THE FINANCIAL MANAGEMENT OF A WITH-PROFIT ......multiple of the capital required to be absorbed by a year’s new business. 2.4 We get a better insight into this process if we notionally

THE FINANCIAL MANAGEMENT OF A WITH-PROFIT

LONG TERM FUND—SOME QUESTIONS OF DISCLOSURE

BY C. S. S. LYON, M.A., F.I.A.

[Presented to the Institute of Actuaries, 25 January 1988]

1. THE STRENGTH OF AN OFFICE AND ITS FORM 9 RATIO

1.1 There are three starting points for this paper. The first is Marshall Field’s challenging Presidential Address to the Institute of Actuaries in 1986 on the subject of ‘Risk and Expectation'.(I)The second is the example, still fresh in our minds, of a medium—sized mutual life office which overstretched itself and found it necessary to merge with a competitor. The third is the impending requirement, stemming from the Financial Services Act 1986, to give an investment client, including the holder or prospective holder of an insurance savings contract, what is described as ‘best advice’.

1.2 The first of these needs no further introduction; members will doubtless have taken it to heart, and I shall return to its theme later in the paper. However, the second and third have served to focus the attention of intermediaries on the need to consider the strength of a with-profits office before recommending its contracts to their clients. Adequate strength had previously been taken for granted and attention focused on comparative projections based on current bonus rates or, at best, levels of current maturity values. With the approach of the new regulatory system governing the sale of investment products, the thought that some offices might be better placed than others to maintain bonuses at current levels has profoundly disturbed some intermediaries. Their reaction (encouraged, it has to be admitted, by one or two offices) has been to calculate the ratio of the market value of an office’s assets to the value of its liabilities as shown in Form 9 of its published returns to the Department of Trade and Industry, on the presumption that the magnitude of that ratio (referred to subsequently as ‘the Form 9 ratio’) is a good guide to an office’s strength. The reducing strength of the mutual office already mentioned was, on that criterion, there for all to see. The presumption, however, is not a good one, whether expressed in absolute or relative terms, for reasons which include the following:

1.2.1 Although assets must be shown at market value in Form 9, an office may elect to place a lower value on them for the purpose of the appointed actuary’s investigation into the financial condition of its long term business. This gives the actuary the freedom to maintain, over a wide range of market conditions, a stable basis of valuation of the liabilities for comparison with what is usually a gradually written-up book value of the assets. Changes in market values do not then distort valuation surpluses in a way which it would be inappropriate to

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Richard KwanJIA 115 (1988) 349-404

350 The Financial Management of a With-Profit

reflect in a distribution, though as a consequence they cause movements in the Form 9 ratio that are of spurious significance.

1.2.2 The published value of the liabilities is determined by the appointed actuary on a basis of his choosing which, for non-linked business, usually has the primary aim of controlling the release of surplus. Since it must at the same time demonstrate statutory solvency, a net premium basis is normally employed for policies subject to contractual future premiums. Emphasis on the rate of release of surplus is particularly important if policyholders are entitled to participate in it. However, such emphasis can have an important bearing on the strength of the actuary’s basis. The chosen parameters, and the decision whether, for example, to incorporate a zillmer, will depend not only on the nature and mix of the business (with and without profits, taxed and untaxed, etc.) but also on the respective demands of existing with-profit policyholders (for bonus), shareholders (for a transfer to profit and loss, or the containment of a transfer from profit and loss), the marketing department (for the financial capacity to support its new business plans), and the investment department (for freedom to adopt a degree of mismatching of assets and liabilities).

1.2.3 The statutory net premium basis does not involve the establishment of an explicit reserve for future bonuses, although it does have the effect of reserving future bonus loadings. Declared bonuses must of course be valued, but their amount will depend on the pace of the office’s bonus declarations, most importantly its use of terminal as distinct from reversionary bonus. Future terminal bonus on existing policies can represent a major moral charge on the excess of assets over published liabilities, but the extent of this charge is not quantified in the returns.

Thus an office’s Form 9 ratio is heavily influenced by internal factors which affect the availability and use of financial resources; factors which need to be properly analysed before the significance of the ratio can be assessed. This is not possible for the intermediary or commentator who does not have ready access to actuarial advice.

2. EMPLOYMENT OF CAPITAL IN NEW BUSINESS EXPANSION AND ASSET/LIABILITY MISMATCHING

2.1 Fundamental to the successful development of any business is the availability of adequate capital, and that depends on lenders and owners being satisfied with the rates of return they can expect to obtain on it within their respective time horizons. They will expect that return to be greater than they could obtain from a risk-free investment, the excess having due regard to the degree of risk involved. Whether mutual or proprietary, a life office is no exception. If proprietary, it will have share capital and reserves external to its long term fund and they will be explicitly disclosed. But the deployment of the working capital of a proprietary or mutual office held within the fund is only partially disclosed in Form 9 (as the assets available to meet the minimum margin

Long Term Fund—Some Questions of Disclosure 351

of solvency), since the quantification of the capital employed in establishing the liabilities at their published level does not enter into the statutory regulations, nor is it required by professional actuarial or accounting standards.

2.2 As actuaries we refer to the working capital as the ‘estate’. We debate its size, its ownership and whether with-profit policyholders should contribute to it temporarily or permanently, but we tend to miss the point that any project that needs initial financing must provide the suppliers of the finance (be they shareholders or the generality of with-profit policyholders or a combination of the two) with an adequate reward. Unless a long term fund has recourse to external capital or has inherited an excessive estate, its capacity for development will depend on the way the office controls the interaction between the part of the fund which represents the estate, and the part generated by the net cash flow from the business on the books. The latter, which we may describe as the business fund, has to absorb capital from the estate to support the office’s new business operation. The amount of capital absorbed depends on the extent to which, having met marketing, sales and installation costs, the net cash flow falls short of the required initial reserve for the business written. This, of course, is familiar to us as new business strain. The capital is gradually released as the fund built up from subsequent cash flow moves towards self-sufficiency.

2.3 If the new business of a mature office is to expand purely on the basis of the recycling of capital already absorbed from the estate, that capital will need to be returned with a net internal rate of return which, on average, is at least as high as the desired long-term rate of growth of new business,(2) though a higher rate of growth could be sustained for a time if the new business became less capital- intensive. Normally, growth of at least the rate of inflation will be sought in order to contain the impact of expenses, so the absorbed capital needs to earn a net real return that is not negative. The actual profile of the growth that can be financed by recycling it will depend on the timing of its release from the existing business. A new office must, of course, continue to obtain new working capital (in this case by transfers from profit and loss) until its portfolio of business becomes sufficiently mature. How long that will take is a function of the duration of its contracts and the speed at which capital is recycled, and these in turn will determine how large the total of outstanding absorbed capital will become as a multiple of the capital required to be absorbed by a year’s new business.

2.4 We get a better insight into this process if we notionally divide the capital absorbed by a block of new business into two parts. The first is the excess of the published reserve, designed to satisfy professional standards and statutory regulations, over a ‘best estimate’ that strips the margins from the published basis other than those which depend on the payment of future premiums. The second is the amount, if any, by which the net cash flow from the new business falls short of that estimate.

2.4.1 The first component of this absorbed capital, which for the business as a whole, including existing business, is described in Australia as the liability estate,(3) is a kind of collateral security for the liabilities. (Collateral is needed

352 The Financial Management of a With-Projit

because any best estimate implies the prescience that F. M. Redington, in his final major essay,(4) told us we had no right to claim.) The collateral remains invested in financial assets; the net return on these is likely to be the dominant factor in the total net return to the estate, but because of the risk of loss it should not be the only factor. If not called upon to meet adverse experience relative to the best estimate, the collateral is released over time as the business fund becomes increasingly self-sufficient.

2.4.2 On the other hand a shortfall of net cash flow relative to a best-estimate liability represents capital that the office must aim to recover, with the necessary total return, out of future cash flows to the business fund. It is in its interest to keep such shortfalls to a minimum: this, for example, is the effect of issuing capital units at the outset of a unit-linked contract.

2.5 The collateral support required for the business as a whole (in other words, the liability estate) will be increased if, due to the office deciding, for example, to hold equities against part of its contractual liabilities, a mismatching reserve has to be implicitly or explicitly established. Assuming that the estate is strong enough to provide it, the outcome may well be a higher rate of investment return on the business fund for the benefit of with-profit policyholders, thereby putting the office in a better competitive position. If, however, the experience is adverse, and the additional collateral finance cannot be recovered with an average rate of return to the estate high enough to support the desired rate of new business growth, the mismatched stance may have to be modified or the rate of new business growth diminished. There may also be consequences for bonus rates.

2.6 It follows that an office wishing to mismatch its liabilities, or to expand its new business at a rate consistently higher than the net investment return on the assets representing its present liability estate, needs to be able to enhance that estate by drawing on part of its asset estate, namely the assets available for the solvency margin, though obviously not to the extent of uncovering that margin. Failing this, it could hypothecate emerging surplus that would otherwise be available for distribution, thereby forcing the shareholders and/or the existing with-profit policyholders to contribute more working capital. In the case of with- profit policyholders that raises the question of whether they should be expected to contribute such capital permanently, or whether it should be returned to them in the form of terminal bonus on leaving the fund.

2.7 There is considerable literature on this last point, in particular R. S. Skerman (5) G. C. Ward,(5) and T. C. Jenkins & A. J. Wilson.(7) F. M. Redington also discussed it in his story of Paul and David in ‘The Flock & the Sheep’,(8) but his analysis should be read in conjunction with Jenkins’ contribution to the discussion on that paper in Sydney.(9) Broadly speaking, it has been shown that there are conditions in which it is theoretically possible for existing with-profit policyholders to finance, through the deferment of bonus, the liability estate required to support a rate of growth of new business greater than the net investment return on the fund’s assets. Such support from the existing


policyholders need not affect their ultimate return, though early leavers are likely to incur a penalty unless commensurate terminal bonuses are payable to them. But what is important for the purpose of the present discussion is the effect of this process on the size of the asset estate and hence on the Form 9 ratio.

2.8 A recent paper by D. O. Forfar and other members of the Faculty of Actuaries Bonus and Valuation Research Group, has given useful illustrations of the so-called profit signatures that result from different bonus structures and valuation bases in conditions of relatively low investment yields.(10) These profit signatures are the year-by-year costs and benefits to the asset estate in its transactions with a new policy during its 20-year lifetime. In one case (Table 18 of that paper) a uniform reversionary bonus of 3.5% p.a. and a terminal bonus of 9.5% of the sum assured and attaching bonuses have been assumed in the context of a 7.5% p.a. net investment yield, and the signatures of three different valuation bases given. In Appendix 2 to the present paper these signatures, slightly modified so that their net present value at 7.5% is as close to zero as possible,(11) have been projected at various new business growth rates, so as to study the pattern of transactions for a portfolio of business built up from scratch and the cumulative effect on the size of the office’s published asset estate. The impact of both the growth rate and the valuation basis is very marked, and although the projections are only of illustrative value they certainly reinforce one’s concern about attaching great significance to the current level of that estate.

2.9 There are two clear messages from the analysis in this section. The first is that an office bent on rapid expansion, or serious mismatching, ought to model the future capital release and absorption patterns of its existing business and its planned new business respectively, to ensure that the latter is consistent with the resources likely to be available and that these are not constrained by an unreasonably stringent basis for the published liabilities. It should also monitor the rate of return to the estate, on which its longer-term growth plans will depend. Through deferring the vesting of bonuses on with-profit policies it may be able to enhance that return without detriment to future maturity proceeds (though policies terminating early would suffer). For a temporary acceleration of new business it may be in a position to run down its asset estate, but this will need very careful control to prevent the situation getting out of hand.

2.10 The second message is to reiterate the warning against taking at face value the asset estate in Form 9. Without an analysis of the actuary’s valuation basis, the office’s bonus structure, and the mix and degree of maturity of its business, it is impossible to tell how much of this estate is truly free and how much is temporary finance from the existing with-profit policyholders, who will expect it to be repaid in the form of terminal bonus; or how large and how accessible is the concealed liability estate. There is no single figure that will serve this multiple purpose and the fundamental question is whether the level of disclosure required in Schedule 4 of the D.T.I. Returns is, in practice, sufficient for an independent appraisal of the office’s true position to be made.


3. BONUS STRUCTURE AND THE AMOUNT OF THE LIABILITIES

3.1 A net premium valuation, such as is required as a minimum standard by the regulations for valuing liabilities, has the merit of increasing the basic liability from 0% to 100% of the sum assured across the duration of the policy, the pace of the progression being determined by the rate of interest, and the starting point being modified if necessary to prevent credit being taken for future net premiums which encroach too closely on the gross premium. In addition, reversionary bonuses are valued as they are declared, and if there is compounding the actuary is likely to choose a conservative rate of interest to provide for it. But in a net premium valuation it is not usual to treat future terminal bonuses as a liability. Instead, they are regarded as covered by asset appreciation, which adds to the asset estate and can be drawn upon as and when required to meet them.

3.2 The effect of such treatment of terminal bonus is to inflate the asset estate of an office which places heavy emphasis on terminal bonuses at the expense of reversionary bonuses as compared with an office which does not. Consider an office which declares a terminal bonus on the sum assured and attaching reversionary bonuses at a term-related rate sufficient to raise the bonus from an effective 4% p.a.,compounded over the duration of the policy, to the equivalent of (a) 4.5%, (b) 5.5%, or(c) 6.5% p.a. compound. It can easily be shown that the terminal bonus will represent the percentages of the total maturity value shown in Table 1A:

Table 1A

Policy duration

Equivalent compound bonus 10 yrs 15 yrs 20 yrs 25 yrs 30yrs

4½% 4.7% 6.9% 9.1% 11.3% 13.4%

5½% 13.3% 19.3% 24.9% 30.1% 34.9%

6½% 21.1% 30.0% 37.8% 44.8% 51.0%

Besides duration, these proportions are dependent on the increase in effective bonus rate (i.e. .5%, 1.5% and 2.5% p.a. in this example) and vary only slightly with the starting point (in this case 4% p.a.). Broadly comparable figures, though less sensitive to duration, are produced if the terminal bonus is (a) 25%, (b) 75%, and (c) 125% of attaching bonuses only, as shown in Table 1B:

Table 1B

Policy duration

Terminal bonus 10 yrs 15 yrs 20 yrs 25 yrs 30 yrs

25% 7.5% lO.O% 12.0% 13.5% 14.7%

75% 19.6% 25.0% 29.0% 31.9% 34.2%

125% 28.8% 35.7% 40.5% 43.9% 46.4%


3.3 In effect, the proportions of claim payments represented by terminal bonus will not have been allowed for in the published valuation of liabilities. When terminal bonuses were first introduced the proportions were quite modest, but today a declaration that effectively raises a compound reversionary bonus of 4% p.a. or more by the equivalent of 2.5% p.a. on the maturity of a 25-year endowment assurance is commonplace: see Tables 2 and 3.

Table 2. Endowment assurances, with profits, maturing after 25 years on 1 August 1987, having been effected on a male aged 29

years 11 months at a gross annual premium of £100

Terminal bonus Terminal bonus Number of (% total benefits) (% sum assured and reversionary bonuses) offices

Not exceeding 20% Not exceeding 25% 5 Over 20% up to 33.3% Over 25% up to 50% 6 Over 33.3% up to 42.9% Over 50% up to 75% 18 Over 42.9% up to 50% Over 75% up to 100% 17 Over 50% up to 55.6% Over 100% up to 125% 9 Over 55.6% up to 60% Over 125% up to 150% 2

57

Source: Derived from the table of individual offices’ past performance on pp. 21 and 23 of Planned Savings, October 1987. Special situations annotated therein have not been excluded.

Table 3. Endowment assurances, with profits, maturing after 25 years on 1 August 1987, having been effected on a male aged 29 years 11 months at a gross annual premium of £100; showing the uniform compound reversionary bonus rates

that are equivalent to the bonuses actually paid.

Number of offices

Normal and special All bonuses including terminal bonus

Not exceeding reversionary bonuses 4½% 5% 5½% 6% 6½% 7% 7½% 8% Total

Not exceeding 3% 2 1 3 " 3½% 1 2 2 5 5 15 " 4% 1 1 2 3 14 " 4½% 1 1 4 5 3 2 16 " 5% 2 2 3 7 " 5½% 1 1 " 6% " 6½% 1 1

Total 4 4 3 7 17 9 11 2 57

Source: Derived from the table of individual offices’ past performance on pp. 21 and 23 of Planned Savings, October 1987. Special situations annotated therein have not been excluded.


Given that for such policies half, or nearly half, of the maturity proceeds represent terminal bonus, is it satisfactory for the published valuation to ignore its accrual—in other words, to treat as free estate the asset appreciation which provides cover for future terminal bonus? One result of so doing is to produce Form 9 ratios that are at best uninformative and at worst misleading.

3.4 In the context of a net premium valuation there may be no way of resolving this problem completely. A partial solution would, however, be better than none, and one such solution would be to require a present value of accrued terminal bonus to be disclosed in Schedule 4 of the DTI returns. Rules would have to be formulated for determining what was deemed to have accrued, since we are concerned here with reasonable expectations and not contractual liabilities. It ought to be related to the secured benefits attributable to past premiums, in the context of the assets currently held. The basis would probably have to be fairly crude, for example by defining the accrued terminal bonus by reference to the rate currently payable on claims of a particular duration in force, and applying that rate to the sum assured and/or attaching reversionary bonuses (depending on the terminal bonus system in use by the office) in the case of death before maturity and to the current paid-up equivalents in the case of survivorship; the respective amounts would then be valued at an appropriate rate of interest. The subject merits some speedy research.

3.5 Information of such a kind, while not creating a mathematical reserve for the accrued terminal bonus for the purposes of the EC Life Directive, might enable intermediaries (with the help, perhaps, of consultants and other commentators) to get a better feel for the significance of the Form 9 asset estate. An office whose apparent free assets were insufficient to cover the accrued terminal bonus would look less strong than a competitor with the same Form 9 ratio where there was cover to spare. The result could be to introduce a much- needed element of discipline into terminal bonus declarations—a subject which is considered further in section 4 below.

3.6 There are, of course, other ways of deferring the vesting of bonus, notably by declaring a higher rate of reversionary bonus on bonuses already attaching than on basic sums assured. The object of this will usually be to reflect more closely the growth of income from ordinary shares and property, given that such growth is not permitted to be anticipated in the yields assumed in the actuary’s valuation. In theory such a system could also involve the temporary use of with- profit policyholders’ funds to finance a rate of growth of new business greater than the rate of return on the assets backing the liability estate, as discussed in section 2 above. However, it is hard to see what additional disclosure could be required of an office to enable its policy in this respect to be understood and its significance assessed.

3.7 Nevertheless GN 1 requires an appointed actuary to obtain information about the office’s marketing plans and investment policy when investigating its financial condition. There is a case for this requirement to be reflected in a more dynamic certificate than he currently has to provide in the DTI returns. There is a


precedent for this in the certificate of prospective five-year solvency required by the Occupational Pensions Board from the actuary to a contracted-out pension scheme. Perhaps the appointed actuary to a life office should be required to certify that he has been informed of the office’s marketing plans and investment policy and that in his opinion they do not prejudice its ability to fulfil the reasonable expectations of its existing and potential policyholders.

4. EQUITY IN BONUS DISTRIBUTION

4.1 But what exactly are the reasonable expectations of policyholders? First and foremost, they are entitled to expect that the office will so conduct its affairs that it will always be able to meet its contractual obligations. This presupposes that it will avoid mutually inconsistent obligations such as maturity guarantees in a unit-linked contract, or guaranteed surrender and loan values in a non-linked contract dependent for its viability on a long-term investment perspective, unless it has sufficient capital to finance them (and, by implication, is satisfied with the return it expects to earn on that capital).

4.2 With-profit policyholders can expect more than that, but what criteria should be applied? In his Presidential Address Marshall Field posed related questions:

“Whereas [a with-profit policy] was originally a contract providing protection with a modest augmentation derived from the profitability of the company, it has now become a policy under which the major part of the ultimate benefit is derived from the distribution of surplus. Has the policyholder really appreciated this—has it changed his expectation from life assurance policies?... And is it fair that so much of the eventual return should be subject to the discretionary process of the bonus distribution?"(12)

These questions may be regarded as a challenge to the profession, for the President refrained from answering them except to point out that, in monetary terms, reasonable expectations are only meaningful at a point of time. In general terms, however, with-profit policyholders must surely expect to be treated fairly by the office when the surplus available for distribution is determined, and its allocation between classes and durations of contract decided. Some offices have in their constitution a requirement that surplus be distributed equitably, but others do not. Marketing departments are not noted for their interest in this subject; their concern is to be able to present a bonus declaration in the best possible light to their sales outlets. The appointed actuary therefore has a crucial role to play in advising his company on what surplus is distributable and how it should be distributed if equity is to be maintained. Yet the Institute and the Faculty say nothing whatever about equity in their guidance to appointed actuaries.

4.3 In a pooled fund whose individual liabilities are not linked in any contractual sense to the value of a particular portfolio of assets, equity has to be regarded in broad terms if it is to have any meaning. That is not to say that it is an impractical concept which should have no place in our guidance. It is hard to see

The Financial Management of a With-Profit 358 what reasonable bonus expectation with-profit policyholders can have unless it is for the office to apply its profit-sharing provisions in a manner that is demonstrably fair within the limitations of pooling. It would be interesting to know how the courts would interpret a typical set of profit-sharing articles if a with-profit policyholder were to allege that he had been unfairly treated relative to others in his class, but I am not aware that there has ever been such a case. Nevertheless, at a time when the protection of investors is occupying so much legislative and neo-legislative effort, it is difficult to defend the right of the directors of a life office to exercise unfettered discretion over so high a proportion of the benefits of its with-profit policies, even with the advice of the actuary. Equity needs not only to be the keystone but be seen to be the keystone, and it is the duty of our profession to point the way. The question is how.

4.4 There are two specific references to with-profit policyholders in GN 8. Paragraph 2.1.3 of that guidance note states that actuarial principles require the actuary to pay due regard in his valuation to their future interests and that this may well necessitate his making other investigations to satisfy himself as to the pace of emergence of surplus. Paragraph 1.4 requires him to include in his valuation report advice on the conditions in which the office could reasonably expect to be able to maintain its current rates of bonus. It would not seem unreasonable to require him also to advise on the equity of a proposed declaration of bonus, whether reversionary or terminal, and regardless of whether the proposition was his own or emanated from the board or management of the office.

4.5 Given that the decision to declare a bonus normally rests with the directors, a requirement to advise on equity would be of limited value unless backed by a statutory disclosure requirement. In Australia the equivalent of the appointed actuary has to give his approval to a bonus declaration. In the United Kingdom that would, I think, be going too far. The alternative is to require him to state, in his certificate in the DTI returns, whether or not any distribution of surplus that has been made as a result of his investigation is in his opinion consistent with the reasonable expectations of all with-profit policyholders, and to support his opinion with information in Schedule 4 on the methods he has used to justify it. Any such requirement would need to be reinforced by additional guidance from the profession.

4.6 What that guidance should be is very much a matter for debate. S. L. Smaller described equity in bonus distribution as an elusive concept and went on to say that:

“Broadly, it involves giving the with profits policyholder what his premiums have earned, subject to underlying guarantees, after deducting mortality costs and expenses, with an adjustment for a share of profits or losses from other classes of business. The results are averaged over time and over classes of business so as to avoid undue fluctuations, and involve additions to, or drawings from, the estate. The statement is ambiguous. For the purposes of this paper I shall equate ‘equity’ with ‘asset share’calculated on unit trust principles. While bonus distributions do not attempt to reproduce asset shares, the concept is helpful in that it identifies values from which departures are made to honour guarantees, iron out fluctuations and reflect profits and losses from other sources."(13)


Forfar et al. considered that terminal bonus should be related to overall asset performance so that the policyholder obtains a ‘fair share’ when the policy matures; however, they said that it is something of an open question as to where the line should be drawn between smoothing out fluctuations in investment returns and granting fair shares.(14)

4.7 The Australian Institute has been actively developing standards of actuarial reporting and in the process has had to face the question of equity. A paper in 1986 by G. C. Ward was devoted to this issue and concluded that:

“It is... in the interests of the profession that general requirements in standards be reinforced by activity... to demonstrate to others that the profession is taking responsible and practical action to cope with emerging problems. An important component in the profession’s activity will be to convince others of the following features of the situation:

(a) Equity is a basic objective of the actuarial profession as key technical advisers to the life assurance industry.

(b) The continuing capacity of the profession to meet this objective will be an important ingredient in the health of the life insurance industry.

(c) While equity is important it must be secondary to soundness. (d) Considerations of equity apply to classes and generations of policyholders but it is essential

that they also extend to shareholders. (e) Precise equity does not exist and any attempt to define it can never succeed. The most viable

result is for a broad framework of principles to be established, within which the actuary can use his or her judgement to produce a solution for any particular case, consistent within itself, which is acceptable as equitable by all those affected by it.

(f) Equity in life insurance demands all the professional skills of the actuary who is the one best equipped to provide the technical advice needed by a Company Board if a satisfactory objective is to be reached.“(15)

Subsequently, the Australian Institute issued a Professional Standard; the section on equity is reproduced as Appendix 1 to this paper.

4.8 The Australian standard notwithstanding, we do not appear ready to give the kind of professional guidance that would ensure a high degree of objectivity and discipline in all bonus declarations. Many offices may be operating in this way of their own volition, but our published thinking is altogether too subjective, given not only the extent of the discretion which now exists, but also a political climate that demands meaningful disclosure to investors of the nature and method of operation of any investment product. Time is not on our side, for there are signs that offices are prepared to fight a bonus war if they find their positions in traditional markets threatened by intermediaries’ equation of ‘best advice’ with ‘best current payouts, subject to a check of the Form 9 ratio’.

4.9 Perhaps the best hope is for a professional standard to be developed based on the quantification of asset shares. It has to be accepted that bonus declarations are in some respects analogous to the declaration of an ordinary dividend by a commercial or industrial public company and that there is no ‘right’ declaration in any given situation. But at least the shareholders of such a company have an annual report on the directors’ stewardship, together with a profit and loss account and balance sheet, to enable them to view their dividend in the context of an overall picture of current and retained earnings and their


sources. Do we not need something similar for the holders of with-profit policies, such as an analysis of the development of asset shares?(16) Yet it would be hard to develop a standard on these lines without the benefit of a full discussion of a sessional meeting paper devoted to the theory of asset shares, their practical application, and their relevance to the kind of disclosure that seems to be necessary to ensure an orderly and equitable market.

4.10 Ward, in the conclusions to his recent paper quoted in §4.7, said it was essential that considerations of equity be extended to shareholders. They are usually entitled under a proprietary company’s articles to a specific proportion of the surplus distributed from its long term fund, or from the with-profit section of it. But it can be argued that, in equity, they ought to benefit in a manner which reflects the risks they undertake. The greater the significance of bonuses relative to sums assured, and of terminal bonuses relative to reversionary bonuses, the less the shareholders’ exposure. Yet the normal basis of participation gives the shareholders a greater reward when bonuses are high than when they are low. Competitive pressures may, of course, constrain the operation of the articles or cause them to be amended. Nevertheless the actuary usually has a role to play in placing a value on the declared bonuses for the purpose of determining the shareholders’ entitlement. He may be unclear as to whether the value should be the same as his published reserve for the bonuses; if he opts for that value and it includes a provision for future compounding the shareholders will obtain a double benefit, for they will also participate in the compounding when it vests. Perhaps the suggested standard should cover this point also.

5. CONCLUSION

5.1 The purpose of this paper is to stimulate a discussion about greater disclosure of the resources of a with-profit fund. Its starting point is the need to deflect intermediaries from the use of crude Form 9 ratios for comparing offices’ strengths, and disclosure of the value of accrued terminal bonuses is suggested as an aid in that direction. The importance of investigating the availability of capital to finance an office’s marketing plans and investment policy is underlined and the proposal put forward that the actuary’s DTI certificate should have specific regard to that issue.

5.2 The paper also argues that the heavy bonus content of the benefits of with- profit policies demands that, for the protection of investors, surplus should be distributed equitably, subject to the limitations of the pooled nature of the business. It is suggested that the appointed actuary should have a statutory duty to certify that in his opinion a proposed distribution is consistent with the reasonable expectations of all with-profit policyholders. This would need to be reinforced by a professional standard covering, for example, the use and broad disclosure of asset shares. Professional guidance may also be needed on the determination of the shareholders’ share of a distribution, if relevant.

5.3 The subject of the disclosure of expenses at the point of sale is outside the


scope of the paper. A study on life assurance charges and expenses has been commissioned by the Securities and Investments Board from Peat Marwick McLintock, and it would be more profitable to defer a discussion on this issue until after the publication of their report, which is expected later in the year.

5.4 In writing this I have drawn heavily on my recollection of many discussions, both in England and Australia, with colleagues in the insurance group with which I spent most of my full-time career. Several of them, and others, kindly commented on a draft, but in view of the haste in which the paper has been written it is better that I do not name them. Its conclusions, like its shortcomings, are entirely my own responsibility.

5.5 This paper is a slightly extended version of a paper presented to the Faculty of Actuaries on 16 November 1987.

REFERENCES

(1) FIELD, M. H. (1987). Presidential Address: Risk and Expectation, J.I.A. 114, 1–14. (2) JENKINS, T. C. & WILSON, A. J. (1975). ‘A study (using projection mathematics) of a change in

the minimum valuation basis’, TIAANZ 1975,45–190, includes at 56 —57 the proof of a theorem attributed to J. C. Coss that ‘the yield(s) on transfers to and from the estate determines the rate(s) of expansion which the business will support’.

(3) In his contribution cited in note (9) below, T. C. Jenkins neatly describes as the liability estate ‘that part of the estate which a cautious basis for valuing liabilities forces into existence’.

(4) REDINGTON, F. M. (1986). ‘Prescience & Nescience’, in A Ramble through the Actuarial Countryside, 518–535. ed. G. Chamberlin, Staple Inn.

(5) SKERMAN, R. S. (1968). The assessment and distribution of profits from life business, J.I.A. 94, 53–100.

(6) WARD, G. C. (1970). ‘A model office study of a terminal bonus system of full return of surplus to ordinary participating policies’, TIAANZ 1970, 21–67 and D1–23.

(7) JENKINS, T. C. & WILSON. A. J. art. cit. (8) REDINGTON, F. M. (1986). ‘The flock & the sheep & other essays’, in A Ramble through the

Actuarial Countryside. 406—428, 411–413. ed. G. Chamberlin, Staple Inn. (9) JENKINS, T. C. in ibid. 452—458.

(10) FORFAR, D. O., MILNE, R. J. H., MUIRHEAD, J. R., PAUL, D. R. L., ROBERTSON, A. J., ROBERTSON, C. M., Scott , H. J. A. & SPENCE, H. G., of the Faculty of Actuaries Bonus and Valuation Research Group, ‘Bonus rates, valuation and solvency during the transition between higher and lower investment returns’ (submitted to the Faculty on 16 March 1987) 22–27.

(11) It looks as though the strain on the intermediate basis in the final year has been overstated by about 34. Taking the figure in the paper (1134) produces a negative rate of return to the estate, which is clearly wrong.

(12) FIELD, M. H. art. cit. 8–9. (13) SMALLER, S. L. (1985). Bonus declarations after a fall in interest rates, J.I.A. 112, 163–204, 167. (14) FORFAR, D. O., et al., art. cit. 19. (15) WARD, G. C. ‘Notes on the search for equity in life insurance’ (submitted to the Australian

Institute, August/September 1986) 30–31. (16) See JENKINS. T. C. (1982). ‘Equity and the liability estate’. T.I.A.A. 1982, 316–367, for a Proposal

for a reporting system designed to disclose the transactions between the competing interests in a fund while recognizing and preserving its capital base.


APPENDIX 1

EXTRACT FROM ‘PROFESSIONAL STANDARD NO. 1: ACTUARIAL REPORTS AND ADVICE TO A LIFE ASSURANCE COMPANY’ ISSUED BY THE INSTITUTE OF ACTUARIES OF

AUSTRALIA

7. Soundness, Reasonable Benefits and Equity

7.1 When the appointed actuary reports on the financial condition of the company in terms of Section 48 of the Life Insurance Act, makes recommenda- tions on the distribution of surplus or approves the treatment of surplus in terms of Section 50 of the Act:

7.1.1 he should seek to protect the ongoing financial soundness of the company;

7.1.2 he should seek to ensure that reasonable benefits are provided to participating and experience related non-participating policyholders;

7.1.3 he should seek to achieve equitable treatment between different groups of participating and experience related non-participating policyholders.

7.2 There is no universally agreed definition of equity and a decision about it can only be a matter of judgement. In making his judgement an appointed actuary should give consideration to the following:

7.2.1 the sources of the surplus disclosed, the relative contribution to it by the different groups of policyholders and by the shareholders, and the release of estates previously committed to support existing business;

7.2.2 the relative risks taken by the participating and experience related non- participating policyholders in paying premiums for benefits either of which may be varied, and by the shareholders in contributing capital;

7.2.3 the need to maintain the overall viability of the company for existing policyholders;

7.2.4 prevailing attitudes within the actuarial profession.

7.3 Likewise a decision about reasonable benefits for the different groups of participating and experience related non-participating policyholders can only be a matter of judgement. In making his judgement an appointed actuary should give consideration to each of, and the inter-relationship between, the following:

7.3.1 the terms and conditions including the premium rates, options and guarantees on which the policies were issued;

7.3.2 the information conveyed by the company to the policyholders in connection with the sale and subsequently;

7.3.3 the experience of the company, subsequent to the issue of the policies, in relation to each of the elements in their terms and conditions such as mortality, morbidity, the return on investments, tax and expenses of administration, forfeiture and surrender experience;


7.3.4 the need, if any, for each policy to make a contribution, from the surplus it generates, to the company’s estate in recompense for and appropriate to the support it may have received from the estate and the company generally.

7.4 In seeking to protect the ongoing financial soundness of the life insurance business of the company the appointed actuary should have regard to all the items listed in 3.3 above* and should pay particular attention to:

7.4.1 the need to preserve sufficient estate in the company for the ongoing support of the continuing business, both existing and new, especially taking account of the likely new business strain which may arise from the company’s marketing plans;

7.4.2 the need for a solvency margin to minimise the possibility of the company getting into financial difficulty.

* These are similar to the items listed in paragraph 4.2 of GN 1.


APPENDIX 2

ILLUSTRATIVE PROJECTIONS ON DIFFERENT VALUATION BASES SHOWING THE IMPACT OF NEW BUSINESS GROWTH ON THE ASSET ESTATE OF A WITH-PROFIT FUND

1. The projections in this appendix are based on the ‘profit signatures’ in Table 18 of the paper by For far et al. cited in note (10). The signatures relate to the transactions between the estate and the business fund when three different valuation bases are applied to a 20-year endowment assurance with profits, with basic sum assured £ 7,000 and annual premium £ 375, in conditions in which the actual net investment yield is a level 7.5% p.a. and uniform compound reversionary bonuses of 3.5% p.a. are declared, with a terminal bonus of 9.5% of the sum assured and reversionary bonuses. Mortality, expenses and tax relief on expenses are in accordance with the premium basis. The estate obtains no permanent contribution from the business, but earns the net investment yield.

2. In these conditions the transfers to and from the estate during the currency of a cohort of such policies should have a present value of zero at 7.5% interest. Minor adjustments have been made to the profit signatures in Table 18 to bring the present values as close to zero as could readily be achieved, with a larger adjustment to the final transfer in column (ii) because an inspection of vertical and horizontal differences suggests that there is an error of calculation.

3. The three series of amended profit-signatures are as follows:

Year (I) (ii) (iii) Year (i) (ii) (iii)

1 –273 –41 –13 11 78 56 47 2 –10 –38 –15 12 90 68 55 3 –2 –30 –10 13 102 81 64 4 7 –20 –4 14 115 95 73 5 16 –10 3 15 127 109 82 6 25 0 9 16 141 123 91 7 35 10 16 17 155 138 101 8 45 21 23 18 169 153 110 9 56 32 31 19 183 169 121

10 67 44 39 20 – 1087 –1100 –1154

The valuation parameters which give rise to them are:

(i) net interest 3%, no zillmer; (ii) net interest 3%, zillmer 3.48%;

(iii) net interest 3.84%, zillmer 3.48%.

Basis (iii) was designed by the Working Group to use the maximum rate of interest and maximum zillmer permitted by the valuation regulations given the other assumptions. Comments could be made about the suitability of any of these bases to control the release of surplus, since they all produce negative


transfers beyond the first year; but that is not the purpose of this purely mechanistic exercise.

4. Let us assume for the purposes of projection that we are dealing with a new series of policy and that all the conditions, including investment yield and bonus rates, remain unchanged throughout the period of our investigation. Let us further assume that in the first year the volume of business written corresponds to 1,000 units of the specimen contract, producing a premium income of £ 375,000.

5. Given the two changes of sign in each of columns (i)–(iii), there are two rates of interest at which the present value of each set of profit-signatures is zero for the initial cohort. One of these is, by definition, 7.5%. The other is negative for column (i), about 7.7% for column (ii) and about 28.2% for column (iii). What this means is that there is no scope on valuation basis (i) for the business written to grow faster than 7.5% unless the office is in a position to keep adding indefinitely to its liability estate, because when, after 20 years, the portfolio became mature there would be negative yearly transfers which would grow at the rate of growth of new business. To all intents and purposes the same is true of basis (ii), but for basis (iii) the business could be expanded by up to 28.2% p.a. and yet the yearly transfers to the asset estate would be positive when mature.

6. (a) Columns A(i)–(iii) of Schedule I show the development of the yearly transfers for the first 20 years if new business is written each year at exactly the same level of premium income as in Year 1. This is unattractive to the asset estate, except on basis (i).

(b) Columns B(i)—(ii) assume a growth rate of 7.5%. On this assumption the transfers would normally grow at 7.5% p.a. after Year 20, but of course 7.5% of zero is zero.

(c) Column C(iii) illustrates the effect of a growth rate of 28.229% using valuation basis (iii) and shows the special stabilization of the transfers at zero.

(d) For comparison, Schedule II demonstrates the transfers for new business growth rates of 10% p.a. (columns D(i)–(iii)) and 20% p.a. (columns E(i)—(iii)). On the assumptions modelled, the transfers in year 20 would increase in subsequent years at 10% p.a. and 20% p.a. respectively.

7. If we ignore what may be happening in other parts of the fund, the financial transactions between the estate and the developing portfolio can be assumed to react on the size of the office’s asset estate. To see the effect, the transfers need to be accumulated at the net investment yield of 7.5%. In Schedules III and IV, columns AA(i)—(iii) to EE(i)—(iii) correspond with columns A(i)–(iii) to E(i)—(iii) of Schedules I and II.

8. In the special case where the rate of new business growth and the net investment yield on the fund correspond to the two rates of interest at which the present value of the set of profit-signatures for the initial cohort is zero, the ultimate cumulative effect on the asset estate is also zero: in other words, temporary finance from the more mature policies not only provides the required


liability estate for the newer policies but has also enabled the asset estate to be restored to the level it would have reached had the new series not been started. On valuation basis (ii), this is virtually the case with new business growth of 7.5% p.a. (see column BB(ii); the zero point would be for a growth rate of 7.7% p.a.). On basis (iii) it happens at a growth rate of 28.229% (see column CC(iii)). On basis (i), however, new business would have to contract.

9. In other circumstances the portfolio has had the effect of depleting the asset estate (because temporary finance from the more mature policies is insufficient to provide the required liability estate for newer business without retaining some support from the asset estate), or enhancing it (because temporary finance is more than enough to provide the liability estate). It will be noted that the higher the new business growth rate, the greater the difference the valuation basis makes to the progressive effect on the asset estate—and hence on the Form 9 ratio. The effect is, of course, misleading because it necessarily ignores the transfers that would take place if the portfolio were to be run off—particularly the transfers from the asset estate in respect of terminal bonuses.

10. The result of closure to new business after 20 years is shown in the second half of each column. The assumptions underlying the model are, of course, such that the cumulative effect on the asset estate is ultimately zero regardless of the rate of growth of new business in the first 20 years. However, shortly before expiry the effect appears highly positive.

Year 1 2 3 4 5 6 7 8 9

10 11 12 13 14 15 16 17 18 19 20

A(i) –273 –283 –285 –278 – 262 –237 –202 –157 – 101 –34

44 134 236 351 478 619 774 943

1126 39

is static A(ii) –41 –79

–109 –129 –139 –139 –129 –108 –76 –32

24 92

173 268 377 500 638 791 960

– 140

21 312 –99 22 322 –61 23 324 –31 24 317 –11 25 301 –1 26 276 –1 27 241 –11 26 196 –32 29 140 –64 30 73 –108 31 –5 –164 32 –95 –232 33 – 197 –313 34 –312 –408 35 –439 –517 36 –580 –640 37 –735 –778 38 – 904 –931 39 – 1087 –1100 40 0 0


SCHEDULE I £ ' 000s

Transfer if new business

A(iii) –13 –28 –38 –42 –39 –30 – 14

9 40 79

126 181 245 318 400 491 592 702 823

–331

B(i) – 273 –303 –328 – 346 –356 –357 –349 –330 – 299 –255 – 196 –121 –28

85 219 376 559 770

1011 0

Transfer if new business grows at 7.5% p.a. (28.229% for C(iii)) B(ii) –41 –82

–118 – 147 –168 –181 –184 –177 –158 –126 –80 – 18

62 162 283 427 597 795

1023 0

(Closure to new business) –318 1160 174 – 303 1289 349 –293 1394 502 –289 1469 625 – 292 1511 714 –301 1518 768 –317 1484 783 –340 1404 752 –371 1271 673 –410 1082 537 –457 832 339 –512 512 75 –576 117 –263 – 649 – 363 –686 –731 –929 – 1201 –822 – 1598 – 1813 –923 –2376 –2535

– 1033 –3272 –3376 –1154 –4295 – 4347

0 0 0

B(iii) C(iii) –13 –13 –29 –32 –41 –51 –48 –69 –49 –85 –44 –100 –31 –113 –10 –122

20 – 125 61 – 121

112 – 108 176 –84 253 –44 345 17 453 104 578 224 722 388 886 607

1073 900 0 0

55 1878 123 4575 175 7311 205 9952 208 12328 185 14509 131 16293 43 17570

–86 18052 –258 17514 –477 15668 –746 12146

– 1074 6330 – 1465 – 2428 – 1923 – 14958 –2453 – 32326 – 3066 – 56041 –3764 –87751 –4560 – 130000

0 0

Note: If not closed to new business, the transfer will remain constant after Year 20 where new business is static, and will be zero where new business grows at 7.5% p.a.


SCHEDULE II £ ' 000s

Transfer if new business Transfer if new business grows at 10% p.a. grows at 20% p.a.

Year D(i) D(ii) D(iii) 1 –273 –41 –13 2 –310 –83 –29 3 –343 –121 –42 4 –371 –154 –50 5 – 392 –179 –52 6 – 406 –197 –49 7 –411 –206 –38 8 –408 – 206 – 18 9 – 392 –195 11

10 –365 –170 51 11 –323 –131 103 12 –265 –76 168 13 –190 –3 249 14 –94 92 347 15 24 210 464 16 167 354 601 17 339 527 762 18 542 733 948 19 779 975 1164 20 –230 –27 127

21 1583 22 1809 23 2003 24 2156 25 2264 26 2323 27 2319 28 2249 29 2097 30 1856 31 1516 32 1063

E(i) –273 –338 –407 –482 – 562 – 649 –744 – 848 –961

– 1087 – 1226 – 1381 –1556 –1752 – 1975 –2229 –2520 –2855 –3243 –4978

(Closure to new business) 246 227 4492 526 350 5774 781 453 7005 993 525 8138

1160 557 9152 1276 552 10024 1336 500 10687 1328 395 11100 1246 226 11173 1075 – 14 10839 805 –331 10016 428 –734 8569

E(ii) E(iii) –41 –13 –87 –31

–135 –47 –182 –60 –228 –69 –273 –74 –318 –73 –361 –64 –401 –46 –437 – 16 – 469 27 –494 88 –512 170 – 520 277 –514 414 – 494 588 –455 806 –393 1077 –303 1414

– 1463 543

–184 1236 2633 3926 5095 6114 6953 7539 7820 7697 7089 5900

33 483 –74 –1239 6372 3975 34 –243 –720 –1853 3238 1128 35 –1121 –1526 –2590 –983 –2825 36 –2182 –2506 –3462 –6586 –8106 37 –3443 –3685 –4487 –13845 –15017 38 –4924 –5082 –5676 –23093 –23886 39 –6648 –6727 –7058 –34727 –35143 40 0 0 0 0 0

1149 1954 2729 3428 3998 4453 4730 4794 4565 3982 2977 1464

–697 –3635 – 7506

– 12496 – 18867 –26858 – 36868

0 Note: If not closed to new business the transfer will increase (with the same sign) after Year 20 at the relevant new business growth rate.

Year 1 2 3 4 5 6 7 8 9

10 11 12 13 14 15 16 17 18 19 20

21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40

SCHEDULE III £'000s

Cumulative effect on Cumulative effect on asset asset estate if new estate if new business grows business is static at 7.5% (28.229% for CC(iii))

AA(i) AA(ii) AA(iii) BB(i) BB(ii) BB(iii) CC(iii)

–273 –41 –13 –273 –41 –13 –13 –576 –123 –42 – 597 –126 –43 –46 –905 –241 –83 – 970 –254 –87 –100

– 1251 –388 –131 –1389 –420 –142 –176 – 1606 –557 –180 –1848 –620 –202 –275 – 1964 –737 –224 –2345 – 847 – 260 –396 –2313 –922 –255 –2870 –1095 –311 –538 –2644 –1099 –265 –3415 –1354 –344 – 700 –2943 –1257 –244 –3971 –1614 –350 –878 –3198 –1383 –184 –4523 – 1861 –315 –1065 –3393 – 1463 –72 –5058 –2080 –227 –1253 –3514 – 1481 104 – 5558 –2254 –68 –1431 –3541 – 1419 357 – 6003 – 2361 180 – 1582 –3456 – 1257 702 –6368 –2377 538 –1684 –3237 –975 1154 – 6626 – 2272 1031 –1707 –2861 – 548 1732 –6747 –2016 1686 –1611 –2301 49 2454 –6694 – 1570 2534 –1344 –1531 844 3340 – 6425 – 893 3610 –837 – 520 1867 4413 –5896 63 4955 0 –520 1867 4413 –6338 68 5326 0

(Closure to new business) – 247 1908 4426 – 5654 247

56 1990 4455 –4789 614 385 2109 4496 –3754 1163 730 2256 4545 –2566 1875

1878 6594

2730 3702 4763

1086 2424 4593 – 1248 1444 2605 4637 177 1793 2789 4668 1674 2123 2966 4678 3204 2423 3125 4658 4715 2677 3251 4597 6151 2873 3331 4485 7444 2994 3349 4309 8514 3021 3287 4056 9270 2936 3125 3711 9602 2717 2843 3259 9393 2341 2416 2681 8499 1781 1819 1959 6760 1011 1025 1073 3995

0 2 0 –1 0 2 0 –1

14399 25431

5872 6986 8046 8988 9738

10205 10284 9855 8781 6904 4046

5781 6338 6988 7717 8503 9325

10156 10960 11696 12316 12763 12974 12873 12374 11380 9780 7447 4241

0

39667 57151 77730

101129 126765 153786 180989 206709 228543 243256 246542 232706 194118 120927

–4 –4

Notes: (1) If not closed to new business, the cumulative effect will increase

(with the same sign) after Year 20 at the relevant new business growth rate. Any unaffected asset estate will however be growing at 7.5% p.a. on the assumptions underlying the model.

(2) The entries have been calculated by accumulating at 7.5% p.a. the unrounded figures underlying the corresponding entries in Schedule I.

33 –1

SCHEDULE IV £'000s

Year 1 2 3 4 5 6 7 8 9

10 11 12 13 14 15 16 17 18 19 20

DD(i) DD(ii) DD(iii) EE(i)

–273 –41 –13 –273 – 604 –127 –43 –631 –992 –258 –89 – 1086

– 1437 –431 – 146 – 1648 –1937 – 642 – 209 –2334 –2488 – 887 – 274 –3158 – 3086 –1160 –332 –4139 –3725 – 1453 – 375 – 5298 –4397 – 1751 – 393 –6656 – 5092 –2059 –371 – 8242 – 5797 –2345 –296 – 10087 – 6497 –2597 –150 – 12224 –7174 – 2795 88 – 14697 – 7806 –2913 441 – 17551 –8368 –2921 938 – 20842 –8828 –2786 1610 – 24634 –9152 – 2468 2492 – 29002 –9297 – 1920 3628 – 34032 –9215 – 1089 5064 – 39827

– 10137 – 1198 5570 –47192 (Closure to new business)

21 –9314 – 1042 6215 – 46884 22 – 8204 – 594 7031 – 44627 23 –6816 142 8011 – 40968 24 –5171 1146 9137 – 35903 25 – 3294 2392 10379 – 29443 26 – 1219 3847 11710 –21627 27 1009 5472 13088 – 12562 28 3334 7210 14464 – 2404 29 5680 8997 15775 8588 30 7962 10747 16944 2007 1 31 10075 12358 17884 31593 32 11894 13713 18491 42531 33 13268 14668 18639 52093 34 14021 15048 18183 59238 35 13951 14651 16957 62698 36 12815 13244 14767 60815 37 10333 10552 11387 51531 38 6183 6262 6565 32302 39 –1 4 –1 –2 40 –1 4 –1 –3

Cumulative effect on asset estate if new

business grows at 10%

Cumulative effect on asset estate if new

business grows at 20% EE(ii) EE(iii)

–41 –13 –131 –45 –276 –95 –478 –162 – 742 – 243

– 1071 –335 – 1469 –433 – 1940 – 530 –2487 –615 –3110 –678 –3812 –701 –4592 –666 – 5449 – 546 –6377 –310 –7370 80 –8417 674 – 9503 1530

– 10609 2722 –11708 4340 – 14049 5208

– 15287 6748 – 15198 9209 – 13705 12628 – 10807 17003 – 6522 22276 – 898 28400 5988 35260

13976 42698 22845 50465 32255 58233 41763 65577 50796 71959 58581 76659 64103 78773 66085 77175 62936 70467 52639 56885 32700 34294

10 –2 11 –2

Notes: (1) If not closed to new business, the cumulative effect will increase

(with the same sign) after Year 20 at the relevant new business growth rate. Any unaffected asset estate will however be growing at 7.5% p.a. on the assumptions underlying the model.

(2) The entries have been calculated by accumulating at 7.5% p.a. the unrounded figures underlying the corresponding entries in Schedule II.

371

ABSTRACT OF THE DISCUSSION

Mr E. B. O. Sherlock (opening the discussion): The with-profits concept has been a valued method of providing for the future of many millions of people over more than two centuries. During most of that time the system has been free from major artificial constraints, but until now has had little competition from other savings media. Our job must be to ensure that it can continue as a savings and protection vehicle as long as the public wants the smoothing effect that it offers. That the concept is under attack, even threat, is undeniable and to some extent the fault lies with those of us who have failed to prepare adequately for the increasingly competitive environment. We have relied on the system’s past reputation and a relatively unthinking public. The response to that must not be to constrain, but to explain.

The system is essentially flexible. Marshall Field’s Presidential Address illustrated the way increasing bonus loadings over the last fifty years have resulted from the use of higher interest rates in the calculation of without-profits premium scales. If we revert to lower interest rates in the future there should naturally be a contraction of bonus loadings. There is a danger that offices will feel constrained by their past statements, or by the expectations policyholders have been allowed to form, and will attempt to maintain bonus rates by increasing premium scales for new with-profits business, Such an approach could lead them into difficulties in justifying the use of past results in advertising material, but, much more fundamentally, it is unsound. If bonus rates for existing business should come down, but do not, the older generation would be subsidized by the new, just as surely as the new generation is subsidized by the old policyholders of a company which distributes reserves it has created by underdistributing in the past. The actuary has the daunting task of advising Boards of directors where the happy medium between strength and weakness lies and, linked to that, the interpretation of equity to which the author refers. It is with directors and their managements that responsibility for running the business lies and they need and deserve all the help this profession can give.

Actuaries have a constructive part to play in response to one aspect of the Financial Services Act: the obligations placed on companies by the advertising and product disclosure rules. Virtually all with-profits policies require cancellation notices containing or accompanied by succinct descriptions of the product and certain factual information. In particular the participating rights must be explained, but, given the formal nature of this document, I expect offices to use a form of words similar to that in their Articles of Association. Greater need for explanation comes at the point of sale. The rules are quite general: we are free to choose our words, but we are not free to conceal. There is an obligation in the SIB rule book “to ensure that such a document and advertisement is not likely to be misunderstood by those to whom it is addressed including persons who cannot be expected to have any special understanding of the matter involved”. Failure to inform adequately may well be a breach of these rules. This provides the opportunity to improve the understanding in the mind of the public of what with-profits business really is. That in itself may not be enough, but it is an essential start, and I would expect it to be followed by pressure for fuller explanations at the time of bonus distributions.

Mr W. Proudfoot, F.F.A.: In § 4.9 the author suggests that the best hope for some kind of standard form of disclosure which would help intermediaries would be one based on asset shares. I support this suggestion and believe that the actuarial profession should devote resources to try to produce something practical as soon as possible. Like disclosure of life office expense rates, this will not be an easy task, but it is one possible way forward which offers some hope.

For many years I have been using one such measure to compare with-profit offices. Of necessity it has been a very crude measure because it has had to be based on gross rates of investment return calculated from published data, but even so it could be seen clearly that the rate of return earned by the office mentioned in § 1.1, was 20% less than that of its major competitors in 1977 and again in 1982. A publication of such figures would have warned intermediaries of this office’s impending problems several years before they surfaced and more clearly than any study of movements in the free asset ratio. Although the method is very crude, there is a marked degree of correlation between the rates of the return earned on life office funds and the pay-outs made under with-profit policies.


Not many policyholders or intermediaries really understand the realities of with-profit business today. This lack of understanding seems to be shared by the media, and even by some life office personnel, mostly in marketing departments. Illustrations based on current bonus rates being maintained indefinitely and the stress placed on stability of reversionary bonus rates have led to a failure to understand that the total eventual pay-out under a with-profit policy will depend very largely on the accumulated value of the investments purchased by the premiums less charges. The new roll-up type illustrations and the widespread introduction of unitized with-profit funds will change this. Some kind of asset share disclosure would be much more readily understood and thus much more helpful to policyholders and intermediaries than any examination of the information currently contained in DTI returns.

The author made other suggestions which he felt might help the intermediary, but if these were implemented they would only add to the confusion which already exists in this area. I dislike the idea of disclosing the value of accrued terminal bonuses because it is wide open to manipulation and misinterpretation. We all have misgivings about how the words ‘reasonable expectations’ might be interpreted. Disclosing the value of accrued terminal bonuses would be certain to boost policyholders’ expectations and result in a most unrealistic interpretation of the expression. I cannot accept that references to ‘reasonable expectation’ in equity should be included in the actuary’s certificate. How can any actuary certify that the bonus distribution takes these matters into account when nobody knows what these phrases mean? Such matters ought to be referred to by an appointed actuary in his confidential report to his Board of Directors, but an obligation to include projections in this report showing the effect on free assets of various possible strategies would be a much more effective control on life offices’ financial management. The actuary’s report should not be published, but it should be available to the authorities if they felt the need for further information. Disclosure of asset shares in some form would not only help the public to appreciate the real meaning of ‘reasonable expectations’, but it would also help them to understand ‘equity’ more easily, or rather the degree of departure from equity. There would then be no need for actuaries to refer to these matters in their valuation certificates.

An intermediary in giving best advice is trying to recommend the life office which will produce the highest pay-outs in the future and since these pay-outs will depend entirely, in the case of unit-linked business and very largely in the case of with-profit business, on the office’s charges and investment performance in the future, that is its asset shares, then the current strength of the office is not really all that relevant to his recommendation. That might sound like heresy, but it is true provided always that the office does not dissipate its strength and continues to remain solvent. We can rely on the Government Actuary’s Department (GAD) and the Department of Trade and Industry (DTI) to monitor life offices from a solvency point of view; intermediaries should not be expected to do so. Where the current strength of an office is taken to mean the length of time that it can maintain its current bonus rates then that strength is much more important to existing policyholders than to new ones.

If investment yields fall and an office continues to pay the same bonus rates as had been earned by existing policies over a period of high rates of investment return, how would an intermediary know whether the office was simply ironing out a trough in this experience or whether it was pursuing this cause to such an extent that it was dissipating its current strength? If offices were to calculate and publish the reversionary bonus rates which would be earned under current with-profit premiums on any reasonable basis, for example the two LAUTRO illustration bases, then intermediaries would quickly realize that current reversionary bonus rates were very much on the high side, particularly in the pensions area. A ‘strong’ office could afford to continue to pay these high rates of reversionary bonus, but only for a limited period, for life offices can only pay out what they have actually earned. If an intermediary was to deduce that an office’s free assets were being used to pay reversionary bonus rates to new policyholders which were unlikely to be earned he would understand that the older policyholders would be subsidizing the newer ones and also that the office, regardless of its current strength, would become steadily weaker. He might even realize that if this action resulted in the office attracting an increasing flow of new business then this weakening process would simply accelerate. The trouble is that this does not seem to be understood by intermediaries or by the media.

At the present time offices which obtain their business predominantly from intermediaries seem to


be very reluctant to reduce their reversionary bonus rates even if these are not being earned, because of the fear that if they were to take this action they would be pilloried by the financial press and be shunned by intermediaries who would almost certainly interpret this as a sign of weakness. The reality, that reducing such rates would eliminate the need for a cross-subsidy and could dramatically improve the office’s strength, seems likely to be completely ignored.

Several offices have already gone to two-tier structures, for bonus rates, separating early and later durations, but in general they have been offices which are not totally dependent on independent intermediaries. However, a large number of offices, both intermediary and direct sales, have effectively reduced the reversionary bonus rates on new pensions business by introducing unitized with-profit funds and all without a single comment from intermediaries or the media that this is a sign of weakness.

The author writes about a much needed discipline in terminal bonus declarations. What evidence is there to suggest that there may be a lack of discipline? If there is a need for more, then it is in reversionary bonus declarations. Who can blame an office for taking what seems be an easy option, especially when it knows it can afford to put off the evil hour? It may not make sense actuarially, but commercially it might seem preferable to continue to maintain the reversionary bonus rates and hope that they will be justified than run the risk of cutting the office off from new business by reducing them.

The industry and this profession have to educate the public, intermediaries and the media to a better understanding of the realities of with-profit business. They have to understand why bonus rates, reversionary and terminal, can go down as well as up; that if current yields continue then inevitably the very high reversionary bonus rates which were earned in the past will have to be reduced and that this is the correct action to take to maintain the strength of life offices, and not a sign of weakness and that only good investment performance and a cost-effective organization will provide competitive pay-outs twenty-five years in the future. The disclosure of asset shares offers the best possible way of succeeding in this task. Together with the reversionary bonus rates supported by current with-profit premium rates, this would result in a much more disciplined approach to bonus declarations than any of the other suggestions which followed in the paper.

Mr E. A. Johnston: The action which might result from this discussion could follow two quite separate lines: one is disclosure to intermediaries and to the public, and the other is greater professional discipline on the bonus decisions made by Boards of Management.

The supervision carried out by the DTI with the aid of GAD aims to protect policyholders, present and future; not shareholders; not management; not even actuaries. Applying this to with-profits business brings the concept of reasonable expectations, which is controlled by the precise wording of the Insurance Companies Act, but the underlying view remains that it is the interests of present and potential policyholders that matter and the right of an office to continue writing new business of any particular type or at any particular level, or indeed at all, is not sacrosanct. Because the policyholders’ rights in a with-profit fund are unstructured, this class of business can only continue if there is public confidence both in actuarial procedures and also that the company will act in accordance with actuarial advice. It is very creditable to the industry and to company managements, as well as to the profession, that this confidence has continued for so long. It is important that it should continue in future, because with-profits business provides a valuable service to the public which is not duplicated by other media.

We must recognize the problems. As the law stands at present it rests with directors whether to listen to the actuary’s advice or not and the coverage and depth of that advice seems to depend entirely on the individual actuary, without help from legislation or from Institute or Faculty guidance.

In today’s competitive market, with rules of best advice and so on, managerial and professional considerations are more opposed than they used to be. It must also be said that the safety margins inherent in with-profit business, which we have always flattered ourselves made it exceedingly safe and solid, can themselves be a source of danger, because they give a bad management time to get well set in its mistaken ways before it comes up against reality. How can we place obstacles in the way of wrong actions by management? The author’s suggestions are worth serious consideration. The certificates he proposes, for instance, would go to the heart of the matter, although I am uneasy at


using the phrase ‘reasonable expectations’ in a certificate, because its meaning is not established at law; may be some more suitable wording can be devised. Even without a certificate it would be well worth considering including in the fourth schedule return material bearing on the equity of, the backing for, and the sustainability of, the bonus distribution. That seems to be a valid topic for public disclosure and would also be of use to GAD.

Quoting the values of accrued terminal bonuses would be a helpful piece of disclosure if wisely used by the reader. This amount should not be held as a reserve because the essence of terminal bonus is that it depends on circumstances from time to time, but if disclosure is done in a way which does not raise expectations it would be helpful.

The suggestion that the actuary’s report should be formalized and extended seems very promising. Its contents need to be developed in detail in a guidance note. It should include material bearing not only on the equity of the recommended distribution, but also on its absolute size and the relationship to reserves. The transfers described by the author between the liability estate, the asset estate and the business fund seem relevant and should be covered.

Most companies already get thorough reports from their actuaries and the directors attend to them and use them. Even so some stiffening of the professional requirements will help managements to think more carefully before deciding on distributions and may help to counterweight short-term marketing considerations. However, a few companies may not be so careful; they need to be brought up to the standard of the majority, but these are precisely the companies on whom an Institute guidance note by itself would have little or no effect. It is relevant that in Australia the report is required by statute, and has to be made available to the commissioner, so it cannot deal with anything too lightly and management has to pay attention to it. Unless legislation can be arranged in this country, we need either to ensure, through professional requirements, that the reports are available on request to DTI and GAD or to repeat some of the material in the published returns. However, it would be better not to make the full report available to the public because in order to perform the function needed it must include material which offices cannot reasonably be expected to publish.

GAD clearly needs to pay more attention to with-profits companies than it has in the past, but the supervisory authorities always aim to encourage management to identify problems and to deal with them. Being both aids to good management and adjuncts to supervision, the author’s suggestions should help to retain public confidence in with-profits assurance.

Mr D. E. Fellows: Our existing professional guidance quite properly focuses on issues of solvency. Considerations of equity must take second place. Even so our guidance already requires the appointed actuary to report on certain aspects of with-profit business and it could be argued that, for a professional body like ours, such guidance ought to suffice. We are, however, probably entering a period when managerial and professional considerations will tend to diverge more strongly than hitherto and I think that we may have to accept that some strengthening of the professional guidance may be needed for the benefit of members as a whole. The most satisfactory route would be to list items normally regarded as essential components of a report to the company in much the same way as is required in GN9, when reporting on retirement benefit schemes. For example, the actuary could be asked to report on the propriety of current levels of pay-out relative to asset shares; the implications for the asset profile of the emerging patterns of contractual and other liabilities; the level and potential trend of the estate and, not least, the financing implications of the company’s marketing plans. It may be difficult for actuaries immediately to comply fully with all these items, but they could perhaps be introduced as examples of desirable practice with a view to making them compulsory at a future date.

All this is based on the view that it should be left to the actuary to judge the reasonableness of the allocation of surplus. It would not be sensible to extend the actuary’s DTI certificate beyond solvency aspects and require the actuary to certify that the bonus distribution is consistent with the reasonable expectations of policyholders. None of us really knows the precise meaning of such expectations. How then can we guard against an irresponsible management which does not have particular regard to the actuary’s advice? We must be careful to retain some room for manoeuvre on both sides. We are, after all, dealing with matters of judgement and not with precisely quantifiable amounts and my inclination is to rely on the constraint effective through our existing professional guidance, which


stems from the fact that an actuary has a duty in certain circumstances to make written and reasoned disclosure to the authorities and may seek help and advice from his professional body.

Should we give further information through the statutory returns to help intermediaries? There is the danger that any quantification of accrued terminal bonuses will become part of the reasonable expectations and akin to reversionary additions for reporting purposes. The result could be a constraint on investment policy to the detriment of the policyholders. We should not take any steps which run the risk of constraining the actuary and reducing the scope for individual judgement simply to help resolve an indeterminate feature of the Financial Services legislation. That is not to say that we cannot help in other ways by providing an intermediary with certain information on some points of detail; for example, disclosing the residual asset backing for the participating business assuming that fixed interest investments are needed to back the non-profit policies. Information of this kind would at least enable an intermediary to form a better picture of an office’s position in attempting to weigh up asset margins on the one hand and the terminal bonus quantum of policy proceeds on the other.

Mr I. C. Lumsden, F.F.A.: We should not support excessive or meaningless disclosures simply in order to satisfy an apparent demand. If we genuinely believe that to be meaningful, disclosure would have to be too complex to be understood, we should say so. The aim of any exposure draft should therefore not be to recommend further disclosure as such but to consider the problems involved and either recommend further disclosure or explain in detail why not.

How likely is a company to become statutorily insolvent on a change in investment conditions such as a substantial bear market? We all seem to agree that Form 9 ratios are not much use here. Adding a terminal bonus reserve would not help much either, since in the kind of circumstances envisaged the terminal bonuses would presumably be much reduced or even eliminated altogether. The only practical way to compare offices’ immediate solvency probabilities is to postulate specific ‘worst case’ investment scenarios and then try to calculate their assets and minimum statutory liabilities in those circumstances. It does not seem impossible for offices to publish, from time to time, the range of interest rates, dividend yields, income levels and currency levels they could withstand without becoming technically insolvent. It would really be the only way to do it properly but if it were not understood then it could be given to GAD on a confidential basis. This would be a better way of dealing with mismatching than the present rather unsatisfactory rule.

The other, and to a substantial extent conflicting, aspect of financial strength is bonus potential. We could make our offices ‘safer’, at least in statutory terms, by investing more heavily in fixed interest stock at the expense of equities, but in the long run to do so would very probably damage our bonus prospects. Mr Proudfoot said that a new with-profits policyholder ought to be at least as interested in offices’ asset mixes as in their solvency standards. It should be reasonably easy for offices to publish the mixes of their with-profits assets and this would be quite a helpful form of disclosure. It might not be easy to achieve a consistent approach to calculating the mixes. Perhaps more important than disclosure itself is that we should take the greatest possible care to explain the real benefits of with-profits policies in order to safeguard a valuable concept. Whenever I say that the higher our rates of reversionary bonus the poorer our long-term performance is likely to be, people tell me I am just the usual over-cautious actuary. It is true, however, especially with bonuses at their current levels, and any actuary who doubts it needs only to project his office’s position forward at least until its current business has matured.

It seems inevitable that unless most offices reduce their reversionary bonuses soon they will have very little hope of maintaining their solvency standards without investing more and more heavily in fixed interest stock, almost irrespective of their new business growth or their present apparent strength. If I had to define the ‘reasonable expectations’ of my own office’s policyholders I would say that, for the most part, they should be able to expect us to invest their premiums as best we can without constraints imposed by the need to maintain our solvency standards. If more meaningful disclosure would help people to appreciate that to recommend an office on the basis of its high reversionary bonuses may well in future be worst, not best, advice, it would more than justify itself.

Mr J. H. Webb: An important source of confusion among the public and intermediaries is the extreme complexity of the bonus systems which have now developed. Offices have altered their systems


frequently to the point where any internal discipline imposed by the office’s own system has been lost. Furthermore, comparability between offices can only be judged on actual pay-outs using tables for selected contracts. The only remaining effect of the part of the bonus declaration which the office describes as basic or normal is to give a misleading impression about commitments for the future. Can we take advantage of the present confusion, and the introduction of a new regulatory regime with its ban on projections based on current bonus rates, to recast our bonus declarations in a form which will give less indication of commitment to future declarations? An extreme approach would be for the bonus notice which informed the policyholder of the reversionary bonus addition to his policy and the terminal bonus which would apply on his policy becoming an immediate claim without setting out the underlying formula. If this were done at a time when the level of pay-outs was being maintained or increased it ought to be possible to present it in a way in which the media would not headline ‘bonus reduction’ and which would retain the confidence of intermediaries.

Documents

THE FINANCIAL MANAGEMENT OF A WITH-PROFIT ......multiple of the capital required to be absorbed by a year’s new business. 2.4 We get a better insight into this process if we notionally