Report by the With-Profits Actuary of Alico UK on the impact of the proposed transfer on its with-profits policyholders. 12 April 2012.

Transcription

1 Proposed transfer of business from the UK Branch of American Life Insurance Company ( Alico UK ) to Reassure Limited ( ReAssure ) (formerly Windsor Life Assurance Company Limited) Report by the With-Profits Actuary of Alico UK on the impact of the proposed transfer on its with-profits policyholders 12 April 2012 Page 1 of 30

2 1 Introduction and Summary 1.1 Introduction On 1 November 2010, American Life Insurance Company ( Alico ) was acquired from American International Group by MetLife. MetLife is performing a restructure and consolidation of the insurance entities within the European region in order to gain operational and capital benefits. As part of this strategy, a decision was made to close down the UK branch of Alico ( Alico UK ), with all the business being transferred to either ReAssure Limited ( ReAssure ) or other insurance entities within the MetLife group. It is the intention of Alico UK s Supervisory Committee to move, by means of a transfer under Part VII of the Financial Services and Market Act 2000, part of its general insurance business and long-term business to ReAssure. The transferring policies include all the conventional with-profits policies in force at the Effective Date. The Effective Date is intended to be 29 July As part of the scheme of transfer (the Scheme ), the with-profits business will be converted to non-profit with guaranteed increases to sum assured. The guaranteed increases will be calculated as at the Effective Date. Indicative guaranteed increases are set out in Appendix A. 1.2 Purpose of report This report has been written for the Supervisory Committee of Alico in my capacity as With- Profits Actuary ( WPA ) in accordance with the Financial Services Authority ( FSA ) requirements set out in SUP 4.3 of the FSA Handbook. This report is referred to by the Scheme and prescribes the assumptions and methodology to be used to calculate the guaranteed increases as at the Effective Date. It is also intended for use by the Independent Expert ( IE ), the Court, the FSA, the ReAssure Actuarial Function Holder ( RAFH ) and ReAssure With-Profit Actuary (RWPA) for the purpose of assessing the Scheme. The report will also be publicly available. Communications to with-profits policyholders will refer to the report which will be posted to both the Alico and ReAssure websites. The transfer is subject to the consent of the High Court of Justice in England and Wales. SUP G states: For long-term insurance business, the affidavit evidence to the court would normally include copies of reports on the transfer by the actuarial function holder and (if the insurance business includes with-profits business) the with-profits actuary of both firms, which should be provided to the FSA at an early stage. SUP R (4) requires a firm to request the advice of its with-profits actuary about the likely effect of material changes in its business plans on the rights and reasonable expectations of the relevant classes of its withprofits policyholders. A transfer would be material unless the liabilities transferred were not material relative to the total liabilities of the firm. The advice on a transfer would normally be in the form of a formal report by the with-profits actuary. The purpose of this report is to consider the terms for conversion of the with-profits policies to non-profit, including the fairness of the principles underlying the conversion terms. The report considers the impact of the conversion on the rights and reasonable expectations of Alico UK s with-profits policyholders in accordance with SUP G and SUP R. It also sets out how the Scheme is consistent with the requirements in respect of Treating Customers Fairly ( TCF ). In this report I have not considered the impact of the transfer on the security of benefits payable to holders of with-profits policies.. Policyholder security has been considered in the Alico AFH report and I have not repeated that analysis in this report. Similarly, the impact on policies of failure to transfer has been considered within the Alico AFH report. Page 2 of 30

3 The report should be read in conjunction with the full terms of the Scheme. The report has been prepared in accordance with the relevant Technical Actuarial Standards issued by the Board for Actuarial Standards. Section 7 confirms compliance with these. The IE for the purposes of the Scheme is John McKenzie of Milliman Inc who will be preparing a report as required by rules governing transfers of business. 1.3 Reliance Statement In making the analysis and conclusions in this report, I have relied on the assurances provided by ReAssure. I have not carried out independent verification of the information provided, other than a high level review of reasonableness. 1.4 Executive Summary With-profits business is to transfer to ReAssure via a Part VII transfer and as part of the Scheme, with-profits policies will convert to non-profit. In my report in my role as Alico s AFH, I have considered the impact on security and benefit expectations of all of Alico policyholders, including the impact on the with-profits policyholders on the assumption that their policies will be converted to non-profit before the transfer. Section 2 of this report summarises the key aspects of the Scheme. Section 3 discusses the fair treatment of with-profits policyholders. The Scheme refers to this report for the provision of the conversion terms. In section 4 I have summarised the conversion terms and analysed the impact of the conversion on the withprofits policyholders of Alico. Section 5 considers the impact of the transfer if the policies were to remain as with-profits. How the Scheme will be communicated to policyholders is explained in section 6. I conclude that the Scheme will have no material adverse impact on the interests of the withprofits policyholders on conversion to non-profit. I will prepare a supplementary report shortly before the Sanction Hearing which will consider the conclusions of this report in light of any additional relevant information available at that time. 1.5 Author Credentials and Declaration of Interest I am a Fellow of the Institute and Faculty of Actuaries. I was appointed as AFH of Alico UK on 4 February I am also the WPA of Alico UK and was appointed to this position on 16 January I am an employee of MetLife Europe Services Limited and seconded to Alico Management Services Limited, which is a wholly owned subsidiary of Alico. My spouse and I have two Premier Access Bonds and one Premier Bond between us issued by Alico. These are unit-linked non-profit policies. I confirm that I have not considered my personal interest or my role as the AFH in reaching any of the conclusions in this report. Page 3 of 30

4 2 Key aspects of Scheme Alico UK and ReAssure have agreed to transfer part of Alico UK s general insurance business and long-term business to ReAssure by means of a Part VII Transfer under the Financial Services and Markets Act It is intended that the transferring policies will be transferred to ReAssure on 29 July 2012, and allocated to ReAssure s Non-Profit Fund. As part of the Scheme, Alico UK s with-profits business will be converted to non-profit with guaranteed future increases to sum assured applying for the remainder of the lifetime of those policies. A summary of the conversion terms is set out in section 4.3. The rationale for converting the business to non-profit is set out in section 2.1 below. 2.1 Rationale for Conversion to Non-Profit Alico UK s portfolio of with-profits business is fairly small ( 72m reserves and 5,329 policies as at 31/05/2011) and at some stage in the future it is likely to become uneconomical to maintain the current status. As indicated in the PPFM, the management would have to consider options to restructure the business by either conversion to non-profit or some other alternative solutions. I have considered alternatives to conversion to non-profit in a separate report (attached as Appendix C). This report was also considered by Alico UK s Supervisory Committee and the outcome was that a conversion to non-profit was considered the best option from both policyholders and shareholders points of view. By industry standards, the with-profits business is small and many other companies would have already considered other options by now. Indeed Alico UK itself did consider alternatives a few years ago. Conversion of with-profits business can be costly to implement and therefore this Part VII transfer process provides an excellent opportunity to consider this course of action. Advantages for the policyholders of converting to non-profit now are: Alico UK and ReAssure have agreed to share the costs in relation to deriving the conversion terms if the conversion is effected at the same time as the Part VII transfer. Therefore by converting now the cost is not being passed onto policyholders. Single integrated communications exercise that provides once-and-for-all clarity over the future of policies rather than drip-feeding changes over time ReAssure is prepared to guarantee future equity, property and liquidity risk premiums in respect of the current proportions of investments in fixed interest, equities and property, throughout the term of the remaining business. Guaranteed increases have been derived assuming a constant equity backing ratio ( EBR ) of 15%. It is likely the EBR would have reduced gradually in future so the current proposal provides a higher uplift to fixed interest returns than may have been the case in future. There are savings that ReAssure are prepared to share with policyholders, and these are reflected in the proposed conversion terms. The degree of necessary knowledge transfer will be lower thereby reducing operational risks. Page 4 of 30

5 The above features and the potential for other risks giving rise to costs which would have had an adverse impact on with-profits benefits in the future make it eminently sensible to include conversion of the with-profits business to non-profit in the Scheme. In addition, it would have been necessary to convert at some point as smoothing becomes more difficult to achieve with a small portfolio compared to a larger portfolio. The maturity profile of the business is such that 25% of the business is expected to mature within the next 5 years and 50% of the business is expected to mature within the next 15 years. From a ReAssure shareholder perspective, conversion now would be cost efficient and also mitigates significantly the operational risks inherent in the management of the transferring with-profits business. Page 5 of 30

6 3 The fair treatment of with-profits policyholders 3.1 Introduction In this section, I summarise the sources of information available to policyholders that would give rise to their reasonable benefit expectations, the regulatory background in relation to TCF and the aspects of management of the with-profits policies which require discretion. These points provide the reference for considering the fair treatment of the with-profits policyholders in the remainder of the report. 3.2 Policyholders Reasonable Expectations The reasonable expectations of policyholders will be derived from various sources. These include policy literature and annual bonus notices sent to policyholders, information provided at point of sale, subsequent communications, marketing literature, statements by the company and past practices. The main document providing details on how the with-profits policies are managed is the Principles and Practices of Financial Management ( PPFM ). This was introduced in 2004 in accordance with FSA requirements, currently contained within COBS The PPFM is a publicly available document and was provided to all existing policyholders when it was first introduced. Each year the Supervisory Committee of Alico UK reports to the with-profits policyholders on the discretion it has exercised in respect of with-profits business and how it has complied with the PPFM over the year. This includes a report from me, as the With- Profits Actuary, opining on whether the interests of policyholders have been taken into account in the decisions and actions of the Company. Since 2006, a consumer friendly version of the PPFM ( CFPPFM ) has also been available. The content of the documents and literature referred to above, including both current and past versions of the PPFM, will influence policyholders reasonable expectations and therefore form an important consideration in assessing the fairness of the Scheme. 3.3 Regulatory Background The FSA handbook imposes further requirements on the fair treatment of policyholders. Principle 6 (PRIN 2.1) requires a firm to pay due regard to the interests of its customers and to treat them fairly and COBS 20 sets out more specific requirements in the areas of policy payouts, distribution, charges, writing of new business, investment strategy, reattribution of any inherited estate and ceasing to write new business. These requirements are also an important consideration in assessing the impact of the Scheme on policyholders. 3.4 Principles and Practices of Financial Management This document sets out the principles and practices that the Company follows in managing the with-profits business. The key principles and practices that are set out are: Amounts payable under a with-profits policy, Participation policy Smoothing policy Investment strategy Exposure to risk Charges and expenses Equity between different stakeholders Wind-up situation Page 6 of 30

7 3.5 Operation of With-Profits Business All of the long term insurance business of Alico UK resides in a single long-term insurance fund ( LTIF ). Alico UK does not maintain a separate fund for its with-profits policies. Bonus and dividend distributions are determined based on the performance of a notionally allocated part of the total investment holdings. There is no ring-fencing of any separate pool of actual assets, nor is there any sub-fund accounting for the participating business. Income and outgo in respect of with-profits policies is not automatically allocated to the notional portfolio of assets. No profits or losses made from any non-participating insurance business are attributed to any participating policy. Sections 2, 3 and 5 of Alico UK s PPFM provide further detail. The distribution methodology followed by Alico UK means that there is no inherited estate or any excess surplus as defined in FSA rules. The Alico UK PPFM clearly states in section 8 that there is no inherited estate in which policyholders participate. The distribution policy and the fact that Alico UK operates only one LTIF means that the distributions to with-profits policyholders as a percentage of the surplus arising in the LTIF would vary materially year on year. The distribution rules limit the variance to 0.5% and therefore the possibility of the variance being greater than 0.5% in the normal course of business has been resolved by means of a waiver granted to Alico UK by the DTI, and grandfathered via the FSMA transition rules. Bonuses are declared once a year for the next calendar year but can be reviewed and changed more frequently if considered appropriate. An annual bonus is added once a year on the policy anniversary. For Series 66 policies bonuses are allocated in the form of dividends which may be left on deposit or converted to a paid-up addition to the sum assured. An investment return is credited annually to dividends on deposit, and the accumulated value is paid out on death, maturity and surrender claim. Final bonuses, if applicable, are paid on termination of the policy. The current practice in setting bonus rates is to target maturity payouts of close to 100% of asset share. If projected payouts are outside of the range % of projected asset share, bonuses are adjusted upwards or downwards as necessary. Over the long term the aim is for at least 90% of maturity payouts to be within the target range. Whole of life policies currently follow the same annual and final bonus recommendations as endowments. This practice would have changed in the future to make bonus recommendations that set the gross premium reserve at product level to be equal to the total asset shares. Current asset shares are calculated as a retrospective accumulation of premiums, expenses and charges using actual historical investment returns on the notional portfolio. Asset shares are projected using central investment returns based on the current asset mix. In line with the PPFM, expense and mortality charges are based on actuarially determined expected costs, rather than actual costs, to avoid policyholders bearing a disproportionate share of the associated risk as the business runs off. Alico UK has been closed to new participating business since Since 2006, smoothing accounts have been maintained. Any underpayment on surrender or maturity relative to asset share is added to the smoothing account and any overpayment is charged to the smoothing account. The intention is that any surplus or deficit in the smoothing accounts is to be distributed or recovered from the payouts that would otherwise be made on future maturities and surrenders. In order to limit the potential impact of smoothing the magnitude of the smoothing account is limited. The maximum depends on several factors including the expected remaining lifetime of the portfolio and is likely to change over time. Currently the maximum set by Alico is 10% of the asset shares. Page 7 of 30

8 4 Impact of the conversion on the fair treatment of withprofits policyholders 4.1 Introduction In this section, I consider the impact of the Scheme on the fair treatment of with-profits policyholders of Alico UK. The Scheme includes the intention that the with-profits policies will be converted to non-profit on transfer. I have therefore considered the terms of conversion in light of the points in section 3. In Section 5, I consider the scenario where the conversion to non-profit is not sanctioned by the Court but the transfer is sanctioned and goes ahead. 4.2 Principles As discussed in section 2.1, the most appropriate course of action for the with-profits policies is to convert them to non-profit as part of the Scheme. When developing the process for calculating conversion terms the following broad principles were followed: There will be no reduction in the level of guaranteed benefits applying to policies. Guaranteed increases will be based upon the bonus rates that would have applied had the policies remained with-profits and future experience had followed central estimate assumptions. In particular, the current approach to setting bonus rates by reference to projected asset shares will be followed. There will be no systematic uplift to asset shares the conversion terms will be neutral to policyholders and shareholder overall. Conversion terms will aim to maintain equity between generations and subclasses of policyholders. Guaranteed maturity benefits expressed as a percentage of projected asset shares will be consistent with the tolerances set out in the PPFM. Asset share projection basis will be on a fair and appropriate asset mix. The existing policy terms and conditions have been considered. In particular: o Any applicable minimum surrender and transfer values will not be reduced. o There will be no change to the guaranteed annuity rates applicable under pension policies. However, from the date of conversion these will apply to the guaranteed non-profit benefits. o o The settlement options - the guaranteed annuity rate offered on life annuities will remain in place post conversion. There will be no changes to any other options. Surrender and transfer bases applying post conversion will reflect principles applied pre conversion and include allowance for guaranteed increases accrued to the date of exit. The scales of guaranteed increases will be, as far as is practicable, simple to explain and practical to implement. Page 8 of 30

9 There will be no impact on the tax treatment of policies from the policyholder s perspective as a result of the conversion, e.g. eligibility for life assurance premium relief and qualifying status should be maintained where applicable. Although not a principle it should be noted that the costs in relation to deriving the conversion terms are being borne by shareholders. I am satisfied that, given the analysis in the sections below, the conversion terms comply with the principles above. 4.3 Conversion Terms Following the conversion of policies to non-participating, asset shares will no longer be determined and annual and final bonus rates will no longer be declared. Instead fixed scales of uplifts to guaranteed benefits ( guaranteed increases ) will be applied from the date of conversion. The guaranteed increases will be in the form of guaranteed annual increases on each policy anniversary in place of an annual bonus and a guaranteed final increase on termination in place of a final bonus (where applicable). Guaranteed annual increases will vary by product and guaranteed final increases will vary by product and maturity year. For endowment policies the guaranteed final increase rate payable on death is the same as the rate payable on maturity. For whole of life policies the guaranteed final increase rate payable on death is the rate applicable in the year of death. Below I describe the process for calculating the guaranteed increases as at the Effective Date which will be performed by ReAssure Overview of process The process to determine the conversion terms as at the Effective Date will be to: determine the asset shares and the value of the smoothing account at the Effective Date; project asset shares to maturity for each policy on a central estimate basis to determine target maturity payouts; in a manner consistent with Alico UK s PPFM and current bonus methodology, develop a set of guaranteed regular and final increase scales that would broadly reproduce the target maturity payouts, allowing for the distribution of the smoothing account; ensure that the resulting set of guaranteed regular and final rates of increase are compliant with the principles of treating customers fairly ( TCF ). Whole of life policies do not have maturity values, therefore the guaranteed rates of increase are determined using a different methodology, detailed below, which satisfies the same basic requirements as set out above Asset Share Projections In line with Alico s PPFM the asset share at the end of each year will be calculated as: Asset share at the start of the year Plus Premiums received Plus Investment return Minus Expected cost of claims (Cost of insurance) Minus Charges for expenses (including renewal commission) Minus Shareholders charges for cost of capital Page 9 of 30

10 Minus Charge to cover cost of options and guarantees Minus Charge for taxation Asset shares will be calculated taking into account actual experience up until the Effective Date. The assumptions detailed below will be used to project the asset shares to maturity. For whole of life policies that do not have a maturity date, guaranteed increases will be determined such that the gross premium value at product level is equal to total asset shares at the Effective Date. The calculation of the gross premium value is covered in Smoothing Account The smoothing account will be calculated as at the Effective Date and will be equal to the smoothing account as at 31/08/2011 plus contributions to the smoothing account from 1/09/2011 to the Effective Date. Contributions to the smoothing account are calculated as the difference between maturity or surrender payouts for each policy (the payout used does not include any additional amount paid in order to meet guaranteed maturity values) and the corresponding asset share as at the maturity/surrender date. The asset share is calculated as at the policy anniversary. For surrendering policies, the asset share as at surrender is found by interpolating between two policy anniversaries. Deaths do not contribute to the smoothing account. For the purposes of determining the smoothing account gross premium values are used instead of asset shares for whole of life policies and paid up Personal Retirement Plan policies. Note that as whole of life policies do not mature only surrenders contribute to the smoothing account. The gross premium value is the amount required to pay future benefits assuming the current annual and final bonuses apply. The calculation of gross premium value is covered in The smoothing account balance will be utilised in full when setting the guaranteed increases Determining the Guaranteed Increases The guaranteed increase scales will be calculated to broadly reproduce the central estimate maturity payouts that would have been paid if conversion had not taken place. These central estimate maturity payouts will be determined by calculating the future bonus rates that might be declared as a result of applying the current bonus philosophy (as detailed in Alico s PPFM) if future experience after the Effective Date followed central estimate assumptions and assuming policies remain as with-profits. For whole of life policies that do not have a maturity date, guaranteed increases will be determined such that the gross premium value at product level is equal to total asset shares at the Effective Date. The gross premium valuation will be calculated: the present value of projected future death benefits (sum assured plus accrued bonuses plus final bonus) assuming 3 times the 2012 dividend scale for Series 66 policies and 0.75%pa for Series 78 policies ; plus the present value of future shareholder allocations (1/9th of the cost of future reversionary bonuses plus 1/9th of final bonuses); plus the present value of projected future expenses to be levied on asset shares; less the present value of future premiums (net of charges for commission). Page 10 of 30

11 The assumptions used are the same central estimate assumptions as those used to project asset shares and are detailed in section 4.4 below. Discount rates are based on the projected future investment returns, net of tax where appropriate. The guaranteed annual increases are specified above; the final guaranteed increase is the final bonus that sets the product level gross premium value to total asset shares. From these guaranteed rates of increase, a smoothing cost over the whole portfolio of policies will be calculated and compared to the level of the smoothing account at the Effective Date. The guaranteed rates of increase will be adjusted globally (via a change in asset shares) to eliminate any difference between these two values. Finally, the resulting guaranteed terminal rates of increase will be smoothed using a 5-year moving average (i.e. 2 years prior to the bonus date, current date, and 2 years into the future) of the unsmoothed rates of increase subject to smoothing by eye in the initial years Ensuring conversion terms are TCF compliant In order to check that the resulting conversion terms are fair to the with-profits policyholders: The resulting guaranteed final rates of increase will be checked to ensure that there are no significant year-on-year changes. This will mostly be achieved via the application of the smoothing rule detailed at the end of the previous section; and, Payout ratios i.e. guaranteed maturity value divided by asset share for each policy will be calculated to check that at least 90% of payouts have a payout ratio in excess of 90%. If this test is failed the guaranteed final increase for policies with payout ratio of less than 90% will be increased to a level at which the payout ratio is 90% Confirmation of calculations The ReAssure Fairness Committee (RFC) is one of the four committees reporting to the ReAssure Board. The RFC oversees the Treating Customers Fairly ( TCF ) environment, has specific responsibilities for reviewing conflicts of interest, with profits governance, and fulfils certain specific responsibilities in respect of previous transfers of business. The Scheme requires the RFC to ensure that the conversion terms calculated as at the Effective Date are drawn up in accordance with the process and assumptions specified in this report Conclusion on Conversion Terms Process I consider that the conversion terms methodology is fair and appropriate and notwithstanding that policyholder benefits would have been a range of outcomes, the conversion to guaranteed terms is not detrimental as central estimates of expected outcomes are used. Page 11 of 30

12 4.4 Assumptions used to calculate Conversion Terms The conversion terms will be calculated as at the Effective Date. However indicative conversion terms will be calculated using data as at 31 August 2011 for the purposes of giving policyholders an indication of the guaranteed increases they might get post conversion. The assumptions for both calculations are detailed in the table below: Asset share projection assumptions For Indicative Terms (as at 31 August 2011) As at Effective Date Risk free rates of investment returns in each future year of projection Forward rates derived from the Bank of England spot curve as at 31 August 2011 (with a constant rate assumed after 25 years) plus 0.1%. Forward rates derived from the Bank of England spot curve as at the Effective Date (with a constant rate assumed after 25 years) plus 0.1%. Projected future gross investment return Investment return from Equity type assets Equity Risk Premium (ERP) Investment return from Property type assets Property Risk Premium PRP) Sum of the relevant Risk free rate and risk premium for each future year. 7.3% per annum in first 10 years followed by 7.6% per annum thereafter Equity Return less relevant Risk Free Rate for that year 6.8% per annum in first 10 years followed by 6.9% per annum thereafter Property Return less relevant Risk Free Rate for that year Liquidity Premium (LP) The difference between yields on the fixed interest assets and gilt yields as at the 31 August 2011 net of an allowance for default. The difference between yields on the fixed interest assets and gilt yields as at the Effective Date net of an allowance for default. Default Allowance Risk Premium in each year Annual expense charge per policy (including an allowance for investment management expenses) Remaining Term Rating <1 yr 1-5 yrs 5-15 yrs >15 yrs AAA 0.00% 0.02% 0.06% 0.05% AA 0.04% 0.09% 0.17% 0.17% A 0.06% 0.15% 0.22% 0.22% The appropriate assumption from the above table plus 35% of any change (increase or decrease) in spread between 31 August 2011 and the Effective Date. No default allowance is applied to UK government bonds. The default allowance will be subject to a minimum of zero. 10% * ERP + 5% * PRP + 85% * LP per annum per policy for policy years beginning in 2011 inflating annually thereafter. Page 12 of 30

13 Expense inflation Mortality charge 3.3% per annum 100% of mortality table AM92 published by CMIB; for the purpose of determining the mortality charge, females are assumed to be 3 years younger. Tax on life business Stand alone I-E basis at 20% Tax on pensions business 0% Charge for renewal commission Charge for guarantees Charge for waiver of premium coverage Charge for cost of capital Rate of investment return credited to dividends on deposit on Series 66 policies 2.5% of premiums paid 4% of premiums payable for Flexible Endowment, Homemaker, Moneymaker, Guaranteed Investor and Blue Ribbon Special policies 1.5% of premiums for Flexible Endowment, Homemaker, Moneymaker, Guaranteed Investor and Blue Ribbon Special policies 1/9 th of the cost of annual bonus declared on each policy anniversary plus 1/9 th of final bonus paid on maturity. Cost of annual bonus determined using the mortality charging basis (see above) and valuation interest rates of 2.5% for pension business and 1.5% for life business The current methodology applied to determine the interest rate credited to Series 66 dividends on deposit will continue to be applied post-conversion. The rate is linked to the 5 year gilt yield net of tax, subject to a minimum of 2.5% per annum. 2.5% per annum was assumed in modelling projections Assumptions are key when determining the guaranteed increase scales. The assumptions used to project the asset share to maturity are the same as those used in the 2012 surplus distribution, with the exception of the future investment return and the annual expense charge. The annual expense charge has been reduced by 5pa to reflect savings made by converting to non-profit. The future investment return will be set equal to the projected riskfree rates plus a risk premium. The majority of the assumptions are long term assumptions based on historical data. The assumptions are based on work carried out by external actuarial advisers. This work is detailed in an internal document that has been made available to both the IE and the FSA. The risk free rates and the risk premiums to be used in the final calculation of the conversion terms will depend on market conditions on the Effective Date. The gilt yield curve plus 0.1% is intended to represent risk-free rates which vary by term. This is more representative of future investment returns than using a single long term gilt yield, which would be more generous to policies maturing in the shorter term. The risk premium will be the sum of (i) an allowance for the realisations of equity risk premium on the 10% assets backing with-profits policies assumed to be invested in equity type investments, (ii) an allowance for the realisation of property risk premium on the 5% assumed invested in property and (iii) an allowance for the realisation of liquidity premium in respect of the 85% assumed invested in fixed interest assets. The liquidity premium is calculated by comparing gross redemption yields on fixed interest assets deemed to back Alico UK with-profits policy asset shares with benchmark iboxx UK Page 13 of 30

14 gilt yields of a similar outstanding term. The liquidity premium is the difference between yields on the fixed interest assets and gilt yields net of an allowance for default. The table below is as at 31 August Term Alico Bond Portfolio (per annum) Markit iboxx Gilts (per annum) Default adjustment Market Vaue m 5 7 years 1.73% 1.82% -0.06% years 2.88% 2.56% -0.06% years 5.00% 3.09% -0.06% years 4.19% 3.85% -0.05% 21.8 Weighted Average 3.33% 2.94% -0.06% 60.4 The difference between annual yields on the fixed interest assets and UK Government bonds (gilts) net of an allowance for default averages at 3.33% % % =0.34% p.a. The risk free rate is gilt yields plus 0.1%. Therefore the liquidity premium used to calculate the indicative conversion terms as at 31 August 2011 is 0.24%. This calculation will be repeated as at the Effective Date using the latest yield information. Appendix B details the fixed interest assets to be used in the calculation. I am satisfied that the assumptions specified, in particular the projected future gross investment return, will result in final guaranteed increases that are fair to policyholders. 4.5 Neutrality/Impact on Shareholder The third principle in section 4.2 is There will be no systematic uplift to asset shares the conversion terms will be neutral to policyholders and shareholder overall. The conversion terms are neutral from a policyholders point of view if: Policyholders in aggregate receive at least the same amount of benefit that they would have expected to receive had there been no conversion; There is no reduction in the level of guarantees that policyholders have come to expect; Any benefit to the company is shared between policyholders and shareholders. These criteria have been satisfied as policyholders are being granted guaranteed increases based on central estimate returns; there are no changes to the terms and conditions; and policyholders share in expense savings through reduced asset share expense charges and in addition shareholders receive a share of this benefit through the cost of capital. The shareholder assesses neutrality by comparing the value of policyholder liabilities pre conversion and post conversion. The actual cost to the shareholder will depend on the investment strategy taken with regards to the assets backing the converted policies. If the shareholder earns less than the assumed risk premium there will be a cost. The current annual bonus rate of 0.25% for paid up Personal Retirement Plan policies is not sustainable in the long term. However, ReAssure has agreed that these policies will receive guaranteed future annual increases of 0.5% when converted to non-profit. This cost will be met by ReAssure. Page 14 of 30

15 4.6 Implications for Policyholders The implications for with-profits policyholders have been assessed under the following headings: Security of benefits Benefit expectation Bonus policy Investment strategy Expenses Tax Surrender values New business Guarantees and options Service standards Security of Benefits As Actuarial Function Holder, I have considered the implications of the Scheme on benefit security in my AFH report and have concluded that there will be no material effect on the benefit security for policyholders, including the with-profits policyholders Benefit Expectation In this section I consider policyholder benefit expectations in respect of death and maturity. Surrender benefits are discussed in section The terms of the conversion and the method used to calculate the guaranteed increases going forward are based on the principle that the guaranteed increases will result in a maturity payout similar to that which the policyholder would have been entitled to expect had the policy remained as with-profits. In the event that the policy remained as with-profits, the benefit expectation of a policyholder would be a payout close to asset share as current practice is to target asset share. Guaranteed increases are calculated by comparing projected payouts to projected asset share and setting guaranteed increase rates such that projected payouts are close to 100% of asset share. The guaranteed increases will be calculated such that at least 90% of policies will have maturity values of 90% of asset share or more. In projecting the asset shares, a central estimate investment return is assumed. This assumes an EBR of 15% (where the EBR is the percentage of the total assets backing withprofits business that is invested in equity and property type investments). Were the business to remain as with-profits, it is likely that the equity backing ratio would need to reduce at some point in the future as the business runs off. The conversion terms assume a constant EBR of 15% throughout the projection period. I am comfortable with this assumption for the following reasons: Historically, the investment strategy for assets backing with-profits business has been heavily weighted towards fixed interest securities resulting in a low EBR. Over the last 10 years the EBR has been approximately 15%. Page 15 of 30

16 I believe that the balance of final bonus and annual bonus would have been managed to ensure that the EBR did not go much higher than 15%. Current practice suggests an EBR in the range 10% to 17.7% (based on the proportion of with-profits liabilities in respect of final bonuses and future annual bonuses). In addition the PPFM principles state that it may be necessary over time to move more assets into fixed interest securities in order to meet the guarantees that have been provided to policyholders. Asset share is not an appropriate measure for whole of life policies. For these polices, future increases have been calculated by determining, at product level, the future rate of increase such that the gross premium policy value is equal to the current asset share. This is the rate of increase that the current asset share can support. Charges for expenses in calculating the asset share also follow current practice of being increased in line with the Retail Price Index (RPI) subject to a maximum of the annual rate of increase in the UK Average Weekly Earnings Index (AWEI). The balance of the smoothing account will be distributed to policyholders if positive, or deducted from payouts if negative, so that the value of the smoothing accounts after all policies have terminated is zero. The smoothing account as at 31 st August 2011 was + 0.7m i.e. that amount was available to distribute to exiting policyholders in the future. There will be a smooth progression from benefits prior to the conversion and benefits post conversion. Guaranteed increases will be either at the same level as pre conversion annual bonuses or higher, and final guaranteed increases will be smoothed over a 5 year period (see 4.3.4). I believe that the conversion terms are such that policyholders will receive the guaranteed benefit that they were expecting to receive as a with-profits policy (if central estimate investment returns were achieved over the policy term) and in fact they may receive more because: It has been assumed that the equity backing ratio remains unchanged and therefore the conversion terms allow for a 15% equity backing ratio throughout the future life of the policies. The charge for expenses has been assumed to never increase more than inflation whereas the charge could have increased by the annual increase in AWEI. An allowance for the expense savings that are expected to be made by ReAssure once the policies are no longer with-profits has been added to the policyholder benefits. See section for details. The central estimate investment return assumptions may exceed the actual returns that would have been achieved if policy benefits remained dependent on market performance. The expectations of the with-profits policyholders are that they will participate in the investment return of the benchmark assets as stated in the PPFM. They expect to receive an annual bonus each year and a possible final bonus when the policy terminates. Following conversion, policyholders will still receive an annual increase but the difference is that the discretionary bonus will be replaced by guaranteed increase. They will also receive a final increase at the termination of their policy if appropriate. Policyholders are being granted guaranteed fixed future increases in exchange for participation in actual future investment experience. It is possible that actual experience could be better or worse than the risk premium being guaranteed. By guaranteeing future increases to policy benefits policyholders will be protected from future falls in the value of the assets backing these policies. However this also means that policyholders will not benefit if the returns on those assets are higher than expected. Overall, I am satisfied that the proposed conversion terms are unlikely to have a material detrimental impact on the benefit expectations of the transferring with-profits policyholders. Page 16 of 30

17 4.6.3 Bonus Policy As detailed in section 4.2, the terms of the conversion have been determined by following the current bonus policy. The exception is for Whole of Life policies where, as mentioned in section 3.5, the practice in future would have been changed to make bonus recommendations that set the gross premium reserve at product level to be equal to asset share. The application of this new methodology has been accelerated by the conversion process However, as this change would have been made anyway I conclude that the conversion terms are fair in respect to bonus policy Investment Strategy Following the conversion, policyholders will receive guaranteed increase on their policies. Therefore the investment decisions of ReAssure will have no impact on with-profits policyholders future benefit expectations. The conversion terms allowed for Alico UK s current investment strategy and therefore policyholders will receive benefits in line with the investment strategy that they will have come to expect from details given in the PPFM and other literature. The investment strategy of ReAssure may impact the with-profit policyholders in terms of security of benefits. I have considered this as Actuarial Function Holder in my AFH report Expenses The conversion terms have been determined assuming that increases in expense charges will be in line with assumed RPI. This is expected to be more favourable than the maximum permissible increase based on AWEI, as AWEI is expected to the higher than RPI in the long term. In addition, the current charge to asset shares has been reduced to take into account an expense saving of 5 per policy per annum expected once the policies are non-profit. Savings are expected as these policies will no longer be subject to the same level of governance requirements and there will no longer be requirements for with-profits related work, e.g. annual surplus distributions or compliance with PPFM reviews. Therefore the conversion terms are fair to policyholders in terms of expense charges Tax The conversion terms have been derived on the basis that the Life business is taxed on a stand alone basis in line with the current methodology. Therefore there is no change to policyholders New Business Alico UK closed to with-profits business in 1992 and the block will remain closed to new business following the transfer. Page 17 of 30

18 4.6.8 Surrender Values Surrender values (and paid up values) are currently calculated using a stable basis. The rationale for this is that the block is in run-off and there is no opportunity for arbitrage. The current surrender value methodology has been reviewed in July 2011 and resulted in an enhancement of surrender values by making all policies eligible for a final bonus (in some cases this may be nil). Post conversion the surrender value methodology will be to discount the guaranteed benefits (including guaranteed final bonus) to the date of exit, allowing for non-payment of future premiums and non-occurrence of future expenses. The basis for discounting will be the riskfree rate for the remaining term (as at the date of surrender) plus the risk premium as at the Effective Date. Any guaranteed surrender values will continue to be honoured following conversion. Postconversion checks will be made for product classes that have guaranteed surrender values currently applying to verify that post-conversion surrender benefits will not be lower than the pre-conversion guaranteed surrender values. Checks will also be in place to ensure that surrender values are at least equal to asset share (calculated using the conversion term assumptions specified in section 4.4). Policies becoming paid up will follow a similar methodology. I am satisfied that policyholder expectations in respect of surrender values and paid up values will continue to be met Guarantees and Options The following guarantees and options are currently available to with-profits policyholders in addition to the underlying guarantees offered by with-profits products: Guaranteed surrender values on Flexible Endowment and Moneymaker policies. Guaranteed minimum benefit on death or maturity on Homemaker policies. Guaranteed annuity options on Personal Retirement Plans. Settlement options on termination of Series 66 Whole of Life or Endowment policies (some with guaranteed annuity rates). Option to change retirement date on Personal Retirement Plans. Option to change frequency of premium payment. Guaranteed insurability options on Flexible Endowment, Moneymaker, Homemaker, Series 66 Whole of Life and Endowments, Series 78 Whole of Life and Endowments. All the above options and guarantees will continue unchanged following conversion. The difference will be that the future maturity benefit of the pension policies will be known and therefore the guaranteed annuity benefit will also be known. Page 18 of 30

19 Service Standards Since 1 st July 2011, the Alico transferring business, including with-profits and non-profit business, has been administered by Admin Re. The administration of policies transferred from Alico will continue to be performed by Admin Re following the transfer. The transferred business will migrate to Admin Re s administration systems. Admin Re have previous history and experience of such migrations and anticipate that there will be no changes to administration as a result of this Scheme that could have a detrimental effect on the service provided to the transferred business. The scale of the transferring business is small compared to the existing ReAssure business and contains no new product types unfamiliar to Admin Re. As Actuarial Function Holder, I have considered the impact on service standards in my AFH report. I noted that service standards would not be affected as the servicing for the withprofits policies is currently outsourced to Admin Re and this would continue following the transfer. Page 19 of 30

20 5 Impact of the Scheme in the event policies remain withprofits If the conversion to non-profit is not approved the Company will have to present a revised Scheme to the Court. The policies will continue to be with-profits and managed in Alico in accordance with the existing PPFM until the Court approves the Scheme. Page 20 of 30

21 6 Communication with policyholders Alico UK intends to communicate with interested parties in relation to the Part VII via a communication pack and press notices. Prior to the distribution of the communication pack, an advance notification letter will have been sent out to with-profits policyholders advising them that Alico is considering making changes to the way with-profits business is managed. The Communication Pack will include a cover letter, which will be tailored to the customer, a Q&A document, a booklet and a legal notice. The booklet will contain a summary of the terms of the Scheme, summary of the IE s report, data protection provisions and some narrative about the details of the transfer, including the date of the court hearing and how policyholder can raise any objections they may have. The communication pack will ensure that the conversion of with-profits business will be given adequate and equal prominence to ensure the with-profits policyholder is aware of the important and material change to participation rights under their policy. For with-profits policyholders with policies maturing after 2013 the letter will include indicative values for the guaranteed annual increases and guaranteed final increase that will apply to their policies (see Appendix A). These indicative values are calculated assuming an Effective Date of 31 August 2011 (the date at which the 2012 bonus declaration is prepared). The figures in the letter are intended to give policyholders an indication of the guaranteed increases they may receive, however it is made clear that the final guaranteed increases may be higher or lower than those illustrated. For policyholders with policies maturing in 2012 the cover letter will include the maturity value which is expected to apply regardless of whether conversion takes places. The final guaranteed increases will be calculated as at the Effective Date. Policyholders will be advised of these terms following the Effective Date. Alico UK will publish notices of the Part VII transfer in a number of national UK newspapers as well as the London, Belfast and Edinburgh Gazettes. A helpline number will be provided which will enable customers to raise queries, concerns and objections as well as request additional information. All documents, including the full Scheme document and the IE s report, will be available on the ReAssure and Alico UK websites. I am satisfied that the communication strategy will result in a satisfactory communication exercise with with-profits policyholders. In particular, I am satisfied that communication will be compliant with the requirement of the PPFM, and that the communication will clearly explain all aspects of both the conversion of the benefits to non-profits and the subsequent Part VII transfer, and clearly distinguish between these. Page 21 of 30