Insurers brace for mis-selling penalties

A host of insurers including Prudential, Pearl, and Allied Dunbar could follow Lloyds TSB in having a fat fine and a hefty compensation bill slapped down on them from the City regulator, if they are found to have mis-sold endowment mortgages to thousands of customers.

Until now, endowment mis-selling has not been taken that seriously in the City as a likely dent on profits. Unlike the pensions mis-selling scandal, which has taken 15 years to put right and cost the insurance industry £15bn, companies have taken the view that misleading customers about the potential risks of an endowment was a more confined problem and unlikely to get them into much trouble with the regulator.

But the Financial Services Authority proved on Wednesday it was serious about punishing those that have mis-sold endowments, as it imposed a £1m fine on Lloyds and told it to pay £160m compensation for the sins of its subsidiary Abbey Life.

Now the hunt was on for other companies which may find themselves having to dig deep in the corporate coffers for similar endowment mis-selling payments.

Ned Cazalet, an analyst of the life insurance sector, said: "This is a big problem and it is going to get bigger, with a lot more bad news coming from quite a lot of companies."

These days a new endowment mortgage is practically unheard of. But they used to be a huge line of business for both banks and insurance companies, with 10 million currently in operation and many more sold as widespread house buying took off in the 1970s and 1980s.

The trouble now is that three years of punishing losses on the stock market have meant that many endowments, which were invested in equities, will probably fall short of their target of paying people's home loans.

As this has become apparent in the past couple of years, complaints from customers have flooded in, prompting the FSA to look at whether customers were properly warned about the potential risks in the first place.

The débâcle has the potential to be far more serious than pensions mis-selling. The Consumers' Association believes five million endowment policyholders have a mis-selling case.

If the FSA agreed, and forced companies to pay each one £3,300, the same amount of compensation on average as Lloyds shelled out on Wednesday for Abbey Life, the bill would be more than £16bn. On top of that the industry could have to find at least another £10bn to administer the payouts.

In fact the FSA has decided to have a lighter touch to endowments on the basis that mis-selling has not been as widespread as personal pensions in the 1980s. But the regulator, which is now looking carefully at the record of 22 companies, is nevertheless gathering momentum and is expected to fire off a number of fines and compensation bills in the new year.

As the City waits nervously to find out who will be next, the feeling is that the most likely targets for endowment fines include those companies which, like Abbey Life, in the past had armies of salesmen.

They look vulnerable partly because direct salesforces typically employed particularly aggressive sales techniques and partly because the FSA has made it clear it is going after whoever sold the endowments, not the manufacturer of the products. So banks and insurers which sold endowments through independent financial advisers can breathe more of a sigh of relief than those which kept the sales process in house.

Mis-selling claims are more concentrated among policyholders whose contracts have fared the worst and these include many unit-linked endowments.

This means that companies in the hot seat over compensation probably include more sellers of unit-linked endowment mortgages than with-profits policies.

The value of so-called unit-linked policies is a complete reflection of the movements of the stock market, which has spiralled down by 40 per cent in the past three years. While many with-profits endowment policyholders have not had cause to celebrate, their policies have been slightly improved by the effect of smoothing away some of the viciousness of the slump in equities.

Unsurprisingly, all companies are keeping quiet about whether they fear the FSA will find against them, but they are beginning to indicate to analysts and shareholders that next year's set of results will include provisions for potential claims.

Prudential, which used to have a 9,000-strong direct sales force, said it was "currently talking to the FSA" about endowments it and its subsidiary, Scottish Amicable, have sold in the past. It added that while it has not reserved any more yet to pay compensation, it was "looking at making an appropriate provision".

The giant insurer, which was one of the largest perpetrators of mis-selling pensions in the 1980s, is generally thought to be a likely guilty party in the endowment problem as well. So is Pearl, owned by the Australian financial services company AMP, which also had a sprawling salesforce.

Prudential, which has sold with-profit endowments, can draw some comfort from the fact that the performance of its endowments has not been as dismal as some. By November 2002, 19 per cent of its policies fell into the category of being unlikely to pay off customers' mortgages.

The record of its rival Allied Dunbar, owned by Zurich Financial Services, is less impressive. As well as having had one of the most strident salesforces in the past, it sold large numbers of unit-linked policies.

The company admitted that only 21 per cent of policies are on track to meet expectations, while 51 per cent are actually unlikely to pay off the mortgage. A spokesman for Zurich would not comment on whether it would show in this year's results that it has made a provision for mis-selling, but said it was "constantly in dialogue" with the regulator.

Having a large number of endowment policies on your books that are set to underperform is not enough to be lumped with a massive mis-selling bill. The FSA has tried to inform consumers that just suffering a loss on your policy does not mean they have been the victim of mis-selling.

But companies know that customers in this unfortunate situation are far more likely to claim they have been mis-sold and have their policy investigated by the FSA.

This trend is set to get even worse next year, when many insurers and banks will have to send out a fresh round of letters updating endowment policyholders. They will say whether their policies are "green", meaning it is likely they will meet expectations, "amber", or "red", meaning it is unlikely the policy will yield enough.

Mr Cazalet said the news is likely to be bad. "Companies have been holding off from sending these letters out this year hoping the stock market would improve so that the numbers wouldn't look so bad. But in fact they have gone into the third year of negative returns, which will only increase the consumerist pressure for compensation, " he said.