Debate with Nick Dumbreck about Terminal Bonus

Hi Mr Tan,

I recently read an article by Nick Dumbreck (an independent actuarial consultant engaged by NTUC Income) about terminal bonus. I wish to send the following comments for posting in your blog.

Yew Ming

Nick Dumbreck (ND): "Limiting the build-up of guarantees enables with-profits assets to be invested more freely, with a significant proportion generally being allocated to equities - and in some cases property. These are expected to generate better returns than bonds in the long run. So a higher guarantee may result in a lower payout as compared to a policy with a lower guarantee and greater investment flexibility."

Yew Ming (YM): Let's look at the facts in the public domain. Here are the figures for the par fund in 2006 :

Company   Equity      Capital
        Allocation  Adequacy
AIA        15%         420%
Aviva      20%         320%
GE         26%         190%
Prudential 40%         280%
Income     31%         170%

Note that MAS requires 120% minimum capital ratio. At best, this gives significant amounts of sleep for senior management and their actuarial consultants.

Also, renowned economist Robert Shiller (Irrational Exuberance) has this to say : "The evidence that stocks will always outperform bonds over long time intervals simply does not exist. Moreover, even if history supported this view, we should recognise that the future will not necessarily be like the past"

And lower payouts from reversionary bonus payers (i.e. Income) compared to terminal bonus payers (i.e every other company)? I really doubt this. Income policyholders who have collected his/her policy payouts will know better.

ND: "My experience is that given the choice between a higher expected payout and a lower guaranteed minimum sum on the one hand, and a lower expected payout but a higher guaranteed minimum on the other, most policyholders would opt for the former. Indeed the basic idea behind the with-profits proposition is that guarantees are limited but policyholders participate in any profits which arise."

YM: This is an assumption made by ND about what the customers prefer. I think companies should never assume what customers want.. Simply ask, and you will know the answer.

ND: "Unfortunately it is not practical to accommodate the different aims of individual policyholders. It is for the board to decide, in the interests of policyholders collectively."

YM: How impractical is it to send a letter to the policyholder to ask him/her which bonus structure he/she prefers?

ND: "As yields on long-dated government bonds fell from over 10 per cent per annum at the beginning of the decade to less than 4.5 per cent at the end of 1998, many companies were slow to cut annual bonus rates despite having high exposure to equities in their participating funds. This led to reduced free assets, and several mutual firms were forced to demutualise to restore a satisfactory solvency position."

YM: There is NOTHING wrong with annual/reversionary bonus. The root cause of insolvencies was "companies were SLOW TO CUT annual bonus rates". Maybe because the industry wanted to illustrate high bonuses to compete for new business and targets high growth rates to impress shareholders.

ND: "Onerous benefit guarantees were a big factor behind the closure of Equitable Life, Europe's oldest mutual life company in December 2000. These examples show the importance of addressing the balance between guarantees and providing attractive returns in the long term."

YM: The real reasons for Equitable's failure are found in http://news.bbc.co.uk/2/hi/business/3547441.stm

Quoting the report - "Dubious practices, used by ALL life insurers to varying degrees was to STOP ALLOCATING BONUSES in the form of REVERSIONARY bonuses. These were guaranteed and had to be counted on the life insurer's accounts as a liability. Instead, an increasing LARGE CHUNK of the bonuses allocated to policyholders took the shaper of TERMINAL bonuses. These could be added or cut with impunity and without affecting the company's solvency - even if they did affect the value the customer EXPECTED". Unquote.

I think, the British Courts finally ruled that these terminal bonuses have to be paid, thus critically damaging the Equitable.

Reversionary bonus (after declaration) are guaranteed and thus needs to be actuarially reserved. This imposes discipline on the financial management of the insurance funds. Terminal bonus on the other hand, is an "actuarial sleight of hand". It breeds complacency and gives the senior management a false sense of security.

ND: "Switching to a lower annual bonus and higher final bonus will align to industry best practice, improve investment freedom and make it easier for the insurer to deliver yields to customers. It will also improve the resilience of the participating fund."

YM: The funny thing about "industry best practices" is the industry is often behaving like lemmings.

Quoting Warren Buffet - "the behaviour of peer companies, whether they are expanding, acquiring, setting executive compensation or whatever, will be mindlessly imitated".

And, we don't need to look far for evidence of lemming-like industry "best practices" e.g. subprime mortgage debacle, tech bubble, the recent global property bubbles, LTCM/Enron blow-up.

I used to view Income's management as standing independent from the sheeples (hybrid of sheeps and people).

Take for example Warren Buffet's description about one of his senior managers at Geico, Louis Simpson : "He derives no pleasure from operating with or against the crowd. He is comfortable following his own reason.".

ND: "In short, both policyholders and the insurer stand to gain from this new bonus structure. The lessons learnt from the UK market serve as a painful reminder of the potential consequences of resisting change in favour of the status quo."

YM: In short, Nick Dumbreck's misleads the uninformed public with THEORY. And we all know, theorectically the recent credit crisis is a 25-sigma event ie happening once every GOOGOLIAN years (1 with 100 zeros behind).

Lastly i wonder what percentage of Singaporean life actuaries invest/save in With-profits-Terminal bonus life insurance? I suggest that the local actuarial institute conduct a survey of this very telling statistic.