With-profits surpluses to be protected from compensation pay-outs

The regulator has published a consultation paper on its plan. The change would mean that shareholders alone would meet the cost of a company's management failures.

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

The inherited estate is an asset of the life company and can be used to provide working capital, smooth out returns between good and bad years and fund future growth.

Under current FSA rules, however, the inherited estate can also be used to fund compensation payments to victims of mis-selling. In recent years, these have included significant pay-outs to meet pension and mortgage endowment claims.

The rule has been criticised for not treating with-profits policyholders fairly because such payments reduce the amount that might otherwise be paid to them on a distribution or reattribution.

At least once a year, a life company operating a with-profits fund must consider whether to distribute any excess surplus. If retention cannot be justified, the excess should be distributed to policyholders and shareholders, usually on a ratio of 90:10.

In recent years, there has been a tendency for more with-profits funds to be closed to new business. In such circumstances, a distribution to policyholders becomes increasingly likely as the need for working capital recedes.

Alternatively, a life company may decide to negotiate with its policyholders to give up their rights in the inherited estate in return for payment (known as a reattribution).

In either case, the amount payable to policyholders can be significantly affected if the inherited estate has been used to meet the company's liabilities for mis-selling.

The FSA now proposes to amend its Conduct of Business Rules to state simply that a shareholder-owned company must not pay compensation or redress from a with-profits fund.
The change would not affect mutually-owned life insurers, who would still be able to use inherited estates to meet compensation costs.

In addition, mortgage endowment "guarantee" schemes, which promise a maturity value sufficient to cover the loan if investment growth achieves a set level, would not be counted as compensation and so would still be payable from the inherited estate.

The proposed changes would take effect for payments after 1st November 2008, regardless of when the mis-selling occurred, and would apply to all types of compensation, whatever the cause. Where a court-approved scheme for payment is already in place, however, that scheme will take precedence.

The deadline for responses to the consultation is 3rd September 2008. The FSA will publish a policy statement and its final rules before the end of the year.

In February this year, a Parliamentary committee launched an inquiry into the use of inherited estates, the results of which are not yet known. The investigation has a much broader remit than the FSA's current consultation and will cover such issues as reattribution and the appropriate division of funds between policyholders and shareholders.