Out-Law Guide | 31 Mar 2008 | 4:52 pm | 5 min. read
This guide is based on UK law and was last updated on 27th February 2008.
The Financial Services Authority's new rules governing linked long-term insurance business allow firms much more flexibility in the choice of assets in which they can invest.
The old permitted links rules, introduced in 1994, failed to keep up with significant developments in the classes of assets available and were out of tune with the parallel regulatory requirements for collective investment schemes. The result was an increasing number of applications to the FSA for waivers.
Reflecting a more principles-based approach, the new regime (which came into effect on 6th October 2007) consists of high-level principles underpinned by more detailed rules on specific assets.
Responsibility for ensuring a firm complies with the new obligations lies firmly with senior management. Monitoring and reporting processes need to be updated and regularly reviewed to ensure the firm can provide documentary evidence of compliance.
Eight high-level principles now apply to firms engaging in linked long-term insurance business (COBS 21.2). These all tie in closely with the Treating Customers Fairly initiative.
The new principles relax the old requirement for some types of permitted investments to be “readily realisable”, which often caused practical problems, particularly with land and suspended or unlisted shares.
The aim of the old rule was to ensure surrender or termination values closely matched quoted values. Insurers operating long-term linked funds, however, can predict with some accuracy when their obligations will fall due. The FSA now recognises that it is unreasonable to prevent a fund from making an “illiquid” investment if it would be to the policyholder’s advantage.
The requirement to notify policyholders about risk strategies and investment profiles is less likely to be appreciated by firms already under pressure to ensure Key Features Documents and policy terms are fair, clear and not misleading.
Clearly, though, firms seeking to change benefits under a linked policy investment need to retain the right to do so in their policy terms or face the cost and delay of seeking policyholder approval.
Managing conflicts of interests is a familiar and recurring theme. A conflict situation may arise, for instance, where the firm is a tenant in commercial property held in a fund. The best course would be to avoid the conflict entirely, but if that is not possible, the FSA would expect the firm to pay a commercial rent to the fund, assessed by an independent valuer.
The requirement to consider economic effect ahead of legal form addresses a concern that an asset might be arranged to take a certain legal form so that it can be treated as a permitted link, when in reality its economic effect is very different. The principle also allows more flexibility in the case of assets that are acceptable economically but whose legal form does not fall within the categories of assets allowed by the permitted links rules.
Where there has been a failure to meet the new requirements, the FSA will take a proportionate approach when deciding what action to take. In particular, it will consider the extent to which the circumstances are exceptional and temporary and any other reasons for the failure.
Subject to the eight principles, COBS 21.3 sets out specific rules for firms engaged in linked long-term insurance business.
Firms must not provide benefits determined by reference to anything other than an approved index or by reference to the value of assets other than those on the approved list, which is largely derived from the Consolidated Life Directive.
The list of approved assets continues the theme of greater flexibility. For example, instead of restricting investment to land situated in listed territories, the new rules allow the firm to invest in land located anywhere where the firm considers there to be a properly functioning market (indicated by 8 criteria set out in the glossary).
Real property can be owned directly or held via structures "that do not impose a materially greater risk to policyholders than a direct holding". This opens the door to investment through unauthorised collective investment schemes and real estate investment trusts.
The rules also remove the restriction that limited investment in unlisted securities to 10% of property-linked benefits. Now they only require that the security be realiseable in the short term. And "Institutional linked investors" (trustees of defined benefit occupational pension schemes) can make unlimited use of authorised or recognised collective investment schemes.
Permitted derivatives contracts are approved if held for the purpose of "efficient portfolio management". This means the firm must reasonably believe the derivatives contract enables it to achieve its investment objectives.
Life offices often offer policyholders the opportunity to link to a fund operated by another insurer. This is usually effected by reinsurance, but exposes the life company (or, depending on policy terms, the policyholder) to the risk of that reinsurer's creditworthiness.
As the policyholder’s benefits are subject to the reinsurer’s discretion and there is no direct contract between the reinsurer and the policyholder, there can be uncertainty over who is accountable for the policyholder’s interests.
This is dealt with by a new rule at COBS 21.3.3, which provides that a firm entering into a reinsurance contract in respect of linked long-term insurance business must discharge its liabilities as if no reinsurance had been effected. The guidance note explains that, in order to comply with the rule, the firm should disclose to policyholders any credit exposure that they may face in relation to the solvency of the reinsurer and monitor the way the reinsurer manages the business.
The FSA’s consultation on the new rules received widespread support, subject to requests that they be reviewed on a regular basis to ensure they reflect EU and UK legislative developments.
Any further changes will be proposed in the Quarterly Consultation Papers. One such consultation, which will affect bulk annuity purchasers, will be on whether to include the Average Earnings Index as a permitted index for the revaluation of GMP (guaranteed minimum pension benefits).
The FSA has not reviewed the governance of unit-linked funds. For the present, it is content with the ABI’s Guide of Good Practice for Unit-Linked Funds, published in June 2006.
Contact: Bruno Geiringer ([email protected] / 020 7418 7306)