This article was last updated by the author in October 2016.
A brief introduction to with-profits and unit-linked funds.
The returns from endowment and whole of life policies can be
linked to investment performance. This can be done in one of two
- With-profits - where benefits are indirectly affected by
investment performance; and
- Unit-linked - where benefits are directly affected by
Historically, with-profits policies have been the main
investment products offered by insurance companies. They are
available in both regular and single premium contracts, although
the bulk of new investment has been in single premium bonds.
Investment performance is reflected in bonuses that attach to
- Bonuses, if declared, are added to the value of the policy
annually. The bonuses are based on the company's profits from its
investments but, over time, bonus rates have been cut severely,
sometimes to zero.
- The largest single investment area of with-profit funds used to
be equities. In recent years there has been a move away from
equities for solvency reasons. Some closed funds (funds that are
not open to new policyholders) are now almost entirely invested in
fixed interest securities, property and cash, while open funds
typically have less than half of the fund invested in
- The annual bonuses are generally set at a rate that the
insurance company's actuary believes represents the long-term
returns from the funds. Annual bonuses therefore, used not to be
particularly volatile, although they have been falling since the
early 1990s. In the main, they reflect the income yields on
investments in a smoothed, long-term fashion. However, financial
pressures have limited the scope for companies to take a long-term
- Terminal bonuses are paid when the policy matures or on death
and generally tend to represent more of the capital growth that the
insurance company has made on its funds. Terminal bonuses are
therefore more volatile and more directly affected by changes in
the investment markets. As annual bonus rates have fallen, terminal
bonuses have become more important. However, some companies suspend
terminal bonuses when stock market conditions are difficult.
- Insurance companies usually reserve the right to reduce the
amount paid on the surrender (but not on maturity or death) of a
policy during times of adverse market conditions. A market value
reduction (MVR) is applied to unitised with-profits funds, whereas
for traditional policies this will be achieved by changing the
surrender value basis.
As intimated above, with-profits policies are available in two
- Conventional (traditional) with-profits - this
type of policy has an initial sum assured that is increased by the
addition of bonuses. Annual or reversionary bonuses and terminal
bonuses are declared as a percentage of the sum assured, or the sum
assured plus attaching bonuses; and
- Unitised with-profits - these are
with-profits investments expressed as a unit-linked policy, where
the premiums buy units in the unitised with-profit fund. The main
difference from other unit-linked funds is that the unit price is
guaranteed not to fall. Virtually all with-profits policies
currently available are written on a unitised basis. The
traditional with-profit contract, while still an important part of
the traded endowment policy market, has all but disappeared in
terms of new business.
The performance of with-profit funds depends on:
- the underlying performance of the investments, which is the
most important factor; and
- for some companies, the profitability of their other
The strength of the company's reserves is often measured by the
size of the free asset ratio (the surplus assets held by a life
office over the value of its liabilities). This can allow reserves
to be maintained, even in those years when the value of investments
and the income from them have fallen. The companies generally try
to maintain a balance between:
- retaining enough of the profits in particularly good years to
smooth out the bonuses in years when investment returns are poor;
- providing each generation of policyholders with the appropriate
returns from their investments.
With a unit-linked policy, the premiums buy units in the fund of
the investor's choice. This might be run by the life office itself,
or it might be a unit trust or open ended investment company (OEIC)
run by the life office or another institution.
It has the following characteristics:
- The value of the policy is measured by the total value of the
units allocated to it.
- Immediately a policy is effected, its surrender value will be
lower than the premium paid. This will be because of the difference
between the buying and selling price of the units, usually 5%
and/or because there is an early termination penalty.
- From then on, a policy's value depends on the performance of
the fund, or funds, to which it is linked.
There is a big difference between the performance of the best
and worst life offices, and the best and worst unit-linked funds
within life offices.
- The more specialised the fund, the greater the chance of
spectacular rises in value and also spectacular falls.
- The more broadly based a fund, the more likely it is to conform
to an average return and the less likely it is to suffer a
- There is some evidence to suggest that new funds tend to
perform better than average in their early years because their
small size tends to make dealing easier.
- There have been problems in the past with small funds investing
too high a proportion in one single investment.
It is fair to say that unit-linked policies therefore have a
higher risk/reward profile than with-profits.
Unit-linked policies maturing when stock market prices are high
will normally outperform their with-profits counterparts. However,
policies maturing when stock market prices are low may perform
badly. For this reason, most policies include an extension option
so that encashment can be deferred at maturity date until depressed
stock markets recover.
Although not as popular in the past, the majority of life
offices provide their policyholders with access to both
with-profits and unit-linked funds via their whole of life
products, most notably in the shape of single-premium investment