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The Actuary The magazine of the Institute & Faculty of Actuaries

The inherited estate in the 21st century

The inherited estate can simplistically be defined as the excess of a life office’s assets over those required to meet the reasonable expectations of existing policyholders. While there remains legal uncertainty regarding the definition of policyholders’ reasonable expectations (PRE), within the actuarial profession there is broad agreement that for with-profits business they should be based on asset shares. Of course, there remains actuarial discretion in the calculation of these asset shares.
The estate could have accumulated from a number of possible sources, such as shareholder capital injections, capital gains on equities prior to efficient terminal bonus distribution systems, undistributed surrender profits, or prudence in past distribution policy, for example as a result of caution during the early years of equity investment.

The 20th century
The alternative and unfashionable ‘orphan estate’ name-tag suggests no evident ‘parent’ of these assets. However, in the 1990s a number of successful attributions were achieved with the agreement of the supervisory authority, formally allocating the estate between policyholder and shareholder interests.

Successful attributions
1991 London & Manchester (April)
1995 United Friendly (February)
Legal & General (November)
1996 Pearl (July), Refuge (August)
1997 Britannic (February)
In February 1995 (with its agreement to the United Friendly case) the DTI issued a formal statement outlining its approach to ensuring the fulfilment of PRE under such circumstances. The key elements were that the proportions of policyholder and shareholder interests should be unaffected by whether the surplus has been distributed, and that in a 90:10 with-profits fund the DTI would expect this ratio to be used as the basis of attribution ‘unless there was clear evidence that a different proportion was appropriate in respect of the surplus arising from some particular part of the business’.
The implication is that where there is ‘clear evidence’ of the application of the 90:10 ratio, for example in the articles of association, this ratio should apply not only to surplus actually declared, but also to undeclared surplus: the inherited estate.
Most of the cases in which attributions were successfully agreed involved industrial branch business. The estate could largely be traced back to surpluses arising when only non-profit business was sold and where, when with-profit contracts were introduced, directors had considerable discretion regarding surplus participation. Cases were facilitated by the lack of reference to the allocation of profits within the company’s articles.
Effectively, the surplus now being attributed was considered to have arisen at a time when the shareholders had 100% participation rights. However, in all but one case a special policyholder bonus was paid from the estate, which would have been in excess of PRE and could be considered as a sweetener to the deal.
In all examples to date, the shareholder entitlement has remained ‘locked in’ under various rules: the shareholder can normally participate in investment earnings on its share of the estate, but has not (yet) been able to invest the capital directly elsewhere. As would be expected, the requirement to retain capital within the business, for example to support bonus smoothing and investment freedom, is a vital consideration, and financial modelling has played a key part in attribution exercises.

A question of ownership
The question of who should become the beneficiary of any inherited estate is unsurprisingly one which has proved difficult for actuaries to answer definitively. An Institute working party reported in 1996 that they were broadly agreed on how to quantify the estate and that creation of future estate should be avoided, but could not draw conclusions on ownership opinions differed widely.
If the estate has largely arisen from contributions from policyholders who are no longer active, then it is clearly not practical to distribute to that class, but is it equitable to distribute it all to current policyholders?
A working party established in 1989 concluded that entitlement to the estate does not normally form part of PRE. But have the successful attributions and precedents set by demutualisations across the financial sector led to the expectation of a special one-off policyholder bonus?
And do not shareholders also have expectations, which may or may not be considered reasonable, but would be likely to include an expectation that directors would endeavour to maximise shareholder value within the normal constraints?
Happy new millennium
The flurry of mid-1990s activity dried up after all the ‘easy hits’ had been secured, leaving vast quantities of inherited estate remaining within with-profit funds without formal attribution, apparently securely locked behind the 90:10 gates.
Then in November 1999 there was an announcement that AXA was in discussion with the FSA regarding the attribution of £2.2bn inherited estate. According to press reports, its first proposal, which would have allocated £1.8bn to shareholders, was rejected but a revised proposal was being formulated which reduced the shareholder allocation to £1.5bn. Given that the with-profits fund in which the estate sits is a strictly 90:10 fund, the proposal appeared to be a direct challenge to the stance taken by the supervisory authority to date.
The announcement put the topic back into the public eye. Inherited estate articles have been appearing regularly in the financial press. In February, the Financial Times highlighted a report prepared by Schroders which estimated a total of £20bn of orphan estate sitting in UK life offices, provocatively referred to in the article as ‘the billions that are stashed away’.
In March this year the Faculty and Institute of Actuaries issued a profession position statement giving more weight to shareholder interests than the then understood stance of the regulators. The Government Actuary responded publicly by expressing disappointment with the balance of the statement and stated his continued support of the DTI’s 90:10 approach. The position statement is believed to be under review at present, having elicited numerous views which may prove difficult to reconcile.
A further angle then emerged in the form of Lord Joffe, a staunch supporter of consumer rights, who proposed an amendment to the Financial Services and Markets Bill which would require with-profits policyholders to have direct representation on the boards of life companies. Initially prompted by concern at Prudential’s use of inherited estate to cover pensions mis-selling compensation, his motivation was to enable policyholders to intervene in decisions which affect their funds, including the attribution of inherited estate. Although withdrawn in the House of Lords, the issue will now be considered in the context of the company law review currently being carried out by the DTI.
The environment in which the insurance industry operates has experienced an increasing swing towards consumer power. With the transfer of supervision to the FSA and its mission to focus on consumer interests, there may have been some expectation that the FSA would be more hostile towards shareholder attribution than the DTI.
The AXA deal
In July, however, the details of AXA’s proposal were announced, together with a statement from the FSA indicating that it did not object to the proposals being put to the policyholders, that it believed them to take policyholders’ interests into account, and that the value of the offer ‘was within a reasonable range’. Broadly, each eligible with-profits policyholder is able to vote either to take a windfall share of the inherited estate now and to renounce any further interest, or to gamble by retaining an interest in the remainder of the estate which may or may not pay out a windfall gain in future. Or as Ned Cazalet put it, those opting for the cash are going for jam today rather than the faint possibility of more jam tomorrow. The interesting point is that the maximum attribution to the policyholders is 31% of the total pre-tax inherited estate, which may be of the order of 40% of the post-tax figure, depending on the tax efficiency of the deal structure. The substantial discount to the 90% figure previously mooted by the DTI seemingly reflects the stringent conditions agreed with the FSA as to the eventual release of the inherited estate there will be considerable interest in the assumptions justifying the discount.
At the time of writing AXA was confident of securing the minimum 35% vote required to implement the scheme on behalf of the ‘yes’ voters, pending court approval at the November hearing. With the FSA giving support to the proposal, the only challenge may be from the Consumers’ Association, which have taken on the cause of those policyholders who feel somewhat short-changed.
The success of the proposal remains to be judged, but what was previously seen as the greatest hurdle regulatory approval appears to have been successfully negotiated. This must now open up opportunities for similar approaches, even if they cannot be structured exactly in the AXA mould. For example, Prudential has been in on/off discussions with the regulators since 1995 over its estimated £8bn estate; a successful attribution could have a significant impact on its share price.

The way forward
In the present environment of increasing pressure to provide consumer clarity while balancing commercial pressure to enhance shareholder value, it remains to be seen what 2001 has in store for the inherited estate debate. Whatever emerges, we should not lose sight of that fact that clarity should apply equally to communications to shareholders as to policyholders, and it must ultimately be in everyone’s best interests to resolve attribution issues at the earliest opportunity.