to determine the appropriate level of regular annual bonuses
• Asset shares are also used in the calculation of investment guarantees under APN 110

Question 25

outline the asset share calculation for conventional with-profit policies? (5)

Answer 25

• There is no standard definition of asset share however companies selling with-profit policies will need to outline clearly how it define, uses and calculates asset share in PPFM document
• A typical definition is premiums less deduction plus miscellaneous profit with all accumulated at a suitable rate of return with an allowance for tax
• The determination of allocations, deductions and the rate of the investment return will depend on past practice and asset share philosophy

• Allocations of miscellaneous profits may include the following:
o Surrender profits on with-profit business
o Profits from without profits business
o Allocations from the free assets (transfers from shareholders)
o Windfall payments e.g. unexpected tax gains

• Typical deductions include
o Commission and expense (net of tax)
o Cost of providing cover and any other benefits or options
o Tax on income, realised and unrealised gains
o Shareholder transfers
o Capital charges (including smoothing and guarantees)

Question 26

outline the inevstment return used in the calculation of the asset share? (3)

Answer 26

• The returns on assets notionally allocated to with-profit business
• Notional returns using a notional asset mix and returns based on an index
• The overall return on non-linked assets in the fund

Most companies use a managed fund approach where a fund of assets is indemnified to back with-profit portfolio

Question 27

outline the handling of surrender profits in the calculation of asset share? (4)

Answer 27

• Historically surrender values would have been calculated as a percentage of asset share e.g. 95%
• Surrender profits mat then be allocated to in-force with profit polices or these can be allocated to shareholders
• Surrenders could also result in losses if the surrender occurs at early durations and there were guarantees or due to smoothing

• Two main methods have been used for this allocation:
o Assets share are accumulated allow for actual surrender profits arising so that broadly profits arising from a cohort is allocated to the cohort
o Alternative surrender profits could be allocated by increase investment rate which would allocate profits to a wider range of policies (depends in equitable treatment in PPFM of company)

Question 28

outline the handling of expense in the calculation of asset share? (3)

Answer 28

• In order to determine appropriate expense deductions past expense will have to be allocated to various categories e.g. acquisition expenses, renewal and investment expense
• New business expenses will usually be expressed as a proportion of premium or commission with possibly administration fee being on a per policy basis
• Renewal expenses would usually be on a per policy basis and investment expense being deducted from investment returns

Question 29

outline the handling of tax in the calculation of asset share? (1)

Answer 29

• For most business taxed on an I-E basis companies would use after tax expenses and not of tax investment returns

Question 30

Describe the calculation of asset share for smoothed bonus products? (3)

Answer 30

• Retrospective accumulation using actual expenses (similar to approach for convention with-profit business)

• Retrospective accumulation using product charges
o Typically done on with-profit business written on 0/100 allocation
o The difference between charges and expense accrues outside the with-profit fund

• Shadow fund
o Calculate in a similar way as for the bid value of units within the unitised fund
o AS is accumulated at the actual investment return rather than the relevant bonus rates
 For unitised fund, accumulation is at bonus rates
 For AS, it is investment return

Question 31

outline the difference between base asset share and aggregate asset share? (3)

Answer 31

• Base asset share usually refers to asset share calculated without allowance for miscellaneous profits and a deduction of capital charges
• Indicates the reliance of miscellaneous profits which may be non-existence in the future
• Aggregate asset share is where the calculation related for a group of polices i.e. specific product line or whole with-profit portfolio

Question 32

outline the requirements for treating customers fairly? (5)

Answer 32

• Requiring companies to achieve target ranges for with-profit polices specified in PPFM
• An approach to surrender values that should balance the interest of policyholders leaving and remaining
• Charges to with-profit funds
• Basis on which new business is written
• Comparison to minimum surrender value in regulation 5 of the LTIA

Question 33

Describe the modelling to detrmine supportability of projected bonus rates? (5)

Answer 33

• The next step is to test whether the projected bonuses can be supported given an actuary’s best estimate of future experience
• The bonuses should be consistent with projected investment conditions, marketing literature and policyholder reasonable benefit expectations (in absence of any communication)
• The results for each policy type and durations should be compared to the earned asset share to consider the equity of the bonus rates
• Significantly different classes of business might lead to the company giving them different bonus rates

• The exercise may indicate the inability to support the same level of bonuses on new and existing business which may lead to:
o Revision of premium rates
o Change to new bonus series for new business
o Decision to gradually adjust bonus rates over a period so that they run into rates supportable by new business

Question 34

Describe the modelling regarding the split between reversionary/terminal and vested vs. non-vested bonuses? (5)

Answer 34

• For convention business this refers to the split between reversionary and terminal bonuses
• For smoothed bonus they refer to the split between vested and non-vested bonuses
• The split will depend in Reasonable benefit expectations regarding investment policy, bonus history and the proportion of claims that have vested
• Reduction in bonuses would need to consider policyholder expectation regarding a reduction, a suitable speed of the reduction as well as competitive considerations
• It would be important to conduct the main investigation under various scenarios to access in what situations bonuses will not be sustainable

Question 35

Describe the modelling regarding the terminal bonus? (4)

Answer 35

• Terminal bonuses are likely to be reviewed whenever there is a change in investment conditions
• The earned asset share and liability value of contracts maturing in the near future can be considered to indicate the scope for the terminal bonus
• The company may want to smooth terminal bonuses based on asset movements in the past three years
• The terminal bonus may be expressed as a rate of (basic benefit and attaching bonuses) depending on the duration of the policy or as the difference between a smoothed asset share and maturity value (excluding the terminal bonus)

Question 36

outline the considerations regarding management of a bonus stablisation reserve? (5)

Answer 36

• The companies smoothing policy can result in contribution from a BSR or subsidies to a BSR
• If BRS is too negative then this may require a loan from free assets which should be repaid once SCR is in a better position
• BSR should not be too large as this would be unfair to existing policyholder therefore bonus rates should not be too prudent
• Allowing the BSR is become negative may affect the insurers ability to write new business as well as create in reasonable expectations for policyholders

• The following questions should be considered
o Can the company continue with its current bonus policy and satisfy supervisory needs in the future?
o Free assets can stay at an adequate level to continue desired new business strategy
o Any constrains on investment policy?

Question 37

outline the concept of a market value adjustment? (5)

Answer 37

• Under a with-profit policy the bonus declarations are smoothed over time while the underlying assets fluctuate with the market
• Therefore at a point in time the policy value may be higher than the asset share
• A policyholder may decide to select against the insurer and surrender their policy
• To protect the interest of other policyholders in the fund in the event of a surrender a MVA is applied to ensure that policy value is brought in line with the underlying asset value
• However a MVA will usually not apply on death or normal maturity as it is meant to prevent anti-selection

Question 38

outline the concept of a capital charges? (2)

Answer 38

• South African legislation requires locally registered insurers to hold a minimum amount of free assets or capital in respect of with-profit business to absorb fluctuations between asset share and liabilities
• The shareholders usually provide this capital and require compensation for the opportunity costs of capital

Question 39

Outline the difference between individual and group life contracts regarding contracts with participation features? (6)

Answer 39

• A MVA will not be applicable if an individual member withdraws from the scheme due to reduce anti-selection (but an MVA would apply if the whole scheme terminates)
• Bonuses tend to follow more closely the investment experience of the fund
• Bonus rates depend on investment experience of the scheme itself i.e. there is no subsidising between schemes
• Reversionary bonus schemes are rare in new group contracts
• Explicit charges are normally made by the life office for administering the fund
• Hedging investment strategies are more common than in individual contracts