COBS 21: changes to permitted links rules

Published by John Hoskin on

Estimated reading time: 8 minutes


Insurance companies can now offer unit-linked insurance funds that have a greater proportion of assets invested in patient capital (long-term capital investments) than previously. But will there be a rush to do so?  

In this blog I look at the changes to the permitted links rules and consider the factors firms need to take into account if they are to offer such funds.

What do the rule changes mean for investors and insurers?

The Financial Conduct Authority (FCA) published its long-awaited policy statement on patient capital for unit linked funds (PS20/4) in March 2020. Rule amendments, which came into effect immediately, let insurers offer funds that invest in new types of permitted assets or that give greater exposure to certain assets than previously allowed. 

The intention is to allow investors greater access to long-term capital investments such as infrastructure that are often, by their nature, illiquid. The new rules provide greater flexibility compared to some other types of collective investment vehicles available to retail investors.

However, the rule changes do not give as much flexibility as was perhaps suggested by the associated consultation (CP18/40) and insurers offering funds under the relaxed rules will have to meet:

  • additional disclosure requirements;
  • customer suitability checks; and
  • certain liquidity requirements.

What are the changes?

The rules setting out the types of assets that can be held in unit-linked insurance funds are set out in section 21 of the FCA’s Conduct of Business Sourcebook (COBS 21) and are commonly referred to as the “permitted links” rules. It is important to note that most of the permitted links rules apply only where the investment risk is borne by a policyholder who is a natural person.

This means that the permitted links rules apply to individual policyholders and also where the policyholder is the trustee of a defined contribution pension scheme as, in the latter case, individuals who are members of the defined contribution pension scheme bear the investment risk. This is important when we look at suitability checks below. 

The rule amendments do not change the pre-existing rules for those firms that choose not to make use of the new flexibility. In particular, contrary to the suggestion in CP18/40, there is no change to the rules which allow insurers to offer funds that are fully invested in permitted land and property.

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In order to offer funds that invest in conditional permitted links, firms need to meet some, er…, conditions, additional to the over-arching permitted links rules.  These can be grouped as quantitative limits, disclosure requirements, liquidity requirements and suitability checks and are discussed below.

Quantitative limits

Where a fund invests in conditional permitted links, no more than 35% of the fund can be invested in a combination of conditional permitted links and holdings in qualified investor schemes and unregulated collective investment schemes that fall within the pre-existing definition of permitted scheme interests.

The 35% limit is lower than the 50% originally mooted in the FCA’s consultation.  While additional exposure to patient capital may be possible via financial instruments meeting the (non-conditional) permitted links rules, the 35% limit suggests that a favoured option may be a balanced-fund type of offering with a patient capital element alongside more traditional asset classes.

Firms will also need to ensure adequate monitoring is in place so that relative movements in value don’t lead to breaches of the 35% limit.

Disclosure requirements  

Firms offering funds invested in conditional permitted links must provide information spelling out the additional risks to the policyholder, particularly around liquidity risk and the potential for there to be a detrimental impact on value if assets need to be sold at short notice or for withdrawals to be deferred if assets cannot be easily liquidated.  The FCA sets out four key requirements:

  • an explanation of the risks associated with any conditional permitted links and the risks associated with investments in permitted scheme interests exceeding 20% of the fund, how these might crystallise and how they might impact on the policyholder;
  • a description of the tools and arrangements the insurer uses to mitigate those risks;
  • an explanation of the circumstances in which these tools and arrangements would typically be deployed and the likely consequences for linked policyholders; and
  • an explanation of the possible impact on the policyholder of any provision in policy terms and conditions that allows for the deferral of the exercise of any rights under the contract.
  • there is clear messaging here that firms need to think about how they will deal with liquidity issues in advance rather than wait until a problem occurs to find a solution.  This is aligned with other FCA work in recent times, particularly following the suspension of property fund redemptions post the UK referendum vote to leave the European Union.

Liquidity requirements

The pre-Solvency II permitted link requirement for linked assets to be capable of being realised in time to meet obligations to linked policyholders is now addressed as part of PRA Investments.

While PRA Investments applies to funds invested in conditional permitted links, perhaps surprisingly, only one of the conditional permitted links category definitions, that for conditional permitted unlisted securities, makes explicit reference to the need to demonstrate that the investment is “realisable in a timeframe necessary to meet the liquidity requirements of the linked fund”.  However, in respect of funds invested in conditional permitted links, the FCA lays out some further requirements.

Essentially, these mean that the insurer cannot unreasonably delay the payment of contractual benefits, i.e. those payable on a certain date or event such as planned retirement date or death. Such benefits must be paid within a reasonable timeframe to meet the needs of the policyholder.  The FCA does not define “reasonable timeframe” but makes it clear that firms cannot defer payment beyond this timeframe, which must be included in the policy terms and conditions.

Payment on other types of event, such as surrender or transfer out before planned retirement date, can be deferred for longer periods.  Here, the FCA describes the timeframe as “that may reasonably be necessary” to allow the fund to be managed prudently and in the best interests of all policyholders.

These requirements mean that firms will need to ensure appropriate governance and monitoring is in place to ensure fund liquidity is managed appropriately, otherwise firms may need to accept box positions in their funds that are invested in conditional permitted links and find liquidity to pay policyholder benefits from other assets.
Suitability checks

Perhaps the most challenging aspect for firms wanting to offer funds invested in conditional permitted links is the FCA’s requirements around suitability.

Insurers must ensure on a continuing basis that the investment risk of a fund invested in conditional permitted links is suitable and appropriate for:

  • circumstances where investment risk is borne by a linked policyholder;
  • the expected period to maturity of the linked long-term contract of insurance; and
  • the purpose for which the linked policyholder holds the linked long-term contract of insurance.

The FCA goes further to say that where a fund investing in conditional permitted links is included in a default or similar arrangement for a pension scheme, the insurer should give ongoing consideration as to whether the investment risks of any conditional permitted links remain suitable and appropriate for a particular cohort of linked policyholders, including as that cohort moves toward retirement.

This hints that firms may need to consider offering “lifestyle” type options that perhaps reduce the weighting in illiquid assets over time.

Exact requirements are unclear and, no doubt, firms will interpret things differently.  At one end-of the spectrum, it may appear that all insurers need to do is to get comfortable with the investments being used, identify the circumstances in which the fund might be appropriate and adequately disclose this to policyholders.

However, CP18/40 refers to the insurer ensuring investments in more illiquid or risky assets are only “offered/taken up” where they are suitable and appropriate.  The use of “taken up” implies that the insurer needs to assess suitability for individual policyholders.

While, for many firms, this suitability assessment may be achievable at outset, the continual assessment may be more difficult as policyholders’ circumstances may change. The suitability assessment is also a potential challenge for firms offering Trustee Investment Plans to defined contribution pension scheme trustees. Under these contracts, the trustee of the pension scheme is the policyholder and the insurance company typically has no information on the underlying pension scheme members.

Without such information it is impossible to assess suitability to an individual and insurers wanting to offer such products under a Trustee Investment Plan may need to amend their approaches. 

The amendments introduce a new category of permitted link, called “conditional permitted links". The assets falling under the definition of conditional permitted links are defined fully in the FCA handbook. In summary, they are:

  • conditional permitted unlisted securities (unlisted securities that are not realisable in the short term) 
  • conditional permitted immovables (assets such as wind farms, bridges or railways that meet certain criteria) 
  • conditional permitted loans (loans secured on conditional permitted immovables)
  • conditional permitted scheme interests (holdings in qualified investor schemes or unregulated collective investment schemes that are not permitted scheme interests under the pre-existing rules and that invest in conditional permitted links either exclusively or in combination with permitted links)

However, in order to offer funds that invest in conditional permitted links, firms need to meet certain conditions, additional to the over-arching permitted links rules. These can be grouped as quantitative limits, disclosure requirements, liquidity requirements and suitability checks and are discussed below.

Quantitative limits

Where a fund invests in conditional permitted links, no more than 35% of the fund can be invested in a combination of conditional permitted links and holdings in qualified investor schemes and unregulated collective investment schemes that fall within the pre-existing definition of permitted scheme interests.

The 35% limit is lower than the 50% originally mooted in the FCA’s consultation. While additional exposure to patient capital may be possible via financial instruments meeting the (non-conditional) permitted links rules, the 35% limit suggests that a favoured option may be a balanced-fund type of offering with a patient capital element alongside more traditional asset classes.

Firms will also need to ensure adequate monitoring is in place so that relative movements in value don’t lead to breaches of the 35% limit.

Disclosure requirements

Firms offering funds invested in conditional permitted links must provide information spelling out the additional risks to the policyholder. This is particularly the case around liquidity risk and the potential for there to be a detrimental impact on value if assets need to be sold at short notice, or for withdrawals to be deferred if assets cannot be easily liquidated. 

The FCA sets out four key requirements, as below.

  1. An explanation of the risks associated with any conditional permitted links and the risks associated with investments in permitted scheme interests exceeding 20% of the fund, how these might crystallise and how they might impact on the policyholder.

  2. A description of the tools and arrangements the insurer uses to mitigate those risk.

  3. An explanation of the circumstances in which these tools and arrangements would typically be deployed and the likely consequences for linked policyholder.

  4. An explanation of the possible impact on the policyholder of any provision in policy terms and conditions that allows for the deferral of the exercise of any rights under the contract.

There is clear messaging here that firms need to think about how they will deal with liquidity issues in advance, rather than wait until a problem occurs to find a solution. This is aligned with other FCA work in recent times, particularly following the suspension of property fund redemptions post the UK referendum vote to leave the European Union.

Liquidity requirements

The pre-Solvency II permitted link requirement for linked assets to be capable of being realised in time to meet obligations to linked policyholders, is now addressed as part of the Prudential Regulation Authority’s Investments Rulebook (PRA Investments).

PRA Investments applies to funds invested in conditional permitted links. However, perhaps surprisingly, only one of the conditional permitted links category definitions (for conditional permitted unlisted securities), makes explicit reference to the need to demonstrate that the investment is “realisable in a timeframe necessary to meet the liquidity requirements of the linked fund”. 

The FCA does lay out some further requirements for funds invested in conditional permitted links.

Essentially, these mean that the insurer cannot unreasonably delay the payment of contractual benefits; i.e. those payable on a certain date or event such as planned retirement date or death. 

Such benefits must be paid within a reasonable timeframe to meet the needs of the policyholder. The FCA does not define “reasonable timeframe” but makes it clear that firms cannot defer payment beyond this timeframe, which must be included in the policy terms and conditions.

Payment on other types of event, such as surrender or transfer out before planned retirement date, can be deferred for longer periods. Here, the FCA describes the timeframe as “that may reasonably be necessary” to allow the fund to be managed prudently and in the best interests of all policyholders.

These requirements mean that firms will need to ensure appropriate governance and monitoring is in place to ensure fund liquidity is managed appropriately, otherwise firms may need to accept box positions in their funds that are invested in conditional permitted links and find liquidity to pay policyholder benefits from other assets.

Suitability checks

Perhaps the most challenging aspect for firms wanting to offer funds invested in conditional permitted links is the FCA’s requirements around suitability.

Insurers must ensure, on a continuing basis, that the investment risk of a fund invested in conditional permitted links is suitable and appropriate for:

  • circumstances where investment risk is borne by a linked policyholder;
  • the expected period to maturity of the linked long-term contract of insurance; and
  • the purpose for which the linked policyholder holds the linked long-term contract of insurance.

The FCA goes further. It says that where a fund investing in conditional permitted links is included in a default or similar arrangement for a pension scheme, the insurer should give ongoing consideration as to whether the investment risks of any conditional permitted links remain suitable and appropriate for a particular cohort of linked policyholders, including as that cohort moves toward retirement.

This hints that firms may need to consider offering “lifestyle” type options that perhaps reduce the weighting in illiquid assets over time.

Exact requirements are unclear and, no doubt, firms will interpret things differently. At one end of the spectrum it may appear that all insurers need to do is to get comfortable with the investments being used, identify the circumstances in which the fund might be appropriate and adequately disclose this to policyholders.

However, CP18/40 refers to the insurer ensuring investments in more illiquid or risky assets are only “offered/taken up” where they are suitable and appropriate. The use of “taken up” implies that the insurer needs to assess suitability for individual policyholders.

While, for many firms, this suitability assessment may be achievable at the outset, the continual assessment may be more difficult as policyholders’ circumstances may change. 

The suitability assessment is also a potential challenge for firms offering Trustee Investment Plans to defined contribution pension scheme trustees. Under these contracts, the trustee of the pension scheme is the policyholder and the insurance company typically has no information on the underlying pension scheme members. 

Without such information it is impossible to assess suitability to an individual and insurers wanting to offer such products under a Trustee Investment Plan may need to amend their approaches. 

New opportunities, with protections 

The permitted links rule changes are welcome and provide opportunities for insurers to offer funds with wider investment abilities. However, the FCA is clear that retail investors need some protections where illiquid assets are held. Firms will need to ensure that they consider relevant factors and have appropriate materials and governance in place before offering funds in line with the changed rules.

Barnett Waddingham can support insurers seeking to take advantage of the updated rules by helping to identify the risks and issues that need to be addressed, assisting with required disclosures and by suggesting and/or reviewing the ongoing governance arrangements that will be needed. 

If you would like to talk about this topic, please get in touch with your usual Barnett Waddingham contact to find out how we can support you. Alternatively, please contact me below.

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