Millions of policyholders may lose out after it emerged that the Financial Services Authority (FSA) is backing insurers’ plans to use some of a £16 billion industry surplus to support their business, rather than to pay cash windfalls.

Britain’s insurers have been exploring plans to release orphan assets, the surplus cash that builds up in life insurance companies. However, a letter from the FSA to Clare Spottiswoode, the advocate for up to a million policyholders with an interest in Norwich Union’s £5.4 billion orphan estate, dashed hopes that it would change its guidance on the issue.

Under FSA rules, insurers can use the surplus cash to subsidise new business, offset some tax charges and pay mis-selling claims. Campaigners say policyholders should be paid the majority share of any orphan assets. The consumer group Which? said that insurers including Norwich Union and Prudential would be able to use the FSA’s stance to withhold up to £8.4 billion in payouts from with-profits funds.

Ms Spottiswoode said that the FSA line unfairly benefited shareholders.

She said: “To me there should effectively be a duty of care. They should run the fund in the interests of policyholders and not divert resources into subsidising business and eroding the value of the estate. There seems to be no fairness to giving the company a big incentive to do this.”

Although the insurers have no obligation to pay out the surplus, most have started dividing up their own pot of cash. Aviva, parent of Norwich Union, began looking at its orphan assets in 2005, appointing Ms Spottiswoode as an advocate for its policyholders.

Which? sought a better deal for AXA policyholders in 2000 on distribution of its £1.7 billion fund. In the end, the insurer paid out 31 per cent.

Dominic Lindley, of Which?, said it was considering legal action to protect policyholders’ interests. “We are calling on the insurers to act with integrity, rather than to try to exploit weak FSA rules to grab as much as they can,” he said.

The FSA told Ms Spottiswoode that insurers can use the surplus in their funds to subsidise new business, pay tax on distributions to shareholders and finance strategic investments. This will let insurers claim more of the estate. In a concession, the FSA said it would consult further on insurers’ right to use surplus funds, often termed the inherited estate, to pay mis-selling claims.

The FSA guidance applies to all UK insurers holding with-profits funds. Together, Pru and Aviva hold an inherited estate worth £14.1 billion. Pru has 4.5 million with-profits policyholders and a fund surplus of about £8.7 billion.

Other insurers, including Standard Life, are considering the return of surplus funds to policyholders.

Stephen Mann, director of Norwich Union Life, welcomed the FSA ruling and denied that customers would be unfairly treated. “It removes a major obstacle in being able to put forward proposals to customers,” he said.

The FSA defended its guidance, put in place in 2005. Sarah Wilson, its insurance sector leader, said: “We don’t think that policyholders lose out by the announcement. We have not made a new ruling. We’ve reaffirmed a brand new set of circumstances.”

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