The sub-prime lending crisis in the US continues to cause damage to the financial markets. Northern Rock was its first manifestation to most people in the UK, and when its problems were first hitting the headlines, shares in general had hardly suffered. The UK dithered over Northern Rock, but it provided a valuable lesson for subsequent problems - and the rescue of Bear Stearns in the US (a much bigger institution) was a big improvement.

Northern Rock relied too heavily on other banks to finance its aggressively expanding mortgage book. Like most banks, it borrowed short and lent long, but the Financial Services Authority (FSA) should have spotted just how much it was out on a limb. By contrast, life insurance companies - including Friendly Societies - are looking after people's long-term savings and most of their investments are highly liquid.

Some of our investors have asked about the implications for our with-profits fund. We spread our investments, with a third in UK government bonds, a similar amount in UK equities, and the rest in several categories including commercial property. We have successfully weathered several equity bear markets over the years, and we met the FSA's solvency requirements comfortably throughout the last one - the "dot.com bust" - when the FTSE 100 plunged by over 50% from top to bottom. It has since recovered, of course, and even now is only about 20% off its peak last summer.

It is always difficult to predict where the market is going - you could make a fortune with that knowledge. But we have definitely moved into a period of high volatility - that is, the day-to-day swings in the market are much higher than usual. High volatility means high risk, so investors want to be compensated with higher returns. In the short term, this drives down prices. But there are other factors behind falling prices - in particular, recession in the US and continuing issues in the banking sector.

If this turns out to trigger a severe bear market, we have the capital required to meet the guarantees that form part of our with-profits contracts. This is generally the case for the whole UK with-profits sector - although this includes many closed funds, some of which have sold all their equities in order to manage their guarantees.

The UK has various means of protecting savings. Savers with life insurance companies and friendly societies are protected for 90% of their investments without limit. There have only been the most trivial claims on this compensation scheme. (The same cannot be said for general insurance companies - the most recent high profile case being Independent.)

Even with our investments spread, we still have good years and not-so-good years. Like most with-profits fund, we aim to smooth the investment returns to our members, rather than passing on the full impact of the market's ups and downs in one go.

We believe that there is a good future for with-profits funds in the mutual sector, where there are no shareholders to satisfy. To take an example, a lump sum invested with us 10 years ago has grown by 78% (about 6% per annum compounded) with basic rate tax paid by us. This 10 year period included the dot.com bust! Other examples are given in the Past Performance page.

Stuart Bell
Chief Executive
March 2008