Insurers face hundreds of millions of pounds in extra costs if the City regulator forces them to pay compensation to customers from their own pockets rather than using policyholders’ cash.

The Financial Services Authority (FSA) said yesterday that it planned to prevent insurance companies from paying compensation out of their multibillion-pound inherited estates.

The regulator also wants to make the rules retrospective to cover compensation payments made in the future for past mis-selling. Consultation on the issue will close on September 3.

Insurers have already paid billions of pounds from their estates to customers who were mis-sold endowment mortgages, with-profits investments and other products over many years.

The estates are usually made up of money left over after maturing policies have been paid out as well as investment returns on the pool of cash. The estates are sometimes returned to existing policyholders and shareholders on a 90-10 basis in a process called reattribution.

The Association of British Insurers (ABI) reacted angrily to the news that the FSA planned to scrap its old compensation rules. Peter Vipond, director of financial regulation, said: “We’re disappointed the FSA seems to have made up its mind before completing its own consultation, and that it includes retrospection, which was not part of any earlier discussion.”

But Clare Spottiswoode, who is representing Norwich Union’s policyholders in discussions about reattributing the insurer’s £2.6 billion estate, was pleased. “This proposal is a step in the right direction,” she said. Ms Spottiswoode also wants rules to prevent insurers paying shareholders’ tax and subsidising new business from the estates.

Peter Vicary-Smith, chief executive of Which?, the consumer body, said that the FSA’s move was a victory for consumers.

In a Treasury Select Committee meeting in April, Prudential, the insurer, said it had spent about £1.6 billion on compensation from an estate worth about £9 billion. Norwich Union has used less than £100 million from its £2.6 billion estate. Legal & General has an estate worth about £1 billion.

The FSA said that paying compensation from the estates encouraged insurers to be lax about mis-selling. “We do not believe the rules as they stand provide sufficient incentive for proprietary firms to address failures of systems and controls and, as a result, with-profits policyholders may not be treated fairly,” the FSA’s consultation paper said. “We take the view that shareholders alone should bear the risk of such management failures.”

Insurers are prevented from paying the regulator’s mis-selling fines from their estates. The FSA is considering proposals from Norwich Union on how it might reattribute its estate.

Research out yesterday from Managing Partners, the investment management company, found that 64 per cent of investors in with-profits funds were unhappy with their current performance.

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