Paying over the odds

Clifford German on the row facing endowments

Few organisations have the potential to dramatically affect sales of investment products. But the Institute of Actuaries came close to achieving this awesome distinction this week when it warned buyers of second-hand endowment policies that they may be paying too much for them.

Its warning, in a letter to the Personal Investment Authority (PIA), the financial watchdog, has set the cat among the pigeons in a market which has grown from barely pounds 5m a year to more than pounds 200m in annual sales over the past decade.

If the institute's claims are true, thousands of people who have invested small fortunes in second-hand with-profits endowments may receive far less than they had expected when their policies mature. What is the argument all about?

The boom in traded endowment sales follows the realisation by thousands of people, who each year cash in endowments originally taken out to help pay off a mortgage, that they will get little if they surrender them back to their life insurer.

By contrast, if sold to specialist buyers, such policies can fetch up to 20 per cent more. In turn, the buyers, called market-makers, sell them on to new investors, who pay the remaining years' premiums and collect the policy's payout at maturity.

The disparity between surrender values and traded values lies in the fact that many life insurers use early surrenders to boost the final payout to those who keep a policy going until maturity.

But the institute argues that the valuations put on traded endowment policies by market-makers, which project annual returns of 10 to12 per cent, are based on annual discount rates (ADR) - the assumption that recent levels of annual bonuses, which are added to the policy, plus the terminal bonus paid at maturity, will continue unchanged.

In reality the trend on bonus rates has been inexorably down because bonuses are no longer benefiting from high levels of inflation which bolstered returns in the Seventies and Eighties.

If traders in the endowment policy market used a far more complicated (and conservative) "asset value" method of valuation, used by life insurance companies when they pay surrenders to their policyholders, the institute believes the market would look overpriced.

Demand was boosted last year when investors started buying policies issued by mutual insurance companies in the hope of picking up a windfall if the company converted to a public company.

Falling bonus rates have already had an impact on prices, which rose only 3 per cent last year and have fallen back a similar amount this year at a time when shares and commercial property prices have both risen sharply.

The fall has meant that Max Rosen, managing director of Securitised Endowment Contracts, the largest market-maker in the business, cut prices for investors a couple of weeks ago to raise the projected rate of return. For a policy maturing in five years' time, SEC's projected rate of return is typically 0.5 per cent higher than the rate offered by competitors.

David Beale, chairman of Beale Dobie, another market-maker, points out that the Institute of Actuaries' call for asset share valuations to be used instead is hardly useful because the life companies favouring it do not make it available to outsiders.

Beale Dobie supplies potential investors with a grid showing the effect which changes in bonuses would have on a policy's annual returns. The assumptions range from increases of 20 per cent to falls of 40 per cent in the current bonus rates.

The row looks set to continue until the PIA completes its review of second-hand endowments. Until savers are given guidelines on how these investments should be priced, it makes sense to adopt a more conservative strategy.