The FCA’s Policy Statement, PS 20/4, published on 4 March 2020, sets out its response to feedback received to CP 18/40 (Consultation on proposed amendment of COBS 21.3 permitted links rules), together with final rules and guidance.
The PS is primary addressed to those insurance companies making index-linked funds available to retail investors within a wrapper (often an insurance-based pension).
What’s changing? And when?
The rules and guidance in the PS are intended to achieve a balance between allowing retail investors to invest in a broader range of long-term assets via unit-linked funds with an appropriate degree of investor protection.
The FCA has decided to:
- remove some restrictions on the type of illiquid assets in which
investment may be made, subject to an overall limit (no more than 35%
of the relevant unit-linked fund may be invested in these illiquid
assets); but - keep the existing limits on investment in land/ real property. These
assets are not included in the overall 35% limit, but are subject to a
different limit of 10% of the unit-linked fund’s assets.
The extended permissions are conditional on the insurer satisfying a number of new requirements, namely:
- ensuring that the investments are, and continue to be, suitable and
appropriate for the policyholder; - ensuring that liquidity issues do not adversely affect the timing of
benefits contractually due to the policyholder; and - setting out the additional risks and consequences involved clearly
and prominently to the policyholder.
The new rules came into force on the publication of the PS on 4 March 2020. They apply, though, only where the insurer chooses to take advantage of the new ‘conditional permitted links’. Insurers may, if they prefer, continue to use the existing ‘permitted links’ rules.
Who do the new rules affect?
The rules set out in the PS only cover unit-linked funds These are contractual-based investments sold by life insurance companies often within a life insurance policy wrapper where the return on the policy is linked to the performance of underlying pooled investments. The investor is allotted nominal units in the underlying (unit-linked) fund according to the premium paid and the unit price on the date of purchase. The investor then receives returns based on the fund’s performance.
Previous work by the FCA had found that illiquid assets make up only a small proportion (£27 bn out of a total of £914 bn, or 3%) of assets held in unit-linked funds.
What’s the context to these changes?
The FCA has, for some time, focused on the role of permitted links in providing adequate protection for those investing in index-linked funds, over and above the requirements contained in the Solvency II Directive.
Following both: (a) its work as part of HM Treasury’s Pension Scheme Investments Taskforce; and (b) recommendations made in the Law Commission’s June 2017 report on Pension Funds and Social Investment, the FCA confirmed it would review how it could remove barriers to long-term capital investment, including those arising from the ‘permitted links’ rules in COBS 21.3. These rules specify the types of investment (or permitted links) which insurers can make when the investment risks of a contract lie with a natural person.
The PS, though, should be seen in the wider context of the FCA’s work on Patient Capital and liquidity in investment funds, not least:
The impact of Woodford
In light of the suspension of the LF Woodford Equity Income Fund in June 2019 (after CP 18/40 had closed), the FCA has been highly alert to the risks of illiquid assets being held in certain fund structures. Though the PS is concerned with unit-linked funds (and not open-ended funds sold direct to retail investors), these risks are explicitly identified as one of the reasons the FCA is not proposing to remove all restrictions for unit-linked funds. Rather, they are attaching a number of conditions to the new flexibility so an appropriate degree of consumer protection is retained.
The FCA’s work with the Financial Policy Committee
PS 19/24 (Illiquid assets and open-ended funds and feedback to Consultation Paper CP18/27) took forward the FCA’s work on illiquid assets held in open-ended non-UCITS retail schemes, but also highlighted potential further work in this area with the Bank of England’s Financial Policy Committee (FPC). This additional work will address how best to align fund redemption terms with the liquidity of their assets in order to minimise financial stability risks.
In PS 20/4, the FCA notes that the FPC work is ongoing and that implementation of the new rules on permitted links “does not preclude our considering other interventions as that work reaches its conclusions”.
An overview of the FCA’s (and international bodies’) work on liquidity can be found in our summary of the FCA’s FS20/2, Patient Capital and Authorised Funds here.
The amendments
COBS 21.3 sets out 12 categories of permitted links (i.e., assets in which firms may invest to provide linked benefits in unit-linked life policies sold to retail customers). Of these, five categories are of particular relevance to long-term capital investment in illiquid assets and subject to change under the new rules.
The FCA has now created further ‘conditional permitted links’ to supplement the existing range. An insurer can make use of these but only if it:
- abides by a new amalgamated limit, restricting to 35% the proportion
of a linked fund’s overall investments that can be held in illiquid
assets; and - meets certain conditions which provide enhanced investor protection
(for example, adequate risk warnings).
Looking at the new rules in more detail:
Amalgamated overall threshold limit
The existing permitted links rules impose limits on holdings of certain asset classes (permitted land and property and permitted schemes) but not on others.
The FCA has amended these rules with the introduction of an overall limit of 35% on illiquid assets held as permitted links or conditional permitted links for firms which meet the investor protection conditions (This is a reduction on the original proposal under CP18/40 of 50% since the FCA felt – in what can perhaps be seen as a wasted opportunity – 50% would be “higher than justified when considering the need to maintain a level of liquidity to meet the reasonable needs of investors”, given its decision to exclude investment in permitted land and property from the overall amalgamated limit.)
A firm making use of the new rules can now exceed current limits for individual categories of permitted links if the overall threshold limit of 35% is adhered to. For firms whose unit-linked funds are linked only to the existing permitted links categories (rather than the new conditional ones), the current limits remain as before.
Note, though, that the overall limit does not apply to the conditional permitted link category for land and property (see below) - the only limit relating to investment in land and property remains the 10% gearing limit on permitted land and property under existing COBS 21.3 permitted links rules.
Investor protection conditions
To avoid unsuitable risks being passed on to retail investors, the FCA has introduced associated investor protections which state that, among other things, where a firm makes use of the conditional permitted links:
it must ensure that the investment does not prevent a policyholder
exercising rights (such as taking benefits or withdrawing from its
unit-linked investments) under the unit-linked contract;it ensures that the investment risks are suitable and appropriate for
the policyholder, including the policyholders’ investment needs; andit gives investors specified and adequate risk warnings about the
additional risks and consequences of liquidity and investment risk.
This should be done prominently, in clear, understandable language in
relevant disclosures at an appropriate point in the investor’s
decision-making process.
The obligations set out in the first two bullets must be monitored “on a continuing basis” as well as being considered in the context of valuation of assets and liabilities and capital requirements. Although the FCA does not specify what frequency it intends firms to use, the ‘continuous’ monitoring may cause some issues in the context of illiquid assets – if the firm determines that the investment risks are no longer suitable for a given investor, having to redeem the investor immediately hardly sits easily with the ability to invest in illiquid assets in the first place.
Permitted land and property
The ‘land and property’ category is defined as ‘any interest in land (and any buildings on it)’.
To allow for broader investment in the infrastructure elements of long-term capital through this category, the FCA is now creating a new ‘conditional permitted immovables’ category, which permits investment in ‘immovable’ structures or installations – such as turbines, hydroelectric schemes, solar farms - on any property situated within the UK, provided they meet both
- the definition of ‘immovable’ under the Collective Investment Schemes
sourcebook; and - the investor protection conditions above.
The FCA has decided against its original plan to change the current limit of 10% on investment in land and property and will not now include such investment in the overall amalgamated limit for other types of long-term capital under the new conditional permitted links.
Unlisted securities
The permitted links rules currently allow unlimited investment in unlisted securities, but only where these are ’readily realisable in the short term’ – since many illiquid securities may not meet this criterion and since many unlisted securities are illiquid, this restricts investment in unlisted securities.
The FCA has introduced a new category of conditional permitted unlisted securities, allowing a firm to invest in permitted unlisted securities which are not ’realisable in the short term’
- provided liquidity requirements at the level of the investment fund
can be met; - subject to the overall limit on illiquid assets under the new
conditional permitted links; and - provided the insurer satisfies the additional consumer protection
conditions.
The FCA has also clarified that venture capital would allowed under (a) the existing permitted links or, if it met the criteria above, (b) the new conditional permitted links. The issue of how venture capital can be held via authorised funds (as opposed to unit-linked funds) forms part of the FCA’s ongoing work on long-term capital in authorised funds (see FS20/2: Patient Capital and Authorised Funds).
Permitted scheme interests
The rules for ‘permitted scheme interests’ (i.e., investment in other funds such as UCITS, QIS, NURS and Unregulated Collective Investment Schemes or UCIS) require the underlying funds to publish their prices regularly.
The existing permitted links rules limit a unit-linked fund to investing no more than 20% in QIS and UCIS – since UCIS are subject to fewer investor protections than UCITS and NURS, an underlying UCIS is itself required to invest only in permitted links and must publish its prices regularly.
The FCA has now removed the 20% limit on holdings of assets in QIS/UCIS where the firm meets the investor protection conditions - see above - but it will remain for firms which continue to use the existing permitted links rules. Investments in permitted scheme interests are now limited by the overall amalgamated percentage limit across all illiquid assets.
The FCA also makes clear in the PS that, contrary to industry perception, regular publication of pricing does not require there to be daily pricing in either the existing or the new conditional permitted links. This is an important clarification and ties in with the FCA’s concern that the demand for daily dealing funds is being driven not by regulatory considerations but by the distribution chain for open-ended funds (including through unit-linked funds) and that that is inappropriate for products that seek to provide exposure to illiquid assets.
Permitted loans
Firms can include, under the existing permitted links rules, loans that are fully secured by a mortgage or charge on permitted land or property.
The FCA has extended this by creating a new category of conditional permitted loans for firms, to include loans secured on immovables within the new conditional permitted immovables category.
Such investment will again be subject to the overall amalgamated limit on illiquid assets and to the additional associated investor protection conditions.
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