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Balancing act

Major life offices have completed their FSA returns, including for the first time “realistic” balance sheets which provide the analyst with a new perspective, and include “rule of thumb” indicators of financial strength – the working capital ratio and the cover for the risk capital margin.

The working capital ratio is similar to the free-asset ratio – commonly derived from old-style company returns and shows what proportion of realistic assets are held over realistic liabilities. The ratio of cover for the risk capital margin shows how many times the risk capital margin stress buffer is covered by excess realistic assets. It is a guide to the firm’s resilience to adverse conditions.

Changes to the format of the FSA forms mean that free-asset ratios will not be as accessible to commentators as they have been – nor as relevant. On the face of it, it is straightforward to find out about firms’ financial strength from their realistic balance sheets but not all is as it seems.

This method of financial reporting was introduced by the FSA following events at Equitable Life, with the aim of establishing a new method for monitoring the financial strength of life offices and, crucially, one allowing for all future payments to policyholders, including guarantees and future bonuses, in a much more sophisticated way.

However, the “realistic” approach applies only to with-profits funds, regardless of whether other assets support that business. The unfortunate result is that the realistic balance sheets and new rule of thumb with-profits financial strength ratios do not provide a reliable comparison between companies, nor do they tell us much about the capital supporting unit-linked or protection business.

So, when a financial adviser looks at FSA returns, it will be essential to decide which set of numbers is most appropriate for assessing the true strength of each company. For example, as a result of the consolidation within the life sector over recent decades, there can be several with-profits funds within the same group of companies.

Aviva is perhaps the best example, with several separate with-profits funds sitting within this group. Each with-profits fund has its own set of numbers and it is possible to calculate an overall number for the group. However, care is needed to ensure that the adviser is focusing on the right set of numbers for their individual customers’ needs.

Additionally, some companies, particularly among the mutuals and the longer established proprietary companies, have a single fund containing most of their business – both with-profits and non-profit. Their realistic balance sheets will include the with-profits liabilities and all long-term fund assets other than those required to cover non-profit business and associated capital requirements. The assets will include the value of future profits arising on their non-profit business, which can be substantial.

Other companies have extensive capital support for their with-profits fund external to that fund (but within the same “long-term fund”). Their published realistic balance sheets will not include that support capital, nor will it include the value of future profits on non-profit business written outside the with-profits fund – even if those profits are potentially available to support with-profits business. In some cases, the FSA may have granted waivers to allow some of the capital support to be included. Comparing companies from the two groups is no easy task and even individual companies within the same group are likely to be different.

Life offices which have demutualised will have court-approved schemes of transfer. These set out how the business must be run, and may provide for support to the with-profits business from assets held outside the with-profits fund.

Taking Scottish Widows as an example, the FSA returns include a with-profits fund working capital ratio and show how many times the working capital (or free assets) covers the risk capital margin. Under a waiver from the FSA, some external capital is included in this calculation but other support capital which is also protected under the demutual- isation scheme, is not covered by the waiver.

The figures are shown in the right-hand column of the table below. However, the rest of the long-term fund also contains assets which support with-profits business. So we get a more meaningful, and very different, result by applying the realistic balance sheet rules to that long-term fund as a whole – as shown in the middle column of the table.

The FSA has indicated that in time it may extend realistic reporting to all business but this will take some time so comparing companies’ figures is not as easy as first hoped when the FSA announced it was to develop a new realistic reporting regime.

This example illustrates the complexities in establishing the true position of just one company. Now all you have to do is establish the true position of another company to compare it to.

Where does this leave clients and advisers? In looking at financial strength, it is important to focus on comparable data. As with the old free-asset ratios, there are various ways of calculating the new measures. Only one is presented on the forms themselves but it can be very misleading.

It seems unlikely that most IFAs, even big adviser firms, will want to put the effort into examining balance sheets in detail. Fortunately for most of us, rating agencies will look at the detail of realistic balance sheets as data becomes available and will have access to firms’ senior management and background information which will help obtain a clearer picture than the published returns alone can possibly give. I would therefore expect financial strength ratings to gain prominence.

It is sometimes argued that financial strength is relevant only to with-profits business but this is clearly not the case. Financial services compan- ies need capital to fund business expansion, new product development and new systems development.

The life business itself will see a move to quality by advisers with a key factor being the efficient use of capital, prudent product management and strength to support guar- antees, maintain investment freedom and grow the business.

It is commendable that the FSA reacted so quickly in light of events at Equitable Life to come up with a new reporting regime for the big with-profits offices.

It has achieved its primary objective in this exercise and, through its engagement with life offices’ management and the realistic balance sheet, a similar situation should become apparent at a much earlier stage.

Unfortunately, the rules now in place do not go quite as far as presenting a consistent set of results on which one life office can be compared directly against another. There is therefore an onus on life offices to help financial advisers understand their true position.


Boulger on Mortgages

Now the general election is behind us there is another important election, or rather referendum, coming up. I doubt that the gilt market would react very much to the result of the general election as the difference in macro economic policy between the two main parties, at least for the first two years after the election, is not big enough to generate wild swings in interest rates.

Isn’t it time we gave with-profits a fair hearing?

I read with interest the front-page article in Money Marketing’s April 21 issue – IFAs told to cover their backs on with-profits. Some of the points made in the piece are valid but painting such a wholly negative picture about with-profits hardly seems to be constructive or helpful for IFAs and their clients.


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