Two of the fundamental principles on which life products are based will be overhauled when the FSA reviews with-profits.
The regulator will look at the concepts of policyholders' reasonable expectations and financial strength as it moves to address some of the bigger financial services issues to hit the headlines over the last year.
The definition of policyholders' reasonable expectations was at the centre of the case brought by the Consumers' Association on behalf of policyholders against Axa over the distribution of orphan assets. It is also key to the debate over cross-subsidisation under with-profits stakeholder pensions.
The regulator's failure to monitor financial strength properly is widely seen as having allowed the Equitable Life debacle to get out of hand.
Speaking at the Money Marketing IFA UK conference in London earlier this month, FSA head of department in the investment business division (PIA firms) John Liver said the FSA sees the need for greater definition of the meaning of policyholders' reasonable expectations.
He said: “We will review with-profits but we are not saying with-profits has no place. We see smoothing having a place in the future.”
The FSA inquiry will look at the exercising of discretion over policyholders' reasonable expectations, the transparency of that discretion and the clarity of what information consumers receive.
Punter Southall principal Stephen Leake says: “With Equitable, they created subdivisions of expectations. People should know what an insurance company's policy on setting bonuses actually is. If there was greater transparency around how bonuses were actually arrived at, then it would take some of the mystique out of the situation.”
The issue of the subdivision of policyholders and their expectations resurfaced again last week when barristers appointed by Equitable reported that non-guaranteed annuity policyholders could pursue their own legal remedies to challenge the interests of guaranteed annuity policyholders. It is hoped greater clarification of these core definitions will reduce the potential for litigation in the future.
CA senior policy adviser Mick McAteer points out that one of the key weaknesses the association has identified is that it is up to actuaries and the boards of life companies to decide what policyholders' reasonable expectations are.
He says: “It has never actually been defined in law. No precedents have been built up, which has allowed actuaries to interpret it as they wish.”
The whole area is not so much a legal minefield as a vacuum. The FSA admits that the term policyholders' reasonable expectations is not defined even though it appears in present legislation.
Axa media relations manager Phil Hickley says: “If you ask 10 different actuaries, you will get 10 different answers.”
The FSA says it is asking itself two questions: “First, to what extent has the fact we have not had a definition of policyholders' reasonable expectations added to the problems with with-profits. Second, how could greater clarity be brought about and what factors should be taken into account?” The CA wants to see greater guidance from the FSA on these issues so consumers can make a more informed choice about where they are putting their money and what they can expect to receive in the future.
Review-weary IFAs are generally welcoming this element of the investigation as clarification of how products work will make their lives easier. The issue is still at consultation stage, with an open meeting at the FSA fixed for June 18 when industry and consumer representatives can offer their views.
The with-profits review also aims to deal with the issue of the supervision of financial strength following criticism of the FSA and the regulators that preceded it for their role in monitoring whether Equitable was financially strong enough to meet its liabilities.
Johnston Financial Services director Adrian Johnston says most IFAs do not have time to look at life company returns and make their own conclusions about financial strength. “With-profits is a murky business but, if the FSA can come up with a useful system for determining financial strength, I would be delighted,” he says.
Liver believes important lessons need to be learned and points out that the system in place for insurance companies is not as sophisticated as that for banks.
Whether the systems for supervising banks and life companies can ever be truly compared is debatable. The nature of their business and the level to which the consumer engages in the performance of the institutions is different. But Liver's comments indicate the direction the FSA wants to regulation to move.
The CA is frustrated, however, that any reforms will be limited because the FSA is reluctant to hand over information it has gathered on regulated companies. McAteer says: “Regulators do not publish material that is commercially sensitive. Even when it is in the public interest, the law prevents them from doing so. We do not see any sign of change in that regard.”
Instituting a new regulatory system in the tangled world of with-profits is certainly a difficult task and a lengthy public debate seems inevitable. The FSA is predicting next spring as the earliest the industry will see substantial changes to the regulatory framework but it says it will require plainer language to be used in consumer documentation before then.
But the tone the FSA seems to be adopting points towards some place for with-profits in the future or at least some product using the same smoothing features.
Whatever changes are made, restoring consumer confidence in the product will require greater scrutiny and greater transparency.