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MPs call for shake-up of rules on with-profits surpluses

The Financial Services Authority (FSA) must control the extent to which life companies can use surpluses in their with-profits funds to subsidise corporate activities, a committee of MPs concluded last week.

The Treasury Committee's report follows a four-month inquiry into the FSA's regulation of inherited estates – the surplus assets that have built up over the years in their with-profits funds.

A with-profits fund is made up of policyholder premiums, investment returns and shareholder contributions, sometimes going back over generations. The inherited estate is that part of the fund that exceeds the firm's realistic liabilities to policyholders.

This surplus provides working capital for the with-profits fund and is used to smooth out returns to policyholders between good and bad years. But it can also be used for the life company’s own purposes, to strengthen its capital base or to fund future growth plans. In some cases, it can be used to pay the shareholder's corporation tax bill following a distribution.

Anything that reduces the size of the surplus reduces the funds that might be available to distribute to policyholders. The concern is that, given the very different interests of shareholders and policyholders, policyholders are not being adequately protected. 

"We are not satisfied that the [FSA] have done enough to provide a robust framework in which these conflicts of interest can be managed," the report concluded.

"Whilst we accept that the with-profits sector is a complex business, all stakeholders in with-profit funds deserve a framework which provides as much simplicity, certainty and clarity as possible," it said. "We would welcome a reopening of the debate about the fundamental design of the regulatory system for with-profit funds and will continue to monitor the FSA's progress in its regulation of the with-profits sector".

Policyholder detriment

The committee found that the payment of shareholder tax from the inherited estate is "a striking example of how certain life firms are able to use their discretion in a way that furthers shareholder interest to the detriment of policyholders".

Current rules allow some life companies to pay the corporation tax (at 28%) 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 its Principles and Practices of Financial Money document (known as a PPFM).

The committee considered it unfair that policyholders should pay anything towards shareholders' tax bills and urged the FSA to consult on the issue by the end of the year.

The payment of compensation costs from the inherited estate was also found to be inappropriate and the committee has welcomed the FSA's own consultation on changing the rule, launched earlier this month.

Phased payments

Another practice the MPs would like to see eradicated is the "phasing" of payments made on a special distribution of surplus funds.

The rules state that, at least once a year, a life company operating a with-profits fund must consider whether to make a special distribution of any excess surplus. If retention cannot be justified, the excess should be distributed to policyholders and shareholders, usually on a ratio of 90:10.

The committee suspected some companies do not try as hard as they might to identify such surpluses. And even when they decide to make a distribution, many of them phase the payments to policyholders over time. Policyholders wishing to receive their full payment are effectively prevented from leaving the fund during this period.

The report said that the FSA "must put forward a very strong case indeed if such phasings should be allowed to continue".

New business

Another area of concern is the use of the inherited estate to fund new business, particularly if the life company is already considering buying out policyholders' rights in the inherited state (a process known as a reattribution). The company may have an incentive to set aside as much as it can, even if the new business might be unprofitable.

For this reason, the report said it is "vitally important" that the FSA conduct a rigorous assessment of the company's assumptions made during reattribution negotiations.

Other proposed reforms include greater transparency in the way companies "smooth" out returns by holding back a proportion of the investment return during a good performance year to ensure a reasonable return can be paid to policyholders during years of poorer performance.

The MPs would also like to see a more effective role given to with-profits committees, whose job it is to ensure the fund is run fairly and that policyholders' and shareholders' conflicting rights and interests are properly addressed.

Bruno Geiringer, a life insurance law specialist with Pinsent Masons, the law firm behind OUT-LAW.COM, welcomed the Treasury Committee's call for further strengthening of the regulatory regime and governance for with-profits funds.

"The life industry continues to fall short of doing enough to win back the trust and confidence of the public who invest in with-profits products," he said. "At a time when this sector is seriously challenged on many fronts, it is failing to get across the benefits of a product that is still attractive to many. This is an opportunity the life industry can't afford to ignore."

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