This business needs a thorough turnaround
(Filed: 30/10/2004)

As Europe's largest mutual insurer considers a flotation, the Telegraph invited its chief executive, Sandy Crombie, and a policyholder to set out opposing views. Both agreed. Then Mr Crombie changed his mind. Here's holder Michael Holder's view

Since 1987, I have invested in a Standard Life (SL) with-profits endowment. I bought it to repay a mortgage and, if there was any surplus, create additional retirement savings.

All perfectly ordinary. I have tracked its value since 1992. It peaked in 2000, when it was about £92,000. It is now worth about £74,000, a decline of about 20 per cent. The real fall is much greater, as I have paid almost £15,000 in additional premiums during the intervening years. Adjusting for premiums and a small rate of return doubles the loss to about 40 per cent.

Until recently, I trusted SL's explanation that the losses on its life and pensions policies were caused by the fall in the stock markets. I now know this to be untrue. To see why, compare SL with Prudential's with-profits performance between 2001 and 2003. SL's losses were twice as bad as Prudential's. The Pru lost 4.41 per cent of its with-profits fund. SL lost 8.38 per cent.

Why was this? Prudential had recognised that values were too high, and had reduced its high-risk equity exposure. SL's management was boasting that it had plenty of capital, and could afford to invest in equities. So it sailed into the post 9/11 market crash, having invested 85 per cent of the with-profits fund in equities and property. The fund, which belongs to SL's members, lost £12.7billion between 2001 and 2003. If SL's management had been as smart as the Pru's, they would have lost £6.7billion, not £12.7billion.

It is important to put the losses in context. This way, we can begin to understand why with-profits investors, both pension and endowment, face huge maturity shortfalls. Insurance companies and their regulators are overwhelmingly concerned about the company's capital strength. This means the capital that they have set aside to pay for disasters. This is their capital surplus. In 1999, SL's capital surplus was £9.4billion. Today, on the same basis, it is £1.32billion.

SL's weakened capital forced it to invest increasingly in lower-return assets. It has cut its exposure to equities and property to 36.5 per cent and 15.1 per cent respectively.

It has also changed the valuation rules for the with-profits fund, so as to release £1.1billion, accounting for most of the £1.32billion. So policyholders have paid to keep SL in business and are rewarded by an endless stream of benefit reductions. Some deal, especially as Pru's investors have suffered no such attack.

Maybe SL's directors have done a better job in investing outside of the fund? The answer is no. SL Bank took six years and losses of £125m before it made a small profit of £4.6m. SL Healthcare's accumulated losses are £44m.

SL Investments is commercially irrelevant as an independent business. It is just the in-house investment management group disguised as a company. SL contributes 85 per cent of its business. Compare it with the Pru's M&G, which has high independent brand recognition, and real value. The story is much the same offshore. Canada apart, these are all companies where SL has invested policyholder's money for negligible or lossmaking returns. The sums at risk are almost £3billion. SL routinely describes its subsidiaries as robust. In truth, they are anaemic.

Robust is a good word to describe directors' pay and benefits. My conservative estimate of the cost of the board between 2001 and 2003 is £21m. For example, Sandy Crombie, the group chief executive, took home £743,000 in 2003 but received an addition to his pension scheme worth £866,000. Add in a further £342,000 accrued for him in the long-term incentive plan, and he cost £1,951,000. His pay in 2003 increased by 27 per cent.

Over three years to 2003, executive directors' costs rose while policyholders have suffered. Why should directors' pay rise by high double-digit percentages for modest profits and even single-percentage figures for record losses?

Many with-profits members hope demutualisation will produce a compensatory windfall, at least for projected policy shortfalls. Unfortunately, this will not happen. The gap is too great between any likely value for SL and the projected maturity shortfalls on life and pensions policies.

My policy illustrates the problem as well as any. The latest projected maturity shortfalls depend on the earnings of the with-profits fund. Instead of the £150,000 which I need to repay a house purchase loan, I should expect a shortfall of £38,353 if the with-profits fund earns a 4 per cent return; a £30,193 shortfall if the fund earns 5.75 per cent; and £21,217 if it earns 7.5 per cent.

Using SL's own figures, I can see that if my shortfall is £38,353, SL has to be worth £19.5billion at demutualisation to make good the shortfall. If my loss is £30,193, SL has to be worth £15.7billion. Finally, a loss of £21,217 needs a value of £11billion. This means, for example, that if my loss is £21,217, then my share of a float worth £11billion would wipe out my loss. The same logic applies to all with-profits policies.

There is a near zero probability of SL being worth between £11billion and £19.5billion by 2006. Aviva, the most valuable insurer, and Prudential are worth about £12.4billion and £9.2billion respectively. They are highly-rated and truly robust. SL is probably worth about £5billion - somewhere between Friends' Provident and Legal & General.

Even at £5billion, members would be sharing with new investors, who will take about £2billion. So, assuming the worst maturity shortfall in my case of £38,353, my share of £3billion would be £5,800, leaving me with a loss of £32,753. Some windfall.

There has to be a better solution for members. This is a business which needs a thorough turnaround.

The current team have been very well paid despite a damning record. They are determined to demutualise. They look forward to their generous pay and pensions, in contrast to the bleak outlook for members. They don't cut the mustard.