Findings of fact
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Introduction
1 In this Chapter, I set out the results of the review I have conducted of all the evidence, submissions and other material that was before me.
2 I also set out the findings of fact that I consider are key to my determination of the heads of complaint within the terms of reference for the investigation which led to this report.
3 This Chapter is structured in the following way:
(i) in paragraphs 4 to 38, I provide an overview of the principal findings of fact which I have made; and
(ii) in paragraphs 39 to 698, I explain, in relation to each finding of fact, the basis on which I have made those findings.
Overview of my principal findings of fact
4 My review of all the evidence, submissions and other material before me has led me to make ten principal findings of fact. Those findings relate to:
- the way in which the DTI, as prudential regulators, handled the ‘dual role’ – that is, the holding by one person for more than six years, from 1 July 1991 to 31 July 1997, of the position of the Society’s Chief Executive simultaneously with the position of its Appointed Actuary – which I cover in paragraphs 40 to 131;
- the scrutiny of the Society’s regulatory returns, which was undertaken by GAD on behalf of the prudential regulators, for each year from 1990 to 1993 – which I cover in paragraphs 132 to 202;
- the way in which GAD, as part of their scrutiny on behalf of the prudential regulators of the Society’s 1993 returns, handled the intimation within those returns of the introduction by the Society of what came to be known as its differential terminal bonus policy – which I cover in paragraphs 203 to 297;
- the scrutiny of the Society’s regulatory returns, which was undertaken by GAD on behalf of the prudential regulators, for each year from 1994 to 1996 – which I cover in paragraphs 298 to 343;
- the way in which GAD, as part of their scrutiny on behalf of the prudential regulators of the Society’s returns for 1990 to 1996, handled issues arising from the presentation by the Society within those returns of two separate valuation results – which I cover in paragraphs 344 to 396;
- the way in which the FSA, acting on behalf of the prudential regulators, handled issues arising from a financial reinsurance arrangement into which the Society had entered – which I cover in paragraphs 397 to 486;
- the way in which the FSA, acting on behalf of the prudential regulators, handled the issue of whether the potential impact on the Society of it losing the Hyman litigation should be disclosed within the Society’s regulatory returns – which I cover in paragraphs 487 to 522;
- the way in which the FSA, acting on behalf of the prudential regulators, approached the taking and recording of their decision to permit the Society to remain open to new business following its loss of the Hyman litigation – which I cover in paragraphs 523 to 613;
- the basis on which the FSA, acting on behalf of the prudential regulators, took their decision to permit the Society to remain open to new business following its loss of the Hyman litigation – which I also cover in paragraphs 523 to 614; and
- the information given by the FSA, acting on behalf of the prudential regulators, to policyholders and others about the Society’s solvency position and its record of compliance with other regulatory requirements during the period after the Society closed to new business in December 2000 – which I cover in paragraphs 615 to 698.
The ‘dual role’
5 My first finding of fact is that, in June 1991, the prudential regulators approved, when they should not have done, the appointment of a new Chief Executive without insisting that he should demit office as the Society’s Appointed Actuary and without applying subsequently a closer degree of scrutiny of the Society’s affairs.
6 Furthermore, for the next six years, those regulators failed to consider the use of their powers to seek the ending of his ‘dual role’, despite the assurance that had been given at the time of his appointment that he would hold such a dual role for 18 months only.
The scrutiny of the Society’s regulatory returns for 1990 to 1993
7 My second finding of fact is that, with regard to the scrutiny of the Society’s annual regulatory returns for the year-ends for 1990 to 1993, GAD, in providing advice to the prudential regulators, failed to satisfy themselves that the way in which the Society had determined its liabilities and had sought to demonstrate that it had sufficient assets to cover those liabilities accorded with the requirements of the applicable Regulations.
8 Accordingly, those regulators were unable to verify the solvency position of the Society as they were under a duty to do. The aspects in respect of which the Society’s returns for these years raised questions which should have been identified, pursued and resolved were:
- the valuation rate of interest used to discount the liabilities, which appeared to be imprudent and/or impermissible (discounting liabilities well below the guaranteed face value of policies); and
- the affordability and sustainability of the bonuses previously declared by the Society, which appeared to raise the expectations of the Society’s policyholders which might not be met.
9 On the information before GAD, the Society’s approach to discounting appeared to suggest that a significant amount of any future surplus would be required simply to fund current guaranteed benefits. This occurred in a situation in which GAD knew that the Society had informed its policyholders that, subject to smoothing, the additional returns they would receive by way of future bonus declarations would reflect the future investment performance of the with-profits fund.
10 In addition, serious questions arose from the information within the returns about whether the Society could afford the level of bonus it was paying and whether it could continue to pay out at that level, in a situation in which, as GAD knew, the Society was unique in illustrating to its policyholders the full policy fund value, including terminal bonus.
11 From the information before GAD, it was not clear how the Society could fund guaranteed future bonuses (applying the guaranteed investment return) or manage to pay future discretionary bonuses, in line with the reasonable expectations of the Society’s policyholders that such bonuses would continue to be paid.
12 Despite those questions, raising issues concerning the prudence of the Society’s approach and whether the Society would be able to fulfil the reasonable expectations of its policyholders, no action was taken by GAD to seek to resolve these questions or raise them with the prudential regulators.
The intimation of the Society’s differential terminal bonus policy
13 My third finding of fact is that GAD identified the introduction of a differential terminal bonus policy when scrutinising the Society’s 1993 returns in October 1994, but failed to inform the prudential regulators, as GAD should have done, of that introduction or to raise the matter with the Society.
14 This failure by GAD to raise the matter occurred despite there having been full disclosure by the Society within its 1990 returns of the extent and level of the guaranteed annuity rates within its older policies and despite the Society referring to such guarantees when it disclosed the introduction of the differential terminal bonus policy in its 1993 returns – which, GAD noted, was a policy which had the effect of reducing the final bonus payable to policyholders.
15 That failure also occurred despite GAD knowing, or having information before them which suggested, both that the Society had told its policyholders that Equitable would only change bonus policy gradually and also that the Society’s With-Profits Guides did not (at that time) inform its policyholders of the differential terminal bonus policy.
The scrutiny of the Society’s regulatory returns for 1994 to 1996
16 My fourth finding of fact is that, in carrying out the scrutiny of the Society’s annual regulatory returns for each year from 1994 to 1996, GAD, in providing advice to the prudential regulators, failed to satisfy themselves that the way in which the Society had determined its liabilities and had sought to demonstrate that it had sufficient assets to cover those liabilities accorded with the requirements of the applicable Regulations. Those regulators were thus unable to verify the solvency position of the Society.
17 The issues arising from the Society’s returns which GAD failed to address and resolve to a satisfactory conclusion were:
- the continuation of the two issues which had arisen within the returns for 1990 to 1993 (questions concerning discounting through the use of imprudent and/or impermissible valuation interest rates and the affordability and sustainability of the Society’s bonus declarations);
- what appeared to be arbitrary changes to the assumed retirement age for personal pension policies, contrary to European Directives and the applicable domestic Regulations;
- the absence of explicit reserves for prospective liabilities for capital gains tax and for pensions review mis-selling costs, stating instead that such liabilities were covered by implicit margins in the valuation basis; and
- the absence of reserves in respect of guaranteed annuity rates, which by then GAD should have known were biting and should therefore have been provided for.
18 GAD failed to identify all those issues, to pursue them with the Society, or to seek to resolve the issues that they raised.
The presentation of the Society’s two valuation results
19 My fifth finding of fact is that GAD failed in certain respects to act, when they should have acted, to question the Society’s practice of producing two valuations within the regulatory returns but omitting crucial information from one of those valuations. After 1996, the Society continued to produce two valuations but published the missing information.
20 That information was the amount of the resilience reserves required in the Society’s appendix valuation, produced to demonstrate compliance with the Regulations. That omission meant that the Society appeared financially stronger than it was and that its solvency position was capable of being misconstrued.
21 While GAD asked the Society for that information in all but one year, GAD did not take steps to ensure that the reader of the returns had that information.
22 Even though the Society was not in breach of any of the applicable Regulations by presenting its valuations in the way that the Society did, GAD recognised at the time that this position meant that the Society’s returns, which were the main mechanism through which ‘freedom with publicity’ was delivered, might mislead those who read them.
23 Although the Society was permitted to produce an alternative valuation from that specified in the applicable Regulations, it was required, by those Regulations, to demonstrate that its chosen alternative valuation was at least as strong as that specified in those Regulations.
24 GAD considered that such demonstration was provided through the provision by the Society to GAD – but not through the returns – of the amount of the reserves omitted from the Society’s alternative valuation. However, GAD failed to ask for this information in November 1996 when they were conducting their scrutiny of the Society’s 1995 returns. GAD were therefore unable to verify whether those returns had complied with the applicable Regulations.
25 In addition, from November 1993 onwards GAD had possessed information, in the form of ratings of the Society produced by Standard & Poor’s – an expert ratings agency, which showed that the position was not only capable of being misconstrued but also that it was being misconstrued.
26 Those ratings, which were provided to GAD by the Society and retained on GAD’s files, were used as part of briefing for Ministers and others. Standard & Poor’s erroneously concluded that the Society was stronger than it really was. This was as a direct result of the information which GAD knew was missing from the returns.
27 GAD took no action to raise or to seek to resolve this issue.
Financial reinsurance
28 My sixth finding of fact is that the FSA permitted the Society, when they should not have done so, to take credit within its 1998 returns, which were submitted on 30 March 1999 and which were available to the public by 1 May 1999, for a financial reinsurance arrangement which had not been concluded either at the valuation date or at the date that those returns were submitted. This was done without an appropriate reporting concession being given.
29 Moreover, even leaving that aside, the FSA permitted the Society within its returns for 1998, 1999, and 2000 to take credit for the financial reinsurance arrangement that did not reflect the economic substance of that arrangement.
30 This was despite the fact that GAD had identified the potential problems with the proposed financial reinsurance arrangement and had informed the FSA of those problems, recognising that this arrangement had little or no value for the purposes of the determination of the Society’s solvency position.
The potential impact of the Hyman litigation on the Society
31 My seventh finding of fact is that the FSA failed to pursue the failure by the Society to include contingent liability notes within its regulatory returns for 1998 and 1999 regarding the potential impact of losing the Hyman litigation. This failure to check why the Society had not included any such disclosure in those returns occurred despite the reminders by the prudential regulators that the Society should do so, reminders given prior to the submission of the Society’s 1998 returns.
32 No action was taken to seek to ensure that the Society had a sound basis for not publicly disclosing the fact that the outcome of the legal action could have profound effects, including for the operation of its differential terminal bonus policy (and hence its reserving practices) – effects which would have a significant impact on the solvency position of the Society and on the amount of money available to meet the liabilities it had to its policyholders.
33 This failure by the FSA to act also occurred in relation to the Society’s 1999 returns in a context in which the FSA knew that the Society had informed its policyholders that no significant costs would be imposed on the Society if it lost the Hyman case.
The decision to permit the Society to remain open to new business
34 I make two findings of fact concerning the decision to permit the Society to remain open to new business following the decision of the House of Lords in the Hyman case.
35 My eighth finding of fact is that the FSA failed to record that decision. No contemporaneous record was made of that decision or of the factors and evidence which were taken into account by the FSA when they took it, or what alternative options, if any, the FSA had considered. That decision was highly significant for the interests both of existing and potential policyholders.
36 My ninth finding of fact is that, having established from those involved the basis on which the FSA took that decision, the decision to permit the Society to remain open at that time was not grounded in a sound factual or legal basis. Relevant considerations – such as the nature of the Society’s business, which meant that it was not just new policyholders who were potentially affected by the decision – were not taken into account. No proper consideration was given to the use of the full range of powers that the prudential regulators possessed.
The information provided by the FSA after closure
37 My final finding of fact is that the information provided by the FSA in the post-closure period was misleading and unbalanced, with assurances being provided that the Society was solvent, when that was in considerable doubt and was not the view held by the FSA, who, on behalf of the prudential regulators, had exercised formal intervention powers on the grounds that the Society was likely to be in breach of its regulatory solvency requirements.
38 Nor were the assurances given by the FSA that the Society was at that time fulfilling and always had fulfilled all of its other regulatory requirements appropriate, when the FSA knew that this was not the case.
The basis for each finding of fact
39 Having summarised the ten principal findings of fact that I have made, I now explain in more detail the basis on which I have made each of those findings.
The basis for my finding concerning the ‘dual role’
The issue and relevant background
40 The role of the Appointed Actuary was, at the time relevant to this report, a central component of the system of prudential regulation of insurance companies. As the actuarial profession noted in the July 1992 version of its mandatory guidance note GN1:
The responsibilities of [appointed] actuaries… are central to the financial soundness of long-term insurance business… It is incumbent upon all Appointed Actuaries to ensure, so far as is within their authority, that the long-term business of the company is operated on sound financial lines and with regard to its policyholders’ reasonable expectations.
41 Key to this role was the relationship that Appointed Actuaries had with the prudential regulators but more especially with GAD. As the then Government Actuary noted in a paper entitled ‘The Supervision of Life Insurance Business in the United Kingdom’ that he gave in 1990 to the Groupe Consultatif Summer School:
The UK system of supervision has worked well over many years and has shown itself well-suited to a diverse and innovative insurance industry, providing flexibility and not inhibiting change. A heavy load of responsibility is placed on the Appointed Actuary, but this is balanced by an active actuarial involvement in the supervisory process through GAD… The result is an effective partnership between the actuarial profession and the supervisory authority for the benefit and protection of policyholders…
42 Given this regulatory role, which was one cornerstone of the system of prudential regulation in the United Kingdom, an Appointed Actuary needed to ensure that he or she had sufficient independence from the executive management of a life insurance company to enable him or her to undertake effectively the responsibilities (to the company, to its policyholders, and to the prudential regulators and GAD) that were conferred on the Appointed Actuary – and to enable him or her to do so in line with the intention of Parliament when it had created the role in 1973.
43 If an Appointed Actuary was unable to secure or retain the necessary degree of operational independence that would raise serious questions about the ability of the Appointed Actuary in those circumstances to perform the regulatory functions conferred on him or her.
The facts
44. On 28 March 1991, the Society notified the DTI, then the prudential regulators of insurance companies, that Equitable proposed to appoint the Society’s then Appointed Actuary to the post of Chief Executive, once its current Chief Executive retired on 30 June 1991. The Society said that it was intended that the Appointed Actuary would not relinquish his existing post.
45 In the event, one person held both posts (Appointed Actuary and Chief Executive of the Society) for six years and one month, during the period between 1 July 1991 and 31 July 1997.
46 The Society’s proposal echoed the position that had prevailed during 1980 and 1981, when the then Chief Executive of Equitable had also been the Society’s Appointed Actuary.
47 The DTI sought the views of GAD on the proposed appointment. As GAD’s policy was believed to be against combining the roles of Chief Executive and Appointed Actuary, the matter was referred to the Government Actuary himself to consider. On 17 April 1991, the Government Actuary commented:
I think we would certainly want to discourage him from holding both positions, other than on a very temporary basis. It would be appropriate for DTI to write asking what [the Society’s] intentions are regarding the Appointed Actuary position, bearing in mind the fact that it is not now generally thought desirable for the same person to be [Chief Executive] and [Appointed Actuary]. If they get a dusty response I will speak to [him].
48 This advice was referred to the DTI, under cover of a note by GAD, in which GAD wrote:
As it is not now thought desirable for the same person to be both Chief Executive and Appointed Actuary I think it would be best to clarify the Society’s intentions.
49 In the light of this advice, the DTI asked the Society’s Secretary what Equitable proposed regarding the Appointed Actuary and withheld consent to the appointment of the Appointed Actuary as Chief Executive, pending clarification of the position. This prompted a telephone call from the Appointed Actuary on 30 April 1991.
50 He explained that, although Equitable had several good in-house actuaries, it was considered that they needed 12 months or so senior management experience before assuming the role of Appointed Actuary. Accordingly, Equitable would prefer him to retain the role of Appointed Actuary for a further period of approximately twelve to eighteen months.
51 On 2 May 1991, the Society’s Secretary wrote to the DTI to confirm the position. He explained that Equitable were of the view that the Appointed Actuary role should be regarded and operated at a senior and influential level. The Secretary confirmed that Equitable did not currently have an actuary with the desired seniority but that they expected to have an appropriate person for the role of Appointed Actuary in twelve to eighteen months’ time. The Secretary continued:
Accordingly, rather than moving away from the general approach and resorting to a purely technical interpretation of the Appointed Actuary’s role, we regard it as substantially more satisfactory in professional and business terms for [him] to continue to undertake the Appointed Actuary role for a limited period longer, as mentioned above.
52 On 8 May 1991, the DTI sought the views of GAD, indicating that they were prepared to accept the position now reached, provided it was for a limited period. In response, GAD commented that they were also prepared to accept the position, on the basis that Equitable had confirmed that the incumbent would remain Appointed Actuary for twelve to eighteen months only after his appointment as Chief Executive.
53 On 16 May 1991, in the light of this advice, the DTI line supervisor for the Society wrote to the Society’s Secretary to explain that the Secretary of State had no objection to the proposed appointment of the Appointed Actuary also as Chief Executive:
… on the understanding that [he] will only retain the Appointed Actuary role for a further 12 to 18 months as indicated in your letter.
54 On 31 May 1991, the Society’s Secretary raised concerns about the terms of the DTI’s letter. He suggested that the Secretary of State’s acceptance of the Appointed Actuary’s appointment as Chief Executive appeared conditional on his only continuing in the role of Appointed Actuary for a further twelve to eighteen months. The Secretary stated:
Whilst it is certainly the Society’s current intention to separate the roles and appoint another Appointed Actuary within that timescale, we would not wish a condition to that effect to apply to [his] appointment as Chief Executive. In making no objection to [his] appointment the Secretary of State appears to accept that [he] is a “fit and proper person”. We cannot see that this will change if for some at present unforeseen reason, [he] does not cease to be the Appointed Actuary within the timescale mentioned. There is, we believe, a point of principle here.
55 The Secretary asked the DTI to accept the appointment without the implied condition. However, the DTI official’s view was that this was unacceptable. He passed Equitable’s letter to the DTI senior line supervisor responsible for the Society, with a note, which said:
I do not think we can accede to [the appointment without condition]. GAD consider 18 months exceptional! Suppose Ifalls ill – no Chief Executive – no Appointed Actuary – a successor should have been groomed by now to take on role of Appointed Actuary. I suggest we initially telephone [Equitable’s Secretary] to express our views – I could not contact him today.
56 The GAD Directing Actuary responsible for the Society intervened and pointed out that the emphasis of the Government Actuary’s advice had been changed subtly, saying:
… he knows our concerns and respects them. However, if someone hasn’t matured as quickly as they had hoped, there is no point in DTI getting up-tight. [The incumbent] now sees this issue as a point of principle for him – and I take his point. We should explain to [the DTI] that Equitable is not a one-man show, likely to be dominated by [him]. There are several good actuaries in the company, and they are unlikely to fall into the kinds of problems we have seen elsewhere purely because he holds two key posts. DTI should accept the company’s assurances that they will separate the two posts as quickly as it is prudent to do so.
57 On 17 June 1991, the DTI senior line supervisor wrote to Equitable’s Secretary to note their:
… current intention to separate the roles of Appointed Actuary and Chief Executive within the time frame suggested… In the light of that and the points made during our conversation I am happy to confirm our acceptance of [the] appointment without condition.
58 The DTI senior line supervisor, in a minute to the DTI official, noted that he had told the Society’s Secretary that:
If the Appointed Actuary is also the Chief Executive and therefore responsible for taking the decisions on the direction of the company there is, almost by definition, a conflict of interest. The Appointed Actuary is most unlikely to blow the whistle on the Chief Executive! [Equitable’s Secretary] took the point but said he would still prefer our acceptance to be unconditional. I said we were prepared to lift the condition but nevertheless we noted the company’s intention to find a new Appointed Actuary within 12-18 months and that we would not be constrained from raising the point again if no appointment had been made at the end of that timescale. On that basis I wrote the letter [of 17 June 1991].
59 During May 1992, GAD identified the continued combination of the roles as one of a number of current concerns they had about Equitable. GAD noted that the incumbent’s ‘position as Chief Executive and Actuary may create problems because there is nobody to blow the whistle when things go wrong’. The DTI also noted that they were not happy with the combined role and had regarded this as a temporary situation.
60 Both GAD and the DTI raised these concerns when they met Equitable on 19 May 1992. The Appointed Actuary and Chief Executive denied any conflict of interest but stated that, if one were to arise, then he would give up one of the posts. He had explained that he was expecting to retire in three to four years’ time, at which point the combined role would end and that, in the meantime, the appointment of a new Appointed Actuary was now at least one year away.
61 Following this meeting, GAD expressed disappointment that they had only met the Appointed Actuary and Chief Executive. In response, the Appointed Actuary and Chief Executive provided information about Equitable’s ‘actuarial management area’.
62 He also explained that this area was under the control of a senior actuary to whom three actuaries reported. One of these provided technical support to him in his Appointed Actuary role. The DTI and GAD did not then pursue further the issue of the combined role at this time.
63 I have seen that, during 1993, the continuing combined role was also a matter of concern within Equitable. In March of that year, Equitable’s former Managing Director advised Equitable’s President that the roles should be separated.
64 The former Managing Director identified a member of Equitable’s staff whom he thought could be appointed to the post of Appointed Actuary within three months. In June 1993, in his personal notes the President highlighted the need to settle the retirement date of the Appointed Actuary and Chief Executive and to separate those roles.
65 The Society’s auditors also advised the President that it was essential that the combined role was terminated at the earliest possibly opportunity, as it was ‘completely wrong’ for any one person to have so much power in his own hands. In September 1993, in his personal notes, Equitable’s President again highlighted the separation of the roles as a matter of great importance.
66 It appears that, during 1993, neither the DTI nor GAD raised the combined role with Equitable. The contact they had with the Society was almost exclusively with the Appointed Actuary and Chief Executive. The DTI and GAD appear to have been unaware of the fact that there was support within Equitable for ending the combined role or that advice to that effect had been provided to the Society by its auditors.
67 In February 1994, the DTI noted the concern that GAD and the DTI had expressed at the meeting in May 1992 but concluded that the situation would be brought to an end when the Appointed Actuary and Chief Executive retired in 1995 or 1996 (that is, three or four years from May 1992).
68 In November 1994, GAD, in their scrutiny report on the Society’s 1993 returns, noted the continuance of the combination of both roles. The DTI identified this as an issue for discussion at a meeting with Equitable to be held on 9 December 1994.
69 At that meeting, the Appointed Actuary and Chief Executive confirmed that the roles would be split on his retirement. His response made clear that the appointment of a new Appointed Actuary prior to his departure was no longer being considered.
70 Neither the DTI nor GAD raised with him (or with the other directors of the Society) the fact that his appointment as Chief Executive in July 1991 had been agreed on the understanding that the roles were likely to be separated within eighteen months. That information had been provided to the prudential regulators as part of the process of authorising the Appointed Actuary to act also as Chief Executive.
71 I have seen that this continued to be a matter of concern within the Society. In June and December 1994 and in August 1995, Equitable’s President and auditors noted that the combined role remained an issue that was in need of resolution.
72 In January 1996, GAD, in their scrutiny report on the 1994 returns, noted again that both roles were combined but that the Appointed Actuary and Chief Executive was ‘due to retire within a few years (though it is dangerous to speculate exactly when!)’. GAD did not pursue this issue with Equitable as part of their follow up work on the returns.
73 However, following correspondence on other matters, the Appointed Actuary and Chief Executive had suggested that GAD and the DTI should take ‘a far tougher line on whom they allow to become appointed actuaries’. GAD replied that neither they nor the DTI had any powers in this respect.
74 The Appointed Actuary expressed surprise at this and, on 15 April 1996, he stated:
Although I accept that the [1982] Act does not require approval of Appointed Actuary appointments, there would appear to be an avenue of influence under the “sound and prudent management” criteria. That is via the requirement that any office “is directed and managed by a sufficient number of persons who are fit and proper persons to hold the positions which they hold”.
75 A handwritten note on the GAD file copy of this letter expressed doubt on this, saying that ‘this would not pass review’. It appears that neither the DTI nor GAD gave any further consideration to the use of the power to which the Appointed Actuary/Chief Executive had drawn their attention in order to influence the situation at Equitable, either before he had done so, at that time, or subsequently. Nor did the DTI give consideration to the use of any other of their powers.
76 In November 1996, in their scrutiny report for the 1995 returns, GAD noted again that the roles of Appointed Actuary and Chief Executive were combined. GAD also noted, apparently as an example of a counterbalance to this concentration of responsibilities, that the Society’s Board of thirteen was chaired by a non-executive director and had a total of eight non-executives on it.
77 GAD did not pursue the combined roles of Appointed Actuary and Chief Executive as part of their follow up work on the Society’s 1995 returns.
78 On 8 November 1996, GAD and the DTI met Equitable. There is no evidence that the combined role of the Appointed Actuary and Chief Executive was discussed with the Society. At that meeting, the Appointed Actuary gave no date for his retirement but explained that he would stay at Equitable until current changes had been consolidated.
]79 On 1 August 1997, following the retirement of the incumbent the roles of Chief Executive and Appointed Actuary were separated. His successor as Appointed Actuary was the member of staff identified to the Society’s President in March 1993.
The statutory and administrative context
80 The prudential regulators were not required to approve the appointment of an Appointed Actuary, although the name of such a person had to be notified to those regulators. The Government Actuary would also meet a new Appointed Actuary shortly after he or she was appointed.
81 The prudential regulators, however, were given powers to refuse to authorise an individual seeking appointment as the Chief Executive of an insurance company, if those regulators did not consider that person to be fit and proper to hold the position that it was intended they should hold.
82 The powers of intervention available to the prudential regulators, with effect from 1 July 1994, included those which enabled them to seek to remove a director, controller, or senior manager on a number of grounds.
83 Where a Chief Executive had already been appointed, section 37(5) of the 1982 Act provided that certain powers of intervention could be exercised within a five-year period from that appointment, whether or not any of the grounds in sections 37(2) or 37(4) of the 1982 Act existed, provided that there was good reason for doing so.
84 It also from that date became a ground for intervention if it appeared to the prudential regulators that the criteria of sound and prudent management – set out in Schedule 2A to the 1982 Act – were not fulfilled or might not be fulfilled in respect of a particular company.
85 Paragraph 2 of Schedule 2A to the 1982 Act provided that one of the criteria of sound and prudent management was that each director, controller, manager, or main agent of an insurance company was a fit and proper person to hold that position.
86 Paragraph 4 of that Schedule also provided that one of the criteria of sound and prudent management was that an insurance company was directed and managed by a sufficient number of persons who were fit and proper to hold the positions that they held.
87 Paragraph 4(1) of Schedule 2D to the 1982 Act provided that, where it appeared to the prudential regulators that the criteria of sound and prudent management were not or might not be fulfilled by reason of the ability of a person who is a controller of an insurance company to influence that company, those regulators could serve on the company a written notice of objection to that person continuing to be a controller of that company.
88 In Guideline 8.10 of the DTI’s Policy Guidance Notes, the prudential regulators dealt with what was described as ‘non-statutory intervention’. Paragraph 4 of that Guideline stated:
The legislation should not be interpreted as setting out exclusively all actions which the Secretary of State can take in pursuance of his duty to regulate the insurance industry. It presupposes that action will be taken, for the purpose of protecting policyholders, which is covered by the statutory provisions.
89 Paragraphs 7 to 9 of that Guideline continued:
In addition to his statutory powers, the Secretary of State enjoys the benefit of the general principle that everything is permitted by law unless it is specifically prohibited. In considering action to be taken, regard must be had not only to whether the action is specifically prohibited by law but whether there is an implicit prohibition either by UK or EC?law.
In principle, if there are express statutory powers to deal with a particular situation, then the situation should be dealt with by the exercise of these statutory powers. Although the exercise of the powers is discretionary, there is a duty to give proper consideration to whether the discretion should be exercised.
Although it is unlikely that a course of action will arise for failure to exercise a discretionary power ... the failure to exercise the powers could well result in criticism of the [prudential regulators].
My assessment
90 At the outset, I should emphasise that, in considering the existence of such a dual role, I make no judgement on the fitness or propriety of the particular individual in this case to hold an individual position within an insurance company.
91 My concerns do not relate to his specific qualities or to those of any other person who held similar dual roles at that time. Whatever his personal attributes or experience, I consider that it is not the specific attributes of the person who held both posts which is in issue, but a wider matter of principle.
92 The purpose of the 1982 Act – the protection of the interests of policyholders and potential policyholders – was, it seems to me, capable of being frustrated if the Appointed Actuary was constrained in the discharge of his or her functions by a conflict of interest.
93 By acting simultaneously as Chief Executive, the Society’s Appointed Actuary was subject to significant constraints on his or her capacity to act as part of the system of prudential regulation.
94 Given the unique position of the Appointed Actuary within that regulatory regime, the centrality of which is recognised by the public bodies, this had the potential to lead to the dysfunction of the system of regulation created by Parliament.
95 An Appointed Actuary was, in my view, by definition not a fit and proper person to hold concurrently the position of Chief Executive of the same insurance company. The Society’s application for authorisation of its new Chief Executive in that context should have been denied unless a condition was imposed that he should demit office as Appointed Actuary forthwith.
96 Once the appointment had been approved, there were a number of possible ways in which the prudential regulators could have prevented an Appointed Actuary and a Chief Executive of a mutual (or any other) life insurance company from holding both posts concurrently. None of those ways was considered in this case by the prudential regulators.
97 Given that the prudential regulators and GAD recognised at the time that the dual role in question led to what they referred to as an inherent ‘conflict of interest’ – one which would exist at the heart of the regulatory system of checks and balances – it seems to me that questions arose as to whether the situation could prejudice the interests of policyholders. Those questions were never considered.
98 From 1 July 1994, three years after the dual role had been created, the failure of the prudential regulators to consider taking action to seek to end the position that they had been told was intended to last for approximately eighteen months became even more inexplicable and unacceptable. Yet those regulators took no action on the continuing situation.
99 The rationale for the Society not appointing a successor to the incumbent as Appointed Actuary – a role which all concerned recognised was central to the efficient operation of the system of prudential regulation of insurance companies – was that there was no-one within the Society of sufficient stature and with the relevant experience to take on this role.
100 Rather than assuaging any concerns that the prudential regulators should have had about one person holding perhaps the two most central roles in a life insurance company at the same time, the information that there was purportedly no-one else within the Society experienced or senior enough to succeed as Appointed Actuary should have raised further concerns.
101 Nor was it necessary for a successor as Appointed Actuary to come from within the Society. Why Equitable had not considered advertising for a replacement or using a firm of actuarial consultants, given the rationale for the dual role which the Society had put forward, was not a question that the prudential regulators considered putting to the Society.
102 Nor was the possibility considered by the prudential regulators of their taking action themselves to seek to encourage the Society to recruit a suitable Appointed Actuary from outside its then current staff.
103 The precise rationale that the Society put forward for the initiation and continuance of the position in which one person held the dual role was the lack of appropriately qualified and experienced people within the Society to take over as Appointed Actuary.
104 Given that rationale, I find it inexplicable that the prudential regulators did not take action to prompt the Society to seek to recruit its Appointed Actuary from outside, using their powers of intervention under the sound and prudent management criteria.
105 From 1 July 1994, there was also a further potential means whereby the dual role of Appointed Actuary and Chief Executive might have been brought to an end.
106 As I have noted above, paragraph 4(1) of Schedule 2D to the 1982 Act gave the prudential regulators the power to object to a controller or senior manager of a company continuing to hold such a position where it appeared that the criteria of sound and prudent management were not or may not in the future be fulfilled by reason of the ability of that person to influence the company.
107 The exercise of this power to resolve the dual role of the Appointed Actuary and Chief Executive of the Society – a situation in which it could not be doubted that he had considerable influence over it – was never considered by the prudential regulators at any time after that power became available to them.
108 Even without relying on the exercise of their statutory powers, to which the prudential regulators gave no consideration, there still remained a wide range of means – for example, non-statutory action, contact with the Society’s President or Board, or professional influence – which could have been considered and/or taken by the prudential regulators but which were not considered and/or taken by those regulators.
109 The prudential regulators should have been concerned that, not only did the dual role negate one of the cornerstones of the regulatory regime, but also that there appeared to be no-one else within the Society with the seniority to temper any abuse of power that might occur.
110 A more intensive level of scrutiny could, moreover, have been applied to mitigate the effect of there being no ‘whistle-blower’, if the prudential regulators had come to the view that it was not appropriate to exercise any of their statutory or other powers.
111 None of these avenues was considered. The prudential regulators took no action to seek the ending of the unacceptable dual role. Furthermore, those regulators and GAD throughout the period had little contact with anyone at the Society other than the Chief Executive and Appointed Actuary.
112 My conclusion is that the prudential regulators failed in two respects. First, those regulators approved, when they should not have done, the appointment of a new Chief Executive without insisting that he should demit office as the Society’s Appointed Actuary and without applying subsequently a closer degree of scrutiny of the Society’s affairs.
113 Secondly, for the next six years, those regulators failed to consider the use of their powers to seek to end that ‘dual role’, despite the indication that had been given at the time of appointment that he would hold such a dual role for a limited period only.
Submissions I have received and my evaluation of those submissions
Submissions by the public bodies
114 When I informed the public bodies that I was minded to come to this view, those bodies told me that, in their view, I had misinterpreted or misapplied the applicable law.
115 The public bodies said that the prudential regulators had had no power to force the incumbent to resign either as Chief Executive or as Appointed Actuary of Equitable, without evidence either that his conduct was such as to justify regulatory intervention or that Equitable were not being properly managed. The public bodies said that those regulators had been aware of no such evidence.
116 In support of these views, the public bodies submitted that:
… there was no legal requirement for the Appointed Actuary of a company to be independent of the company’s executive. It was plainly permissible for the Appointed Actuary to be on the company’s board, and to hold the role of Chief Executive. Similarly, there was nothing which either required or prevented the Appointed Actuary from being a policyholder and/or a shareholder.
117 The public bodies told me that they did:
… not accept that there was in fact a conflict of interest within Equitable, or that the prudential regulator recognised such a conflict of interest to exist. There was no reason to consider that, for a mutual such as Equitable, the Chief Executive and the Appointed Actuary would not have interests that were broadly coincident interests in favour of the policyholders. Moreover, particular safeguards against conflicts of interest in respect of Appointed Actuaries were put in place by the actuarial profession, as reflected in specific provisions in both the Memorandum of Professional Conduct and GN1.
118 The public bodies told me that, accordingly, ‘put at its highest, there was a potential for conflict, in respect of which the prudential regulator had been given assurances that [the incumbent] would relinquish one of his roles’.
119 The public bodies submitted that, in addition:
… one person holding both roles was not unique to Equitable, this situation having also applied in the then recent past to at least four other large mutuals in particular. Consistency of approach between companies was (and remains) an important principle of regulation, save where different treatment was specifically provided for by the Insurance Companies Act 1982 or justified by the systems of priority ratings and other objective criteria employed by GAD and the prudential regulator relating to solvency and compliance with the Insurance Companies Act 1982 and its associated regulations. There was no justification for different treatment on either basis in Equitable’s case.
120 The public bodies then told me that they did not accept that the powers within the Insurance Companies Act 1982, to which I have referred above:
… provided a legal basis that would have enabled the prudential regulator to intervene in respect of the dual appointments… none of the… powers of intervention could have been used by the prudential regulator to object to [the incumbent]’s dual role. The prudential regulator was well aware that it did not have the power to force [him] to relinquish one or other post.
121 The public bodies submitted that, additionally, ‘it must be presumed that Equitable’s auditors took the same view’, as:
From 1 July 1994, the auditors had a duty to report to the prudential regulator in circumstances in which they had concerns that there was a question as to whether the prudential regulator ought to consider exercising its powers of intervention, including in relation to potential breaches of the criteria of sound and prudent management… At no point did Equitable’s auditors make such a report to the prudential regulator.
122 The public bodies concluded that, for all these reasons, ‘given the pressure which the prudential regulator had already brought to bear on Equitable on this point, the bodies under investigation consider that it was reasonable for the prudential regulator not to have taken action beyond what it actually did’.
123 The public bodies told me that any adverse finding would be unreasonable and flawed.
My evaluation of those submissions
124 I was not persuaded by the submissions made by the public bodies on this matter. Whether or not the position which existed at the Society was unique seems to me to be an irrelevant consideration.
125 That other situations which are incompatible with the regulatory regime designed by Parliament have arisen and been accepted by those operating that regime does not make the underlying incompatibility acceptable.
126 Nor have I said that Appointed Actuaries were, or should have been, prevented from sitting on a Board or becoming a policyholder or shareholder, where relevant. Those submissions go therefore to conclusions which I have not reached and are irrelevant to the dual role issue.
127 As will be seen, in their other submissions, the public bodies have suggested that the prudential regulators and GAD were entitled to rely on the certification of the Appointed Actuary when considering the Society’s regulatory returns and the information he provided in correspondence or at meetings.
128 I have had regard to the nature of the duties which the prudential regulators had at the relevant time, which included the verification of the solvency position of insurance companies and of the way in which those companies had determined their liabilities and sought to demonstrate that they had sufficient assets to cover those liabilities.
129 I do not accept that it was open to the prudential regulators to fail to consider the taking of action to deal with the conflict of interest arising from the dual role, whereby the person who was their main means of ascertaining information from within the Society about those questions – the Appointed Actuary – was also the Chief Executive of that company.
130 The failure by the prudential regulators to consider whether to take appropriate action was exacerbated by their failure to ensure through other means – heightened scrutiny of the Society’s affairs – that the information they were being provided with was accurate and reflected a prudent assessment of the Society’s position.
My finding
131 I find that the way in which the DTI, as prudential regulators, handled the ‘dual role’ – that is, the holding by one person for more than six years, from 1 July 1991 to 31 July 1997, of the position of the Society’s Chief Executive simultaneously with the position of its Appointed Actuary – fell short of the standard that could reasonably be expected of such regulators.
The basis for my finding concerning the scrutiny of the Society’s returns for 1990 to 1993
The issue and relevant background
132 Each year, the Society, like every other insurance company, was required to submit annual returns to the prudential regulators. Those returns set out a considerable amount of detail about the business of the Society, about its liabilities, about the assets covering those liabilities, and about the solvency position of the Society.
133 The submission and scrutiny of those returns were the two prime mechanisms of prudential regulation during the period covered by this report.
134 The Society’s returns for the years 1990 to 1993 raised certain issues about the approach that the Society was adopting to its business, which the scrutiny process was designed to highlight in order to enable the prudential regulators, acting with the advice and assistance of GAD, to ascertain whether there was any need to raise and pursue those issues.
135 The particular issues which arose during these years were:
- the valuation rate of interest used to discount the Society’s liabilities, which appeared to be imprudent and/or impermissible (and resulted in the discounting of liabilities well below the guaranteed fund – the sum assured plus allocated guaranteed interest and bonuses – of policies); and
- the affordability and sustainability of the bonuses previously declared by the Society, which appeared to raise the expectations of the Society’s policyholders which, on the information before GAD, the Society was unlikely to be able to meet.
The facts
136 The contents of the regulatory returns submitted by the Society each year, the notes and reports which together constituted the scrutiny of those returns by GAD, the correspondence between the Society and the prudential regulators and GAD, and the meetings held between them are extensively cited within Part 3 of this report. They are also summarised within Chapter 6 of this report. It is not practicable to reproduce all of that material again here.
137 Table 10a sets out the principal entries within Part 3 of this report which are relevant to the scrutiny of the Society’s returns for each year from 1990 to 1996.
138 I have noted above that, with respect to the Society’s returns for each year from 1990 to 1993, the issues arising from those returns which should have raised questions in the mind of those scrutinising the Society’s returns were the valuation rate of interest used to discount the Society’s liabilities and the affordability and sustainability of the bonuses it had previously declared.
139 Table 10b shows the Mathematical Reserves for non-linked business as shown in the Society’s appendix valuations within its returns for 1992 and 1994, along with the average valuation interest rates and the appropriate regulatory asset yields, as estimated by my actuarial adviser. The last column shows the margin between the asset yields and the valuation interest rates.
140 To meet the requirements valuation regulations, this margin should be greater than zero and significantly so if an allowance is made for future bonus on with-profits business.
The statutory and administrative context
141 Section 22(5) of the Insurance Companies Act 1982 required the prudential regulators to consider the regulatory returns, prepared pursuant to sections 17 and 18 of the 1982 Act and deposited pursuant to section 22(1) of that Act.
142 Section 22(5) also required those regulators, if it appeared to them that those returns were inaccurate or incomplete in any respect, to communicate with the company with a view to the correction of any such inaccuracies and the supply of deficiencies.
143 Section 18(4) of the 1982 Act required, when an investigation into the financial condition of the company was undertaken by the Appointed Actuary, that the value of any assets and the amount of any liabilities should be determined in accordance with the valuation Regulations. The valuation Regulations applicable to the Society’s returns for 1990 to 1993 were those contained in the Insurance Companies Regulations 1981.
144 Section 18(5) of the 1982 Act required the Appointed Actuary to produce the abstract of his or her report of the results of that investigation into the financial condition of the company in conformity with the Accounts and Statements Regulations. The Regulations applicable to the Society’s returns for 1990 to 1993 were those contained in the Insurance Companies (Accounts & Statements) Regulations 1983.
145 The prudential regulators issued internal guidance in 1991 – the DTI Policy Guidance Notes, which set the policy framework for the discharge by those regulators of their statutory functions. Those functions included the duty to consider the regulatory returns submitted by insurance companies.
146 The prudential regulators had, in 1984, also issued guidance to insurance companies on the preparation of the annual returns. Paragraph 12.1 of that guidance stated that:
… sufficient information must be given about the basis of the valuation to enable the Department to be satisfied [that the Mathematical Reserves conformed to the applicable Regulations], and in particular that the reserves meet the minimum standards required under Regulations 55 to 64 of the 1981 Regulations.
147 Paragraph 12.3 of that guidance also stated that the returns should:
… give details of any guarantees and options on non-linked contracts which the actuary considers to be significant. Common examples are guaranteed surrender values, guaranteed annuity rates, guaranteed minimum rates of interest on deposit administration contracts, and options to increase sums assured without evidence of health.
148 Paragraph 12.4 continued that ‘the guarantees and options to be specified… should include details of any guaranteed surrender basis which is specified in the policy, whether expressed in monetary terms or as percentage deductions from the value of units’.
149 Acting under the terms of a service level agreement made in 1984, GAD undertook the scrutiny of the regulatory returns on behalf of the prudential regulators.
150 Paragraph 25 of that agreement specified that, as soon as possible after the receipt of the returns, GAD would ‘carry out an initial scrutiny of the return with a view to advising [the prudential regulators] of any serious solvency or compliance problems in respect of the company’s long-term business and to determine an order of priority for GAD’s main examination of the returns’.
151 That main examination aimed to produce a detailed scrutiny report which GAD would submit to the prudential regulators. The primary objectives of those reports were:
- to form a view about the solvency position of the company and to determine whether, at the valuation date for the returns, the company met the margin of solvency required in respect of its long-term business and whether, in the foreseeable future, it seemed likely that the company would continue to meet that margin;
- to determine if the returns complied with the relevant statutory requirements; and
- to determine, as far as possible from the returns, whether the company appeared to have complied with other requirements relating to its long-term business.
153 The detailed scrutiny report was, pursuant to the terms of the service level agreement, to include:
- a general description of developments in the year covered by the returns which might affect the company – examples of such developments were said to be changes in the company’s philosophy or business approach, changes in the type, volume or mix of its business, and any other internal or external factors that could have a special effect on the company;
- a general commentary on the present and future financial position;
- details of breaches, or possible breaches, of the applicable Regulations or of any undertakings given by the company to the prudential regulators;
- details of significant errors in or omissions from the returns;
- details of any qualifications in any of the certificates which were required to be submitted with the returns;
- details of high lapse rates; and
- details of correspondence between GAD and the company.
154 GAD also issued internal guidance, the Insurance Supervisory Work Manual, to assist those of its actuaries who had responsibilities for the scrutiny of the returns of insurance companies. Paragraph D.9 of that manual stated that:
If a company’s business is straightforward and we have no concerns, we should not ask for information which is not required, explicitly or implicitly, by the Regulations, but where there is anything which suggests concern, we should not hesitate to ask for further information to be given. If the matter is one that the public should know about, particularly where the returns are misleading, we should ask through DTI for an amendment to the returns. A middle course is to ask for an answer by letter and for future returns to be amended.
155 Paragraph K.5 of the GAD manual said:
In general, it is not necessary to look at interest, mortality and expenses in watertight compartments. The main point is whether the valuation basis as a whole is adequate. However, where weaknesses in one area are offset by strengths in another, we may need to ask questions to establish that the overall result is adequate.
156 Section K of the GAD manual also invited scrutinising actuaries to:
- consider whether a company’s contracts had been ‘adequately described’, saying in relation to deposit administration contracts, that the description in the returns should include a description of any guarantees and surrender options contained in those contracts and any interest guarantees built into them;
- consider the resilience test and whether the GAD guidance on the tests to be applied had been followed;
- consider whether any reserve for maturity guarantees had been calculated in line with the basis set out within the report of a professional working party; and
- consider whether the valuation interest rates were supportable and in compliance with the applicable Regulations, noting that, ‘in doubtful cases, it may be necessary to ask for a “matching rectangle”’.
157 For the 1993 returns, GAD also developed a scrutiny proforma with notes on the content to be included in those detailed scrutiny reports. Among the issues which the proforma stated should be included were:
- ‘a view as to the soundness of the company in the short and longer term’;
- ‘cover for the solvency margin’ – which was said to be ‘a key DTI supervisory responsibility’;
- a clear statement ‘where there is any doubt as to whether the valuation basis used is in accordance with the Regulations’; and
- a series of ‘key features’, including ‘recent trends in financial results, especially if adverse’, the ‘approach to valuation and a general view as to strength’, and the ‘supportability of bonuses and recent trends in bonus declarations’.
158 Professional guidance was also issued by the Faculty and Institute of Actuaries with regard to the conduct of the Appointed Actuary when undertaking an investigation under section 18 of the 1982 Act.
My assessment
159 The Society’s returns for 1990 to 1993 gave rise to a number of questions as to whether the Society was acting in contravention of the applicable Regulations with respect to the valuation interest rates used as part of the determination of the Society’s liabilities within the returns for all these years.
160 In 1990, 1991 and 1992, the valuation interest rates used by Equitable for most of their non-profit business were near the maximum that could be supported by the current assets, leaving little or no margin between those rates and the appropriate risk-adjusted yields.
161 However, the current assets were of shorter duration than a significant proportion of the liabilities, which meant that those assets would have to be reinvested at some future date.
162 In such circumstances, Regulation 59(7) of the 1981 valuation Regulations limited the yield that could be assumed to be earned after such reinvestment and, in turn, this limited the valuation rate of interest that could be supported by those assets.
163 This rate was significantly below the rate supported by the current assets. Overall, the maximum valuation interest that could be used was the weighted average of (i) the risk-adjusted yield on the current supporting assets and (ii) the maximum yield that could be assumed to be earned on future reinvested assets.
164 As the valuation interest rates used by the Society were close to, or equalled, the maximum that could be supported by its current assets, the content of the Society’s returns raised issues as to whether the Society had properly allowed for the requirements of Regulation 59(7) when determining what valuation rates to use.
165 GAD did identify the existence of, and raise concerns about, some of these issues with Equitable. However, GAD did not do so in relation to every potential contravention of the Regulations. For example, GAD did not identify that, in the Society’s 1992 returns, the valuation rates used in relation to significant elements of the Society’s business appeared not to be supported by the backing assets.
166 Moreover, on the occasions that GAD did raise concerns with the Society, GAD did not pursue those concerns to a satisfactory resolution.
167 On 15 November 1994, GAD wrote to the Society concerning its 1993 returns. GAD noted that the valuation interest rates that had been used by the Society seemed high compared to the available yields on assets shown in Form 45 of those returns.
168GAD asked the Appointed Actuary to provide a matching rectangle in relation to the valuation basis prescribed in the Regulations, in order that GAD could be satisfied that the returns complied with the requirements of Regulation 59 of the applicable Regulations.
169 The Society replied on 22 November 1994. The Appointed Actuary provided rudimentary information which did not include a hypothecation of assets to categories of business.
170 The Appointed Actuary said that the weighted average valuation rate of 4.78% was supported by the asset yields shown on Form 45 of the return. The Appointed Actuary stated that he did not consider that, when establishing the maximum valuation interest rates allowed by the Regulations, hypothecation of assets to categories of liabilities was necessary or required by the applicable Regulations.
171 GAD responded on 23 November 1994 and expressed some surprise at the interpretation of the Regulations that the Appointed Actuary professed to hold.
172 GAD reminded the Society’s Appointed Actuary that the Regulations did not permit an individual valuation interest rate to be higher than the overall yield on the assets hypothecated to liabilities valued at that rate – and that, consequently, valuation rates could not be averaged for the purposes of demonstrating compliance with the statutory requirements.
173 GAD asked the Society to hypothecate assets to each category of business for which a different interest rate had been used.
174 Further correspondence ensued. On 2 December 1994, GAD told the Society’s Appointed Actuary that GAD did ‘not agree with your interpretation of Regulation 59’. GAD explained their understanding of the applicable Regulations and concluded:
We trust that in considering your bases for the net premium test in the 1994 valuation you will verify that each interest rate can be supported in terms of the new Regulation 69(11) with the application of paragraph 12 if required.
175 That correspondence culminated in a letter from the Appointed Actuary to GAD on 7 December 1994, in which he stated that he did ‘not wish to prolong this correspondence unduly since, on this occasion, it relates only to our “appendix” demonstrations of compliance with the Regulations’. However, he accepted that the position adopted by GAD would ‘become more pertinent under the new Regulations and I shall give further consideration to that’.
176 The Society’s Appointed Actuary also stated that ‘looking back through my files, I see that a similar presentation to that [used by the Society]… has been provided on a number of occasions in the past without being questioned by your predecessors’.
177 Thus, GAD’s attempt to secure compliance with the relevant Regulations was left unresolved, with only an indication from the Appointed Actuary that GAD’s interpretation would be ‘considered’ for future returns.
178 Using higher valuation interest rates to calculate the Mathematical Reserves than was supportable by the assets held by the Society meant that the amount of the liabilities that were used when calculating the solvency position of the Society would be significantly understated, thus giving a more favourable impression of its financial condition.
179 The content of the Society’s returns for 1990 to 1993 also gave rise to a number of issues regarding the affordability and sustainability of the Society’s bonus declarations. Those issues related to the interest rate differential which the Society applied and the associated issue of reserving for future declarations of reversionary bonus.
180 The way in which Equitable made provision in its reserves for the payment of future reversionary bonuses, above the guaranteed interest rates which applied to policies written before 1996, should have raised concern. This was because the Society’s practice did not appear to be consistent with the reasonable expectations of its policyholders.
181 The Society used net discount rates – that is, valuation interest rates less any explicit allowance for future bonuses – which were higher than the guaranteed investment return in the calculation of its Mathematical Reserves. The Society did so (i) in the appendix valuations for all years from 1988 to 1999 and (ii) in the main valuations from 1990 to 1996. This is illustrated in table 10c, which sets out the information contained within those returns.
1823 The difference between the net discount rate and the guaranteed investment return constitutes an ‘interest rate differential’. Where such interest rate differentials were used, the resulting Mathematical Reserves were lower than the guaranteed fund in respect of each policy.
182 The information in the Society’s regulatory returns did not demonstrate that the Society was complying with the requirements of the applicable Regulations in regard to these matters. However, GAD did not query this with the Society or bring it to the attention of the prudential regulators.
184 I consider that the contents of the Society’s returns for 1990 to 1993 raised a number of issues which GAD should have raised with the Society. That was not done and that failure constitutes a departure from the proper performance by GAD of its obligations under the service level agreement with the DTI.
Submissions I have received and my evaluation of those submissions
Submissions by the public bodies
185 When I informed the public bodies that I was minded to come to this view, those bodies told me that, in their view, any conclusion that the Society’s returns raised questions as to the compliance of the Society with the applicable Regulations, or as to the affordability and sustainability of its bonus policy had no sound basis in fact or in the relevant law.
186 Those bodies provided detailed actuarial analysis to support their view with regard to the valuation rates of interest used. It is not practicable to reproduce that detailed analysis here – nor that of my actuarial advisers in response.
My evaluation of those submissions
186 I was not persuaded by the submissions of the public bodies. While I accept that it might now be possible to show that the Society was acting appropriately, the question before me is not what, with the benefit of hindsight, the true position was at the time.
187 Instead, I have to consider whether the information available at the time enabled GAD, in carrying out the scrutiny of the Society’s returns, to be satisfied that the Society was acting in accordance with the obligations to which it was subject – and in such a manner that would not give rise to the risk that it would be unable to fulfil the reasonable expectations of its policyholders and potential policyholders.
188 I consider that the information within the Society’s returns gave rise to questions which should have been asked in order to enable GAD to be so satisfied.
189 On the information before GAD at the time, the Society’s approach to discounting appeared to suggest that a significant amount of any future surplus would be required simply to fund guaranteed benefits.
190 That occurred in a situation in which GAD knew that the Society had informed its policyholders that the additional returns they would receive by way of bonus declarations would reflect the investment performance of the with-profits fund.
191 In addition, the information within the Society’s returns gave rise to serious questions about whether the Society could afford the level of bonus it was paying and whether it could continue to pay out at that level, in a situation in which, as GAD knew, the Society was unique in illustrating to its policyholders the full policy fund value, including terminal bonus.
192 From the information before GAD, it was not clear how the Society could fund future guaranteed bonuses and pay future discretionary bonuses, in line with the reasonable expectations of the Society’s policyholders that such bonuses would continue to be paid. Nor was it clear that the valuation rates of interest used by the Society accorded with the applicable Regulations.
193 Despite those questions raising issues concerning the prudence of the Society’s approach and whether there was a risk that the Society would not be able to fulfil the reasonable expectations of its policyholders, no action was taken by GAD to seek to resolve those questions or to raise them with the prudential regulators.
194 This was despite the fact that GAD had raised concerns at the time. As can be seen in the entries for the relevant dates in Part 3 of this report:
- GAD’s Scrutinising Actuary B had noted, on 14 May 1992, that ‘Equitable had used up investment reserves quickly in paying very good bonuses’ and, on the same day, it was noted that GAD’s Chief Actuary B ‘thinks they have been paying too much in bonuses’;
- GAD’s Directing Actuary A had referred, on 30 July 1992, to the Society as being one among the ‘companies on whom we have been keeping a close watch for a number of years’ and which ‘remain companies which cause serious concern’ – referring on 21 August 1992 to the Society’s solvency position as being ‘a cause for concern’;
- a note from GAD to the prudential regulators on 15 September 1992 had said, in relation to GAD’s view of the Society’s position, that ‘our view is that the Society has over-distributed in the last few years, compared with the return on investments.’;
- a further note from GAD to the prudential regulators on 29 October 1992 had said that ‘in order to pay bonuses in [respect of 1990 and 1991] the company had to earn 11.25% per annum on the assets backing the with profits contracts… In fact the company earned about +3% over the two years rather than the required +23%, and this is the main reason why the available assets have been reduced and the valuation basis has been weakened’; and
- the Head of Life Insurance for the prudential regulators commented on the above further note from GAD on 4 November 1992 that ‘this paints a worrying picture. Over-distribution by a company with a (deliberately) small coverage of its RMM and a (continuing) policy of high equity exposure’.
195 The Society was also described, in internal briefing by the prudential regulators (see the entry for 26 October 1993 in Part 3 of this report), as a company to whom those regulators should be ‘paying special attention to in the remainder of 1993 and 1994’.
196 However, despite the views as to these issues which I have set out above – and those other occasions on which such doubts were expressed which any reader of the chronology of events that is set out in Part 3 of my report will identify – GAD failed to raise those questions with the Society or to seek to resolve them in other ways.
197 I am not suggesting that it can be established that the Society was in breach of the regulatory requirements to which it was subject. Nor am I coming to a view as to whether what is generally called ‘over-bonusing’ has occurred.
198 I am of course aware that the basis of the complaints which were made to me was that the Society operated a uniquely flawed business model which was always going to, and did, cause the Society to fail.
199 However, I also recognise that a view could be taken that, in a context in which the smoothing implicit in with-profits business meant that policies would typically receive more or less than their unsmoothed asset share, a particular sequence of financial conditions led most with-profits offices, including the Society, to pay out more than unsmoothed asset share to maturing policyholders throughout much of the 1990s.
200 Whether one or other view is the right one is not a matter for me to determine and I have no power to do so. My focus is on the acts and omissions of the prudential regulators and/or GAD.
201 Given the doubts that existed within GAD at the time and the nature of the information before GAD when it conducted the scrutiny of the Society’s returns for 1990 to 1993, the submissions of the public bodies on these matters did not persuade me to come to a different conclusion.
My finding
202 I find that the failure by GAD, as part of the scrutiny process, to question and seek to resolve questions within the Society’s regulatory returns for each year from 1990 to 1993, related to (i) the valuation rate of interest used to discount the Society’s liabilities and (ii) to the affordability and sustainability of the Society’s bonus declarations, fell short of what could reasonably be expected of GAD.
The basis for my finding concerning the introduction of the differential terminal bonus policy
The issue and relevant background
203 As is well known, the Society wrote policies containing guaranteed annuity rates. Those policies guaranteed the rate at which the proceeds available at retirement (based on the sum assured plus associated bonuses) would be converted to pension – and thus the minimum amount of pension available at retirement.
204 The Society stopped providing guaranteed annuity rates on new policies from June 1988, although new members of some existing group schemes continued to be provided with policies containing guaranteed annuity rates until the early 1990s.
205 The Society’s guaranteed annuity rates continued to apply to the benefits that would be purchased by the future premiums (including in relation to recurrent single premium policies) that might be paid in respect of policies which already enjoyed this guarantee.
206 Those guaranteed annuity rates were both more flexible, in that they applied over a wide range of ages without penalty, and potentially more widespread than was the case with similar guarantees provided by other companies. In addition, policyholders could pay future premium payments and still benefit from the same guaranteed annuity rate at the same range of ages.
207 No new fund was established by the Society at the time of the changes it made to exclude guaranteed annuity rates and, subsequently, to exclude guaranteed investment returns from the policies it wrote.
208 Thus the assets held in respect of the different classes of policy thereby created were held in one fund. Nor was there a separate bonus series declared or any differentiation in treatment between the various classes of with-profits policyholders in terms of the level of bonuses declared by Equitable, despite the changes in policy terms and the associated guarantees that had occurred.
209 In late 1993 and early 1994 and continuously from April 1995 onwards, the Society’s guaranteed annuity rates became generally more favourable than then current annuity rates. This meant that the cost of providing the guaranteed annuity benefit exceeded the total policy fund, which was only sufficient to provide the lower benefit available at the current annuity rate.
210 In order to deal with this situation, the Society introduced what came to be known as the ‘differential terminal bonus policy’, by restricting the value of benefit paid to the amount of the total policy fund.
211 The Society said that this was done to enable it to continue to reflect the Society’s philosophy of ‘full and fair’ distribution to all its policyholders through its bonus policy and to pay each policyholder just their share of the fund.
212 Therefore, under the Society’s differential terminal bonus policy, the amount of final bonus payable when a policyholder took benefits would be dependent on the form in which those benefits were taken and so, if the guaranteed annuity benefit was selected, the amount of the final bonus attributed to that policy was reduced.
The facts
213 Equitable submitted a statement of their business within Schedule 5 of their regulatory returns in both 1985 and in 1990. In those statements, the Society produced tables which disclosed both the level of the guaranteed annuity rate and the value of the business to which such a rate was applicable.
214 For example, in Form 67 of Schedule 5 of both the 1985 and 1990 returns, it was stated underneath tables which set out the value of the business that, for ‘Individual Pension Arrangements – Variable Premiums’:
Examples of the guaranteed annuity rates applicable to this business are:
Men – at 60 £10.26%; at 65 £11.55%.
Women – at 60 £9.34%; at 65 £10.33%.
215 There is no evidence that, in either year, the GAD scrutinising actuary considered that information or any other such information within Schedule 5 of the Society’s regulatory returns.
216 The Society had also stated in its regulatory returns for each year from 1988 onwards (until 1997) that ‘it was considered unnecessary in current conditions to make explicit provision for the other guarantees and options described’ within the returns.
217 The description provided was that ‘the premiums provide a cash fund at the pension date, to which (for policies issued prior to 1 July 1988) a guaranteed annuity rate is applicable’.
218 Equitable stated, on page 71 of their 1993 returns:
Where benefits are taken in annuity form and the contract guarantees minimum rates for annuity purchase, the amount of final bonus payable is reduced by the amount, if any, necessary such that the annuity secured by applying the appropriate guaranteed annuity rate to the cash fund value of the benefits, after that reduction, is equal to the annuity secured by applying the equivalent annuity rate in force at the time benefits are taken to the cash fund value of the benefits before such reduction.
219 This was a description of the differential terminal bonus policy that the Society had adopted and which was used from the date of bonus declarations in respect of the 1993 year-end until the date of the decision of the House of Lords in July 2000.
220 That description was included in each of the returns from 1993 to 1997. In their 1998 returns, Equitable stated:
If the contract guarantees minimum rates for annuity purchase the aggregate final bonus otherwise applicable is reduced when benefits are taken by the amount, if any, necessary such that the annuity secured by applying the appropriate guaranteed annuity rate after such reduction, is equal to the annuity which would be secured by applying the Society’s annuity rate for an equivalent annuity in force at the time benefits are taken to the cash fund value of the benefits before that reduction, subject to a minimum value for the final bonus after such reduction of zero.
221 The copy of the Society’s 1993 returns that was held on the GAD file was annotated in red ink and in pencil. Several sections of the returns were marked ‘new’, including the disclosure of the differential terminal bonus policy.
222 On 24 October 1994, GAD prepared ‘detailed scrutiny notes’ as part of their consideration of the Society’s 1993 returns. In these notes, the GAD scrutinising actuary listed the key points arising from his first read-through of the returns. On the third page of his notes, the actuary typed:
Bonus rate changes
- New rules reducing final bonuses, see page 71
- Various changes in bonus rates.
223 However, while the GAD actuary identified this in his notes to assist him to conduct the detailed scrutiny of the returns and to write a scrutiny report to the DTI, the issue was not covered in the scrutiny report he provided to the prudential regulators on 15 November 1994.
The statutory and administrative context
224 Section 17 of the Insurance Companies Act 1982 required every insurance company to prepare a revenue account for the year, a balance sheet as at the end of the year, and a profit and loss account for the year in a prescribed form. Those documents formed part of the regulatory returns.
225 All insurance companies which wrote long term business were also required by Section 18 of the 1982 Act to cause an annual actuarial investigation to be made into its financial condition by its Appointed Actuary, who had to report the results of that investigation in a prescribed form. The abstract of the actuary’s report formed part of the regulatory returns.
226 The amount of the long term liabilities as calculated by the Appointed Actuary, pursuant to Section 18 of the 1982 Act, were included in the balance sheet required by section 17 of the 1982 Act.
227 Section 18(4) of the 1982 Act provided that, for the purposes of the investigation that the Appointed Actuary undertook into the financial condition of the company, the value of any assets and the amount of any liabilities were required to be determined in accordance with the applicable valuation Regulations.
228 With effect from 1 July 1994, those regulations were set out in Part VIII and Part XI of the Insurance Companies Regulations 1994, replacing the Insurance Companies Regulations 1981.
229 Regulation 54 of the Insurance Companies Regulations 1981 stated that:
The determination of the amount of long term liabilities (other than liabilities which have fallen due for payment before the valuation date) shall be made on actuarial principles and shall make proper provision for all liabilities on prudent assumptions in regard to the relevant factors.
230 Regulation 64(1) of the Insurance Companies Regulations 1994 stated that:
The determination of the amount of long term liabilities (other than liabilities which have fallen due for payment before the valuation date) shall be made on actuarial principles which have due regard to the reasonable expectations of policy holders and shall make proper provision for all liabilities on prudent assumptions that shall include appropriate margins for adverse deviation of the relevant factors.
231 Regulation 64(3) of the 1994 Regulations provided that the amount of a company’s long-term liabilities should take into account, among other matters, all guaranteed benefits and all options available to the policyholders under the terms of their contracts.
232 Regulation 62(1) of the Insurance Companies Regulations 1981 required that provision should be made to cover any increase in liabilities caused by policyholders exercising options under their contracts. Regulation 72(1) of the Insurance Companies Regulations 1994 required that provision should be made on prudent assumptions to cover any increase in liabilities caused by policyholders exercising options under their contracts.
233 Section K of the GAD Insurance Supervisory Work Guidance Manual invited the GAD scrutinising actuary to ‘draw DTI’s attention to changes in bonus rates, compared to those of the previous year (or at previous declarations)’.
My assessment
234 GAD did not identify the full disclosure within Schedule 5 of the Society’s 1990 returns of the nature and extent of the Society’s exposure to guaranteed annuity rates. GAD therefore did not take this information into account when undertaking their scrutiny of the Society’s 1990 returns, or in relation to their scrutiny of subsequent returns, or when the issue of reserving for such guarantees became a matter of considerable concern. That was a missed opportunity.
235 While it seems to me arguable that GAD should have used the information provided within Schedule 5 of the 1990 returns in order to assist the prudential regulators to verify the solvency position of the Society, I do not, on balance, conclude that GAD acted unreasonably by not doing so at the time that they scrutinised those returns.
236 However, the Society in later returns continued to refer to the existence of policies which contained guaranteed annuity rates and did so in meetings with the prudential regulators and GAD.
237 GAD and the prudential regulators were aware that interest rates had lowered for a sustained period and that mortality was improving. Thus, when the Society introduced its differential terminal bonus policy – designed to address the fact that the Society’s guaranteed annuity rates were now ‘biting’ in an environment of lower current annuity rates – that introduction cannot have been seen in isolation.
238 Yet, while the GAD scrutinising actuary noted that the Society had introduced this policy and that it had the effect of reducing the terminal bonus payable to certain policyholders, this was not taken forward as part of the scrutiny process nor notified to the prudential regulators.
239 I find this omission inexplicable. Moreover, the disclosure within the Society’s 1993 returns of the differential terminal bonus policy did not feature in GAD’s scrutiny of those returns.
240 I consider that the disclosure in the 1993 returns of the differential terminal bonus policy raised three separate issues which should have been considered and addressed: the first being how the Society’s new policy impacted on the reasonable expectations of its existing policyholders; the second being whether that policy was being clearly described to potential policyholders; and the third being its impact on the Society’s approach to reserving.
241 On 20 July 1993, Equitable had provided GAD with their completed response to a with-profits survey then being conducted by GAD on behalf of the prudential regulators.
242 In that response, Equitable explained that ‘part of the Society’s stated philosophy is to achieve a reasonable degree of stability in proceeds with gradual, rather than sudden, changes in proceeds’. The response also stated that, while no specific information was given within the Society’s publications about the period and magnitude of smoothing or the likely frequency of changes to final bonus rates, general comments in their ‘With-Profits Guide’ could be expected to lead policyholders to expect relatively gradual changes to bonus rates.
243 The actuarial profession had also noted, in the report of the professional working party on PRE, published in June 1993, that it was reasonable to expect that an insurance company would exercise continuity in its approach to determining benefits and change its approach to smoothing only gradually.
244 GAD had been provided with information by Equitable that suggested that the Society’s policyholders would not generally expect changes to bonus rates and to its distribution policy. That information had also expressed the view that the philosophy of the Society was to effect gradual and not sudden changes in the way in which it disbursed proceeds to its members.
245 Given all of the above, I consider that GAD should have pursued with Equitable the new policy, which GAD noted had the effect of reducing bonuses, in order to be able to advise the prudential regulators as to whether the differential terminal bonus policy accorded with policyholders’ reasonable expectations.
246 In a letter sent by the Government Actuary to Equitable on 7 July 1993, in response to the Appointed Actuary’s concerns about how the survey had been announced, the Government Actuary emphasised that ‘GAD and the DTI have always taken a close interest in policyholders’ reasonable expectations’ and that the rationale for the survey had been partly to underline ‘the need to focus on this area and for DTI to be seen to be doing something positive to indicate that it has policyholders’ reasonable expectations very much in mind’.
247 GAD did not, however, bring the new policy to the attention of the prudential regulators or raise the matter with the Society. That was a lost opportunity to establish the way in which the Society’s differential terminal bonus policy worked and how that policy affected policyholders and their reasonable expectations.
248 Given that GAD were aware that the material published by Equitable led the reader to expect only gradual changes to bonus policy, that was also a lost opportunity to recommend to the prudential regulators that liaison with the conduct of business regulators should be undertaken and to advise the prudential regulators that concerns should be raised with the Society as to whether it was properly describing this new policy in the Society’s marketing and other literature, in order that the reasonable expectations of potential policyholders were fulfilled.
249 The disclosure of the differential terminal bonus policy in the Society’s 1993 returns also referred to the ‘guaranteed annuity rate’. That reference was further indication of an issue that could and indeed did become critical in later years. Had it been pursued at the time, the question of whether the Society was reserving for such policies might have arisen earlier.
250 GAD’s failure to ask the Society to explain what the new bonus policy entailed, why it had been adopted, and the nature and extent of the problem that it was designed to address was a lost opportunity to identify and address the issues that would cause the Society great problems some years later.
251 The failure by GAD to pursue this at the time led to a further lost opportunity. The Society’s bonus statements and With-Profits Guides did not reflect this change in bonus policy until some years later. That might have been identified and remedied had GAD pursued this matter when it first arose.
252 I consider that GAD should have raised, pursued and sought to resolve issues arising from the introduction of the Society’s differential terminal bonus policy – but failed to do so. GAD should, moreover, have reported those issues to the prudential regulators but also failed to do so.
Submissions I have received and my evaluation of those submissions
Submissions by the public bodies
253 When I informed the public bodies that I was minded to come to this view, those bodies told me that, in their view, I had attached far too much significance to the disclosure of the differential terminal bonus policy, at a time when there had been no basis for concluding that it was unlawful or otherwise objectionable, and at a time when its ultimate implications for Equitable, following the decision of the House of Lords in the Hyman litigation, could not have been foreseen.
254 The public bodies also said that, at the time that Equitable had introduced and disclosed the differential terminal bonus policy, such a policy had not been generally seen as imprudent or surprising.
255 The public bodies told me that disclosure by Equitable of the new policy within its 1993 returns would not, at that time, have raised any concerns with regard to PRE, the way in which the policy was described to potential policyholders, or the impact on reserving by Equitable.
256 The public bodies said that any adverse finding on this matter would be unreasonable and could only be made with the benefit of hindsight.
257 The public bodies accepted that the introduction of the differential terminal bonus policy had been identified by GAD as part of its scrutiny of the Society’s 1993 regulatory returns.
258 However, in support of their view that such a conclusion was unreasonable, the public bodies submitted that:
… the reference to “new rules” in the scrutinising actuary’s notes, and his recognition that these rules involved the reduction of terminal bonus in certain circumstances, were no more than records of fact. They did not indicate that the scrutinising actuary had identified the [differential terminal bonus policy] as a matter of potential concern for any reason, or that it ought to be commented on in the detailed scrutiny report which he would be preparing for the prudential regulator…
259 The public bodies further submitted that:
In these circumstances…, it is wholly unsurprising that no comment was made on the [differential terminal bonus policy] in the detailed scrutiny report. There was no reason for the scrutinising actuary to consider the description of [that policy] in the 1993 returns… as referring to a practice which Equitable was not contractually entitled to carry out. Indeed, it was only the House of Lords’ judgment in 2000 that established that the practice was in breach of Equitable’s Articles of Association.
260 The public bodies went on to submit that:
The practice described was not unique to Equitable, a similar approach having been adopted by several other companies.
Nor was it considered by most actuaries at the time to be unfair or to raise any issue with regard to PRE.
261 The public bodies said that the view taken by GAD, that no action needed to be taken as part of the scrutiny of the Society’s returns, had been a reasonable one for GAD to take at the time.
262 Turning to the issue as to whether the introduction of the differential terminal bonus policy raised questions regarding its impact on the reasonable expectations of existing policyholders, whether and how the policy was being described to new policyholders, and on the reserving practice of the Society, the public bodies submitted that ‘the disclosure of [that policy] in the 1993 returns did not (and reasonably did not) give rise to concerns in any of these respects.’
263 As for issues regarding the impact of the policy on the reasonable expectations of existing policyholders, the public bodies submitted that recognition that this policy might have had such an impact was:
… based entirely on an assessment made with the benefit of hindsight. At the time, other companies used a [differential terminal bonus policy] and it was generally regarded by actuaries as an approach which was consistent with contractual rights and PRE. In particular, it resulted in a maturity payment to the policyholder which was targeted on the individual “asset share”, which was widely accepted among actuaries at the time as setting a benchmark for satisfying PRE.
264 The public bodies further submitted that:
… there was no PRE reason why mention of the [differential terminal bonus policy] should have been made in GAD’s report to the prudential regulator on its detailed scrutiny of Equitable’s 1993 returns. This was also the case in later years. It is only with the benefit of hindsight, and knowledge of the House of Lords’ judgment, that [that policy] can be seen as having been an improper approach to bonus distribution for Equitable to have adopted.
265 The public bodies went on to submit that the ‘circumstances in which the prudential regulator would have considered intervention on PRE grounds in relation to bonus declarations were far from being fulfilled at the material times in relation to the [differential terminal bonus policy]’.
266 As for issues regarding whether and how the Society’s policy was being described to new policyholders, the public bodies submitted:
The marketing to potential policyholders through Equitable’s literature (including the bonus statements and With-Profits Guides…) was a matter for the conduct of business regulator, not the prudential regulator. It was not the responsibility of GAD or the prudential regulator to raise with the conduct of business regulator the issue of the [differential terminal bonus policy] and how it might be communicated by Equitable to potential policyholders.
267 As for issues regarding the reserving practice of the Society, the public bodies submitted that:
… the point is misconceived because there was no need to reserve for terminal bonus under the regulations, and the [differential terminal bonus policy] (relating as it did only to payments of terminal bonus) would therefore properly have been considered by GAD to have no impact on Equitable’s reserves. The subsequent wholly inappropriate reliance that was placed on the [policy] by Equitable, in relation to avoiding setting up reserves which should properly have been held under the regulations for the benefits guaranteed under the relevant contracts, could not have been foreseen from the disclosure of the [differential terminal bonus policy] in the 1993 returns.
268 As regards the disclosure within Schedule 5 of the Society’s regulatory returns for 1990, and also within the Society’s returns for later years, of its policies containing guaranteed annuity rates, the public bodies told me that, in their view, it was only with the benefit of hindsight that the Society’s disclosure regarding guaranteed annuity rates in the years from 1990 to 1996 could be seen to have been misleading.
269 The public bodies also said that it was not reasonable now to criticise GAD for failing to use the disclosure of the extent and nature of the guarantees within the Society’s 1990 returns to test the Society’s assertion that it did not need to establish an explicit reserve for the liabilities associated with policies which contained guaranteed annuity rates.
270 The public bodies told me that:
With the benefit of hindsight, it is clear that, had GAD interrogated the relevant Schedule 4 disclosure using the data in the Schedule 5 statements, it would have discovered the problem with Equitable’s GARs and the lack of an explicit reserve in respect of them.
271 The public bodies submitted, however, that my conclusion had been informed by:
… the impermissible application of [such] hindsight and a failure to acknowledge
(i) the inadequate and misleading nature of Equitable’s disclosure in the returns and
(ii) that any deficiency that there may have been in the relevant reserves was not significant before 1997.
272 The public bodies also said that they did not consider that the disclosure of the position by the Society within its returns had been adequate, submitting that:
With the benefit of hindsight and in the knowledge of the extent of its exposure to GARs revealed by its reply to the GAR survey, it is now clear that Equitable did not provide the disclosure required by the regulations. Further, Lord Penrose, in his report, described the disclosure provided by Equitable as wholly inadequate. It is now clear that the disclosure was insufficient to enable GAD to have a clear understanding of the true position at the time the disclosure was made.
273 The public bodies further submitted that:
GAD was entitled to rely on the Appointed Actuary to provide full and proper disclosure in the returns in accordance with his professional responsibility. The Appointed Actuary was a professional, subject to mandatory guidance and codes of conduct and accountable in that regard to the actuarial profession. GAD did not “police” Appointed Actuaries; that was not GAD’s function and it was never intended that it be resourced or staffed to undertake any such task.
274 The public bodies went on to submit that:
It is only with the benefit of hindsight that the disclosure provided by Equitable can be seen to have been misleading. At the time of the relevant disclosures, the clear implication of the information which Equitable provided was that the need to make explicit provision for the GARs had been considered and dismissed by the Appointed Actuary because they were not “in the money”, or they attached to an immaterial amount of business, or both.
The information available to GAD in the relevant years was not such as to have caused it to question whether Equitable was being disingenuous in giving this impression. In particular, Equitable made no reference to the Differential Terminal Bonus Policy, a policy which it is now known Equitable relied upon to seek to justify the lack of a GAR reserve. GAD did not know, nor could it at the time reasonably have been expected to discern, that (contrary to Equitable’s assertion) reserves were in fact required in respect of its GAR exposure, arguably in 1993 and 1994 (although at that time only in respect of the resilience reserve), and in the base valuation from the 1995 returns onwards.
275 In relation to any meetings held between the Society and the prudential regulators and GAD, at which mention had been made of the existence of the guaranteed annuity rates, the public bodies submitted that:
With the benefit of hindsight, it can now be seen that the comments made by [the Society’s Appointed Actuary] at the meeting in relation to the GARs were misleading. Contrary to the clear impression that he gave, the GARs must in fact have been at least close to biting in the base valuation at that time, and would have been biting to some extent in the resilience scenario in which interest rates were assumed to fall. At the time, however, GAD and the prudential regulator had no way of knowing this, and it was reasonable for them to have accepted the statements made by the Appointed Actuary.
276 In relation to the full disclosure of those guarantees within Schedule 5 of the Society’s 1990 regulatory returns (and in similar earlier returns), the public bodies told me that:
[We accept] that, in providing the periodic statements of its long-term business required under Schedule 5… as part of its returns for 1982, 1985 and 1990, Equitable did disclose data from which the level and extent of its GAR exposure could be discerned.
277 However, the public bodies went on to submit that:
… there was no explicit requirement under the terms of its Service Level Agreement with the prudential regulator for GAD to “review the returns for previous years” at the time in question. Nor did GAD’s own internal guidance require reference back to Schedule 5 statements submitted for earlier years.
278 The public bodies also submitted that:
Further, from 1990 to 1997, Equitable stated expressly in Schedule 4 to its returns that no explicit GAR reserve was required. That assurance was made by Equitable’s Appointed Actuary, who had professional responsibility to provide full and proper disclosure of Equitable’s financial position.
Accordingly, the prudential regulator, through GAD, was entitled in all of the [relevant] years… (including 1990) to rely on that assurance when scrutinising the relevant returns and was not required to go behind it and test its veracity against the data contained in Equitable’s Schedule 5 statements.
The position would have been different if, as it ought to have done in at least some of [those] years…, Equitable had disclosed in Schedule 4 to its returns the need for it to establish an explicit GAR reserve. In that case, [we] accept that the prudential regulator, through GAD, would have been required to verify the sufficiency of the reserve established with reference to the data in the Schedule 5 statements.
279 The public bodies concluded by submitting that they did:
… not accept as well-founded criticism of GAD for failing to:
- detect the inadequacy of Equitable’s (opaque) disclosure of the existence and extent of its GARs in its 1990 to 1996 returns; and
- advise the prudential regulator to seek further information from Equitable¸ whether under section 22(5) of the Insurance Companies Act 1982 or otherwise, about its exposure to GARs.
GAD’s scrutiny of the returns was conducted in a proper and appropriate manner. [I had] rightly acknowledged, and endorsed, the robust approach which GAD and the prudential regulator adopted in relation to Equitable’s 1997 returns. However, that approach reflected a key change in circumstances – namely the unambiguous disclosure by Equitable in a single statement in those returns of the existence, level and extent of its exposure to GARs, and the way in which it was using its [differential terminal bonus policy] to seek to justify avoiding the need to set up reserves for the GARs. GAD and the prudential regulator simply did not have that information when scrutinising the returns for each of the years up to 1996.
My evaluation of those submissions
280 The public bodies have accepted that, had GAD used the information provided by the Society within Schedule 5 of its 1990 returns, ‘it would have discovered the problem with Equitable’s GARs and the lack of an explicit reserve’. Had GAD done so, it is thus reasonable to conclude that much of the subsequent history of the Society’s problems might have been different.
281 The public bodies have submitted, however, that any criticism of GAD’s failure to use that information can only be sustained by having regard to hindsight. However, I am not persuaded by the submissions of the public bodies on this matter.
282 While I accept, on balance, that there was nothing before GAD when it scrutinised the Society’s 1990 returns that would have made that scrutiny focus on the existence, nature and extent of maturity guarantees within the Society’s business, the position was entirely different when GAD were scrutinising the Society’s 1993 regulatory returns.
283 GAD knew that interest rates had fallen on a sustained basis over the previous years. More importantly, the Society disclosed within those regulatory returns that it had introduced a new bonus policy directed at the reduction of bonuses in a context of policies which contained guaranteed annuity rates.
284 It is arguable whether the Society provided sufficient and sufficiently clear disclosure of the guarantees contained within its business and whether its description of the differential terminal bonus policy was appropriate. I consider, however, that it was sufficient to put GAD on notice that questions about those matters needed to be asked if GAD did not fully understand the position.
285 But, in any event, in undertaking the scrutiny of the regulatory returns on behalf of the prudential regulators, GAD was required to verify the solvency position of the Society, and to verify that it had determined its liabilities in accordance with the applicable Regulations.
286 Those Regulations provided that appropriate reserves should be established within the Society’s Mathematical Reserves in respect of liabilities arising from the guaranteed annuity rates.
287 The Society, however, did not include in its regulatory returns any provision for the liabilities which would arise in respect of any policyholder taking the guaranteed default benefits, calculated by applying the guaranteed annuity rate to the guaranteed fund, or for the liabilities which would arise where such policyholders paid additional premiums to ‘top-up’ the existing policies they held which had the benefit of guaranteed annuity rates.
288 Instead, the Society merely held reserves equal to the guaranteed fund of each policy, which provided only for less valuable annuities calculated at the current annuity rates.
289 I accept, on balance, that none of this was obvious on the face of the Society’s regulatory returns. However, the very ‘opaque’ disclosure which the public bodies submit made it unreasonable to expect GAD to have picked up these issues from those returns was, on the contrary, something which should precisely have prompted GAD to raise questions with the Society.
290 I do not accept that GAD would only have had to satisfy themselves that appropriate reserves had been established if the Society had stated within its returns that it needed to reserve for those guarantees.
291 The statements that the Society had such guarantees and that it did not consider that there was any need to reserve for them should have prompted GAD to ask questions. That was even more the case in a context of a sustained downturn in interest rates, the introduction of a new bonus policy to address the cost of those guarantees, and the tight financial position that the Society was then disclosing within its regulatory returns.
292 If GAD could not ascertain what the Society’s reserving practice was, why a new differential terminal bonus policy had been introduced, and the resulting effect on the Society’s solvency position, then GAD was required to take the matter further, pursuant to GAD’s obligations under the service level agreement to provide advice and assistance to the prudential regulators.
293 That could have been done either by asking the Society to explain the approach it was adopting or by recommending to the prudential regulators that further information about the Society’s new bonus policy was sought. GAD could also have looked back at the Society’s returns for earlier years, including those for 1990, to ascertain how the issue had developed over time and what previous discussions or action had been undertaken.
294 I consider also that the submissions of the public bodies regarding the PRE issues that were raised by the introduction of the differential terminal bonus policy do not address all the relevant facts.
295 GAD had before them information that the Society was not communicating its new policy to its policyholders. It is not the case that such matters were only matters for the conduct of business regulators, although recommending to the prudential regulators that liaison with those regulators was needed was one option open to GAD. The fulfilment of the reasonable expectations of the Society’s policyholders was central to the role of the prudential regulators.
296 I was not persuaded by the submissions of the public bodies. I conclude that GAD should have addressed these issues as part of their scrutiny of the Society’s 1993 returns.
My finding
297 I find that the failure by GAD, when the introduction of the Society’s differential terminal bonus policy, intimated within the Society’s 1993 returns, was identified by GAD as part of their scrutiny of those returns, (i) to inform the prudential regulators about the policy, (ii) to raise the matter with the Society, or (iii) to seek to identify what the rationale was for the introduction of the policy and how it was being communicated to policyholders, fell short of the standard that could reasonably be expected of GAD.
The basis for my finding concerning the scrutiny of the Society’s returns for 1994 to 1996
The issue and relevant background
298 Further issues arose in respect of the Society’s regulatory returns for 1994 to 1996, namely:
- the continuation of the two issues which arose from the returns for 1990 to 1993 (questions concerning discounting through the use of imprudent and/or impermissible valuation interest rates and the affordability and sustainability of bonus declarations);
- apparently arbitrary changes to the assumed retirement age for personal pension policies, contrary both to European Directives and the applicable domestic Regulations;
- the absence of explicit reserves for prospective liabilities for capital gains tax and for pensions review mis-selling costs, stating instead that such liabilities were covered by implicit margins in the valuation basis, when GAD knew that the effect of the applicable Regulations was that they should be provided for explicitly; and
- the absence of reserves in respect of the liabilities arising from guaranteed annuity rates, which GAD by then should have known were biting and should therefore have been provided for.
The facts
299 Again, it is not necessary to reproduce all of the material again here concerning the contents of the regulatory returns submitted by the Society each year, the notes and reports which together constituted the outcome of the scrutiny of those returns by GAD, the correspondence between the Society and the prudential regulators and GAD, and the meetings that were held.
300 That material is contained in Part 3 of this report and is summarised in Chapter 6 of this report. Table 10a above sets out the entries within Part 3 of this report of most relevance to the scrutiny process.
The statutory and administrative context
301 The statutory and administrative context for the scrutiny of the Society’s returns for 1994 to 1996 was largely unchanged from that which was applicable to the scrutiny of the Society’s returns for 1990 to 1993, with the exception that the valuation Regulations were now contained within the Insurance Companies Regulations 1994 and that, in 1996, the Insurance Companies (Accounts & Statements) Regulations 1996 replaced the 1983 Accounts and Statements Regulations.
302 For the scrutiny of the 1995 and 1996 returns, a new service level agreement was in place between GAD and the prudential regulators. In this agreement, the primary objective of prudential regulation was said to be:
… to regulate the insurance industry effectively (within the duties and powers set out in the Act) so that policyholders can have confidence in the ability of UK insurers to meet their liabilities and fulfil policyholders’ reasonable expectations.
303 The prime function of GAD was to ‘advise [the prudential regulators] in the fulfilment of these aims’. GAD’s scrutiny reports were now required to set out where a company was not complying with statutory requirements, was failing to meet the statutory solvency requirements, or was in danger of failing to meet them in the future, or appeared not to be meeting policyholders’ reasonable expectations.
My assessment
304 In addition to the two issues which had arisen from the Society’s returns for 1990 to 1993, which were questions concerning discounting through the use of apparently imprudent and/or impermissible valuation interest rates and the affordability and sustainability of bonus declarations, three further issues arose.
305 The first was the way in which the Society assumed the retirement age that would be chosen by its policyholders when calculating its liabilities. Changes to those assumptions appeared to breach the requirements of the applicable Regulations.
306 This question arose because, in both 1994 and 1996, the Society changed in what appeared to be an arbitrary manner the retirement age it assumed would be prudent when calculating its reserves. On both occasions, the effect of those changes was to reduce the reserves that the Society needed to hold.
307 After July 1988, Equitable wrote large numbers of recurrent single premium personal pension policies, which allowed policyholders to retire without penalty at any time from age 50. Thereafter, a cash sum equal to the guaranteed benefits that had accrued in respect of a policy became available and could be used to buy an annuity either from the Society or, using the open market option, from any other pension provider.
308 In the years prior to 1993, the Society calculated its reserves for these policies by discounting the guaranteed benefits from the age of 50, the earliest retirement age allowed under the policies. That was a prudent approach.
309 However, the Society in its 1994 returns assumed, for the purposes of determining the liabilities in respect of such policies, that personal pension policyholders would retire aged 55. The Society did the same in its 1995 returns.
310 In the years from 1996 to 1999, Equitable changed its approach again and assumed that personal pension policyholders would retire aged 60.
311 In addition, for policyholders retiring between the ages of 50 and 55 – and later between 50 and 60 – this meant that the reserves held by the Society in relation to their policy might be less than the cash sum that would be immediately available to those policyholders by way of guaranteed benefits, or under any other option in those policies, or which was available to buy an annuity from another pension provider.
312 The effect of those changed assumptions was that, in all its returns from 1994 onwards in the period covered by this report, the liabilities that the Society showed in its returns, in respect of which it needed to hold reserves, could have been considerably understated. Information that this was so was available to GAD when they scrutinised those returns but GAD took no action until November 2000.
313 The second issue that arose was the failure by the Society to hold explicit reserves for prospective liabilities to tax on capital gains and for pensions mis-selling costs. This was in a context in which GAD had recognised that there were only small, if any, margins in the Society’s valuation basis, and that the Society had selected that basis at the limits of what the Regulations allowed.
314 In the years prior to 1997, the Society stated in both its main and appendix valuations that, although a liability for capital gains tax existed, a provision for that liability was not made as it could be covered by margins elsewhere in the basis used to determine its long term liabilities.
315 That approach did not appear to be consistent with Regulations 60 and 64 of the Insurance Companies Regulations 1994 or the professional guidance in GN8, the effect of which required explicit provision for those liabilities.
316 The Society failed to establish reserves for its disclosed capital gains tax liability – of £22m, £37m and £48m respectively in 1994, 1995 and 1996 – within both its main and its appendix valuations. From 1997, the Society provided for this liability.
317 GAD identified this issue in their scrutiny of the Society’s 1994 returns but did not take any action to raise it with the Society or with the prudential regulators. GAD did comment on the issue in its detailed scrutiny report to the DTI on the 1995 returns, however – but again GAD did not raise the issue with the Society.
318 GAD identified the issue once more when they were scrutinising the Society’s 1996 returns and this time pursued it with the Society.
319 GAD asked the Appointed Actuary to reconsider this matter for the 1997 returns. The failure to establish a reserve for the Society’s prospective liability to tax on unrealised capital gains was rectified in the Society’s 1997 returns, although no amendment was required to be made to its 1996 returns. The 1994, 1995 and 1996 returns may therefore have understated the Society’s liabilities in this respect.
320 With regard to personal pensions mis-selling, the Society stated that its liability in that respect could be covered by margins elsewhere in the valuation basis.
321 That too appeared not to be consistent with Regulation 64 of the applicable Regulations. Although GAD was aware of the issue, as it had been discussed in a meeting that GAD and the prudential regulators held with the Society on 9 December 1994, GAD took no action in respect of this breach in relation to the 1994 and 1995 returns.
322 However, on 16 January 1998 during the scrutiny of the Society’s 1996 returns, GAD wrote to the Society, requiring it to make explicit provision for those reserves in future returns. Yet GAD did not seek any amendments to the Society’s 1996 returns. The Society made provision for those reserves in later returns. However, the Society’s 1994, 1995 and 1996 returns understated the Society’s liabilities in this respect.
323 The final issue which arose was the failure by the Society to reserve for the liabilities associated with those policies which contained guaranteed annuity rates.
324 The Society did not make any provision for the liabilities associated with those guarantees, despite the fact that the applicable Regulations required that the calculation of the Mathematical Reserves should include provision for such liabilities. The public bodies told me during my investigation that, by their reckoning, reserves of £275 million and £325 million were omitted from the Society’s returns for 1995 and 1996 respectively. My advisers suggest a higher figure, but either way the omission was, in my view, material.
325 Whilst the Society had disclosed the existence of those guarantees within its returns for each year, no information had been provided within those returns about the level and extent of the guarantees since that information had been provided within Schedule 5 of the Society’s 1990 returns.
326 This issue, the failure by the Society to establish reserves in respect of the liabilities associated with those of its policies containing guaranteed annuity rates was not noted by GAD in its scrutiny of any of the Society’s returns from 1994 to 1996 and did not come to the attention of GAD or the prudential regulators prior to July 1998.
Submissions I have received and my evaluation of those submissions
Submissions by the public bodies
327 When I informed the public bodies that I was minded to come to this view, those bodies told me that, in their view, any criticism of GAD’s scrutiny of the Society’s regulatory returns was misconceived.
328 In support of that view, the public bodies submitted that:
There was no requirement to hold an explicit reserve for the contingent liabilities for tax on unrealised capital gains or pensions mis-selling costs. Equitable’s practice of making implicit provision for these through reliance on margins elsewhere in the valuation basis was in accordance with the applicable regulations.
Equitable’s retirement age assumptions complied with the applicable regulations and there is no evidence that changes made to them were arbitrary.
The requirement for a reserve for guaranteed annuity rates in the base valuation can only be established with the benefit of hindsight, but, in any event, only a very limited GAR reserve was required in 1995 and none for 1994.
There was no requirement for an explicit allowance for future reversionary bonus to be made in Equitable’s appendix valuation and Equitable’s practice was again in accordance with the applicable regulations.
There is no evidence that Equitable’s use of an “interest rate differential” was not reasonable, which… was not precluded by the applicable regulations at the time in question.
329 The public bodies submitted that, given the above, the contemporaneous view of GAD and the prudential regulators, that there were no grounds for regulatory intervention, was a reasonable one. Accordingly, any adverse finding would be unreasonable and flawed.
My evaluation of those submissions
330 I was not persuaded by the submissions of the public bodies on these matters. By the time that GAD undertook the scrutiny of the Society’s 1994 returns, they had available to them information which indicated that the Society’s valuation basis appeared to be weaker than the minimum permitted by the valuation Regulations.
331 As part of the preparation by GAD of their annual report to the prudential regulators on the industry, GAD carried out work to analyse the strength of the valuation bases used by the principal life insurance companies in the United Kingdom.
332 That work included a comparison of those valuation bases, measured by reference to the difference between the valuation rate of interest adopted and the rate of return available on the backing assets, against the minimum standards set out in the applicable Regulations.
333 As a result of that work, GAD now had information before them that the valuation basis that the Society had adopted within its 1993 returns appeared to be materially weaker than that minimum standard. The Society’s result was 66.8%, where 100% denoted that a valuation basis was approximately aligned to the minimum prescribed strength.
334 GAD was also aware, from the equivalent work it had done in respect of the 1994 returns of life insurance companies (including the Society), which was available to GAD prior to their scrutiny of the Society’s 1994 returns, that the valuation basis that Equitable had adopted within those returns appeared still to be below the minimum prescribed strength, at 96.3%.
335 The analyses carried out by GAD in respect of the Society’s 1993 and 1994 returns also indicated that the Society was significantly out of step in this regard with the rest of the life insurance industry.
336 However, despite this empirical evidence, no action was taken by GAD to secure that the Society’s valuation basis complied with the applicable Regulations – beyond an enquiry about the valuation rate of interest that had been used. The Society’s response to this enquiry was not analysed, or pursued to a satisfactory resolution by GAD or raised with the prudential regulators. It was simply accepted at face value.
337 I received further submissions from the public bodies which said that the original analysis that had been undertaken by GAD had been vitiated with arithmetical errors and which submitted that, once those figures were re-worked, the figure for the strength of the Society’s valuation basis was approximately 100%. The public bodies also submitted that the type of business in respect of which GAD’s analysis had been undertaken was a small part of the Society’s business and that, thus, that analysis was ‘irrelevant’ for the Society.
338 I do not accept those submissions. Whether it can now be shown that the valuation basis met the statutory requirements is itself irrelevant. I have to be concerned only with the information that was before those scrutinising the Society’s returns at the time. Nor do I accept that the material in question would have been irrelevant to the way in which GAD should have conducted the scrutiny of its returns.
339 I consider that GAD, in advising and assisting the prudential regulators through undertaking the scrutiny of the Society’s returns, were required to satisfy themselves that the Society was acting soundly and prudently, in accordance with the applicable Regulations, and in such a way as to fulfil the reasonable expectations of its policyholders. GAD were also required to advise the prudential regulators of any issues of concerns which came to the attention of GAD.
340 Questions as to whether the Society was so acting or questions as to whether its valuation basis, including the interest rate used to determine the Society’s liabilities, was appropriate – and as to whether the method by which the Society determined its surplus was appropriate – had to be raised by GAD with a view to verifying the Society’s financial position. The information before them at the time should have been taken into account, but was not.
341 I would finally note, as to the relevance to the Society of the comparative analysis that GAD undertook, that the types of business in respect of which that analysis was undertaken were precisely the same business types as formed the basis for evidence provided to me by the public bodies, also based on comparative analysis, to support their submission that industry-wide bonus cuts had occurred around the time that the Society made its policy value cuts in July 2001, as part of their submission that financial injustice had not been sustained by policyholders.
342 I was not persuaded by the submissions of the public bodies on these matters and those submissions did not persuade me that my conclusions are flawed.
My finding
343 I find that the failure by GAD, as part of the scrutiny process, to question and seek to resolve questions within the Society’s regulatory returns for each year from 1994 to 1996, related to (i) the valuation rate of interest, (ii) the affordability and sustainability of bonus declarations,
(iii) apparently arbitrary changes to the assumed retirement ages, and (iv) the holding of no explicit reserves for the liabilities associated with prospective liabilities for capital gains tax, for pensions mis-selling costs, and for guaranteed annuity rates, fell short of what could reasonably be expected of GAD.
The basis for my finding concerning the presentation of the Society’s two valuations
The issue and relevant background
344 Most insurance companies used the valuation method and basis set out in the applicable Regulations to calculate their Mathematical Reserves.
345 However, throughout the period covered by this report, insurance companies were entitled to use an approach which differed from the statutory minimum basis, so long as the alternative method that was used produced Mathematical Reserves that were at least as high as that which would have been produced using the statutory minimum basis.
346 During the period covered by this report, the Society always used an alternative valuation method within its returns.
347 In order to seek to demonstrate compliance with the Regulations, the Society set out information about the amount of its Mathematical Reserves using a basis that its Appointed Actuary considered was compatible with the method set out in the Regulations. This was done in an appendix at the end of Schedule 4 of the Society’s returns.
The facts
348 In its regulatory returns for every year from 1990 to 1996, the Society, when producing its appendix valuation, did not provide complete information in that valuation. The amount of the resilience reserves that would be needed if the statutory minimum basis had been used by the Society was omitted from each of those returns.
349 For each year from 1990 to 1994, as part of their scrutiny of those returns, GAD asked the Society to provide the omitted information. This the Society provided.
350 This was done so that GAD could verify what the amount of the Society’s Mathematical Reserves using the statutory minimum basis would be, before comparing the results of the Society’s chosen method with the results on the statutory minimum basis. GAD could thereby be satisfied that the Society’s chosen alternative had produced a result at least as strong as would have been produced on the statutory minimum basis.
351 GAD carried out their scrutiny of the Society’s 1995 regulatory returns in November 1996. Although the Society again omitted the figure for the resilience reserve, GAD did not ask the Society to provide that figure. Instead, GAD simply assumed that it would be less than the difference between the Mathematical Reserves in the main and appendix valuations before the allowance for resilience reserves.
352 During their scrutiny of the Society’s 1992 returns, GAD had suggested to the Society’s Appointed Actuary that this information should be disclosed. The Appointed Actuary did not agree and GAD did not pursue the matter further.
353 At no other time did GAD seek to require the Society to include within its published returns the missing figures for the resilience reserves, so that the information which GAD possessed, for years other than 1995, would become available to all readers of the returns.
354 GAD and the prudential regulators were also in possession of information about how the Society’s financial position as set out in its regulatory returns was being interpreted by industry commentators.
355 The ratings given by Standard & Poor’s, an expert ratings agency, were used extensively by Equitable in their marketing material and other policyholder communications. Those ratings were also cited in support of the Society’s position when doubts were expressed about the long-term viability of the Society.
356 Standard & Poor’s first considered Equitable in 1993, when the Society received an ‘AA (Excellent)’ rating, which it continued to receive until May 1999. Companies which were given such a rating by Standard & Poor’s were described as offering ‘excellent financial security’ with their ‘capacity to meet policyholder obligations [being] strong under a variety of economic and underwriting conditions’.
357 Explaining its rationale for giving the Society this rating, Standard & Poor’s stated, in November 1993, that:
On the basis of its published valuation, [Equitable] appears to have relatively weak free asset and investment leverage ratios: 2-5% (since 1990) and above 920%, respectively. However, free assets are understated by the use of a very conservative valuation basis. Adjusted to a more conventional reserving basis, the free asset ratio is much stronger, nearer 10% in 1992… S&P expects these levels of strength to continue.
358 The same rating was given to the Society in April 1995. A similar rationale for that rating was given by Standard & Poor’s, as follows:
Although [Equitable] uses a conservative valuation methodology, S&P still believes that it shows a significant degree of capital strength. The Society’s published returns display a strong level of capitalization, despite a significant strengthening of the valuation in 1993, with the free asset ratio rising to 9.4% and coverage of the required minimum margin to 3.7 times… from 5.09% and 2.4x, respectively, in 1992. An alternative net premium valuation, more comparable with peers, would increase the free asset ratio to almost 12% and coverage of the required margin to over 4.4x.
359 Similar explanations as to why the ratings agency believed that the Society’s financial strength was understated in its main valuation – and that the (incomplete) appendix valuation indicated a much stronger real financial position – were provided as late as October 1997. Those ratings were provided by the Society to the prudential regulators and GAD.
360 Table 10d summarises the information available from the Society’s returns for 1990 to 1993 and the surplus assets understood by Standard & Poor’s to be available, as based on the main and appendix valuations, and measured in terms of the free asset ratio and cover for the required minimum margin.
361 The table then shows the resilience reserve information provided to GAD and how this reduces the surplus assets and the free asset ratio available based on the appendix valuations to levels near that in the main valuations.
The statutory and administrative context
362 Regulation 54 of the Insurance Companies Regulations 1981 required that the amount of the Mathematical Reserves reported in the returns (the published reserves) should not be less than those calculated under Regulations 55 to 64 of the 1981 Regulations (the minimum reserves).
363 Regulation 57(1) of the 1981 Regulations required that, for the purpose of calculating Mathematical Reserves, the future premiums to be valued by an insurance company should not exceed the net premium value of those premiums.
364 The requirements on the valuation of future premiums did not materially change when the Insurance Companies Regulations 1994 came into force. However, Regulation 64(3) of the 1994 Regulations required that a company’s liabilities had to comply with each of the provisions of Regulations 65 to 75 of those Regulations. This meant that the calculation of the minimum reserves under Regulations 65 to 75 had to comply with each of these Regulations and not just that the total did so in aggregate.
365 Guidance issued by the prudential regulators (PGN 1984/1, paragraph 12.1) stated that, where an insurance company was using a method other than that prescribed in the Regulations, that company was required to provide sufficient information about the basis of the valuation to enable those regulators to be satisfied that the requirements of the Regulations were fulfilled.
366 GAD’s scrutiny proformas, which assisted them to conduct the scrutiny of the regulatory returns, stated that those scrutinising such returns should look for ‘sufficient demonstration’ of this.
My assessment
367 I consider that, in two ways, omissions by GAD bring into question whether they were fulfilling the obligations to which they were subject.
368 The first relates to the failure by GAD to ask the Society to provide the figure for the missing resilience reserves in the appendix valuation within the Society’s 1995 returns.
369 In my view, it is arguable that the Society should have been asked to set out the missing figure within its returns to enable the reader of those returns to be provided with sufficient demonstration that the alternative method of valuation used by the Society had produced a result at least as strong as the minimum prescribed in the Regulations.
370 Without this information, the returns were capable of being misconstrued. However, on balance, I accept that, as this was not required by the Regulations, it was not something that GAD or the prudential regulators could insist on. However, there was also nothing to prevent them from taking non-statutory action to ask the Society to consider the point.
371 That said, it was quite another thing for this information not to be sought by GAD as part of their scrutiny of the Society’s returns.
372 The prudential regulators were under a duty to verify the financial position of life insurance companies. In order to do this, they needed, among other things, to be satisfied that the Society had determined its liabilities in such a manner as would produce Mathematical Reserves at least as high as was prescribed in the Regulations.
373 By not asking the Society for this information in respect of its 1995 returns, GAD, acting on behalf of the prudential regulators, were unable to verify that the Society’s alternative method had produced a result at least as strong as the statutory minimum. Without that information, GAD could not be satisfied that the Society had acted in accordance with the regulatory requirements to which it was subject.
374 The second way in which the actions of GAD bring into question whether they were fulfilling their obligations relates to how GAD handled the information before them, contained in the ratings about the Society produced by Standard & Poor’s. Those ratings demonstrated that the Society’s method of presenting the two valuations, but without including the figure for the resilience reserve, was being misconstrued.
375 GAD knew that, contrary to the information contained within Standard & Poor’s ratings, Equitable did not adopt a conservative valuation approach – quite the opposite.
376 GAD also knew that, contrary to the information within those ratings, there was little difference between the results of the Society’s alternative method of valuation and the minimum prescribed in the Regulations. In substance, there were no margins, as had been wrongly assumed, between the statutory minimum reserves and the results which the Society’s alternative method had produced.
377 The way in which the Society presented its returns – and was permitted to present its returns – led directly to financial analysts misunderstanding the true financial condition of the Society and to misleading information being disseminated about the ‘hidden’ strengths of the Society’s position. Yet GAD failed to take any action concerning this matter.
378 I consider that both these failings – to ask for the Society’s figure for the missing resilience reserves in respect of the 1995 returns and to inform the prudential regulators of the fact that the Society’s returns were being misconstrued due to the way in which those returns were presented – represent a failure to do what GAD should have done in the circumstances.
Submissions I have received and my evaluation of those submissions
Submissions by the public bodies
379 When I informed the public bodies that I was minded to come to this view, those bodies told me that, in their view, I had misinterpreted or misapplied the applicable law.
380 The public bodies said that Equitable had disclosed the fact that any resilience reserves required in the appendix valuation could be financed without recourse to the investment reserve in the main valuation. Those bodies said that this disclosure had complied with the applicable law and related guidance.
381 The public bodies also told me that there had been no obligation on GAD to ask for the amount of the resilience reserve required in the appendix valuation within the Society’s 1995 regulatory returns.
382 Furthermore, the public bodies said that they did not accept that ‘ratings agencies (or other industry commentators), on whom reliance might reasonably have been placed by policyholders, were misled by Equitable’s returns, nor that, even if they were, the prudential regulator or GAD bore any responsibility for this’.
383 As to whether or not GAD should have asked the Society for the amount of the resilience reserve required in the appendix valuation within the Society’s 1995 returns, the public bodies, after accepting that the amount of the resilience reserve required in the appendix valuation had not been requested by GAD in respect of the 1995 returns, submitted that:
However, as for previous years, the returns were not misleading in that year, and the amount of the resilience reserve required in the appendix valuation did not have to be provided to GAD, nor did it have to be requested by GAD.
384 The public bodies further submitted that:
The 1995 detailed scrutiny report shows that it was a deliberate decision by GAD not to request the amount for that year and not an oversight. The basis for this decision was reasonable. The disclosure provided the required demonstration of compliance with the 1994 Regulations, and GAD stated in their report that they had no reason to doubt this, giving their reasons.
These were: (1) the size of the quantified excess of the aggregate liability in the main valuation over the aggregate policy reserves shown in the appendix valuation; (2) the Appointed Actuary’s statement that the resilience reserve required in the appendix valuation was covered by that excess; and (3) the lack of evidence from the returns to doubt that statement, having made appropriate comparison with the previous year’s returns.
That comparison took into account the margin between the resilience reserve required in the appendix valuation in 1994 on the one hand and the excess of the aggregate liability in the main valuation over the aggregate policy reserves in the appendix valuation in 1994 on the other, and also the percentage increase in the aggregate liability in the main valuation between 1994 and 1995.
385 As to the use made of the content of the Society’s regulatory returns by ratings agencies and other industry commentators, the public bodies submitted that:
The very nature of rating agencies’ work was to undertake analysis and make their own, independent assessment of companies, and policyholders and other parties would reasonably have expected them to do so. In carrying out this task, the rating agencies had access not just to the returns but generally also to much additional information, and it was reasonable to expect them to discuss any issues arising with the companies they were rating, such that they were confident they had a full understanding of the position of those companies.
386 The public bodies further submitted that:
To the extent that rating agencies placed any reliance on Equitable’s appendix valuation, and if they failed to recognise from the disclosure provided in the returns that the amount of the resilience reserve required in that valuation was not disclosed, then those were entirely matters for the agencies concerned. The prudential regulator and GAD had no duty to vet the rating agencies’ understanding of the regulations; it was for the agencies to analyse the results of the main and appendix valuations and the disclosure provided in relation to the resilience reserve required in the appendix valuation, and seek any further information they required to be satisfied that they fully understood the position before commenting on it.
387 For these reasons, the public bodies told me that, in their view, any adverse finding would be unsustainable.
My evaluation of those submissions
388 I was not persuaded by the submissions of the public bodies on these matters. With respect to the failure by GAD to ask for the figure for the 1995 returns, what should have prompted them to ask for it was not a judgement on their part that those returns were misleading, as appears to be the basis of the submissions of those bodies, but instead the need for GAD to satisfy themselves as to the conformity of the Society’s returns with the applicable law.
389 That it was a conscious decision not to ask for this figure on the part of GAD does not excuse this failure. The prudential regulators were under a duty to verify the financial position of the Society. In giving advice to those regulators on this question, without the information that they had asked for in every other year, GAD could not have verified the financial position of the Society, including by being satisfied that the Society had determined its liabilities in such a manner as would produce Mathematical Reserves not less than the statutory minimum reserves.
390 It was impossible for GAD to have concluded that the Society’s chosen valuation method had produced a result that was at least as strong as that which would have been produced had the Society used the method prescribed in the Regulations, unless GAD knew what that prescribed method would have produced.
391 Without access to the omitted information, GAD could not know whether the Society had conformed to the regulatory requirements to which it was subject.
392 Nor was I persuaded by the submissions with regard to the ratings produced by Standard & Poor’s.
393 While I accept that the prudential regulators and GAD were not responsible for the content of the ratings produced by such agencies, that does not explain why the Society’s ratings – despite them containing assessments which GAD should have known were fundamentally flawed – were used by GAD and by the prudential regulators in a number of contexts – such as in scrutiny reports, as briefing for Ministers and to deal with enquiries as to the strength of the Society.
394 The flaws in those ratings derived not from error on the part of those producing them but were a direct result of the way in which the Society presented its returns without objection from GAD.
395 Given that this presentation was not contrary to the Regulations, I do not suggest that GAD should have recommended intervention action or action under section 22(5) of the 1982 Act. However, I consider that GAD should have alerted the prudential regulators to the issue and should have recommended that those ratings should not be used as briefing material and to respond to enquiries.
My finding
396 I find that the failure by GAD (i) to ask for the information GAD needed in respect of the Society’s 1995 returns to enable them, as part of the scrutiny process, to be sure that the Society had produced a valuation that was at least as strong as the minimum required by the applicable Regulations, and (ii) to pursue the information before them that the omitted information had led to the users of the returns misconstruing the financial strength of the Society, fell short of what it was reasonable to expect from GAD.
The basis for my finding concerning financial reinsurance
The issue and relevant background
397 During 1998, the prudential regulators and GAD became aware that the Society had not made provision for the liabilities arising from guaranteed annuity rates contained within certain of its policies. Those regulators had required that the Society should do so within its 1998 returns.
398 That requirement had led to an immediate increase of £1,600 million in the amount of reserves required to be shown as at 31 December 1998, as well as additional associated resilience reserves. As a result, the Society investigated means whereby those additional liabilities could be offset – in order not to disclose a much weaker financial position in those returns.
399 Had such offsetting action not been taken, the 1998 regulatory returns would have shown such a weak financial position that the Society’s future as an independent mutual would have been threatened and its continued ability to write new business and declare bonuses would have been in doubt. Indeed, the prudential regulators told the Society in December 1998 that they would take action if they considered that the 1998 bonus declaration made by the Society was imprudent.
400 The Society therefore needed to take urgent action to either raise capital or to reduce its Mathematical Reserves.
401 This the Society did through a financial reinsurance arrangement. Within its published returns for 1998, 1999 and 2000, the Society took credit for such an arrangement that it had entered into with IRECO, a reinsurer based in Dublin. That treaty, in its original and subsequently amended forms, is reproduced within Part 4 of this report.
402 The amount of the credit taken for those years was, respectively, £809 million, £1,098 million, and £808 million. The Society’s Mathematical Reserves were reduced by more than those amounts, however, as the resilience reserves that the Society was required to hold were also reduced.
403 The Society’s published returns for 1998 showed that it had excess available assets and implicit items of £1,516 million over the required minimum margin, the returns for 1999 showed the excess asset figure as £2,747 million, and those for 2000 showed a figure of £411 million. The prudential regulators permitted those credits to be taken.
The facts
404 The full account of the events relevant to the development of the Society’s reinsurance arrangement, how it was treated within the Society’s returns, and the later developments on those issues is set out within Part 3 of this report. It is not practicable to recount the relevant events here. That account is also summarised within Chapters 7 and 8 of this report. This is only a brief summary of those events.
405 At a meeting on 3 December 1998, the Society’s Appointed Actuary informed the prudential regulators and GAD that he considered that reinsurance was an ‘option for protecting the balance sheet’ but that a reinsurance agreement was unlikely to be in place by 31 December 1998. Those regulators informed the Appointed Actuary that it might be possible to give a reporting concession (under section 68 of the 1982 Act) so that the effect of any such arrangement would be retrospective to cover the 1998 year-end position.
406 A letter dated 7 December 1998 from the prudential regulators to the Society’s Managing Director, recording the outcome of the meeting on 3 December 1998, stated:
Reinsurance was suggested as a possible means of overcoming the difficulties that Equitable Life would face in reserving on the assumption that 100% of policyholders took their benefits in the form of a guaranteed annuity. You pointed out that it would be difficult to put in place such an arrangement before the end of the month. We acknowledged this but indicated that we would be willing to consider the possibility of treating any such reinsurance arrangement as having been effective from the year end provided that at least the broad terms of the agreement were in place by that date and a firm intention to enter into the agreement could be shown.
407 On 31 December 1998, the Society informed the prudential regulators that it had received an offer in respect of a financial reassurance arrangement and enclosed a fax from IRECO, which confirmed that a meeting was to take place on 7 January 1999. The Society informed the prudential regulators that it hoped that the remaining issues could be resolved at that meeting in order to enable a contract to be drawn up.
408 On 21 January 1999, the Society wrote to the FSA, enclosing ‘draft detailed terms’. On 27 January 1999, GAD informed the FSA that they had reviewed the reserving effect of the draft terms sent under cover of the Society’s letter of 21 January 1999.
409 Among other things, GAD:
- raised the absence of information as to the financial strength of IRECO;
- identified the proposed treaty as a ‘financing arrangement’ (as opposed to a traditional contract of reinsurance);
- identified that no payment of any reinsurance claims amount would be made by IRECO to the Society;
- identified that the draft terms limited IRECO’s (non-cash) ‘overall exposure’ to £100 million;
- drew attention to the wide cancellation clause (which was retrospective to 31 December 1998); and
- drew attention to the term that the treaty would also be cancelled if the Society changed its practice on guaranteed annuity rates (that is, changed its differential terminal bonus policy), including as a result of losing litigation.
410 GAD further advised the FSA that ‘the treaty will not achieve the intended reserving effect for a number of reasons set out in GAD’s advice including the definition of reinsurer’s liability, the breadth of the cancellation clause and the provision for the treaty to be cancelled retroactively’.
411 GAD went on to advise the FSA that:
The treaty limits the total withheld reinsurance claims balance to £100m at any 31 December or otherwise the treaty would have to be restructured. It is difficult to reconcile this with [the Society’s] intention to allow a reinsurance credit in their returns of around £700m. We believe therefore that there should be a commitment for the treaty to be continued, but that the schedule of reinsurance payments to the reinsurer could be revised in the event of this credit of £100m being exceeded.
412 GAD also provided, as an annex to their advice, a simplified example ‘for the purposes of demonstrating that the reinsurance treaty fails to achieve its intended reserving effect’.
413 None of those matters were the subject of substantive amendment in the terms of the agreed slip (evidencing the financial reinsurance contract entered into between the Society and IRECO on or shortly after 1 April 1999) or in the treaty entered into between them (signed on behalf of the Society on 11 October 1999).
414 Notwithstanding that this was the case, the FSA permitted the Society, without challenge, to take a reinsurance offset of £809 million within its 1998 returns – without any concession under section 68 of the 1982 Act.
415 Nor did the FSA take any adequate steps to ascertain the financial strength of IRECO. Reliance was instead placed on the credit rating given to IRECO by Standard & Poor’s.
The statutory and administrative context
416 Financial, or finite, reinsurance is often an arrangement under which, as part of a traditional reinsurance treaty, the reinsurer undertakes to make a loan to the ceding office, in this case the Society, either immediately or in the future. The availability of the loan is normally related to a claim event under the treaty.
417 Without modification to such a treaty, ceding offices could not take a full reserving credit for the future availability of such a loan as, if they did, they would also have to provide for the liability to repay it. One modification that was frequently used in such treaties during the period covered by this report was to make the liability to repay the loan dependent on sufficient profits being generated by the ceding office.
418 Once any loan where the liability to repay was dependent on sufficient profits being generated was received by a ceding office, it would not have to be recognised as a liability in the balance sheet contained in the regulatory returns the ceding office produced. In this way, the value of the initial cash payment provided by the loan could be recognised in the returns of the ceding office even before such a loan was drawn down.
419 Therefore, even though credit was taken for the loan, the liability to repay that loan did not have to be recognised in the calculations of the Mathematical Reserves of the ceding office, as that calculation excluded liabilities that would arise only if sufficient profits were generated – for example, the liability to pay terminal bonus.
420 This treatment contrasted with the way such transactions would be shown in Companies Act accounts, where the liability to repay such a loan, in those circumstances, could not be omitted.
421 If, in the event of a claim, a reinsurance treaty did not pay cash or if a reinsurer delayed claim payments, then the ceding office would account for the monies due to it as a debtor on its balance sheet within the regulatory returns, which would count as an asset for the purposes of matching policyholder liabilities.
422 In such circumstances, section 35A of the 1982 Act applied. This provided that an insurance company was required to secure that its liabilities under contracts of insurance were covered by assets of appropriate safety, yield and marketability and such considerations would apply to the recognition of that debt.
423 Insurance companies could recognise the future availability of such an asset by reducing their Mathematical Reserves by an amount that represented the full value of debt for which they intended to take credit.
424 Such a reduction in respect of reinsurance was, at the relevant time, generally permitted by Regulation 64(3)(e) of the Insurance Companies Regulations 1994. That Regulation provided that the amount of the long-term liabilities ‘shall take into account any rights under contracts of reinsurance in respect of long-term business’, having regard to Regulation 64(1) of those same Regulations.
425 Regulation 64(1) of the Insurance Companies Regulations 1994 required that the determination of those liabilities were to be made on actuarial principles, which meant, amongst other things, that those liabilities had to be determined by taking into account the time value of the cash flows due under a policy or contract of reinsurance.
426 Paragraph 6 of section 5.5 of the Treasury’s 1998 guidance on the preparation of the annual returns provided, with respect to the determination of long-term liabilities:
The Insurance Directorate interprets “liabilities arising under or in connection with contracts for long term business” to include liabilities arising under reinsurances of those contracts for long-term business. This includes liabilities under financial reinsurances and by extension even liabilities under non-reinsurance financing arrangements provided the liability under the financing arrangement is closely linked to performance of contracts for long-term business. Therefore liabilities under financial reinsurances and such analogous financing arrangements… are to be determined under actuarial principles.
This is important as the crystallisation of such liabilities is often – although not invariably – linked to the emergence of future profits. Future profits are not in themselves an asset admissible to match liabilities… However, provided the reinsurance or financing liability is repayable – as a matter of form and economic substance – only upon the emergence of future profit, actuarial principles may sometimes allow for the future profit to be taken into account in determining the amount of the liability.
427 Paragraph P.3 of the GAD Insurance Supervisory Work Guidance Manual stated that the ‘points to consider’ in relation to any reinsurance agreement were:
- ‘If the agreement is not with a company that is authorised to transact business within the UK, do we know enough about it? Is it commercially sound? It may be necessary for [the prudential regulators] to write to the authority that supervises the reinsurer’s home country to obtain more information’;
- ‘Does the agreement give appropriate cover? Too much? Too little?’; and
- ‘Are the arrangements… on a fair commercial basis?’
428 Section 37 of the 1982 Act gave the prudential regulators powers of intervention where they considered that an insurance company had failed to satisfy an obligation to which it was subject by virtue of the 1982 Act or where those regulators were not satisfied that adequate arrangements were in force or would be made for the reinsurance of risks against which persons were insured by the company.
My assessment
429 In considering the acts and omissions of the FSA and/or GAD in respect of the events relevant to the Society’s reinsurance arrangement, I have considered two questions:
(i) whether the Society was entitled within its 1998 returns to have regard to the financial reinsurance arrangement – which revolves around the date on which that arrangement was entered into and whether the arrangement had any legal effect at the date to which those returns applied; and
(ii) whether the financial reinsurance arrangement had any value for the purposes of the Society’s 1998, 1999 and 2000 returns and, if so, what that value should have been.
430 I am advised that, in order to constitute a valid contract as a matter of English law, there must be: (i) a sufficiently certain agreement in the form of an offer which has been accepted; (ii) an intention that the agreement be legally binding; and (iii) save in the case of a contract under seal, consideration moving from each party to the other.
431 What was required before a legally binding contract between IRECO and the Society came into existence was agreement upon every material term of the contract of reinsurance which the parties wished to make, accompanied by an intention on the part of both parties that the contract was intended to be legally binding.
432 The financial reinsurance arrangement between IRECO and the Society was not entered into on or before 31 December 1998. In the absence of a reporting concession pursuant to section 68 of the 1982 Act, the Society was, accordingly, not entitled to have regard to that arrangement within its 1998 returns, which were prepared with the valuation date of 31 December 1998 and submitted on 30 March 1999.
433 No such concession was sought or granted. No credit for the financial reinsurance arrangement was permissible within the Society’s 1998 published returns in the absence of such a concession.
434 However, even had a reporting concession been granted, the Society was not entitled to take the credit that it did for the financial reinsurance arrangement within its 1998 returns. Nor could such credit have been taken within the Society’s 1999 and 2000 returns.
435 Article 4 of the financial reinsurance treaty provided that IRECO was to be ‘liable for claims arising from the business covered to the extent detailed in Appendix 1’ of the treaty. Appendix 1 provided that a Reinsurance Claims Event (RCE) occurred if the proportion of guaranteed annuity rate policyholders electing to take their benefits in guaranteed annuity rate form exceeded 25% by value of the retirements of such policyholders in any calendar year.
436 The Reinsurance Liability represented the extra cost, compared to current annuity benefits, to the Society of providing benefits at guaranteed annuity rates – but only in respect of the guaranteed funds (rather than the total policy value, including terminal bonus) of the relevant policies.
437 However, the Reinsurance Liability was reduced by the terminal bonus on the relevant policies, prior to the application of the differential terminal bonus policy, to give the Reinsurance Claims Amount (RCA). The RCA matched the Society’s extra costs above the total policy values (including terminal bonus) as long as the differential terminal bonus policy continued to operate.
438 The treaty, however, placed no obligation on IRECO to make any payment to the Society in respect of the RCA. On the contrary, Article IV of the treaty, expressly provided that ‘the [RCA] as defined in the said Appendix 1 will be withheld by [IRECO]’, i.e. no payment in respect of the RCA was to be made by IRECO to the Society.
439 The obligations, under Article IV of the treaty, on IRECO to make payments under the treaty to the Society arose following the occurrence of an RCE and were limited to:
- an obligation, on request, ‘to pay an interest amount … on the outstanding [RCA] but only if that payment was required by [Equitable] to properly satisfy the requirements of s35(1)(a) of the Insurance Companies Act 1982’: any such payment was to be calculated by reference to 12 months LIBOR and the RCA; or
- an obligation, on request, to pay ‘a cash amount of up to 10% of the outstanding RCA’ but only if payment of an ‘interest amount’ had not been requested by Equitable.
440 If IRECO was called upon to make a payment to the Society of an interest amount or a cash amount, the Society became liable to pay to IRECO ‘a fee of LIBOR plus 3.5% … annually on the opening balance of this individual portion for each annual period until such time as this interest amount or cash payment is repaid in full to [IRECO]’, according to Appendix II of the treaty. That annual fee was payable by the Society to IRECO irrespective of any future surplus achieved by it.
441 The substance was that the Society was entitled, according to the terms of the treaty, to require IRECO to make a loan to Equitable of the interest amount or the cash amount at a penal rate of interest. Neither the repayments of any loan nor the annual fee payable in respect of the loan were dependent upon any surplus being achieved by the Society.
442 The calculation of the offset to the Society’s Mathematical Reserves in respect of the treaty had to value the cash flows actually payable under the treaty. In the circumstance of a loan to the Society, those cash flows would include both the amount of the loan (cash to the Society) and the payment of interest and repayments of cash to IRECO. In that case, the net value of these cash flows was nil.
443 In terms of the calculation of this offset, the intended effect of the treaty was that the Society could take full credit for the Reinsurance Liability, rather than the RCA. This meant that the reserves held were reduced by the terminal bonus on the relevant policies.
444 No cash was payable, but any future liability to repay that amount by way of additional premiums was disregarded, since any such repayment was dependent on the emergence of future surplus. The offset used by the Society was calculated in this way and, in effect, assumed that a reinsurance asset would arise in the event of a claim.
445 In addition, the permissibility of the reductions in its guaranteed annuity rate reserve which the Society made within its returns was, under the terms of the applicable Regulations, dependent on the arrangement being a contract of reinsurance.
446 A reinsurance contract is one whereby, for a consideration, the reinsurer agrees to indemnify another wholly or partly against loss or liability by reason of a risk the latter has assumed under a separate and distinct contract as the insurer of a third person.
447 Here, the second part of that definition of a reinsurance contract was satisfied. The Society had assumed a risk under contracts with a guaranteed annuity rate option into which it had entered. The Society suffered loss or liability if a guaranteed annuity rate policyholder exercised his or her option to take his or her benefits in guaranteed annuity rate form.
448 However, the first part of that definition of reinsurance was not satisfied. The only payment, pursuant to the treaty, which IRECO might have been required to make to the Society was a loan at a penal rate of interest under a drawdown facility which was not (and was not intended to be) utilised.
449 On the contrary, the Society agreed to make payments to IRECO as consideration for IRECO lending its name to a transaction which had no genuine economic purpose. IRECO did not agree in any respect to indemnify the Society against any loss or liability to which the Society might become subject under policies with a guaranteed annuity rate option.
450 It follows that the treaty did not constitute reinsurance and therefore could not be taken into account in determining the Society’s long term liabilities. I consider that the Society should not have been permitted to take any credit for this arrangement in any of its returns for 1998, 1999 and 2000.
Submissions I have received and my evaluation of those submissions
Submissions by the public bodies
451 When I informed the public bodies that I was minded to come to this view, those bodies told me that, in their view, the Society’s reinsurance treaty had been an example of an acceptable arrangement commonly used by insurance companies to manage their liabilities, and that such arrangements had been expressly permitted by the regulatory regime.
452 The public bodies also said that it was their view that Equitable had concluded their reinsurance contract in January 1999, with the reinsurance cover effective from 31 December 1998.
453 The public bodies also told me that the terms of the treaty had been such as to justify the amount of credit which Equitable had taken in their returns in all the years in question.
454 In support of these views, the public bodies submitted that:
A binding contract, complete with payment of premium by Equitable, was entered into in January 1999, to be effective from 31 December 1998. By the time the 1998 returns were submitted, on 30 March 1999, the prudential regulator and GAD had also requested Equitable to amend the terms of this contract to meet their concerns relating to the amount of credit that could properly be taken for it in the returns, and it was the professional responsibility of the Appointed Actuary to take credit for the treaty in the returns taking into account those requests.
455 The public bodies further submitted that:
The amount of the credit taken for the contract in the returns was fully consistent with, and reflected the present value of, the cash flows payable under the contract… The contract was undoubtedly a contract of reinsurance; but even if it had not been, the regulations in force at the time still permitted credit to be taken for it in the returns.
456 The public bodies also submitted that, accordingly, there had been nothing impermissible or unreasonable ‘in permitting credit to be taken for the reinsurance contract in the returns in the manner and to the extent that it was’.
457 The public bodies submitted that:
At the time of submission of Equitable’s 1998 returns on 30 March 1999, the prudential regulator knew the following:
(a) Equitable had stated, by letter dated 21 January 1999, that it had entered into a binding contract of reinsurance;
(b) Equitable’s returns acknowledged the first premium of £150,000 in relation to this contract;
(c) The detailed terms of the reinsurance had been amended a number of times to comply with the requests of the prudential regulator and GAD, over a period of many weeks, and all the points which they considered needed to be addressed in the final terms of the contract to achieve the desired reserving effect in the returns had been advised to Equitable over a month previously.
Furthermore, on 20 April 1999 the prudential regulator was provided by Equitable with the final version of the term sheet. Before the scrutiny of the 1998 returns was completed, GAD was also provided by Equitable with the signed reinsurance treaty wording itself, and GAD satisfied itself that the credit that Equitable had taken for the reinsurance treaty in those returns was appropriate in the light of the finally executed treaty – which was fully in accord, in all respects relevant to the credit that could properly be taken for the reinsurance in the returns, with the final version of the term sheet, and confirmed to be so by GAD.
For these reasons, GAD and the prudential regulator were of the view that the treatment of the reinsurance treaty in Equitable’s 1998 returns (and those for subsequent years) was satisfactory. The bodies under investigation consider that, on the basis of their knowledge at the time, they were reasonably of that view.
458 The public bodies then turned to the credit taken for the financial reinsurance arrangement within the Society’s 1999 and 2000 returns, and specifically as to whether the credit taken ought to have reflected the net present value of the cash flows payable under the reinsurance treaty, which was nil.
459 The public bodies first said that they agreed that, under the terms of the treaty, the Reinsurance Claims Amount ‘was not payable in cash to Equitable, but was rather to be withheld by IRECO (a feature which was common to many types of financial reinsurance arrangements at the time in question)’.
460 The public bodies submitted, however, that it would be wrong to suggest that the Society had in fact taken credit within its returns for the Reinsurance Claims Amount ‘to an extent which was not justified having regard to the present value of the cash sums, associated with and expressed as percentages of the Reinsurance Claims Amount, which Equitable was entitled to receive under the treaty’. The public bodies said that ‘on the contrary, the amount of credit taken for the treaty was justified having regard to the present value of those cash sums’.
461 The public bodies further submitted that:
The real issue is whether and to what extent Equitable was entitled to take credit for the Reinsurance Claims Amount on the basis of the cash sums it was entitled to receive under the reinsurance treaty.
462 The public bodies went on to submit that:
These cash sums included, in particular, the interest amounts on the Reinsurance Claims Amount available to Equitable annually under Article IV of the treaty. In the calculation of the credit taken for the treaty, it was appropriate to assume that these interest payments would be drawn by Equitable. This was because they provided the positive yield on the reinsurance offset against Equitable’s gross liabilities which was required to comply with section 35A of the Insurance Companies Act 1982.
Furthermore, the annual interest payments applied to the Reinsurance Claims Amount, unreduced from its original level, and were payable in perpetuity. The reason for this was that the Adjustment Premiums, by which the Reinsurance Claims Amount would be repaid over a number of years under the treaty, did not need to be allowed for in the calculation of the offset. This was because their payment was contingent on the emergence of future surplus in Equitable (in accordance with sections 5.5 and 5.6 of PGN 1998/1). The present value of the annual interest payments exceeded the face value of the Reinsurance Claims Amount in all the years 1998 to 2000.
It was for this reason that the terms of the treaty justified the amount of credit that was taken for it in the returns.
463 The public bodies further submitted that:
Article IV of the treaty also entitled Equitable to make annual 10% draw downs in cash against the Reinsurance Claims Amount, as an alternative to drawing the annual interest payments described above.
This provision was included in the treaty to ensure that cash amounts were still available to Equitable in respect of the Reinsurance Claims Amount in circumstances in which the reinsurance offset was made against gross liabilities valued at a zero rate of interest and the annual interest payments were therefore not required to comply with section 35A of the Insurance Companies Act 1982.
464 The public bodies submitted that ‘accordingly, the criticism of GAD and the prudential regulator… for allegedly failing to follow up concerns which they had expressed in relation to the terms of the treaty in the period during which these were amended is entirely misplaced’.
465 The public bodies went on to submit, in relation to cash repayments and interest fees, that my conclusion was based on an assumption:
… that, in valuing the cash sums payable to Equitable under the treaty, it was necessary to include both the amount of the repayments of the cash sums, and the accumulated interest on the cash sums due to IRECO, because their payment was not contingent on the emergence of future surplus in Equitable. On this basis, [I have concluded] that the net present value of the cash flows under the treaty was zero, so that no credit could properly be taken for it in Equitable’s returns.
466 The public bodies further submitted that:
This view of the appropriate treatment of the reinsurance treaty under the applicable regulations and associated prudential guidance depends upon adopting an interpretation of the treaty which is contentious and contrary to the intention and contemporaneous understanding of the actual parties to the treaty. The way in which the treaty was intended and understood to operate at the time was as requiring cash repayments and interest fees to be payable only out of future surplus (so that Equitable’s liability in respect of them could be left out of account in accordance with sections 5.5 and 5.6 of PGN 1998/1 and in particular its paragraph 5.5.6).
467 The public bodies submitted that it had been reasonable for GAD and the prudential regulators to have understood this to be the effect of the treaty at the time.
468 The public bodies went on to submit that:
If the prudential regulator or GAD had taken the view that a change to the wording of the treaty was required in order for it to achieve its intended effect of making cash repayments and interest fees payable only out of future surplus, there can be no doubt that such a change would have been requested and made. As it was, it was reasonable for Equitable, IRECO, the prudential regulator and GAD to understand that the treaty had this effect without the need for amendment.
It was not the general policy of the prudential regulator to instruct counsel to review the legal contracts entered into by the companies they were regulating. The bodies under investigation have, however, received legal advice in the context of this investigation that the understanding of all concerned at the time as to the effect of the treaty is arguably correct.
469 The public bodies continued by submitting that ‘the fact that…, acting years later with the benefit of hindsight, [it is possible to conclude] that another legal interpretation of the treaty is preferable does not in any way undermine the reasonableness of the conduct of the prudential regulator or GAD at the time’.
470 Dealing with the limit of £100 million to the reinsurer’s exposure under the treaty (with the implication that any credit taken by Equitable in their returns for the reinsurance should not have exceeded £100 million), the public bodies submitted that it was ‘essential in this regard to distinguish the position under the terms of the treaty and the position under the side letter between Equitable and IRECO’.
471 The public bodies further submitted that:
By the side letter the parties agreed that “should the withheld fund exceed £100,000,000 sterling and no solution can be found” under the terms of the agreement, then the treaty would be cancelled.
However…, the regulator and GAD were not aware of this letter as Equitable did not disclose it at the time, and it did not come to light until 24 September 2001. The side letter should therefore be left out of account for present purposes.
472 The public bodies went on to submit that:
The relevant term of the treaty (the last paragraph of Article XIII) provided: “In the event that the total withheld reinsurance claims balance exceeds £100,000,000 at any December 31 negotiations will take place to find a mutually agreeable restructuring of the treaty which will include a redefinition of the Adjustment Premiums in respect of future years.”
The only obligation which this term even purported to impose on Equitable was an obligation to take part in negotiations. There was no obligation to act in good faith, or even reasonably, in the conduct of such negotiations, let alone to agree anything. Furthermore, as a matter of law, an agreement to negotiate is unenforceable. Accordingly, this term did not impose any legal obligation on Equitable or confer any legal right on IRECO at all. In those circumstances, the treaty remained in force indefinitely and could not be cancelled by IRECO. It is therefore wrong to suggest that the terms of the treaty imposed a limit of £100 million (or any limit) on the reinsurer’s exposure, or meant that the credit taken by Equitable for the treaty in its returns should have been limited to £100 million.
473 The public bodies concluded by submitting that, for all these reasons, any adverse finding would be unreasonable and flawed.
My evaluation of those submissions
474 I was not persuaded by the submissions of the public bodies on this matter. The absence of a concession under section 68 of the 1982 Act – a concession to which the Treasury referred when they first discussed with the Society the possibility of arranging a financial reinsurance treaty – meant that no credit could be taken within the Society’s 1998 regulatory returns as it was concluded after the valuation date for those returns.
475 While I have not examined the financial reinsurance arrangements of all other life insurance companies at the time relevant to my report, I gain no assistance from the fact that others are said to have used such arrangements.
476 Nor am I persuaded that the issues concerning the proper reserving treatment for the Society’s arrangement can only be identified with the benefit of hindsight or through contentious interpretations of the terms of the treaty.
477 GAD at the time identified the issues which I have concluded meant that no offset was permissible and notified the FSA of those issues. The concerns expressed by GAD were not resolved but the FSA, acting on behalf of the prudential regulators, nevertheless permitted the Society to take credit in its regulatory returns for the financial reinsurance arrangement with IRECO. The FSA were wrong to do so.
478 Nor do I agree that the existence of the ‘side-letter’ had any impact on the amount of offset that the Society could take for the arrangement within its regulatory returns – although in reaching my conclusion, I disregarded the existence and terms of the side-letter.
479 I would note also that the FSA received an opinion, first given orally to them by Counsel on 22 November 2001 (see entry 4 for this date within Part 3 of this report), with a written draft provided on the following day (see the entry for that date at 17:01) which (i) advised that the side-letter added nothing to the provisions of the arrangement and (ii) which otherwise confirmed the conclusion to which I have come as regards the economic substance of both the original and revised versions of the IRECO treaty. Such legal advice was not sought at the time that the FSA had to decide whether to permit the credit sought.
480 Nor would I accept that the existence of side-letters in relation to financial reinsurance treaties was something distinctive about the Society at this time. As was noted in a paper prepared for the actuarial profession’s 1991 General Insurance Convention:
It is not easy to describe an elephant but “you know one when you see one”. Financial reinsurance is similar… Financial reinsurance contracts will tend to depart from some of the features [of traditional reinsurance]… and examples of such departures are… [that] there may be side agreements which significantly modify the terms of the policy document… In order to operate effectively, a number of financial reinsurance contracts may need side agreements not apparent from the contracts themselves, or at least a clear understanding between the parties covering how the contract is to be managed over the longer term.
481 The declaration by the Society of a bonus in March 1999, and the publication of its regulatory returns shortly afterwards, were together a critical juncture in the story which unfolded in relation to the Society.
482 The context in which the Society decided to conclude a financial reinsurance arrangement needs to be remembered. The prudential regulators told the Society that, without some means of improving its solvency position, those regulators would act to prevent the declaration of a bonus.
483 Given the nature and extent of the problems which had brought the Society to that position, the prudential regulators were, in my view, under an obligation not simply to accept assurances about the existence, scope, nature and effect of the proposed arrangements, without having verified that those assurances were correct and could be relied on.
484 Those regulators should not have accepted any reserving offset unless and until they had seen the terms of the financial reinsurance arrangement, had considered those terms, and concluded that the terms and economic substance of the treaty entitled the Society to take the credit that it took.
485 None of that happened. The submissions of the public bodies do not detract from the reasons underlying my conclusion. If anything, those submissions serve to confirm the correctness of that conclusion.
My finding
486 I find that the failure by the FSA, acting on behalf of the prudential regulators, to (i) ensure that the financial reinsurance arrangement was not taken into account within the Society’s 1998 returns without an appropriate concession being given, and (ii) ensure that the credit taken by the Society within its returns for 1998, 1999 and 2000 properly reflected the economic substance of that arrangement, fell short of the standard that could reasonably be expected of such regulators.
The basis for my finding concerning the disclosure of the potential impact of the Hyman litigation
The issue and relevant background
487 While the Hyman litigation was proceeding through the Courts, the Society – and the prudential regulators – undertook scenario planning to consider the likely impact of a range of possible outcomes to that litigation.
488 Consideration was given to what those scenarios would mean for the financial position of the Society and for its freedom to maintain the policies it had adopted to manage its affairs, and what other consequences the possible outcomes of the Hyman case could have for the Society and its members.
489 Even assuming that the financial reinsurance arrangement which the Society had entered into, and for which it proposed to take a substantial offset within its 1998 regulatory returns, entitled the Society so to do, the continuation of that arrangement was contingent on the Society being able to continue to apply its differential terminal bonus policy. Yet that ability was precisely the issue at stake in the Hyman proceedings.
490 Furthermore, if the Society were found not to have been able to apply its differential terminal bonus policy, the question would arise as to how to remedy the position of those policyholders with policies which contained guaranteed annuity rates who had retired since 1 January 1994, but who had not been provided with the option of taking benefits without the reduction in terminal bonus applied under the Society’s differential terminal bonus policy. The question of compensating such policyholders would thus arise if the Society lost the Hyman case.
The facts
491 On 7 December 1998, the Treasury, then the prudential regulators of insurance companies, had written to the Society to record the outcome of a meeting which had been held on 3 December 1998. The Treasury recorded that, at that meeting:
We also indicated that we expected an appropriate statement on contingent liabilities to appear in your regulatory returns, related to the risk [of] successful challenge to the Equitable Life’s bonus practice with regard to guaranteed annuities.
492 However, no such statement was made in the Society’s 1998 or 1999 returns, despite the invitation of the prudential regulators at the meeting and in the follow-up letter.
493 In addition, continuation of the financial reinsurance arrangement that Equitable were negotiating at the time their 1998 returns were submitted to the prudential regulators was dependent on the continuation of the Society’s differential terminal bonus policy. That was also not disclosed within the Society’s 1998 returns.
494 On 4 May 1999, the Society informed the FSA – by now, under contract, undertaking on behalf of the Treasury the prudential regulation of insurance companies – that it estimated that an immediate provision of £400 million would be required if the Society lost the Hyman litigation, in order to compensate those GAR policyholders who had retired between 1995 and 1998 without receiving benefits which had attracted the full guaranteed annuity rate applied to the total policy fund. No statement to that effect was made within the Society’s regulatory returns.
495 On 21 January 2000, prior to Equitable submitting their 1999 returns, the Court of Appeal had ruled against Equitable in the Hyman case, thus increasing the likelihood that the differential terminal bonus policy would be found to be unlawful and that compensation would have to be paid.
496 On 1 February 2000, the Society wrote to its policyholders, informing them that, even if the Court of Appeal ruling was upheld by the House of Lords, no significant additional costs would be imposed on the Society. A copy of this letter was provided to the prudential regulators and to GAD.
The statutory and administrative context
497 Section 17 of the Insurance Companies Act 1982 required every insurance company to prepare a revenue account for the year, a balance sheet as at the end of the year, and a profit and loss account for the year in a prescribed form. These documents formed part of the regulatory returns.
498 All insurance companies which wrote long term business were also required by Section 18 of the 1982 Act once in every twelve months to cause an actuarial investigation to be made into its financial condition by its Appointed Actuary, who had to report the results of that investigation in a prescribed form within the returns.
499 The amount of the long term liabilities as calculated by the Appointed Actuary, pursuant to Section 18 of the 1982 Act, were then included in the balance sheet required by Section 17 of the 1982 Act.
500 Section 18(4) of the 1982 Act provided that, for the purposes of the investigation that the Appointed Actuary undertook into the financial condition of the company and reported in the returns, the value of any assets and the amount of any liabilities set out therein were required to be determined in accordance with the applicable valuation Regulations. With effect from 1 July 1994, those Regulations were set out in Part VIII and Part XI of the Insurance Companies Regulations 1994.
501 Regulation 60 of the 1994 Regulations provided that, subject to the detailed requirements of Part XI, the amount of liabilities of an insurance company in respect of long term business was required to be determined in accordance with generally accepted accounting concepts, bases and policies or other generally accepted methods appropriate for insurance companies. It also provided that, in determining the amount of liabilities of an insurance company, all contingent and prospective liabilities were to be taken into account within the returns.
502 Schedule 1 to the Insurance Companies (Accounts & Statements) Regulations 1996 set out the form of the balance sheet to be reported in the returns. Paragraph 13(1)(c) of that Schedule required the disclosure of contingent liabilities, subject to a de minimis exemption, not already recognised in the balance sheet, other than those arising under inward contracts of insurance or reinsurance.
503 Paragraph 12(2)(d) of Schedule 4 to the Insurance Companies (Accounts & Statements) Regulations 1996 required the Society to indicate the nature and extent of the cover given under each outward reinsurance treaty.
504 Paragraphs 25 and 26 of section 5.6 of the Treasury’s 1998 guidance on the preparation of the returns stated:
“Inward” in the expression “inward contracts of insurance and reinsurance” is intended to exclude from the [disclosure] exemption contracts of reinsurance where the reporting company is the reinsured.
The disclosure of contingent liabilities is subject to a de minimis exemption. One or more contingent liabilities need not be disclosed provided that the aggregate value of the non-disclosed contingent liabilities does not exceed 2.5% of the… long term business amount.
My assessment
505 The question arose as to whether the two issues raised above – that the continuation of the Society’s financial reinsurance arrangement was contingent on the Society maintaining its differential terminal bonus policy, and that the Society, if it lost the Hyman case, would be exposed to significant compensation costs – should have been disclosed within the Society’s regulatory returns for 1998 and 1999 as being contingent liabilities above the minimum disclosure threshold.
506 I am aware that other proceedings are ongoing which focus, among other matters, on the treatment that the Society and its auditors gave to these issues within the Society’s Companies Act accounts and within its regulatory returns. In that context, it seems to me appropriate to make no finding regarding that matter.
507 However, whatever the position may be as to that, the prudential regulators at the time asked twice – first in a meeting on 3 December 1998 with the Society and then in a follow-up letter from the Treasury on 7 December 1998 – that such disclosure should be made. That indicates that those regulators at the time considered that this needed to be done.
508 Yet when no such disclosure was made, those regulators did not query that omission or ask for justification as to the basis on which the decision not to make such a statement had been made.
509 Nor did those regulators, when considering the Society’s regulatory returns for 1999, ask the Society to justify the content of the letter it had sent to its policyholders. That letter had said that no significant additional costs would be imposed on the Society. However, the information provided by the Society to the prudential regulators was that an immediate provision of £400 million would be needed in respect of the compensation costs alone. That appeared to be inconsistent with the content of the Society’s returns.
510 I consider that the prudential regulators should have followed up their concerns and should have satisfied themselves that the Society’s decision was reasonable and that it was, in this respect, acting prudently and not contrary to the interests of its policyholders.
Submissions I have received and my evaluation of those submissions
Submissions by the public bodies
511 When I informed the public bodies that I was minded to come to this view, those bodies told me that, in their view, neither the lapse of the Society’s financial reinsurance arrangement nor the potential costs of it losing the Hyman case had constituted a contingent liability under the applicable Regulations.
512 In addition, the public bodies said that, even if one or both of those matters constituted a contingent liability, they were less than the threshold value, below which there had been no disclosure requirements, and therefore they did not have to be disclosed.
513 The public bodies also told me that those matters had also not been disclosed in the Society’s Companies Act accounts, which had been approved by Equitable’s external auditors. Those bodies said that the treatment in the returns was required to follow that in the accounts, and Equitable’s auditors had also agreed with the position taken in the returns.
514 In support of these views, the public bodies submitted that, with regard to the decision by the Society not to disclose these matters within its 1998 and 1999 returns:
Equitable’s decision not to disclose these matters was reasonable in the light of the legal advice which Equitable had received at the material times. Any criticism of Equitable in this regard relies on the use of hindsight, with knowledge of the House of Lords’ judgment in the Hyman litigation, rather than being judged in the context existing at the relevant times.
515 As to the two occasions, prior to the submission of the Society’s 1998 regulatory returns, on which the prudential regulators had asked the Society to include such notes within those returns, the public bodies submitted that:
Notwithstanding the fact that there was no requirement to this effect under the applicable regulations, and that there was therefore no formal basis on which to insist upon it, the prudential regulator did suggest to Equitable that it should include a statement in its returns concerning the risk of successful challenge to the [differential terminal bonus policy], as indicated in HMT’s letter to Equitable dated 7 December 1998. This was entirely a matter for Equitable (and its auditors) to decide, and not an issue in respect of which the prudential regulator could have required Equitable to amend its returns. Ultimately, Equitable chose not to include such a statement in its returns. At that point, there was nothing further that the prudential regulator reasonably could do, given that Equitable was not in breach of the regulations.
My evaluation of those submissions
516 I was not persuaded by the submissions of the public bodies on this matter. It may well be that it can now be established that the Society had received legal advice to support its position.
517 However, that the Society was acting on such advice does not help explain why those regulators failed to pursue a matter which they had raised and about which they received further information that the Society’s public position may not, at that time, have been consistent with what the Society had told the prudential regulators.
518 The legal advice received by the Society was not known to the prudential regulators at the time nor had those regulators been told then on what basis the Society’s decision had been taken.
519 Moreover, the submissions by the public bodies have addressed a conclusion that I have not reached – nor is it one that I could reach. It is not for me to question the reasonableness of the Society’s decisions. What I am concerned with is the acts and omissions of the prudential regulators.
520 There is no evidence that the existence of legal advice to the Society concerning its obligations in respect of the disclosure of the possible impact on it of losing the Hyman case was known to the prudential regulators at the time or that GAD took such advice into account when scrutinising the Society’s regulatory returns.
521 The failure by the prudential regulators to pursue, as part of their consideration of the Society’s returns, matters which they had raised and which were of potential significance to the Society and its policyholders constituted a departure from what it is reasonable to expect from those regulators.
My conclusion
522 I find that the failure of the FSA, acting on behalf of the prudential regulators, to pursue the issue of the proper disclosure, within the Society’s regulatory returns for 1998 and 1999, of the potential impact on the Society of it losing the Hyman litigation fell short of the standard that could reasonably be expected of such regulators.
The basis for my two findings concerning the decision to permit the Society to remain open
The issue and relevant background
523 Following the decision of the House of Lords in the Hyman case, the Society had been faced with an extremely serious situation. That decision had profound effects.
524 The financial reinsurance arrangement that the Society had entered into was to lapse, as a result of the ending of the Society’s differential terminal bonus policy. Without the credit that had been taken by the Society within its returns for that arrangement, a serious question arose as to whether the Society could meet its required solvency margin.
525 The Society was immediately faced with a significant reduction in what the Society regarded as the assets available to meet the costs in respect of those policyholders who chose to take benefits calculated with regard to guaranteed annuity rates. Those costs had to be shared, almost certainly by benefit reductions, across all policyholders – as any ‘ring-fencing’ of policyholders with annuity guarantees had been declared unlawful by the House of Lords.
526 That gave rise to inbuilt conflicts between the interests of different classes of policyholders which, in the circumstances facing the Society at the time, could not be resolved using the normal mechanisms available to life insurance companies – and which meant that the Society’s situation was inherently unstable.
527 In that context, the Society decided to put itself up for sale. The question arose as to what the regulatory response to that decision should be. The FSA decided not to intervene to require the Society to close to new business whilst it sought a buyer.
The facts
528 I have been unable to find any documentary evidence relating to the decision taken by the FSA to permit the Society to remain open to new business after the Hyman judgment. During the investigation, the basis on which that decision was taken by the FSA was explained to me.
529 According to the FSA, the basis of their decision to permit Equitable to remain open to new business and seek a buyer, which, according to the FSA, was the right decision in light of all the facts and circumstances known to the FSA at the time, was as follows.
530 I have been told that the FSA believed that it took a reasonable decision to allow the Society to remain open, balancing the interests of those persons holding approximately one million existing policies against the possible risks to a small number of new joiners, on the basis that new joiners could be compensated if there were any mis-selling – and that the FSA had taken a reasonable view of the availability of compensation in the event that any mis-selling did occur.
531 I have been told that, if the FSA had not allowed the Society to write new business, this would have had a detrimental effect on its sale value, which would, in turn, have been damaging to the interests of the Society’s existing policyholders. It is said that the proceeds of de-mutualisation and sale would have benefited all policyholders and would have enabled the Society to restore the bonus cuts which it had imposed following the decision of the House of Lords.
532 I have also been told that, at the time, the FSA believed that the Society was ‘in compliance with its statutory requirements and was also solvent on a regulatory basis’. Accordingly, had the FSA decided to intervene to close the Society to new business or to prevent it from advertising, it was not clear what powers the FSA would have had to do so.
The statutory and administrative context
533 By section 11 of the Insurance Companies Act 1982, the prudential regulators were empowered to withdraw the authorisation of an insurance company to write new business, where it appeared to those regulators either that the company had failed to satisfy an obligation to which it was subject by virtue of the 1982 Act or where there existed a ground on which those regulators would have been prohibited from issuing an authorisation to the company.
534 With effect from 1 July 1994, section 12A of the 1982 Act gave the prudential regulators powers in urgent cases to suspend the authorisation of an insurance company to write new business.
535 The grounds on which that power could be used included that the company appeared not to be satisfying the criteria of sound and prudent management. Those criteria included requirements that the company carried on its business with integrity, due care, and the professional skills appropriate to the nature and scale of its activities and that the company conducted its business with due regard to the interests of policyholders and potential policyholders.
536 Throughout the period covered by this report, the prudential regulators also had powers of intervention which could be used in situations where it appeared that a company might not be able to fulfil the reasonable expectations of policyholders or potential policyholders, where it appeared that a company might not be able to meet its liabilities, or where it appeared that a company might not be able to satisfy an obligation to which it was subject by virtue of the 1982 Act.
537 The grounds on which those powers were exercisable were specified in section 37 of the 1982 Act and the powers of intervention were set out in sections 38 to 45 of that Act.
538 Public authorities are under an obligation generally to act in accordance with established principles of good administration. As part of that obligation, those authorities are required to take reasonable decisions based on all relevant considerations and leaving out of account irrelevant considerations.
539 Such public authorities are also required to keep proper and appropriate records as evidence of their activities, including a record of the reasons for their decisions.
My assessment
540 I accept the account provided by those involved in the decision not to intervene to close the Society to new business and I have assessed that decision having regard to that account. However, the lack of any documentary record means that I have been unable to verify the evidence which underpinned that decision at the time.
541 I consider that the failure to record their decision and the reasons for that decision at, or shortly after, the time it was taken represents a departure by the FSA from the standard expected of such regulators.
542 But what of the basis on which that decision was taken? The question before me is whether the rationale for that decision indicates that the FSA took their decision having regard to all relevant considerations, leaving irrelevant considerations out of account, and whether they reached a decision that, acting reasonably, it was open to the FSA to make.
543 Parliament bestowed on the prudential regulators a power to intervene where it appeared that an insurance company might not have been able to fulfil the reasonable expectations of policyholders and/or of potential policyholders.
544 When that power was introduced, Parliament recognised that circumstances would arise where the interests and expectations of existing and potential policyholders would be different or might conflict.
545 The prudential regulators were under a duty to consider whether particular circumstances or events amounted to grounds for the exercise of a power of intervention and, if so, whether it was appropriate to exercise such a power.
546 There can be no doubt that, after the decision of the House of Lords in Hyman, the circumstances which gave rise to the duty to consider what action, if any, to take to protect the reasonable expectations of potential policyholders had arisen.
547 Those regulators were therefore under a duty to consider whether it would be appropriate to exercise any of the powers of intervention that the prudential regulators possessed for that purpose.
548 However, in the circumstances which pertained after the decision of the House of Lords in the Hyman case, it was not only the reasonable expectations of potential policyholders which required consideration. Those of existing policyholders were also at stake.
549 I consider that, in this context, the aim of the FSA, acting on behalf of the prudential regulators and acting reasonably, should have been to identify an appropriate course of action which met the aim of protecting the interests and reasonable expectations of both existing and potential policyholders and which minimised any adverse impact on the other class of policyholder if the interests and/or expectations of those different classes were considered to conflict.
550 Consideration had to be given, as distinct questions, to what action was necessary in order to protect the interests of (i) existing policyholders, (ii) potential policyholders, and (iii) both classes of policyholder.
551 A number of factors were not taken into account by the FSA, acting on behalf of the prudential regulators, which were relevant to their consideration of the question of what action, if any, was appropriate to protect the interests and reasonable expectations of both the existing and potential policyholders of the Society.
552 Without ring-fencing and in a context of increased liabilities to others, it was inevitable that new policyholders would be significantly disadvantaged by entry into a fund which the FSA knew, or should have known, could not continue to honour the guarantees that the Society had given, as it was required to do, while at the same time continuing to provide the investment return which potential policyholders would reasonably have expected to receive once they joined.
553 I consider that any prudential regulator, acting reasonably, would not have made the assumptions that the FSA made about the nature of the expectations that the Society’s advertising might be creating or about the availability of compensation which might exist for any mis-selling as a result of such advertising.
554 The FSA did not, for example, review the advertising that the Society was issuing to ensure that the FSA understood what the reasonable expectations of new policyholders were likely to be.
555 The FSA also made no enquiries to satisfy themselves that mis-selling compensation, the cost of which in any case would have to be met by the members of the Society themselves – including those joining in this period – was in principle and in practice likely to be available. Those considerations were left out of account by the FSA.
556 That brings me to a further point. The basis of the FSA’s decision to take no action appears to have been largely predicated on a balancing exercise undertaken to weigh the relative interests of the Society’s existing policyholders against those of new entrants. That the former, in the FSA’s view, were considerably larger in number than the latter was a significant consideration in their decision.
557 However, for two reasons I consider that this approach was significantly flawed. The first is that those who might be directly affected by the decision by the FSA to take no action were not limited to those who became new policyholders during this period. The second is that the FSA had no sound basis at the time they took their decision for assuming, as the FSA did, that the number of people newly investing in the Society would be minimal.
558 As the FSA knew, the bulk of the Society’s business constituted recurrent single premium business, where an existing policyholder had the right – but not the obligation – to pay further premiums at any time. The majority of the Society’s existing policyholders, including those with guaranteed annuity rates, were entitled to pay further money into the with-profits fund during this period.
559 Those who were considering whether to do so – particularly those whose policies did not contain guaranteed annuity rates, who were most exposed to the risks inherent in the position – were directly affected by the FSA’s decision to take no action concerning the Society’s continued ability to write new business.
560 Even though the withdrawal or suspension of authorisation would not itself have prevented policyholders from making further contributions under existing policies, such intervention action would have put those existing policyholders on warning as to the problems that such action was designed to address.
561 That relevant consideration was not among the considerations to which the FSA had regard in coming to its decision.
562 The FSA’s assumption that only a small number of new policyholders would be affected by their decision to take no action was, furthermore, not based on any empirical analysis that might have provided a sound basis for such a decision. The FSA did not seek, as they did after Equitable had closed to new business, information from the Society as to the number of the transactions it was undertaking.
563 The FSA did not therefore know the number of new entrants or the number of further premiums being paid. The FSA’s decision was largely based on an assumption, for which there was no apparent basis, that only a small number of people might be affected by that decision.
564 I consider that the decision by the FSA to take no action did not take into account relevant considerations that should have been taken into account and that considerations which were accorded importance in their decision-making process were based on assumptions made by the FSA which had no sound basis in fact.
565 That conclusion is strengthened when consideration is given to the legal basis on which it is said that the FSA’s decision was taken. It is not the case, as has been suggested to me, that the prudential regulators had no powers to take intervention action unless an insurance company was already in breach of its regulatory requirements or was insolvent on a regulatory basis.
566 The powers which Parliament conferred on the prudential regulators were exercisable in situations where those regulators considered that there was a risk that a company might not be able to fulfil the reasonable expectations of policyholders or potential policyholders, where it appeared that a company might not be able to honour its liabilities, or where it appeared that a company appeared to have failed to satisfy an obligation to which it was subject by virtue of the 1982 Act. The exercise of those powers should have been, but were not, considered by the FSA when they took their decision to take no action.
567 Furthermore, given the financial position of the Society at that time, any prudential regulator, acting reasonably, could not have been satisfied, without reviewing the information contained in the advertisements that it was using, that the Society, by advertising and writing new business, was acting in line with the interests of its potential policyholders in this respect. The FSA, however, did not review those advertisements.
568 Nor do I consider that any prudential regulator, acting reasonably, could take into account of the possibility of compensation for mis-selling when it had not established that such compensation would be available.
569 I consider that the FSA acted unreasonably in assuming that such compensation would be available where the FSA knew, or should have known, that it was not likely to be available to those existing policyholders who made further contributions without relying on anything that the Society did or said.
570 I am not suggesting that it was unreasonable for the prudential regulators to give the Society an opportunity to find a buyer. However, it does not follow that the only options open to the FSA in such a situation were either to close the Society to new business or to do nothing.
571 The FSA had other options available to them which the FSA failed to consider. A requirement could have been imposed on the Society as to advertising. Equitable, after all, had made much of its ability to attract new business without the assistance of third parties and had also treated much of its new business as ‘execution-only’.
572 A premium limitation could have been imposed, which restricted new business to a certain amount. That would have enabled the FSA to be sure that those effecting new business with the Society were indeed limited in number or that such business was at least limited in value, as the FSA had simply assumed would be the case.
573 The authorisation of the Society could also have been suspended as a matter of urgency, pending the completion of the sale – after which time the Society could have submitted an application for re-authorisation. Any such suspension could have been explicitly linked to the sales process and imposed as an interim way of recognising the desirability of progressing the sale of the Society while seeking to protect the interests of existing and potential policyholders.
574 Given that the Society’s attempts to sell itself were no secret, such a suspension, if linked to that process, should not have been seen as anything other than caution while the sales process was underway. That might have protected the interests of those existing policyholders who were considering making further contributions and also the interests of potential policyholders, pending the outcome of the sales process.
575 Even in the absence of considering any of these actions, non-statutory action could have been considered by the FSA with a view to persuading the Society to take a different line.
576 The DTI had used such action in the Nation Life case in the 1970s, persuading that company to delay banking any cheques it received from existing or new policyholders and/or to delay issuing new policies while the sales process continued. The FSA should have considered what equivalent forms of non-statutory action were available to them – but did not do so.
577 My conclusion is that the decision by the FSA to permit the Society to remain open to new business was flawed. That decision was taken leaving out of account relevant considerations which should have been taken into account and without having regard to the range of powers and other options available to the FSA.
Submissions I have received and my evaluation of those submissions
Submissions by the public bodies
578 When I informed the public bodies that I was minded to come to this view, those bodies told me, in relation to the failure to record the decision by the prudential regulators to permit the Society to remain open after the decision of the House of Lords in the Hyman case, that, in their view, there was no doubt that the decision to allow Equitable to remain open was taken after careful consideration and at the most senior level of the FSA.
579 While accepting that the decision had not been recorded, the public bodies disputed that this justified an adverse finding as, they said, there is no public law obligation to record decisions not to take action.
580 In support of that view, the public bodies submitted that, ‘whilst it is undoubtedly good practice, it is not obligatory and in a crisis situation it is not always achievable’ to record such decisions.
581 In relation to the basis on which the decision was taken by the prudential regulators to permit the Society to remain open after the decision of the House of Lords in the Hyman case, the public bodies told me that, in their view, it had been not just appropriate but necessary for the FSA to balance the interests of existing and potential policyholders when taking that decision.
582 The public bodies told me that the FSA had considered that a successful sale of the business was in the best interests of policyholders, and that allowing Equitable to remain open to new business was essential to give Equitable the best chance of finding a buyer.
583 In the circumstances, the public bodies said, none of the other regulatory steps available to the FSA would have been appropriate and they would instead have acted to undermine the prospects of a successful sale.
584 In support of these views, the public bodies submitted that my conclusion rested on:
… the misplaced belief that there were realistic options available to the FSA which would have protected such investors and which were consistent with permitting Equitable the opportunity to find a buyer. The reality is that any such options proposed would have undermined the sale process and would therefore have acted counter to the overall course of action which was reasonably being pursued.
585 As to why the FSA had not made enquiries into the availability of compensation for those existing or new policyholders who might suffer loss as a result of the Society being permitted to remain open, the public bodies submitted that:
No specific enquiries were made by the FSA because none was necessary: there was no uncertainty on the FSA’s part as to whether compensation would be available in principle or in practice. New policyholders who were victims of mis-selling would have recourse to the Financial Ombudsman Service (FOS) or its predecessor, in the event that Equitable itself did not resolve a complaint satisfactorily. The FSA was well aware of the operation of both bodies, not least because it was involved in setting up the FOS during 2000 and 2001 …
The only circumstance in which compensation would not have been available by this route would be in the event of Equitable’s insolvency. However, in this situation the Financial Services Compensation Scheme (or its predecessor) would have been available to pay claims (subject to the rules of that Scheme).
586 As to the basis on which the FSA had concluded that only a small number of people would be potentially affected by the decision to permit the Society to remain open, the public bodies submitted that they:
… consider that it was reasonable for the FSA to have formed the view that the number of policyholders who might pay new premiums to Equitable (including existing policyholders) would be small relative to the total number of existing policyholders. The FSA formed this view on the basis of its knowledge of Equitable (which was under intense scrutiny at this stage), including the fact that existing and potential policyholders were aware of the problems facing Equitable from widespread reports in the press.
587 The public bodies also submitted that:
Furthermore, the FSA had already noted that it would only allow Equitable to remain open if “a suitable buyer for the Society was likely to be found quickly”. Equitable itself had set a deadline for bids of 20 November 2000 and believed that a sale would be agreed “in principle” by the end of 2000. This would further have limited new premiums which might be paid.
588 The public bodies went on to submit that:
The common sense conclusion that the number of policyholders who may pay new premiums to Equitable would be small was also reasonable in light of information from previous years. It could reasonably have been anticipated that the number of new policyholders joining, up to the point at which it was clear there would (or would not) have been a buyer, would have represented no more than 2-3% of the number of existing policyholders, and their premiums would be no more than 1% of the total fund. In the event new business turned out to be much smaller even than that estimate; only around 16,000 policyholders joined Equitable between the House of Lords’ judgment and closure to new business – some 1% of the existing membership.
589 The public bodies submitted that, in addition:
Existing policyholders paying further premiums were historically a smaller group than new policyholders, and given the extra information they had received it was reasonable for the FSA to conclude that their premiums would represent less than 0.5% of the total fund.
590 As to the inevitable disadvantage that new policyholders would suffer, the public bodies submitted that:
The FSA was mindful of the possible risks of investing in Equitable during this period and this was a factor which was taken into account when balancing the interests of different groups of policyholders and potential policyholders. However, there were no realistic options available to the FSA which would have protected such investors and which were consistent with permitting Equitable the opportunity to find a buyer, which was the FSA’s overriding objective.
591 Turning to the available options that had been open to the FSA by way of the powers of intervention, the public bodies told me that they agreed that:
… the FSA’s regulatory powers could be used where it appeared that a company may be unable to meet its liabilities or fulfil the reasonable expectations of policyholders, and that the FSA had at the relevant time a discretionary power (under section 12A of the Insurance Companies Act 1982) to suspend the authorisation of an insurance company to write new business in urgent cases.
592 However, the public bodies submitted that:
… the regulator only needs to consider the exercise of the available powers where they may be useful. There is no need to consider exercising powers when there is no action the regulator wishes to take.
The duty of a reasonable prudential regulator is to assess each situation on its merits, determine what outcome it wishes to achieve and consider what, if any, powers it might exercise to that end. In accordance with that obligation, and fully aware of the legal powers available to it, the FSA consciously decided in this case that taking any action against Equitable would have undermined the desired outcome of a successful sale.
593 The public bodies further submitted that:
In circumstances where the prudential regulator does not wish to take action against a firm, it cannot sensibly be suggested that the prudential regulator is guilty of maladministration if it does not go through each and every potential legal power one by one and explain why its use is not appropriate in the particular case.
In this case, the options available to the FSA were in fact very limited, if it did not want to undermine the achievement of a sale.
594 Turning to each of the specific powers the prudential regulators at that time possessed, the public bodies, with respect to the power to impose a requirement on advertising, submitted that:
… it was reasonable for the FSA to permit Equitable the opportunity to find a buyer. In practice, it was a necessary consequence of that decision that Equitable must be permitted to remain open to new business. Permitting Equitable to advertise for such new business was consistent with that decision. It is difficult to envisage a situation where the FSA would intervene to prevent a firm advertising, while not intervening to prevent it from selling at all: either the company is open and therefore allowed to advertise, or it is not.
To have insisted on a ban on advertising or to have required riskwarnings would also have undermined the prospects of a successful sale. This would have had a detrimental effect on the interests of existing policyholders.
595 The public bodies further submitted that:
… in considering whether Equitable should have been subject to a ban on advertising, it was legitimate for the FSA to take into account the fact that a conduct of business regulatory regime was in force which monitored financial promotions and prohibited firms from advertising in a way which was misleading. Further, the possible need for risk-warnings was reduced due to the knowledge which … both potential and existing policyholders could reasonably be assumed to have had about Equitable’s situation.
596 As to why the FSA had not reviewed the Society’s advertising in that period, the public bodies submitted that:
… it was reasonable for the prudential regulator not to review Equitable’s advertising. Quite apart from the existence of a separate conduct of business regime, there were no particular requirements which the prudential regulator would have wished to impose on Equitable in this respect, as to do so would have undermined the prudential regulator’s main objective of maximising the prospects of a sale.
597 With respect to consideration of the use of the power of intervention which would have imposed a limit on the premium income received by the Society, the public bodies submitted that:
Imposing a limitation on premiums would not have been appropriate in this case because it would have indicated to potential purchasers that the FSA lacked confidence in the future of the business and the prospects of a sale. This would itself have made the firm a less attractive purchase prospect. A previous report from the Ombudsman’s office, into the DTI’s regulation of Nation Life, concluded that it would not have been appropriate to apply premium limits, precisely because it would have damaged attempts to find a buyer for that firm.
598 With respect to consideration of the use of the power of intervention to suspend the authorisation of the Society, the public bodies submitted that:
Suspension of authorisation, whether or not linked to the sale process, would have had the same effect as closure to new business. Either would have made Equitable a considerably less attractive prospect for purchase as it would have made it difficult for Equitable to retain its main asset, the sales force. In any event, to have taken such action in order to put existing policyholders “on warning” would have been an arbitrary step which bore no direct relation to the risk involved.
599 With respect to the consideration of non-statutory action, the public bodies submitted that:
Even if such persuasion would have been appropriate, the bodies under investigation do not consider that the FSA can be guilty of maladministration for failing to consider persuading a company to take unenforceable non-statutory action. In any event, such action would have undermined the principal objective of securing a sale because it would have meant that the product which consumers were considering purchasing was not in practice available: this would have been tantamount to closure with the same negative consequences on the prospects for a sale.
600 The public bodies told me that, for all these reasons, any adverse finding that the basis on which the decision had been taken to permit the Society to remain open to new business would be, in their view, unreasonable and flawed, submitting:
The FSA reasonably decided not to intervene to prevent Equitable from seeking to secure a successful sale having taken the view that this was the best way to protect policyholders’ interests. Having taken this decision, it was reasonable to conclude that there were no additional actions which could have been taken further to protect the interests of policyholders, either by the exercise of any discretionary powers, or by the provision of any additional or different information, or by any other means which would not undermine this wider objective.
My evaluation of those submissions
601 I was not persuaded by the submissions of the public bodies on these matters. Whether or not there is a legal obligation on public bodies to record their decisions, it is a basic principle of good administration that public bodies should record and maintain adequate records of their decisions and the reasons for those decisions, including the factors taken into account or left out of account and the alternative options considered.
602 The public bodies have accepted that no record was made of the decision to permit the Society to remain open for new business. I conclude that the failure by the FSA to record their decision and the reasons for that decision constitutes a departure from accepted principles of good administration.
603 As for the basis on which the decision was taken, I will first address the surprising submission by the public bodies that:
… the regulator only needs to consider the exercise of the available powers where they may be useful. There is no need to consider exercising powers when there is no action the regulator wishes to take.
The duty of a reasonable prudential regulator is to assess each situation on its merits, determine what outcome it wishes to achieve and consider what, if any, powers it might exercise to that end.
604 I reject that submission. It is necessary for a public body to consider the range of powers and options open to it before deciding what course of action to take and which of those powers, if any, that body will exercise.
605 In Chapter 5 of this report, I have explained that there are certain basic principles of public law to which public bodies exercising statutory functions must have regard.
606 Those principles include that such bodies must carry out their legal duties in accordance with the law and that, when public bodies exercise a power, they must act reasonably and in accordance with any conditions imposed by law.
607 Public bodies must properly consider whether to exercise any statutory powers given to them. A public body must give proper consideration to the use of its powers at the point when it reasonably considers that grounds for the exercise of those powers have or may have arisen. Such a body cannot fetter or constrain its ability to give proper consideration to the exercise of its powers.
608 I consider therefore that the FSA were required to consider whether it would be appropriate to exercise any of the powers that they possessed, in acting on behalf of the prudential regulators, before taking a decision not to do so. That consideration did not take place.
609 Finally, I am not persuaded by the submissions which deal with the assumptions made by the FSA. I am satisfied that, at the time that they took their decision, the FSA did not have sound evidence on which they could base those assumptions.
610 That it later turned out to be the case, so I am told, that a limited number of people were affected by that decision does not detract from the fact that the FSA had no basis at the time that they were made for the FSA’s assumptions on these matters.
611 I would also note that it is still not known how many existing policyholders with policies which did not contain guaranteed annuity rates paid further money towards those policies during the relevant period. It is by no means certain, even now, that the number of those affected by the decision of the FSA was as limited as has been suggested to me.
612 The submissions of the public bodies on this matter do not provide any basis on which to change my conclusions on these matters. I consider that the FSA, in failing to record their decision and in failing to take into account all relevant considerations when making it, departed from the standard that could reasonably be expected from the FSA.
My finding
613 I find first that the failure by the FSA, acting on behalf of the prudential regulators, to record their decision to permit the Society to remain open to new business, following its loss of the Hyman litigation fell short of the standard that could reasonably be expected of such regulators.
614 I find secondly that the basis on which the decision was taken by the FSA, acting on behalf of the prudential regulators, to permit the Society to remain open to new business was unsound, not taking into account all relevant considerations and not having a proper legal and factual basis and that this fell short of the standard that could reasonably be expected of such regulators.
The basis for my finding concerning the information provided by the FSA in the post-closure period
The issue
615 In the period between the Society’s closure to new business on 8 December 2000 and the end of my jurisdiction in relation to relevant events on 1 December 2001, the FSA, acting on behalf of the Treasury as the prudential regulators of insurance companies, were contacted by many hundreds of the Society’s policyholders, concerned about the position that the Society was in and about their own future options.
616 The FSA also during this period issued general information relating to the Society through updates, website material, and factsheets.
617 As the Society prepared proposals for a scheme of arrangement under the Companies Act 1985, to compromise the competing claims of the Society’s policyholders, the FSA was also contacted by policyholders about the Society’s proposals and about the attitude of the FSA to those proposals.
The facts
618 In Chapter 8 of this report, I set out the terms of the information published or otherwise provided by the FSA through its general publicity, through its specific responses to the correspondence it received, and through its published assessment of the Society’s Compromise Scheme proposals.
619 I will not repeat all that information here. However, it can be seen from the account given in Chapter 8 of this report that the information produced by the FSA contained the following two key messages:
(i) that the Society was and always had been solvent; and
(ii) that the Society had always met and at that time continued to meet all of the regulatory requirements to which it was subject by virtue of the applicable law, particularly those related to the required minimum margin of solvency.
620 That information, it was said, was based on the information that had been provided by the Society to the FSA and on the assessment that the FSA had made of that information.
621 The Society began to submit monthly solvency figures to GAD and the FSA on 11 August 2000, providing information about the position at each month-end from June 2000 until November 2001, with the exception of November 2000 when no report was submitted. The figures in those monthly reports were based on the Society’s valuation approach.
622 However, at the same time the Society was in protracted discussions with the FSA and GAD about outstanding issues concerning the way in which the Society had determined its liabilities and had purported to establish sufficient provisions to cover those liabilities. Work was also ongoing at that time to establish what the additional potential liability of the Society might be in respect of compensation for any mis-selling of policies which did not contain guaranteed annuity rates without informing those new policyholders of the potential impact of that issue.
623 The monthly solvency reports provided by the Society did not take these issues into account and thus were statements of the solvency position of the Society before the impact on its solvency position of several significant issues was assessed – all of which had an adverse effect on its solvency position, although not all of the issues affected the position in every month.
624 The Society often quantified and provided to GAD and the FSA such quantification of the impact of these issues. GAD or the FSA sometimes sought to quantify other issues themselves.
625 This information informed the analysis that the FSA undertook in relation to the difficulties faced by the Society. That analysis often set out the views of FSA officials and actuaries as to what the solvency position of the Society was at any given time.
626 For example, on 9 July 2001, the FSA’s Head of Actuarial Support asked whether the Society’s Appointed Actuary or its auditors had expressed a view as to the solvency position that the Society was in, commenting:
It is not at all clear to me from the limited information provided at present that there is much margin at all on a Companies Act basis, particularly if they have in due course to make any material provision for mis-selling claims.
627 The Head of Actuarial Support was informed in response on the same day that the Society had said that it was solvent as at 30 June 2001, but that such a view had been given before any provision was made for any mis-selling claims.
628 On 10 July 2001, the FSA’s Head of Actuarial Support provided an estimate of what the quantum of the liability in respect of any such mis-selling claims might amount to, based on the work that Counsel had been doing to seek to establish who might be eligible to make such a claim and how such claims could be quantified. The Head of Actuarial Support noted that the Society ‘could have mis-selling liabilities of £1.5 bn or more. In present investment market conditions, this would very likely mean that the company was insolvent.’
629 On 19 July 2001, the FSA’s Head of Actuarial Support recorded the main points to emerge from an internal FSA discussion about the Society. Those points included an observation that ‘a provision for mis-selling would take them right up to the line’ in Companies Act (i.e. absolute) insolvency terms.
630 On 23 July 2001, by which time further work had been done as to liability for mis-selling and as to the quantification of any such liability, the FSA’s Head of Actuarial Support noted that:
If, for example, [Equitable] are likely to incur mis-selling claims on all post-1993 policies, then the liability could be around £3-4 billion, which would be well beyond their current free reserves on a Companies Act basis of around £1½ billion. If the potential claims extend back to 1988 or even earlier, then the situation is clearly even worse. Even if the Limitation Act applies (which seems very odd to me as a layman given that it was not the fault of the policyholders that they could only have been likely to have become aware of the alleged non-disclosure in 1998 or even later), then the liability could be around £2½ to £3½ billion, assuming that there would be a liability in respect of all premiums paid in the last 6 years. The result is still then likely to be insolvency.
631 A note made by the conduct of business regulators of the discussion at a meeting they had attended with the FSA on 25 July 2001 referred to the view of Counsel, set out in his draft Opinion, which ‘implied that [Equitable] was insolvent (and had been for some years)’.
632 In the meantime, in the initial scrutiny of the Society’s 2000 returns, undertaken by the FSA on 19 July 2001, it had been noted that the absolute level of coverage for the required minimum margin was a matter ‘of concern’ and that, even with the sale of assets to Halifax (which had improved the Society’s free assets), ‘the position remains tight’.
633 Those assessments took place in a context in which the Society’s reported position made no allowance for liabilities arising from any mis-selling and in which credit had been taken of approximately £800 million for the financial reinsurance arrangement.
634 On 20 July 2001, the Society informed the FSA, as part of the scrutiny process on the 2000 returns, that:
… at the low point of the market at around lunchtime on 19 June 2001 when the FTSE 100 stood at 5320 it is likely that the cover ratio was about 1.0, i.e. just covering the required minimum margin. As discussed …, further equity market falls could lead to the required minimum margin being breached.
Shortly thereafter, on 1 August 2001 the FSA noted that the FTSE index had stood at 5220 as at 25 July 2001.
635 Towards the end of July 2001, the Society was getting ready to pay the latest instalment of interest due on the subordinated loan capital it had issued. That instalment was at the time estimated to total approximately £30 million. The tight position that the Society was at that time in – even with no provision for mis-selling and having taken substantial credit for the financial reinsurance arrangement – gave rise to concerns that the Society might be unable to make this payment.
636 At a pre-meeting before the Tripartite Standing Committee meeting on 25 July 2001, the Chairman of the FSA reported that the Society had informed the FSA that it could make the payment but only if a waiver were obtained from the FSA in respect of the need to meet statutory solvency requirements.
637 Whether the Society could make that payment and remain solvent continued to be a matter of doubt. On 26 July 2001, after receiving information from the Society as to its financial position, the FSA recorded that:
On the basis of the 2000 regulatory returns, submitted at the end of June 2001, and reflecting the valuation as at end 2000 … the payment could properly be made, as the [Required Minimum Margin] would remain intact after the interest payment. But [the Chief Executive] implicitly recognised that in the Equitable’s current circumstances, this test lacked some credibility. Therefore the directors were giving thought to whether it would be appropriate for them to make the interest payment if the company was insolvent in Companies Act terms. They might decide to do so, on the basis that a £28m payment was justifiable if it could sustain the Society through the period until an orderly administration could be arranged. But [Equitable’s Chief Executive] recognised that this would be a brave decision.
638 Further doubts were expressed as to the solvency of the Society. At the full meeting of the Tripartite Standing Committee, the FSA Chairman had informed the Committee that ‘something between £3 and £5bn would make [Equitable] solvent’.
639 On 1 August 2001, the FSA noted that ‘the cover for the margin of solvency looks very thin at present, (after making a resilience provision but before allowing for potential mis-selling costs)’ – but also including a substantial offset for the financial reinsurance arrangement.
640 The FSA required the Society to commission an independent report into its financial condition. On 24 August 2001, a note was sent to the Chairman of the FSA, in which was recorded the outcome of discussions that the FSA had held with the Society after the receipt of a draft of the report. The note recorded that:
… a surplus of assets over liabilities [is reported]. At one extreme, on the Insurance Companies Act basis, … Equitable covered its required minimum margin by £758 million at the end of June 2001 (£1,025m at the end of July). At the other extreme, on the Insolvency Act basis, they report that Equitable had a surplus of £2,200m. These figures do not take into account any explicit liability for future discretionary bonuses or for compensation to non-GARs.
Those figures were, moreover, produced on a basis that allowed the Society to take £664 million in credit for the financial reinsurance arrangement.
641 The FSA continued to discuss internally what the appropriate regulatory response to this ongoing situation should be. On 28 September 2001, the FSA met the Society and its auditors. The FSA’s note of that meeting recorded that, although the Society had yet to apply for a section 68 Order and despite the estimates of the quantification of the potential mis-selling liability that Counsel for both the FSA and the Society had provided:
[Equitable’s Appointed Actuary] said that the Equitable continued to meet its required margin of solvency. The assumptions which he made in reaching this view were that the Equitable would be granted a Section 68 order to take credit for the changes to the valuation rate of interest being brought in at N2; that the resilience test would not impose any additional liability; that the provision for non-GAR mis-selling was £220 million; that only £100 million credit could be taken for the Reinsurance Treaty; that the GAR takeup rate was assumed to be 85% rather than 90% as at present; and no provision had been made for those leaving the fund. On this basis, there would be an excess of about £400 million over the RMM.
642 On 8 October 2001, the FSA’s Head of Life Insurance noted that it was not clear whether the Society was in breach of its required minimum margin. He continued:
On the other hand, there is sufficient doubt about the position to make the present [public] line [taken by the FSA as to the solvency of the Society] difficult to sustain. What is new is that we now have (confidential) information which throws doubt on the credit for £700 million claimed under the Reinsurance Treaty. We are not yet in a position to reach a view on this.
643 Later that day, after doubts had been expressed within the FSA as to whether they had the power to intervene, one of the FSA’s Chief Counsel stated that ‘just to be clear, I think we do have the power now to require a plan … [as Equitable] are almost certainly underprovisioning for both misselling and resilience’.
644 On 9 October 2001, the FSA decided to take formal intervention action under the Insurance Companies Act 1982 by requiring the Society to submit a plan for the restoration of a sound financial position. The FSA’s letter informing the Society of that decision said that the information provided by the Society had made it:
… clear that the Society faces considerable uncertainty as to its ability to cover its required margin of solvency. Indeed, it appears that on 24 September 2001, which is the date used for the presentation of the figures quoted in the letter, on the basis of the scenario in which credit for reinsurance would be restricted to £100 million and mis-selling liabilities of £220 million are assumed, the Society would only just be able to cover its solvency margin, but with no free assets. However, in this scenario, credit is assumed for a concession under section 68 of the Insurance Companies Act 1982 (“the 1982 Act”) for a modification of regulation 69(5), for which an application has been made only today. At the same time no provision is made for a resilience reserve. On the basis of that scenario, and in the light of our present dialogue on reserving for mis-selling, the FSA believes that the Society must have been in breach of its solvency margin requirement on that day. While markets have improved slightly in the last week, the FSA can have no confidence that this unsatisfactory position does not continue.
645 The Society responded to this requirement by referring to the Compromise Scheme proposals that it was developing, saying that this was the plan that was to be used to restore the Society to a sound financial position. As has been noted elsewhere, the FSA later published an assessment they had made of that Scheme – which is reproduced in Part 4 of this report.
646 Doubts continued within the FSA as to the solvency position of the Society. On 15 November 2001, the FSA’s Director of Insurance sent the FSA’s Chairman a draft letter for consideration. This was to be sent to the then Economic Secretary to the Treasury to provide advice about how the Treasury should handle an application by the Society for a section 68 Order.
647 The Director of Insurance explained that:
We believe the Society to be £200m below its [solvency] margin requirement. This is [the] latest estimate this morning … It does not include allowance for the [section 68] order concession or for the reinsurance treaty beyond the £100m initial limit. The effect of the s68 order, if granted, would just about restore the Society’s margin.
The statutory and administrative background
648 The information which the prudential regulators could give to the public about the entities which they regulated was limited by the terms of the European Directives, implemented in the United Kingdom through the Insurance Companies Act 1982 and by subsequent amendments to that Act.
649 There is also no common law or statutory duty on public authorities, such as the prudential regulators of insurance companies, to give information or advice to the public.
650 However, the prudential regulators were under an obligation generally to act in accordance with established principles of good administration. As part of that obligation, where those regulators chose to give information to the public, they were required to provide information which was clear, accurate, complete and not misleading.
My assessment
651 Did the information that was before the FSA during the post-closure period provide a sound basis in fact for the information provided by the FSA that the Society did meet, and always had met, its solvency and other regulatory requirements?
652 There are two factors which suggest that the information provided by the FSA during the post-closure period relevant to this report was not soundly based and was thus potentially misleading.
653 The first is that the information provided to the FSA and GAD about the financial position of the Society showed that, objectively, the Society’s solvency position was in real doubt. The second is that such doubts were held and expressed by the FSA internally on numerous occasions.
654 The Society provided estimates as to the quantification of the outstanding reserving issues to which I have referred above. The FSA also internally considered those issues. Taking all that into account, I have analysed, with the assistance of my actuarial advisers, what the estimated solvency position of the Society would have been, if all those issues had been reflected in the Society’s estimate of its position in respect of each month, for which figures are available, between June 2000 and November 2001.
655 That analysis shows, first, that, on the basis of the monthly solvency reports it provided, the Society was, throughout the period covered by the analysis, solvent for regulatory purposes on the basis of the information it provided to GAD and the FSA.
656 However, that analysis also shows that, once adjustments are made to the reserving requirements reported by the Society to take into account the outstanding issues of which GAD and the FSA were aware, there arose considerable doubt as to the Society’s cover for the required minimum margin of solvency.
657 In response to a draft of my report, the public bodies produced similar analysis, although based on different assumptions. While that analysis produced different results, it did not remove all doubt as to whether or not the Society was meeting its regulatory solvency requirements throughout the relevant time.
658 Neither the analysis that I have undertaken nor that carried out by the public bodies resolves the doubts that should have concerned the prudential regulators at the time both about the compliance by the Society with all its regulatory requirements and also as to whether the Society was solvent on a regulatory basis throughout the post-closure period.
659 Furthermore, I would note that no such analysis was undertaken at the time. Whatever detailed analysis would show now, the question before me is what information was before the FSA at the relevant time, not what the ‘true’ position might now be found to be using a range of assumptions.
660 I consider that it is impossible to reconcile the reassurances that the FSA routinely provided with the information before the FSA – to which the FSA informed policyholders that they had had regard when concluding that the Society was solvent for regulatory purposes and always had been so solvent, and was meeting and always had met the regulatory requirements to which the Society was subject.
661 I recognise that the figures provided by the Society were estimated and had not been subject to audit. However, the provision of unqualified assurances by the FSA at that time was untenable, given the position disclosed by the Society to those regulators.
662 That there existed very real doubts as to the ability of the Society to meet the regulatory solvency requirements to which it was subject and/or that it might be insolvent for regulatory purposes is further demonstrated by the fact that, during the post-closure period, on a number of occasions GAD and/or the FSA recognised in internal discussions that the Society was either in breach of its regulatory solvency requirements or might have been in such breach.
663 Indeed, with respect to at least two significant issues – the failure by the Society to establish reserves for all the liabilities associated with those of its policies which contained guaranteed annuity rates and the use by the Society of a quasi-zillmer adjustment, which had the effect at the 1999 year end of reducing the amount of the Society’s liabilities it determined by £950 million – the FSA had no doubt at the time that the Society had not always satisfied the requirements to which the FSA considered the Society was subject.
664 It is thus unclear how the FSA reasonably have concluded that the Society had not been in breach of its regulatory requirements.
665 The Compromise Scheme was the Society’s means both of responding to the prudential regulators’ requirement to restore a sound financial position and of restabilising its broader financial condition in the light of the events which had led to its closure to new business.
666 In addition to removing the guaranteed annuity rates from those policies which had contained those guarantees, the Society’s proposals involved remaining policyholders giving up the right to pursue complaints or claims against the Society for alleged mis-selling or other matters.
667 While those policyholders were considering how to respond to the Society’s compromise proposals, the information provided by the FSA to the Society’s policyholders emphasised that care needed to be taken if a policyholder was considering transferring out of the Society and indicated what some of the potential ramifications of exit at that time would be.
668 However, the FSA did not provide similar information to those who were considering their options about the possible ramifications of remaining with the Society.
669 Policyholders looked and were entitled to look to the FSA to ascertain reliable information about the financial condition of the Society as part of the process of considering the available options. Given that the Society did not generally do business through independent financial advisers or other such intermediaries, the FSA was an important potential source of relevant advice.
670 I accept that there was no obligation on the FSA to provide information or advice to policyholders. However, having chosen to provide information, such information as the FSA provided had to be clear, accurate, complete and not misleading.
671 The FSA, acting reasonably, should have known that the Society had been and still might be in breach of its regulatory requirements. From the solvency figures presented by the Society to the FSA, and without taking into account any of the reserving issues about which the FSA was well aware and which GAD or the FSA had quantified, it appeared that the Society could barely cover its regulatory solvency margin. During the early part of 2001, the FSA also knew that the Society’s basis for determining its solvency position was further open to doubt, given the position of the OFT regarding market value adjusted.
672 The FSA, acting reasonably, should also have known that, when regard was had to the evidence before the FSA as to the financial impact of a number of highly material reserving issues that had not been resolved, it was possible that the Society was insolvent for regulatory purposes.
673 Indeed, it was on this basis that the FSA took formal intervention action in October 2001 to seek to rectify that position by requiring the Society to produce a plan for the restoration of a sound financial position.
674 Yet the FSA told policyholders that, having monitored carefully the financial condition of the Society and based on the information available to the prudential regulators, the FSA was satisfied that the Society was able fully to meet its obligations and had not breached the regulatory requirements to which it was subject. That was misleading.
675 By the time that the FSA provided a form of words to the Society for use within the scheme documentation to be provided to policyholders considering how to vote on the compromise proposals, neither of those things was a matter about which the FSA could have been satisfied at the relevant time. Nor could the FSA have been satisfied as to these matters on 1 December 2001, when my jurisdiction came to an end.
676 My conclusion is that, by giving reassurance through the information provided by the FSA that the Society was meeting its regulatory solvency and other requirements, when that was not something about which the FSA at that time could reasonably have been satisfied, the FSA failed to act in accordance with the standards reasonably to be expected of such regulators.
Submissions I have received and my evaluation of those submissions
Submissions by the public bodies
677 When I informed the public bodies that I was minded to come to this view, those bodies told me that, in their view, the information provided to policyholders in the period after Equitable’s closure to new business had been accurate and not in any way misleading.
678 Those bodies said that it had been reasonable for the FSA to have taken the view that Equitable had been solvent at all times, and meeting the regulatory solvency margin requirements up to October 2001.
679 The public bodies told me that this had been the FSA’s considered view, although part of its task was also to question and communicate the possible impact of various uncertainties on the position. The FSA’s public statements about solvency, those bodies said, had properly and appropriately reflected this approach.
680 In support of that view, the public bodies submitted that:
The FSA’s public statements about solvency were carefully considered, regularly reviewed, soundly based, and consistent with the considered view of the FSA, as determined by internal experts and supported by advice from third party experts.
It is wrong to say that the FSA’s statements about Equitable’s solvency and wider regulatory position had no sound basis in fact, or that the FSA … “should have known” this to be the case. The FSA believed that Equitable was and remained solvent at all material times, and compliant with the regulatory solvency margin requirements up to October 2001, and it was entirely reasonable for it to have taken this position.
681 The public bodies told me that the basis on which the FSA had reached that position had been informed by the facts that:
- The Appointed Actuary reported that Equitable was meeting all of its regulatory requirements at all times.
- The FSA made its own judgements about Equitable’s solvency and reasonably concluded that Equitable was solvent at all times, and did not breach the solvency margin requirements until October 2001.
- The FSA required Equitable to commission an independent review of its position in July-August 2001, and this confirmed the view which both Equitable and the FSA held at the time, that Equitable was meeting all its regulatory requirements.
682 The public bodies told me that the views expressed within the FSA about the solvency position of the Society, which I have cited above, do not support my conclusion that the FSA had known that the Society’s solvency position was questionable. The public bodies said that those views:
… cover a period from 9 July 2001 to November 2001. They show that throughout the period, uncertainties were expressed about the impact of non-GAR mis-selling liabilities and other factors on Equitable’s solvency position.
The comments are examples of the kinds of internal questioning and probing which was an integral part of the prudential regulator’s considerations at that stage. The interim views were often differing or conflicting … but in the end a considered and agreed view was taken by the FSA and no weight can properly be attached to the interim views of individuals.
683 I was told that ‘alongside this continual questioning of the position, there were at least three occasions during this period when the FSA took additional steps to satisfy itself as to Equitable’s solvency’. Those three occasions were:
- the meeting with Equitable on 29 July 2001, at which, the public bodies told me, ‘Equitable (with its auditors, solicitors and Counsel) satisfied the FSA that it was solvent on all three bases and would have “no difficulty in making the payment on the subordinated loan”’;
- the commissioning in July 2001 of an independent report on the financial condition of the Society, the results of which, the public bodies told me, ‘confirmed that Equitable was solvent on all three bases, and had sufficient surplus assets to absorb the estimates of mis selling compensation calculated (even on a worst case basis) at the time’; and
- the prompt action taken in October 2001 to require the Society to produce a plan for the restoration of a sound financial position once ‘the FSA’s analysis indicated that Equitable had breached the regulatory solvency margin requirements’.
684 The public bodies submitted that:
It was these carefully considered views of Equitable’s solvency position, rather than the points raised in the interim questioning and debate, which were – rightly – used to inform FSA’s external communications …
Having taken the reasonable decision to communicate with the public, the FSA gave careful and continuous consideration to the content of its statements. Great care was taken to ensure that the language was clear, accurate, up to date and balanced and there were rigid processes in place (including involving technical and legal experts) to ensure that all public statements reflected the FSA’s most up-to-date analysis. Rigorous procedures were also put in place to ensure that the agreed text was used consistently across all communications (letters to policyholders, letters to MPs, the FSA website and press enquiries).
685 The public bodies continued:
Although the public statements always reflected the FSA’s considered view that Equitable remained solvent, no reader of the FSA’s public communications could fairly have concluded that they provided “unqualified assurances” about Equitable’s prospects. In the period between the House of Lords’ judgment and closure to new business, letters sent by the FSA commonly referred to Equitable’s financial position being “significantly weakened” or that the House of Lords’ judgment had “significant financial implications/impact”. Later correspondence from the FSA stated that Equitable’s “difficulties significantly increased” after the judgment, and from August 2001 there were statements that its “problems stemmed from uncertainties around GARs”. Furthermore, the FSA’s communications repeatedly referred to the “fundamental uncertainties” in the way that Equitable’s financial situation might develop. The FSA also reminded policyholders that it could not give advice. A common statement was that “we would recommend that you do not make any hasty decisions and seek financial advice before taking any action”.
My evaluation of those submissions
686 I was not persuaded by the submissions of the public bodies on this matter. There can be no question but that the solvency position of the Society was a matter of great uncertainty throughout the post-closure period covered by this report. That is evident from the information before the FSA at the time and from the views expressed by them internally.
687 I accept that many of the opinions expressed within the FSA as to the real doubts surrounding the Society’s solvency position were not concluded views but part of an ongoing process of supervision.
688 However, I do not accept, for example, that the reported view of the then FSA Chairman given to a Tripartite Standing Committee meeting can reasonably be seen as ‘internal questioning and probing’ or ‘interim questioning and debate’.
689 Nor do I accept that the commissioning in July 2001 of a report into the financial condition of the Society, from the company for whom the Society’s Appointed Actuary was a consultant, reflects assurance on the part of the FSA that the Society was, in regulatory terms, fully meeting its solvency margin requirements. The commissioning of such a report instead underlined the doubts that existed at that time.
690 I also do not accept the notion that, after October 2001, the information given by the FSA was consistently changed to reflect the exercise of intervention powers on the basis that the Society was in breach of its regulatory solvency margin.
691 For example, as can be seen from the relevant entry in Part 3 of this report, on 26 November 2001 the FSA issued a press statement about the disclosure of the existence of the reinsurance ‘side-letter’. After dealing with the implications of that letter, as the FSA saw those implications, that press statement stated that ‘on the basis of the information received by the FSA, Equitable Life continues to meet its regulatory solvency requirements even taking account of the lower credit for the revised reinsurance policy’.
692 In any case, the submissions of the public bodies on these questions appear to me to miss the point. If a public body is giving clear assurances about something, the onus is on them to have established that those assurances have a sound basis in fact before giving such assurances.
693 It is not the case, in terms of established principles of good administration, that such a body can proceed to give such assurances and continue to do so, while internal discussion and debate as to the real position continues, until the view underpinning those assurances is disproved. The very fact that many of the people directly involved in the supervision of the Society were expressing real and, sometimes, grave doubts as to the true position should in itself have led to no such assurances being given.
694 The submissions of the public bodies also address views which I have not expressed. I do not suggest that a reader of the FSA’s information ‘could fairly have concluded that they provided “unqualified assurances” about Equitable’s prospects’.
695 What I have concluded is that the information provided by the FSA promoted the assurance that the Society was, and had always been, solvent for regulatory purposes and that it was meeting, and had always met, the regulatory requirements imposed on it.
696 That the future of the Society was subject to uncertainty is a matter of common ground. Indeed, it was that very uncertainty which prompted many people to contact the FSA for information in the first place.
697 I conclude that the information provided by the FSA was misleading and fell short of what it would be reasonable to expect them to have provided.
My finding
698 I find that the misleading information, about the Society’s solvency position and its record of compliance with other regulatory requirements, that was produced by the FSA, acting on behalf of the prudential regulators, during the period after the Society closed to new business fell short of the standard that could reasonably be expected of such regulators.
Conclusion
699 In this Chapter, I have set out the results of my review of the evidence I have obtained and made findings of fact concerning the subject matter of the complaints which were contained within the terms of reference for the investigation which led to this report.
700 In Chapter 11 of this report, I set out my conclusions as to whether those facts disclose that maladministration has occurred.
