Quenching your thirst for guidance on unit linked funds

Unit linked funds are big; millions of UK consumers have invested over £900bn in these funds and this number is on the rise. Given the significance of these products, the Association of British Insurers (ABI) created a set of good practice guidelines for unit linked funds in 2006.

Since then the guidelines have been updated to reflect the evolving view of what constitutes good practice. The guidelines cover a range of topics from unit pricing and valuations to operating and merging funds.

Why have the guidelines been updated?

The Financial Conduct Authority published the results of its thematic review into the governance of unit linked funds in October 2013. This led the ABI to review its guidelines; it consulted the industry during March and published its revised guidelines in May 2014.

We described the findings of the FCA’s thematic review in this blog.

What are the key changes in the ABI’s guidelines?

Parts of the guidelines have remained relatively untouched. Other parts have had more significant changes. Here we have outlined key changes in the guidelines.

Governance scope

Guidelines on governance already existed in the previous version of the guidelines. Following the FCA’s thematic review, they have been significantly expanded. The ABI recognises that the scope of the required governance will depend of firm specific structures and operations. Nonetheless, it has spelled out its expectation for the governance arrangements of a ‘typical’ unit linked fund.

The governance section of the guidelines have also been expanded to cover outsourcing, conflicts of interest and documentation.

Outsourcing

Poor oversight of outsource service providers was one of the key findings of the FCA’s thematic review. Firms need to understand the nature of any work that is outsourced. They should ensure that appropriate and proportional controls are put in place to oversee outsourced work. Example management information that firms should use include:

• Key performance indicators of agreed service levels
• Validation of outsourced work
• Key risk indicators

Firms need to perform both an initial and an ongoing assessment of the outsourcing arrangement and ensure that there is a business continuity plan in place in case the third party provider fails.

Regardless of whether any work is outsourced, firms must ensure that they have an appropriate skill base capable of understanding and challenging all aspects of the unit-linked operation.

Conflicts of interest

Firms need to ensure that they have a clear conflicts policy covering all aspects of their business. The policy should set out how conflicts will be identified, recorded and managed. When managing conflicts, firms need to ensure that no customers or stakeholders are unfairly disadvantaged.

Documentation

Firms need to have and regularly review documentation relating to the operation and governance of their unit-linked funds.

The guidelines set out the ABI’s expectations on what each firms’ internal and external documentation should cover.

The paperwork that firms provide to their customers should enable them to understand, at a high level, how the firm operates its unit linked fund and how it manages its investments.

Mandate compliance

Firms need to ensure that the asset documentation given to customers is consistent with that used by its investment managers. Firms also need to ensure they have a good reporting process in place so they can provide timely reports to their customers and regulators on topics such as investment performance and non-compliance.

Stock lending

Stock lending is the lending of tradable financial assets from one party to another.

The guidelines clarify that firms can participate in stock lending. If they do, then firms must disclose the extent of counterparty default risk to their customers. Firms need to show that the fund receives a proportionate benefit arising from stock lending transactions.

Permitted links

Regulatory rules dictate that firms must not provide benefits determined by reference to anything other than an approved index or by reference to the value of assets other than those on the approved high level list of permitted links.

The guidelines remind firms that they need to conduct sufficient analysis to make informed decisions as to whether assets are appropriate as permitted links. Firms need to take particular care when dealing with third party firms’ collective investment schemes.

Pricing

When switching between bid and offer pricing, or when applying a dilution levy, firms should aim to ensure broad neutrality between new, continuing and outgoing policyholders.

Firms should have systems and controls in place to monitor and identify customers who may be trying to arbitrage market timing opportunities. Firms should be mindful of when market timing opportunities detriment some customers and take appropriate action to mitigate this.

Valuations

Firms need to ensure that they have a robust written valuation policy.

Firms should plan for expected and unexpected unavailability of valuation information. Firms should have reasonable and proportional controls to prevent valuation errors. Firms to ensure that they use sufficiently experienced resources in its valuation process.

The FCA’s thematic review found that there was an overly stretched operational capacity in some firms leading to errors occurring and delays in rectifying them. Firms need to ensure that they have enough staff to perform specialist valuations/judgements for any funds or asset classes that their funds are allowed to link to.

Tax

The guidelines on tax have been significantly expanded and they recognise that tax related calculations can be complex. Firms’ approach to tax should be documented and the methodology used should be consistent with information sent to policyholders.

The overarching principle should be to comply with the tax regime and to deliver a fair outcome between various generations of policyholders and shareholders.

What next?

The ABI expects firms to review their operations against the updated guidelines and to begin making progress towards following them by 31 December 2014.

The results of the FCA’s thematic review are available here.

The ABI’s revised guidelines are available here.