Life Offices’ Financial Strength Update

Introduction

Life offices have recently filed their FSA Returns, setting out their financial position at the end of 2004. These are a rich source of information, given added interest this year because the larger withprofits offices have had to report their Realistic Balance Sheets (RBS) for the first time. This Executive Briefing sets out Deloitte’s summary of the key data. The analysis covers all but a very few of the UK’s large with-profit funds, 40 in total. This article is based only on data in the published FSA Returns.

The UK Life sector hasn’t had a great deal to smile about in recent times, and there were plenty of gloomy predictions that the introduction of RBS reporting would be another severe blow. Happily, those predictions have proved largely unfounded. Coupled with recent announcements of improved profits and respectable new business growth by most of the main players, the picture painted in the latest FSA Returns suggests that the industry may be emerging from its recent storms. This is due in part to implementation of de-risking strategies by several companies, which should also improve stability in the years ahead. The fact that M&A activity has picked up pace in the last six months also suggests that confidence is returning – our experience is that purchasers were being put off by potential "black holes" in insurer balance sheets, but that these issues are now better understood, and such liabilities will now generally be valued properly.

The graph below shows a headline comparison of financial strength, showing how many times the required solvency standard (formerly the Required Minimum Margin, now the Capital Resources Requirement) is covered by the free assets. The average coverage used to be just under 2.75 times, but is now about 2 times. It would be wrong, however, to conclude that the industry is significantly weaker than a year ago. The more accurate interpretation is that the new CRR measure is a tougher minimum standard – as it covers the new "Twin Peaks" requirement, meaning that each fund must report on the more demanding of the old regulatory standard and the new realistic test. Our research suggests that the many offices have actually grown stronger on a like-for-like comparison with last year, so the lower ratios shown below are driven very strongly by the change in reporting rules.

The strongest offices on the new measure are Wesleyan and NFU (they were also the strongest pair last year), and they fare well in several other measures we have analysed. At the other end of the spectrum, the Sun Alliance and Royal funds fare worst, but they now have the backing of Resolution Life. Equitable Life is next in line, but its position is virtually unchanged by the new reporting requirements, indicating greater robustness than many would have expected. It is more surprising to see the Norwich Union fund at the lower end of the range.

 Of all the funds in our analysis, this one has been the most affected by the new RBS measures. In particular, that fund has a high "Cost of Guarantees" liability, meaning that underlying guarantees exceed asset shares on many of its policies. The excess amount is now provided for explicitly on the balance sheet. The second measure, see above, looks only at the realistic balance sheet. It shows the surplus assets as a percentage of the fund’s available assets, so is akin to the old "Free Asset Ratio" but on the new RBS basis. Wesleyan and NFU lead the way again, with Royal London’s Refuge fund looking particularly strong too. At the other end, several funds have no excess assets at all – but this does not mean they are insolvent –see below!

Importantly, these ratios only allow for assets held within the withprofits fund (which may in some instances incorporate some nonprofit business or loan arrangements), and ignore other assets may be available elsewhere in a Group, including for example shareholder funds. All of the funds to the left of the graph that appear to be underwater, have access to additional capital in this way, so policyholders and advisers should not assume they are (near) insolvent. However, the fact that other capital may have been excluded does not invalidate these measures. They will actually be of considerable interest to companies and shareholders and to FSA, because they give a feel for how likely it is that additional capital will have to be "called in" – for example from shareholders or subordinated debtholders, or the drawing down of contingent loans. It is interesting to note that the mutuals are generally well-placed on these measures – it is important that they are, because they have no recourse to shareholder pockets.

• Though RBS reporting is not perfect, we believe it provides a much more robust picture of an office’s financial strength than the old regulatory balance sheet alone. This should improve policyholder and investor confidence.

• Many in the industry, and the FSA itself, had expected that almost every firm’s realistic balance sheet would be weaker than their regulatory balance sheet. This has not happened – of the 40 funds, the regulatory test bites for 20 and the realistic test for 20. In other words, the realistic balance sheet position is actually stronger than the traditional one for half of the funds. We consider this is evidence that the industry’s capital position is more robust than many had thought.

• As usual, there is more to the figures than the raw data suggests. For example, the apparently weaker offices can point to additional sources of capital outside the with-profits fund. Perhaps more interestingly, the results depend on the type of management actions that are assumed in adverse scenarios, such as a large fall in equity and property values. Some offices will have assumed that all of the losses are passed to policyholders, while others will have shared the burden. There will be an intense period of analysis as companies compare their assumptions, which may lead to changes in the next round of reporting.

• Several of the funds are closed to new business. Their management teams have a difficult balancing act between retaining enough capital to cover risks, and distributing the surplus assets fairly. FSA’s new Individual Capital Assessments add an extra dimension to this problem – the outcome of these assessments will be of great interest to policyholders and shareholders alike.

• As ever, there are more challenges ahead, with companies needing to improve their realistic balance sheet processes (including how to calculate and report analysis of change), respond to FSA’s Treating Customers Fairly initiative, and cope with further significant changes in reporting at the next year-end, when FRS 27 rules come in. We believe that much of the groundwork has been done, and that firms can begin to look to the future with more confidence.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.