FCA's thematic review on the governance of unit-linked funds

Out-Law Analysis | 23 Oct 2013 | 8:51 am | 10 min. read

FOCUS: Unit-linked funds should review their governance practices even though a Financial Conduct Authority (FCA) review has not found systemic failings in the sector.

The FCA's thematic review of the governance of unit-linked funds (24-page / 958KB PDF) found that there were no "significant widespread, systemic failings in the sector", but it did identify some firm-specific problems that could leave policyholders at a disadvantage.

Unit-linked funds are a type of pooled investment offered by life insurers via their life and pensions products.

Through this review, the FCA has highlighted the importance of the unit-linked industry and demonstrated what it considers good and bad practice within it. The review is described by the FCA as "pre-emptive", possibly signalling stronger FCA action in future if arrangements fail to protect customers' interests effectively.

Whilst the FCA did not find significant, systematic failings across the 12 firms reviewed, three firms were identified as having particularly serious issues regarding whether customer benefits were being calculated fairly and accurately. The FCA required these firms to appoint Skilled Persons under section 166 Financial Services and Markets Act 2000 to investigate further.

In the future, we would expect stricter enforcement action when firms fail to abide by the rules, for example, further appointments under section 166. This would mean greater costs and reputational damage for firms if they don't adhere to the FCA's standards.

The review also confirmed that the Association of British Insurers (ABI) is working on an updated version of its "Guide to good practice for unit-linked funds". We expect this to be issued within six months and to be made available to both ABI member and non-member firms.

The FCA provided some excellent operational and compliance guidance as a result of this review. Firms have now been given time and space to ensure that their arrangements comply with this guidance and the imminent updated guide from the ABI. If there are any serious failings after a reasonable period has elapsed, the FCA may consider that voluntary, industry-led standards are not sufficient to protect customers and step in with their own rules instead. The industry should heed these clues as to best practice and implement improvements if and where they may be needed.

Why was the review undertaken?

A thematic review was considered by the FCA necessary because of the size and importance of the unit-linked funds market. Currently, over £900 billion is invested in unit-linked funds, approximately 85% of which is pension savings. The market is also expected to expand substantially with the initiation of auto-enrolment in the pensions sector. This involves employees automatically being entered into an employer-arranged pension unless they opt out.

The FCA identified the unit-linked market as having received relatively light regulatory scrutiny to date, when compared, for example, to with-profits funds so it sought to ensure that unit-linked funds are complying with the FCA rules and principles in terms of treating customers fairly and protecting customers' investments.

What did the review entail?

In order to gain a representative picture of the market, twelve firms were selected for review. These varied in size, type and business model and included open and closed funds as well as retail and institutional providers. Between them, the sampled firms manage a large proportion of the total amount invested in unit-linked funds.

The review looked at three key areas:

  • do the firms have adequate systems and controls to administer and manage funds fairly?
  • are the assets backing unit-linked policies appropriate for customers?
  • are customer benefits calculated fairly and accurately?

General findings – relationships between funds and third parties

A key theme emerging from the review, and applying across all three review areas listed above, is the FCA's interest in and concern with how unit-linked funds manage relationships with third parties. This appears to be particularly focussed on outsourcing to third party specialist providers; exposure to third party firms' regulated collective investment schemes; and access to funds offered by third party firms through reinsurance.

In all of these areas, the FCA's concern is with the primary insurer satisfying its obligations to customers and its compliance with regulatory requirements, despite the involvement of third parties.

Outsourcing to third party specialist providers

The FCA's existing rules make clear that a unit-linked fund will not escape responsibility for fulfilling obligations to customers and complying with regulatory requirements simply by outsourcing activities of its business operations, such as fund management and pricing/valuation.

During the review, the FCA identified a failure in the oversight of outsource service providers in approximately half of the sample firms.

The review findings include examples of poor and good practice in this area. The former involved the outsourcing of the asset valuation and unit pricing function to one service provider and relied on a third party to oversee that arrangement. The FCA found that this arrangement deprived the insurer of sufficient engagement and control over the valuation and pricing process to be able to satisfy itself of its compliance obligations.

In contrast, an example of good practice was where a firm engaged regularly with its outsource service provider at a range of levels of seniority and had in place several mechanisms to allow extensive oversight and control over the outsourced function:

  • separate forums for issue and change management;
  • a contractual requirement for the outsource service provider to adopt "industry best practice" and comply with the firm's own policies;
  • comprehensive management information requirements; and
  • bi-annual reviews of standing data used by the outsource service provider.

These examples demonstrate that the FCA expects firms to be involved in frequent and detailed operational oversight activity and compliance monitoring of the outsource service provider's work and that a demonstrable level of control is crucial.

Where services are outsourced to more than one provider, it is important to set out clearly and adequately what the duties of each service provider are, how the duties of one provider relate to those of another and how they relate to the insurer's duties, so that the insurer, who has the responsibility of meeting regulatory requirements, can better supervise its outsource service providers. As in all outsourcing, whilst the activity can be delegated to a service provider, the firm will always be accountable to its customers and be responsible for compliance with regulatory requirements.

The FCA also noted a trend of firms being over-reliant on informal group controls when outsourcing to companies in the same group. Such arrangements, including Group Internal Audits, tended to revolve around personal relationships as opposed to specific audit and reporting arrangements. The FCA cautions against firms assuming that outsourcing to an intra-group entity will carry reduced operational risk and so failing to apply the reviews and controls with the same rigour as would be the case for third parties.

Exposure to third party firms' regulated collective investment schemes

Where unit-linked insurers offer policyholders exposure to third party firms' collective investment schemes through their own unit-linked life and pension funds, the FCA highlighted that such insurers still have an obligation to customers and they have to comply with the regulations. As such, procedures need to be in place such that firms can asses whether the collective investment schemes are performing as expected and any problems, such as pricing errors, are being identified and addressed.

The systems of two firms were given as examples of good practice. The first firm had a strict due diligence assessment to accompany the selection process of collective investment schemes. It would only invest in collective investment schemes with pricing points that corresponded with its own. The second firm conducted bi-annual reviews of all fund managers, including those through which the insurer invested via collective investment schemes.

Access to funds offered by third party firms through reinsurance

Where firms wish to invest in other insurers' unit-linked funds, they can only do so by entering into reinsurance contracts with those other insurers. However, the FCA requires firms that enter into such reinsurance contracts to discharge their responsibilities as though no reinsurance contract was in place. To comply with this, firms must explain to customers the implications of being exposed to any credit risk associated with the solvency of the reinsurer and they must monitor the way the reinsurer manages the business.

The FCA considers that it is up to insurance firms to decide who should take on the credit risk of the reinsurer. However, if the policy is silent on who should hold this risk, it will continue to fall on the firm. On the other hand, if the insurer wants the customer to take on the risk, the firm must make this clear in the policy wording and customer documents. This is particularly important as the customer's contract is with the primary insurer and not the reinsurer. Hence, in the event that the reinsurer does fail, the customer will not be covered by the Financial Services Compensation Scheme (FSCS), which only covers customers for the failure of the primary firm with whom there is a contract. The insurer should make this clear to the customer.

In the review, the FCA notes that more firms are considering transferring the credit risk of the reinsurer to the customer motivated in part by the capital requirements under the anticipated Solvency II regulations. Where firms wish to change customer policies to transfer this risk, firms will have to show that they are treating customers fairly and complying with the FCA's Principles for Businesses. The FCA also highlighted the basic requirement that firms will require sufficient and enforceable contractual powers to allow such changes to the policy by transferring such risk.

Firms are also required to monitor the way the reinsurer manages the business. One firm had a risk-based system in place to determine how much business it would place with a reinsurer. This involved scoring the reinsurers on issues such as regulatory jurisdiction, capital position and the auditor's opinion of accounts. The FCA commented that this methodology helped the insurer manage its own risks and its customers' and consequently helped the firm discharge its obligations to customers.

Good legal advice is needed when entering into linked life reinsurance arrangements to ensure proper compliance with the "treating customers fairly" regime. Extra care will also be required if firms later attempt to vary their policy terms with the intention of transferring credit risk of a reinsurer to customers. Based on our experience and in light of the clear guidance from this review, this is an area where firms may need to review their existing arrangements with reinsurers and policyholders to check they are treating customers fairly.

Other areas for improvement highlighted in the review

As explained above, the review did not find any evidence of significant, widespread systemic failings, but we set out below some of the more firm-specific issues highlighted as these may also provide a useful reference point against which firms can assess their own performance.

Pricing and valuation

Whilst the FCA found that valuation methods for mainstream assets were largely appropriate, some firms were found to be underperforming in respect of the valuation of more complex asset types, such as property, derivatives and unlisted shares. The FCA highlighted the importance of using a range of price sources for valuation purposes and pointed to the positive example of one firm which established a clear hierarchy of sources based on their experiences. The top position in the hierarchy would be the preferred value and any significant variations in the values between the sources would be investigated further. Nearly half of the sampled firms were found to have room for improvement in their valuation processes.

In a third of the sampled firms, the FCA identified concerns about the extent of controls related to historic pricing attributed to complacency about the extent of the risks involved in such a pricing method.

Further, the FCA found evidence of firms having inappropriate powers to switch between offer and bid pricing in reaction to certain events. An example of this which was highlighted in the review saw a firm with a long-term approach that was unable to "swing" the price in response to a material transaction against the trend which could lead to customers obtaining an inappropriate price.

Permitted links

The FCA found that firms in the retail market generally invested in mainstream assets and avoided those assets which required greater investigation as to permissibility. The FCA reported no concerns around retail firms in respect of permitted links.

Institutional firms which sought to make more use of the flexibility of the permitted links rules however did not always perform a sufficient level of analysis to make informed decisions as to whether the links were permitted.

Management of conflicts of interest

The FCA highlighted the range of potential persons between whom conflicts may arise in respect of unit-linked funds – between shareholders and customers, with-profits customers and unit-linked customers or even between the generations of unit-linked customers.

Almost half of the sampled firms failed to fully consider the specific unit-linked conflicts that may arise, but acknowledged that no evidence was found of issues posing a serious threat to customers' interests.


The FCA reported that most of the sampled firms had appropriate governance arrangements. In summary, this meant that the governance structure was able to consider fund issues in sufficient depth and was able to provide robust challenge. An example of good practice was the firm which had a structure of senior committees reporting into the board, and specialist sub-committees below that with responsibility for areas such as stock lending, mandate compliance and unit pricing.


The thematic review assessed how firms managed liquidity and was particularly focussed on property funds but did not identify significant concerns in the area. By way of a good example, the FCA highlighted one firm which established clear metrics for identifying liquidity in its property fund and when the established tolerance level was missed, a working group would be established for the specific purpose of managing fund liquidity.

Stock lending

The FCA reminded firms of the INSPRU rules on stock lending and managing the risk of borrower default. The customers are entitled to benefit from a fair share of stock lending revenues as it is their money enabling the stock lending to occur. The FCA identified a high standard of control amongst stock lending firms and that most indemnified customers against the risks.

One firm was highlighted as failing to pass on a fair share of revenues from stock lending to customers. The firm in question employed a sister company to oversee the stock lending operations and between the two firms was allocated a disproportionately high revenue share relative to the level of risk. Following discussions with the FCA the firm increased the share of revenues allocated to customers.

Contact: Bruno Geiringer ([email protected] / 020 7418 7306)