The Financial Services Authority (FSA) has proposed that insurance firms should no longer be permitted to subtract compensation for mis-selling from the inherited estates of with-profit funds. This will apply to firms with shareholders, but not mutuals.

Inherited estates, or orphan assets, are the part of the with-profit fund that is left over after the fund's liabilities are covered. Money is set aside to meet costs – discretionary benefits, say, or terminal bonuses – but often there is cash left over at the end of the year. Money also accumulates from premiums from past policyholders and capital injections from shareholders.

Currently, companies are allowed to pay the costs of compensation from the surplus cash that makes up the inherited estates. This money comes exclusively from policyholders. After vigorous campaigning by Policyholder Advocate Clare Spottiswoode, the FSA has been re-assessing whether it is fair that policyholders alone should meet the cost of compensation.

At present, inherited estates are retained as working capital by firms. Legally, the whole fund (including the inherited estate) is an asset of insurers. The FSA has acknowledged that the current policy does not help them act in the best interests of the policyholder.

Ms Spottiswoode said the new proposal was "a step in the right direction," adding: "I hope the consultation will confirm the need to do away with this provision, which allows erosion of the inherited estate to the detriment of policyholders. [But] it is regrettable that the FSA has not seen fit to consult on other uses of the estate ... such as paying shareholders' tax."

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