The FSA Feedback Statement On The With-Profits Review

In May the FSA published its feedback statement on the comments received on the five issues papers published as part of the With-Profits Review. The feedback statement includes a summary of the comments received from respondents on the issues papers, the FSA’s preliminary conclusions and its plans for taking these forward, together with an outline timetable for the issue of consultation papers.

The feedback statement states that the FSA considers that with-profits policies are likely to remain a significant feature of the long-term savings landscape for the foreseeable future. However, the FSA also identifies a number of concerns which it has regarding the management of with-profits funds and the way in which with-profits policies are currently sold. The purpose of the With-Profits Review is to address these concerns and to rebuild consumer confidence in with-profits products generally.

The next step following the issue of the feedback statement is for the FSA to publish a number of consultation papers dealing with the issues raised in the feedback statement. The FSA has also indicated that, in addition to matters arising from the With- Profits Review, it will consider the recommendations put forward by others carrying out relevant review work (such as Ron Sandler in his report on the medium and long term retail savings industry, which was published in July). This article summarises and comments on the more important aspects of the FSA’s conclusions and its proposals for future consultation, as outlined in the feedback statement.

The FSA considers that the key requirements for improving the governance framework for the management of with-profits funds are:

• greater transparency in the nature and extent of the discretion retained by insurers in the management of with-profits funds;
• improvements in the way in which policyholders’ interests are accounted for in managing with-profits funds; and
• clearer mechanisms to demonstrate that directors are exercising their discretion in a manner which balances the competing entitlements of persons interested in a particular with-profits fund and treats customers fairly.

The FSA has undertaken to issue a Consultation Paper (CP) on the governance of with-profits funds by the end of this year and has indicated that the two key proposals in the CP will be that insurers which transact with-profits business should define and publish Principles and Practices of Financial Management (PPFM) and that each insurer should constitute a With-Profits Fund Committee, the role of which will be to safeguard the interests of with-profits policyholders. These two proposals are considered in more detail on the next page.

The FSA is proposing that the PPFM will set out the nature of the discretion retained by the directors and the parameters within which the directors will exercise their

discretion in relation to the management of with-profits funds. The FSA’s proposals for consultation (to be issued by the end of this year) comprise the following:

• The PPFM will disclose the principles and practices which the insurer would apply in relation to, amongst other things, investment management, bonus and smoothing policy, charges and expenses, the setting of surrender values and management of the inherited estate.
• The PPFM will need to distinguish between principles, on the one hand, and practices on the other. It is envisaged that the principles would be a set of enduring standards reflecting the general approach to be adopted in managing a with-profits fund. Principles would rarely be subject to change, and then only following prior notice being given to policyholders. Practices would reflect the insurer’s current approach to the management of the with-profits fund in the light of prevailing economic conditions and other relevant circumstances. Prior notice of changes to practices would not be necessary.
• The PPFM will be required equally in relation to both new and existing business in both open and closed funds.
• The directors will need to publish an annual statement confirming that the with-profits fund had been managed in accordance with the PPFM.

The FSA will also consider whether it is appropriate for it to publish a form of "model code" for PPFMs, reflecting its view of good practice on the management and operation of with-profits funds. The existence of a "model code" would presumably be of considerable assistance to insurers and their advisers charged with drawing up PPFMs for the first time, provided of course that, in drafting the PPFMs, they are free to depart from the model code wherever it is appropriate for them to do so.

Given that principles cannot be altered except following notice to policyholders, it will be important to ensure that the nature and scope of an insurer’s principles do not jeopardise its ability to react to changes in commercial or economic circumstances as quickly as necessary. For example, insurers will need to retain enough flexibility to react to changing marketing conditions without prior notice to policyholders. Accordingly, careful consideration will need to be given to the distinction between principles and practices in the drafting of PPFMs.

Whilst the proposal for PPFM is certainly welcome, it should not necessarily be assumed that even the most carefully drafted set of PPFM will cater for every issue which comes up in practice. Our experience of those cases where similar principles of financial management have been established following transfers of insurance business has been that difficult questions can arise on the meaning of the principles in circumstances which were perhaps not anticipated by the draftsman.

The FSA suggests in the feedback statement that its objectives as regards strengthening the governance framework could be achieved by each insurer setting up a With-Profits Fund Committee, the role of which would be to consider and safeguard the interests of with-profits policyholders and specifically:

• to monitor the exercise of discretion by the board, and satisfy itself that the competing interests within the with-profits fund have been appropriately managed in line with the PPFM;
• to be consulted on and consider any proposed changes to the PPFM and provide an opinion to the board on how these affect the interests and fair treatment of policyholders;
• to be consulted on and consider other decisions that affect the interests and fair treatment of policyholders, including bonus rates, expenses, and investment strategy; and
• to publish a report annually for policyholders on the work of the committee and the firm’s compliance with PPFM.

The FSA envisages that the With-Profits Fund Committee could either be constituted as a sub-committee of the board of the relevant insurer or separately from the board. If established as a sub-committee of the board, the FSA envisages that a perspective independent from that of the board could be achieved by drawing members from amongst the non-executive directors of the insurer in question or, indeed, from external non-directors. The FSA appears to prefer the former option.

One of the most difficult questions is how the With-Profits Fund Committee would interact with an insurer’s board. Creating a committee with a supervisory role over an insurer’s business but which is not ultimately answerable to the board of the insurer in question sits uneasily with existing legal principles, particularly the common law rules on the powers and duties of directors in managing a company.

It is also unclear whether such a committee would be answerable to policyholders by virtue of their responsibilities towards policyholders and, if so, whether members of such a committee could obtain indemnification out of policyholder funds, for example. Another problem which a non-board committee in particular could give rise to are difficulties in resolving conflicts between the committee and the board: unless the board were to be released from its duties in relation to matters within the responsibility of the committee, the board would be keen to be able to override the committee’s views.

On the other hand, establishing the With- Profits Fund Committee as a sub-committee of the insurer’s board should make the sub-committee answerable to the board, which would be consistent with the fact that the board is normally ultimately responsible for running the insurer’s business. However, this approach might not encourage as much independent scrutiny of the board as making the committee entirely separate from the board. The fact that its members will either be current board members themselves, or be appointed by the board, will inevitably dilute the committee’s independence in practice even if (as we would expect to be the case) the chairman and a majority of the members of the committee are not executive directors of the insurer in question.

It is also difficult to see how a With-Profits Fund Committee will be able to take account of conflicts between the interests of different groups of with-profits policyholders. Should there be such a committee to represent the interests of each group? If so, who will resolve disputes between them?

In any case, it is questionable whether the With-Profits Fund Committee, however constituted, will bring a greater degree of independence to the monitoring of the exercise of discretion by the board, or indeed a higher level of protection for policyholders, than that already provided by the appointed actuary. If the appointed actuary’s work is to be monitored independently (see the next article in this briefing), then there is arguably even less of a real benefit in establishing With-Profits Fund Committees.

It also remains to be seen whether, in the light of the problems experienced by Equitable Life and its directors, external non-directors will be willing to take on supervisory roles in insurers the practices and operations of which are likely to be unfamiliar to them and over which they do not exercise direct managerial control. Indeed, the cost of persuading individuals to take on these roles may be difficult to justify unless the industry can be persuaded that With-Profits Fund Committees are likely to give rise to real benefits.

The responses to Issues Paper 2 generally supported the need for greater clarity and openness about the financial condition of with-profits business. The FSA’s proposals in this regard are as follows:

• A CP has been issued this Summer which contains suggestions for the clearer and more directly comparable presentation of information on the solvency of with-profits funds and their ability to meet guaranteed benefits. It is proposed, amongst other things, that such information should be provided at an individual fund level and should disclose the effects of financing and capital support on an insurer’s solvency.
• Proposals concerning the provision of additional information to help assess an insurer’s ability to meet guaranteed and discretionary benefits, based upon the disclosure of the insurer’s realistic assessment of current policyholder liabilities, will form part of a CP to be issued by the end of this year on the new regulatory reporting environment.
• The FSA will also specifically consider introducing compulsory minimum disclosure requirements, possibly based on average fund size over a defined period, taking account of the likely costs and benefits for small funds.
• The publication of regulatory returns will take place on the FSA website.
• Indicators of individual insurers’ financial strength will be developed in a more readily understandable form.

The FSA recognises the difficulties which customers often have in understanding the nature of with-profits investment products and the risks attached to them. In particular,

the FSA is of the view that prospective policyholders could be discouraged from reading point of sale literature by the format, volume and complexity of the information provided. Furthermore, the FSA believes that the wide variation in the current format and content of annual statements does not help customer expectations of what the product would deliver. With a view to improving the policy information available to customers the feedback statement provides as follows:

• The FSA will consult on the introduction of a "tiered" approach to the disclosure of information to customers, consisting of core information to be provided to all customers and supplementary information to be made available for customers on request.
• Proposals on point of sale information and price disclosure will form part of a CP to be published under the Product Disclosure Review in Autumn of this year. Proposals on annual statement disclosure requirements will form part of a CP on post-point of sale information which the FSA will publish in the second quarter of next year.
• The FSA proposes that the benefits of enhanced disclosure should be available to existing and new policyholders equally, subject initially to the outcome of a cost benefit analysis in respect of insurers whose legacy systems may not be able routinely to provide the requisite information on an individual basis.
• The FSA will consult on the removal of the requirement on insurers to produce with-profits guides in their current form, in the light of the proposals for the preparation of PPFM and the enhanced disclosure of with-profits information to customers and also in regulatory returns. This will not affect the production of with-profits guides for this year.
• The FSA will review the current price disclosure rules for with-profits products, the intention being to make more transparent the effect of expenses and charges on with-profits products and the way in which other factors, such as surplus arising from miscellaneous sources, are taken into account.
• The FSA will consider advocating the development of simpler, straightforward terms to be used when describing with-profits products in product literature and policy documentation.

The need to improve the information given to customers and their advisers on with-profits policies was, according to the FSA, accepted by most respondents to Issues Paper 3. However, by their nature, with-profits products are amongst the most complex of all retail savings products. Care will therefore need to be taken to ensure that the policyholder documents (whether issued at the point of sale or subsequently) are not over-simplified such that they fail to convey the complexities of the product. Similarly, the FSA will need to avoid introducing requirements which lead to what is referred to in the feedback statement as "information overload", the effect of which will be that policyholders cannot reasonably be expected to read or understand the information given to them. Critics of the complexity of with-profits products would arguably be entitled to take failure by the FSA in this regard as further justification for Ron Sandler’s argument that simply introducing disclosure and governance changes is inadequate and that a new type of simplified "stakeholder" with-profits policy is required.

The Feedback Statement contains suggestions as to how the current process for dealing with the re-attribution of inherited estates might be made more open and transparent. In particular, the FSA has identified a need for a "policyholder advocate" to be appointed to represent and negotiate on behalf of policyholders where a re-attribution proposal is put forward. The FSA is also proposing to introduce a framework of enhanced publicity with the aim of introducing more transparency into the re-attribution process. Both of these proposals are considered in more detail below:

• The FSA will consult with industry, consumer bodies and other interested parties in drawing up the detailed responsibilities of the policyholder advocate and in deciding how, in practice, this function could be best introduced into the current process. The FSA states that this consultation process will have taken place by the second quarter of next year.
• The preliminary view of the FSA is that the policyholder advocate’s role should be to "secure the best deal that he or she can for policyholders". It would then be for the policyholders to decide whether they are satisfied with the proposals put to them. The FSA will also need to be satisfied that the deal is fair from the point of view of policyholders.
• The policyholder advocate would, according to the FSA, need to be involved from an early stage in the negotiation process and, in practical terms, would probably need to be an individual, rather than a panel or firm.
• It is recognised that some form of indemnity for the policyholder advocate will need to be provided and the FSA will consider the ways in which such an indemnity could be provided.

The FSA states that in the responses to Issues Paper 1 some respondents, including consumer bodies, were of the view that the objective of the policyholder advocate should be to obtain the "best possible deal" for policyholders; the view of remaining respondents was apparently that this objective was not appropriate or realistic. We share the latter view. Any attribution proposal will involve an element of commercial negotiation between persons with different interests, namely shareholders (in proprietary companies), members (in mutual companies) and different generations of policyholders. However, commercial negotiation, by definition, takes place in the context of a recognition of each party’s position. It is difficult to see how the "best possible deal" for policyholders could be commercially acceptable to other parties.

The FSA states that its role in an attribution proposal will be to ensure that the proposal is fair to policyholders and, as such, this does not represent a change from past practice. The FSA’s approach to assessing the value of the offer made by AXA to policyholders of AXA Equity & Law in the AXA attribution and transfer scheme in 2000 was neatly summarised with approval by Mr Justice Evans-Lombe in his judgment in that case:

It is to be hoped that the FSA’s recognition of the commercial imperatives inherent in an attribution proposal are recognised in setting the role of the policyholder advocate in future attribution proposals.

We note that in his report Ron Sandler urged the FSA to complete outstanding attribution proposals as soon as possible, so it may be that the FSA’s rather leisurely timetable for taking these proposals forward (publication of a timetable in the second quarter of 2003, with no indication what that timetable will provide) will have to accelerate.

As regards the issue of the indemnity to be provided to the policyholder advocate, it is difficult to see who other than the company which is implementing the attribution proposal could provide the indemnity. However, the issue of where any liability under the indemnity should fall (i.e. whether upon shareholder or policyholder funds) is likely to prove more difficult to resolve.

The FSA intends to develop, in consultation, a framework to provide for enhanced publicity of attribution/re-attribution proposals on the following lines:

• the announcement of the start of negotiations will be made upon the appointment of the policyholder advocate becoming effective and will be accompanied by a statement of the outline details of the initial proposals;
• regular progress reports will be made to policyholders, for example at six monthly intervals, commenting on the progress of negotiations; and
• there will be full disclosure of the final terms of the proposal before it is implemented.

Care would need to be taken by insurers when issuing progress reports to policyholders commenting on the progress of negotiations. Indeed, one might expect that such reports will necessarily be vague given the need for insurers to preserve their commercial confidentiality and to avoid the potential embarrassment of issuing progress reports only for the proposal to fail. Where the insurer is part of a listed group, the requirements of the UK Listing Rules, or equivalent for companies listed abroad, will also need to be considered when preparing and publishing such reports. Given that a policyholder circular summarising the terms of the proposal will inevitably be required, it is perhaps difficult to identify any material benefits for policyholders arising out of the issue of progress reports before a final proposal is made to them.

Conclusion

The proposals arising from the With-Profits Review, as set out in the Feedback Statement, are still at a very early stage. However, if, following the consultation process, the key proposals are eventually adopted, then the With-Profits Review will have given rise to a comprehensive overhaul of the way in which with-profits funds are managed (and seen to be managed) and with-profits products marketed. One would expect consumers, analysts and IFAs to welcome the greater transparency and accountability that the proposed changes will bring. However, it remains to be seen whether the introduction of the disclosure and governance changes proposed in the feedback statement will serve to remedy in full the problems identified by the FSA in the feedback statement. It should be noted that the position adopted by Ron Sandler is that the problem essentially lies with the nature of the with-profits products themselves rather than with the accompanying disclosure and governance regime, hence his proposal for a new and simplified "stakeholder" with-profits policy.

It also remains to be seen how the with-profits insurers themselves will react to the introduction of some of the proposals set out in the feedback statement. In particular, one would doubt that insurers will welcome the extra expense and management time which will inevitably need to be incurred in drawing up PPFMs, constituting With-Profits Fund Committees and producing more detailed regulatory returns.

© Herbert Smith 2002

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