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The Actuary The magazine of the Institute & Faculty of Actuaries

Regulation: Fair treatment of with-profits

Effective governance and management of the conflicts of interest inherent in with-profits funds are vital in ensuring that all classes of with-profits policyholders are treated fairly. This is one of the major themes of the FSA’s new consultation paper, ‘CP11/5 Protecting with-profits policyholders’.

One of the main findings of last year’s With-Profits Regime Review (the Review) was that governance of with-profits funds is often weak, and does not ensure that all with-profits policyholders’ interests are always taken into account by firms operating with-profits funds. This criticism applies equally to shareholder-owned firms as it does to mutually owned ones.

Actuaries have always been central to the operation and decision-making process of with-profits funds. Whether it is the creation and implementation of an effective smoothing strategy, which allows for the fair treatment of all policyholders - or in some cases declaring unsustainably high bonuses and offering guarantees that have ultimately forced a fund to close - actuaries have always played a leading role.

CP11/5 contains far more than proposals for strengthening governance (see below). The issues being consulted on here have been generated primarily from the Review.


Issues consulted on in CP11/5
>> Governance
>> Conflicts of interest
>> The fair treatment of with-profits policyholders in with-profits funds
>> The terms on which new business is written
>> Material reductions in new business
>> Market value reductions
>> Strategic investments
>> Charges made to with-profits funds
>> Excess surplus
>> Reattribution of inherited estates.

But they also include matters relating to mutuals arising out of Project Chrysalis (which considered the fair treatment of with-profits policyholders in mutually owned with-profits funds) and to existing concerns we have had over the effectiveness of some of our rules. Arching over all of the individual proposals is the need to ensure that the rules and guidance are applied properly and the need to strengthen the governance requirements to make sure this happens.

We make several proposals in relation to governance. Our intention here is to make sure that firms give appropriate weight to the interests of with-profits policyholders during their decision-making processes.

Many funds are consolidating and moving into run-off and difficult decisions will have to be made about surpluses and the way in which they are distributed. We want to make firms do more to ensure their decisions affect with-profits policyholders in a fair manner.

The key proposals are to strengthen governance in with-profits funds by requiring all funds with assets of more than £500m to have a with-profits committee (WPC). Funds under that size can continue to have an independent person instead.

In requiring this we have set out two options in relation to the composition of WPCs - either all members are independent and completely external to the with-profits fund or funds they oversee, or we allow directors and non-executives of the firm to sit on WPCs, but there must be an independent majority.

A number of WPCs and independent persons see their remit as being narrowly confined to considering whether a firm has complied with its PPFM (principles and practices of financial management).

We take the view that WPCs or independent persons should be taking a much broader view of their responsibilities. So we would not accept, for example, that WPCs or the independent person should confine their attention to that part of the fund backing asset shares only. The estate is an integral part of the fund in which with-profits policyholders have a contingent interest.

It follows that WPCs or independent persons must also monitor the uses of any estate in a fund.

We propose that, in addition to monitoring compliance with PPFMs, WPCs or independent persons will also have their terms of reference published and that they can make reasonable requests for external advice if they believe that will help their decision-making. Firms will have to tell us if they do not follow advice given to them by WPCs or their independent person, and record why they chose not to do so.

One of the most obvious conflicts of interest currently allowed within our existing rules on governance is that the with-profits actuary, whose job it is to advise firms on the use of discretion and report on this annually to with-profits policyholders, is either a paid employee of the firm or a consultant retained by the firm. We propose that with-profits actuaries do not have reporting lines, or have their remuneration determined in a way that may create a conflict of interest over the advice he or she gives.

Other issues
We propose that the current guidance on the need to manage conflicts of interest between policyholders and shareholders becomes a rule and that we expand it to make it clear that our rules relate to all types of conflicts of interest. These can be between with-profits and non-profits policyholders, different classes of with-profits policyholders, with-profits policyholders and managers and with-profits policyholders and other members of mutually owned firms.

The continuing fall in new with-profits business poses particular challenges to mutually owned firms who wish to continue to write new non-profit business.

In particular, there can be a tension between the interests of with-profits policyholders in the fund, the desire for firms’ management to hold back money to fund new non-profit business and, in some cases, other members who also have an interest in the long-term fund.

We propose to amend our rules relating to distributions to with-profits policyholders so that the required percentage reflects a firm’s established practice. We expect this will give the clarity that mutually owned firms running with-profits funds have been seeking.

Currently, new business can be written into with-profits funds provided it is unlikely to have a material adverse effect on existing with-profits policyholders.

We no longer accept that this is appropriate, so we propose to require it to be likely that there will be no adverse effect on them. By ‘likely’ we mean any new business plan has to be properly costed and deliver a credible analysis. We are making a similar change so that strategic investments can only be made if there is no likely adverse effect on existing with-profits policyholders.

We want to move away from the stark ‘open or closed’ distinction under the current rules. Instead, firms will have to tailor their operational and financial planning, including distribution plans, to reflect the level of new business they are writing and expect to write.

In addition, with-profits funds that closed before the current rules took effect in 2005 will be required to have run-off plans.

Firms will no longer be able to apply market value reductions (MVRs) if there is a high volume of surrenders alone. MVRs will only be applicable if the market value of the with-profits assets is lower than the face value of the policy and their amount will be limited to the extent of the shortfall.

We are making it clear that our rule, which sets a limit on the expenses firms can charge to a with-profits fund, applies equally to in-house management services arrangements. An arrangement under which amounts in excess of cost are charged subverts the stated distribution ratio by a back-door leakage of value.

We propose to rectify the position under the existing rules where a reattribution of any excess surplus might be used as an alternative to a distribution. In future, only a distribution can be used for this purpose. We see reattributions and distributions as entirely different events that take place for entirely different reasons. Finally, we are tightening our rules on reattributions to strengthen the role of the policyholder advocate and to speed up the process.

This is a brief overview of the issues we are consulting on in CP11/5, all of which are of interest to the actuarial profession. If you have not already done so then I urge you to read the paper and send in your response to us. Consultation closes on 24 May.

Peter Smith is the head of Investments Policy at the FSA