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The Actuary The magazine of the Institute & Faculty of Actuaries

With-profits myth-busting

Over the past couple of years a lot has been
said and written about with-profits prod-
ucts. Much of it has been negative and, while some criticisms have a ring of truth, many are sensationalist and have no foundation.
Together with Sandler and the Financial Services Authority (FSA), the industry is soon to reinvent the with-profits concept. We should be careful when creating the new with-profits to retain what is good about the old with-profits. In particular, we should not blindly accept myths those criticisms without foundation as fact, and we should squarely bust those myths that are plainly wrong.

‘With-profits is unclear’ true
Before we start on our myth-busting campaign, it’s worth acknowledging a truth: the with-profits concept is unclear.
Recent research shows that even after all the press coverage of 2002, consumers have little understanding of the workings of the product, especially when it comes to the concepts of smoothing or market value adjustment (MVA). Some consumers apparently believe the name ‘with-profits’ means ‘it was more likely the product would make a profit than putting money in a savings account’.
If the industry had clearly described the product, consumers would surely have had a better understanding than this. Raising standards of selling is certainly a step in the right direction, but providers and intermediaries should continue to make sure their customers understand with-profits. As we shall see, lack of understanding can lead to all sorts of myths.

‘With-profits is unfair’ myth
Accusations of unfairness fall in many areas, and in nearly all cases are unjust.
– Pooling is unfair Here we begin to see the importance of customers understanding the products they buy. The concept of some members giving up money after especially good returns to aid those leaving the fund in poor years is central to with-profits. If people understand this is the deal before signing on the dotted line, they cannot really complain it is unfair later. Would they complain if they had to surrender in lean years?
– Exposure to other losses is unfair Accusations of unfairness would also have been avoided by consumers having a better understanding of this aspect of the with-profits concept. Upon signing up, if investors wanted to participate in the profits of a provider’s businesses, then it’s reasonable to expect the losses too.
Complaints often focus on the use of inherited estates to pay mis-selling fines. Critics may suggest shareholders take all the profits and policyholders suffer all losses if the fines are levied on the estate, but the implicit assumption here is that ownership of the estate is solely by the policyholders. There is simply not enough information available to determine fairness.
To a certain extent, the point is academic. Sandler’s proposals for ‘charges minus expenses’ remove any exposure to profits or losses from other businesses, although mutual companies will have to do some thinking about policyholder rights.
– Discretion is unfair No matter how well customers understand with-profits, the need for discretion means the main work of the actuary is hidden from the man in the street. The consumer just sees the insurance company, and not the actuary working on their behalf (and their behalf alone). Unfortunately, pensions scandals, claim mishandling, and other criticisms against insurance companies tar actuaries with the same brush.
Critics point to a conflict of interest between responsibilities to shareholders and policyholders when actuaries also hold executive positions in proprietary companies. But there is little evidence of actions being taken favouring shareholders over policyholders. Should we really allow people to say discretion is unfair? Discretion requires trust, and trust should be earned, but is the current mistrust of actuaries justified?
– MVAs are unfair Actuaries determine the application and level of MVAs using their judgement and experience judgement and experience that most critics don’t have. Yes, MVAs are unpleasant for policyholders, but that doesn’t make them necessarily unfair.
Policies of keeping payment values within a certain percentage of (unsmoothed) asset value mean that while MVAs could be large, the result is broadly the same for all policyholders and thus fair. In fact, for Prudential’s with-profits bondholders, the average MVA is not excessive (see table 1).
However, one element of the argument claiming MVAs are unfair certainly seems true:
Companies defend MVRs [market value reductions” as necessary to stop smart policyholders making an easy profit at the expense of the remaining policyholders. There may well be entrepreneurs who would take advantage of this flaw in with profits operations. But stopping them means that companies are also penalising the large numbers of policyholders who genuinely want to surrender or transfer or other reasons. (John Chapman, GMFS special report ‘Should with-profits be closed down?’, July 2001)
– Early surrenders unfairly pay for bigger maturities The Tillinghast Towers-Perrin survey in the summer of 2001 noted that early surrenders and transfers of 25-year policies averaged 90% of asset share while maturities ranged from 103% to 110% of asset share. This is cited as especially unfair because most policyholders do not hold products for their full term.
It is undoubtedly unfair when it happens. It is not, however, endemic. Companies that do not follow this practice should not tolerate the myth that this is an industry-wide problem, and would do well to advertise their approaches.
‘The with-profits concept is flawed’
myth (for the moment)
Smoothing is of little value. At the time of writing equities are seriously depressed. The asset shares of with-profits funds are consequently also deflated, yet smoothing means policy values have been much less affected than the stockmarket. Figure 1 shows prudence bond values in comparison to building society and UK equity performance.
Although the prudence bond fund benefits from a wide asset mix and good fund management, smoothing is playing a part in keeping the pale blue bars above the red and black lines. This is a great comfort to those holding a bond that comfort is of value for the customer.
– Adverse selection means smoothing is unsustainable In theory, whenever we have the situation where smoothed values are above fully exposed values, consumers would all cash in their policies. Providers would be forced to apply MVAs right up to the asset share level, and with-profits funds would become nothing more than managed unit-linked funds.
Thankfully for with-profits, theory and practice are not the same, partly because investors are in for the medium to long term, not the short term.
Figure 2 shows full and part surrenders for the prudence bond since January 2000. There is no obvious link to the ups and downs of the stockmarket. Indeed, peaks in November, March, and May seem more connected to a need for money for Christmas, Easter, and summer holidays than anything else.
So adverse selection has not been a problem for ten years at least how sustainable do critics want the smoothing concept to be?
– There is no with-profits outside the UK (so it can’t be a valid concept) Do people who say this think fish and chips shops should be closed down? Despite entering a global market, UK consumers may well differ from those in other countries in their attitude to risk and desire to manage their own finances/investments.

‘There are alternatives that are better than with-profits’ myth?
Alternatives vary, depending on the product discussed. Advocates of with-profits have much work to do to defend the full range of products, but here are some examples concerning with-profits bonds. Criticisms vary from plainly wrong to possibly valid, especially when you pause to consider what ‘better’ means.
– With-profits bonds cost more than unit trusts Comparing charges without performance is not a particularly good measure of ‘better’, so this criticism is not well thought out. Worse still, it is plainly wrong. FSA comparative tables for insurance bonds and ISAs are directly comparable for premiums of £5,000. Care needs to be taken in splitting with-profits from other bonds, and tracker ISAs from other ISAs.
Figure 3, using data from the FSA tables in August 2002, clearly shows with-profits bonds are roughly the same cost as trackers over ten years.
– With-profits bond commission is higher than that on unit trusts ‘An adviser can get commission of up to 6% or 7% for selling a with-profits bond compared with possibly 3% for the sale of a unit trust with a similar underlying strategy’ (Deborah Hargreaves, Serious Money ‘Blunderball’, Financial Times, 12 January 2002).
Deborah Hargreaves conveniently forgets that most unit trusts have trail commission too. It is true that commission paid on a unit trust will be lower if surrender occurs before the end of year seven.
However, the vast majority (over 73%) of Prudential Bond policyholders retain their investment for seven whole years or more.
Other providers may find similar statistics to disprove this myth.