Fans and opponents of with-profits will remember 2001 as the year that the subject emerged from the shadows into the full glare of the spotlight.
Following a series of papers, reviews and consultations (and with more to come in 2002), changes to with-profits as we currently know it are certain to follow.
The year was not very old when we had the views of the actuarial profession in a paper on transparent with-profits. By a happy coincidence this happened in the same week that Howard Davies gave a speech which, in effect, kicked off the FSA review of with-profits. He, too, was seeking more transparency.
Running alongside both of these was the ABI work examining ways that information on with-profits could be presented in a more meaningful way to investors.
All these reviews are related in that they are all seeking to explain the workings of with-profits more clearly. The FSA review will obviously be the main catalyst for change so it is worth looking in more detail at the process they will be following.
The starting point was the speech given by Howard Davies on February 23 in which he described a number of issues “with different roots which have come together to create a combustible mixture leading to claims that with-profits funds are no longer appropriate savings vehicles”.
Following an open meeting in June, the FSA announced more details of the format of its review. Consultation will be in two stages. The first stage will be a series of issue papers on five different topics. These are:
Procedures for handling inherited estates.
Transparency and plain language.
Disclosure and regulatory reporting.
Unfair contract terms.
Governance and discretion.
These papers look at a number of ways of dealing with each of these topics and seek views on each of the alternatives. They are not consultation papers in the normal FSA sense, in that specific proposals are not being put forward for discussion. A consultation paper with specific proposals will follow in spring 2002 once the FSA has digested the responses to the issue papers.
At the time of writing, two issue papers had been published – inherited estates and disclosure and regulatory reporting – and these give a greater insight into how the debate will be carried out.
For inherited estates (a term which is now preferred to the previous references to “orphan assets”), we have a paper which it is hoped will address the issues raised in the Axa story which hit the headlines about a year ago.
The essence of that case was that, as part of a reorganisation of its UK life business, Axa wanted to do a number of things, including allowing with-profits policyholders the choice between sharing in future distributions (which were not certain) or taking a payment now which would mean that they would not participate in any future distributions.
The headlines were about the suitability of the price offered to policyholders in return for giving up the right to future distributions.
For many policyholders, Axa's proposal was acceptable but a significant number were concerned that it did not represent fair value for what they were giving up. The Consumers' Association agreed with them and backed a representative legal challenge from one of these policyholders. Axa won the case but concerns remained about the nature of the process.
The FSA paper looks at options for changing that pro-cess. Having first defined an inherited estate, it then looks at how it can be attributed between policyholders and shareholders before going on to re-attribution that is, what happens when shareholders want to alter an attribution by buying out the rights that policyholders have to future distributions.
The main part of the paper deals with policyholder representation in discussions on a proposed re-attribution. Although the Axa case was settled in court, that ends up as a win/lose decision on one specific proposal rather than true negotiation whereby each party tries to work towards a deal acceptable to the other.
Five options are looked at, three of which specifically look at possible negotiators on behalf of policyholders: the FSA, the independent actuary or other independent expert, a proxy person or organisation.
Obviously, it is difficult for anyone to act as negotiator for the policyholders if they also act in another capacity in the re-attribution. This is the case with the FSA.
Equally, the independent actuary – who currently advises the court – would have a conflict of interest. Although the FSA does not express a preference at this stage, the proxy route looks the most suitable.
The second issue paper deals with regulatory reporting. The assumption is that with-profits will remain an attractive form of investment but more meaningful and relevant information is necessary for advisers to be more confident in their recommendations about with-profits providers.
The paper looks at ways of improving the information for “informed users”- that is, regulators, analysts, rating agencies, IFAs, etc. It is not concerned with the way that information is presented to the general public as that will be the subject of a separate paper.
The paper starts by looking at the different areas where the public can currently find financial information on a company. Companies Act accounts are one such area but change here looks like a non-starter, not least because the FSA has no formal responsibility for the information in these accounts.
Consequently, the rest of the paper concentrates on the information in the regulatory returns. These are filed each year with the FSA and their primary purpose is to demonstrate that the insurer can meet its guarantees.
One change proposed for the returns is very straightforward and unlikely to be contentious. This is the proposal to make the returns available on the FSA website to improve public access. This will be subject to a cost-benefit analysis but greater accessibility looks like a necessary prerequisite to better use of the information.
The real issues concern the information held in the returns and the way it is presented. On presentation, the returns currently contain lots of big value-based numbers (assets, mathematical reserves and the like) which analysts convert into a series of ratios or key indicators to enable comparison between different providers.
The paper asks whether the returns themselves should contain the key indicators as this might standardise the calculation and make comparison more meaningful.
The paper then looks at the actual information disclosed. Meaningful comparison between companies is possible only if the data from which the key indicators are produced are calculated in a consistent way. In the existing returns, the value placed on the with-profits business depends on the appointed actuary's assessment of future conditions and, as the FSA paper says: “This will vary within a prudent range between more cautious and more optimistic approaches.”
In other words, the published data are not calculated in a consistent way from company to company, making meaningful comparison impossible.
To combat this, the FSA goes on to consider the disclosure of information which does not currently appear in the returns but instead makes use of numbers used in the setting of bonus rates. Given the objectives this looks like a more promising approach but it, too, has its difficulties.
The proposal involves the publication of asset shares, that is, the hypothetical share that each with-profits policy has of the aggregate with-profits assets, taking into account the investment made, the deductions for expenses, taxes, etc, and the additions due to investment returns. Because with-profits involves smoothing, the policy will at times stand above and at other times stand below its asset share but the cumulative affect of these differences should tend to zero over time.
The difficulty here is that, if asset share disclosure is to become a regulatory requirement, the calculation rules must be capable of being expressed with some degree of precision and asset shares have not reached that level of sophistication.
They are a relatively new actuarial technique and, on older policies, they depend on information which may not have been collec-ted many years ago and which now has to be approximated.
Approximation is acceptable in the context of a planning tool used to determine bonus rates but is not normally acceptable in the context of regulatory disclosure.
Furthermore, on the use of asset shares, there is a concern that disclosure of this type will allow analysts to establish when policy values are above asset share and when surrender of the policy (or, perhaps a switch into cash) might be to the investor's advantage. Smoothing only works well and fairly if the options like this do not exist.
This demonstrates that the issues involved in this review are not straightforward. Howard Davies, at the start of the review, said he did not wish to throw out the baby with the bathwater. Clearly, he will have his work cut out.