Memorandum from Prudential plc
PRUDENTIAL PLC
Established in 1848, Prudential[41]
is a leading international financial services company with more
than twenty million customers world-wide and major businesses
in the UK, the US and Asia.
In the UK, Prudential provides a range of financial
products and services including annuities, corporate and individual
pensions, with-profits bonds, savings and investment products
and Individual Savings Accounts (ISAs) to around seven million
customers. Prudential in the UK also includes the Scottish Amicable
business, which was acquired in 1997.
In 1999, Prudential acquired fund manager M&G,
which now acts as the Group's UK and European fund manager and
is one of the largest active investors in the UK, with nearly
400,000 investors and over £160 billion funds under management.[42]
EXECUTIVE SUMMARY
A with-profits product offers investors a valuable
investment option, providing the prospect of competitive long-term
rates of return while smoothing the peaks and troughs of volatile
market movements and providing valuable guarantees.
The operation of with-profits funds is subject
to rigorous governance which ensures that policyholders are treated
fairly.
Prudential's with-profits policies have consistently
performed well. Strong with-profits performance relies on having
a strong with-profits fund which, in turn, means having a large
and strong inherited estate.
The inherited estate plays a vital role in ensuring
the financial strength and performance of the Prudential With-Profits
Fund. It provides the solvency capital that ensures security as
well as enabling smoothing and investment flexibility. The Prudential
With-Profits Fund needs to have sufficient working capital to
give it the investment freedom to continue to provide policyholders
with outstanding investment returns. To put the size of the fund
into context, Prudential's inherited estate of £8.7 billion[43]
supports an overall fund of £74 billion[44]
and is only around three times the size of the annual with-profits
bonus declaration in February 2008.
The generation of policyholders whose policies
have paid out since 1990 are net beneficiaries from the inherited
estate rather than contributors to it. We do not expect the current
generation of policyholders to be net contributors to the inherited
estate. Prudential's inherited estate has accumulated from a variety
of sources including shareholder contributions. Any payment to
the current generation of policyholders in respect of the inherited
estate would be a pure windfall.
Policyholders have a contractual relationship
with Prudential, and expect to receive their contractual benefits.
No expectation has been created that they would receive a distribution
of the inherited estate and the legal ownership of the estate
is clearly with the company.
It is Prudential's view that the whole of the
inherited estate is currently required to support the with-profits
fund and particularly so in light of present market conditions.
Prudential's overriding priorities are policyholders' long-term
financial security and providing good investment returns for policyholders.
A one-off windfall for the current generation of policyholders
would reduce the strength of the fund. Prudential's current assessment
is that it would not be prudent to weaken the inherited estate
by a distribution.
There is a fundamental difference between reattribution
and distribution. These words have been used interchangeably but
incorrectly by some commentators. In reality they are two different
and quite distinct processes.
Any possible reattribution involves shareholders
buying-out the policyholders' contingent interest in any potential
future distributions of the estate. Current policyholders would
get a definite payment now in exchange for a possible payment
in the future. The inherited estate would remain in the long-term
fund to support with-profits policyholders. Shareholders would
have to fund this payment from their own resources and therefore
would need to believe an adequate return was possible on this
investment.
We have announced publicly that we are looking
at the possibility of reattribution of the inherited estate but
we have not yet taken a decision. We will proceed with a reattribution
only if it is in the best interests of both policyholders and
shareholders.
The Court process and the reattribution process
set by the FSA provide many safeguards for policyholders on a
reattribution.
1. INTRODUCTION
1.1 Prudential welcomes the Committee's
Inquiry into Inherited Estates. There is a great deal of interest
in inherited estates and it will provide a useful opportunity
to clarify some important issues and to address a number of misunderstandings,
misconceptions and myths about inherited estates.
1.2 Any with-profits fund needs to be financially
strong to give policyholders the security that their policies
will pay the benefits they are expecting. The near demise of Equitable
Life underlines this point. A strong fund can support a higher
risk, higher return investment strategy than a weak fund, providing
better long-term returns for policyholders without compromising
their security.
1.3 There are a significant number of with-profits
funds in the UK. It is important to understand that each fund
is different; they vary in terms of their history, financial strength,
how they are managed (for example, in how they assess what should
be paid to policyholders), some are open, others closed to new
business, some are in mutual companies (ie companies which are
owned by their policyholders) and others in proprietary companies
(ie companies which are owned by shareholders). This variety means
that a "one size fits all" approach cannot be taken
to with-profits funds. The FSA recognises this in its approach
to regulation.
1.4 There are, however, strong governance
requirements around all with-profits funds, including With-Profits
Committees (or other independent review), With-Profits Actuaries[45]
and FSA regulation in general. This ensures the fair operation
of the fund, maintaining the balance between current and future
generations of policyholders and between policyholders and shareholders.
1.5 Some commentators have raised uncertainties
about the status and purpose of the inherited estate which risks
creating misleading expectations among policyholders. In this
submission, we clarify why the maintenance of a strong inherited
estate is so important to protect policyholders' interests. Comments
on the Committee's specific areas of interest are set out at Annex
A. Annex B includes more detail on how with-profits works in general
and the Prudential With-Profits Fund in particular.
2. AN INTRODUCTION
TO WITH-PROFITS
2.1 A with-profits product offers investors
a valuable investment option, providing the prospect of competitive
long-term rates of return while smoothing the peaks and troughs
of volatile market movements and providing valuable guarantees.
2.2 The main features of with-profits products
are set out below:
— With-profits often combines insurance
(the protection element) and medium to long-term investments (the
savings element);
— Policyholders' premiums are pooled
with the existing assets of the fund;
— Investment risk and return is spread
by means of investment in a broad-based multi-asset portfolio;
— With-profits policies offer investors
the prospect of competitive long-term rates of return while smoothing
the peaks and troughs of day-to-day market volatility;
— Smoothing occurs when a proportion
of the money gained in good years is kept in the fund to enable
a reasonable return to be paid during years of poor performance;
— Bonuses are the way policyholders
receive their share of the profits of the fund and smoothed payout
values. Prudential decides annually on the amount it is prudent
to distribute to policyholders by way of bonuses;
— Annual (or regular) bonuses are added
to policies each year and, once added, are guaranteed; final bonuses
are added at the end of a policy;
— With-profits products can include
other guarantees to provide security and certainty for policyholders;
— In a 90:10 fund, policyholders receive
90 per cent of the distributed profits from the with-profits fund,
by way of bonus additions to their policies, and shareholders
receive the remaining 10 per cent. Sharing investment returns
in this way aligns the interests of policyholders and shareholders
because both are interested in securing the best possible outcome;
— Companies are required to provide
regulatory capital. The provision of guarantees and smoothing
requires capital to absorb the impact of market volatility. The
maintenance of a multi-asset portfolio containing equities also
requires capital to help protect the value of policyholder investments
against market movements.
2.3 With-profits funds need a strong inherited
estate to provide the financial stability, solvency and investment
flexibility necessary for a successful with-profits fund.
2.4 With-profits is used across a broad
spectrum of products including annuities, pensions and savings
products, such as bonds. The with-profits concept is particularly
important for pensions, Prudential has over 2 million pension
savers in with-profits, where a falling market just before retirement
can have a significant impact on the value of the fund. This would
have a lasting impact on income throughout retirement. With-profits
is also a valuable option for customers with relatively small
amounts to invest who want to mitigate the risk of direct investment
in higher risk, higher return assets.
3. GOVERNANCE
OF WITH-PROFITS
BUSINESS
3.1 The operation of with-profits funds
is subject to rigorous governance which ensures that policyholders
are treated fairly.
3.2 With-profits businesses are subject
to rigorous governance designed to ensure that:
— policyholders are treated fairly
— conflicting interests between policyholders
and shareholders are dealt with fairly.
3.3 Within this governance regime, for Prudential,
the With-Profits Actuary and the With-Profits Committee (chaired
by Andreas Whittam Smith and other expert members independent
of Prudential) act to protect the interests of with-profits policyholders.
3.4 A firm must also explain how it manages
its with-profits business in a public document called the Principles
and Practices of Financial Management (PPFM). More detail on the
governance regime is included at Annex B.
4. THE PRUDENTIAL'S
WITH-PROFITS
FUND
4.1 Prudential's with-profits policies have
consistently performed well. Strong with-profits performance relies
on having a strong with-profits fund which, in turn, means having
a large and strong inherited estate.
4.2 The Prudential With-Profits Fund is
the largest with-profits fund in the UK, with assets totalling
some £74 billion. Prudential has approximately 4.4 million
with-profits policies. Of these, 1.3 million are policies with
an average value of less than £1,500. Prudential continues
to write substantial volumes of new with-profits business—with-profits
sales were approximately £2.3 billion in 2007, up 21% on
2006 and sales of Prudential With-Profits Bonds increased 59%
in 2007.
4.3 The chart below illustrates how the
performance of a Prudential with-profits product compares to a
range of other potential products.
4.4 The chart clearly shows the benefits
of a strong with-profits fund, providing a smoothed return for
policyholders and providing protection against market volatility,
compared with the performance of other types of funds and products
over the same period. For individuals who are reasonably risk
averse, and particularly those who do not have large sums to invest,
with-profits is a good way of accessing higher risk, higher return
investments with the added benefit of protection from the extremes
of market volatility.
4.5 The financial strength of the Prudential
With-Profits Fund has allowed Prudential to protect policyholders
in adverse market conditions. Even in 2002, when markets crashed,
provided that a policyholder's investment had been held for at
least 5 years, the policyholder had access to funds up to £10,000
with no exit penalties, and those relying on regular income withdrawals
were also not affected. Since 2004, the exit penalty free limit
has been £25,000, again provided that the investment has
been held for at least 5 years. This protection for policyholders
was funded from the inherited estate, which was reduced by nearly
30% of its value during 2002 alone.
4.6 The financial strength provided by the
inherited estate has also allowed Prudential to follow an investment
policy which enabled it to add £2.7 billion in bonuses to
with-profits policy values (£1.2 billion in regular bonuses
and £1.5 billion in final bonuses) in its February 2008 bonus
declaration.
5. THE INHERITED
ESTATE
5.1 The inherited estate plays a vital role
in ensuring the financial strength and performance of the Prudential
With-Profits Fund. It provides the solvency capital that ensures
security as well as enabling smoothing and investment flexibility.
The Prudential With-Profits Fund needs to have sufficient working
capital to give it the investment freedom to continue to provide
policyholders with outstanding investment returns. To put the
size of the fund into context, Prudential's inherited estate of
£8.7 billion supports an overall fund of £74 billion
and is only around three times the size of the with-profits bonus
declaration in February 2008.
5.2 In simple terms, the inherited estate
is the capital buffer and working capital for the Prudential With-Profits
Fund. More technically, it is the amount of assets in the with-profits
fund in excess of what Prudential expects to pay out to meet its
obligations to policyholders, based on our assumptions about factors
including investment growth, mortality, persistency and new business
volumes.
5.3 The inherited estate therefore provides
the necessary financial strength for the With-Profits Fund which
contributes:
SECURITY
A strong inherited estate provides a real benefit
for policyholders and helps ensure policyholders get the benefits
they are expecting, even in volatile market conditions. Weaker
with-profits funds, which do not have a large inherited estate,
cannot offer the same levels of security and smoothing.
SUPERIOR INVESTMENT
RETURNS
A strong inherited estate allows for greater
flexibility in investments. It allows a greater exposure to higher
risk, higher return assets and has allowed the Prudential fund
to achieve outstanding investment returns for its policyholders
over a consistent period. With a weaker inherited estate a more
conservative investment strategy would have to be adopted, which
would be expected to lead to lower returns to customers.
SMOOTHING
The ability to smooth returns is fundamental
to how with-profits works as it reduces peaks and troughs in payouts
and therefore helps protect the policyholder against market volatility.
A strong inherited estate is needed to provide this protection.
SOLVENCY
It is a regulatory requirement to continuously
hold sufficient capital to withstand adverse conditions, including,
in particular, large market falls. Failure to meet this requirement
would destroy consumer confidence.
SUPPORTING NEW
BUSINESS
A strong inherited estate is needed to ensure
we can continue to develop valuable with-profits products to meet
the investment needs of current and future generations of policyholders.
Weakening the fund could result in reduced consumer choice
5.4 Therefore, contrary to some popular
misconceptions, the inherited estate is not surplus to requirements.
It is not possible to run a with-profits fund prudently for the
benefit of current and future policyholders without a sufficiently
strong inherited estate.
5.5 The inherited estate has allowed Prudential
to support and protect the interests of policyholders in times
of stress and catastrophe, such as the two World Wars, the Spanish
flu epidemic and a number of stock market crashes. It is Prudential's
view that the whole of the inherited estate is required to support
the with-profits fund, particularly in light of current market
conditions.
6. SOURCES OF
THE INHERITED
ESTATE
6.1 The generation of policyholders whose
policies have paid out since 1990 are net beneficiaries from the
inherited estate rather than contributors to it. We do not expect
the current generation of policyholders to be net contributors
to the inherited estate. Prudential's inherited estate has accumulated
from a variety of sources including shareholder contributions.
Any payment to the current generation of policyholders in respect
of the inherited estate would be a pure windfall.
6.2 A commonly held assumption is that all
inherited estates have built up solely from under-payments to
policyholders. However, this is not the case for Prudential's
inherited estate.
6.3 Overall there has been no contribution
to the inherited estate from policyholders whose policies have
paid out since 1990 (this includes those who took out policies
many years before 1990 which were paid after 1990), as a result
of the modern techniques described below. We expect this to continue
to be the case for existing policyholders.
6.4 Technological and technical advances
in actuarial tools and techniques over the last twenty years have
allowed Prudential to be far more confident in calculating what
can be paid to policyholders and what should be retained for prudence.
Prior to 1990, Prudential did not have access to modern statistical
tools which now enable the calculation of multiple scenarios involving
changes in equity prices, interest rates, mortality, persistency
and new business volumes.
6.5 The main contributors to Prudential's
inherited estate:
— The shareholders have made a significant
contribution to the inherited estate. They contributed the original
working capital to establish the company as Prudential has never
been a mutual. Shareholders have also made capital injections
over the years. For example, by 1906, accumulated shareholder
contributions in the fund were more than £10 million. This
becomes more than £6 billion if accumulated to 2007, at the
rates of return earned by the fund, after an allowance for tax.
— In addition, from 1951-1988, shareholders
took less than their 10% bonus entitlement. During this period
of rapid expansion of with-profits sales the working capital,
that is the inherited estate, needed to be increased, whilst at
the same time preserving policyholder benefits. The shareholders
reduced their share of profits over this time to achieve that
strengthening.
— Without the benefit of modern actuarial
tools and techniques, some past with-profits policyholders (ie
those generations whose policies were paid before 1990) received
less than they would have using today's methods of calculation.
However, at the time it was right that Prudential gave priority
to financial security and prudence in deciding what to distribute
each year. All Prudential With-Profits policyholders over the
years have enjoyed security and competitive returns which has
led to Prudential's strong market position.
— In 1990, once Prudential had developed
and validated the new "asset share"[46]
methodology, it reviewed all in-force policies and enhanced their
value to bring them into line with modern asset share methodology.
7. OWNERSHIP
OF THE
INHERITED ESTATE
7. 1 Policyholders have a contractual relationship
with Prudential, and expect to receive their contractual benefits.
No expectation has been created that they would receive a distribution
of the inherited estate and the legal ownership of the estate
is clearly with the company.
7.2 The FSA has confirmed that, it is clear
that "A with-profits fund (including the inherited estate)
is in law an asset of the insurer".[47]
Prudential is not, and has never been, a mutual company and its
with-profits fund is not a mutual fund.
7.3 It is Prudential's view that the whole
of the inherited estate is currently required to support the with-profits
fund and particularly so in light of present market conditions.
Prudential's overriding priorities are policyholders' long-term
financial security and providing good investment returns for policyholders.
A one-off windfall for the current generation of policyholders
would reduce the strength of the fund. Prudential's current assessment
is that it would not be prudent to weaken the inherited estate
by a distribution.
7.4 It is ultimately the Directors' responsibility
to determine the risk appetite for the With-Profits Fund. In doing
so, they need to take a long-term view of the volatility of markets,
the cyclical nature of economic factors and lessons learned from
previous bear markets.
8. THE DIFFERENCE
BETWEEN A
DISTRIBUTION AND
A REATTRIBUTION
8. 1 There is a fundamental difference between
reattribution and distribution. These words have been used interchangeably
but incorrectly by some commentators. In reality they are two
different and quite distinct processes.
Distribution
8.2 A distribution of the inherited estate
may follow the emergence of excess surplus. An excess surplus[48]
is that part of the inherited estate the Directors have assessed
as being additional to the long-term capital needs of the with-profits
fund.
8.3 In a distribution:
— the amount distributed is shared
on a 90:10 basis (90% to policyholders, 10% to shareholders)
— only current policyholders benefit;
— the Directors are required to decide
how much can prudently be distributed;
— the money leaves the estate and is
no longer available to support with-profits policyholders.
8.4 Given market conditions and uncertainties
about the future, there can be no certainty for current or future
policyholders that an excess surplus will develop and hence that
a distribution could take place in the future.
REATTRIBUTION
8.5 Any possible reattribution involves
shareholders buying-out the policyholders' contingent interest
in any potential future distributions of the estate. Current policyholders
would get a definite payment now in exchange for a possible payment
in the future. The inherited estate would remain in the long-term
fund to support with-profits policyholders. Shareholders would
have to fund this payment from their own resources and therefore
would need to believe an adequate return was possible on this
investment.
8.6 In a reattribution:
— Policyholders are compensated by
shareholders for giving up their potential participation in any
possible future distribution(s);
— Reattribution will give current policyholders
a certain benefit now rather than a potential benefit in the future;
— The company makes an agreed payment
now to current policyholders; and
— All capital remains in the long term
fund to support with-profits policyholders.
9. THE CURRENT
PRUDENTIAL POSITION
9.1 We have announced publicly that we are
looking at the possibility of reattribution of the inherited estate
but we have not yet taken a decision. We will proceed with a reattribution
only if it is in the best interests of both policyholders and
shareholders.
— Prudential has consistently said
over many years that the status of the inherited estate should
be clarified. The current debate on inherited estates in general
has the potential to create unfounded expectations in relation
to ownership. The FSA has now provided detailed guidelines for
reattribution.
— Prudential is following this clearly
defined FSA process in considering a reattribution to clarify
this uncertainty, but we have not yet decided to proceed.
9.2 Deciding whether to proceed is a complex
process. It requires complex actuarial calculations, to take account
of regulatory capital requirements and to model diverse scenarios
over the next 40 years. There are also weighty operational issues
to consider. With a large number of small policies it is likely
that the average payments to policyholders would be relatively
small. The decision about whether to proceed with reattribution
will only be taken if it is in the best interests of both policyholders
and shareholders taking into account policyholder long-term security
and investment returns.
10. POLICYHOLDER
PROTECTION
10.1 The Court process and the reattribution
process set by the FSA provide many safeguards for policyholders
on a reattribution:
— The current reattribution process
is set, and is overseen, by the FSA and is designed to protect
policyholders by ensuring they are treated fairly in the reattribution.
— The FSA requires each company to
appoint an independent Policyholder Advocate (PHA) to negotiate
on behalf of policyholders—at present Prudential has only
nominated a PHA, Peter Bloxham, because we have not yet decided
to pursue a reattribution.
— The PHA (and his terms of reference)
must be approved by the FSA. This is to ensure his independence
and suitability.
— A Reattribution Expert is also appointed
by the company[49]
to assess the reattribution proposals objectively and prepare
a report for the Court on the implications of the proposals for
policyholder security and benefit expectations.
14 April 2008
41 This submission is from Prudential plc, the group
holding company. The Prudential Assurance Company Ltd is the main
UK life assurance operating company. For convenience, both companies
are referred to as "Prudential" in this submission. Back
42
As at 31st December 2007. Back
43
As at 31st December 2007. Back
44
As at 31st December 2007. Back
45
See Annex B for an explanation of the role of With-Profits Committees
and With-Profits Actuaries. Back
46
See Annex B for a definition of asset shares. Back
47
Letter from FSA to Clare Spottiswoode and Mark Hodges on reattribution
of inherited estates, 6 December 2007. Back
48
A fuller definition of excess surplus is given at Annex B. Back
49
The terms of reference and suitability of the Reattribution Expert
must also be approved by the FSA. Back
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