AFM Response to CP11/5, Treating With-Profits Policyholders Fairly

AFM Response to CP11/5, treating with-profits policyholders fairly

About the Association of Financial Mutuals

The Association of Financial Mutuals (AFM) was established on 1 January 2010, as a result of a merger between the Association of Mutual Insurers and the Association of Friendly Societies. Financial Mutuals are member-owned organisations, and the nature of their ownership, and the consequently lower prices, higher returns or better service that typically result, make mutuals accessible and attractive to consumers.

AFM currently has 57 members and represents mutual insurers and friendly societies in the UK. Between them, these organisations manage the savings, protection and healthcare needs of 20 million people, and have total funds under management of over £80 billion.

Within the with-profits sector mutuals are particularly well-represented in areas such as regular savings and annuity payments. As such, the mutual sector continues to believe that with-profits products fulfill an important role for many consumers, and many of our members, large and small, remain committed to it being a core product.

Executive Summary

This paper has been written by the Association of Financial Mutuals and its members in response to FSA consultation CP11/05. We have also explored at length the issues raised in the previous Dear CEO letters to mutuals, on which we had previously not been invited to provide an industry viewpoint.

Over 25 million people hold a with-profits policy, and despite a downturn in sales the product still represents a quarter of all assets held in the UK life insurance sector. Many consumers are attracted to the product, and over half of all AFM members have a significant holding of with-profits.

FSA’s approach to fairness in a mutual with a with-profits fund is shaped almost entirely by its views on protecting the interests of the current generation of with-profits policyholders. The original legal advice on which FSA framed its position has been largely discredited, not least by FSA itself. Yet despite this and a profusion of contrary legal opinion from the industry, FSA has not agreed to an independent review of the legal opinions. Indeed rather than show itself to be fair and even-handed, FSA has adopted an uncompromising approach and, whether intentionally or not has misinformed MPs, misrepresented the industry position, and demonstrated insensitive handling by some supervisors.

In a mutual, the common fund, which is labelled as a with-profits fund under the Glossary definition, fulfils the role of the with-profits fund in a proprietary company and the role of the proprietary company's shareholders' fund.At the heart of our concerns is an attempt to force the proprietary business model onto the mutual sector. FSA has sought to do this by proposing to extend the rights of with-profits policyholders at the expense of all other policyholders and members, in a way that goes beyond its legislative powers and such that many mutuals will become impossible to manage.

A survey by AFM demonstrates that the sector strongly believes FSA’s approach will have a significant effect on many mutuals’ ability to run their business for the good of all policyholders, and that it is already having a significant impact on strategic decision-making and product development.

As a sector, we continue to believe that there is scope for a workable solution. So as well as responding to the issues raised by FSA in the consultation, we have also set out some proposals for a sustainable with-profits mutual sector, and we urge FSA to engage on this in a constructive manner.

Answers to specific questions

Q1: Do you agree with the proposal to include guidance setting out our view of some of the interests of policyholders in with-profits funds?

In principle we believe it would be helpful to include guidance setting out the FSA’s views on the interests of with-profits policyholders in with-profits funds. However, in the case of mutuals, it seems to us manifestly clear that those interests cannot be determined by considering the position of with-profits policyholders alone. It is common ground that other stakeholders also have an interest in the common fund of a mutual insurer and in its with-profits fund (although we would emphasise that we do not accept that the with-profits fund should be treated as being identical to the common fund except in rare cases); in order to determine what the interests of the with-profits policyholders are, it is essential also to consider what the interests of other stakeholders are - unless such a balancing exercise is carried out, the conclusion may well be advantageous to with-profits policyholders, but is unlikely to be "fair" in any meaningful sense of that word.

It also seems to us manifestly clear that any guidance on the interests of with-profits policyholders in with-profits funds which is included in the FSA's Handbook must be based on a settled legal determination of what those interests are. It seems to us to be inappropriate to justify them on the premise that there is "no universally-accepted legal analysis which [the FSA's] rules ignore" as set out in the letter from the Chief Executive of the FSA to Jonathan Evans MP of 17 February 2011. As far as the AFM's research has revealed, there appears to be a great deal of consistency between the legal analyses which the AFM itself and many of its members have received, and which disagree with the legal analysis on which the FSA's two Dear CEO letters were based. Indeed the March 2011 statement of legal advice itself accepted the original advice was wrong. Similarly the ruling in the Aviva reattribution appears in part to take a different view on the interests of with-profits policyholders[1].

In order to resolve this, the AFM would be willing to join with the FSA in seeking a ruling of the Court to confirm the legal position on this point.

Q2: Do you agree with our proposal to convert elements of COBS 20.2.1G into mandatory requirements in a rule and to clarify the types of conflicts that may arise?

We are disturbed at the FSA's emphasis in paragraph 2.7 of CP11/5 in which it states that one of the central aims of COBS20 is to ensure that conflicts of interest are settled in ways that are fair to with-profits policyholders: as stated above, the rules and guidance need to be fair to all parties and cannot be "fair" in any meaningful sense if their fairness is assessed by reference only to one group of parties. Similarly, in paragraph 2.9 the aim should be to ensure that any conflicts do not lead to the unfair treatment of any group of stakeholders, not just to the group of with-profits policyholders (or any sub-groups of them).

FSA’s approach to exploring conflicts of interest in with profits is defined “by virtue of its nature and the extent of discretion applied by firms in its operation” (COBS 20.2.1G). FSA is right therefore to highlight that there is a series of possible conflicts of interest, and the same could be said of any financial product. We question therefore whether it is right to single out with-profits as needing further definition, as this could potentially conflict with FSA’s principles of good regulation, on the grounds of competition and efficiency.

That said, subject to those very important qualifications, we would welcome the conversion of COBS 20.2.1G into mandatory requirements in a rule. We believe though that greater clarity is needed in relation to the status of non-Directive friendly societies, which are not currently exempt from COBS 20.2, but are exempt from COBS 20.3.2 which covers governance arrangements now, but which FSA intends to delete. Similarly, Holloway providers are exempt from COBS 20 in its entirety.

Q3: Do you agree with our proposed approach to the use of COBS 20.2.17R and to the clarifying amendments to the definition of ‘required percentage’ that we propose to make? Do you consider the guidance that we propose to make in this area to be adequate and clear?

It will be apparent from sections A to D of this response that we disagree with much of the analysis set out in paragraphs 2.10 to 2.32 of CP11/5. In particular, it ignores the different roles played by the common fund in a mutual insurer and the with-profits fund in a proprietary insurer. We do not dispute that the effect of the definition of a "with-profits fund" in the FSA's Glossary is to treat the two as being the same but we reiterate our view that this is wrong and that, as a result, the proposals in CP11/5 benefit the current generation of with-profits policyholders and disadvantage all other customers of the mutual. The with-profits fund of a proprietary insurer clearly has a different economic functionfrom the common fund in a mutual and treating them as if they were the same (as the proposals in CP11/5 effectively do) will result not only in the demise of the mutual sector but also in the unfair treatment of all stakeholders in a mutual insurer in contravention of the FSA's statutory objective to act in a way which is compatible with the protection of all customers, including both current and potential policyholders.

Paragraph 2.18 suggests that the inter-generational transfer would not apply for the future where there is no succeeding generation of with-profits policyholder. This places the entire future of with-profits mutuals in the hands of existing policyholders, and a product which for many companies has seen a significant decline in recent years.

As we point out in paragraph A.25 above, legislation imposed on mutuals requires Directors to consider the interests of the company as a whole, including future members. Whilst the paper refers to the interests of future members (proposed rules 20.2.28 and 20.2.29) there is general a disproportionate bias towards the interests of the current generation of with-profits policyholders[2].

It is clearly wrong to suggest, as in paragraph 2.20 of CP11/5, that the way of resolving this is for the mutual to "make proposals to its with-profits policyholders for continuing to write non-profit business without realising the economic value for the benefit of the with-profits policyholders, thus creating a reserve of mutual capital over time". The demands of "fairness" require that the mutual capital held by mutual insurers is recognised now rather than starting at some future point to build it up from scratch and there can be no justification for giving with-profits policyholders- as one of the groups of stakeholders in the mutual- a right of veto over these arrangements: with-profits policyholders have no duty to act fairly or to consider the interests of their fellow stakeholders in the mutual and it is to be expected that they would ordinarily exercise their right of veto to prevent mutual capital in the firm being recognised and to crystallise a windfall gain for themselves.

We also challenge the assertion in paragraph 2.26 of CP11/5 that where mutually owned firms have made distributions to with-profits policyholders from their with-profits fund they have done so consistently on a 100% basis. "Project Chrysalis" revealed a practice among mutual insurers of distributing part of their surplus to with-profits policyholders and reserving part of the surplus for the benefit of members as a whole (sometimes to add to the mutual's working capital, sometimes to fund member benefits or to carry on social and benevolent activities for the benefit either of members or of a wider constituency of beneficiaries). If the FSA looks only to the part that is actually distributed, then of course 100% would usually go to the with-profits policyholders but that is not the whole picture and logically the FSA cannot conclude from this that with-profits policyholders have a reasonable expectation of ultimately receiving 100% of the whole surplus.

Similarly, the FSA makes the point in paragraph 2.27 of CP11/5 that with-profits policyholders in a mutual would not expect to be treated less favourably than their counterparts in a proprietary company. We do not believe they would be if mutual capital were recognised: this comes back to the different functions of the with-profits fund in a mutual and a proprietary company and to the definition of the term "with-profits fund".

FSA might usefully reinforce the significance of future membership in guidance, to explain the nature of the considerations and to clarify, in the case of a mutual, that future members may include those who are not with-profits members. The concept of intergenerational transfer of surplus remains important to support the needs of that future wider member group. As a minimum, Directors are likely to be challenged if they seek to restrict future membership as a consequence of these proposals to solely with profits product holders. FSA rules also need to acknowledge that, in mutuals, membership can be conferred by different criteria and not exclusively through holding a with-profits product.

As yet unpublished research by Chris O’Brien of Nottingham University Business Schools’ Centre for Risk and Insurance Studies confirms that in the early days of mutuals in the late 18th and 19th century, “while policyholders strove hard to ensure they received a fair deal, they also appreciated that the firm was an ongoing entity, with an expectation that new policyholders would join the fund. In other words, there was an expectation that it was right that an appropriate amount of surplus be carried forward in order to maintain the solvency of the firm for the foreseeable future and to enable it to attract new customers on satisfactory terms. Such an acceptance did not extend to existing policyholders agreeing that there should be "excess surplus". However, it did imply that existing policyholders could accept some appropriate level of surplus being retained in the fund for the successful continuation of the entity.” This is clear evidence that the approach pre-dates the development of with-profits in the twentieth century.

In a mutual, the common fund, which is labelled as a with-profits fund under the Glossary definition, fulfils the role of the with-profits fund in a proprietary company and the role of the proprietary company's shareholders' fund. Therefore, the fact that a with-profits policyholder in a proprietary company can expect to get 90% of the distributed surplus on his company's with-profits fund does notlogically lead to the conclusionthat a with-profits policyholder in a mutual should expect to get 90% of the whole of the surplus on the common fund, only that he should get 90% of the surplus on that part of the common fund which equates to the proprietary company's with-profits fund.

Conversely, the with-profits policyholder in a proprietary company is not ultimately entitled to 90% of the aggregate amount in the with-profits fund and the shareholders' fund and neither is it necessary, in order that his counterpart in a mutual should not be materially worse off, that the mutual with-profits policyholder should expect to be ultimately entitled to at least 90% of the whole common fund.

That said, we do welcome the FSA's proposal to recognise the concept of "established practice" in COBS 20.2.17A. However, the proposal in COBS 20.2.17A that established practice should only be recognised if it has been communicated to with-profits policyholders in a "clear, timely and unambiguous manner" is, in our view, entirely unreasonable as it effectively means that established and consistent practice over a significant period maynever be taken into account. Precisely because the established practice of a particular organisation is the established and accepted norm, it may not have been communicated in such a manner either to with-profits policyholders or to other stakeholders. However, that does not mean that it would be "fair" to disregard established practice; on the contrary to ignore it simply because it has not been communicated to one group of stakeholders (which is the effect of the FSA's proposals as drafted) would make it more likely that outcomes were unfair.

Proposed text COBS 20.2.17A (3) (a) links established practice to a firm’s PPFM (Principles and Practices in Financial Management). As a significant proportion of AFM members are exempt from producing a PPFM (non-Directive friendly societies and Holloway societies in particular), the wording of this and related paragraphs will need revision.

Q4: Do you agree with our proposal to strengthen our rule and guidance on the terms of new business written into a with-profits fund?

We agree that where a firm writes new business into a with-profits fund, it should have regard to the profitability of that new business. We consider that the current rule, COBS 20.2.28R, provides clarity on this, and do not feel a stronger rule is justified. Indeed, FSA has stated in its risk outlook this year that FSA is pursuing enforcement action against two with-profits providers on this basis.

The proposed new text for COBS 20.2.28R and COBS 20.2.29 is likely to make it very difficult, if not impossible, for the Board of a mutual organisation to have confidence they can discharge their duties effectively as well as write any new business:

COBS 20.2.28R means that a business plan would need to be presented to the with-profits committee, or equivalent, for new business written into the fund, and given FSA’s assertion that the with-profits policyholders have an interest in each and every part of the with-profits fund, the with-profits committee could veto any new business if they felt there was a threat to any aspect of the fund. As the single common fund is the only source of capital available to a mutual, the governing body is then entirely hostage to whether the with-profits committee, or individual equivalent, accepts their analysis;
The change to the wording in COBS 20.2.29, by removing the word “material” from “material adverse effect”, prevents the Board from making sensible and appropriate decisions for the long-term, either because there is a short-term likelihood of an adverse effect, or because any long-term investment needs to include a balance of risk and return;
Where historically the challenge was with regard to “no material detriment”, a shift to “no detriment” makes a significant impact: this suggests that the firm should avoid embarking on any new business which has any risk of downside outcomes, which is of course unrealistic. The perverse effect of the proposed rule and guidance changes will be to prevent any new business being written by mutuals, leading to their inevitable demise.

We are concerned that in this respect FSA is not only acting in a wholly unreasonable and discriminatory manner towards mutuals, but that it may also be operating outside the powers vested in it by FSMA, by enhancing the position of one particular cohort of policyholders to the detriment of all others. FSA has an obligation to protect all customers - not just existing with-profit policyholders. This proposed rule change (in common with several of the other proposed changes in CP11/5) will in fact advance the position of existing with-profits policyholders to the detriment not only of existing non-profit policyholders in a mutual, but also potential future without-profit policyholders. .