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Riders on the with-profits

The pressure on with-profits products remains high, exacerbated by poor asset values. The recent change to the FSA&#39s resilience test was a pragmatic move, given market falls, but it did highlight the current situation and the plight of weaker offices as their solvency came under pressure.

The purpose of the resilience tests is to ensure that life offices are strong enough to withstand adverse investment market movements. In effect, the tests are an examination of “what if” scenarios. One such test was to check that the life office would remain solvent if equity values dropped by 25 per cent from their current level.

The problem for a life office actuary is that, if the resilience test could not be met, the office might be forced to move to other assets, such as cash, where the 25 per cent test would have a lesser or no effect. The consequence would be forced selling of equities at a bad time for consumers and leading to further declines in equity values – a vicious circle.

The revised test allows the life office to take account of the rolling three-month performance of the market. For example, if equity prices are 10 per cent below their three-month average, life offices will only need to test against a further 15 per cent (25 per cent less 10 per cent) fall.

As we might expect, the impact of this change is more significant for weaker offices. The strongest offices remained solvent without the relaxation and a few have very substantial explicit resilience reserves.

Free-asset ratios have taken several hits over the last couple of years. According to company returns, the majority of free-asset ratios were in the teens at the end of 2000. By the end of 2001, most were in single digits and current industry estimates have them another 2 or 3 per cent below that level.

Free-asset ratios are not the whole story, however. They often disguise the true position by the use of adjustments. Two factors often employed are to take account of future profits in the valuation of assets and to use financial reinsurance to sell future margins in return for cash now.

Although it may be legitimate to use such approaches – and at Prudential we do not – it is important to appreciate how financially strong a life office is when directing business to it.

Different life offices react in various ways to declining asset values. Some have sufficient financial strength to ride out the storm. Others choose to introduce market value reductions at potentially substantial levels. The challenge is to deliver good value to the consumer while observing current asset values.

Of course, all this should be done while taking account of policyholders&#39 reasonable expectations and avoiding nasty surprises. The stronger funds and robust offices are inevitably best placed to react in consumer-friendly ways.

Appropriate questions to ask of providers are regarding their policies on MVRs. Does the office apply MVRs automatically? Has its policy changed recently and, if so, in what way? Is its current approach in line with its long-term policy?

Ultimately, returns to policyholders are delivered by way of bonuses. As a result, the bonus philosophy of each provider is extremely important. How are bonuses set? Have bonuses changed recently? How often does the office set bonuses and has it changed bonus levels mid-year recently?

Inevitably, bonus levels have declined to reflect poorer returns in recent years. However, the stronger offices have been better placed to smooth returns to consumers and to avoid substantial bonus changes from one year to another.

In summary, reliance on relaxations in resilience tests, approach to determining free-asset ratios and bonus philosophy should all be considered by the advisers when selecting a with-profits provider.

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