ABI RESPONSE TO FSA WITH-PROFITS REVIEW ISSUES PAPER NUMBER 5 - GOVERNANCE AND THE FUTURE ROLE OF THE APPOINTED ACTUARY INTRODUCTION AND SUMMARY 1 ABI supports the following options put forward for discussion in this

paper:

• Option 1: directors to define principles and practices of financial management.

• Option 3(b): with-profits committee as a sub-committee of the Board.

• Option B2: appointed actuary not to be chairman, CEO, finance

director, marketing or sales director, or to hold senior executive positions fulfilling similar functions.

• Option D1: the FSA to require appointed actuaries to carry out an

annual Financial Condition Report for all firms.

• Options E1: independent review of appointed actuary’s work by an actuary external to the firm and to the FSA.

2 We believe that this combination of changes to the governance of with-

profits and the role of the appointed actuary will provide with-profits policyholders with greater clarity and certainty that their interests are being properly represented and protected.

3 In particular, we believe that the governance of a with-profits fund can be

enhanced if the appointed actuary is also a Director. In carrying out his role in advising the Board on the interests and fair treatment of customers, the appointed actuary will have a significant day-to-day involvement in managing the interest of policyholders. It would strengthen the governance of a with-profits fund if the Board were able to discuss these issues with immediate access to the detailed knowledge and expertise provided by the appointed actuary. But as the appointed actuary has a professional responsibility to consider the interests of all the stakeholders in the fund, we do not believe that management of the conflicts between different groups of policyholders, or between policyholders and shareholders, is compromised if the appointed actuary is not a Director. We believe that companies should have the freedom to include the appointed actuary as a director if they wish.

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4 The cost benefit analysis for these options will be particularly important

for these changes, as there are ways they can be implemented giving policyholders this additional clarity and certainty with manageable costs. Other methods of implementation could present considerable threats to the future viability of the with-profits concept with no obvious benefit to policyholders.

5 In particular it is vital that the establishment of the With-Profits

Committee is carried out in such a way as to ensure that with-profits policyholders’ interests are fully taken into account by that group without compromising the authority of the board to manage the company’s affairs. We believe this is achievable by modelling the Committee on the Audit Committee concept and we put forward suggested terms of reference here, based on the specimen terms of reference for an audit committee put forward in an annex to the Cadbury Report.

6 This paper continues by answering the questions raised in the paper,

followed by Appendices covering (A) an assessment of each of the Options, with likely levels of costs indicated, (B) a copy of the Annex to the ABI response to the Sandler Review consultation paper, putting forward ideas for alternative governance structures (also submitted to FSA in response to the with-profits review Scope paper), and (C) draft terms of reference for the With-Profits Committee.

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QUESTIONS Part 1: Governance of with-profits funds Q1.1: Do you agree with the issues set out in paragraphs 26 to 37? Q1.2: Are there any other issues relating to the governance of with-profits funds that should be considered? We agree with the issues set out in the paragraphs 26 to 37 and have been unable to identify any other issues relating to the governance of with-profits funds that should be considered. However, some of the issues, eg asset mix, also apply to other types of pooled investment vehicles. Q1.3: Do you have any comments on the contextual points made in paragraph 40? No. Q1.4: Do you think one or more of the options set out in paragraphs 41 to 68 would strengthen the governance of with-profits funds? We believe that some of the options might strengthen the governance of with-profits funds. But in particular we believe that the introduction of some of these proposals will make it clear that with-profits funds are being governed fairly. Q1.5: If so, which options, or combination of options, would you favour, and why? We assess the options in turn in Appendix A. In summary, our preferred options are: Option 1: Directors to define principles and practices of financial management. We supported this option in our response to Issues Paper 4 on Discretion. Option 3(b): With-Profits Fund Committee as a sub-committee of the Board. We examined this option in our response to the FSA’s scope paper. Q1.6: What do you think would be the cost implications of the various options? Where possible, we have indicated the scale of the costs that might be involved against each option in Appendix A. Q1.7: If Option 1 were to be followed (principles and practices):

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i. Do you think there should be a published annual statement by the directors on how the fund has been managed in accordance with the principles and practices?

ii. What form should this take?

iii. Should the published annual statement by directors be subject to

audit? We agree that there should be a published annual statement confirming that the fund has been managed in accordance with the published principles and practices. It should be a short statement that could be included with the with-profits policyholders’ annual statement, the published report and accounts and viewed on the company’s website. It should also be included in the regulatory returns to the FSA. With-profits policyholders should be advised in pre-sale disclosure literature (where the principles and practices themselves will be disclosed, or made available) that this is the method for confirming compliance with any principles and practices. The annual statement of compliance should not be subject to audit in the same way as are the accounts. The statement should be signed on behalf of the Board on advice from the Appointed Actuary, and could be considered by the with-profits fund committee. The appointed actuary’s advice should be subject to external peer review. Q1.8: If Option 3 were followed (With-Profits Fund Committees): i. Which of the alternatives, 3(a) or 3(b) would you prefer, and why?

We prefer option 3(b) for the reasons set out in the appendix – principally to ensure that it is an influential committee reporting at a high level.

ii. Should the members of the With-Profits Fund Committee be appointed by the board? If not, who do you think should appoint the members?

The members of the Committee should be appointed by the Board, or by its holding company board if that is where decisions are made about the with-profits fund. It should have a similar status to the Audit Committee and should similarly comprise some or all of the non-executive directors of the company or holding company.

iii. Should the Appointed Actuary be a member of the With-Profits Fund Committee?

The Appointed Actuary should not be a member of the committee but should attend meetings and have a role in advising and assisting the committee. He should also of course retain his current role of reporting to and advising the Board.

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iv. What responsibilities should the With-Profits Fund Committee be given?

We agree with the point in the opening part of Paragraph 55 of the paper that the power and responsibilities of the With-Profits Fund Committee would need to be clearly defined, and support the idea of FSA model terms of reference. We believe the committee should be explicitly tasked to consider with-profits policyholders’ interests first. However, we do not agree with the suggested responsibility outlined in subsequent paragraphs 55 (a) and (b). We do not believe it is possible or appropriate for a committee of non-executives to advise the board on issues that affect the interests and fair treatment of policyholders, except from the position of lay people. To perform such functions would require a level of actuarial qualification unlikely to be found or desired in non-executives on life company boards. It also risks adding a third tier of management to that of the Appointed Actuary and the External Actuarial Reviewer.

We support the suggestions in paragraph 55 (b) (i), (c) and (d). We believe these better articulate the role for the committee – basically the right to be consulted on the specified decisions listed to be taken by the Board. Any advice, or view, given by the committee would be that of an informed layperson rather than of an actuary or other expert, although professional advice should be available to the committee.

v. Do you agree the With-Profits Fund Committee should report annually on the work of the committee and the compliance of the company with its stated principles and practices of financial management? How detailed do you think the report should be?

As mentioned in response to Question 1.7 we believe the company’s directors should issue a statement of compliance with the company’s principles and practices, after taking advice from the appointed actuary. This advice would be subject to peer review. The committee could be invited to express a view, although we believe this risks undermining the role of the peer reviewer.

The committee should write a short annual report of its work, to be included in the company’s report and accounts and its website. Annual policyholder communications could point with-profits policyholders to this report, which should be brief. We recognise that some policyholders would not have easy access to the appropriate report and accounts, for instance if they held a policy with a small, possibly closed-fund subsidiary, and it would be important for the signposting to the information to be clear.

vi. What constraints or limits, if any, should there be over the With-Profits Fund Committee’s access to information and professional advice?

There should be no restriction to the committee’s access to information and professional advice except in terms of cost. An annual budget should be set

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and agreed with the Board and not exceeded without prior Board approval. As the services of the Appointed Actuary and peer reviewer would be provided by the Board at little additional cost (if any) there should not be great need for the committee to commission additional external advice and costs should not be excessive.

vii. Do you think that there would be an adequate supply of appropriately qualified individuals who would be willing to serve as members of With-Profits Fund Committees? What type of skills do you think members would need to have?

This would rather depend on the exact role of the committee. If they were required to give advice we believe the supply could be poor in view of the exposure to liability. If the role were to be to take a lay view to act primarily in policyholders’ interests and if the members of this committee were to be appointed from amongst the company’s non-executive directors we believe there should be an adequate supply of suitable people. The committee should not be actuaries providing a second peer review of the Appointed Actuary.

viii. What do you think the minimum size of the With-Profits Fund Committee should be?

We support the suggestion in paragraph 59 of the paper that three would be a reasonable minimum for most funds. While two might be suitable for smaller funds we would consider that one would be inappropriate for any but the very smallest fund. Some companies may choose to have a larger committee. We also recommend there should be a quorum of two. We do not believe the Appointed Actuary should ever be a member of the committee.

ix. How do you think ‘independent’ should be defined?

We believe that the use of the company’s non-executive directors would give sufficient independence, perhaps subject to their not having been executive directors or employees of the company within the last two years.

x. Do you agree that the With-Profits Fund Committee would not be an appropriate body to take on the role of policyholder negotiator as described in the first Issues Paper on the process for dealing with attribution of inherited estates?

Yes. The policyholder negotiator would need to be a suitable professional, probably an actuary, whereas this is a lay committee. However, we can imagine a role for the committee in an attribution process, possibly the right to express a view which should be taken into account by the Board. But if the committee members are already Board members they will already have the right to be heard.

Q1.9: If Option 4 were to be followed (a general statutory duty on directors to have due regard to the interests of policyholders):

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i. What should its scope and purpose be?

ii. Should the duty apply to policyholders individually, or only as a class or group? Or both?

iii. What enforcement mechanism should there be?

iv. Given the requirements of the regulatory regime and powers of enforcement, how much value do you think a general statutory duty would add? Would it represent a proportional response to the problems identified?

The Issues Paper outlines the difficulties with this option and these questions throw these even more clearly into focus. We do not believe that this option adds value or is a proportionate response. Q1.10: Are there alternative approaches to improving governance that should be considered? If so, what are those alternatives? We have not been able to identify any alternative approaches. Part 2: Future Role of the Appointed Actuary Q2.1: Are there any further issues relating to the role of the appointed actuary that the FSA should be considering? We have not been able to identify any further issues. Q2.2: Would relying directly on the Board’s responsibility for ensuring that appropriate actuarial functions are carried out provide the best option for protecting consumers? What are the key arguments that support your view? The Board is currently responsible for ensuring that all functions within the company are appropriately carried out, whether by its own employees or by third party providers or outsourcers. However, this question suggests that the role of the actuarial function is to protect consumers. The role of the actuarial function is to manage the long-term development of the office. This is wider than just protecting consumers. It encompasses, as one aspect, achieving a fair balance. Where the function is to protect policyholders it is to protect all policyholders and to ensure that there is fairness to all cohorts and groups and all are treated fairly. To buy a with-profits policy is to take part in a joint venture – a pooled investment with others, with special characteristics of smoothing and protection. These elements generate their own issues of fairness, with conflicts between individuals and the group as a whole. If those elements were not wanted it would be more appropriate to invest in some other kind of investment vehicle.

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The actuarial function is one of the most important of all life insurance company functions, especially so for those companies with with-profit funds. This is usually demonstrated by the size of the actuarial team led by the appointed actuary and the level of qualification and professional supervision required of members of that team. If the Board cannot be responsible for ensuring that the actuarial function is appropriately carried out it cannot properly be responsible for managing an insurance company, especially under the new requirements of senior management responsibility. This is the case with or without the Appointed Actuary system Q2.3: If option A were to be adopted, should an actuarial function be introduced as a controlled function? Who should have the responsibility for monitoring the financial condition of the firm? Yes, and the head of the actuarial function should have responsibility for advising the Board on the financial condition of the firm. However, responsibility for monitoring the financial condition of the firm is the responsibility of the Board. Such an important function as the Head of the actuarial function might well command a seat on the Board and would be the appointed actuary under a new name. Q2.4: If option A were adopted, do you think that it is sufficiently clear that the responsibilities of the board are not diluted by the role of the appointed actuary? If not, what changes should be made? No. This is why we do not support his option. The sorts of changes that would be needed would effectively reintroduce the current appointed actuary regime, but with less individual responsibility. Q 2.5: Should a rule be introduced restricting the other positions an appointed actuary may fulfil? If so, which of the options B1 to B4 should be pursued? Should a different approach be adopted for different types of firm and, if so, what should be the criteria used? For the reasons given in Appendix A we support option B2. We can see that this has the potential of causing difficulty for smaller companies and it might be appropriate if the FSA were to introduce this as best practice rather than a rule, making exceptions as appropriate for smaller companies on examining individual circumstances and possibly obtaining suitable undertakings from their boards. Q 2.6: Should firms be left to make their own judgement on what role is appropriate for their appointed actuary? The appointed actuary is bound by professional rules and guidance as well as being answerable to the company and his own employer, if different. He also has responsibilities, eg whistle-blowing, to the FSA. If companies are to be able to manage their own business they must use their judgement on the appropriate role for their appointed actuary, beyond the constraints imposed by Option B2.

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Q 2.7: Should rules be introduced concerning appointed actuaries who are sole traders or who are in small partnerships? If so, what rule should apply? The circumstances outlined in paragraph 111 of the paper, whereby a sole trader external actuary relies heavily on one company for his income, is no different from a directly employed appointed actuary. We are unable to identify any reasons why any special considerations should apply in these circumstances. Obviously there would need to be adequate external peer review. There might be an issue of resources, eg he would have to rely on the company’s actuarial department for routine processing. Depending on the circumstances, this might not be a bad thing. Q 2.8: Should the FSA be considering other options? If so, what are they? We have not been able to identify any other options Q2.9: Should a rule be introduced prohibiting or restricting profit-related remuneration for appointed actuaries? Does your view on this issue depend on what is decided in relation to Options B1 to B4? For the reasons given against option B5 in Appendix A we do not believe this is appropriate. Q2.10: If you consider that a different approach should be taken, what approach do you favour? Appointed actuaries, and Boards, have to consider conflicting interests all the time, whether it is between shareholders and policyholders, different cohorts of policyholders or the company and its employees. It is not appropriate to try to eliminate all these sources of conflict, nor to seek to isolate the leader of the actuarial team by creating a separate remuneration structure that might have the effect of making the role unattractive. Q2.11: Should a rule or guidance be introduced on the number of appointed actuary appointments that can be held? No. Some groups contain several companies sharing one appointed actuary. It would be unnecessarily costly and administratively untidy to require different appointed actuaries, when there is common overall management of the companies and of the funds as well in many cases. It would also constitute professional misconduct for an actuary not to do his job adequately through taking on too many appointments. There is also often a substantial team supporting the appointed actuary in his work.

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Q2.12: Should a rule or guidance be introduced that a firm should satisfy it that an appointed actuary would be able to devote sufficient time and resources to his duties? No. For reasons set out in our assessment of this option in Appendix A. Q2.13: Do you consider that the FSA should require appointed actuaries to carry out an annual Financial Condition Report for all firms? Should disclosure to the FSA be automatic, or only at the request of the FSA? Do you consider that the report should be made public? We suggested this route in our response to the Regulatory Reporting Issues Paper. The FCR should be provided automatically to FSA but not made public as it will contain information confidential to the company. Q2.14: Would a requirement on appointed actuaries to provide an annual FCR assist senior management in its responsibilities for all aspects of risk management? There is little doubt that it would, although for many companies it would also be a considerable additional burden to prepare. It is important to avoid overlap with corporate governance aspects of risk review, which might not be carried out by an actuary. Q2.15: Are there alternatives to an annual FCR that should be considered? If so, what would you suggest? Are there circumstances in which an FCR should not be required and if so what are they? We have not been able to identify any such alternatives or circumstances. Q2.16: Which of options E1 to E4 is preferable? Should different elements of the scope of the independent review be split between options E1 to E4? For the reasons set out in Appendix A we favour option E1. We can see no merit in splitting elements of the peer review. Q2.17: What alternatives would you suggest? We support option E1. Q2.18: Should the scope of the review cover all aspects set out in paragraph 125? If not, how should the scope be amended? To what extent is the cost of independent review likely to vary depending on the scope of the review? The review should cover all mandatory aspects of the appointed actuary’s role, including:

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• valuation reports and regulatory returns; • the systems and controls to ensure adequacy of terms on which new

business is written; • systems and controls to monitor solvency; • bonus philosophy and distribution of surplus; • Financial Conditions Report; • Disclosure projections.

Paragraph 125(b) in particular is very wide and goes beyond the mandatory level. Paragraph 125 in general covers all actuarial advice given by the appointed actuary. Guidance notes issued by the actuarial profession, eg GNs 2, 8 and 22 are relevant here, although only GN8 is mandatory. Q2.19: What restrictions should there be on who could perform external reviews? The review should be carried out by someone at least qualified to be an appointed actuary himself. There would not be credibility in the process if this were not the case. The reviewer should be appointed by the Board, and possibly be subject to FSA approval. Q2.20: Should the independent reviewer have a maximum term of appointment? If so, how long should the maximum term be, and what constraints, if any, should be put on the replacement? We do not believe it is any more appropriate to limit the term of appointment than to limit the term of an auditor’s appointment, nor for there to be any constraints on replacements. But good auditing practice is to replace the audit partner regularly, and this could also be appropriate.

Q2.21: How frequently should a review be undertaken? Should this vary depending on the circumstances of the firm? What form should certification by the reviewer take? Should there be some form of public certificate? If not, in what form should the reviewer report to the regulator? The review should be annual for all companies. The form of certification shown in paragraph 127 has our support. The certificate should be sent to the regulator or included in the company’s report and accounts. Q2.22: To what extent should options A to E be applied to appropriate actuaries or syndicate actuaries? Do you have any other comments on the role of appropriate actuaries and syndicate actuaries? We do not have the experience to answer. Relevant organisations are not members of ABI.

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Q2.23: Are there particular links that should be made between the options set out for conflicts of interest, independent review etc? There could be advantages if the peer review is conducted by the actuarial teams of the firm conducting the audit, as they will have familiarity with the details of how the with-profits fund is managed. However, any potential conflicts of interest should be considered by the with-profits committee, as well as the firm that accepts the appointment as a peer reviewer.

Q2.24: How do the costs and benefits of the various alternatives compare? We have indicated possible levels of cost against each option in Appendix A. Q2.25: Are there any other points you would like to make regarding the issues raised over the future role of the appointed actuary? All points are covered in this response.

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APPENDIX A: GOVERNANCE PAPER – OPTIONS Governance Option 1: Directors to define principles and practices of financial management As outlined in detail in our response to Issues Paper 4 we support this option and look forward to working with FSA to develop its implementation in a practical, realistic and manageable way. Sensible implementation should lead to only moderate costs. Option 2: Policyholder Representation on Boards The paper clearly outlines the difficulties with this option, which does not have our support for those reasons. The cost would be high. We can imagine the election process alone costing in excess of £1 million per company. Option 3: With-Profits Fund Committee: Option 3(a): With-Profits Fund Committee constituted separately from the board For the reasons outlined in paragraph 50 of the paper we do not support this option. Direct costs would be modest, but potential costs of interference to the business could be high. Option 3(b): With-Profits Fund Committee as a sub-committee of the board This option establishes the committee in a similar manner and with similar status to the Audit Committee as an influential committee reporting to the Board. A committee without that link would have considerably less status and locus. The committee should report to either the life company board or the holding company board, depending on where the main decisions are made about the management of the with-profits funds, and should be appointed by that board. The board should not delegate its responsibility for treating customers fairly, and indeed cannot do so. However, a committee with explicit responsibility for reviewing the treatment of with-profits policyholders would contribute significantly to countering any potential for, or appearance of, unfair treatment of those policyholders. We believe the committee should be made up by some or all of the company’s non-executive directors, who will already have considerable knowledge of the company and access to information they may wish to see. They should disclose and record their own holdings of with-profits policies with the company to ensure that there is no risk of one or two cohorts of policyholders having excessive predominance.

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The appointed actuary should attend committee meetings to advise members, who should also have access to advice from the peer reviewer (although his reporting route is to the board and this committee should not undermine this relationship). There should therefore be little need for other professional advice, although this could be sought if needed. Costs would have to be kept under control and a budget should be set and agreed with the Board. The budget should not be exceeded without the Board’s consent. As a committee of the Board, we believe that it is really the Board which has the whistle-blowing responsibility, although we can understand that others may feel there should be a direct right of approach to the FSA. If the members of the Committee are already approved persons they will already have a duty to whistle-blow to the FSA if they feel the Board is not properly addressing their concerns. The terms of reference should record the need for the committee to safeguard the ongoing vitality of the company as well as the interests of with-profits policyholders. The committee must recognise the long-term nature of the business venture, including the interests of the newest policyholder and future policyholders. References to advice to be given to the Board by the committee should be explicitly stated to be the advice of a sensible layperson and not professional or actuarial advice. Members of the committees would need modest payment in addition to any remuneration as non-executive directors. We envisage a figure of around £10,000 per person per annum, and the committee meeting two to four times a year. Administrative costs should be modest. If the committee members were already Board members this would have the advantage that they would already be authorised persons with the FSA and covered by the company’s Directors’ and Offices’ Liability insurance. This would have to be extended to cover any non-Board committee members and possibly any holding company Board members. The Cadbury Report included model Terms of Reference for Audit Committees and we believe these can easily be adapted to be appropriate for the With-Profits Committee. A possible draft is attached as Appendix C to this response. We appreciate that this has not yet had the scrutiny it will need, because of the time constraints of responding to this paper, and it will benefit from further development. We look forward to working with FSA to finalise a suitable model.

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Option 4: Place a statutory duty under company law on directors to have due regard to the interests of policyholders The Paper clearly identifies the difficulties with these options, which we do not support for these reasons. Implementation costs are hard to assess, but might be modest. Option 5: Beneficial ownership of assets by policyholders The Paper clearly identifies the difficulties with these options, which we do not support for these reasons. Implementation costs would be very high, with a vast amount of legal work needed. Such a change would have very high disruption costs. Role of the Appointed Actuary Option A: Rely on responsibilities placed on boards: appointed actuary system to be discontinued Surprisingly this option has intrinsic attractions for us, particularly as it removes the public face of the appointed actuary and rightly identifies the Board as the decision-making body. The appointed actuary’s role is to advise the Board and to report as required to the regulator, and this might be clearer if the title were changed. However, we do not believe there could be more to this option in reality than a change of name and for this reason reject it, somewhat reluctantly. At a time of greater individual responsibility eg Health and Safety officers, Money Laundering Reporting Officer, it seems inappropriate to move ultimate responsibility for such a vital function of a life office from an individual to a group. Implementation costs of this option would be modest. Option B: Conflicts of interest/ lack of independence - Position on the board Option B1: appointed actuary not to be chairman or CEO Option B2: appointed actuary not to be chairman, CEO, finance director, marketing or sales director, or to hold senior executive positions fulfilling similar functions Option B3: appointed actuary not to be on the board, but to be invited to attend all board meetings and receive all board papers (subject to certain exceptions e.g. remuneration committee papers). Appointed actuary to report directly to the CEO or Group CEO. Appointed actuary not to hold senior executive positions responsible for finance, marketing or sales Option B4: appointed actuary not to be an employee or on the board, but to be invited to attend all board meetings and receive all board papers

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Our preferred option is B2. While the appointed actuary has to manage a variety of conflicts (as indeed do the Board members) we believe that the posts identified in B2 have the potential to create the most uncomfortable conflicts and certainly can be hardest to explain, eg to policyholders. While this is the best option for larger companies, we can envisage problems for smaller companies (especially small mutuals), who may often combine eg the functions of appointed actuary and finance director. We believe the FSA should be flexible in this area, with this option being recognised as best practice but not enforced absolutely in cases where there is good reason for a different system prevailing. We are not aware of any areas currently where the FSA rule that certain posts cannot be held by the same person, although clearly in the approval of office holders such considerations will nevertheless be taken into account by FSA. This seems an appropriate and proportionate approach in this case, although professional guidelines may also be suitable. The appointed actuary needs to be a senior executive (not necessarily a Board member) who is very close to the decision process and relevant management information. For some companies this may best be achieved by the appointed actuary being a member of the Board he advises. If he is not even able to be an employee (option B4) he may well be deprived of this position of influence and knowledge. It seems wrong that any company should be forced to take advice from someone external when it has the internal resources available. This is clearly relevant beyond with-profits and would apply to all protection products and companies with no with-profit fund. Many companies that currently follow this route from choice do so for economic reasons rather than out of belief that it is necessarily the best solution. In these circumstances the company may well work harder to make good the deficiencies of the arrangement and might not do so if the course were thought to be the regulator’s preferred option. While some companies already follow the B3 route, whether by making that explicit choice or because of individual circumstances, we do not believe it is appropriate for it to be mandated. Option B5: To prohibit, or restrict in some respects, the granting of share options, or other profit-related remuneration, to appointed actuaries. It is most unlikely that the appointed actuary’s duty to policyholders would be overlooked for personal gain, but if this were to happen, the independent review of the appointed actuary’s work would identify it. We do not believe either that any appointed actuaries are so overwhelmingly driven by the interest of shareholders that their duty to their policyholders is overlooked in shareholders’ favour for personal gain. It would be odd to suggest that the appointed actuary either is or would appear to be so driven, to the extent of isolating him as perhaps the only employee of the company not to be offered these benefits. They can indeed sometimes be more beneficial to the company than to the individual.

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It also has be remembered the actuarial function is a team effort in most companies with the appointed actuary as team leader. For him to be incentivised differently from his team, or from the rest of the management team, is also inappropriate. Even an external appointed actuary, whose firm is paid on a time-spent basis, often has his personal remuneration linked to the success of his firm and his contribution to that success. We believe it would be more appropriate for the actuarial profession to consider whether professional conduct standards might be amended to banish remuneration packages where the results-related element is felt to be material in order to avoid any impression of an inappropriate reward structure in case of appearance of abuse. This would bring the issue within professional conduct standards. Alternatively the remuneration committee could have an additional oversight role in cases where the appointed actuary is not a director. (It already has such a role for directors.) There are no significant direct costs to these options. Option C: Number of appointments Option C1: To restrict the number of appointed actuary appointments per individual This would create difficulties in groups where the appointed actuary holds this position for more than one company in the group. It would be impractical, inefficient and therefore costly to operate differently. Option C2: The FSA would consult on a rule or issue guidance that a firm should satisfy itself that the appointed actuary would be able to devote sufficient time and resources to his duties This option represents good practice, as it is good practice for boards to ensure all personnel have sufficient time and resources to carry out their duties. FSA requirements of senior managers also apply here and we cannot support a proposal for such formal guidance in only one of many key areas of insurance company operations. Existing rules (SUP 4.3.17(b)) require firms to provided appointed actuaries with sufficient resources. Option D: Financial risk management - Financial Condition Report Option D1: The FSA to require appointed actuaries to carry out an annual Financial Condition Report for all firms We have already suggested this option, which we continue to support. There will be a cost for many companies to reach the required standard, although many larger companies will already be close to complying. The depth of the report is important. Costs would come if the depth requirement increased significantly.

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Option E: Independent review: Option E1: Independent review of appointed actuary’s work by an actuary external to the firm and to the FSA This is our preferred option, which we have proposed in the past. The requirement for peer review is one of the more costly of any of the options in this paper. We believe it is likely to be comparable to the cost of the annual audit, regardless of which of these options is adopted. Option E2: Independent review of appointed actuary’s work by an FSA actuary We believe that FSA have neither the resource nor the desire to carry out this work, especially in view of the considerable conflict of interest it could present. The one advantage of this option is the FSA’s immunity from suit, but we do not believe this is adequate reason to adopt this otherwise unattractive option. But this risk could discourage others from taking over this work and we wonder whether current levels of professional indemnity insurance are adequate. Option E3: Independent review externally within scope of audit This option would risk bringing the scope of the actuarial review under the control of the audit partner in a firm of accountants, which would not be appropriate. Although actuaries are employed by audit firms and already conduct work in connection with the audit, this work is tightly focused on supporting the audit function. Extending it to encompass the FCR would be a significant extension of this work, but we have no objection to the peer reviewer being employed by a firm of auditors, if that is the choice of the company concerned. Option E4: Review of appointed actuary (where not an employee) carried out within the appointed actuary’s professional firm In general we believe it would be wrong for actuarial consultants to review themselves. Any problems might be problems of house style or approach that would not be identified in this way. However, as suggested in paragraph 137 of the paper, this approach might be appropriate in limited circumstances, such as for small closed funds.

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APPENDIX B – ANNEX TO ABI RESPONSE TO SANDLER REVIEW CONSULTATION APRIL 2001 (ALSO SUBMITTED TO FSA IN RESPONSE TO THE WITH-PROFITS REVIEW SCOPE PAPER) ALTERNATIVE GOVERNANCE STRUCTURES FOR WITH PROFIT FUNDS: AN ABI ANALYSIS 1. INTRODUCTION 1.1 The structures under which with-profits funds are managed have been

questioned by some commentators recently. 1.2 The areas of governance that have been called into question are:

• The discretion of the directors in setting bonuses • The ownership of the fund, or more importantly, ownership of

the surplus in the fund. • The investment and allocation of assets within the fund.

1.3 The main suggestions for change which have been advanced publicly by

consumer representatives or others are:

• Make the Appointed Actuary independent of the company • External Review of the Appointed Actuary’s recommendations • Place the assets of the with profits fund under trust • Consumer representative(s) on the Board of the life company • A separate policyholder Board • A Board Sub-Committee to deal with policyholder issues.

1.4 This paper analyses each of these options, plus the further one of no

change to existing arrangements. 1.5 In considering this analysis it is also necessary to take into account the

Company Law Review proposals published 26 July 2001. They are likely to mean that the existing framework will itself alter to some extent.

2 DETAILED EXAMINATION OF OPTIONS A1 Option 1: Continue with the status quo. Summary of current powers A1.1 Directors’ primary obligations are to shareholders (or members in a

mutual company), modified by prudential guidance, contractual obligations to policyholders and PRE. This is an obligation on all directors. Note that in a mutual, not all policyholders may be members.

A1.2 Boards can include non-executive directors from a variety of backgrounds.

A1.3 An actuarial investigation is required before any distribution of surplus.

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A1.4 The extent of the Directors discretion in distributing surplus depends on articles of association. Four general variants on a scale with increasing discretion to the directors are:- • “take actuarial advice”, or “in light of actuarial advice” – directors

could be expected to follow Appointed Actuary’s recommendations nearly all the time.

• “may, having taken actuarial advice” – directors could be expected to follow Appointed Actuary’s advice most of the time. Would need to have very good reasons for departing from Appointed Actuary’s advice.

• “consider actuarial advice” – gives the directors broader powers to consider other factors. Decisions made need to be reasonable.

• “consult” – The directors are not bound to follow the Appointed Actuary’s advice, but need to give it some prominence.

A1.5 Professional guidance requires the Appointed Actuary to take reasonable steps to ensure that the directors have considered his recommendations before deciding on any distribution of surplus

A.1.6 The distribution of surplus as between policyholders, and between policyholders and shareholders, may be determined by the Company’s Articles or a Court scheme. Changes in proportion of surplus distributed to policyholders are limited to ½% per year unless previous notification given. For some companies, a Court scheme may also place some limits on the distribution of surplus between different groups of policyholders, but such limitations are the exception rather than the rule.

A1.7 Ownership of funds set out Court Scheme (reconstruction or demutualisation) or may be in Articles of Association. However, the Articles of Association may be silent making ownership undefined or where the current situation has arisen through custom and practice.

A1.8 A reconstruction of the fund that occurs under Schedule 2C of the Insurance Companies Act has to be accompanied by a report by an Independent Actuary whose role is to consider whether any policyholders are adversely affected by the reconstruction.

A1.9 Assets of a long term insurance fund may only be used for the purposes of that fund.

A1.10 As a special case, Stakeholder pension funds can only be used for Stakeholder pensions.

A1.11 Investment not restricted to particular assets. Main restrictions through inadmissibility requirements and valuation for solvency purposes.

A1.12 The FSA are required to approve the appointment of directors, who must satisfy the FSA test that they are a “fit and proper” person.

A1.13 The FSA requires that directors establish operating principles to safeguard the interests of policyholders. Advantages

A1.14 Flexibility to deal with changing circumstances and conditions.

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A1.15 The Appointed Actuary is actively involved in day-to-day affairs of the company, and hence is in a better position to influence company practice and changes.

A1.16 The Appointed Actuary’s responsibility to protect the interests of the policyholders. Disadvantages

A1.17 In this system, professional guidance requires the Appointed Actuary to advise the Board on his interpretation of PRE (rather than manage wider factors affecting PRE) and advise whether a proposed distribution of surplus is consistent with his interpretation and does not jeopardise the solvency of the fund. This effectively leaves the judgement on these matters to the Appointed Actuary, who is not required to explain his judgement to policyholders.

A1.18 It has been suggested that the Appointed Actuary can be subject to shareholder influence against the interests of policyholders, and his reward package may be thought to bias his recommendations (eg share options).

A1.19 It is a disadvantage that directors and the Appointed Actuary are seen to be the same thing. This is possibly because of the lack of promoting the Appointed Actuary’s role.

A2 Option 2: Make the Appointed Actuary independent of the

company Summary of changes. A2.1 The Appointed Actuary would not be an employee of the company. It

will need to be established who would appoint the Appointed Actuary and how this appointment would be reviewed. The financing of the position will also need to be decided upon.

Advantages A2.2 Some smaller companies use an external Appointed Actuary

successfully. This is less common with large companies within more complex groups.

A2.3 The Appointed Actuary could, in framing his advice, be required to consider primarily the interests of the policyholders.

A2.4 The Appointed Actuary could be perceived as being more insulated from shareholder and marketing pressures.

A2.5 Independent Appointed Actuaries could lead to more consistent standards across the industry as a whole.

A2.6 The Appointed Actuary’s role would need to be clearly and tightly defined.

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Disadvantages A2.7 An independent Appointed Actuary could not be involved in the

company’s affairs on a day-to-day basis, which would make him less able to defend the interests of policyholders.

A2.8 Bonus recommendation process may be less efficient, as this recommendation would have to be prepared by the board, and then reviewed by the Appointed Actuary. This compares to current practice where the AA is actively involved in preparing the bonus recommendation (and hence has greater control).

A2.9 On its own, may not be fully effective, depending on the extent to which the directors are required to take the advice of the Appointed Actuary.

A2.10 A tightly defined role for the Appointed Actuary is likely to lead to a narrower role than currently performed by internal Appointed Actuaries, reducing their opportunity to influence the day-to-day operations of the fund.

A2.11 The cost of the appointment and the cost of reviewing the appointment. A2.12 The internal actuarial team is likely to have a position of strength in any

detailed discussions due to their detailed working knowledge of the company.

A2.13 There is currently only a limited pool of suitable consulting actuaries. A3 Option 3: External Review of Appointed Actuary’s

recommendations. Summary of Changes. A3.1 The Appointed Actuary’s reports would be subject to an external

actuarial review. Various models could be contemplated and might for example include:

• Statutory investigations into solvency (“Solvency Reports”),

• Advice on distribution of surplus (“Bonus Recommendations”) and

• Financial Condition Reports. (which might also be sent to the FSA).

A3.2 Note that Financial Condition Reports are, at present, not a statutory requirement, and are only considered to be “Recommended Practice”. An Institute of Actuaries Working Party is currently reviewing Financial Condition Reports.

A3.3 The external reviewer would be independent of the company and would need to meet the requirements of an Appointed Actuary practising certificate. In the main, the review would be after the event, although consideration may be given to the review of the “bonus recommendations” before Board approval if timing allows.

A3.4 The reviewer would be required to provide a public opinion, for example, included in the FSA returns, but accompanying comments

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which are commercially confidential should be addressed to the Appointed Actuary.

A3.5 The reviewer would be appointed and paid for by the company, subject to FSA approval of the appointment.

Advantages A3.6 Gives a second, ‘independent’ opinion on whether the regulations and

guidance are being followed, and whether policyholders’ interests are being protected.

A3.7 If “bonus recommendations” are reviewed before Board decision is taken the directors would probably need to feel very confident that their reasons for not following the Appointed Actuary’s advice were sustainable.

A3.8 FSA have a policyholder interest role, and this would need to be considered in their approval of the external reviewer.

A3.9 Consistent with good corporate governance. A3.10 External review of assumptions will give Appointed Actuary’s opinion

more weight. A3.11 An external review will require companies to have documented the

principles used to manage with-profits business. A3.12 In practice, the review process is likely to require involvement of

external reviewer in development of proposals and in preparation of reports.

Disadvantages A3.13 Sign off “after the event” reduces ability to prevent actions that are

harmful to the policyholders interests, unless there is a time lag between a report and the implementation of its recommendations.

A3.14 Sign off of “Solvency Valuations” relate to historic positions, and it is not clear that the external reviewer is being asked to sign off on any recommendations.

A3.15 Public interest in a Financial Condition Report would probably be limited to the fact that one has been prepared in accordance with professional guidance and that the Directors have been informed of the material risks that might affect ongoing solvency.

A3.16 External reviewer becomes very similar to Independent Actuary in a demutualisation or reconstruction, which has in itself attracted some criticism in the AXA case.

A4 Option 4: Assets of the with-profits fund held under trust. Summary of Changes The impact of this depends on the terms of the trust.

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A4.1 A base level is for the assets to be held by trustees, to be used to meet obligations to policyholders and shareholders as instructed by the directors. The trustees would have discretion over the investment of the assets.

A4.2 At a higher level, the trustees would have responsibility for the distribution of surplus.

A4.3 In practice, the trustees would need to take professional advice regarding the management of the assets, and if appropriate actuarial advice on the distribution of surplus.

Advantages A4.4 May give a perception of independent control and build confidence in

the industry. Disadvantages A4.5 If trustees are required to use the assets to meet obligations to

policyholders and shareholders as instructed by the directors, then in practice this gives no additional protection for either party. If they also have responsibility for the distribution of surplus, then this effectively replaces directors by trustees who in practice have the same powers.

A4.6 Practical difficulties in the appointment of the trustees:

• Who would appoint them, and how?

• Who would pay them, and how?

• What happens if the fund also includes non-profit or unit-linked business

• May fail legal tests due to uncertainty of trust regarding:

• Lack of clarity of beneficiaries

• How entitlements of policyholders and shareholders are articulated

• Breadth of discretion on benefit entitlement. A4.7 If proposals only affected new business, then it would have no impact

on inherited estates. A4.8 Adds an extra layer of complexity to the process of managing the fund.

Also adds costs that will fall directly on the existing policyholders. A4.9 It is understandable whether the trust-based approach used in unit

trusts does add any visible benefit. A4.10 A trust set up to provide safekeeping of assets gives no additional

protection compared with current legislation. A trust requiring the exercise of discretion will need the same level and nature of advice as currently received by directors.

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A5 Option 5: Consumer Representative on the Board. Summary of Changes A5.1 A policyholder representative is elected to the Board of the life

company. Advantages A5.2 Gives direct visibility of policyholder interests. Disadvantages A5.3 How to ensure the policyholder representative is representative of all

policyholders rather than a select subgroup. A5.4 What nature and level of reporting would the policyholder

representative have to make? A5.5 Would cause a conflict with Companies Act requirements that apply to

all directors which places their primary obligation as being to the shareholders.

A5.6 Practical difficulties in the appointment of the policyholder representative;

• Who would appoint them and how?

• How to ensure commercial confidentiality A6 Option 6: Separate Policyholder Board. Summary of Changes A6.1 A Policyholder Board is formed to monitor the financial management of

the life company. To achieve this, there would need to be a documented and agreed set of principles of financial management. The Policyholder Board would need independent actuarial advice. The powers and duties of the Policyholder Board need to be well defined.

Advantages A6.2 Gives direct visibility of policyholder interests to ensure that the fund is

being managed in accordance with an agreed set of principles Disadvantages A6.3 If the Policyholder Board has responsibility for all policyholders, rather

than subset in a particular fund, then in effect it would be duplicating many of the functions of the main Board. This would make decision making more cumbersome and time consuming.

A6.4 If the Policyholder Board has responsibility for a subgroup of the policyholders, then its powers and discretions would need to be tightly defined to avoid any conflicts of interest with other groups of policyholders.

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A6.5 The Independent Actuary advising the Policyholder Board will be less involved in the day to day affairs of the fund that the current Appointed Actuary.

A6.6 The nature and level of reporting the Policyholder Board should have to make would need to be decided.

A6.7 Practical difficulties in the appointment of the Policyholder Board;

• Who would appoint them and how?

• How to ensure that the Policyholder Board represents the interests of all policyholders, rather than just a particular subgroup.

A6.8 The Policyholder Board’s terms of reference would need to be clear,

probably being based on the requirement to ensure PRE is met. However, since PRE is undefined would this fail because of the lack of clarity?

A7 Option 7: Establish a Board sub-committee to consider PRE. Summary of changes A7.1 A sub-committee of the Board is established to consider Policyholders

Reasonable Expectations and to review the Appointed Actuary’s bonus recommendations. This committee would consist of non-executive directors and one or two executive directors. It would be a sub-committee of either the life company Board or of an appropriate higher level group Board.

Advantages A7.2 Gives direct visibility that policyholder interests are being considered. A7.3 Provides a forum for the Appointed Actuary’s recommendations to be

reviewed by non-executives who can bring a wider perspective to ensuring customers are treated fairly.

A7.4 Will give bonus recommendations more weight once agreed by the sub committee.

A7.5 Sub-committee could be required to provide an annual statement on its interpretation of PRE and its other work.

Disadvantages A7.6 Sub-committee is still composed of directors whose primary obligations

are to shareholders. A7.7 Sub-committee still has no accountability to policyholders. A7.8 Having a sub-committee takes PRE and bonus recommendations off

the agenda of the main Board and reduces its profile.

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A7.9 There may be substantial call on the time of non-executive directors, to make it more of a full-time commitment, so being more like the role of the executive director.

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APPENDIX C - SPECIMEN TERMS OF REFERENCE FOR A WITH-PROFITS COMMITTEE For Guidance Only

Constitution

1. The Board hereby resolves to establish a Committee of the Board to be known as the With-Profits Committee.

Membership

2. The Committee shall be appointed by the Board from amongst the Non-Executive Directors of the Company and shall consist of not less than three members. A quorum shall be two members.

3. The Chairman of the Committee shall be appointed by the Board.

Attendance at the meetings

4. The Finance Director, the Appointed Actuary and the External Actuarial Reviewer shall normally attend meetings. Other Board members shall also have the right of attendance. However, at least once a year, and at other times at the Committee’s request, the Committee shall meet with the External Actuarial Reviewer without executive Board members present.

5. The Company Secretary shall be the Secretary of the Committee.

Frequency of meetings

6. Meetings shall be held not less than twice a year. The Appointed Actuary and the External Actuarial Reviewer may request a meeting if either considers that one is necessary.

Authority

7. The Committee is authorised by the Board to investigate any activity within its terms of reference. It is authorised to seek any information it requires from the Independent Actuarial Reviewer and any employee of the Company, and all employees are directed to co-operate with any request made by the Committee. The Board shall give sympathetic consideration to requests from the Committee for information from the Company’s external advisers or managers, such as investment managers.

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8. The Committee is authorised by the Board to obtain outside legal or other independent professional advice and to secure the attendance of outsiders with relevant experience and expertise if it considers this necessary.

9. The Committee is required to set an annual budget, which shall be agreed by the Board and not exceeded without prior Board approval

Duties

10. The duties of the Committee shall be recognised to be non-actuarial in nature. The services of the company’s Appointed Actuary and the External Actuarial Reviewer shall be made available to the Committee, but its members shall not be expected to be able to make judgements that require professional actuarial skills. Their advice to the Board shall be that of an informed layperson. On that basis, specifically the Committee’s duties are:

(a) to consider the interests of all with-profits policyholders and to satisfy themselves that those interests can be demonstrated by the Appointed Actuary to have been properly taken into account so that all with-profits policyholders have been treated fairly;

(b) to recognise the needs of the company to remain a going concern and to be in a position to develop new sources of business;

(c) to be notified by the Board before the appointment of the External Actuarial Reviewer and notified by the Board of any questions of the Reviewer’s resignation or dismissal;

(d) to be consulted by the Board on certain specified decisions they will be taking, including:

(i) any changes in stated Principles and Practices of the operation of the with-profits fund

(ii) the declaration of bonus rates

(iii) the levying of expenses

(iv) investment strategy

(v) new business strategy

(e) to publish a report annually on the work of the Committee and the company’s compliance with stated Principles and Practices of financial management, after taking advice from the Appointed Actuary; this advice to be subject to peer review by the External Actuarial Reviewer.

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(f) to consider other topics, as defined by the Board.

Reporting procedures

10. The Secretary shall circulate the minutes of the meetings of the Committee to all members of the Board.

L/325/004 12 April 2002 [Governance Response LIKFLA.With-profits]