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A Far-sighted view

Following the publication of the 2001 FSA returns, we can now take the most up-to-date look possible at the published financial strength of the major UK with-profits companies. The recent turmoil in worldwide equity markets has given rise to much media comment on the solvency and financial strength of these companies. It is important to consider the latest information in a careful and reasoned manner and avoid jumping to premature conclusions.

Over 2001, the UK equity market produced a total return of -13 per cent. For 2000, the return was -6 per cent. These negative returns have, not surprisingly, led to a reduction in the free-asset ratios of most companies in Table A. To put these returns in context, the returns achieved on the main asset classes since the late 1980s are shown in a table on page 44.

The free-asset ratio can be considered as a simple, if somewhat crude, measure of the financial strength of a life office. It provides an indication of the available assets an office can use to counter adverse experience or to adopt a more aggressive investment strategy. A low free-asset ratio will mean, for example, that an office has less flexibility with its investment strategy. It is well known that FARs are affected by the strength of the actuarial valuation basis adopted and by the type, mix and maturity of the business in force. They are also affected by the use of financial engineering techniques, such as financial reassurance.

Nevertheless, they represent the only published information which policyholders and IFAs can easily make use of. Also, given the low state of the stockmarket and general reduction in free assets, it is now even more likely that most companies will have removed any excess margins in the valuation basis, thereby taking this factor out of the equation.

One of the features of the updated Table A is the increase in the number of offices using the future profits implicit item. At December 31, 2000, seven out of 34 offices used the future profits item. At December 31, 2001, as Table A now shows, this had increased to 17 out of 39 offices. Use of the future profits item has been subject to significant media attention in recent months and so it is worth considering what this item actually is in some detail.

The ability to use the future profits item has existed for many years and stems from the EU solvency regime. One can find examples of its use within individual companies over a long period. It is only recently, however, as a result of the pressures of falling equity markets, that use of the future profits item in the UK has grown. In continental Europe, use of the future profits item has been more widespread.

The maximum amount of future profits which can be taken into account is subject to FSA rules and guidance. These ensure that even this maximum amount represents a prudent assessment of the future profits which are likely to emerge. Use of future profits is subject to FSA approval and sometimes offices choose to make use of an amount of future profits less than the maximum allowable.

One important point to appreciate is that the future profits item can only be used to count towards covering the required minimum solvency margin. It cannot be used to cover basic actuarial and other liabilities. Moreover, even where future profits are used, one-sixth of the required minimum solvency margin must be covered by assets other than the future profits item.

Financial strength is very much a relative concept although clearly there does come a point when the situation becomes so tight that the absolute position becomes relevant. In seeking to compare offices, the future profits item does make life more complicated as its use is voluntary. Many of the companies which do not have a future profits item at December 31, 2001 could most likely have had one if they so wished.

For this reason, Table A now shows two additional columns compared with previous versions. Columns (E*) and (F*) show the free assets and free-asset ratios with the future profits item removed. Where these adjusted columns are negative, reliance is being made on the future profits to cover fully the required minimum solvency margin. Where columns (E*) and (F*) remain positive, use of the future profits item is not actually necessary to cover the required minimum solvency margin fully.

Under an EU directive, the ability to use future profits will be phased out by 2009 at the latest. Further, it is expected that the FSA&#39s forthcoming consultation paper on financial engineering will regard future profits as coming within the ambit of financial engineering and it is expected that the FSA will require the effect on free assets of all forms of financial engineering to be disclosed in the FSA returns. Thus, whichever way you look at it, the usefulness of future profits is set to decline and ultimately to disappear. Importantly though, over a similar timescale, we expect the current EU review of the solvency regime to produce changes which should lead to a more sophisticated approach to determining solvency margins than the current fixed formula approach.

For the offices included in Table A, the average headline FAR has fallen from 10.1 per cent to 6.3 per cent, these averages incorporating the effect of future profits where used. If we exclude future profits (both at December 31, 2001 and December 31, 2000), the fall in the average FAR is from 9.6 per cent to 5.0 per cent – clearly a steeper fall.

The results in Table A are, of course, based on the resilience test in force before the amendment made by the FSA at the end of June. For December 31, 2001, companies were required to test a 25 per cent fall in equity values.

Although the equity market performed poorly in 2001, the fall was not sufficient to trigger the tapering formula which existed at December 31, 2001. The amendment introduced at the end of June provides an additional tapering formula, where the amount of any fall in the average equity index value over a rolling three month period is deducted from the 25 per cent fall which has to be assumed.

At the time of writing, the equity market had fallen by 11.5 per cent since December 31, 2001. The effect of the additional tapering formula in the revised resilience test is such as to require only a further fall of 17 per cent to be assumed.

If, however, the market remains constant for three months (or goes up), then the fall to be assumed will revert back to the standard 25 per cent unless relief is provided by the original tapering formula. The extra relief currently afforded by the additional tapering formula could, therefore, prove to be only temporary.

A table on page 44 shows the full details of the resilience test in force in respect of equities at December 31, 2001 and also shows the amended test introduced at the end of June. In both cases, the appointed actuary has to decide what would be appropriate changes to test in relation to other investment classes, such as property and fixed interest.

A further factor to be considered in relation to FARs is the proportion of unit-linked business written by the office in question. Some organisations write their unit-linked business in the same company as their with-profits business and some use separate companies for unit-linked. Sometimes, unit-linked business written in the with-profits company is reassured out to a unit-linked subsidiary.

Unlike with-profits business, unit-linked business does not have terminal bonuses. Thus, unit-linked business neither generates nor, in the normal course of events, needs the same level of free assets as with-profits business. Column G1 of Table A shows the proportion of the liabilities (net of reassurance) which are unit-linked (or index-linked, which is similar). Column G2 shows the FAR with the effect of the linked business excluded, thereby producing a higher FAR. The average value of 9.2 per cent is just under 3 percentage points higher than the average overall FAR. This modified FAR is clearly relevant for the with-profits business. However, even unit-linked business can from time to time give rise to unexpected losses, for example, pension misselling, and thus the overall FAR cannot be ignored.

Column (H) of Table A shows the yield on the assets as at December 31, 2001. See the glossary on page 41 for further details of this item.

Table B shows the updated position in respect of acquisition and other expense ratios. The average acquisition and other expense ratios for 2001 have remained virtually unchanged compared with 2000.

The average acquisition ratio has crept up by one percentage point to 80 per cent and the average other expense ratio has remained unchanged at 8 per cent.

Table C on page 44 shows the latest available information in relation to the investment mix underlying with-profits funds. This information is as at December 31, 2000 rather than December 31, 2001 bec-ause the with-profits guides giving the information as at December 31, 2001 will not become available until later this year. Table C shows a small average shift out of equities and into fixed interest.

We can expect that the December 31, 2001 information will show greater proportions held in fixed interest as opposed to equity investments – due both to the falls in equity markets over 2001 and due to further switching into fixed interest.

The fall in the equity market since December 31, 2001 will almost certainly have resulted in a continuation of this trend.

Glossary

Total assets – These are the total assets the company is allowed to take account of in calculating its solvency position. It may exclude some assets that are not allowable under the applicable regulations. Generally, assets are valued at market value wherever this can be obtained.

Future profits – See commentary in accompanying article.

Total liabilities – This is an estimate of the amount that needs to be held now so that, with future investment returns and expected future expense levels and claims, there will be sufficient assets to meet all the obligations of the company in the future, provided that the estimates are borne out in practice. Determination of these liabilities is the responsibility of the company&#39 appointed actuary. (Miscellaneous non-actuarial liabilities are also included with the total liabilities).

Required minimum margin – This is the extra amount of capital that the insurance company must hold above the total liabilities to help protect solvency. It is calculated by a formula and is an EU requirement.

Free assets – This is the amount of capital the insurance company has in excess of the total liabilities and required minimum margin. It is used to finance new business sales and meet unexpected claims and provide a cushion to allow the company to pursue a potentially more rewarding investment strategy. The measure should be used with care as a low amount of free assets could mean either that the company is very weak or that it has a very strong method of reserving and hence holds more in respect of its liabilities than others. In the case of with-profits business, part of the free assets can be regarded as the liability for accrued terminal bonuses because such bonuses are not included within the total liabilities as defined above.

Free-asset ratio – This is the amount of free assets expressed as a proportion of the total assets that the company is allowed to quote in the regulatory returns. The ratio, and its trend, is more relevant than the actual amount of free assets.

Unit-linked liability percentage – This is the proportion of the total liabilities that relates to unit-linked business only.

Non-linked free-asset ratio – This is the amount of free assets expressed as a proportion of the total assets that do not relate to linked business. The ratio gives a clearer picture of financial strength relating to non-linked business than just the standard ratio. Linked business does not generally require a high level of free assets

Resilience test – This is the test companies are required to carry out to determine the extra amount of capital they would need to cover liabilities in certain extreme investment market movements.

Form 48 yield – This is the average yield on the non-linked assets. For fixed-interest securities, the yield is the redemption yield to maturity. For equities and property, the yield is the running yield based on dividends and rental income only, and does not include any future changes in capital value. The yields on Form 48 drive the maximum valuation rates of interest which a company can use. Companies are, however, allowed to utilise the highest yielding assets first and to match particular types of assets to particular types of liabilities.

Acquisition expenses ratio – An indication of the proportion of new business premiums are spent on acquiring the business. Makes used of equivalent annual premiums as the denominator.

Equivalent annual premiums – A way of converting single and regular premiums into a single measure that is comparable with annual premiums. 10 per cent of single premiums are added to the regular premiums. The rationale behind this is that regular-premium business is normally more profitable/valuable than single-premium business due to its recurrent nature and that a ratio of 10:1 is broadly appropriate.

Other expense ratio – An indication of the proportion of total premium income that is spent on expenses, other than acquisition expenses. Such other expenses include regular ongoing maintenance expenses, together with any one-off or exceptional expenses which have been incurred.

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