With-profits industry fears for its future under new regime

The prospect of a serious shake-up of the with-profits industry increased this week when the Financial Services Authority fired off another paper calling for far greater clarity on the terms and conditions of the notoriously opaque products.

This is the latest in a series of public criticisms by the FSA of the multibillion-pound with-profits industry and added to insurers' fears that they are soon to be bounced into reforms that could make the business uncompetitive and unprofitable.

The official line from the Association of British Insurers is that it welcomes the FSA's views on with-profits, which account for nearly half of all life insurance and pensions business in force. John Tiner, the managing director of the FSA, said: "Formally the industry is quite supportive and informally the industry sees the need to change to maintain consumer demand."

But Mr Tiner is aware that insurers have little choice. Consumer confidence in the industry is at one of its lowest points, following the escalating problem of underperforming with-profits mortgage endowments and the collapse of Equitable Life.

The problem with the with-profits industry is that the shortcomings which have always been there ­ that customers cannot see clearly what growth they are likely to get and how good their deals are ­ have been compounded by economic trends in the past decade. Lower interest rates and inflation, and in the past two years a 24 per cent fall in the FTSE 100, have brought with-profits bonuses down from about 15 per cent a year in the 1980s to about 4 per cent this year.

There has also been the realisation that with-profits policies must be written by life offices with rock-solid financial strength. On with-profits, companies must have enough money to underwrite guarantees they make about future pay-outs, whereas in a simple unit trust the customer invests money and then bears all the risk about what they will get back.

Equitable crashed spectacularly because it did not have enough reserves, but other life offices are feeling the pinch of the declining stock market and increasing liabilities due to problems such as guaranteed annuity contracts. According to research by Ned Cazalet, an independent life insurance analyst, the industry as a whole has gone from having £130bn of excess reserving capital in 2000 to just £30bn now.

Most insurers realise that change is necessary. As well as making their reserving policy far more prudent, insurers are trying to explain with-profits more effectively. Some companies have launched a "raising standards" initiative which is policed by the ABI and requires companies to explain definitions such as a "reversionary bonus" ­ the annual payment which is made to a customer on their with-profits policy.

Pushed by the FSA, insurers are considering bigger concessions. This week the ABI proposed that its members send customers yearly statements which shows the actual return on their money ­ which they do not receive ­ and the return they are paid through their bonuses.

Insurers have refused to send out investment return figures, preferring to keep the amount they hold back out of the public eye. Disclosing the figures will enable customers to judge whether their bonus seems fair and will allow them to compare effectively different insurers.

There are plenty of doubts from insurers about where else the FSA's with-profits reform project will go over the next two years. John Hylands, a senior actuary at the Institute of Actuaries, said: "Insurers are a little bit nervous that things could happen to make it difficult to preserve equity-style returns."

Top on their list of fears is that the regulator ­ under pressure from the former Lloyd's of London chief executive Ron Sandler, who is investigating problems with long-term savings, and the inquiry into Equitable by Lord Penrose ­ will take a knife to the structure of with-profits.

Many countries have life insurance industries which offer with-profits contracts, so called because the policyholder shares in the profits made by the company. A feature common to all policies is that the insurer "smooths" the return, so that a portion of the return is held back in good investment years to make up in part for bad years. But few systems are similar to Britain's, where companies pay reversionary bonuses ­ which accrue every year and are guaranteed ­ and terminal ones ­ paid out when the policy matures. Terminal bonuses also grow annually but can be taken away at any point up to maturity if the stock market plunges.

So far Mr Tiner has said the FSA supports the twin bonuses approach. But behind the scenes the FSA is working on changes to be introduced in 2004 under its integrated rule book for regulation of banks and insurers. Most radical of its ideas is to force insurers to guarantee not just the annual bonus but also the terminal one, on the basis that policyholders have a reasonable expectation to be paid an extra lump sum at the end.

This comes on top of the FSA's intention to tighten regulatory reporting so that insurers cannot use fancy financial work such as reinsurance contracts to underwrite the guarantees.

Insurers argue that both initiatives could have dire consequences because they might force life offices out of investments in equities and into gilts. Historically, Britain's with-profits industry has invested between 70 per cent and 80 per cent of its funds in equities. It is keen to be able to continue doing this in an attempt to make up for some of the poor returns of this decade.

While the structural and corporate governance changes seem more radical, many experts believe it will be the simple task of explaining with-profits more clearly that will transform the industry. The contracts last year performed better on average than unit trusts (see our table) and have done so for six of the past 12 years. Contrary to common suspicion, most insurers have also not held back cash which rightfully belongs to policyholders.

Mr Cazalet said: "This year will be tough for life offices. But with-profits have recently done much better than if you were directly invested in the stock market and if life offices had better consumer disclosure they would not have run into half of the difficulties that they face."