7.11 Stress and scenario testing analysis: RLCIS 68
7.12 Consideration of guaranteed benefits: RLCIS 72
7.13 Considerations of additional AFH analysis 73
7.14 Summary of stress and scenario testing conclusions: RLCIS 74
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7.15 Stress and scenario testing analysis: RLMF 74
7.16 Summary of stress and scenario testing conclusions: RLMF 75
7.17 Conclusions 75
8 Other risks and other key considerations 77 8.1 Operational risks of the transfer 77
8.2 Service levels 77
8.3 Legal risk 77
8.4 Chancellor’s Budget on 19 March 2014 78
8.5 Tax risk 78
8.6 Regulatory risk 78
8.7 Supplementary report 79
9 Overall conclusions 80
Appendix 1 81 List of main documents reviewed 81
Appendix 2 86 Areas covered by the RLCIS PPFM 86
Appendix 3 88 Main risks faced by the RLCIS Fund and the RLMF 88
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1 Introduction
1.1 Background Royal London (CIS) Limited (“RLCIS”) and The Royal London Mutual Insurance Society Limited (“RLMIS”) are both UK long-term insurance companies open to new business. RLMIS is a mutual company and owns 100% of RLCIS. It is intended to transfer all of RLCIS’s long-term business (the “Transferred Business”) to RLMIS by way of an insurance business transfer scheme (“the Scheme”) under Part VII of the Financial Services and Markets Act 2000 (“FSMA 2000”).
Under Section 109 of FSMA 2000, a scheme report must accompany an application made to the High Court of Justice (the “Court”) in London for an order sanctioning a scheme to transfer insurance business from one company to another. The scheme report must be provided by an independent expert (“the Independent Expert”) and it must be made in a form approved by the Prudential Regulation Authority (“PRA”) and the Financial Conduct Authority (”FCA”). The PRA and FCA have issued guidance on the form of the scheme report, as set out in sections 18.2.31G to 18.2.41G of the Supervision Manual (“SUP”).
I have been jointly appointed by RLCIS and RLMIS as the Independent Expert in connection with the Scheme. I have also been approved by the PRA (as the appropriate approving authority) to carry out this work, and I understand that the PRA has liaised with the FCA in relation to my approval.
I am a Fellow of the Institute and Faculty of Actuaries, having qualified as an actuary in 1988. I am currently a Partner in KPMG LLP. I hold a Life Actuary Certificate (including with-profits) issued by the UK actuarial profession. I have previously performed the role of Independent Expert in relation to Section 109 of FSMA 2000.
1.2 Independence I do not hold and have never held any policies with either RLCIS or RLMIS.
KPMG (through its subsidiary company KPMG Audit Plc) has previously and for a number of years been the statutory auditor of RLCIS prior to its acquisition in 2013 by RLMIS. KPMG audited the 2012 Report & Accounts and regulatory returns of RLCIS, but is not the auditor in respect of 2013 and subsequent years. I have previously provided actuarial assistance and internal KPMG actuarial opinions in relation to KPMG’s audit of the RLCIS Report & Accounts and regulatory returns. The last financial year end for which I provided such input was 31 December 2008 with the work being concluded by 31 March 2009 and I have had no involvement with RLCIS since then.
The only work I have carried out for RLMIS comprised a small assignment in 2012 to provide RLMIS with factual information in relation to the range of industry practices for distributing the estate of a closed with-profits fund. No actual advice was provided.
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During 2013, another KPMG actuarial partner (Mr Timothy Roff) provided RLMIS with interim actuarial advice on routine matters for a period of time following the retirement of the Actuarial Function Holder (“AFH”) of RLMIS. This engagement commenced in June 2013 and ended in October 2013, and I had no involvement in the provision of the services or the advice.
KPMG has provided and continues to provide other services to RLMIS, primarily around the efficiency of its financial management and accounting systems. In addition, in 2013, KPMG provided corporate finance advice to RLMIS in relation to the sale of a subsidiary company (which was branded as RL360°) which offered offshore investment, savings and tax planning products to international investors. Each of these services is completely separate to my role as Independent Expert, and I have no involvement in their provision.
Given the above, I believe that I am independent for the purpose of the proposed transfer. The information set out in this section was shared by RLMIS with the PRA prior to them approving me as the Independent Expert for this proposed transfer.
1.3 Parallel transfer In addition to the proposed transfer of RLCIS’s long-term business to RLMIS, there is a separate but simultaneous proposed transfer of the long-term business of Royal London Pooled Pensions Company Limited (“RLPPC”) to RLMIS. RLPPC is a 100% owned subsidiary of RLMIS. I am also the Independent Expert for the proposed transfer of RLPPC’s long-term business to RLMIS and I have produced a separate Independent Expert report on that proposed transfer.
I can confirm that both proposed transfers are independent of each other and that there is no reason in my opinion why either transfer could not take place without the other. For the sake of completeness however I have provided in the relevant sections of this report some additional commentary on the pro-forma position of RLMIS following the transfer of the long-term businesses of both RLCIS and RLPPC.
In addition to the Scheme, separate parallel schemes are required in Jersey and Guernsey to transfer to RLMIS: (i) the long-term insurance business carried on by RLCIS in or from within Jersey; and (ii) any policy of long-term insurance issued by RLMIS under Guernsey law or to a person resident in the Bailiwick of Guernsey. My considerations and conclusions in this report apply equally to the Jersey scheme and the Guernsey scheme as to the Scheme. In this report, references to "the Scheme" should be taken to include the schemes in Jersey and Guernsey.
This report is also intended to be presented to the Royal Court of Jersey and the Royal Court of Guernsey, to satisfy the requirement for a report by an independent actuary on the terms of the Jersey scheme and Guernsey scheme respectively. I recognise that this report will be used by the Royal Court of Jersey and the Royal Court of Guernsey in connection with their consideration of the Jersey scheme and Guernsey scheme.
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1.4 Restrictions This report has been prepared for the Court under Section 109 of FSMA 2000 solely in connection with and for the purposes of informing the Court of my findings in respect of the work that I have performed at the request of RLCIS and RLMIS regarding the Scheme. A copy of this report may also be made available by RLCIS or RLMIS to the PRA, the FCA, the Jersey Financial Services Commission (“JFSC”), the Guernsey Financial Services Commission (“GFSC”), the Royal Court of Jersey, the Royal Court of Guernsey and to any person who requests a copy of it. Paragraph 2.1 of this report sets out the basis on which this report has been prepared and confirms my overriding duty to the Court.
This report is designed to meet my obligations as Independent Expert under Section 109 of FSMA 2000, the requirements of Chapter SUP 18.2 of the Handbook issued by the PRA and FCA, and the agreed requirements and particular features of RLCIS’s and RLMIS’s respective circumstances determined by their needs at the time. I recognise that the Court will use this report in connection with the Court’s discharge of its statutory functions concerning the Scheme.
Reliance may be placed on this report by the PRA, the FCA, the JFSC and the GFSC (in connection with the discharge of their regulatory objectives), the policyholders of RLCIS and RLMIS, and any other affected persons. This report should not be regarded as suitable to be used or relied on by any person wishing to acquire any right to bring action against KPMG LLP in connection with any such use or reliance other than RLCIS, RLMIS, the PRA, the FCA, the JFSC and the GFSC (in connection with the discharge of their regulatory objectives), the policyholders of RLCIS or RLMIS, or any other affected persons. Any person other than RLCIS, RLMIS, the PRA, the FCA, the JFSC and the GFSC (in connection with the discharge of their regulatory objectives), the policyholders of RLCIS or RLMIS, or any other affected persons who obtains access to this report or a copy and chooses to rely on this report (or any part of it) will do so at their own risk. To the fullest extent permitted by law, KPMG LLP and I will accept no responsibility or liability in respect of this report to any other person.
1.5 Summary report I have produced an appropriate summary of this report for inclusion in the documentation to be distributed or otherwise made available to policyholders, as envisaged in SUP 18.2.48G.
1.6 Supplementary report As is normal practice, I will produce a Supplementary Report for the Court prior to the final Court hearing. My Supplementary Report will provide updated financial information, together with certain other updates (as referred to in several places in this report), and will confirm whether there are any modifications arising to the conclusions which I reach in this report.
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2 Scope and method of preparation
2.1 Scope This report has been prepared in accordance with: ■ SUP 18.2.31G to 18.2.41G forming part of the Handbook of Rules issued by the PRA
and FCA;
■ Part 35 of the Civil Procedure Rules 1998, to the extent relevant.
In particular, I owe an overriding duty to the Court (including in this context, the Royal Court of Jersey and the Royal Court of Guernsey) to assist the Court and to give the Court independent expert evidence on the proposed transfer.
This report is prepared primarily to assess the likely impact that the Scheme will have on the transferring policyholders of RLCIS and the existing policyholders of RLMIS if it proceeds. It is limited in its scope to the assessment of this Scheme alone and not to any other possible scheme. It is intended that this report be submitted, in full, as evidence to the Court when it considers whether or not to sanction the Scheme. It is not part of my scope to consider the position of new policies written into RLMIS following the transfer.
The term “Effective Date”, as used in this report, refers to the date as at which, if the Scheme proceeds, the Transferred Business of RLCIS will be transferred to RLMIS. It is expected that the Effective Date will be 30 December 2014.
It is not part of my scope to consider the effect of the Scheme on the Companies Act accounts of RLCIS or RLMIS. My consideration of the financial effect of the Scheme has been based on the method of reporting required for the regulatory returns to the PRA (“the PRA returns”). I have also considered the effect on the Individual Capital Assessment (“ICA”) calculations that all long-term insurance companies need to carry out and make available to the PRA on a private basis. I have further considered, at a high level, the likely effect of the new European Union (“EU”) Solvency II regime which is currently due to replace the existing UK solvency regime with effect from 1 January 2016. I am satisfied that consideration of the PRA returns and ICA calculations, together with a high level consideration of Solvency II, is appropriate for the purposes of this report.
Although the scope of my role as Independent Expert covers wider aspects than the actuarial aspects of the proposed transfer, the actuarial aspects do form a major part of my scope. In preparing this report I have therefore had in mind the requirements of Technical Actuarial Standard R: Reports (“TAS R”), Technical Actuarial Standard D: Data (“TAS D”) and Technical Actuarial Standard M: Reports (“TAS M”) as issued by the Financial Reporting Council. This report complies in my opinion with the relevant requirements of TAS R, TAS D and TAS M. In terms of TAS R definitions, this report constitutes an aggregate report, which is one which the user (i.e. primarily the Court but
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also the policyholders) can use in order to make a decision. This report also complies in my opinion with the Transformations TAS also issued by the Financial Reporting Council.
2.2 Method of preparation In preparing this report I have done my best to be accurate and complete. I have considered all matters that I regard as relevant to the opinions I have expressed, and I have considered all matters that I believe may be relevant to the policyholders of RLCIS and RLMIS in their consideration of the Scheme. All the matters on which I have expressed an opinion lie within my field of experience. RLCIS and RLMIS both have the same AFH and I have received confirmation from him that there is nothing in this report which is contrary to his understanding. I have also received confirmation from senior executives of RLCIS and RLMIS that the information contained in this report which relates to RLCIS and RLMIS and to how the transfer will be effected in practice is factually correct.
The AFH has produced a report on the proposed transfer for the RLCIS and RLMIS Boards of Directors and I have reviewed that report.
In addition to the AFH, each of RLCIS and RLMIS has a With-Profits Actuary (“WPA”), whose role it is to advise the relevant Board of Directors on the discretionary aspects of the company’s with-profits business. The WPAs of RLCIS and RLMIS are separate individuals, and each has produced a report on the proposed transfer. I have reviewed each of these reports.
In the course of carrying out my work and preparing this report I have considered various documents provided to me by RLCIS, RLMIS and Ashurst LLP (who are the legal advisers to RLCIS and RLMIS). A summary list of the main documents I have considered is set out in Appendix 1.
All of the data and information which I have requested has been provided to me by RLCIS, RLMIS and their advisers as appropriate. I have relied upon the accuracy and completeness of this data and information, which has been provided to me both in written and oral form by RLCIS, RLMIS and their advisers. I believe that it is reasonable for me to rely on this information because it has been provided by PRA/FCA approved persons and other senior employees from RLCIS or RLMIS, or by responsible senior professionals from their advisers. In addition, I have, where possible, reviewed the information provided for reasonableness and consistency with industry best practice. Where critical information has been initially provided orally, I have requested and obtained written confirmation.
I have discussed the proposed transfer with the appropriate individuals within the PRA and the FCA, and the PRA (to whom the formal role falls) have approved the form of this report.
2.3 Key areas for consideration As the Independent Expert, the key areas in my opinion that I need to consider are:
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■ policyholder benefits and benefit expectations, including the operation of the with-profits policies and the on-going determination of investment policy, expense charging, and the determination of bonus rates;
■ security of policyholder benefits;
■ wider Treating Customers Fairly (“TCF”) issues;
for the two main groups of policyholders that are potentially affected by the Scheme, namely:
■ the transferring policyholders of RLCIS;
■ the existing policyholders of RLMIS.
Within the above two main groups of policyholders, there are various sub-groups within both RLCIS and RLMIS, and these sub-groups are also considered within this report.
In addition to the above two main groups of policyholders I have also considered the position of any Excluded Policies as discussed in Section 4.3 below.
For completeness, I confirm that I have considered SUP 18.2.38 which is concerned with the rights of the members of RLMIS as a mutual company.
As will be seen from the following sections within this report, a particular aspect of this proposed transfer is my consideration of what is known as the RLCIS General Reserve, both from the viewpoint of benefit expectations and from the viewpoint of security of benefits.
I note that RLCIS may have a number of policyholders where the State of Commitment is an EEA State other than the UK. I can confirm that I have considered whether the position of any such policyholders is in any way different to those of UK policies as far as the above issues are concerned. My conclusion is that these policyholders are in no different a position to the UK policyholders as far as the proposed transfer is concerned.
Before considering each of the above areas specifically, the following sections first provide background to RLCIS and RLMIS (including the acquisition of RLCIS by RLMIS), and an overview of the Scheme and its key provisions.
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3 Background
3.1 RLMIS RLMIS is a mutual long-term insurance company and has written all common forms of long-term life and pensions businesses, including both Ordinary Business (“OB”) and Industrial Business (“IB”). IB is a form of life savings business where the premiums and benefits are small, and where traditionally (although not necessarily currently) the premiums are collected from policyholders by door to door collection.
RLMIS is the top level entity of the Royal London Group. RLMIS consists of a number of partitioned subfunds as follows:
■ Royal London Main Fund (otherwise known as the Royal London Open Fund or the Royal London IB and OB Subfund) and which includes the former Refuge Assurance OB business
■ Refuge Assurance IB Subfund
■ United Friendly OB Subfund
■ United Friendly IB Subfund
■ Scottish Life Closed Fund
■ Phoenix Life Assurance Limited (“PLAL”) With-Profits Subfund
■ Royal Liver Subfund
The Royal London Main Fund (“RLMF”) is the original fund of RLMIS. The other six subfunds referred to above all contain with-profits business and have been taken in over a number of years by RLMIS from various other long-term insurance companies. These ring-fenced subfunds have been set up as a result of these past transfers in order to ensure (as is common practice) that the entire with-profits assets of the insurance company or fund being transferred in are ring-fenced for the benefit of the transferring in with-profits policyholders. The RLMF is open to new business and the six ring-fenced subfunds are closed to new business (although increments to existing policies are still accepted). For the avoidance of doubt, I note that the RLMF contains the non-profit and unit-linked business in relation to certain past acquisitions made by RLMIS, i.e. only the acquired with-profits business was put into the ring-fenced subfund for certain past acquisitions.
For the purposes of this report, the six ring-fenced subfunds are referred to as the RL Closed Funds. The RLMF is named as such (i.e. the term Main Fund is used) as it is the RLMF which provides the ultimate security for the benefits of the RL Closed Funds, and it is the RLMF which incurs the running costs of the RL Closed Funds and receives charges from them in return.
The table below sets out a summary of the business of RLMIS as at 31 December 2013, showing its total assets and liabilities (including the nature of the liabilities), and split
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according to the various subfunds. The table also indicates the number of policies in each subfund. With-profits liabilities are stated after the distribution of surplus at 31 December 2013.
The above table shows that the RLMF is much larger than any of the RL Closed Funds. The liabilities within the RL Closed Funds are predominantly with-profits liabilities. The liabilities within the RLMF are predominantly unit-linked, although there is a material amount of with-profits business.
Each of the subfunds referred to above is accounted for separately, and with separate assets, within the PRA Returns (i.e. the detailed financial returns to the regulator which all UK insurance companies have to submit and make public annually). Within some RLMIS documentation (for example the Principles and Practices of Financial Management) (“PPFMs”), the Refuge Assurance IB Subfund, the United Friendly OB Subfund and the United Friendly IB Subfund are presented as being subfunds of the RLMF. However, this is a difference of presentation only, and these three subfunds are fully ring-fenced subfunds as are the Scottish Life Closed Fund, PLAL With-Profits Subfund and Royal Liver Subfund. I note that former Refuge Assurance OB business is contained within the RLMF and is not in a separate ring-fenced subfund.
I note that RLMIS has two key subsidiaries relevant to the operation of its long-term business. The first is Royal London Asset Management Limited (“RLAM”), which provides investment management services to RLMIS. The second is Royal London Management Services Limited (“RLMS”), which incurs the running expenses of RLMIS and receives charges from RLMIS in return. Both of these subsidiaries are owned by the RLMF.
As mentioned in Section 1.3 above, RLMIS has a subsidiary, RLPPC, whose long-term business is undergoing a simultaneous proposed transfer of business to RLMIS, similar to RLCIS, on the Effective Date. RLMIS has a further key subsidiary, RLCIS, which is the subject of the proposed transfer. RLCIS is owned by the RLMF and is described further below.
RLMIS Summary of Regulatory Assets and Liabilities at 31/12/13 (Pre Transfer)
Number of PoliciesWith-profits 568,672 110,415 197,989 674,518 44,795 14,996 225,098 Non-profit 1,323,104 383,600 - - 8,853 - 1,775,540 Unit-linked 1,050,392 - - - 1 - 56,222 Total 2,942,168 494,015 197,989 674,518 53,649 14,996 2,056,860 Source: PRA Returns 2013
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3.2 RLCIS Prior to 31 July 2013, the Co-operative Insurance Society Limited (“CIS”) was owned by the Co-operative Banking Group (“CBG”). RLMIS acquired CIS on 31 July 2013 under a Sale and Purchase Agreement dated 18 March 2013 and an Amendment to the Sale and Purchase Agreement dated 22 July 2013 (collectively referred to as the “SPA” in this report). Just prior to the acquisition, CIS was converted from an industrial and provident society to a limited company. Just after the acquisition, CIS was renamed to RLCIS.
RLCIS’s business comprises life insurance and pensions businesses written in its Long Term Business Fund (“LTBF”). RLCIS previously also wrote general insurance business in its Shareholder Fund and pre-acquisition this was 100% reinsured to CIS General Insurance Limited (“CISGIL”), a general insurer also owned by CBG. Under another insurance business transfer scheme which became effective on 31 March 2014, this general insurance business was fully transferred to CISGIL, and hence RLCIS is now a pure long-term insurer.
RLCIS currently has three subfunds within its LTBF, these being the main OB & IB Fund, the With-Profits Stakeholder Fund and the With-Profits Pension Fund. I note that the current PPFM states the With-Profits Pension Fund actually forms part of the main OB & IB Fund but with its own identifiable assets. This is due to RLCIS’s previous reporting convention, which has been amended for the 2013 PRA Returns. This change (which I consider to be presentational rather than fundamental) and will be incorporated into the revised PPFM from the Effective Date of the Scheme. Both the With-Profits Stakeholder Fund and the With-Profits Pension Fund need to have separately identifiable assets for certain product administration reasons. All investment profits and losses arising from these two subfunds flow to the relevant policyholders (subject to smoothing). Other profits and losses (including in respect of expenses) flow to the OB & IB Fund as it is the OB & IB Fund which provides the ultimate support for these two subfunds. Additionally, the PPFM for the With-Profits Stakeholder Fund contains a provision for any expense profits to be shared in certain circumstances with the relevant policyholders.
RLCIS has two operating subsidiary companies which are owned by the OB & IB Fund, namely RLUM (CIS) Limited which sells retail investment products and RL Marketing (CIS) Limited which markets products and services to RLCIS customers.
The table below sets out a summary of the business of RLCIS as at 31 December 2013, showing its total assets and liabilities (including the nature of the liabilities), and split between the three subfunds. With-profits liabilities are stated after the distribution of surplus at 31 December 2013. The table also indicates the number of policies in each subfund.
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The above table shows that the liabilities are predominantly with-profits, and that the RLCIS OB and IB Fund is considerably larger than the RLCIS With-Profits Stakeholder Fund and the RLCIS With-Profits Pension Fund. The high value of the current liabilities arises essentially as a result of assets in respect of certain reinsured liabilities being invested back with RLCIS in order to provide security in the event of reinsurer default.
In addition to the assets and liabilities shown in the above table, RLCIS has a Shareholder Fund. Following the transfer of the general insurance business to CISGIL, the amount of this Shareholder Fund is £211m, which comprised the £200m of RLCIS General Reserve and £11m of other shareholder capital. Further comment and discussion of the RLCIS General Reserve is given within various sections of this report, commencing in particular with Section 5.3 below. As explained in Section 4.1 below, the Scheme does not transfer the RLCIS General Reserve or any of the other shareholder capital to RLMIS.
3.3 Key provisions of the SPA The SPA governs the terms under which RLCIS was acquired from CBG by RLMIS, and is a long and extensive legal document. Much of it relates to the acquisition itself and to the operation of RLCIS during the interim period prior to any Part VII transfer of RLCIS’s long-term business to RLMIS.
I have considered the SPA to the extent that it is relevant to my role as Independent Expert. Several areas of the SPA are relevant as they affect or now determine the “current position” against which I have to judge the effect of the Scheme. I note that during the acquisition process there were, as would be expected, extensive governance arrangements to consider and protect the interests of the RLCIS policyholders, and this
RLCIS Summary of Regulatory Assets and Liabilities at 31/12/13 (Pre Transfer)
Number of PoliciesWith-profits 2,224,969 515 32,184 Non-profit 1,015,876 - - Unit-linked 46,280 - - Total 3,287,125 515 32,184
* This number is actually £312,000 but is nil when rounded to show to the nearest £m. Source: PRA Returns 2013
RLCIS LTBF
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process resulted in a number of provisions being put into the SPA and which are being carried forward into the Scheme.
The key aspects of the SPA relevant to my role as Independent Expert are:
■ Expenses: The RLCIS Fund (i.e. the entire LTBF of RLCIS) will be levied charges for “business as usual” administration and associated services according to a tariff arrangement for a fixed period of 20 years, and will be levied charges for asset management according to an Investment Management Agreement. For administration and associated services, the SPA specifies an approach for the charges based on costs after the expiry of the fixed period. Further, the RLCIS Fund will bear exceptional costs according to a detailed schedule as to what is allowable and what is not allowable. These arrangements were effective as regards RLCIS from the date of acquisition (i.e. 31 July 2013);
■ Capital Support: The RLCIS Fund will be managed so far as possible within the limits of its own capital resources. In circumstances when its own capital resources are not sufficient to meet its capital requirements, then the SPA provides for the General Reserve to provide capital support, and for the RLCIS Fund to pay a charge for that capital support. It should be noted that this refers to the SPA position, and the position in relation to capital support under the Scheme is covered in Section 4.3 below;
■ Mis-selling liabilities: This clarifies where any liabilities in respect of past and future mis-selling will be borne. As by definition liabilities in respect of mis-selling are not business as usual liabilities, it is desirable for there to be clarity as to where they are to be borne, taking account of the FCA rules which exist in this area;
■ Deferred Consideration: This relates to the £200m of the RLCIS General Reserve. In the event of a Scheme being sanctioned by the Court which does not require the transfer to or retention within RLMIS of the RLCIS General Reserve (or otherwise require RLMIS specifically to set up an equivalent arrangement), a deferred consideration of 90% of the RLCIS General Reserve (i.e. £180m) becomes payable to CBG.
The SPA provisions referred to above in respect of expenses, capital support, and mis-selling liabilities are incorporated into the Scheme, subject to certain amendments and subject to further detail being included where necessary within the Scheme. I consider and comment in detail on these aspects in Section 4 below. As stated in Section 4 below, the Scheme does not transfer the RLCIS General Reserve to RLMIS, and I consider and comment in detail on the effects of this in Sections 5.3 and 5.4 below.
In addition to the SPA, I also note that there is a Transitional Services Agreement between RLMIS and CFS Management Services Limited (a company still within the CBG Group) which ensures the continuity of certain services (including IT, premises, finance and tax support) to RLMIS/RLCIS for a period of 24 months from 31 July 2013 while the RLCIS business is being separated from CBG. Further, there is a Capital Support Deed between CBG and RLCIS which provides, inter alia, for any capital support charges which the RLCIS Fund has to pay (as referred to above) through any use of the RLCIS General Reserve to be passed back to CBG.
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I note further that the legal agreements provide for investment income on 90% of the RLCIS General Reserve of £200m (i.e. on £180m) to be paid over from RLCIS to CBG. The investment income on the remaining £20m accumulates within RLCIS.
3.4 The rationale for transfer Although not formally part of my role as Independent Expert, it is I believe important for me to be aware of the rationale for carrying out the proposed transfer. This is so that I can be aware of and understand any commercial drivers and ensure that I consider fully any aspects of the proposed transfer which are connected with these commercial drivers. In the case of this proposed transfer the key rationales are:
■ A desire to have all of the long-term business within the same legal entity, as this helps to maximise expense and capital efficiency for the benefit of all policyholders and RLMIS members;
■ The fact that the SPA requires the proposed transfer to be pursued on a best endeavours basis, for reasons connected with the RLCIS General Reserve and the Deferred Consideration.
The first rationale above is a perfectly valid one and would apply to any situation where one long-term insurer owns another long-term insurer. This is particularly so given the forthcoming EU Solvency II regime, under which the capital requirements are more driven by the underlying risks than the current regime. The second rationale above is specific to this case, as explained below in this report.
Further, and for completeness, I note that RLMIS has been successful in effecting the inwards transfer of a number of portfolios of with-profits businesses and their integration into RLMIS.
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4 Description of the Scheme
4.1 Overview of the Scheme The Scheme will transfer the entire LTBF of RLCIS into RLMIS, such that the LTBF of RLCIS will become a new subfund within RLMIS, to be called the Royal London (CIS) Sub-Fund, sitting along-side the existing subfunds of RLMIS. There will be three new subfunds within the Royal London (CIS) Sub-Fund, one for the RLCIS OB & IB Fund, one for the RLCIS With-Profits Stakeholder Fund and one for the RLCIS With-Profits Pension Fund. These three new subfunds will replicate the pre-transfer fund structure of the LTBF of RLCIS.
The RLCIS With-Profits Stakeholder Fund and the RLCIS With-Profits Pension Fund will in the first instance look to the RLCIS OB & IB Fund for any capital support which is required and any such capital support will be provided without charge. This is the same position as that which currently exists. The capital support provisions for the RLCIS OB & IB Fund itself are described in Section 4.3 below.
Within this report, where the term RLCIS Fund is used, it refers to the RLCIS OB & IB Fund, the RLCIS With-Profits Stakeholder Fund and the RLCIS With-Profits Pension Fund combined, both before and after the Effective Date, according to the context in question. Further, it should be noted that given the relative sizes of these three subfunds (see Section 3.2 above) and the capital support arrangements described in the paragraph above, references to the RLCIS Fund are in practice for most purposes (and unless otherwise stated) references to the RLCIS OB & IB Fund.
The RLCIS General Reserve is not transferred to RLMIS under the Scheme. Following the implementation of the Scheme, the Deferred Consideration of £180m referred to in Section 3.3 above will I understand be paid by RLMIS to CBG to satisfy the requirements of the SPA, following the transfer by way of a dividend of £180m of the RLCIS General Reserve from RLCIS to RLMIS. The remaining £20m of the RLCIS General Reserve (along with the other shareholder capital) will I understand be paid from RLCIS to the RLMF by way of a dividend and will be retained within the RLMF.
The absence of the transfer under the Scheme of the RLCIS General Reserve to RLMIS is part of my detailed consideration and analysis in the remainder of this report. As the intended dividend payment of £20m from RLCIS to the RLMF following implementation of the Scheme is not part of the Scheme itself, I have ignored it for the purposes of the analysis.
As indicated in Section 3.3 above, the Scheme incorporates a number of protections for the benefit of the RLCIS policyholders, and these are considered below.
Although not part of the Scheme itself, I note that the former RLCIS subfunds will become closed to new business coincident with the Effective Date of the Scheme. Additional premium payments into existing policies will still be allowed, as is the usual practice. There are some additional regulatory requirements arising from this closure,
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and there are additional considerations arising in relation to certain costs of closure being incurred coincidentally with the costs of implementing the Scheme. These aspects are considered in Section 4.3 below.
Subject to one exception, there will be no changes to any of the policy terms and conditions of the Transferred Business and the Excluded Policies. The exception is that the Scheme provides for all references to the RLCIS General Reserve and the RLCIS Shareholder Fund within any policy (including Excluded Policies) or other relevant documents to be deleted. These deletions are consistent with the RLCIS General Reserve not being transferred to RLMIS under the Scheme, and with RLMIS being a mutual company.
4.2 Diagrammatic illustration of the effect of the Scheme The diagram below illustrates the position prior to the implementation of the Scheme. The values shown are the regulatory asset values of the various subfunds as at 31 December 2013.
The diagram below illustrates the position as it would be immediately after the implementation of the Scheme and the RLPPC insurance business transfer scheme. As explained below, on the implementation of the Scheme, £180m of the RLCIS Shareholder Fund is paid to CBG, leaving the remaining amount of £31m as shown below.
RLMIS Long Term Fund
Royal London Main Fund
£23,069m
Refuge Assurance IB Subfund
£306m
United Friendly OB Subfund
£2,279m
United Friendly IB Subfund
£1,093m
PLAL With-Profits Subfund
£705m
Royal Liver Subfund
£2,352m
RLCIS
RLCIS OB & IB Fund
£19,204m
RLCIS With-Profits Stakeholder Fund
£298m
RLCIS Shareholder Fund /
General Reserve
£211m
RLCIS Long Term Business Fund
RLPPC Long Term Fund
£2,449m
RLPPC
RLPPCShareholder Fund
£4m
Note: Prior to the implementation of the Scheme, RLCIS and RLPPC are wholly owned subsidiaries of the Royal London Main Fund Source: PRA Returns 2013
RLCIS With-Profits Pension Fund
£5m
Scottish Life Closed Fund
£2,664m
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Although not part of the Scheme in question, I have for completeness included in the above diagrams the movement of the long-term business of RLPPC from being within a subsidiary of RLMIS to being within the RLMF. The RLPPC position is considered in detail in my separate Independent Expert report on that transfer. If the RLPPC insurance business transfer scheme did not go ahead, the above diagram would be similar, except that the assets of the RLMF post-transfer would be £2,449m less and the RLPPC long-term business would remain within the subsidiary of the RLMF.
After implementation of the Scheme, my understanding is that the following is intended to happen:
■ £180m of the RLCIS General Reserve will be paid to CBG, via a dividend from RLCIS to the RLMF, and then via a payment from the RLMF to CBG;
■ The remaining £20m of the RLCIS General Reserve, together with the £11m of other shareholder capital, will be paid via a dividend to the RLMF once RLCIS has been fully de-authorised as an insurer;
■ The £4m within the RLPPC Shareholder Fund will be paid to the RLMF via a dividend once RLPPC has been fully de-authorised as an insurer.
As the above transactions are not part of the Scheme, I have excluded them for the purposes of my analysis. My analysis is thus on the basis that none of the RLCIS General Reserve is available within RLMIS post-transfer.
4.3 Detailed review of the Scheme In the following sections I describe the key provisions of the Scheme in more detail and I also provide my comments and opinions on those provisions.
Subfund operation and PPFM The Scheme describes how RLMIS will replace the existing subfunds within RLCIS with a new subfund within RLMIS. The new subfund will itself have three subfunds, which will operate as ring-fenced funds. As all of the three former RLCIS subfunds are with-profit subfunds, the operation of each is governed by its own PPFM, which is a detailed
RLMIS Long Term Fund
Royal LondonMain Fund incl. RLPPC Long
Term Business
£25,518m
Refuge Assurance IB Subfund
£306m
United Friendly OB Subfund
£2,279m
United Friendly IB Subfund
£1,093m
Scottish Life Closed Fund
£2,664m
PLAL With-Profits Subfund
£705m
Royal Liver Subfund
£2,352m
RLCIS OB & IB Fund
£19,204m
RLCIS With-Profits
Stakeholder Fund
£298m
RLCIS
Royal London (CIS) Shareholder
Fund
£31m
RLPPC
RLPPC
Shareholder Fund
£4m
Royal London (CIS) Sub-Fund
RLCIS With-Profits
Pension Fund
£5m
Source: PRA Returns 2013
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and publicly available document required by FCA rules and which sets out how a with-profits fund is operated. I have reviewed the three current PPFMs of RLCIS and the three proposed modified PPFMs that would apply following the implementation of the Scheme. Essentially the operation of the subfunds themselves in normal and in most adverse circumstances is unaffected by the Scheme, i.e. the subfunds will operate and policyholder benefits will be determined according to the PPFM in the same way post-transfer as they were pre-transfer, subject to the areas highlighted in this section. The modifications to the PPFM post-transfer are largely those consequential on the subfunds being within RLMIS as opposed to RLCIS, and becoming closed to new business. I note that the modified PPFM for the RLCIS OB & IB Fund contains reference to the capital support arrangements which are described below.
For a with-profits subfund existing within a larger company alongside other with-profits subfunds, the key areas of consideration are the investment strategy and the management of the subfund’s assets, the expenses charged to the subfund, the tax charged to the subfund, and the approach to capital management of the subfund. These are the key areas where the subfund interacts or can interact with the wider company. If these key areas are dealt with satisfactorily, the PPFM and the processes set out therein can be relied upon for the normal operation of the subfund and the determination of benefits to policyholders within the subfund.
Although the position is essentially as stated above there are some important potential differences arising from consideration of the RLCIS General Reserve not being transferred as part of the Scheme. These aspects are considered in Section 5.3 and 5.4 below.
Expenses
As previously referred to, the SPA put into place tariff arrangements for the charging of administration expenses to the RLCIS OB & IB Fund and these arrangements are formally included within the provisions of the Scheme. Under the relevant PPFMs, the charges to the RLCIS With-Profits Stakeholder Fund and the RLCIS With-Profits Pension Fund are already fixed, and the tariff arrangement in respect of these funds is applied via the RLCIS OB & IB Fund.
The tariff arrangement itself applies to the business as usual expenses, and the charges to the RLCIS Fund are expressed as amounts per policy per annum. These charges are guaranteed for a period of 20 years from the date of acquisition (i.e. to 31 July 2033), subject to their amounts being revalued annually in line with inflation, which for this purpose is defined as being a 50/50 blend of Retail Price Inflation and Earnings Inflation. The Scheme sets out the mechanisms under which the annual charges are in practice collected monthly. The Scheme also provides a mechanism whereby the tariff can be adjusted (subject to proper governance processes) if any dormant policies are deemed to be permanently out of force and are removed from the data records.
I note for completeness that a significant part of the business as usual services are provided by an outsourcing company, namely Capita Life & Pensions Regulated Services Limited (“Capita”). However, the tariff arrangement described above is between the
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RLMF and the RLCIS Fund. Hence any differences in either direction between the charges levied under the tariff and those payable to Capita fall to the RLMF. In the event that a different outsourcer were used, there would be no effect on the tariff charges paid by the RLCIS Fund.
Under the FCA rule COBS 20.2.23, a firm must only charge costs to a with-profits fund which have been, or will be, incurred in operating the with-profits fund. At present, and prior to the implementation of the Scheme, this rule is satisfied as the tariff charges are levied on RLCIS by RLMIS, and those charges are then passed through to the RLCIS Fund. After the implementation of the Scheme, an FCA direction in respect of this rule will be necessary and will be sought by RLMIS. This will be necessary as the RLCIS Fund will, after the Effective Date, become a part of the RLMIS LTBF and will thus no longer be part of a separate entity. The Scheme is conditional on RLMIS receiving on or before the Effective Date a communication from the FCA confirming that the FCA will issue such a direction on or before 9 January 2015. It will of course be for the FCA to determine whether to issue the direction. I do however note that the situation in question is a common one, i.e. whereby a with-profits fund is initially charged more than the actual costs in return for that fund receiving the benefit of a fixed tariff and thus avoiding additional costs which would otherwise be charged as the fund runs down and diseconomies of scale arise.
After the expiry of the 20 year period, the tariff arrangement is replaced by one whereby the RLMF can make charges to the RLCIS Fund which are based on actual direct internal and external costs to RLMIS plus a margin of up to 7.5%, subject to a periodic market benchmarking test. This market benchmarking test is based on the average of three suitable market providers of the services. If the benchmarking average is lower than the actual costs, then RLMF will charge the RLCIS Fund up to the actual costs with no margin. If the benchmarking average is higher than the actual costs by an amount less than 7.5%, the charges will be benchmarking average (and the effective margin will be less than 7.5%). If the benchmarking average is higher than the incurred cost by an amount greater than 7.5%, up to the full 7.5% margin (but no more than 7.5%) will apply.
I note that the Scheme specifies that the determination of the actual costs as referred to above will be subject to review and agreement by RLMIS’s internal audit function. This in my view provides a suitable means of ensuring that the determination of those costs is reasonable.
Asset management services are now provided to the former RLCIS subfunds under an investment management agreement with RLAM, and this will continue following the implementation of the Scheme. The Scheme states that the level of fees payable to RLAM for investment management will not be materially changed unless the RLMIS With-Profits Committee (“WPC”) considers that a change is necessary to ensure that such fees are consistent with market rates for the provision of the services in question. This in my opinion places a suitable onus on the RLMIS WPC to review the level of fees from time to time in order to ensure that they are consistent with market levels.
In addition to the above business as usual charges, the Scheme also provides for exceptional costs to be charged to the RLCIS Fund. Both the SPA and the Scheme
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provide for exceptional costs to be charged directly to the RLCIS Fund in respect of projects, certain IT rectification costs, any increase in separation and integration costs as compared with those expected at acquisition, rectification costs in respect of pre-acquisition issues emerging, and costs in respect of changes in legislation, regulation or taxation. This list is not an exhaustive list, and the actual listing of allowable exceptional costs within the Scheme is extensive. However, I draw comfort from the following factors:
■ The exceptional costs allowed to be charged to the RLCIS Fund post implementation of the Scheme are the same as those which have already been agreed to within the acquisition and SPA process, and thus would apply even if the Scheme is not implemented. Further, I note that the Board and WPC of RLCIS accepted that the terms of the acquisition were fair to the RLCIS LTBF and its policyholders;
■ The Scheme contains governance provisions to ensure that the charging of exceptional costs to the RLCIS Fund is in all respects fair, and that reasonable endeavours are used to keep such costs to the minimum. Such governance arrangements include advice from the WPA of RLMIS and oversight from the RLMIS WPC;
■ The Scheme contain an over-riding provision which states:
“Notwithstanding any other provision of this Schedule 5, Royal London may only charge to the RLCIS LT Sub-Fund or a LTBF Subsidiary the Exceptional Costs that the Royal London Board (having regard to the advice of the Royal London WP Actuary, the RLCIS LT Sub-Fund Actuary and the Royal London WPC (or equivalent supervisory body or function if the Royal London WPC is replaced)) considers appropriate for: -the operation of the RLCIS LT Sub-Fund; and/or -the operation of a LTBF Subsidiary; and/or -the integration into Royal London of the Transferred Business, the Transferred Assets, the Transferred Liabilities, the Residual Assets and the Residual Liabilities.”
The third point listed above is in my view particularly clear in providing protection to the RLCIS Fund policyholders.
A particular exceptional expenses aspect which I have considered relates to those exceptional expenses that occur for any long-term insurance company for its business overall. Examples of such expenditure include that in respect of the implementation of regulatory, fiscal or taxation changes, with Solvency II being a particular example. I note that under the existing arrangements and practices adopted by RLMIS, some of the existing RL Closed Funds are charged limited amounts in respect exceptional expenses. Assuming that the transfer proceeds, then it will in my opinion be important to ensure (given that a wide range of exceptional expenses can be charged to the RLCIS Fund) that the RLCIS Fund does not bear any share of general company-wide exceptional expenses that would have been borne by any of the existing RL Closed Funds absent the current arrangements and practices in respect of them. Any such share would need to be borne by the RLMF. I am satisfied that the provisions set out within the Scheme are sufficient to address this aspect.
The costs of implementing the Scheme itself will be met by the RLMF. To the extent that there may be an overlap of costs between the costs of implementing the Scheme and the
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costs of closing the RLCIS Fund to new business, some costs may be charged to the RLCIS Fund on a fair apportionment basis. This is considered further in Section 5.2 below.
Based on the above I can conclude that the implementation of the Scheme will give rise to no adverse effect on any RLCIS with-profits policyholders as a result of expenses.
Capital support The overriding principle, stated both in the SPA and the Scheme, for the management of the RLCIS Fund (and by implication the RLCIS With-Profits Stakeholder Fund and the RLCIS With-Profits Pension Fund) is that the subfund will be managed within its own capital resources. A full discussion on the risks of contagion between subfunds is given in Section 7.10 below, but the principle means that the assets and liabilities of the subfund will be managed so far as possible such that the subfund is able to meet its own liabilities and cover its own regulatory capital requirements. This principle of managing a subfund within its own capital resources is both common and sensible as it ensures that the different interests and features of different subfunds are kept separate as far as possible. However, there may be times when a subfund cannot meet its own liabilities and regulatory capital requirements, and in these circumstances capital support from outside of the subfund is necessary. The fund which would provide any capital support required by the RLCIS Fund (and ultimately the RLCIS With-Profits Stakeholder Fund and the RLCIS With-Profits Pension Fund) is the RLMF.
In considering the issue of capital support for any subfund, there are two situations to be considered. The first relates to the situation when it is necessary to inject assets into the subfund. The current UK regulatory regime requires each subfund of a long-term insurance company to have sufficient assets to cover its own Pillar 1 liabilities (and Section 7.1 below covers the different aspects of the Pillar 1 liabilities). If this is not the case, then it is necessary to inject additional assets into the subfund to restore the position. Such an injection is in the first instance done on a temporary basis, allowing the injection to be repaid if the position of the subfund recovers. If there is no recovery, then the injection becomes permanent. For ease of reference, I refer to this first situation as Type 1 capital support. Where Type 1 capital support is provided, and the position recovers allowing the capital support to be repaid, it is common for the repayment to include interest at a reasonable rate or the actual investment returns earned on the support assets provided whilst such assets were within the subfund. The second relates to the situation where the subfund is covering its own Pillar 1 liabilities, but cannot fully cover its Pillar 1 or Pillar 2 capital requirements. There is currently no UK regulatory regime requirement for a subfund to cover its own Pillar 1 or Pillar 2 capital requirements, and it is acceptable for such capital requirements to be met fully or partially from assets held outside of the subfund in question. In such circumstances the capital required to be held outside of the subfund but in respect of that subfund is effectively earmarked for that subfund and cannot in practice be used for any other purpose unless and until the subfund becomes able again to cover its own capital requirements. For ease of reference, I refer to this second situation as Type 2 capital support.
The current PPFM provides for both Type 1 and Type 2 capital support to the RLCIS Fund from the RLCIS General Reserve. The provisions include the repayment of Type 1
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capital support with appropriate interest, but there is no reference to any charges being levied on the RLCIS Fund for Type 2 capital support.
The SPA also provides for both Type 1 and Type 2 capital support from the RLCIS General Reserve during the period prior to any Part VII transfer, and the level of charges for both Type 1 and Type 2 support are specified. Any charge for Type 2 capital support would require a change to the principles of the PPFM, for which three months advance notice to the policyholders would be required. The SPA also states that post any Part VII transfer the basis for capital support will be on commercial terms, assessed without reference to the interim SPA arrangements.
Given the PPFM and SPA positions as stated above, I have considered particularly carefully the provisions within the Scheme for capital support to the RLCIS Fund, including in relation to the charges to be levied on the RLCIS Fund for such capital support.
The Scheme provides for the RLMF to provide capital support to the RLCIS Fund on the following basis:
■ Where Type 1 capital support is provided and can be subsequently repaid, that repayment includes the investment return earned on the relevant capital support assets. On repayment therefore, both the RLMF and the RLCIS Fund are effectively restored to the position they would have been in had no Type 1 support been necessary;
■ Where either Type 1 or Type 2 capital support is provided, a charge becomes payable by the RLCIS Fund to the RLMF to reflect the fact that the RLMF cannot make alternative use of the capital involved;
■ In assessing the need for Type 1 or Type 2 capital support, allowance is to be made (subject to what the PRA may seek to permit) to all available management actions down to guaranteed benefit levels, taking into account the requirement to treat customers fairly in the circumstances under consideration (including the adverse circumstances envisaged by the capital requirement calculations);
■ There is a duty on RLMIS to seek to minimise the need for capital support;
■ Where capital support is necessary and is provided, the Scheme specifies fixed annual charge rates for that support (both Type 1 and Type 2), which range from 0%pa on the first £10m of capital support, to 3%pa on any capital support in excess of £20m.
Having reviewed carefully the detailed provisions of the Scheme for capital support and the charges for it, and having engaged in detailed discussions with the relevant RLMIS actuaries in relation to the operation of the arrangements in practice, I am satisfied that the arrangement are fair, both to the RLCIS Fund and its with-profits policyholders, and to the RLMF and its with-profits policyholders. In reaching this conclusion, I have taken into account the following:
■ The arrangements are such that capital support will only be provided and charged for where it is strictly necessary;
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■ Any capital support provided (whether Type 1 or Type 2) will be deducted from the relevant calculations for the purposes of the mutual dividend arrangements within the RLMF (see Section 6.4 below), and will thus reduce (normally only temporarily) the mutual dividend to the RLMF with-profits policyholders. It is thus only fair that the RLMF is compensated by the receipt of charges for providing capital support to the RLCIS Fund;
■ Any capital support charges paid by the RLCIS Fund will to the maximum extent possible be charged to the estate of the RLCIS Fund and not directly to the asset shares of the with-profits policyholders. I note that the closure of the RLCIS Fund post-transfer, and the intended distribution over time of the estate to with-profits policyholders will mean that with-profits policyholders will bear the effect of the charges for capital support, but nevertheless it is in my view relevant that it will be the additional estate benefits (and not the basic with-profits benefits) which will be reduced;
■ The rates at which charges for any capital support are levied are fixed and are the same as those used by RLMIS for the capital support arrangements under its most recent previous transfer in of long-term business. There are advantages and disadvantages of charges which are fixed as opposed to those which are related to current interest rates. Given the precedent from the previous transfer, and the fact that charges should only arise in adverse circumstances, I am satisfied that the fixed charge approach is fair. I also note that the 0% charge rate on the first £10m of capital support reduces the possibility of charges arising for what might be spurious effects within the detailed calculations.
In summary, the position is that the RLCIS Fund will be managed within the limits of its own capital resources as far as possible and, if these capital resources become insufficient to meet regulatory requirements (such requirements allowing for treating customers fairly), then as far as possible the RLMF will provide capital support subject to charges being levied. Additionally, any assets actually transferred into the RLCIS Fund will be repaid as and when possible together with the relevant investment return.
In addition to concluding that the capital support arrangements are fair, I can also given the above conclude that charges for capital support are only likely to arise in adverse circumstances, and thus that the possibility of charges for capital support arising does not constitute a material potential reduction to the benefit expectations of the RLCIS with-profits policyholders.
I note that the capital support provisions within the Scheme have been drafted such as to be able to deal with the changes arising in relation to the new EU Solvency II regime from 1 January 2016 (see Section 7.9 below). This new regime is more onerous than the current UK regime, which is an additional reason why I have considered the capital support arrangements in detail.
I note that any requirements placed on RLMIS by the PRA in relation to the management actions which RLMIS is allowed to assume in calculating the liabilities and capital requirements for the RLCIS Fund may have a direct effect on the need for capital support and hence charges for capital support. I have discussed this aspect with the PRA in order
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to ensure that going forward the PRA is fully aware of the construct of the Scheme when it exercises its regulatory duties and powers.
Tax The Scheme provides for tax to be charged to the RLCIS Fund post-transfer as if the RLCIS Fund was a separate stand alone mutual life insurance company. The effect of this is that any synergies or dis-synergies with the RLMF and the RL Closed Funds will arise in or be borne by the RLMF. This is a standard approach for dealing with a mutual ring-fenced fund, and the position post-transfer is effectively the same as that which applies pre-transfer. From the viewpoint of the with-profits policyholders within the ring-fenced fund (i.e. the RLCIS with-profits policyholders this case), it is normally considered preferable to forego any possible synergy benefits in return for being insulated from the effects of any possible dis-synergies, and this is a view that I generally support.
The Scheme provides for any carried forward tax losses or unused tax reliefs which exist within RLCIS pre-transfer to be attributed to the RLCIS Fund post-transfer.
It is possible that some or all of the carried forward tax losses referred to above may be utilised post-transfer by a part of RLMIS other than the RLCIS Fund. This is because the HMRC tax computations consider the overall RLMIS position, and the allocation of the benefit of losses which reduce the overall tax liability is a matter for RLMIS and not for HMRC. The same could apply in respect of new tax losses emerging within the RLCIS Fund post-transfer. I have discussed this matter with the relevant RLMIS/RLCIS taxation experts, and they have confirmed that any tax losses in respect of the RLCIS Fund (whether existing at the point of transfer or arising subsequently) will continue to be tracked and allocated to RLCIS Fund even if they are actually used by another part of RLMIS. In this way, such tax losses will give rise to a cash benefit to the RLCIS Fund as and when the RLCIS Fund has taxable income or gains of the appropriate type against which the losses can be offset. This is fully consistent with the “stand alone mutual” principle set out above. If a tax loss in respect of the RLCIS Fund was initially utilised by another part of RLMIS to reduce the overall RLMIS tax liability, and then only utilised later by the RLCIS Fund under its notional stand alone assessment, then a cash payment into the RLCIS Fund would be made (in practice from the RLMF) at that time, regardless of the overall RLMIS tax position. I am satisfied that the wording of the relevant part of the Scheme is sufficient to ensure that this detailed aspect is properly covered.
The above is consistent with the approach to taxation adopted by RLMIS in respect of the existing RL Closed Funds.
For completeness, I note that the RLCIS Fund has in the past tended to generate more investment income than expenses. The RLMF has tended in the past to be the opposite, and has generated less investment income than expenses. Given that the life company taxation calculations involve a significant element which is based on the excess of income over expenses, the transfer of the RLCIS Fund into the same legal entity as the RLMF would in the past have given rise to a significant tax synergy in favour of the RLMF. However, the combination of recent and current market conditions, and recent amendments to the life company taxation basis by HMRC, means that this is no longer
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the case. There are thus no material tax synergies expected as a result of the implementation of the Scheme and, moreover, RLMIS’s analysis shows that any material future tax synergies are (based on current tax legislation) unlikely.
Further comment on taxation is given in Section 8.5 below.
Mis-selling
The SPA and the Scheme specify the arrangements as to where liabilities and costs in respect of mis-selling are borne. It is appropriate to be clear on such liabilities and costs given that they are, by definition, not business as usual liabilities and costs.
Prior to 31 July 2009, it was permissible under the relevant regulatory COBS rules to charge liabilities and costs arising in respect of mis-selling to a LTBF. From 31 July 2009, the regulatory rules were changed such that for non-mutual companies (i.e. those which have a Shareholder Fund), liabilities and costs in respect of mis-selling events after that date have to be borne by the Shareholder Fund rather than the LTBF.
Both the SPA and the Scheme provide for Post-2009 (i.e. post 31 July 2009) mis-selling liabilities and costs to be borne as follows:
■ Post-2009 mis-selling incurred by RLCIS prior to the Effective Date will be charged to the RLMF. The rationale here is that such mis-selling cannot be charged to the RLCIS LTBF as RLCIS is not a mutual company. Such mis-selling could be charged to the RLCIS General Reserve while it exists, but this approach would not be possible if such mis-selling only comes to light after the Effective Date when the RLCIS General Reserve no longer exists within RLMIS;
■ Post-2009 mis-selling incurred by subsidiaries of RLCIS prior to the Effective Date may either be charged to the RLMF or to the subsidiaries themselves if this is deemed appropriate by the RLMIS Board. Charging such mis-selling to the subsidiaries is allowable under the regulatory rules, and would in effect amount to charging the mis-selling to the RLCIS LTBF as subsidiaries are owned by the RLCIS LTBF;
■ Post-2009 mis-selling incurred after the Effective Date will be charged to the RLCIS Fund, as after the Effective Date all the business is within a mutual organisation.
For the avoidance of doubt I note that there are still long-term liabilities arising within the RLCIS LTBF in respect of pre-2009 mis-selling. The Scheme is silent on these liabilities and they will thus remain liabilities of the RLCIS Fund post implementation of the Scheme.
I have enquired and been informed by RLMIS and RLCIS that at the present time there are no material liabilities or potentially material liabilities existing in respect of Post-2009 mis-selling. I note further that as from the Effective Date of the Scheme, the RLCIS Fund will become closed to new business, thus effectively eliminating the possibility of mis-selling liabilities arising for which under the Scheme would be charged to the RLCIS Fund.
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Based on the above I can conclude that the implementation of the Scheme will give rise to no adverse effect on any RLCIS with-profits policyholders as a result of the allocation of mis-selling liabilities.
Operational risks Mis-selling is a particular form of operational risk, and this has been covered above. This section covers other operational risks, and relates primarily to the following risks:
■ Errors and faults in computer systems;
■ Human errors and omissions incurred in the carrying out of administration, accounting, investment, actuarial, and all the various functions which are involved in running a long-term insurance company.
These errors could exist or arise within the insurance company itself, or within any of the outsourced providers of services to the insurance company. Whilst some errors and faults can be corrected without cost to the company or fund, others (for example claim over-payments) result in irrecoverable costs, and some require additional expense to be incurred in order to correct them.
Where a long-term business fund or subfund is bearing all its own costs and does not have an expense tariff arrangement with another fund or party, it is normal for that fund to bear its own costs from operational errors which arise. This was the case with the RLCIS Fund prior to the acquisition of RLCIS by RLMIS. However, where a fund or subfund does have an expense tariff arrangement, it is nowadays normal that alongside such an arrangement there is specific agreement as to where the costs of operational errors will be borne. This is usually covered in the negotiation and documentation of the tariff itself. The fund or party providing the services under the tariff would normally seek a higher level of fees if it is to bear the risk of errors as compared to if the fund itself continues to bear the risk of errors.
In the case of RLMIS and RLCIS, the RLCIS Fund has an expense tariff provided by the RLMF, with Capita providing the main administration services (as was the case prior to RLCIS being acquired by RLMIS). As referred to previously within this report, the expense tariff was introduced under the SPA, and this expense tariff continues under the Scheme. The SPA specifies at high level the intended treatment of operational risk, and the Scheme provides further in this area, including the associated on-going governance arrangements. My role as Independent Expert in this area has therefore been to ensure that the key operational risk provisions within the Scheme are consistent with the intentions of the parties when RLCIS was acquired by RLMIS and the expense tariff introduced, and that the more detailed provisions set out in the Scheme are reasonable and fair both to the RLCIS policyholders and the RLMF policyholders.
The Scheme essentially provides for the following in relation to the costs arising from operational risk events (other than mis-selling which has been covered separately above):
■ Costs arising from deliberate wrongful acts or negligence are borne by the RLMF;
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■ Any costs arising from any amendments made on or after 18 September 2013 to the contractual arrangements with Capita are borne by the RLMF;
■ Costs arising from errors made by Capita (and which cannot be recovered from Capita) are borne by the RLCIS Fund. The Scheme places a duty on RLMIS to seek to recover such costs from Capita wherever possible. If however RLMIS chooses for commercial reasons (including its wider relationship with Capita) not to pursue the recovery of such costs, then such costs have to be borne by the RLMF;
■ Costs arising from errors and omissions (including computer systems and process errors) arising prior to the Effective Date are borne by the RLCIS Fund;
■ Costs arising from errors and omissions (including computer systems and process errors) arising after the Effective Date are also borne by the RLCIS Fund, but only to the extent (and subject to actuarial advice) that they are each of relatively small amount and are substantially similar to what the RLCIS Fund experienced pre-acquisition. Otherwise the costs are borne by the RLMF.
The summary stated above is simplified, and the Scheme itself specifies further detail in relation to a number of aspects. The Scheme also contains provisions for the advice of the WPAs of RLMIS and the RLCIS Fund to be provided, and for them to agree in relation to the operation of the last two of the four provisions summarised above. In particular, where the relatively small amounts as referred to above charged to the RLCIS Fund accumulate to more than £1m (this amount being increased over time for indexation) in any year, the Scheme provides for the WPAs of RLMIS and the RLCIS Fund to consider the position and agree where any subsequent costs arising in that year should be borne. The Scheme also contains overriding provisions for the Board of RLMIS, having taken the advice of the WPAs and the WPC, to make the final decisions in any circumstances where the WPAs cannot reach agreement or in any circumstances where they deem the allocation of costs according to the provisions (as summarised above) would not be fair.
In addition to reviewing the provisions of the Scheme in this area, I have as part of my work attended a meeting of the current RLCIS WPC, and which was also attended by the current RLCIS WPA. I have reviewed the minutes of the meeting I attended and those of the subsequent WPC meeting, including the associated note produced by the RLCIS WPC chairman. I have ensured to my satisfaction that the current RLCIS WPC and the current RLCIS WPA are aware of and are content with the contents of the Scheme in this area. Based on the above, I am satisfied that the arrangements are fair, both to the RLCIS Fund and its with-profits policyholders, and to the RLMF and its with-profits policyholders. Furthermore, the implementation of the Scheme should not in my view give rise to any adverse effect on any policyholders as far as this operational risk aspect is concerned.
Governance In addition to the overall governance afforded by the Board of any long-term insurer, the governance arrangements required under FCA rules for with-profits funds and with-profits business comprise the following:
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■ A detailed set of PPFMs, the minimum content of which is prescribed by FCA rules;
■ A WPC, whose role it is to exercise independent judgement and scrutiny of the discretionary aspects of the operation of the fund. (Alternatives to a WPC are possible but a WPC is the most common approach and is the approach used by RLMIS.);
■ A WPA, whose role it is to advise the Board (and in practice usually also the WPC) on the discretionary aspects of the operation of the fund.
In addition to the above normal governance arrangements, the Scheme provides for the following:
■ Each year, the Board of RLMIS, having taken the advice of the AFH and the WPA of RLMIS, will be required to certify to the PRA that its obligations under the Scheme have been complied with (or, if applicable, to detail where the obligations have not been complied with);
■ Each year, the WPA of the RLCIS Fund will be required to certify to the PRA that the provisions of the Scheme in relation to the investment and bonus policy of the RLCIS Fund, together with other actuarial matters subject to the advice of the RLCIS WPA, have been complied with (or, if applicable, to detail where the provisions have not been complied with).
Copies of the above certificates to the PRA will be sent to the WPC and will be included in the publicly available regulatory returns to the PRA.
In my view, the above provisions are adequate to ensure that the terms of the Scheme will be properly followed through in practice.
The Scheme makes a number of references to the WPA of the RLCIS Fund and the WPA of the RLMF, and I have referred to these roles at various places in this report. I note that currently RLMIS has a single WPA for the RLMF and each of the RL Closed Funds and that, following the implementation of the Scheme, it is intended that the same actuary will become the WPA of the RLCIS Fund. It is common for a company with a number of with-profits funds to have a single WPA for all of the funds, there being a number of advantages of consistency and cost efficiency in this approach. As is the case with the (single) WPC, it is the responsibility of a WPA to give advice which considers the interests of the policyholders in the with-profits fund in question. In the event that the WPA (or the WPC or the Board) was of the view that it was not possible for a single WPA to advise in a particular situation where there was a material conflict of interest between two or more with-profits funds, it would be possible for specific additional actuarial advice for each fund to be sought from different actuaries. This would be a more proportionate and effective solution than having a different WPA for each with-profits fund.
Future changes to unit-linked funds
As shown in Section 3.2 above, unit-linked business is a small part of the business of RLCIS. Nevertheless the Scheme contains specific provision in relation to the unit-linked funds underlying this business, as set out below.
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The Scheme provides for each RLCIS unit-linked fund to be replicated post- transfer by a corresponding new unit-linked fund, comprising the same number and the same value of units as pre-transfer. Upon the transfer taking effect, the assets within each new unit-linked fund will be the same as in the old unit-linked fund pre-transfer. This is the standard approach for a Scheme transferring unit-linked business.
The Scheme includes provisions which give RLMIS powers to make the following changes to the new unit-linked funds:
■ Close (to new or further investment), or amalgamate any linked funds;
■ Divide into one or more linked funds;
■ Wind up;
■ Any combination of the above;
■ Modify or enlarge the investment objectives of any linked fund to permit investment of similar assets or investment exposure.
These provisions are wide, but I note the following:
■ The Scheme states that any changes are subject to regulatory requirements (comprising FSMA 2000 and both PRA and FCA rules) , and that effectively means that the requirement to treat customers fairly will have to be followed;
■ Any changes are subject to the advice of the RLMIS AFH, the RLMIS WPA, or the RLCIS WPA as appropriate;
■ The Scheme provides for policyholders to switch, once, free of charge, to alternative funds if they are not satisfied for any reason with the change being made provided that the switch is made within 12 months from the date of the change;
■ The Scheme provides for compensation to be paid should any change give rise to any disadvantage to any policyholder.
Hence, although the powers given in the Scheme to make these changes to the new unit-linked funds are wide, I note that the exercise of such powers is subject to proper governance. I am thus satisfied that there is no detriment to any of the RLCIS unit-linked policyholders as a result of the provisions of the Scheme. Equally, I am satisfied that the governance arrangements would ensure that the interests of the unit-linked policyholders within any of the other subfunds of RLMIS would be protected should, as is possible, any fund mergers take place which transcend the RLMIS subfund structure.
Excluded policies, residual assets and liabilities When carrying out an insurance business transfer, it is often not possible to transfer at the Effective Date all of the policies in question. Some policies (Excluded Policies) have to be temporarily excluded as a result of the process for consulting the regulators in other EEA States for policies where the State of commitment is not the UK. It is standard practice for there to be an Excluded Policies Reinsurance Agreement to reinsure fully such policies to the transferee (in this case RLMIS). Formal transfer follows when the
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relevant approvals or UK regulator certificates are issued. The Scheme contains these provisions, and I have reviewed the agreed form of the Excluded Policies Reinsurance Agreement. Similarly, certain assets and liabilities may for practical or legal reasons not be immediately transferable, or may only be immediately transferred on disadvantageous terms. The Scheme contains provision for these residual assets and liabilities to be subject to a subsequent transfer as soon as circumstances allow.
These provisions are standard for a Scheme such as the one in question and I am satisfied that these provisions give rise to no adverse effect on any policyholders.
At the time of signing this report I understand that it is not expected that there will be any Excluded Policies. I will provide an update on this position in my Supplementary Report.
Cessation
The Scheme contains provisions for the RLCIS Fund to cease to be maintained as a separate subfund when it has declined to a certain size. The Scheme provides the option for RLMIS to make this change when the RLCIS Fund has declined to £500m (subject to RPI indexation on this amount) and for RLMIS to be required to make this change when the RLCIS Fund has declined to £100m (subject to RPI indexation on this amount). The value of the RLCIS Fund for this purpose is defined on the basis of actual assets, and excludes the value of reinsurance recoveries (which are regarded as an asset for some purposes). On cessation of a separate RLCIS Fund, the with-profits policies will remain with-profits policies and any excess of assets over liabilities will be allocated to the RLCIS Fund with-profits policyholders on a basis which is deemed fair by RLMIS having regard to the advice of the RLMIS WPA. This allocation will be paid to policyholders through the normal bonus mechanisms.
In addition to the above, the Scheme contains an option for the RLCIS Fund to cease to be maintained as a separate subfund before the £500m (plus indexation) level referred to above is reached provided that:
■ maintaining the RLCIS Fund has become materially adverse in its effects on the RLMF policyholders, and ceasing the RLCIS Fund would not be materially adverse to the RLCIS Fund policyholders; or
■ maintaining the RLCIS Fund has become materially adverse in its effects on the RLCIS Fund policyholders, and ceasing the RLCIS Fund would not be materially adverse to the RLMF policyholders.
In the application of the above two tests, the Scheme contains appropriate provisions for the AFH and the relevant WPAs to provide appropriate advice to the Board of RLMIS. My understanding is that RLMIS and RLCIS currently have no specific circumstances in mind as to when this early cessation mechanism might be invoked, but regard it as a sensible provision to include within the Scheme to protect both RLMF and RLCIS policyholders against unknown future events. I am satisfied that the conditions which would need to be satisfied, including the provision of the relevant actuarial advice, are both unbiased and sufficient.
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In the event of the RLCIS Fund ceasing to be maintained as a separate subfund for any of the reasons referred to above, the Board of RLMIS will need to consider whether the RLCIS with-profits policyholders should then participate in the RLMF mutual dividend arrangements (see Section 6.4 below). Such a consideration will in my view be particularly pertinent before any option is exercised to cease the maintenance of the RLCIS Fund before the £500m (plus indexation) level referred to above is reached.
Options to take out new or replacement policies
It is possible that some of the RLCIS policies have the option or right to take out a new or replacement policy. The Scheme provides for such options or rights to continue within RLMIS after the Effective Date, subject to the approval of the RLMIS Board and subject to an alternative type of policy being offered if RLMIS is no longer writing the type of policy to which the option relates. This is a standard provision in schemes of this nature.
Reinsurance
RLCIS currently has a large number of outwards reinsurance agreements in place. A list of these agreements is set out in a schedule of the Scheme. The Scheme transfers all of these arrangements to RLMIS, both in terms of the assets and the liabilities associated with each reinsurance agreement. I note that, other than the Excluded Policies Reinsurance Agreement as referred to above, there will be no new reinsurance agreements or changes to existing reinsurance agreements arising from implementation of the Scheme itself.
Scheme costs
The Scheme provides for the costs of its implementation to be met by the RLMF, except that where any costs may reasonably be regarded as also relating to the closure of the RLCIS Fund, an apportionment of such costs can be made to the RLCIS Fund. I have considered this apportionment and commented on it in Section 5.2 below.
Membership of RLMIS
For the avoidance of doubt, the Scheme does not confer membership of RLMIS on any RLCIS policyholder. I note that none of the policyholders in any of the existing RL Closed Funds became members of RLMIS by virtue of various Part VII or equivalent transfers.
Membership of RLMIS is vested in those policyholders within the RLMF who satisfy the criteria set out in Article 2 of the RLMIS Articles of Association. This Article confers membership on:
■ any policyholder (both with-profits and non-profit) who was a member on 25 April 1995 and who continues pay periodic premiums;
■ any policyholder who effected their policy after 25 April 1995 and where there is the entitlement to participate in profits.
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The majority of the members now fall into the second category above. This category includes unitised policies which do not currently invest in unitised with-profits but where the policyholder has the option to switch into unitised with-profits benefits.
I am satisfied that the Scheme has no effect on the position as members of those policyholders of RLMIS who are also members of RLMIS.
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5 RLCIS Policyholders Benefit Expectations
5.1 Introduction In the circumstances of this case, it is necessary and appropriate to consider the benefit expectations of the RLCIS policyholders both excluding and including the General Reserve. The consideration excluding the General Reserve is set out in Section 5.2 below, and then the additional considerations in respect of the General Reserve are set out in Section 5.3 below.
There are three groups of RLCIS policyholders to consider, namely:
■ with-profits policyholders, where the benefits are discretionary and are determined according to the PPFM;
■ non-profit non-linked policyholders, where the benefits are fixed (possibly subject to some index linking such as to the RPI);
■ non-profit linked policyholders, where the benefits are directly related to the market value of a unit-linked fund of assets.
Each of these is considered below.
My consideration of benefit expectations considers what benefits policyholders can expect to receive other than in the event of extreme circumstances arising. Extreme circumstances cover both extreme financial and non-financial circumstances arising, for whatever reason. Consideration of such extreme circumstances, and the effect on policyholders, falls under the heading of Security of Benefits and is set out in Section 7 below.
5.2 Consideration excluding the General Reserve Operation of RLCIS Fund pre and post-transfer For with-profits policies, the primary benefit amounts are determined using the asset share approach and the benefits payable under the policies depend on the experience of the fund. The RLCIS Fund is currently operating as a fully ring-fenced fund within a subsidiary of RLMIS, and post-transfer the entire assets and liabilities of the RLCIS LTBF will be ring-fenced within RLMIS, i.e. it will be ring-fenced from the RLMF and the RL Closed Funds. The experience of the RLCIS Fund business will be retained in the subfund and thus the future benefits will be determined in the same way as if RLCIS continued to operate as a subsidiary company as is currently the case. The transfer itself will not give rise to any change in the day to day operation of the RLCIS Fund or the determination of policyholder benefits. Some further details are set out below in relation to the PPFM, investments, expenses, and taxation, but the fundamental point is that the RLCIS Fund will remain ring-fenced.
Although RLCIS is a proprietary company (i.e. it has a shareholder and a Shareholder Fund) the RLCIS Fund is a mutual fund and the entirety of the profits and losses arising
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within the fund are for the benefit of the fund and the with-profits policyholders. There are no transfers of surplus out of the RLCIS Fund to the Shareholder Fund (as is commonly the case with a normal proprietary company). Post-transfer, the RLCIS Fund will continue to be a mutual subfund but within an actual mutual company (i.e. within RLMIS), and the entirety of the profits and losses arising within the fund will continue to be for the sole benefit of the funds and the with-profits policyholders.
As from the Effective Date, the RLCIS Fund will become formally closed to new business. Although (as is customary), existing policyholders will still be able to pay additional premiums or increase their regular premiums into existing policies, no genuinely new business will be transacted. Such new business as is currently being written into the RLCIS Fund may be written into the RLMF, and the consideration of that new business is outwith the scope of my work as Independent Expert.
The closure of the RLCIS Fund to new business is not set out as part of the Scheme itself, but is a separate process that RLCIS has decided to undertake coincidentally with the Scheme. The closure will trigger a number of requirements under the relevant PRA/FCA rules, the most material one being a requirement for a run-off plan and estate distribution plan to be put into place and communicated to with-profits policyholders. This is to ensure that an orderly and fair run-off of the fund takes place and that the surplus assets within the fund (known as the “estate”) are fairly distributed to the with-profits policyholders as the fund runs-off. The communication of the closure of the RLCIS Fund is being made to with-profits policyholders in the same mailing pack as that for the required policyholder notification under the Scheme.
Consideration of the run-off plan is outwith the scope of my work as Independent Expert. I understand and note that no immediate commencement of estate distribution is planned following closure at the Effective Date, although the ultimate distribution of the estate following closure is likely to mean additional benefits arising to with-profits policyholders over time. Such additional benefits would also have arisen absent the transfer had the RLCIS Fund become closed with RLCIS remaining as a subsidiary of RLMIS. A particular consideration for me however where the two changes (i.e. the Scheme and the closure to new business) do interact is the amount of exceptional costs charged to the RLCIS Fund. This is considered further below.
As noted in Section 4.3 above, the Scheme allows the RLCIS Fund to bear a proportion of the costs which can reasonably be attributed to both the implementation of the Scheme and the closure to new business. When a with-profits fund closes to new business, the FCA rules require the company to write to the policyholders, and for the RLCIS Fund this closure mailing is being combined with the mailing to RLCIS policyholders in respect of the Scheme. RLMIS has proposed that the allocation of the relevant costs to the RLCIS Fund should be as follows:
■ 50% of the mailing costs (this comprising the work to extract the appropriate records and the postage costs themselves);
■ A proportion of the printing costs based on that proportion of the printed material which relates to closure. This has been estimated as being less than 10%;
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■ A proportion of the telephone call centre handling costs, determined retrospectively once the content of the calls (which will be monitored) becomes known. This proportion is currently estimated to be 20%.
Based on the above and current estimates, the proportion of the total combined Scheme and closure costs in respect of RLCIS which would be borne by the RLCIS Fund would be just less than 20%. I am satisfied that the above allocation approach, and the outcome based on current estimates, is fair to the RLCIS Fund with-profits policyholders.
PPFM and management actions
The PPFM is a key document in the operation of any with-profits fund. Its minimum contents are governed by FCA rules. It covers how the fund operates and is managed overall, how the assets are invested and managed, how benefits are determined, and how charges are applied to the fund and to the with-profits policyholders. Appendix 2 to this report sets out a complete list of the areas which the PPFM covers.
As explained above, the RLCIS Fund will operate in the same way post-Scheme as compared with pre-Scheme, with the main changes being those set out below.
The revised PPFM post-Scheme is thus an important one, and the revised PPFM is a document which is being made available to both RLCIS policyholders and the Court as part of the transfer process. I have reviewed the revised three PPFMs and compared them with the current three PPFMs and I am satisfied that the changes proposed are either:
■ changes which are a consequence of the RLCIS Fund being a subfund of RLMIS as opposed to being part of a separate company;
■ changes which cover the arrangements for capital support and charges for that support;
■ changes as a result of the General Reserve not being transferred under the Scheme to RLMIS;
■ changes which are a result of the closure of the RLCIS Fund to new business and the ultimate intention to distribute the estate.
Of particular relevance to the operation of a with-profits fund is the range of management actions which can be undertaken in adverse (but not necessarily extreme) circumstances. The current and revised PPFM for the RLCIS Fund provides for certain management actions that could be taken in order to ensure that the fund is managed within its own capital resources. The specific management actions listed in the PPFM are as follows:
■ the removal of the past allocations of miscellaneous surplus from asset shares (and hence from ultimate benefits);
■ a reduction in the proportion of riskier but potentially higher yielding assets, such as equities and property;
■ setting future rates of annual bonus to zero (so that all bonuses are then in non-guaranteed form);
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■ increasing charges to asset shares for the costs of guarantees to 1.00%pa (subject to certain conditions).
If more stressed conditions arise in which there is a need to take further actions to help meet the fund’s solvency requirements then one or both of the following actions may be taken:
■ increasing charges to asset shares for the costs of guarantees from 1.00%pa to 1.25%pa (subject to certain conditions);
■ applying a more severe reduction in the proportion of riskier put potentially higher yielding assets such as equities and properties.
I note that the current charge for the costs of guarantees is 0.5%pa. The regulator currently requires the last two management actions listed above to be notified to it prior to their use. Further and more severe management actions (which would under the current PPFM require the advance approval of the regulator) may be required in severely adverse circumstances, and the PPFM gives examples of these in general terms. Ultimately, and in extreme circumstances, benefits may have to be reduced to the guaranteed minimum levels which underpin most with-profits policies and which are a key design feature of most with-profits policies. The position in such extreme circumstances is considered in Section 7 below.
Management actions such as those listed above are a necessary part of the operation of any with-profits fund, and I can confirm that these management actions, and their sequencing, are not in my experience materially different to those which would be adopted in adverse circumstances within other with-profits funds. I note in particular that the list of possible management actions (including the more detailed descriptions of them) is the same in both the current PPFM and the revised post-Scheme PPFM. Thus the operation of the RLCIS Fund, including the application where necessary of management actions, and subject to the clarification below, will be the same post-transfer as was the case pre-transfer.
The clarification referred to above relates to the current PPFM requirement for regulatory approval prior to the application of more severe management actions. The post-Scheme PPFM contains no such requirement, and this is as a consequence of the General Reserve not being transferred under the Scheme. The consequences and possible effects of the General Reserve not being transferred to RLMIS under the Scheme is considered in detail in Sections 5.3 to 5.5 below and in Sections 7.11 to 7.14 below.
The above discussion is concerned mainly with the actual management actions which may be implemented in adverse conditions and circumstances. In addition, also of relevance are the management actions which are assumed in carrying out the calculations of the capital requirements of the RLCIS Fund. I note that following the implementation of the Scheme, the level of management actions assumed within the capital requirements calculations will have a direct effect on the charges paid by the RLCIS Fund to the RLMF for capital support, and this is covered in Section 4.3 above.
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For the avoidance of doubt, I confirm that the references above to my review of the existing and post-transfer versions of the PPFMs applies to the three PPFMs in respect of the RLCIS OB & IB Fund, the RLCIS With-Profits Stakeholder Fund and the RLCIS With-Profits Pension Fund.
In addition to the PPFMs, RLCIS also has an internal document known as a Capital Management Policy (“CMP”). This provides further detailed internal information on the approach to the management of RLCIS Fund, and this document will continue to apply post-transfer. I have reviewed the existing version of the CMP and I have been informed by RLCIS and RLMIS that there will be no changes to the CMP as a result of the implementation of the Scheme. I note that it is common for companies to have a CMP or an equivalent to it, and that such documents are necessarily updated from time to time. A particular aspect of the approach to the capital management of the RLCIS Fund is the use made of derivative type investments, and this is covered in the section below.
Investment policy and investment management The investment policy of the RLCIS Fund will follow the principles laid down in the PPFM and the CMP. As these documents are fundamentally the same both pre and post-transfer, there will be no practical effect on policyholders. For information purposes, the table below shows the asset mix of the three with-profits funds as at 31 December 2013. The significant (i.e. 54%) investment in Bonds (i.e. fixed interest securities) for the main OB&IB Fund reflects the fact that certain classes of with-profits policies have been 100% invested in this asset class on account of the fact that the guarantees on these classes are biting heavily, with this being expected to continue. Allowing for this, the table below shows that for all three subfunds there is a significant investment in Equity/Property assets, and this is expected to continue largely unchanged following the implementation of the Scheme. Other Assets in the table below comprise financial derivatives and cash on deposit.
Following the acquisition of RLCIS by RLMIS, the investment management of the assets of the RLCIS Fund has been migrated to RLAM (which now effectively incorporates The Co-operative Asset Management Ltd (“TCAM”), which was the CBG company which managed the assets pre-acquisition). As noted previously, there is a provision within the Scheme which effectively allows the WPC to request changes to the level of charges paid by the RLCIS Fund for investment management services to ensure that they are consistent with market levels.
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The RLCIS Fund makes extensive use of derivative type investments to help manage the exposure to the guarantees within in the fund. The main derivatives held and their purpose is as follows:
■ Equity options and futures are held to reduce a proportion of the equity price risk arising from using equities to back guaranteed benefits on with-profits policies;
■ Interest rate swaps and swaptions (i.e. an option to enter into a swap) are held to meet the expected liabilities in respect of guaranteed annuity options;
■ A portfolio of gilt total return swaps and interest rate swaps are held to hedge the risk of adverse movements in swap spreads. This swap spread is the difference between the interest rates underlying government bonds (i.e. gilts) and the interest rates underlying interest rate swap transactions. Movements in this spread affect the financial position of the RLCIS Fund.
It is in the nature of derivative transactions that they can at various times either represent an asset or a liability – this being an inherent part of how they operate to reduce the risks in question. At 31 December 2013, the derivatives held by the RLCIS Fund had an asset value of £1,181m and a liability value of £884m. These amounts are material in relation to the size of the fund and its working capital (see Section 7.3 below), although I note that the use of derivatives to manage the risks due to guarantees within a with-profits fund is common.
In addition to actual derivative type investments as listed above, the RLCIS Fund also operates an internal hedge between the working capital of the fund and with-profit asset shares. Under this arrangement, less risky assets (e.g. equities, but other asset classes as well) are actually held than are used to determine policyholder investment returns in the first instance. This reflects the fact that the presence of guarantees under the policies acts to reduce the final impact on the fund of the returns earned on those risky assets. This technique is also quite commonly used to manage the guarantee risks within a with-profits fund.
Although there will be no change to the CMP or the use of derivatives arising directly as a result of the implementation of the Scheme, I have been informed by RLCIS that a review is being undertaken to the approach to the use of derivatives within the RLCIS Fund. This review is being carried out by RLCIS in conjunction with external consultants whose formal views are being sought, and the PRA is aware of this review. I have seen and reviewed a draft of the relevant report and I am satisfied that there are no material issues arising from it that affect my conclusions as the Independent Expert. It is expected that the relevant report will be finalised before I produce my Supplementary Report. I will therefore review the final version of the report and comment further as necessary in my Supplementary Report.
Taxation
As described in Section 4.3 above, the RLCIS Fund will be taxed following the implementation of the Scheme as if it were a standalone mutual insurance company, with any synergy benefits or dis-benefits flowing to the RLMF. There is thus no change in
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benefit expectations for any RLCIS Fund policyholders as a result of this approach to taxation.
Expenses As already noted within this report, a tariff based arrangement was put into place for the costs to be borne by the RLCIS Fund from the date of the acquisition of RLCIS by RLMIS. In addition to the tariff in respect of business as usual costs, exceptional costs are charged in addition. These arrangements will be the same after the implementation of the Scheme as before, and the Scheme itself will have no effect on them.
I have already commented in Section 4.3 above on the arrangements for charging exceptional costs to the RLCIS Fund, and the protections which the Scheme provides.
Scheme and closure costs The Scheme provides that the costs of implementing the Scheme will be borne by the RLMF, and in practice these costs will be borne by the estate of the RLMF so that the with-profits policies of the RLMF are not adversely impacted (see Section 6.3 below). However, for costs which are partly related to the Scheme and partly related to the closure of the RLCIS Fund (such as the mailing costs of the combined Scheme/closure policyholder information pack) the Scheme provides for a fair allocation of such costs between the RLMF and the RLCIS Fund. I covered this aspect above, and concluded that the proposed allocation basis for the costs to be borne by the RLCIS Fund is fair.
I have reviewed the proposed RLCIS policyholder communications, which are in the form of a covering letter and a policyholder booklet. The covering letter covers both the transfer and the closure aspects. The policyholder booklet does likewise in more detail, and includes details both of the proposed transfer and the proposed closure. In particular I note that the policyholder booklet has separate sections describing the transfer and the closure. I am satisfied that this combined communication is clear and should not give rise to any confusion to the policyholders as to the two distinct aspect of the communication.
Non-profit and unit-linked policyholders Most of the consideration set out above within this section has been in respect of with-profits policies and with-profits benefits. Such policies and benefits comprise the majority of the RLCIS Fund. However, as shown in Section 3.2 above, the RLCIS Fund does contain non-profit policyholders – both where the benefits are fixed (or revalued in accordance with a published index such as the RPI), and where the benefits are linked to the performance of a specific fund of assets (i.e. unit-linked benefits).
The determination of benefits for these non-profit policies will not in my opinion be adversely affected by the Scheme. For the non-profit non-linked benefits, no discretion is involved. For the non-profit linked benefits, the unit-linked fund structures and the application of charges to the policies and the funds will continue in the same way after the implementation of the Scheme as before. For some products (eg the With-Profits Stakeholder product) the charges are subject to legal maxima. Additionally, certain personal pension contracts contain a guarantee that the total charge for management expenses made after 5 April 2001 will not exceed the charges made to a comparable
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stakeholder pension policy. For other products, there are no fixed or maximum charges, and any increase would need to be justified in terms of treating customers fairly. I have discussed this issue with representatives of RLCIS and RLMIS (including the AFH of both companies) and I have no reason to believe that the exercise of discretion in relation to non-fixed unit-linked charges will be any different post-transfer as compared with pre-transfer. The Scheme contains provisions for unit-linked funds to be restructured, and I have commented on this aspect in Section 4.3 above.
For the avoidance of doubt, I note that for some classes of with-profits business within the RLCIS Fund the guarantees provided are “biting” significantly, and no further bonuses are likely to be added. RLCIS has previously amended the asset backing for this business to be 100% in fixed interest securities as there would be no benefit to be gained for policyholders by continuing to invest in assets such as equities. Although still formally with-profits, this business is more akin to non-profit business and is effectively now managed as non-profit business. I confirm the implementation of the Scheme will have no effect on this situation.
Further non-profit business is likely to arise within the RLCIS Fund in respect of maturing with-profits pensions policyholders who choose to take their annuity with the RLCIS Fund or for whom the guaranteed annuity benefit makes it advantageous to retain the annuity with the RLCIS Fund.
For the avoidance of doubt, I note that the existing non-profit business within the RLCIS Fund will be retained within the Fund post-transfer and will not (for example) be transferred to the RLMF. Further, the new non-profit business arising in respect of maturing with-profits pensions policies will also arise within the RLCIS Fund post-transfer as described above. The position here is the same post-transfer as pre-transfer, and the Scheme will not have any effect on this position. Although beyond the scope of my role as Independent Expert, I note that the run-off and estate distribution plan referred to above following the closure of the RLCIS Fund on transfer may need to address the question of how the non-profit business runs-off alongside the with-profits business and whether any further restructuring or reinsurance will be necessary.
5.3 Consideration of the General Reserve The General Reserve is a fund of £200m of RLCIS assets which are outside the RLCIS LTBF. As noted above, RLCIS is a proprietary company and the General Reserve is part of its Shareholder Fund.
My consideration of the General Reserve, and the fact that it is not being transferred under the Scheme to RLMIS, is in two parts. I first consider (in this section) the issue of benefit expectations arising from the General Reserve, i.e. the question of whether any policyholders have an expectation of any increase in their benefits as a result of the General Reserve. My second consideration is in respect of the additional security of benefits afforded by the General Reserve, and this aspect is considered in Section 7 below.
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In carrying out my work in relation to the General Reserve, I have made use of a number of documents produced by RLCIS and its legal advisers. These documents summarise the references made to the General Reserve in various policy documents, policyholder communications, and various published accounts and regulatory returns. I have reviewed a sample of such documents personally, and I have in particular personally studied the references to the General Reserve in the PPFM and in various key items of correspondence between the RLCIS and the PRA/FCA (and formerly the FSA). Although I have made use of and relied upon the factual accuracy and completeness of a number of documents in relation to the General Reserve, the analysis and my conclusions are entirely my own as Independent Expert and I have relied on the advice or views of no other party or person in forming my conclusions. The key documents which I have relied upon in terms of factual information are set out in Appendix 1.
Given the importance of the consideration of the General Reserve, RLMIS and RLCIS have taken counsel’s opinion on the position of the General Reserve from Mr Martin Moore QC. As the Independent Expert in this case I was invited to discuss the General Reserve in conference with Mr Moore prior to him finalising his opinion, and I have reviewed carefully the written opinion and conclusions from Mr Moore. I have not sought to summarise here Mr Moore’s conclusions as his full opinion is being made available to Court as part of the documents in respect of the transfer. However, I note that Mr Moore’s conclusions are consistent with those which I have reached, both in the remainder of this section in relation to (what I call) benefit expectations and in relation to the necessary conditions in relation to (what I call) financial security, as covered in Section 7 below. Although I have carried out my own analysis as Independent Expert, I draw additional comfort from the fact that Mr Moore’s conclusions based on his analysis are consistent with my own.
The history of General Reserve dates back to 1874 when it appears that the General Reserve was originally established as a contingency fund from part of the profits arising from the RLCIS general insurance business. As noted above, a key consideration for me is whether the General Reserve has been used to increase benefits on any of the with-profits policies. There have in the past been transfers from the General Reserve into the RLCIS Fund, and the history of these transfers since 1972 is as set out in the table below.
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Net Cashflows from the General Reserve to the CIS LTBF
Year Net
Cashflow
Year Net
Cashflow
Year Net
Cashflow 1972 (2.0)
1986 3.6
2000 24.9
1973 (2.0)
1987 3.6
2001 28.8 1974 (0.3)
1988 4.7
2002 14.6
1975 (0.5)
1989 5.4
2003 10.0 1976 0.1
1990 6.2
2004 8.0
1977 0.5
1991 6.2
2005 6.0 1978 0.9
1992 4.5
2006 4.0
1979 1.7
1993 4.4
2007 2.0 1980 2.5
1994 10.3
2008 0.0
1981 0.4
1995 13.2
2009 0.0 1982 1.2
1996 14.0
2010 0.0
1983 1.5
1997 31.8
2011 0.0 1984 1.8
1998 32.6
2012 0.0
1985 2.8
1999 34.0
2013 0.0 The above table shows that in the period 1972 to 1975, there were net transfers out of the LTBF to the General Reserve. The relevant Board papers make reference to these transfers being made in order to increase the free reserves in respect of the general insurance business to what was considered a more appropriate level. Given that these transfers were some 40 years ago, before the inception of most of the currently inforce business, I have not considered these further. For the period 1976 to 2007 there were transfers from the General Reserve to the LTBF, and it is known that these transfers were applied within the LTBF to enhance benefits to with-profits policyholders via increases in their assets shares. In determining the transfers into the LTBF, account was taken of the investment income arising on the General Reserve, and the allocation of that investment income between the general insurance business and the long-term business (i.e. to the LTBF).
In 2002, it was decided that the transfers from the General Reserve into the LTBF should cease, and that the size of General Reserve should be frozen at £317m (with the balance of the Shareholder Fund being regarded as ordinary shareholder funds). In order to recognise that it would be unfair to cease the transfers immediately, the transfers were tapered down to zero over the period 2003 to 2007, becoming zero in 2008. The pattern of the taper is set out in the table above, and since 2008 there have been no transfers from the General Reserve into the LTBF. The change in practice was I understand specifically notified to the regulators in 2002, and I note that the transfers from the General Reserve into the LTBF were disclosed in the annual regulatory returns.
My conclusion arising from the above is that during the period 1976 to 2002 a reasonable expectation did build up that there would be ongoing transfers from the General Reserve to the LTBF. This expectation would have increased and would have been at its height in the late 1990s and early 2000s. However, it is the case that it is possible to change expectations, provided that such changes are made gradually and with appropriate disclosure. I believe that this has been the case here, and that the tapering down to zero of the transfers, together with the associated regulatory disclosure, has removed the
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previous expectations. Given that no transfers from the General Reserve to the LTBF have been made in respect of the 6 years from 2008 to 2013 inclusive, I am satisfied that no reasonable expectation now exists.
By way of analogy, I note that there have been similar instances in the UK life insurance industry where policyholders’ expectations have been modified by means of making a gradual change with the appropriate regulatory notification and disclosure. For example, within a proprietary company, the Articles of Association commonly specify a 90:10 distribution rule, whereby the with-profits policyholders receive a minimum of 90% of distributed surplus, with the shareholders receiving a maximum of 10%. There have been a number of instances, and there is at least one currently in progress, where the policyholder proportion has been or is being reduced to the minimum and the shareholder proportion increased to the maximum. This has to be done gradually, and there is a regulatory requirement that it cannot be done quicker than steps of 0.5% over any year without significant publicity being undertaken. The actual change each year is disclosed in the regulatory returns. So for example where a distribution might have been 92.5:7.5 for some time, it can then be changed to 90:10 over a period of 5 years, and there have been several instances where changes of this nature have taken place in relatively recent history. The tapering to zero of the transfers from the General Reserve to the LTBF is in my view analogous to this situation.
I note that it is unlikely that policyholders were generally aware that the transfers above were taking place, nor that they were tapered down to zero as explained above. This does not in my view alter my analysis or my conclusions. The issue of policyholders’ reasonable expectations (and the more up to date terminology of it, namely treating customers fairly) has been subject to much debate and analysis within the insurance industry and the actuarial profession (including dialogue with regulators), and I believe it is generally accepted that policyholders can have reasonable expectations as a group without the individual policyholders being aware of the issues involved which are by definition complex.
As from 31 December 2011, the amount of General Reserve was reviewed and reduced by £117m to £200m. The £117m was transferred out of RLCIS to its then parent CBG by way of a dividend payment. This reduction and transfer was done in consultation with and with the agreement of the FSA which was the regulator at the time. The £200m which was retained was equal to the amount which had been allocated to (but not transferred into) the LTBF within the regulatory returns since 2004 when the Pillar 2 regulatory system (see Section 7.6 below) was introduced.
In addition to the above analysis based on the past history of transfers from the General Reserve to the LTBF, I have also (assisted by the various documents referred to in Appendix 1), considered the various references which have been made to the General Reserve in various public RLCIS documents. A summary of my review of these references is set out below.
The With-Profits Guide, which was the forerunner to the PPFM prior to 2004, stated:
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“The Society has a General Reserve which provides additional security for the policyholders of both its long-term and its general business“.
The PPFM has, since its inception in 2004, stated the following within the Principles. The Principles are intended to be the high level and infrequently changed approaches to the running of the fund, the Practices represent the current more detailed aspects which could change more frequently.
“In exceptional circumstances, we may use other assets of our business held by us outside the fund (the Share Capital and General Reserve), if available, to help meet the fund’s solvency requirements. In some circumstances, this may require a transfer of assets into the fund. In such cases we would continue to manage the fund with the aim of repaying these assets (accumulated with interest at an appropriate level) over time from within the fund.”
and
“In the event of closure of the fund to all long-term business, we would retain sufficient working capital within the fund to manage the existing with-profits and non-profit policies. We would also aim to repay any support provided to the fund from the Share Capital and General Reserve. Subject to this, we would distribute any remaining profits that have accrued from transacting life and pensions business to with-profits policyholders.” The Practices section of the current PPFM states:
We currently hold a separate shareholder-owned fund (the General Reserve) outside the CIS Long-Term Business Fund which, if available, may be used in exceptional circumstances to help meet the CIS Long-Term Business Fund’s solvency requirements. During 2011 we assessed the level of risks within the CIS Long-Term Business Fund and this showed that the fund was expected to remain strong under a wide range of future financial and other conditions. Therefore our Board, after careful consideration of independent advice, notably from our With-Profits Actuary and With-Profits Committee, and with the agreement of the regulator, decided to reduce the size of the General Reserve by £117m to a new level of £200m. The General Reserve could be reduced further or removed altogether, subject to our Board ensuring that with-profits policyholders continue to be treated fairly. The Board would consider independent advice and seek the approval of the regulator before taking such action.
The Glossary of the PPFM defines the General Reserve as:
General Reserve: this is a shareholders fund held by us outside the fund. If available, it may be used in exceptional circumstances to help meet the fund’s solvency requirements. In some circumstances, this may require a transfer of assets into the fund. In such cases
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we would continue to manage the fund with the aim of repaying these assets (accumulated with interest at an appropriate level) over time from within the fund.
In addition to the PPFM there is shortened version called the Customer Friendly PPFM, and this states:
“In the event of closure of the fund to all long–term business, we would retain enough working capital within the fund to manage the existing with-profits and non-profit policies. We would also aim to repay any support provided to the fund from outside the fund. Subject to this, we would distribute any remaining profits that had arisen from the life and pensions business in the fund to with-profits policyholders.”
I note that the Customer Friendly PPFM is actually communicated to policyholders as a “With-Profit Guide”, although this should not be confused with the With-Profits Guide as referred to above which was the forerunner of the PPFM.
All of the above references clearly point in my view to the General Reserve being available to provide solvency support to the fund. There is no reference to any of the capital of the General Reserve or the investment income on it being used to enhance benefits in the normal course of events. This information supports my conclusion above that there is currently no expectation of additional benefits arising from General Reserve.
Policy Documents
The policy document itself is clearly the key legal contract between the policyholder and the insurance company. A typical RLCIS policy document includes the following:
“The benefits provided by this policy can be met only out of our Ordinary Long-Term Fund together with our Share Capital and General Reserve Fund”.
This wording states where the benefits under the policy can be met from, but does not give any indication of how the benefits themselves are determined. I do not believe that this statement within the policy document gives any indication that the General Reserve will give rise to additional benefits from the General Reserve.
Financial Statements
The 2010 published financial statements under the Companies Act included the following:
“CIS has a general reserve of £317m which is available to support both CIS long-term business and general insurance business. The general reserve is shareholder capital and is held outside the long-term business fund. However, as at 31 December 2010, £200m of the general reserve was allocated to the long-term business fund."
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The 2011 published financial statements under the Companies Acts included the following:
“During 2011 the level of risks within the long-term business fund was assessed and this showed that the fund was expected to remain strong under a wide range of future financial and other conditions. Therefore the Board, with the agreement of the FSA, decided to reduce the size of the general reserve by £117m, through a payment of a dividend, which included the dividend in specie for the transfer of owner occupied and investment properties to a new level of £200m. The general reserve could be reduced further or removed altogether, subject to the Board ensuring that with-profits policyholders are treated fairly."
Both of the above references are consistent with previously quoted messages from the PPFM.
Regulatory Returns
As from 31 December 2004, a revised approach to the solvency regulation of UK life insurance companies was introduced. Further details of this new approach are included within Section 7.6 below, but the new approach involved a more realistic and complete assessment of the risks and liabilities of all UK life insurance companies, and with-profits funds in particular. From 31 December 2004, £200m of the General Reserve was allocated to the long-term business. This has been specifically shown in the regulatory returns since 31 December 2004, and this remained the case as at 31 December 2013.
The references to the General Reserve within both the Financial Statements and the Regulatory Returns are consistent with the disclosures in PPFM as set out above.
Conclusion in respect of the General Reserve
Based on the above, I can summarise as follows my conclusions in relation to benefit expectations in relation to the General Reserve:
■ There was a period in the past when there was a reasonable policyholder expectation that transfers from the General Reserve to the LTBF would be used to enhance benefits;
■ However, a decision was made to cease the practice of carrying out these transfers/enhancements. The practice was phased out over a reasonable period of time, with the relevant regulatory returns reflecting this. This change, and its implementation, were not inconsistent with other analogous changes made by other companies;
■ The policyholder communication information, in particular the With-Profits Guides and the PPFM, is consistently clear that the purpose of the General Reserve is solvency support to the LTBF, and no indication of any additional benefits arising in the normal course of events is referred to;
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■ Past disclosures within Companies Act accounts and regulatory returns are consistent with the above.
I can thus conclude that the RLCIS with-profits policyholders have no benefit expectation arising from the General Reserve. They do have an expectation that the General Reserve will provide solvency support to the LTBF if necessary, and I consider that aspect in Section 5.4 below.
5.4 Use of the General Reserve in adverse circumstances My conclusion as set out in Section 5.3 above relates to the benefit expectations of the RLCIS with-profits policyholders, including expectations in respect of the General Reserve, in the normal course of events. Before proceeding further, it is appropriate to consider in what circumstances the General Reserve would actually be used to support policyholder benefits.
The General Reserve sits within the RLCIS Shareholder Fund. In my analysis below, I consider first in what circumstances the assets of a Shareholder Fund may be called upon to support a LTBF for a normal proprietary company. I then go on to consider whether any modification to the normal position applies in the particular circumstances of this case.
Under current UK regulations, there is no requirement within a proprietary company for the LTBF to cover its capital requirements. It is acceptable for the capital requirements to be partially or fully covered by the Shareholder Fund. It is however a regulatory requirement for a LTBF to cover its own regulatory liabilities. In any adverse or other circumstances where the LTBF does not cover its regulatory liabilities, there is regulatory requirement to transfer assets from the Shareholder Fund into the LTBF to correct the position. It is generally accepted that any such transfer would initially be in the form of a contingent loan, whereby the assets can be repaid back to the Shareholder Fund (normally together with some suitable rate of interest or investment return) if the position of the LTBF recovers, and it becomes able again to cover its liabilities without the additional assets. This situation could arise for example when a reduction in interest rates temporarily increases liabilities, and a subsequent increase in interest rates reduces them again. Within a with-profits fund, discretionary benefits can be temporarily or permanently reduced when circumstances are adverse (this being referred to commonly as management actions), and hence the need for any transfer from the Shareholder Fund would only arise to the extent that reductions in discretionary benefits following management actions were insufficient to keep the LTBF covering its liabilities.
If the situation becomes sufficiently severe and sufficiently long lasting, the initial transfer from the Shareholder Fund to the LTBF may need to become a permanent transfer. This situation is commonly referred to as “burn through” (i.e. the liabilities of the LTBF burn through into the Shareholder Fund), and this is when there is a permanent loss of Shareholder Fund assets. Where the LTBF is a with-profits fund, it is generally accepted that all discretionary benefits are reduced to zero before a burn through is recognised. This means that all bonus rates are set to zero, all surplus assets within the LTBF have already been used up, and it is necessary for assets from the Shareholder Fund to be used to meet liabilities to pay the guaranteed minimum benefits. It is normally
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the case that the circumstances which would give rise to a burn through situation are at the most extreme end of the spectrum, and the financial modelling that most proprietary companies carry out normally demonstrates that the burn-through risk is small.
Turning now to the specific RLCIS position, I note the following:
The PPFM makes clear references to what I have set out above as the usual position for a proprietary company. In particular, the definition of the General Reserve in the Glossary states:
General Reserve: this is a shareholder owned fund held by us outside the fund. If available, it may be used in exceptional circumstances to help meet the fund’s solvency requirements. In some circumstances, this may require a transfer of assets into the fund. In such cases we would continue to manage the fund with the aim of repaying these assets (accumulated with interest at an appropriate level) over time from within the fund.
Additionally, the following statement is made at the end of section of the PPFM which refers to management actions:
In general, it is not envisaged that the General Reserve will be used to provide policyholder benefits in excess of the guaranteed contractual amounts. However, it will be up to our Board and regulator to determine in any specific set of circumstances whether this is consistent with the principle of Treating Customers Fairly.
The first extract from the RLCIS PPFM is a long-standing statement and was part of the PPFM prior to it being updated following the acquisition of RLCIS by RLMIS. The second extract was added to the RLCIS PPFM post acquisition of RLCIS by RLMIS.
As noted in Section 5.2 above, the RLCIS PPFM sets out a sequence of six specific management actions which could be applied in increasingly adverse circumstances. The PPFM also states that in even more severe circumstances further more general management actions would be necessary, effectively if necessary taking the benefits down to their guaranteed levels as explained above. However, the current PPFM states that the application of any such more severe management actions beyond the six listed in Section 5.2 above would require the approval of regulator as well as (as noted above) that of the Board. The regulator (in the form of the FSA prior to the introduction) has indicated to RLCIS that it would be likely to take the view that the General Reserve (if available) should be utilised in preference to more severe management actions than the six actions listed in the PPFM. This could mean that part of the General Reserve is permanently used to support benefits in excess of guaranteed minimum levels.
Under the terms of the Scheme, the General Reserve is not being transferred to RLMIS. There is however a capital support arrangement under which, as set out in Section 4.3 above, the RLMF provides similar support to the RLCIS Fund post-transfer to that
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provided by the General Reserve pre-transfer (subject to certain charges being made, as set out in Section 4.3 above).
The key consideration for me thus becomes (a) the capacity of the RLMF to provide that support, and (b) whether the level of that support in adverse circumstance is materially different to that which currently exists. These issues are considered further in Section 7 below under the heading of benefit security. As set out in Section 5.1 above, my consideration of benefit expectations is focussed on what policyholders can expect to receive other than in extreme circumstances. My conclusion as set out in Section 5.3 above in relation to benefit expectations is thus my overall conclusion in this respect of this area, and consideration of the position in extreme circumstances is considered as part of benefit security in Section 7 below.
For the avoidance of doubt, I acknowledge that the circumstances in which the General Reserve might currently be used to provide permanent support to the RLCIS Fund are potentially different to those in which the post-transfer arrangements provided by the RLMF might provide permanent support to the RLCIS Fund. However, my analysis in Section 7 below demonstrates that the circumstances under which this question would actually arise are extreme and remote. Thus any such differences between the pre-transfer and post-transfer permanent support arrangements are in practice immaterial.
5.5 Conclusions Based on the above analysis, my conclusion is that the implementation of the Scheme will not have any material adverse effect on the benefit expectation of any of the RLCIS policyholders.
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6 RLMIS Policyholders Benefit Expectations
6.1 Introduction As for the RLCIS policyholders, my consideration of benefit expectations considers what benefits policyholders can expect to receive other than in the event of extreme circumstances arising. Extreme circumstances covers both extreme financial and non-financial circumstances arising, for whatever reason. Consideration of such extreme circumstances, and the effect on policyholders, falls under the area of Security of Benefits and is set out in Section 7 below.
Within RLMIS there are different groups of policyholders at a number of different levels. These groups and levels can be considered as follows:
■ the policyholders in the RLMF;
■ the policyholders in each of the RL Closed Funds;
■ and within the RLMF and within each for the RL Closed Funds there are with-profits, non-profit non-linked, and non-profit unit-linked policyholders.
I note that not all of the six RL Closed Funds have all three type of business within them, although they do all have with-profit business.
I first consider below the position of the RL Closed Funds, and then the position of the RLMF.
I note that RLMIS has an internal management services company, RLMS, which provides administration services to the RLMIS and incurs the actual expenditure. RLMS is owned by the RLMF, and RLMS is managed so that it makes a small profit (which ultimately is dividended to the RLMF). For one of the RL Closed Funds (the PLAL With-Profits Subfund) the actual administration is outsourced via RLMS to Capita. For another RL Closed Fund (the Royal Liver Subfund), a small part of its business is outsourced via RLMS to Capita.
6.2 RL Closed Funds Each of the RL Closed Funds is operated as a separate ring-fenced subfund, with benefits to with-profits policyholders determined by the experience of that subfund. Each subfund has its own PPFM (or is covered by the RLMF PPFM), and each subfund either has its own separate pool of assets or a hypothecated pool of assets from the RLMF. Further, each of the RL Closed Funds has an agreed and established approach with the RLMF for the charges for administration which are paid from the relevant closed fund to the RLMF. These charges have been agreed under the terms of past Part VII (or the friendly society equivalent) and in the case of Scottish Life Assurance, the Insurance and Companies Act 1982, transfers into RLMIS. Where the terms of such charges are not fully specified by such previous legal arrangements, established governance processes are in place, with the RL WPA and the RL WPC having key advisory and oversight roles respectively. The
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position is similar in relation to the charges paid by each of the RL Closed Funds to RLAM for asset management.
None of these arrangements will be changed by the implementation of the Scheme, and there will be no one-off additional costs charged to any of the RL Closed Funds as a result of the Scheme. Further, although I have not reviewed any of the previous Part VII schemes or equivalent transfers and their associated reports, these schemes will have specified various arrangements (for example for the charging of tax) for the fund in question. The Scheme does not make any changes to any previous schemes, and the arrangements put in place under those previous schemes will continue.
Given the above, it is straightforward for me to conclude that the benefit expectations of the policyholders in each of the RL Closed Funds will not be adversely affected by the Scheme. Moreover, this conclusion applies to all classes of policyholders within each of the Closed Funds, i.e. with-profits, non-profit non-linked, and non-profit unit-linked. If any discretion is involved in determining any benefits, the governance process which oversee the exercising of that discretion will continue similarly post-Scheme to pre-Scheme.
6.3 RLMF The position of the policyholders within the RLMF is more complex to consider as it is the RLMF which acts as the overall support and consolidation fund for the entire RLMIS. I consider first the position of the non-profit policyholders within the RLMF and then the position of the with-profits policyholders. Lastly I consider the position of the with-profits policyholders as members.
Non-profit policyholders
The position of the non-profit policyholders is straightforward. For non-profit non-linked policies, the benefits are fixed or determined by reference to published indices. For non-profit unit-linked policies, benefits are determined by reference to the performance of certain unit-linked funds, subject to the application of charges. These processes will continue post the implementation of the Scheme, and I see no reason why the exercise of discretion (for example in relation to non-guaranteed unit-linked charges) should be applied any differently post-Scheme as compared with pre-Scheme. The existing governance arrangements will continue similarly post-Scheme to pre-Scheme.
I can therefore conclude that the Scheme will have no adverse effect on the benefit expectations of the non-profit policyholders within the RLMF.
With-profits policyholders
The with-profits policyholders within the RLMF ultimately bear the risk of the RLMF and by extension the entire RLMIS. However, for my consideration of benefit expectations (as opposed to the security of those benefits), I am concerned with how the current approach to the determination of with-profits benefits within the RLMF take place and how that will be or could be impacted by the Scheme.
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The PPFM in respect of the RLMF sets out how benefits are determined using assets shares, which is the same approach as that used for other with-profits funds generally and within the RL Closed Funds. The expense charges which are applied to the RLMF asset shares are based on an agreed set of fees which are payable to RLMS. However, given that (as explained above) RLMS essentially receives fees sufficient to cover its costs, the key question is how those fees are determined. The approach used is an Activity Based Costing (“ABC”) approach, which is a recognised technique to determine the actual costs of carrying out certain tasks. This ABC approach is subject to governance, provided through the advice of the RL WPA and the oversight of the RL WPC. I have discussed the approach used with the RL WPA and I understand and note that this process will not be materially affected by the transfer into RLMIS of RLCIS’s long-term business. Essentially, the ABC process is operating already with the presence of RLCIS as a subsidiary of RLMIS, and making the RLCIS Fund a subfund of RLMIS is not expected to have a material effect. As explained below, it is possible however that there will be some beneficial effect, and my understanding is that the RL WPA will particularly seek to ensure that there will be no adverse effect.
In addition to the charging in respect of expenses, the approaches adopted in respect of asset allocation, investment management, and the allocation of tax will not change as a result of the Scheme. In relation to the allocation of tax, the RLMF will gain from or bear the cost of any synergies or dis-synergies in relation to the charge for tax post-Scheme to the RLCIS Fund being determined on a stand-alone mutual company basis. However, I have been informed by the RL WPA that, as is the case for the current RL Closed Funds, the effect of this synergy or dis-synergy will be borne by the estate of the RLMF and not the RLMF with-profits policyholders.
As noted previously, there will be exceptional costs in respect of implementing the Scheme which will be charged to the RLMF. The RL WPA has confirmed that these exceptional costs will be borne by the estate of the RLMF and not the RLMF with-profits policyholders.
As will be seen in Section 7.4 below, the RLMF is expected to benefit from the tariff expense arrangement that was put in place in respect of the RLCIS Fund at acquisition. The capitalised value of the benefit is some £140m, which following the implementation of the Scheme will effectively become an asset on the RLMF balance sheet. This value will be taken into account by RLMF when considering its “mutual dividend” as set out in Section 6.4 below. I note that in addition to this benefit, there will be some additional capital requirements arising within the RLMF as a result of the additional risks taken on, and this has been taken into account in my consideration of the capital requirement in Section 7.8 below.
Based in the above analysis, I can conclude that the Scheme will have no adverse effect on the benefit expectations of the with-profits policyholders within the RLMF.
6.4 Mutual dividend arrangement RLMIS operates a mutual dividend arrangement for the with-profits policyholders within the RLMF. Under this arrangement the Board of RLMIS, on a discretionary basis,
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declares each year an uplift to the asset shares of the with-profits policyholders within the RLMF, and the bonus setting mechanisms then converts this uplift into additional final bonus rates for the benefit of the with-profits policies. The Board takes into account the overall performance of the RLMF and its capital resources over the year in question, and this mutual dividend thus provides a benefit to the with-profits policyholders in the RLMF to reflect that they are ultimately bearing the effect of risks within the overall RLMIS organisation. In terms of the PPFM, the mutual dividend is regarded as a form of estate distribution, and the PPFM for the RLMF provides a mechanism for estate distributions. For the avoidance of doubt, I understand and note that a mutual dividend is not guaranteed to be declared each year, and that in some years it may thus be zero. I further note that currently the mutual dividend is the only mechanism used to uplift asset shares for the with-profits policyholders within the RLMF to reflect the overall performance of the RLMF.
RLMIS has declared a mutual dividend of 1.7% for the calendar year 2013. This percentage has been applied to uplift asset shares within the RLMF with effect from 1 January 2014, and final bonus rates have consequently increased from this date as a result. The mutual dividend for 2013 includes an allowance for part of the expected long-term synergy benefits arising from the acquisition and integration of RLCIS into the RLMIS Group, and I understand that future mutual dividends are expected to include further allowances for the synergy benefits as these benefits become fully realised over time. Some of the synergy benefits are not dependent on the implementation of the Scheme, and some of the synergy benefits may be dependent on the implementation of the Scheme.
For the avoidance of doubt, I note that the mutual dividend arrangement applies to all with-profits policyholders within the RLMF. Where such with-profits policyholders are also members, they are not receiving any additional benefits in their capacity as members (as distinct from with-profits policyholders) and the Scheme will have no effect on this position. I also note that the policyholders in the United Friendly OB Subfund also benefit from a payment from the RLMF into that subfund which, although not formally mutual dividend, is triggered by the declaration of mutual dividend. Such payments into the United Friendly OB Subfund are currently being retained within the estate of that subfund. Again, the Scheme will have no effect on this process.
As discussed in Section 4.3 above, there is a capital support arrangement under which the RLMF may be required to provide support to the RLCIS Fund in the circumstances when the RLCIS Fund is not able to meet its regulatory capital requirements or its regulatory liabilities. Provision of this support would have an effect on the mutual dividend calculations, both directly due to the support provided, and potentially also indirectly through the investment returns used in the calculations. However, the RLMF will receive the charges payable by the RLCIS Fund for the provision of capital support.
Overall, I am satisfied that there will be no material detriment to the interests of the RLMF with-profits policyholders in relation to their mutual dividends.
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6.5 Conclusions Based on the above analysis, my conclusion is that the implementation of the Scheme will not have any material adverse effect on the benefit expectation of any of the existing RLMIS policyholders, both those in the RLMF and those in any of the RL Closed Funds.
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7 Financial considerations
7.1 Introduction The purpose of this section is to consider the impact of the Scheme on the financial and solvency positions of the companies, and in particular on the financial and solvency impact on RLMIS of the transfer in of the RLCIS’s long-term business. This analysis then informs my consideration of the effect of the Scheme on the security of RLMIS and RLCIS policyholder benefits.
Effective from 31 March 2014, RLCIS completed a Part VII insurance business transfer scheme which transferred its remaining general insurance business to CISGIL. RLCIS is thus now a pure long-term insurer. For the purpose of the analysis set out below, it is assumed that this transfer had been effective as at 31 December 2013.
The current regulatory regime for UK long-term insurance companies is one which has been inforce since 31 December 2004. Under this regime two sets of balance sheets and solvency calculations are carried out:
■ Pillar 1, is a set of calculations which are publicly disclosed in the regulatory returns (i.e. detailed statements in a prescribed form which are submitted to the PRA and which are public);
■ Pillar 2 (also known as the Individual Capital Assessment, or “ICA”), which is based on a wider ranging self assessment of the risks faced and the corresponding capital requirements. The assessment is done to a 1 in 200 year probability of ruin, and the results are submitted to the PRA on a private basis only. The PRA reviews the self assessment and can if it believes appropriate impose an addition to the company’s own calculated capital requirement (this being known as Individual Capital Guidance, or “ICG”).
For large with-profits funds, Pillar 1 is subdivided into two bases (known as Peak 1 and Peak 2), and the final result is whichever is the more onerous. Peak 1 is based on a prudent valuation of guaranteed benefits only, and stems from the current EU Solvency I regime. Peak 2 is based on a realistic assessment of the assets and liabilities, and is known also as the Realistic Balance Sheet method.
From 1 January 2016, it is expected that a new EU wide solvency system will come into force (subject to transitional arrangements), this being known as Solvency II. Several detailed aspects of this new regime are as yet unclear and have yet to be fully defined, but the key aspects are now sufficiently defined in order for me to consider the effect of the proposed transfer under Solvency II.
In the sections below I have considered the effects of the Scheme based on both Pillar 1 and Pillar 2 of the current regime, and on the new Solvency II regime as far as can be determined at present. In addition to this, and in particular to assess the effects of not
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transferring the General Reserve from RLCIS to RLMIS, I have also considered the outcome of certain extreme stress tests to the current balance sheet positions.
For completeness, a summary of the key risks faced by the RLCIS Fund and the RLMF are included in Appendix 3. These are the key risks which are taken into account in the evaluation of the capital requirements on the Pillar II basis.
7.2 RLMIS Pillar 1 position pre-transfer The table below illustrates the Pillar 1 financial position of RLMIS pre-transfer as at 31 December 2013.
RLMIS Summary of Realistic Balance Sheet at 31/12/13 (Pre Transfer)
£m'sRoyal London
Main FundRefuge
Assurance IB Subfund
United Friendly OB Subfund
United Friendly IB Subfund
Scottish Life Closed Fund
PLAL With-Profits Subfund
Royal Liver Subfund
Assets(1) Regulatory assets 6,676 279 2,279 1,093 2,266 705 1,674 (2) Value in-force for non-profit business 1,712 1 - - 62 - 86 (3) Value in-force for subsidiaries 200 - - - - - - (4) Other assets 1 - - - - - - (5) Total realistic assets = (1)+(2)+(3)+(4) 8,590 280 2,279 1,093 2,327 705 1,760
(18)Additional pillar 1 requirement for Royal London Main Fund (165)
(19) Deferred Consideration payable to Co-operative Banking Group (180)(20) Removal of subordinated debt liability for solvency purposes 640 (21) Regulatory excess assets as p = (17)+(18)+(19)+(20) 2,749
Source: PRA Returns 2013
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The above table has a column for each of the six RL Closed Funds, and a column (the first column) for the RLMF. The table shows the Pillar 1 Peak 2 realistic balance sheet for each subfund, setting out the assets, the liabilities (each broken down by their main components) and the working capital, i.e. the excess of assets over liabilities, which is labelled as Row (11). The capital requirement is shown in Row (12) and the excess assets above that capital requirement in Row (13). Under the usual reporting convention for closed subfunds, the liabilities are set equal to the total assets, indicating the intention to distribute the entire assets of the subfund to the with-profits policyholders.
The capital requirement for the RLMF has reduced from £39m as at 31 December 2012 to zero as at 31 December 2013. RLMIS has confirmed that the reason for the reduction in capital requirement is due to changes in financial conditions. I am aware that a nil capital requirement can occur occasionally and am satisfied that this is the case for 31 December 2013 audited position.
A useful statistic is the working capital ratio (Row (14)), which is the working capital expressed as a percentage of the assets. Given the approach of settting liabilities equal to total assets for closed funds, the table also shows an alternative working capital ratio (Row (16)) which is the result before that equalising adjustment takes place.
The above table shows that the working capital of the RLMF is £2,454m, which is a working capital ratio of 28.6% of the RLMF assets. This is thus a strong position. Additionally, there are some further relevant adjustments for the RLMF, which are shown at the bottom of the first column of the table. The Peak 1 basis (as referred to above) bites for the RLMF giving rise to a reduction in excess assets of £165m. Further, RLMIS has raised subordinated debt of £640m (measured at market value) which is included as a liability in Row (10) but which is not in the final analysis a liability for solvency purposes as it is subordinated to the policyholders. In addition, the RLMF Peak 1 basis includes (I understand for certain accounting reasons) the £180m Deferred Consideration, which is payable to CBG assuming the release of the RLCIS General Reserve. Allowing for these three adjustments the final regulatory excess assets of RLMIS/RLMF are £2,749m. However, as this value does not take any credit for the RLCIS General Reserve itself, this value is in reality understated by the £180m Deferred Consideration, and a more realistic value is £2,929m.
The working capital ratios of the RL Closed Funds (Row (16)) indicate that four of them are strong with ratios in excess of or close to 15%. Two of RL Closed Funds, (i.e. the PLAL With-Profits Subfund and the United Friendly OB Subfund), one of which is in any case a small fund, are weaker, and there is a greater likelihood here of the RLMF being called upon to provide support.
7.3 RLCIS Pillar 1 position pre-transfer The table below illustrates the Pillar 1 financial position of RLCIS pre-transfer as at 31 December 2013.
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The above table shows the position of the RLCIS Fund in the same format as that for RLMIS. As the RLCIS Fund is currently open to new business, the presentation of the balance sheet is along the lines of the RLMF as opposed to the RL Closed Funds. The working capital amounts to £1,445m, giving a working capital ratio of 8.2%. Long-term assets in excess of capital requirements are £1,232m excluding the General Reserve. Including the General Reserve these excess assets are £1,432m. Additionally, following the implementation of the general insurance transfer scheme on 31 March 2014, there is an additional £11m of RLCIS shareholder funds shown on Form 1 of the PRA Returns, giving a total shareholder fund value (including the General Reserve) of £211m.
The RLCIS With-Profits Pension Fund and RLCIS With-Profits Stakeholder Fund sit alongside the RLCIS OB & IB Fund, and is supported as necessary by the OB & IB Fund.
7.4 RLMIS Pillar 1 position post-transfer The table below illustrates the pro-forma financial impact of the Scheme on RLMIS as at 31 December 2013.
RLCIS Long Term Fund Realistic Balance Sheet at 31/12/13 (Pre Transfer)
£m's
RLCIS OB & IB Fund (excluding
RLCIS With-Profits
Stakeholder Fund and RLCIS
With-Profits Pension Fund )
RLCIS With-Profits
Pension Fund
RLCIS With-Profits
Stakeholder Fund
Assets(1) Regulatory assets 17,271 5 298 (2) Value in-force for non-profit business 284 - - (3) Value in-force for subsidiaries - - - (4) Other assets - - - (5) Total realistic assets = (1)+(2)+(3)+(4) 17,556 5 298
(10) Total realistic liabilities = (6)+(7)+(8)+(9) 16,111 5 298
(11) Working capital = (5)-(10) 1,445 - - (12) Capital requirement 213 - - (13) Excess assets = (11)-(12) 1,232 - - (14) Working capital ratio = (11) / (5) 8.2%
(15) Working capital (excl planned enhancements allocated back as a balancing item) 1,445
(16) Working capital ratio (excl planned enhancements allocated back as a balancing item) = (15) / (5) 8.2%
Regulatory solvency summary(17) Excess assets = (13) 1,232 (18) General reserve 200 (19) Regulatory excess assets as per Form 2 is PRA returns = (17)+(18) 1,432
Note: The working capital (excluding planned enhancements allocated back as a balancing item) is the level of working capital that would Capital requirements for the CIS Stakeholder Fund are included within the capital requirements of the CIS LTBF* This number is actually £312,000 but is nil when rounded to show to the nearest £m. Source: PRA Returns 2013
RLCIS LTBF
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RLMIS Long Term Fund Realistic Balance Sheet at 31/12/13 (Pro Forma Post Transfer)
(15) Working capital (excl planned enhancements allocated back as a balancing item) 2,594 1,445 - - 54 127 184 321 31 254
(16) Working capital ratio (excl planned enhancements allocated back as a balancing item) = (15) / (5) 29.7% 8.2% 0.0% 0.0% 19.2% 5.6% 16.8% 13.8% 4.4% 14.5%
Regulatory solvency summary(17) Excess assets = (13) 2,594 (18) Additional pillar 1 requirement for Royal London Main Fund (165)(20) Removal of subordinated debt liability for solvency purposes 640 (21) Regulatory excess assets as per Form 2 in PRA returns = (17)+(18)+(19) 3,069
Note: The value in-force for non-profit business of the RLMF has been increased by £140m to allow for the expense VIF realised by the RLMF upon the implemetation of the Scheme.Source: PRA Returns 2013
Royal London (CIS) Subfund
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The above table shows the RLCIS Fund (comprising the OB & IB Fund, the Pension Fund and the Stakeholder Fund) “slotting in” as new subfunds alongside the existing RL Closed Funds. It remains the case that the Pension and Stakeholder Funds look in the first instance for support as required to the RLCIS OB & IB Fund, as opposed to the RLMF.
The above table shows the RLCIS Fund becoming closed, with zero working capital, following the same closed fund presentation as explained above for RLMIS. The working capital ratio shown in Row (16) is however the same as the pre-transfer position.
The above table also shows an increase to the RLMF working capital of some £140m, and a corresponding increase to the RLMF working capital ratio from 28.6% to 29.7%. This arises as a result of the additional value to the RLMF of the tariff expense arrangement with the RLCIS Fund. In return for providing certainty, the RLMF gains a benefit, and post-transfer it is allowable (and the regulator has agreed) that the value of this benefit is credited in the RLMF balance sheet. Prior to the transfer, with the two separate legal entities, it is not possible to take credit for this benefit. For the avoidance of doubt I note that the RLCIS balance sheet (both before the transfer and after) does allow fully for the costs of the tariff arrangement. The benefit of the arrangement to the RLMF thus emerges as part of the transfer, on both Peak 1 and Peak 2 bases. The regulatory excess assets of £3,069m shown above is £140m more than the adjusted value of £2,929, referred to in Section 7.2 above.
Based on the above analysis of the Pillar 1 position, I can see no material adverse effect on the security of any RLMIS or RLCIS policyholder benefits as a result of the Scheme.
The table above illustrates the position absent the parallel transfer into RLMIS of RLPPC. If the transfer of RLPPC into the RLMIS (and into the RLMF) also takes place, there will be no change to any of the results in the RLMF column of the above table up to and including Row (16). The regulatory solvency summary at the bottom of the above table will be subject to immaterial change and thus the above table does also effectively illustrate the position if the RLPPC transfer also takes place.
7.5 Recent further RLCIS reinsurance In May 2014, RLCIS entered into a new reinsurance agreement with a major reinsurance company. This arrangement reinsured the investment and longevity risks under some 70,000 non-profit annuities in payment, with total (pre-reinsurance) liabilities of some £965m. Appropriate arrangements were put in place to protect against the risk of default by the reinsurer. RLCIS has in the past effected similar reinsurance arrangements on a number of occasions to remove the risks in relation to blocks of non-profit annuity business, as this business builds up from maturing pension policies.
The effect of this new arrangement was to increase the Pillar 1 working capital by £14m, and the arrangement is thus beneficial. In addition to this Pillar 1 benefit, the Pillar 2 capital requirements (see below) also reduce.
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7.6 Overview of Pillar 2 As noted above, the Pillar 2 valuation of assets, liabilities and capital requirements is carried out on a private basis with the PRA and the results are not in the public domain. As this is effectively a publicly available report I have not therefore included the numerical results, and have confined myself within this report to a description of the position sufficient to support my conclusions. Should the Court wish to see numerical details of the Pillar 2 positions, I will arrange for that information to be provided to the Court on a non-public basis.
The overall presentation of a Pillar 2 balance sheet for a with-profits fund or subfund is similar to that included above for Pillar 1, and can be summarised as follows:
Value of Assets
less Value of Liabilities
gives Capital Resources (or Working Capital using Pillar 1 terminology)
less Capital Requirements (including any ICG add-ons imposed by the PRA)
gives Excess Assets
It is then common practice to determine a capital coverage ratio by expressing the capital resources as a percentage of the capital requirements. A ratio greater than 100% indicates that the capital requirements are covered with a buffer, and the greater this ratio the stronger the position.
The capital requirements are determined by carrying out various stress calculations on the assets and liabilities, taking into account the specific risk characteristics of the business. Each relevant stress is intended to correspond to a 1 in 200 year level of severity. The results of the stresses are then combined into the final capital requirements number using an aggregation methodology which takes account the statistical likelihood of the various stresses happening together or affecting each other. In carrying out the calculations, allowance is made for the management actions which the company might reasonably take in response to the adverse stresses in question, and this reduces the capital requirements.
For the avoidance of doubt, I have not regarded it as part of my scope to review the actual Pillar 2 capital requirement calculations. Additionally, the processes, the choices of stresses and the other key parameters are subject to internal governance and review within the companies, and to review from the PRA. I have however had discussions with the relevant actuarial staff within RLMIS and RLCIS sufficient to enable me to understand the results and the effect of the Scheme on them for my purposes as Independent Expert.
My consideration as set out below of the Pillar 2 positions of both RLCIS and RLMIS pre-transfer, and the effect of the Scheme, has been based on the 31 December 2012 Pillar 2 balance sheets, with appropriate pro-forma adjustments having been made to those balance sheets to reflect the acquisition of RLCIS by RLMIS. The 31 December 2013
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Pillar 2 balance sheets were not available at the time of finalising this report. I will however review the 31 December 2013 Pillar 2 balance sheets when they become available and report on them in my Supplementary Report.
7.7 Consideration of Pillar 2 pre-transfer For RLMIS, the Pillar 2 capital resources for the RLMF and each of the RL Closed Funds are the same as for Pillar 1. This is a common position as both are based on realistic valuations of the assets and liabilities. There are sometimes adjustments or differences between the two pillars for various reasons but no such adjustments apply to RLMIS.
Each of the RL Closed Funds comfortably covers its Pillar 2 capital requirements, with the relevant coverage ratios being materially above 100%. This is the case even for the two subfunds (i.e. the PLAL With-Profits Subfund and the United Friendly OB Subfund) which were identified as being less strong under Pillar 1 in Section 7.2 above.
For the RLMF similarly, the fund comfortably covers its capital requirements, and the coverage ratio is materially above 100%. This is the case including the subordinated debt as a liability.
For the RLCIS Fund, the capital resources are greater than those under Pillar 1. This is because the value of the fund’s subsidiaries can be included on a fully realistic basis, which is not possible under the more prescribed approach of Pillar 1. The Pillar 2 balance sheet as at 31 December 2012 has been adjusted, on a pro-forma basis, to allow for the effect of the acquisition of RLCIS by RLMIS, including the application of the expense arrangements which the RLCIS Fund is now subject to. The capital coverage ratio is comfortably above 100%.
Additionally, as discussed in Section 7.5 above, the new reinsurance arrangement entered into in May 2014 has given rise to a material reduction in the RLCIS Pillar 2 capital requirements, thus improving the overall RLCIS Pillar 2 position.
Hence, pre-transfer, all the funds within both RLMIS and RLCIS are covering their Pillar 2 capital requirements, and are doing so by a comfortable margin.
7.8 Consideration of Pillar 2 post-transfer The post-transfer Pillar 2 balance sheet is of the same format as that set out for Pillar 1 in Section 7.1 above, albeit on a Pillar 2 basis.
As the pro-forma pre-transfer Pillar 2 balance sheet for RLCIS already reflects the terms of the expense arrangements, there are no further material adjustments arising.
The post-transfer Pillar 2 balance sheet for the RLMF has been adjusted, on a pro-forma basis, to allow for (a) the value of the benefits from the expense tariff arrangement (i.e. similar to that for Pillar 1), and (b) the additional capital required as a result of this arrangement.
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A key consideration for me is the comparative strengths of the RLMF and the RLCIS Fund post-transfer. This is because, post-transfer, the RLMF will act as the fund which provides the ultimate capital and solvency support to the RLCIS Fund in the same way as it currently does for the existing RL Closed Funds. If the RLCIS Fund were materially weaker on a Pillar 2 basis than the RLMF then, given the significant size of the RLCIS Fund, there could be a financial security detriment to the policyholders of the RLMF (and by extension to the RL Closed Funds).
Based on the pro-forma 31 December 2012 Pillar 2 balance sheets and the applicable capital coverage ratios, the RLCIS Fund is not as strong as the RLMF. However, it is the case that a material proportion of the capital resources of the RLMF are in the form of expected future profits on non-profit business. This proportion is greater for the RLMF than for the RLCIS Funds. This form of capital resources is less liquid than ordinary capital resources, as it is necessary to await the emergence of the relevant future profits. In my analysis I have therefore applied what I consider to be an appropriate reduction to this part of the capital resources within the RLMF, and on this basis the capital coverage ratios of the two funds are similar.
I also note that the Pillar 2 capital resources of the RLMF are significant in absolute terms at £2.2 billion, this being the same value as under Pillar 1 (net of the subordinated debt liability). This amount is significant when considered in relation to the Pillar 2 capital requirements of the RLCIS Funds and the existing RL Closed Funds.
Based on the above analysis of the Pillar 2 position, I can see no material adverse effect on the security of any RLMIS or RLCIS policyholder benefits as a result of the Scheme.
7.9 Consideration of Solvency II The new EU Solvency II regime is expected to come into force on 1 January 2016, subject to certain currently expected transitional provisions. The development of the new regime has been highly controversial, and the relevant approach has been through a great number of iterations. Various aspects have yet to be finalised, including the details of the transitional arrangements and the circumstances when the PRA might approve the use of the transitional arrangements. However, the key aspects of Solvency II are now sufficiently defined in order for me to consider the effect of the proposed transfer under Solvency II.
Under Solvency II, companies are able to adopt either a “standard formula” or an “internal model” approach, with the latter being much closer to the current UK Pillar 2 approach than to the current UK Pillar 1 approach. Larger companies are expected by the PRA generally to adopt the internal model approach, although some larger companies will be adopting the standard formula approach initially. RLMIS (which will include the Transferred Business if the Scheme proceeds) will be among these larger companies which will adopt the standard formula approach initially, but which are expected to move to the internal model approach following formal PRA approval of the relevant internal models.
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The Solvency II calibration standard is 1 in 200 years, as is the case for UK Pillar 2, but with an important difference. Whereas under UK Pillar 2, it is only necessary to demonstrate having sufficient assets to meet liabilities after a 1 in 200 year event, under Solvency II it is necessary to demonstrate having sufficient assets to transfer liabilities to another provider after a 1 in 200 year event. As that other provider would require to be remunerated for the cost of the capital that it would have to hold, Solvency II liabilities include an additional Risk Margin over and above the best estimate of the liabilities. For many companies, this Risk Margin is a significant addition to the liabilities, and thus effectively Solvency II is a stronger standard than the current UK Pillar 2 regime. It is thus to be expected that, all else being equal, a Solvency II balance sheet will show a more adverse position than a current UK Pillar 2 balance sheet.
The capital requirement under Solvency II is known as the Solvency Capital Requirement (“SCR”). This is the equivalent of the ICA under the current UK Pillar 2 regime.
Given that Solvency II is not yet inforce, and given that various detailed aspects of it (including the transitional provisions) have yet to be finalised, it is in my opinion sufficient for my role as Independent Expert for me to be satisfied that both RLCIS and RLMIS can cover their Solvency II capital requirements, and that this is likely to remain the case post-transfer if the Scheme is implemented.
I have been provided with the latest available Solvency II balance sheets for RLMIS and RLCIS. These are as at 31 December 2012, but allow on a pro-forma basis for adjustments arising from the acquisition of RLCIS by RLMIS. The RLCIS General Reserve is excluded from the assets of RLCIS – which is consistent with the terms of the proposed transfer under the Scheme. As these results are not yet in the public domain I have not included them in this report. However, as for the current UK Pillar 2 positions, should the Court wish to see the numerical details of the Solvency II positions, I will arrange for that information to be provided to the Court on a non-public basis.
Notwithstanding the initial use of the standard formula approach as explained above, Solvency II balance sheets for both RLMIS and RLCIS have been produced on the internal model approach as well as the standard formula approach. The internal models are I understand well developed, even though (as is the case for other companies) they have not yet been approved for use by the PRA. The results under the internal model approach are, for both RLMIS and RLCIS, more onerous than those under the standard formula approach, and I have thus focussed my consideration of Solvency II on the internal model results. References below to the Solvency II position of either company are references to the internal model approach unless otherwise stated.
For RLMIS, the current Solvency II position is similar to that of the current UK Pillar 2 position, in that each of the RL Closed Funds covers its own Solvency II liabilities and capital requirements, and in that the RLMF has a material excess of assets over its Solvency II liabilities and capital requirements. As for the current UK Pillar 2, any deficiency within any of the RL Closed Funds would lead to an increase in the capital requirements of the RLMF. Any surpluses in the RL Closed Funds are ring-fenced within those funds and do not contribute to the excess assets in the RLMF (this being the case as at 31 December 2012). For RLCIS, the 31 December 2012 Solvency II position has been
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determined including an SCR which incorporates the benefit of the first four management actions which are set out in the PPFM and which are referred to in Section 5.2 above. These are the same four management actions which are allowed for in the current UK Pillar 2 balance sheet. The Risk Margin has however been based on all six management actions set out in the PPFM and which are referred to in Section 5.2 above. I understand that the PRA has agreed to this approach to reflect the possibility of the additional two management actions being incorporated into the SCR calculation if necessary.
On the basis described above (i.e. four management actions assumed in the SCR), and excluding the RLCIS General Reserve assets, RLCIS meets its Solvency II liabilities and capital requirements but only by a small margin of excess assets. If the additional two management actions are included in the SCR (as they are in the Risk Margin) then RLCIS meets its Solvency II liabilities and capital requirements comfortably.
My understanding is that it is likely that RLCIS (and RLMIS if the Scheme proceeds) will actually determine its SCR based on only the first four management actions referred to above, this being a more prudent approach intended to reflect that the last two management actions would only be used in severely adverse circumstances.. However, given that all six management actions can (under the current regime) be adopted without approval from the regulator, and given the more onerous standard of Solvency II as compared with current UK Pillar 2 due to the Risk Margin, it is appropriate in my view to include all six management actions for the purposes of considering the effect of the Scheme. On this basis, as noted above, RLCIS covers its Solvency II liabilities and capital requirements comfortably.
Although I have stated above that both RLMIS and RLCIS cover their Solvency II liabilities and capital requirements comfortably (on the bases stated above), it is the case that the excess capital over and above liabilities and capital requirements under Solvency II is lower for both RLMIS and RLCIS than that under the current Pillar 2 regime. The main reason for this is the Solvency II Risk Margin which, as explained above, is an addition to liabilities. As at 31 December 2012, the Risk Margin is equivalent to 16% and 31% of the SCR for the RLMF part of RLMIS and for RLCIS respectively which shows the significance of this item. For RLMF, this percentage of 16% is towards the lower end of the range which I have seen, this reflecting the large proportion of unit-linked business within in the RLMF. For RLCIS, this percentage of 31% is at the centre to higher end of the range which I have seen, and this is due to the long tail risk which the RLCIS Fund has in relation to guaranteed annuity options. The difference in the Solvency II regime (as compared with the current UK Pillar 2 regime) thus bears more heavily on the RLCIS Fund. The Solvency II regime includes a number of transitional arrangements to phase in the new requirements, together with certain specific arrangements (known as the “matching adjustment”) in respect of annuity business to ensure that the requirements are not unduly onerous. Both act to reduce the Solvency II liabilities, as opposed to the capital requirements. Use of these beneficial transitional and specific arrangements is subject to the approval of the local regulator (i.e. the PRA for the UK). As the PRA has (naturally) not granted any approvals as yet, the results referred to above exclude any beneficial effect which may in due course arise.
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I understand that RLCIS (and RLMIS in respect of the RLCIS Fund if the transfer proceeds) does not intend to use the matching adjustment for any of its Solvency II liabilities. This is because use of this adjustment gives rise to certain consequential restrictions in the calculation of the capital requirements, making the overall benefit marginal.
RLCIS does however intend to include the benefit of the so called “volatility adjustment” in the calculation of its liabilities (subject to any regulatory approval that may be required for this). The volatility adjustment increases the discount rate applying to all non-linked business and will vary over time because its level depends on the excess of yields on a notional portfolio over risk free rates. The volatility adjustment is country specific and will be prescribed by the European Insurance and Occupational Pensions Authority (“EIOPA”). The results referred to above for RLCIS include the benefit of, the volatility adjustment, which has been estimated to be 40bps (i.e. a 0.4%pa addition to the liability discount rate) as there has not yet been any formal EIOPA determination.
In relation to the transitional arrangements, my understanding is that RLCIS (and RLMIS in respect of the RLCIS Fund if the transfer proceeds) would intend to make use of the transitional arrangements to phase in the effect of Solvency II if regulatory approval for this can be obtained. Moreover, and as referred to in Section 4.3 above, I note that the provisions of the Scheme in relation to capital support for the RLCIS Fund place an onus on RLMIS to act so as minimise the capital requirements of the RLCIS Fund. This will help to ensure that the RLCIS Fund meets its own liabilities and capital requirements as far as possible without having to rely on the additional two management actions referred to above.
In addition to the internal model based results referred to above, I have also been provided with and have reviewed the results on the standard formula approach. These results show that the internal model approach is the more onerous (by a significant margin) for both RLMIS and RLCIS.
Section 7.7 above referred to the beneficial effect on the RLCIS Pillar 2 position from the new reinsurance arrangement entered into in May 2014. This new arrangement has also had a material beneficial effect on the RLCIS Solvency II position, resulting in more material excess assets when only four management actions are considered.
Overall, there are a number of aspects of Solvency II which have yet to be finalised, and there are a number of areas where regulatory approval on a company-by-company basis is required. However, even if a prudent approach is taken to each of these areas, it is clear that both RLCIS and RLMIS can both cover their Solvency II capital requirements, both as standalone entities and post-transfer as a single entity. In the case of the RLCIS Fund, it may be necessary to counter the more onerous Solvency II standard with a higher level of assumed management actions in the capital requirement calculations. Based on this analysis, I can see no material detriment to the security of benefits for any policyholders arising from Solvency II as a result of the implementation of the Scheme.
The above analysis has been based on the Solvency II balance sheet positions as at 31 December 2012. RLCIS and RLMIS will be updating these balance sheets to 31
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December 2013. For RLCIS, this update will include, on a pro-forma basis, allowance for the new May 2014 reinsurance arrangements referred to above. As for the current UK Pillar 2, I will review the 31 December 2013 Solvency II balance sheets when they become available and report on them in my Supplementary Report.
7.10 Stress and scenario testing overview In the above sections, I have considered the financial effect of the Scheme based on the usual metrics of the current UK Pillar 1 and Pillar 2 approaches, and the forthcoming EU Solvency II regime. These are important methods of consideration as they are all related (to a greater or lesser extent) to the actual risks of the business and the with-profits funds in question.
However, when several ring-fenced with-profits funds sit alongside each other within a single legal entity company, the question arises as to possible “contagion” between the funds. Contagion is where the normal ring-fencing approach to the operation of a fund breaks down, and it is necessary for one fund to provide a permanent and irreversible capital injection into another fund. In the case of RLMIS, that contagion risk exists already between RLMF and the RL Closed Funds, and will have been considered by previous Independent Experts for the relevant schemes of transfer. Given that the Scheme transfers RLCIS’s long-term business into RLMIS, it is necessary for me to consider the additional contagion risk arising from this transfer. This consideration is particularly pertinent in the current proposed transfer given that the Scheme does not transfer the General Reserve to RLMIS.
Whilst the above considerations of the Pillar 1, Pillar 2 and Solvency II metrics do implicitly address the contagion issue, it is appropriate in this case in my opinion for some further and more specific analysis. To this end, I have requested the actuarial staff of RLCIS and RLMIS to prepare for me certain stress and scenario testing results which indicate the severity of the circumstances which would have to arise in order for contagion to materialise. Stress and scenario testing is now an established part of the wider regulatory regime, and I have reviewed the stress and scenario testing which the companies have already carried out for regulatory purposes. This, combined with the specific scenarios described below, has been sufficient for me to form conclusions on the potential contagion position.
My key focus has been on the stress testing position of the RLCIS Fund, given that this is the fund being transferred into RLMIS and that the RLCIS General Reserve is not being transferred into RLMIS.
7.11 Stress and scenario testing analysis: RLCIS The issue of contagion is necessarily concerned with extreme and permanent adverse events. For this reason I have chosen to focus on adverse events which would reduce the capital resources (or working capital) of the RLCIS Fund to zero. In other words, under these adverse events, the realistic value of the assets would reduce to the then realistic value of the liabilities with no surplus then existing. If the severity of the adverse event necessary to reach this position is such that it can be regarded as extremely remote, then I can conclude that there is in practice no material contagion risk in existence. This
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approach is not dependent on whether one is considering Pillar 1, Pillar 2, or Solvency II, as it focuses on the fundamental assets and liabilities. I acknowledge that in normal circumstances, and even following adverse circumstances, it is necessary for a company to maintain coverage of a further capital requirement. And as circumstances become more severe, more management actions will need to be taken to protect the solvency of the fund. However in very extreme circumstances, the maintenance of coverage for a further capital requirement becomes moot.
Three adverse scenarios have been considered for the RLCIS Fund as follows:
■ An adverse Insurance Risk Scenario A. This is concerned with adverse events applying to the non-financial aspects of the fund;
■ An adverse Market Risk Scenario. B This is concerned with adverse events applying to the financial markets which affect the fund;
■ An adverse Combined Risk Scenario C. This is concerned with a combination of the above two scenarios.
In carrying out each of these scenario tests allowance has been made for the first four management actions (listed above in Section 5.2) only. No allowance has been made for the fifth and sixth management actions, and this thus provides a prudence margin. In particular, no allowance has been made for further management actions down to guaranteed benefits level, and in each case the benefits payable are 100% of asset share subject to guaranteed benefits.
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Each of these is now considered below.
Scenario A
The following table sets out the details of the Scenario A.
Scenario A: Insurance Risk Scenario
Scenario Explanation of the scenario
Zero pension transfers.
Zero early retirement.
100% GAO take up rate.
Immediate longevity stress of 5% and a longevity improvement factor of 3.5%.
In this stress scenario, no policyholders transfer their pension elsewhere and none take early retirement. The guaranteed benefits on maturity are thus maximised.
Many RLCIS policyholders have valuable guaranteed annuity options (GAOs). Under these options an insurer guarantees to convert the policyholders’ accumulated funds into a life annuity at a fixed rate on maturity. If the annuity rates provided under the guarantee are more beneficial to the policyholder than the prevailing rates in the market the insurer has to make up the difference. The scenario assumes that all the policyholders will take up this option. On longevity there are two types of stresses that can apply. One is that mortality will reduce immediately by 5% and another that the longevity will improve every year by 3.5%. The impact of these will be to increase in the length of time that the annuities will be paid and the consequent increase in the present value of future annuity payments.
The above Insurance Risk Scenario has been derived by looking at the key insurance risks faced by RLCIS and by further strengthening the stresses used under Pillar 2. The transfer, early retirement, and GAO parameters have all been set to the worst they could possibly be. The longevity stress is such that it produces an average life expectancy at retirement for a male personal pension customer aged 65 of 35 years - i.e. each pensioner lives to age 100. This insurance risk scenario is thus very extreme and the likelihood of its occurrence is extremely remote.
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Scenario B
The following table sets out the details of the Scenario B.
Scenario B: Market Risk Scenario
Scenario Explanation of the scenario
Equity (90%) Property (67.5%) Yields+700bps
Credit spreads– AAA +752bps AA +876bps A +1000bps BBB +1500bps <BBB +3000bps
This scenario assumes that equity values will go down by 90% and property values will go down by 67.5% - both being immediate stresses.
The scenario also assumes that long-terms yields increase by 7%pa and consequently values of fixed interest securities reduces. This direction is the most onerous for the fund.
The scenario also includes an increase in the spreads on corporate bonds yields as compared to yields on government bonds. The increase in spread on AAA rated bonds is assumed as 7.52%, for AA-8.76%, A-10%, BBB-15% and other lower rated bonds by 30%.
The basis of the creation of this market risk scenario is the end 2012 stress testing exercise conducted by PRA. The market risk scenario shown in the above table is much stronger than the PRA prescribed scenarios. For example, one of the PRA prescribed scenarios was Equity (40 %); Property (30%); Yields +200bps; Credit Spread Stress of AAA +188bps; AA+219bps; A+250bps; BBB+375bps and <BBB +750bps.
In the available history of the financial markets, equities have never gone down by 90% and property values by 67.5% - at least not over a short period of time. These stresses are more than double the strength of the PRA stresses. Further, the credit spread stresses are extremely strong considering for example that the average spread on AAA bond is 50bps-70bps whereas the stress in this scenario is more than 700bps. This market risk scenario is thus very extreme and the likelihood of its occurrence is extremely remote.
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Scenario C
The following table sets out the details of the Scenario C
Yield curve: The short end of the curve rises to 5%-7%, with the long end of the curve falling to around 2.5%. Equity-20% fall Property-20% fall Corporate bonds 8% fall Pensions transfers-50% reduction Early retirements-50% reduction Longevity level stress 7% Longevity trend stress-1.85% Inflation-1.25% GAO take up: non-trivial cases- 100%
This combined scenario includes a change in the shape of the yield curve, where the short end of the curve increases by 5%-7% and yields at the long end of the curve decrease by 2.5%. This is an adverse shape movement for the fund. An inflation stress is also included.
Equity and property have also been assumed to go down by 20% and all corporate bond values go down by 8%.
The insurance risk stresses includes reductions in pension transfers and early retirements by 50%. The scenario also includes immediate increase in the longevity by 7% and an annual longevity improvement rate of 1.85%.
The scenario also includes the stress that 100% of policyholders eligible for a GAO take it.
This scenario comprises stresses on all the key insurance and market risks faced by the RLCIS. Again this combined scenario is very extreme and the likelihood of its occurrence is in my view extremely remote.
7.12 Consideration of guaranteed benefits: RLCIS In addition to the above analysis, there is a further way in which the ability of the RLCIS Fund to withstand stresses can be considered.
The with-profits policy liabilities include both liabilities in respect of guaranteed benefits and liabilities in respect of discretionary benefits (i.e. future bonuses). The guaranteed benefits are the minimum payouts to the policyholders and cannot be reduced under any circumstances short of insolvency. The discretionary benefits are the benefits which can be reduced, if necessary to zero, in extreme scenarios. This situation is essentially as outlined in Section 5.4 above. It is therefore possible to consider an alternative presentation of the realistic liabilities of the RLCIS Fund, and this is shown in the table below:
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Liability Amount (£m’s) Liability Amount (£m’s)
Asset Shares 11,293 Value of guaranteed benefits
7,454
Planned enhancements and cost of guarantees, options and smoothing
1,375 Value of future discretionary benefits
5,214
Other liabilities 4,236 Other liabilities 4,236
Total realistic liabilities 16,904 16,904
The left hand column of the table above shows the normal regulatory presentation. The basic liability is the asset shares of the with-profits business, and this is augmented by a much smaller liability to represent the circumstances where the asset shares have to be topped up to pay the guaranteed minimum benefits.
The right hand column of the table above divides the liabilities in a different way, distinguishing between the liability in respect of guaranteed benefits only, and an additional amount representing all future discretionary benefits. This shows that out of some £12.7bn of liabilities (excluding other liabilities which are the same under both approaches), some £5.2bn of liabilities (i.e. more than one-third) are discretionary. This proportion of discretionary benefits is not in my experience atypical for an established with-profits fund.
The above presentation and analysis provide further comfort that the RLCIS Fund is able to withstand very extreme stresses before it would have to call upon the assets of the RLCIS General Reserve in any permanent way.
In considering the above analysis, it is important to note that the requirements to treat customers fairly continue to apply, even in extreme scenarios, and it would not be justifiable or possible for the discretionary benefits to be reduced without good justification. What the above analysis shows is the capacity for discretionary benefits to be reduced provided that there is good justification – for example due to adverse financial or other circumstances. For the avoidance of doubt, I also note that some of the with-profits business in the RLCIS Fund does not actually have any guaranteed benefits, and all the benefits are in discretionary form. For this business, considerations of treating customers fairly still apply in the same way as for business with guaranteed benefits. For the purposes of the above analysis, the business which does not actually have any guaranteed benefits has been treated for the sake of prudence as if all the benefits were in fact guaranteed. Given that this is not actually the case, the true position is actually even stronger than that illustrated by the above table.
7.13 Considerations of additional AFH analysis The AFH of RLMIS/RLCIS has carried out his own analysis of the strength of the RLCIS Fund and its ability to withstand stresses in the absence of the RLCIS General Reserve. The AFH has summarised the conclusions of his analysis in his report to the policyholders and the Court.
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I have reviewed the analyses carried out by the AFH and I have discussed them with him. In addition, as the Independent Expert, I have been able review the stress and scenario testing carried out by the AFH at a more detailed level than that summarised in the AFH’s report. The AFH’s analyses have focussed on the Pillar II excess assets position, after meeting capital requirements, in stressed conditions. My own analyses have focussed on a comparison of the assets and realistic liabilities in stressed conditions – with no capital requirements. Both approaches are valid and are complementary to each other. All else being equal, the stresses which a fund can withstand are more severe on the approach I have adopted as compared with the approach adopted by the AFH. However, allowing for this presentational difference, both approaches support effectively the same conclusions.
7.14 Summary of stress and scenario testing conclusions: RLCIS The above analysis shows that the scenarios under which the assets and liabilities of the RLCIS Fund would become equal are extremely remote – and for the most part almost beyond contemplation in terms of all the aspects of the scenario occurring simultaneously. It would thus require events even more extreme than these scenarios for the General Reserve to be called upon to support the RLCIS Fund on a permanent basis, or (post-Scheme) for the RLMF to be equivalently called upon. The additional analysis in relation to the proportion of the total RLCIS liabilities which are in discretionary form adds further weight to this conclusion.
For the avoidance of doubt I can confirm that the basis on which I have carried out this analysis allows for the different groupings within the portfolio of with-profits policyholders, for example those with different product types, moneyness of guarantees and different maturity dates.
7.15 Stress and scenario testing analysis: RLMF In Section 7.11 above, I looked at three extreme scenarios such that the RLCIS assets are just sufficient to meet the liabilities. This section covers the impact on the RLMF capital resources of two of the same scenarios - Scenario A: Insurance Risk Scenario and Scenario B: Market Risk Scenario. By considering the impact of these scenarios on the RLMF, I am able to assess the ability of the RLMF to support the RLCIS Fund in such adverse circumstances.
Under Scenario A, the Pillar 2 capital resources of the RLMF reduce by approximately 12%. The RLMF under this extreme scenario is still able to cover its revised capital requirements with a reasonably significant level of excess assets above those revised capital requirements. The RLMF would thus still be able to support the RLCIS Fund if conditions worsened further from this level.
Under Scenario B, the available capital resources of the RLMF would become minimal, although the RLMF would still be able to meet its own policyholder liabilities. This result is not surprising, given the extreme nature of the scenario in question. This
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demonstrates that in this scenario the position of the RLMF and the RLCIS Fund would be similar.
All long-term insurers have to submit stress and scenario testing information to the regulator periodically, and I have reviewed the most recent submissions of both RLCIS and RLMIS, with the latter covering the position for each of the RL Closed Funds. The stresses and scenarios are defined by the regulator. The stresses and scenarios evaluated in these submissions are not as onerous as Scenario A and Scenario B considered here, but they are done on the basis of the fund in question still needing to cover a further capital resources requirement following the stress. The results which I have reviewed show that the RLMF is always able to cover its capital requirements, and the RL Closed Funds are mostly able to cover their capital requirements, with any deficiencies being readily covered by excess assets of the RLMF. This situation would also still apply post-transfer with the RLCIS Fund as an additional closed fund within RLMIS.
7.16 Summary of stress and scenario testing conclusions: RLMF Under the extreme insurance risk and market risk scenarios considered above, the RLMF is still able to meet its liabilities. Both the scenarios are very extreme and the possibility of their occurrence is remote. Under the insurance risk scenario, which is particularly onerous for the RLCIS Fund, the RLMF would still be able to support the RLCIS Fund.
The stress and scenario testing which has been routinely carried out by both RLCIS and RLMIS shows that the RLMF has adequate resources to provide support to the RL Closed Funds and (post-transfer) the RLCIS Fund.
7.17 Conclusions I have considered the effect of the Scheme (including specifically the fact that the General Reserve is not being transferred to RLMIS under the Scheme) under the current UK Pillar 1 and Pillar 2 approaches, and under the forthcoming EU Solvency II regime to the extent that can currently be ascertained and using a prudent approach. I have also considered the results of some specifically tailored extreme adverse scenario testing for the RLCIS Fund, as well as the adverse scenario testing carried out by RLMIS. All of this information supports a conclusion that there will be no material adverse effect on the security of benefits for any of the policyholders in RLCIS or RLMIS. In particular, the scenarios under which the absence of the General Reserve would give rise to a detriment are in my opinion both extreme and remote.
The extreme scenario testing for the RLCIS Fund also supports my conclusion as set out in Section 5.4 above. Although there could be differences in the circumstances when permanent support would currently be provided by the General Reserve, as compared with the circumstances when permanent support would provided by the RLMF post-transfer, the conditions under which this question would actually arise are extreme and remote. Thus any such differences between the pre-transfer and post-transfer permanent support arrangements are in practice immaterial.
In the last paragraph of Section 5.1 above, I set out that my consideration of benefit expectations is in relation to circumstances other than those which are extreme, and that
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my consideration of extreme circumstances was one of benefit security, as covered in this Section 7. I note that it is, alternatively, possible to regard the benefits payable to policyholders in extreme circumstances as a further aspect of benefit expectations. If this alternative is considered, then the analysis set out in this Section 7 can also be used to conclude that there is no material adverse effect on any benefit expectations in extreme circumstances.
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8 Other risks and other key considerations
In this section I consider the other risks and certain other key considerations that have not been covered in the previous sections of this report.
8.1 Operational risks of the transfer When a Part VII transfer takes place, there is general scope for operational errors to occur. Ongoing operational risk has been covered in Section 4.3 above, but my focus in this section is that of operational errors arising from the transfer itself. If any such errors do occur, it will be the responsibility of the RLMF to correct them in order to put the relevant policyholders back into the same position they would have been in had the error not occurred.
In the case of this proposed transfer, the scope and likelihood for operational errors to arise as a result of the transfer itself is in my opinion limited. This is because the key operational processes in relation to administration, investment, and the determination of policyholder benefits (including bonuses for with-profits policies) will not change as a result of the transfer. This applies both to RLMIS and to the RLCIS Fund, but is particularly relevant to the latter it is it the business of the RLCIS Fund which is being transferred. The same people will carry out the same processes using the same systems after the transfer as compared with before the transfer. Where external parties are used to provide services (e.g. Capita), these services will continue to be provided by the same party. Over time, RLMIS may wish to integrate and streamline the RLCIS processes into the RLMIS processes, but the risk of such changes will be mitigated by normal testing and change management procedures.
8.2 Service levels I have discussed the issue of ongoing customer service levels with the relevant individuals from RLMIS and RLCIS. Following the transfer, and consistent with the analysis set out in Section 8.1 above, I can see no reason to expect that there will be any changes in the level of service or the customer service experience as compared with the position before the transfer.
8.3 Legal risk In considering any legal risks arising from the transfer, I have relied on the fact that RLCIS and RLMIS have followed the advice of their legal advisers and Counsel in finalising the legal agreements in relation to the transfer. In particular, I note that Counsel’s opinion has been obtained in relation to the legal aspects of the RLCIS General Reserve, and this is covered in detail in Section 5.3 above. Thus, in my opinion, all reasonable steps have been taken to reduce the legal risks arising from the Scheme to a minimum.
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8.4 Chancellor’s Budget on 19 March 2014 On 19 March 2014, the Chancellor of the Exchequer announced major changes to the UK pensions industry from April 2015. Under these changes, it will no longer be compulsory for policyholders with defined contribution pensions arrangements to purchase annuities from insurance companies by (at the latest) age 75. In addition, other changes were announced (and which are now already in force) which allow retiring pension policyholders with relatively small accumulated funds to take their entire benefits in cash form.
As discussed previously in this report (for example in Sections 7.9 and 7.11 above), the RLCIS Fund is heavily exposed to guaranteed annuity options (GAOs), and the various balance sheets, valuations and stress and scenario testing results all allow for the benefits under these valuable policyholder options. However, where policyholders are able and choose to take their benefits in cash form, the additional liabilities arising from these GAOs fall away. As will be the case for companies generally, RLCIS (and RLMIS post-transfer) will have a duty to inform retiring policyholders wishing to take their benefits in cash form of the valuable GAOs which they will be forsaking. Notwithstanding this, it is expected that the March 2014 Budget changes will lead to fewer policyholders taking up their GAOs, and this will lead to an improvement in the financial position of the RLCIS Fund.
I can thus conclude that the March 2014 Budget does not invalidate any of my conclusions and analyses as set out in this report, and moreover that the March 2014 Budget if anything strengthens my conclusions. The updated financial information which I will consider as part of my Supplementary Report (see Section 8.7 below) is expected to take into account the likely effect of the March 2014 Budget to the extent that it is possible and prudent to do so.
8.5 Tax risk RLMIS and RLCIS have confirmed to me that all the relevant tax clearances in relation to the transfer have been formally obtained from HM Revenue & Customs.
The tax position itself in relation to the RLCIS Fund following the implementation of the Scheme is as set out in Section 4.3 above.
I can thus conclude that the risks of any adverse tax outcome for any policyholder has been reduced to the minimum.
8.6 Regulatory risk There is a risk that changes to the UK regulatory environment as a result of the implementation of Solvency II in the EU may adversely affect the capital requirements of RLMIS (in particular the RLMF) and the RLCIS Fund. I have considered the financial implications of Solvency II in Section 7.9 above. I note in particular that the absence of the RLCIS General Reserve post-transfer does have a bearing on position of the RLCIS Fund post-transfer, but all of the analyses which I have carried out, and for which the
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outcome has been satisfactory, are on the assumption that the RLCIS General Reserve is not transferred to RLMIS.
The FCA has relatively recently announced that it will carry out a review of certain aspects of legacy type business within the UK life insurance industry. It is not at this stage clear what the exact scope, nature and timing of this review will be, nor what the costs or liabilities arising might be for any company or fund. In the event that, following the implementation of the Scheme, this review gives rise to any additional costs or liabilities for RLMIS, then I would expect that each subfund within RLMIS (including the RLCIS Fund) would bear the costs and liabilities which relate to its own legacy type business.
Overall, my conclusion is that other than the specific issue of the RLCIS General Reserve (which has been specifically covered within this report), the amount of regulatory risk together with where and how any such risk might fall, is not materially different after the transfer as compared to the position before.
8.7 Supplementary report My consideration within this report of the financial effects of the Scheme is based on Pillar 1 information as at 31 December 2013 and Pillar 2 information as at December 2012. Prior to the final Court hearing, I will produce a Supplementary Report updating my consideration of the financial effects of the Scheme to be based on 30 June 2014 information for Pillar 1, and 31 December 2013 (with adjustments for the new May 2014 reinsurance arrangements) information for Pillar 2. I will consider in my Supplementary Report whether any of my conclusions are affected by this updated financial information. I will also include as necessary and applicable any update in relation to Solvency II. My Supplementary Report will also consider any objections arising from any RLMIS or RLCIS policyholders, as well as any new aspects or issues which emerge in relation to the proposed transfer. I will further include those other updates to which I have referred in this report as being covered in my Supplementary Report.
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9 Overall conclusions
My conclusions in relation to the effects of the Scheme are as follows:
■ There will be no material adverse effect on the benefit expectations of any of the policyholders involved, with this conclusion encompassing the transferring policyholders of RLCIS, and the existing policyholders of RLMIS (both in the RLMF and in the RL Closed Funds);
■ There will be no material adverse effect on the security of benefits for any of the policyholders involved, with this conclusion encompassing the transferring policyholders of RLCIS, and the existing policyholders of RLMIS (both in the RLMF and in the RL Closed Funds). In reaching this conclusion I have in particular taken into account that the Scheme does not transfer the RLCIS General Reserve to RLMIS;
■ Both of the above conclusions remain applicable whether or not the proposed simultaneous transfer of the long-term business of RLPPC into RLMIS proceeds.
As stated in this report, the RLCIS Fund will become closed to new business as from the Effective Date of the Scheme, and the estate of the RLCIS Fund will be distributed over time to the RLCIS with-profits policyholders. The method of estate distribution to be adopted, the timing of its commencement, and the pace at which the estate is to be distributed, are all areas which are outside the scope of my role as Independent Expert.
At the time of signing this report, I have not reviewed either the PRA or the FCA first reports to the Court in respect of the proposed transfer. In the event that either the PRA or FCA first reports, or either of their final reports, contain any new considerations which are relevant to my role as Independent Expert, then I will consider these in my Supplementary Report to the Court.
John A Jenkins Fellow of the Institute and Faculty of Actuaries Partner, KPMG LLP
14 July 2014
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Appendix 1
List of main documents reviewed Main RLCIS documents
RLCIS PRA Returns as at 31 December 2013
RLCIS ICA Position as at 31 December 2012
A series of Pillar 1 and Pillar 2 Balance Sheets under a range of prescribed economic scenarios – a paper to Royal London (CIS) Ltd Internal Model Working Group (IMWG)
Principles and practices of financial management of CIS Long-term Business Fund
Principle and practices of financial management of CIS With-Profits Pension Fund
Principles and practices of financial management of RLCIS OB & IB Fund
Principles and practices of financial management of RLCIS With-Profits Stakeholder Fund
Rules and regulations within the company
Reviewed and recalculated policy numbers for various Board products and systems
The Group’s financial performance during 2012 as in the Annual Report
The Group’s financial performance during 2012 as in the Annual Review
Major Financial commitments of the Long-Term funds on Peak 2 (realistic) basis
Royal London (CIS) Limited Capital Management Policy with effect from September 2013
CIS capital management plan to The Royal London (CIS) Ltd Board on 27th January 2014
CIS Capital Management Policy
The Group’s interim financial performance during 2013
Skilled Persons Review of CIS ICA at YE 2011
Support deed of CBG and CIS on sale, use of General Reserve, General Business Capital Charges, Notices, General Law and Jurisdiction etc
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(continued)
Letter from CBG to FSA on 16 July 2012 regarding Project Jupiter – CIS Ltd Life & Savings Compensation Costs
Letter from FSA to CBG on 26 October 2012 regarding Jupiter – CIS Ltd Life & Savings Compensation Costs
Summary of RLCIS policyholder booklet on the RLCIS Scheme
RLCIS policyholder letter on the proposed transfer of RLCIS policy to Royal London
RLCIS policyholder booklet on the RLCIS Scheme
CIS Rate Card as on January 2014
Tax Explanation of Tax Assets / Liabilities of RL (CIS) for Independent Expert
Detail report on General Reserve – history, use, considerations to be made before a partial release of it, legal advice, solvency test etc
FSA letter dated 26 September 2012 to the Chief Executive of the CBG related to Project Jupiter revised transaction
PRA Stress and Scenario testing
Summary of RL(CIS) Part VII Investigation - Extreme Demographic Stress as at 31/12/2012
Royal London Submission of PRA Life Insurance Stress Testing Exercise as at 31/12/2012
Amendments to the Project Granite Operational Risk (Paragraph 15)
Proposed sale of CIS to Royal London - A note from the With-Profits Actuary
Report on Project Jupiter to the CIS With-Profits Committee
Project Jupiter Update to the With-Profits Committee dated 10 November 2011 prepared by Anthony Lee
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Main RLMIS documents
RLMIS PRA Returns as at 31 December 2013
PPFM Royal London Group
RLMIS Pillar 2 & Solvency II post acquisition balance sheet split by fund
Articles of association of RLMIS
Business Review, Governance, Financial Statements and additional information for Royal London Group
Pillar 2 balance sheet of RLMIS Long-term Fund as at 31/12/2012
Pillar 2 and SII position as at 31 December 2012 post acquisition
Summary of Base Results as at 31/12/2013 for Royal London Group (Form 18 &19)
Breakdown for RBS Working Capital into Assets and Liabilities for the YE12 Base and the 10 sensitivities
Includes Director’s Conflict, Jupiter Transaction Summary, General Reserve and Management Actions, Due Diligence Reports, CRO Recommendation to the Board
Contains Customer & Members Benefits, Customer Journey and Corporate Governance
Agreement for Management of Royal London Business – RLMIS and RL Management Services Limited
Capital Management Plan and RL Group Capital Position as at 30 June 2013
Key risks and mitigation options related to Project Jupiter
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Main documents related to the transfer and to both RLCIS and RLMIS
Actuarial Function Holder’s Report on the proposed transfer of the Business of RL (CIS) Limited to The RLMIS Limited
Report of the With-Profits Actuary on the proposed transfer of the Business of RL (CIS) Limited to The RLMIS Limited (i.e. report of the RLMIS With-Profits Actuary) Proposed transfer of the long term insurance business of RLCIS to The RLMIS Limited – Report of the With-Profits Actuary (i.e. report of the RLCIS With-Profits Actuary) RLCIS WPC Minute dated 29 April 2014 v7 RLCIS WPC Minutes dated 5 June 2014 v3
4.1 Part VII Transfer Subcommittee Update by David Keeler on activity since last RLCIS WPC meeting on 29 April 2014 Sale and Purchase Agreement between CBG & RLMIS on 18 March 2013
Amendment to the Sale and Purchase Agreement between CBG & RLMIS on 22 July 2013
Transitional Service Agreement between CFS Management Services Limited & RLMIS on 18 March 2013
Amendment dated 29 July 2013 to the Transitional Service Agreement between CFS Management Services Limited & RLMIS as on 18 March 2013
Control structure and Governance and Risk Management framework– Change in Control. The sale of CIS Limited and TCAM from The Co-operative Banking Group to The Royal London Mutual Insurance Society Limited
SII impact on excess capital for RL (CIS) and for RL
RLCIS Scheme
RL policyholder letter on the RLCIS Scheme
RL policyholder booklet on the RLCIS Scheme
RLCIS Legal Notice
Ashurst advice in relation to application of MVRs or other deductions to Accumulating With-profits Policies
Ashurst advice in relation to the General Reserve
Project Granite – Rights and interests of policyholders in the General Reserve (opinion of Mr. Martin Moore QC)
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Excluded Policies Reinsurance Agreement – RLCIS and RLMIS
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Appendix 2
Areas covered by the RLCIS PPFM Section
Introduction
What are the principles and practices of financial management? - How do we ensure that the PPFM is followed in practice?
What is the Royal London (CIS) Sub-Fund?
What are the profits and losses of the fund and how are they shared?
What methods are used to determine bonuses? - Traditional with-profits policies - Accumulating with-profits policies
How are annual bonuses determined?
How are final bonuses and market value reductions (MVRs) determined? - Traditional with-profits policies - Accumulating with-profits policies
How are bonuses applied when a payment is made on a policy? - Endowment assurance policies - Traditional with-profits whole life assurance policies - Pension policies with a minimum guaranteed cash amount at retirement - Other pension policies where some or all of the guaranteed contractual amount is expressed as an annuity - Accumulating with-profits
The investment strategy of the fund - Matching - Reducing investment risk - Other uses of derivatives and similar investments - Business premises and subsidiaries - Investment strategy reviews
The charges made for expenses on with-profits policies
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(continued)
The business risks associated with investing in the fund - Major risks - Longevity risks and guaranteed annuity options - Other guarantees associated with with-profits policies - Investment risks - Expense risks - Potential compensation claims - Policy options and unit trust business - Investment in subsidiaries - Risks associated with the Royal London Long Term Fund - Miscellaneous business risks affecting the with-profits business - Impact of risks on payouts
The working capital of the fund - including management actions
Glossary
The above listing of the areas covered applies both to the pre-Scheme and post-Scheme version of the RLCIS PPFM except the Introduction Section which is included in the post-Scheme PPFM.
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Appendix 3
Main risks faced by the RLCIS Fund and the RLMF The top five risks for the RLCIS Fund are:
■ Longevity: This risk arises because of the existence of annuity business in the portfolio and from annuity policyholders living longer than expected;
■ Persistency: This risk arises from policyholders deciding whether to continue with their policies or not. Higher or lower levels of persistency can increase liabilities depending on the policy type and the terms of the policy;
■ GAO take-up: Many policyholders have guaranteed annuity options (GAOs) on their pension policies which, when taken up, increase liabilities. The risk relates to the proportion taking up their GAO at retirement;
■ Interest rate risk: This risk arises from interest rates rising and falling. For the Pillar 1 working capital, a rise in interest rates in the most onerous direction. For the Pillar II excess assets a fall in interest rates is the most onerous direction;
■ Expense inflation: This risk relates to higher than expected inflation rates of expenses.
The top five risks for the RLMF are:
■ Equity: The risk of a fall in equity values, which results in lower assets and (for with-profits products) higher liabilities for guaranteed benefits;
■ Real interest rate: The real interest rate is the nominal interest rate less inflation. A fall in the real interest rates is the most onerous direction;
■ Persistency: As above for RLCIS;
■ Operational: The risk of losses due to errors, failed processes/systems or external events. (Note that this definition is not exhaustive.);
■ Expenses: This is the risk of expenses increasing above expected levels, the effect of which cannot be passed, or fully passed, on to policyholders.
