Following the publication of the 2001 FSA returns, we can now take the most up to date look possible at the published financial strength of the major UK with-profits companies. The recent turmoil in the worldwide equity markets has given rise to much media comment on the solvency and financial strength of these companies. It is important to consider the latest information in a careful and reasoned manner, and to avoid jumping to any premature conclusions.
Over 2001, the UK equity market produced a total return of ᆡ%. For 2000, the return was ǈ%. These negative returns have, not surprisingly, led to a reduction in the free asset ratios of most of the companies in Tables A1 and A2. To put these returns into context, the table inset summarises the returns achieved on the main asset classes since the late 1980s.
Free asset ratios (FARs) can be considered as a simple, if somewhat crude, measure of the financial strength of a life office. They provide an indication of the available assets an office can use to counter adverse experience or to adopt a more aggressive investment strategy. A low free asset ratio will mean for example that an office has less flexibility with investment strategy. It is well known that FARs are affected by the strength of the actuarial valuation basis adopted, and by the type, mix, and maturity of the business in force. They are also affected by the use of financial engineering techniques, such as financial reassurance - more below. Nevertheless, they represent the only published information which policyholders and IFAs can easily make use of. Also, given the low state of the stock market and the general reduction in free assets, it is now even more likely that most companies will have removed any excess margins in the valuation basis, thereby taking this factor out of the equation.
One of the features of the updated Tables A1 and A2 is the increase in the number of offices using the future profits implicit item. At 31/12/00, 7 out of 34 offices used the future profits item. At 31/12/01, as Tables A1 and A2 now show, this had increased to 17 out of 39 offices. Use of the future profits item has been subject to significant media attention in recent months, and so it is worth considering here what this item actually is in some detail.
The ability to use the future profits item has existed for many years, and stems from the EU solvency regime. One can find examples of its use within individual companies over a long period. It is only relatively recently, however, as a result of the pressures of falling equity markets, that use of the future profits item in the UK has grown. In continental Europe, use of the future profits item has been more widespread.
The maximum amount of future profits which can be taken into account is subject to FSA rules and guidance. These rules and guidance ensure that even this maximum amount represents a prudent assessment of the future profits which are likely to emerge. Use of future profits is subject to FSA approval, and sometimes offices choose to make use of an amount of future profits less than the maximum allowable.
One of the most important points to appreciate is that the future profits item can only be used to count towards covering the required minimum solvency margin ("RMSM"). It cannot be used to cover the basic actuarial and other liabilities. Moreover, even where future profits are used, one-sixth of the RMSM must be covered by assets other than the future profits item.
Financial strength is very much a relative concept, although clearly there does come a point when the situation becomes so tight that the absolute position becomes relevant. In seeking to compare offices, the future profits item does make life more complicated as its use is voluntary. Many of the companies who do not have a future profits item at 31/12/01 could most likely have had one if they so wished. For this reason, Table A1 now shows two additional columns compared with previous versions. Columns (E*) and (F*) show the free assets and the free asset ratios with the future profits item removed. Where these adjusted columns are negative, reliance is being made on the future profits to cover fully the RMSM. Where columns (E*) and (F*) remain positive, use of the future profits item is not actually necessary to cover the RMSM fully.
Under an EU directive, the ability to use future profits will be phased out by 2009 at the latest. Further, it is expected that the FSA's forthcoming consultation paper on financial engineering will regard future profits as coming within the ambit of financial engineering, and it is expected that the FSA will require the effect on free assets of all forms of financial engineering to be disclosed in the FSA returns. Thus, whichever way you look at it, the usefulness of future profits is set to decline and ultimately to disappear. Importantly though, over a similar timescale, we expect the current EU review of the solvency regime to produce changes which should lead to a more sophisticated approach to determining solvency margins than the current fixed formula approach.
For the offices in Tables A1 and A2, the average headline FAR has fallen from 10.1% to 6.3%, these averages incorporating the effect of future profits where used. If we exclude future profits (both at 31/12/01 and 31/12/00), the fall in the average FAR is from 9.6% to 5.0% – clearly a steeper fall.
The results in Table A1 are of course based on the resilience test inforce before the amendment made by the FSA at the end of June. For the 31/12/01, companies were required to test a 25% fall in equity values. Although the equity market performed poorly in 2001, the fall was not sufficient to trigger the tapering formula which existed at 31/12/01. The amendment introduced at the end of June provides an additional tapering formula, where the amount of any fall in the average equity index value over a rolling three month period is deducted from the 25% fall which has to be assumed.
At the time of writing (early July), the equity market had fallen by 11.5% since 31/12/01. The effect of the additional tapering formula in the revised resilience test is such as to require only a further fall of 17% to be assumed. If, however, the market remains constant for three months (or goes up), then the fall to be assumed will revert back to the standard 25% (unless relief is provided by the original tapering formula). The extra relief currently afforded by the additional tapering formula could therefore prove to be only temporary.
The table inset shows the full details of the resilience test in force in respect of equities at 31/12/01, and also shows the amended test introduced at the end of June. In both cases, the appointed actuary has also to decide what would be appropriate changes to test in relation to other investment classes, such as property and fixed interest.
A further factor to be considered in relation to FARs is the proportion of unit-linked business written in the office in question. Some organisations write their unit-linked business in the same company as their with-profits business, and some use separate companies for unit-linked. Sometimes, unit-linked business written in the with-profits company is reassured out to a unit-linked subsidiary.
Unlike with-profits business, unit-linked business does not have terminal bonuses. Thus, unit-linked business neither generates nor, in the normal course of events, needs the same level of free assets as with-profits business. Column G1 of Table A1 shows the proportion of the liabilities (net of reassurance) which are unit-linked (or index-linked, which is similar). Column G2 shows the FAR with the effect of the linked business excluded, thereby producing a higher FAR. The average value of 9.2% is just under 3 percentage points higher than the average overall FAR. This modified FAR is clearly relevant for the with-profits business. However, even unit-linked business can from time to time give rise to unexpected losses (for example pensions misselling), and thus the overall FAR cannot be ignored.
Column (H) of Table A shows the yield on the assets as at 31/12/01. See the glossary for further details of this item.
Tables B1 and B2 show the updated position in respect of acquisition and other expense ratios. The average acquisition and other expense ratios for 2001 have remained virtually unchanged compared with 2000. The average acquisition ratio has crept up by one percentage point to 80%, and the average other expense ratio has remained unchanged at 8%.
Table C shows the latest available information in relation to the investment mix underlying with-profits funds. This information is as at 31/12/00 rather than 31/12/01 because the with-profits guides giving the information as at 31/12/01 will not become available until later this year. Table C shows a small average shift out of equities and into fixed interest. We can expect that the 31/12/01 information will show greater proportions held in fixed interest as opposed to equity investments - both due to the falls in the equity market over 2001 and due to further switching into fixed interest. The fall in the equity market since 31/12/01 will almost certainly have resulted in a continuation of this trend.
Table D shows the latest available information in relation to new business reductions in yields (RIYs), which are a measure of overall expenses/charges. For personal pensions, the averages for 2001 show a reduction compared with the previous year. This is probably due to the effect of stakeholder pensions. Additionally this time, a column showing the RIYs for single premium with-profits bonds has been included. This shows an average RIY of 1.2%pa.
John Jenkins is a partner in the Financial Sector Actuarial Practice of KPMG