deductions, in estimating what should be a fair bonus payout.17 This has become increasingly important as companies have moved to increase flexibility by substituting terminal for reversionary bonuses, so that an increasing proportion of the overall return to the policyholder depends not on the bonuses declared during the life of the policy (which once added cannot be revoked) but on the amount of terminal bonus allocated only on death or maturity. The equitable approach is that the terminal bonus should be sufficient to match the total return to the policyholders to their asset shares: so that companies have a ‘constructive obligation’ to pay out to policyholders at least their asset shares. The reasonable expectations of policyholders are also influenced by the policy the company has adopted in respect of bonus payouts on policies that have recently matured and by its marketing illustrations and other literature that informs with-profits policyholders as to how the company approaches the smoothing of returns and the allocation of benefits to different classes and generations of policyholders. The FSA will now require a formal statement of this policy in a statement of the ‘principles and practice of financial management’ (‘PPFM’) which each life fund must make available to its policyholders setting out, inter alia, a description of the fund’s investment management and bonus distribution policies. For the purpose of the solvency returns, the FSA will also expect each life fund to calculate its policy liabilities on a ‘realistic’ valuation basis which recognizes the constructive liability for these future bonuses (FSA, 2004c; ASB, 2004b). 18
Regulatory concerns were reinforced by the disastrous collapse of the business of the Equitable, the oldest life insurer in the world. Until then the existing UK regulatory framework had generally avoided any major life insurance company failures but the Equitable case revealed three main deficiencies in the current regime. First, the provisions in respect of options and guarantees embedded in policies (such as the guaranteed annuity rate options offered by many companies which would pay the guaranteed rates even when current interest rates were lower) were being estimated by insurers purely on their ‘intrinsic’ value (i.e. whether they were currently, or perhaps were likely to be, ‘in the money’19) without taking account of their ‘time value’ (based on the probability that they could move into the money before they expired) and were therefore out of line with the way market values were determined for similar traded options.20 Secondly, the prevailing actuarial valuation methodology made no explicit provision for terminal bonuses even though it could be argued that a company’s practice, marketing literature and statements to policyholders created a ‘reasonable expectation’ that a certain pattern of bonuses would be paid/maintained thereby creating a ‘constructive obligation’21 to policyholders which,
17 As with other forms of ‘historical cost’ accounting this process leaves considerable discretion to management in deciding on appropriate bases for allocating the constituents of the asset shares. In addition the asset shares are generally ‘smoothed’ (e.g. Forfar & Masters, 1999).
18 For an outline by its Managing Director of the FSA’s new regulatory approach, see also http://www.fsa.gov.uk/pubs/speeches/sp137.html. Note that it will still be the FSA’s new solvency requirements, not the ‘true and fair’ accounts under FRS27 or IFRS4, that will determine permissible bonus levels and thereby permissible dividend levels.
19 20 And sometimes not even then. This problem was further complicated in the case of the Equitable by the legal uncertainty over whether the company was justified in avoiding this risk by allocating differential levels of terminal bonus according to whether or not policyholders chose to exercise their guaranteed annuity rate option (Penrose, 2004).
21 A ‘constructive obligation’ is defined by IAS37 (equivalent to FRS12 (ASB, 1998)) as arising ‘from the entity’s actions through which it has indicated to others that it will accept certain responsibilities, and as a result has created an expectation that it will discharge those responsibilities’. FRS12 requires