In essence, most insurers adopt smoothing of bonuses for its participating policies. Be that as it may, this technique creates stability in your policy’s return over its life span.

Example of Participating Policy: Traditional Whole Life Insurance Policy, Endowment Savings Policy

Generally, these financial instruments mitigate the risk and volatility as compared to investing your money into the market directly. With this in mind, let’s understand how smoothing of bonuses work, and whether this technique is sustainable.

Table of Contents:

1. Participating Fund’s Framework
2. In the years of Good Experience
3. In the years of Poor Experience
4. Is Smoothing of Bonuses sustainable?

Part 1: Participating Fund’s Framework

Part 1.1: Returns & Risk

Overall, a participating fund’s objective is to provide stable returns in the medium to long-term. With this intention, the fund manager will pool and invest your money into a wide range of assets.

Example of invested assets: Bonds (forms the majority of the fund), Listed Equity, Private Equity, Real Estate

Despite that, every investment faces some form of investment risks. For example, a high claim experience may reduce the fund’s net returns in a particular year. What’s more, all investments cannot escape from systematic risk.

Part 1.2: Guaranteed Returns and Non-Guaranteed Bonuses

By and large, you will receive the guaranteed returns every year. Furthermore, the shareholders are obliged to cover the shortfall in the assets required to meet the guaranteed benefits. Even if the participating fund continues to perform poorly, you will definitely receive this benefit in due time.

Additionally, you may also receive declared bonuses each year. In brief, these are discretionary bonuses that are based on the participating fund’s experience. To point out, this is when smoothing of bonuses comes into play.

Part 2: In the years of Good Experience

In this situation, the insurer may not increase the non-guaranteed bonuses immediately. This is with the intention to avoid huge adjustments during an economic downturn.

As a result, the insurer will keep some of the additional profits earned in the year. Thereupon, it will declare and maintain the same rate of bonuses as the previous year.

In the long run, the insurer may choose to declare a higher rate of bonuses. This is because of the regulatory requirements. In detail, there is a 9:1 ratio on policyholders to shareholders’ distribution. To explain, for every $9 given to the policyholder, the shareholder will receive $1. Therefore, giving you higher bonuses will mean more bonuses for the shareholders too!

Part 3: In the years of Poor Experience

As I have noted in Part 1.1, the participating fund’s objective is to maintain a stable rate of returns. Under those circumstances, the insurer may withdraw part of its reserve from the previous years. Thereupon, it will be used to cover the shortfall this year (as compared to last year’s bonuses). In effect, you will receive the same rate of bonuses for your participating policy.

Despite that, the insurer may also choose to cut bonuses in view of the fund’s poor outlook. This is also why they are categorised as non-guaranteed returns in your policy illustration.

Part 4: Is Smoothing of Bonuses sustainable?

In order for smoothing of bonuses to be effective, the insurer must have the available surplus in its reserve. Otherwise, there is simply nothing to give you.

For that reason, it is important to choose a participating fund with proven track records. For instance, it could be from a reputable insurer with a strong financial position and respectable assets under management. Together with a low expense ratio, this means the fund can be managed in an efficient manner.

Finally, I will strongly encourage you to conduct regular financial portfolio reviews. In particular, you may wish to obtain the latest policy illustration from the insurer. On balance, this allows us to evaluate whether the insurer has given us the promised rate of return. What’s more, we will also be able to determine the participating fund’s projected performance for the future. Altogether, we need these information to help us make an informed decision for our financial planning journey.

Checklist:

1. Have you obtained the latest policy illustration?
2. How has the participating fund’s track records been?
3. What are some ways to integrate a participating policy into your financial portfolio?

First Published: 2 October 2019
Last Updated: 23 July 2020