By: L. Carlos Lara
Divisible Surplus. What is it? Where does it come from? Why is it so relevant in the structure of a mutual life insurance company? Who determines when and how it is to be divided? Even more importantly, how do the insurer, the government regulator, the agent and the policy owner see, or how should they see, its importance from their particular points of view? These are some of the questions that we will attempt to answer in this article, but I warn you some of the answers may surprise you.
Divisible Surplus, once we understand its true meaning, quickly becomes one of the most, if not, the most important element of a mutual life insurance company simply because it represents the company’s profit—its gain from operations. This profit is the aggregate amount of gains coming from 4 specific areas.
1. Gains from Investment Earnings.
2. Gains from Mortality.
3. Gains from Loading.
4. Gains from Surrenders.
(Please note that gains from mortality, loading and surrenders are actually expense savings from each of these three anticipated operating experiences of the company.)
Since it is profit all interested parties of the life insurance company naturally want their fair share of it. You may recall from previous articles in this publication that the policy owners own a mutual life insurance company and this fact makes this profit all that much more significant. Just to be clear, mutual companies do not have stockholders, only policy owners. Policy owners share in company profits through dividends paid on their policies. So already we see that the policy owner in a mutual company has a special interest in this surplus, but then again so do management and the agents that sell the policies. But, we must not overlook statutory laws in that they too play a key role in determining the surplus’s divisibility.
It is important to point out at the outset that life insurance companies are organized by state laws and are highly regulated entities. This is a fact that will grow more relevant as we proceed in the examination of our subject. Federal oversight also exists, but is still somewhat limited. By and large insurance remains a state regulated industry.
Before we go any further, we should also say something about insurance vernacular. It’s different.For example, we are already thrown off by the use of the term surplus for what we have already identified as the insurance company’s profit. However, once we see what all is taken into account in order to arrive at it, we realize that the term surplus is really more appropriate. For example:
“If an insurer bases its reserves on the assumption that it will earn 5 percent but actually earns 7 percent, that 2 percent difference represents the excess of investment earnings over the return BankNotes – Nelson Nash’s Monthly Newsletter – November 2012 2 www.infinitebanking.org [email protected] necessary to maintain reserve liabilities, and it may be returned to the policy owners who were responsible for its existence, if this is considered advisable.” 1
In other words, it is profit, but it is much more than just positive cash flow. It is truly the left over after all factors and contingencies have been accounted for. It is the excess an insurer has accumulated at the end of the year after establishing statutory policy reserves and other liabilities of the company. Due to the heavy influence of statutory accounting procedures, this profit/surplus is more appropriately understood to be “statutory surplus.” 2
While we are still establishing some of the more basic fundamentals of life insurance and its special terminology, we should also clarify the term “dividend.” Once again, dividend as used in insurance should not be confused with the same term used to refer to earnings on shares of stock. One typically pays taxes on dividends earned on shares of stock, but that is not the case when mutual companies pay dividends into individual policies.
The reason insurance dividends are not subject to taxation is because they are, at least in the early years of the policy, a return of a portion of the premium. Both state and federal laws recognize this distinction and we must recognize it as well if we are to fully understand the nature of a policy that participates in this type of dividend distribution. This is important because not all policies participate in this way. Most stock owned insurance companies rarely have participating policies of the kind we are describing here and stock owned companies make up over 90% of all life insurance companies in operation in the United States. Mutal life insurance companies are by far the minority.
Having laid out this preliminary groundwork, we should now insert this important caveat. Mutual life insurance companies are not only expected to have a surplus at the end of each year, but they are also expected to pay a dividend at the end of each year even if they have to draw down on contingency funds to do so. Notice the next time you look at an insurance illustration that all of their dividend scales will project this outcome even though dividends are not guaranteed. One obvious motivator for illustrating this profitable expectancy is competition within the industry, but there is an even stronger motivator – state law! This is why mutual insurance companies will reserve from their year-end surplus into a contingency fund to contend with this possibility, if it should occur.Let’s remember, however, that it’s not only for this type of an occurrence that contingency funds are set aside, but also for all other types of contingencies and liabilities of the company that require such surplus consideration. All of these factors must be accounted for and approved by state regulators. There are state laws that prohibit mutual companies from keeping their entire surplus. In the end it must be returned to policy owners.
“Although insurers may, in the absence of legislation, use their discretion in determining the amount of surplus to be distributed, some states regulate this matter by statute. New York limits the amount an insurer can retain on its participating business to an amount not to exceed 10 percent of its policy reserves and other policy liabilities.” 3
How much to keep—How much to return
What we start to see is that surplus and divisible surplus are two distinct elements. In practice here’s what makes them different. At the end of the year the directors of a mutual life insurance company decide how much of the total surplus (this is previously existing surplus plus additions for the year) should be retained as a contingency fund and how much should be distributed to the policy owners. The amount set aside for distribution is the divisible surplus. Once it is accounted for this purpose, the divisible surplus ceases to be surplus and becomes a liability of the company.
How much to keep as a contingency fund and how much to distribute as dividends requires a balance between competitive requirements, sound management and statutory laws. The existing dividend scale, however, is what sets the target amount for the return of premium. If the surplus is insufficient in any given year to meet its current dividend scale, the contingency fund is drawn upon to meet this deficiency. If on the other hand, additions to surplus are well above meeting the required dividend scale, the excess may be distributed as dividends or added back to the contingency fund. Dividend scale revisions we should point out is a process that, in more recent years, is done annually. With the help of computers, what once was an expensive process has become more cost efficient and improved.
The process involved in distributing the divisible surplus is quite extraordinary. In order to fully grasp it we must not forget that we are dealing with an institution unlike any other in an economy. This is, after all, insurance, not Wall Street. Unlike other institutions such as money and banking, insurance is unique. Insurance is an institution that safeguards against financial misfortune. To use it is to practice risk management.
“Gambling creates risk where none existed. Insurance transfers an already existing risk and, through the pooling of similar loss exposures of other insured actually reduces risk.” 4
In the case of life insurance the financial risk can be virtually eliminated! This is its unique attribute. Life insurance is the substitution of a small and predictable “loss” (the premium payment) for a large and unpredictable loss (death). The death benefit, therefore, represents a substantial financial asset that carries with it a rate of return, which could be quite substantial depending upon the timing of death. Coupled with its favorable tax treatment, the death benefit is an integral part of the life insurance equation. But if a life insurance policy is to protect the insured for his or her whole life, an adequate fund must be accumulated to meet a claim that is certain to occur (though at an uncertain time). This is the process we are examining. We are attempting to place our focus on the process by which divisible surplus is calculated and then how the dividends are ultimately distributed to policy owners. (Note that there are also “living benefits” to be considered in these policies, but they are a separate discussion to this subject.)
It all starts with the premium
It all starts with the rate or premium payment and it must be “adequate.” This means that the total amount of payments collected by the insurer plus the investment earnings should be sufficient to cover the current and future benefits promised plus cover related expenses. This must occur on all blocks of policies issued under the same schedules of rates and on the same policy form.
Arriving at premium adequacy begins with the use of historical records. We must not overlook the fact that most mutual life insurance companies are over a hundred years old. This makes their chief raw material their operating experience. For this reason we find that premiums for participating policies are based on fairly conservative mortality, interest and expense assumptions. Built into the premium is also an allowance for some level of dividend payments that the companies fully expect to pay. If actual results equal the assumptions, the dividends illustrated will be paid. If the results are more favorable, dividends will be higher than illustrated and, of course, vice versa if the results are not favorable.
“Historically, the dividend allowance included has been fairly conservative, with the result that most insurers selling participating insurance policies in the past paid higher dividends than illustrated.”
However, with the new low interest rate environment, paying higher dividends than illustrated has become much more challenging in more recent years, but the process remains conservative.
Though premium pricing is conservative when developed, it is nevertheless scrutinized thoroughly.For example, the insurer, in order to determine if all of the assumptions and benefits promised could be met will test each block of policies. This calculation derives an expected fund per $1,000 of insurance held by the company at the end of each policy year in order to arrive at each policy’s “share of assets.” It staggers the imagination to think about this process since an insurance company can have thousands of policies made up of many blocks of insurance. Nowadays computers are certainly essential in completing such a procedure.
But then again, a similar process in reverse is used when actually distributing dividends from the divisible surplus at the end of each year. The principle objective in this process is “equitable distribution.“
“One way of obtaining reasonable equity would be to return to each class of policy owner a share of the divisible surplus proportionate to the contribution of the class to the surplus. This concept is known as the Contribution Principle.” 6
It stands to reason that a policy that contributes to the surplus should also have an equitable share returned to it in the way of dividends. In practice, however, this distribution process seems to be easier said than done. Similar to the process of determining a policy’s share of assets, the contribution principle is a very complex matter, which involves an analysis of the sources of surplus and develops dividends that vary with the plan of insurance, age of issue and duration of the policy. It is also an area where a company’s management philosophy is expressed.
For example, some insurers will base their dividend interest rate on an average return of their entire asset portfolio, while others tie their dividend interest rate directly or indirectly to the policy loan rate or loan activity. Since most insurers offer favorable interest rates relative to the market rate when a policy loan is exercised, the lower investment earnings for the company are reflected in the total surplus. Consequently, under a “direct recognition approach” a policy owner who borrows from his policy will have his dividend distribution reduced by the company in order to equalize the dividend interest rate distribution for all policy owners. Such provisions result in higher dividends paid under non-borrowing policies, whereas with companies without these provisions (a “non-recognition” approach), the link between policy loans and surplus are not directly related.
Finally, we cannot close this article without emphasizing the creative flexibility that exists in a policy owner’s ability to maximize the contribution principle to his advantage through the adjustment of premiums and death benefits, as well as with payments of large single sums of money into a policy’s cash values. The resulting dividends, that carry with them such favorable tax advantages, can become quite impressive through the use of these mechanics. Qualified advisors should be sought to point out these creative advantages.
In the end, distributing the divisible surplus, though highly complex, is not an exact science. The final say as to how much of the divisible surplus is to be returned to policy owners ultimately rests with the board of directors of the insurance company after a complete review by management and their actuaries. Aside from the statutory requirements already mentioned they have the final word on the matter. The point is that computations are not simply computerized analyses. Real people make the final decisions about the company’s future, as it should be.
With regards to reliability, the conservatism exhibited in the manner in which funds are developed to meet the promised benefits and the dividend scales that come from this process can and are reasonably trustworthy. The proof supporting their reliability is available in the oldest method of recognizing actual experience—paid policy dividends. Paid policy dividends reflect the insurer’s actual past experience and it’s a solid one. For over a hundred years most mutual life insurance companies have paid dividends each and every year. It’s hard to argue with that kind of record.
1. Life Insurance, 12th Edition, Kenneth Black, Jr. and Harold D. Skipper, Jr., Simon & Schuster Company, Englewood Cliffs, New Jersey 07632, Chapter 21, Footnote at the bottom of page 605
2. Life Insurance, Chapter 21, Page 604
3. Life Insurance, Chapter 21, Page 607
4. Life Insurance. Chapter 2, Page 20
5. Life Insurance, Chapter 21, Page 608