Life assurance companies are very vulnerable when markets perform poorly, because of the types of financial services products they sell. In extreme circumstances, as in the case of Fedsure, markets can lead to the failure of a company, particularly when unwise investments decisions have been made.
Last week the life assurance industry under its representative organisation, the Life Offices' Association (LOA), held its first annual convention. The focus of the convention was on life assurers being able to pay you out when your benefits become due.
Policyholders are protected by two types of regulations. They are:
- Prudential regulation. This is essentially the ability of life assurance companies to pay out benefits, whether as proceeds from an investment policy or a risk policy (against death or disability). On this front, the law and regulations are fairly well developed;
- Market conduct regulation. This is the protection you receive that you will not be sold a product that does not meet your needs or reasonable expectations. Here the law has been fairly weak, but was improved by the introduction of the Policyholder Protection Rules two years ago, and will be significantly improved when the Financial Advisory and Intermediary Services Act comes into full force early next year.
Although the average policyholder only really comes into contact with market conduct regulations, prudential regulations are just as important.
Prudential regulation failure can be just as severe as the failure of market conduct regulation. You need only ask the policyholders of Fedsure, the life assurer that disappeared because of prudential governance problems.
If there was no prudential regulation, policyholders would face greater risks, as a life assurer could more easily go bankrupt, and the assurer would not pay out benefits.
Prudential regulation is complex and extensive. Much of it centres on life assurers being able to properly assess their assets and their liabilities (how much they will have to pay out in benefits in the future).
Life assurers hold assets in two ways. These are:
- Policyholder assets. This is the money that you pay in premiums and is invested on your behalf to pay out your benefits when these are due, and to provide profits for shareholders.
- Shareholder assets. These are the investments that shareholders make, which are essentially used to finance the running of the organisation and, in the case of life assurance companies, to pay out to policyholders if something goes wrong with the policyholder assets (for example, if the value of the policyholder assets is dramatically reduced because of poor investment performance).
It is very difficult to work out all the figures, because actuaries (the expert number crunchers responsible for such calculations) must take account of how investment markets will change in the future and when they expect liabilities will be paid out. They must also estimate how many people will die each year and the benefits that will need to be paid.
In order to make sure your life assurance company stays solvent, it has to hold what are called capital adequacy requirements, which are set down by regulation but differ from company to company, depending on the type of assets it holds and the type of business it does (for example, if policyholders are provided with a lot of guarantees). If a life assurance company holds a lot of equities, which are more volatile than cash investments, then the capital adequacy requirements are higher.
The past 12 months have been very difficult for life assurance companies because of fluctuating investment markets. These problems were dealt with at the LOA convention by a number of speakers, both from Britain and South Africa.
In Britain, where investment markets have been far harder hit than here, the life assurance companies have been sweating blood. The regulators there have had to change the way they assess capital adequacy requirements to prevent companies going bankrupt.
In South Africa the regulator, the Financial Services Board, is also having another look at capital adequacy requirements, mainly because of the virtual collapse of Fedsure.
Falling investment markets have impacted on all investors but have caused particular concern for life assurance companies because of policies where there are guarantees given on both capital and some growth. In the main, these are policies where your capital and some growth (up to 4.5 percent) is provided. Most of these guarantees are on smoothed or stable bonus policies and annuities.
The problem has been that while the liabilities have stayed the same (that is, the guarantees) the value of the underlying assets (mainly held in shares) has fallen.
The results have included:
- Returns on "with-profit" policies (which are paid out as bonuses) have dropped significantly and can be expected to stay low into the future, unless there is a significant improvement in investment markets.
- Capital adequacy requirements have increased because your life assurance company must hold assets (both policyholder and shareholder) that will meet the liabilities. So if the value of the assets drop, the companies have to find more money to cover those liabilities.
Peter Clark, the immediate past president of the Institute of Actuaries in Britain and an adviser to the British regulator, says the effect of falling investment markets has been so severe in Britain that life assurers have stopped selling guaranteed "with profit" policies and have been selling equities and transferring the money into cash. They have done this because when equities are taken into account for reserves, they are given a lower value than cash, because equities can and do often lose value over short periods.
However, selling equities also has its consequences because they are being sold at a "loss" under poor market conditions and there will be a further opportunity "loss" when equity markets recover. Also, the selling of equities has other spin-offs, including forcing equity prices to decline even further. So your investment returns in the future could be decidedly lower.
Roddy Sparks, the chief executive of Old Mutual in South Africa, spoke at the convention about the need for regulators to take a new look at the way capital adequacy requirements are met in South Africa, pointing out that the assessment of how much capital is enough does not take account of all the ways in which assets and liabilities can be assessed, or even the development of new investment strategies, such as using derivative markets to protect value.
In an interview this week, Sparks however was quick to emphasise that the problems in South Africa were not nearly as bad as they have been in Britain, with Fedsure being the one exception.
He is emphatic that no major life assurance company is contemplating closing down its "with profit" and guaranteed business.
However, some have closed specific portfolios to new business, and he says a new look has to be taken at pricing guarantees correctly. In the past, mainly because of high inflation rates, policyholders have paid very little for guarantees. Now guarantees are being better costed.
Sparks says local policyholders and life assurance companies in South Africa are in better shape for a number of reasons, including:
- The JSE Securities Exchange did not hit the improbable highs of foreign equity markets and did not fall to the same extent;
- Life assurance companies in South Africa have a much sounder process of balancing assets and liabilities, including keeping policyholder and shareholder assets separate (the one exception was Fedsure). This separation enables the assets to be structured in different ways, and an appropriate level of cash to be held in the shareholder funds. So, shareholder funds can be structured so that they have the stability provided by non-equity investments, while policyholders with a higher equity exposure get the full upside of the average long-term better performance of equities.
- Inflation. Inflation works in the life assurer's favour because in real terms (after inflation has been deducted) the guarantee is reducing in value. For example, if you have six percent inflation and growth of four percent is guaranteed, it is easier to meet the guarantees than when inflation only averages one percent or lower, as has happened in many other countries.
Sparks is optimistic that a recovery in the fortunes of companies listed on the JSE will solve what he sees as short-term problems and that "with profit" investments remain one of the best long-term investments for you.
One last note. All the main life assurance companies in South Africa have maintained reserves far in excess of the minimum of the local capital adequacy requirements.
If you are concerned about the financial stability of your life assurer, ask your financial adviser by how much the company exceeds its capital adequacy requirements. Anything over double and you should be more than secure.