1) CMP Chapter 21, page 9 “Rate of return required by shareholders will usually exceed the rate at which undistributed surplus accumulates within a life insurance company”. Why so? 2) CMP Chapter 21, question 21.8 Why is the BEP similar between new business and recently written business? 3) CMP Chapter 21, page 21 Why is competition more important under AWP than CWP? Why is sustainability of bonus rate less important under AWP than CWP Thanks!
Hi. Can someone please respond to question 1) above as I had the same query? 1) CMP Chapter 21, page 9 “Rate of return required by shareholders will usually exceed the rate at which undistributed surplus accumulates within a life insurance company”. Why would deferring surplus impact PH and SH differently? If deferring surplus could increase the value to PH due to the possibility of investing in equities then why would the same idea not apply to SH?
This is just saying that: The investment return on undistributed surplus at a life insurance company would be less than what the shareholders' expect to receive on regular basis via shareholder transfers. Therefore, for shareholders it does not make sense to count on this investment return at the end of the term. They prefer to receive regular shareholder transfers as they are better off this way.
Thanks your reply. If investment return is less than what SH will expect then why would SH have money invested here? Regards Seddak
Because they can get more money in "shareholder transfers" than from the investment return on the fund. Let's wait for Lindsay to confirm as I am not a tutor but using "common sense".
SHT are based on bonuses which are smoothed. If anything, I would have thought the bonuses would be lower than the investment return to build up a cushion?
Hi - let's see whether we can untangle these points as so many of you are interested! 1) The undistributed surplus in the WP fund would be invested in a mixture of the standard asset types: e.g. cash, fixed interest bonds, equities, property, with a reasonable proportion potentially in the lower risk & lower return asset classes. The shareholders are likely to require a higher return from providing equity to the insurance company than they could receive by investing in these assets, otherwise they would just invest directly in those assets themselves. Also, the accumulation of surplus will incur investment costs and (to the extent to which BLAGAB business) taxation of investment returns, which erodes the rate of accumulation. The conclusion is therefore that the shareholders' required rate of return would exceed the return that would be earned by undistributed surplus. Therefore deferring the distribution of profits to shareholders would, in general, not be a good thing: they would rather have the profits distributed as early as possible e.g. in order to be able to invest them in other ventures that would earn them higher returns. 2) Bonus earning power (the ability of the business to support a certain level of bonus) will depend principally on expectations of future investment returns. This should be similar between business which was written recently and current new business. 3) The solution to Q21.9 says that "arguably" competition is more important under AWP than CWP - so it is not a definitive statement. There is very little conventional with profits business being written in the UK now. And AWP business has tended to be more competitive in terms of comparison of the bonus rates offered, because such policies do not have a sum assured (just a fund value purchased by the premium(s) paid) and so the regular bonus tends to be the most visible component of the benefit or return that the policyholder is receiving. Sustainability of bonus rate tends to be less important for AWP than for CWP because AWP policies are generally more flexible, e.g. flexibility of premium levels and timings, and because they are more similar to a unit-linked product - hence policyholders tend to be more accepting of variation in bonus levels. Basically, there is less policyholder expectation of continued bonus at the same rate as present under AWP as there is under CWP. [But as the solution says, this is also "arguable", i.e. not necessarily strictly the case.] Hope that helps.
Hi: we need to be a little careful here. This isn't about the rate of return earned by shareholders on their initial equity investment, it is about the rate of return being earned on profits whilst these profits are retained within the fund and before they are distributed to the shareholders via dividends. The point is about whether shareholders would prefer to receive those profits now or later. The shareholders are not earning a return on their equity investment which is equal to the investment return on the assets invested: they are receiving dividends from the company which will reflect profits arising on all of the insurance business which is being written. The amount of these dividends will depend partly on investment returns earned (which will, for example, contribute to the amount of dividends arising from shareholder transfers on with profits business). But it will also depend on the volume of new (and existing) business written, profits from other sources (including on without-profits business) etc. Effectively the profits arising from all of the business written by the company is extra profit to the shareholder on top of the investment return being earned on their equity assets. That is why they invest.
Good point: and it does apply to shareholders too. But the extra value potentially arising from that increased investment freedom is generally insufficient to make up for the "opportunity cost" of not being able to get their hands on the profits immediately.
