The FSA has been criticised for failing to protect with-profit policyholders and not providing transparent regulation by a Treasury committee.
The Commons Treasury committee has accused the Financial Services Authority (FSA) of not providing a "robust framework" for the with-profits sector and failing to protect policyholders.
One of the problems identified by the committee was that some firms have charged mis-selling compensation costs to inherited estates - putting at risk policyholders rather than shareholders.
Chairman of the committee, John McFall MP said: "I was astonished that the Prudential had taken £1.6 billion from their inherited estate to pay the costs of compensation arising from mis-selling.
"By reducing the size of the inherited estate in this way, the firm's policyholders have a much lower chance of receiving a special distribution than they would have done otherwise."
Peter Vipond, director of financial regulation and taxation for the Association of British Insurers (ABI), said: "As the benefit of these funds is usually 90/10 in favour of with profits policyholders, it is fair that the costs of these funds, including any strategic development, or the payment of mis-selling compensation, should be borne by them in broadly the same ratio.
"Any other outcome is unfair to both policyholders and shareholders.
"Insurance companies are working hard, in the interests of consumers, to make sure that the reattribution and distribution of these estates is undertaken in a fair and timely manner."
In addition, the report calls on the FSA to consult on the charging of shareholder tax to inherited estates by the end of 2008. The committee said certain life firms are able to further shareholder interest to the detriment of policyholders - a practice Mr McFall called "barmy".
The committee also criticised the phasing of special distribution payouts - where a special payout is staggered over several years - as policyholders whose policies mature before the date of the last phase miss out on part of the payment.
Tens of thousands of Norwich Union's longest-standing policyholders will not receive the whole value of the recently announced special distribution - presenting an unfair barrier for those who want to leave the fund, the committee said.
Peter Vicary-Smith, Which? chief executive, said: "This is a damning indictment of the FSA's lax regulation of the with-profits industry, which has allowed firms to take huge sums of money from their customers' pockets.
"The Treasury Select Committee's recommendations leave the FSA with no place to hide - they must act now to ensure that these firms offer a fair deal to their customers or face the charge that they are failing consumers yet again."