Issue: September/October 2006
Editorials

Caught? Or Caught Out

The courts will have to decide. From his landmark ruling on smoothed bonuses, the Adjudicator has again shown what a tiger he can be with the life offices. But they can be pretty tigerish, too, and in this instance there’s no alternative.

Ngalwana ... sharp teeth
Ngalwana ... sharp teeth
 Hudson ... biting back
Hudson ... biting back

Pension Funds Adjudicator Vuyani Ngalwana is either horribly right or horribly wrong. In his determination against a provident fund run by Old Mutual, the middle ground is obscure.

His ruling that Mutual cannot apply the market-value adjuster (MVA) to “smooth” the payout on a policy’s early termination, and had to reverse the MVA-calculated deduction for the benefit of complainant R Mungal, creates a precedent riddled with ramifications. It also bears the hallmark of a classic showdown, destined for the courts, between the equity which the Adjudicator seeks to promote and the legality on which the life offices tend to rely.

If Ngalwana is right, the consequences are potentially horrible for the life offices offering smoothed-bonus products. The principle is similar to the deductions he disallowed for early termination of retirement-annuity (RA) products. With RAs, the Adjudicator’s orders were against the funds and sometimes jointly against life offices. Nevertheless, under the “statement of intent”, the affected life offices and not the funds agreed to pick up the whole R2,6 billion bill for reversal of the deductions to RA policyholders.

In the Mungal case, he has made the order against Mutual. So there’s no rigmarole about how a fund, whose assets comprise insurance policies, is supposed to pay for the reversal of MVA deductions from smoothed-bonus policies. It leaves open the question of whether life offices are in for another smack.

What applies in the case of Mungal could apply equally in the cases of thousands, tens of thousands, of other policyholders with an eye for the gap. This is the gap between the surrender value of market-linked and smoothed-bonus policies stripped of the MVA. On the basis of the Mungal determination, investors can switch from the one to the other as relative advantage suits them: to surrender smoothed-bonus policies when share prices are depressed, for life offices to pay them at the (higher) smoothed value and vice versa.

Originally, they’d contracted for smoothed-bonus to obviate the risk of a weak return from weak share prices on their policies’ maturity. Now, when markets are especially strong, they really should be buying smoothed-bonus in anticipation of share prices someday turning south.

That way, they’re protected from the downside by smoothed-bonus and gain on the upside from market-linked. But a merry-go-round of switching between the two mocks both, defeating the purpose of smoothed-bonus and denying the perils in market-linked. It also makes smoothed-bonus products inoperable because, being long-term, they rely on years of good investment returns supporting the bad.

The MVA is always an adjustment downwards. Its flip-side is bonuses, which are always upwards. Without them, there can be no smoothing. Old Mutual executive Dave Hudson points out: “They’re not there just to prevent arbitrage potential, so that investors can’t trade against the funds, but to protect fairness so that people who prematurely leave the fund don’t benefit at the expense of people who stay.”

As smoothed-bonus products are big business for the life offices – particularly for Old Mutual, Sanlam and Metropolitan – the amounts of money involved are huge. In a worst-case scenario, the Adjudicator’s ruling could intone a death knell for these products because application of the MVA is necessarily integral to them; in a best-case, it will cause the insurers considerably to jack up the clarity of their policy- holder communications.

Mutual is virtually obliged to challenge the Adjudicator in court, and has signalled its intention to do so. The life offices have nothing to lose and everything to gain. Until there is a High Court judgment, and appeals are exhausted, it’s as-you-were. And it give investors pause to reflect that the present period of buoyant share prices is the best time to buy smoothed-bonus products, not shy away from them.

If the Adjudicator is wrong, and this all-important Mungal determination is not upheld, it will be a thorn in the superb work of his office that has promoted consumer awareness and fought unfair practice with an impact that nobody else has managed before. To lose the impending court case, coming after his defeat on a substantive issue in the Sanlam case (TT Nov-Dec ’05), won’t enhance his authority or reputation.

For too long, he and the industry have been at one another’s throats. They trade in recriminations of arrogance. Enough! Whichever way this High Court case goes, the value to come of it might yet be a setback for confrontation and an advance for cooperation with an industry trying hard to reform.

WHY THE ADJUDICATOR THINKS HE’S RIGHT

At issue in the Mungal determination was not whether smoothed-bonus products were good or bad. It was about the adequacy or otherwise of disclosure, the discretion and conflicts of Mutual as fund administrator and insurer simultaneously, and the validity of relevant contracts. Ngalwana set out to decide whether the fund rules allowed the MVA when the market value of the smoothed-bonus portfolio decreased against its book value, and when a policy is surrendered before its maturity:

  • A pertinent rule of the fund, to do with “accumulated credit”, says nothing about MVA application or about the determination of surrender value;
  • Another rule says that “accumulated credit” is whatever Mutual determines with reference to market value of underlying assets, and that “surrender value” is whatever Mutual considers “appropriate”, while participation in the fund is subject to conditions determined by Mutual from time to time. This rule is silent on what deductions are permissible from “accumulated credit”, leaving wide discretion to Mutual;
  • The “surrender value” cannot be left to the “untrammelled inclination” of the insurer-cum-fund administrator “bereft of any considerations of reasonableness, good faith and fairness”. Some reasonable standard had to be met;
  • Although the policy document constituted a contract between the fund and Mutual, in their dealings with Mutual the members of the fund’s management board (appointed by Mutual) still had fiduciary duties to each member of the fund;
  • The “binding force” of the fund’s rules must extend to Mutual, but the policy document says nothing about MVA application and its reader is “left to deduce” the implications of investing in a smoothed-bonus portfolio;
  • The disinvestment costs, unrecouped expenses, debts and legal limits are not defined. The complainant could never have known the charges to be triggered on early termination; u The scope of these terms is “so fatally vague” that this part of the policy document is legally unenforceable;
  • Mutual did not explain how it arrived at the MVA rate. Under the definition of “surrender value”, neither the charges listed nor the appropriate MVA rate could reasonably be applied. Under “disinvestment costs”, Mutual could “capriciously” include its costs “of running an entirely unrelated business without members of the fund’s management board being able to pick it up”;
  • The policy document did not authorise application of the MVA;
  • The fund, and ultimately the member who has to bear the costs, is left in the dark as to whether the MVA can be accommodated under “administrative and investment selection costs” and to the factors determining the MVA rate at any given date of surrender;
  • There was nothing in the fund rules, the policy document or the annual benefit statements authorising Mutual to apply the MVA for reducing the benefit on early surrender.

Accordingly, the complaint succeeded.


WHY THE LIFE OFFICES THINK HE’S WRONG

There are two contracts in place. One is between the fund and the member; the other between the fund and the insurer’s policy. The Adjudicator had taken into account only the former.

  • The operation of smoothed-bonus funds, inclusive of the MVA, is supervised by the Financial Services Board and implicitly approved by it;
  • These funds had also been approved by the High Court. At the time of the Mutual and Sanlam demutualisations, in the mid-1990s, the mechanisms by which policyholders were protected were exhaustively explained;
  • There is no diversion of monies paid by policyholders, to build the stabilisation reserves which enable smoothing, to shareholders of the insurer. These monies are hermetically sealed. As Mutual had put it in documents before the High Court on its demutualisation proposal: “Balances in the bonus-smoothing accounts, whether positive or negative, are to be regarded as part of the actuarial liabilities in respect of unmatured policies and therefore form part of the policyholders’ funds”.
  • Were there any diversion, it would show in the insurers’ financial statements. They don’t. In fact, a note in the 2005 accounts of Mutual states: “Smoothed-bonus products constitute a significant proportion of the business. Particular attention is paid to ensuring that the declaration of bonuses is done in a responsible manner, such that sufficient reserves are retained for bonus-smoothing purposes. The return not distributed after deducting charges is credited to a bonus stabilisation reserve, which may only be used to support bonus declarations.”
  • Bonus declarations are not made arbitrarily. They depend on the state of the fund’s reserves and the insurer’s outlook for investment markets. They also need to be approved by the company’s statutory actuary in compliance with professional guidance notes;
  • Empirically, the amount of bonus declaration is validated by fund performance. Over almost any period of years, smoothed-bonus policies have shown smooth trends consistent with – but in contradistinction to – the jagged trends of market-linked policies. Accordingly, over the long run, the returns on smoothed- bonus and market-linked should be much of a muchness. The accompanying graph is an example;
  • The intention of the MVA is to create neutrality between investors leaving and investors staying. Were there no MVA, investors who leave will benefit at the expense of investors who stay. There is no benefit to the insurer’s shareholders;
  • The Adjudicator has implied there should also be MVA on the upside. Well, there is. It’s called a bonus. If the MVA were applied on the upside, it would be in addition to the bonus;
  • The MVA is a blunt instrument, but it is dynamic. In the 20 years to 2005, it has broadly ranged between 5,5 percent and 20 percent annually;
  • Application of the MVA is disclosed in that annual benefit statements set out the policy value on maturity. With terminations prior to maturity, it’s difficult to disclose the effect of the MVA before the market circumstances and the particular date of surrender of each individual policy are known;
  • There’s a fundamental difference with the dispute over RAs. They were widely seen to be unfair for their low values on early surrender. Smoothed bonuses, on the other hand, are not unfair.

Accordingly, it’s probable that the appeal against the Adjudicator’s determination will relate less to the structure of smoothed-bonus products than to the effectiveness of disclosing the MVA’s application.


ISSUES AT ISSUE

The Adjudicator looks like a lawyer, talks like a lawyer, thinks like a lawyer, and actually is a lawyer. His determinations, unless overturned by a court of law, have the force of law. But the complaints procedure differs from court procedure in some important respects.

Parties submit their complaints, and counterparties, then respond. This is more limited and selective than the court procedure of affidavit exchanges because, rather than advancing argument, it confines answers to the questions asked. Also, without evidence being led and witnesses being cross-examined, there can be holes in the information on which the Adjudicator makes his findings. The Mungal determination illustrates the point in two respects. First, the Adjudicator was highly critical of Mutual for not having explained – “and the question was directly and expressly put to them” – how the rate of 10 percent as the applicable MVA was arrived at. Neither did Mutual explain the charges listed under “disinvestment costs”, nor the appropriate MVA rate “that can reasonably be applied upon a member withdrawing from the fund prior to the maturity date”.

It isn’t apparent why Mutual elected not to explain. Under cross-examination, it would have had to answer these questions.

Second, the Adjudicator asked in his finding what happened with the accumulation of bonuses that had not vested at the time of withdrawal from the fund: “Is it shared between remaining policyholders, on the one hand, and the insurer’s shareholders at the end of the insurer’s financial year on the other? Or is it treated as a ‘profit’ and declared as a dividend for the benefit of the insurer’s shareholders?”

He left these questions unanswered “because it is not necessary to deal with them for purposes of this determination”.

Here, it isn’t apparent why he asked them only in his determination. Had they been asked in gathering information to assess the complaint, they could easily have been answered. Instead, the life offices have had to embark on a flurry of explanations subsequent to the ruling not least because the Adjudicator – again unlike a court of law – highlighted them in a press release.

Good does come of it, in the sense that public awareness is heightened. But there’s also bad in the implication of unfair practice.

DEFINITIONS

  • A smoothed-bonus policy is essentially a “with profit” endowment policy. It aims to provide a smoothed growth as opposed to a fixed predetermined sum assured (as in a without-profit policy) or a potentially volatile sum assured (as in a unit-linked policy).
  • Jannie Venter of Metropolitan, who convenes the Life Offices Association standing products committee, points out that smoothed-bonus funds are designed to smooth out the fluctuations in market returns of the underlying assets. This is achieved by “retaining a portion of the returns during times of excellent market performance in order to beef up the returns in bear markets”. Normally, bonuses are declared annually and added to the fund’s value.
  • A minimum or vested bonus is guaranteed. After its declaration, it cannot be taken away from investors provided the policy is held to maturity. At the same time as its declaration, an interim bonus rate is set in advance. Its aim is to provide a fair return to policyholders who exit the fund before the next bonus declaration. This rate might be adjusted upwards or downwards during the year, depending on market movements, to provide fair values for both investors who exit and investors who remain.
  • The market-value adjuster (MVA), also known as the market-level indicator (MLI), is the actuary-determined rate used to calculate downwards the market value against the smoothed value of the fund, when its market value is below its smoothed value, for an investor who surrenders his policy prior to maturity. This serves to protect investors who remain in the fund by ensuring that its assets are not eroded by investors who exit early, at times of market weakness, so that the cross-subsidisation that enables smoothing can take effect. The MVA/MLI is not applied when the market value of the fund exceeds its smoothed value.