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Briefing note BN017/06
14 March 2006

This year, a number of life insurers that manage closed with-profits funds are likely to present their accounts in a different way from last year. This may give the impression that the funds managed by the firms are financially weaker than last year. In practice, however, this is an issue of presentation rather than an issue of financially weaker funds.

This briefing note sets out the reasons for these changes and explains their impact on the accounts and regulatory returns, and their implications for policyholders.

Source of the changes

With-profits funds typically have working capital which is the excess value of assets over and above that needed to cover the current estimated realistic liabilities of each fund. It supports the business of the with-profits fund but can also be put to other uses for the fund such as funding new business. The working capital will have been derived from money paid in by policyholders and shareholders over the years. Once a firm closes for new business it no longer needs working capital to fund new business.

Two FSA requirements dictate how a closed with-profits life fund should deal with its working capital in its regulatory returns:

• the prudential rules (PRU) give guidance that a firm which plans to reduce its working capital by enhancing the asset shares in a with-profits fund should provide for such payments in its realistic balance sheet. Typically this situation may arise in the context of a closed with-profits fund planning to distribute its working capital. In practice, such a distribution would mean enhancing the potential payouts to policyholders (their asset shares) by way of a distribution. The distribution would ultimately split the working capital between policyholders and shareholders (typically on a 90 /10 basis, although the exact split will vary from fund to fund); and
• the conduct of business rules (COB) introduced last year require a firm whose with-profits fund closes to new business to produce a plan showing how it plans to distribute its working capital.

To assist actuaries and their firms to interpret and comply with the FSA's rules, a guidance note (GN45) was introduced by the actuarial profession late in 2005. Under GN45 guidance, a firm should normally establish a realistic liability to enhance asset shares, where there is a general intention to distribute some or all of the working capital to enhance policy benefits.

A new accounting standard, FRS27, is due to be applied to the 2005 year-end accounts for insurers. It is built around moving towards what the FSA calls a "realistic" basis for insurers' accounts. As a result of FRS27, our understanding is that auditors have agreed that they will "rely" on the realistic basis figures used for FSA returns to determine the level of working capital held by with-profits firms. In practice this means that we expect the accounts of firms managing closed with-profits funds to reflect the treatment of working capital under FSA rules described above.

What impact will this have on firms' accounts?

The impact of the changes described above on a life insurer's regulatory returns, can be seen in the table below. It shows a notional with-profits insurer with £100 of working capital.

The firm above would previously have shown a working capital of £100. In this example, the working capital is composed of a risk capital margin of £30 and excess working capital of £70. Under the new requirements all the working capital is now shown as a planned enhancement – ie assets that will be distributed between shareholders and the policyholders. The planned enhancement is treated as a liability on a firm's realistic balance sheet.

The FSA's expectation is that many closed funds that previously showed a positive working capital will now show zero working capital as in the example above. This does not have an impact on the strength of the closed fund. Whether the assets are shown as a planned enhancement or as working capital, they are still available to meet any risks to the fund should they materialise.

It is possible that some funds will not have prepared their plans for distributing some or all of their working capital and so will not show zero working capital.

Impact for policyholders

There will be no immediate impact for policyholders in closed funds as a result of these changes. In many ways this is a positive step for policyholders as firms now have to draw up plans for distributing working capital within a with-profits fund as soon as the fund closes to new business. Barring future problems, policyholders in closed funds can expect payouts on their policies to be enhanced as a result of the distribution of working capital over the remaining lifetime of the fund. The amount and timing of any distribution remain at the discretion of the firm.

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