The new FSA rules relating to investment of unit linked funds came into effect on 6th October 2007. They are currently to be found in COB 6.14 but will become COBS 21 on 1st November 2007. The rules have been a long time in the making but it is hoped they will provide more flexibility for operators of unit linked funds–in particular those linked to personalised funds such as SIPPS.

The new rules (COBS 21.2. 3-11) incorporate high level principles in relation to the operation of unit linked funds. One of the principles is that firms must look at the substance of any transaction rather than purely the legal form. Underlying all of the principles is the need to treat customers fairly by considering the effect of any decision on them “first and foremost”. Although the new rules begin with the high level principles they are supplemented by some fairly detailed rules.

Readily realisable

There were a number of issues with the permitted links rules the FSA inherited back in 2001. One of the issues which caused most difficulty in practice was the requirement that both listed and unlisted securities be capable of realisation at 97.5 per cent of their value within 7 days. A similar requirement applied to the underlying assets of collective investment schemes other than UCITS. A new principle (COBS 21.2.5) provides that all linked assets need to be capable of being realised in time for the firm to meet its obligations to linked policyholders. The FSA indicated in its Policy Statement 07/17 that this requirement and the need to realise assets in the short term (which is a requirement for permitted unlisted securities) could be met if a firm satisfies itself that it cannot reasonably foresee any circumstance in which it would need to realise the asset at a few days' notice and would not be able to do so. It is worth noting that the value of unlisted securities in a unit linked fund is no longer subject to a 10 per cent limit.

Collective investment schemes

It should also now be possible to invest in a wider range of collective investment schemes. UK authorised non UCITS and all recognised schemes will be permitted without any “look through” to their underlying assets. In addition, linked funds may be invested in a Qualified Investor Scheme (or its EEA equivalent) or any unregulated scheme that invests only in permitted links and publishes its prices regularly, but such investment is limited to 20 per cent of the gross assets of the linked fund. Institutional policyholders (limited to trustees of defined benefit occupational schemes) may also invest in both such schemes but without the 20 per cent limit.

Property

There are also new rules on the type of real property a unit linked fund can invest in, whether directly or indirectly. These place greater emphasis on the insurer to satisfy itself that the underlying property market is appropriate and that any structures used to hold property do not pose a materially greater risk than a direct holding. Unregulated property funds will be permitted, subject to the 20 per cent limit referred to above, for collective investment schemes.

Gearing

A number of other issues previously dealt with in guidance appended to IPRU (INS) are also covered by the new rules. COB 6.14.5 provides that a firm must ensure that there is no reasonably foreseeable risk that the aggregate value of any of its linked funds will become negative. There is also an explicit gearing restriction in relation to property funds of 10 per cent of the gross value of the linked fund (excluding UCITS, UK authorised and recognised schemes). This 10 per cent restriction does not however apply to funds held on behalf of an individual beneficiary where they or someone acting on their behalf requests that the firm hold such investment (eg member directed investments such as SIPPS).

Stock lending

One of the other issues formerly dealt with by guidance was the use of linked funds' assets for stock lending. The previous guidance is now incorporated into the rules together with an extended list of counterparties. It makes clear that where a unit linked fund bears the risk of stock lending it should receive all the profit (less expenses) and even where it does not bear the risk of loss, it should receive fair recompense for the fact that its assets have been used.

Derivatives

The FSA has also responded to comments about the restrictive nature of the definition of efficient portfolio management (EPM) as part of the test of whether a derivative contract is a permitted investment for a linked fund. For the purposes of the permitted links rules the definition of EPM is now stated to be wider than that for admissibility of non linked fund assets but it is not clear what this is intended to permit. The FSA commentary in the relevant policy statement (PS07/17) does not shed any further light on this.

Reinsurance

The FSA has also introduced requirements relating to the reinsurance of unit linked obligations. As a result of changes in insurance insolvency rules, direct policyholders of a reinsurer have priority over other non-secured debts (eg reinsurance obligations). In practice, many insurers create the same effect by use of suitable legal charges, but (reinsurance) policyholders would not normally be aware of this. Policyholders must now be made aware of the implications of any credit exposure they face in relation to the insolvency of a reinsurer. The firm must also continue to discharge its responsibilities under the contract as if there was no reinsurance. This will include monitoring the way the reinsurer manages the business.

If the investment risk on the unit linked contract is with the policyholder, this obligation will not however require the firm to hold additional capital.

Notification of failure to comply

In future, firms will not necessarily need to apply for a waiver in respect of a breach of the permitted link rules. Firms are now required to notify the FSA of any failure to comply with the rules whether or not it is material to the size of the fund. However, COBS 21.2.11 G makes clear that in considering whether any action is necessary the FSA will have regard to the extent to which the cause is exceptional or temporary in nature (eg action is unlikely to be required for a short term suspension). The rules should allow a greater range of both listed and potentially unlisted investments. They should also permit investment in property in countries that were not permitted under the previous rules.

There are a number of areas (eg definition of institutional investors) which the FSA intends to monitor in relation to these rules and it may be that further changes could be made in the future although any such changes are likely to be tinkering around the edges rather than substantive.