Lessons from Equitable Life - high terminal bonus

An article appeared in the Straits Times: 'Salutary bonus lessons from the UK'
(http://www.asiaone.com/Business/My%2BMoney/Starting%2BOut/Insurance/Story/A1Story20080528-67478.html)

Tan Yew Ming studied the detailed report by Lord Penrose, who headed a comprehensive investigation into the reasons for Equitable’s debacle. This report can be found at : http://www.hm-treasury.gov.uk/independent_reviews/penrose_report/indrev_pen_index.cfm

Here are the key Below are key extracts from Part 7 (conclusions and lessons) of the report, regarding the bonus policy of Equitable Life:

38 ... from the early 1980s the Board’s bonus policy became increasingly driven by the pursuit of growth in new business...
45 ... the Society maintained a bonus record that enabled it to achieve consistent growth in new business premium income, ... growth could not have been achieved without the support of a bonus allocation and distribution policy that produced high policy values and high policy proceeds.
49 ... The Society followed the general view that terminal bonus was not guaranteed and did not have to be provided for in mathematical reserves or technical provisions.... By disregarding accrued terminal bonus, the Society was able to over-allocate bonus beyond its available assets at market value, and in particular to make payments on claims that exceeded the relative available assets at the time.
80 ... The failure to cover future terminal bonus by the retention of funds, given the expectations generated by representations, and by the Society’s sustained practice of paying such bonuses on maturities and other claims, contributed significantly to its ultimate weakness...
95 ... It is appropriate to comment in the first place on bonus policy.... Having adopted a rational approach to bonus distribution policy in 1973 that involved prudent reserving for future reversionary bonuses and related terminal bonus to sums standing at credit of investment reserve, the Board as constituted over the material period began progressively to reduce the reserves held for future reversionary bonuses from 1983 until that aspect of the previous reserving policy was abandoned entirely in 1985. In and after 1983 the amount allotted as terminal, later final, bonus was progressively increased.

240 ... The following may be regarded as the key conclusions arising from this report:

(3) The Society adopted a policy whereby unguaranteed terminal or final bonus became an increasing proportion of total allocations. This was in line with industry trends, but had the intended effect of reducing over time the share of benefits which required to be reserved for or recognised as liabilities in the Society’s statutory accounts and regulatory returns.

(4) As a consequence of this shift towards terminal bonus, and in the absence of any coherent or consistently applied smoothing policy, the Society began to over-allocate from the late 1980s onwards, with the effect that the realistic financial position (as reported regularly on internal systems and therefore known to the executive management) was progressively weakened, and policy claims progressively withdrew funds in excess of prudently calculated policy values. By the end of 2000, the position reached could only be dealt with by radical re-alignment of policy values, as happened in July 2001...

Here is my understanding from the Penrose’s report:

- Equitable wanted to pursue new business growth and high bonuses was used attract customers.
- Reversionary/annual bonuses require prudent reserving as opposed to Terminal/special bonuses. Since they are at the full discretion of the company, not guaranteed nor reserved, Terminal/Special bonus was an ideal “strategy” for Equitable’s management to promise high returns (to attract new customers).
- Over the years, Equitable shifted from the prudent reversionary bonus to the obscure terminal bonus, effectively setting up a Ponzi scheme to payout high bonuses at the expense of other customers.
- The actuary also adopted dubious valuation methods to release unearned profits to support the bonuses.
- Eventually all Ponzi schemes collapse.

To grow, all businesses need capital. Capital is scarce, ie limited. How to get capital besides asking from stakeholders (ie shareholders and policyholders)? More fundamentally, is growth at the expense of current stakeholders?

Yew Ming