Stop the panic! Everyone makes the Equitable situation sound like the Titanic disaster.
The huge loss of life on the Titanic was largely due to inappropriate action.
Everything that is happening at Equitable appears to be as it should be, given the circumstances. The problem is being confronted head-on and the vessel is built to minimise damage and maximise survivors. With appropriate action, everyone will get to the destin-ation relatively unscathed.
The media went into hyper-drive to give inappropriate advice to abandon ship even before the collision had happened. At present, Equitable is in open water.
Those who have Peps and Isas accept the current losses because the stockmarket has suffered a fall.
If we examine a with-profits bonus statement from Equitable Life, we find three items as reproduced here from an actual statement.The bracketed items here come from press comment.
£154,616.24(£84,000)Non-guaranteed final bonus
It is common practice across the life industry to adjust terminal bonuses or, as Equitable calls them, non-guaran-teed final bonuses, in line with stockmarket performance.
The market has gone down so maturities are adjusted.
Terminal bonuses were introduced to give fair return in good times and bad in line with investment returns.
The most important point about the life insurance fund and those responsible for it is that the contractual obligation is to those who stay on board.
One can see there are two actions that should be taken.
1: Non-guaranteed bonuses should be reduced in line with the stockmarket fall.
2: Some mechanism should be put in place to stop people injuring themselves and their fellow journeymen. This is achieved by creating a restric-tion to a premature exit that secures a safe arrival for the majority. The surrender values are adjusted to make jumping overboard less attractive.
Make no mistake, the Equitable is a Titanic. Its funds exceed £20bn.
If people stop panicking and stay rational and calm, then the iceberg can be hit head-on. It may jar a few bodies but probably the arrival at its destination, even with a blunt nose, will herald a cheer or two and the band might even play.
It is worth considering another force that is acting within Equitable and every other life insurance fund at present. It may well have been partially responsible for Equitable and other insurers before it having to stop taking on new business. New business strain creates a liability within the funds that is now exemplified by those stopping payments to Equitable as they contracted they would.
I have a 58-year-old lady client who was one of thousands making payments to Equitable six weeks ago. She has now decided to stop because of media “advice”.
An insurer has to have a balance of assets against liabilities. The mechanism of taking on new business creates a strain on the assets.
When a policyholder starts a £100 per month policy it costs money to set up the records, pay the salesperson, abide by the rules, etc. Those costs may take five or more years to wash out of the system. That is new business strain.
In a life insurance fund, which has to have £100 of assets to £100 of liabilities, the balance can be precarious and if, as was the case with Equitable, there was an inherent weakness created by the guaranteed annuity debacle, new business can be seen to weaken its asset ratio position.
The company is required to stop taking on new business and over a fiveor six-year period, that new business strain will wash out of the negative side of the accounts.
The current mechanism is not a cause for panic. It is an act of prudence. The policyholder takes all the risk in an Isa, Pep or other unitised fund. The risk in an assured fund is assumed by the life insurer in order to meet the guarantees.
The basic sum assured is a guarantee. The reversionary bonus adds value to the basic guarantee. Once it is added, it cannot be taken away. As has already been stated, the guaranteed funds are not being affected for those who continue with their contractual obligations. The terms are variable, with full discretion of the actuary, if changes to the contractual obligations change.
Stopping paying premiums does make the situation worse, temporarily at least, because the new business strain does not reduce as quickly as it otherwise would.
A major problem is the restriction imposed on the life insurance industry by the regulator with regard to future projections. One thing is for sure, if you restrict fund managers with regard to their projections and the returns that they might achieve, then you also increase the liabilities against assets.
A 25-year fund provides us with a very good benchmark for comparison. £100 per month invested in 1975 to 2000 produced a return from life insurance funds of an average of £200,000. That was from a taxed fund. Pension funds are now partially taxed funds.
The FSA is forcing life companies to illustrate a return of £56,000 for £100 per month over that same timescale. This is achieved on the basis of 4.8 per cent average real return and adding the current inflation rate to it to provide the projection mechanism. A 7 per cent median rate for pensions and 6 per cent median rate for endowments before charges – less than many a bank deposit.
It is interesting to note that £56,000 represents the return that was achieved by the worst-performing 25-year endowment over the 25 years ending 1972.
Interestingly enough, had the same formula been used in 1975 as a forecast for the life insurance fund which has now produced £202,000 for the £100 per month, the FSA would have allowed a life insurer to forecast £4.24m. Is the formula valid?
Much of the problem emanates from an authoritarian body that appears to create its own mechanism for crisis creation. That body, the FSA, contributes much to mutual firms such as Equitable closing their doors to new business.
The captain of the ship must be given credit, with his crew, for listening to comment but also to knowing the attributes of his vessel and using experience and technical know-how to deal with matters appropriately.
Titanic was on its maiden voyage. The Equitable was launched in 1762.
O'Halloran & Partners,