In this case, a company's financial strength is critical for several reasons. It determines whether it will be able to continue delivering high annual and terminal bonuses, what its investment strategy should be, even whether it should sell its shares to meet its obligations to policyholders.
All with-profits bond providers will invest in a mixture of equities, property, cash, gilts and fixed interest securities. The ratio of that mix is itself determined by a company's strength: if you are weak, then in order to pay out annual bonuses on the bond you must invest more in securities. This affects the performance of your fund which gets less exposure to higher-return equities.
Conversely, a strong provider will be able to invest more of its funds in equities, while still meeting any guarantees to policyholders. Returns will be higher. Financial strength also determines what happens in the event of a market melt-down.
So how is financial strength measured? By way of a "free asset ratio", or FAR, which is a calculation of the freely-available assets a company has, compared to its total assets. The higher the FAR, usually a percentage, the better.
A note of warning: a company's FAR may also be higher because over the past year or two it has paid out less annual bonuses.
FARs are calculated by Standard & Poor's, the credit reference agency, which assesses a life insurer's financial strength. S&P will then allocate a rating, ranging from AAA, which denotes superior financial strength, to CCC, meaning "extremely weak".
Whenever you are deciding which with-profits bond to buy, always check what S&P rating it has. The higher the better.
`The Independent' has produced a free 24-page `Guide to With-Profits Bonds'. Written by Nic Cicutti, our personal finance editor, the guide examines the arguments for and against investing in bonds. It explains the tax implications and where to buy a bond. For your copy of the guide, sponsored by The With-Profits Bond Shop, call 0845 2711007Reuse content