In the outcry over with-profits policies, both the ABI and the FSA have to be seen to be paying attention. So, they have been calling for the industry to make sure it is giving customers “clear explanations of how with-profits works”.
To all those conscientious IFAs who want to respond to this – good luck.
After all, even the Office of Fair Trading does not appear to understand with-profits. In a recent exchange of letters, it questioned Equitable Life's decision to levy a 10 per cent exit penalty. Equitable wrote back saying that, actually, by surrendering early, policyholders were breaking a contract – typically a 25-year one. That was what enabled it to insert a clause in the small print of its policies giving it “absolute discretion” over surrender values.
The OFT replied saying it did not find the level of the 10 per cent penalty unfair but was concerned about this “absolute discretion” clause.
According to its spokesman, in theory, there was nothing to stop a life insurer from paying back absolutely nothing on early surrender. The OFT warned it might use its powers under the Unfair Terms in Consumer Contracts Regulations to force Equitable to change this clause.
Does the OFT know what it is messing with? If it does find this level of discretion unfair, it is attacking not just Equitable but the entire industry. Almost every life insurer has a clause along these lines in its with-profits policies. It is simply a way of asserting the right to apply a market value adjustment.
But how many of the millions who hold with-profits policies know that, on early surrender, they are so completely at the mercy of the life insurer and could, at least in theory, get nothing back?
Discretion, as the Institute of Actuaries said in a major report last week, is the most fundamental feature of with-profits. It is what allows actuaries to smooth their returns each year and generally look after their policyholders.
The trouble is, that discretion has repeatedly been abused. Actuaries have used it to make policyholders pay for their mistakes rather than have to face the wrath of shareholders (for example, the use of life fund surpluses to pay compensation for pension misselling).
If actuaries are over-generous through the years, then policyholders will eventually pay (Equitable Life). And if they underpay for years, policyholders cannot “reasonably expect” to get more than a small share of the resulting surplus (Axa).
Because surrender values on with-profits policies are so poor, the only time smoothing will really help investors is when their policies are maturing. If it is a pension policy, that smoothing effect can be replicated in a unit-linked contract by lifestyle switching from equities to safer investments in the run-up to maturity (just as soothing as smoothing).
As an argument for with-profits versus unit-linked investments, the smoothing effect is weak. With-profits is meant to be less risky than unit-linking. But many life insurers are so terrified of constraining their investment freedom that they are paying less and less in the form of guaranteed annual or reversionary bonuses. Even the mighty Standard Life has scrapped a guarantee of minimum returns on with-profits policies of 4 per cent a year so it will not have to reserve for it with safer investments that might hamper its investment performance.
Across the industry, more and more of an investor's return is tentatively promised, rather than guaranteed, in the form of a terminal bonus. So it is the policyholder, not the life insurer, who bears the risk that poor stockmarket performance might damage returns.
Indeed, life insurers are off-loading risks on to policyholders to such an extent that you wonder whether IFAs can still be justified in saying that with-profits investments are less risky than other investments. Not only is a much bigger part of the policyholder's investment at risk of a stockmarket slump because of the shift from annual to terminal bonus but with-profits policies also contain a big element of what might be called lifestyle risk.
Are they really suitable for a young woman who may wish to start a family in a few years or a young man in an insecure job? If they are lucky, the life insurer may give good surrender values. But if it runs into financial trouble, it will use its “discretion” to give lower ones.
We know from regulatory statistics that, after four years, 30 per cent of regular-premium policies are surrendered or lapsed. As well as being more and more vulnerable to a stockmarket crash, and as vulnerable as ever to lifestyle risk, we now know there is a big additional risk in with-profits policies – the risk that the actuary will make a dreadful blunder.
What Equitable's example serves to demonstrate is that actuaries' discretion, far from reducing risks for policyholders, can serve to increase them. If the FSA really wants to make with-profits policies transparent, it should force life insurers to make it absolutely clear that with-profits can also mean with losses.