Know your onions. Be protected

Phil Oxenham, Marketing Manager at Skandia International, explains how the different layers of investor protection available can provide security for your investments.

To quote that big green philosopher, Shrek, “Onions have layers. Ogres have layers. Onions have layers. You get it? We both have layers.” Well, to add another analogy, the protection surrounding offshore investment products too have multiple layers, although rather more like an onion than an ogre.

Of course, I don’t want to trivialise a topic that has become a significant issue for advisers and clients over recent times. With a number of sizeable financial companies getting into difficulty, it is important that we ‘peel back the layers’ and offer clarity about how your assets are protected.

There are two main risks to an offshore investment policyholder – the risk that the available assets of the life company are inadequate to meet its liabilities, and investment risk. This article will assess each in turn.

Life company risk

Layer 1 – choosing a financially secure provider

A policyholder protection scheme is only required when things go wrong. The more financially secure and established a company, the less chance there is of it being unable to meet its financial liabilities. An added layer of additional financial support may be provided by a large parent company.

Layer 2 – regulatory safeguards

On the Isle of Man, for example, all authorised life assurance companies are closely regulated by the Isle of Man Insurance and Pensions Authority. Regular internal and external audit activity and strict reporting requirements ensure that companies comply with the regulator’s safeguards; one of those safeguards is a solvency margin.

Solvency margin

The solvency margin is the comparison between what a company owns (its assets) and what it owes (its liabilities) and indicates the ratio of assets to debt. Therefore, the solvency margin provides a good indicator of the financial stability of that company. The Isle of Man Insurance and Pensions Authority, as the regulator, monitors any falls in solvency below 150%.

Isle of Man Insurance Act 2008

All authorised life assurance companies must also comply with the Isle of Man Insurance Act 2008 (‘the Act’), which specifies the following areas of close supervision.

Ring fencing

A key reason why a firm may be unable to meet its liabilities is if it goes into liquidation. The Act imposes a number of safeguards to protect policyholder assets should this occur. The Act:

• requires Isle of Man life assurance companies to set up a long-term business fund (LTBF), to hold assets linked to policies issued, and
• restricts how these assets should be used, i.e. only for the purposes of meeting liabilities of the policies, and
• requires a life office to keep its LTBF separate (or ring fenced) from its general business accounts.

The fact that policyholder assets are segregated from the company’s own means that in the event of liquidation, the liquidator or administrator cannot access policyholder funds.

Winding up

The Act ensures that no insurance company can be wound up voluntarily. It also ensures that, if wound up, the ring-fenced assets are earmarked for policyholder/clients’ liabilities and cannot be used for other purposes. Clients assets are therefore not available to liquidators if the life company or its parent company fails.

Layer 3 – compensation schemes

If a life assurance company is unable to meet its obligations, compensation schemes may come into play. While this will depend upon the life company’s home jurisdiction, in the Isle of Man the Life Assurance (Compensation of Policyholders) Regulations 1991 protects all investors whose policies were taken out after 31 January 1991. The compensation scheme offers investors up to 90% of their policy value, minus any contractual charges, and has no upper monetary limit. This applies no matter where the investor lives in the world.

This protection only applies if the Isle of Man based life company is unable to meet its liabilities. It does not cover any loss incurred as a result of investment in shares, bonds, funds, property and cash deposits (the underlying investments) whose value subsequently falls.

Investment risk

Layer 4 – diversification

By diversifying the underlying investments, investors can reduce many of the risks associated with the reliance upon one particular fund or asset. This provides a further safety net. The main choice is between cash, bonds, property and shares. Not only do they have different risk/return characteristics, but they also behave in different ways; the theory being that when one asset class is underperforming, another may be outperforming.

Third party fund managers

All underlying investments held in offshore investment products are owned by the life assurance company. As a result, all rights relating to these funds and assets belong to the company. Unless providing some form of guarantee, the company accepts no responsibility for the performance of an underlying investment. The value of the product will be directly linked to the investment performance of the chosen bank deposits and investments, which are usually managed by third parties such as banks and fund managers.

As with the life assurance company’s ‘layers’ of protection, some or all of the layers will generally apply to those third parties, especially those that are fully regulated. There is, however, a key difference with regard to compensation schemes. In the event that the provider of an asset (including bank deposits) fails, compensation will depend upon where that provider is registered.

As all assets are owned by the life assurance company, any compensation arrangements are likely to relate only to the life assurance company’s aggregated holdings across all affected policies rather than to individual investors. If preservation of capital is the primary objective, then it is imperative to ensure appropriate diversification is in place to reduce these risks.

Conclusion

Offshore investment solutions offer access to a wide range of underlying investments. You can switch between these to match any changes to your risk profile in the prevailing climate. By using this flexibility and ensuring that investments are adequately diversified, you can benefit from the layers of available protection and from the added security for your investments.

This article is based on Skandia’s interpretation of the relevant laws and regulations as at May 2010. While we believe this interpretation is correct, we cannot guarantee it. Although every effort has been made to ensure the accuracy of this article, we do not give investment or legal advice and can accept no responsibility for any act or failure to act based upon its content.