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The Actuary The magazine of the Institute & Faculty of Actuaries

No future for with-profits

With-profits investing has no place in a modern market for investment products. I am not describing a perfect world in which all consumers are well-informed and act rationally, but one in which they can easily inform themselves and are protected against agents systematically exploiting information advantages. This is a marketplace objective which government, regulators, consumer groups, and the Association of British Insurers (ABI) all share.
Even with the FSA’s reforms currently under consultation, products based on the with-profits concept will not meet these market criteria for two reasons:
– The likely return paths and outcomes relative to alternatives cannot be described without fuelling unrealistic expectations.
– The information disadvantage is inherent in the trade-off the customer makes against the promised benefits of smoothing.
At the heart of the problem is an unscientific assumption about how smoothing transforms investment risk, on which the with-profits sales pitch is totally dependent. That this assumption has survived the FSA’s long review process and the Sandler review reflects poorly on the Life Board and actuaries working in or consulting to life insurers.

The changing face of with-profits
In any discussion of with-profits it is helpful to differentiate between the types of contract. I prefer to do so using four contract types two old and two new.
Most of the problems consumers and life insurers have had so far relate to type 1 funds because guarantees make marketing and managing a with-profits business tricky. From a management point of view, some of the weakest aspects of type 1 policies were addressed by type 2 unitised policies. However, most investors, and even many financial advisers, never grasped the implications for guarantees.
It is the remaining ugly features of both policy types that were supposed to be addressed by the blueprints from actuaries, the FSA, and Sandler. Other than governance issues, the key is setting limits possibly only discretionary on the scale of the smoothing pool in both reformed type 3 and any type 4 contracts.

Smooth talking
The sales pitch for with-profits has adapted with changing consumer needs, but has always included smoothing. Claims to reduce risk might refer to smoothing the path of returns or smoothing policy payouts at maturity. The distinction is important.
Unless liquidity is provided during the life of the policy at smoothed asset share, so that policyholders can turn notional values into cash, claims to reduce the volatility of returns along the way are a deception: cosmetic not real. No such liquidity has been provided in the past and a huge question mark exists over its future availability. The persistence of the deception in sales literature points to the dominance of marketing departments over the intellectual rigour of actuaries.
As with-profits turned themselves from bond funds to ‘real asset’ funds, better suited to our inflation experience, the riskier asset mix did at least confer some genuine value on the cushioning effect of smoothing maturity values. Reserves could be used to slow the rate of decline in maturing policy payouts during a bear market phase. Although this was the only realistic benefit of smoothing, it was not trumpeted as smoothing the path of returns, perhaps because it focused attention on outcome risk, which might hinder the sale. Neither would marketing departments want to drag into the sales pitch ‘active manager risk’, although smoothing relative returns has been a significant use of reserves. Marketing rewards tempted life insurers to keep payout performance above average, even when their asset share performance was below average. Before tracker funds existed this was great for investors, but should have rung alarm bells with actuaries.
Even smoothing market volatility at maturity involved an element of deception. Providing any significant cushion relied on the surrender with low payouts of most policies, although it has also come to rely on the reserves unintentionally created by inflation and the bull run in real equity and property values. This led to huge transfers of wealth between different generations of policyholders, instead of those with policies maturing a few years apart.

The liquidity issue
If consumers are to be clear about the benefits of reformed with-profits or smoothed investment funds, any claims to reduce volatility will have to be backed up by liquidity. Sandler was explicit that reformed with-profits contracts should not have a set maturity date, and some unitised funds are already open-ended. Smoothed investment funds would be open-ended. Market use is also driving this change. The use of with-profits vehicles to meet needs at specific dates, mainly mortgage repayments and pensions, is declining and the only buoyant area is ‘investment bonds’ usually sold to meet general investment needs.
The life industry and the FSA are glibly extrapolating from a history of scheduled maturities (perhaps amounting to no more than 20- of the book in a bear market run of, say, two or three years) to a new regime in which investors can test the life insurer’s liquidity at will.

The asset share conundrum
The only basis for hoping a smoothing pool will not be quickly overwhelmed relies on investors’ being kept in the dark about their asset share. Concealing this vital information runs contrary to the strategic objective of removing the agents’ information advantage. Proponents of concealment argue that revealing it would give too much advantage to consumers. If so, it underscores the point that meeting the requirement for more information is inconsistent with smoothing. The FSA has posed the asset share question in Discussion Paper 20 (which covers Sandler issues), but it has not gone as far as questioning whether disclosure and smoothing are fatally incompatible.
The information trade-off is a rotten one for consumers. For instance, after a large market fall, some traditional policies will have acquired significant time value in the embedded option represented by a floor of sum assured plus past annual bonuses. Policyholders would be disadvantaged surrendering or selling policies without valuing their option, but they cannot do so unless they know how far above the floor their asset shares are. Holders of unitised policies are also unable to make a rational judgement about penalties if they are kept in the dark about asset shares. In both cases there is a need for advice, but unfortunately the FSA has scared off independent financial advisers from giving advice that, without information, they cannot fully justify.
Life insurers may feel it is perfectly fair to enforce contract terms that perpetuate their information advantage, but it is also a huge gamble. Whether consumer confidence will take additional knocks probably boils down to a 5050 stockmarket bet. The wrong fall of the die and the confusion and suspicion that surrounded Equitable Life will break out across the industry. Life insurers will forever be handicapped in selling their own direct investment products.
Rather than wait for the die to fall, insurers who want to be sure of a future without with-profits should already be closing funds to new business and offering the option to surrender, based on a published unsmoothed asset share after appropriate charges a policyholder-determined voluntary wind-up.

Where’s the statistical case for smoothing?
To be absolutely sure investors are not misled about the smoothing side of the trade-off, any reforms must be based on thorough statistical analysis of smoothing. As far as we know, the FSA has not formally commissioned any stochastic modelling of smoothing costs and benefits under different assumptions about pool limits and different scenarios for both asset returns and consumer and agent behaviour.
Two papers by Barrie and Hibbert (available at www.barrhibb.com) are highly sceptical of the scope for reducing outcome risk, and that is on the basis of single premium investments with a fixed ten-year maturity. In the target market for reformed products, full liquidity and regular contributions are most likely. The stochastic outcomes in Barrie and Hibbert’s research reflect the fact that, even applying a random walk model of investment returns, runs of bull and bear returns are common enough to overwhelm any limited pool of smoothing capital. Privately, consulting actuaries who have modelled smoothing are also sceptical but their ties to life insurers and their fear of offending the FSA make it difficult to speak out, even as part of consultation processes.
If smoothing does not change the range of expected outcomes relative to the same underlying asset mix, will this prevent the industry’s encouraging false hopes of risk reduction? Of course not. We will actually be worse off, as the stamp of government approval for type 3 and 4 products, possibly including stakeholder status, will give added comfort to consumers.

Tomorrow’s investments
Why are we even having this debate? The investment industry can already manage assets so that outcome risks at different time horizons are fully or partially hedged, in real or nominal terms as required. We can combine risky and risk-free assets to manage path and outcome probabilities matched to personal risk tolerances. We can do it dynamically, using strategic asset allocation models that combine a ‘lifestyle’ horizon feature with responsiveness to changing market conditions. The same models can be used to plan targets, resources and risk tolerance, to manage risk along the way, and to inform people of progress against their goals. We can use trackers to avoid active-manager risk. We can sell option-based products when option features are needed. We can unbundle life cover cheaply and easily.
Packaging these different risk choices for the mass market, to combine the greatest possible scale economies of pooling with individual customisation of exposure, is not a big technical challenge. This is what life insurers should themselves be doing. Actuaries and the FSA do life insurers no favours (and set back the cause of consumer education) by pretending we just need to tweak the old perpetual motion machine so it still delivers free lunches.