Bonus declaration and estate distribution in a closed with-profits fund
You are the appointed actuary of a closed with-profits life fund with assets of £2.1bn and total asset shares of £1.85bn. The fund has 40,000 policies, mostly 20-year endowment policies maturing over the next six years, plus 8,000 annuities in payment. The estate is therefore about £250m, against a regulatory capital requirement of £180m on the current risk profile. Equity markets fell 18% during the year. The fund holds 45% equities, 40% corporate bonds and 15% gilts. The board proposes a reversionary bonus of 1.5% and a 10% reduction in the terminal bonus scale. A policyholder advocate has challenged the estate distribution, arguing that maturing policyholders are receiving smoothed payouts funded by those who remain. The regulator has asked for evidence that the estate is not being run down in a way that disadvantages continuing policyholders, and the fund has no new business.
1. Assess whether the proposed bonus declaration is consistent with fair treatment of policyholders, using the fund's figures.
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Why the numbers matter. The free estate is £250m - £180m = £70m, or 3.8% of asset shares. That is the entire smoothing capacity. An 18% equity fall on £945m of equities is a £170m loss, or 8.1% of total assets; if borne proportionally, asset shares drop to about £1.70bn and the estate to about £230m. So the estate can absorb only about 3.8% of an 8% asset-share fall: full smoothing is impossible and the payout cut must come through the terminal bonus, not through raiding the estate.
Bonus cost. A 1.5% reversionary bonus on roughly £1.6bn of sum assured costs about £24m, or 1.3% of asset shares, and it is guaranteed from the moment declared. Declaring it ahead of a 10% terminal bonus cut shifts value from exiting to continuing policyholders - arguably the right direction, but it must be funded.
Fairness test. The right framework is a published estate-distribution policy with a target estate that declines as the fund runs off, so that the estate is returned to policyholders before the last policies mature rather than being trapped. Compare each cohort's payout to its asset share; maturing endowments should receive a smoothing adjustment within a stated band, not a subsidy. A 10% terminal bonus cut applied uniformly preserves relativities and is defensible if the advocate can see the cohort-by-cohort comparison. Declaring 1.5% reversionary while cutting terminal bonus may be defensible as protecting the guarantees of continuing policyholders, but it transfers risk to the estate and should be sized against the £70m free figure.
2. The regulator asks what would happen if equity markets fell a further 15% and corporate spreads widened 100bp. Outline the analysis and the management actions you would present.
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Stress arithmetic. A further 15% equity fall costs £945m x 0.85 x 0.15 = £120m. A 100bp spread widening on £840m of corporate bonds, with duration around 8, costs about 8% x £840m = £67m. Combined, roughly £187m against a free estate of £70m - the fund would breach its capital requirement unless something gives.
Consequences. Asset shares would fall another 9-10%. The 1.5% reversionary bonus already declared cannot be removed, so the guaranteed liability stands while asset shares shrink; the estate would be exhausted and the regulator would see a fund with negative free assets. Smoothing would have to stop and payouts would fall below asset share for maturing policies, which is exactly the cross-subsidy the advocate alleges.
Actions to present. First, quantify the estate run-off profile and show that the estate reaches the required £180m floor in year three under the central scenario. Second, show a de-risking plan: switch 15% of equities into gilts over 12 months, capping the equity exposure at 30%, with the cost to expected returns quantified. Third, propose a terminal bonus policy that responds automatically to asset-share falls beyond a trigger, so the fund does not rely on discretionary cuts. Fourth, show the effect on the 8,000 annuities, whose payments are fixed and which therefore cannot share in the reduction - the estate absorbs that risk. Finally, present the run-off solvency test and the communications plan for maturing policyholders.