Excess surplus

51.  Chapter 2 briefly explained how a firm may identify that a with-profits fund is in a sufficiently strong position to conduct a special distribution, when excess surplus in the inherited estate can be distributed to the fund's stakeholders in line with the normal basis of profit distribution in that fund. An excess surplus is defined by the FSA as an amount in the inherited estate which is "over and above the value of the assets required to match the fund's liabilities and the amount required as working capital".[100] The FSA laid out its rules regarding excess surplus in inherited estates:

Our rules require firms with with-profits funds to consider at least once a year whether the fund(s) contain an 'excess surplus' ... If they do, firms must consider whether retaining it would be in breach of Principle 6 of our Principles of Business - "A firm must pay due regard to the interests of its customers and treat them fairly". We expect firms to be able to justify why it would not be unfair to keep the surplus assets, which are assets which are not required for the purposes of the fund's business. If the firm cannot properly justify retention of the assets then we would expect it to be distributed on a 90/10 (policyholder to shareholder) basis in line with the 1995 Ministerial Statement …, or other basis applicable to the particular fund.[101]

The Ministerial Statement referred to by the FSA was issued on 24 February 1995 by Jonathan Evans, the then Minister for Corporate and Consumer Affairs, who stated that:

A life office may make distributions from surplus in the long-term fund as shown by the statutory annual actuarial valuation. It is common practice to make distributions to policyholders and shareholders in the proportion 90:10. In assessing policyholders' reasonable expectations, the Department [the then Department of Trade and Industry] would expect this ratio to be used as the basis of attribution between policyholders and shareholders.[102]

52.  The senior management of the life firm are responsible for deciding whether an excess surplus exists, and deciding what to do with it. The FSA said that, "As part of our supervisory work we challenge firms on the decisions they make on how much of any surplus they should retain, for example, to support new business, strategic investments and the firm's risk appetite, and how much might be available for distribution".[103]

53.  Mr Lister explained that Norwich Union, on an annual basis, looked at the capital contained within its fund and assessed whether or not there was an excess.[104] In 2007, Norwich Union had identified that £2.4 billion of the inherited estate was excess and had distributed this money on a 90:10 basis in February 2008.[105] This was Norwich Union's first such distribution since "the late 1980s".[106] Norwich Union's distribution was possible because the firm had decided to shift some of its assets backing guarantees out of equities and into (lower risk) fixed-income securities, so that less capital was required in the inherited estate to mitigate against the risk of investments under-performing.[107]

54.  Mr Hodges said that the special distribution was linked to the firm's reattribution negotiations. In undertaking the reattribution process, Norwich Union had "sharpened [its] ability to look at the inherited estate and what may or may not be surplus". According to Mr Hodges, it was through the reattribution process that the firm came to the conclusion that, if Norwich Union were to change its investment appetite, they would be able to identify an excess surplus and make a special distribution.[108] Mr Hodges did not say that, if a reattribution had not been pursued, a special distribution would not have been made, but that when Norwich Union commenced its reattribution process, "the idea that a special distribution may be part of that process was something we had in mind".[109] Mr Lister clarified these comments by saying the distribution did not occur because of the reattribution as such, but because the reattribution led the firm to look in more detail at the with-profits fund.[110]

55.  Mr Vicary-Smith argued that "the very fact there has not been a distribution up to now suggests either that the firms have been woefully incompetent in how they have assessed the level of that capital or that the FSA has not been sufficiently robust in challenging the numbers".[111] Sir Alan Budd and Sir Bryan Carsberg, two of Ms Spottiswoode's expert advisers, argued that the FSA should prevent firms from building up undistributed excess surpluses by setting actuarial limits on the assets that could be accumulated in a with-profits fund.[112]

56.  The requirement for life firms to assess whether they have excess surplus in their with-profits funds, on an annual basis, is welcome. We are somewhat concerned, however, that firms might not be trying particularly hard to identify such excess surpluses. A situation where firms only identified excess surpluses as a result of launching into reattributions would be unsatisfactory, but the rarity of special distributions across the industry may indicate such a situation is not too far from reality. The Financial Services Authority should do more in this area to convince policyholders that its scrutiny of firms' self-assessment of excess surpluses is sufficiently robust to protect policyholders' interests. The Financial Services Authority should give due consideration to the suggestion that actuarial limits be placed on the accumulation of assets in with-profits funds.

Policyholders' reasonable expectations

57.  The obligation placed on firms by the FSA to assess annually whether their with-profits funds contain excess surplus means that some policyholders will wait with interest for the results of that assessment to see whether they can expect a special distribution. Whether such policyholders would be acting reasonably in doing so was a contentious topic during our inquiry. Placing a value on the policyholder's expectation of special distributions is particularly important in the context of a reattribution, because the firm would need to offer policyholders a sum at least equal to the benefit they would stand to gain from special distributions if they were to retain their contingent interest in the fund.

58.  Prudential said that policyholders had a contractual relationship with the firm, their expectations were to receive their contractual benefits and no expectation had been created that they would receive any distribution from the inherited estate.[113] Prudential also warned that the current public debate on inherited estates "had the potential to create unfounded expectations in relation to ownership".[114] Norwich Union stated that their policyholders had no right to expect any special distributions during the lifetime of their policy.[115] Consequently, argued Norwich Union, any special distribution "should be considered a windfall".[116]

59.  However, in his January 2008 oral evidence to us, Mr Sants said that policyholders did have a reasonable expectation of receiving some money from the inherited estate.[117] The FSA position was expanded on in its written evidence:

Policyholders have a right to a share of a distribution from an inherited estate if one is made. There is no guarantee that a distribution will be made during the lifetime of their policy and policyholders have no right to a distribution during the life of their policy. In line with the Ministerial Statement of 1995, the right to a share in any distribution gives policyholders as a class an interest in any surplus retained in the inherited estate. That interest has no absolute value unless and until a distribution is made, and it is not an interest of any individual policyholder. In the context of a reattribution, however, its value can be negotiated and we expect a value to be placed on it and paid to current policyholders in a reattribution. As we confirmed in our oral evidence to the Committee in January 2008, we take the view therefore that policyholders' interests are not zero.[118]

60.  Ms Spottiswoode welcomed the FSA's declaration that policyholders' interests in an inherited estate were not zero:

When I came into this job all the industry was claiming that policyholders could have no reasonable expectations of any payout and therefore any payment was going to be good for them … It is really important we know that the FSA does support that expectations are not zero. It means the industry can no longer make that argument.[119]

She stated that the FSA's clarification meant that firms would be unable to present a reattribution offer as a "windfall", because policyholders, if they accepted, would be surrendering something of tangible value.[120] Mr Peter Bloxham, Prudential's nominee policyholder advocate, argued that "in a reattribution, the starting point is that policyholders do have expectations of a future distribution from the inherited estate. If a company announces its intention to explore or propose reattribution, it is implicitly acknowledging these expectations as, otherwise, there is no transaction to negotiate".[121]

61.  In response to these points, Mr Lister gave a slightly confusing explanation of what he thought policyholders should expect to receive from the inherited estate via special distributions:

What we have tried to set out for policyholders is that they should have no expectations of such a distribution. So I would agree with the FSA that policyholders' reasonable expectation is not zero, but I am not sure what it is.[122]

Norwich Union argued that policyholders as a group should expect that, if and when an excess surplus arose, they would be eligible for a distribution on a 90:10 basis.[123] On an aggregate basis therefore, policyholders could have "some reasonable collective expectation of a distribution of an uncertain amount at an uncertain future time".[124] However, no individual policyholder "should have any real expectation of a special distribution since the company is under no obligation to distribute the inherited estate to any or all policyholders at any particular time".[125] Mr Hodges said that policyholders' expectations did have a value in the ongoing reattribution negotiations,[126] but his firm's written evidence appeared to downplay this value, warning that it was "extremely unlikely" that distributions would be made from its with-profits funds in the near future:

Now this [recent £2.4 billion] distribution of surplus capital has taken place a further sizeable special distribution is extremely unlikely in the short to medium term and existing policyholders are therefore unlikely to benefit from future distributions.[127]

62.  The Policyholders' Action Group, a group of Norwich Union with-profits policyholders concerned by that firm's reattribution, characterised the announcements by firms, including Norwich Union and Prudential, that current policyholders should not expect any distributions, as "unreasonable", "unfair" and "a crude attempt to create a 'bird in the hand' mentality amongst policyholders, and bully them into voting for reattribution".[128]

63.  Mr Dominic Lindley, Principal Policy Adviser at Which? expressed surprise and disappointment that Norwich Union was advising its policyholders that they should have no expectation of payout from the inherited estate by referring to documentation issued to policyholders at the start of their policies. Norwich Union argued that it had "always made it clear in policy literature and communications with customers that they should not expect a distribution from the inherited estate".[129] Which?'s examination of Norwich Union's 1990s marketing material and policy documentation had found no reference to the inherited estate or any clear indication that people should not expect distributions.[130] Mr Lister admitted that in the 1990s the whole topic of the inherited estate was not discussed at all, and no reference was made to the inherited estate in policyholder documentation. He explained that reference was now made to the inherited estate in the firm's Principles and Practices of Financial Management document.[131]

Phasing of special distributions

64.  Firms are permitted to phase payments from a special distribution if they deem it appropriate. Norwich Union decided to phase their recent distribution of £2.4 billion across three annual payments. With-profits policies eligible for the special distribution must be invested in the CGNU or CULAC with-profits funds on 1 January 2008 to receive the first payment, and then on 1 January 2009 and 1 January 2010 to receive the subsequent instalments. The impact of this phasing is that approximately 4% (or 40,000) of policyholders, those whose policies mature before 1 January 2010, will not receive all three payments. Norwich Union argued that the decision to phase the distribution over three years was fair because:

• "It rewards loyalty - and policyholders have indicated that they support this;
• It rewards the vast majority of existing policyholders (around 96%);
• It does not disproportionately reward a policy which has just been taken out, especially substantial, single premium policy types; and
• There were also real concerns … that the with-profits funds could become destabilised as a result of increased surrenders—which could seriously affect the potential returns of both remaining and future policyholders".[132]

Mr Hodges explained that Norwich Union "was trying to balance various interest groups within the fund, various groups of policyholders".

In terms of the profile of payments, obviously 100% of people will receive the first payment; something like 98% will receive two payments; and 96% will receive three. Even though it is three accounting periods that those payments are made over, in elapsed time it is 24 months, so that does allow, we felt, a reasonable balance between rewarding loyalty, keeping the funds stable—there are something like 120,000 people in the fund who are not eligible for a distribution because of the nature of their individual policy, and they benefit from the strength of the fund, so we had to balance their interests.[133]

65.  Norwich Union has a With-Profits Committee, whose role is "to ensure that, inasmuch as their actual and prospective benefits and security are concerned, with-profits policyholders are treated fairly".[134] Sir Nicholas Montagu, the Chairman of that committee explained why his committee had supported Norwich Union's proposals to phase its special distribution:

In reaching that view, we recognised that the surplus had built up over a long period of time and that, as a whole, the current generation of policyholders had not contributed to it. We felt that it was desirable to benefit long-term investors more than short-term ones; and also that it was important, in the interests of the generality of policyholders, not to put the funds at risk. Under this head, we were anxious not to encourage a run-off of business—which would have a detrimental effect on remaining policyholders.[135]

66.  Mr Vicary-Smith described the phasing of payouts as "utterly outrageous". His first complaint was that the phasing would "penalise some of the loyalist customers" of Norwich Union:

There are people who have paid in for 20, 25 years and their policies maturing within the next three are not going to get the full pay-out. This is their money as much as it is anybody's but they are going to be denied it.[136]

He also decried the argument that, in phasing the special distribution, Norwich Union would prevent opportunism as "quite ludicrous":

Once the special distribution has happened people will only take their money out of the fund if they believe that the returns that they are going to get from those investments will be worse than the returns they are going to get from other investments. If the returns are going to be good, they will stay in the fund … What, effectively, is happening is that, because the returns are not going to be great, people are being locked in unreasonably, which we believe to be contrary to the FSA's own requirements that people do not face unreasonable barriers to exiting; so they are going to be locked in, in order to not take their money out and go to a better investment because they have got the hope of a distribution coming further on[137]

67.  Ms Spottiswoode admitted that, because her role specifically concerned Norwich Union's reattribution, she had no particular locus on arrangements for the firm's special distribution.[138] Notwithstanding this, she said that the decision to phase the special distribution was "a shame".[139] In particular, she was unsympathetic to the argument that a single payment would have caused a problem for the stability of the fund.[140] Ms Spottiswoode also felt that phasing breached the FSA requirement that "Consumers do not face unreasonable post-sale barriers imposed by firms to change product, switch provider, submit a claim, or make a complaint."[141]

68.  Mr Sants admitted that the issue of phasing payments fell into the "category of difficult judgments" for the FSA. The reason for the FSA's approval of Norwich Union's phasing plan was to maintain the Fund's "sustainability".[142] The FSA's written evidence explained this point;

Receipt of a single lump sum could create an incentive for some policyholders to cash in their policies … the firm needs to guard against the risk of a significant increase in surrenders of policies and so protect the strength and security of the continuing fund for remaining policyholders. Phasing payments may help to mitigate this risk. Whilst this will mean that those policies which mature during the three years will be eligible for only part of the distribution, it serves to protect the continuing interests of those policyholders who remain in the fund. A firm needs to consider the interests of all groups of policyholders in ensuring that the actions it takes are fair.[143]

The FSA also mentioned that the Norwich Union With-Profits Committee had granted their approval to the plan and that the FSA considered that phasing was "not an unreasonable barrier" to exit.[144]

69.  We disagree with the argument that the phasing of a special distribution rewards loyalty. One could argue that such a scheme incentivises loyalty, encouraging people not to leave the fund within the 24-month distribution period, but it is hard to see how it rewards loyalty, when some of the longest-running policyholders of a fund stand to receive only a fraction of the distribution awarded to policyholders who had joined more recently. If a firm did wish to incentivise loyalty through a special distribution, we do not see why it could not phase its payments, but make all payments to all qualifying policyholders, including those whose policies had matured within the phasing period. The suggestion that a single payment would seriously destabilise a fund making a special distribution would appear to suggest that policyholders were desperate to leave that fund, and continued as policyholders only to receive their special distribution payouts. If so, the phasing of payouts, in our view, must be considered an unreasonable barrier to exit. We expect the Financial Services Authority to set out why it considers such barriers to be reasonable in its response to this Report. We do not believe that the Financial Services Authority has so far put forward an adequate case for permitting the phasing of special distribution payouts. If this permission is to persist, the Financial Services Authority must provide a very strong case indeed.

101   Ibid. Back

102   HC Deb, 24 February 1995, col 360  Back

103   Ev 79 Back

104   Q 201 Back

105   Q 172; Ev 83 Back

106   Q 202 Back

107   Q 208; Ev 86 Back

108   Q 205 Back

109   Qq 206-207 Back

110   Q 211 Back

111   Q 27 Back

112   Ev 56 Back

113   Ev 90 Back

114   Ev 95 Back

115   Ev 82; See Chapter 5 on special distributions Back

116   Ev 85 Back

117   Oral evidence taken before the Treasury Committee on 22 January 2008, HC 258-i, Q 2 Back

118   Ev 81 Back

119   Q 72 Back

120   Ev 60 Back

121   Ev 137 Back

122   Q 235 Back

123   Ev 85 Back

124   Ibid. Back

125   Although new FSA rules do require firms to distribute excess surplus as soon as it has been identified. Back

126   Qq 236, 238 Back

127   Ev 83 Back

128   Ev 104 Back

129   Ev 85 Back

130   Q 23 Back

131   Qq 230-232 Back

132   Ev 83 Back

133   Q 215  Back

134   Ev 151 Back

135   Ev 154; See Chapter 6, paras 93-94 for more information about Norwich Union's With-Profits Committee Back

136   Q 20 Back

137   Q 20 Back

138   Q 63 Back

139   Q 46 Back

140   Q 62 Back

141   FSA, Business Plan 2008-09, p 24, box 3; Ev 60 Back

142   Q 120 Back

143   Ev 79 Back

144   Q 141 Back