Understanding inherited estate

1.  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. (Paragraph 10)

Uses of the inherited estate

2.  Inherited estate plays an important role in providing security to policyholders investing in a with-profits fund. The existence of inherited estate enables the life firm to mitigate risks to its ability to meet its liabilities and guaranteed returns to policyholders. Furthermore, an inherited estate provides an important comfort blanket, enabling the fund to invest in higher risk, but potentially higher return, asset classes, which is of tangible benefit to policyholders. (Paragraph 22)

3.   It would be in the interests of life firms to improve the transparency of their application of smoothing techniques. If the industry does not introduce such transparency by the end of 2008, the Financial Services Authority should use its regulatory powers to ensure that firms' provide sufficient disclosure to enable greater understanding of how smoothing has impacted on policyholder returns over various time periods. (Paragraph 25)

4.  The funding of new business from the inherited estate represents an intergenerational transfer from current policyholders to the future beneficiaries of the inherited estate. By the same token, current policyholders benefit from such transfers made prior to their investment in the with-profits fund, and this capital recycling has been a common feature of with-profits funds. However, this recycling causes particular problems during reattributions because the future beneficiaries of this intergenerational transfer will be shareholders, who have (through the firm's managers) discretion over both the strategy and portion of the inherited estate to be put aside for the funding of new business. A firm has a clear incentive to maximise the amount set aside for the funding of new business prior to a reattribution, even if that new business might prove to be loss-making. The Financial Services Authority does not permit the funding of loss-making business, which gives firms the incentive to make over-ambitious forecasts. In this context, it is vitally important for the Financial Services Authority to conduct rigorous assessment of the reasonableness of assumptions made by the firm during reattribution negotiations, ensuring that these assumptions reflect the trend of the declining popularity of with-profits products. Once a reattribution has been completed, firms should not be permitted simply to distribute (to themselves) set-aside funds intended for new business. The Financial Services Authority has indicated that such distributions will be limited, and we expect it to set out how this would be achieved in its response to this Report. (Paragraph 34)

5.  We note that the Financial Services Authority was unaware of any evidence that the use of with-profits funds' assets gave rise to competition concerns, and the similar findings of the Office of Fair Trading's preliminary analysis. Whilst welcoming this reassurance, the continuing concerns raised by some witnesses deserve full analysis and we urge the Office of Fair Trading to consider performing a more thorough analysis. As a minimum we expect the Office of Fair Trading, alongside the Financial Services Authority, to monitor the competition aspects of the funding of new business from inherited estates on an ongoing basis. (Paragraph 39)

6.  We view the charging of mis-selling compensation costs to the inherited estate as inappropriate. All businesses make mistakes and some residual level of mis-selling may be in the "nature of the beast", for which charging the inherited estate may be justifiable. But the vast bulk of mis-selling costs must be borne by shareholders, as it is the duty of shareholders, through the managers of the firm, to ensure that staff behave appropriately when selling products. We are unconvinced by the argument that the charging of mis-selling compensation costs to inherited estates has no impact on the likelihood of current policyholders receiving special distributions. Any use of an inherited estate that reduces the estate's size has a direct bearing on such a prospect. We therefore welcome the publication of the Financial Services Authority's consultation paper on this issue, and the fact that the Financial Services Authority also believes that the charging of mis-selling compensation costs to the inherited estate is inappropriate. (Paragraph 46)

7.  The charging of shareholder tax to the inherited estate is, in our view, a striking example of how certain life firms are able to use their discretion in a way that furthers shareholder interest to the detriment of policyholders. This tax liability is only incurred as a result of shareholder involvement in the with-profits fund (no such liability would arise in a mutual fund, for example), so it seems unfair that policyholders should pay anything towards this charge. It would seem that the FSA shares our view, given that firms in general are disallowed from charging the estate shareholder tax, unless they have been doing it in the past. In the case of the charging of shareholder tax to inherited estate, different rules apply to different firms, providing yet more complexity. We believe consistency in regulation is paramount. We urge the FSA to consult on the charging of shareholder tax to the inherited estate by the end of 2008. Our view is that it should not be permitted. (Paragraph 50)

Special distributions

8.  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. (Paragraph 56)

9.   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. (Paragraph 69)

Reattribution

10.  The Financial Services Authority has made clear that parties to a reattribution negotiation should consider not just the value of potential special distributions to current policyholders, but also the total value that the firm's shareholders stand to gain from the transaction. The bargaining power of the policyholder, however, is limited to the former consideration, because a firm undergoing a reattribution would know that most policyholders would accept any offer that provided adequate compensation for the foregone chance of benefiting from future distributions. If a firm decides to tell policyholders not to expect any special distributions at all whilst they remain policyholders, that bargaining power is weakened further, to such an extent that most policyholders would accept even a derisory offer. Given, this weak bargaining position, the Financial Services Authority has a crucial role to play in a reattribution. The Financial Services Authority must ensure that, when the firm concerned frames its offer to policyholders, a fair value has been assigned to the gains accruing to shareholders in the transaction. In these circumstances, it is incumbent upon the FSA to ensure that a fair price is offered, not just an adequate price. They are two quite different things. (Paragraph 74)

11.  We welcome the advent of the role of policyholder advocate, to negotiate on behalf of policyholders in a reattribution negotiation. One specific power we wish to see future policyholder advocates armed with would be the ability to communicate with policyholders whenever they wished to. The Financial Services Authority should stipulate that policyholder advocates' contracts and terms of reference allow such communication. (Paragraph 79)

12.  Given the complexities involved in with-profits funds, and the widely differing views from various stakeholders about what might constitute a fair offer to policyholders, reattribution negotiations may be expected to take a long time. We do not believe that the Financial Services Authority should impose a rigid timetable for any future reattributions, or permit companies to do so, because the most important outcome is that an appropriate offer should be made. (Paragraph 86)

Protecting policyholders' interests

13.  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. (Paragraph 100)

14.  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. (Paragraph 101)

15.  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. (Paragraph 109)