It is becoming a familiar story. A giant company is formed in a few short years by a series of mega-mergers, justified in good times with the jargon of unprecedented opportunities for growth and in bad times by the need to cut costs and consolidate. The growth opportunities fail to materialise as hoped. In fact, the much-heralded new markets are only a fraction of their predicted size. Cost-cutting opportunities and synergies have largely been used up. With the feelgood factor gone, the company seeks to present its financial state in the best possible light. The rulebook is raided for legal ways to tweak the figures and introduce a bit of colour into an increasingly pallid-looking set of financial reports.
I am not talking about Enron or WorldCom. This familiar story, carefully read, applies to none other than our very own CGNU. Britain's biggest life insurer is not, of course, under any suspicion of wrongdoing or illegality, nor would I suggest it intended anything of the sort. Everything this life company has done is not only legal, it is respectable within the life insurance world. It is accepted practice among senior life insurance practitioners and allowed by the regulator. That is the whole problem.
When CGNU confirmed that it had counted £2bn pounds of future profits as a current asset, it admitted that the move had a beneficial effect on its free-asset ratio. Of course, that could only help it distribute products through the regrettably large number of IFAs who do not bother to look beyond this extremely malleable measure of financial strength. But it could also point out that this is quite a normal procedure in the life insurance world and nothing to fuss about. CGNU even justified it by saying the solvency requirements on life insurers can make the financial position look worse than it really is.
So this sort of made up for its decision to use the future profits tweak – a bizarre argument. If the regime makes the finances look worse than they really are, that must also be the case in the good times when the FTSE is riding high. In those times, every life insurer looks robustly healthy without the help of any financial cosmetics. So why use them now, when the market is down, if not to downplay the impact of the market slump?
But let us not be unfair on CGNU just because it is the biggest. A recent study by the University of Nottingham showed that 11 of the UK's 20 biggest life insurers count future profits as a current asset in their latest returns to the FSA, thus boosting their free-asset ratio. This is nonsense. By counting in future profits, life insurers are pretending they can predict and rely on a profit stream from the policies currently on their books. But anyone who has ever examined the regulator's persistency figures knows how many clients lapse or surrender policies after divorce, unemployment, illness and so on. The profits are neither predictable nor reliable. Counting profits as a current asset is spurious, to say the least. The fact that it is legal speaks volumes about the inadequacy of the law and very little about the ethics of the practice.
Of course, there are a number of other common tweaks (to put it delicately) which are also perfectly legal. Equitable Life pulled off one of them – financial reinsurance. This is where you get some of the liability off your balance sheet by paying a premium to a reinsurer to take on the risks. The trouble is that it is quite possible to get the liability off your balance sheet without really transferring the risk. So although the free-asset ratio looks a bit more robust, the company's financial position will be just as bad if things go wrong.
How ironic, then, that at a time when fears about aggressive accounting practices have dented financial markets more than the worst terrorist atrocity we have ever seen, these practices are blithely allowed. The incentive to tweak like this is clear – there are plenty of IFAs out there without the time or research budgets to do a more thorough financial healthcheck and who rely on the free-asset ratio as their only measure of financial strength. For the life office, the logic is simple – the bigger the free-asset ratio, the more policies that will be sold.
The FSA actually reviewed the use of future profits as an asset in life office returns. Its conclusion came out in May. With the toughness we have come to expect from the FSA, it concluded the practice is perfectly acceptable.
Surely, in these choppy markets, there can be few more important questions when buying an investment than the financial strength of the life insurer issuing it? Yet the use of these accounting practices robs even the most conscientious IFAs of any simple method of measuring that. Is this problem going to be addressed? The Sandler review – supposedly the Government's big attempt to make financial services focus on the consumer – barely touches on this.
Who are we consumers to argue? Why should we want a reliable measure of the financial state of the company looking after our life savings? Per=haps the regulators and Treasury, like some in the actuarial profession, are still stuck in an old-fashioned paternalistic mindset. It is not desirable for millions of us ignorant customers to know the truth about financial strength. It would only cause unnecessary panic.
If we need a crackdown on aggressive accounting practices in the UK, we need it most of all in the life insurance sector. These practices may be legal but should they be?
Andrew Verity is personal finance corresondent at the BBC