SURPLUS DISTRIBUTION

Question 1

What are the four main ways reasonable benefit expectations can arise?

Answer 1

1. PH will expect content in policy contracts is followed.
2. PH could be influenced by insurer’s marketing and other literature (could say how surplus is distributed, split between different types of bonuses and how they may be determined).
3. An office’s actual past practice will be expected to continue into the future.
4. An office may be expected to conform to what other offices are doing in the market place.

Question 2

Important considerations when it comes to surplus distribution

Answer 2

• Avoid big changes to investment strategy
• Don’t endanger the solvency and stability of the company - Long-term Insurance Act
• Consider regulatory and industry requirements applicable at the time (PPFM)
• Account for any restrictions in terms of the company’s Memorandum and Articles of Association
• Be consistent with premium bases of the premium scales, where appropriate, and the valuation of liabilities.
• If policy has been transferred from another company there are usually safeguards in place which need to be honored when distributing surplus.
• The system must be easily understood by sales and administration staff, and most importantly, by policyholders.
• The system should be capable of accurate implementation, given the computer resources available.

Question 3

What is the difference between smoothed bonuses and reversionary bonuses?

Answer 3

1. How they are added: RB added to sum assured payable on maturity/death whilst SB added to current value of policy similar to interest on savings account
2. Transparency: RB less transparent because PV is less than nominal amount due to discounting, but SB more transparent because direct increase made to policy value which policyholder can see
3. Stability: RB tend to remain very stable over time with little fluctuation year to year, while SB follow actual investment returns more closely while still providing smoothing
4. Vesting mechanism: RB fully vest once declared and become guaranteed additions, whereas SB typically split into vesting and non-vesting portions with only vesting portion guaranteed
5. Policyholder expectations: RB create strong expectations they will be maintained at similar levels, but SB create less expectation about maintaining specific levels making it harder to predict maturity proceeds
6. Investment freedom: RB create higher financial strain and may constrain investment freedom, while SB provide more flexibility due to non-vesting component
7. Reserve requirements: RB require reserving for both declared bonuses and future expected bonuses, whereas SB have different reserving implications particularly for non-vested portions
8. Policyholder understanding: RB more complex for policyholders to understand (future benefit increases vs. current values), but SB generally easier as they resemble how banks add interest
9. Timing of value recognition: RB value realized only at maturity or death, while SB value recognized immediately in current policy value

Question 4

What are miscellaneous profits considered in the EAS calculation of conventional WP business?

Answer 4

• Surrender profits from other policies (often 5% of asset share from surrendering policies)
• Profits from without-profits business (allocation methods vary)
• Transfers from free assets/shareholders
• Windfall profits like unexpected tax gains

Question 5

What are deductions considered in the EAS calculation of conventional WP business?

Answer 5

Deduct actual expenses occurred (typically net of tax) not charges state in the policy:
- Commission and acquisition expenses (typically front-loaded)
- Ongoing administration expenses (often per-policy basis)
- Investment management costs (typically percentage of assets)

Deduct Cost of Benefits based on actual mortality/morbidity experience

• Cost of providing life cover
• Cost of other benefits and options included in the policy

Deduct Tax:

• Includes income tax, tax on realised and unrealised gains, tax on profits,
• May use actual tax rates paid or notional rates based on different years

Deduct Shareholders’ Transfers:

• In proprietary companies, often one-ninth of the cost of bonus on valuation basis
• Most companies deduct these from policy asset shares

Deduct Capital Charges:

• Cost of providing guarantees
• Cost of smoothing process
• Cost of return on capital employed in writing the contract
• Cost of building up the company’s capital base

Question 6

What are investment returns considered in the EAS calculation of conventional WP business?

Answer 6

Use one of these approaches (some most to least ‘individual’):

1. Return on assets specifically allocated to with-profits business
   - useful when there is a seggregated fund for WP business
   - helps ensure very accurate tracking of returns of underlying assets
   - allows for customised investment strategies for different policy types
   - this is the most common approach, policy’s asset share is invested proportionally in this fund, so know the exact investment return attributable to that asset share
2. Return on notional asset mix with market index returns
   - defines a theoretical asset allocation (e.g., 60% equity, 20% bonds, 20% cash)
   - applies market index returns to each asset class (e.g., JSE All Share for equity portion)
   - combines these weighted returns to determine the overall return
   - helpful if historical data on actual returns is not complete
   - if business still new and portfolio is still being established
3. Overall Return on the Non-Linked Assets in the Fund
   Approach:
   - Uses the aggregate investment return on all non-linked assets in the company
   - All with-profits policies share the same investment return regardless of type

Question 7

Why might you use individual asset share vs. aggregate asset share?

Answer 7

• Whether actual expenses or product charges are used
• The mechanics of accumulation (conventional vs. unit-like approach)
• The level of granularity in calculation (individual vs. aggregate)
• The inclusion or exclusion of miscellaneous elements (base vs. full)

Question 8

Important modelling considerations when it comes to calculating bonuses

Answer 8

Modelling involves projecting asset shares and comparing them to liabilities, using either deterministic or stochastic approaches.

Important considerations:
1. Assessing relevant business experience (mortality, expenses, withdrawals, investments)
2. Testing supportability of projected bonus rates against best estimates
3. Comparing results across policy types to ensure equity
4. Determining the split between reversionary/terminal bonuses (or vested/non-vested bonuses)

Other important things:
- Companies need to evaluate different investment scenarios to assess when current bonus rates may become unsustainable.
- Terminal bonus rates may be reviewed more frequently than reversionary/vesting rates, especially when investment conditions change significantly.
- Guarantees and options should be modelled, typically using stochastic methods.
- Dynamic interactions between projection assumptions (such as how bonus declarations affect policyholder behavior) must be considered.

Question 9

What are the other important considerations when it comes to managing the with-profits book?

Answer 9

• Market Value Adjuster (MVA) - A mechanism to protect continuing policyholders when others surrender their policies, especially after market falls
• Capital charges - Requirements for insurers to hold minimum capital for with-profits business and how shareholders might be compensated for providing this capital. The riskier the investments, the more capital we need to hold + more fees payable to shareholders. In mutual company, there are no shareholders, on policyholders so no additional compensation necessary.
• Group business - How the principles of surplus distribution apply to group/employee benefits contracts with some differences from individual policies

Question 10

What are the differences between surplus distribution for individual vs. group business.

Answer 10

• MVAs normally do not apply when individual members withdraw from a group scheme (but an MVA would apply if the whole scheme terminates). This is because of the
  reduced risk of anti-selection. Individuals only withdraw when they terminate their employment, die or become disabled.
• Bonus rates tend to more closely follow the investment experience of the fund (but this depends on the investment strategy).
• 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 subsidies
  between schemes are limited. (Smaller schemes might be pooled in a single fund.)
• The reversionary bonus system is rare with new group contracts. Most new with-profits
  group schemes employ the smoothed bonus approach.
• 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.
• Hedged investment strategies are more common than under individual policies.