Terminal bonus lead to Equitable Life's failure

Hi Mr Tan,

Guarantees cost more money. Why does terminal bonus (with less guarantees) contributed to the Equitable Life's failure?

1) Penrose report, chapter 14, para 185 and 186 analysed some financial data :

185. In 1983, the investment reserve was approximately 37% of the long-term liabilities. In 1999, it was approximately 17%. Over the period 1986 to 2000 terminal bonus payments increased by more than 14 times. Further from 1983, the mix of reversionary to terminal bonus shifted in favour of terminal bonus.

186. ...the accelerating growth in terminal bonus payments was fairly consistent over time... Had the Society recognised terminal bonus in its statutory accounts and regulatory returns on any basis consistent with PRE, its financial weakness would have been exposed throughout the 1990s.*

This shows that the Equitable was diverting free assets into terminal bonus payments. More importantly, it implies that reversionary bonus that requires prudent reserving (ie setting aside money) for all generations of policyholders is a fairer approach and helps to avoid misappropriation of funds.

2) Lets see what a policyholder had to say (http://www.emag.org.uk/index.htm?documents/assessment_28112003.html~content) :

.... throughout the 1990s Equitable declared bonuses well in excess of the value of assets to improve its marketing appeal. In consequence it was paying out departing policyholders in excess of their asset value with money from new investors. This pyramid selling left a hole of some £3bn which all policyholders who did not leave before July 2001 have paid for in savage reductions in policy values...

3) How did Equitable declare bonus in excess of the value of assets? My understanding is as follows :

- management was driven by growth (ie new business)
- terminal bonus is not guaranteed and is more flexible to increase/decrease
- so management started to shift more to terminal bonus, projecting high terminal bonus (to attract customers)
- these bonuses were not sustainable, but the terminal bonus had become a marketing tool (decreasing it will lose market share)
- so management misused the investment reserve, using it to pay high bonuses to maturing policyholders at the expense of younger generations
- management thought that since terminal bonus is not guaranteed, they can always decrease it
- management thought that when the investment market booms, all problems will be solved but investment did not boom
- effectively, they had a ponzi scheme running which did not hold up in the courts

4) How reversionary/annual bonus could have prevented the collapse?

- imposes more discipline, ie set aside provisions for bonus, ensure unsustainable bonus are cut, control new business growth
- fairer way to share profits with all generations of policyholders and not just the maturing/claiming ones

5) Why do different actuaries have different opinions?

Quoting a friend : "the one who pays the piper calls the tune".

Yew Ming