In June 2010, the Financial Services Authority (FSA) published its "With-profits regime review report". On 24 February 2011, the FSA published a consultation paper that proposes amendments to its with-profits regime. The amendments are designed to address most of the weaknesses identified by its regime review report.
Some of the proposals are straightforward and uncontroversial. But others will increase the administrative burden on an industry that is already responding to significant regulatory change.
Protecting with-profits policyholders
The FSA's current "treating with-profits policyholders fairly" regime includes:
- The rules in chapter 20 of the FSA's "Conduct of Business" sourcebook; and
- Principle 6 (Customers' interests), Principle 7 (Communications with clients) and Principle 8 (Conflicts of interest) of its "Principles for Businesses".
The rules in chapter 20 of the Conduct of Business sourcebook were introduced in 2005 and simplified in 2007. They have been controversial in practice; especially for mutuals, firms that have been required to pay compensation or redress, firms approaching run-off, and firms wanting to reattribute an inherited estate.
In 2009, the FSA began a review of its with-profits regime and an assessment of how well firms were complying with its rules. It published its conclusions in June 2010 in the "With-profits regime review report". In particular, it found that:
- Most firms couldn't show their practices were consistent with those of a well run with-profits business;
- Firms were not doing enough to provide independent input into the management of their with-profits funds;
- Governance and communication weaknesses were common across a range of firms;
- Too many firms relied too heavily on the personality and professional standing of their with-profits actuary to over-come potential conflicts of interest. And, instead of providing the actuary with a supportive management structure, they left him to mitigate the additional risks that structure created;
- These problems have created potential risk for a significant number of policyholders.
The FSA's "Consultation Paper 11/5*** Protecting with-profits policyholders" includes proposals for addressing some of these concerns. The FSA will publish a second consultation paper in late 2011 to address the remainder.
Summary of proposals
If the FSA's proposals are implemented, chapter 20 of its Conduct of Business sourcebook will be amended to:
- Include guidance which confirms the FSA's (controversial) view that with-profits policyholders have an interest in the whole of a firm's with-profits fund, including a contingent interest in any surplus prior to a distribution;
- Include guidance that more fully describes the range of circumstances in which a conflict of interest can arise between:
- One class of with-profits policyholders and another;
- The firm's with-profits policyholders and its non-profits policyholders; and
- The firm's with-profits policyholders and its (shareholder or member) owners;
- More clearly assert that Principle 6 (Customers' interests) and chapter 20 of the Conduct of Business sourcebook don't just apply to open funds and proprietary firms, but to closed funds and mutuals as well. As a result (for example) mutuals are also required to determine whether they have an "excess surplus" once a year, and to carry out a distribution unless there's a good reason not to;
- Confirm the FSA's view that inter-generational transfers between one class of with-profits policyholder and another class with similar interests are an intrinsic part of a with-profits fund. But (perhaps controversially) transfers to succeeding generations with dissimilar interests are not. It would therefore be unfair (for example) for a mutual to retain surplus capital to support new non-profit business while its with-profits business runs off, unless its with-profits policyholders have given their consent; and
- Include slightly stronger "new business" rules, so that new business can only be written if a firm's governing body "is satisfied, so far as it reasonably can be,...that the new business is likely to have no adverse effect on the interests of its [current and future] with-profits policyholders". This may be a welcome change from a policyholder perspective, but it will be difficult for the FSA to enforce.
Market value reductions
The FSA is proposing to:
- Delete the rule that allows a firm to apply a market value reduction (MVR) if it's experiencing (or expecting) a high volume of surrenders. This is a change that some commentators have suggested represents a significant tightening of the rules, but no firm has relied on this ground to apply an MVR so far; and
- Relax the rule that allows a firm to apply an MVR if the market value of the assets in the with-profits fund is, or is expected to be, less than the assumed value of the assets on which the policy's unit value has been based. This change will (perhaps reasonably) make it easier for firms to apply an MVR because, at the moment, they can only do so if the market value is "significantly" less than the assumed value.
New with-profits distribution and with-profits management plans
In proposals that seem to borrow from the FSA's run-off regime, Solvency II and banking's Living Wills, the FSA plans to require all firms to prepare and maintain:
- A with-profits distribution plan , which demonstrates "how the firm will...ensure a fair distribution out of each with-profits fund...to with-profits policyholders". This should take into account, for example, the impact that current and projected levels of new non-profit and with-profits business, and the firm's investment strategy, will have on the fund over time; and
- A with-profits management plan, demonstrating how the fund will deal with investment, credit, operational and other risks associated with a significant and sustained fall in the volume of non-profit or with-profits policies written into the fund.
The FSA will also extend the existing requirement to have a run-off plan to firms that closed to new business before 2005. If implemented, the FSA will require these firms to submit a run-off plan within three months of the new rules coming into force (anticipated autumn 2011).It is not yet clear how the new distribution and management plans will fit with firms' existing Principles and Practices of Financial Management (PPFM) and run-off plans (if any), which cover similar ground.
The FSA will expect firms to consider whether it is appropriate to publish information about their distribution and management plans (but not the plans themselves). There may therefore be a debate about whether to require firms to publish their plans, instead of requiring them merely to consider publishing some information about them. If there is, that debate may extend to run-off plans, where there's no current obligation to publish, and no proposal to change the status quo.
The conduct of with-profits business
The FSA proposes to:
Amend its "strategic investments" guidance and then convert it into a rule so that it:
- Applies to mutuals, as well as proprietary firms; and
- Prevents a firm from using its with-profits assets to make or retain a "strategic investment" , "unless its governing body is satisfied...and can demonstrate that the purchase or retention is likely to have no adverse effect on the interests of its with-profits policyholders";
- Amend its rules to prevent firms paying group service companies more than it costs to provide services to a with-profits fund. That prohibition will apply even if the group service company provides the service for a total cost (including a reasonable profit) that is lower than the cost of maintaining an in-house service function or outsourcing the services to the market, where the profit margin may be higher;
- Remove the "reattribution option" so that firms with "an excess surplus" can no longer choose between a distribution and a reattribution.
Under the existing with-profits regime firms are expected (COBS 20.2.3G), and may be required (SYSC 3.2.6R and SYSC 6.1.1R), to maintain governance arrangements which ensure they comply with their PPFM. Firms are also expected to include some independent judgment in the PPFM compliance assessment and when they seek to resolve conflicts of interest.
At the moment, that independence can be provided by a with-profits committee (Committee), an independent person with appropriate skills and experience, or (for small firms) a non-executive member of the firm's governing body. The FSA's proposals (if implemented) will materially change that position. For example:
- Be required to have a Committee (unless they are a non-directive friendly society or have less than £500 million of with-profits liabilities);
- Be required to provide the Committee with the resources it reasonably requires to perform its role effectively;
- Be expected to discuss the Committee's terms of reference with the FSA and to publish them on their website;
- Although it's not clear how this could be done, the FSA seems to propose that firms should also be compelled to use the Committee's terms of reference (a delegation from the firm's governing body) to require "the governing body to consult the [Committee on] all matters the [Committee] could reasonably expect to be consulted on" (CP covering text);
- Be encouraged to make it clearer that the Committee advises the governing body on issues, and the governing body decides what to do in the light of that advice;
- Be required to notify the FSA if their governing body departs from the Committee's advice on significant issues, if the Committee asks the firm to do so.
The Committee will:
- Be required to have an independent majority and a quorum of at least two;
- Be required to satisfy itself that the firm's PPFM properly reflects how the firm operates its with-profits fund;
- Be required to consult the firm's with-profits actuary on all material discretionary actions proposed in relation to the firm's with-profits business;
- Be entitled to ask:
- For external advice (including external actuarial advice) if that is required to perform its role effectively; and
- The firm to pay for that advice without charging the cost to the with-profits fund (unless the firm is a mutual);
Although the firm won't be required to comply with either of these requests;
- Give advice on the appointment, and contribute to the annual appraisal, of the with-profits actuary; and
- Have a right to ask the firm's governing body to tell the FSA if the governing body departs from the Committee's advice on a material issue (but no right or duty to report directly, if that would deliver a better outcome).
These proposals may generate some difficulties in practice. For example:
- Increasing the number of funds with a Committee means recruiting and retaining more people to staff them, and that will increase firms' costs. It may also be difficult to find suitability qualified and experienced individuals who are prepared to take on the role. That is especially so because they will have a rare skill set that is keenly sought after for Solvency II and other (more lucrative) projects. Their "approved person" status also means that - quite properly - they will face a regulatory interview before their appointment is confirmed. While there is not much the FSA can do about these things, it does at least commit to ensuring there is enough time for firms to recruit appropriate people;
- The FSA is proposing a quorum of two for the Committee to prevent a single dominant individual exercising undue influence. But a quorum of three may be more likely to achieve this objective;
- Because the new governance arrangements will depend on a properly resourced and properly informed Committee, the FSA argues that the Committee "should have the right to ...request...external advice. [And] In shareholder-owned funds... should be able to request that such advice is obtained at the shareholder's expense...[because] if [it] was done only at the fund's expense, firms could seek to restrict the availability of resources...thereby forcing [the Committee] to make...sub-optimal recommendations or to load additional costs on to the fund..."
- It therefore seems strange that the FSA uses guidance to suggest that the Committee "should be able to obtain external...advice" (the rule doesn't seem to create a right). And that it is only guidance that allows the Committee "to request" that the cost is met from shareholder funds;
- Finally, of course, one can only imagine the conflicts that will arise if the Committee exercises its right to ask the governing body to tell the FSA that the governing body has ignored the Committee's advice on a material issue.
The FSA is inviting formal responses on its proposals by 24 May 2011.