We explain what endowment policies are and how they work.
A with-profits endowment policy is a contract written by a Life Assurance company to pay a fixed sum (called the basic sum assured), plus accumulated profits that are declared annually, to an assured person on a fixed date in the future (or to his/her estate if the person dies prematurely), provided that the premiums have been paid as required by the contract.
Policy contracts are assignable, allowing the assured person to irrevocably pass the beneficial rights to a third party such as a mortgage lender, a bank, or an investor in traded policies. A regular premium is paid (normally monthly) to a Life Assurance company. A small part of this premium goes towards providing life cover to the original lives assured, but the bulk of it provides funds for the life company to invest for the term of the contract. The profits earned on this investment are apportioned annually to each policy. This is how the final maturity value builds up in a policy.
Each year the actuaries at the life office review the growth made by their investments and they then apportion the profit to all the policies in force at the time, by way of declaring bonuses which are then permanently attached to the policies. In effect, the owners of the policies are participating in the profits of the life company.
There are three types of bonuses:-
Reversionary Bonuses:
These bonuses are declared annually as cash values computed as percentages of the basic sum assured and of bonuses declared in previous years. Once granted, these bonuses are guaranteed, cannot be withdrawn and are also known as attaching bonuses.
Special Bonuses:
These are one-off bonuses, granted at the discretion of the life company and are also guaranteed. For example, if a friendly society converts to a public company they may grant such special bonuses to each policy in force, instead of issuing free shares in the new company.
Terminal Bonuses:
Most life companies currently grant an additional bonus at the end of the life of a policy. In essence this is a loyalty bonus designed to encourage the policy holders to keep the policies in force until the maturity date. The size of the terminal bonus is dependent upon the investment conditions prevailing at the time of maturity, as well as upon the investment performance of the life company. Although it can be a large part of the final sum paid out, it is not guaranteed.
Bonuses issued by any life company are dependent upon its financial strength which, in turn, relies heavily on its investment performance.
It is in the interests of the life companies to even out the vagaries of the investment environment, by declaring bonuses which are reasonably consistent. However, bonuses may be increased or decreased from year to year, thereby affecting the final value of the underlying policy.
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