RECENT media coverage of NTUC Income's bonus restructuring has raised important issues about participating life assurance. I would like to share my experience from the UK market, which has gone through challenging times.
With-profits or participating products are designed to provide smoothed returns to policyholders through investing in a mixed portfolio of equities and bonds.
They allow policyholders to invest long-term for potentially better returns, but without being fully exposed to the risks of equity investment.
Participating products deliver returns through two forms of bonus - an annual bonus which is an addition to the sum assured each year, and a final bonus which is payable upon claim, surrender or maturity. Annual bonuses are guaranteed once they are declared, whereas rates of final bonus can vary each year.
Limiting the build-up of guarantees enables with-profits assets to be invested more freely, with a significant proportion generally being allocated to equities - and in some cases property. These are expected to generate better returns than bonds in the long run. So a higher guarantee may result in a lower payout as compared to a policy with a lower guarantee and greater investment flexibility.
My experience is that given the choice between a higher expected payout and a lower guaranteed minimum sum on the one hand, and a lower expected payout but a higher guaranteed minimum on the other, most policyholders would opt for the former. Indeed the basic idea behind the with-profits proposition is that guarantees are limited but policyholders participate in any profits which arise.
However, in any participating fund there may be some policyholders for whom attaining a certain minimum level of benefit regardless of investment conditions at the time of claim is more important than maximising the expected benefit - perhaps because they are using the policy to fund a fixed payment, such as the redemption of a loan.
Unfortunately it is not practical to accommodate the different aims of individual policyholders. It is for the board to decide, in the interests of policyholders collectively.
It is salutary to consider the experience of companies with participating business in the UK over the past 20 years. In the 1990s, there was intense competition, in terms of the level of payouts on maturing policies and the level of annual bonuses.
As yields on long-dated government bonds fell from over 10 per cent per annum at the beginning of the decade to less than 4.5 per cent at the end of 1998, many companies were slow to cut annual bonus rates despite having high exposure to equities in their participating funds. This led to reduced free assets, and several mutual firms were forced to demutualise to restore a satisfactory solvency position.
When equity markets suffered a decline between 2000 and early 2003, a number of participating funds experienced severe distress. Despite capital injections from shareholders, they were forced to sell all or most of their equity holdings and cease accepting new business. Some of these funds have made a partial recovery, while others remain largely locked into fixed-interest investments and are delivering mediocre returns.
Onerous benefit guarantees were a big factor behind the closure of Equitable Life, Europe's oldest mutual life company in December 2000. These examples show the importance of addressing the balance between guarantees and providing attractive returns in the long term.
Over-generous guarantees cannot be reversed and action should be taken to limit the build-up of guarantees while financial conditions are still benign. When conditions deteriorate, there are fewer options available, and it may also be too late.
Switching to a lower annual bonus and higher final bonus will align to industry best practice, improve investment freedom and make it easier for the insurer to deliver yields to customers. It will also improve the resilience of the participating fund.
In short, both policyholders and the insurer stand to gain from this new bonus structure. The lessons learnt from the UK market serve as a painful reminder of the potential consequences of resisting change in favour of the status quo.
This article was first published in The Straits Times on May 28, 2008
