House of Commons - Treasury

Select Committee on Treasury Eighth Report

6 With-profits products

56. The ABI told us that "with-profits business makes up a substantial proportion of in-force policies. It has traditionally offered more cautious savers a way of investing in assets other than cash, without being exposed to the extremes of stock market volatility. Benefits are smoothed down in good years in order to boost returns in bad years."[162] With-profits products have nevertheless proved particularly problematic for investors in recent years. The major problems at Equitable Life, for example, focused on its with-profits fund. It is clear from the evidence we have heard in the course of this inquiry that consumer faith in with-profits products has been severely dented. The major insurance companies told us that the market share of with-profits products has fallen sharply.[163] The ABI told us with-profits funds had once been "the insurance industry's staple product"[164], but the companies giving us evidence told us with-profits now accounts for around 10%-15% of new business.[165] Not only have investment returns often been disappointing, many funds have closed to new business. The press has reported that £161 billion of savings is now in closed funds.[166] The ABI told us that there was currently a total of £365 billion[167] of with-profits policies in force, in a mixture of closed and open funds and the Chief Executive of the FSA confirmed to us that roughly half of all with-profits funds were now closed to new business.[168] Mr Tiner told us that when a fund closes to new business "it does not necessarily follow that policyholders are worse off but many of them are."[169]

Reform of with-profits funds & smoothed investment products

57. In recognition of the problems besetting the with-profits sector, the FSA has published proposed reforms for with-profits products in a consultation paper CP 207, commonly referred to as "Principles and Practices of Financial Management". In the course of our inquiry a variety of expert witnesses told us that these reforms were unlikely to be effective in providing reassurance to doubtful investors. Mr O'Brien of Nottingham University told us that CP 207 would help, but he felt that for most investors "with-profits will still be an act of faith and… you are not going to be able to understand exactly what has gone on."[170] The Committee also notes that Lord Penrose, in his report on Equitable Life, commented that "The proposals [CP207] lack definition and as currently framed appear to leave unanswered many of the issues that would inevitably have arisen in the [Equitable Life's] case… the present proposals do not equip the regulator to take effective action."[171] Lord Penrose also discussed the doubt that with-profits policies could exist without some degree of mystery, noting that "There is a view that with-profits cannot survive without mystery. But that cannot continue to provide an excuse for delay in the open provision of financial information."[172] Equally, however, several of the major product providers told us that fuller disclosure would make it difficult to operate a with-profits fund. Prudential told us "we strongly oppose proposals for disclosure of asset shares at an individual policyholder level, as this would allow informed policyholders to deal against the fund and thereby profit at the expense of other policyholders. We are also concerned that similar arbitrage opportunities would occur if pay-out values were applicable for a whole year."[173] Standard Life expressed similar concerns "that excessive limitation of companies' discretion may impair the performance of with-profits products, and that excessive disclosure may make the smoothing of returns to reduce volatility more difficult to achieve."[174]

58. Most of the major industry operators feel that the with-profits concept of a smoothed investment fund still has a valuable role to play. Aviva, for example, told us that the company saw "an important role for 'smoothed' investment type products going forward"[175] and Prudential[176] and Standard Life[177] expressed similar views. Equally, however, it is plain that a rapid return of public confidence in the with-profits model is unlikely without much greater transparency about the operation of smoothed investment products. The Government has thus announced that a "smoothed investment fund" option will be available within the Sandler suite of stakeholder products, with the "with-profits" nomenclature dropped as a potentially confusing piece of jargon.[178] The smoothed product will be distinguished by a separate smoothing account and improved transparency, but the fund will still be able, in "exceptional" circumstances, to introduce market value adjustment exit penalties,[179] a source of considerable policyholder dissatisfaction in with-profits funds in recent years. In addition savers will only see the difference between the smoothed value of their individual savings and its unsmoothed value on surrender, in order "to prevent selection against the fund."[180] It is evident that in many instances savers are no longer content to allow the managers of with-profits funds wide discretion or to accept limited disclosure of the performance of the funds on which their savings depend. Many investors also do not understand the reasons for apparently large market value adjustment (MVA) exit penalties and consider they are unfair. It is not clear from the evidence presented to our inquiry that either the FSA's proposed reforms for existing with-profits funds—CP207—or the proposed disclosure requirements in the new smoothed investment Sandler products go far enough in terms of disclosure to satisfy consumer concerns in this area. As long as investors cannot regularly see the performance of the underlying investment fund and can be subject to MVA exit penalties without clear explanation there may be consumer reluctance to re-enter this area of the long-term savings industry. Firms should be required to give a much clearer explanation of the scale of, and reasons for, any MVA exit penalty imposed.

Closed funds

59. In our report on endowment mortgages we concluded that the treatment of investors in closed funds was "unfair",[181] not least because on closure the investment characteristics of a fund often changed dramatically from those that pertained in the fund the saver originally bought. We urged the FSA to examine the case for allowing savers to transfer out of closed funds without attracting penalties. In its reply, the FSA told us that while it still saw difficulties in allowing individual transfers from closed funds without penalties, there was "scope for market-based solutions to address concerns about closed funds…. Chief amongst these is the sale of closed funds, effectively transferring a whole fund to another firm through a sale rather than on a policy by policy basis."[182] This would allow economies of scale[183] and Mr Tiner told us that he was hopeful that if the new managers of such funds "can inject new equity, it can provide the opportunity for the managers to have a balance of the portfolio which is relevant to the maturity of the fund."[184] Nevertheless there remains concerns, both because, as Mr Tiner confirmed, "we are going to see more funds closing probably over the next several years"[185] and because consumer understanding of the exit penalties applied to policyholders, particularly as funds close or change hands, remain poor. Mr Tiner agreed that the issue of fair exit terms was an area of concern and promised that the FSA would pay close attention to "the level of policing"[186] in this area. The FSA also stressed that there would be a "regulatory imperative for companies to treat their customers fairly"[187] in transactions involving the purchase of closed funds.

60. £160 billion is now invested in closed funds. This is an issue in that policyholders can often feel their savings are now trapped in policies offering lower prospects of growth. All the signs are that this problem will grow further in the future. The Committee recognises that a consolidation process among the many with-profits funds that have now closed to new business is both desirable and inevitable. It places the highest priority on the FSA ensuring that policyholders are treated satisfactorily through this process. They should not be confronted by punitive exit penalties and should receive a fair share of the efficiency benefits that will hopefully result from such transactions.

The role of actuaries

61. In the wake of Lord Penrose's report on events at Equitable Life the Treasury have asked Sir Derek Morris to conduct "a wide-ranging review of the actuarial profession."[188] At the same time the FSA has proposed sweeping changes to the role of actuaries within the regulatory regime. The regulator told us "from the end of 2004 the role of appointed actuary is to be replaced by two new advisory functions: the actuarial function (applicable to all life insurers); and the with-profits actuary function (only for firms carrying on with-profits business). Both will be controlled functions, whose holders will require prior approval from the FSA."[189] Given the current changes that are sweeping the with-profits sector, the precise role of the with-profits actuary is clearly of particular importance. The FSA told us: "The holder of the with-profits actuarial function will be responsible for advising the governing body on its use of discretion within its with-profits fund(s) as this relates to the fair treatment of policyholders. This is an area where there may be particular tensions between policyholder interests and those of management and any shareholders."[190] In our report on endowment mortgages, we agreed that there was an "urgent need for change" in the conduct of the actuarial profession and its role in the long-term savings industry; we added that we considered "it important that the FSA's proposed reforms of the actuarial process within insurance companies are effective in providing warnings and more proactive and independently minded actuarial advice"[191] than had been evident as the endowment mortgage problem unfolded through the 1980s and 1990s.

62. The Morris Review will hopefully ultimately deliver an actuarial profession "fit for purpose" in terms of giving the public the protection and reassurance it has a right to expect from the profession. The Review's consultation document observes: "The problems that arose with both endowment mortgages and pensions mis-selling highlight the issues around potential conflicts of interest and whether actuaries are primarily accountable to their client or employer or to policyholders, consumers, pension scheme members and the broader public interest. Other commentators have pointed to actuaries' role in designing unit-linked insurance policies as further evidence that actuaries' primary responsibility appears to have been towards maximising sales for their clients or employers rather than in delivering policies that are likely to meet policyholders' expectations."[192] Given the role actuaries have in ensuring the fair treatment of policyholders within with-profits funds, we are concerned that there is little evidence to date of the actuarial profession fully recognising wider responsibilities in this area. In evidence to us Mr Goford, the President of the Institute of Actuaries, reassured us that that "actuaries understand the mechanics of the insurance business. We know what is going on."[193] The profession's view of its role nevertheless still appears to be a relatively limited one. Mr Goford also told us "actuaries are advisers and it is the managers of insurance companies which do the execution."[194] It is still far from clear to the Committee that the actuarial profession can be relied on actively to alert the public in cases where policyholders' interests are being sacrificed in favour of the interests of management or shareholders. We welcome the Morris review of the actuarial profession and consider reform here to be overdue. Nevertheless, any recommendations made by Sir Derek are necessarily going to take some time to implement. In the meanwhile, a period of rapid change is taking place in the with-profits industry and many of the changes could lead to particular tensions between the interests of policyholders and the interests of managers and shareholders of with-profits funds. In the face of continuing doubts about the readiness of the actuarial profession to safeguard policyholders' interests through this period of change we consider it particularly important that the FSA scrutinises closely changes and transactions in the with-profits area and demonstrates to investors that their interests are being preserved.

162 HC 275, Ev 25 para 4.1 Back

163 Q 1705 Back

164 HC 275, Ev 10 para 1.10 Back

165 Qq 1702 and 1703 Back

166 Financial Times 26 May 2004, page 24 Back

167 HC 275, Ev 25 para 4.1 Back

168 Q 2062 Back

169 Q 2052 Back

170 Q 27 Back

171 Report of the Equitable Life Inquiry, led by the Rt Hon Lord Penrose (Penrose Report), HC (2003-04) 290, page 732, para 18 Back

172 ibid., page 737, para 41 Back

173 HC 275, Ev 173 para 51 Back