Conventional With Profits

Discussion in 'SP2' started by Orainn, Oct 1, 2013.

  1. Orainn

    Orainn Member

    This is a very simple question but it's still bugging me!

    I understand how AWP contracts work - the notes have a good description.
    I also understand how they're different to CWP - sort of. According to the Flashcards it's to do with the amount of benefit that each premium gives rise to being explicit for AWP and implicit for CWP.

    What I don't get is - exactly how does CWP operate? What does that difference in premium vs benefit look like? The cards also state that using CWP defers surplus distribution more than AWP, but I'm not sure why that's the case. Does it rely more on TB?

    I've read a lot of descriptions online (the course notes seem to gloss over it), and they all sound exactly like AWP to me.

    The descriptions I've read are along the lines of:

    Regular premiums paid
    Guaranteed minimum benefit
    Regular smoothed bonuses
    Possible special bonuses
    RBs become guaranteed
    Terminal bonus at time of claim

    .....which is exactly what I'd write if you asked me how AWP operates. What am I missing?!
  2. Mark Willder

    Mark Willder ActEd Tutor Staff Member

    The big difference between CWP and AWP is the way that the guarantees build up.

    If you were to draw a graph of the CWP guarantees, they would start at the sum assured and then regular bonuses would build on this sum assured. Note that this guarantee cannot be realised now, as the policyholder has to wait until maturity (or death) to get it. So the true value of the guarantee is really the present value of the guarantee.

    If you were to draw a similar graph of the AWP guarantees it would basically show the value of the unit fund. This would grow gradually over time as premiums were added (less any charges). Bonuses are added to this fund value (and not to any sum assured). In this case, the guarantees are in current money terms and do not need to be discounted. The policyholder could surrender the policy now and realise the value of the guarantee (possibly subject to a MVR or surrender penalty).

    So, for a regular premium policy, the big difference is that AWP guarantees are initially small but build more rapidly, while CWP guarantees are initially quite high, but then build more slowly.

    As you've said, many of the other features (eg smoothing and TB) are just the same for AWP and CWP.

    You also mentioned deferral of surplus. CWP may well have a bigger TB than AWP and hence defers the surplus distribution more. As the AWP guarantees are in current money terms they look quite small compared to the CWP guarantees (as policyholders won't realise the importance of discounting these values to get a current value). As a result, we tend to need to declare bigger regular bonuses for AWP and hence have less left over for TB.

    I hope this helps to clarify the differences.

    Good luck in the exam.

  3. rathi

    rathi Keen member

    Sorry to butt in, but the explanation lead to a couple of questions in my mind!

    >> So how does that work for a non unitised version of AWP? The core reading says that there is an explicit relationship between premium and benefit, but I don't see anywhere an explanation of how.

    >> If we are declaring bigger bonuses in AWP, then how is the guarantee smaller? Do you mean in present value terms, the guarantee is lower than in CWP?
  4. Mark Willder

    Mark Willder ActEd Tutor Staff Member

    Both unitised and non-unitised AWP work in exactly the same way in this respect.

    The benefit will be based on the fund value. The fund value will be the premiums less charges rolled up with the regular bonuses.

    A simple example may help. Consider an annual premium of 50. The charges are 10% of the premium plus a deduction of 5 from the fund at the start of each year. The bonuses are 4%.

    So the guarantee at time zero is 50 - 0.1x50 - 5 = 40

    The guarantee then rolls up with bonuses to the end of the year to be 40 x 1.04 = 41.6

    We then add on another premium and deduct charges to get a guarantee of 41.6 + 50 - 0.1x50 - 5 = 81.6

    This then rolls up with bonuses to the end of the year to be 81.6 x 1.04 = 84.864 and so on.

    Different contracts will have different charges, and so the explicit relationship between premiums and benefits will be different. However, we can see that the guarantees are directly related to the premiums paid.

    A unitised AWP contract may then go one stage further and break this guarantee into a number of units and a unit price.

    Imagine that the unit price is 1 at outset and that bonuses are added to the unit price.

    Guarantee = number of units x unit price

    Guarantee at time 0 = 40 = 40 units at price of 1 per unit

    Guarantee at time 1 (before premium) = 41.6 = 40 units at price of 1.04 per unit

    Guarantee at time 1 (after premium) = 81.6 = 78.4615 units at price of 1.04 per unit

    and so on.

    No, I actually mean the opposite. To make a fair comparison between the AWP and CWP guarantees we should discount the CWP guarantee. However, policyholder won't do this, so they think that CWP guarantees are bigger than AWP guarantees (when really they are not). As a result, policyholders demand bigger AWP regular bonuses to compensate.

    So the result is that the AWP guarantees are bigger than CWP in present value terms, but policyholders actually believe that CWP guarantees are more valuable.

    Best wishes


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