In this bulletin we discuss a series of problems that have recently arisen in the regulation of unit-linked insurance products.
Long term insurance contracts may provide for defined benefits. Or the benefits may sometimes be linked to a with-profits fund. They may also be linked to the value of property, such as a piece of land, a unit trust, a fund managed by the insurer itself or an index such as the FTSE.
Policies in this category are usually referred to as "unit linked" (not always very accurately as the property does not need to be unitised). Unit-linked products may include pension policies, annuities, mortgage endowments, whole of life policies, equity release contracts and investment bonds.
1. Benefits of unit-linked products
From the customer's perspective unit-linked products can give policy holders the benefit of income from securities and rises in their value (if in fact they do rise and do not fall). These products may be bought by people whose ISA allowance has already been used up. A unit-linked policy has significant tax advantages over direct investments in unit trusts, especially when it is a "qualifying life insurance policy". Even if it is not, the policyholder can withdraw up to 5% of his investment without triggering an immediate tax liability. For people on state benefits, such as housing benefit, the surrender value of a life policy is not treated as "capital" for the purpose of assessing their means.
From the insurer's perspective, the fact that the investment risk falls on the policyholder reduces the amount of regulatory capital that must be held. The selling of unit-linked policies is thought to be less likely to give rise to mis-selling claims than with-profit policies. So many firms have closed their with-profit funds and are concentrating on unit-linked business.
2. Technical provisions under Solvency II
The new Solvency II regime is due to come into force on 1 January 2015. Its impact will extend, among other things, to unit-linked products. Technical provisions will be calculated on a completely new basis. They will consist of a best estimate of future cash flows and a risk margin. Article 132(3) of the directive requires the assets covering the technical provisions to match the benefits as closely as possible. This follows Solvency I.
It is not clear how literally this principle should be followed. Not all of the technical provisions covering a unit-linked fund are calculated by reference to the value of the units. Where they are not so calculated there is little point in matching them. How far matching goes affects the calculation of the Solvency Capital Requirement and the price of the product to the policy holder. The regulator has yet to make a pronouncement on this issue.
3. Look through and reporting
The "look through principle" applies to unit-linked funds. The Solvency Capital Requirement has to be calculated on the basis of each of the underlying assets of collective investment undertakings and other investments packaged as funds. This creates particular problems for unit-linked products linked to a fund of funds.
The same principle applies under Pillar III reporting when the firm publishes its Solvency and Financial Condition Report.
4. Permitted link rules
Under Solvency I, as interpreted by the FCA and most other EEA insurance regulators, unit-linked insurance contracts can only link to a narrow range of assets. The assets are the same as those which direct insurers must use to cover technical provisions. The assets in question are listed in article 23 of the Life Directive.
The list is transposed, so far as the UK is concerned in COBS 21.3.1R. The UK transposition is more restrictive than the list in the directive because the FCA considers that is needed to protect consumers. The FCA and its predecessor the FSA have, however, been willing from time to time to grant rule waivers allowing firms to depart (safely) from the list in relation to specific products.
Under Solvency II there are no rules as to what assets firms should invest their technical provisions in. Equally there are no permitted link rules. Article 133 of the Solvency II Directive, however, permits member states to apply permitted link rules "only where the investment risk is borne by a policy holder who is a natural person and [the rules] shall not be more restrictive than those set out in the [UCITs Directive]".
The FCA has therefore amended the permitted links as they will apply from 1 January 2016 to firms covered by Solvency II (the existing rules will continue to apply to smaller firms who are out of scope of the new regime). Most notably, approved money market instruments become a permitted link for the first time. Derivatives will no longer need to be held "for the purpose of efficient portfolio management or to reduce risk".
The permitted links will no longer apply under Solvency II to products sold to corporate bodies rather than individuals. Pension funds are the most significant customers in this category. So in theory they could buy insurance products linked to commodities such as gold, or intangible items such as intellectual property rights. Nonetheless in its thematic review of the governance of unit-linked funds, the FCA noted:
"Where firms operated in the institutional market, they were more likely to invest in alternative, more exotic assets and legal structures, which can be more risky. Institutional customers such as pension trustees could be investing on behalf of underlying retail customers, so it remains important that protections are in place. Our review found that these firms needed to improve their assessment and decision-making processes for determining that such assets complied with our rules."
It is arguable, however, that the task of determining the suitability of the product is the responsibility of the trustees rather than the product provider.
5. Territoriality issues with permitted link rules
There is an inconsistency in how the permitted link rules discussed above apply to UK firms, on the one hand, and to firms authorised in other EEA states on the other hand. These "territoriality rules" may put UK insurers and intermediaries at a serious disadvantage, as we explain below.
The permitted link rules currently apply, and will apply under Solvency II, to linked long term contracts that are effected by (1) insurers other than EEA insurers; and (2) EEA insurers in the United Kingdom (COBS 21.1.1.R). So the rules do not apply to intermediaries.
Condition (1) is aimed at UK authorised insurers and at non-EEA insurers with branches in the UK. The "effecting" of a contract of insurance covers the making of the contract, underwriting and the preparatory process of offering and negotiating insurance business.
In the case of unit-linked contracts, a firm or group will generally do all or most of the effecting in one jurisdiction, say, France. Selling in other jurisdictions, say the UK may be done by the insurer or, more often, by an intermediary. Selling need not involve "effecting". Thus a French firm can sell unit-linked policies to an English customer, if it effects the contracts in France, without being required to comply with the UK permitted link rules.
French law, consistently with article 7 of the Rome I Regulation, will treat the contract as governed by English law, but that cannot re-apply the FCA permitted link rules, which have been dis-applied by the FCA in relation to EEA firms.
Moreover the effect of the rules is to require UK firms to comply with the permitted link rules in relation to all their linked business. So unless the French permitted links rules are identical to the UK rules, UK firms would not be able to sell FCA-compliant linked policies in France. Nor would they be able to sell French-compliant policies, because that would be inconsistent with COBS 21.1.1.
The problems described above arise from the fact that the UK territoriality rules for unit-linked products date back to the 1990s when the permitted link rules were regarded as prudential and thus "home state" based. By contrast, under Solvency II the rules are conduct based and have no link to the prudential rules.
The permitted link rules should arguably be subject to the default territoriality rule in COBS 1.1.1R. This treats most of COBS as applying to a firm's (whether an insurer or an intermediary) activities (including sales, but not necessarily "effecting") "carried on from an establishment maintained by [the firm], or its appointed representative, in the United Kingdom".
This issue may become more significant depending on the extent to which a European market in unit-linked products develops. There seems to be a preference for insurers to underwrite unit-linked insurance in offshore jurisdictions such as the Isle of Man, Guernsey and Switzerland. Luxembourg is also very popular, even though the Luxembourg permitted link rules are quite strict. The permitted links rules in Ireland are more generous than in the UK and allow policies to be linked, for instance, to hedge-funds.
Unit-linked policies qualify as "packaged retail and insurance-based investment products" (PRIIPS) and will therefore be subject to the rules in the EU PRIIPS Regulation. This is due to have direct effect in member states on 31 December 2016. The regulation will require the preparation of a standardised key information document (KID) providing full information about the product to be sold. The KID is aimed at allowing consumers to make better informed choices and also to support the development of the European market in investment products. The regulation also provides for enforcement action to be taken against firms when they do not measure up to their responsibilities.
7. Governance issues
The FCA carried out a thematic review of the governance of unit-linked funds in 2013. The FCA found no material issues posing a serious threat to customers’ investments. It did, however, find specific material problems in individual firms which, if left unchecked, could have led to customers being disadvantaged, for example:
- poor oversight of an outsource service provider,
- insufficient controls over permitted assets,
- overly-stretched operational capacity in a pricing team.
8. Mis-selling issues
Mis-selling claims are quite commonly made in relation to unit-linked policies, although probably less often than in relation to with-profits products. This is sometimes because over enthusiastic statements are made when the product is sold. In one case, for instance, a low risk unit-linked bond was described as being equivalent to cash, but lost much of its value after the fall of Lehmann Brothers and after the insurer suspended withdrawals from the linked fund. The customer was awarded compensation.
In many other cases the ombudsman has taken the view that the insurer or intermediary selling the product made an incorrect assessment of the customer's risk appetite. Often these determinations have to be made by reference to a transaction entered into many years or decades earlier with poor records and before the practice of recording telephone calls. A key point is sometimes the fact that the unit-linked product being sold has no guarantee or "safety net". The question whether customers realised that some products are reviewable and the implications of that fact also arises.
9. Reinsurance arrangements
Insurers often give their customers access to "guest funds" operated by other insurers. Here a reinsurance arrangement with the second firm will be necessary. In the event of the insolvency of the reinsurer the customer will not be eligible to make a claim against the Financial Services Compensation Scheme and will not (unless security is provided) qualify as a [preferred] "insurance creditor" under the winding up rules.
The FCA considers that the full position should be explained to the customer and that "If the policy is silent on reinsurance credit risk exposure, our view is that the risk continues to fall on the firm".
10. Obligations of product provider
Most of the FOS mis-selling cases relate to sale processes either used by the insurer selling directly or by an intermediary. The insurer will not be a party where the sale is made by an intermediary.
In Seymour v Ockwell  EWHC 1137 a financial adviser, O, negligently advised her client to invest in an insurance bond. She relied on advice given to her by the marketing arm of a major insurance company, Z. The advice was to invest in a managed bond issued by another company in the Z group. The fund collapsed and the client lost all her money. O was held to have been negligent and liable to the client. Z was held liable to O, but Z was held not to have a duty to the client herself and therefore not to have any liability to her.
However, FCA guidance says that product providers:
"should ensure the information [provided to distributors] is sufficient, appropriate and comprehensible in substance and form, including considering whether it will enable distributors to understand it enough to give suitable advice (where advice is given) and to extract any relevant information and communicate it to the end customer".
So it is possible that an instance of mis-selling could be the responsibility of the provider rather than the intermediary (or the joint responsibility of both) if the insurer's documentation is wrong as to, for instance, the risk rating of the product. Tony Boorman of the Financial Ombudsman Service may have had linked insurance (as well as with-profits) in mind when he remarked:
"On another occasion, we might discuss the extent to which the insurance industry can insulate itself from responsibility for the ways in which its products are sold by others. For what it is worth, I think the industry will need to place far greater weight on the fair distribution of its products.
11. Mis-management of the fund
In a number of ombudsman cases the claimant has sought to recover compensation not for mis-selling, but for the allegedly negligent way in which the linked fund has been managed and the losses arising. Invariably the ombudsman declines to investigate these claims. They need the full rigour of High Court procedure.
A claim relating to the management of a unit-linked equity release transaction by a Luxembourg insurer was filed in the High Court in 2010 and dismissed by the Court of Appeal. The court considered that the claim should have been made either in Spain, where the claimants lived, or in Luxembourg, but not in the English courts.
A second way of in which compensation can be recovered for mismanagement of a unit-linked fund is for the FCA to bring enforcement proceedings against the firm concerned and to include a claim for compensation on behalf of the policyholders. The FCA having found that there are no serious problems with the governance of the firms covered by its thematic review is perhaps unlikely to take this course.