Features of with profit policies
Conventional life insurance products are categorized into two types.
1. With profits / Participating products
2. Without profits / Non Participating products
With profits products, also known as participating products are life insurance contracts that will participate in the surplus/profit of the product portfolio. Due to the nature of sharing profits, usually with profits products are expensive than without profit products. At the declaration of profits, with profits policyholders are ranked first and profits are allocated to them before deciding the amount of profit transferred to shareholders of the company (Proprietary Company). There are companies which only have with profits policies which are called Mutual Insurance Companies (Do not exist in Sri Lanka).
In Sri Lankan insurance industry with profit/ participating insurance contracts have a significant history. Most insurance companies that were incorporated with the privatization of the insurance industry in 1987, have started their business with participating products. Almost all the companies issuing with profit policies uses the increase in sum assured method in Sri Lanka instead premium reduction method.
This surplus/profit which is shared with the policyholder is called a bonus. Bonuses are either added to the Sum Assured at each year or used to reduce future premium. There are several ways of adding bonuses to a with profit policy. Namely these are;
- Reversionary Bonus
- Terminal Bonus
- Special Bonus
Reversionary bonus is usually added to policies each year. Once added, the company cannot take these back and it will become a guaranteed benefit. But normally, the bonus amount is paid to the policyholder with the main benefit. Terminal bonus is not guaranteed. This is usually being paid at the maturity or claim, depending on the overall profitability of the product/ policy. Special bonus is not a regular bonus. A company would pay a special bonus depending on the profitability performance of the with profit portfolio in a particular year, for example, If the portfolio has extraordinary mortality surplus in a particular year. This bonus is again not guaranteed and not regular.
Sri Lankan insurance companies, mostly have the reversionary bonus method. But there are few companies that give all three types of bonus to their policyholders in the industry.
Reversionary bonus takes many different forms around the world. Simplest to most complicated ways exist. Most commonly known methods are
- Simple reversionary bonus
- Compound reversionary bonus
- Super Compound bonus
Simple reversionary bonus is the type that bonus amount is calculated as a percentage of the original sum assured each year. But the bonus rate could vary each year. Compound Reversionary bonus would pay bonus on Original Sum Assured and all the bonuses added previously, so basically, bonus is paid on past bonus too. Super compound bonus system is the most complicated system of all. It is declared as two compound bonus rates each year. Usually the smaller rate applies to the basic sum assured and the second one applies to the bonus paid up to date. Sri Lankan insurance industry uses only the simple reversionary bonus system.
Regulation around the world and Sri Lanka in managing a with profits portfolio
There are tight regulations in most developed countries in managing the with profits portfolios. Even though it may not be tight, but most regulators around the world have stringent regulations on with profit portfolios. In Sri Lanka also, the regulator is very keen on how the participating portfolio is managed and treating these customers fairly.
It is important to note that with profits policyholders do participate in the profits by paying an additional premium as opposed to a policyholder who purchased the same benefits under a without profits arrangement. Hence, it is the company’s ultimate duty to manage this portfolio of business in order to make profits.
It is important to maintain with profit fund separately from other life insurance funds as the profit sharing basis differs. Most common profit sharing basis is 90:10 between policyholders and shareholders respectively. But this could differ from country to country. Shareholder is eligible for 10% of participating profits if policyholders are given 90% of the profit only. In most countries, it is required by the regulator to manage the with profit fund separately. Some benefits of having a separate fund are;
- Easy governance of the fund and ensuring that with profits policyholders’ interests are properly protected and treated fairly;
- Makes sure that with profit policyholders bear costs that are incurred in the running of the participating fund only and no charges related other funds are borne by them. Any overheads incurred by the firm charged to the fund are proportionate to its size.
- Easy to ensure that investments are appropriate to the with profit fund and these assets are well matched with the with profit liabilities.
- Ensures that new business is written on terms that, existing with profits policyholders may not be worse off.
Most life companies in the Sri Lankan insurance industry do not maintain a separate fund for with profit policies. Initially in the absence of any regulatory requirement to keep a separate fund for with profit fund and most of the companies were issuing only with profit. Subsequently, almost all companies started writing without profit policies in the same fund. After about 25 years later, the regulator is now requesting companies to segregate these funds with the implementation of a new regulatory framework centering Risk Based Capital.
We will discuss more about the with profits regulations around the world, the issues that a company will face in segregating the combined life fund into Participating and Non Participating and the possible approaches for segregation in our next discussion thread.