The prudential regulation of Equitable Life in the period prior to June 1998

Introduction

1 In this Chapter and in the two Chapters which follow it, I set out how the prudential regulation of the Society was undertaken during the period from when the Society’s regulatory returns for 1988 were submitted to the prudential regulators until the end of my jurisdiction on 1 December 2001 – with the coming into force of the current regulatory regime, which replaced that which existed during the period relevant to this report.

2 Given the history of events which unfold during the period covered by my report, this account is structured in three time-periods which are covered in these three separate Chapters. This is in recognition that, within the regulatory regime that was applicable at the relevant time, the way in which the prudential regulation of a life insurance company was undertaken, including the degree of intensity of the scrutiny given to such a company’s affairs, would reflect the circumstances of that company as those circumstances were known to the prudential regulators and/or GAD at the time.

3 Where a life insurance company showed no signs of being in financial difficulty or where the prudential regulators and GAD considered that there were no such signs, the way in which that company’s affairs would have been scrutinised followed the routine pattern of supervision, with the focus being on the regulatory returns.

4 However, where the prudential regulators and GAD had been provided with information which raised significant doubts about the financial condition of such a company or about its ability to meet its liabilities or about its compliance with the obligations imposed on the company, the supervision of such a company would have been undertaken with heightened intensity.

5 That might include more regular liaison between the prudential regulators and/or GAD and the company, as well as more detailed consideration by those regulators of the specific issues and problems which the company faced and the options open to it to resolve those problems.

6 Moreover, where such a company had been closed to new business, the issues faced both by that company and by the prudential regulators and GAD were of a different nature to those facing companies which were still writing new business. The regulatory approach accordingly changed.

7 Crisis management or the supervision of a company that is already deeply in financial trouble and where the effects of such trouble have already been triggered throws up very different questions from those which arise in a situation in which the issue has yet to develop or crystallise – and where prudential regulation might still have a role to play in preventing its occurrence or mitigating its impact.

8 As I have explained in paragraphs 85 to 88 of Chapter 5, during the period covered by this report, the prudential regulation of insurance companies such as Equitable was primarily undertaken through two mechanisms.

9 The first mechanism was the submission of regulatory returns. Each company was required each year to submit to the prudential regulators returns, containing detailed information in a prescribed format about the business and financial strength of the company. Once checked by those regulators for completeness, the returns were placed by the prudential regulators in the public domain at Companies House – and were required to be provided by the company to any policyholder on request. One purpose of the publicity given to those returns was to enable an independent assessment of the financial strength of the company to be undertaken by policyholders, potential policyholders, or by those advising such individuals.

10 The second mechanism was the scrutiny of those returns to enable the prudential regulators to verify the financial position of the company. GAD, who assisted those regulators in the discharge of their responsibilities and who gave them advice, undertook the scrutiny of the returns. The aim of that scrutiny was to ensure that the company had complied with the statutory and other obligations imposed on it. This included taking all reasonable steps to verify the financial position of the company and to check that the company was both able to meet its liabilities and to fulfil the reasonable expectations of its policyholders and/or potential policyholders.

11 However, as I have also explained in paragraphs 89 and 90 of Chapter 5 of this report the prudential regulators and GAD obtained information about these matters other than through their scrutiny of the regulatory returns, not least through visits to, and meetings with, insurance companies – and through the information provided to them by such companies on an ad hoc basis. GAD also undertook industry-wide analysis, which informed their scrutiny of the returns.

12 The information which the prudential regulators and GAD possessed – whether by way of disclosure within the regulatory returns, whether arising from the scrutiny process undertaken in respect of those returns, or whether provided through other means – was the principal basis on which those regulators would undertake their statutory functions.

13 I have explained in Chapter 5 that, where the circumstances for the performance of any of the duties imposed on the prudential regulators or for the use of any of their discretionary powers may have or had arisen, those regulators were required to consider what, if any, action was necessary in respect of a particular company and to record the reasons for their considered decision.

14 This Chapter begins my account of how the prudential regulators and GAD undertook those responsibilities. That account is continued in Chapters 7 and 8 of this report. What follows in these three Chapters is by necessity only a summary of how the prudential regulation of the Society was undertaken. Part 3 of this report contains an extensive and detailed chronology of events, to which the reader is referred if they wish to obtain a more detailed knowledge of the history of the prudential regulation of the Society during the relevant period.

 

15 My account of the first period in the prudential regulation of the Society covered by this report is set out in this Chapter. That period covers events from the submission in late June 1989 of the regulatory returns for 1988 until late June 1998.

16 During this period, the Society was not considered by the prudential regulators or GAD to show any signs of serious problems and its supervision was thus conducted in the normal way, with the focus of such supervision being on scrutiny of the regulatory returns and on consideration of any other information which came into the possession of the prudential regulators or GAD.

17 My account of the second period is set out in Chapter 7 of this report. That period covers events from 20 June 1998 – approximately at the time of the Society’s submission both of its response to an industry-wide survey about the exposure of life insurance companies to guaranteed annuity rates and of its 1997 regulatory returns – until 8 December 2000, when the Society closed to new business.

18 As information about some of the problems which were in time to engulf the Society had been provided to the prudential regulators and GAD both in that survey response and within those regulatory returns (and as further information about those problems began to emerge), during this period those regulators and GAD were closely involved in discussions with Equitable about the significant problems that it was now known that the Society faced.

19 My account of the third period is set out in Chapter 8 of this report and deals with events occurring in the period from the Society’s closure to new business until the end of my jurisdiction over the relevant actions on 1 December 2001.

20 Throughout this third period, Equitable was not writing new business and the supervision of the Society reflected that fact. A large amount of supervisory activity was undertaken within this period on a wide range of matters, covering the whole spectrum of the issues facing Equitable in the context of the Society being a closed fund.

The structure of this Chapter

 21 The rest of this Chapter is structured in the following way:

• in paragraphs 22 to 25, I summarise the events relevant to the scrutiny of the Society’s 1988 regulatory returns;
• in paragraphs 26 to 42, I summarise the events relevant to the scrutiny of the Society’s 1989 returns;
• in paragraphs 43 to 56, I summarise the events relevant to the scrutiny of the Society’s 1990 returns;
• in paragraphs 57 to 82, I summarise the events relevant to the scrutiny of the Society’s 1991 returns;
• in paragraphs 83 to 118, I summarise the events relevant to the scrutiny of the Society’s 1992 returns;
• in paragraphs 119 to 131, I summarise the events relevant to the scrutiny of the Society’s 1993 returns;
• in paragraphs 132 to 158, I summarise the events relevant to the scrutiny of the Society’s 1994 returns;
• in paragraphs 159 to 170, I summarise the events relevant to the scrutiny of the Society’s 1995 returns; and
• in paragraphs 171 to 212, I conclude this Chapter with a summary of the events relevant to the scrutiny of the Society’s 1996 returns.

The period prior to 20 June 1998

Events relevant to the 1988 returns

 22 The Society submitted its 1988 regulatory returns to the prudential regulators on 29 June 1989. A detailed description of the content of those returns is contained within the chronology entry for that date within Part 3 of this report. GAD completed the A1 initial scrutiny check on the returns on 24 July 1989 and completed the A2 initial scrutiny check on 11 September 1989. No concerns about the Society’s position as disclosed in those returns were raised in either initial check and no detailed scrutiny was undertaken of those returns.

23 On 19 February 1990, the Society’s Appointed Actuary and another actuary who worked for Equitable presented their paper, With Profits Without Mystery, to a sessional meeting of the Faculty of Actuaries. This paper set out the authors’ account of the business model that Equitable operated. The discussion generated lively debate as to the appropriateness of the approach that the Society was adopting. That paper had also earlier been presented to the Institute of Actuaries, on 20 March 1989.

24 A DTI Minister attended a lunch engagement at Equitable’s offices on 23 May 1990. Briefing provided for the visit by DTI officials in advance of that engagement included the statement that the ‘Society appears to be sound, and has expanded steadily, with the underlying trend of expenses being satisfactory. Its strong solvency position makes it low priority in the companies supervised by Insurance Division. Consequently, contact with the Society is infrequent, and there appear to be no important issues’.

 25 There were no further events relevant to the 1988 returns.

Events relevant to the 1989 returns

 26 The Society submitted its regulatory returns in respect of the 1989 year end to the prudential regulators on 29 June 1990. A detailed description of the content of those returns is contained within the chronology entry for that date within Part 3 of this report. GAD completed the A1 initial scrutiny check on the returns on 6 July 1990 and completed the A2 initial scrutiny check on 10 July 1990. No concerns about the Society’s position as disclosed in those returns were raised in either initial check.

27 On 14 November 1990, DTI and GAD officials met the Appointed Actuary of the Society and another actuary employed by Equitable, as the first in a recently initiated round of such meetings with insurance companies. A detailed description of the content of the note of that meeting, prepared by GAD, is contained within the chronology entry for that date within Part 3 of this report.

28 The meeting discussed the financial position of Equitable and ways of improving their reported financial position. Equitable informed the DTI and GAD that they were considering not paying any reversionary bonus for 1990, although the Society indicated that it would pay an interim bonus in respect of policies maturing in 1991. GAD’s note of the meeting records:

When he informed me of the current position, i.e. that free assets were £55m assuming the same valuation basis as last year, [the Appointed Actuary] asked me whether I had any qualms about the position of Equitable. I had to say that I did. He asked why? I replied that I had not looked at the figures in detail although I knew it was possible to weaken the valuation basis. However, the society had to comply with the valuation regulations and my main concern was whether it would be able to do this if the market fell any further (or even remained at its present level). What about next year, for example? [The Appointed Actuary] said he took my point and he thought that if the market fell by a further 20% they would have problems and he would have to consider what action should be taken. He implied that at such a point he would have to consider reducing the level of new business taken on.

29 GAD’s note concluded with two comments. The first was to note that the Appointed Actuary had stated that ‘the Society is solvent. However, as he is considering not paying a reversionary bonus this year (while at the same time paying terminal bonuses) he must be feeling very uneasy about the current position of the Society’. The second was to record that GAD would be ‘carrying out a detailed scrutiny of the 1989 returns in order to get a better feel for the position of the society, and in particular for what margins there are in its current valuation basis and in the alternative net premium basis’.

30 On receipt of GAD’s note of the meeting, on 22 November 1990, a DTI official commented on the note ‘if the Equitable is not going to declare a bonus we need to warn the Minister before it becomes public. Will there be publicity? What about Equitable’s advertising? Does it need to be changed?’

31 GAD wrote to the Society on 4 December 1990, as part of their detailed scrutiny of the 1989 returns. The questions raised with Equitable included whether there were any surrender/transfer guarantees relating to their pension business fund contracts and ‘… what investment return is required to support (i) the current reversionary bonus rates and (ii) the current reversionary and terminal bonuses’.

32 The day after GAD had written to Equitable, GAD provided the DTI with a short note which explained that GAD had completed their detailed scrutiny of the 1989 returns. That note included the statement that ‘if the property values remain depressed and the equity market does not show any bullish tendencies in the [1990s] and beyond, we think that the Society may have problems in maintaining the current bonus rates on its with-profit life and pensions contracts’. GAD explained that they had written to the Society and enclosed a copy of their letter. However, GAD also informed the DTI that they considered that ‘we do not anticipate that the replies will affect our view of the solvency position’.

33 Equitable replied to GAD’s letter on 17 December 1990. In response to GAD’s question about the existence of surrender and transfer guarantees, the Society stated that ‘our pensions contracts generally carry guarantees of the amount that will be paid in the event of actual retirement (whether on the originally stated pension date or otherwise) or death. There are, however, no guarantees on withdrawal in other circumstances, e.g. transfer to another pension provider. It is our aim to pay full value in those circumstances also but there are no guarantees in the matter’.

34 In response to GAD’s question about what investment return was required to support the current reversionary bonus rates and to support current reversionary and terminal bonus rates, the Society explained, in relation to the former, that the declared bonuses rates, announced at 31 December 1989, required annual earnings of 11¼% for pensions business and around 8% net for life business. In relation to the latter, the Society did not answer the question directly, and instead explained that, due to the way in which the Society operated their business, ‘the question of what rate of growth is needed to support “current reversionary and final bonuses” is not … meaningful in our case’.

35 On 19 December 1990, GAD wrote to the Society to thank it for the information provided in the above letter, which they described as ‘most helpful’ and to inform the Society that GAD had ‘no further queries on your 1989 returns’.

36 On the same day, GAD sent two notes to the DTI. A detailed description of the content of those notes is contained within the chronology entry for that date within Part 3 of this report. The first note began by stating that:

There is one point which we think you may need to consider following our meeting with Equitable. If, as seems possible, the society decides not to declare reversionary bonuses this year you would need to consider whether or not there is a risk that the society may be unable to fulfil the reasonable expectations of present and future policyholders.

37 After explaining their understanding of the position, GAD stated that:

… on balance, we do not think that the society’s possible course of action, in itself, leads to a risk that the society may be unable to fulfil the reasonable expectations of such policyholders. If the society had another bad year (or this year’s performance is worse than anticipated) and the company was unable to establish sufficient mathematical reserves on current guaranteed levels of benefits (including past reversionary bonuses) within the resources of the company, that would be a different matter.

38 GAD concluded by stating that ‘at present we do not have enough information about the society to be more specific and indeed, unless the society makes more signals, we do not suggest that further information should be sought. The society is our longest established life company and is well respected in the market’.

 39 The second note recorded the fact that GAD had spoken to the Society’s Chief Executive on the telephone to discuss certain concerns that GAD had about the financial position of Equitable. The note explained that the background to this discussion had been, in part, related to concerns that the DTI had expressed about the Society’s current advertising. It was said that:

This was in the context that, if the Equitable were unable to pay a reversionary bonus this year, policyholders who had taken out policies on the basis of recent advertisements (which highlighted the returns achieved by the Equitable over the past 10 years), might have justification for wondering whether their reasonable expectations would be, or were being, met. You would like the Equitable to examine their advertising to ensure no such complaint could be justified.

40 The note continued by recording that the Society’s Chief Executive had told GAD that he considered that Equitable was now ‘pretty unlikely to be in a position of not being able to declare a bonus this year given the optimistic assessment of investment returns achievable by the company next year’ and that ‘there was clearly a risk in this strategy, but there is a risk in all bonus declarations taken in similar circumstances’.

41 GAD concluded their note by informing the DTI that it now seemed likely that a bonus would be declared, by agreeing that there was ‘clearly some risk’ in this strategy, and by recording the view of GAD that ‘if the Equitable goes ahead with a bonus distribution this year and the market subsequently falls considerably, we will need to hold some urgent talks with the company’s actuary, as we would, of course, with other companies that take similar decisions and who are in a similar financial position to (or an even less strong position than) the Equitable’.

42 On 20 December 1990, the day after the above notes were sent, Equitable applied for a section 68 Order which would permit them to include a future profits implicit item of £250 million within their 1990 returns. The DTI granted this, after taking GAD’s advice, on 11 January 1991.

Events relevant to the 1990 returns

 43 On 27 June 1991, the Society had submitted its regulatory returns in respect of the 1990 year end to the prudential regulators. A detailed description of the content of those returns is contained within the chronology entry for that date within Part 3 of this report. GAD completed the A1 initial scrutiny check on the returns on 24 July 1991 and completed the A2 initial scrutiny check on 29 July 1991. No concerns about the Society’s position as disclosed in those returns were raised as part of the A1 initial check. As part of the A2 initial check, GAD had noted two points, being ‘ deteriorating cover for the [required minimum margin]’ and ‘loss of working capital for future expansion’.

44 On 11 June 1991, shortly prior to the submission of the returns, the Society’s Appointed Actuary had sent certain Board papers to GAD, saying:

The papers are of course confidential and offered as a good will gesture to promote greater understanding and I should prefer restricted circulation in your department.

Those Board papers are published in full in Part 4 of this report and a detailed description of the content of them is contained within the chronology entry for that date within Part 3 of this report. Amongst the other information which the papers contained, the Board papers gave a great deal of detailed information about the financial condition of Equitable, about the approach that the Appointed Actuary took to managing the reported solvency position of the Society, and the relationship between that solvency position and bonus declarations.

45 On 12 September 1991, as part of more general internal commentary concerning guarantees on with-profits bonds, GAD had commented that:

Generally we are aware that a number of companies are now issuing this type of contract. These include for example Equitable Life and others which apparently held reserves below the face value of the units at the end of last year. This practice can only be justified if they currently apply market value adjustments on surrenders, and can reasonably hope to earn a positive rate of return (in addition to future bonus declarations that may be “reasonably expected”) over the period to death or “maturity” of the policy. Furthermore, we have to be satisfied that they can still set up adequate reserves under changing investment conditions, including a 25% fall in the value of equities and a 3% variation in yields on fixed interest securities.

 46 On 19 November 1991, GAD wrote to Equitable concerning their returns. In addition to asking for information to be supplied about various miscellaneous issues, GAD asked the Society to justify against the relevant provisions of the 1982 Act and the applicable Regulations the method by which the Appointed Actuary had completed the returns in respect of the use of sub-funds, without providing individual portions of the returns for each sub-fund. GAD also asked about the guarantees on the Society’s with-profits bond.

47 GAD also asked Equitable what the cost had been of the change in the Society’s main valuation basis as at the 1990 year end, when compared with the equivalent basis used at the previous valuation. GAD also noted that:

… you refer to the resilience test which you have carried out in connection with the valuation using the net premium method. I note your comments and that you would not need to have recourse to assets shown at line 51 of Form 14 of the Returns. There is however a substantial difference in the mathematical reserves shown at line 11 of Form 14, and the amount of the reserves arrived at using the net premium method of valuation. I would therefore like to know the amount of the mismatching [i.e. the resilience] reserve which you would have needed to set up had you used the net premium method in arriving at the amount shown in line 11 of Form 14.

 48 GAD also asked Equitable to provide their estimate of the figures, including the likely amount of the available assets, which would be shown within the 1991 returns.

49 On 20 November 1991, GAD provided the DTI with a detailed scrutiny note. After noting that Equitable had experienced falls in the market values of equities and other assets, GAD noted that, as a result:

… the actuary has decided to weaken the valuation basis of the with-profits business. The rates of interest he has used are within the limits laid down in the regulations and could be supported by the yields shown [in the returns] although the margin is small. We are asking a few questions about the valuation basis and we will comment in detail after the replies from the Society.

50 GAD also explained that:

The cover for the required minimum margin is reduced from 477% (1989) to 177% [for] this year. The main reason for this is the fall in value of the assets (referred to … above). Part of the fall has been covered by a release of £214m from the mathematical reserves arising from the weakening in the valuation basis. Other reasons for the reduction in cover for the [required minimum margin of solvency] are (a) growth of new business and (b) maintenance of unchanged bonus rates on with profit policies.

51 Equitable replied on 22 November 1991 to GAD’s letter of 19 November 1991. The Society explained that, if it had shown mathematical reserves for the resilience reserve, calculated using the net premium method of valuation, the Society would have needed to set up an additional resilience reserve of £450 million.

52 Equitable also explained that, if the reserves shown in the main valuation had been calculated as at the 1990 year end, using the basis used for publication at the previous valuation, their reserves would have been £557 million higher. Equitable also explained that they would:

… need to publish a substantially stronger valuation at the end of 1991, either by explicit strengthening of the basis or the inclusion of an explicit [resilience] reserve, than at 31 December 1990 reflecting the reduction in yields during the year. My current view is that it is unlikely that the [solvency] position at the end of 1991 will be any stronger than at 31 December 1990, although the underlying liability valuation will, of course, be substantially stronger.

 53 On 16 December 1991, Equitable were granted a section 68 Order by the DTI for a future profits implicit item of £300 million for possible use in their 1991 returns.

54 On 31 January 1992, GAD wrote to the Society in response to its letter of 22 November 1991. GAD continued to seek further information about the with-profits bond but made no comment on either the information provided by Equitable concerning the resilience reserves, about the impact of the change in the valuation basis adopted in 1990, or the comments made by Equitable about the likely solvency position in the 1991 returns. GAD wrote to the DTI on the same day to set out what had been done as part of the detailed scrutiny.

55 Equitable replied to GAD on 13 February 1992. The Society explained that the guarantee of ‘full value’ payment on the with-profits bond applied only at certain specific dates set out in the policy document and that the valuation basis took account of those dates.

56 However, although Equitable’s current practice was to pay out ‘full value’ on early surrender, ‘… we do not guarantee this. I do not see that the reserving basis for the bonds needs to take any particular account of this practice’. The Society also stated in relation to its with-profits bonds that: ‘If our surrender experience deteriorates or if financial conditions worsened significantly, we should certainly impose surrender penalties’. GAD informed the DTI on 24 February 1992 that the detailed scrutiny was completed.

Events relevant to the 1991 returns

 57 Prior to submission of their 1991 returns, Equitable wrote to GAD on 12 May 1992 and informed GAD that the solvency position at 31 December 1991 showed that the cover for the Society’s required minimum margin was likely to be 1.17. This would signal a drop in solvency cover from 1.77 the previous year (and from 4.77 the year before that).

58 An internal GAD minute, dated 14 May 1992, contained analysis of Equitable’s letter. A detailed description both of the content of the Society’s letter and of the GAD minute is contained within the chronology entries for these dates in Part 3 of this report. GAD’s analysis and notes made separately as part of an assessment of the Society’s position included observations:

(i) that the margins in the valuation basis were ‘very thin’ in 1990, ‘with an average interest rate used of 7.12%’;

(ii) that the strengthening of the valuation basis in 1991 had increased reserves by £150 million, whereas the weakening in 1990 had reduced reserves by £557 million;

(iii) that Equitable had over £100 million of single premium with profits bonds in force, which had been valued on an acceptable basis, ‘although the reserves held were less than current surrender values (not guaranteed). This led to some release of premiums into surplus’;

(iv) that it had been expected, with the increase in market values, that the Society’s position would have seen an increase in excess assets available in 1991 but that, surprisingly, there had been instead a reduction in the value of those assets;

(v) that the Society’s free asset ratio was low and that, when the 1991 returns were published, financial advisers would question the strength of Equitable;

(vi) that the Society had used up its investment reserves (i.e. its free assets) quickly in paying ‘very good bonuses’; and

(vii) that Equitable’s recurrent single premium business (i.e. its principal line of business) would be ‘exposed to cancellation as soon as there is adverse publicity about the strength of Equitable’.

59 The DTI were copied into GAD’s note. On their copy, the DTI official responsible for the supervision of Equitable noted that GAD ‘thinks they have been paying too much in bonuses’.

 60 The DTI and GAD met Equitable on 19 May 1992, as part of a planned series of company visits. Prior to the meeting, on 14 May 1992, the DTI prepared briefing, which included the observation that there had been a:

… considerable reduction in excess assets between 1989 and 1991 … [the] Society has experienced falls in the market value of equities and other assets, and the actuary has decided to weaken valuation basis of [with-profits] business. Reduction in cover for [required minimum margin of solvency] is due to fall in value of assets, growth in new business, and maintenance of unchanged bonus rates on [with-profits] policies. GAD meeting with Equitable on 14.11.90 noted that they were considering not paying any reversionary bonuses for 1990. In the event a bonus was declared for 1990 at same rate as for 1989.

61 A detailed description of this briefing and of the note of the meeting prepared by the DTI is contained within the chronology entry for these dates within Part 3 of this report. The latter records that the Society disclosed the existence of its policies with a guaranteed investment return, that GAD had observed that the solvency position of the Society was ‘arguable’, and that GAD had noted that they ‘would be concerned about Equitable’s performance if there were dramatic falls in the market’. After the meeting, Equitable provided GAD with some further information on 28 May 1992.

62 On 29 June 1992, the Society submitted its regulatory returns in respect of the 1991 year end to the prudential regulators. A detailed description of the content of those returns is contained within the chronology entry for that date within Part 3 of this report.

 63 GAD completed the A1 initial scrutiny check on the returns on 3 August 1992 and completed the A2 initial scrutiny check on 10 August 1992. No concerns about the Society’s position as disclosed in those returns were raised in the A1 initial check. In the A2 initial check, GAD noted that the valuation interest rate of 10% for immediate annuities was ‘very high’. GAD also identified three aspects that ‘look worrying’: a low free asset ratio, the amount of other management expenses, and ‘transfer from [investment reserve]’.

64 On 30 July 1992, GAD had described, in general internal briefing, the Society as being one of the ‘companies on whom we have been keeping a close watch for a number of years’ and that Equitable remained a company ‘which cause serious concern’.

65 Other briefing, prepared by the DTI on 19 August 1992, observed that the Society’s ‘solvency margin, whilst well covered, has reduced in recent years mainly due to falls in the market value of equities’. This was subsequently corrected, following GAD informing the DTI that ‘since 1990 … the solvency margin position has worsened, and is a cause for some concern … Equitable Life will be one of the first companies we will be talking to in our imminent discussions with appointed actuaries’.

66 At this time, GAD expressed some more general concerns in their discussions with the DTI about the then current weakness in investment and foreign exchange markets and the possible effect on the free asset ratios of life insurance companies. GAD explained that they had sought meetings with the Appointed Actuaries of a number of insurance companies to discuss their company’s current and projected financial position. Prompted by concern about Equitable’s worsening solvency position, GAD had included the Society in this exercise.

67 GAD and the DTI met Equitable on 15 September 1992. Before, at, and after the meeting Equitable provided additional information about their past and projected performance. This information is summarised within the entries in Part 3 of this report for 10 September 1992, 15 September 1992, and 17 September 1992.

68 The Society stated that it remained confident that it would be able to meet the regulatory solvency requirements at the end of 1992 and 1993, although Equitable at the same time cautioned that the implications for bonuses would need to be considered carefully. In their note of the meeting, Equitable recorded that, at the meeting, GAD had asked about:

… the extent to which the Society’s minimum statutory reserving basis might be weakened by removing “unnecessary” margins.

In response, on 17 September 1992 the Society pointed to a number of measures which it might use to protect its position, including weakening the valuation basis ‘on account of zillmerisation’ and using a future profits implicit item.

69 Following the meeting and in the light of the additional information provided by Equitable, GAD observed in an internal note, copied to the DTI, that the Society had implied that too stringent liability valuation regulations were forcing it to invest in fixed interest securities rather than in equities, which the Society considered a better long term investment. GAD concluded:

Our view is that the society has over-distributed in the last few years, compared with the return on investments. This has eroded the level of free assets available in the society, which are needed to provide for market changes in the value of assets.

On 29 October 1992, GAD provided the DTI with their scrutiny report on the 1991 returns. GAD explained that they had compared the average valuation rate of interest used by Equitable with the average rate of interest earned on the corresponding allocated assets (using the highest yielding assets first). GAD noted that there appeared to be little or no margin in the interest rates used and that this was an issue they were taking up with Equitable.

70 GAD highlighted the fact that Equitable’s earnings on assets had fallen well short of what was required to meet bonuses paid in 1989 and 1991. As a result, Equitable had transferred funds from their investment reserves and had weakened the valuation basis. GAD also noted that the Society still had over 60% of its non-linked assets invested in equities and property.

71 GAD also attached a copy of their letter to Equitable, taking up a number of matters from the 1991 returns. In this, they asked Equitable to:

• explain how their with-profits immediate annuity contract worked;
• explain why the proportion of reserves not matched by assets in the same currency had risen from 0% to 7.7% in one year;
• clarify the paragraph in their returns which dealt with the calculation of the final bonus for a group of policies, including recurrent single premium deferred annuities, and to provide an example of how this worked in practice ‘including the effect of both reversionary and final bonuses’;
• provide a ‘matching rectangle showing what assets you would hypothecate to the net premium mathematical reserves1’; and
• explain the amount of the valuation strain in respect of additional business written in 1991.

On the last point, GAD stated:

… we wish to know (i) the reserves set up at the end of 1991 (ii) the total cost of any bonuses allocated during 1991 and provided for in the 1991 returns (iii) the cost of any claims paid in 1991 (iv) the total premiums received in 1991 and (v) the total related expenses incurred in 1991.

72 By way of annotations made on their copy of GAD’s report and letter, the DTI’s Head of Life Insurance commented:

This paints a worrying picture. Over-distribution by a company with a (deliberately) small coverage of its [required minimum margin] and a (continuing) policy of high equity exposure. I think we should ask GAD for a fuller assessment of the position and of the options available to the company in the event of a significant further downturn in the market (unless we have this already, in which case I should like to see it).

The Head of Life Insurance also suggested that GAD should ask Equitable how long they could continue with their present bonuses in the event of a zero investment yield.

73 On 6 November 1992, in response to GAD’s letter, Equitable:

• provided details of their with-profits immediate annuity contract, including an example of how annuity payments were determined by bonus rates. These showed that the annuity calculation implicitly guaranteed growth of 3.5%, which was taken into account in the calculation of the guaranteed annuity payment. Equitable also explained that, for with-profits annuity contracts, policyholders were allowed to select at the outset an assumed future reversionary bonus of up to 5.5% (in addition to the 3.5% guarantee) – the higher the level of assumed future bonuses the higher the initial annuity payment. But, if in future the actual level of bonuses fell short of the assumption, the annuity payment also would fall;
• explained that the proportion of reserves not matched by assets in the same currency had been overstated – the correct figure should have been 2.9% (or zero on a net premium basis);
• explained that each with-profits policy had a ‘total claim value’ based on the accumulated value of the premiums paid, increased as appropriate by annual bonus declarations – and that the amount by which the total claim value exceeded the value of the guaranteed benefits (including reversionary bonuses) determined the final bonus element;
• provided matching rectangles – but these did not show assets allocated to liabilities calculated at a particular valuation rate of interest; and
• explained that information on the valuation strain generated by business written in 1991 was not readily available and would take a great deal of time and effort to produce. Instead, Equitable provided an analysis of the financial impact of new business, which did not include ‘regular’ recurrent single premium renewals, in 1991. The Society stated that the new business did not produce a valuation strain. This, it was said, was due mainly to the fact that ‘the valuation bases for recurrent single premium business released monies at outset in a similar way to the release produced by a zillmer adjustment’.

 74 In reply, GAD told Equitable that their response would be considered in detail shortly. However, the Society’s letter was given no further consideration at that time. It appears that this was because its receipt coincided with a change in the GAD actuary responsible for scrutinising the Society’s returns.

75 On 3 March 1993, GAD advised the DTI that Equitable’s replies to their questions on the 1991 returns:

… seem satisfactory. The operation of the bonus system (as described in the responses to Questions 1) and 3) seems complex, and even more difficult for policyholders to understand than that of most companies, but there is nothing inherently unsound about it.

76 The DTI had passed to GAD in January 1993 the queries that they had raised. In their advice to the DTI, GAD highlighted a number of unusual features about the Society. Those features included that Equitable had a very high proportion of with-profits business and, even more unusually, that 80%-85% of their with-profits business was in the form of single or recurrent single premiums, with the annual premiums in force being very modest in relation to the size of the company. GAD stated this could be:

… both a strength and a weakness. A strength because it has only to secure the benefits bought by premiums already paid, and needs less by way of protection for the future premiums to be received under the contracts. A weakness because it will have less by way of “free reserves” and is therefore more vulnerable to changes in asset values.

77 GAD also noted Equitable’s use of a bonus reserve valuation in their main valuation. GAD stated that the Society’s high proportion of single or recurrent single premium business made this more appropriate than the net premium approach. GAD observed that the results in the main valuation would be similar to those that would be disclosed on the appendix basis.

78 GAD noted from reports of earlier meetings that, in setting bonus rates, Equitable had considerable regard to gilt yields. GAD commented that this was not entirely consistent with the bonus system or the asset mix but that it no doubt explained what, in retrospect, had been an over-distribution by the Society in 1990. GAD added:

It seems possible from the [required minimum margin] cover ratios that the over-distribution followed a period of some underdistribution; but without going back into previous history in detail I could not be sure.

79 GAD noted that, in the event of a downturn in the market, the option of reducing bonuses would be less of a protection for Equitable than would be the case for other companies, as terminal bonus did not represent such a high proportion of their total payouts. GAD concluded:

Overall, I suspect that Equitable could survive a short-term fall in market levels, even a substantial one, as well as most companies. Their portfolio, however, must leave room for concern, were there to be a prolonged period of depressed share values. Their recent shift towards fixed interest securities will ease the difficulties, although they would argue at the expense of the expected ultimate benefit to policyholders.

80 Also on 3 March 1993, GAD wrote to Equitable, in response to the Society’s letter of 6 November 1992. GAD explained ‘[t]here seems little point in asking further questions on the matters relating to the 1991 Returns’. GAD asked, instead, for the Society’s initial assessment as to what its position would be at the end of the year, including the position regarding the cover for the required minimum margin, the actual rate of return on the fund in 1992, and details of the 1992 bonus distribution.

81 GAD explained that, in due course, they would also be seeking details of how the Society’s assets were allocated to liabilities, as well as the yield on the assets so allocated and an analysis of new business.

82 Equitable provided their initial assessment of the end of 1992 position on 9 March 1993. The Society described an improved position and, on 11 March 1993, GAD advised the DTI that they regarded the scrutiny of the 1991 returns as ‘fully completed’.

Events relevant to the 1992 returns

 83 In June 1993, the Institute of Actuaries held one of its regular one-day conferences on current issues in life assurance, attended by nearly 200 actuaries. One topic for discussion was the disclosure and reporting of terminal bonus costs.

84 The conference heard that disclosure of some information would help avoid creating unreasonable policyholder expectations and would demonstrate that policyholders were being treated fairly. However, the actuarial profession’s Valuation Regulations Working Party favoured private disclosure (for example through a report by the Appointed Actuary to the Board or through a new ‘financial condition report’2 to the DTI) rather than public disclosure (for example through the annual returns or a with-profits guide).

85 Contributors to the discussion also favoured private rather than public disclosure. A spokesperson for GAD:

… made it clear that this body would like to see some private disclosure. The Government Actuary’s Department will be seeking further information on surplus distribution, given the inadequacy of the information provided in Schedule 4 of the DTI returns. It is particularly interested in marketing material and the methodology used in determining bonus distributions. The information will be collected through a survey of larger offices or by other means, such as company visits3.

86 On 5 July 1993, the Society’s Appointed Actuary complained to the Government Actuary (following a press report that GAD were to launch an investigation into the way life companies distributed bonuses to their policyholders). He argued that Equitable had a very open bonus system and so the consequences of such a survey were likely to be to their advantage. However, he expressed concern that the intended survey was announced first in the press rather than direct to companies, that it might further weaken confidence in the industry, and that it might be a precursor of tighter regulation – for example of bonus rates.

87 On 7 July 1993, the Government Actuary replied and explained to the Appointed Actuary that the survey had been announced at the recent conference on current issues in life assurance and that there had been no intention to weaken confidence in the industry or to introduce tighter regulation. He added:

In one sense there is nothing new in this, since GAD and the DTI have always taken a close interest in policyholders’ reasonable expectations. Indeed, this has been the central issue in many Section 49 Transfers [i.e. transfers of the whole or part of a company’s long term business], in the setting up of sub-funds, in changes to the proportion of surplus going to shareholders and in a number of other areas. We have been signalling for some time that asset share calculations would be one of the aspects on which we would seek to focus during the next round of company visits. On top of this there have been particular pressures on companies because of falling investment returns and some evidence that proprietary companies are under more than usual pressure to demonstrate value to shareholders. These and other factors pointed to 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.

88 On 9 July 1993, the DTI wrote to all life insurance companies in the United Kingdom writing with-profits business and explained:

The Department has an ongoing responsibility to keep itself informed of developments within the life insurance industry, and a particular responsibility to protect policyholders’ reasonable expectations. In this context we wish to gain a clearer picture of current industry practice in respect of bonus methodology.

We have therefore asked the Government Actuary’s Department to conduct a survey of leading UK offices which write with-profits business, in order to obtain more detailed information about companies’ bonus philosophies, and the actuarial techniques used in assessing bonus payments.

89 The DTI enclosed a letter which had been sent at the same time by GAD to Appointed Actuaries, giving more detail on the background to the survey. In their letter, GAD explained that actuaries had introduced new methodologies for assessing bonuses, including the technique known as ‘asset shares’.

 90 However, GAD recognised that there was no clearly accepted definition of how such asset shares were calculated, nor was there information in the regulatory returns about how the appropriate rates of bonus could be assessed. The survey had been designed, GAD said, to obtain this information.

91 Attached to GAD’s letter was a questionnaire, which sought detailed information in response to 11 questions. GAD explained that the survey was divided into two broad headings:

(i) the content of current marketing literature, combined with information on the principles of distribution in the constitution of the company and (ii) the company’s actual methodology in respect of the determination of appropriate levels of final or terminal bonus payable on with-profit policies.

92 On 20 July 1993, Equitable wrote to GAD enclosing their completed questionnaire for the with-profits survey. The Society was the first to respond. Within the Society’s responses to part (i) of GAD’s survey (about marketing literature and the principles of distribution), Equitable stated that their Articles of Association gave:

… the Society’s Directors absolute discretion as to bonus allocations4. Beyond that, there is no statement of bonus philosophy in the Society’s constitution. The main statement of the Society’s long-standing philosophy on bonus distribution in marketing literature is contained in … the With Profits Guide.

Equitable further explained that their With-Profits Guides gave no specific information on the period and magnitude of smoothing or the likely frequency of changes to final bonus rates. The Society said that general comments in the Guides could be expected to lead policyholders to expect relatively infrequent changes to the latter.

93 Equitable provided the detailed information sought in part (ii) of GAD’s survey (about actual methodology for determining final or terminal bonuses). The Society explained in particular:

• that, for surrenders, ‘the full policy value (including final bonus) is normally adjusted to ensure that the surrender value paid does not exceed the underlying asset share. The level of adjustment required is monitored monthly’;
• that, when determining the annual expense level attributed to with-profits contracts for recurrent single premium business, ‘allowance is made for an implicit fund charge of ½% p.a. That is, the gross rate of accumulation … is taken to be ½% p.a. higher for conventional contracts, such as endowment assurances, than for recurrent single premium contracts’;
• that, in assessing appropriate final or terminal bonuses, the Society made no allowance for a charge for the guarantee provided in respect of benefits payable on maturity or for a contribution to an ‘estate’;
• that Equitable did not discriminate between different contracts in their smoothing process;
• that the smoothing of final or terminal bonuses ‘is determined by the relationship between the accumulation rates determined each year and actual investment earnings. That smoothing is also reflected in the comparison of the aggregate total policy values with actual asset values. In normal circumstances the Directors look to apply a 3 to 5 year averaging cycle but expect to apply that more flexibly in more unusual circumstances’; and
• that, when valuing their assets for the above comparison, ‘allowance is made for the accumulated new business strains which will be recouped from future premium loadings’.

94 Equitable added:

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 approach to smoothing needs to reflect that philosophy, particularly in volatile investment conditions.

95 Equitable submitted their 1992 returns on 29 June 1993. GAD completed their A1 Initial Scrutiny check on 30 June 1993. GAD noted that the cover for the required minimum margin was 2.36. They identified no concerns. GAD completed their A2 Initial Scrutiny check on 5 July.

96 GAD lowered the Society’s priority rating from 2 to 3 and identified the valuation basis for unit-linked business as a worrying aspect, although it was also noted that this was not a major part of the Society’s business. GAD noted that the proportion of assets invested in fixed interest securities had risen from 26% to 38%. GAD identified no items to notify to the DTI, to be taken up immediately with Equitable.

97 Following receipt of the 1992 returns but prior to GAD’s detailed scrutiny both GAD and the DTI considered other information about Equitable. On 30 November 1993, GAD and the DTI met Equitable to follow up the meeting in September 1992, at which they had discussed the effect of market conditions on the Society’s solvency position. Prior to the meeting, GAD had signalled that they wished to discuss Equitable’s current and projected financial position, their bonus and investment policy and their resilience reserves.

98 On 25 November 1993, Equitable had provided a number of papers, including a report by Standard & Poor’s giving Equitable a ‘very good rating’[5] and papers considered by the Society’s Board in October and November. The entry for that date in Part 3 of this report includes a detailed description of the information that those papers contained.

99 At the meeting, Equitable indicated that they expected their position at the end of 1993 to be significantly stronger than had been the case at the end of 1992. The Society also expected to eliminate the recent excess of payouts over asset shares and that future bonuses would depend primarily on earned returns. In response, GAD noted that Equitable ‘… appeared to be moving to a lower proportion of the total bonus payout being guaranteed (i.e. declared as distinct from terminal)’[6].

100 The issue of guarantees arose at the meeting in other ways. The DTI noted that Equitable had ‘no guarantees that bite’. In the course of discussion about the resilience test, GAD noted the following comments by the Society’s Appointed Actuary and Chief Executive:

Pensions business has a guaranteed annuity rate at about 7% but this was not as onerous as it appeared since, because “old” policies had been given the benefit of more modern features and options, it would be reasonable (in his view) for the allocation of final bonus to be conditional on the waiving of this guarantee …[7]

Equitable added that they were sure that allowance for the resilience reserve had been made within the appendix valuation but agreed that they would check and confirm whether this was so[8].

101 Prior to the meeting, GAD had informed Equitable that they might wish to clarify some points from Equitable’s response to the bonus survey. I have seen no evidence that GAD raised any issues concerning this response at the meeting.

102 Meanwhile, in the autumn of 1993, the DTI had analysed which life insurance companies had shown a significant deterioration in their 1992 solvency cover, compared with 1991.

103 As a result of that exercise, the DTI identified sixteen companies which they ‘… should be paying special attention to in the remainder of 1993 and 1994’. Although it was said that Equitable had shown a ‘marked improvement’ in terms of solvency, the Society was listed as being one of these companies[9]. The DTI also noted that Equitable had been one of 11 included in GAD’s ‘free asset ratio list’, prepared on 16 August 1993, as raising concerns.

104 The DTI arranged a meeting to be held on 6 January 1994 to discuss those 16 companies. By way of a note headed ‘1992 returns – “Problem Companies”’, the DTI line supervisor with responsibility for Equitable was asked to attend. On 5 January 1994, the line supervisor explained that he could not attend. The line supervisor pointed out that GAD had held a ‘mainly actuarial’ meeting with the Society, also attended by the DTI (i.e. the meeting on 30 November 1993). He continued:

At the time [this] list was drawn up, both [Equitable and another named company for which he was responsible] seemed rather marginal candidates for inclusion, a view confirmed by recent contacts. They are both well-managed and reasonably successful; neither appears to be anywhere near the slippery slope at present. I believe they need no special attention before submission of the 1993 returns.

105 No-one was asked to attend in his place. I have been unable to establish what happened at the meeting.

106 On 24 March 1994, GAD considered Equitable’s 1992 returns in detail and drew attention in their detailed scrutiny notes to their advice to the DTI of March 1993 and the note of the meeting on 30 November 1993, both of which GAD said ‘should be noted in particular’. GAD also explained that, according to the Society’s letter of 9 March 1993, the Society had strengthened its valuation basis by about £100 million.

107 GAD stated that there was ‘nothing to note’ from the Society’s reply to the with-profits survey. I have seen no other evidence to suggest that the information in the bonus survey informed the scrutiny of the 1992 returns10.

108 On 28 March 1994, GAD provided the DTI with their ‘detailed’ two page scrutiny report on the returns. GAD highlighted the Society’s improved cover for the required minimum margin (2.36 compared with 1.67 at the end of 1991) and noted the Society’s practice of using a bonus reserve valuation in the body of its returns and publishing a net premium valuation as an appendix.

109 GAD also pointed out that, under the net premium valuation, Equitable’s cover was 3.9 and referred to past concerns which GAD had had that Equitable had over-distributed. However, GAD now felt able to provide reassurance to the DTI:

More recently matters seem to have been brought under better control. The situation as at 31 December 1992 is more satisfactory than the previous year, and as you will know from recent reports (eg the notes of the meeting held on 30 November last) we expect the position as at the end of 1993 to have improved still further. Reversionary and terminal bonus rates were reduced at the end of 1992 and it has just been confirmed that reversionary bonuses have been reduced again from the end of 1993.

110 Also on 28 March 1994, GAD wrote to Equitable to ask them to provide copies of their recent bonus announcement and of their most recent With-Profits Guide. GAD requested that these documents should be supplied routinely in the future. GAD also asked Equitable:

• In the Appendix (where the net premium results are set out) you mention in para. 5(a) on page 98 that resilience reserves could be set up without recourse to the Form 14 line 51 assets. However you do not give an indication of the amount of any resilience reserve which would be required on the net premium basis and which is not covered by the net premium liabilities. Could you please advise this amount as at 31 December 1992, and ensure that the corresponding figure is disclosed in future returns;
• to provide the figure for the growth rate of non-unit reserves, if a rate of return of 2% rather than 3% were used;
• to explain why, for certain linked business, Equitable had reduced their reserves in respect of tax on unrealised capital gains;
• … the rate of 9% used to value the non-profit immediate annuities seems on the high side. Could you please supply more details of the assets that are deemed to be backing these liabilities, and their yields, having regard to Regulation 59(2) and (6)(a); and
• to provide a preliminary estimate of the Society’s position at the end of 1993, including an indication of the extent to which the valuation basis had been strengthened.

111 In response, on 7 April 1994 Equitable sent to GAD a copy of their ‘Bonuses’ booklet, which set out their most recent bonus rates. The Society undertook to supply its With-Profits Guide when that had been updated and to add GAD’s details to the Society’s press release distribution list. In addition, the Society’s Appointed Actuary, in response to the specific issues that GAD had raised on 28 March 1994:

• informed GAD that the figure for the resilience reserves required in the statutory minimum valuation was £462 million. The Appointed Actuary said that he was not prepared to publish the figure in future returns as he considered it to be confidential. The Appointed Actuary added:

GAD have previously indicated that they feel the Society provides much fuller information than the norm in this area11. To require even more from us seems unreasonable;

• explained that there would be no increase in the non-unit reserves, if a return of 2% rather than 3% had been used;
• explained that Equitable had net unrealised losses in their linked funds and accordingly the capital gains tax reserve was negative;
• explained that, in the Appointed Actuary’s view, the valuation of the assets backing the non-profit liabilities in the Society’s gross premium valuation was a matter for his professional judgement. He further explained that, within this group, there were different categories of annuities and that Equitable considered that the valuation rate used was suitable, as some assets actually yielded a higher rate; and
• provided an estimate of the position at the end of 1993, showing a strengthening in reserves of £1,076 million and cover for the required minimum margin of 3.75.

112 Handwritten comments on this letter show that, after some discussion, GAD were satisfied that, with the addition of the resilience reserves, the Society’s published valuation was ‘(just) OK’12. GAD expressed surprise that non-unit reserves would not increase if a return of 2% rather than 3% had been used, but suggested that GAD should ‘let this pass’.

113 On 19 April 1994, GAD sent the DTI copies of their correspondence with Equitable. GAD explained that they were generally satisfied with the Society’s responses and noted that, once the resilience reserves were taken into account, there was little difference between the Society’s main and appendix valuations, although the latter valuation was weaker than that used by most with-profits offices.

 114 GAD noted that the Board papers that had been supplied showed that the Society’s bonus rates had been reduced by less than was justified by their usual approach of relating declared rates to prevailing interest rate levels, primarily on account of the good performance of assets during 1993. GAD also explained that they were asking Equitable some additional questions.

115 GAD also enclosed a copy of their letter to Equitable, in which they had pursued two points. The first point was whether the Society’s approach to unrealised tax losses was prudent. The second point was whether the valuation interest rate used for non-profit immediate annuities could be supported by the assets deemed to have been backing those liabilities. GAD explained:

You will appreciate, I am sure, that our primary concern is with the net premium valuation published in the Appendix to Schedule 4, rather than with the office basis. This question was posed in the context of the net premium assumption (where 9% was also used), and I am sorry if that was not clear. Could you please now provide the information that we are seeking; the yields shown in Forms 45 and 46 do not, after allowing for the 7½% margin, seem to support the 9% assumption.

116 In response, on 25 April 1994 Equitable provided a justification of their approach to the treatment of unrealised capital losses. The Society also explained that the average valuation rate of interest used had been 6.5%, which was less than the average yield of 7.0%.

117 Equitable explained that it was their view that, while the applicable Regulations permitted the allocation of assets to specific liabilities, those Regulations did not require this. Equitable reiterated that the valuation of the assets was a matter for the professional judgement of the Appointed Actuary. GAD decided not to pursue either point further.

118 On 7 June 1994, GAD copied this correspondence to the DTI and explained that GAD had ‘no further questions for the actuary, and this scrutiny [of the 1992 returns] is regarded as complete’.

Events relevant to the 1993 returns

 119 Equitable submitted their returns for 1993 on 27 June 1994. GAD completed their initial scrutiny in a different order than had been the case for earlier years, completing the A2 Initial Scrutiny check first on 7 July 1994. GAD gave Equitable a priority rating of 3 (unchanged from the previous year). GAD again identified the valuation basis for unit-linked business as a matter of (small) concern.

120 GAD noted that the Society had not set up any provision to meet potential exposure for pension mis-selling but commented that such a problem was unlikely to be significant. GAD identified no items to notify to the DTI, to be taken up immediately with Equitable. GAD completed their A1 Initial Scrutiny check on 15 July 1994. GAD noted that the cover for the required minimum margin was 3.75.

121 On 24 October 1994, GAD prepared three pages of ‘detailed scrutiny notes’ on the 1993 returns. As part of these, GAD noted ‘New rules reducing final bonuses’, citing the page in the returns which set out the Society’s differential terminal bonus policy. GAD commented that the valuation rates of interest looked too high and needed to be justified by a matching rectangle.

GAD also queried Equitable’s mortality assumptions for annuities.

122 On 15 November 1994, GAD provided the DTI with a 14 page scrutiny report on the 1993 returns. The report followed a new standardised format adopted by GAD, comprising thirteen specific sections13. In their report, GAD drew attention to a number of matters. In particular:

• GAD noted that particular care was needed when reviewing the appendix (net premium) valuation, as the figure for the resilience reserves necessary under that valuation had been omitted from the returns;
• GAD explained that the valuation bases used for Equitable’s main (gross premium) valuation were primarily a tool to support the method of determining bonus distributions and commented that they were not particularly relevant to the prudential supervision of the Society. GAD observed that the adequacy of the Society’s valuation ‘is demonstrated by publishing a net premium valuation on the minimum basis necessary to meet the regulations’. GAD noted that this appendix valuation had a number of apparent weaknesses, including that the valuation rates of interest appeared somewhat high. GAD explained that they had little concern about the Society’s solvency, given its cover for the required minimum margin. However, GAD said that, if Equitable’s reserves were too thin as a result (that is, if the Society were using valuation rates of interest that were too high):

… it may lead to inappropriate conclusions being drawn by policyholders and prospective policyholders as to the financial strength of the Society14
. We are therefore seeking confirmation of the prudence of certain of the assumptions; and

• GAD noted that some mortality tables appeared on the optimistic side and further information as to their justification was required.

123 GAD explained that they would seek further information from the Society on each of the above points. GAD also observed that Equitable carried no reserves for pension mis-selling, due to the Society’s selling methods ‘which are based upon largely approaches from prospective policyholders’, but that it remained to be seen if this was correct.

124 Also on 15 November 1994, GAD wrote to Equitable. GAD asked the Society to disclose the amount of the resilience reserve required in the appendix valuation, to provide a matching rectangle, to demonstrate the notional allocation of assets to liabilities, and to explain why Equitable had chosen the particular mortality tables they had used.

125 In response, on 22 November 1994 Equitable:

• explained that the figure for the resilience reserves required in the appendix valuation was £236 million15;
• provided a rudimentary matching rectangle which did not allocate assets to specific liabilities. Equitable stated that the average yield of the assets was 5.32% and that, after the required reduction of 7.5%, those assets supported the average valuation rate of interest of 4.78%.

Against this, GAD noted ‘Seems OK, but the averaging should only be assets’; and

• provided details of the mortality experience Equitable were using for annuity contracts and acknowledged that some slight strengthening might be appropriate for the valuation at 31 December 1994.

126 On 23 November 1994, GAD copied the Society’s reply to the DTI and commented:

In view of the nature of the net premium valuation for this company, which is published to demonstrate the adequacy of the published main bonus reserve valuation, and the undoubted adequacy of the reserves in aggregate, we are satisfied with the reply received.

GAD concluded:

We regard this scrutiny as complete.

127 Nevertheless, on the same day GAD pursued with Equitable their treatment of valuation rates of interest. GAD explained that the applicable Regulations did not permit the averaging of valuation interest rates, and that each interest rate used had to be supported by the yield on the assets matching the corresponding reserve. GAD also suggested to the Society that, for the 1994 valuation, its assets should be allocated to each category of contracts for which a different interest rate was used.

128 On 30 November 1994, Equitable replied and disputed GAD’s interpretation of the relevant Regulations. Following another exchange of correspondence, on 7 December 1994 Equitable undertook to give the matter further consideration in relation to the 1994 returns. The Society explained that it did not wish to prolong the correspondence unduly as ‘it relates only to our “appendix” demonstrations of compliance with the regulations’. The Appointed Actuary also stated that he had provided a similar presentation on a number of occasions in the past without being questioned. GAD did not pursue the point further.

129 On 9 December 1994, shortly after the conclusion of the scrutiny of the 1993 returns, GAD and the DTI met Equitable. The meeting was the second with Equitable arranged as part of GAD’s rolling programme of visits to life companies[16].

130 In preparing for the meeting, the DTI had noted GAD’s comments, contained within their scrutiny report on the 1993 returns, about the prudence of the Society’s assumptions in its valuation. The DTI also queried whether GAD had pursued these matters following the scrutiny but also commented:

The point which concerns me … a little is that, as from the 1994 returns, it is not sufficient for the actuarial liabilities to be estimated prudently. Each of the assumptions which goes into the actuarial calculation has itself to be prudent. Equitable need to be alive to this.

131 At the meeting on 9 December 1994, Equitable provided a number of reports and papers including details of their recent rating from Standard & Poor’s of ‘AA’17. The entry for that date within Part 3 of this report contains a fuller description of the information provided by the Society. In discussion on their bonus philosophy, Equitable commented:

… it was expected they would “overshoot” in 94 – they were not worried – but DTI may be!

In response, GAD commented:

… that it looked like over-distribution, compared with market values.

Equitable also commented that they were not concerned at how small their free assets got. The Society had, so far, chosen not to show an implicit item in its regulatory returns, as to do so ‘would make them look weak’ – but, if the free asset ratio became negative, Equitable said that they would use a future profits implicit item and would not declare a bonus if they were unable to do so.

The Appointed Actuary asserted that a well managed office would not become insolvent in such circumstances and that a vigorous expanding office might have a low free asset ratio. It does not appear from the DTI’s note of the meeting that this statement was challenged. There is nothing in the note of the meeting to suggest that there was any discussion of the DTI’s concerns, which they had expressed prior to the meeting, about the need to ensure the prudence of each of the assumptions within the Society’s valuation.

Events relevant to the 1994 returns

 132 Following the meeting with Equitable in December 1994, the DTI reminded them that the Society had not yet submitted an application for a future profits implicit item for use in its 1994 returns. On 15 December 1994, Equitable sought a section 68 Order for an implicit item of £500 million. The calculations submitted in support of this application suggested that Equitable were entitled to seek an Order up to the value of £2,140 million.

133 In their review of the application in order to advise the DTI as to whether to grant the Order, GAD expressed concern at the way that Equitable had omitted from the calculations some exceptional losses even though they were not matched by exceptional profits. However, having reworked the calculations to eliminate the exceptional items, GAD concluded that a maximum implicit item of £1,590 million was still justified.

134 On GAD’s recommendation, the DTI granted the Order, for possible use in Equitable’s 1994 returns. When doing so, the DTI reminded Equitable that exceptional losses should only be omitted if they were matched by exceptional profits.

135 On 4 January 1995, in response, Equitable stated that they had excluded exceptional losses only to the extent that they were matched by exceptional profits. The Society sought some more general advice from the DTI about how to treat profits and losses arising from changes in the valuation basis. This advice was not provided at that time.

136 On 23 March 1995, Equitable pressed the DTI for a response, explaining that they were now thinking of using the implicit item in their 1994 returns. The DTI sought advice from GAD and passed this on to Equitable.

137 On 27 March 1995, Equitable replied and acknowledged that they had not carried out past calculations in accordance with this advice, but stated that this had had ‘… no material effect on the applications for a future profits implicit item submitted by the Society in previous years’.

138 When considering this matter, the DTI noted that one GAD actuary took the view that ‘the calculation of the implicit item was essentially flawed, and he didn’t fuss too much about [very] technical details’.

139 Meanwhile, Equitable raised a second query about the use of implicit items, pointing out that, in the Society’s 1993 returns, the required resilience reserves were considerably below the available future profits implicit item. Equitable asked if, on this basis, it would be acceptable for the Appointed Actuary to conclude that no explicit reserve was required. GAD advised that this approach was not acceptable.

 140 On 23 March 1995, Equitable told the DTI that their excess over the required minimum margin as at 31 December 1994 would be about £400 million, which would ‘present a marginally stronger position than at the end of 1991’. Equitable did not say what this figure represented in terms of cover for the required minimum margin.

141 On 13 April 1995, the DTI asked the Society again for an update on its liability for compensation payments for pensions mis-selling, which had first been requested in October 1994 but to which request the Society had not replied. Following this reminder, Equitable stated that it was not possible to quantify their liability, even crudely, but that the Appointed Actuary still believed that the Society’s exposure was relatively small, adding:

We are therefore making no explicit provision against this contingency in the accounts although I have “over estimated” the technical liabilities by £50m as a very full implicit provision. Our auditors have given a “true and fair” certificate on our accounts in the new Insurance Accounts Directive in the full knowledge of our approach.

142 I have seen that, at this time, the conduct of business regulators were still in correspondence with Equitable about their sales of pension policies. I have seen no evidence that the DTI checked the position with those regulators. During April 1995, discussions were also taking place within the DTI about the possible nomination of the Society’s Chief Executive and Appointed Actuary for recognition in the New Year honours list for 1996. The factors cited in support of a nomination included that Equitable had no known pensions sales malpractice and had avoided the bad image afflicting the industry generally as a result of poor selling methods.

143 Equitable submitted their returns for 1994 on 30 June 1995. GAD completed their A1 Initial Scrutiny check on 24 July 1995. The design of the check form had changed and there was no longer an entry showing the cover for the required minimum margin. GAD identified no concerns.

144 GAD completed their A2 Initial Scrutiny check on 25 July 1995. GAD gave Equitable a priority rating of 3 (unchanged from the previous two years). GAD noted, again, that Equitable had not set up any reserves to meet their potential exposure for pension mis-selling and that there should be a ‘check into mis-selling’. GAD also noted that Equitable’s mortality rates were reasonable ‘but thin’.

 145 GAD identified mismatching as a worrying aspect and highlighted as other issues derivatives, ethical fund general investments, and reserves for contingent liabilities to tax on unrealised capital gains. GAD identified no items to notify to the DTI, to be taken up immediately with Equitable.

146 GAD took no further action on the 1994 returns until 8 December 1995, when GAD asked Equitable about their ‘significant’ use of derivatives. In his reply of 14 December 1995, the Appointed Actuary pointed out that such derivatives accounted for only 0.1% of the Society’s assets and denied that this was significant.

147 On 23 January 1996, GAD provided the DTI with a 20 page scrutiny report on the 1994 returns. The report followed the format used for the 1993 returns. In their report, GAD drew attention to a number of matters. GAD noted, inter alia:

• l that GAD had derived much useful information from Equitable’s With-Profits Guide of May 1994 and that they were requesting a later edition. (GAD had previously asked Equitable to send such documents routinely and Equitable had agreed.)
• l that Equitable took advantage of their main valuation to ‘hide’ their resilience reserve. GAD explained that at least a substantial part of the difference between the main and the appendix valuation was accounted for by the resilience reserve which was not disclosed. GAD said they would ask for this ‘yet again’.
• l that, following the visit to Equitable in December 1994, it was known that the Society’s Appointed Actuary had decided that its interests were best served by using a weak valuation basis, in order to show as strong a free asset position as possible (albeit that this had fallen in 1994). GAD stated:

This means that the valuation basis is selected at the limits of the regulations. This requires us to exercise particular vigilance in ensuring that users of the returns are not misled.

GAD set out in tabular form the valuation rates of interest used by Equitable and compared these with the asset yields (although Equitable did not allocate specific yields to specific liabilities). GAD concluded that this gave rise to some doubt as to the sufficiency of the higher yielding assets and noted that, in the main valuation, cover for the required minimum margin was 2.36.

• l that, for general annuities, Equitable used a mortality table showing death rates well in excess of recent industry experience.
• l that one of the strengths in the Society’s valuation was its assumption that recurrent single premium business would pay no more premiums, although this was ‘arguably only in line with the best practice’. GAD pointed out that, if the business were treated as regular premium business, the margins in future premiums might allow lower reserves and that it was likely ‘that some credit is being taken implicitly for this in the expense reserves’.
• that Equitable had had a few ‘PIA and compliance problems’ but that GAD understood that these were not significant. GAD stated:

Although the Equitable take a highly esoteric line on a number of issues, and are inclined to argue their case rather longer than most, they have a culture which would not permit the continuation of a compliance breach.

GAD explained that they were raising with Equitable areas of concern, the most pre-eminent of which were the Society’s valuation rates of interest and mortality bases. GAD said that they were pressing Equitable on the latter point ‘quite vigorously’.

148 Also on 23 January 1996, GAD wrote to Equitable. GAD sought the latest version of Equitable’s With-Profits Guide, asked that the amount of the resilience reserve required in the main valuation and a matching rectangle were both provided, the latter in order to demonstrate the notional allocation of assets to liabilities.

149 GAD asked the Society to provide this information in the new format that would be required for the 1996 returns. In addition, GAD asked Equitable to justify their mortality assumptions for annuitants and to explain how allowances had been made for future improvements in mortality rates, as well as for adverse deviations.

150 In response, on 21 February 1996 Equitable supplied their latest With-Profits Guide. The Appointed Actuary explained that the figure for the resilience reserves required in the main valuation was £171 million18. He provided matching rectangles. Because Equitable amalgamated liabilities, the Appointed Actuary explained that this information had been provided only ‘approximately’ in the requested format.

151 The figures, as presented by Equitable, showed that the valuation rates of interest used were supported by the allocated assets. However, the notional matching was to reserves which excluded any resilience reserves. Equitable explained that their mortality experience was some 106% of the a(90) table, rated down one year.

152 The Appointed Actuary said that he felt that using this table was appropriate. However, as Equitable had experienced a modest improvement in mortality and that their 1994 experience was close to 100% of a(90)-1 year19, the Appointed Actuary said that he would deduct a further year in future returns.

153 On receipt, GAD considered the information that Equitable had provided and noted that the figure for the resilience reserve was ‘OK’. GAD accepted the Appointed Actuary’s wish not to publish the figure and simply asked him again to supply this information at the same time that future returns were submitted.

154 GAD also noted that the information provided by the Society as to the hypothecation of assets to liabilities was:

Supplied approximately in the requested format except that, surprise surprise, the resilience reserve is omitted. OK apart from the missing resilience line. It is probably pushing it a bit to complain and I intend to turn a blind eye.

GAD raised no objection to the Society’s amalgamation of its liabilities, with the proviso that the valuation rate of interest used had to be the highest for the group. GAD concluded that Equitable’s explanation of their mortality tables was ‘OK for now’.

155 GAD wrote to the Society on 5 March 1996 and offered some advice to Equitable on the mortality tables that might be appropriate. Equitable replied on 3 April 1996, objecting to what they saw as GAD’s intrusion into matters which the Society saw as being the preserve of its Appointed Actuary.

156 Following clarification by GAD of their remarks in a further letter, on 15 April 1996 Equitable stated that they shared GAD’s concerns about the need to manage the risk of future improvements in mortality on an annuity portfolio. The Appointed Actuary added:

That was one of the reasons why we introduced our with profits annuity some years ago. Any unexpected improvement for that class could, of course be reflected in the bonus rate granted. You may be interested to know that around two thirds of our current immediate annuity new business is with profits.

157 Meanwhile, on 5 March 1996 GAD sent the DTI an update on their scrutiny report. Taking account of the figure for the resilience reserves that had been provided by the Society, GAD assessed that, in the appendix valuation, the Society’s cover for the required minimum margin was 2.65 and its free asset ratio was 4.1% (compared with 2.36 and 3.1%, respectively, in the main valuation).

 158 GAD concluded:

We are now satisfied with the valuation basis. The net premium cover for the required minimum margin is greater than that for the published basis, and a priority of 4 could have been justified20. The scrutiny is now complete.

Events relevant to the 1995 returns

 159 Equitable submitted their returns for 1995 on 28 June 1996. GAD completed their A1 Initial Scrutiny check on 8 July 1996. GAD identified no concerns. GAD completed their A2 Initial Scrutiny check on 18 July 1996 and lowered Equitable’s priority rating from 3 to 4.

160 GAD noted, among other things, that the reserve held by the Society for additional liabilities arising due to mortality strains caused by AIDS was contained within the reserve for future bonus in the main valuation, that unit costs had not been updated, that Equitable had used a future profits implicit item of £264 million, and that the Society’s cover for the required minimum margin was 2.89.

161 GAD noted, again, that Equitable had not set up any provision to meet potential exposure for pension mis-selling but that the Society had indicated in April 1995 that technical liabilities had been ‘overstated’ by £50 million. GAD identified no worrying aspects and no items to notify to the DTI, to be taken up immediately with Equitable. At the end of July 1996, Equitable sent GAD a copy of their latest With-Profits Guide.

162 GAD’s initial target date for completing the detailed scrutiny of the Society’s returns had been December 1996. However, this was brought forward to October 1996, apparently because of an impending visit to Equitable.

163 On 1 November 1996, GAD provided the DTI with their 16 page scrutiny report on the 1995 returns. The report followed the format used since the 1993 returns. In their report, GAD drew attention to a number of matters. GAD noted, inter alia:

• that the Appointed Actuary:

… indicates that the resilience reserve required in relation to his net premium valuation would be covered by the difference between the bonus reserve gross premium valuation liability and the net premium valuation liability.

This difference is revealed as £436m, and we have no reason to doubt its adequacy – although managing the distribution and consequent growth in guaranteed liabilities in respect of the very substantial (over £8.6bn) portfolio of unitised with profit type business is a potential problem to be monitored.

GAD also observed that they were unconvinced of the value of Equitable’s main valuation and would be happier to see a ‘clearer exposition’ of Equitable’s ability to react to possible falls in the value of their assets, particularly given their ‘exceptionally large exposure to unitised with profit type liabilities’. However, GAD did not indicate that they would seek an actual figure for the resilience reserve from Equitable.

• GAD noted that Equitable’s main valuation:

… includes only an allowance for modest levels of future bonuses, with the result that the disclosed liability is actually very similar to that that would be derived from an acceptable net premium valuation with due allowance for resilience reserves. Thus, the picture shown above may reasonably be compared directly with other offices who prepare Returns on standard net premium valuation bases. Without the implicit future profits item, cover for the [required minimum margin] would be by a factor of 2.44. This is satisfactory.

• that Equitable had revised their valuation rates of interests to reflect falling interest rates and rising asset values. GAD set out in tabular form the valuation rates of interest used by Equitable and compared these with the asset yields (although they did not allocate specific yields to specific liabilities). GAD concluded that the assumptions made by the Society were acceptable.
• that Equitable had revised their mortality assumptions for general annuities, following the discussion of their 1994 returns. GAD considered it desirable to keep pressing Equitable ‘quite vigorously’ on this point as longevity improved.
• that, again, one of the strengths in the Society’s valuation was the assumption that its recurrent single premium business would pay no more premiums, although this was ‘arguably only in line with the best practice’. GAD pointed out that, if the business were treated as regular premium business, the margins in future premiums might allow lower reserves and that it was likely ‘that some credit is being taken implicitly for this in the expense reserves’.
• that the Society’s failure to set up a specific reserve for tax on capital gains of £37.4 million was ‘dubious – relying on other margins in the valuation basis’.
• that, although Equitable:

… might be expected to be beyond reproach, we understand that an over-estimation of pension liabilities of £50m has been incorporated into its reserves as a provision against possible costs arising from pensions mis-selling. No other [compliance] problems are known.

• that it would be helpful to learn what scenario-testing Equitable undertook.

164 GAD stated that they had not raised any points directly with Equitable. However, it was noted that GAD, with the DTI, were due to meet Equitable at the third of GAD’s rolling programme of visits to life companies^[21].

 165 In their 1 November 1996 scrutiny report, GAD also suggested that, at the meeting, it would be ‘interesting’ to discuss Equitable’s continued fall in expenses, the reasons for their increased investment in non-insurance companies^[22] and the sustainability of their present contract structures, the scenario tests they performed in relation to falls in assets values, and how they would react to ‘sustained unfavourable market movements’. On 5 November 1996, the DTI wrote to the Society to put these matters on the agenda.

166 The meeting took place on 8 November 1996. At the meeting, Equitable explained that their expenses had fallen partly in relative terms as a consequence of the high expenses which had been incurred in previous years because of their investment in information technology software. The Society offered some reassurance about its investment in non-insurance companies, explaining that it had majority holdings in some companies for investment purposes.

167 Equitable confirmed that they did not reserve for terminal bonuses, as these were whatever was left after the declared reversionary bonuses and thus ‘instantaneous’. Equitable acknowledged that their main valuation was not really any stronger than the appendix valuation. GAD expressed concern about the Society’s bonus statements and warned that Equitable needed to ensure that customers were not misled.

168 Equitable, looking ahead, indicated that they might apply for a section 68 Order for a subordinated loan. The DTI had also signalled a wish to discuss the Society’s liability for pensions mis-selling. The Appointed Actuary explained that, although £50 million had been included in the Society’s technical reserves, it was his view that only £10 to £15 million would be needed.

169 Equitable also reported that a conduct of business team had visited them for a week earlier in the year. The Appointed Actuary told the meeting that he:

… thought [the conduct of business regulators] had misunderstood the issues, and [he] had sent them away! It was hoped that all cases would be settled by Autumn [1997].

170 I have seen no evidence that the DTI checked the position after the meeting with the conduct of business regulators. Nor have I seen any other correspondence between the prudential regulators and Equitable about the 1995 returns or about any of the issues which had been discussed at the meeting on 8 November 1996. I have also seen no note from GAD to the DTI or to Equitable formally concluding their scrutiny of the 1995 returns.

Events relevant to the 1996 returns

 171 Equitable submitted their returns for 1996 on 30 June 1997. GAD completed their A1 Initial Scrutiny check on 18 July 1997. GAD identified no concerns. GAD completed their A2 Initial Scrutiny check on 7 August 1997. The check was more detailed than in the past. GAD raised Equitable’s priority rating from 4 to 3. GAD highlighted a number of matters, including:

• that Equitable, as a major with-profits office, ‘was unlikely to be insolvent but it may be building higher expectations than could be met’;
• that the valuation basis appeared weak and that the valuation rates of interest used for certain with-profits business did not appear to make proper provision for policyholders’ reasonable expectations;
• that the Society’s matching rectangle might need review;
• that Equitable’s description of discretionary adjustments relating to surrender values made during the reporting period was not satisfactory; and
• that it was not clear if Equitable had set up any identifiable pensions mis-selling reserves.

172 Under ‘Aspects that look worrying’, GAD noted that the Society had declared high reversionary bonuses for its substantial unitised with-profits business. Moreover, it was noted that Equitable held reduced reserves and could be relying too much on the potential application of market value adjusters.

173 Under ‘Other Notes’, GAD stated that reviews were required of the Society’s mortality assumptions for their pensions and annuity business, their assumptions for unit growth rates for their unit-linked business, and their unitised with-profits reserves in the resilience scenario. GAD identified no items to notify to the DTI, to be taken up immediately with Equitable.

174 On 1 August 1997, the position whereby one person had held both the posts of Appointed Actuary and Chief Executive came to an end. On 8 August 1997, prompted by this change, GAD provided briefing about Equitable to the Government Actuary.

175 That briefing stated that, as a mutual, the Society made a ‘strong play’ of not building an excessive estate which led to it declaring high non-guaranteed terminal bonuses on its substantial accumulating with-profits contracts. The briefing expressed doubts about the ability of Equitable to apply a market value adjustment in all the circumstances covered by the resilience test (which was what their valuation assumed). The briefing noted that Equitable had insisted that their bonus system gave them the necessary flexibility.

176 Before the 1996 returns were submitted, another issue – namely whether the Society should be permitted, as a mutual, to issue subordinated loan capital with the consent of the prudential regulators but not to recognise such capital as a liability – arose for consideration.

177 At the meeting with GAD and the DTI on 8 November 1996, Equitable had advised the DTI and GAD that they might apply for a section 68 Order for a subordinated loan. This matter had first been raised in 1993. At that time, GAD had made a number of observations, including the importance of subordinating the rights of depositors to those of policyholders. GAD had then commented:

As the rate of interest would presumably need to be fairly high, perhaps above the market rate, how would the issue of such deposits benefit the security and, more importantly, the reasonable expectations of members generally?

On GAD’s advice, the DTI had put this query to the Society and had sought other information about this proposal. There is no record of a reply from Equitable to this query.

178 Following the meeting in November 1996, Equitable noted, internally, that the DTI appeared to be ‘relaxed’ about the issue of the subordinated loan.

179 On 27 November 1996, the Society asked the DTI to indicate in principle if they would agree to the necessary application for a section 68 Order, in order to allow the Society to count the loan towards their required solvency margin. Equitable presented the proposal as a means of raising finance and providing benefits to policyholders.^[23]

 180 The DTI sought GAD’s views. As in 1993, GAD was cautious about this proposal. In their reply to the DTI on 14 February 1997, GAD said that they were ‘uncomfortable’ with the idea that Equitable could market the subordinated loan products, treat the proceeds as free capital, and not hold reserves to cover the repayment liability.

181 GAD also pointed out that the loan could only count for up to 25% of Equitable’s required minimum margin and warned the DTI that they would need to be satisfied that early redemptions could not suddenly threaten cover for the required minimum margin of solvency.

182 On 14 March 1997, Equitable signalled their hope that it would not be necessary to set up a subsidiary company and also their wish to pursue the proposal swiftly. On 24 March 1997, GAD told the DTI that they understood it to be that department’s view that it would not be possible to satisfactorily issue subordinated debt from within a company’s long term fund.

183 GAD also said that a proper degree of subordination could best be achieved if the debt were issued through a subsidiary company. There followed further exchanges between the DTI, GAD and Equitable.

184 GAD remained unconvinced about the proposal. In further advice to the DTI, given on 29 April 1997, GAD questioned in what way it would be possible for the loan to be treated as not being a liability on the long term fund and how Equitable could make interest payments and eventual capital repayment, if they held no assets outside the long term fund. Equitable’s proposal initially involved loans potentially of the value of £325 million.

185 GAD pointed out:

It should be appreciated by the DTI that the potential sums involved in these proposed issues are substantial … and this amount of gearing could cause problems to the Society unless the terms are reasonable and proper subordination to policyholder rights is achieved.

186 The DTI’s legal advisers shared the view that a subordinated loan taken out by a mutual was likely to constitute a liability on the long term fund. But, in advice given on 9 May 1997, those advisers noted that the DTI had already issued section 68 concessions to mutuals:

… despite the apparent lacking of the safeguard that would be in place in a proprietary company.

The legal advisers suggested that the DTI should not change what had become their policy, namely to agree a section 68 Order, subject to the proposal being reasonable – particularly in relation to adequate subordination. They also drew attention to Prudential Guidance Note 1994/1 on hybrid capital, which had set out the need to establish a proper degree of subordination^[24]. But they also considered that it was not necessary for there to be a subsidiary company to achieve this and that the terms of Equitable’s proposal already demonstrated the necessary subordination.

187 Equitable continued to share the view that it should not be necessary to set up a subsidiary company. Discussions continued on this basis, although GAD remained ‘uncomfortable’ about the proposal, citing the advice in Prudential Guidance Note 1994/1. In the event, on 3 July 1997, Equitable changed their approach. The Society announced that it now proposed a subordinated loan of £350 million and that:

In line with market practice, the issuer will be a wholly owned subsidiary of the Society and the issue will be guaranteed by the Society.

188 Having considered the issue again, on 25 July 1997 GAD told the DTI that they were satisfied that the revised proposal was acceptable and in line with precedent. The outstanding details were settled and, on 20 August 1997, the DTI issued the necessary section 68 Order to allow Equitable to count the loan towards their required solvency margin.

189 While the scrutiny of the 1996 returns was underway, other issues arose. On 26 September 1997, the Government Actuary met with Equitable’s new Appointed Actuary.

190 On 30 September 1997, the DTI had again asked Equitable and other companies for details of their provision for potential liabilities arising from pensions mis-selling. On 24 October 1997, Equitable replied and explained that their estimated liability was £85 million compared with £50 million as at the end of 1996.

191 The Appointed Actuary stated that one reason for this increase was that a number of cases had been brought back into their review following discussions with the conduct of business regulators. He anticipated showing the provision more explicitly in the Society’s 1997 returns^[25]. I have seen no evidence that the DTI checked the position with the conduct of business regulators in the light of this information.

192 On 17 November 1997, the administrators of the NHS pension scheme wrote to the DTI. Those administrators explained that they were reviewing the NHS’s arrangements for enabling members of their occupational pension scheme to make additional voluntary contributions (AVCs).

193 The administrators said that they were considering appointing Equitable as their AVC provider and needed further information in order to advise the Secretary of State for Health, as the sponsoring employer, whether to do so. The administrators asked the DTI if there had been any points of contention with Equitable within the last three years or whether there were any material facts of which the Secretary of State should be aware before a decision was made.

194 The DTI sought the views of their lawyers and also other internal advice. In seeking the view of officials, the DTI line supervisor responsible for Equitable said:

To my knowledge there are no outstanding supervisory “points of contention” with Equitable Life (and would we say anything if there were?) … Personal pensions mis-selling — Equitable appears to be getting on well with this — as at 30/9/97 compensation offers of £11m had been made. Total provision at 30/9/97 is £85m, including non-priority cases. New Chief Executive from 1/7/97 and separate Appointed Actuary. Previously [the Chief Executive] was also the [Appointed Actuary]. Issue of £350m subordinated loan capital August 1997. Future profits implicit item agreed for 1997 returns of £700m.

195 The DTI line supervisor also noted that, as at 31 December 1996, Equitable’s cover for the required minimum margin had been 2.53. Against this, an official noted that, without the future profits implicit item, the cover would be 2.07.

196 It was agreed that the DTI should reply to the NHS scheme administrators, confirming Equitable’s solvency position and indicating that the DTI were not aware of any matters that should be brought to the Secretary of State’s attention. On 26 November 1997, the DTI did so and informed the administrators of the NHS pension scheme that, on the basis of Equitable’s 1996 returns, and in the absence of interim information, they would say that the company was financially sound. The DTI added that there were ‘no outstanding issues of a material nature pertaining to DTI’s regulation of the Equitable Life Assurance Society …’.

 197 The wording in the letter was based on one sent in respect of another company, although the DTI recorded that they had omitted a reference from the precedent letter to strong solvency cover of more than 6.00 because, in the Society’s case, ‘their solvency cover [without] the implicit item is [2.07], which isn’t that hot’.

198 On 16 December 1997, GAD provided the DTI with their 19 page scrutiny report on the 1996 returns. The report followed the format used since the 1993 returns. In their report, GAD drew attention to a number of matters. GAD noted, inter alia:

• that Equitable had a ‘modest free estate’.
• that there was one hidden strength in the valuation basis relating to the Society’s treatment of recurrent single premium contracts, where it was assumed that no further premiums would be received. GAD note that this was in line with best practice.
• that it was thought that the resilience reserve should be a grossed up figure of £668 million, rather than the £501 million reported.
• that the Society’s main valuation did not appear to be any stronger than its appendix valuation.
• that the Society’s mortality bases were ‘reasonably conservative’, and Equitable had insisted in the returns that they contained sufficient allowance for future improvements.
• that, as reversionary bonuses included credit for asset appreciation (that is, as yet unrealised gains), future bonuses appeared vulnerable to a sustained stock market downturn and that it would seem desirable for policyholders to be given greater warning of this.
• that Equitable reserved the right to penalise early surrenders, including guaranteed benefits under unitised contracts, and that it might be desirable to give this greater prominence in their literature.
• that the Society’s failure to set up a specific reserve for the contingent liability to tax on unrealised capital gains of £47.7 million was, as had been the case in 1995, ‘dubious – relying on other margins in the valuation basis’.
• that, while Equitable had included in the main valuation a reserve of £50 million for the potential liability from pensions mis-selling, it was not clear if a similar provision had been established in the appendix valuation.
• that Equitable ‘informs its holders of accumulating with profit contracts of the amount of their accumulating final bonus (although clearly stating that it is not guaranteed), but only holds reserves for a discounted sum compared with the current guaranteed value’.

GAD explained to DTI that:

Because of the large proportion of business written on a participating basis and the high level of annual emerging surplus, there are not considered to be any actual potential solvency problems for the Society, but it does seem that, in the event of a marked fall in asset values, the Society might find itself in a position where it had to cut back severely the level of payout to members.

It would seem desirable for the Society to hold back more of its emerging surplus by declaring lower guaranteed bonuses – although it could still attempt to pay out generous final bonuses to members (preferably without raising expectations too much in advance with its declarations of “non-guaranteed final bonuses”).

GAD said that they were taking up a number of points with Equitable, including the provision made for resilience, possible tax on capital gains, and pensions mis-selling.

199 Also on 16 December 1997, GAD pursued five specific issues with Equitable:

• GAD pointed out that Equitable did not state which assets were backing the required resilience reserve. GAD queried if the figure indicated in the report on the appendix valuation (£501 million) should be grossed up.
• GAD queried whether it was acceptable for Equitable to assert that other margins were available to cover the contingent liability to tax on unrealised capital gains and invited Equitable to advise what other margins were considered to be available.
• GAD noted the provision for £50 million for pensions mis-selling in the main valuation and asked where the corresponding provision was in the appendix valuation.
• GAD noted that Equitable stated that terminal bonus additions were implicitly covered by the amount of excess admissible assets held over the mathematical reserves — shown in the 1996 returns as being about £1,400 million (including the required minimum margin). GAD added:

However, since your reserves already value current guaranteed benefit values at a combined discount of some £1.3bn, it seems likely that the total current “asset shares” (including the final bonuses indicated to members) exceed total current admissible assets. Is this a correct deduction? Please provide a figure for the accumulated asset shares for all in-force accumulating with-profit contracts at end 1996.

• GAD asked if the reserves for any accumulating with-profits policies were less than the basic surrender values (i.e. excluding terminal bonus) available on the valuation date and, if so, what was the total of those differences.

200 In their initial scrutiny report on 7 August 1997, GAD had noted that Equitable did not appear to have made proper provision for policyholders’ reasonable expectations in the valuation rates of interest used for with-profits business. GAD did not refer to this issue in their detailed scrutiny report nor did they pursue it with the Society.

201 On 13 January 1998, Equitable replied to each of GAD’s five queries. They explained:

• that the resilience reserve required in the appendix basis was the grossed-up value.
• that substantial margins were available in the expense reserves that could be used to cover the contingent liability to tax on unrealised capital gains. The Appointed Actuary suggested that, as the tax would essentially relate to gains that Equitable would distribute as terminal bonus, it was not necessary to reserve for it.
• that a provision for pensions mis-selling was held in the appendix valuation, on a similar basis to that held in the main valuation.
• that they were unclear what GAD meant by their question, explaining that: ‘The face value of benefits is the current value of guaranteed benefits if a contractual event (e.g. death) occurred at the valuation date. In most cases there is no contractual right to receive the current accumulated benefit at the valuation date’. Equitable went on to say that GAD were ‘correct in deducing that at 31.12.96 the total face value of policies including accrued final bonus was in excess of the value of the assets attributable to the with profits business. Those assets will include items like the accumulated new business strains and so are higher than a pure share of the Form 9 admissible assets’. For accumulating with-profits business, the total smoothed asset shares at 31 December 1996 were some £14,700 million.
• that surrender values were not guaranteed for Equitable’s accumulating with-profits business. The Society said that the valuation ‘took account of the range of ages at which benefits could be taken at full value, including on retirement, which explains why the discounted value of benefits was 95% of their face value when the typical outstanding period to the selected pension date would lead one to expect a much more substantial degree of discounting’. Equitable did not answer GAD’s question as to whether reserves were less than the surrender values for any policies as at 31 December 1996.

202 On 16 January 1998, GAD wrote again to Equitable:

• GAD stated that it would be easier for them to follow the resilience reserve calculation if this reserve were included in the matching rectangle. GAD asked Equitable to reconcile the change in asset and liability values in the resilience scenario disclosed in the main valuation and the change disclosed in the appendix valuation (as the figures were different).
• GAD stated that they were not convinced that it was appropriate to use margins within the expense reserves to cover the contingent liability to tax on unrealised capital gains. Neither did GAD accept Equitable’s view that they did not need to reserve for this liability. GAD asked Equitable to reconsider this matter for the 1997 returns.
• GAD noted that the reserve for pensions mis-selling was included in the reserves for personal pensions business in the appendix valuation. GAD asked Equitable to disclose this reserve separately in future returns.
• GAD accepted that the amount of the current face value of guaranteed benefits was not immediately payable at the valuation date. However, GAD noted that the total asset share for accumulating with-profits business of £14,700 million exceeded the reserves in the appendix basis by £3,800 million. This, they said, clearly exceeded the amount of free assets shown in the returns. GAD stated that, whilst this did not necessarily cause concern, the lack of a free estate highlighted the importance of not building up policyholders’ expectations too far.
• GAD again asked Equitable to confirm whether the policy reserves in the appendix valuation for any accumulating with-profits policies were less than the basic surrender values (i.e. excluding final bonus) available on the valuation date.

On the same day, GAD provided the Treasury^[26] with copies of their post scrutiny correspondence with Equitable.

203 On 4 February 1998, the Society responded to GAD’s further queries. The Appointed Actuary:

• explained that the differing amounts quoted for the change in asset and liability values were accounted for by the differing treatment of index-linked business.
• noted GAD’s comments and undertook to reconsider the matter for the 1997 returns.
• explained that the Society’s approach in the 1996 returns reflected the difficulty of quantifying the amount of the possible liability. He stated that, as Equitable now had more data, he would be ‘showing an explicit reserve in the 1997 returns’.
• suggested that the figures given by GAD in their letter of 16 January might have somewhat misrepresented the position, as GAD had compared the excess of policy values over the appendix net premium reserves with the available assets shown in Form 9 of the returns, which were determined by reference to the reserves established under the main (gross premium) valuation.^[27]
• explained that the Society took great care to emphasise that the final bonus element of the current policy value was not guaranteed in any way. He suggested that declared bonuses were being kept imprudently high by some offices, particularly on with-profits bonds ‘partly due to a failure of [those] offices to communicate the developing terminal bonus position adequately to their clients’.
• again did not answer GAD’s question regarding whether the policy reserves in the appendix valuation were less than basic surrender values.

204 On 27 February 1998, GAD wrote once more to Equitable to seek a response to the last point. GAD stated:

It is clearly in the best interests of the whole industry for all participants to be wary of either granting over-generous guaranteed bonuses or of building up any false expectations in relation to final bonuses. The manner in which Equitable operates as a mutual – giving the best possible returns to each generation of policyholders, with the consequent lack of any substantial unutilised free estate, does mean that you do not have much of a cushion to enable you to protect holders of such contracts from the natural effects of future falls in the market value of assets. We remain confident that your company is fully aware of this.

 

On the same day, GAD advised the Treasury that there were no compliance points in relation to the 1996 returns to follow up. GAD confirmed that:

… even though our correspondence is not yet concluded about their accumulating with-profit business we are basically satisfied with the prudence of their reserving bases as adopted for the 1996 returns.

The position revealed is very tight, since Equitable operates on the basis that, as a mutual, it should endeavour to give full value to each generation of policyholders. It therefore does not accumulate any meaningful free estate. Hence our desire to ensure that it does not build up any false expectations for its policyholders, because it would be hard for it to establish reserves for any greater liabilities than those it currently recognises.

GAD concluded that the Treasury could regard the scrutiny of the 1996 returns as complete.

205 On 12 March 1998, the Society’s Appointed Actuary wrote to GAD to explain that he now understood the question about whether any reserves for accumulating with-profits policies were less than basic surrender values.

206 He stated that the Society could not ‘state categorically that the non-contractual surrenders we were actually paying on 31 December 1996 were, in all cases, lower than the mathematical reserves held’. The Appointed Actuary added that he was not clear as to the relevance of the point raised by GAD, as:

The surrender values being paid were only “available” because we were prepared to pay them on the low incidence of early non-contractual terminations being experienced. If we had been experiencing a significant volume of surrenders we should have exercised our right to reduce further the values paid – possibly to below the level of the mathematical reserves in all cases – in order to protect the fund.

 207 In the light of this further exchange, GAD invited Equitable to a meeting to discuss the issue. GAD explained that:

The whole area of the appropriate bonus methodology to be used for accumulating with-profits business, the expectations built up for policy holders and the establishment of proper reserves has become more difficult as a greater proportion of investment returns is being derived from asset appreciation – which could prove to be ephemeral.

208 On 28 May 1998, GAD met Equitable. GAD made no formal record of the meeting but noted the following:

Non [guaranteed] element could be negative.

Particular problems with Bonds rather than pensions [business].

Has company done specific market research on policyholder understandings? Analysed telephone queries.

Further discussion to take place on reserves. – Equitable.

Discussed PRE surrender test.

209 According to the Society’s note of the meeting, the discussion had been fairly unstructured and GAD had gone through a ‘ragbag of not particularly well thought through concerns’ that they had. However, GAD’s main points had seemed to be that ‘Declared bonus rates are still too high’, that offices had been incautious in distributing recent high capital returns and that it would be difficult to change terminal bonuses without ‘severely damaging policyholders’ perceptions of them’.

210 Equitable also recorded that, at the meeting, they had strongly refuted GAD’s concern that the Society was more exposed to these risks than most other life insurance companies, as a result of its ‘full distribution’ approach to bonuses and anecdotal evidence that policyholders believed their full fund value to be guaranteed. The Society’s note recorded that GAD had stated that GAD were ‘considerably more reassured about our approach than they had been at the start’.

211 Following the meeting, GAD explained in a letter to Equitable on 8 June 1998 that:

I think that there is little more to be said or done at this stage in relation to the reserving bases that are appropriate for accumulating with-profits business but it is clear that we are agreed that great restraint should be exercised in relation to the setting of guaranteed bonus levels at a time when a large part of investment returns is being derived from capital gains.

 212 On 8 June 1998, GAD provided an update to the Treasury on the position. GAD confirmed that, in the light of those discussions, GAD ‘did not conclude that any particular strengthening of their reserves was needed in relation to accumulating with-profits business, although I remain somewhat concerned that not all holders of such contracts (with this and other offices) appreciate what could happen at future bonus declarations if we saw a sudden downturn in the market values of assets. The whole industry is relying on a soft landing, so that reductions can be achieved gradually and without trauma’.

213 Events were soon to take a different turn for the prudential regulation of the Society. In the next Chapter, I turn to summarise those events.

Footnotes

1 A matching rectangle is a table showing the assets hypothecated, or notionally allocated, to liabilities. It thus allows the regulators to establish if the valuation rate of interest for any liability is supported by the yield on the notionally allocated assets. A specimen is annexed to Part 2 of this report.

2 A report on the actions available to the company for dealing with particular circumstances, traditionally prepared by the  Appointed Actuary for the Board.

3 Quoted in the Journal of the Institute of Actuaries, Volume 120, pp. 481 – 482.

4 Article 65 of Equitable’s Articles of Association stated that the amount of any bonus which may be declared or paid and the amount to which any policyholder may become entitled ‘shall be matters within the absolute discretion of the Directors, whose decision thereon shall be final and conclusive’.

5 Standard & Poor’s are an international company providing credit ratings and other financial services. Their reports were paid for by the companies concerned.

6 When scrutinising Equitable’s 1991 returns, the GAD actuary had noted that the option of reducing bonuses was less of a protection for Equitable, as terminal bonus did not represent a high proportion of their total payouts.

7 Shortly after the meeting, in December 1993, the Appointed Actuary presented a report to Equitable’s Board, which set out amendments to Equitable’s Statement of Bonuses, including the insertion of wording describing a differential terminal bonus policy for policies with guaranteed annuity rates. The amendment was agreed.

8 Equitable did not provide any further information on this point until GAD raised the issue in March 1994.

9 Equitable’s cover had fallen from 4.77 at the end of 1989 to 1.67 at the end of 1991.

10 In December 1993, GAD produced a question by question summary of the responses to the survey. This was largely factual and did not refer to companies by name. GAD did not include any further analysis of the responses or seek to draw any general conclusions. I have seen no other evidence regarding whether and, if so, how Equitable’s response to the bonus survey, or the responses from other companies, were assessed with regard to policyholders’ reasonable expectations or any other considerations, at that time or subsequently. In March 1995, Equitable wrote to GAD to state that they had seen a press report from which it appeared that GAD had decided to take no action as a result of the survey. Equitable complained that it had been discourteous of GAD to disseminate the results of the survey in such a way. In April 1995, GAD replied. GAD stated that they had explained to the journalist in question that ‘… the grounds for intervention available to the Secretary of State are prescribed in the [Insurance Companies Act] 1982, as amended, and if higher bonuses are awarded than have been earned, this is principally a matter of commercial judgement provided the reasonable expectations of the other policyholders are not affected.’ GAD denied that they were disseminating the results of the survey through the press and added: ‘In fact, during the conversation I told [the journalist] that it was decided not to publish the results of the survey due to the difficulty of not laying ourselves open to the charge that one could identify particular companies’ practices.’

11 I have seen no evidence to support that statement. I have been told by the Society’s former Appointed Actuaries that it is their recollection that: ‘it was GAD’s consistent view that, by publishing an appendix valuation which was intended to be close to the statutory minimum, ELAS revealed much more about the strength of its main valuation than was the norm whereby offices just published one net premium valuation on a basis stronger than the statutory minimum’. Those former Appointed Actuaries also pointed out to me that GAD had not challenged the comment at the time.

12 The apparent margin of £476 million, between Equitable’s published valuation (£8,557 million) and their statutory minimum valuation (£8,081 million), fell to just £14 million when the resilience reserve of £462 million was added.

13 GAD had established a Scrutiny Strategy Working Party in 1994, and it appears that it was as a result of this that the Service Level Agreement (SLA) between the DTI and GAD came to be revised in 1995. The revised SLA included a new detailed format for scrutiny reports and it appears that GAD’s report on the 1993 returns anticipated its adoption.

14 By this, GAD meant that policyholders could conclude that Equitable’s position was stronger than was in fact the case.

 

15 The apparent margin of £323 million, between Equitable’s published valuation (£11,450 million) and their statutory minimum valuation (£11,130 million), fell to just £81 million when the resilience reserve of £236 million was added.

16 The first such meeting had been held in May 1992.

17 See footnote 5, earlier in this Chapter.

18 The apparent margin of £301 million, between Equitable’s published valuation (£12,380 million) and their statutory minimum valuation (£12,080 million), fell to £130 million when the resilience reserve of £171 million was added.

19 See the glossary of terms for an explanation of this term.

20 That is, a lower priority.

21 The previous two meetings had been held in May 1992 and December 1994.

22 GAD noted that the level of investment had increased from £52 million to £94 million. The latter figure represented 0.62% of Equitable’s non-linked assets.

23 However, I have seen that, in a report to Equitable’s Board in January 1997, the Appointed Actuary had justified the pursuit of a subordinated loan by reference to Equitable’s relatively weak solvency position, the tightening of the valuation regulations and the way they were interpreted, and the increased scope for GAD to challenge his choice of bases. This report was not seen by the prudential regulators or GAD at that time.

24 See paragraphs 715 to 723 of Part 2 of this report.

25 In May 1998, Equitable explained that their estimated liability was now £75 million.

26 Responsibility for prudential regulation had passed from DTI to the Treasury on 5 January 1998.

27 GAD subsequently pointed out, on 27 February 1998, that the available assets, calculated by reference to the appendix valuation reserves (including the resilience reserves), were in fact very little different from those shown in the main valuation.