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Select Committee on Treasury Twelfth Report

2 Understanding inherited estate

With-profits funds and their regulation

3. With-profits funds offer long-term investment products and are managed by life insurance companies, both proprietary and mutual. Whereas in mutual companies the policyholders own the fund, in proprietary companies the policyholders contribute to the fund, which the shareholders own. With-profits products enjoy potentially high returns via exposure to, for example, equity shares, whilst guaranteeing a minimum level of return. Policyholder premiums are held in a pooled fund that is invested in a range of assets, with a significant proportion in equities and property. The risk borne by the investor in such asset classes is limited by guarantees, which usually increase over the lifetime of the policy. Firms will often "smooth" out returns to policyholders in order to cushion policyholders from the extremes of fluctuations in the property and equity markets. Prudential told us that "a with-profits product offers investors a valuable investment option, providing the prospect of competitive long-term rates of return while smoothing the peaks and troughs of volatile market movements and providing valuable guarantees".[2]

4. The FSA noted that the with-profits sector attracted particular scrutiny in the early part of this decade, prompted by concerns about the high degree of discretion given to life companies over the management of with-profits funds; the complexity and opacity of the products; poor early surrender values; and a lack of consumer understanding of the nature of the risks involved.[3] In March 2004, our predecessors reported on Restoring confidence in long-term savings: Endowment mortgages,[4] identifying several areas where the FSA could improve the market for with-profits products, including transparency and financial advice to customers. The then Committee concluded that the FSA should have been much more rigorous in ensuring that its policies and strategies were being effectively implemented by the financial services industry. In response to such concerns, in 2005 the FSA implemented a new regulatory regime for the with-profits sector, with the overall objective of achieving greater protection of policyholders. The FSA argued that the new regime had delivered rules and guidance to firms on the management of with-profits funds, provided clarity on how management should exercise discretion, set limits to that discretion in key areas, and improved assessments of the true extent of firms' liabilities and of their resulting capital requirement.[5] This Report considers the FSA's approach with regard to one aspect of with-profits funds—inherited estates—but in doing so considers wider issues such as the role and effectiveness of with-profits committees.

Introduction to inherited estate

5. The term 'inherited estate' is not a statutory concept and it does not have a universally agreed definition. The FSA defined inherited estate as "the part of the with-profits fund over and above what is required to meet the fund's liabilities that the insurer retains as working capital. It will also include any excess surplus in the fund."[6] Norwich Union gave a similar definition—"money that has built up in a with-profits fund over many generations, which is over and above the amount that is expected to be needed to meet current and future policyholder commitments and other obligations of the with-profits fund".[7]

6. Norwich Union explained that its with-profits funds were composed of several elements: money needed to back policy liabilities; money needed to back guarantees attached to policies; and money needed to mitigate risks to the with-profits funds' ability to meet its liabilities and guarantees (such as a potential stockmarket fall). From time to time, the with-profits fund might contain "excess surplus", which they defined as money in excess of what was forecasted to be needed for the three purposes cited above. Broadly speaking, according to Norwich Union, the inherited estate comprised the aggregate value of the money needed to mitigate risks to the fund, and any excess surplus.[8] Norwich Union argued that the size of the inherited estate was "by no means fixed", and was best described as the difference between two very large amounts—the assets and liabilities of the with-profits company—both of which were highly volatile and susceptible to external influences such as interest rates, equity movements and property markets.[9] Mr John Lister, Norwich Union's Chief Actuary, explained that, at the end of 2007, the inherited estate held within the CULAC and CGNU funds was some £2.6 billion, out of total funds under management amounting to £26 billion.[10] Prudential's inherited estate of £8.7 billion supported an overall fund of £74 billion.[11]

7. Legally, the pooled assets of the with-profits fund (including the inherited estate) are assets of the insurer, rather than the policyholder.[12] In a mutual society providing with-profits investment products, policyholders themselves own the with-profits fund, so the fund would be run solely in the interests of policyholders and conflicts of interest would not arise. However, in a proprietary life insurance firm, owned by shareholders, managers of the fund face competing demands—to run the fund in the interests of the shareholders and to ensure that policyholders are treated fairly. This inherent conflict of interest requires a regulator, the FSA, to ensure that the interests of both shareholders and policyholders are protected.

Origins of inherited estate

8. According to the FSA, in most with-profits funds the inherited estate has built up over many years, "from premiums from past generations of policyholders and the investment returns on them, and/or past injections of capital from shareholders or reinvestment of shareholders' dividends".[13] Norwich Union explained the historical background of their with-profits funds:

Mr Mark Hodges, the Chief Executive of Norwich Union, argued that, as a result of their with-profits funds' 200-year history, it was very difficult now to trace the origins of the inherited estate and be absolutely explicit about where it came from. He did say, however, that the company had established that "none of the current generation of policyholders has contributed to the inherited estate".[15]

9. Mr Lister had identified certain contributions from shareholders in 1945 and 1950, but did not suggest that these contributions were a major source of the inherited estate. Instead, the estate arose from the way that the fund was run.[16] Mr Nick Prettejohn, the Chief Executive of Prudential, identified a similar origin for his firm's inherited estate, saying that "a very considerable proportion … of the estate—and it is difficult to put a precise number on it—has been contributed by shareholders over the course of the century of the operation of the fund".[17] Prudential stated that the generation of policyholders whose policies had paid out since 1990 were net beneficiaries from the inherited estate rather than contributors to it. Prudential also stated that it did not expect the current generation of policyholders to be net contributors to the inherited estate either. Therefore, in Prudential's view, "any payment to the current generation of policyholders in respect of the inherited estate would be a pure windfall".[18]

10. During our inquiry, it became evident that inherited estates have arisen from a variety of sources, including contributions from generations of shareholders and policyholders, and that the relative contributions made by stakeholders have varied across firms and funds. Some funds have histories dating back centuries, to a time when record-keeping was inadequate to enable determination of precise contributions, but the most significant contribution to inherited estates has resulted from the way that inherited estates have been managed over time.

Special distributions

11. From time to time the assets of a with-profits fund might exceed the liabilities of that fund to such an extent, and the inherited estate has grown so large, that the life firm is in a position to pass this surplus to the two groups of stakeholders in the fund, the shareholders and the policyholders. The division of this surplus between the two stakeholder groups in such a "special distribution" is dependent on the specific nature of the with-profits fund concerned. Many with-profits funds operate on a "90:10" basis, where policyholders receive 90% of any surplus distributed, and the firm receives the remaining 10% on behalf of its shareholders. The FSA requires firms to assess whether or not they have an "excess surplus" in their with-profits fund on an annual basis. If an excess surplus is identified, the FSA expects that a special distribution of these assets will be made by the firm to the stakeholders in the fund. Therefore, whilst policyholders do not own the inherited estate of a fund, they do have a contingent interest in that estate arising from potential special distributions. The impact of a special distribution is that the size of the inherited estate in the fund concerned is reduced. We discuss special distributions in more detail in
Chapter 4.

Reattribution

WHAT IS A REATTRIBUTION?

12. We have just noted that policyholders have a contingent interest in possible future special distributions from the inherited estate. If a firm chooses to, it can enter into a transaction called a "reattribution", where it buys this contingent interest from policyholders. Policyholders choose whether to accept the offer or not. If they reject the offer, they retain their contingent interest in the with-profits fund and are not allowed to be disadvantaged by the reattribution process.[19] In a reattribution, the fund itself retains its inherited estate. The only change to the fund following a reattribution is that possible future special distributions would accrue to shareholders rather than policyholders.[20] There are several stages in the approval process of a reattribution scheme: the firm must decide that it is in the shareholders' interest, then the FSA assesses whether the offer made to policyholders is fair, and then individual policyholders choose whether to accept the offer. Finally, once policyholders have made their choice, the reattribution scheme would go to the High Court for final sanction.[21]

THE AXA REATTRIBUTION

13. In 2000, AXA brought forward proposals for reattributing the £1.7 billion inherited estate in its with-profits fund. The transaction was approved by the FSA and accepted by policyholders. The offer made to policyholders by AXA was considered by Which? to have been unreasonably low. According to Which?, AXA made various deductions from the inherited estate prior to the reattribution, all of which reduced the likelihood of potential special distributions, so reducing the value of the offer that AXA needed to make to purchase the contingent interest of policyholders in the inherited estate.[22] In response to concerns raised by the AXA reattribution, the FSA introduced changes to its regulation of inherited estate, including the advent of the role of "policyholder advocate", who, in future reattribution cases, would be appointed to negotiate on behalf of policyholders a fair reattribution offer.

THE ROLE OF THE POLICYHOLDER ADVOCATE

14. The first life firm to commence reattribution negotiations since the AXA transaction was Norwich Union, which announced in November 2006 the start of a reattribution process which has still not yet been concluded. At that time Norwich Union also announced that Clare Spottiswoode would be appointed policyholder advocate. Ms Spottiswoode, who is the first person to occupy such a position, told us that her "absolutely key role is to represent policyholders in this really complex transaction" and, if the reattribution negotiations resulted in an offer being made to policyholders, her role would entail explaining to policyholders what the deal meant, putting it in context and trying to ensure that each individual policyholder was sufficiently well-informed in their personal decision as to whether or not to accept Norwich Union's offer.

15. At the present time, reattribution negotiations between Norwich Union and Ms Spottiswoode are ongoing. On 30 April 2008, Mr Hodges told us that his sincere hope was that the negotiations would conclude "in weeks rather than months".[23] Following the conclusion of these negotiations, the FSA will consider whether the firm's proposal was fair. If the FSA approve the terms of the reattribution, Norwich Union will put their offer to the relevant funds' policyholders.

16. The Prudential have announced that they are exploring the possibility of reattributing the inherited estate held within their with-profits funds, and would make a decision by the middle of 2008.[24] They have nominated a policyholder advocate, Peter Bloxham, to negotiate on behalf of Prudential policyholders, if a decision were taken by Prudential to proceed with a reattribution. Mr Bloxham's appointment is contingent on such a decision being made, but he is already familiarising himself with Prudential's with-profits funds and the issues at stake.[25]

The role of the FSA in regulating inherited estates

17. We have already noted the inherent conflict of interest facing managers of proprietary life firms. Managers have a fiduciary duty to look after the interests of shareholders, but also have obligations to treat policyholders fairly. Decisions made by the life firm regarding how the inherited estate is used, for example, affect the size of the inherited estate, and consequently the prospect that policyholders have of receiving a potential special distribution. Policyholders have no power in relation to how managers of a with-profits fund exercise their discretion in operating that fund, so their interests must be protected by the regulator, the FSA. Mr Sants explained that the FSA had an obligation, which it took very seriously, to make sure that policyholders receive a fair deal and that their interests were looked after. He added that "we have a clear mandate to do that and therefore I think that it is right and proper … that our mandate is properly adhered to".[26]

2 Ev 90 Back

3 Ev 76 Back

4 Treasury Committee, Fifth Report of Session 2003-04, Restoring confidence in long-term savings: Endowment mortgages, HC 394 Back

5 Ev 76 Back

6 Ev 76 Back

7 Ev 83 Back

8 Ev 86 Back

9 Ev 83 Back

10 Q 170 Back

11 Ev 90 Back