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The test of strength

A means of analysing strength is needed for IFAs to give the best advice to clients and to protect themselves in the event of an office&#39s failure.

Prior to the Financial Services Act, with the exception of UK Provident, the strength of a life office was taken for granted.

Even today, many people believe that such strength need not be ques- tioned by IFAs because of the regulation of life offices by the Department of Trade and Industry.

But, despite the long-term nature of its business, a life office should be assessed on its financial strength as with any other commercial organisation.

While it is probably true that little or no financial risk attaches to some life offices, other than the effect of low returns, I believe some life offices will cease trading and they, unlike UKPI, may be unable to find a buyer.

Before you bite off my finger, take very careful note of the direction in which I am pointing.

I have previously made an impassioned plea to the Institute of Actuaries for the introduction of a grading basis for life-office strength.

The logic of this plea is, if there are any other UKPIs likely to happen in the future, then it is of the greatest concern.

Under the provisions of the Policyholders&#39 Protection Act, the IFA stands directly in the financial-loss recovery line.

The PPA provides that, in the event of a life office failure, the IFA is required to repay 50 per cent of the excess over an exempt portion of commission (£5,000) received in the preceding 12 months and 25 per cent of the excess in the previous 12 months.

IFAs should observe that their PI policy provides no financial protection in the event of the failure of a life office.

Quite clearly, such an event would have a detrimental effect on an IFA&#39s financial resources under Fimbra rules, let alone his cashflow and profit.

So why question the financial strength of any life office?

Earlier this year, a report from Phillips and Drew said: “One-third of mutual life companies will disappear by the end of the decade.”

Smith New Court analyst Roman Cizdyn has said: “Quite a few life offices are already weak in a straight capital sense and distribution sense. Mergers with other companies are inevitable.”

What about the prospects for future bonuses? Money Marketing&#39s January 16 issue included a table relating to investment returns as drawn from 1991 with-profits guides and Department of Trade and Industry returns.

It indicates the annualised average yield required over the next 10 and 25 years by 17 of the leading life offices in order to maintain current bonus rates. It then lists the average yields on market value by each office over five-plus years.

I calculate that the average investment return of those leading 17 offices needs to be 15.76 per cent a year over the next 10 years in order to maintain current bonus rates.

But average yield on market value of those same 17 companies over the past five or more years has been only 9.85 per cent a year. While that leaves an average shortfall of 5.9 per cent a year, it should be noted the highest shortfall is seen to be 11.2 per cent a year.

Where is that extra 5.9 per cent (or 11.2 per cent) a year going to come from in the future, if it was not possible during the 1980s when higher investment returns were available?

If future average returns have to be higher than the average over the past five or more years, how then do IFAs view the statement by Norwich Union general manager (finance) Philip Scott: “The average with-profits fund has an annualised average return of only 2 per cent in 1990 and 1991.”

NU financial manager Melvin Lay has said: “If the maturity value of a policy is greater than the amount earned, you have got to find the money from somewhere else and one place is the free assets.”

I accept that adding to or subtracting from free reserves is all part of the smoothing mechanism and it is fundamental to with-profits if the shifts are gradual. I also recognise the dangers of looking only at the investment returns of a fund when other forms of profits also contribute to bonuses.

Even though the free-asset ratio is one element of a wider financial picture, if there is a shortfall after all profits are taken into account, then the difference ultimately will have to be made up by using a portion of free assets.

In January, Eagle Star marketing manager (individual business) Chris Bagguley said: “There are times when the markets are down and you expect with-profits payouts to exceed market fluctuations but you cannot put your hand into the free assets for ever.”

One illustration puts the average free-asset ratio of 18 of the top 25 offices for which figures were available to December 31 1989 as falling by 51.3 per cent from the previous year.

For the 10 of the 18 which were mutual, the average free-asset ratio fell by 57.87 per cent between December 31, 1989 and December 31, 1990.

The situation for proprietaries was not much better, with an average fall of 40.29 per cent over the same period.

So, free-asset ratios are well down, investment returns for 1990 and 1991 are down to an average of 2 per cent (compared with 19.3 per cent a year during the 1980s) while average yields need to increase by 5.9 per cent a year to maintain current bonus rates.

On this basis, it becomes more understandable why analysts agree that small mutuals are ripe for merger with other mutuals or they will demutualise and be sold to a bank or building society.

One of the reasons given for leading with-profits offices to be in dire straits is their failure to reduce bonuses, both reversionary and terminal. Criticism has been made of the arrogance of market leaders, which increased bonuses when their underlying assets were falling in value.

Surely, offices are at risk if they continue to compete in the with-profits tables and fail to make necessary bonus-rate cuts?

It may be true returns from with-profits policies will not diminish in real terms but it is reasonable to ask whether or not the maturity value of an endowment policy needed to repay a mortgage will be sufficient to repay the original loan.

While IFAs cannot be certain which companies will survive and which will not, they should discover the available ways of assessing life offices&#39 financial strength.

Advice given to the Institute of Insurance Brokers by barrister Derek Holwill stated: “If a client actually asks the broker: &#39Is this a good/sound insurer?&#39 and the broker makes a representation to this effect, he is plainly liable under common law if representation is negligent – specifically if the broker does not have reasonable grounds for giving the answer which he gives to the client.”

I conclude that IFAs need to obtain guidance from independent consulting actuaries or via other financial reports in order to be able to prove they have taken reasonable steps to satisfy themselves as to the strength of the life offices they are recommending.

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