The issue of realistic reporting has raised its head only in the last few weeks as far as most IFAs are concerned. The first reaction for many must have been: “So are you telling me that the financial strength figures I have been using are not realistic?” What changes are proposed and what will they mean for life companies, advisers and their clients?
The FSA's forthcoming Integrated Prudential Sourcebook introduces new rules for reserving with the aim of creating greater consistency in how banks, building societies, investment firms and insurers manage their finances.
Changes are being made to the way in which with-profits reserves are calculated although only companies with more than £500m in with-profits liabilities will be affected by the proposals.
Although with-profits business is in decline, most IFAs have large numbers of clients with money in with-profits products and have a keen interest in ensuring that these clients are soundly invested.
With-profits liabilities have traditionally been valued using mathematical reserves which have evolved over many decades going back to old-style conventional with-profits products. These methods put a value on guaranteed benefits without explicit allowance for future bonuses. The various assumptions used in these calculations contain margins for prudence which approximate for the hidden cost of the uncertainties inherent in with-profits, for example, fluctuations in future guarantee costs, which depend heavily on future investment returns. They are a blunt instrument.
The FSA is now consulting on the introduction of realistic reporting alongside the existing mathematical calculation of reserves – it must keep the existing reserving rules as they are required by EU legislation. Under the proposed approach, firms must hold the higher of a weakened version of the existing statutory or mathematical reserves and the realistic reserves, together with a capital buffer for risk. This is the so-called twin peaks approach.
The FSA has been introducing the new form of financial reporting since summer 2002. Some media coverage has focused on potential problems facing companies still to submit financial reports for 2003 but all major with-profits offices have been providing the FSA with realistic balance sheet information since mid-2002.
A key element of this new basis is that it will involve a much more explicit approach to valuing future benefits under with-profits policies, taking account of future bonuses and risk. This involves using complex financial projection models that simulate management actions in a range of random financial scenarios. In theory, the result is the price that a third party might charge to take on the liabilities.
The results will depend heavily on the models, approximations and scenario generators used and there is no market in with-profits guarantees against which to calibrate results. Comparability between companies will be limited, particularly while the techniques are so new.
A company's realistic liabilities will reflect not only the policies on its books but also the way in which it manages its businesses, as described in its principles and practices of financial management. Every with-profits office must publish its PPFM in the spring, setting out its approaches to bonus setting, smoothing and the other discretionary aspects of managing with-profits funds. The PPFM will be of value to advisers in reviewing client portfolios but do not expect an easy read.
One feature of the realistic approach is that the value of liabilities is more responsive to changes in investment conditions and we have seen some real swings in equity markets in the last few years. In tougher times, the regime tended to overstate the realistic value of liabilities, giving concerns that companies might need to dump equities to shore up solvency when there was less need than the statutory balance sheet suggested.
In response, in January 2003 the FSA invited life company chief executives to apply for waivers to the old approach, which was the start of a gradual move towards the new method of reporting. Companies which applied for waivers must publish their realistic balance sheets as they stood at the end of 2003.
The effect of the waivers is to weaken the current statutory rules, which means even the traditional free-asset ratio figures from form 9 of companies' FSA returns could be less of a like-for-like comparison for the end of 2003 although arguably this has always been a crude measure.
Under current proposals, all companies coming under the twin peaks approach will publish realistic balance sheets from the end of 2004.
Where does this leave clients and advisers? In looking at financial strength, it is important to focus on comparable data. There are several measures of free-asset ratio currently available. Realistic balance sheets will not be published under the new rules until the end of 2004 and even then comparability between offices may not be quite what the realistic description suggests.
Ratings agencies will look at the detail of realistic balance sheets as data becomes available. Inevitably, this will have an impact on the ratings themselves and I would expect financial strength ratings to gain prominence.
It seems unlikely that most IFAs will wish to put the effort into examining balance sheets in detail as the complexity of maths behind the new figures is far advanced on older actuarial techniques.
It is sometimes argued that financial strength is relevant only to with-profits business but this is not the case. Companies need capital to fund business expansion, new product development and new systems development.
The life business itself will see a move to quality – a key factor being the efficient use of capital, product management of the business and strength to support guarantees, maintain investment freedom and grow the business.
The way in which companies manage with-profits portfolios will affect balance sheets and realistic liabilities will have to reflect extravagant smoothing methods, systematic enhancements to payouts or failure to charge adequately for guarantees. If this reinforces prudent management and fosters customer confidence, it will benefit the industry.