LONDON (Reuters) - The Financial Services Authority has failed to develop clear principles to regulate the uses of surplus assets held in insurers' with-profits funds and is not protecting policyholder interests, MPs said on Thursday.

The Treasury Committee said in a report that the Financial Services Authority was not doing enough to manage conflicts of interest over the multibillion pound surpluses -- for example, over the use of the money to fund new business or to pay mis-selling compensation costs.

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

Known as the "inherited estate", the surplus is money built up in the funds over years beyond the amount needed to meet policyholder commitments, and is used to help smooth returns.

Britain's two largest insurers, Aviva and Prudential, are currently considering restructuring that surplus in a move that should allow them to use the money more efficiently.

At the end of 2007, according the Treasury Committee's report, Aviva's inherited estate was worth some 2.6 billion pounds, while Prudential's estate was worth 8.7 billion.

The inherited estate is owned by the with-profits company and not policyholders, but the lawmakers said conflicts with shareholder interests can arise, highlighting the payment of mis-selling compensation out of the estate as "inappropriate".

The FSA said earlier this month it was considering changes that could bar insurers from using the funds for compensation payments -- an option which consumer groups argue allows insurers off the hook for poor practices.

Clare Spottiswoode, who represents policyholder interests in the proposed reattribution at Aviva, said the report was a "giant leap forward" in bringing clarity to inherited estates.