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The Actuary The magazine of the Institute & Faculty of Actuaries
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PPFM have you finished yours?

T he FSA’s with-profits review has spawned a new acronym for the industry. Principles and practices of financial management, already known universally as PPFM, are aimed at improving the transparency and governance of with-profits business.

Background
In February 2001 the FSA initiated its review of with-profits business. The progress of this review is outlined in table 1 across. In Issues Paper 4 the FSA suggested that it might require PPFM and this was carried over to Consultation Paper (CP)167, which contained new rules and guidance over the governance of with-profits business. CP167 stated that firms must:
– define and make publicly available the PPFM applied in the management of with-profits funds;
– ensure that their governance arrangements offer assurance that they have managed funds in line with the established and published PPFM; and
u produce annual reports for with-profits policyholders detailing compliance with the above obligation, including the methods for addressing competing or conflicting rights, interests or expectations of policyholders, and, if applicable, shareholders.
The FSA requires firms to define and publish their PPFM by the end of March 2004. Copies will be available to policyholders, their advisers, and market commentators on request, and companies’ annual statements must inform policyholders that copies can be provided. Firms will be expected to publish PPFM on their websites.
All firms conducting with-profits business (apart from non-directive friendly societies) must comply, including those with closed funds. Directive friendly societies will not need to produce PPFM for ‘Holloway’ sickness business.

Principles and practices
Figure 1 describes the areas the PPFM should cover. Annex F of CP167 provides the detailed draft rules and guidance which covers some general areas and the six sections shown in figure 1.
When considering changes to their principles and practices, firms must be aware of the current proposals stating:
n Principles Changes must involve discussion with the with-profits actuary and the with-profits committee. Policyholders must be given three months’ advance notice.
– Practices Changes must involve discussion with the with-profits actuary, and then written notice to policyholders (this does not need to be in advance of the change).
The FSA does not expect the principles to change frequently. However, changes to practices may occur more often, for example every few years. Changes to either principles or practices are likely to trigger firms’ obligations to inform the FSA.
The FSA defines the broad scope PPFM must cover, including any area that may have a significant impact on the firm’s management of with-profits funds. Any requirements or constraints arising from previous events, such as business transfers, should be reflected.
If you haven’t yet started addressing your PPFM, then don’t panic but time is getting short and considerable work is involved. Existing documentation and procedures are the starting point. However, a great deal of the required information may be in the heads of staff, so some brainstorming sessions are needed. Transferring this ‘expert system’ into a paper record is possibly the main intellectual challenge. The actuarial staff are likely to have most information, but don’t forget others. Above all, don’t underestimate the time and resource needed to produce PPFM.

Overview of PPFM content
Payment methods, bonuses, and smoothing
Firms will need to describe the general methods used to assess the amounts payable to with-profits policies. This won’t be as straightforward as stating that the firm uses an asset-share methodology. The aims of the methods will need to be made clear, as will the broad assumptions used and the degree of approximation allowed. Discussion of the items comprising the asset share will be required, including allocation of investment returns, expenses, and tax. Charges for guarantees and use of capital, shareholder transfers, and any other relevant items must also be described. Companies should avoid getting bogged down in the theoretically ‘correct’ methodology; it is more important that the method described should reflect what happens in practice.
The approach of setting annual and final bonuses must be documented. Aspects to cover are:
u the aims;
u any constraints in changing economic climates;
u the weight placed on recent economic circumstances;
u the maximum amount of change in rates from one year to the next;
u the approach to interim bonuses;
u the approach to final bonus on maturity or surrender; and
u the use of smoothing.
Investment strategy
The significant aspects of investment strategy must be covered, including a description of the degree of matching between with-profits liabilities and the backing assets. If assets outside the with-profits fund are used to help implement investment strategy, this must be stated. The risk appetite for assets of differing credit and liquidity quality, and those of differing market volatility, will need consideration. A description of the extent to which derivatives are used, and the control mechanisms in place, is required.

Business risk
The PPFM must include a description, and possibly an explanation, of how with-profits funds are exposed to business risks, such as writing non-profit business, guarantees, investment in subsidiary companies, compliance risks, and countless others. The guidance indicates that companies must describe how business risks are considered before they are entered into, and how risks and rewards will be dealt with in the future. Firms are expected to set out the alternatives when reviewing existing and new business risks to ensure that rewards are reasonable, given the risks undertaken.

Charges and expenses
The methods used for applying charges and apportioning expenses to with-profits business must be covered. Under practices firms must disclose current charges and expenses. Firms must also discuss how actual charges and expenses could vary compared with those assumed in determining amounts payable on with-profits policies.

Inherited estate
The purposes for which any inherited estate is used will form part of the PPFM. Firms will need to describe the level of inherited estate being targeted, and the implications of this for with-profits policies. Restrictions on the use of the inherited estate, for example arising from previous business transfers, must be documented.

New business
The general approach to setting volumes of new business written from the with-profits fund (whether with-profits or non-profit) should be explained. Arrangements in the event of closure to new business, including the impact on the distribution of the inherited estate, must be described.

Shareholders
For proprietary companies, the profit-sharing arrangements between shareholders and with-profits policyholders should be considered. In particular, this will include the scope for changes in the allocation of profits to both parties, and the approach to be taken before any changes are implemented.

What does this mean for you?
Leaving aside the question of whether consumers will find the PPFM useful, the industry itself may find them valuable. The regulator undoubtedly will, and so may the Financial Services Ombudsman. They will help firms to crystallise thoughts and to develop procedures, and may even help firms to manage their business more effectively. On the downside, the extensive documentation required could result in firms’ giving away too much information, resulting in exploitation by policyholders or undesirable lack of flexibility. To combat this, the PPFM will need to be subject to rigorous examination. This could mean involving many people and functions of the business in their development and review, perhaps during PPFM workshops. It should not be left to actuarial departments to produce them in isolation.
The split of information between principles and practices will be important. Principles are likely to contain generic information, describing in general terms the processes and methodologies followed. Practices will add detail to the principles, reflecting the management of the business in the current environment. In considering the PPFM, firms will need to consider how the company could react in numerous situations, and try to minimise the restrictions which PPFM could impose. Firms must decide whether any competitive advantage is being lost. For example, information on investment strategy should not enable competitors (or other market participants) to predict the actions the firm would take in certain economic circumstances.
The PPFM must be tested against the business. Besides the general views of staff, this is likely to require actuarial models of the statutory and realistic positions of the company. These must incorporate the rules outlined in the PPFM, and incorporate scenario testing to check the appropriateness of the PPFM. This could include stochastic modelling to test how the PPFM would apply in various investment climates. The influence of the PPFM on other models, such as those used for internal capital assessment, must also be considered.
There will be circumstances where particular parts of the PPFM conflict or restrain each other. It may be appropriate to introduce a hierarchy into the PPFM, so that particular parts take precedence over others. As shown in figure 1, some form of overarching principles may also be necessary. For instance this could explain that maintaining solvency is critical, and that no other principle or practice could act to override this.
Finally, you’ve probably guessed that the PPFM document isn’t going to be short! Nor is it likely to be particularly user-friendly for the average consumer. The FSA is considering if PPFM can be published in a ‘consumer-friendly’ format. This may lead to a shortened overview document, with access available to the full PPFM on request.

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