I'm aware that there are three in specific: 1) Simple Rate 2) Compound Rate 3) Super Compound Rate What are the advantages of the bonuses for both insurer and the policyholder? Also, are there any good historical examples anyone can think of for With-Profit Policies?
The advantages and disadvantages are mainly about balancing security and returns. For example, the simple method defers bonus the least, so this is a positive for policyholders because their guarantees go up quicker (negative for the insurer). But it's also a negative for the policyholder because it means that the insurer is likely to take less risk since guarantees are higher, meaning that overall returns could be lower. At the other end of the scale, super-compound gives the longest deferral of bonus payments, which reduces security for members (negative) but gives the insurer the most investment freedom (positive). Because of that extra investment freedom, overall returns should be higher (positive for policyholder). Obviously compound lies between the two extremes, and is actually the most common method of bonus distribution. What do you mean by historical examples?
Historical examples - any instances where there is of evidence in the last say 30 years of a With-Profit Policy going either right or wrong on the basis of bonus distribution?
Hi Your question is difficult to answer. Falling interest rates and investment returns (e.g. during the dot.com crash) is the most likely (single) material factor that would have caused WP to go 'wrong'. Policy values (asset shares) plummeted whilst customers benefited from the guarantees inherent within WP policies and insurer's smoothing policies. Those insurer's who deferred bonuses the most (e.g. via super-compound) would have been better placed to adjust customer benefits than say those insurer's who deferred the accrual of bonuses the least (e.g. via simple). Remember, guarantees already accrued cannot be reduced. An insurer can only adjust the bonus rates in future (RB &/or TB)
Thanks. I've come across an example in the UK around 1999/2000 regarding the Equitable Life company policies collapse... http://www.bbc.co.uk/news/business-10725923
Equitable Life didn't collapse because of its bonus distribution method though. It collapsed because it gave policyholders very generous guarantees about the level of annuity they would receive in retirement. When interest rates dropped heavily in the mid 90's, these guarantees suddenly became very valuable and many customers started exercising them, which ultimately was set to cost about £1.5bn more than Equitable Life had. They tried to reduce terminal bonuses to offset the guarantee but this was deemed unlawful and Equitable Life closed to new business and started to wind down. Using a different bonus distribution method would have made almost no difference to Equitable Life's position.
As a follow-up question, for super-compound type, I can see that it is usually the case that sum-insured has a lower rate and RB has a higher rate. Is there any reason for this, please? Is it because this way, the deferral works better? Mathematically speaking, there can be an infinite number of rate combination I guess. Thank you!
It's helpful to think about the objectives an insurer is trying to achieve with its chosen bonus policy. A super-compound bonus policy is seeking to defer the build up of guaranteed bonuses (relative to a simple or compound bonus policy). The sum assured will be higher than the (initial) regular bonus. Given then objective to defer the build up of guaranteed bonuses it follows that this is most likely to be achieved with a lower / higher bonus rate being applied to the sum assured / regular bonuses. Create a spreadsheet and play around with the numbers to get a feel for the dynamics. The rates an insurer applies will depend on a number of factors in practice (e.g. rates applied historically, marketing etc).
