Changes to the regulation of UK with-profits insurance businesses

The background to the PRA's paper (20-page / 354KB PDF) and the FCA's feedback statement (67-page / 1MB PDF) is the split of functions of the former UK regulator, the Financial Services Authority (FSA), between the PRA and FCA in April 2012 and that each now has different statutory objectives. Currently, the existing FSA Handbook sets out each new regulator's designated rules and guidance.

The PRA now has a supervisory role in ensuring that with-profits businesses maintain adequate financial resources to provide security of benefits for both guaranteed and discretionary policyholder benefits and that discretionary increases in policy benefits do not adversely affect the insurer's ability to meet the PRA's safety and soundness requirements and its objective to contribute to the securing of an appropriate degree of protection for policyholders. The FCA is now responsible for ensuring that the insurer's proposed bonus payments or other benefits to with-profits policyholders are fair.

The PRA's paper clarifies the role and the objectives of the PRA in relation to supervision of with-profits in light of the existing memorandum of understanding between the PRA and FCA, which sets out the framework for how they currently co-ordinate the regulation of with-profits business; explains how the new PRA Rulebook will affect the designation of with-profits provisions in the current shared FSA Handbook, and proposes changes in anticipation of the prudential regulations associated with the Solvency II Directive.

The PRA's paper is relevant to all insurers writing with-profits insurance business in the UK, including closed funds, whether or not they are within the scope of Solvency II and proposes rules to Solvency II directive insurers and non-directive insurers.

The FCA's paper provides feedback on the conduct elements of the FSA's previous consultations on the transposition of Solvency II, primarily about section 20 of the Conduct of Business Sourcebook (COBS 20) with-profits business but also on COBS 21 unit-linked business.

The PRA's approach to with-profits insurance business

As part of the creation of the PRA Rulebook, the PRA is proposing deleting all existing PRA-designated COBS 20 provisions and replace them with three new prudential rules applicable to all UK with-profits insurance business.

The three rules will require insurers carrying out with-profits insurance business:

• to ensure that it holds assets in each of its with-profits funds of a value sufficient to cover the with-profits policy liabilities in respect of all of its business written in or transferred into that with-profits fund;
• to ensure at all times that its strategy for distribution of discretionary benefits in respect of each of its with-profits funds is affordable and sustainable and cannot reasonably be expected to have an adverse effect on the safety and soundness of the firm as a whole or on the benefit security of all policyholders of the firm, and
• if it uses or intends to use support arrangements to contribute to benefit security for the policyholders of a with-profits fund, to ensure that all the terms and conditions governing those support arrangements including the circumstances in which they take effect and the terms on which they are or may be repayable are adequately documented in the firm's records and the extent of any restrictions on the firm's use of those support arrangements is clearly identified.

The paper also proposes new relevant glossary terms and a draft supervisory statement which sets out the PRA's expectations of insurers in respect of with-profits business as a supplement to the proposed with-profits rules. The statement is aimed at promoting the safety and soundness of insurers writing with-profits business and the benefit security of policyholders.

The PRA expects that restrictions on assets and own funds will generally mean that each with-profits fund displays the characteristics of a ring-fenced fund (RFF) under the Solvency II regime. Each Solvency II insurer will therefore be required to reflect the lack of availability of assets and own funds within the with-profits fund to cover the risks of the rest of the insurer. Where an insurer operates sub-funds within a with-profits fund, it will need to determine whether any or all of those sub-funds should be treated as separate with-profits funds as provided in FCA COBS 20. If the arrangements governing a sub-fund mean that the fund needs to be treated as a separate with-profits fund then the PRA expects that each such fund would be treated as a RFF under Solvency II.

Where support arrangements are provided to a with-profits fund from financial resources outside of that fund and are intended to provide benefit security for policyholders, the PRA expects insurers to justify their use of these arrangements where the financial resources may also be intended to support other areas of the insurer's business. The PRA also expects Solvency II directive insurers to consider whether any support arrangements that exist in relation to a with-profits fund also fall within the RFF requirements, namely the restrictions on the use of the assets associated with support arrangements and the expected availability of such assets in stressed conditions.

The PRA expects that these restrictions will be met if the terms of the support arrangements clearly state that they are for the exclusive use of a with-profits fund, meaning the assets cannot be used to meet losses arising in other areas of business. If not exclusively for the use of a with-profits fund, the assets associated with that support arrangement should not form part of the RFF.

The supervisory statement also sets out the PRA's expectations in relation to distributions from with-profits funds. Insurers should not make distributions which could endanger the safety and soundness of the insurer overall or which could have a detrimental impact on the benefit security of any group of policyholders.

In addition, the PRA's expectations are articulated in the supervisory statement in relation to setting the investment strategy for a with-profits fund taking into account the prudent person principle set out in the Solvency II Directive and the maintenance of separate accounting records in respect of each with-profits fund. If insurers are planning to make significant changes to the operation, management or business strategy of a with-profits fund, the PRA expects the insurer to inform their supervisors in advance so the PRA can take view on the impact of those changes on its statutory objectives.

These changes would include ceasing new business, changes to run-off plans for closed funds, proposing a reattribution, demutualisation or a Part VII transfer.

The FCA's feedback statement on Solvency II and COBS rule changes

Whilst the PRA is the lead regulator for transposing Solvency II into rules as most of Solvency II concerns prudential content, the FCA is the lead in transposing a small number of Solvency II articles covering conduct issues, including information provision and permitted links in unit-linked business. The FCA's feedback statement provides feedback on the conduct elements of the previous FSA papers on the transposition of Solvency II. In its summary, the FCA notes that respondents to previous FSA consultations were broadly supportive of the FCA's proposals on changes to COBS rules 20 and 21 although the FCA has amended the proposals in some areas in reaction to the feedback and it has simplified and clarified some of the consulted-on rules.

The FCA's response considers the conditions relevant to distributions, including planned enhancements to remain as "conduct" liabilities for the purposes of COBS 20 and makes changes to the definition of excess surplus. Loans and guarantees to connected persons using assets in the with-profits fund still need to be in the best interests of policyholders in the reasonable opinion of the insurer's senior management which the FCA sees as being consistent with the Prudent Person Principle. The response also deals with how contingent loans and other support assets are described to policyholders.

The FCA is also intending to proceed with changes to a number of definitions, aligning with Solvency II terminology where relevant, such as definitions of "with-profits policy", "with-profits fund"; "with-profits assets" and "inherited estate".

The FCA's feedback statement also includes draft rules to be put to the FCA's Board in early 2015 relating to derivatives, permitted stock lending and governance.

Timing and next steps

The recent Omnibus II agreement means that Solvency II will need to be transposed in UK rules/regulations by March 2015 and insurers will need to comply from 1 January 2016.

The PRA's consultation closes on 14 January 2015 and a policy statement with feedback and final rules and a supervisory statement will be published in early 2015. Rules changes will come into force from 1 January 2016.

Similarly, the FCA intends to make all their rules changes early in 2015 and for them to come into force from 1 January 2016. Meanwhile, the FCA warns insurers affected by the changes to ensure they take appropriate steps to prepare for Solvency II rules compliance by 1 January 2016 and to discuss their progress with their FCA supervisors.

Bruno Geiringer is an insurance expert at Pinsent Masons, the law firm behind Out-Law.com