On 19 December 2012, the Financial Services Authority (FSA) released a consultation paper “CP12/38: Mutuality and with-profits funds: a way forward”.
This paper proposes a fundamental change of approach to the FSA's rules for with-profits mutuals operating a single common fund, such as friendly societies and mutual life insurers.
The proposals are extremely good news for the mutual and friendly society sector and, although there are a number of areas in the proposals that need clarification, this development offers many mutuals and friendly societies the potential to develop a different strategy and approach towards obtaining new business growth in the future and to compete with proprietary companies operating with-profits funds. The proposals do not apply to with-profits proprietary firms.
The consultation closes on 19 March 2013 and is expected to stimulate a lively debate in the with-profits sector. After the period for consultation has closed on 19 March 2013, the regulator , which is most likely to be the Financial Conduct Authority (FCA) in consultation with the Prudential Regulatory Authority (PRA), will finalise draft guidance and publish a policy statement with final draft rules.
With-profits mutuals have experienced both recent declines in demand for with-profits products and increasing maturity of existing books of business. Coupled with the current rules in Chapter 20 of the FSA's Conduct of Business sourcebook (COBS 20), mutuals which are not writing sufficient amounts of new with-profits business are being forced to consider closing to new business in order to go into orderly run-off that is fair to with-profits policyholders.
As a result of the FSA's rules, some mutuals have had to consider whether they can continue in business beyond the end of the with-profits run-off and need to close. Mutuals have lobbied the FSA saying that closure is not the best outcome for policyholders and the rules are too prescriptive and prevent them planning for future business models around moving into new non-profits business.
The aim of the proposed changes in the FSA's consultation paper is to make it easier for with-profits mutuals to continue in business and to write non-profit business despite their with-profits business having become less significant or run-off completely whilst also ensuring that firms treat their with-profits policyholders fairly. Another objective of the proposals is to ensure that policyholders of with-profits mutuals are no worse off in terms of policy benefits than their counterparts in proprietary firms.
A significant issue is that, currently, with-profits mutuals need the approval of with-profits policyholders to write new non with-profits business. With-profits policyholders are unlikely to be inclined to approve something which might affect the amount of surplus in the with-profits fund which would otherwise be distributable to them. However, as the FSA acknowledges in the paper, this does not take sufficient account of the interests of other members who are not with-profit policyholders or the constitutions of some mutuals and their structures, origins and circumstances.
It is therefore proposed that mutuals with a single fund will be able to separate these interests from the with-profits fund into a "mutual members’ fund" or "mutual capital". Although such reorganisation is possible through certain legal procedures, such as the scheme of arrangement undertaken by Reliance Mutual last year,, such procedures are not legally or commercially viable for all mutuals.
Instead, it is proposed that with-profits mutuals may apply for a modification of the FSA rules to change the definition of a with-profits fund to allow these mutuals to clarify members' interests and with-profits policyholders' interests. Direct application of the current prescriptive rules in COBS 20 will not apply to the mutual members' fund which would be regarded for regulatory purposes as separate from the with-profits fund.
The management of with-profits funds has been a concern for the FSA since the near-collapse of Equitable Life in 2000. In 2005, following a major review, it introduced specific rules and guidance in COBS 20.
But in 2008 the Treasury Select Committee criticised the FSA for failing to provide a robust framework for managing conflicts of interest. In response, the FSA carried out a further with-profits review to see how firms have been putting the COBS 20 rules into practice.
As a result of the with-profits review, many mutuals raised a number of concerns with the FSA about how the COBS rules were impacting them which led to the regulator engaging with mutuals over the next few years in a process called Project Chrysalis. A key issue was whether a mutual was entitled to divide its common fund into a with-profits fund and another fund for "mutual capital". This was significant for mutuals faced with the prospect of a decline in new with-profits business.
The FSA issued a 'Dear CEO' letter in response in October 2009 confirming the FSA's position that with-profits policyholders are entitled to all, or nearly all, of the assets in the mutuals long term fund. It set out options for mutuals facing a decline in with-profits business but the letter prompted further responses from mutuals industry. A second 'Dear CEO' letter was published in September 2010 in which the same position was effectively reiterated by the FSA.
One outcome of the with-profits review was the March 2011 consultation paper (CP11/5) 'Protecting with-profits policyholders', which proposed changes to the rules on how with-profits funds are managed. On 7 March 2012, the FSA published a policy statement (PS12/4) on how it intended to proceed, together with the final text of the amended rules in COBS 20.
Industry respondents, however, particularly those in the mutual sector, maintained that this approach was "incorrect and misleading". They argued that legal and beneficial ownership of a with-profits fund lies with the insurer and that the interests of with-profits policyholders was limited to those parts of the fund that will meet expected payouts under their contracts. The FSA however, did not change its mind. For further details on the March policy statement see Reforming the With-Profits Rules.
Reasons for the FSA's change of heart and new approach
The FSA's intention behind the new approach is to enable mutuals with a single common fund to move forward in a way that seeks to ensure that with-profits policyholders are treated fairly whilst allowing due weight to the potential unfairness to other policyholders of closing down a mutual's non-profits business. Thus, the FSA is encouraging firms to provide new means of sharing in profitable future experience with their members.
This development is a change to the priorities of the FSA which were not aligned with the Government's objective to promote mutuals but now accords very well with promoting mutuals and fostering diversity in financial services, as promised in the Coalition Agreement in 2010.
Current options versus the FSA's new approach
Currently, the approval of with-profits policyholders is needed to effect a division of the with-profits fund and move into new non-profit business. This may be achieved by some mutuals which are subject to the Companies Act by effecting a court approved scheme of arrangement with the approval of the with-profits holders voting in favour of the scheme at a special general meeting. However, this process is not possible for all mutuals, whether for legal or commercial reasons, and it is not available to friendly societies.
For some mutuals, an alternative would be a transfer of insurance business under Part VII of FSMA to a new mutual and this process could involve a restructuring of the mutual fund. The Part VII FSMA transfer is also a court approved process in which the FSA is similarly heavily involved. Again, this would not be appropriate for all. For instance, if the business is being transferred from a friendly society, Part VII of FSMA would not apply and any transfer of engagements would need to be under the Friendly Societies Act 1992 and be approved by the FSA.
The FSA's consultation paper offers a new approach and states, in paragraph 2.16, that "Firms may, but will not necessarily be required to, use available legal processes, for example court sanctioned schemes of arrangement to effect a fair separation. However, where such options are not available or viable in the circumstances of a particular firm, firms will still be able to put forward proposals for effecting a separation which gives a fair outcome for all relevant categories of policyholders, taking all relevant circumstances into account. These proposals will vary from firm to firm and so each proposal will need to be assessed on its merits."
This raises the question of the extent to which the proposed change of approach will be adopted in practice but it is a welcome and big step in the right direction for with-profits mutuals.
The new approach will be effected by means of firms applying for a modification of the relevant regulatory rules under the new section 138A of FSMA (being introduced by the new Financial Services Act) and meeting certain statutory tests referred to below.
As the paper states, funds with insufficient capital and inadequate business plans may be better advised to merge or close in the interests of their policyholders. "A key relevant factor will be the individual features of the mutual concerned," it said.
Proposed process for application
- The firm will apply to the regulator to change the definition of a with-profits fund for the firm and present its proposals to identify that element of the fund which relates specifically to the with-profit holders as opposed to the "mutual capital" or "mutual members' fund".
- Mutuals will need to demonstrate that they meet the statutory tests for a rule modification expected to be set out in s138A of FSMA (Modification or waiver of rules).
- A report from an independent expert approved by the FCA and, where appropriate, the PRA, will be required.
- The FCA will consult with the PRA as appropriate and the PRA will consider matters and implications relevant to it, such as the safety and soundness of the firm, ongoing capital resources and capital requirements related to the modification applied for.
- Where appropriate, pre-consultation with policyholders and other members will take place. In recognition that convening and holding a special general meeting is an expensive exercise for mutuals, the FSA is proposing to remove the requirement for with-profits policyholders to be asked to approve the arrangements for carrying on non-profit business after the run-off of the with-profits business.
- Seven high level principles are proposed as a guide to the consideration of an application (see below).
High Level Principles applying to firms making applications under section 138A
- A convincing and robust business case is required by the firm.
- The proposals are demonstrable as compatible with the obligations to treat policyholders fairly
- An independent assessment of the proposals and how they affect policyholders is carried out
- With-profits policyholders under the firm's proposals will be no worse off than equivalent with-profits policyholders in a proprietary with-profits fund
- The firm has a strategy to ensure that with-profits policyholders and the wider membership of the mutual are appropriately engaged and informed
- Safety and soundness issues are identified and addressed appropriately
- The rule variation applied for meets the appropriate statutory tests.
Once the modification is granted, COBS 20 will still apply to the with-profits fund but not the mutual members' fund.
"However, fair treatment of policyholders may still affect the mutual members' fund in other ways, such as the role of mutual members' funds as support for the with-profits fund or in terms of allocation of compensation and redress costs between the funds," paragraph 2.16 of the paper said.
The modification will be time limited, although it should be of sufficient duration that the mutual can run off its with-profits business "fairly and safely" without renewing the modification "provided the original justification for granting [the modification] continues to hold," it said in paragraph 2.35.
Conclusion – things to consider
There remain a number of areas where the with-profits industry will be looking for greater certainty such that if and when they embark on an exercise to modify the rules to effect a separation, they can be sure what is required and can see a positive outcome if the requirements are met. It would be useful to know how long the regulator would take to process an application. Also, would the regulator be charging a fee and if so, how much? Further guidance is definitely required to know what is needed to show that other legal processes are "not available or viable" – the word "viable" being an ambiguous term used by the FSA.
One further concern that some mutuals may query is the time limitation of any such modification and whether this would hold a gun to management's head to complete the run-off of the with-profits business in a certain time-frame with the potential for unintended outcomes to arise when attempting to achieve fairness.
Finally, these proposals have arrived after a torid time for with-profits mutuals and it could be argued are about 10 years too late. It would be helpful for managements in these firms to be given a clearer timetable to inform their future business planning about when these proposals would come into effect, bearing in mind the change of regulator taking place this year and the potential for further delay.
Contact: Bruno Geiringer