A with-profits policy (Commonwealth) or participating policy (U.S.) is an insurance contract that participates in the profits of a life insurance company. The company is often a mutual life insurance company, or had been one when it began its with-profits product line. Similar arrangements are found in other countries such as those in continental Europe.
With-profits policies evolved over many years. Originally they developed as a means of distributing unplanned surplus, arising eg from lower than anticipated death rates. More recently they have been used to provide flexibility to pursue a more adventurous investment policy to aim to achieve long-term capital growth. They have been accepted as a form of long-term collective investment whereby the investor chooses the insurance company based on factors such as financial strength, historic returns and the terms of the contracts offered.
The premiums paid by with-profits and non-profit policyholders are pooled within the insurance company's life fund (Commonwealth) or general account (USA). The company uses the pooled assets to pay out claims. A large part of the life fund is invested in equities, bonds, property to aim to achieve a high overall return.
The insurance company aims to distribute part of its profit to the with-profits policy holders in the form of a bonus (Commonwealth) or dividend (USA) attached to their policy (see the bonus section). The bonus rate is decided after considering a variety of factors such as the return on the underlying assets, the level of bonuses declared in previous years and other actuarial assumptions (especially future liabilities and anticipated investment returns), as well as marketing considerations.
Types of policies
There are two main categories of with-profits policies:
Single premium contracts - insurance bonds (with-profit bonds), single premium endowments, single premium pension policies.
Regular premium contracts in which premium payments are usually made monthly - endowment policies, pension policies.
Conventional and unitised
Conventional with-profits contracts have a basic sum assured to which bonuses are added. The basic sum assured is the minimum amount of life assurance payable on death; for endowment contracts it is also the minimum lump sum payable at maturity.
The basic sum assured attracts reversionary bonuses which are used to distribute profits to the policy. Once a reversionary bonus is added it cannot be removed from the policy. For policies with a maturity date the required premiums must have been maintained to receive payment of the basic sum assured and bonuses. If the premiums have not been maintained a reduced amount will be paid. For insurance bonds the basic sum assured plus bonuses represents the plan value. When the policy matures, a final bonus may be added to reflect the policy's share of profits which have not yet been distributed.
Unitised with-profits policies work in a similar way except that the policy value is represented by units. Various models have been adopted by different insurers, but typically either:
the fund value is represented by the bid value of units which increase with time or
the number of units increases each year to represent the increase in value and the unit price remains fixed.
Endowments still retain a basic sum assured (in most cases) although this may be notional rather than a structural part of the policy.
Unitised with-profits policies were introduced as a response to competition from unit-linked life policies that became available in the 1970s. There never was a clear consumer advantage in with-profits policies being unitised rather than conventional.
The conventional policies have an element of guarantee conferred by the contractual nature of their basic sum assured. This guaranteed element which is non profit related has caused issues for insurers in the realistic reporting regime (see below). Most policies issued today are unitised and often represent ring fenced tranches of the life fund rather than participating in the full profit of the life company.
With-profits funds employ the concept of smoothing. That is, a proportion of the profits earned during good years is held back to aim to ensure that a reasonable return is paid during years of poor performance. This may result in a smoothed effect on the increase of the unit price, as opposed to fluctuations that would normally occur in the daily price for other stocks or shares. An important difference between this and the normal statistical sense of smoothing is that it has to be attempted without knowledge of future developments, which may cause the "smoothed" value to move further and further out of line with the "unsmoothed" value, necessitating a sharp correction at some point in the future.
Types of bonus
A reversionary bonus (or annual bonus) is paid at the end of each year. The annual bonus may consist of two parts. The guaranteed bonus is an amount normally expressed as a monetary amount per £1,000 sum assured. It is set at the outset of the policy and usually cannot be varied. The rest of the annual bonus will depend on the investment return achieved by the fund subject to smoothing.
The terminal bonus is paid at the maturity and sometimes the surrender of the policy. It is sometimes referred to as the final bonus. The terminal bonus represents the member's entitlement to a proportion of the fund that has been held back for the purpose of smoothing. In certain circumstances a Market Value Adjustor may be applied to reduce the overall policy value to limit the payout to a reasonable multiple of the member's fair share.
The insurance company has some freedom to decide what mix of bonuses to pay. An insurance company may decide to pay low annual bonuses and a high terminal bonus. Such a policy will protect the insurance company from falls in the investment markets because annual bonuses cannot be taken away once given. However, this policy might be unattractive to investors because it does not contain many guarantees and offers a low rate of return (until the maturity of the policy).
Occasionally an insurer may decide to pay an exceptional bonus possibly due to restructuring of the company or exceptional investment returns. This is almost unheard of these days.
An insurer may pay an interim bonus when a claim (be it maturity or earlier death) is made between the firm's bonus declaration dates. For example, if the reversionary bonus payable for the previous year is declared in February, and a policy matures in September, the insurer's actuaries are likely to calculate and award a bonus for the 'part year' for which bonus rates have not yet been declared.
Market Value Reduction (MVR)
A Market Value Reduction or Market Value Adjustor is a mechanism used by the insurance company to ensure that policy withdrawal payments are reasonable in relation to the policy's fair entitlement to the assets of the life fund. After a period of poor investment performance the value of the withdrawal is reduced to reflect the reduction in the underlying value of the assets of the life fund.
The overall purpose is to protect the interests of policyholders who remain invested when the market is performing poorly. By using this contractual clause the insurance company restricts (non-contractual) withdrawals that would otherwise reduce the value of the remaining policies.
As a simplified example, imagine a fund of £10,000 with 5 investors each with rights to £2,000.
Let's assume the underlying assets fell in value to £8,000 and one investor decided to surrender their policy.
If the insurer paid out £2,000 (the notional value), then the policyholder would receive more than their fair share of the assets (i.e. one fifth of £8,000: £1,600).
Therefore the insurance company applies a market value reduction of £400 to ensure the interests of the remaining policyholders are protected.
MVRs are sometimes euphemistically referred to as Market Value Adjustments or Unit Price Adjustments however they never adjust upwards. It's more correct to think of MVRs as an extension of the smoothing process - a negative terminal bonus.
Perceived risk and actual risk
For many years with-profits policies were seen as a safe alternative to deposit accounts for many investors (especially elderly investors). Years of steady reliable returns in combination with unscrupulous sales tactics from insurers fostered the impression that a 'low-risk' investor should invest in with-profits. This perceived low risk belied the reality of the underlying investment strategies of many insurers who used high equity exposure and high-risk financial instruments to achieve the returns.
In the middle of the bear market of the early 2000s the UK regulator (the Financial Services Authority) imposed a new regulatory regime for with-profit providers, in response to growing consumer complaints following the introduction of market value reductions. The realistic reporting regime had the combined effect of requiring the insurers to move more of their funds into lower-risk investments (corporate bonds, and gilts) to cover liabilities; and to lower projection rates in line with the new asset mix of the fund to more accurately predict future returns. Industry commentators cite this as the death knell for the with-profits policy.[who?]
The policy value is either the basic sum assured plus the bonuses given (for conventional contracts) or the bid value of a unitised with-profits policy. This value is broadly equivalent to the value of the underlying assets. However, because of investment fluctuations this value may exceed the market value of the underlying assets.
Without appropriate regulation an insurance company might not have enough money to pay the value of its policies. This was the case with The Equitable Life Assurance Society in the UK when the costs of annuity guarantees promised to some policyholders meant that the company was forced to suspend the introduction of any new business to the With Profits fund and nearly led to the collapse of the company itself.
The Financial Services Authority (FSA) altered regulation as a consequence of this and other management failures to ensure that an insurance company keeps enough free reserves to protect the company in the event of falls in the markets. The new valuation method requires realistic valuation of the funds assets and growth prospects. In addition each firm must now publish a document called the Principles and Practices of Financial Management (PPFM) for each with-profits fund with a break-down of the assets and an explanation of the management processes for the fund. These documents although comprehensive are largely indigestible for consumers and are thought to be of use only for Independent Financial Advisers and other industry professionals. The realistic reporting method has been cited as a contributing factor to the demutualization of Standard Life Assurance Company.
In the USA, insurance companies are regulated on a state-by-state basis. However, they must not only comply with the requirements of the state in which they are incorporated, but with the regulations of each state in which they are licensed. The National Association of Insurance Commissioners (NAIC) provides suggested guidelines which each state is free to follow or not. For example, the Insurance Information Institute, "Life insurers are the object of the NAIC’s Intestate Insurance Product Regulation Compact, launched in 2002 as a way to develop uniform standards and a central clearinghouse to provide prompt review and regulatory approval for life insurance products."
For many years with-profit funds were very popular and large numbers of such policies were sold within the United Kingdom and in the United States.
Recently with-profit funds have had a large amount of negative press due to the introduction of MVRs. This has led people to question the opacity in setting bonus rates and the over-complexity of the product in general. Simple to understand products have been encouraged recently and the nature of the conventional with-profit fund does not fit with such simple policies. Alternatives such as a more fund-type product, CPPI or smoothed managed funds are yet to show a significant popularity amongst consumers.
Secondly the Equitable Life company sold a large number of policies with guarantees in the contract. After a series of court cases the company was required to meet these guarantees, which it did not have the money to meet. This resulted in a reduction of the value of all the policies issued by the company. This reduction received considerable negative publicity and damaged the reputation of with-profit policies.