Introduction: The Reward for Good Management
Welcome to the study notes for Distribution and Retention of Surplus! In previous chapters, you learned how to design products and set assumptions. Now we are in the "Living with the Solution" phase. This is where we look at the results: Did the business make more money than expected? If so, what should we do with it?
Think of surplus/profit as the "extra" money left over after a provider has set aside enough to pay all future benefits (the provisions) and met its expenses. Deciding whether to give this money back to stakeholders or keep it in the business is one of the most important balancing acts an actuary performs.
1. What exactly is Surplus/Profit?
In the simplest terms, surplus is the excess of Assets over Liabilities. In CP1, we use the combined term surplus/profit because the principles apply whether you are a for-profit company, a mutual insurance company, or a pension scheme.
\( Surplus = Assets - (Liabilities + Capital Requirements) \)
Where does it come from?
Surplus arises because the actual experience of the business differs from the assumptions made when pricing or valuing the product. This is known as Actual vs. Expected performance.
Common sources of surplus include:
• Investment income: Earning a higher return on assets than the discount rate used to value liabilities.
• Mortality and Morbidity: Fewer claims than expected for life insurance, or more deaths than expected for a pension scheme (which reduces the total pension payments).
• Expenses: Running the business more efficiently than the expense loadings allowed for in the premiums.
• Withdrawals/Lapses: If customers leave the contract early and the provider keeps a portion of the accumulated funds (though this can sometimes cause a loss if initial costs weren't recovered).
Did you know? While we usually think of "profit" as a good thing, a very large surplus might suggest your products were priced too high, which could hurt your competitive advantage (Syllabus 2.2).
2. Why Analyze Surplus?
A provider doesn't just look at the total surplus; they perform an Analysis of Surplus (which is covered in detail in a following chapter). For this chapter, you need to understand why we do this analysis:
• To validate assumptions: If we consistently see surplus from high interest rates, our investment assumptions might be too conservative.
• To demonstrate solvency: Showing regulators and stakeholders that the provider is financially healthy.
• To identify trends: Is the surplus growing or shrinking? This helps with financial planning for the next cycle.
• To inform management actions: Knowing where the money comes from helps managers decide how to control it.
Key Takeaway: Analyzing surplus is a core part of the Actuarial Control Cycle. It closes the loop by using actual results to update future models.
3. Management Actions to Control Surplus
Management doesn't just sit back and watch surplus happen. They can take specific actions to influence the level of surplus/profit in the business:
• Changing Investment Strategy: Shifting to riskier assets to seek higher surplus (with higher risk) or safer assets to protect existing surplus.
• Expense Control: Implementing cost-cutting measures to improve the expense surplus.
• Underwriting Standards: Tightening who can buy the product to improve the claims experience.
• Reinsurance: Using risk transfer to reduce the volatility of surplus.
4. How is Surplus/Profit Distributed?
Once a surplus is identified, the provider must decide how to share it. The method depends on the stakeholders involved.
Common Distribution Methods:
• Dividends to Shareholders: For proprietary companies, a portion of the profit is paid out as cash to owners.
• Bonuses to Policyholders: In "with-profits" or "participating" insurance, surplus is added to the policy value, often through a smoothing process.
• Reduced Future Contributions: In a pension scheme, a surplus might allow the employer to take a "contribution holiday" or reduce the amount they pay in.
• Improved Benefits: Increasing the payout to members without increasing the cost.
• Premium Reductions: Lowering the price for future or existing customers to increase market share.
5. The Rationale for Retention: Why keep the money?
It is tempting to distribute all the surplus to make stakeholders happy. However, there are very strong reasons to retain some surplus within the organization.
• Regulatory Capital Requirements: Regulators require a "buffer" to ensure capital adequacy. If you distribute everything, you might fail your solvency tests.
• Smoothing: In bad years, you can use retained surplus from good years to maintain a steady level of dividends or bonuses. This avoids "shocks" to stakeholders.
• Financing Growth: New business often requires a "capital strain" (initial costs). Retained surplus acts as internal funding for expansion.
• Protection against Uncertainty: Surplus acts as a cushion against low likelihood but high impact risks (Syllabus 4.7), such as a sudden market crash or a pandemic.
• Maintaining Credit Rating: Stronger retained reserves usually lead to a better rating, making it cheaper to borrow money if needed.
Don't worry if this seems tricky! Just remember the simple trade-off: Distribution makes people happy today; Retention keeps the business safe and growing for tomorrow.
6. Summary of Considerations
When deciding how much to distribute, an actuary considers:
1. Contractual Obligations: Does the policy document guarantee a share of the profit?
2. Policyholders' Reasonable Expectations (PRE): Have we signaled that we will pay a certain level of bonus?
3. Statutory/Regulatory Limits: What does the law say about minimum capital?
4. Competitive Position: How much are our competitors distributing?
5. Tax: Is it more tax-efficient for the company to retain the money or pay it out?
Quick Review:
• Surplus = Assets minus Liabilities.
• Sources = Difference between Actual and Expected experience.
• Distribution = Dividends, bonuses, or lower premiums.
• Retention = Safety, smoothing, and growth.
For more on how to measure these changes, see the next chapter on Analysis of surplus and performance against benchmark.