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Friday, July 31, 2009

Insurance funds need more transparency

Insurance funds need more transparency
Straits Times
31 Jul 2009

Distribution of bonuses is still a mystery to many policyholders

FOR a mass market product, insurance ranks among the most difficult financial products to understand. To raise the comfort level of consumers, the insurance industry has stepped up its efforts to better inform consumers, but there is still room for improvement.

For instance, policyholders are only now waking up to the fact that the way insurers go about operating the so-called participating (par) fund still remains largely a mystery. This is despite the past efforts of insurers to enhance the transparency and disclosure requirements of these funds.

To recap: The premiums that policyholders pay for their par plans, such as for whole life and endowment, go into a common pool called the par fund. This fund is invested in a variety of assets such as equities, property and fixed income to provide policyholders with a stable return.

As a participating policyholder, you get to share in the profits of this fund in the form of annual and terminal bonuses. These bonuses are determined on the basis of the fund's past and future potential performance, claims and expenses.

These policies are particularly popular in Singapore, with 3.5 million par policies with total assets of more than $50 billion. Yet, despite their popularity, many policyholders are dissatisfied with the way the funds are administered and bonuses are declared.

To their credit, insurers did take measures last year to close the information gap for these funds. Prior to the changes, most insurers did not disclose the returns (or losses) on their funds, their targeted rate of returns and payout levels, or the funds' investment strategy and allocation mix. As a result of the measures implemented in March last year, it is now compulsory for insurers to disclose annually how they invest the premiums they collect as well as the performance of the funds.

So why are policyholders still dissatisfied? It boils down to two reasons.

First, they are still in the dark as to how insurers decide the distribution of bonuses. It does not help that following a deterioration in financial markets late last year, several insurers appear to have cut both the annual and terminal bonuses this year. In some cases, the reduction in annual bonuses was as high as 50 per cent or more.

Annual bonuses are bonuses added to the policy annually. Once declared, annual bonuses increase the amount of money that policyholders are guaranteed to get back once their policies mature.

Terminal bonuses are meant as loyalty bonuses to reward policyholders who hold their plans till maturity. They typically form a large portion of a policy's projected value and are more sizeable than the annual bonus. So when insurers remove or reduce the terminal bonus, it usually involves a substantial amount. Both annual and terminal bonuses are not guaranteed.

While it is clear why there is a need to cut bonuses in bad years, insurers have explained that it is also necessary to set aside some surplus in the fund in the good years so as to ride out the bad years. This principle of 'smoothing' allows insurers to manage through good and bad times, and it also means that any bonus change will be gradual. As a result of cutting both the annual and terminal bonuses, many insurance firms have accumulated a large amount of undistributed profit.

This brings us to the second reason for discontent among customers. Policyholders are uncomfortable that insurers appear to have full control as to how they can use the par fund to fund their management expenses. After all, it is the policyholders' premiums that contribute to the par funds. The so-called management expenses may range from paying sales commissions to advisers to covering the cost of recruiting advisers.

Insurers can always justify that such expenses are for the benefit of policyholders. If the expenses serve to attract more premiums, more can be added to the par fund, and more can potentially be distributed as bonuses in the future. But how would such expenses benefit policyholders whose policies have already matured? Furthermore, there is no way for policyholders to find out if the distribution of bonuses has been fair.

It is no wonder that par policies have fallen out of favour in the United States and in Britain. The British government has imposed a lot of rules on the industry to make the policies more transparent.

For instance, in Britain, the term 'inherited estate' is used to describe the part of the par fund that is over and above what is needed to meet the fund's immediate liabilities, such as payments to policyholders and expenses. The term recognises that the 'inherited estate' has been built up over many years and would include past generations of policyholders' premiums that have been retained and not distributed. The 'inherited estate' may also include past injections of money from shareholders in the insurance companies.

The British authorities acknowledge that insurers do use some of the capital from the fund to support their activities outside the fund, such as to reduce general management costs. But the British authorities have decided that insurers can use the funds for such purposes only if they buy out the interests of the policyholders in the 'inherited estate'. Policyholders typically receive a one-off cash payment as compensation for the interests they are giving up. The payment can be paid out to policyholders and shareholders according to their shares in the fund. The payment can be in the form of increasing the value of the policy or as cash, and may be paid out at once or over a period of time.

Perhaps the authorities and the life insurance industry here can study the British system and consider something along the same lines here.

The recent saga over failed structured products has highlighted the importance of consumer confidence in financial institutions. It is always prudent to act proactively to protect consumer rights. After all, consumers do not want to be taken for a ride and it is only a matter of time before they get wiser.

Let us not wait for another scandal before we act.

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