Assessing Financial Strength with the Free Asset Ratio
In this blog post, we take a look at a key financial measure – the free asset ratio. This is something that has the potential to come up in a number of CII exams including R01, R02, R05, and CF1.
Choosing a Provider
When an independent financial adviser (IFA) is determining which product provider to select for their client, there are a number of factors to consider, including:
- the product itself and the cover it gives;
- the provider’s underwriting requirements;
- the premium rates on offer when compared to other providers;
- the quality of the provider’s service; and lastly, but by no means least;
- the provider’s financial strength.
Today it’s the provider’s financial strength that we are concerned with.
An IFA will want to ensure, as best as they possibly can, that the provider they choose to recommend to a client will still be trading and solvent in the event of a future claim.
The Prudential Regulation Authority (PRA) regularly monitors the financial strength of regulated firms. A weakening of financial strength below certain parameters will result in PRA sanctions. These include being prohibited from accepting new business.
Providers must make their financial data public, meaning that an IFA can scrutinise it and make their own judgement call as to whether a provider is in a good position or not. A key measure for assessing financial strength is the provider’s free asset ratio (FAR).
Free Asset Ratio (FAR)
So, for example, if a provider has total assets of £5m and liabilities of £4m, it’s FAR would be:
This means that the provider’s assets exceed its liabilities by 20%.Learn how to calculate the Free Asset Ratio, used for measuring financial strength - perfect for your #CII exam revision. Click To Tweet
Interpreting the FAR
Generally, the higher the FAR, the better. A high FAR suggests a strong provider that can cover its existing financial obligations with assets to spare that can then be invested to grow the company further. Where with-profit policies are involved, it suggests that bonuses will be affordable and can be maintained for some time.
However, like many ratios, the FAR has been called into question. In particular, there is some discretion in accounting methods when it comes to valuing assets and liabilities. A provider can also reduce their liabilities by reassuring them elsewhere. Care needs to be taken that any guarantees made in the past are fully provided for in reserves.
Given the above limitations, ratings agencies can provide an additional or even an alternative source of information. These agencies assign their own strength ratings to providers. The IFA can then use these in conjunction with their other research.
Grab the resources you need!
If you’re studying for your CII R02 exam, and you aren’t feeling confident, grab our free taster to try out one of Brand Financial Training’s mock papers for yourself. Click the link to download the R02 mock paper taster now!
Information in this article is correct as at 27 January 2021.