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The bones of the bonus

Recently, a trio composed of some of our oldest and most respected life

offices, Friends Provident (formed by Quakers in 1832), Legal & General

(1836), and Scottish Widows (1815) incurred the wrath of an organisation

known as Chartwell by refusing to disclose the underlying investment

performances of their with-profits funds.

Instantly, the media was crammed with highly critical comment from the

nation&#39s financial experts and the Financial Services Authority has

threatened to make such disclosure compulsory in furtherance of its brief

to ensure that customers are provided with “more and clearer information”.

All these developments indicate a widespread lack of any real

understanding of how a with-profits fund works. And, sadly, that lack

extends into groups of people who should know better than to stir up

trouble where none is warranted.

Disclosure of the underlying investment performance of a with-profits

fund, of itself, would most certainly not ensure clearer information to the

customer. Indeed, it would probably cause confusion where none existed


The bonuses derived from a with-profits life insurance fund constitute the

surplus which is allocated to those policies which are entitled to a

proportionate share of the profits. This surplus is the excess money

available after reserving adequate funds for future claims and expenses and

making intentionally pessimistic assumptions as to the future success of

the fund&#39s investments. Highly complex valuation formulae are employed in

making the necessary calculations for valuing a life fund.

Eminent actuaries through the ages have wrestled with what is, by virtue

of its involvement with the future, a very inexact science. Messrs

Zillmer, Sprague, Elderton, Lidstone and Karup all devised their own

methods at various times.

Bonuses do not arise either directly or solely from investment surplus. A

life office also makes “trading” profits on its life insurance operation by

pitching its premiums at a level which assumes that human mortality will be

heavier than it is known to be according to mortality tables derived from

census statistics. This is called mortality surplus. It comes from all the

classes of policy that the office issues, such as term insurance and

sometimes unit-linked business, and it all goes into the with-profits pot.

Cancellation penalties give rise to surrender surplus. One of the most

important skills of the actuary is to assess how much of the surplus he

should give away as bonus, so as to achieve a smooth and cautious rate of


He must ensure the retention of adequate reserves to provide for future

rainy investment days. This is the very cornerstone of the with-profits

system. It was the adroit application of that principle which has enabled

Scottish Widows – one of Chartwell&#39s culprits – to chalk up an amazing

record of not reducing its bonus rate for 120 years, except during the two

world wars.

To comply with the demand now that the rate of investment performance be

disclosed, baldly, without a lengthy appendix dealing with all the other

factors affecting the bonus, would serve only to obfuscate the issue. And

the inclusion of such an appendix would, with respect, probably confuse the

average customer even more.

If the fund were enjoying a golden period, any public announcement of this

would, not unnaturally, lead to clamorous demands for high bonuses, bowing

to which could upset an actuary&#39s reserving programme and, therefore,

defeat the with-profits principle of cautious growth. In fact, this was

arguably the cause of a recent flurry of bonus reductions.

Conversely, if investment returns were disappointing at that juncture and

bonuses were being propped up by reserves, it would create an unwarranted

and, therefore, unfair lack of confidence in the life office&#39s prospects.

In summary, the “need to know” principle is often the wisest course to

adopt in many walks of life – and it is probably so here. The FSA would do

best to let sleeping dogs lie. The supply of statistical information

available for the assessment of life offices is already quite adequate for

the purpose.

The most telling factor is the rate of interest that the actuary has

assumed in making his valuation – the lower the stronger.

Indeed, the baring of the with-profits soul was widened only a few years

ago, when following another wave of criticism, the concept of free-asset

ratio (the ratio of surplus to total liabilities) was brought into the

debate. For nearly 200 years, few people have ever had cause to complain

about the performance of their with-profits policies – low-cost (that is,

hybrid) with-profits mortgage endowments apart.

If bonus rates in general ever start falling consistently below what is an

acceptable par, that will be the time for the FSA to ask questions. Until

then, in the common interest, it should resist the urge to do what so many

other quangos have done – fix things that ain&#39t broke. Especially where

200-year-old copper-bottomed time-proven British-invented institutions such

as with-profits are concerned.


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