Long-standing policyholders do not deserve much compensation

`Mr Stretton argues that payments should be reduced with the length of time a policy has been held'

Tens of billions of pounds are being handed out to the owners of Britain's insurance companies and building societies as they convert to conventional companies with ordinary shareholders.

Yet it is extraordinary that, with so much at stake, and seven years after the first large-scale demutualisation, there is still a complete muddle over how to distribute the proceeds fairly to to the owners - the policyholders, depositors and borrowers.

Building societies have already thrown up a fair share of anomalies in the way they pay their former owners for agreeing to give up mutual status.

Abbey National was the first to convert to a bank in 1989, and gave a flat-rate reward in shares to all qualifying customers, regardless of how much business they did with the society. Other societies decided the fairest way was to relate payments to the size of members' deposits and loans, until Alliance & Leicester caused a row last month by switching back to flat-rate payments, just like Abbey National.

But these differences among the building societies about what constitutes fairness pale into insignificance beside those thrown up by life insurers, where questions of compensation are proving far more complicated.

Norwich Union will be the first life insurer to float on the stock market, but many others have already dropped mutual status to allow themselves to be bought by another company. In all cases, with-profits policyholders, the owners, must be compensated for giving up control.

Most people have assumed that payments should be larger for those who have been members for a long time and have built up substantial funds. This follows the conventional building society model (excluding, of course, the anomalies of Alliance & Leicester and Abbey National).

Jim Stretton, chief executive of Standard Life, has thrown the cat among the pigeons by suggesting that the fair method for insurance companies is exactly the opposite of the commonly accepted practice.

Mr Stretton has an axe to grind because he is a determined opponent of demutualisation. But he says the shorter the time a policyholder has been with a company and the lower the funds built up, the higher the compensation should be. Perverse though this sounds, there is a compelling logic to it, which derives ultimately from the different behaviour of building societies and life insurers.

Many building societies have run themselves just like banks, accumulating large reserves to expand their businesses, instead of handing their profits back to their owners in the form of lower mortgage interest and higher deposit rates.

The characteristic that sets mutual insurers apart from building societies is that they have always routinely distributed most of their profits to their policyholders through annual and terminal bonuses.

There is a fuzzy dividing line, because insurers also build up their reserves to a certain extent from their profits, as their businesses grow. But the basic philosophy, that the financial success of the organisation should be shared with customers each year, is much more evident among insurers than building societies.

Some building societies have belatedly realised that this is the only way to justify the continuation of mutual status, and have begun to distribute their profits by giving cheaper deals on mortgages, and better deposit rates.

Mr Stretton's argument is that long-standing policyholders of mutual insurance societies have already received their fair rewards as owners, because the societies' profits have been used over the years to improve their bonuses. Indeed, he goes further, and says the policyholders who deserve the most compensation are those who have taken out policies just ahead of demutualisation. Therefore payments to policyholders for accepting demutualisation should be structured so they reduce with the length of time a policy has been held.

Mr Stretton says: "The customer whose policy matures one day before demutualisation takes place deserves no compensation, because his or her policy has been fulfilled under the terms and conditions he or she originally contracted for. However, anyone who has just taken out a policy, or who may be committed to the process of taking out a policy, suffers the greatest change and the greatest risk that the outcome for them may be substantially worse than they were originally led to expect."

In other words, a policyholder who has recently joined is shortchanged by the loss of mutuality. Having signed up expecting the long-term benefits of mutual ownership, the policyholder becomes just another customer of an ordinary company. The longer the policy has to run after conversion, the more the cumulative shortfall will be.

This argument only stands up if there is evidence that mutual societies produce better results than proprietary insurers. It is certainly true that 10 per cent of the profits in the life funds of proprietary companies belong to shareholders, whereas the entire amount belongs to with-profits policyholders in a mutual company.

Michael Doerr, chief executive of Friends Provident, calculates that his mutual policyholders receive 15 per cent more in bonuses than they would after a switch to proprietary ownership. There is a gearing effect, because Friends is owned by a diminishing percentage of its customers. The proportion of with-profits policies on the books is falling as it diversifies into other areas of insurance.

Last month, The Independent published research by John Chapman, a former senior official at the Office of Fair Trading, showing that mutual societies produced better returns for their customers. Mr Stretton produces similar evidence that mutuals perform better than the rest (see table).

If Mr Stretton is right, companies such as Scottish Equitable, that have paid nothing to new policyholders and most to those who have been with the society a long time, have got it back to front.

If there is so much disagreement about the fundamentals, perhaps a halt should be called to the demutualisation process while the actuarial and insurance professions sort out who owns what and how much they are owed.

Otherwise, when somebody does establish to everyone's satisfaction what fairness means, vast numbers of people will find they have been robbed and others will have received rewards they do not deserve.

With-profit policy performance 1986-95

Percentage of average payout

Endowment assurances Personal pensions Total

Mutuals 102.8 102.3 102.6

Proprietary 92.2 97.5 97.3

Expense ratios %

1995 1991

Mutual Proprietary Mutual Proprietary

Acquisition* 72.2 103.9 77.7 101.3

Renewal** 5 7.3 5.1 8.4

Lapse rates 1995 %

Mutual Proprietary

First year 5.3 8.3

Average 5.4 7.8

*of new business **of existing business Source: Standard Life