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28 Sep 2004

Speech by David Strachan

  1. Good morning. My thanks to Ned Cazalet for inviting me to address this conference today. As far as I am aware, this is the first major conference to devote itself entirely to the subject of closed funds – so I am very pleased to be here today to give the FSA's perspective on this little understood and growing part of the insurance industry. The fact that there are so many in the audience this morning testifies to the increasing importance of, and interest in, closed funds as a topic in their own right.
  1. Whatever you choose call them - "zombie funds", "forgotten funds" or even the less sensational "funds that have closed to new business" - closed with-profits funds have made the headlines of late. A catalogue of charges has been laid at the industry's door. Moreover, and regardless of the fairness of these allegations, there is a real and present danger that closed funds become the latest albatross to hang from the life insurance industry's neck. I also think that the impact of closed funds goes far beyond the closed funds sector itself. It is capable of affecting consumers' perceptions of with-profits contracts more generally and the reputation of the owners of such funds, especially if they are engaging in other, "open" financial services business. So I do not see this as a narrow issue.
  1. For some time now, concerns have been raised over the position of policyholders in these funds, with many arguing that they are trapped in an impossible position, with future benefits and payouts severely constrained by very conservative investment strategies. Commentators add that the plight of these policyholders is compounded by the potentially hefty surrender penalties that will be incurred if they wish to cash in their policies. There is also a perception that the FSA as regulator of the sector is powerless to do anything, leaving millions of policyholders exposed.
  1. It is undoubtedly right that closed funds have been flung into the spotlight. Our subject matter today is, however, deeply complex and as such it is extremely difficult to generalise and make sweeping statements. This is particularly true when considering the position of policyholders. It is eminently possible that for one type of policyholder in a closed fund the best course of action would be for them to hold the policy to maturity whereas for another, surrendering the policy would be the more rational option.
  1. I think it is fair to say that to date, the debate has been largely one-sided and driven by anecdote. Left unchallenged, perceptions about the performance of closed funds, the prospects for policyholders and the role of the FSA will take root. In an attempt to redress the balance, I can announce this morning that we are today publishing a document that sets out clearly and calmly some general considerations relating to closed funds and explores some of the complexities surrounding them. For the rest of my time with you this morning then, I will focus my remarks on some of the key themes that emerge, covering the current regulatory regime for closed funds, forthcoming changes to the regime and finally some wider challenges for the industry.

 

Size of the market

  1. To begin with though, it is perhaps helpful to sketch an outline of the size and shape of our subject. In terms of actual numbers, out of 110 with-profits funds 66 are closed to new business. These 66 have £191bn of assets under management invested in equities, fixed and managed or pooled investments, cash and property. To give you a sense of scale, our year-end returns show that assets invested in the entire long-term insurance sector equate to £940bn. As such closed with-profits funds occupy around a fifth of the entire market.
  1. With their strong equity holdings, not surprisingly many with-profits funds fell foul of the sustained bear market that began in the early part of 2000. And although we have not yet seen any closures this year, the likelihood is that the market share of closed funds will increase as many firms adjust their business strategies to take account of the sharp fall in demand for the product and as others respond to the realities of their financial strength in the current economic environment.

 

Current regulation of closed funds

  1. The Sector Briefing that we are publishing today devotes an entire chapter to the way that we currently regulate closed funds. Essentially, the regime we apply to closed funds is no different to that for open ones. Inevitably though, there are some issues which are specific to closed funds. Key considerations for us are the fair treatment of policyholders and the financial security of the fund. Implicit in this is our ongoing interest in ensuring that the fund is operated in a sound and prudent manner. As such, once the senior management of the firm has made a commercial decision to close the with-profits fund to new business, we expect to receive a detailed plan for the fund's run-off, including the firm's assessment of the benefits and risks to policyholders.
  1. As I mentioned at the outset, one of the charges levied at the industry is that closed funds pursue only very conservative investment strategies. Many with-profits contracts allow firms a degree of discretion over investment strategy and when a fund moves towards maturity, it will tend to move into fixed income assets to match its liabilities more closely. If the fund has closed because it is financially weak – just one of a whole host of reasons why a fund may close - it may also invest in lower risk assets to protect both the position of both the fund and its policyholders. Any change in investment strategy is evaluated to determine whether it is consistent with the firm's regulatory obligations – including the obligation to treat customers fairly. We would, for example, look extremely closely and challenge proposals to de-risk a fund on the basis of protecting shareholder funds.
  1. Another issue that we are very much alive to is the risk that when a fund closes to new business it simultaneously haemorrhages its best staff. Given that our rules require that collective and individual skills are appropriate, we keep a watchful eye on staff retention issues. Other areas that we pay particularly close attention to in our supervision of a closed fund include the outsourcing of investment management and firms' systems and controls.
  1. Underpinning all of this though is the fundamental pre-eminence of the need for robust governance. From the FSA's inception, the responsibility of a firm's senior management has been a cornerstone of our regulatory regime and the onus on this is no less important for the management of closed funds. Indeed, arguably it is more so, given the potential impact of closure on policyholders. If we think a firm has neglected to exercise this responsibility properly we intervene – this can take a variety of forms but if serious enough can mean disciplinary action against the senior management team itself, as individuals. Senior management responsibility is an immutable feature of our current regime and will continue to occupy centre stage once we have introduced our proposed forthcoming changes.

 

Forthcoming changes in regulatory requirements

  1. It is widely recognised that management's exercise of discretion in with-profits funds has often been less than transparent. To address this, our With-profits Review, which began in 2001, recommended a comprehensive package of reforms to provide greater clarity on the operation of with-profits funds. Consultation on some aspects of the reform programme is still under way – most notably the proposals in our second consultation on Treating with-profits policyholders fairly – or for those in the know, CP 04/14. This consultation contains a range of proposals designed to drive up transparency in the with-profits sector. Most proposals apply equally to open and closed funds, but there are some which specifically target just the latter.
  1. Communicating to policyholders clearly in plain language is an integral part of the requirement to treat customers fairly. Following the successful introduction of PPFMs for all with-profits funds we are proposing that firms be required to produce a consumer friendly version. This document would include the most important information from the main PPFM, thereby better equipping policyholders with the information they need to make informed decisions about their investments in with-profits fund. This requirement is for both open and closed with-profits funds, but clearly will be of particular benefit for consumers who have policies in closed funds and who may be trying to decide whether to stay or go.
  1. More specifically to closed funds, we have also proposed that firms be required to notify policyholders within 28 days of the closure. Information sent to consumers should include an explanation of why the fund closed; the impact on policyholders and options open to them; and any other relevant material. Firms will also be required to submit a detailed run-off plan to us as soon as possible – or at least within three months of closure. This must set out how the firm intends to ensure that there is a full and fair distribution of the closed fund and any inherited estate. Amongst other criteria, the run-off plan should also identify and explain: any material differences with the PPFM; any changes to maturity and surrender payout target ranges and smoothing policy; and any changes to the investment strategy – for example, any proposal to shift from equity and property holdings to fixed income assets.
  1. The run-off plan must also explain how the costs charged to the fund may change. This is of course one area that is particularly relevant to the fair treatment of policyholders and in CP 04/14 we have proposed that funds must only bear the costs connected with their operation. Ostensibly then, it might appear obvious that expenses in a closed fund should fall given the lack of acquisition costs. Further, given that the assets and liabilities are more closely matched, it would not be unreasonable to think that transaction and investment management charges should fall as well. However, as with so many other aspects of the closed funds sector, that is not the end of the story as the closure of a fund may actually entail some additional costs. These include, for example, redundancy payments and one-off costs of operational changes to facilitate long-term efficiency gains. And so, it is difficult to say conclusively whether charges made to a closed fund should be lower or higher than those made to an open one. Thus furnishing us with another illustration of how closed funds defy the confines of a generalisation. But we are very clear that we need to continue to look very closely at charging within closed funds, both as a general matter and specifically in preparation for the introduction of the new rules in this area.

 

Challenges for the industry

  1. The final chapter in the document that we are publishing today explores some of the challenges that the industry is facing. Although by no way exhaustive, we have focused on three: treating customers fairly and management actions; the sale or restructuring of closed books of business; and lastly reputation. I will confine myself this morning to remarks on the latter two; our thinking on the former is set out clearly in chapter 5 of today's publication.
  1. In the first instance, I would just like to stress that the sale or restructuring of a fund is a commercial decision, and as such one for firms' senior management. Inevitably though, there are attendant regulatory issues. Although the volume and scope of commentary on this topic has increased of late, we are still in largely uncharted territory in terms of proprietary companies divesting their insurance interests to innovative consolidation vehicles. It is encouraging though to see that the industry is actively exploring innovations in this area – indeed, the number of delegates here today is testament to the increasing attention that this issue is attracting.
  1. It is, I think, fair to say that a lack of transparency over risks carried within closed books of business has in the past proved an obstacle to acquisition. Our efforts to drive up transparency in the with-profits sector through the introduction of PPFMs and Individual Capital Adequacy Standards should mean that prospective purchasers are able to quantify and price risks more accurately, thereby helping pave the way to greater consolidation and restructuring.
  1. From our vantage point, areas of particular interest include: capital engineering; the structure of governance arrangements; quantification of mis-selling liabilities; investment strategies; and the delivery of returns. Perhaps unsurprisingly though, head and shoulders above the rest for us, is the concern that policyholders continue to be treated fairly. And to be clear on this point for a moment, fair treatment should not be translated as meaning policyholder returns that outstrip the market. Nor should the word be used in a technical, specialist sense from the lexicon of accountants, lawyers or actuaries. Instead, we mean the ordinary, simple English language meaning of the word.
  1. The second challenge that the industry must grapple with is one of reputation. Detailed knowledge and appreciation of with-profits rarely strays beyond the sector itself, or those with a strong incentive to follow it. One regrettable consequence of this is that a relatively low level of consumer knowledge and understanding can provide fertile breeding ground for misconception and error. There is of course no overnight solution to this. Clearly the industry needs to address actual shortfalls (as opposed to perceived ones) and, importantly, be seen to doing so. But in parallel there needs to be an increase in consumer understanding. Given the growing market share that closed funds enjoy, the need for this is all the more pressing.
  1. Before drawing my remarks to conclusion though, I would like to spend a few moments highlighting five common misconceptions that have gained currency of late.
  1. First: open funds good; closed funds bad. Perhaps the most popular misconception is that closed funds perform poorly, have the worst payouts and will continue to do so in perpetuity. In contrast, open funds are perceived to perform well and so provide the best payouts. As we illustrate in the document published today, data from our annual maturity payout survey shows that this generalisation does not hold true. Although some closed funds do perform less well and tend to reside at the bottom of the league tables, others do not.
  1. Second: funds only close to new business because they are financially weak. Again, another generalisation that does not apply across the board. With-profits funds close for many different reasons. While it is true that some close because they are financially weak this is not the driver for all closures. Other reasons might include for example, change in business strategy away from capital intensive lines; viability of the fund in terms of size; and changes in the economic and regulatory environment.
  1. Third: policyholders in closed funds should cash in their policies as soon as possible. Consumers should not assume that, just because they have a policy in a closed fund, payouts and future bonuses will be poor. Indeed, performance in some closed funds has rivalled that of open funds. Any action in relation to a with-profits policy requires careful and considered thought: in terms of guarantees and options that may be lost; in terms of protection cover that may lost; and in terms of any surrender penalties that may be incurred. Policyholders also need to take into account the cost of taking out a replacement investment and whether to restore any life insurance protection that they will have lost. They will also need to have regard to the financial strength of the fund. So, while cashing in a policy will clearly be the right course of action for some; for others it could be sub-optimal.
  1. Fourth: the problems surrounding closed funds could be solved by firms offering penalty free exits. Although this may appear an attractive option to some, it is not a practicable – or indeed a fair – solution. Generally, policyholders who cash in a policy or transfer their funds to another provider will receive a value that broadly reflects the value of the premiums that they have paid plus the returns that have been earned over the life of the policy, less expenses – in other words, the asset share. However, the amount paid on surrender or transfer may be reduced to take into account the costs to the fund of allowing the policyholder to leave, for example costs associated with disposing of the relevant assets and the un-recovered expenses that would have otherwise been deducted from the value of the policy over time. If these costs are not charged – i.e. an exit free penalty is allowed – then they would have to be picked up by the policyholders who stay behind.
  1. Lastly fifth: closed funds are beyond the FSA's remit. Just because a fund has closed to new business does not mean that it has special dispensation from the regulatory regime. At present, closed funds are subject to the same regime as that for open funds, and when the new proposed requirements for with-profits take hold, closed funds will be subject to requirements over and above those for open funds. The key tenets of our proposals are the fair treatment of policyholders and increased transparency over a firm's exercise of discretion. And, as I mentioned earlier, where we have concerns we can make firms take action to protect policyholders' interests. And in the extreme, if a fund has been mismanaged we are able to take regulatory or enforcement action – including against the firm's senior management if necessary.

 

Conclusion

  1. I hope it is clear from my remarks that the issues surrounding closed funds are a real priority for us and that today's publication attempts to articulate a reasoned contribution to the debate.
  1. To date, we have focused our efforts on identifying gaps in the current regime and developing new requirements to fill these. We are now moving towards implementation of the proposed new requirements, but alongside that exercise, we will be looking very closely at the arrangements in place within closed funds. Rule-making is important but needs to be set alongside day-to-day supervisory work. In light of this we will be looking at the information that we currently obtain from firms about their charging structure, how they have changed as a result of closure and how they relate to the new rules that we are proposing. There is also more work to be done on the calculation of MVRs and how MVR exemption dates are communicated to policyholders. Governance arrangements and high level systems and controls will also remain on our agenda.
  1. Closed funds are here to stay, and I think all us need to be realists in the face of that fact. As regulator, subject to the consultation, the FSA needs to implement and embed the new requirements for closed funds and ensure that these help ratchet up transparency and fairness in the closed funds sector. Firms' senior management need to confront and embrace the challenges that closed funds bring – particularly in terms of fairness. Market participants more broadly should continue to tease out and pick through market-based solutions that safeguard the fair treatment of policyholders. And finally, policyholders too have a role to play. They must appreciate - and you and we must help them appreciate - that closed funds do not readily lend themselves to generalisations. As such, policyholders must consider the specifics of their own circumstances as well as those of the fund they are invested in, taking financial advice as necessary.