The bonus declaration season is upon us once more but what used to be an exciting time of year has now degenerated into a round of hand-wrin ging and hard-luck stories.
Bonus reductions are now so commonplace that we have almost come to expect them but, for well over a century, they were almost unheard of. They simply did not happen bec ause cautious prudence to facilitate smooth ing was the cornerstone of the with-profits system.
Today, life offices would have you believe that the cuts are due to poor inv estment returns. That is true but it is far from being the whole truth and is wearing a bit thin.
There are several reasons, other than poor investment returns and low interest rates, why maturity payouts have been depressed rec en tly. All these could be grouped under a paper entitled, Falling Standards in the Life Insurance Industry. They are due mainly to the actions of the life offices alth ough the FSA is by no means blameless.
Around 1960, several life offi ces found themselves sitting on extraordinarily huge res erves. What to do? Increase the annual bonus? They could easily afford it.
Nah, said the wise old heads, it is high enough already. Put it too high and you may have to red uce it later and that would be too unbecoming.
OK, but what about all this loot, then?It is embarrassing.
Right, tell you what then. Let's box clever. We will keep it in the fund and let some of it dribble away by paying a special additional bonus when with-profits policies mature or when a life assured dies. That way, we will dangle a carrot to keep contracts in force for the full term.Discourage surrenders and all that, see?
A policy is a contract, do not forget, and it is only fair to reward those who keep to it. No need to commit ourselves to any particular rate of special or final or terminal bonus or whatever else you want to call it. No need to make it reversionary, even. Right, we will do that then.
All went well for many years. There were never any complaints about payouts. But then one or two people started moaning that they had had to surrender their endowments only a couple of years before maturity and had therefore missed out on the terminal bonus.It was not fair, whinge, whinge.
Rather than take the trouble to educate the public about the rashness of surrender at such a late stage in the term of a policy and explain the various means that exist to raise cash other than by the drastic measure of outright surrender, one or two provi ders took the cowardy-custard way out and started paying an element of terminal bonus on surrenders within a short time of maturity. Then others said they would do so a bit earlier and so on.
The dumbing down conti nued until, today, some life offi ces pay a terminal bonus immediately any surrender value accrues at all. The media, even the so-called quality press, run frequent pieces about which offices pay the best surr en der values, so they have bec ome a fashionable selling point.
This is political correctness, pure and simple, and as usual it has done precious little real good. Why? Because life funds now suffer under a state of constant haemorr hage that never existed before the PC mentality took over.
Under the rules of the old Life Offices' Asso ciation, it was prohibited to pay up-front commission and for several very good reasons.
It was tantamount to granting interest-free unsecured loans using existing policyholders' money to buy new business and it very quic kly led to undesirable pressure selling and the temptation to participate in scams by any underfunded intermediary who was going through a bad patch of early lapses.
The LOA insisted that commission had to be earned from ringfenced premium income before it was paid. Nobody in their right mind could argue with that but the LOA became defunct in the mid-1980s and the FSA now sees nothing wrong in the practice of paying commission in advance on indemnity terms which, understandably has become widespread practice. Again, the result is a haem-orrhage from the life fund.
At best, a new policy may be maintained in force until the amount of commission paid in advance is amortised by its premiums. However, the fact remains that, in the meantime, less money has been available to the life fund for investment on behalf of the with-profits policyholders.
At worst, the policy lapses very early and the interme diary goes out of business. There is no possibility of clawback, with the result that the bad debt has to be written off. Either way, ultimately, it must result in lower payouts.
The amazing thing is that the product pro vi ders are not req uired to quantify the amount of irre co ve rable clawback or unearned com mission in the returns they make to the FSA. The item is simply lumped in with other debtors.
If you want to know about the effect that indemnity commission is having on the fund, you have to refer to another set of statistics dreamed up by accountants – the persistency rate – which is supposed to sort of give you the answer.
All these headaches never arose under the commonsense regime of the old LOA and I am genuinely surprised the FSA allows them to do so now. Reabolish indemnity commission and a whole range of other problems goes away. But that is another argument.
Reversionary bonuses result from the distri bution of surplus, which is the money left over after the life office has put by some for expenses and topped up the reserves in the claims kitty.
Surplus does not arise simply from investment pro fits, it comes from operational profits, too, such as the mortality surplus arising from term ins urances, annuities and unit-linked business and from permanent health insurance and all the other classes that do not share in profits themselves but help swell the surplus.
Traditionally, 90 per cent of the surplus from all sources of a proprietary life office went to pay the bonuses while the remaining 10 per cent went to the shareholders. In the case of a mutual life office, 100 per cent went towards bonuses.
Today, there are several provi ders which do not pass over the profits from non-pro fit business to the with-profits fund at all. Others ceased to do so when they were demutualised or absorbed.
Some broadly stick to the 90/10 formula but exclude certain classes such as PHI and personal accident insurance from the with-profits meltdown. The result? Some, if not all, of the non-investment surplus goes to the share holders. It is another mugging for the with-profits policyholders and another ratchet down of the image of our business.
The good old days lasted for about 200 years. You learn an awful lot in 200 years, mos tly from your own mistakes. What a shame that such a lot of old-time wisdom seems to have been discarded and forgotten in less than 20 years.
That is probably the big gest mistake of all. But it is never too late to do something about it, if only certain key people can be strong enough.