The cost of protection

Werner Scholtz at the existing business solutions business at Momentum, speaks to Angelo Coppola about the mechanics of smoothed bonus products, and they answer two questions.

We had several questions following the PFA ruling on smoothed bonus products.

1. Where do all the profits go?

2. What happens to the accumulation of the funds (now swelling the stabilisation reserves in the insurer's books) where there is no "market adversity" for many successive years?

Health warning: It is important to note that this response is focused on providing generic information regarding smooth bonus portfolios, the bonus stabilization reserve (BSR), and the practice / impact of market value adjusters (MVA).

This response is therefore not focused on the specific PFA ruling that you are referring to.

Now that we have the small print out of the way: At the heart of smooth bonus portfolios lies the practice of smoothing investment returns, according to Momentum.

The bonus stabilization reserve (BSR) is the key mechanism used to facilitate the smoothing "process" and the resultant bonus declarations.

A positive BSR represents an under-distribution of investment returns and could be viewed as funds that will be distributed to policyholders in future. Similarly, a negative BSR represents an over-distribution of investment returns.

Insurers must protect remaining policyholders, and of course their shareholders, against investment losses (in times where the BSR is negative) where withdrawing policyholders have discretion over the timing of exiting their policy contracts, i.e. through surrenders.

Those selecting to withdraw their funds at a time when the BSR is negative stand to gain at the expense of the remaining policyholders. To prevent this from happening, insurers generally apply a market value adjuster (MVA) to surrender values during times of depressed equity markets.

Q: Where do all the profits go?
We assume this question refers to the application of a MVA and the possibility that this could lead to a surplus ("profit") in the fund.

The application of a MVA should not result in a surplus in the fund if accurately calculated. However, if it does for some reason, the resulting surplus belongs to the remaining policyholders.

Q: What happens to the accumulation of the funds (now swelling the stabilisation reserves in the insurers books) where there is no "market adversity" for many successive years?

Investment markets have been performing exceptionally well over the last 2 years, improving the levels of the BSR. Given that most insurers maintain a BSR within certain parameters (target ranges), this should lead to higher bonus declarations.

For example, Momentum's recent final annual declarations on smooth bonus portfolios under retirement annuities have been 2.25%, 7% and 17% for 2003, 2004 and 2005 (final bonuses as at 30 June each year).

Where the BSR exceeds the target ranges, terminal bonuses are often declared and paid on maturing policies.

Terminal bonuses in good times can be seen as the opposite of MVA's in bad times. For example, Momentum has recently introduced terminal bonuses (on maturing policies) on all its closed smooth bonus portfolios to ensure that the BSR is equitably distributed.

Editor's thoughts:
* It appears that there is movement towards transparency.