Investors urged to exit weak life companies

Investors who hold with-profits policies are being advised to check the financial strength of the life insurance company managing their money.

Those with weaker life offices are being advised to ditch the policies altogether, as insurance companies announce cuts to bonus rates and final payouts. Already this month, Friends Provident has said its with-profits policies will pay up to 20 per cent less than they did last year, while Norwich Union will pay up to 15 per cent less.

Tom McPhail, head of pensions research at Hargreaves Lansdown, says there is not enough awareness – both among advisers and investors – of how to judge whether a with-profits policy is likely to perform well.

“Retail investors need to take greater notice of the strength of financial insurers,” he urges. “We could all do with updating our expectations of what the insurance companies can deliver in terms of investment returns.”

A good way of measuring the financial strength of a life company is by looking at its free asset ratio (FAR) – which shows the ratio of assets to liabilities. The higher the FAR, the stronger the life company and the more likely it is to be able to pay out decent bonuses to its policyholders.

“Free asset ratios are the best way to see how much scope a company has for being generous or appearing mean,” notes Kevin Ryan, an insurance analyst at ING.

FARs are also particularly relevant given current market conditions. “The strong companies will be taking advantage of market opportunities as they start to emerge,” argues McPhail. In contrast, he says he would “certainly stop” giving the weaker life insurers any more money, and might be tempted to take it elsewhere.

But advisers warn that very few life companies have solid FARs. Smaller mutual societies, such as Teachers Provident and Wesleyan, tend to have robust finances. But there are few household names in the top 10 as compiled by Money Management, the FT publication. Norwich Union, Friends Provident and Legal & General are all weaker than the average, although Prudential and Royal London are above average.

However, even when taking FARs into account, it is still difficult to predict how a with-profits policy will fare because of the opaque nature of the products. Life companies use a process called “smoothing”, which holds back some of the profits in good years to pay them out in the bad years, meaning that often the payouts are determined by the actuaries and not the actual investment returns.

Final payouts can even be adjusted for marketing reasons – one criticism of the failed with-profits provider Equitable Life was that it paid bonuses that were too generous to encourage people to buy policies, only to find itself unable to meet guarantees. As a result, some advisers recommend getting out of with-profits policies altogether. However, insurance companies have been reintroducing exit penalties, known as market value reductions (MVR). Even so, many policies have MVR-free years, so policyholders are advised to check when these dates are.

Geoff Tresman, chairman of Punter Southall Financial Management, says: “We have been advising clients for a number of years to take advantage of MVRs.” He says the only exception is Prudential, which he believes made better calls on asset allocation than the other household names.