Leading independent analyst Ned Cazalet of Cazalet Financial Consulting has launched a scathing attack on life offices' free-asset ratios, claiming they are useless and misleading.
Cazalet's attack in his IFA Guide to With-profits comes as Chancellor Gordon Brown announces a Myners-style investigation into retail investing which also calls free-asset ratios into question.
His analysis of the life industry shows how life offices can manipulate free-asset ratios to boost solvency ratings.
Financial strength is becoming key to IFAs' selection process in light of Equitable Life's closure to new business.
Stakeholder margins are proving tight as firms such as Prudential and Britannic axe their direct salesforces to cut costs.
Free-asset ratios are supposed to represent the difference between a life office's liabilities and its available assets.
But Cazalet says they are rendered useless on their own as determining a life office's liabilities is left up to its actuarial discretion.
He says: “The calculation of the raw FAR does not really tell us anything particularly useful for the purpose of deciding whether the life office is strong or weak, either as a stand-alone exercise or in the context of other life offices. It is generally impossible to compare one life office's strength to that of another on the basis of a crude FAR.”
Cazalet compares Prudential and Friends Provident, which reported identical free-asset ratios on December 31,1999. But he says the financial strength and bonus-paying capabilities of the two offices are not comparable.
Life offices discount future liabilities using a rate of interest which is supposed to represent a conservative return on investments. But a small change in the interest rate that the life office chooses to use can produce dramatically different free-asset ratios. Choosing a discount interest rate of between 2 per cent and 4 per cent will change the FAR from between 3.7 per cent and 20 per cent.
Cazalet also claims life offices use subsidiaries of their own businesses to reinsure business to bolster FAR and, as in Equitable Life's case, use external companies to remove liabilities from balance sheets. Future profits are also used to offset liabilities.
Cazalet says: “A few life offices pad out their asset position by taking account of future profits but we disregard these on the grounds that this is simply accounting for tomorrow's profits today and is the equivalent of placing a sack of cash in Doctor Who's Tardis.”
But life offices are defending their calculation methods and say FARs alone should not be the basis of selection.
Clerical Medical spokesman Tony Muir says: “We apply most vigorous measures to our FAR. We do not use it as a promotional tool so we do not need to manipulate them.”
Cazalet rates companies with a different measure, the with-profits excess assets ratio, which he says reveals a life office's true solvency position.
It takes account of inadmissible assets and other stores of capital and tax reserves.
Wentworth Rose director Philip Rose says: “FARs have always been another area where actuarial discretion and spin comes into play, which make it difficult to take too simple a figure as a guide.
“A degree of transparency would be incredibly useful and an overhaul of the system is needed to give clear guidance to make meaningful comparisons between companies.”
Cazalet is warning IFAs to pay careful attention to the valuation bases that life offices use.
Torquil Clark pensions development manager Tom McPhail says: “FARs can be manipulated and the industry has widely acknowledged this. The reporting requirements give life offices a lot of latitude in accounting for reserves and liabilities. Unless we can get an accurate measure of financial strength, with-profits investments become a bit of a dart-board selection process.”