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Is financial strength important?

The topic of with-profits funds is under the microscope at present for various reasons, including the FSA review.

The FSA review has generated five consultative papers which have received mixed reviews. I am not sure why. The documents propose a range of improvements to with-profits which mostly seem very sensible. Indeed, some of the major with-profits funds are already moving towards the new position.

A key area for any financial product is disclosure to customers. Striking the balance between being informative and supplying so much information that the investor is swamped is key. This is particularly true with regard to with-profits.

Provision of pertinent information presented in an understandable way is essential. The FSA has noted this issue and has placed an emphasis on ensuring documents are short enough to be read.

Those providers which have been accredited under the ABI&#39s Raising Standards initiatives are already committed to incorporating standardised wording and a “plain English&#39” approach in all literature and illustrations as quickly as possible.

The FSA proposals cover prescribed content and layout, which should build on the concept of standardised wording and are a welcome step.

Taking this a stage further, the FSA comments that communications targeted for specific audiences should be considered, are welcome and should be supported. Focused communications will enable investors and advisers to select the most appropriate product provider.

Important in all discussions on with-profits is the strength of the with-profits fund. The identification of a strong with-profits fund is not always the easiest of tasks.

Free asset ratios, for example, appear to be a ready measure but they are dependent on the strength of the valuation basis adopted by the fund. A useful guide is the categorisation of with-profits funds by the rating agencies.

Another factor to consider is the extent to which the fund is having to rely on future profits to justify solvency.

A strong fund will afford investors protection and the provider flexibility in operation (thus benefiting the investors) – that is not the case for the weaker funds.

An example of investor protection is the ability of a strong with-profits fund to smooth returns to investors in a sensible way.

This does not mean consistently paying out above the policies rightful share of the fund. Such an approach is a short-term game which should not be supported.

Positively, it means being able to move bonus rates from one period to the next in a way which investors can understand and appreciate.

This has been a key issue in recent times given the poor market returns available in 2000 and 2001. Stronger funds have been able to dampen the impact on returns to investors rather than immediately reflect them in bonus rates.

A second example of the policyholder protection afforded by a strong fund is market value reduction flexibility. All with-profits funds need to protect continuing policyholders against the actions of those withdrawing by reserving the right to impose MVRs.

The crunch comes when the pressure is on – a strong fund is more likely to be able to operate a stable MVR approach which is protective of the interests of withdrawing and continuing investors.

With-profits funds offer a second level of professional investment expertise that is missing or heavily restricted in the case of other investment vehicles – asset allocation control.

The provider with a strong with-profits fund will have the investment flexibility to amend the asset mix of the fund. The benefit to the investor is that the fund has an extra lever, the ability to move assets from one investment type to another.

For example, over recent years corporate bonds have become a much more attractive investment class. With-profits funds, particularly the strong ones, have been able to take advantage of such changes in investment conditions to benefit investors.

Ultimately, of course, the benefit of a strong with-profits fund is the ability to continue to write new business when weaker funds might falter.

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