An influential group of MPs will today condemn the City regulator, the Financial Services Authority, for failing to safeguard the interests of policyholders hoping for a share of the billions of pounds of surplus cash in insurers' with-profits funds.

In a damning report, the cross-party Treasury Select Committee will say the FSA failed to manage the innate conflict of interest between the needs of shareholders and policyholders when insurers' with-profits funds generate far more capital than they need to pay out.

The Committee will tell the FSA to launch a review of its regulation of the industry, in a move that could result in a regulatory overhaul of the way insurers calculate their surplus capital - the so-called inherited estate.

MPs will also condemn rules, currently under review, that mean insurers can use their surplus assets to settle mis-selling claims. This has cost Prudential £1.6 billion so far.

Today's report could mean a new set of rules governing payouts to millions of policyholders. The FSA could be forced into an embarassing second grilling before MPs.

The MPs also recommended that the committees overseeing with-profits funds should be told to run the funds in line with the FSA's principle of "treating customers fairly, rather than merely considering the firm's compliance with its own internal rulebook".

MPs suggested that pay-outs currently being considered at Norwich Union would be "adequate" rather than "fair" thanks to the regulatory tack taken by the FSA.

John McFall, the committee's chairman, said: "The approach taken by the FSA towards inherited estates seems a long way from the philosophy of 'principles-based regulation' to which it aspires.

"Policyholders need to have confidence that their interests are being protected, but the current oversight by the FSA gives no such assurance."

The Committee's report comes as Norwich Union prepares to offer more than 1 million policyholders a cash payout in order to forego future bonuses on an inherited estate worth about £2.6 billion.

Norwich Union is weeks away from concluding talks on a cash deal with Clare Spottiswoode, the NU policyholder advocate.

Ms Spottiswoode welcomed the MPs report and said the FSA would now have to publicly defend its assessment of whether the deal offered to NU policyholders was fair or not.

The report also comes as Prudential prepares to update investors at the end of the month on its plans for the future of an inherited estate worth about £8.7 billion.

The FSA, Pru and NU were all called to appear before the MPs in hearings used to prepare the report.

It prompted a flood of responses from a host of interested parties, including Which?, the consumers' organisation and the Association of British Insurers, which represents the interests of insurance companies.

The policyholder action group for NU and its parent company, Aviva, welcomed what it described as a "kick up the backside for the FSA".

Insurers such as NU and the Pru argue that they need the surplus cash to help underwrite new business and maintain the strength of the fund. They also argue that they are accountable to their shareholders, who also get a share of any payout, which convention has set at about 10 per cent.

Policyholder groups argue that the surplus capital built up during the life of a fund should be allocated to savers and investors.

The FSA said: "This is an important issue and we welcome the select committee's report. We will give the report our full consideration and respond formally in due course.

"At the select committee hearing we made clear that we would keep the current regime for reattributions under review and we will review the TSC's report in that context."

Mark Hodges, chief executive of Norwich Union Life, said: "Norwich Union supports the committee's call for greater transparency and is already taking steps towards this. Norwich Union has always operated strictly within the regulations laid out for use of inherited estates and will work with the FSA to review the committee's proposals, as appropriate."

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