• Protecting With-Profits Policyholders - Policy Statement 12/4 - Feedback on CP11/5 and Final Rules
  • April 9, 2012
  • Law Firm: Norton Rose Canada LLP - Montreal Office
  • Introduction

    On 7 March 2012, the Financial Services Authority (FSA) published PS12/4 Protecting with-profits policyholders - feedback on CP11/5 and final rules (the Policy Statement). The Policy Statement follows the publication of CP11/5 Protecting with-profits policyholders, in February 2011 (the 2011 Consultation Paper). The 2011 Consultation Paper had proposed a range of changes to the FSA rules and guidance on the operation of with-profits funds, which are primarily contained in the Conduct of Business sourcebook (COBS) Chapter 20. The changes will, subject to specified transitional arrangements, come into effect on 1 April 2012.

    This paper summarises the final rules and guidance on:

    • the extent of with-profits policyholders interest in a with-profits fund;

    • distribution of excess surplus;

    • the required percentage for distributions;

    • the basis on which new business can be written;

    • run-off and material reductions in new business;

    • market value reductions;

    • strategic investments;

    • reattributions;

    • conflicts of interest; and

    • corporate governance.

    It also reports on the changes proposed in the 2011 Consultation Paper that were not retained by the FSA, including those relating to charges made by intra-group service companies to with-profits funds, and distribution and management plans.

    Perhaps the most important point to come out of the Policy Statement is the FSA’s recognition that it needs to look again at the issues facing with-profits mutuals and the impact on their with-profits policyholders and other members as soon as possible. In particular, the FSA acknowledges that the process it proposed, whereby a mutual can create "mutual capital" by splitting the long-term fund into a with-profits fund (held for the with-profits policyholders) and a mutual fund (which can be used as working capital), needs to be clarified. It is hoped that the FSA addresses these issues sooner rather than later.


    Extent of with-profits policyholders interest in the with-profits fund

    Retained Proposals

    The FSA has reiterated its view that with-profits policyholders have an interest in the whole and every part of the with-profits fund into which their policies are written. It has inserted guidance in COBS 20 to reflect this principle. The ‘narrow’ view, that such policyholders’ interest is limited to their asset share, is not accepted by the FSA.

    Comment

    The FSA has consistently maintained this position since it introduced requirements for treating with-profits policyholders fairly in 2005, so its confirmation of its view on this issue should not come as a surprise.


    Distribution of excess surplus

    Retained proposals

    Excess surplus exists if, based on the firm’s chosen risk appetite, a fund has additional money which there is no "fair" reason to retain. The current rules give firms the option of carrying out a reattribution or a distribution of such surplus. The FSA does not believe that a reattribution is an appropriate action in relation to an excess surplus and is taking this option away. Under the new rule, where an excess surplus is identified, it must be distributed in the "required percentage" to with-profits policyholders.


    The required percentage

    Retained proposals

    The FSA has clarified the definition of required percentage, (which is applicable to distributions referred to in COBS 20.2.17R, see above), to make it clear that it should reflect the firm's established practice, save where the required percentage is set out in the firm's articles or by court order. In order to demonstrate its "established practice", it is not enough for firms to simply rely on a percentage specified in the Principles and Practices of Financial Management (PPFM).

    Policy Statement clarifications and amendments

    The FSA had planned to add further guidance to highlight the need for a firm’s established practice to have been "clearly and unambiguously" communicated to with-profits policyholders (originally set out in COBS 20.2.17AG).

    Comment

    The FSA has maintained the requirement to distribute in accordance with 'established practice'. Although it has dropped the requirement that such practice must have been "clearly and unambiguously" communicated to policyholders, it makes it clear in the Policy Statement that such established practice should be “adequately demonstrated by the firm in its policyholder communications”.


    New business

    Retained proposals

    Under the new rules and guidance, new business can only be written if the governing body is satisfied, and can demonstrate, that there is likely to be no adverse effect on with-profits policyholders’ interests (compared to the current rules which say that new business can only be written if it is considered unlikely to have a material adverse affect on with-profits policyholders’ interests).

    Policy Statement clarifications and amendments

    Firms were originally to be required to carry out and obtain all appropriate analysis (including a profitability analysis) on the impact of the new business to support their conclusion and to provide that analysis to the firm's with-profits committee (or independent person) for independent assessment. Many respondents were critical of this aspect of the proposal and now, under the amended rules and guidance:

    • firms will need to carry out and obtain only "appropriate" advice as opposed to "all appropriate" advice, and firms can take a proportionate approach in determining what is appropriate having regard to relevant factors;

    • the consideration of the impact of new business should be by reference to each new business line when viewed as a whole, having regard to expected volumes and duration; and

    • the impact of new business should be assessed by reference to the with-profits policyholders in the relevant fund when considered together, rather than to each individual policy at any single point in time. Accordingly, short-term deferrals or the emergence or distribution of surplus, or a marginal reduction in the Equity Backing Ratio do not necessarily mean that there is an adverse impact, provided the new business is financially self-supporting and adds sufficient value.

    The FSA has stipulated a transitional period, under which new business based on compliant decisions taken by a firm's governing body prior to 1 April 2012 will be deemed to be compliant with the new rule until 1 July 2012.

    Comment

    The FSA has described the changes implemented as "a modest tightening of an existing rule". Having said this, firms should note that "no adverse effect" clearly imposes a stricter requirement than "no material adverse effect". The clarifications provided by the FSA are welcomed as they give firms some flexibility.


    Run-off and material reductions in new business

    Retained proposals

    The FSA wants to move away from the binary "open/closed" position under the current rules, which the FSA believes often leads firms to avoid actions that the FSA considers to be in their with-profits policyholders’ best interests. The FSA has replaced existing COBS 20.2.55R with a rule requiring firms to discuss their position with the FSA at an early stage and to consider whether they should take any particular action in their with-profits policyholders’ interests.

    Under the new rules, firms are under an obligation to discuss their position if they experience sustained and substantial falls in either:

    • the volume of new non-profit insurance contracts; or

    • the volume of new with-profits policies,

    written into the with-profits fund.

    However, the new guidance confirms that if a firm is no longer writing a material volume of new contracts of insurance but can demonstrate that the business is expected to be profitable, then it is likely to be able to continue to write new business, as long as it proposes to treat its with-profits policyholders fairly. The FSA has also clarified that new business, for the purposes of this requirement, will not normally include increments or business resulting from the exercise of options by policyholders.

    The current rules require run-off plans for funds that have been closed to new business since 2005; under the new rules, the FSA will now require a run-off plan for all closed firms.

    Policy Statement clarifications and amendments

    The FSA has made a minor amendment to its original proposal, by removing the references at COBS 20.2.54R and COBS 20.2.41BG(2) to material volumes of non-profit business being relevant to whether a with-profits fund should be regarded as having ceased to effect new contracts of insurance. It has, however, retained the reference to non-profit business in COBS 20.2.41AR. The effect is that firms can consider non-profit business when construing the rule on initiating a discussion about fairness, but not when considering the closure of a fund.

    In relation to firms with with-profits funds that were closed prior to 2005, the FSA’s original proposal (requiring such firms to submit plans to the FSA within three months of the proposed rules coming into force (i.e. 1 July 2012), if they had not already done so) has been extended to allow firms until 31 December 2012 to submit their plans.


    Distribution and management plans

    The proposal

    Under the 2011 Consultation Paper, the FSA proposed to require firms to have:

    • a fair distribution plan, based on their current and future prospects, and an investment strategy consistent with it; and

    • a management plan, including contingency arrangements against their plans not being achieved or unexpected risks arising.

    Firms would have needed to ensure that their distribution and management plans were reviewed and kept up-to-date to reflect any material changes in both current and expected levels of new non-profit insurance contracts and new with-profits policies. If firms experienced a significant and sustained fall in the levels of business they were expected to amend their plans accordingly and submit them to the FSA at least a week before the required discussion with the FSA.

    Policy Statement clarifications and amendments

    The FSA has accepted that the requirement to produce a fair distribution plan and a management plan creates the risk of duplication given the existing UK capital adequacy reporting requirements and future Solvency II requirements. Accordingly, the FSA is not proceeding with these rules at this time, but may revisit the proposals once it has greater clarity on the contents and level of detail available under the Own Risk and Solvency Assessment (ORSA) and other Solvency II reporting requirements.

    Comment

    This proposal would have been a significant burden to firms already trying to manage the burden of addressing Solvency II, and the FSA’s decision not to proceed with this proposal is welcomed.


    Market value reductions

    Retained proposals

    The FSA has removed the ability of firms under COBS 20.2.16R to impose market value reductions (MVR) on the grounds of surrender volumes alone, so an MVR can only be applied where the face value of the policy is higher than the value of the underlying assets. The FSA has also removed the requirement for the difference in value to be "significant" (as even a small difference applied to a large number of policies can potentially justify an MVR).

    Policy Statement clarifications and amendments

    The FSA has essentially retained this proposal, but recognises that there needs to be an element of pragmatism in how the rule is applied to reflect the intention to deliver asset share payouts in aggregate over time, not necessarily on each individual maturing policy at all times. The FSA has confirmed that it will not regard natural smoothing (which takes an asset share payout below 100 per cent) as inconsistent with the rule. It has amended the proposed rule accordingly so that firms will only need to comply “to the extent that it is reasonably practicable to do so”.

    The FSA has also added a new COBS 20.2.16AG, which provides that once the requirements of COBS 20.2.16R are satisfied, the firm can take into account the volume of surrenders (actual or expected) from the with-profits fund in considering whether or not to apply an MVR, and its amount. The FSA has also clarified that a reduction in amounts distributed to policyholders (eg a reduction in bonuses or the application of an MVR) must be treated as a "negative distribution" and be reflected in ongoing or future calculations of the "required percentage".

    Comment

    The concern with the original proposal was that it could indirectly result in policyholders being treated unfairly: for example, if there was a high volume of surrenders in a short period of time, the first policyholders to surrender their policies would not be as affected by an MVR as those who subsequently elected to surrender because (for example) the firm may only have a right to impose an MVR after the initial surrenders have taken place (and the fund has disposed of assets to cover payments to the surrendering policyholders, resulting in a fall in market value). As the FSA supports a pragmatic approach under which asset share payouts will be made in aggregate over time, these concerns appear to have been noted. However, it is not entirely clear how COBS 20.2.16AG is intended to operate in practice.


    Profit margins and charges made to with-profit funds

    The proposal

    In the 2011 Consultation Paper, the FSA proposed that an intra-group company providing services to a with-profits fund should only be permitted to charge costs, ie no element of profit.

    Policy Statement clarifications and amendments

    The FSA will not proceed with the proposed change. It will, however, look at alternative approaches, possibly allowing for charges to include an element to represent the realistic impact of risk transfers from the fund to the service provider.

    Comment

    The FSA’s change of view on this issue is welcomed; this proposal would have included in-house asset managers (who may then have had to impose "two tier" charging for with-profits and non-profits funds) and may also have had implications for funds which have undergone an insurance business transfer scheme and whose charges are set out in the court-approved scheme.


    Strategic investments

    Retained proposals

    The FSA has modified its existing rules on strategic investments. Where strategic investments are made or retained, the firm's governing body must now be satisfied (so far as it reasonably can be) and must demonstrate, that the purchase or retention is likely to have no adverse effect on the interests of with-profits policyholders. Firms must record the strategic purpose for which the strategic asset is purchased or retained, and consider whether the investment should be disclosed to with-profits policyholders. Where a firm reviews its strategic investments and concludes that it is no longer in the interests of its with-profits policyholders to retain them, the FSA expects firms to put disposal plans in place enabling them to realise the best price for the assets they are selling.

    The FSA has restored the guidance on strategic investments previously contained in COB 6.12.86G (setting out factors firms should take into account in relation to strategic investments) which was removed in 2007. The guidance is amended to reflect the revised rule.

    Policy Statement clarifications and amendments

    To assist firms, the FSA has included guidance listing the main investments that should fall within the definition of "strategic investment". The intention remains that investment in, for example, a group subsidiary or a large and illiquid asset such as a firm’s head office, should fall within the definition of strategic investment.

    The FSA has inserted a transitional rule, which states that retaining a strategic investment based on compliant decisions taken by a firm’s governing body prior to 1 April 2012 will be deemed to be compliant with the new rule until 1 October 2012.

    Comment

    The previous rule required that the strategic investment was "fair". The test is now more focussed on the with-profits policyholders interests, although it is not clear how in practice the amended rule will result in different outcomes from the original rule.


    Reattributions

    Retained Proposals

    When a firm proposes a reattribution, the FSA believes that it should be required to discuss the issue with them in advance. The firm will need to show whether it has an excess surplus and, if so, the amount of it. The FSA will also discuss the firm’s projected capital requirements for future business.

    The potential actions that a firm is obliged to take in relation to a reattribution will be discussed with the FSA, including the distribution of any identified excess surplus before the proposed reattribution of the remaining working capital is progressed. The forecast level of new business is crucial as it drives the level of capital the firm will need to retain (rather than distribute), and the level of surplus to be reattributed. A firm must be able to set out:

    • a solid basis for its view on the excess surplus;

    • its plan for distributing the excess surplus to policyholders; and

    • its overall justification for removing the remaining working capital in the estate from the with-profits fund in a reattribution.

    Once that is done, a policyholder advocate should be identified and brought into the process. Firms need to discuss governance arrangements with the regulator, including the terms of reference for the policyholder advocate. The FSA has amended the guidance to reflect their expectation that, in practice, discussions in respect of the policyholder advocate will lead to an agreement about the policyholder advocate’s precise role.

    Policy Statement clarifications and amendments

    The FSA has stated that the reattribution process was designed for proprietary firms, and is not the process that mutuals seeking to separate capital from the common fund have to follow. The FSA will consider in due course what process mutuals undertaking such a separation should follow.

    The FSA originally stated in the 2011 Consultation Paper that the policyholder advocate should have the right to communicate with policyholders without the firm approving the content of the communication. The FSA has now amended this proposal: the policyholder advocate will be required to consult the firm about policyholder communications and to agree messages, where possible. The policyholder advocate will, however, still enjoy a residual right to communicate independently if agreement is not reached in a reasonable time.

    The FSA’s current rules permit firms to use the statutory process of a solvent scheme of arrangement to effect a reattribution. In effect, this allows the majority to bind the minority. In the 2011 Consultation Paper, the FSA stated that it did not believe that the use of a scheme in the context of a reattribution would be fair, as it removes the policyholders’ option to reject a firm’s offer and to retain their interests in the estate. The FSA has now recognised that preventing all reattributions that seek to bind the minority could be seen as inflexible, as the regulator has the opportunity to object in court if appropriate, and will not be following up its proposal to ban reattributions by way of a solvent scheme.

    Comment

    The big issue outstanding is clarification of the process mutuals will have to follow when separating capital from the common fund. The FSA hopes to issue a Discussion Paper on this subject in 2012/2013.


    Conflicts of interest

    Retained proposals

    The FSA has converted COBS 20.2.1G (relating to the fairness of a firm’s operating practices and conflicts of interest) into a new rule. The guidance has also been expanded to make clear that potential conflicts of interest are not limited to those between shareholders and with-profits policyholders, but include conflicts between with-profits policyholders and:

    • non-profit policyholders within the same fund;

    • the members of mutually-owned funds;

    • management; and

    • different classes of with-profits policyholders (e.g. those with and without guarantees).

    Policy Statement clarifications and amendments

    Whilst the proposals have been retained, the FSA has made one notable change. Initially COBS 20.1.AR imposed an absolute requirement on a firm to ensure that all aspects of its operating practice are fair to the interests of its with-profits policyholders and do not lead to an undisclosed, or otherwise unfair, benefit to shareholders or to other persons with an interest in the with-profits fund. This has been watered down to a requirement to take reasonable care to do so.


    Corporate governance

    With-profits committee

    In the 2011 Consultation Paper, the FSA suggested that all with-profits funds (save for those with liabilities smaller than £500m) should be required to have a with-profits committee. Although this proposal has now been dropped, the FSA believes that there is considerable merit to the suggestion that it make a with-profits committee the general rule, except for those firms whose low level of complexity makes one unnecessary (and who would retain the existing ability to use an independent person to fulfil the role). This proposal may be consulted upon in the future.

    The FSA has also chosen not to proceed with the provision requiring firms with more than one with-profits fund to appoint the same with-profits committee for all of them.

    The FSA has also concluded that with-profits committees do not need to be wholly independent - it believes that if committees have an independent majority, possibly with a senior independent non-executive or external person chairing the committee, then they can reasonably include internal appointments to link them more effectively to the business.

    In defining independence, firms must have regard to the guidance the FSA has issued, which is in line with the Financial Reporting Council’s guidelines, including the annotated version used by mutual insurers.

    The FSA has made a transitional rule, so that firms’ existing governance arrangements are deemed to comply with the provisions in COBS 20.5 until 1 July 2012.

    Terms of reference and matters for consultation

    The FSA proposed in the 2011 Consultation Paper, and remains of the view, that a firm should discuss the terms of reference of the with-profits committee with the FSA and publish them on the firm’s website. However, the publication rule has been relaxed for firms without a website, in particular small mutual firms; for such firms, terms should be made available on request.

    The terms of reference must include a requirement for the governing body to consult with the with-profits committee in a timely manner concerning all matters the committee could reasonably expect to be consulted on. Finally, the proposal that with-profits committees should have the right to request external advice is retained, but the suggestion that such advice be provided at the expense of shareholders, has been dropped. These costs may be shared according to whether the issue under consideration is wholly or partly for the benefit of the firm rather than its policyholders.

    Issues with-profits committees should consider include, but are not confined to:

    • the firm’s compliance with its PPFM as currently drafted and whether the way in which the fund is run in practice is properly reflected in the PPFM;

    • how conflicts of interest have been identified and managed;

    • the identification of surplus and excess surplus and the merits of its distribution versus retention;

    • how bonus rates and MVRs (if relevant) have been set and applied and the application of smoothing;

    • any significant changes to the risk/investment profile of the with-profits fund - including the management of material illiquid investments and strategic investments;

    • the impact of any planned or implemented management actions;

    • the firm’s strategy for future business in the with-profits fund;

    • the firm’s customer communications;

    • relevant management information, such as customer complaints data;

    • drafting and adherence to the distribution, management and run-off plans and court schemes as appropriate;

    • the costs incurred in operating the with-profits fund; and

    • any other issues the with-profits policyholders may reasonably expect the with-profits committee to scrutinise.

    Interaction between the with-profits committee and with-profits actuary

    The FSA had intended to add a new item to the section on conflicts of interest contained in the Supervision Manual (SUP) 4.3.17R, which would have prevented the with-profits actuary reporting or having his remuneration determined in a way that could give rise to a conflict of interest. The FSA now accepts that with-profits actuary roles tend to be part-time or combined with other roles and that it can be difficult for the individuals concerned to operate effectively while still managing their future career prospects. The FSA will revisit the rule to make it less prescriptive, such that, when a conflict of interest arises it should be identified and managed effectively.


    Conclusion

    In general, the Policy Statement is to be welcomed, providing useful clarification on certain issues and modifying the FSA’s stance in relation to other matters that would have been difficult or unduly burdensome for firms to comply with in practice. However, there are some important issues remaining, most notably in relation to mutuals, and it is to be hoped that the FSA finds time to consult on, and implement rules relating to, these issues as soon as possible. The FSA has said that it will prioritise its work on mutuals, and on preparing for Solvency II, over revisiting any other unresolved issues arising from the 2011 Consultation Paper, and its planned work on customer communications.