Ch 10: With-profits surplus distribution 2

Question 1

Summary Card

Answer 1

• Revalorisation method
• Contribution method
• Reducing with-profits bonuses
• PRE
• Deferring profit distribution
• Profit distribution strategy

Question 2

Describe the revalorisation system of surplus distribution

(1)

(1,2)

(1)

(1)

Answer 2

1. Bonuses are granted by increasing reserves, benefits and premiums of with-profits contracts by a percentage, r% say
   
   • Most countries operating this bonus system also offer option of constant premium policies, ie reserves increase by r%, benefits increase by s% (s <=r) and premiums don’t change

​

1. In determining r%, it’s common to divide surplus into
   
   • savings profits (ie investment surplus) and
   • insurance profit (ie surplus from other sources)
2. A high proportion of savings profit is usually given to policyholders, with rest retained for shareholders
3. All insurance profit may go to shareholders or, depending on market, it may be divided between shareholders and policyholders

Question 3

State 4 advantages of revalorisation system of surplus distribution

Answer 3

1. Simple to apply
   
   • therefore cheap to administer
   • exceptions if policyholder takes portion of insurance profits
     
     • one off profits/losses usually spread over time and judgment may be needed
2. Codifies exactly how company should declare part of its profits as bonus, so objective and relatively cheaper to administer
3. Objectivity generally protects policyholders from ungenerous life insurers
4. Takes assets at book value
   
   • thus includes appropriately smoothed writing-up adjustments/smooth emergence of investment profit is usually achieved

Question 4

State 4 disadvantages of the revalorisation method of surplus distribution

Answer 4

1. Company has no discretion (except to extent of spreading of one-off costs, if insurance profits is distributed to policyholders)
2. Tends to discourage equity investment, as there is no deferral of profit distribution.
   
   • meaning all investment losses would be borne by company and would constitute unacceptable insolvency risk
   • also problem regarding treatment of unrealised gains, which are not easy to distribute directly under current revalorisation systems
3. Versions that do not share insurance profit with policyholders go against principle of mutuality
4. Difficult to explain to policyholders with constant premiums policies who see very small additions to their guaranteed benefits early in policy term

Question 5

Describe the contribution system of surplus distribution

(1)

Answer 5

Distributable surplus should be distributed among policies in same proportion as those policies are judged to have contributed to surplus

Question 6

State a formula for the dividend under the contribution method of surplus distirbution. Define all terms.

Answer 6

Dividend = (V₀ + P)(i” - i) - (q” - q)(S - V₁) - [E”(1+i”) - E(1 +i)]

Where:

V₀ = value of contract at beginning of year on valuation basis

V₁ = valut of contract at end of year on valuation basis

P = gross premium

i” = actual rate of interest earned

i = valuation basis rate of interest

q” = actual mortality rate

q = valuation basis rate of mortality

S = sum assured

E” = actual expenses experienced under contract

E = valuation expenses under contract

Question 7

State 2 common variations of the contribution method of surplus distribution

Answer 7

• Dividend may be converted into paid-up addition to benefits, rathern than paid out in cash
• Terminal dividend may be given

Question 8

State 3 advantages of the contribution method of surplus distribution

Answer 8

1. Policyholders receive benefits earlier than under additions to benefits or revalorisation methods
2. Objective, so more transparent and may appear fairer
3. Equitable (dividends based on policy’s contribution to surplus)

Question 9

State 3 disadvantages of the contribution method of surplus distribution

Answer 9

1. Payment of cash dividend reduces final benefit. May not be popular if policyholder wishes to pay set premium or is targeting a set benefit for specific purposes
2. Overall return may be lower, as no deferral of surplus (unless there’s a terminal dividend)
3. Increased admin of making dividend payments….need to ensure system is set up for the change

Question 10

List 3 reasons why it may be difficult for an insurer to reduce with-profits bonuses to reflect poor experience

Answer 10

1. PRE
2. Bonus method e.g revalorisation method usually only distributes investment profits, so any other expense or mortality losses must be born by company
3. Gurantees mean that there is some level of adverse experience beyond which any further losses cannot be recouped (as cannot declare negative bonuses)

Question 11

Define PRE (policyholder’s reasonable expectations)

(2)

Answer 11

• Relates to PRE with regard to level of benefits, or charges, under contracts where these are at discretion of insurer
• There is no generally accepted definition of PRE, but they will be influenced, for example, by the past practice of a company and any literature issued by it.

Question 12

List

• 3 influences on policyholder’s expectations as regards the form of the profit distribution and level of bonuses or dividends given
• 3 potential consequences of a failure to meet those expectations

Answer 12

• Influences on policyholder’s expectations
  
  1. documentation issued by insurer
  2. company’s past practice
  3. general practice in life insurance market
• Possible consequences of failure to meet those expectations
  
  1. policyholder dissatisfaction
  2. risk of losing existing and/or new business
  3. intervention by insurance supervisory authority in affiars of company

Question 13

State 2 possible benefits of deferring distribution of profits to policyholders.

Give 3 features of an additions to benefits surplus distribution system that could be used to help defer distribution of profits to policyholders

Answer 13

• Deferring profit may be
  
  • used to augment company’s free assets and it ability to take on risk
  • available to support new business (depending on the regulatory regime)
• Using additions benefits system to defer profits distribution
  
  • high proportion of terminal bonus (and lower reversionary)
  • conventional with-profits (rather than accumulating with-profits)
  • super-compound bonuses (rather than compound or simple)

Question 14

List 4 aims of profit distribution strategy

(Note this card has been included in the following card regarding factors to consider when setting bonus distributions. Still may be useful to considser it by itself)

Answer 14

1. To meet PRE regarding payouts and to treat customers fairly
2. To meet shareholders’ requirements for profit from company’s with-profits business (where appropriate)
3. To manage capital efficiently/control solvency risk
4. To control marketing risk

(Note this card has been included in the following card regarding factors to consider when setting bonus distributions. Still may be useful to considser it by itself)

Question 15

List considerations in making bonus declarations (11)

Answer 15

1. PRE
   
   • Level
   • volatility
2. Equity between different
   
   • categories e.g. same policy size, sex, territory
   • policyholder generations (smoothing over time relative to asset share)
   • between policyholders/shareholders
3. Asset shares, and whether it can support bonuses declared
4. Not threatening company’s:
   
   • future business plans,
   • investment strategy and
   • solvency position
5. Surplus distribution philosophy/strategy; aims to
   
   • Meet PRE regarding payouts and to treat customers fairly
   • Meet shareholders’ requirements for profit from company’s with-profits business (where appropriate)
   • To manage capital efficiently/control solvency risk
   • To control marketing risk
6. Long term investment return: influences rates, should be able to support bonus rates
7. Profit emergence e.g. profit may only emerge after with profits business has gone of book
8. Flexibility through discretion
9. Supervisory influences
10. Simplicity
11. Changes in communication

Question 16

List 8 possible components of a profit distribution strategy

Answer 16

1. Amount of each year’s profit distributed (regular bonus) and deferred (terminal bonus)
2. Split of profit distributed between policyholders and shareholders
3. Bonus method used
4. Level of initial guarantees provided
5. Extent
   
   1. of smoothing of payouts over time
   2. to which profit distributions to individual policyholders reflect actual profit earned by those policyholders
   3. to which policyholders share in profits from other business
6. Contribution of with-profits business to company’s estate, or vice versa

Question 17

Discuss the various factors the insurer should consider when deciding on which bonus method to use

(1,3)

(1,4)

(1,3)

(1,2)

Answer 17

• Policyholders Reasonable Expectations
  
  • ​From: documentation, company past practice, general market practice
  • Failure to meet: policyholder dissatisfied, risk losing new/existing business, TCF problems
  • Adverse publicity
• Deferal of profit (leading to capital being raised)
  
  • Balanced: over/under distribution to prevent excessive free assets drain
  • Addition to benefits: greater deferral => greater investment freedom
  • Revalorisation method: doesn’t appear to defer profit distribution
  • Contribution method:
    
    • depending on balance between regular/final dividends, may also lead to deferral, but usually less than ‘additions to benefits method’
• Margins for future experience
  
  • Revalorisation method: usually only distributes investment profit so any insurance losses to be born by insurer; unlikely to suffer losses from this since products priced prudently, but still a factor
  • PRE: may be difficult for insurers to reflect poor experience fully in bonuses
  • Impact of gaurantees
• Business objectives
  
  • Competitive perspective: maximise eventual payout to policyholders
  • Bonus reductions:
    
    • required sometimes (solvency problems, tough financial environment)
    • reduces competitiveness