SIR CALLUM MCCARTHY AND MR HECTOR SANTS

22 JANUARY 2008

  Q1 Chairman: Good morning, Sir Callum, Mr Sants. Welcome to the Committee's hearing on your Annual Report. We have taken evidence from you previously on Northern Rock and this is the opportunity for us to focus exclusively on your Annual Report. Can you introduce yourselves for the shorthand writer, please?

  Sir Callum McCarthy: Certainly, Chairman. I am Callum McCarthy, Chairman of the FSA.

  Mr Sants: Hector Sants, Chief Executive of the FSA.

  Q2 Chairman: Mr Sants, when you were here in October I asked you a question at the end in terms of inherited estates and you said that you were going to take a personal interest in this issue. The FSA has advised that its rules require firms to distribute excess capital in inherited estates as the excesses arise. Can you confirm this means that companies with inherited estates can no longer claim that policyholders' reasonable expectations are zero?

  Mr Sants: Yes. Our material that we have recently produced, including our exchange of letters with the Policyholder Advocate, Clare Spottiswoode, makes that point absolutely clear.

  Q3  Chairman: The reason I am asking is that Sarah Wilson, Director in charge of insurance, said in October that it was insurance firms, not policyholders, who owned the inherited estate and that policyholders had at best a "contingent claim". You are saying, for the record, that is not the case?

  Mr Sants: No. I think both the statement "yes" and the comments that you have read out are compatible with each other. To elaborate, I was trying to be very clear by answering "yes".

  Q4  Chairman: On the point about insurance firms owning inherited estates, we know how this came about with the with-profits funds and the smoothing and insurance companies held this money back, so it is not really insurance companies' monies here, it is policyholders' monies, and it is important to get that on the record.

  Mr Sants: No. As you say, rightly so, there has been a lot of debate around this and media commentary. It is undoubtedly the position, it is legally the position, that those estates are not owned by the policyholders, they are part of the company's assets on which the policyholders have a contingent claim, so they are not owned by the policyholders and I think some of that belief has coloured some of this debate. That is a legal matter, not a matter of FSA rules. The reason I answered "yes" is we absolutely agree that they have a contingent claim on those assets, we are completely aware of that and our rules are framed around the ministerial statement concerning the 90/10 point.

  Q5  Chairman: Is that the 1995 statement?

  Mr Sants: Yes. Therefore, it is absolutely reasonable for policyholders to have an expectation that they will get more than zero, which was the answer "yes" to the question.

  Q6  Chairman: That ministerial statement, the 90/10, do you abide by that?

  Mr Sants: Yes, we abide by that fully. If you are fully distributing then we base it on the 90/10 rule. If you are making a reattribution, which is not a distribution but the movement of the assets out of the fund into the company so that they can then, going forward, be solely at the disposal of the shareholders, then obviously the policyholders are entitled to be compensated for the removal of their contingent rights when the company takes control of that money and places it solely at the disposal of the shareholders. That compensation discussion should be referenced and based on the 90/10 rule, but it is not the same as a distribution of surplus assets.

  Q7  Chairman: Do you think it is fair that insurance companies are allowed to take money from the inherited estate to pay the shareholders' tax bill, to subsidise new business and, indeed, to pay compensation for mis-selling claims?

  Mr Sants: Those are three separate points with three different answers.

  Q8  Chairman: Exactly, that is why I put it in that way.

  Mr Sants: At the moment our rules do allow all those three points that you have articulated. As you mentioned in your opening comment, I have been personally focused on this matter and the FSA is very focused on the matter. We thought it proper to reassess our current rules and as part of that reassessment process we have said that we will take a look again at the issue of being able to charge mis-selling costs and will consult on that. Therefore, it follows from that, obviously, we think there is an argument that says mis-selling costs should not be chargeable and we should consult with industry to assess that argument. In other words, we do not think it is absolutely the case that mis-selling costs should be charged and thus we will look again at that rule. On the first two points, we need to bear in mind that this is not a closed-end fund. All policyholders understand when they buy into such vehicles that they are buying into an open-ended vehicle which in normal circumstances continues over a long period of time with new policyholders joining and policyholders falling away, it is an open-ended process, and as part of an open-ended process it is reasonable to charge those types of costs that you have alluded to, to do with new business and tax, because a vibrant and successful long-term fund is to the advantage of policyholders in the long-term.

  Q9  Chairman: So you think it is fair that tax bills by shareholders could be taken out of this fund and policyholders could lose as a result?

  Mr Sants: That is a longstanding practice that has been reflective of the philosophical approach I have described and was in place when we properly reviewed our rules and it seems reasonable to allow that practice to continue. I come back to the point that this is not a closed-end fund that has a finite life solely for the benefit of the current policyholders, it is an open-ended vehicle that is meant to have a long-term—

  Q10  Chairman: When a fund is closed to future policyholders the estate is distributed over time 90/10 to current policyholders, but a reattribution closes off an estate to future policyholders. Am I correct there?

  Mr Sants: The reattribution takes away that particular set of money from the policyholders which is why they have a contingent claim and can be compensated for the removal of that money to be placed at the disposal of the shareholders.

  Q11  Chairman: So a reattribution closes off an estate to future policyholders?

  Mr Sants: Not necessarily, it depends on the circumstances of the particular reattribution. Individual circumstances could be different.

  Q12  Chairman: But, largely speaking, what we have seen is a reattribution.

  Mr Sants: Yes, largely speaking.

  Q13  Chairman: Exactly. That is just closing a fund completely. Do you think that fairness requires that current policyholders should be compensated for the fact that shareholders are purchasing the whole estate?

  Mr Sants: They should be compensated, yes, that is why we made it clear that they have an expectation of more than zero.

  Q14  Chairman: The reason I am asking you, Mr Sants, is people are contacting us and they say there has not been any clarity on the situation. I want clarity here. Indeed, I will be following this up with letters to you. It is for the clarity element that I want you to answer.

  Mr Sants: We would very much like to clarify this. We have been taking an approach to try to keep everybody fully informed, which was why we published on our website our correspondence with the Policyholder Advocate and we completely support your objective of getting clarity here. If there are any areas where we are not clear I would be more than happy to respond with further public communication in response to any further questions. We are seeking to ensure a fair process for the policyholders as well as the companies and that process should be one that is fully understood by all. If there is any confusion we will be more than happy to clarify any issues.

  Q15  Chairman: Fine. The Sandler Review of 2002 stated that inherited estates distorted competition between insurers. He said insurers have built up this money and are allowed to use it as an alternative source of investment funding to subsidise new business and an alternative place to charge expenses, therefore, Ron Sandler goes on: "certain providers, not necessarily the most efficient ones, have pools of capital which can be used to subsidise various activities". Do you agree with Sandler that it distorts competition?

  Mr Sants: Our current rules would not allow what I think most people interpret when they hear the word "subsidy". We do not allow new business to be subsidised. We do believe that it is reasonable for reasonable costs of new business to be charged, and that is not the same as a subsidy, so I think my response to that point would be that we have amended our rules and we are not supportive of subsidising new business out of funds.

  Q16  Chairman: Have you discussed this issue with the OFT mindful that the FSA's job, along with the OFT's, is to ensure a healthy and vibrant financial services sector where competition flourishes?

  Mr Sants: I am not aware of us having any specific conversations with the OFT around the particular point that I think you are raising in relation to subsidies for new business. However, we take a rigorous regulatory supervisory approach to ensuring that our rules in respect of new business are not being breached. We have a number of ongoing supervisory engagements on that topic.

  Q17  Chairman: I will perhaps copy the OFT into the correspondence I have with you. We would be grateful for any information you can send us on any discussions you have had, or will have, with the OFT. The reason I am raising this, Mr Sants, is over the insurance industry there are estimates of £20-25 billion being at stake here for people and the press in particular are beginning to catch on to this issue. I noted The Economist in October described the FSA as a "watchdog that didn't bark", and The Times in December said, "It is up to the FSA to act as an honest broker and to push harder to secure these assets for policyholders", and The Sunday Telegraph has said, "Policyholders across the insurance industry could end up being diddled out of £89 billion, a colossal amount of money. What is the FSA playing at and why aren't the politicians kicking up a fuss?" In my own understated way I am doing that just now and putting you on notice that we will keep communicating.

  Mr Sants: I would just like to reassure you, as I said before, we are treating this matter with great seriousness and we consider it a very important issue for the FSA to focus on. We are absolutely aware of our obligation to ensure a fair deal for policyholders. I genuinely believe that we are very focused on achieving a fair deal for policyholders and making clear the deliberations and the basis upon which we reach those conclusions on any given set of circumstances. I also remind you that there can be individual variances around this, but certainly in relation to the two cases which currently have the most prominence, a court deliberation is also required and the policyholders will have an opportunity to express their own individual views. We are part of a process but we take our part of that process extremely seriously and I completely reject any suggestions of the nature that the media—not yourself—are making that we are not properly focused on ensuring a fair deal for policyholders, I just do not believe that is the case.

  Q18  Chairman: Sir Callum, I am sure that as a former regulator and as one who is keen to see competition in the market you will have more than a passing interest in this over the next couple of months.

  Sir Callum McCarthy: Absolutely, as will the FSA Board as a whole.

  Q19  Mr Dunne: One of the main issues about reattribution and one of the biggest difficulties is over this new business subsidy that you said has been banned. Could you just clarify that if the cost of doing new business generates losses and those losses can be absorbed by the surplus, does that not amount to the existing policyholders, in effect, subsidising a new business channel and acquisition?

  Mr Sants: As you rightly say, this is a complicated area and we seek to make an individual judgment on any particular set of circumstances. Clearly the general concept that new business is a reasonable and, indeed, a requisite part of a healthy long-term fund which is then of benefit over the long-term to that fund and, therefore, to policyholders in the round over generations is understood and, therefore, it has to be reasonable to say that working capital can be used from the existing funds to help the generation of new business. As I am sure you appreciate, that that type of business at its initiation, if you look at it in narrow terms in terms of costs against return in the opening period, is not going to be profitable. You cannot say if you look at the very, very short-term that we would not allow business which is not making an absolute and immediate return to be conducted through the fund because, given the nature of the business, I think that would be unreasonable. We just have to make a judgment as to whether that degree of start-up cost is reasonable in the circumstances and we try to make it on a fund-by-fund basis. What we would not be allowing is a clear, unreasonable degree of subsidisation against what would be considered to be reasonable industry norms.