Schrodinger's life fund

Editor's letter

In quantum theory, a subatomic particle can exist in several states at the same time. The act of measuring the particle's state takes place in the macroscopic world where only one reality is acknowledged. Physicists have attempted to reconcile these diverging pictures by arguing that measurement 'collapses' the particle's state to a single outcome. But putting the measurement apparatus in a box leads to paradox, dramatised by the fictional Schrodinger's cat whose fate is linked to a subatomic process. The unfortunate feline can be alive or dead at the same time - until the box is opened.

Does the with-profits concept in life insurance have similarly paradoxical properties? Obviously, there is nothing subatomic about vast funds backing the long-term expectations of myriad policyholders. But the idea that with-profits is a sustainable long-term proposition is very sensitive to the strength of these funds, especially the inherited estate not directly allocated to policyholders.

Some analysts cheekily refer to the estate as a 'slush fund'. But what is the estate? Life office actuaries choose their words carefully when answering this question. Like a stalactite in a cave, the estate accumulates slowly over time as the drip drip of policyholder premiums leaves a deposit of excess capital in a life fund. Of course, the word 'excess' is a loaded term, dependent on how regulators require obligations like policyholder guarantees to be measured.

Who owns the estate? It is one of those questions that change everything as soon as it is broached. Policyholders put the money there in the first place, so arguably they should own 90% of the estate. But shareholders arguably should get rewarded for taking the risk of having to bail out the fund if it is insufficiently strong to pay policyholder guarantees. Just ask Munich Re, Royal & Sun Alliance or AMP about this risk.

If the estate somehow manages to survive years of market volatility and changing regulation, what does its existence say about a with-profits business? Were the estate not present, the decline in customer demand for the product would kill it off commercially.

With a healthy estate providing the capital however, the possibility remains of relaunching the product in the future, which sits alongside the other possibility of distribution and run-off. Putting it another way, the real argument over the estate is between current policyholders and future policyholders whom the estate can be used to lure into the fund. Like Schrodinger's cat, the with-profits ideal can simultaneously be alive or dead, as long as one does not open the box of estate attribution.

But regulators have grown impatient with this quantum-like ambiguity in the new 21st century world of transparency. In the UK, the Financial Services Authority is believed to have pressured Aviva and Prudential to let current policyholders know what their estate share is. In Germany, the Justice Ministry has proposed a 50-50 split between shareholders and policyholders.

Once the attribution question has been asked, it can't be unasked. Or as quantum physicist Erwin Schrodinger said, "The task is not so much to see what no one has yet seen; but to think what nobody has yet thought, about that which everybody sees."