Smoothing of bonus

Dear Mr. Tan,
There was a report in the Straits Times that several insurance companies are able to maintain their bonus rates last year, in spite of the financial turmoil. This is due to the practice of smoothing the bonus. How does it work?

REPLY
These insurance companies already cut their bonus by about 50% in recent years. The reduced rate of bonus gives a yield of about 1% to 2% per annum. Life insurance policies now give a poor yield, compared to other long term financial products.

Using the concept of smoothing the bonus rates, the insurance companies now declare a low rate of bonus. A large part of the surplus is kept in the life fund as "orphan money". This orphan money is contributed by the current generation of policyhholders, but are likely to be used to pay high commission rates to expand the sales of new policies (which do not benefit the current policyholders).

In some countries, the regulators disallow the use of orphan money in this way. To protect the interest of policyholders, they have mandated the use of asset shares in distributing the bonus. The regulators in Singapore has not mandated this practice yet.

Due to the low yield, it is best to avoid investing in life insurance products.