Select Committee on Treasury Tenth Report


TENTH REPORT

The Treasury Committee has agreed to the following Report:

EQUITABLE LIFE AND THE LIFE ASSURANCE INDUSTRY:

AN INTERIM REPORT

Summary of Conclusions and Recommendations

    (a)  We would like the Financial Services Authority (FSA), Faculty and Institute of Actuaries (F&IA) and Institute of Chartered Accountants of England and Wales (ICAEW) to take on board the points we make in this Report in the context of their own inquiries, so that the Equitable Life affair can be properly and fully explained and to help the Committee continue the investigation (paragraph 5).

    (b)  We could not form a firm conclusion as to whether rapid institutional change coupled with continuity in staff did or did not contribute to the Equitable Life affair. The Committee will wish to return to this issue (paragraph 10).

    (c)  The F&IA report should consider whether the actuarial guidance provided by the F&IA was appropriate at the time, and whether such general advice was suitable. It should also consider the extent to which the F&IA's opinion was based on the prudential insurance regulator's view (paragraph 17).

    (d)  Equitable Life's risky decision in 1993 not to build up a reserve to cover the cost of Guaranteed Annuity Rate (GAR) liabilities was a crucial turning point. We return later in this Report to the level of information given to policyholders and potential policyholders (paragraph 19).

    (e)  The relationship between firms' Appointed Actuaries and management boards, and with the body of policyholders, is in need of review, in the light of the Equitable Life affair (paragraph 20).

    (f)  It is unclear to us why the issue of GAR liabilities and reserving was not considered by the prudential insurance regulator at least by 1993, rather than only in 1998. We believe that the current inquiries should pursue this closely (paragraph 21).

    (g)  We ask the FSA to consider whether cash reserves only need to be accumulated when required by the economic circumstances—or whether there are other circumstances in which cash reserves may be required (paragraph 26).

    (h)  We ask the FSA to reconsider whether it was right to accept the reinsurance contract given its terms, and whether it was prudent to allow such a contract to have accounted for half of the Equitable Life's statutory reserves (paragraph 28).

    (i)  Equitable Life demonstrated that the information provided to policyholders, through the statutory accounts, and to the regulator, through the regulatory return, differed substantially in their treatment of the GAR liabilities and the consequential reserving that had been undertaken. As a result, policyholders were not able easily to establish the true position of the company. We ask both the FSA and the ICAEW to consider whether statutory accounts and regulatory returns should draw upon the same information and assumptions wherever possible, in order to improve transparency. In addition, the FSA should consider whether a life office's reserving policy should be made clear to policyholders, either in statutory accounts or in some other way (paragraph 31).

    (j)  We do not believe that the auditing arrangements for the statutory accounts and, in particular, the regulatory returns of life offices were adequate. In their memorandum to us, Ernst and Young set out the judgments that they made concerning disclosure. We ask the FSA to consider the justification for the auditors' judgments and whether there are implications for future reporting practices by auditors generally (paragraph 32).

    (k)  Equitable Life failed to explain to their policyholders the full implication of Lord Woolf's judgment. The FSA should therefore consider whether the assessment made by Equitable Life, and indeed by themselves, of whether the eventual House of Lords ruling could have been predicted, was justified, especially given Lord Woolf's judgment (paragraph 37).

    (l)  We welcome the FSA's review of Equitable Life's selling practices after the Court of Appeal decision and we ask the FSA to review the Equitable Life's practices when pension policyholders gave up rights to guaranteed annuity rates (paragraph 42).

    (m)  We welcome the announcement of an FSA review of management discretion in the with-profits business. We recommend that the FSA analyse the extent to which financial services, in particular life assurance, rely on managerial absolute discretion (paragraph 46).

    (n)  It is important that the role of regulator since 1993, when Equitable Life began to operate a policy of terminal bonus differentiation, should be analysed in order for the regulatory lessons to be properly learnt, for policyholders to fully understand the history of the affair and for Parliament to undertake its scrutiny of this topic properly and fully. The Committee will await the FSA's report. It will want to examine what it has to say on the regulatory background to the Equitable Life affair between 1993 and 1999, and then decide how to proceed (paragraph 50).

    (o)  We welcome the announcement that the FSA inquiry will have access to Government Actuary's Department (GAD) files and personnel. In our recent report on GAD, we recommended that GAD should publish a regular report to Parliament on the life assurance sector, so that public attention can be drawn to trends and issues of concern. We recommend that the FSA inquiry make suggestions as to how this could best be achieved and how better public information about the condition of individual life assurers can be published, on the basis of the actuarial advice received by the FSA (paragraph 53).

Introduction

1. On 20 July 2000, the House of Lords ruled against the policy of Equitable Life Assurance Society of applying differential terminal bonuses between groups of with-profits policyholders depending on whether the Guaranteed Annuity Rate option (GAR) in their contract was exercised.[2] Immediately following the ruling, the board of Equitable Life announced it was having to put the Society up for sale; on 8 December 2000, when the last interested party pulled out of negotiations, Equitable Life announced it was closing to new business. Equitable Life subsequently (5 February 2001) reached agreement with Halifax Group plc in regard to the sale of part of the company. We return to this arrangement in paragraph 54.

2. As these events potentially affect over half a million policyholders,[3] we announced, on 16 January 2001, our intention to undertake an inquiry "to examine the regulatory environment and the management of risk in the life assurance sector following the Equitable Life affair".[4]

3. We took evidence on 15 February from representatives of Equitable Life and the Financial Services Authority (FSA). We also took the opportunity of the Chancellor of the Exchequer's appearance in front of the Committee during our inquiry into the 2001 Budget to ask him some questions about the Government's regulation of life assurance firms prior to 1999. Our Sub-committee's inquiry into the Government Actuary's Department (GAD)[5] also touched on the Equitable Life affair and we refer to the evidence it took at appropriate points in this Report.

CURRENT INQUIRIES INTO THE EQUITABLE LIFE AFFAIR

4. There are a number of other ongoing investigations into the events surrounding Equitable Life: the Actuarial Profession (the Faculty and Institute of Actuaries (F&IA)) announced on 21 December 2000 that it would establish a "Committee of Inquiry" to consider the affair, focussing on the issue of professional guidance,[6] which it is hoped will report during the spring; the FSA issued a press notice on 22 December 2000 saying that its board had agreed that the organisation's executive management should undertake an internal investigation of its regulation of Equitable Life[7]—the report is intended to be completed in summer 2001 and sent to HM Treasury before being published;[8] and the Institute of Chartered Accountants in England and Wales (ICAEW) have announced that they will be "looking into the role" of its members in relation to Equitable Life.[9] We refer further to the FSA's inquiry later in our Report (paragraph 47).

AIM OF THIS REPORT

5. This report is intended to be an interim assessment, based on the written and oral evidence taken by us to date. We felt that it was important for us to set out the background to the Equitable Life case and the key factors explaining its recent problems, to help inform the House and to suggest questions which the other inquiries need to address. We would like the FSA, F&IA and ICAEW to take on board the points we make in this Report in the context of their own inquiries, so that the Equitable Life affair can be properly and fully explained and to help the Committee continue the investigation.

6. The structure of the report follows a chronological approach to events. The complicated regulatory environment is explained in the first instance, to allow the Equitable Life's policy of differential terminal bonuses and the consequences of this approach to be put in the context of the applicable regulatory regime over the period from 1993 to December 2000. This is followed by an examination of the issue of guaranteed annuity rate options (GARs), the Equitable Life's response of giving different terminal bonuses depending on how a policyholder took his or her pension, and the Equitable Life's reserving policy. The consequences of the Equitable Life's approach to terminal bonus provision, leading to a representative action by Mr Hyman, and the ensuing judicial process is then considered. We examine the scope of the FSA's inquiry. The Report ends with a review of the deal between Equitable Life and the Halifax Group, and the outlook for with-profits policyholders.

Regulation of the Life Assurance Sector

7. Regulation of the life assurance industry, including Equitable Life, is currently undertaken under two separate statutory regimes. One type of regulation is conduct of business, under the Financial Services Act 1986: this relates primarily to how companies deal with their customers, for example, advertising and advice given to consumers at the point of sale. This regulation remains the legal responsibility of the Personal Investment Authority (PIA),[10] although under a service level agreement the work has been carried out, under contract, by staff of the FSA since 1 June 1998.[11] These arrangements were set up in preparation for the implementation of the Financial Services and Markets Act (FSMA), when responsibility for conduct of regulation will transfer to the FSA, and the PIA will be wound up. We return to the information given to new investors by Equitable Life during 1999 and 2000 in paragraph 41.

8. The other type of regulation is prudential supervision: this relates to whether life assurance companies (or life offices, as they are also known) can meet their liabilities. In regard to prudential supervision, there have been three different regulators since the early 1980s. Until the end of 1998, responsibility was held by the Department of Trade and Industry (DTI). In May 1997, the incoming Government decided that prudential supervision of insurance companies should be transferred to the proposed new single financial regulator. In anticipation of this transfer, responsibility, including Ministerial responsibility, moved to HM Treasury on 5 January 1998.[12] On 1 January 1999, the FSA became responsible for prudential insurance regulation, although ministerial responsibility continued to rest with HM Treasury.[13] At the time of the transfer of prudential insurance regulation to the FSA, however, the FSMA had yet to receive Royal Assent,[14] and it is still to be implemented in regard to insurance regulation.

9. Until the FSMA is implemented, the transfer to the FSA of HM Treasury's role in prudential insurance regulation has been achieved by contracting out.[15] This has meant that the majority, but not all, of the Treasury's powers under the Insurance Companies Act 1982 have become exercisable by the FSA—the FSA is responsible only for the day-to-day task of prudential insurance regulation,[16] and remains accountable to HM Treasury for prudential insurance supervision until the FSMA is implemented.[17]

10. Through this period of change, however, there has been a measure of continuity in the staff involved in prudential insurance regulation. Mr Martin Roberts was appointed Director of HM Treasury's Insurance Directorate in February 1998, and was subsequently transferred to the FSA in January 1999 and continued in the same role with his new employer.[18] Other members of Mr Roberts' directorate at HM Treasury also transferred to the FSA when the contracting out of prudential insurance regulation came into effect in January 1999, including Mr Roger Allen, who continued in his post as Deputy Director of the Insurance Directorate, with responsibility for the Life Assurance sector. Mr Allen had worked in the Insurance Directorate of the DTI and then the Treasury since 1993. Additionally, the legal advisers (previously part of the Treasury Solicitors) were transferred to the FSA. GAD, which provides advice on the supervision of insurance companies to the prudential insurance regulator, reported directly to the FSA. Sir Howard Davies, Chairman and Chief Executive of the FSA, said, referring to the staff, that "there has been, therefore, a high degree of continuity of approach [towards prudential insurance regulation] through 1998, 1999 and 2000".[19] We could not form a firm conclusion as to whether rapid institutional change coupled with continuity in staff did or did not contribute to the Equitable Life affair. The Committee will wish to return to this issue.

The issue of Guaranteed Annuity Rate options and the response of Equitable Life

"WITH-PROFITS" POLICIES

11. As a mutual, Equitable Life has no shareholders; instead, holders of "participating policies" are the "members", or owners, of Equitable Life. These members share in the profitability of the company through their participating policies—in other words, "with-profits" policies.[20] The key feature of with-profits policies, in contrast to unit-linked ones, is that they allow the insurer to smooth the returns to policyholders over the life of the contract. Policyholders earn a "reversionary" bonus every year during the life of the policy, which cannot be taken away. The level of the reversionary bonus is intended to be broadly stable from year to year, despite underlying market conditions. In addition, if the maturity date of the policy is reached, or if the policyholder dies, a "terminal" bonus is paid. This bonus is usually decided only at the time of payment. The lack of certainty means that the terminal bonus does not have to be backed by reserves.[21]

GUARANTEED ANNUITY RATE OPTIONS

12. Guaranteed Annuity Rate options (GARs) provide a fixed rate at which the policyholder is entitled to obtain an annuity based on the repayment value of his or her investment.[22] GARs were a feature of pension contracts issued by Equitable Life between 1957 and July 1988. Their inclusion in policies was at no charge to the policyholder, and Equitable Life said that they were not used as a "major marketing tool", adding that it was standard market practice to include a GAR provision.[23] Until 1975, the interest rate underlying the guarantee was 4 per cent; after 1975 until 1988, a period of high inflation, the rate was increased to 7 per cent.[24] GARs were not included in policies sold after 1988, although contracts sold with GARs remained valid and such policies could still be paid into.

13. A policyholder does not have to take the GAR option when seeking an annuity. The other options are to purchase an annuity from the life assurer at the current annuity rate, or purchase an annuity with another provider.[25] However, the inclusion of a GAR within a with profits policy created added certainty for the policyholder, as Mr Headdon, then Chief Executive of Equitable Life, explained: "All with-profits policies provide a certain minimum level of guaranteed benefit ... Typically it is a minimum cash sum that is payable at some future date. These contracts [i.e with profits with a GAR included] were unusual in that, as well as providing a minimum cash benefit, they also provided a minimum level of income".[26]

The increasing worth of GARs during the 1990s

14. During the period when Equitable Life included GARs in with-profits policies, current annuity rates were above the GAR, and therefore policyholders tended not to choose to take the GAR option. However, as UK inflation fell, so expectations of future interest rates declined as reflected in the yield on long-dated UK government bonds (gilts), and therefore annuity rates. Sir Howard Davies explained that "there is roughly a break-even point at somewhere between 8 and 8½ per cent on long-term gilt rates where these [GAR] policies trigger significantly higher annuities than you would otherwise have got [if you took the current annuity rate]".[27] At the end of 1993, current annuity rates had declined to the extent that they were below the the GARs held by those who had purchased Equitable Life with-profit policies between 1975 and July 1988. Although current annuity rates rose in 1994, in 1995 they had once again fallen below GARs and this situation has since persisted. Between 1995 and 1998, the gap between GARs and current annuity rates widened (and has since stabilised around 1998 levels), with the effect that the value of the GAR to policyholders has increased.[28]

The response of Equitable Life: to pay different terminal bonuses

15. In response to the fall in interest rates, Equitable Life's policy was "to adopt a 'differential final bonus practice' to equalise, so far as possible, the benefits taken by policyholders in GAR form with those benefits in cash form".[29] Mr Headdon said that the board of Equitable Life had considered in the 1980s the scenario of GARs exceeding current annuity rates. The conclusion was that different terminal bonuses should be paid to those who exercised the GAR "consistent with the type of bonus approach that we have described to our members".[30] This strategy was implemented at the end of 1993, when GARs exceeded current annuity rates. Because the lowest terminal bonus for benefits taken in GAR form is zero, there would be occasions where, even allowing for zero terminal bonus, the benefits that are in GAR form exceed those that are taken at the current annuity rate. To cover for such circumstances, Equitable Life made a provision of £200 million in their statutory accounts.[31] A consequence of this approach was to discourage policyholders from exercising their GAR. Mr Cazalet argued that the policy of terminal bonus differentation was undertaken "with the intention of seeing to it that practically none of its customers would opt to take the annuity on the terms guaranteed in their contracts".[32]

16. Sir Howard explained that Equitable Life were "not an unusual/unique company" in their approach to addressing the problem.[33] Indeed, the life offices that did adopt this approach to the GAR issue appeared, in the view of Mr Cazalet, to have "the explicit backing of the Insurance Directorate of HM Treasury".[34] In a letter to all managing directors of life offices, Mr Roberts, then as HM Treasury's Director of Insurance, wrote on 18 December 1998:

"It would appear possible, depending on the particular circumstances relating to the contract, that any terminal bonus added at maturity may be somewhat lower than for contracts without such options or guarantees [GARs] ... [This] is the Treasury's considered view, and is without prejudice to any decision of the courts which may affect it".[35]

The F&IA explained that the letter "confirmed HM Treasury's view at that time ... that, in appropriate circumstances, any final bonus added at maturity for contracts containing Guaranteed Annuity Rates might be lower than for contracts which did not contain Guaranteed Annuity Rates".[36] Mr Headdon told the Committee that when Equitable Life introduced differential terminal bonuses, it had not sought advice from the prudential insurance regulator.[37] But Mr Peter Martin, Vice-President of Equitable Life, explained that, in the view of Equitable Life, the letter from Mr Roberts "confirmed in a modest way that what we were doing [since 1993 by differentiating terminal bonuses] was not out of order".[38]

17. In addition, the F&IA issued a statement in regard to GARs in March 1999, from which an extract is reproduced below:

"The policyholder is likely to receive the full value of the funds built up to support the policy, regardless of whether they take a cash option or pension option under their policy. The final bonus rates for individual policies will be set so that the accumulated fund equals the cost of the annuity provided. The 'guarantee' may seem to be lost, but the position is no different from the position of the past under older policies with a guaranteed conversion the other way—from pension to cash. The guarantee will still bite if final bonus rates fall to zero".[39]

The statement was amended in October 2000. The F&IA report should consider whether the actuarial guidance provided by the F&IA was appropriate at the time, and whether such general advice was suitable. It should also consider the extent to which the F&IA's opinion was based on the prudential insurance regulator's view.

18. While Equitable Life apparently had regulatory approval for its approach to the issue of GARs, the Annuity Bureau told us that "this risk [from GARs] is usually managed by setting reserves aside to meet the potential costs and/or reassuring part of the expected liabilities".[40] Mr Cazalet confirmed that: "With a couple of minor exceptions, all other life offices chose to take their [GAR] hits squarely on the chin, using their excess capital to meet the cost of their emergent liabilities".[41]

The lack of reserves

19. Equitable Life has been a mutual organisation since its inception, and operated on a philosophy of "full and fair" distribution of its profits to "with-profits" policyholders. This had the effect of increasing the returns to such policyholders; and this was reflected in Equitable Life's superior performance relative to other life offices.[42] However, the consequence of this policy was that, unlike other life offices, including many with mutual status, Equitable Life did not accumulate any substantial reserves (alternatively referred to as an "inherited" or "orphan" estate). Equitable Life explained: "if part of the surplus otherwise available for distribution to policyholders was set aside for future emergencies, this would have been at the expense of policyholders whose policies were in force or maturing when those surpluses arose".[43] Mr Headdon said that policyholders were "not explicitly" told that the policy of full and fair distribution was at the expense of creating "a reserve fund that could meet some unforeseen contingency".[44] Mr Headdon admitted to the Committee that if reserves had been accumulated from 1993 onwards, then Equitable Life could have responded to the subsequent House of Lords ruling "in a less dramatic and worrying way", and the problems that afflicted Equitable Life in the light of that ruling would probably not have arisen.[45] Equitable Life's risky decision in 1993 not to build up a reserve to cover the cost of GAR liabilities was a crucial turning point. We return later in this Report to the level of information given to policyholders and potential policyholders.

The role of the appointed actuary

20. The role of the appointed actuary is set out in the Insurance Companies Act 1982 and includes determining the value of the company's liabilities, so that they can be balanced off against the assets in order to calculate the "mathematical reserves". An important part of this calculation is the "potential effects of guarantees and options under the Company's policies ... [and] any reinsurance arrangements".[46] The appointed actuary should also advise the board of their interpretation of what policyholders' reasonable expectations (PRE)[47] are, including the treatment of with-profits policyholders through bonus declarations.[48] The F&IA describe the Appointed Actuary system as "central to the financial soundness of life companies in the UK".[49] Mr Headdon was the finance director and the appointed actuary of Equitable Life during the period August 1997 to December 2000. The F&IA have said that the arrangements that were in place at Equitable Life are regarded as "desirable in many ways", as the appointed actuary has close contact with the board. However, the F&IA warned that "it is important that the Board should be clear about when the individual is giving advice formally as the Appointed Actuary and when he or she is acting in another capacity".[50] Mr Deakin told us that he had no concerns about an appointed actuary also having an executive role or a directorship within a company, except, as a general rule, being the managing director.[51] The relationship between firms' Appointed Actuaries and management boards, and with the body of policyholders, is in need of review, in the light of the Equitable Life affair.

GAD Review of regulatory reserving for GARs

21. Mr Cazalet noted that during the 1990s, as the potential GAR liabilities increased, so life offices made extra provisions but did so "ad hoc and subject to a great deal of actuarial discretion".[52] Sir Howard explained that the prudential insurance regulator became concerned about the level of reserves held by life offices in regard to GARs in 1997, when long-dated gilt yields started to decline sharply, thereby increasing the benefit of exercising a GAR, and so increasing the costs of life offices.[53] In 1998, the regulator (HM Treasury) asked the Government Actuary's Department to undertake a survey of life offices. It is unclear to us why the issue of GAR liabilities and reserving was not considered by the prudential insurance regulator at least by 1993, rather than only in 1998. We believe that the current inquiries should pursue this closely.

22. Sir Howard said the GAD survey followed three lines of inquiry in regard to GARs: "one, how many have you got and how significant are they in terms of your fund, two, how are you dealing with the bonusing arrangements and, three, how are you reserving for them".[54] The results of the survey showed that some life offices were adjusting the terminal bonus, while others were setting aside reserves for this provision. However, Sir Howard said that Equitable Life "stood out" because "it had, one, a lot of them [GARs] because they had sold more of these policies than most people because they are predominantly a pensions house and they made a strong marketing effort in these between 1957 and 1988, secondly, they were particularly flexible policies and, thirdly, they did not have this carried forward 'free estate' [i.e reserves], which again had been a strong part of their overall marketing".[55] Mr Roberts said that the GAD survey had led the prudential insurance regulator to become "acutely aware that the Equitable was in a very much more exposed position than anyone else".[56] The extent of the concern is reflected in an internal briefing document regarding Equitable Life from Mr Allen to Mr Michael Foot (Managing Director and Head of Financial Services of the FSA), dated 5 November 1998: "Our primary concern is over the company's ability to reserve adequately for these guarantees [i.e GARs]. The information received to date is unconvincing, and raises serious questions about the company's solvency".[57] (It is worth noting that the review, and its conclusions, were based on the law as it then stood in regard to differentiation of terminal bonuses between groups of policyholders; it did not consider provision for the subsequent ruling of the House of Lords.) Sir Howard said that alarm bells started ringing at the FSA as a result of the briefing document sent to Mr Foot.[58]

23. In a general response to the findings of the GAD survey, the Government Actuary, in conjunction with the FSA, issued guidance to life offices that the level of reserving expected for GAR contracts[59] should be based on a "prudent" assessment[60] of the extent to which GARs were taken.[61] Mr Cazalet explained that the GAD "indicated" that life offices should "reserve on the basis that substantially all of the benefits were taken in guaranteed annuity form,[62] irrespective of actual experience".[63] The advice from GAD was an attempt to create a more uniform approach to the issue of reserving for GARs.[64]

24. As a result of the findings of the GAD survey in regard to Equitable Life, the prudential insurance regulator entered into what Sir Howard described as a "lively debate" with Equitable Life. Even though Equitable Life's approach to terminal bonus differentiation was "not unreasonable", Sir Howard explained that the prudential insurance regulator "did not think that their reserving approach was necessarily appropriate." Sir Howard explained that the "lively debate" with Equitable Life at one stage led to a threat by Equitable Life to take the prudential insurance regulator, which at that time was HM Treasury, to judicial review.[65] The prudential insurance regulator's legal advisers were, however, able to convince their Equitable Life counterparts that their approach was appropriate; as a consequence Equitable Life put in place the reserve in their 1998 regulatory return,[66] by purchasing a re-insurance contract, an issue which we return to in paragraph 27. Sir Howard said that Equitable Life only accepted that it had to put in place regulatory reserves when the FSA told them it was stating a requirement, rather than giving advice.[67]

The response of Equitable Life to the GAD review of regulatory reserves

25. Equitable Life faced an exposure of £1.59 billion from its GAR policies, based on the prudent assumptions of the new GAD guidance. Whereas the GAD guidance assumed a very high take-up of GARs, Equitable Life had previously set its reserves on an assumption of the prevailing, and expected, very low take-up of GARs.[68] In response to the requirement to meet its regulatory reserving obligations for GARs, Equitable Life chose not to accumulate cash reserves to cover the whole of the provision. For Equitable Life, such an approach would have run counter to its policy of "full and fair" distribution of profits to its policyholders. Mr Headdon explained that to create reserves "there is no magic external source of money that can be brought in. The money can only come from policyholders in one shape or form".[69]

26. The approach undertaken by Equitable Life was approved by the FSA: Sir Howard explained that "[in the absence of] the House of Lords judgment, we are not in economic circumstances which would have created the need for these reserves to be available in cash form".[70] However, this perhaps misses the point: reserves should not be accumulated at the time when the economic circumstances necessitate, as there is not always sufficient time to react to economic circumstances. In addition, while economic circumstances are one reason for accumulating reserves, as was demonstrated in the case of Equitable Life, there are other eventualities that can arise with, or without, warning that necessitate drawing on cash reserves. We ask the FSA to consider whether cash reserves only need to be accumulated when required by the economic circumstances—or whether there are other circumstances in which cash reserves may be required. Sir Howard also argued that "by that time [late 1998] the only alternative in terms of creating cash [reserves] for everything would have been to pay no bonus whatsoever—effectively to do in 1999 what the company had to do as a result of the House of Lords [ruling] in the year 2000—and it did not seem to us to be at that point ... reasonable to insist on that".[71]

Purchase of a Reinsurance Contract

27. Faced with the need to find sufficient reserves, Equitable Life sought to fund some £800 million, or about half, of the necessary regulatory reserves through a reinsurance contract purchased at the end of 1998.[72] The terms of the reinsurance policy stipulated that the cost of any claim was recouped by the reinsurer, by taking in future years any surplus in excess of that needed to support the regulatory reserves; in effect, the reinsurance policy would spread the cost of meeting the GAR liabilities over a number of years.[73] The terms of the reinsurance contract were specifically intended to insure Equitable Life against "extreme economic conditions ... [when] the cushion of surplus assets over and above the contractual liabilities might no longer be available to pay out the guaranteed annuity rate".[74] However, it did not cover against any other eventuality, as Mr Headdon explained: "The reinsurance was against the economic exposure of the Society in the circumstances envisaged by the statutory returns. It was not and never purported to be an insurance against a change of legal ruling" on bonuses (see paragraph 34).[75]

28. Equitable Life told us that the reinsurance treaty was negotiated after full discussion with GAD and "was accepted by them for the purpose intended".[76] Although the reinsurance contract provided only limited cover, Sir Howard said that the FSA, which had access to the terms of the reinsurance contract,[77] had also "accepted it". Sir Howard explained that the FSA "thought that ... some kind of provisioning should be put in place and a reinsurance policy to do that was, we thought, ... in the circumstances ... a reasonable response to this particular risk".[78] We ask the FSA to reconsider whether it was right to accept the reinsurance contract given its terms, and whether it was prudent to allow such a contract to have accounted for half of the Equitable Life's statutory reserves.

The reporting of the regulatory reserving requirement

29. Equitable Life, like other life offices, is required by statute to produce two sets of financial reports:[79]

  • the statutory (or annual) accounts, as required by the Companies Act 1985, which are intended for policyholders. The accounts should present a "true and fair" view of the state of affairs of the company as at the end of the financial year, and the profit or loss for the financial year. Ernst and Young note that the term "true and fair" is undefined, but, they add, "for working purposes ... this does not mean wholly accurate", although a judgement is required to ensure the accounts do not present a materially misleading picture of the company's state of affairs.[80] These accounts provide information on the overall performance of the company.[81]

  • the regulatory return, as required by the Insurance Companies Act 1982, is submitted annually to the prudential insurance regulator, although others can obtain a copy on request. The return is significantly longer and more detailed than the statutory accounts. The regulatory return is intended to provide the regulator with a wide range of information to facilitate its monitoring functions.[82]

30. The provisions that Equitable Life had put in place, including the reinsurance contract, were intended to meet the £1.59 billion GAR liability as required by the regulator and GAD. Therefore, the provisions were included in the Equitable Life's regulatory returns for 1998 and 1999 (i.e after the introduction of the new GAD approach to calculating GAR liabilities). Ernst and Young explained that: "the method of valuation of assets and liabilities in regulatory returns is prescribed by the Insurance Companies Regulations of 1994, and requires the use of detailed rules, the application of which is more pessimistic than the prudently realistic basis used for statutory accounts".[83] However, no reference was made in the statutory accounts to the figure of £1.59 billion, or the measures (including the reinsurance contract) that had been taken in regard to it. This was because Equitable Life did not share the view of GAD in regard to the take-up rate of GARs: Equitable Life argued that for the statutory reserves to be fully called upon "would have required there to be not just a significantly adverse set of conditions, but for these conditions to prevail throughout the whole period during which retirement benefits would be drawn".[84] Equitable Life therefore based the statutory accounts on its own assumptions of the take-up rate. In the statutory accounts, Equitable Life made a provision of £200 million in order to reflect the additional cost of the GARs and viewed this as a prudent approach, given that, on the basis of actual take-up of GARs up to 1999, it was estimated that it would incur a cost of £50 million.[85] Mr Sclater, the then President of Equitable Life, explained that Equitable Life had "tried to present in our [statutory] accounts for that year ... a true and fair view of what we believed the circumstance of the Society to be".[86] Professor Richard Dale, of Southampton University, argued that the statutory accounts provided to policyholders were "a dangerously misleading set of accounts" which "proved to be virtually meaningless".[87]

31. While there was a disparity between the GAR liability reported in the statutory accounts and the regulatory return, Sir Howard argued that the regulatory return was in the public domain and could be considered by analysts and rating agencies,[88] but admitted that the FSA have no control over the contents of the statutory accounts.[89] The FSA have recognised that the present reporting requirements of life offices "may not provide readily accessible information to policyholders and other users".[90] It suggests that the statutory accounts of life offices move towards the format of statutory accounts undertaken by non-insurance companies; this would result in the inclusion of insurance liabilities in the narrative description of uncertainties and provision being made for both legal and constructive liabilities. The FSA told us that they are "actively participating" in international work to create a new accounting standard for the insurance sector based on this approach.[91] Equitable Life demonstrated that the information provided to policyholders, through the statutory accounts, and to the regulator, through the regulatory return, differed substantially in their treatment of the GAR liabilities and the consequential reserving that had been undertaken. As a result, policyholders were not able easily to establish the true position of the company. We ask both the FSA and the ICAEW to consider whether statutory accounts and regulatory returns should draw upon the same information and assumptions wherever possible, in order to improve transparency. In addition, the FSA should consider whether a life office's reserving policy should be made clear to policyholders, either in statutory accounts or in some other way.

32. The directors of Equitable Life had responsibility for drawing up the statutory accounts while Ernst and Young, as auditors, were responsible for forming an independent opinion of Equitable Life's statutory accounts, and for determining that the statutory accounts gave a true and fair view of the company's finances, and were free from material misstatements.[92] However, only specific parts of the regulatory return are subject to an independent assessment by the auditors;[93] for Equitable Life's 1999 regulatory return, Ernst and Young's audit covered only 28 of its 420 pages. The areas of the regulatory return that the auditors were not required to examine included the estimation of the reserves in regard to the estimation of the GAR liability based on the regulator's assumptions. The auditors have a duty to report on whether the particular parts of the regulatory return subject to audit have been "properly prepared", rather than provide a "true and fair view".[94] We do not believe that the auditing arrangements for the statutory accounts and, in particular, the regulatory returns of life offices were adequate. In their memorandum to us,[95] Ernst and Young set out the judgments that they made concerning disclosure. We ask the FSA to consider the justification for the auditors' judgments and whether there are implications for future reporting practices by auditors generally.

Legal proceedings

33. Although Equitable Life adopted its differential bonus policy in 1993, it appears that complaints about it to the PIA Ombudsman did not emerge until late in 1998.[96] Mr Martin explained that representative action, where one decision would apply to all GAR policyholders, was better than "death by a thousand cuts" from many ombudsman's hearings.[97] This prompted Equitable Life to seek "guidance from the courts" as to whether its practice was lawful, in order to avoid a situation where the ombudsman ruled against Equitable Life in a case which could lead to overwhelming pressure to follow the same treatment for all cases, even if the case in question had distinctive features.[98] A representation order was duly made by the court: the Society was appointed to represent the non-GAR policyholders and Mr Alan David Hyman, separately advised, was appointed by the Court to represent the GAR policyholders.[99]

THE PROCESS OF THE REPRESENTATIVE ACTION THROUGH THE COURTS

34. The case went before the High Court, the Court of Appeal and finally the House of Lords. The High Court verdict, handed down by the Rt Hon Sir Richard Scott on 9 September 1999, backed Equitable Life, although Mr Hyman was granted leave to appeal. The Court of Appeal ruling, delivered on 21 January 2000, was split 2-1 in favour of Mr Hyman, although the majority differed in their opinion. While Lord Woolf (then Master of the Rolls) accepted the appeal unconditionally, Lord Justice Waller proposed that Equitable Life was entitled to ring-fence the GAR policyholders (i.e. to calculate their terminal bonus levels separately from non-GAR policyholders). Lord Justice Morritt, however, rejected the appeal. Leave was granted for Equitable Life to appeal to the House of Lords. The House of Lords' five judges ruled unanimously in favour of Mr Hyman on 20 July 2000, thereby determining that Equitable Life's policy of paying different terminal bonuses, dependent on whether a policyholder exercised their GAR, was unlawful. The House of Lords also ruled out the option of ring-fencing the GAR policyholders. The ruling meant that Equitable Life had to pay the same terminal bonus to all with-profits policyholders, irrespective of whether they were entitled to a GAR or not and, if so, whether they took up the guarantee.

DID THE HOUSE OF LORDS RULING DIFFER FROM THE COURT OF APPEAL'S?

35. Following the verdict against Equitable Life by the Court of Appeal, Equitable Life made an assessment of the potential costs it faced if it lost the House of Lords ruling: "if the approach of Lord Justice Morritt to the analysis of the GAR policyholder's contract, or that of Lord Justice Waller to ring-fencing, had been upheld in the House of Lords, the cost to the Society would be no more than £50 million, for which there were adequate reserves".[100] Equitable Life's interpretation of the Court of Appeal decision was that "a GAR policyholder should receive the same proportionate final bonus irrespective of the form of benefits selected. The Court did not however rule that the Society could not differentiate between GAR and non-GAR [with-profits policy]holders in this respect". They added that "the House of Lords' ruling took matters one stage beyond this by saying that the Society could not apply a different bonus policy to GAR and non-GAR [policy]holders".[101] Mr Headdon admitted that Equitable Life did not expect the House of Lords decision, and considered it, in the light of the legal advice that Equitable Life had received, to be a "very remote possibility".[102]

36. The FSA's interpretation of the Court of Appeal's verdict was that Equitable Life "could not pay different levels of [terminal] bonus according to whether or not a guaranteed annuity was taken up. But it did not rule out the possibility that different levels of bonus could be awarded to different types of policyholder [i.e the ring fencing argument]". The FSA concurred with Equitable Life in that the House of Lords ruling "went further than merely upholding the Court of Appeal judgement. It ruled that when setting final bonuses the Equitable was not entitled to differentiate between policyholders depending on whether or not their policies contained GARs, or on the form in which benefits were taken".[103]

37. However, this interpretation of the judgements has been challenged in evidence to us by Mr Stephen J. Suttle, a barrister of 1 Brick Court, Temple and an Equitable Life with-profits GAR policyholder. He contended that: "the House of Lords upheld the approach in the Court of Appeal of the senior of the two majority judges, the [then] Master of the Rolls Lord Woolf ... and did not accept the less draconian approach suggested by the other majority judge (Waller LJ) and described as the 'ring-fencing issue'".[104] We also note that Lord Steyn, in his House of Lords ruling (which the four other House of Lords judges agreed with), said that his verdict was "in substantial agreement with Lord Woolf".[105] Equitable Life failed to explain to their policyholders the full implication of Lord Woolf's judgment. The FSA should therefore consider whether the assessment made by Equitable Life, and indeed by themselves, of whether the eventual House of Lords ruling could have been predicted, was justified, especially given Lord Woolf's judgment.

THE IMPLICATIONS OF THE RULING OF THE HOUSE OF LORDS

38. The House of Lords ruling meant that Equitable Life faced a estimated liability of £1.5 billion. However, Mr Cazalet warned that "the true total, being based on ever-changing mortality and interest rate factors, is highly volatile".[106] Mr Sclater also said that the liability could increase if GAR policyholders continued to pay additional contributions to their policies.[107]

39. Equitable Life, in their written evidence, question the House of Lords decision. In particular, they point out that the decision to protect the value of the guarantee resulted in the necessary funds being taken largely from the later, non-GAR policyholders. Equitable claim that this could not have been an unintended consequence of the ruling, as the point was made "repeatedly" to the Lords by their counsel.[108]

40. In response to the liability that had arisen, Equitable Life announced that it would exclude the first seven months of the year from the 2000 reversionary bonus for all with-profits policyholders—Equitable Life said that it hoped to restore the lost bonuses once a buyer was found. In addition, for those with-profits annuities already in payment the growth would be adjusted downwards. All other Equitable Life policies were unaffected. The ruling also meant that Equitable Life had to increase its statutory reserves, so diminishing the capital strength of the company and meaning that, in order to maintain its solvency, the company would have to invest in less risky assets, such as gilts, which also tend to provide lower returns.[109] As a result, the board of Equitable Life announced immediately after the House of Lords ruling that the Society was having to put itself up for sale.

INFORMATION TO POLICYHOLDERS FOLLOWING THE COURT OF APPEAL VERDICT

41. After the Court of Appeal verdict, the FSA discussed with the Society a range of scenarios based on possible House of Lords rulings. Although the FSA believe that the eventual House of Lords ruling was different from that of the Court of Appeal (see paragraph 35), the possibility of such a ruling being delivered by the Lords was considered to be high enough to merit discussions of its implications with Equitable Life. The FSA were unable to disclose the precise date that these discussions took place, however.[110] Equitable Life predicted that, under the scenario which eventually transpired, take-up of GARs would increase, at the expense of non-GAR with-profits policyholders, and additional reserves would be required.[111] It told the FSA that it would meet these liabilities by announcing it was putting itself up for sale, and withholding the reversionary bonus for the first seven months of 2000, the tactics that it eventually employed when the House of Lords ruled. The FSA considered that this response was "consistent with the regulations and appropriate in the circumstances", although it pointed out that the approach was the decision of the Equitable Life.[112]

42. However, policyholders were not privy to the detailed planning that the Equitable Life and FSA had undertaken. This may have been because they were planning for what was considered to be, in the view of Equitable Life at least, a "very remote possibility".[113] In a letter to all policyholders following the Court of Appeal verdict, Equitable Life said that "there would be no significant costs imposed on the Society if the Court of Appeal's decision were upheld in the House of Lords"[114]—this was based on Equitable Life's assumption of the cost and the Court of Appeal's verdict (see paragraph 35). Mr Sclater explained that, while no specific warnings were given in regard to the possibilities that Equitable Life and the FSA were contemplating arising from the House of Lords ruling, "from late 1998 onwards I think our financial circumstances were debated very widely in the newspapers".[115] Indeed, the day after the Court of Appeal ruling, the Daily Telegraph reported that: "about 90,000 policyholders with Equitable Life may share £1.5 billion after a Court of Appeal ruling yesterday".[116] However, Mr Martin ridiculed the article as a basis for assessing the financial position of Equitable Life, and Mr Headdon added that the article "misrepresented" the Court of Appeal's verdict.[117] Mr Sclater said that, after the House of Lords ruling, "any new policyholder taking out a policy was particularly asked to clarify the fact that he or she was aware of the circumstances in which the Society then was".[118] However, Sir Howard explained that the FSA "have received complaints about the selling of policies in the year 2000, both before the House of Lords and after, and we are carrying out a review of those selling practices during that period to see whether there is a case for action on misselling and whether there are investors who have been missold".[119] We welcome the FSA's review of Equitable Life's selling practices after the Court of Appeal decision and we ask the FSA to review the Equitable Life's practices when pension policyholders gave up rights to guaranteed annuity rates.[120]

The issue of management discretion and the complexity of the contracts

43. Perhaps one of the most surprising facts of the Equitable Life case is that in order to determine what should, in theory, have been a straightforward matter ended up proceeding though the three highest courts in the land and being put before nine of the country's most senior judges. The complexity of the policy and of the Equitable Life's Articles of Association, which govern the relationship between the Society and its members, were highlighted by the fact that they were open to such wide interpretation as demonstrated by the verdicts produced during the representative action.[121]

44. It may not be surprising that Equitable Life's reliance upon "absolute discretion" is also called into question in relation to another aspect of Equitable Life's control of with-profits policies. When the closure to new business was announced on 8 December 2000, Equitable Life also increased the market value adjuster (MVA), commonly referred to as the exit penalty, from five per cent on the with-profits fund to ten per cent. Following complaints from those Equitable Life policyholders affected, the Office of Fair Trading (OFT) undertook an investigation.[122] The OFT's view was that while the ten per cent penalty in itself was not unfair, a view with which the FSA concurred,[123] it was unfair to impose the MVA simply by using "absolute discretion".[124] Equitable Life has since further raised the MVA to 15 per cent on 16 March 2001.

45. It would appear that "absolute discretion" was used by Equitable Life as a universal justification for implementing changes to policyholders' reasonable expectations in the absence of contractual or other justification. More precisely defined contracts would have allowed policyholders to know what to expect, and would have increased transparency. Further, as was proved during the representative action of Equitable Life's policy of bonus differentiation, and the recent OFT inquiry, reliance on absolute discretion rather than contract specificity would seem to be risky.

46. Sir Howard, in a speech on 23 February 2001, said that an FSA review of the with-profits business would include "the extent of the discretion available to management over the operation of with-profits funds, and how that discretion is exercised".[125] We welcome the announcement of an FSA review of management discretion in the with-profits business. We recommend that the FSA analyse the extent to which financial services, in particular life assurance, rely on managerial absolute discretion.

The FSA inquiry

47. On 22 December 2000, the Board of the FSA requested the executive management to provide a report on the regulation of Equitable Life. In anticipation of the formal announcement by the FSA, Miss Melanie Johnson MP, Economic Secretary to the Treasury, told the House that the report would "cover the FSA's actions as a prudential regulator and in carrying out its functions under the Financial Services Act 1986 ... The Treasury will publish the conclusions of the review".[126] The FSA clarified the review in its press release, stating that the report would cover: "the FSA's discharge of the functions (under the Insurance Companies Act 1982) which it undertakes as delegate for HM Treasury; and the ... [PIA's] discharge of its functions as a recognised self regulating organisation (under the Financial Services Act 1986)". The report will be a full account of the prudential regulation of Equitable Life from 1 January 1999 to 8 December 2000, analysing the course of supervisory work over that period when the FSA was the regulator. The role of HM Treasury and DTI will be covered only to the extent that the report will "describe" the "background and events leading up to the FSA assumption of responsibility ... on 1 January 1999".[127] Sir Howard explained that the remit of the report was decided in discussion with HM Treasury. Although the Treasury was initially uncertain of the merits of including reference to the pre-1999 situation in the FSA report, Sir Howard told the Committee that in their dialogue with HM Treasury: "we [the FSA] said we cannot sensibly review our own inheritance and what we did unless we described the background up to the point at which we took it on".[128]

48. Miss Johnson told the Sub-committee that "the [FSA] report is down to cover the background to the events prior to 1 January 1999 and, clearly, issues can be brought into consideration in that background".[129] The limited range of the "issues" which the FSA will be able to consider was revealed during the questioning of the FSA witnesses. Mr Roberts was unable to tell the Committee what involvement there had been with Ministers.[130] Sir Howard explained that the Committee's questioning of Mr Roberts in this instance had entered into "unchartered constitutional waters"[131] and explained that "there are constraints on former civil servants, about revealing advice to ministers and debates with ministers and precise ministerial involvement in that matter".[132] He added that the FSA report will "give a description of that process [before 1 January 1999] without commenting on the merits of it".[133]

49. The Chancellor advocated that the Treasury and our Committee should "await ... the report of the FSA and then we can draw conclusions once we have seen what the report has said".[134] However, the Financial Services Consumer Panel[135] told the Committee that the lack of an inquiry into the role of the prudential insurance regulators before 1999 is a "serious gap in the scrutiny of the events that led up to Equitable Life's closure to new business". The view of the Panel was that the FSA Report would therefore be "an incomplete analysis of the causes of the Equitable Life crisis, and that important lessons therefore might be missed".[136]

50. It is important that the role of regulator since 1993, when Equitable Life began to operate a policy of terminal bonus differentiation, should be analysed in order for the regulatory lessons to be properly learnt, for policyholders to fully understand the history of the affair and for Parliament to undertake its scrutiny of this topic properly and fully. The Committee will await the FSA's report. It will want to examine what it has to say on the regulatory background to the Equitable Life affair between 1993 and 1999, and then decide how to proceed.

51. The FSA report will be produced by a team led by Mr Ronnie Baird, the FSA's director of internal audit, who will be supported with legal and accountancy advice from Norton Rose and PricewaterhouseCoopers respectively.[137] Sir Howard explained that the FSA had previously "set up an internal audit and a quality insurance function which was partly in place in order to deal with questions where people raise issues about our regulatory effectiveness",[138] and told the Committee that Mr Baird had previously undertaken other internal FSA investigations of a "very sharp-pencilled kind".[139] Sir Howard added that, in his opinion: "I believe that [the FSA report] will give an independent view of the events that took place ... I think this will be a scrupulous and independent investigation of those activities [by FSA]".[140]

The role of the Government Actuary's Department

52. In order to complete a full account of the regulation of Equitable Life, there is a need to consider also the actuarial advice given to the prudential insurance regulator: GAD has performed this function since the early 1960s.[141] A confidential report on each insurer is sent to the FSA, setting out the result of this analysis (although not necessarily to suggest what regulatory action should be taken).[142]

53. The Government Actuary, Mr Daykin, was unable to tell the Sub-committee about GAD's analyses of Equitable Life's financial position: he said that it was "a matter of client confidentiality", and that he was bound by the professional code of conduct of the F&IA. Mr Daykin noted that it was "of course ... open to the client if they wish to disclose information".[143] The client was defined as the prudential insurance regulator[144] by Mr Daykin. Mr Daykin said that GAD had, at that time, no formal role in the FSA's inquiry.[145] In a letter to Sir Michael Spicer MP, Chairman of the Sub-committee, Miss Johnson said that the FSA review "will include an examination of GAD's files and interviews with relevant GAD staff".[146] At present, advice given to the regulator is not published. Sir Howard argued that, because GAD's analyses are based on the regulatory return (see paragraph 29), publication would not be the best way to improve the quality of information given the public. We welcome the announcement that the FSA inquiry will have access to GAD files and personnel. In our recent report on GAD, we recommended that GAD should publish a regular report to Parliament on the life assurance sector, so that public attention can be drawn to trends and issues of concern. We recommend that the FSA inquiry make suggestions as to how this could best be achieved and how better public information about the condition of individual life assurers can be published, on the basis of the actuarial advice received by the FSA.

The future for Equitable Life policyholders

54. On 5 February 2001, the Halifax Group plc announced that it had agreed to buy Equitable Life's operating assets, salesforce and non-profit and unit-linked business. Equitable Life will consist only of the with-profits fund, the fund management and administration of which will be conducted by Clerical Medical, part of the Halifax Group. However, Equitable Life will remain a mutual organisation owned by its members. The deal is worth a minimum of £500 million, which will support the with-profits fund. If agreement can be reached between the GAR and non-GAR policyholders to cap the liability arising from the outcome of the representative action (see paragraph 38), a further £250 million will be paid unconditionally. In addition, if the performance of the Equitable Life's saleforce meets new sales and profitability targets in 2003 and 2004, a further £250 million will be paid by Halifax Group. The deal will, however, not restore the seven months of lost reversionary bonuses to with-profits policyholders as originally hoped (see paragraph 40). The Halifax Group deal followed the sale by Equitable Life of the Permanent Insurance Company on 22 December 2000 for £150 million.

55. Mr Headdon described the deal as a "good result for policyholders",[147] adding before the Committee that the new money coming into fund "will help to strengthen it and improve investment freedom and, compared to a closed fund situation, we have secured cost­effective administration for policyholders going forward".[148] Sir Howard said that following the deal "the prospects have become somewhat better"[149] for policyholders, although a return towards normality "does depend heavily on the result of the vote" of policyholders on whether to accept a settlement to cap the GAR liability.[150]

56. Although Sir Howard saw advantages to policyholders accepting a settlement, he did not wish to advocate to policyholders whether or not to accept any deal. The FSA will, however, offer a view on the "fairness of that deal" when the terms are negotiated, highlighting the pros and cons of the deal and allowing individual policyholders to make up their own minds.[151]


2  The term Guaranteed Annuity Rate option (GAR) is interchangeable with: Guaranteed Annuity Rate; and Guaranteed Annuity Option (GAO). It is explained in paragraph 12. Back

3  In addition to with-profits pension policyholders, of whom there are about 90,000 with guaranteed annuity rates and 370,000 without (Q 16), there are over 200,000 non-pension with-profits policyholders. Back

4  Treasury Committee, Press Notice, No. 3 (2000-01), 16 January 2001. Back

5  Seventh Report, Session 2000-01, The Government Actuary's Department, HC 236 (hereafter GAD Report). Back

6  Appendix 2, paras 15.1, 15.2. Back

7  Financial Services Authority, News Release, "Equitable Life: FSA Report", FSA/PN/163/2000, 22 December 2000. Back

8  Q 159. Back

9  "Equitable Life auditors face probe by peers", Financial Times, 12 December 2000. Back

10  The PIA is a "self-regulatory organisation" recognised by the FSA under the Financial Services Act 1986. It replaced the Life Assurance and Unit Trust Regulatory Organisation (LAUTRO), which had had this responsibility from 29 April 1988 to 18 July 1994. Back

11  Ev p 23 para 8; Appendix 6. Back

12  Appendix 6. The staff transfers to the Treasury were made "pending the onward transfer of supervision to the FSA". Back

13  The decision to contract out prudential insurance regulation to the FSA was an early step towards the integration of financial regulation and the benefits of a single regulatory culture, to the maximum extent possible under existing law prior to Parliament's consideration of the Financial Services and Markets Bill (see Appendix 6). Back

14  The Financial Services and Markets Bill received Royal Assent on 14 June 2000. Back

15  Under the Deregulation and Contracting Out Act 1994. Back

16  Most of the functions transferred to the FSA were those carried out under the Insurance Companies Act 1982, although a small number were under other Acts. HM Treasury, however, retained the following provisions: powers to make subordinate legislation; certain activities that affect the liberty of individuals, and; the power to raise fees. These arrangements will remain in place until the FSMA is implemented (Appendix 6). Back

17  Ev p 23, para 6. Back

18  Q 159. Back

19  Q 159. Back

20  In addition, Equitable Life had sold other types of policies, namely non-profits and unit-linked. However, these were not affected by the issue of Guaranteed Annuity Rates, and therefore are not considered in any significant detail in this report. Those holding such policies are not members of the Society. Back

21  Q 56. Back

22  In exchange for tax concessions on pension contributions, Inland Revenue rules require policyholders to purchase an annuity with most of the proceeds of the pension contract. Back

23  Ev p 1. Back

24  The interest rates quoted are not the same as the actual annuity rates, which are higher because there is an element of return of capital depending on the expected remaining life of the policyholder, but they are the rates to be compared to current market interest rates in order to determine whether a guarantee is worth taking up. Back

25  Ev p 1. Back

26  Q 24. Back

27  Q 226. Back

28  See graph, ev p 30; Appendix 5. Back

29  Ev p 2. Back

30  Q 5. Back

31  Q 39; although the provision was for £200 million, Equitable Life said that their expectation was that the liability would be only £50m (see paragraph 30). Back

32  Appendix 5. Back

33  Q 203. See also Mr Roberts (Q 224). Back

34  Appendix 5. Back

35  Letter from Mr Martin Roberts, HM Treasury, 18 December 1998 (quoted in Appendix 5). Back

36  Appendix 2, para 10.3. Back

37  Q 28-9. Back

38  Q 35. Back

39  Appendix 2, para 11.3. Back

40  Appendix 1, para 2.5. The terms "reinsurance" and "reassurance" are interchangeable. Back

41  Appendix 5. Back

42  Appendix 5. Back

43  Ev p 1. The Equitable's policy on reserves is set out in detail in an extract from a discussion on the subject in the memorandum from the F&IA (Appendix 2 paras 12.1-12.2). Back

44  Q 62. Back

45  Q 57-60. Back

46  The Role of the Appointed Actuary in the United Kingdom, The Actuarial Profession, May 2000, p 6 (hereafter Appointed Actuary). Back

47  The Insurance Companies Act 1982 states the requirement that provision is make for policyholders' reasonable expectations (PRE), and not just contractual liabilities. However, the Act does not define PRE, and therefore interpretation is the judgment of the Appointed Actuary, and, in some cases, the Courts. The F&IA believe that the PRE of policyholders should be influenced by: "the fair treatment of policyholders vis à vis shareholders (where applicable); any statements by the company as to its bonus philosophy and the entitlement of policyholders to share in a profit, for example, in its articles of association or in company literature; the history and past practice of the company; general practice within the life insurance industry; and fair treatment amongst different groups and generations of policyholders". See Appendix 2, sections 6 and 7. Back

48  Appointed Actuary, p 7. Back

49  Appointed Actuary, p 8. Back

50  Appointed Actuary, p 5. Back

51  GAD Report, Q 28. Back

52  Appendix 5. Back

53  Q 226. Back

54  Q 226. Back

55  Q 226. Back

56  Q 244. Back

57  Official Report, 19 December 2000, col 48WH. Back

58  Q 169. Back

59  Ev p 24, para 14. Back

60  Mr Cazalet explained that prudent assessment was an assumption that 80 per cent of policyholders with pensions savings contracts incorporating GARs would be likely to exercise such options (Appendix 5). Back

61  Letter from Mr Daykin to all appointed actuaries, 13 January 1999, para 6. Back

62  See footnote 59. Back

63  Appendix 5. Back

64  Q 227. Back

65  Q 169, 261. Sir Howard explained that although HM Treasury was the prudential insurance regulator at the time of the threatened judicial review by Equitable Life, this threat was made only two weeks before prudential insurance regulation transferred to the FSA, and therefore the case would have concerned Equitable Life and the FSA (Q 261). Back

66  Q 169. Back

67  Q 170-1. Back

68  Q 86. Back

69  Q 64. Back

70  Q 179. Back

71  Q 176. Back

72  Appendix 4, para 4.7. In an article in March 2000, Mr Cazalet explained that the effect of the reinsurance contract was to allow Equitable Life to meet the requirements of the GAD's guidance yet, in terms of their balance sheet, "release part of the £1.5bn reserves for final bonus back to the free assets (i.e back from the liability to the asset side of the balance sheet), thereby arriving at what Equitable regards as being a presentation closer to the true underlying position" (Life 2000, Cazalet Financial Consulting, March 2000, in Appendix 5). Back

73  Q 133-4. Back

74  Q 196. Back

75  Q 94. Back

76  Ev p 5. See also Appendix 15. Back

77  Q 96. Back

78  Q 174. Back

79  Appendix 4, paras 2.1-2.9. Back

80  Appendix 4, para 2.3. Ernst & Young are Equitable Life's auditors. Back

81  Appendix 4, para 2.9. Back

82  Appendix 4, para 2.9. Back

83  Appendix 4, para 2.7. Back

84  Appendix 15. Back

85  Ev p 2. Back

86  Q 75. Back

87  Appendix 8. Back

88  Q 193. Back

89  Q 194. Back

90  Ev p 45, para 6. Back

91  Ev p 45, para 6. Back

92  Appendix 4, para 3.1. Back

93  In accordance with the Insurance Companies (Accounts and Statements) Regulations 1996. Back

94  Appendix 4, para 3.2. Back

95  Appendix 4. Back

96  Ev p 2, p 45 paras 8-11. Back

97  Q 46. Back

98  Ev p 2. Back

99  Ev p 3. Back

100  Ev p 3. Back

101  Appendix 15. Back

102  Q 7-8. Back

103  Ev p 24, para 18. Back

104  Appendix 13. Back

105  House of Lords judgement: Equitable Life Assurance Society v. Hyman, Opinions of the Lords of Appeal for Judgement in the Cause Equitable Life Assurance Society v. Hyman, 20 July 2000. Back

106  Appendix 5. Back

107  Q 82. Back

108  Ev p 4. Back

109  Q 184. Back

110  Q 199. Back

111  Ev p 24, para 20. Back

112  Q 199. Back

113  Q 8. Back

114  Letter to policyholders, Equitable Life, 1 February 2000 (see Appendix 13). Back

115  Q 117. Back

116  "Equitable hit by £1.5 bn bonus ruling", Daily Telegraph, 22 January 2000. Back

117  Q 50-1. Back

118  Q 117. Back

119  Q 236. Back

120  See Appendix 16. Back

121   In the Court of Appeal Lord Woolf said that Article 65, on the declaration of a bonus or cash payment, is "in very wide terms". Lord Woolf noted that the only obligation is for the Directors of Equitable Life to declare a bonus at least once every three years; "subject to this the directors' powers are expressed in the widest of terms. They have an 'absolute discretion' and their decision is to be 'final and conclusive'". However, Lord Woolf argued that, in his view, "even a discretion expressed in these wide terms is not unlimited", specifying breach of contract and the just and fair exercise of the Directors' powers as the boundaries (Lord Woolf, Court of Appeal judgement, The Equitable Life Assurance Society and Alan David Hyman, Judgment as approved by the Court, Case No: 1999/1025/3, 21 January 2000, paras 13 and 15-6). In contrast, Lord Justice Morritt, who denied the appeal, believed that there was "no ground on which the exercise of discretion given to the Directors of the Society by Article 65 so as to declare differential bonuses can be successfully challenged (Lord Justice Morritt, Court of Appeal judgement, The Equitable Life Assurance Society and Alan David Hyman, Judgment as approved by the Court, Case No: 1999/1025/3, 21 January 2000, para 111). Back

122  "OFT probes Equitable Penalties", Sunday Telegraph, 31 December 2000. Back

123  Ev p 26 para 33. Back

124  "Equitable faces OFT threat over exit penalty", Financial Times, 27 February 2001. Back

125  "The Future Regulation of With-Profits Business", Speech to the The Institute of Welsh Affairs, Cardiff, 23 February 2001, para 29. Back

126  Official Report, 19 December 2000, col 56-7 WH. Back

127  Financial Services Authority, News Release, "Equitable Life: FSA Report", FSA/PN/163/2000, 22 December 2000. Back

128  Q 249. Back

129  GAD Report, Q 117. Back

130  Q 245. Back

131  Q 246. Back

132  Q 247. Back

133  Q 249. Back

134  Minutes of Evidence, 20 March 2001, The 2001 Budget, HC (2000-01) 326-i to iii, Q 433. Back

135  The Financial Services Consumer Panel was set up by the FSA in 1998 and is being given a statutory basis by section 10 of the Financial Services and Markets Act 2000. Back

136  Appendix 7. Back

137  Q 159. Back

138  Q 192. Back

139  Q 240. Back

140  Q 191, 241. Back

141  The task requires GAD to analyse the financial returns of insurance companies, including the valuation reports by appointed actuaries, in order to assess the current financial position of the insurer and also consider the effects of any adverse features or trends as disclosed in the returns. GAD issues advice to all insurers on the parameters to be adopted for the purpose of "resilience testing": this generic advice does not have any mandatory status but is provided to show the general standard of testing that GAD would expect to see included in the regulatory returns to the FSA. This standard is intended "both to protect consumers and to promote market confidence". GAD is also often called to advise upon a range of other financial matters, such as restructuring, that affect individual insurers (see also GAD Report, Ev p 11-12, paras 2, 9-10, 13). Back

142  GAD Report Q 20-21; this is accompanied by a copy of any correspondence with the company's actuary resulting from the scrutiny of the returns (GAD Report, Ev p 11, para 9). Back

143  GAD Report Q 15, 16. Back

144  GAD Report Q 17. Back

145  GAD Report Q 31. Back

146  GAD Report, Appendix 8. Back

147  Equitable Life Assurance Society, Press Release, 5 February 2001, p 2. Back

148  Q 150. Back

149  Q 160. Back

150  Q 161. Back

151  Q 162-3. Back


 
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