Out-Law Guide | 20 Jul 2010 | 4:18 pm | 10 min. read
This guide is subject to UK law and was last updated on 20th July 2010.
With-profits funds are being managed without sufficient independent challenge from with-profits committees and firms are failing to communicate effectively with their policyholders, a review by the Financial Services Authority (FSA) has found.
This is despite rules and guidance specifically intended to ensure policyholders are treated fairly and various warnings from the regulator highlighting its ongoing concerns.
The aim of the review was to find out how senior management have implemented the with-profits regulatory regime introduced in 2005.
As a result of its findings, the FSA is to carry out a further policy review of the rules and will publish any proposed changes in a consultation paper before the end of the year. Proposals which might be directly affected by Solvency II, however, will not appear until 2011.
The regulator will also be focusing supervisory attention on the weaknesses identified in its report. It has already begun enforcement investigations into two with-profits firms.
Ken Hogg, the FSA's insurance sector director said:
"This review shows that, while there has been some progress, there is still more work to be done by firms in the with-profits sector to make sure that their policyholders are treated fairly. We expect all firms to raise their game in this area, not just the firms that we reviewed."
But Adam Phillips, chair of the Financial Services Consumer Panel expressed serious concern at the findings.
"There are 25 million with-profits policies currently being used for pensions and other savings," he said. "It is totally unacceptable that firms’ failure to play by the rules is still potentially exposing substantial numbers of consumers to risk."
Bruno Geiringer, a partner specialising in life insurance at law firm Pinsent Masons, urged the sector not to see the review as another condemnation of with-profits but as an opportunity to review their own practices.
"Let's not forget these policies are still attractive to investors looking for relatively low-risk returns with some exposure to equity investment, steady performance and often extremely valuable guarantees. Some friendly societies' and mutuals' with-profits funds have significantly outperformed interest rates from savings and RPI.
"What the review makes apparent, however, is the difficulty involved in fitting a product designed many years ago into the current consumerist regulatory regime" said Geiringer. "The missing ingredient is demonstrating fair treatment. If the further review can retrieve trust and if management engage more with the regulatory demands, there is every reason for with-profits products to regain market popularity.
"Some firms will spot this opportunity, while others may see it as a bridge too far."
Firms managing with-profits fund must abide by the high levels Principles for Business in the FSA Handbook: in particular, the requirement to treat customers fairly (Principle 6), to manage conflicts of interest (Principle 8) and to ensure that all communications with customers are clear, fair and not misleading (Principle 7).
Specific rules and guidance governing with-profits funds were put in place in 2005, following a major review of the with-profits regulatory regime and can be found in chapter 20 of the Conduct of Business Sourcebook (COBS).
COBS 20 introduces a requirement for firms to produce and maintain Principles and Practices of Financial Management (PPFM) setting out how they run their with-profits funds, and a consumer-friendly version (the CFPPFM), summarising the main points in clear and plain language.
Special rules apply to firms closing funds to new business, including providing the FSA with a run-off plan within three months showing how they will ensure a fair distribution of the fund and any surplus (known as the inherited estate).
The COBS 20 guidance also introduces new governance requirements requiring "some" independent judgment in assessing the firm's compliance with its PPFM and addressing conflicts of interest. Firms may meet this by appointing an individual, a non-executive director or a with-profits committee to protect policyholders' interests.
Firms, however, have been slow in adapting to the new regime. In 2007, following two thematic reviews of the with-profits sector, the FSA wrote a "Dear CEO" letter warning that the independent input from with-profits committees and firms' management of closed funds were falling short of the required standards.
A further report on post-sale client communications about life products found a significant number failed to meet Principles 6 (the obligation to treat customers fairly) or 7 (that all communications be clear, fair and not misleading).
In 2008, the Treasury Select Committee criticised the regulator for failing to provide a robust framework for managing conflicts of interest and suggested there should be a debate on the fundamental design of the with-profits regulatory system.
The main focus of the Select Committee's report was the use of the inherited estate to meet compensation payments. In 2009, the FSA introduced a new rule preventing shareholder-owned life companies from using this surplus to fund compensation or redress payments arising from events occurring after 31st July 2009.
The aim of the FSA's most recent review was to see how firms have been putting the rules into practice. It also sought to address wider concerns raised by the Treasury Select Committee and consumer representatives on conflicts of interests and transparency.
The regulator looked at 17 firms operating both open and closed funds, including proprietary firms, mutuals and friendly societies, representing about 80% of the with-profits market as at the end of 2009.
It found that the majority of the firms reviewed could not demonstrate that their practices were consistent with well-run with-profits business in one or more respects.
The main areas of concern were governance and communication. In particular, the FSA found material shortcomings in the effective governance of with-profits funds, a lack of independent challenge provided by with-profits committees and significant weaknesses in the way firms communicated with policyholders.
"The findings are particularly disappointing in light of our previous communications to the sector," the report states.
"We have concluded that there is a case for reviewing COBS 20 and are carrying out a detailed analysis of how COBS 20 deals with several specific areas, namely: governance, post-sale consumer communications, payouts, charges to with-profits funds, new business, and closed funds specifics of with-profits funds."
The review found that, although most firms had set up with-profits committees (or made equivalent arrangements), some were unable to show that their boards took sufficient notice of the committee's views or that policyholders' interests were being adequately taken into account.
In some cases, with-profits committees were not made aware of key operational issues at the right time. Most of them were reactive to the firm's proposals instead of proactively seeking to influence or challenge the firm's agenda. Only a few routinely monitored the level or nature of complaints received about with-profits products.
The FSA also found examples of committee members having other roles in the firm, which called into question their independence. In one firm, all the members of the with-profits committee also sat on the board.
In light of these findings, the regulator will be reviewing whether the COBS 20 rules need to be tightened up.
"We will consider new proposals to mandate the existence of with-profits committees more widely and bolster their role and responsibilities in providing independent judgment on with-profits matters and reporting to policyholders on issues affecting their interests, including the management of conflicts of interests".
The review raised similar concerns about the with-profits actuary, a role introduced in 2004 to enhance consumer protection and confidence.
All the firms reviewed were found to have a with-profits actuary in place with relevant experience and qualifications. But most of them were internal appointments and so were "already ensconced in the firm's culture and hierarchy".
The FSA found insufficient evidence that with-profits actuaries were raising appropriate challenges on material issues and little recognition within firms of the conflict inherent in a role that required the actuary to confront management decisions, but whose performance would later be judged by the same management.
The FSA will consider whether new rules and guidance are needed to give the with-profits actuary greater prominence and clearly distinguish the position from other roles in the firm.
Generally, the FSA found that firms' annual reports were satisfactory. But their CFPPFMs and other, event-driven communications, such as pre-maturity information and bonus, surrender and transfer notices, fell far short of the required standards.
Most of the CFPPFMs reviewed "made it difficult to understand in any useful depth how a firm's with-profits fund is being operated or the risk and reward balance of the fund".
Explanations about basic elements of with-profits, such as smoothing, were weak and firms failed to include clear warnings, for instance that annual bonuses were not automatic. Information about expenses and charges was limited and there was minimal disclosure about how the fund was operated or how it might be used for the wider business.
Event-driven communications were also disappointing. In particular, a significant number of firms failed to explain clearly that there would be any loss of guarantees, options or other benefits if the policy was surrendered.
Only one firm in the sample asked its policyholders for their views on its literature, improving the quality of its communication as a result.
"Overall, we are not confident that the with-profits sector as a whole is delivering information of sufficient quality to policyholders," the report concludes. "This is a concern found across the with-profits sector and not specific to any type or structure of the firm or whether they have closed or open funds".
The FSA believes a policy change may be required. One option would be more guidance about the content of the CFPPFM. Another would be to remove the CFPPFM altogether, instead placing the emphasis on better information at the point of sale, backed up by annual reporting on any major changes to the fund and how the firm has complied with its PPFM.
The regulator is also considering consumer testing with-profits policy documents and post-sale communications.
In the meantime, firms are encouraged to make sure there is clear ownership and oversight of all their policyholder communications and to undertake their own reviews to ensure they are providing information in a manner that is clear, fair and not misleading.
The current rules allow firms to set target ranges for payouts and apply "market value reductions" to the face value of unitised with-profits policies where the value of underlying assets is, or is expected to be, significantly less than the assumed face value of the policy.
Firms, however, have a significant amount of discretion in this area, subject always to their obligations to treat customers fairly, manage conflicts of interest and achieve fair outcomes for policyholders. The review looked at how firms were exercising that discretion.
The FSA was generally satisfied with firms' approach to market value reductions and target ranges, although it noted that very wide target ranges were a common feature and that some firms' payment fell outside even those ranges.
It also found that some firms were not monitoring effectively how they smoothed returns from good and bad years, in accordance with an overall, neutral smoothing strategy.
The FSA is considering whether to give the with-profits committee or with-profits actuary a greater role in monitoring target ranges and firms' smoothing operations. It will also be looking at the rules on identifying and distributing excess surplus, subject to Solvency II and potential changes to the taxation of insurance companies currently being considered by Revenue and Customs (HMRC).
The FSA found no evidence to suggest that current charges made to with-profits funds were excessive or unfair across the sector, but it had expected to see more firms carrying out some form of costs comparison to satisfy themselves their costs were reasonable.
One specific practice heavily criticised by the Treasury Select Committee, however, is the payment of shareholder tax from the inherited estate.
Current rules allow some life companies to pay the corporation tax that arises on the share of profits attributable to shareholders on a distribution, provided it is the company's established practice and the policy is set out in the PPFM. The Treasury Committee said it was unfair that policyholders should pay anything towards shareholders' tax bills.
The FSA's report confirms it will be reviewing this rule, taking into account any taxation changes that might be introduced following HMRC's consultation.
The FSA is also considering whether to introduce a requirement for firms to demonstrate the likely benefit to all policyholders of writing new business. Under current rules, the firm merely has to show (in the reasonable opinion of its governing body) that the new business is unlikely to have a material adverse effect on existing with-profits policyholders.
The regulator may also strengthen the rules and guidance on strategic investments, so that the firm will have to demonstrate the benefit to existing policyholders of making or keeping such investments within the with-profits fund.
Another FSA concern is the lack of thought firms give to the option of closing to new business or to the trigger points that would result in a review of whether or not to close to new business.
"While not identified as a key issue from firm assessments, given the current long-term decline of with-profits sales in total across the sector, we believe there is also a sufficient case to consider whether COBS 20 requirements for funds that are closed or that are substantially closed should be amended to move away from the current polarised position of being either formally closed or open," the report states.
"Instead we will consider whether to require firms to ensure distributions to with-profits policyholders reflect the actual circumstances of the fund: primarily that it is appropriate to the level of new business a firm realistically expects to write in the medium term.
"This could include requiring firms to create contingency run-off plans for all with-profits funds with the focus on declining funds, for example, those where maturities and surrenders exceed the amount of new business."
Overall, however, the review found that the management of closed funds had improved since the FSA's "Dear CEO" letter of 2007. Most with-profits committees were found to be sufficiently involved and, in general, there were no obvious weaknesses in the running of closed funds.
The report also contains a summary of the lessons learned from the recent Aviva reattribution, focusing on ways in which the process can be improved.
Contact: Bruno Geiringer ([email protected] / 020 7418 7306)