The UK has the largest insurance industry in Europe and the third-largest in the world. More than 400bn [pounds sterling] is invested in with-profits life insurance. In 2001 the newly established Financial Services Authority (FSA) undertook a wide-ranging review of insurance regulation in the UK. It recognised that the controls were weak and set out plans to strengthen them. The key event that triggered the FSA's actions was the crisis at the Equitable Life Assurance Society in 2000 after a House of Lords judgment ruled that its bonus policy was illegal, creating a significant additional liability for the society. Equitable put itself up for sale and, when no buyer was found, it stopped taking new business.
The Equitable affair led to a number of high-level investigations that identified actuarial issues of particular concern, including the high levels of discretion retained by insurers over investments, bonuses and smoothing. To address these issues, the FSA introduced a requirement for all firms operating with-profits funds to publish principles and practices of financial management (PPFMs). Insurers are now required to manage with-profits funds in accordance with the PPFMs and confirm annually in a formal report to policyholders that they have done so. In addition, there must be an element of independent judgment in confirming their compliance. Often this is provided by a "with-profits committee" of non-executive directors or independent members.
The FSA requires firms to give information on the following topics in their PPFMs:
* Amounts payable.
* The investment strategy.
* Business risks.
* Charges and expenses.
* Arrangements of the "inherited estate".
* Equity between with-profits policyholders and shareholders.
Our CIMA-sponsored study explored how PPFMs were being used both internally in firms and externally by consumers, policyholders, independent financial advisers, auditors and the FSA. We also investigated how they were being used for benchmarking.
The research involved reviewing the PPFMs and governance arrangements of mutual, proprietary and conglomerate UK life insurers. We also interviewed actuaries, accountants and other stakeholders.
Our main finding was that PPFMs--and the later, more "consumer friendly" PPFMs--were of little or no use to consumers, policyholders and independent financial advisers. This was the opposite of what the FSA had intended.
Our findings with regard to three aspects of running with-profits funds--internal management, external governance and benchmarking--were as follows.
An important concern emerging from our study was the independence of members of with-profits committees. For example, one insurer's with-profits committee included executive directors at group level as non-executives of the insurance subsidiary. It can be argued that only genuinely independent members without any other connection to the firm are able to safeguard the interests of with-profits policyholders properly.
Our interviewees agreed that PPFMs had made a big contribution to improving internal governance. This was achieved initially by the practical step of writing everything down and consolidating it in a single publication. For those respondents who were involved in fund management, PPFMs were vital documents to which they referred regularly.
Other benefits included the insurers' implementation of new management information systems to monitor and report on compliance with PPFMs. The new with-profits committees also challenged actuaries to communicate complex mathematical issues in a meaningful way to board and committee members without actuarial experience.
We found that there was no common approach to directorial "sign-offs". Some PPFM reports had no signatures, while others had a range of signatures or a statement of collective approval by the board.
There were variations with regard to the basis for the board's opinion on compliance with PPFMs, too. For example, some reports were structured using terms related to FSA governance themes and some used terms more closely related to those used in policy contracts, while others were structured in a "frequently asked questions" format.
Overall, our interviewees agreed that PPFMs were of little use to consumers, and that the wording and format of board statements and with-profits actuaries' reports could usefully be standardised. But the consensus was that they provided real benefits to policyholders because of the internal governance response by firms to the external compliance requirements.
Our auditor interviewees pointed out that PPFMs were an important tool in reviewing the "realistic" balance-sheet approach to the preparation of the statutory accounts. PPFMs also form part of the information used by the FSA to supervise insurers.
We were surprised to find that PPFMs were not being benchmarked either by the firms themselves or by stakeholders such as independent financial advisers or the FSA. This represents a missed opportunity to gather important comparative information. A big benefit of benchmarking PPFMs would be to identify and disseminate best practice. It also represents a missed opportunity for management accountants--a source of benchmarking expertise--to get involved.
Despite these disappointing findings, our accountant interviewees generally believed that the implementation of PPFMs had led to improved decision-making and accountability because they had introduced new internal governance mechanisms, such as with-profits committees.
PPFMs and related reforms to the governance framework of with-profits funds represent a significant innovation by the FSA to protect the interests of with-profits policyholders. With the regulation of financial services firms being called into question as a result of the credit crunch, PPFMs have undoubtedly contributed to an improvement in the governance of with-profits funds.
Although we found that PPFMs weren't used routinely for benchmarking, the practice would probably benefit firms, consumers, policyholders, independent financial advisers, auditors and the FSA. If a PPFM benchmarking exercise were to be conducted by the with-profits industry, it could be seen as making a positive contribution to the FSA's "Treating customers fairly" initiative by providing consumers and policyholders with new and useful comparative information. Benchmarking data may also encourage firms to adopt best practice.
Our interviewees identified other factors contributing to the improved governance of with-profits funds. These included:
* Making insurers' boards collectively responsible for their decisions.
* The introduction of "realistic" reporting.
* An emphasis on independent reviews.
* The application of business rules.
* An emphasis on corporate governance for firms generally.
PPFMs may not be useful to policyholders in the ways that the FSA had originally envisaged, but their real benefit is improved internal governance. Indeed, such a framework might benefit other industries and sectors that are subject to a high degree of public interest by, say, requiring the provision of information and the application of independent judgment to safeguard the interests of key long-term stakeholders.
The objectives of PPFMs
According to the Financial Services Authority, the PPFMs system is intended to achieve the following three goals:
* To secure an appropriate degree of protection for actual and potential with-profits policyholders by requiring firms to define and make available their principles and practices of financial management.
* To strengthen the governance of with-profits business by requiring insurers to manage their with-profits business in line with the principles and practices defined in their PPFMs.
* To make the management of with-profits business more transparent, thereby enabling actual and potential with-profits policyholders, through their advisers, to have a better understanding of the way in which funds are managed.
The researchers' recommendations
* More attention needs to be paid to ensuring the independence of with-profits committee members possibly by making them subject to election by policyholders.
* The diversity of PPFMs and associated documentation should be reduced and standardised.
* The benchmarking of PPFMs would clarify individual firms' arrangements for ensuring independence in their with-profits governance structures.
* A review of cost allocation practices in with-profits funds to identify best practice would be a useful and informative exercise.
Ian Dewing and Peter Russell are senior lecturers in accounting at Norwich Business School.…