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The FSA has issued CP08/11 in relation to charging compensation and redress costs to with profits funds.

The FSA's proposal in this consultation paper is that the costs of mis-selling, other compensation and redress should all be borne by the shareholders of proprietary with profits firms. The FSA says that its proposal would better align the conduct of business sourcebook rules on the operation of with profits funds with principle six and its treating customers fairly requirements.

By necessity, the proposed change can only apply to proprietary, that is, shareholder owned companies and mutual funds will still need to bear such costs, although as the FSA points out, such policyholders will also be shareholders and so will have greater rights in relation to the running of the company, for example the right to elect and reject the management of the company.

The FSA gave a commitment to review this issue in December 2007 in letters now published on the with profits pages of its website. The issue of who should pay for mis-selling also featured in the evidence, presented by the FSA amongst others, at the recent Treasury Select Committee sessions relating to inherited estates. There, a potential distinction was drawn between systematic mis-selling which it is arguably easier to see is the shareholders' responsibility and other ad-hoc mis-selling, which could arise from a number of causes much harder to anticipate.

The FSA's current proposals apply to all mis-selling as the FSA says that such a distinction would be difficult to frame and open to abuse.

This issue arose originally in requests for the FSA to clarify its position in relation to inherited estates and policyholders' interests in them, and it is precisely this issue which is behind the FSA's proposal. An inherited estate is a with profits firm's working capital and the cushion that often allows it to smooth payouts and maintain a particular investment strategy.

Essentially, it is the amount the firm holds which is over and above its provision for policyholder benefits. In 2005, the FSA introduced rules as part of its treating with profits policyholders fairly initiative to constrain a with profits firm "so that it cannot unfairly use the assets retained in the inherited estate as working capital in ways that are detrimental to the interest of with profits policyholders."

These rules require the interests of policyholders to be considered if the firm wishes to use the inherited estate to enter into or fund significant transactions, acquisitions or to significantly increase the amount of new business being written. The rules also explicitly require, where such is not already the practice of the firm in question, the distribution or reattribution of any excess surplus the firm cannot justify keeping.

An excess surplus arises when, based on the firm's own risk appetite, for example, its view of the risk of insolvency, it has more money than it needs to cover the risks it anticipates. To retain such a surplus, a firm must justify "why it would not be unfair to keep the surplus assets that are not required for the purposes of the fund's business".

The highest profile excess surplus distribution to date was that announced by Aviva on 6 February 2008. Aviva announced that it intends to distribute £2.3bn over three years, approximately 45 per cent of its inherited estate, as an excess surplus distribution.

Although the FSA makes the point that the inherited estate may not actually be available for distribution to current policyholders in the lifetime of their policies, it sees the need to protect their contingent interests in the inherited estate. The examples apparently in the contemplation of the FSA are distributions of excess surplus and distributions as a closed fund runs off. There has, as the FSA comments, been a tendency in recent years for with profits funds to close to new business. Closure to new business triggers a requirement to produce a run off plan which includes details of how the firm will ensure a "full and fair distribution" of its inherited estate as the business runs off. This will normally involve the inherited estate being paid out over time in the normal ratio, for example, on a 90/10 basis, to the policyholders in the run off. The FSA states its policy objective as preventing such payouts to policyholders being affected by the costs of mis-selling and so reducing the value of the inherited estate available for distribution.

The FSA's current rules already prevent payment of fines and, where there is an inherited estate, compensation and redress payments coming directly from assets held to cover policy liabilities. The FSA states that they do not believe the rules as they stand provide sufficient incentive for proprietary firms to address system and controls and as a result with profits policyholders may not be treated fairly. They go on to say that shareholders alone should bear the risk of management failures as they already do for non profit business.

Life companies have until 3 September 2008 to respond to the consultation paper. If adopted the new rules will apply to new compensation and redress "made" after 1 November 2008 regardless of when the mis-selling occurred.

The FSA has also said the new rules on compensation and redress will not refer to "guarantee schemes". These are schemes typically guaranteeing that there is no shortfall on a mortgage endowment. It is not clear whether this will include similar promises given in relation to pensions mis-selling. Clearly, if any redress could be made in the form of a guarantee, the ultimate cost of which could still be charged to the inherited estate, such form of redress might become very popular and it is therefore assumed that the FSA will provide a comprehensive definition of this term.

For many companies who can pay outstanding compensation by 1 November, the proposals will not have retrospective effect. For others and depending on the definition of guarantee schemes, it is possible that they could have such an effect. Many closed funds may feel that this is less of an issue for them but it is worth bearing in mind that the proposals cover redress as well as compensation. The cost of rectifying mistakes may in future need to be captured separately to ensure that it is not charged to the inherited estate. Companies would presumably also need to update their principles and practices of financial management and the consumer friendly principles and practices of financial management.

Noleen John is a consultant with Norton Rose