A conflict of interests

87.  We observed in Chapter 1 that directors of proprietary life firms have fiduciary responsibilities to look after the interests of their firm's shareholders, but also have obligations placed on them by the FSA to treat their customers fairly. Mr Hodges said that he had a duty to shareholders, but he also had a duty to policyholders and other stakeholders: "We look, as I think any successful company would do, to balance the interests of all stakeholder groups".[182] Mr Vicary-Smith said this conflict of interest was "inherently large", particularly where company directors received bonuses based upon the returns to shareholders. In such a situation, he argued, it was important that the FSA "holds the ring in a firm and robust way, and we feel in the case of the inherited estate that that is not happening sufficiently".[183] Given that managers of life funds faced significant conflicts of interest, Ms Spottiswoode was surprised at the level of discretion granted to firms in deciding how the inherited estate should be used. In this context she argued that the FSA therefore had a particular responsibility to protect with-profits policyholders, but she was not confident that the FSA's current rules did afford such protection. In fact, she said, the rules, particularly about the permitted uses of inherited estates, seemed to favour shareholders over policyholders.[184]

Principles and Practices of Financial Management

88.  One safeguard for protecting policyholders' interests lies in the requirement for each life firm to publish the framework by which the firm's management will run the with-profits fund. The FSA requires each firm to produce such a document, called Principles and Practices of Financial Management (PPFM). 'Principles' are statements of the overarching standards which a firm adopts in managing its with-profits business, and must describe the business model used by the firm in meeting its duties to with-profits policyholders and in responding to longer-term changes in the business and the economic environment. 'Practices' describe a firm's approach to managing its with-profits business and responding to changes in the business and economic environment in the shorter term. The PPFM is required to cover the main areas where a firm has discretion in relation to its with-profits business, such as investment and bonus policy, smoothing, charges and expenses, volumes of new business and the management of any inherited estate.[185]

89.  In the case of Norwich Union, the PPFM is published on the firm's website. Mr Lister explained that the PPFM "is not something that we give to policyholders; it is really there to enable the running of the fund and a check by the FSA and our with-profit committee on the running of the fund".[186] A "consumer-friendly" version of the PPFM is made available to all policyholders.[187]

90.  Which? argued that a reliance on a PPFM left a firm with significant discretion as to how the inherited estate might be used. Firms are allowed to draft their own PPFM, stating how the inherited estate will be used, and must then report on their compliance with this document. Which? said this was "equivalent to letting firms set and mark their own exam papers".[188] For example, Mr Lindley claimed that Norwich Union had simply amended their own PPFM in order to allow themselves to charge the inherited estate a contribution towards the firm's pension deficit. The CGNU/CULAC PPFM document was amended on 1 January 2006 to clarify "how certain parts of the Staff Pension Scheme deficit can be credited or charged to the inherited estate".[189] Mr Lindley said this "really illustrates the massive freedom that companies have to use the inherited estate in ways which are detrimental to policyholders and, if they do not like the rules, the company are able to change them".[190] He argued that the FSA should actively be preventing such changes from being made, and should specify exactly what the inherited estate could be used for to minimise discretion.[191] Mr Lister denied that Norwich Union's PPFM had been changed in relation to the funding of the pensions deficit.[192]

91.  The Financial Services Consumer Panel argued that the FSA's Treating Customers Fairly regime could be strengthened by introducing a requirement for a firm's management to produce a simplified annual financial statement setting out how it had used policyholder capital, including the inherited estate, over the past year and why it expected this use would provide a good return to the fund for the policyholders' benefit. The FSCP argued that:

Although in theory this information can be gleaned from the PPFM, with-profits experts interviewed for the [FSCP's] research said, of PPFMs, that the management could 'tick all the right boxes' but may still not provide a clear picture of how capital has been used. The simplified statement could set out how the fund is invested, including its asset allocation and information about the asset management team. In addition it could include all other uses of capital, for example for new business purposes, to buy closed funds, to pay shareholder tax, to pay mis-selling claims, and to pay comparatively high levels of commission (relative to similar products) to advisers for the sale of new products.[193]

With-Profits Committees

92.  In 2005, the FSA introduced guidance requiring firms to put in place governance arrangements which "involve some independent judgement in the assessment of compliance with the PPFM". The independent judgement can be provided in different ways including, but not confined to, establishing a With-Profits Committee (WPC) which includes some non-executive directors and external non-directors, or using an independent person with appropriate skills to perform the role.[194] Firms are expected "to ensure that they consult their with-profits governance arrangements on all significant issues affecting with-profits policyholders' interest". These governance arrangements should also be able to provide an independent challenge in the firm's overall assessment of how any conflicts of interest between policyholders and, if applicable, shareholders have been addressed.[195]

93.  Sir Nicholas Montagu, the Chairman of Norwich Union's WPC, provided us with an extensive insight into the role, responsibilities and operation of his Committee. According to Sir Nicholas, the Norwich Union WPC's role was to "advise the [Norwich Union] Board on the day to day activities of the with-profits funds and ensures that the Board's ability to exercise discretion is subject to appropriate scrutiny and challenge".[196] The WPC had an independent majority, with three independent members (including Sir Nicholas), and two officers of Norwich Union, the Marketing Director and the Director of Risk and Governance. The WPC met eight times between its inauguration in July 2007 and March 2008. In total, the time commitment for Sir Nicholas amounted to 35-40 days over 10 months. The other independent members had a time commitment of around 20 days over 10 months. The WPC was assisted by internal staff support (amounting to 25% of the time of one actuary, who acted as the WPC's secretariat, and a member of the firm's legal staff who took minutes at meetings of the WPC) and a group of independent advisers. The Norwich Union With-Profits Actuary was "heavily involved, both at and in between meetings, providing the main technical link to the committee and, with the head of the secretariat taking the lead in pre-meeting briefings".[197]

94.  The Norwich Union WPC reports to the board, who ultimately make all decisions.[198] Mr Hodges, said the WPC did not make "recommendations" to the board, but "express views which we [the Board] would be well advised to take strongly into account".[199] Mr Lister added that "if the board chooses not to take the advice of the With-Profits Committee then the With-Profits Committee can go to the FSA".[200]

95.  Mr Prettejohn believed that Prudential's WPC managed the potential conflict of interest between shareholders and policyholders "very well". Contributing to this stated success of this WPC was the fact that all three members of Prudential's WPC were independent, with two of the members being qualified actuaries. Mr Prettejohn said that his firm's WPC provided "a very robust and detailed critique of the decisions that potentially affect the interests of policyholders versus shareholders".[201]

96.  Mr Vicary-Smith did not share the industry's praise for the performance of WPCs. He wanted to see WPCs "turned from poodles into rottweilers", but in order for them to have teeth, they would need to be appointed by policyholders rather than the company; they would need to have a responsibility to act in the interests of the policyholders; and companies would have to be obliged to listen to, and act upon, the WPC's challenges.[202] Ms Spottiswoode added to Which?'s wish list the need for transparency, "because it is the only way in which you can be shown to be undertaking your duties on behalf of policyholders". She supported Which?'s suggestion of giving a WPC a very clear duty to look after the interests of policyholders and no other.[203] She noted that when her role as policyholder advocate came to an end (once reattribution negotiations had concluded), there would be "nobody who is looking after [Norwich Union's] policyholders' interests directly".[204] If the Norwich Union WPC were to take on her mantle, she argued, it would need greater support from independent advisers:

We [the Office of the Policyholder Advocate] have been working on [the reattribution] solidly for over two years … nearly full time. It is difficult for us to get to grips with it. How you do it on a part-time basis, on monthly or quarterly visits to the company, I just do not know. They have to be well supported.[205]

97.  The Financial Services Consumer Panel (FSCP) voiced several concerns about WPCs in a recent report, including a perceived lack of independence from the boards of their companies in the case of many WPCs. The FSCP's research found that, while some companies had moved towards a genuinely independent model, 60% of funds had a WPC that was not independent. In some cases the WPC was a sub-committee of the main board, while in others WPC members consisted of current directors, former directors and non-executive directors.[206] The FSCP believed that the independence of the WPCs should be strengthened to enable them to provide a public and regulatory 'window' on the firm's use of policyholder capital. The primary purpose of a WPC, in the FSCP's view, would be to ensure that the financial management of the fund, including the inherited estate, was in the best interests of policyholders and to achieve this clear objective the WPC would require independence from the firm's board.[207] Such a revised role for WPCs could be strengthened, in the FSCP's view, by an FSA-established 'knowledge and guidance centre' for WPC members, and increased visibility of WPCs through, for example, a dedicated website linked to the company's website.[208]

98.  The FSCP suggested further that the remit of WPCs be expanded to include a specific requirement to explicitly consider the FSA's principle of treating customers fairly.[209] At present, WPCs assess management decisions against the firm's PPFM. Whether or not such assessments alone would satisfy the firm's requirement to treat customers fairly would depend on the extent to which the PPFM itself complied. The FSCP's proposals might mean that the WPC could report on the company's use of capital in relation to its opinion of both the PPFM and the explicit requirement to treat customers fairly, setting out any discrepancies between the two.[210]

99.  Ms Wilson said that the FSA had put in place a robust system "if operated properly". Whilst disputing the figures produced by the FSCP on the proportion of WPCs that were independent, she conceded that the FSA's own research had found examples of firms that lacked adequate independent input, as well as examples where WPCs were insufficiently consulted by management in a timely way. The FSA had "made it abundantly clear that that is unacceptable and we have seen some changes as a result".[211] The FSA's view was that independence of WPCs was critical, and they were "very much looking" for the development of effective WPCs that could provide appropriate advice, input and challenge.[212] Mr Sants agreed that improvements needed to be made.[213]

100.  We welcome the advent of With-Profits Committees and believe that they have the potential to fulfil a very important role in protecting policyholder interests in with-profits funds. In too many firms though, With-Profits Committees are insufficiently independent of the firm's board to provide any reassurance that they are vigorously protecting and promoting the interests of policyholders. We expect the Financial Services Authority to accelerate its work in enforcing its requirements for independence of such committees. We are also concerned that With-Profits Committees are inadequately resourced. Norwich Union's policyholder advocate and her team have spent two years analysing just one part of with-profits funds on an almost full-time basis. In the context of strong potential conflicts of interest on the part of a firm's management, policyholders' interests need defending at all times, not just in the run-up to a potential reattribution. But we do not see how a part-time With-Profits Committee with staff support of one or two individuals can truly master the complexities of with-profits funds. We recommend that the Financial Services Authority require companies to provide an appropriate level of support for policyholders' interests to be protected by With-Profits Committees.

101.  We see a good deal of merit in the proposal that With-Profits Committees consider the principle of Treating Customers Fairly as well as checking the firm's compliance with its own Principles and Policies of Financial Management. It is important that With-Profits Committees have such a strong, clear commitment to protecting and promoting policyholder interests, so the Financial Services Authority should consider consulting on whether such a role should be granted to With-Profits Committees. Efforts must also be made by firms to raise the visibility of With-Profits Committees, to reassure policyholders that their interests are being represented and protected. This could mean, for example, With-Profits Committees having their own dedicated website, linked to the relevant firm. We will continue to monitor the performance of With-Profits Committees during our ongoing scrutiny of the Financial Services Authority.

The Financial Services Authority

102.  Mr Sants said that the FSA had an obligation, which it took very seriously, to make sure that policyholders were given a fair deal and their interests looked after.[214] Mr Sants thought that "It seems to me we have a good framework to which we are now seeking to deliver specifics to enable a balanced judgment in the round which is fair to be reached".[215]

103.  The uses of inherited estate discussed in Chapter 3 have highlighted the large degree of disagreement over those uses that are appropriate. Inappropriate use of inherited estate is important because, by reducing the size of the inherited estate, policyholders' expectations of special distributions fall. A common refrain from policyholders, policyholder advocates and Which? is that the management of life firms enjoy too much discretion over the day-to-day running of with-profits funds. Where a firm is opposed by a vocal policyholder representative, common ground on the uses of the inherited estate seems hard to find. At this point, the FSA is obliged to step in and provide guidance.

104.  Ms Spottiswoode suggested that the issues surrounding the inherited estate would be greatly simplified if the FSA were to adopt two general principles. The first would require that an inherited estate was subject to the same discipline as the rest of the with-profits fund. The second would require the firm to treat policyholder capital the same as shareholder capital. Such a general principle would preclude, she contended, the use of inherited estates in ways that favoured shareholders' interests over the interests of policyholders:[216]

The whole thing would be transformed if we just had those general principle-based regulations because what that would do is change the nature of the negotiation. I had no idea that all this quite weird and wonderful regulation existed in with-profits.[217]

She struggled to see any logic in permitting uses of the inherited estate which were disallowed with other parts of with-profits funds:

If certain costs are not allowed by the FSA to be charged to policyholders' asset shares, then they should not be able to be charged to inherited estates. An inappropriate charge to asset shares could be expected to have a detrimental effect on policyholders' reversionary (annual) or terminal (final) bonuses. A charge to the inherited estate will have a similar outcome, in that it could reduce the value of policyholders' special bonuses from distribution of the inherited estate. It is difficult to see how different uses of the inherited estates, as compared to the remainder of the with-profits funds, can be justified.[218]

105.  Ms Spottiswoode argued that, if these two basic principle were in place, "you would have a very clear litmus test for every decision that was made and, because it would be so clear, the companies would be clear, the FSA would be clear, [and] the policyholders would have more confidence that actually their interests were being looked after".[219]

106.  Sir Alan Budd and Sir Bryan Carsberg were keen proponents of such a system. Such principles, they argued, would prevent undue discrimination both between groups of policyholders and between policyholders and shareholders:

If the regulatory regime was to establish clearly, by way of such a general principle, that shareholders were not able to benefit from inappropriate uses of an inherited estate (uses that had detrimental effects on policyholders) then a firm's incentives in relation to the making of distributions would also be more correctly aligned. This is because, in these circumstances, a firm would have less reason to under-estimate the potential of or postpone the possibility of distributions. In the absence of more profitable alternatives (that is, the use of the inherited estate to give undue preference to shareholders), it would be in shareholders` interests to make calculations about possible distributions as accurately as possible. Such a principle would also better facilitate competition between with-profits insurers with or without inherited estates, since shareholders would no longer be able to use funds that would otherwise be distributed 90:10 to subsidise new with-profits business.[220]

The Financial Services Consumer Panel suggested that, in light of the concerns encountered in its research, firms' use of policyholder capital be reviewed more widely in an open debate.[221]

107.  When we put Ms Spottiswoode's suggestion to the FSA, Ms Wilson answered:

There is a very clear framework within our rules now about the handling of the funds within an inherited estate and they are either the working capital or they are an excess, … Whatever they are, it is absolutely clear within our framework that policyholders have an interest in that, they have a contingent claim over it and there are big restrictions on what the shareholders may use those funds for and generally they may only be used in the interests of policyholders. It is quite clear the way our framework works and I think going forward we have a basis based on the consulted new approach which gives that.[222]

108.  Mr Sants summed up the FSA's objectives regarding with-profits investment products:

We are trying to deliver a fair deal for the policyholders but we also have a principle of saying that this is a credible and worthwhile investment product that should remain in the savings market. We do not think it is a good result for the marketplace, for the consumers as a whole, the UK, if this product disappears.[223]

109.  Despite changes made by the Financial Services Authority to the regulation of the with-profits sector earlier this decade, we still have serious concerns about the extent of disagreement between stakeholders across many issues in with-profits funds. We are not satisfied that the Financial Services Authority has done enough to provide a robust framework based on strong principles against which decisions can be made and performance assessed. Issues raised by the special distribution and ongoing reattribution of the Norwich Union with-profits fund have highlighted the inadequacy of the regulatory regime. Rather than developing clear principles for the regulation of inherited estate, the Financial Services Authority has become embroiled in making judgements "in the round" and micro-regulation of particular firms' situations, including providing ad-hoc guidance in the middle of a reattribution negotiation. In the case of the charging of shareholder tax to inherited estate, different rules apply to different firms, providing yet more complexity. This approach seems a long way from the philosophy of 'principles-based regulation' to which the Financial Services Authority aspires. Whilst we accept that the with-profits sector is a complex business, all stakeholders in with-profits funds deserve a framework which provides as much simplicity, certainty and clarity as possible. If the Financial Services Authority believes that with-profits is just too inherently complex for such a regulatory panacea to be achieved, it must make a strong rationale for its support for the continuation of with-profits investment products in the marketplace. We would welcome a reopening of the debate about the overall regulatory system for with-profits funds and, to this end, recommend that the Financial Services Authority consult on such a redesign during 2008. We will closely monitor the Financial Services Authority's progress towards improving its regulation of the with-profits sector and will return to this issue.

183   Q 5 Back

184   Ev 55 Back

185   Ev 99 Back

186   Q 196 Back

187   Q 199 Back

188   Ev 45 Back

189   Norwich Union, CGNU/CULAC PPF: Summary of Change, Norwich Union product literature, April 2004, available at http://www.adviser.norwichunion.com/  Back

190   Ev 48 Back

191   Q 17 Back

192   Q 195 Back

193   Ev 146 Back

194   Ev 81 Back

195   Ibid. Back

196   Ev 84 Back

197   Ev 151 Back

198   Qq 161-162, 291 Back

199   Q 163 Back

200   Q 266 Back

201   Q 276 Back

202   Q 34 Back

203   Qq 66, 86 Back

204   Q 86 Back

205   Ibid. Back

206   Ev 145 Back

207   Ibid. Back

208   Ev 146 Back

209   Ibid. Back

210   Ibid. Back

211   Q 136 Back

212   Q 137 Back

213   Q 138 Back

214   Q 90 Back

215   Q 95 Back

216   Ev 57; Qq 44, 53, 56, 64 Back

217   Q 85 Back

218   Ev 59 Back

219   Q 61 Back

220   Ev 63 Back

221   Ev 144 Back

222   Q 131 Back

223   Q 95 Back