A conflict the City's watchdog must solve

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The deal announced last week by insurance giant Aviva in which it proposed to liberate some of the capital within its life fund and share it 70% to policyholders and 30% to shareholders is not the kind of thing to set the pulses racing unless you are close enough to the company to be a beneficiary. But it should be because, interestingly and unwittingly, it puts a stake through the heart of the Financial Services Authority by dramatically underlining how its remit is too broad, how its internal conflicts of interest get in the way of its doing the job properly and how it cannot be all things to all people. This is not because of the success of the Aviva negotiation with policyholder representative Clare Spottiswoode, but because a similar exercise by the Prudential was abandoned. The issue is simple. The FSA is involved to ensure policyholders are not short-changed. This is because Axa - when, incidentally, it was run by Mark Wood, the man now leading the charge into pension buyouts with Paternoster - imposed a reattribution of surplus capital where policyholders got only 40%.

There was a huge row and policyholders sought to challenge the allocation in court but this was messily inconsequential. Accordingly, it was decided that in future the FSA should look after the policyholders' interest and it developed a two-pronged strategy. First, in any future proposed re-attribution of capital there had to be an independent policyholders' advocate - in Aviva's case this was Spottiswoode, and at the Pru it was Peter Bloxham. Then any deal which was thrashed out has also to be approved by the FSA before going to policyholders.

Aviva has successfully completed the course. Prudential dropped the idea - as it was perfectly entitled to do - just after the Aviva terms became common knowledge. So Aviva policyholders are to get £1 billion between them - an average of £1000 each. Prudential customers get nothing. And though Prudential never said why it had decided to drop the idea, the common assumption in the business is that it had hoped to retain a bigger slice for shareholders than the Aviva deal indicated would be acceptable. It was not prepared to be similarly generous to its policyholders.

The fact that the FSA allowed the Prudential to walk away - or rather drafted the rules in a way which gave the Prudential the perfectly legal option of walking away - shows how compromised the regulator is.

One half of the FSA is concerned with ensuring that insurance companies are as well capitalised and safe as possible. From this perspective, the walking Pru is a sounder beast in capital terms than the generous Pru - because it retains the use of all the capital within the with-profits funds. had the negotiation continued, the FSA as a regulator concerned with financial soundness has an interest in seeing the company retain the lion's share of the capital up for reattribution. But the other part of the FSA's mandate is to make sure customers are treated fairly and get what they deserve. So at the same time the FSA has to fight for the policyholders' interest to be maximised and the company to keep as little of that capital as possible.

The two positions are self-evidently incompatible. Because it is such an arcane issue, they have been able to get away with it but it has come to the surface now because Prudential policyholders are clearly losing out when one sees what Aviva people will get. In allowing the Pru to abandon its plan, the FSA has failed in its mandate to ensure customers are treated fairly though it has fulfilled it mandate to make sure the insurer is well capitalised.

It needs to sort out on which side of the fence it belongs.