Abstract of the discussion held by the Faculty of Actuaries

The President (Mr R. S. Bowie, F.F.A.): Mr Tuley has been chief actuary at the FSA, and, prior to that, he had a lot of hands-on experience of various companies. He was one of the architects of the realistic balance sheet regime at the FSA, and in the development of the FSA's handbook on treating with-profits customers fairly.

He has been involved in numerous discussions with firms over with-profits issues, and, as his paper demonstrates, he has a lot of a practical insight into some of the real issues.

Mr P. J. Tuley, F.I.A.: I start the paper by saying I feel that we should talk more about what treating customers fairly (TCF) means. We are central to many of the management actions that are modelled, that are planned and indeed that are taken in reality. Yet where are we in defining TCF?

There is something of a shortage of more up-to-date papers or expressions of what is right and what is wrong coming from the profession. If you look at the position statements on our website, they will not give you a huge insight into how to run a with-profits fund. So, there is a lot of reliance on the FSA. There is a current FSA survey of practice across a large number of with-profits funds, and the FSA is also pressing some quite interesting questions on some of the mutuals as to how they are running their businesses.

Is this not something that we should be grasping as a profession and leading on, rather than leaving it to the regulator?

The second issue is where we have got to as a profession in terms of the structures we work within. In my paper, I suggest the with-profits fund should be run and viewed as a separate commercial entity fighting its own corner, very much dealing with its stakeholders as, indeed, they deal with it, on a third party basis.

Where does that leave the with-profits actuary who often might have a wide range of responsibilities, might need further support, and does not always have a very clear-cut role with other stakeholders? Could he be backed up by the profession in terms of position statements, or are we always going to be hamstrung by our need for consensus before we come out with a position?

If all the with-profits funds were much the same, it would be a lot easier to have some pretty universal and clear-cut principles, and there would be an opportunity for us all to benchmark our actions.

Or is the reality that this is such a social, and unique, sharing of experience that you would always have complexity and a lack of comparability? I think that you have an ideal product for consumers but that product's fundamental opaqueness is going to be challenged by regulators because you cannot write down in sufficient detail what you must do in every event.

Lastly, the FSA, and indeed the Treasury Select Committee, makes great play about excess surplus. This results in the whole business of economic capital, excess surplus and what you do with it. Have we solved that? Or are we just on a pro-cyclical ride that when we have too much capital we must do something with it; when we have too little capital, we have manifestly not managed the fund well.

Finally, will management look to neutralise risks? Are we in the defined benefit scheme arena where management is looking to close down risks to stop this fund becoming a problem for the future, in whatever sense that might mean, or does the management really buy-in to what is a fairly paternalistic construct? There again, I would come back to the fact that this is a very good product for our policyholders – when run well.

Mr H. G. Pollock, F.F.A. (opening the discussion): The author has touched on the fact in his paper and in his introduction that the level of professional debate on the concepts of policyholders’ reasonable expectations and treating customers fairly has not been as prevalent in the recent past as one might expect, given the increasing interest from the regulator on the subject. That is a view that I would wholeheartedly endorse and therefore I welcome the author's paper as an excellent contribution to the debate.

It is clear that over the last 20 years asset shares have become the almost universal standard as the starting point for determining what constitutes a fair value. Indeed, the development of the target range concept, in the PS 05/1 changes to the FSA handbook, has cemented that position. The codification and publication of companies’ positions in terms of how they treat asset shares and other aspects of managing with-profits business within the PPFM is a significant move towards explaining each company's view as to what constitutes treating customers fairly. However, given the differences in practices, I think it is clear that “fair” means different things to different people.

In section 2.5 the author states that treating customers fairly is not dependent upon expectations. That is an interesting view, but one with which I am not sure I fully agree. One of the key outcomes that the FSA expects to see as a result of embedding TCF is that consumers are provided with products which perform as they have been led to expect.

By publishing what principles and practices we follow in managing with-profits funds, I think we set expectations for customers even if conditions change beyond the levels previously anticipated. Do these principles and practices not limit the extent to which a company can take action that a policyholder could reasonably consider fair? This may lead us not to be too prescriptive in the PPFM about management actions in extreme circumstances. I think therefore there is a difficult balance to be struck.

One particular issue that the author identifies as potentially not meeting TCF is the reduction in equity backing ratios in a number of funds. This seems to me to be an area where it is potentially fair and necessary to make these changes. Although such action may alter the expectations that policyholders had at the outset, it seems to me that such changes can be said to be consistent with TCF if the changes are appropriately communicated to policyholders.

In section 4 the author talks about a realistic balance sheet and the fact that it assumes a number of management actions that may not have been tested. I guess over the last 12 months the difficult market conditions have probably changed beliefs about what the range of possible actions might be in extreme conditions. However, it is interesting to speculate about whether actions modelled will actually be taken in some adverse scenarios that are perhaps not quite as extreme as has happened over the past year.

The author talks about the inherited estate in section 5. In the past year, I think the existence of estates has been useful in protecting policyholders from potentially extreme actions in reaction to market conditions. Any decisions on reattribution of the estate and early distribution of it, I think, should be viewed in the light of this recent experience. Once distributed, the protection offered by the estate is lost and the risk appetite of the fund will, potentially, have to reduce, and that will adversely affect likely investment returns. It is not clear that such a distribution is necessarily in the best interests of the policyholders.

The author also touched on the evolution of with-profits committees and with-profits actuaries. The concept of the with-profits committee and the with-profits actuary still has some way to develop. I think it is useful in ensuring that debates on these issues, at least internally, are being held more explicitly than in the past.

One area I was particularly interested in is where the author goes on to discuss charging for guarantees. I think there does appear to be a move towards more explicit charging for guarantees. Such an approach aids explanation to customers, particularly supporting one of the FSA's key TCF outcomes, but also has the added advantage of underlining the cost, and therefore the value, of the guarantee.

The author talks about setting prospective guarantee charges at a level which accords with the cost of the guarantees at outset. I think, in principle, it is difficult to argue with such an approach. But, practically and administratively, there is some value in having a degree of stability in these charges. This may be an example where it is appropriate to utilise the estate to support some degree of smoothing to maintain consistency in the level of the guarantee charge over time. This will give more certainty to the customer and is still capable of ensuring that, over time, the estate receives a fair payment in respect of the guarantees that it is supporting.

In section 8 the author talks about management actions designed to restore a particular level of economic capital as opposed to restoring regulatory solvency. He suggests that it may be argued that this is not fair. I would have thought that actions taken to restore economic capital to a level consistent with a company's risk appetite was fair and consistent with what an informed policyholder might expect. I wonder whether the author believes that this might not be fair because the risk appetite is not necessarily in the public domain or is there something else behind that assertion?

Having said that, I would agree with the author's assertion, in section 10, that fairness post abnormal times should normally involve reversion to the previous position, among other things in respect of the asset backing, subject to the solvency and capital position of the fund being acceptable.

The key here, I think, is that customers have entered the fund with a particular risk profile. While it would seem difficult to justify any unilateral reduction or increase in the equity backing ratio, if the risk profile of the fund was such that it was pushing in one direction or the other, I think it can be strongly argued that such a change is consistent with treating customers fairly. Perhaps, however, it is important to consider ways in which the risk appetite of the fund can be communicated to policyholders and their advisers in an appropriate way without implying that the current equity backing ratio is likely to be maintained in all investment scenarios.

Finally, I think the principle of the PPFM is laudable. It has required much thought to be given as to how companies manage their with-profits funds, and perhaps, more importantly, how to explain that to customers. I think it could be argued that the increase in clarity as a result of the production of PPFMs must help to address the information needs of customers, as expected by the FSA.

However, it is dangerous to be too prescriptive and the author has touched on this as well. The past year has shaken perceptions of what constitutes an extreme event. One of the beauties of with-profits has been its ability to ride out market storms. It would be unfortunate if, by codifying and prescribing practice to too large a degree, this ability was ultimately damaged. I do not think that would necessarily be in the best interests of our customers.

The President: One of the shortest sections in the paper was about communicating with policyholders.

The Financial Reporting Council's Actuarial Stakeholder Interests Working Group have indicated that the profession should design and communicate in a way that allows policyholders to understand the risks involved in products, and what their reasonable expectations might be.

Does the author have any suggestions on how we might address that concern of those stakeholders?

Mr Tuley: If you have a rather socialising paternalistic product, I suggest you axiomatically have a problem with describing it because the precise definition, the precise level of charging, is actually quite difficult to construct and get across if you have a lot of discretion to change how you do that.

I worry that there should be good communication; there should be good definition about limits to discretion and what the fund is trying to do. But I keep on coming up against this fundamental problem of how to describe uncertainty.

Dr D. J. P. Hare, F.F.A.: There were several things I want to discuss. I think PPFM as a management tool and part of the valuation documentation is definitely a good thing and has left us well placed for Solvency II in terms of assessing management actions.

Where I find it difficult, though, is when you start to then build on that and try and develop quite a tight framework of risk appetites for making discretionary decisions – effectively turning discretion into pre-defined formulaic action plans. One of the beauties of with-profits is that it can actually respond to the unforeseen as well as respond to the foreseen. PPFMs are good at clarifying how you adapt to things that you can see, and then presumably we all have suitable phrases that give us the room to do what we feel is the appropriate, fair and noble things at times which are unforeseen and might be more extreme than the norm.

It was interesting where the author said it was a rule-of-thumb that EBRs should not fall below the level of 20%–25%. But I wonder whether there needs to be several rules-of-thumb, depending on the level of guarantees that policies start with in the first place. Depending on the make-up of the liabilities, a single rule-of-thumb could lead to significant cross-subsidies between different groups of with profits policies, particularly in adverse investment conditions.

I can think of at least one company where the EBR for some business is very, very low. I am not sure that would necessarily be inappropriate for the business that they are running.

Another thing worth dwelling on is where the author talks about the fair distribution of capital, in particular the fair distribution of an estate. This is probably one of the hardest things. What is the right answer? Something will happen that will mean it is not the outcome for some people that they might have wanted. But we have a statement in paragraph 11.6.1: “The security expectation of policies is that the distribution should not reduce the expected security for the later policies beyond the current position.”

I am not sure how you would actually quantify that as you go forward. I think that is going to end up being quite dependent upon the evolution of the fund, particularly in a run-off situation, and could also be quite dependent on what happens. I think that the trouble is, when you are in a stress situation, what are your expectations for the future compared to not being in a stress situation?

When you are setting risk appetite, and you set that in one set of conditions, and then the conditions change, how do you then react? This touches on the issues of pro-cyclicality. If your risk appetite is set to withstand 1 in 200 events with a certain margin on top of that, then has your 1 in 200 events actually changed because you have another year's worth of data and a lot more extreme data, which might have been the case over the last couple of years?

In which case, what do you do about the expectations in the future of the policyholders that you are trying to keep the same as the expectations now? The beauty of the ICA approach is that it sounds very clear and analytical. The difficulty is actually trying to compute it in a unique way. I do not know if anybody has exactly the same credit spreads test; I do not know if everybody has the same swap spreads test: yet we are all calibrating to the same market out there.

We all have different approaches, I would imagine, in what to do with your stresses once you are in the position, so it will be interesting to see at the year-end who increases their credit spread stress in the light of what happened in 2008 and 2009. How extreme do those increases become, or do other people keep them constant and go through the cycle stresses?

These are huge decisions that then impact on the decisions that you make regarding with-profits management. I wonder whether you end up with anything which is tighter than the current approach where, in some cases, it may be less articulated in terms of risk appetite but is more driven by what is the right thing to do for customers just now, recognising all the inherent cross-subsidies?

Mr Tuley: First, I hope in the paper where I talked about 20%–25% EBR, I was trying to include all risky asset exposures.

Interestingly, the rule-of-thumb never works because there will be unique situations. That, of course, is the recurrent theme of with-profits. There is always somewhere a unique situation that overturns any particular rule-of-thumb.

I was putting the challenge up that if you are a policyholder and you have been told you are going into a mixed investment fund and there are guarantees, you are actually expecting both: a mixed investment fund underpinned by guarantees, not necessarily one that the investment policy slides away from you as you get closer or blast through, as it were, the guarantees.

Once the guarantees are heavily in the money, then I agree perhaps different criteria apply. I was trying to explore and put out for debate how much we are keeping our promises in the sense of how the policyholder would view what we have actually delivered. I suppose that I am always worried that it is quite easy to focus on maturity amounts, but actually a lot of the policyholders surrender and therefore some of the actions we take are quite bad for quite a number of policyholders who surrender.

It worries me that actuarial caution means we are likely to suggest a slower distribution than would otherwise seem fair to policyholders. So, instead of giving every policyholder a percentage of their asset share, say, which was actually quite typical in demutualisations, when it comes to a closed fund you are necessarily, as an actuary, concerned how this fund will work out in the future. But it would be very easy to create unknowingly, and for all the best reasons, quite a tontine effect.

A number of firms have large shareholders sitting beside these funds. If the bad event happens, it could be in the long-term future, when the fund is very small. The actual quantum of grief is also going to be quite small. Are we over-worrying about a future that, quite possibly, will happen but is not the most likely of the things we should be planning for?

Mr J. Galbraith, F.F.A.: I wondered to what extent you thought the whole concept of managing with-profits funds and TCF is now dominated by a regulatory viewpoint that is much more akin to, or derived from, a lawyer's view of the world rather than actuarial principles.

Mr Tuley: I am not sure whether it is a lawyer's view. The Treasury Select Committee, which has quite a powerful influence, it seems to me, on the FSA, had a long debate and a lot of evidence was taken as to who owns the estate in the context, mostly, of the Aviva re-attribution.

I was one of the supervisory actuaries on the Aviva case. I had no problem with the transfer of capital to future generations. Obviously, when you are looking at any transaction you would be sceptical and challenging and all the good things that actuaries always are. The theory of with-profits has always struck me as: you have inherited the capital from your predecessor; it is going on to your successors. That, for the mutuals, is still the case.

I wonder whether the current letter about Project Chrysalis which started life, as I understand it, as a question about some of the smaller mutuals – as to whether what sort of future they might have and whether they could become non-profit writers – has unfortunately come to apply to all mutuals.

To my view that is still an acceptable possibility because you are still serving your membership. I save in a building society; I do not have a problem with that sort of mutuality. I am a member of the National Trust; I do not have a problem with that mutuality. I do not quite see why I should have a problem with capital moving forward within a with-profits fund.

But I could see why the pressure from the Treasury Select Committee, and the logic of the debate with some of the smaller funds, has outgrown what perhaps should have been a more limited question to the mutual sector.

Mr P. H. Grace, F.F.A.: I wish to make a few observations, that are based on my experiences in a non-executive capacity with four separate and distinct with-profit funds, three of them the subject of demutualisation schemes in the past 15 years or so. All are effectively closed to new traditional with-profits business and three of the four are closed to any new business. I hasten to add that my comments do not necessarily reflect the experience at all four funds and mostly relate to one or other of them.

I noted several references to out-sourcing in the paper, one of them is linked to new business and thus not to a closed fund but the others can apply to a closed fund.

Firstly, in paragraph 2.8, it indicates that “out-sourcing makes a fund look less like a profit sharing entity and more like an investment fund managed at arm's length”. But I pose the question: is that necessarily to the detriment of a fund closed following a scheme of demutualisation? Many such schemes prescribe the basis of charges, perhaps subject to periodic review. This has the effect of containing costs which, if the fund had to provide the services itself, would escalate as the fund declines in size.

As regards any periodic review, the fund's with-profits committee (or independent expert performing that function) should be satisfied that the review of the charging structure has been carried out in accordance with the scheme.

I agree entirely with the comment in paragraph 5.8 that outsourcing to the shareholder gives him a duty as regards errors. I am aware of funds that have sought and received compensation in respect of errors made either directly by the shareholder or by sister companies in the group.

Paragraph 5.9 draws attention to the effect on shareholder's profits of the choice of management actions. But as mentioned elsewhere in the paper, potential management actions are spelt out in documentation, in particular the fund's PPFM. I agree with Mr Hare's observation that the PPFM is targeted not at policyholders but at the FSA and the fund's Board. Is the shareholder always aware of his commitments in this respect? Even disregarding the effects of internal reconstructions, I am aware of one fund which has had four distinct owners since it became a closed fund. The present shareholder was not involved in determining the contents of the PPFM and their implications. A due diligence exercise may or may not have made the shareholder aware of the implications of the PPFM.

Hypothecation is dealt with in paragraph 9.3, in particular that the industry has to a remarkable degree avoided hypothecation. However, I am aware of one fund where various distinct classes have had their own dedicated mix for a number of years. This has simplified the management of that fund considerably. I would add that in the case of some with-profit policies with a higher level of underlying guarantees, the EBR is below the range mentioned in the paper. In the case of another fund a substantial proportion of the fund is in respect of policies with, in the words of the paper, guarantees heavily in the money. There is no provision in the fund for hypothecation; this acts as a serious drag on the benefits payable under other policies. With input from the non-executives, the company sought to make changes to the original demutualisation scheme, including hypothecation of assets, to improve the position for those policies without such guarantees. Unfortunately, one aspect of the proposals, not specifically hypothecation, failed and the issue is currently being revisited.

Paragraph 11.7 draws attention to the need to use management actions in order to avoid the dangers of a tontine. I believe that many of the demutualisation schemes incorporated a de minimis limit, whereby, when the size of a fund reaches that limit, it is merged into other funds owned by the shareholder. In such cases management actions should not need to take into consideration the possibility of a tontine.

Paragraph 12.5 refers to the “hard coding” of certain aspects of management actions. Whilst I do not think potential actions should be written in tablets of stone, never to be altered, as a non-executive, I take comfort from the fact that management have discussed with their Board and obtained their approval to the actions that will be taken in the event of a particular scenario developing. Given the speed of change in the modern world, the alternative of waiting to see what happens before seeking Board approval is, I believe, untenable.

Mr B. J. Murray, F.F.A.: I come from a background of Scottish Life, which has gone through a number of challenging times in the past 10 or 15 years. It demutualised back in 2001 and became part of a larger mutual. We do not have any shareholders, although our parent mutual acts, in many ways, as if it was a shareholder. But there are obviously distinct differences in the risk appetite of the with-profits policyholders in that parent mutual as opposed to shareholders more generally.

I agree that it is a significant move forward to have the PPFM in place codifying what had been done for a number of years. But part of the strength of the PPFM regime is the ability not to say everything, so it is not a prescriptive set of rules that the fund must necessarily follow.

One specific example is target ranges. When target ranges were first introduced into the PPFM, there were probably a lot of companies that thought: “Asset share, that is the true measure of fairness. We must get our target ranges closely aligned to asset shares, plus or minus 10%.”

I was keen at Scottish Life to ensure that we have a fair amount of leeway for target ranges, so we had plus or minus 25%, because, to my mind, if you have a narrow range around the asset share you have effectively thrown away what was with-profits and become a unit linked contract.

The paper touches on policies where the guarantees are very heavily in the money. We have not, within the Scottish Life fund, gone to the extreme of 100% bond allocation, but it is something that is in the thinking. I agree with the author that to do so there has to be only an extremely remote chance of getting anything other than the guaranteed benefits at the end of the day.

We have generally touched on the “Dear CEO” letter that mutuals have recently received. If the letter was addressed primarily at smaller mutuals, it has hit us in an unexpected way. It is interesting that the conclusion from the “Dear CEO” letter is that the vast majority of the inherited estate should belong to with-profits policyholders.

It takes no account of the history of what has given rise to that estate. We certainly look to challenge the exact thrust of that “Dear CEO” letter as it could signal the death knell for with-profits mutuals as we see it, and that would be a shame.

Communication was touched on by a number of earlier contributors. I think if Mr Tuley believes that with-profits is a useful product for consumers then we really do have to get the communication right. So often I see policyholders write in to us and say, “What are you doing with this fund? You have given us only a quarter per cent. Did you not see that the FTSE rose by 20% over the course of 2007?”

You think, “Yes, that is right; but from 2001 to 2003 the FTSE halved.” But, again, we have the situation in 2009 that the FTSE is racing away. Trying to communicate that to policyholders is very difficult.

The topic here is management actions, and what we have agreed within the Royal London Group is we will have a ladder of different actions that will kick in at different stages. I would be interested to hear if any other offices have a similar concept that when a particular target measure gets down to this level, we will apply this action a bit further; another action, and so on.

The closed fund being part of another mutual group creates its own interesting problems in terms of equity between two different sets of with-profits policyholders. Again, we have this idea of a tontine possibly building up where, if capital is held back in the closed fund, say to cover an ICA event, then in 199 times out of 200 that will prove to be too much. In such cases, probably, most life offices will have a large book of with-profits endowments going off in the next few years. Is it fair to hold back capital from those maturing policies to cover an extreme event in the future for the others?

The President: You said that in this “Dear CEO” letter, as I understand it, the inherited estate is to “belong” to the with-profits policyholders. You then went on to say that you thought that could spell the death knell of with-profits policies. I am struggling to make that connection. It sounds to me that by having it there, effectively as a long-term source of capital to support the with-profits business, sounds like a good thing for the future of with-profits. I am missing that connection.

Mr Murray: What the letter says is, “If you are not writing sufficient volumes of with-profits business in a mutual then you must consider yourselves de facto closed to new business and go into run off unless you can use one of a number of options that are cited, perhaps coming up with a new type of with-profits. But if you do that you have to balance the interests of existing with-profits policyholders and these new with-profits policyholders, or perhaps, if you are writing significant volumes of non-profit business within a with-profits fund, you need to find a way of extracting the profits from that non-profit business in line with the run-off of your with-profits fund.”

Again, coming back to “Where did the estate come from?” if your mutual has an inherited estate that came from a prior existence as a proprietary company, for example, you might think that the capital that was brought into the mutual can be turned into a viable business for future non-profit business on a mutual basis.

Mr B. J. Duffin, F.F.A.: For the first half of my career, with-profits were driven by market pressures to a large extent. This reflected a regulatory regime that was certainly lighter in touch than we have at the moment. It was not necessarily an unmitigated success. The result of market pressure was competition for endowment payouts at 25 year maturities, persuading offices to increase their bonus levels to a very significant extent so that they could attract new business.

But that all changed very dramatically in the ‘nineties, when we swung the other way, where regulatory pressure became the dominant factor driving with-profits funds. The regulatory pressure was itself driven by political pressure, which was all about avoiding the embarrassment of any future insolvency. That was a critical change in the way with-profits funds were regarded and had to be run in future.

Most of the issues we have today concerning the decline in with-profits as a product which can be sold, or seen as attractive, come from that change in perspective. It emphasises a crucial point in this debate, which is how we should treat so many of the with-profits funds which are now actually closed and running down or are very close to that position and are certainly declining.

We can talk very easily about the dangers of a tontine when it gets to its final stages and how volatile and unfair that can be. But actually the most critical parts of all this process are the early stages when the fund is perhaps declining at 10% per annum, taking the rough with a smooth, and that process can go on for another 15 years.

What attitude should be taken to the policyholders within that fund? The regulatory pressures, as they currently stand, will force funds to be run on a very conservative basis. If they are within a proprietary structure, there will be strong pressure to avoid the risk of any burn-through which would fall back on the shareholder. So there is pressure both to run the asset management policies as conservatively as possible, and to restrain the distribution of surplus assets from that fund. This is not necessarily in the best interests of those policyholders who are exiting the fund for perfectly good reasons at this stage. But if we do not intervene to change the strategy, this is the way it is going to work out – those who exit will get perhaps half, at the most, of the distribution that they might reasonably expect if they knew exactly what was going on.

The only way this log-jam can be freed is if the regulators, the profession and the industry tackle this issue together and come up with a more appropriate regulatory approach than we have at the moment.

The profession should be able to influence not from the position of a vested interest but from the viewpoint of knowing what will happen if certain regulatory or political moves are undertaken. The profession will not ultimately call the shots on this, quite rightly, but it should be having a voice saying, “We have a problem here. We cannot solve it on our own. This is a tripartite problem. Maybe even quadripartite if you throw in the politicians as well.”

It is not going to get any easier. We have Solvency II coming down the tracks towards us which will, if nothing else changes, also force us away from what many would regard as a fair distribution of surplus assets.

Mr R. K. Sloan, F.F.A.: I would like to give an alternative view, not from someone who has taken management actions in a with-profits fund, but from one who has undertaken a lot of analysis on behalf of consumers and IFAs in analysing asset shares and generally looking at with-profits from the other side of the fence.

I would start by commenting on some of the things that have been said previously. First, I have always understood the equity backing ratio or EBR to include equities and property, in other words ‘real’ assets, and I have assumed that this is what was meant throughout the paper.

At paragraph 7.12, I was interested to see that “higher benefits” included an “improved EBR”. That seemed clearly to imply that having a higher EBR was indeed an improvement. I simply comment that that is not necessarily the case, depending on which way markets move.

This leads me on to the question of hypothecation, where I am aware that a good number of life offices have indeed, for quite a number of years, been hypothecating different asset mixes not only to broad types of policy, but to quite narrow categories of policy, for instance those with specific rates of underlying minimum guarantee. In one case the EBR varied from 21% to 60%, a significantly wide spread within this one company's existing product range.

This then leads me on to the fundamental difference, or not, between with-profits and unit-linked – note that I mean unit-linked and, not unitised, which is but a variant of with-profits. The closer one gets to having a separate asset mix for each class of policy, and the more closely the payouts follow the performance of that asset mix, then the harder it becomes to distinguish between such with-profits products and unit-linked. So, I think it is important for the with-profits industry to hold firm to its original idea of smoothing, a point I keep having to emphasise to IFAs who often try to make direct comparison with the specific underlying investment performance.

Mention was made in the paper about some closed life funds having EBRs as low as possibly 5%, which I have certainly come across. My question is whether this is always fully disclosed to policyholders. I have read all too many PPFMs, and often find difficulty in unravelling which bits apply to which particular tranche of policies. I am not aware that life offices issue separate letters thereon directed at each tranche of policyholder. However, when reading the whole document, one certainly has to go through it with a fine-tooth comb, and even then one cannot always readily determine which asset mix applies to which particular tranches of policies.

A fundamental problem with with-profits is an historic one, namely the use of bonus rates. Bonuses are usually based on the sum assured or flat sum of total prospective premiums, and thus bear little or no relationship to identifiable rates of investment return, a measure with which the public are now becoming fairly familiar. I think that a fundamental problem with a bonus rate of, say, 2% is that it is difficult to see what that means as a return on the man in the street's policy premiums. It could actually reflect quite a significant rate of return, but does not sound like it.

Of course, things have since moved on to unitised policies where each year's premiums have their own performance, which evidently comes much closer to reflecting a true rate of return.

Another point on the comparison with unit-linked, I have often found undue volatility in Market Value Reductions (MVR). In fact, I experienced this with a with-profits policy of my own where the MVR literally changed every day when I tried to accept the value quoted. If I had wanted the contract to reflect market movements from day to day, or week to week, I would have taken out not a with-profits policy by a unit-linked policy.

Another aspect of volatility on a long-term basis, as referred to by an earlier speaker, is the treatment of early leavers which I believe has been overdone. The media played a part in this by comparing the return on, say, a 15 year maturing policy with a policy surrendered 15 years through a 25 year term. This, I believe, led life companies to pay ever-closer attention to asset shares on early surrenders, which is all very well, but is not really what the policies were designed to do. My concern is that this has impacted adversely on the far more important aspect of policy guarantees at maturity which mortgage holders, and similar, were relying on to repay their loans.

Finally, I come back to the issue of policyholder communication, where I would like to see some very straightforward information, including the asset mix of their policy. I think people can understand that, in conjunction with a potted guide to the PPFM that explains how the smoothing process operates. But specific asset-mix figures are still key, particularly for closed funds, under which, as someone has mentioned, there can be frequent changes of manager whose investment policies are quite likely to be different.

So the message really is that it is difficult for policyholders and their advisers to understand where with-profits returns are coming from and how they are being expressed.

With-profits has done a great job over the last 50 years or more in providing the public with a useful, and profitable, degree of equity exposure on their savings, something they would otherwise probably not have chosen. While one can say that this is as a result of opacity, overall I think the result has been quite a good thing, which I would like to see continue.

The President: I have often wondered why, when insurance companies do the frequently asked questions on the bottom of the bonus statement, why it does not start with the question: “What is it I will get when this policy matures?” We do not know the answer to that, but we are all shy about saying we do not know. We all feel, even as actuaries, we have to play the game that somehow we know the answer, whereas in reality we do not have a clue.

A possible answer is: “We are managing the assets in this way and that means that, with a favourable wind, these things will happen.” We seem to lack self confidence to be upfront and say that.

We produce all these rules, and all the other things, and inhibit our investments in order to play this game of illusory precision. In the most unregulated of our present financial markets, hedge funds, the good hedge funds seem to be answerable to nobody except their customers and seem to be able to produce pretty satisfactory, steady returns in the 7%–9% per annum bracket. I dare say that will come to an end when they get regulated and they will be all over the place or out of business.

Mr D. Nicholson (visitor): President, you kindly invited views from a non-actuary. I have had a peripheral involvement with life assurance companies for some 50 years.

It is apparent that communication has been an issue with the actuarial profession for many, many decades. I can clearly remember a meeting of chief executives of Scottish life offices that must have been held more than 20 years ago when that very issue was being discussed and strong views were being expressed then that communication had to be improved.

Over recent years we have seen the advent of PPFMs. That is welcomed. But then we got customer-friendly PPFMs, and some even shorter versions. Mr Sloan suggested a shorter version of customer-friendly PPFMs.

There are two areas where communication to my mind is vitally important. One is the area of guarantees, and certainly there is a group of policyholders who are not aware that they are picking up the cost of guarantees which might turn out to be more costly than originally envisaged. There is a very clear need to explain to many dismayed with-profits policyholders why they suddenly find themselves with something akin to a unit-linked policy when faced with market value reductions, and how constructively to communicate better with the man in the street.

In relation to communication, I wonder whether the actuarial profession is too precise and too analytical in terms of descriptions; it seems to come out that way in PPFMs. What is needed is a customer friendly communicator. Whether that should come from the actuarial profession or some other profession is debatable. I suspect that it is a skill that is required from some other area.

Mr C. M. Murison, F.F.A. (closing the discussion): Thank you to Mr Tuley for a very clear and thought-provoking paper.

There have been a number of recurring themes from those who have contributed. I have written down: the link between treating customers fairly, the existence of PPFMs and customer-friendly versions of them, and communications.

Let us start with TCF, as it just seems central to so much of the debate that we have had. Perhaps one of the problems we have lies in the definition of TCF and what we think is fair. Whether we like it or not, the reality is firms move very much to the position where TCF means what you need to do to satisfy the FSA's view of TCF My perception is that the intervention of the regulator more than anything is going to drive the way in which companies manage this business moving forward.

As an example, Mr Murray spoke about the target payout ranges that were implemented at the end of 2005. That came in after PPFMs had been drafted. Companies probably had quite a lot of discretion available to them at that point in time. Then here was something from the FSA which forced everybody to re-visit their PPFMs and introduce some additional restrictions. So I suppose one of the questions I would pose is: given the current regulatory environment and how the world has moved on, do firms need to revisit their PPFMs at the current point in time with a closer eye on TCF and what that might mean?

A good example of that would be the degree to which you charge for guarantees within your asset shares. PPFMs generally leave companies with quite a lot of flexibility, I think, in terms of what they could do in extreme conditions. The acid test would be if your PPFM, for example, let you increase your guarantee charge to some level like 5% per annum, or maybe not even as much as that, do you think you could ever actually do that if the circumstances arose? Would the FSA actually let you do that? I suspect they probably would not. They would want to have some very difficult discussions with you and your board.

2008 was a very uncomfortable year for life companies in general. It does provide some help in this area. Which companies have gone out and back-tested the management actions that underpin the realistic balance sheet calculations and their ICA calculations? If you looked at the investment conditions that we saw in 2008, what did the management actions that underpin these calculations imply? Did you change your equity backing ratios or did you not? That is an important thing to remember. It is important to be seen to live and breathe the assumptions that you have underpinning these calculations.

One area which, in my own of reading the paper, came across quite strongly was the importance of setting risk appetite statements within your funds.

Something which has come across very clearly from the conversation is that no two with-profits funds are the same. There are some very complicated interactions between the risks and the fund. If you are going to manage your business properly, you absolutely have to have some clear risk appetite statements to go with that. I would strongly support the views of Mr Tuley within the paper around the importance of setting these.

We had some discussion on the estate distribution, the pace at which the estate should be distributed and whether or not funds that are in an estate distribution mode should be capitalised effectively to economic capital standards. By that I mean holding back enough capital to have a ruin probability of, say, 1 in 200 or something less, but certainly quite a high level. My view on that is there are some difficulties in doing that because you hold back too much capital and slow down the pace of distribution. How do you square that off the capitalisation of a with-profits fund to a 1 in 200 level with 20 years to go until its run off is complete against the fund which has actually got a reasonably limited shelf life? There are no right and wrong answers, but I do not necessarily think it is right to capitalise it to such a high level.

Many talked about the hypothecation issue, and whether or not that is a good thing and can assist with the running of the fund. From my own experience it works very successfully. I think it works successfully because we have consistently communicated the approach to policyholders. Within the paper, in section 9.3 in particular, the hypothecation aspects discussed are actually quite difficult to implement in practice. You would find it difficult to explain. It is all about how you have marketed products to policyholders, and whether you have consistently told them about the asset mixes from the point-of-sale straight through to the current point in time. Providing you have done that, yes, I think that hypothecation can work very well.

We have had a number of comments about the role of the profession and whether it could take a more active role in promoting with-profits business. I think, unquestionably, it could. Here is an area in which the actuarial profession is the renowned expert. It is not easy and anything we can be doing to get that message across is surely to be welcomed.

Mr Murray made some very valid points about the pressure to de-risk funds as soon as funds start to move into run off. There is a real risk that that could be to the long-term detriment of policyholders in terms of returns. I know it is an easy thing to do, and again it is easy for the profession to say it, but getting the sounding board is also important. Here it is about getting that message out. With-profits funds are not all about bad news under any circumstance.

Mr Sloan made some valid and interesting points about how you differentiate between with-profits business and unit-linked business. As we have seen, there has been significant restriction in the use of discretion in recent years. It is difficult to differentiate if policyholders see great fluctuations in with-profits payouts.

Interestingly, now there are two differentiators left. One is the value of the guarantees that exists in your with-profits business. It can sometimes be difficult to attach a value to that in the eyes of the policyholder. In many cases with funds in run off, the key differentiator is the distribution of the estate. If you are sitting in a fund with a reasonably high equity content, something akin to a managed fund, you might be getting a very, very good deal because you have an underpinning guarantee but even more so if you are having your asset shares enhanced from the estate. So that maybe is a key thing to be focusing on as well in terms of communications.

Finally, Mr Nicolson brought out the point about the importance of communication. Are communications on with-profits too technical? Yes, they are in many ways. It is just trying not to dumb it down to such a degree that you lose the important level of detail. It recognises the ongoing challenge that we all have in trying to make the product more understandable.

The PPFM regime is a management tool. While it has been greatly beneficial in many ways, one of the problems is that it is not about communicating with policyholders, which probably never was the FSA's intention when it came out. It is actually quite revealing if you look at the number of hits on your website for PPFMs. I suppose the associated point is that however clear you make it, how many people are really interested in it? The communication point remains a fundamental one and we should, as a profession, continue to work on that.

The President: As a profession, actuaries know that the world is very uncertain. It strikes me that is a double-edged sword. It gives us an insight that few other professions have. It also means we tend not to want to opine on something until we have ourselves narrowed down that uncertainty. I constantly hear from people in government and elsewhere from other stakeholders, that, in fact, these people are so clueless about the uncertainty involved in population statistics that they yearn for even the most basic guidance from the profession and not the level of precision that we always seem to feel that we need to get to before we will say anything.

I repeat that at the Financial Reporting Council's Actuarial Stakeholder Interests Working Group there was a huge and, for me, heart-warming, support for the profession as an organisation which really can help to lead the population to a safer place in financial services, and a plea from them that we should use our expertise wisely and not be as bashful as we appear to be about offering that guidance.

Several times Mr Duffin and others have said that this is an opportunity for the profession to show some leadership. We have learnt that if our voice is to be heard most effectively, it must be not as advocates or with any hint of vested interest but in an objective way setting out the pros and cons of different courses of action and the likely consequences of different courses of action.

I am struck by this “Dear CEO” letter as a perfect excuse for us to make representations. Otherwise, the combination of that and Solvency II is going to further constrain the freedom of financial institutions, and with-profits funds in particular.

It is my earnest hope that more and more actuaries will break free from feeling that their day job is about complying with or gaming against various regulatory bodies and instead is actually about being creative, trying to create products and reserving methods and financing that does the public good.

Despite what we may think, we are enormously trusted by the public and we should, in my view, have the confidence to say, “Nobody can tell you what it is you are going to get from this policy in 20 years’ time. We have designed it so that as you get towards the end of these 20 years we will narrow the range of outcomes in the way that life styling does in defined contribution pension schemes.” We should be much more creative with that.

Whether the with-profits fund can make a comeback or not, I am sure it is not beyond our wit to design things that are both compliant with regulations and also good for the customer.

I would like you, on behalf of the Faculty, to show your appreciation to the author, the opener and closer.