Thursday, June 12, 2008

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

6 comments:

zhummmeng said...

A top saleswoman and 15 others from NTUC who called themselves consultant wrote to the ST public forum claimed that the restructuring of the bonus
lowers the risk of their par products.This is incorrect and it is misrepresenting to the public.
Restructuring MAY increase the return but it brings with it the increased risk too and this must be disclosed.
The Equitable Life debacle is a good example of how high terminal bonus can be a source of potential danger during bad investment climate.Safer is still a reasonable and sustainable annual bonus.
I gathered from some NTUC friends many of the top agents or salespeople are selling the par products with guaranteed return. This is unethical.

SingaSoft said...

You quoted:

"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..."

Just a second thought:

The quote above could imply that the over-pay was due to high annual bonuses DECLARED in previous years, and not necessarily the terminal bonuses.

ym said...

Re-read pt 1 "Penrose report :... 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..."


Yew Ming

SingaSoft said...

From the Penrose report:


The valuation and distribution policy adopted was designed to maintain the DECLARED bonus rate to continue to attract new business, despite market conditions placing the bonus
structure under strain
. No reserves remained to meet future income shortfalls by way of the second call concept.

40. This placed heavy reliance on the future performance of equity markets. That involved risk, because the Society was lean and had little or no room to manoeuvre.
The position was aggravated by the failure to make any provision for terminal bonuses expected to be paid during the following triennium on maturing policies, an essential element in the Society's marketing strategy. The protective cushion of capital appreciation of £52m (representing 36% of fund value) that had existed at the end of 1972 had been lost. The Society did not have the resources to make any provision.

ym said...

singasoft, thanks for doing more research on the Equitable's problems...

firstly, this passage (from chapter 3 : growth and bonus policy) just highlights that mgmt was driven by new business growth and neglected financial strength.

secondly, that was just the 70's. when you get to the 80s, you will see the FATAL blow :
(95. Objectively, the period from the end of 1982 through to early 1984 saw a momentous change in the Board's policy, largely for competitive reasons, that laid the basis for the Societ's subsequent weakening. But this was not apparent from published information. The release of the second call reserve increased the amount available for allocation as terminal bonus, and increased substantially the amounts credited on maturities, surrenders and transfers.)

as i mentioned previously, from 1980s terminal bonus was used to run a ponzi scheme, since financial weaknesses can be easily disguised (ie not apparent from published info)..


Yew Ming

siewkhim said...

Dear Yew Ming and Kin Lian,

I am not to clear regarding the reserving standard under RBC in Spore. Just a suggestion only.

I would suggest that reserve for each participating policy should be at least equal to or greater than the policy's earned asset share computed based on actual experience as at the valuation date. In this way impending terminal bonus would automatically be reserved.

Does it sound stupid to you guys?

If no, maybe we can suggest to our regulator the MAS.

Thanks.

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