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A fair split of the profits

One of the principal Sandler report recommendations on with-profits

is that in future they should operate on a 0:100 basis. This proposal

has made it through to discussion paper 20 and is therefore due

careful attention.

Our starting point before considering the merits of 0:100 is to

review its operation and the alternative.

In a 0:100 fund, the shareholders get all the profits. In return,

they generally accept responsibility for the provision of capital to

support the business.

The alternative approach in a proprietary life office is a 90:10

arrangement. In this situation, the profits, largely reflecting the

investment returns, are split between the policyholders and the

shareholders in the ratio 90 to 10.

Here, the capital support is largely provided from within the life

fund although it may also be supported by shareholders funds outside

the life fund. Most of the 0:100 offices have arisen through

demutualisation whereas, by contrast, many of the 90:10 offices are

long term proprietary offices.

The 90:10 approach delivers a range of benefits for policyholders.

Perhaps the most significant is that the interests of policyholders

and shareholders are aligned. This is because the shareholders&#39

profit is fixed as £1 for every £9 allocated in bonus to

the policyholders. So the shareholder can only increase his profit if

there is a corresponding increase in policyholder bonuses.

In addition, the shareholders have a direct interest in the

investment performance of the fund. Why? For the same reason as

above. The better the performance, the higher the bonus for

policyholders which delivers better returns for shareholders and

hence the direct interest.

The issue of the provision of capital support is more significant

than it may appear at first sight. In a 0:100 fund, the shareholders

provide the capital. The consequence is that they will seek to obtain

a return on that capital which may lead to an investment strategy

which is inconsistent with the long term best interests of the

policyholders.

By contrast, where the capital is provided from within the life fund,

as in a 90:10 fund, the investment strategy for the capital is

matched to the overall strategy for the fund, taking into account its

liabilities and without external restrictions.

Taking this a stage further, the provision of capital by the life

fund itself can often mean that there are less likely to be capacity

restrictions on sales where the with profit fund operates on a 90:10

basis.

Ensuring volumes through the fund helps to reduce costs and improve

returns and is therefore beneficial for policyholders.

A key element of with-profits products is, of course, smoothing of

returns. In principle, this works by holding back some of the

performance in good times and using it to soften the blow in bad

times.

In the case of 90:10 funds, this smoothing has generally had the aim

of being neutral in the long term. By neutral we mean having no net

cost to or profit for the fund.

However, the smoothing fund could be significantly in surplus or

deficit during the cycle. If the funds for smoothing are being

provided directly by shareholders, however, they are much less likely

to accept a significant deficit. This may restrict the scale of

smoothing and damage the product proposition.

In order to restrict the scale of smoothing we may see more frequent

bonus announcements, reductions in annual bonus and increases in

terminal bonus.It is not clear to me that this would be a good move.

In summary, it is easy to reach the conclusion that 0:100 would be

the ideal solution. However, on closer insp-ection there are

significant disadvantages which do not exist in a 90:10 world.

The challenge we should focus efforts upon is improving the

transparency of 90:10 rather than moving all funds to 0:100.

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