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The Actuary The magazine of the Institute & Faculty of Actuaries

A red RAG to a bull?

As phase 3 of the red, amber, and green
endowment re-projection letters go out to
indicate the extent of any potential short-
fall in the maturity value of mortgage endowment policies, the life insurance industry is facing a significant challenge: predicting the likely volumes of endowment mis-selling complaints it will encounter in the months and years ahead.
Quite apart from the matter of compensating those policyholders for whom it has been proven that their policies had been mis-sold, the industry needs to know how many complaints it can expect and of vital importance when they are likely to materialise.
The problem of predicting complaint rates is far from easy to solve and the implications of getting it wrong are rising complaint backlogs and attendant FSA scrutiny. Looking at some of the numbers involved gives an idea of the scale of the problem. The most recent data, albeit dating back to 2000, shows that there were then some 11m policies to be reviewed. This may well have decreased to under 10m since then as a result of surrenders (boosted by surrenders due to upheld complaints), but by any measure the problem is enormous.

Take a look at history
What can we learn from history? Phase 1 of the three-phase endowment complaint process saw complaint rates of around 1.25% of the total UK endowment population and, although the full details are not yet known for phase 2 (which has yet to be completed), complaint rates are known to be at least two to three times those seen in phase 1. Accurate prediction of complaint rates for phase 3, which is just starting, is therefore vital for an assessment of the compensation and reserving requirements.
Higham Group’s experience of handling of complaints tells us that the size of the shortfall which is forecast has historically been by some way the largest significant factor in determining complaint rates. In order to achieve an accurate prediction of complaint rates, the industry must take a number of additional factors into account, not least, the timing of the dispatch of re-projection letters and press activity. Press activity can be a major determinant, as some 20% of complaints over the past year had not received a phase 2 re-projection letter as at the date of complaint.
The story is complicated further by the FSA’s recent guidance that re-projection letters should have regard to asset allocation mix a move away from the more standardised rates used in phases 1 and 2. Given the impact that size of shortfall has on complaint rates, this guidance will have a huge influence on complaint rates but it is by definition specific to each life company there is no one-size-fits-all solution.

How long is the tail?
An equally important challenge for the industry is to determine the timing of likely complaints. Policyholders do not necessarily complain immediately rather, responses are made over a lengthy period with the ‘tail’ extending to up to 12 months. There is little point arranging an increase in staff to deal with expected complaints if a better answer is to use half the staff for twice as long! There is also a danger of complacency, as complaint rates early in the reprojection exercise will appear low if no regard is had to the tail.
Conventional general insurance claims run-off techniques can be used to assess the ‘decay curve’ from phases 1 and 2, identifying those who should have complained but have yet to do so. These decay curves are notoriously difficult to forecast. For example, the Consumer Association’s Endowment Action campaign materially affected the profile of complaints in phase 2 and pulled forward many complaints. It did not, however (as has widely been assumed), materially increase complaint volumes compared with what would be expected on the basis of increased shortfalls. Once the run-off table has been established from phases 1 and 2, it can be applied to the mailing profile for phase 3.
It is also worth mentioning that the recent recovery in the stockmarket is unlikely to be the saviour that many believe. While unit-linked policies respond immediately to market recovery, the trend for with-profits policies is down for some time ahead a feature of the smoothing process which used to appear so attractive!

Levels of compensation
What then are the implications for the insurance industry’s compensation bill and reserving requirements? Based on the average compensation to date of £4,000 per complainant, we estimate £840m to £1,120m has been, or will be, paid in compensation as a result of phase 2 alone. This is over and above the compensation paid as a result of phase 1 projections. Any prediction of the cost of phase 3 would be little more than speculation at this stage, but suffice it to say that conditions for endowments have not improved dramatically the FTSE All-Share is still over 15% down on May 2002 levels (when phase 2 mailings commenced), and only 15% above the December 2002 level.
The effects of complaint uphold rates on compensation and reserving also need to be taken into consideration. Uphold rates vary from company to company depending on sales practices and the documentation retained. Commercial consideration can also have an impact. In April 2001, the FSA’s John Tiner gave guidance on complaint handling expectations after which uphold rates increased on average by some 20%. Current uphold rates should be examined rather than those from phase 1.
The industry is working hard and with considerable success in addressing the problem of endowment redress. However, there is a risk that all the good work done is endangered by a failure to achieve the accuracy of forecasting required for phase 3. Of one thing we can be sure: complaint backlogs are likely to be given the same short shrift by the FSA that we have seen to date and failure is not an option.