2001 was a poor year for UK equities, which showed a clear downward trend. The events of September 11 resulted in a fall of over 27 per cent before recovery to an overall drop of 13 per cent for the year.
UK equity values have now fallen substantially in the last two years, with a drop of 6 per cent being suffered in 2000. By the beginning of May this year, there had been virtually no change from the 2001 year-end position.
The fall in UK equity values was also mirrored in overseas equities, which fell by 14 per cent in 2001.
The return on index-linked gilts and conventional gilts has fared rather better, however, with only a 1 per cent fall being suffered by each class in 2001 – still a substantial drop on the 8 per cent and 4 per cent gains respectively for 2000.
Property and cash provided better returns in 2001 of 7 per cent and 5 per cent respectively. This illustrates that these are perhaps more reliable and less volatile investments. Looking at the 10 years to 1999, 2000 and 2001, the return on property has actually risen by between 3 per cent and 10 per cent while UK equities have fallen by the same amount.
However, despite the big fall in equities over the last two years, the annualised growth of UK equities over both 10 and 15 years has still outperformed property, index-linked gilts and cash.
The RPI figures show a gradual but steady decrease in inflation. The average of the 10 years to 2001 is down by 2 per cent from 4 per cent for the 10 years to 1998. The low-inflation environment appears to have become a reasonably permanent feature of the UK economy.
The free-asset ratios shown in Table A on page44 are based on the regulatory returns to the FSA for 2000.
The returns for the year ended 2001 have recently been submitted to the FSA and will be available publicly soon. We are currently starting to compile updated Tables A and B.
Free-asset ratios can be considered as a simple measure of the financial strength of a life office. They provide a good indication of the available assets that a life office can use to counter adverse experience or adopt a more aggressive investment strategy.
A low free-asset ratio will mean that a company has less room for manoeuvre with its investments. However, differences in valuation bases can distort these figures, so it could be said that they are not directly comparable.
A downward trend in free-asset ratios from 1999 to 2000 can clearly be seen in Table A, with all but two companies showing a decrease. The average overall free-asset ratio has dropped from 14.4 per cent to 10.1 per cent. Possible reasons for this could include the strengthening in valuation regulations and the poor performance of equities in 2000.
Clerical Medical improved its free-asset ratio from 13.4 per cent in 1999 to 15.9 per cent in 2000 and Scottish Legal Life improved from 10.5 per cent to 12.2 per cent. These increases could be a result of better than average investment returns or the reduction of any unnecessary margins because of changes in resilience test and valuation bases or changes in investment mix.
It is also possible to look at the non-linked free-asset ratio, shown in column G2 in Table A. This can provide better information about the strength of offices' with-profits funds. Again, a decrease can be seen from 16.5 per cent at the end of 1999 to 10.9 per cent at the end of 2000. This is a bigger fall than the overall free-asset ratio, possibly due to the need to provide assets for smoothing during the period of decreased equity returns.
Table B on page 45 shows that the average acquisition expense ratio dropped slightly from 85 per cent in 1999 to 79 per cent for 2000. This has been a decreasing trend since 1995. However, many of the individual companies have seen big variations in their expense ratios.
Acquisition expenses are generally dependent on the mix of business written by particular offices. For example, a company writing large amounts of protection business in comparison with savings business will incur higher expenses as a result of increased underwriting and administration costs.
The average acquisition expense ratio in Table B can also be calculated in a slightly different way to that shown. The table shows a conventional average of 79 per cent. However, adding columns A and B together and then taking the ratio, an average of 69 per cent is obtained. Calculated this way, the ratio gives more weight to bigger offices. This implies that they usually have lower acquisition expenses than the smaller offices, which are given equal weight in the conventional average.
Average other-expense ratios are also showing a decrease, falling from an average of 10 per cent in 1992 to 8 per cent in 2000. Using a similar weighted average method to that mentioned above, the average expense ratio is just 6 per cent, which again implies lower expenses for bigger offices.
It should be noted that Royal Liver has been excluded from these averages due to the big increase in both acquisition and expense ratios.
The drop in equity values in 2000 appears to have had little effect on the average investment mix employed by the major with-profits providers. The average percentage of UK equity held has dropped by 3 per cent from 54 per cent to 51 per cent from 1999 to 2000 and there is a 2 per cent rise in the amount of fixed-interest securities held.
Some offices have made a notable shift in investment mix. Scottish Legal Life, for example, has decreased its holding in UK equities from 54 per cent to 39 per cent and increased both fixed interest and property by 7 per cent.
If the conditions of the FSA's resilience test in force at the start of September 2001 had remained, life offices could have been forced to sell equities and purchase fixed-interest securities due to the drop in equity values.
The FSA reacted by modifying the resilience test three times in 2001. Clearly, the variation in equity markets over the last two years has provided a great challenge for life offices seeing to maximise returns without excessive market risk.
The resilience test in place at December 31, 2000 is shown in the table on page 48. These are the criteria referred to in Table A. The current, simpler version of the test as applied at the end of 2001 is also shown in the same table.
The effect of recent acquisitions is also clear to see from Table C on page 48. An identical investment mix can be seen for the following companies – AMP NPI and AMP Pearl, Scottish Amicable and Prudential, and Royal London and Scottish Life. This reflects the fact that both portfolios now share the same with-profits fund, either directly or via a reinsurance mechanism.
Reduction in yields
The introduction of stakeholder pensions last year has had a marked effect on the reduction in yield for all with-profits pensions. Looking at Table D on page 49, compared with 1999 and 2000, the reduction in yield for a 10-year personal pension has dropped by 1.1 per cent from 3.2 per cent in 2000 to 2.1 per cent in 2001. Similarly, the 25-year term products have dropped by 0.4 per cent since 2000.
However, looking down the list of RIYs, there is a big difference in the values quoted. For example, for a 10-year personal pension, Norwich Union and Royal Liver quote 3.7 per cent, which is high compared with the 0.8 per cent quoted by Standard Life.
Endowment insurances, which are becoming ever more unpopular, appear to have a steady average RIY, both for 10and 25-year terms.
It can be seen that there is substantial difference throughout the table. A 10-year policy with Britannic results in an RIY of 4.9 per cent whereas Scottish Mutual and Scottish Friendly have an RIY of just 1.5 per cent. Clearly, in times when investment growth is low, these charges will have a notable effect on policies.
The single-premium bonds seem to have a more favourable average RIY of 1.2 per cent, possibly due to the lower costs of dealing with one-off premiums compared with regular premiums.