Policies have their prayers answered

After bonus cuts and financial crises, holders of with-profits funds at last have something to cheer about. Simon Hildrey reports

With-profits policyholders have had a rough time in the past few months as bonus cuts have become a part of life. But there was finally some reassuring news, of sorts, last week: life insurance companies are unlikely to go bust in the immediate future after the City regulator relaxed the rules on solvency requirements.

The Financial Services Authority (FSA) made the move to halt the rapid decline in the FTSE, which plunged 10 per cent in January. At least one big life insurer is rumoured to have contributed to this fall by selling its equities because its assets risked breaching the minimum regulatory capital requirements.

The FSA now says life insurers can apply for a waiver if the value of their assets risks falling below the minimum required to meet their liabilities safely. The hope is that this will stop insurers selling equities to shore up their reserves.

The problem with the current rules, known as the regulatory minimum margin, is that if stock markets fall, reducing the insurers' assets closer to the level of their liabilities, insurers are forced to sell out of equities and into bonds, which are less volatile and so more likely to meet future liabilities. But if insurers, which own about 25 per cent of the shares on the UK stock market, sell billions of pounds' worth, this pushes down equity prices and the whole process starts again.

The pressure on insurers and their with- profits funds was demonstrated again last week as Standard Life, Royal & SunAlliance and Clerical Medical announced cuts in bonus rates. Standard Life, which has reduced bonuses by 15 per cent on average this time, has made three cuts in the past year.

The FSA's decision has been welcomed by insurers, fund managers and financial advisers. They agree the relaxation of the solvency rules will benefit policyholders, life companies and investors in the short term. But the move does not come without dangers for policyholders in the medium term. The regulator imposed solvency requirements for a reason: to protect policyholders by guaranteeing that insurers have sufficient assets to meet their liabilities.

Adrian Shandley, director of Premier Wealth Management, says if the solvency requirements are not reimposed, some insurers may "make investment mistakes".

"With the relaxation of the rules, insurers might raise their exposure to equities if they fall below the minimum solvency margin to try to increase returns to get above this level again," he says. "The danger is that if markets fall again, the problem will be exacerbated."

The way for policyholders to avoid these problems, he argues, is to invest in unit-linked funds instead of with-profits. "At Equitable Life, it's only investors who have with-profits policies who have suffered, not unit-linked policyholders."

In the short term, however, Mr Shandley believes the FSA's decision will provide a lifeline for with-profits policies. It means insurers won't be forced to sell shares that have fallen in value, which in turn will provide reassurance for policyholders about the financial health of the firms with which they are invested.

Ben Gunn, managing director of Friends Provident, also applauds the move. "There is no substantive threat of a stock market-listed insurer being insolvent at current levels of the FTSE," he argues, adding that taking into account the overall financial strength of life insurers is more realistic and effective. "There are many things insurance companies can do to avoid insolvency rather than change their asset mix by selling equities," he says. "These include cutting bonus rates and raising exit penalties on with-profits policies, as well as not writing new business."

He also stresses that insurers do not need to meet all their liabilities right now, as they are stretched out over the next 25 years. "If a company has 3.5 million policyholders, 1.5 million are not going to ask for their money tomorrow."

But Richard Peirson, manager of the Framlington Financial fund, is less confident "smaller and more challenged" insurers were not close to insolvency before the FSA's decision, though he accepts that no listed firms were in danger.

"Although this is the fourth time the FSA has relaxed solvency rules in the past 18 months, it is important, as it has removed one of the factors driving down stock markets," he says. "The FSA has been pragmatic in relaxing the rules. It gives insurers more room for manoeuvre, and as long as they have new inflows of investment, they can rebalance their portfolios. It also improves investor sentiment about insurers and the stock market."

If sentiment does improve, this will push up stock markets, in turn improving the financial strength of insurers and reducing the chances of any of them becoming insolvent. And this will benefit policyholders – the first bit of good news they'll have had in ages.