Under the regulator's original proposal, the rule change would have applied to all payments made after the regulations came into force, regardless of when the policies were sold or any mis-selling occurred.
The modification means that companies managing "closed" with-profits funds that are no longer selling new policies will fall outside the scope of the new rules.
Consumer watchdog Which? has strongly criticised the move as enabling life companies to avoid meeting the cost of their own mis-selling.
"The FSA has, once again, left policyholders in the lurch and sided with the financial services industry," said Which? chief executive Peter Vicary-Smith. "This regulator repeatedly shows it’s unwilling to stand up for the interests of with-profits policyholders".
But Bruno Geiringer, a life insurance expert at Pinsent Masons, the law firm behind OUT-LAW, warned against getting the effect of the revised changes out of proportion.
"The compensation rules only affect the relatively small number of with-profits policies that are sold directly to the public by life insurance companies," he said. "The vast majority of policies – 90% on the FSA's figures – are sold by independent financial advisers who are, and will remain, responsible for compensating their clients if any mis-selling has occurred".
"Retrospective application of new regulations is a dangerous tool which the FSA is rightly not using here," said Geiringer. "These proposals have been carefully thought through and are fair to those who are currently invested in with-profits funds".
A with-profits fund is made up of policyholder premiums, investment returns and shareholder contributions. The part of the fund that exceeds the firm's realistic liabilities to policyholders is known as the "inherited estate".
This surplus is an asset of the life company and can be used to provide working capital, smooth out returns between good and bad years and fund future growth. It can also be used for the life company’s own purposes, to strengthen its capital base or to fund future growth plans. In some cases, it can be used to pay the shareholder's corporation tax bill following a distribution.
Under current FSA rules, the inherited estate can also be used to fund compensation payments, for instance to victims of mis-selling. In recent years, these have included significant pay-outs to meet pension and mortgage endowment claims.
At least once a year, the life company must consider whether there is an excess surplus in the fund. If so, and if the company cannot justify retaining it, the surplus should be distributed to policyholders and shareholders, usually on a ratio of 90:10.
Alternatively, the life company may decide to negotiate with its policyholders to give up their rights in the inherited estate in return for payment, known as a reattribution.
In either case, the amount payable to policyholders can be reduced if the inherited estate has been used to meet the company's liabilities to pay compensation.
In June 2008, the FSA consulted on changing its Conduct of Business Rules so that shareholder-owned life companies would not be able to pay compensation or redress from the inherited estate. The change would have applied to all payments made after 1st November 2008, regardless of when any mis-selling occurred.
After further consideration, however, the FSA has decided not to make the new rules retrospective. They will now only apply to events taking place after the date the regulations come into force, expected to be 31st July 2009. Effectively, this means that only with-profits policies sold after that date will be affected.
The FSA acknowledges that this "clean slate" approach will mean that companies managing with-profits funds that are closed to new business will fall outside the new rules. But such companies will still have to abide by the overriding principle of treating customers fairly.
"Firms running closed funds…may wish to examine whether continuing to make compensation and redress payments (referable to events prior to the proposed rules change) from their with-profits funds, constitute unfair treatment of their customers" the regulator states.
The FSA published its revised proposals in a new consultation paper on 23rd February. The paper includes feedback from the consultation exercise carried out last year.
Other changes have also been introduced. Under a new exception, life companies would still be able to pay compensation from any assets in the with-profits fund that are attributable to shareholders. In other words, from that portion (usually 10%) of any declared distributable surplus that has been earmarked for shareholders.
The FSA has also clarified that the new rules will not affect payments made to rectify errors, such as refunds of overpaid premium, as these are not compensation as such, but intended to put the policyholder in the position he would have been in but for the mistake.
As under the original proposals, mutually-owned life insurers will be unaffected. They will still be able to use inherited estates to meet compensation costs, provided they are satisfied that the costs cannot be met out of any other assets in the with-profits fund.
And where a court-approved scheme for payment is already in place, that scheme will take precedence over the new rules.
The consultation closes on 22nd May. The FSA has also promised carry out a review this year of how its with-profits rules as a whole are working in practice.
Last June, a House of Commons Treasury Select Committee report criticised the regulator for failing to provide a robust framework for managing conflicts of interest in with profits funds and suggested there should be a debate on the fundamental design of the with-profits regulatory system.