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Speech by Sarah Wilson, Director TCF and Insurance Sector Leader, FSA
Infoline conference on Ensuring and evidencing TCF in with-profits
29 October 2008

Thank you for the invitation and the opportunity to speak to you today.

Experience has taught us that the effective running of a with-profits fund is always a challenge for senior management. So I hesitate to say that the pressures on senior management created by recent asset price falls are greater than those that exist in more usual market conditions. But we are living in exceptional times. And in the course of my remarks, I will include mention of some – if not all – of the particular issues that might be expected to be exercising senior management at present.

So my agenda this morning is threefold:

• one, setting out the key TCF issues for the with-profits sector;
• two, a reminder of the responsibilities of senior management for the fair treatment of policyholders and the regulatory safeguards in place; and
• three, our plans to review how well senior management are implementing FSA rules in practice.

As you know, in 2001 we embarked on a major reform of the regime for the regulation of with-profits. At the time we recognised that the management of with-profits funds was too opaque and allowed firms too much discretion. We increased the transparency of the operation of funds and introduced new limits to managements' discretion. Alongside this, the new regime also introduced radical reforms to the prudential aspects of life insurance regulation.

The overall objective was greater policyholder protection, and the new regime we introduced in 2005 delivered a much improved regulatory regime for the with-profits sector.

Importantly, the new regime recognised that the very nature of with-profits means that every aspect of the business is inextricably linked to treating customers fairly. So our powers to constrain the discretion exercised by firms' management ranges from rules and guidance on:

• governance, and managing conflicts of interest;
• to communication of the way the management plan to manage the fund (within the so-called 'PPFM'), and a requirement to manage assets accordingly such that policyholders' are treated fairly and their expectations are met;
• to specific safeguards in the case of uses of the inherited estate; as well as
• decisions on payouts, surrender values, and charges to the fund.

We also introduced new obligations should a fund close to new business, although I don't intend to focus on these today – not least, while there are particular issues which require careful attention where a fund closes, our thematic work has tended not to show that it is appropriate to draw a distinction between the TCF performance of open and closed funds. 
Of course by the end of December this year, we expect all firms – not just with-profits funds and not just insurers – to be able to demonstrate that they are consistently treating their customers fairly. So the issues I refer to today are those that you will need to fix – and prove that this is the case – if you are to deliver the TCF outcomes and meet the deadlines.

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Key TCF issues in with-profits

So let me start by outlining four key aspects areas where senior management in with-profits firms need to take an interest in the fair treatment of policyholders.

First the need to manage conflicts – between shareholders and policyholders, and between generations of policyholders.  Here we are entirely clear that it is the Board's responsibility to identify and manage such conflicts, and specifically to ensure that policyholders are treated fairly.  Equally, however, we have very clearly said that there must be some independent judgement in assessing the appropriateness of the management of the with-profits fund and compliance with the PPFM.

You will know that, when we carried out some thematic work last year, we found that some firms' arrangements for acquiring such independent judgement were restricted to monitoring compliance with the PPFM, rather than thinking about the broader outcome that the governance arrangements are intended to achieve. As a result, in some firms the range of issues referred to their independent oversight function was more limited than we expected it to be. Senior management need to ensure that their With-profits Committees – or other source of independent judgement – are consulted on all significant issues affecting with-profits policyholders' interests. For clarify this includes matters such as changes to investment strategy, charges and bonuses.

We accept that independent judgement can be provided in different ways. We also agree that the Board could take a different view to any independent input it receives. That said, and whatever the form of the arrangements, our intention is absolutely that the with-profit governance is an important and powerful input to the running of the firm and to securing the fair treatment of customers. In the thematic work already mentioned, we found potential weaknesses in the governance arrangements in some firms in a number of areas. I wrote to Chief Executive Officers setting these out and restating our expectations. This will be a key area of focus in assessing whether firms have met the December deadline.

Whatever the underlying position, however, it is clear that the external perception of the strength of firms' with-profits governance arrangements is poor. Statements by the TSC, the Consumer Panel and others suggest a view that the arrangements are simply not delivering the protection to policyholders which they were designed to provide. So I would encourage firms to consider not just the effectiveness of their arrangements, but also the way in which this effectiveness is communicated more widely. Improved visibility of the effects of the arrangements and the results which they have achieved is likely to be one factor which could promote confidence in the with-profits market.

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The second TCF issue is around firms' investment strategy, and the management of assets within the firms risk appetite and the guidelines set out in the firms' PPFM. Our rules quite clearly state our expectations that a firm's PPFM must describe how it manages its with-profits funds, including significant aspects of its investment strategy, and that these statements must enable the 'knowledgeable observer' to understand the risks therefore of maintaining a with-profits policy with it. Our rules also state that firms can only change their principles and practices in certain circumstances, and in doing so the interests of the policyholders must be a key consideration. I emphasise these points because they underline both the reach of our treating with-profits policyholders fairly rules, and the depth of senior managements' responsibilities to their policyholders.  Meeting the December deadline requires consistent adherence to these rules.

Third, there is the question of the legitimate uses of the inherited estate.  This is an issue subject to much interest and comment – including of course most recently from the TSC.
I think it bears repeating that while legally, the whole of a with-profits fund (including the inherited estate) is an asset of the insurer, we constrain the uses to which an insurer can put an inherited estate because with-profits policyholders have an interest in it arising from their right to a share of a distribution if one is made.  Most notably, the inherited estate must only be used to provide capital to back new business where this does not have a material adverse effect on the interests of existing policyholders, and may only finance strategic investments where these do not prejudice the interests of those policyholders. 

As you will be aware, it has been argued that our rules do not go far enough in constraining how firms use the inherited estate. We carefully considered the arguments put to us, and earlier in the year we consulted on the charging of mis-selling and compensation costs. We have received a substantial response to the consultation, representing a wide spectrum of strong views, and are currently considering these.  We have also been asked to look again at our rules on the charging of shareholder tax to inherited estate.  Here, in the context of the past wide-ranging review of our rules, which imposed a number of significant constraints on the uses of capital in with-profits funds, we remain of the view that the decision to permit this specific practice to continue where it was disclosed to new and current policyholders was reasonable.  But of course in accordance with usual practice, we will keep this rule – along with the overall framework – under review. 

Generally, we expect to see evidence that firms' with-profits governance arrangements scrutinise very closely the uses of the fund and any changes proposed by the firm.
My fourth issue concerns insurers' communication with individual policyholders.  Again, I reiterate this – notwithstanding the fact that our thematic work is in some cases a little out of date now – because it is a key aspect of fair treatment of policyholders and relevant to the December deadline.  To recap, in May last year we published the results of a review of communications from a number of insurers.  As you will remember, although our review found some good examples there was a significant proportion where firms failed to comply with FSA Principles 6 and 7. These failings were across all types of firms – large and small.  Key failings were:

• valuable product features such as Market Value Reduction (MVR) free-dates and Guaranteed Annuity Rates (GARs) were not always mentioned and/or clearly explained;
• some used complex terms which were not adequately explained; and
• some documents lacked explanation about how the actions or practices of the insurer may affect the policyholder.

Interestingly most firms in our sample had not undertaken any consumer testing on the effectiveness of their post-sale communications.  And while this is not a requirement, and firms will choose review methods proportionate to their size, we were disappointed with the general sense of a lack of care in preparing these communications. This same sense came across in our more recent reviews of Key Features documents and of Open Market Options communications. Providing clear and timely policyholder communications is a key aspect of firms' treatment of their policyholders. And it is particularly relevant to you given the complexity of with-profits policies.   We expect senior management of all insurers to have reviewed their consumer communications in the light of these findings, and to ensure that necessary changes are introduced no later than December 2008 – the TCF deadline.

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TCF challenges in current market conditions

I hope I have succeeded in convincing you of the range of TCF issues inherent in any with-profits business, and helped focus your attention on some of the most important risks as the regulator sees it. But what of the risks and challenges posed by current market conditions?

Let me start by saying that as a whole the industry is in a stronger position than it was in the early part of the decade when equity markets fell dramatically. Back in 2003 we had a regulatory regime that was not risk-sensitive, did not require insurers to hold capital to meet all their promises to policyholders and did not encourage good standards of risk management. The prudential reforms we introduced in 2004 transformed the regulatory framework. As we have reported elsewhere, the quality of firms' risk management (including understanding of their balance sheet risks) has also significantly improved. Let me also remind you that the concept of with-profits – in which investment returns are smoothed to balance out the profit made in good years against losses made in bad one – means that in difficult times like this with-profits policyholders do have some protection against short term volatility. 

But of course the market conditions at present are exceptional, and may remain volatile for some time. And this means that insurers will be reassessing asset exposures, and taking decisions on bonus rates and MVRs. These are difficult issues, and it will be extremely important that at the same as taking timely and decisive action, senior management seek independent input and act in accordance with our rules and guidance. 

Let me recap briefly on the safeguards in place for policyholders. First, senior management will be considering asset management in the context of the public description of how they manage their fund as set out in their PPFM.  Second, on MVRs: in order to ensure policyholders do not leave a with-profits fund with more than their fair share, and to the detriment of the continuing investors, our rules allow insurers to apply a market value reduction (MVR) to reduce the payout. Our rules also provide constraints around the use of MVRs, which mean that the value of the MVR applied must be proportionate to either the fall in the value of assets or the impact of a high volume of surrenders.  Third, on bonuses: on maturity of a policy, the amount paid out must reflect the policyholders' asset share and must be within a certain target range. In conditions where markets have fallen sharply, policyholders may find they receive less terminal bonus than expected, but firms must ensure that the amount they do receive represents their fair share of the fund.

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Lack of confidence in with-profits

The final comments I would like to make are around the perceived lack of confidence in the with-profits sector, and in the regime for regulating it. The Treasury Select Committee (TSC) published their final report on inherited estates in June, and our response was posted on their website on Monday. In that response we considered first the issues raised on reattributions of inherited estates.  We noted that, in our view, the new rules designed to protect policyholders have worked well in the case of the Aviva and Prudential transactions (the latter of course terminated by the company at an early stage).  We went on to cite a number of lessons we have learned about the process of reattributions, and how we believe these will lead to process improvements in the future.  As the Aviva transaction proceeds through the remainder of its process we will continue to seek areas for improvements and will communicate fully in due course.

Looking at with-profits more widely, however, we also said to the TSC that after three years of the new regulatory regime for with-profits, we plan to conduct a review of how senior management of with-profits firms have implemented the new regime.   This is in a context where, while we supervise individual firms as issues arise, we have not yet carried out a systematic information-gathering exercise to understand the standard of firms' implementation.

Our starting point in conducting the review is not that significant changes are needed to the regime: as I said, we believe it offers significantly more protection to policyholders than was previously available. What we want to explore now is how firms are actually operating the regime on the ground. That means the review will cover a range of areas, including:

• the firm's own internal arrangements (such as with-profits governance, and the level of knowledge of its historical contracts);
• financial issues (Market Value Adjusters, charges, asset mixes, assessments of excess surplus etc); and
• the interface with consumers (i.e. communications).

We will also look at the effects of new business on the interests of existing with-profits policyholders, and issues related to closed or nearly closed funds such as the adequacy of run-off arrangements.

What this does not necessarily mean is a lot of new work. We have already carried out thematic work in several of these areas which we can utilise. That has two consequences. First, you have a clear point of reference of our requirements and expectations, and so you should be well placed to demonstrate how your implementation of the regime has delivered improved consumer protection. Second, it means that for at least some firms in some areas, we will already have a good knowledge of firms' practices. So many aspects of this review can, I believe, be dealt with without additional extensive visits to firms.

As a result of this review, to be completed by the end of 2009, we will be able to focus our supervisory attention on areas of particular concern, and consider whether in the event there are aspects of our rules which need amendment or clarification.

In conclusion, I started by acknowledging the challenges of current markets, but also noted that management of with-profits funds in the interests of policyholders is an on-going challenge given the nature of the product.  Whatever the circumstances, we have a regulatory regime designed to protect the policyholder.  I am sure you will be working to ensure that you meet the December TCF deadline; and look forward to further evidence of this in the review of senior management implementation next year.

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