Recently, a trio composed of some of our oldest and most respected life
offices, Friends Provident (formed by Quakers in 1832), Legal & General
(1836), and Scottish Widows (1815) incurred the wrath of an organisation
known as Chartwell by refusing to disclose the underlying investment
performances of their with-profits funds.
Instantly, the media was crammed with highly critical comment from the
nation's financial experts and the Financial Services Authority has
threatened to make such disclosure compulsory in furtherance of its brief
to ensure that customers are provided with “more and clearer information”.
All these developments indicate a widespread lack of any real
understanding of how a with-profits fund works. And, sadly, that lack
extends into groups of people who should know better than to stir up
trouble where none is warranted.
Disclosure of the underlying investment performance of a with-profits
fund, of itself, would most certainly not ensure clearer information to the
customer. Indeed, it would probably cause confusion where none existed
The bonuses derived from a with-profits life insurance fund constitute the
surplus which is allocated to those policies which are entitled to a
proportionate share of the profits. This surplus is the excess money
available after reserving adequate funds for future claims and expenses and
making intentionally pessimistic assumptions as to the future success of
the fund's investments. Highly complex valuation formulae are employed in
making the necessary calculations for valuing a life fund.
Eminent actuaries through the ages have wrestled with what is, by virtue
of its involvement with the future, a very inexact science. Messrs
Zillmer, Sprague, Elderton, Lidstone and Karup all devised their own
methods at various times.
Bonuses do not arise either directly or solely from investment surplus. A
life office also makes “trading” profits on its life insurance operation by
pitching its premiums at a level which assumes that human mortality will be
heavier than it is known to be according to mortality tables derived from
census statistics. This is called mortality surplus. It comes from all the
classes of policy that the office issues, such as term insurance and
sometimes unit-linked business, and it all goes into the with-profits pot.
Cancellation penalties give rise to surrender surplus. One of the most
important skills of the actuary is to assess how much of the surplus he
should give away as bonus, so as to achieve a smooth and cautious rate of
He must ensure the retention of adequate reserves to provide for future
rainy investment days. This is the very cornerstone of the with-profits
system. It was the adroit application of that principle which has enabled
Scottish Widows – one of Chartwell's culprits – to chalk up an amazing
record of not reducing its bonus rate for 120 years, except during the two
To comply with the demand now that the rate of investment performance be
disclosed, baldly, without a lengthy appendix dealing with all the other
factors affecting the bonus, would serve only to obfuscate the issue. And
the inclusion of such an appendix would, with respect, probably confuse the
average customer even more.
If the fund were enjoying a golden period, any public announcement of this
would, not unnaturally, lead to clamorous demands for high bonuses, bowing
to which could upset an actuary's reserving programme and, therefore,
defeat the with-profits principle of cautious growth. In fact, this was
arguably the cause of a recent flurry of bonus reductions.
Conversely, if investment returns were disappointing at that juncture and
bonuses were being propped up by reserves, it would create an unwarranted
and, therefore, unfair lack of confidence in the life office's prospects.
In summary, the “need to know” principle is often the wisest course to
adopt in many walks of life – and it is probably so here. The FSA would do
best to let sleeping dogs lie. The supply of statistical information
available for the assessment of life offices is already quite adequate for
The most telling factor is the rate of interest that the actuary has
assumed in making his valuation – the lower the stronger.
Indeed, the baring of the with-profits soul was widened only a few years
ago, when following another wave of criticism, the concept of free-asset
ratio (the ratio of surplus to total liabilities) was brought into the
debate. For nearly 200 years, few people have ever had cause to complain
about the performance of their with-profits policies – low-cost (that is,
hybrid) with-profits mortgage endowments apart.
If bonus rates in general ever start falling consistently below what is an
acceptable par, that will be the time for the FSA to ask questions. Until
then, in the common interest, it should resist the urge to do what so many
other quangos have done – fix things that ain't broke. Especially where
200-year-old copper-bottomed time-proven British-invented institutions such
as with-profits are concerned.