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Mutuality and with-profits funds in the UK

On 28 March 2014, the Financial Conduct Authority (FCA) published a policy statement “PS14/5: Mutuality and with-profits funds: a way forward”.

This guide was last updated in April 2014

This policy statement follows up on a FSA consultation paper, CP12/38 from December 2012 which proposed a fundamental change of approach to the rules for with-profits mutuals operating a common fund, such as friendly societies and mutual life insurers. We considered CP12/38 in a previous guide. PS14/5 confirms that the FCA will proceed with the FSA's proposals as modified in light of responses received during the consultation process.

Since CP12/38 was published, the FSA has been divided and replaced by the FCA and Prudential Regulation Authority (PRA). Whilst PS14/5 is an FCA policy statement, the PRA Handbook is also impacted by the proposed change and as a result the PRA published its supervisor statement "SS1/14: Mutuality and with-profits funds: a way forward” simultaneously with PS14/5. This guide focuses on both of the regulators' statements, taking the FCA's position first.

The changes introduced as new guidance in COBS 22.2.60G (2) and 22.2.61G are good news for the mutual and friendly society sector and offer many mutuals and friendly societies with viable businesses 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 new guidance does not apply to with-profits proprietary firms.

The consultation in CP12/38 closed on 19 March 2013 and drew 26 responses from mutual with-profits firms, trade bodies, consultancy firms, consumers and interested individuals the majority of which were, in the FCA's opinion, supportive of the proposals.

Overview

With-profits mutuals have experienced both recent declines in demand for with-profits products and increasing maturity of existing books of business. In order to satisfy the COBS 20 rules in such a climate, mutuals which were not writing sufficient amounts of new with-profits business have previously been 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 these 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. PS14/5 comes after considerable lobbying of the FCA and PRA (and their predecessor, the FSA) by mutuals on the basis that closure is not the best outcome for their policyholders and members and the rules are too prescriptive and prevent them planning for future business models around moving into new non-profits business, even where this would be demonstrably fair to all policyholders and be in the interests of the members.

The aim of the changes implemented by PS14/5 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, prior to the revised guidance, with-profits mutuals needed the approval of with-profits policyholders to write new non-profit 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. The danger of such decisions being decided by the with-profits policyholders is that the interests of any non-profit members would not necessarily be considered and promoted.

The new guidance enables mutuals with a common fund to apply to the FCA for a modification to COBS 20 which will permit the firm to separate its common fund into a "mutual members’ fund" and a with-profits fund. Although such reorganisation is possible through certain legal procedures, such as a scheme of arrangement for mutuals incorporated under the Companies Act 2006, such procedures are not legally or commercially viable for all mutuals and as such PS14/5 creates a more even playing field amongst the range of mutual firms.

The prescriptive rules in COBS 20 will not apply directly to the mutual members' fund (such as having a separate PPFM), which will be regarded for regulatory purposes as separate from the with-profits fund, but the other FCA and PRA Handbook requirements, such as the Principles for Business and INSPRU rules, will continue to be applicable.

The FCA's decision to implement the changes to its guidance has been primarily influenced by avoiding hampering product innovation and making it harder for consumers to access relevant services and, in particular, the following:

  • maintaining effective competition in markets serving particular consumer groups or niches (in respect of the specific product and services provided) occupied by mutual firms;
  • supporting the continuation of the mutual business model; and
  • avoiding the adverse impact on consumers in the event of these firms incurring significant business wind-up or transfer costs in response to diminishing with-profits business.

The FCA concedes that there is some legal uncertainty around the extent of the respective rights and interests of the with-profits policyholders and members in the assets held in a common fund and sets out its own understanding of the legal position as an annex to PS14/5. The FCA has cautioned that this legal uncertainty means that there is no guarantee that a court will support the application of its new guidance, and we expect there to be some challenge by representatives of with-profits policyholders in the event that the new guidance is used to their perceived detriment.

The new approach

PS 14/5 amends the FCA Handbook by adding to COBS 22.2.60G (2) and introducing a new COBS 22.2.61G. The new guidance will be applicable to with-profits mutuals in run-off and those continuing to write new business.

Prior to PS14/5, the approval of with-profits policyholders was 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 incorporated under the Companies Acts by effecting a court approved solvent scheme of arrangement with the approval of the relevant classes of policyholder 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 the Financial Services and Markets Act (FSMA) to a new mutual and this process could involve a restructuring of the mutual fund. A Part VII transfer is also a court approved process in which the PRA and FCA are 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 PRA in consultation with the FCA.

The change to COBS 20.2.60G (2) provides, for the first time, a mechanism, via the new COBS 22.2.61G, by which a mutual may avoid obtaining the agreement of its policyholders and members to making alternative arrangements for continuing to carry on non-profit business. This is significant as the reluctance of with-profits policyholders to agree to measures which may effectively reduce the surplus which would otherwise be distributable to them is considered to be a significant roadblock which prevents mutuals from exploring alternative business models and products. By enabling firms to apply to circumvent this requirement, the FCA has given mutuals the freedom to look to new business lines where with-profits business is declining.

To ensure with-profits policyholders have an appropriate degree of protection in the absence of a vote, the FCA expects firms to notify policyholders and consider any objections in a similar way as for an insurance business transfer under Part VII of FSMA. The independent expert would also consider the interests of policyholders and the extent of policyholder engagement.   

COBS 20.2.61G sets out the FCA guidance on obtaining its approval to modify COBS 20 so as to give regulatory effect to the mutual's division of its common fund into a with-profits fund and mutual members' fund. The process and factors described in this new provision are designed to ensure appropriate protection of the with-profits policyholders and are described in more detail below.

In accordance with s.148 FSMA, the FCA may revoke such modification. Also, conditions may be applied to the grant of any such modification waiver. The FCA explains in PS14/5 (and the PRA concurs in SS1/14) that it is intended that the modification shall only be granted to mutuals for such time as it takes for that mutual to run-off its with-profits fund.

The basis for modification

The FCA is relying on the general rule making power conferred on it by s.138 FSMA to modify COBS 20 so as to enable mutuals to divide the common fund. As such, the applicant mutual must satisfy the FCA that modifying the rules in respect of its specific common fund is justified on the grounds that:

  • complying with the unmodified rules would be unduly burdensome;
  • complying with the unmodified rules would not achieve the purpose for which the rules were made; and
  • the modification would not adversely affect the advancement of the FCA's objectives (i.e. securing appropriate protection of consumers, protecting and enhancing the integrity of the financial system and promoting effective competition in the interests of consumers).

In respect of establishing that compliance with the existing rules would be unduly burdensome, the FCA states that it would consider granting a modification where a firm could argue that closing the fund to new business and going into run-off due to the rules would be unduly burdensome. This also supports the FCA's objective of promoting effective competition by avoiding a reduction in the number of mutuals in which consumers can elect to invest.

Whilst the FCA does not provide detailed consideration of how to establish that compliance with the unmodified rules would not achieve the purpose for which the rules were made, we consider that this could possibly be achieved by a similar argument to that suggested by the FCA above, i.e. that the rules are driving the firm towards run-off and that this is not the objective of the rules.

The FCA is clearly comfortable that the new guidance will promote effective competition in the interests of consumers, as the justifications in PS14/5 regularly return to this as being a major driver of the changes. The FCA goes as far as to say that "the retention of the [with-profit policyholders'] vote is difficult to justify in light of our competition duty". The FCA appears therefore to require firms to demonstrate that a failure to modify the rules will result in a reduction of competition in the provision of the products and services of the type provided by the mutual and that this will be contrary to the interests of all consumers.

The FCA application process

A further statutory test imposed by s.148 FSMA, and which the FCA alludes to throughout PS14/5, is the requirement that the modification does not result in undue risk to the persons whose interests the rules are intended to protect. The application process implemented by the new guidance has been designed to establish whether the modification would adversely affect the FCA's consumer protection objective.

Under the new guidance implemented by PS14/5, in addition to satisfying the statutory tests set out above, an applicant mutual must satisfy the FCA of at least the following:

  • demonstrate (including by consideration of the point by the independent expert) that the division of the common fund does not amount to a reattribution (as defined in the FCA Handbook);
  • demonstrate that the proposal is fair to with-profits policyholders and other policyholders;
  • obtain a report from an independent expert (such expert to be approved by, and be instructed on terms of reference approved by, the FCA) on the fairness of the proposal to with-profits and other policyholders;
  • demonstrate the with-profits and other policyholders have been appropriately engaged in and informed of the proposal;
  • demonstrate compliance with its constitutional documents;
  • demonstrate the existence of a convincing and robust business case for continuing in business as opposed to entering run-off;
  • demonstrate how continuing membership rights will benefit with-profits and other policyholders;
  • explain the nature and extent of any continuing support of the with-profits fund from outside such fund;
  • demonstrate that its with-profits policyholders will not be at a disadvantage compared to equivalent with-profits policyholders in a proprietary fund; and
  • explain how any compensation or redress will be payable to any policyholder or former policyholder.

The FCA acknowledges that the result of dividing a common fund is likely to be a reduced fund from which the with-profits policyholders are entitled to benefit and that therefore such an outcome is open to challenge from a customer fairness perspective. The application process described above is intended to ensure successful firms have clearly weighed up the rights and interests of their policyholders and members. The FCA also believes that any with-profits committee or equivalent would have a key role in agreeing the fairness of any proposals to split the common fund.  

The FCA considered responses to its consultation that objected, on such fairness grounds, to removing the requirement to obtain a with-profits policyholder vote on the new business arrangements. The FCA consider the right of veto afforded to the with-profits policyholders must be weighed against its other regulatory objectives and were concerned that the previous rules permitted such a veto even when a division of funds had been assessed as fair by an independent expert and the FCA and PRA. In such circumstances, the FCA considered that its duty to promote effective competition in the interests of consumers was best served by creating a mechanism for denying a right of veto to a specific group of policyholders.

In further guidance to be implemented by PS14/5, the FCA requires that, where the independent expert is valuing the rights and interests of with-profits policyholders, it also takes into account alternative methods of valuing such rights and interests which may be more favourable to the policyholders than the mutual's own analysis. Further, the FCA suggests that the independent expert seek independent legal advice in the event of any uncertainty in this regard.

These requirements reflect the FCA's concern regarding the lack of legal certainty in measuring with-profits policyholders' and members' rights and interests in a common fund. The FCA has set out its understanding of the legal position in an Annex to PS14/5. The main objective of this legal opinion appears to be to clarify and consolidate the FCA's opinion on the matter, further to the earlier publication by the FSA of several "Dear CEO" letters and other publications which attempted to cover the same issue.

The FCA clarifies in PS14/5 that a court may interpret the law differently to the FCA and that therefore the change introduced is subject to legal challenge. The FCA appears to seek to avoid such legal challenges by suggesting dissatisfied with-profits policyholders and the firms reach an agreement outside of the court process.

PRA - Supervisory Statement SS1/14

The changes introduced in PS14/5 also impact on the PRA Handbook and, as a result, the PRA has issued a parallel statement on its policy and requirements for mutuals and friendly societies seeking a waiver from the COBS 20 rules to permit a division of a common fund into separate with-profits and mutual members' funds.

The PRA's statement focuses on the PRA's objectives and responsibilities and how it will approach applications for these waivers. Particularly prevalent in this paper is the PRA's desire to advance its objective of discharging its functions in a way that facilities competition. The PRA is making a clear effort to increase or at least maintain the current level of the range of products on offer from mutuals which is to be welcomed.       

In its statement, the PRA recognised the same strategic imperatives that the industry had raised in Project Chrysalis, i.e. that the rules were too prescriptive and ran the risk of these firms having to completely close to new business and go into run-off. Thus, the PRA has built on the proposals from the FSA to allow a common fund to be split following a successful application for a waiver under section 148 of FSMA.   

The PRA application process

The PRA's statement sets out the process for applying for such a waiver. Firstly, the application must state the rules which the firm wishes to be disapplied to the members' fund.  Secondly, the regulators will both look to see that the application meets the statutory tests in FSMA. Reflecting the duty on both regulators to cooperate, the PRA has agreed that the FCA will be the regulator to agree the choice of independent expert (IE) and the terms of the IE's appointment (in consultation with the PRA).  In view of the FCA's role early in the process concerning the appointment of the IE, the PRA has agreed that it is appropriate for the application and all supporting documentation to be sent to the FCA first and the FCA will send relevant information to the PRA. If satisfied of compliance with the statutory tests in FSMA, each regulator will give its approval in a joint waiver direction.       

The PRA has provided guidance on the supporting evidence it will require before approving a waiver of the with-profits rules in respect of a mutual members' fund. In addition to meeting the statutory tests described above, the application should include:

  • a medium term business plan (including credible estimates on new business volumes and profitability);
  • evidence on how the new business written in the new fund will adequately provide for the risks of that business (noting that the COBS 20 rules will limit the extent to which the with-profits fund can be used to support such risks);
  • evidence on the sustainability of the new products (demonstrating that the business plan will be based on existing products and on those which the firm has adequate knowledge and expertise);
  • projected capital requirements for the whole firm and the quality of capital that will meet such requirements; and
  • evidence on how any distributions in respect of members' rights will affect the firm's financial and capital position.

The PRA recognises that not all firms will be able to provide such evidence and in that case, the best outcome might be to go into run-off.

The PRA will aim to consider applications as quickly as possible but, given that the applications will amount to a considerable submission, firms should plan for a long-term project. This also reflects the importance that the decision is likely to be permanent and difficult, but not impossible, to reverse. The PRA therefore accepts that the duration of the waiver should be for as long as there is with-profits business but does so whilst reserving its right to revoke a waiver or to agree a shorter period if that is more appropriate. Also, the PRA warns firms that performance will be monitored on an ongoing basis following any grant of a waiver, and that the power to revoke the waiver will be employed should the firm fail to meet the statutory tests or the waiver is not appropriate for other reasons, such as failing to meet the new business plan targets or adversely affecting the PRA's objectives.

Solvency II

The PRA also provides guidance on the expected impact of Solvency II on the division of funds. The PRA does not expect the division of common funds into a with-profits and mutual members' fund will breach the ring-fenced fund requirements under the Solvency II regime. Rather, the PRA expects that the with-profits funds will be treated as a ring-fenced fund and the restrictions placed on such funds (i.e. that the ring-fenced fund will not be used to support risks elsewhere in the business including the members' fund) reflects the COBS 20 rules on with-profits funds. Whether a members' fund is treated as a ring-fenced fund will depend on the extent to which it is restricted and therefore have a reduced capacity to absorb losses on a going concern basis due to a lack of transferability within a firm. If not restricted, the members' fund should not be treated as a ring-fenced fund.

Conclusion

It has been generally agreed by regulators and respondents that an important starting point in establishing the nature and extent of stakeholders' interests in a with-profits fund is for the mutual firm to take their own legal advice to ensure that their proposal is appropriate and legally defensible in the context of their circumstances. Pinsent Masons, as a member of the Association of Financial Mutuals and having advised a number of mutuals about the rights and interests of their with-profits policyholders and members in the assets in their common fund, is well placed to help mutuals seeking to take the first step along the road to establishing a members' fund.

Contact: Bruno Geiringer