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Has the 'dinosaur' had its day?

WITH-PROFITS policies have complex structures, largely because they evolved by accident. An early life insurer studied the mortality data of its home town and calculated appropriate premiums for the local community. The idea was that financial help could be extended to any unexpectedly widowed family. With a margin for administrative costs built in, the general principle was mutual benefit, not commercial profit.

As demand grew policies were sold far and wide. Then came the accident. It transpired that people throughout the country on average lived longer than in the town where the sample arose. This meant that most had overpaid and there was a large surplus of cash.

As the system was supposed to be mutual, the insurer was obliged to start doling this "profit" back to lucky policyholders. They liked this so much that the insurer carried on overcharging people for insurance and sending them back the difference as a bonus. In this way, the with-profits policy was born.

Today, with-profits, which has to fight with its unit-linked rivals, is increasingly seen as a dinosaur . "They can still be useful in the right circumstances, but overall I feel they have had their day," says Mark Howard, managing director of financial adviser Maddison Monetary Management. "It is not so much a case of which is better - with-profits or unit-linked - as much as what is required to fit the client's circumstances. Today, the more sophisticated attitude of even the modest saver means that flexibility and transparency are 'in', with mystery and lack of control definitely 'out'."

Most with-profits endowments are used as repayment vehicles for home loans. Very few are bought on a stand-alone basis for general savings purposes. Mr Howard says: "For mortgages or lump-sum investment without the thrills of the stock market, a with-profits approach certainly lets you sleep at night. But over the last 10 and more years, the performance of unit-linked has been superior. So an investment portfolio - as opposed to a house-buying exercise - should certainly be biased towards unit linking."

Fans of with-profits plans say that because not all the profit is credited to the policy in one go, the insurer can "smooth" the long-term performance curve by adding some sort of bonus in years where profits are lean. At the end of the term, a "terminal" bonus is usually paid to credit the remainder of the due profits.

Unit linking, by comparison, is simplicity itself. The money pooled together from thousands of investors goes into a fund. The fund is notionally carved up into "units" priced by simple arithmetic division. As the holdings in which the money is invested change in value, so do the units.

Critics say that with-profits results place heavy reliance on terminal bonuses, and these are only paid to those policyholders who last the course. Peter Kelly, protection marketing director at Allied Dunbar, says: "The risk of losing your terminal bonus by pulling out a few years early to pay off your mortgage and save on interest payments amounts to a whopping surrender penalty."

All leading companies seem to agree; they now offer unit-linked options as well. David Riddington, Norwich Union's actuary, says: "It is very much horses for courses. The important thing is that customers know what they are getting. If you've got a fixed liability to meet at a specified date in the future, the smoothing effect of with-profits might be your choice. Unit-linked plans, on the other hand, give access to flexibility of fund management and appeal to investors who want to tailor their exposure to risk. It is healthy to have both options on the table."