Chapter 20 CMP 2017

Hi Edward

We would find it easier to reply if you were to break your posts down into smaller groups of questions, particularly during the busy teaching period as we are currently in - and this would also likely encourage more responses to your issues from other visitors to this forum.

I will have a go at working through your questions in small groups when I have the chance.

Note that the reading only says that they "aim" for a zero smoothing cost - not that this is always achieved in practice. If a company does not maintain a smoothing account, then they could aim for a neutral smoothing approach by using a symmetric smoothing algorithm rather than one that is biased in a particular direction, so that it would broadly smooth up as much as smooth down over a long period of time. Companies may not operate an explicit "smoothing account", but they may calculate both smoothed and unsmoothed asset shares and monitor the difference between these over time at a fairly high level (e.g. monitor the ratio).

 

Question 1:

Bear in mind that asset shares are an internal management tool used by companies for setting bonuses and payouts. If the company was distributing the estate via additional terminal bonus, then the most effective way in which to do this would be to increase all asset shares, because asset shares drive how terminal bonus is set. Higher asset shares lead to higher terminal bonuses, thus distributing the estate.

If a company decides instead to distribute the estate by using a special bonus, say, then either:
- the company could increase each asset share by the amount of estate distributed as special bonus and then set terminal bonus by comparing asset share with guaranteed benefits including special bonus or
- the company could not increase the asset shares and then set terminal bonus by comparing asset share with guaranteed benefits excluding special bonus.

Basically, if it chose to distribute the estate through a special (or increased reversionary bonus) and not to increase asset shares accordingly, the company would need to be careful that it didn't end up effectively taking away the estate distribution through giving lower terminal bonus. So it is probably easier to increase asset shares.

Alternatively, the company could just calculate its terminal bonus rates normally, using unadjusted asset shares, and then choose to add x% to all of these rates as a method of estate distribution. It wouldn't have to increase the asset shares in order to do this, since by definition terminal bonus is paid out on policies that are claiming - and it would not have to continue to monitor the asset share for such policies, so it doesn't matter whether it bothers to increase the asset shares or not in such cases. But the company would have to increase the liabilities that it holds for such policies, once it has decided to distribute (part of) the estate in this way. On a regulatory basis, this means that the BEL would increase - and if this is calculated directly from asset shares (rather than from using terminal bonus rates) then the most efficient way for the company to take account of this would be to increase the asset shares. For internal management purposes, it would similarly need to allow for the expected cost of these higher terminal bonus rates - and if this is done using asset shares as the basis for these calculations, then it would be most efficient simply to increase the asset shares by the intended amount of estate distribution.

Question 2:

Only surpluses arising on without-profits business written inside the with-profits fund would be added to asset shares. Business written in a separate without-profits fund would be 100% owned by shareholders, and so they would receive the surpluses arising on that business - not the with-profits policyholders.

The main reason for proprietary companies having without-profits business written into with-profits funds is historical: such funds started out as mutuals, which subsequently demutualised. In a mutual company the profit arising on all business belongs to the policyholders, so there is no need for a separate fund. With-profits funds have also, in the past, been well capitalised and so provided a useful source of capital with which to support new business strain. However, more recent regulatory requirements (since 2005) to reserve for future terminal bonus have meant that this is no longer the case.

 

1. 1st point = actual returns on that subset of actual assets held in the fund which has been deemed to be backing the with profits business (i.e. separating out and ignoring assets which are deemed to be backing without profits business), also possibly with a different set of actual assets backing different types of product. 2nd point = returns on indices rather than actual returns, and notional asset mix (e.g. 75% equities, 25% fixed interest) rather than actual assets held.

2. Non-linked assets = all assets backing business written in that fund except those held in unit-linked funds.

3. Practical reasons: if the asset shares are calculated frequently (e.g. daily, such as for a shadow fund approach) then the actual return on each individual asset held is unlikely to be available sufficiently quickly. Even if the asset share calculation is less frequent, it is more efficient and speedy to use indices. And indeed it may be the only realistic option for some assets such as property.

 

Bear in mind that asset shares are only tools that are used as a guide to set bonus rates, which are themselves quite broadbrush. There are many approximations made: smoothing over time, smoothing between policies, using specimen policies rather than actual policies etc. Asset shares do not have to be exact and precise.

Many of the other (i.e. non-investment return) components of an asset share calculation are high level and broadbrush, e.g. the charges made for cost of guarantees, cost of life cover etc.

Any difference between actual investment return received and actual investment return allocated to asset shares will fall to the estate. The company will aim to ensure that the notional allocation approach used is fair and reasonable. If there are material differences arising, then it may decide to make "truing-up" adjustments to asset shares to allow for this.

 

This is not saying that the policy level asset share does not vary with duration. It is saying that the investment return applied to each asset share does not depend on the duration or outstanding term of that particular policy.

Basically, it means that all policies are assumed to have the same asset mix, irrespective of how long they have been in-force.

This is reasonable: policyholders would not have any expectation that the mix of assets in which they are invested would change over time, if this is not what they have been led to believe (by the PPFM, product literature etc).

 

The main issues are:
- How is "profit" to be defined? On a Solvency II basis? On a Companies Act/IFRS accounting basis? On an EV basis?
- This is about business written within the wider with-profits fund, so the company would need to somehow split out cashflows such as overhead expenses, asset mix/investment return in order to determine the profit arising purely from the without-profits business - which can be messy and time-consuming.
- How is the profit to be allocated to the asset shares? Actual profit as it arises? Smoothed over time? A notional amount e.g. as an addition to investment return?

 

1. This means that policyholders can choose to vary their premium amounts.

2. It would depend on how exactly the product is designed and described, but charges would typically be taken to cover all such non-investment aspects, including expenses, the cost of additional death benefits and the cost of guarantees (which seems to be the main one missing from your list, I think). The charges may also cover the cost of smoothing and cost of capital - although there may not be such explicit charging. (Bear in mind that taxes on investment return would be charges to the policyholder through use of a net rate being added to asset share for BLAGAB policies.)

3. If it is positive, then it might be required to remain in the estate in order to support these other uses that you mention, such as smoothing, meeting the cost of guarantees that bite etc.

 

4. e.g. cost of smoothing, cost of guarantees, cost of options

5. The shadow fund method is just a way in which the asset share of a UWP policy can be monitored. It doesn't affect the charging structure or product design, or how the business is otherwise managed, so this is just the same as in the previous sections.

6. This just means any UWP product written on a 90:10 basis where actual expenses are charged to asset share rather than having, say, a 1% annual fund charge deducted from units.

 

This means that the profits/losses on this business is no longer directly attributable to with profits policyholders via their asset shares and will instead accrue to/from the estate. This is likely to require a change of Principle within the PPFM. It might be being done as an intermediate stage towards the third bullet point, i.e. transferring the business out of the fund.

 

Yes - perfect!

There would be an impact on the BEL if it is done by enhancing asset shares, since this will also lead to higher TB rates and higher future expected benefits, so again the discretionary element of the BEL would be higher.

My explanation was in response to the question about whether the estate could be distributed without increasing asset shares. I was trying to get across the point that whilst companies could choose to increase TB rates without increasing asset shares, the BEL would still have to increase - so the end result is the same as if asset shares had been increased (leading to higher TB). And it generally makes more practical sense for the company to increase asset shares, hence this is what normally would be done.

Hope that helps

 

Yes (or deducted from the estate if a loss is made).

Yes - that's right.

Profits arising on without-profits business written outside the with-profits fund would in the first instance accrue within the long-term business fund in which it is written (often called the "non-profit fund"). The profit arising may be retained within that fund, at least for a while, e.g. in order to protect against losses and to support solvency capital requirements. Assuming that it doesn't get wiped out from losses, at some point the company will decide to transfer it into the shareholder fund, from where it can be used to pay dividends.

 

Hi - the word 'estate' does not have any explicit meaning in Solvency II terminology. Under Solvency II, 'own funds' refers to the excess of assets over TPs and the term 'surplus' or 'free surplus' or 'surplus assets' can be used to refer to the excess of 'own funds' over the SCR.

If there is a With-Profits Fund, the 'own funds' in that fund are generally those whose ownership is not yet determined - although for a 90/10 fund the working assumption would normally be a 90% policyholder & 10% shareholder ownership split (although note that the present value of shareholder transfers on future bonuses is part of these own funds, and this is 100% shareholder-owned - see comment on page 8 of Chapter 12).

As per the CR, the 'estate' of a WP Fund does not have a formal definition, but is usually taken to refer to the excess of the realistic value of its assets over the realistic value of its liabilities. This could be interpreted as being equivalent to 'own funds' (excluding future s/h transfers) in a WP Fund.

 

Hi - the 6 in the example is the amount that is being paid out to the shareholder. It would get transferred out of the With-Profits Fund and into the Shareholder Fund in the first instance, and then be used to pay dividends as and when the company decides to do that.

The 4 that is not distributed in this way is retained within the With-Profits Fund, as part of the estate. For whatever reason, possibly commercial, the company has decided that it shouldn't distribute this all to the shareholders now. In the future, when the company is deciding how to distribute the estate (eg when the With-Profits Fund is closed to new business and running off) the shareholders could argue that they are entitled to more than 10% of the estate, because 4 of the estate can be shown to be "their" money, due to this past under-distribution.

Hope that helps clear it up.

 

No - estate is just WPF assets minus WPF realistic liabilities. You don't add on the 'capital retained' - this is retained within the WPF. So, in the example we were using, the 4 is retained in the WPF and so it is already included in WPF assets - you don't have to add it in again. To do so would be double-counting.