Select Committee on Treasury Written Evidence


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


 
previous page contents next page

House of Commons home page Parliament home page House of Lords home page search page enquiries index

© Parliamentary copyright 2008
Prepared 19 June 2008