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Verity&#39s view

In the hope of emulating the style of that esteemed professional qualification, the Financial Planning Certificate, here is a nice, easy multiple-choice question designed to build your confidence, a bit like the ones they ask for £100 on Millionaire.

Over the last 100 years, which sector would have generated the most money for its investors as a direct result of a series of tragic and premature deaths? a: Oil companies, b: arms dealers or c: life insurers.

Now I cannot claim to be in full possession of all the relevant statistics but without doubt the answer is c.

To be clear, I am not passing any moral judgements. The name life insurance was always a bit euphemistic for an industry that is all about death. As every IFA knows, life insurance protects you from dying too soon, pensions from living too long.

In a pool of annuitants, it is perfectly natural for life insurers to profit from early deaths, the same way that they will lose money if we live into our 90s.

But there is a serious point here. Over the years, life insurers have benefited hugely by paying out less than they might have done to those who died early while building up a pension. Most would not repay the full fund but only give back the saver&#39s contributions plus an interest rate of 4 per cent. So, in many cases, there would be a big profit to be made if a saver died while still paying into the scheme rather than after retirement.

As IFA Alan Steel points out, it is this – and other factors – that really make up the profits in with-profits. This is one way that life insurers came to build up such giant surpluses – the life insurer&#39s inherited estate – before the current bear market came and wiped out most of that money.

Another factor would be under-distribution of bonuses. In the past (but not lately), life insurers thought it prudent to keep some of their money back for future generations.

By paying out less than they made on the market, the fund would be strengthened. Policyholders would get less back than they might but the benefit of that prudence would be inherited by future generations and, of course, that is exactly what has happened. Those who died prematurely, and with less money than they might have had, did not do so in vain. In fact, their relative misfortune has been directly to the benefit of the current generation.

As the ABI rightly points out, with-profits policies have massively outperformed any investment linked to the performance of the stockmarket.

The FTSE has fallen by 43 per cent since the start of 2000 but with-profits policies have grown in value. It was surpluses built up in the past through premature deaths in relative poverty that made that possible.

Far from being tight-fisted, today&#39s life insurers have gone out of their way to maintain with-profits performance to keep policies growing (or at least not shrinking by much).

The bear market has drained even the biggest and oldest offices of their excess of financial strength. On a reasonable estimate, they have spent well over £100bn shielding policyholders from the bears. With-profits, in other words, have been great.

Ironically, that may be exactly why IFAs should not recommend them. That £100bn-plus is, in effect, a massive subsidy, a great benign inheritance from past generations of policyholders to existing ones. The “smoothing” that allows life offices to subsidise existing bonuses was made possible only the inherited estate (which in turn was only possible because of the relative impoverishment of policyholders in the past).

But now that money is spent. Smoothing, as we have seen over the last three years, costs money – billions and billions of pounds – and to make it possible there has to be billions and billions in reserve. The money is simply not there and, worse, it will take life offices years and years of being less than generous with bonuses to build those reserves back up.

To really benefit from with-profits, you have to be in the lucky generation where all the money foregone by policyholders in the past is spent (you could say squandered) on your age group. Today&#39s policyholders are in that bracket, tomorrow&#39s are not. As the FSA is always keen for us to note, past performance is no guide to the future. If you are thinking of recommending with-profits as a new investment, that is truer than it has ever been.

Andrew Verity is a personal finance reporter at the BBC

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