While many other investment types have suffered as a result of the changing economic climate, the TEP market has benefited, with reduced risks and increased potential returns
Over the past few years the changes to the financial markets and the economic climate have made investors re-evaluate expectations from their investments. The traded endowment policy (TEP) market has not been immune and has experienced some of the most significant changes since the introduction of market makers to the market over 14 years ago.
The main impact reduced the risk and increased the potential future returns associated with TEPs. This has been achieved due to changes to the life office's asset mix, distribution of bonuses, calculation of surrender values and reduction in bonus rates, along with the implementation of new legislation.
The TEP market exists because there is a differential between what a life office values and pays on the surrender of a policy compared with the valuation of the policy on a continuing basis at maturity. The life office's surrender valuation will take account of charges that are applied in the contract's early years and penalties applied for the early cancellation of the contract. This allows a buyer of a TEP to not only avoid the charges, which are paid by the original policyholder, but to acquire the underlying guaranteed value and future value at a discount.
The recent application by life offices to apply increased surrender penalties has led to a reduction in the acquisition cost. Other factors have also increased the opportunities for buyers of TEPs, not least the long awaited changes in legislation that requires life offices to advise policyholders of the option to sell their policy rather than surrender it. This has provided increased volumes of policies being offered to the market. This is very good news for buyers of TEPs, who can now be very selective while enjoying the benefit of the increase in supply which has softened prices and provided them with greater choice.
TEP investors or buyers can still choose from a wide range of investment levels, investment terms, life offices and also the level of capital guarantee.
Changes in the market have also increased the level of capital guarantee that TEPs are able to provide. The level of capital guarantee now provided by TEPs is typically from 65% to over 100%. The majority of policies being offered for sale can provide a minimum capital guarantee in excess of 90%. The capital guarantee is calculated as the total of the sum assured and the attaching bonuses to date.
There is some correlation between the valuation of the TEPs potential future returns indicted as price discount rates (PDRs) and the level of guarantee accrued within the policy. The discount rates applied to the future value of the TEP range typically from 6% to 13.5%. Those TEPs that have a higher capital guarantee will usually be valued with a lower discount rate, compared with a relatively lower capital guaranteed TEP that will offer a relatively higher discount rate.
There are of course many exceptions to the previous example where the discount rate has been increased to provide better value on an already very low risk TEPs as there is less demand for the particular life office or investment term. This imarket can be particularly advantageous for the astute investor, who does not follow the market trend.
Recent bonus rate reductions have been advantageous to investors, as these have been incorporated into the valuation of the policy. Policies are valued using current declared bonus rates, which are assumed to remain unchanged throughout the remaining term of the policy, to calculate the value of the policy at maturity, which is termed the formula maturity value (FMV). The FMV is then discounted to achieve a price. The PDR applied represents the annual return, which would be achieved by the investor if the assumptions used in the calculation were achieved.
The PDR applied will vary depending on a number of factors, such as the investment term, the risk associated with the investment and the demand for a particular type of policy. The TEP market is currently offering competitive future potential returns with other investment products, which offer, in many cases, lower levels of guarantees.
The risk of investing in TEPs has reduced due to the reduction in bonus rates that have already taken place, and the lower rates, which are now used in the valuation of policies. The risk of exposure to future reductions in bonus rates has much reduced in the last two years.
The recent falls in bonus rates now mean that the assumption of the future maturity values have been reduced as they are based on lower growth rates, yet there are still discounted at a competitive rate in the current market. The rate of growth now being used to calculate the future maturity value is considerably less than that used two years ago. In the past two years the annual bonus rate has reduced by an average of 68% and the terminal bonus rate has reduced by an average of 43% for a 25-year term policy.
In addition, during the equity bull market the distribution of bonuses in the form of annual bonus payments and terminal bonuses changed to place greater emphasis on the terminal bonuses. This increased the risk that these bonuses may need to be cut in the future if the returns from equities could not be maintained. This in itself should not have been a problem, as after all, it is just a way of distributing the profits achieved. However, it may have increased policyholders' expectations for continuing returns to be paid in this way and at this level.
Bonus rate reductions were due to the fall in the underlying returns from the assets held by the with profit fund. Changes have taken place in the average asset mix of life offices over the past few years, which has led to limiting exposure to risk from volatile equities. During the equity bull market many life offices increased their exposure to equities in order to produce competitive returns. For example, the average life office asset mix in 2001 compared with 2003 is shown above.
It could be argued that the future growth rates used to value TEPs are conservative. A simple example of this is shown in the valuation of Pearl policies. Pearl has declared for this year that no annual or terminal bonuses will be paid.
The valuation method of most market makers, in such cases, is such that the future value of the policy at maturity will be equal to the current guaranteed value of the policy. This is because although the life office has declared no bonuses are to be paid this year, the market maker has assumed in its calculation that this will be the case for the remaining term of the policy until maturity, and hence the result is no increase in the valuation of the policy.
Although there is an assumption of zero growth, a discount rate has been applied which will equal the minimum annual return of investment which can be achieved, as the bonus rates can not be reduced further. For such a policy, the potential future return of investment can only increase, as it is possible that at some future date Pearl may declare future bonuses once again. Should it do so the increase in the future maturity value should result in a considerable increase in the return. This is a completely new effect within the TEP market and an extreme example.
But why is it that a future annual return can be achieved if the life office pays no further bonuses? This is due to the higher past returns achieved compared with today's. Bonuses have already been paid and once paid cannot be taken away, so they are guaranteed. The PDR applied to these guarantees enables a return, in this case irrespective of any future bonuses being paid by the life office.
Other policies also provide potentially higher returns but they will rely on some further bonuses being paid during the remaining term of the policy. The key to a good return is to assess what will be the actual bonuses paid during the term of the policy compared with those used in the valuation calculation.
For many years the assumption has been that bonus rates will reduce and the buying of TEPs has been done in conjunction with a sensitivity table which gives an indication of the effect of future rate changes on individual policies. But where as before the view was a negative one, for policies which offer a medium to long-term investment, many investors are considering that we may have seen the bottom of the market in terms of reductions in bonus rates. Now some positive results are being achieved from equities although many do not anticipate bonus rate increases in the near future. The current valuation of policies in the market provides good potential future returns without the need for increases in bonus rates
Most market makers can provide sensitivity tables, which are a unique set of calculations for each policy to indicate the effect of changes to the current bonus rates being applied. In addition, we can provide an historic table of bonus rates. The combination of the information of the past bonus rate history and future scenario calculations gives the investor or their adviser much more information on which to base their investment decision compared with many other products.
Increased surrender penalties has led to a reduction in TEP acquisition cost.
The level of capital guarantee under TEPs has increased.
The risk of investing in TEPS has reduced due to lower growth assumptions.
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