Life Insurers' Financial Strength

Life insurance companies' returns to Financial Services Authority (end-2002): a preliminary survey

by Chris O'Brien, Director, Centre for Risk and Insurance Studies,
Nottingham University Business School

A preliminary survey of the returns to the Financial Services Authority of the top 20 with profit life insurers1 confirms that the "free assets" of many offices have reduced. Many life insurers have been under pressure as stock markets have fallen sharply.

Chris O'Brien commented:

"Life insurer solvency has been hit by falling stock markets: the average free asset ratio fell from 9.6% in 2001 to 6.6% in 2002 (it was 22.5% in 1999) [these ratios are before the required solvency margin].

"However, the rules require the calculations to be on a prudent basis; "true" financial strength will be greater; and it should help when FSA has completed its work on a "realistic balance sheet" for life insurers.

"The current figures are boosted by over £11 billion of what FSA calls "financial engineering"; while this raises some issues, it can also stabilise funds and improve policyholder security."

The survey covers the 20 top with profit companies1. It shows that, at the end of 2002, the average free assets ratio2 was lower than in 2001. However, all these companies had more than the minimum solvency margin required at the end of the year, reflecting the way in which companies have been managing their businesses in a way that takes into account the adverse changes in financial markets. Actions companies have taken include changing their mix of investments, arranging reinsurance, restructuring assets that were "inadmissible" and injecting new capital. They have also declared lower bonuses, although policyholders have generally fared better over the last year than if they had had wholly equity-based investments. Some companies have closed to new business. It is worth emphasising that companies can, and do, carry out the financial management of the funds, to reduce the likelihood of their breaching the solvency requirements.

We need to emphasise that there are a number of issues surrounding the calculation of free assets ratios. The free assets ratio can be calculated in different ways: different ratios have different characteristics and none is ideal; we calculate it as the excess of assets over liabilities, divided by liabilities. We calculate, separately, the ratio after subtracting the minimum solvency margin that companies are required to hold.

The ratio is given for the company's business as a whole. However, to gain a better understanding of an individual company, one needs to consider the mix of its business (e.g. whether it transacts unit-linked business, which has fewer risks).

The free assets ratio depends on the company's liabilities. The rules require prudence in the assumptions used to calculate liabilities (including testing resilience to more adverse economic conditions) but many would also say that the methodology prescribed is artificial. We also need to recognise that companies carry out the calculations in different ways, and make different assumptions. A "realistic" solvency calculation would appear more favourable. Indeed, FSA is now suggesting that companies can apply for waivers, which will allow them to place a lower (but still prudent) value on their liabilities. When the FSA's work to introduce a "realistic balance sheet" has progressed, that will give more helpful information than we currently have.

The figure used for assets, which is calculated in accordance with the regulations, may also understate the resources available to the company.

Bearing in mind that the standard valuation of assets and liabilities typically contains significant margins for prudence, the rules allow companies to use "implicit items" in certain circumstances. The implicit item used by certain companies is "future profits". Companies may choose not to use this facility, or to use less than the maximum amount that would be permitted. We calculate the free assets ratio (after the minimum solvency requirement) both including and excluding future profits.

The ratios can also be affected by the company's reinsurance and financing arrangements. This year, FSA has introduced a new form in the annual returns, which gives information on "financial engineering adjustments". These adjustments comprise implicit items, financial reinsurance, outstanding contingent loans and any other charges on future profits. Although such adjustments raise some issues, they can represent prudent financial management, stabilising the fund, increasing investment flexibility and improving the security of policyholders' benefits: this takes into account that assets and liabilities, as calculated, can contain significant margins. Note also that some insurers have subordinated loan arrangements; such financing is considered elsewhere in the insurers' returns.

It is clear from the above that simple comparisons of free assets ratios should therefore be treated with extreme caution. However, the work that FSA is doing should lead to a better understanding of firms' financial position being available in the future.

The average free assets ratio has fallen as follows:

* The top 20 companies were different

In 2002 16 companies included future profits, totalling over £8 billion (12 companies in 2001, totalling over £6 billion). The "other financial engineering adjustments" in 2002 totalled over £3 billion.

Equities are a large part of companies' investments, and the free assets ratios have been affected by the decline in the stock market. Over 2002 the FT-Actuaries All Share Index fell by 25% from 2524 to 1894. Furthermore, interest rates fell somewhat - the yield on 15-year gilts reduced from 4.98% to 4.45%, which will have led to an increase in the value attributed to insurers' guaranteed liabilities. For comparison, the FT-All Share Index on 12 May 2003 was 1928; at this date the yield on 15-year gilts was 4.42%.

Chris O'Brien
13 May 2003

1 The with profits life offices with the highest long-term fund admissible assets at the end of 2001.

2 Using form 9 of the returns: line 21 (long-term fund admissible assets) plus line 22 (other assets) minus liabilities*, minus required solvency margin (where "after required solvency margin"), plus line 31 if applicable (future profits#), expressed as a proportion of liabilities. *Liabilities are the sum of lines 23 (mathematical reserves) and 24 (other liabilities). #For the purpose of this calculation, future profits were restricted to 5/6 times the required solvency margin. Note: some commentators use other definitions of the free assets ratio.

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The assistance of Standard & Poors is appreciated.

 

Free assets of with profits offices
Note that figures from lines 21 to 41 on form 9 and line 19 on form 9A are expressed in £m.
		Long-term admissible assets	Other assets	Math reserves	Other liabilities	Free assets ratio1 before required solvency margin	Required solvency margin	Future profits2	Free assets ratio3 after required solvency margin		Future profits	Other financial engineering adjustments	Sum of financial engineering adjustments form 9A line 19
Form 9: line:		21	22	23	24		41		incl	excl	31
									future profits2
2002
AXA Sun Life plc		10875.162	103.532	9776.904	251.507	9.5%	453.566	375.000	8.7%	5.0%	375.000	71.428	446.428
CGNU Life Assurance		10802.763	30.267	9497.972	436.671	9.0%	687.265	572.721	7.9%	2.1%	572.721	0.000	572.721
Clerical Medical Inv Grp		19887.535	584.882	18412.138	693.519	7.2%	677.653	110.000	4.2%	3.6%	110.000	603.740	713.740
Co-operative Ins Soc		16671.876		14132.657	1114.185	9.3%	607.152	0.000	5.4%	5.4%	0.000	0.000	0.000
Commercial Union L.A.		13344.925	56.305	12550.869	343.938	3.9%	494.168	411.807	3.3%	0.1%	411.807	-52.971	358.836
Eagle Star Life Ass		11361.355	547.186	10958.442	249.483	6.3%	402.201	0.000	2.7%	2.7%	0.000	0.000	0.000
Equitable Life Ass		18927.597		17520.081	528.436	4.9%	722.879	200.000	2.0%	0.9%	200.000	0.000	200.000
Friends Prov L & P		19835.319	632.116	18466.459	1045.447	4.9%	720.349	600.000	4.3%	1.2%	600.000	530.000	1130.000
Legal & General Ass		37148.364	1835.000	35175.429	782.084	8.4%	1463.442	1219.535	7.7%	4.3%	1219.535	48.425	1267.960
National Provident Life		8240.791	212.939	7550.972	475.946	5.3%	322.326	0.000	1.3%	1.3%	0.000	1195.654	1195.654
Norwich Union L & P		27651.194	368.778	24950.102	721.061	9.1%	1171.831	976.526	8.4%	4.6%	976.526	123.644	1100.170
Pearl Assurance		14745.756	440.296	14128.781	562.189	3.4%	601.537	500.000	2.7%	-0.7%	500.000	-0.022	499.978
Prudential Assurance		74222.752	696.230	67187.081	1924.353	8.4%	2654.676	0.000	4.6%	4.6%	0.000	74.110	74.110
Royal London Mutual		18888.418	125.000	17807.099	633.020	3.1%	613.062	510.885	2.6%	-0.2%	830.000	-0.808	829.192
Royal & Sun All L & P		10156.107	64.054	9393.020	349.968	4.9%	431.121	250.000	3.0%	0.5%	250.000	-4.670	245.330
Scottish Equitable		11138.161	184.117	10495.468	134.004	6.5%	482.760	400.000	5.7%	2.0%	400.000	0.000	400.000
Scottish Mutual Ass		14517.031	202.371	13348.378	868.348	3.5%	507.782	250.000	1.7%	0.0%	250.000	542.295	792.295
Scottish Widows plc		20962.076	813.018	19295.401	467.974	10.2%	822.657	400.000	8.0%	6.0%	400.000	0.000	400.000
Standard Life Ass4		64549.649	969.652	60359.758	2446.898	4.3%	2014.364	1500.000	3.5%	1.1%	1500.000	0.000	1500.000
Sun Life Assurance		11791.544	234.042	10923.796	239.073	7.7%	486.205	200.000	5.2%	3.4%	200.000	-63.051	136.949
Total		435718.375	8099.785	401930.807	14268.104	6.6%	16336.996	8476.473	4.7%	2.7%	8795.589	3067.774	11863.363
2001
AXA Sun Life plc		11315.422	75.745	9597.891	272.903	15.4%	439.005	0.000	11.0%	11.0%	0.000
CGNU Life Assurance		11166.625	88.596	9458.780	489.582	13.1%	681.838	565.442	12.0%	6.3%	565.442
Clerical Medical Inv Grp		21075.784	365.557	18429.986	803.134	11.5%	638.908	470.000	10.6%	8.2%	470.000
Co-operative Ins Soc		19615.969		15312.631	1665.237	15.5%	659.450	0.000	11.7%	11.7%	0.000
Commercial Union L.A.		13869.617		12369.412	279.923	9.6%	486.252	405.000	9.0%	5.8%	405.000
Eagle Star Life Ass		10925.814	724.696	10502.176	225.325	8.6%	396.669	0.000	4.9%	4.9%	0.000
Equitable Life Ass		23994.958		22260.104	752.008	4.3%	917.341	500.000	2.5%	0.3%	500.000
Friends Prov L & P		22476.343	529.558	19674.975	1405.657	9.1%	750.158	600.000	8.4%	5.6%	600.000
Legal & General Ass		38635.011	461.000	34273.870	690.086	11.8%	1375.195	0.000	7.9%	7.9%	0.000
National Provident Life		9840.837	252.290	8545.917	827.967	7.7%	355.196	295.997	7.0%	3.9%	400.000
Norwich Union L & P		31275.582	832.574	27641.587	1393.024	10.6%	1245.900	1038.250	9.9%	6.3%	1038.250
Pearl Assurance		16404.184	132.982	15395.426	632.386	3.2%	651.190	542.658	2.5%	-0.9%	900.000
Prudential Assurance		77452.450		65882.544	3127.254	12.2%	2770.966	0.000	8.2%	8.2%	0.000
Royal London Mutual		21004.990	125.000	19424.169	676.809	5.1%	673.985	561.654	4.6%	1.8%	830.000
Royal & Sun All L & P		11034.311	45.021	10081.634	235.094	7.4%	461.710	380.000	6.6%	2.9%	380.000
Scottish Equitable		11405.299	163.923	10467.117	214.111	8.3%	484.846	400.000	7.5%	3.8%	400.000
Scottish Mutual Ass		14774.229	294.498	13578.699	801.555	4.8%	485.048	300.000	3.5%	1.4%	300.000
Scottish Widows plc		22426.962	501.653	20171.947	385.797	11.5%	849.558	0.000	7.4%	7.4%	0.000
Standard Life Ass4		67681.732		60963.762	1304.803	8.7%	2056.936	0.000	5.4%	5.4%	0.000
Sun Life Assurance		12277.943	20.224	11543.026	170.307	5.0%	554.415	0.000	0.3%	0.3%	0.000
Total		468654.062	4613.317	415575.653	16352.962	9.6%	16934.566	6059.001	7.1%	5.7%	6788.692
Source: companies' returns to the Financial Services Authority
1 Free assets ratio = (lines 21 + 22 minus lines 23 and 24)/(lines 23 and 24)
2 Here we use the lower of the future profits shown in line 31 and 5/6 times the required solvency margin
3 Free assets ratio = (lines 21 + 22 + 31 minus lines 23, 24 and 41)/(lines 23 and 24) where excluding future profits, line 31 is omitted (no company used implicit items other than future profits)
4 Year-end 15 November; otherwise, figures are at year-end 31 December
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