There is concern within the Life Board as to whether policyholder expectations set by the marketing literature for with-profits bonds are entirely reasonable. Alternatively, are the reserves being set adequate for the expectations rather than for the detailed explanations in the policy documents? There are also concerns about the pricing and reserving implications of office practice on Market Value Adjustments, particularly if there is a practice (rather than a guarantee) of non-application of MVAs.
The position of older contracts is likely to be satisfactory since equity markets have performed so well. There is no reason to believe that this will continue indefinitely and this year may prove to be an exception. The Life Board is minded to produce a position statement setting out in more detail what constitutes best practice for these contracts and how Appointed Actuaries should respond to particular aspects of office practice. The purpose of this letter is to give you advance notice of this intention so that you may consider whether (if your office issues or is considering issuing with profits bonds) either the office practice should change for future sales, or alternatively heavier reserves should be set.
The issues can be grouped under 2 headings – policyholders' reasonable expectations and guidance of the Board of Directors.
The major issue for PRE, is the potential for confusion between headline bonus rates and underlying reality. An example serves to illustrate the point.
The first year bonus rate may appear to the policyholder to be the sum of the annual reversionary bonus rate, say 5 per cent, plus a reduced expense allowance, e.g. 2 per cent (added at the end of the first year rather than giving an initial 102 per cent allocation), and an upfront terminal bonus, e.g. 2 per cent, giving a total of 9 per cent in the first year. This number may appear in marketing literature. It seems unlikely that many policyholders understand that these 3 components are of very different types. The first may be expected to repeat each year but is currently too high in the context of the current PIA projection rates. The second is one-off which is actually added to the policy so to that extent is genuine, but the headline rate misleads since it will not be repeated.
The third item is simply a hostage to fortune in that it will be part of the terminal bonus paid at the end of the term and therefore represents no additional value to the policyholder unless eventual investment returns are below the amount necessary to cover already declared bonuses.
We believe that the practice of adding dissimilar items should cease. For an office which continues to present the sum of these amounts in its marketing literature, the Appointed Actuary should reserve on the assumption that bonus starts at the aggregate amount and reduces over a period of years to the sustainable rate. In the example above this would be likely to add probably 10 per cent to 20 per cent to the reserves.
Sales practices, such as an indication that there will be no market value adjustment in certain circumstances, cannot be ignored. The fact that they are not in the policy document is irrelevant. If the Appointed Actuary becomes aware that this presumption has been given to the market (whether by a direct or by an IFA salesforce), then he or she must make it clear to the Board that reserves must be set up to meet the consequences of there being no MVA on existing business and, if market practice is not changed for the future, then reserves will need to be set up for all future business.
In terms of informing the Board of the true cost of no MLA dates, it is necessary to undertake stochastic modelling. The cost of a 5 year no MLA date is substantial and although the cost drops dramatically for a 10 year no MLA date, it is still a significant amount to be incorporated in pricing and in reserves.
The new valuation regulations may deal with the necessary reserves to cope with the fall from current bonus rates to the rate sustainable under the PIA projection scenarios. The Appointed Actuary needs to be sure that this risk is adequately covered in the marketing literature or else a further reserve is likely to be required since policyholders will expect a less rapid decline (or no decline at all) in bonus rates. Again, the reserves necessary if this message is not clearly given will be substantial.
C G Thomson
Faculty and Institute of Actuaries