CP12/38 – a welcome change of tack by the FSA?

The FSA defines with-profits business as policies where the policyholder has a right to a share of the surplus arising from the fund in which the business is written. The premium the policyholder pays includes an allowance for this right.

With-profits business is rather out of fashion. I shall leave details of its woes for another blog but suffice to say that sales have been declining for many years now and are not expected to recover. This is leading many with-profits funds to run into the FSA’s rules that state that when with-profits business goes into terminal decline the firm must describe how it plans the orderly closure and run-off of the fund. The rationale for this can be thought of as follows:

• If the volume of with-profits sales declines then any inherited estate will be available to benefit fewer and fewer with-profits policyholders. This will clearly be good for those who remain, but they will be disproportionately favoured compared with those leaving earlier. Hence the firm should close the fund to new with-profits business to allow all with-profits policyholders to share in the estate equitably.
• If a with-profits fund which is closed to new with-profits business continues to write non-profit the problems or questions associated with the inherited estate would be exacerbated. Once all the with-profits policyholders have left there will be no one to benefit from surpluses arising on non-profit business and these surpluses will become trapped.

A proprietary firm writing with-profits business will be operating several funds; at the most basic level it will need a shareholder fund to separate shareholders’ interests from those of policyholders. Having to close a with-profits fund is therefore a hurdle that can be overcome: it can carry on writing non-profit business in a new or existing non-profit fund.

For mutuals however the story is different. The absence of shareholders means that multiple funds have generally been unnecessary and mutuals have written all of their business, with-profit and non-profit, in a single fund. A decline in with-profits business therefore obliges the mutual to close to new business completely.

If the with-profits policyholders are also the sole owners of the mutual then this seems sensible. However it is not necessarily the case that a mutual’s owners ('members') and with-profits policyholders are one and the same. Some mutual have conferred membership status on non-profit policyholders who must have some sort of interest in the future of the company.

It is also not clear that a closure to new business is in the interests of the with-profits policyholders, who are the very people that the rules are designed to protect. A firm in run-off will see the expenses allocated to each policy rise as the number of policies in force shrinks and the firm loses economies of scale. This will reduce the surplus available to distribute as bonuses. The firm may also need to reduce risk in its investment strategy in order to ensure a smooth distribution of capital during run-off: this may reduce returns to with-profits policyholders.

What does CP12/38 do?

CP12/38 appears to represent a change in the FSA’s views on the issue. Their previous position had been that, because with-profits policyholders are the only people with a right to receive the surplus, they must be entitled to all of it. In practice, all policyholders benefit from a mutual’s capital regardless of whether or not they receive any of it (for example, retained surplus allows the firm to weather adverse experience and help to meet policy guarantees).

CP12/38 proposes that mutuals should be allowed to recognise the dual purpose of their single fund: allowing with-profit policyholders the chance to share in surpluses and protecting the interests of policyholders generally.

• Firms will be able to identify which part of their fund relates to the interests of with-profits policyholders.
• The remainder will be termed the “mutual members’ fund” and will be identified as being the capital available to support the firm’s operations such as writing new business.
• Firms would be able to apply for a modification of the FSA’s rules so that the part of the FSA’s rules that is termed “COBS 20” (which covers the management of with-profit funds) would not apply to the newly identified mutual members’ fund. This would mean that new non-profit business could continue to be written in the mutual members’ fund whilst the with-profits part of the fund is run off.

So what are the hurdles to overcome?

CP12/38 is a welcome change in the FSA’s views that should give mutuals greater flexibility. However, there are still some uncertainties to be resolved:

• It is not clear how the split between the with-profits business and the mutual members’ fund will be determined. Some working in the field have suggested a reasonable approach would be allocate assets to the with-profits business that are equal to aggregate asset share plus a reasonable amount of capital to cover the cost of guaranteed benefits, policyholder options etc. This could leave the majority of the estate falling to the mutual members’ fund, which would be available to invest in the firm’s future operations.
• A decision will also be required regarding where non-profit business would fall in the new structure. Presumably the intention is that new non-profit policies will be written in the mutual members’ fund. However it is not entirely clear where existing business will sit.
• Many concerns have been expressed relating to whether the plans will lead to the with-profits business becoming a separate ring-fenced fund. This would have implications under Solvency II (assuming Solvency II is ever brought in!) and could lead to a requirement that the with-profits business is entirely self-supporting, without being able to rely on any support from the mutual members’ fund.
• The application for a waiver will need to be supported by an independent expert’s opinion. Smaller firms will be looking for a cost-effective way to obtain this.
• There will be concerns that the FSA could remove the waiver in future.
• It has yet to be seen how consumer groups will react and whether they may view this as a way of reducing the surplus distributed to with-profits policyholders.

We will be watching the situation keenly to see how things unfold.