The prudential regulation of Equitable in the period between 20 June 1998 and 8 December 2000

Introduction

1 In this Chapter, I summarise the way in which the prudential regulation of the Society was undertaken during the period from 20 June 1998 until the Society closed to new business on 8 December 2000.

2 As was explained in Chapter 6 of this report, this covers a period where the supervision of the Society was undertaken with heightened intensity as a result of information provided by it to the prudential regulators and GAD concerning serious financial difficulties which Equitable faced. This Chapter is structured in the following way:

• in paragraphs 3 to 12, I explain how the Society’s annuity guarantees problem became known to the prudential regulators and GAD;
• in paragraphs 13 to 60, I explain how those regulators and GAD reacted to the Society’s guaranteed annuity issue and how, in particular, they dealt with three questions that arose for consideration, relating to:

(i) the Society’s practice as to reserving for the annuity guarantees, which I cover in paragraphs 17 to 41;

(ii)what the Society had told its policyholders, which I cover in paragraphs 42 to 52; and

(iii) what the Society had told the prudential regulators and GAD, which I cover in paragraphs 53 to 60;

• in paragraphs 61 to 75, I set out the events relevant to the consideration given by the prudential regulators and GAD to the Society’s financial position in the immediate aftermath of their awareness of the annuity guarantees problem;
• in paragraphs 76 to 172, I summarise, on a monthbymonth basis, the events which occurred during the period starting from the preparations for the handover on 1 January 1999 of regulatory functions from the Treasury to the FSA and ending with the decision of the House of Lords in the Hyman case, which was handed down on 20 July 2000; and
• in paragraphs 173 to 231, I summarise the events which occurred during the period between the Hyman judgment and the Society’s decision to close to new business on 8 December 2000.

The Society’s GAR problem

The intimation of the problem

3 On 20 June 1998, GAD wrote to all life insurance companies enclosing a questionnaire seeking information on the annuity guarantees they had written, their methods of reserving for such guarantees, and related issues.

4 GAD’s survey followed a similar exercise (which they had instigated) undertaken by the actuarial profession who, in January 1997, had set up an Annuity Guarantees Working Party to consider the issue of annuity guarantees and how companies should reserve for them in the context of low interest rates and improved mortality, which made such guarantees more valuable. As part of their enquiries, the profession’s Working Party had surveyed offices that had written business containing guaranteed annuity rates.

5 On 1 November 1997, the Working Party published its report and approximately one month later, at the profession’s annual Life Convention held from 30 November 1997 to 2 December 1997, that Working Party presented their findings to the industry.

6 Their report, which dealt with companies on an anonymous basis, identified three approaches to reserving for contracts containing annuity guarantees that had been used by companies, none of which were found to be entirely satisfactory. One of the approaches identified involved covering the guarantees by adjustments to terminal bonus. The Working Party considered that this ‘could be viewed as unsound because no explicit provision is made for an explicit guarantee’.

7 One of the members of the Working Party had been an actuary from GAD, who was party to the results of their work. However, it has been said that the Working Party had collected the information which underpinned their conclusions on a confidential basis and GAD considered that it could not use this information for other purposes, including in providing assistance and advice to the prudential regulators.

8 On 10 February 1998 at an internal directorate meeting, GAD discussed the annuity guarantee issue and the fact that the findings of the profession’s Working Party demonstrated that a problem existed and that 75% of companies were not reserving properly^[1]. The minutes of that meeting record that GAD had decided to conduct its own survey into the issue.

9 On 18 June 1998, GAD informed the Treasury that they intended to conduct a survey of companies about annuity guarantees. GAD explained that ‘a number of [companies which had sold policies containing guaranteed annuity rates] may now be significantly exposed to additional liabilities in respect of these guarantees’. On 19 June 1998, the Treasury gave their agreement for GAD to conduct the survey. GAD sent out the survey questionnaires on the following day.

10 On 29 July 1998, Equitable submitted their completed questionnaire to GAD. In this, the Society explained:

• that Equitable had sold policies between 1956 and 1988 which carried a guaranteed annuity rate (which also applied to future premiums);
• that Equitable did not reserve for thoseguarantees (against this, GAD wrote ‘?’);
• that Equitable made no general allowance for the guarantees, when establishing maturity values, and took no significant account of the guarantees when determining investment policy and matching guidelines;
• that, for any policy for which the annuity guarantee was ‘biting’ (that is, where such a guarantee had become more advantageous than an alternative option), Equitable reduced the amount of terminal bonus to pay for the cost of the guarantee; and
• that Equitable did not advise policyholders of any available options to receive a guaranteed annuity when they reached retirement (against this, GAD also wrote ‘?’).

Equitable added as a final comment:

The cost of annuity guarantees has more than adequately been covered by the terminal bonus cushion to date for all but a few small policies, as described … above. As the business to which annuity guarantees apply ages, the increasing terminal bonus cushion will make it increasingly unlikely that guarantees will actually bite.

GAD sidelined this comment and wrote: ‘Is thisacceptable?’.

11 This constituted disclosure of the GAR issue – thatis, that the Society had extensive exposure in itsolder business to such guarantees and that it hadmade no explicit provision for the liabilities arisingfrom those guarantees.

12 That disclosure gave to the prudential regulatorsand to GAD a clear indication that the Society’sreported financial position might not have beenprudent and that its liabilities might have beenunderstated. Those issues still had to be resolved.An enhanced level of scrutiny and supervision wasnow to be given to the Society.

Regulatory treatment of the GAR issue

13 On 1 September 1998, GAD wrote to the Treasuryconcerning the monitoring of the behaviour ofcompanies towards policyholders whose policiescontained a valuable guarantee. GAD advised thatthe Treasury had a duty to ensure that insurancecompanies did not try to avoid meeting theirobligations, as this would be a breach ofpolicyholders’ reasonable expectations. GADsuggested that the Treasury had a number ofoptions, those being:

• to advise all companies that avoiding theirobligations would constitute unacceptablebehaviour;
• to ask all companies to report on theprocedures that were in place to ensure thatguaranteed rates would be applied in maturity option quotations, and that the existence ofoptions was made known (although GADqueried this internally as being perhaps ‘a steptoo far’);
• to use any policyholder complaint or one madeby an independent financial adviser as a triggerfor a visit to review a company’s procedures inthese respects;
• to carry out an investigation under section 43Aof the 1982 Act^[2] should there be anysubsequent failures; and
• to take further action, including a review ofcases and consideration of ‘fit and proper’  action^[3], if a substantial problem were identified.

14 On 3 September 1998, the Treasury’s Head of LifeInsurance welcomed GAD’s note as a clarification ofthe issues. At the same time, in the light of pressattention being given both to annuity guaranteesand to Equitable, and prior to the Treasurycontracting out their prudential regulatoryfunctions to the FSA4, he advised the relevant FSAManaging Director of the action that the prudentialregulators and their advisers had taken on annuityguarantees.

15 The Treasury explained that, ‘when it became clearthat a number of companies had issued policieswith these guarantees’, GAD, on the Treasury’sbehalf, had written to all companies seekinginformation about such guarantees and how thosecompanies had reserved for them.

16 On 15 September 1998, GAD advised the Treasury toexplore further the issue of meeting the costs ofproviding guaranteed annuity rates by reducingterminal bonus. There followed, over the next threemonths, detailed correspondence between theTreasury and the Society about the latter’sapproach. Officials from the Treasury and GAD alsomet Equitable four times. In the course of theseexchanges, three questions emerged:

(i) Did Equitable need to reserve for the annuityguarantees within the policies that they hadsold – and, if so, at what level?

(ii) What had Equitable told their policyholdersabout their practice?

(iii) What had Equitable told the prudentialregulators?

Reserving for annuity guarantees

17 The first question which arose in the discussionsbetween the Society and the prudential regulatorsand GAD concerned the approach which Equitabletook to the establishment of the reserves requiredin respect of those policies which containedguaranteed annuity rates. Throughout thosediscussions, the Society defended its approachrobustly.

18 On 29 September 1998, the Society explained thatit had introduced the differential terminal bonuspolicy in order to be fair to all policyholders (in thatthis resulted in benefits of broadly equivalent value,irrespective of whether or not a guaranteed annuitywas taken). Equitable stated that this had been theirpolicy since the end of 1993.

19 Equitable, in their response to GAD’s questionnaire,had implied that the Society had not reserved in its1997 returns for the annuity guarantees because,where the guaranteed rate was ‘biting’ (i.e. theguaranteed rate was higher than any availablecurrent annuity rate), Equitable were protected bythe cushion of the differential terminal bonuspolicy. In the subsequent exchanges with theTreasury and GAD, Equitable informed thoseregulators and GAD that the position had changed.

20 On 2 October 1998, at a meeting with the Treasuryand GAD, Equitable’s Chief Executive stated that:

… no provision had been made for GAOs as at31 December 1997 since it had only beenrecently that the guarantees were biting on theguaranteed fund. The Equitable does not as amatter of course reserve for GAOs that existon policies; the recent practice has only beento reserve once the guarantees bite.^[5]

 21 Equitable further explained that, even where theguarantees were more advantageous than the openmarket option, there had been a low take-up of theguaranteed options.

22 On 30 October 1998, Equitable stated that, in thefirst nine months of 1998, only 3% of retirementannuity benefits had been taken in the form of aconventional non-profit annuity. Equitable alsostated that ‘[all] retirement cases are checked todetermine whether, if a conventional non-profitsannuity is required, the guaranteed annuity ratewill produce a higher level of income’^[6] than aconventional non-profit annuity at the current rate.This, they said, had been so in around 30% of cases.

23 Equitable said that they had advised thepolicyholders concerned but none had taken up theguaranteed option^[7]. The Society concluded that, ina worst case scenario of 100% take up of thoseguaranteed options which produced a higherincome, the reserving requirement amounted tosome £170 million and that their 1998 experiencesuggested that £50 million would be the more likelycost.

24 For their part, GAD took the view from the outsetthat guarantees had to be reserved for, whether ornot they were more advantageous. On 3 November1998, GAD observed that the Society’s analysis atthe end of October 1998:

… does not take account of the key point thatthe existence of a guaranteed annuity rateincreases the level of cash that needs to bepaid in substitution for that annuity (asotherwise policyholders would not agree totake the cash sum in place of the guaranteedannuity).

GAD advised the Treasury that:

… appropriate mathematical reserves need tobe established for the full value of theseguaranteed benefits and the associatedobligations to policyholders in accordance withPart IX of [the Insurance Companies Regulations1994], including in particular Regulation 64. It isnot acceptable in this context to regard theseguarantees as covered by a “first charge” againsta final bonus for which no provision is made.

GAD stated that, on this basis, a reserve of  £170 million was quite inappropriate and advisedthe Treasury to ask Equitable how they proposedestablishing the reserve that was required. GAD alsosuggested that, if the Society were unable to meetthis obligation, intervention using the powersavailable to the prudential regulators might bewarranted. GAD added that ‘we believe thatpolicyholders would expect Equitable to maintainadequate mathematical reserves to cover theirobligations’.

25 The Treasury conveyed those views in writing tothe Society on 5 November 1998 and also at ameeting on 13 November 1998. On 24 November1998 in response, Equitable estimated that, usingthe Treasury’s approach, the reserving requirementat the end of 1997 would have been approximately  £675 million. Equitable estimated the equivalentfigure for the end of 1998 could be between  £955 million and £1,360 million. An annotation madeby GAD on the Society’s letter suggested that GADconsidered that the figure might actually be as highas £1,650 million.

26 The Society continued to dispute strongly therequirement that it should reserve on the basis of100% take up of guaranteed annuity options. On24 November 1998, Equitable suggested that therewas some misunderstanding of the precise policybenefits in question which the exchanges with theTreasury and GAD had not resolved.

27 The Society accordingly provided three examples ofhow the differential terminal bonus policy wasapplied, in order to demonstrate ‘why the vastmajority of policyholders selected the cash fund[that is, the open market] form of benefit’ ratherthan the guaranteed annuity. Equitable claimed thattheir approach to reserving fulfilled therequirements of the applicable Regulations. TheSociety warned that the consequences for it ofadopting GAD’s approach to reserving were  ‘potentially extremely serious’.

28 Equitable then set out five options available tothem in those circumstances:

(i) Passing [that is, not making] the bonusdeclaration, either for all business or for theclasses incorporating guaranteed annuityrates.

(ii) Raising capital either through furthersubordinated debt (limited scope at present) orfinancial reassurance.

(iii) Trying to obtain some sort of protection basedon derivatives.

(iv) Publishing a [statement of solvency] where therequired minimum margin is only just covered.

(v) Making a sizeable switch from equities to fixedinterest or cash.

The Society went on to explain:

Of the above (ii) is now probably ratherdifficult to put in place by 31 December [1998]and there must be doubts as to how effective(iii) could be. Approaches (i) – (iv) carry verysignificant [public relations] risks – possibly of ascale which would threaten the continuedindependence of the Office. Approach (v) willdamage the future prospects of policyholdersfor a number of years.

29 GAD remained of the clear view that Equitable hadto reserve in full. At the meeting on 3 December1998, the Society’s Chief Executive stated that ‘thereserving basis required was excessively prudentand bore no resemblance to commercial realityand policyholders would be damaged by this(through a change to a more conservativeinvestment policy, passing bonuses or throughthere being a run on the office)’.

30 The Chief Executive was told by the Treasury’s Headof Life Insurance that he could not see any scopefor granting Equitable any concession, as thereserving requirements derived from EuropeanDirectives. Equitable’s Chief Executive was also toldthat the only avenue of appeal would be to seekjudicial review of the Treasury’s decision. The ChiefExecutive said that the Society ‘might well have totake up this option’.

31 In response to the suggestion from GAD’s ChiefActuary C that financial reinsurance could be usedto offset their reserving requirements, Equitable’sAppointed Actuary confirmed that he hadconsidered that that was ‘[an] option for protectingthe balance sheet’. However, the AppointedActuary pointed out that it was unlikely that anyreinsurance agreement could be put in place by31 December 1998.

32 The Treasury said that, in those circumstances, itmight be possible for the prudential regulators togrant Equitable a concession so that the effect ofany such agreement was pre-dated to cover the1998 year-end position.

33 The Appointed Actuary expressed his concern that  ‘from a professional point of view … he was beingforced to adopt a reserving approach that was  “wildly prudent”’. He said that he might have toconsult the actuarial profession on that matter.

34 In response to this, GAD’s Chief Actuary C said thathe did not think there was a professional issue toconsider as, in his view, ‘[there] was … a distinctionbetween the legal position as required byRegulation 64 and [for example] the resiliencereserve, where there was more scope forprofessional judgement and interpretation’.

35 On 8 December 1998, GAD advised the Treasurythat:

… it could be reasonable to assume that lessthan 100% of policyholders elected to take theguaranteed annuity provided that the reserveheld in respect of those policyholders who areassumed to take an alternative annuity benefitis based on a realistic value of that alternative.

GAD noted that the Society’s approach had beenone identified by the actuarial profession’s AnnuityGuaranteesWorking Party as potentially ‘unsound’^[8]. After some doubt, legal advice provided within theTreasury supported the view that Equitable had toreserve on a 100% basis^[9]. The Treasury reiterated thisposition to Equitable.

36 On 15 December 1998, the Treasury advised the FSAas part of the discussions held with them in advanceof the FSA taking on the day-to-day regulation ofinsurance companies, that in their view:

Equitable is effectively having to “guarantee”  to pay terminal bonuses at a level whichmeans that the cash option is worth as muchas the annuity option in order to be able toassume policyholders continue to take thecash option. If terminal bonus is effectivelyguaranteed we consider the company needs toreserve for it (it has effectively become a  “guaranteed benefit”).

37 On 18 December 1998, Equitable supplied to theTreasury a copy of Counsel’s opinion they hadreceived which supported their stance. Counsel hadadvised that, had Equitable reserved on the basisnow suggested, the Society would have beenunable to pay bonuses in previous years.

38 Counsel also advised that, had the prudentialregulators taken a consistent line on the issue from1994, it would have been possible for the Society tohave absorbed any need to establish reservesgradually. But, as a result of the Treasury seeking toimpose their interpretation of the Regulations forthe first time at the end of 1998, Counsel said that itappeared that the prudential regulators were nowrequiring the Society to establish a ‘one-off’ reserveof approximately £1,500 million.

39 In the course of these discussions, Equitabledisclosed that policyholders could apply theguaranteed annuity rate to money they transferredin from other schemes, prior to retirement.

40 On 22 December 1998, the Treasury and GAD metEquitable once more. There was no agreement onthe issue of reserving. The Treasury offered toconsider any case Equitable put forward for thephasing in of reserves. But the Treasury warned thatthey would take regulatory action if the Society’sreturns disclosed that the reserves established byEquitable were inappropriate, or if the Society’sactions imperilled its solvency cover. The Treasuryalso agreed to consider and respond to Counsel’sopinion which the Society had shared with them.

41 On 11 January 1999, the FSA advised Equitable thatthat opinion did not cause them to change theviews which had been expressed by the Treasury.The FSA stated that, in their view, the company’sdiscretion not to pay additional bonuses was  ‘substantially fettered’ and that ‘prudence wouldrequire the actuary to hold a reserve which iswithin a few percentage points of the reserverequired for the guaranteed benefit’.

What had Equitable told their policyholders?

42 The second question which arose during thediscussions between the Society and the prudentialregulators and GAD concerned what informationhad been given to its policyholders about theguaranteed annuity rates contained within thepolicies that Equitable wrote and about theirdifferential terminal bonus policy. Again, theSociety robustly defended its position.

43 In doing so, on 29 September 1998 Equitable toldthose regulators and GAD that the Society haddescribed its approach to bonuses ‘in the mostgeneral terms in marketing literature’. However,Equitable also said that, when writing topolicyholders, they had made it very clear thatterminal bonus was allotted only at retirement, thatthe amount could vary, and that it was notguaranteed. Equitable explained that a noteindicating the possibility of a different terminalbonus had been added to the 1995, 1996 and 1997policyholder annual statements^[10].

44 For their part, GAD advised the Treasury toestablish if Equitable had marketing literature orother evidence to support their approach, as theTreasury needed ‘to be satisfied that the reasonableexpectations of policyholders are being met’.

45 On 21 September 1998, the Treasury had askedEquitable for copies of marketing literature andpolicy documents, which were then supplied. TheTreasury’s initial view was that the Society’sapproach was in accordance with the contracts soldand that Equitable were endeavouring to fulfil thereasonable expectations of their policyholders.

46 On 6 November 1998, the Treasury noted that theprudential regulators still needed to take a view onwhether Equitable were acting with due regard tothe interests of their policyholders and moregenerally in accordance with those policyholders’  reasonable expectations.

47 On 12 November 1998, GAD set out a number of ‘fundamental questions’ – including whetherEquitable had made their differential terminalbonus policy sufficiently clear to policyholders(GAD said that they doubted that the availableevidence demonstrated that policyholders’  reasonable expectations had been adequatelymodified) and whether the introduction of thepolicy was itself contrary to policyholders’  reasonable expectations. GAD identified a need toreview Equitable’s documentation ‘to assess thereasonableness of their approach on [guaranteedannuity options] in terms of PRE’.

48 GAD and the Treasury both considered that theyrequired further documentation from the Society(as the Treasury were concerned that Equitablemight have ‘cherry picked’ those supplied so far). Atthe meeting with Equitable on 13 November 1998,GAD and the Treasury therefore asked for anadditional selection of documents ‘to get a feel forwhat impression had been given to policyholdersover the years’.

49 At a meeting on 3 December 1998, the Treasurysought more documentation, relating to theprevious 40 years. The Treasury explained that thedescription of Equitable’s contracts and bonuspolicy in the documentation supplied so far ‘did notappear to be fully in line with the approachadopted by the company’.

50 On 23 November 1998 and 17 December 1998, theSociety supplied the further information sought byGAD and the Treasury. That information includedcopies of the literature which had been sent to GARpolicyholders over the lifetime of the contract.Equitable also supplied a copy of a leaflet recentlyprovided to policyholders considering retirement,explaining the guaranteed annuity rates issue andthe operation of the differential terminal bonuspolicy.

51 While those exchanges were taking place, theTreasury considered whether to provide guidanceto the insurance industry. On 18 December 1998, theTreasury issued to Managing Directors of all UnitedKingdom life companies guidance on ‘GuaranteedAnnuity Option Costs and Policyholders’  Reasonable Expectations’. That guidanceacknowledged the possibility that the terminalbonus added at the maturity of a contract with aguaranteed annuity might be somewhat lower thanthe terminal bonus for contracts without suchoptions or guarantees or where benefits were takenin other forms. The Treasury added that:

… the appropriateness of any adjustments tobonus allocations for participatingpolicyholders would need to be assessed byeach office in the context of the reasonableexpectations of policyholders. This assessmentwill be influenced by their policy documentsand any representation made throughmarketing literature, bonus statements orelsewhere.

52 Also on 18 December 1998, Equitable announcedtheir intention of taking a test case to theHigh Court, in order to seek confirmation thatthey had acted within their powers in adoptingthe differential terminal bonus policy. On26 January 1999, the FSA, which was now exercisingthe prudential regulatory functions contracted outby the Treasury, took the view that the issue ofpolicyholders’ reasonable expectations should beput on hold, pending the outcome of that Courtcase. As a result, there was no further analysis atthat time of the information supplied.

What had Equitable told the regulators?

53 The third question which arose in the discussionsbetween the Society and the prudential regulatorsand GAD related to whether Equitable had properlydisclosed the position with regard to guaranteedannuity rates to those regulators. Again, the Societydefended its position and maintained that Equitablehad disclosed their differential terminal bonuspolicy in the 1993 returns and in each subsequentyear.

54 At the meeting on 3 December 1998, Equitableargued that GAD should have been aware fromthose returns that the Society was writing businesswhich contained guaranteed annuity rates. By notquestioning that disclosure, the Society said thatGAD had since 1993 ‘tacitly accepted’ Equitable’sapproach to reserving.

55 On 22 December 1998, the Society noted thatCounsel had expressed the view that Equitable, intheir returns from 1993 to 1997, had ‘consistently’  notified the prudential regulators of theirdifferential terminal bonus policy, and that thoseregulators had been well aware that there existedpolicies containing guaranteed annuity rates withinthe Society’s business^[11].

56 For their part, on 16 November 1998 GAD notedthat the differential terminal bonus policy had been  ‘mentioned’ in the 1993 returns but disputed thatEquitable had disclosed their reserving basis inthose returns or that GAD had acquiesced in theSociety’s approach.

57 On 8 December 1998, GAD argued that thereferences in the 1997 returns had been ‘brief’ and  ‘[as] the Actuary signed a certificate whichconfirmed that the liabilities had been determinedin accordance with the regulations we had noreason to challenge that Actuary’s basis’^[12].

58 GAD developed this point on 4 January 1999,accepting:

… with hindsight that we might have addressedthe issue rather earlier by asking some pointedquestions about their guaranteed annuities.However, the presentation of their valuationmethodology in their returns was somewhatobscure, and required the reader to pick upcomments in three quite separate parts of thereturn and draw certain inferences from them.There was nothing said to indicate that thelevel or extent of these guaranteed annuitieswere regarded as significant.For example, the wording in paragraph 5 refersto no explicit provision being made in currentconditions for the “other” guarantees inparagraph 3, without clarifying exactly whichguarantees have or have not been included, orsaying whether allowance had been madeimplicitly for guarantees within themethodology adopted or within the othervaluation assumptions.

59 GAD expressed ‘some sympathy’ with Counsel’sargument that, had the prudential regulators taken aconsistent line on the issue of reserving from 1994,it would have been possible for the Society toabsorb the need to make reserves gradually. However, GAD noted that ‘most of the increase inthe £1.5bn provision has arisen in 1997 and 1998 …’.

60 The FSA shared GAD’s views on the informationwhich had been given within the regulatory returns.On 11 January 1999, in commenting on Counsel’sopinion, the FSA rejected the suggestion that theinformation in those returns could be seen asconstituting notice to the DTI or to the Treasury ofthe Society’s reserving practice. The FSA argued:

… the statements in the returns are brief in theextreme and do not disclose the reservingmethod, the rate of guarantee or the volumeof business affected. (In fact, as an aside, wehave some concerns about Equitable’scompliance with paragraphs 4(1) [whichrequired full description of benefits foraccumulating with-profits policies] and 6(1)[which set out the principles and methods to beadopted in the valuation] of Schedule 4 to theInsurance Companies (Accounts andStatements) Regulations 1996 which we hopewill be put to rest in the 1998 return).

Regulatory consideration of the Society’s financialposition

61 On 26 June 1998, the Society had submitted itsregulatory returns for 1997. A detailed description ofthe content of those returns is contained within thechronology entry for that date within Part 3 of thisreport. GAD completed their A1 Initial Scrutinycheck on 17 July 1998. They identified no concerns.GAD completed their A2 Initial Scrutiny check on20 August 1998. That check followed the moredetailed format first used for the 1996 returns. GADlowered Equitable’s priority rating from 3 to 4 andhighlighted a number of matters, including:

•  that the interest rates used by Equitable were  ‘just about’ supported by the risk adjustedyields on the matching assets;
• that the Society’s overall interest basis was  ‘adequate’ and that the valuation basis was  ‘adequate’ to ‘weak’;
• that Equitable had an ‘Enormous GrowingLiability for terminal bonus on [unitised withprofits]business [which] is not reserved for, sothat FORM 9 margin overstates strength!’;
• that the absolute level of cover for the requiredminimum margin was ‘adequate’. However, GADreferred to their comment about the Society’sliability for terminal bonus (see directly above)and to the fact that Equitable had raised capitalof £350 million through the issue of thesubordinated loan;
• that the Society’s level of sales was very highand that it held a negligible estate; and
• that Equitable were known to have materialexposure to annuity guarantees and that theSociety ‘Adjusts terminal bonuses – so no valueto policyholders! No additional reservesconsidered necessary’.

62 Under ‘Aspects that look worrying’, GAD queriedwhether Equitable’s position on annuity guaranteeswas satisfactory. Under ‘Other notes’, GAD initiallynoted that Equitable appeared to have failed todisclose provision for pensions mis-selling but GADappear later to be satisfied that provision had beenmade within the Society’s returns.

63 GAD also stated that a review of annuitant mortalityassumptions was required and that the issue of thesubordinated loan appeared to be the sole reasonfor the increase in available assets over the year.GAD identified no items to notify to the prudentialregulators, to be taken up immediately with Equitable.

64 There was no detailed scrutiny of the 1997 returnsat this time. Comment on the 1997 returns wasincluded in the detailed scrutiny of the 1998returns, on which GAD reported in May 1999. Thiswas despite the fact that consideration of certainissues arising from GAD’s Reserving for AnnuityGuarantees survey had raised questions aboutEquitable’s 1997 returns, their on-going solvencyposition, and, as would be seen in due course, aboutthe options open to the prudential regulators.

65 On 22 October 1998, the Treasury provided anupdate to the Tripartite Standing Committee (aCommittee of senior officials from the Treasury, theFSA and the Bank of England) on the effect ofcurrent market conditions on UK life insurers. Theyreferred to a paper, submitted to a previous meetingof the Committee, which listed eight ‘fairly wellknown offices that we are monitoring particularlycarefully’. Equitable was one of those companies.

66 In an annex to that paper, the Treasury gave detailsfor each company, stating that Equitable ‘are notwell placed to weather difficult investmentconditions’. This was said to be because of a lack ofestate and exposure to liabilities associated withthe guaranteed annuity rates within a significantnumber of policies.

67 Figures attached to the update paper recordedthat Equitable’s free reserves (excluding any itemfor future profits) were £1,752 million – and thatthe Society’s solvency margin requirement at31 December 1997 was £845 million. The Treasuryestimated that the current additional cost of theSociety’s annuity guarantees was between £1,000million and £2,500 million, the large range reflecting  ‘uncertainty about the nature of their guarantees’.The Treasury estimated that the Society’s current freereserves were estimated to be between (a negativefigure of) £750 million and (a positive figure of) £700million, and that Equitable faced a further £5 millionin costs as a result of personal pensions mis-selling^[13].

68 On 27 October 1998, GAD produced a preliminaryreport on the annuity guarantees survey. The reportstated that a number of companies held substantialreserves for those guarantees and that Equitablewere one of two notable exceptions. The reportnoted that the Society seemed to be ‘particularlyvulnerable because the relevant business isapproaching 30% of their total’.

69 GAD identified Equitable as one of twelve officeswith potential solvency margin problems and one offive that could be ‘technically insolvent’. GADstated ‘we shall certainly need to raise the issue ofannuity guarantees with each of these offices aspart of the scrutiny process for their returns’. GADalso identified Equitable as one of seven officeswhich had not told policyholders about theexistence of a guaranteed annuity option, and oneof eight that were considering whether they shouldreduce the final bonus payment to policyholderswith guarantees, to reflect part or all of the cost.

70 On 5 November 1998, the Treasury noted thattheir principal concern was the Society’s abilityto reserve adequately for those guarantees. TheTreasury concluded that the information receivedto date had been unconvincing and raised ‘seriousquestions about the company’s solvency’^[14].

71 At the meeting on 13 November 1998, Equitable’sAppointed Actuary stated that he was convincedthat the Society was still solvent. On 16 November1998, the Treasury sought an estimate of Equitable’sfree assets and solvency cover.

72 On 24 November 1998, Equitable explained that, asat 30 October 1998, and before taking account ofany implicit items or any liabilities associated withguaranteed annuity rates, the Society had availableassets of £2,090 million to cover the requiredminimum margin of £926 million. Equitable providedfigures which showed that, having establishedreserves for the full cost of those annuityguarantees, the Society had available assets of £300million, which, with the release of marginscontained within the valuation basis of £100 millionand a future profits implicit item of £850 million,could be increased to £1,250 million.

73 On 26 November 1998, GAD provided the Treasurywith a ‘2nd Update on the Effect of CurrentMarket Conditions on UK Life Insurers’, to beprovided to the Tripartite Standing Committee. Inthat update, GAD stated that Equitable were only  ‘just solvent’, if it were assumed that 100% ofpolicyholders exercised their guaranteed annuityoptions. GAD’s update continued:

While this is reassuring it should be realisedthat publication of such a low solvencyposition is likely to severely undermine thecompany’s reputation in the market and couldthreaten its survival as an independent entity.

74 On 1 December 1998, GAD advised the Treasury thatEquitable ‘would just have sufficient cover for theirrequired margin of solvency’, but that this was  ‘before any declaration of bonus’.

75 On 11 December 1998, the Treasury gaveconsideration as to whether the applicableRegulations gave them the power to require theSociety to resubmit its 1997 returns, with properreserving for the liabilities associated withguaranteed annuity rates. The initial legal view wasthat the Regulations did not allow this. GADdisputed this and, on 15 December 1998, GADexpressed surprise that the Treasury believed:

… that there is no power in the Act or anyRegulations which would enable [the Treasury]to require a company to “reissue” or amendaccounts when it has breached [Regulation] 64of the Insurance Companies Regulations 1994.In our opinion there are grounds to requirereproduction of the abstract of the actuary’sreport and resubmission of the returns…

 The handover to the FSA and events up tothe decision of the House of Lords

December 1998

76 On 15 December 1998, the Treasury met the FSA tobrief them about Equitable. The Treasury describedthe Society as ‘just solvent’ if it reserved fully forthe liabilities arising from policies which containedguaranteed annuity rates.

77 However, the Treasury also noted that the Society’sfree assets figure had made no allowance for thedeclaration of any bonus and that Equitableappeared to have insufficient assets to declare abonus in 1999.

78 The Treasury also noted that, if Equitable reservedfully for guaranteed annuity rates, the Societywould be close to breaching the requirement thatonly five-sixths of the required minimum margincould be covered by implicit items. In suchcircumstances, the Treasury noted, a relatively smallfall in equities or gilt yields could wipe out thecompany’s explicit free assets.

79 The Treasury set out for the FSA a ‘Strategy forRegulatory action’, which formed the basis for afurther meeting with the Society in December 1998,and which would be used to:

•  Clarify that [the Treasury are] not minded totake action against the company for its failureto reserve fully for [guaranteed annuity options]in its 1997 returns. (This would be consistentwith [the] approach taken with othercompanies);
• Formally put the company on notice that thereserving approach that the company isproposing (assuming this remains to reserve for25-35% of the [guaranteed annuity rateliabilities]) is not acceptable in [the Treasury]’sview;
• Indicate that in the context of settling its yearend position it is for Equitable to decide thereserving approach that it intends to adopt inits 1998 returns since it is for the company tocomply with the Regulations. But make thecompany aware that if in FSA’s view thereturns submitted at the end of June are notcompliant, FSA will take action;
• Seek an undertaking from the company that itwill not declare any further bonuses withoutprior discussion with [the Treasury]. If necessaryuse the lever/threat of intervention action onthe grounds of sound and prudentmanagement to obtain agreement from thecompany.

80 The Treasury stated that intervention action wouldbe likely to take the form of closing the Society tonew business and that this could happenimmediately, if Equitable did not agree to refrainfrom declaring further bonuses without priordiscussion with the Treasury. The Treasury notedthat, if Equitable did agree:

… intervention action would only becomenecessary when the company indicated itsintention to declare a bonus which would havethe effect of making the company breach its[required minimum margin] if the [guaranteedannuity options] were fully reserved for. (Thecompany usually declares bonuses inFebruary.) If agreement is obtained and nobonus is declared the need for interventionaction/prosecution would probably not ariseuntil July when the annual returns weresubmitted and it was clear from those returnsthat the [liabilities associated with guaranteedannuity rates] had not been adequatelyreserved for.

The Treasury warned that the Society could beexpected to seek judicial review of any interventionaction on reserving for guaranteed annuityoptions^[15].

81 The FSA asked the Treasury about the potentialimpact of a policyholder challenge to the Society’sdifferential terminal bonus policy. The Treasurystated that the Society’s financial position wouldnot be made worse, assuming that it had reservedon a 100% basis. The only additional costs to itwould arise from compensation payments topolicyholders who had already retired and who hadbeen adversely affected by the operation of thatpolicy.

82 According to the Treasury’s note of the meeting,the FSA also asked why no action had been takenon Equitable’s 1997 returns, when those returnsshowed no reserves for the liabilities associatedwith guaranteed annuity rates. In response, theTreasury ‘explained that the approach taken by thecompany had not been clear from the return’.

83 On 18 December 1998, GAD, on seeing the note ofthe meeting, disputed the assertion that no actionhad been taken on those returns. GAD pointed outthat the current discussions on guaranteed annuityrates had followed directly from questions whichGAD had raised on the reserving basis within thosereturns. GAD also noted:

It should be remembered by [the Treasury] thatGAD invited [Equitable] to a meeting on 28thMay this year (following consideration of their1996 returns), at which we discussed thereserving bases appropriate to accumulatingwith-profits business, attempted to clarifycertain PRE aspects of the bonus notices beingissued by Equitable and urged great restraint inthe granting of guaranteed bonuses.

January 1999

84 On 4 January 1999, GAD advised the FSA that:

We need to set out in writing to Equitable thatwe are not satisfied with the level ofmathematical reserves (ie zero) established forannuity guarantees in their 1997 returns.(Otherwise, they would have a good case nextyear in saying that we accepted these returnsin full knowledge, through detailedcorrespondence and discussion, of theirreserving methodology and assumptions).

85 GAD produced a list, detailing the additionalinformation that they would like to receive fromEquitable. GAD said that this would enable them toform a better understanding of the Society’scurrent financial position.

86 On 7 January 1999, the FSA’s Director of Insuranceput to the FSA’s Chairman an options paper,suggesting the courses of action open to the FSA inrelation to companies whose 1997 returns had beensubmitted on an imprudent or unacceptable basis.

87 The Director advised the Chairman that:  

… there are significant doubts about whetherthe legislation empowers us to requirecompanies to correct their returns where weconsider them to have been prepared on aninappropriate basis…

 Given those doubts, the Director recommended tothe Chairman that the FSA should requireaccelerated returns from those companies whichhad submitted ‘misleading’ returns for 1997. TheFSA’s Chairman later agreed to this recommendedapproach.

88 On 13 January 1999, the FSA wrote to all insurancecompanies to express their concern that theregulatory returns of some companies might havepresented ‘a materially misleading impression ofcompanies’ financial positions as at the end of1997’. The FSA stated that:

Where there was a material effect on theoverall financial position shown in the 1997returns, and where the company has notsubsequently taken commensurate action tostrengthen its financial position, it is the FSA’sview that it would be appropriate for suchcompanies to submit their 1998 returns early–  and in any case not later than 31 March – sothat the FSA and potential policyholders andtheir advisers can form a proper view of thesecompanies’ financial position.

89 On the same day, the Government Actuary issuedguidance to all Appointed Actuaries, remindingthem of the need to make proper provision forguaranteed annuity rate liabilities on prudentassumptions.

90 On 15 January 1999, in response to complaints fromsome of their policyholders about the legitimacy oftheir differential terminal bonus policy, Equitableinitiated legal proceedings against a representativeguaranteed annuity rate policyholder, Mr Hyman, sothat the arguments for and against their differentialterminal bonus policy could be put before – and beresolved by – the courts.

91 On 18 January 1999, the FSA asked Equitable formore information about their mathematicalreserves and aggregate asset shares as at the 1998year-end. On 21 January 1999, Equitable’s ChiefExecutive told the FSA that the Society planned todeclare a 5% annual reversionary bonus (down from6.5% for 1997).

92 The Chief Executive said that the Society had  ‘entered into a financial reinsurance arrangementwith effect from 31 December 1998’, at a cost of  £150,000 each year. It was said that this arrangementwould provide support to Equitable when thoseholding more than 25% by value of the guaranteedannuity rate business maturing in that year selectedto take benefits applying a guaranteed annuity rate.

93 On 22 January 1999, FSA noted that Equitable wereone of four companies giving cause for concern,and that it was questionable whether the Societywould be able to declare a bonus that year. Basedon the GAD estimate, it was also noted that theSociety, without reinsurance, was only just coveringthe required minimum margin at the end ofOctober 1998, with £1,150 million available assets tocover a regulatory solvency margin of just under  £1,000 million.

94 The FSA noted that, should the court case goagainst the Society, ‘its financial position wouldbecome even more precarious (there would be apotential liability to enhance past settled claims)and it would have to reduce the level of terminalbonus paid to its other policyholders – thusupsetting its status in the market’.

95 On 26 January 1999, Equitable provided theinformation that the FSA had requested on18 January 1999. The Society’s Appointed Actuaryinformed the FSA that the ‘aggregate smoothedasset share was 103% of the value of the actualassets attributable to the with profits business’.The FSA responded by asking for furtherinformation, including sight of any bonusrecommendations made to the Board during theprevious year.

96 On the same day, the FSA decided that it would notcontinue earlier efforts to reach a view onpolicyholders’ reasonable expectations until afterthe conclusion of the court case as, although thatcase would not preclude the FSA from taking a viewon whether the Society’s policy had beenconsistent with policyholders’ reasonableexpectations and as to the possible need forintervention, the Court’s judgment on whether ornot such expectations had been met would be sureto influence the FSA’s view on those matters.

97 On 27 January 1999, GAD raised a number ofconcerns with the FSA about Equitable’s proposedreinsurance arrangement, including the fact that thedraft reinsurance agreement could be cancelledretroactively, if the Society changed its practice onguaranteed annuity rates (which GAD presumedincluded Equitable losing their court case).

98 At a meeting between Equitable, GAD and the FSAthe next day to discuss the matter, the Society wasasked to seek various revisions of the draftagreement from the reinsurer. The FSA alsoquestioned at that meeting whether the Societywas satisfied that the proposed reinsurer wassufficiently strong to be able to fulfil theobligations under that treaty ‘(i.e. to cover apotential £1bn+ liability)’. The FSA recorded that theSociety’s response to their questioning indicatedthat:

Equitable Life appeared to be relying on thecompany’s AAA rating for comfort as to thereinsurer’s financial strength. The Actuary wasreminded that it was his responsibility to besatisfied with the security of the reinsurancefor which he was [taking] credit in hisvaluation.

99 How the reinsurance treaty could be presented in thereturns was also discussed at thatmeeting. TheSociety’s Appointed Actuary said that he was keennot to have to show a reserve for the annuityguarantees ofmore than £1,000million, as he thoughtthat the press would wrongly interpret such a figure asrepresenting the real cost to Equitable. The AppointedActuary also said that instead he would like to showthe reserve net of reinsurance – while including astatement that ‘the reserve had been established atthe 25% level because reinsurance providedprotection for liabilities in excess of that level’.

100 The response from the FSA and GAD to thissuggestion was that:

GAD were concerned that this was notconsistent with the Directive requirementswhich required insurers to calculate their grossliabilities and then deduct the liabilitiescovered by reinsurance. It was also potentiallyinconsistent with the guidance issued by the[Government Actuary] and endorsed by FSA. Itwas emphasised that FSA’s main concern wasthat the reserving basis should be clear fromthe annual returns. FSA would explore theimplications of the presentation Equitable Lifewere seeking to adopt before expressing adefinitive view on the issue.

The FSA’s note of the meeting also records thecomment that:

… having reviewed the structure of the relevantforms, it is clear that any presentation whichdid not show separately the gross liability andreinsurance cover would be artificial and hencepotentially misleading. In view of thesignificance of the reinsurance treaty to thecompany’s solvency position it was importantthat the level of dependence on thereinsurance was clear to readers of the returns.

101 On 29 January 1999, GAD commented on the Boardpapers that the Society had forwarded in respect ofits proposed bonus declaration. GAD said that,while the financial position shown was likely toappear reasonably satisfactory, Equitable ‘would bepotentially close to regulatory action underSection 33 [of the 1982 Act – that is, for failure tomaintain the required minimum margin of solvency]if their proposed reinsurance is not completedsatisfactorily’.

102 GAD noted that, while it would be difficult for theFSA to object formally to what Equitable wereproposing, the prudential regulators would need tomonitor the Society’s position carefully.

103 GAD commented that both GAD and the FSAshould voice their concerns to Equitable about theSociety’s vulnerability and ask Equitable to producesome contingency plans to show how they wouldreact to adverse investment conditions. GAD alsopointed out that the Society continued to issueannual notices to policyholders showing a high levelof projected benefits, thereby generating furtherexpectations.

February 1999

104 On 1 February 1999, the FSA wrote to Equitable onthe lines suggested by GAD, underlining the factthat, in the absence of a robust reinsuranceagreement, it would not be prudent to declare anybonus for 1998. The FSA advised the Society that,even with a reinsurance treaty in place:

… we consider it necessary for the company toconsider carefully the scope for declaring abonus because of the uncertaintiessurrounding the financial implications of thecourt case in relation to the company’spayment practice in respect of contractscarrying guaranteed annuity options. In particular it would appear necessary forEquitable Life to consider the prudence ofdeclaring a bonus in the light of the risk oflosing the court case and the potential coststhat might be incurred as a result. We alsoconsider it necessary for the company to takeaccount of the risk, even after the terms of thereinsurance treaty have been revised asdiscussed with GAD, of the treaty beingcancelled by the insurer…

The FSA concluded that, were the reinsuranceagreement to be revised to resolve GAD’s concerns,the FSA would not be minded to object to theSociety’s proposed bonus declaration. Two weekslater, the Society sent the FSA a copy of the reviseddraft reinsurance terms, which led to both the FSAand GAD raising further matters regarding thosedraft terms.

105 On 22 February 1999, GAD confirmed to Equitablethat the principle whereby the reinsurancearrangement offset the guaranteed annuity rateliabilities, as set out in the terms of the agreement,was acceptable to GAD. This was, however, subjectto the resolution of GAD’s outstanding queries andsight of a final version of the agreement.

106 On 24 February 1999, however, the FSA raised aconcern of a different nature with the Society, thatbeing:

… we think that the returns might have givenpotential policyholders a misleadingimpression as to Equitable Life’s financialposition at the end of 1997. You indicate thatthere would have been a net decrease in thecoverage of the required minimum marginfrom 2.5 to 2 times after allowing for the use ofmargins which existed in the valuation basisand taking account of a much larger futureprofits implicit item.We consider that such adecrease is material and that some accountmust be taken for the greater reliance onimplicit items that would have been necessary(and apparent in the returns) if a furtherreduction in the solvency margin coverage wasto be avoided.

Equitable were asked to agree by 3 March 1999 tosubmit their 1998 returns by 31 March 1999 or facepossible regulatory action.^[16]

March 1999

107 Equitable were not specifically mentioned at thefirst quarterly liaison meeting between the Treasuryand the FSA on 10 March 1999. The following week,the relevant FSA Managing Director informed theFSA Board about the Society’s particular difficulties.

108 On 19 March 1999, the FSA summarised in aninternal note the position of the six companiesidentified as being potentially at risk fromguaranteed annuity rates and whose statutorysolvency could be threatened, if economicconditions were to deteriorate further. Of those sixcompanies, it was said that Equitable were viewedas giving rise to the greatest concern, as theirfinancial position had been very severely affected.

109 The FSA recorded that, despite action which hadbeen taken to restore the Society’s solvency marginto a more acceptable level, the FSA remained  ‘concerned about the financial viability of thecompany in the longer term’, and they set out theirparticular concerns. The FSA also noted that theposition might worsen if Equitable lost the Hymancase and incurred significant compensation costs asa result.

110 The Society submitted its 1998 regulatory returnson 30 March 1999, as the FSA had requested. Adetailed description of the content of those returnsis contained within the chronology entry for thatdate within Part 3 of this report. On the same day,the Society applied for a section 68 Order for theuse of a future profits implicit item of £1,000 millionwithin the Society’s returns for 31 December 1999.Equitable had included a future profits implicit itemof £850 million within their 1998 returns.

April 1999

111 On 8 April 1999, GAD completed the A2 InitialScutiny check. GAD’s scrutinising actuary’sobservations during that check included that:

(1) We still need to be satisfied that [thereinsurance] treaty with [IRECO] works in theway intended—REQUEST COPY OF TREATYas finally agreed.

(2) Loss of the Court case on treatment of[Guaranteed] Annuities would put position indoubt – would need to cut all bonuses.

112 On 9 April 1999, GAD reported to the FSA theresults of their initial scrutiny of the Society’s 1998returns, saying that the Society’s financial positionappeared satisfactory, but that GAD had not yetseen a copy of the finalised reinsurance treaty. GADasked the FSA to request it urgently, which the FSAdid.

113 On 20 April 1999, Equitable told the FSA that thereinsurance treaty had not yet been concluded, andthe Society sent a copy of the term sheet whichwould form its basis. That term sheet showed thatthe reinsurance treaty remained contingent on nochange being made to the Society’s then currentguaranteed annuity rate bonus practice, either bychoice or as a result of legal action; and that, if the withheld claims balance exceeded £100 million,negotiations would take place to find a mutuallyacceptable restructuring of the agreement.

114 The Society also enclosed a copy of a paperprepared by the Appointed Actuary for its Board onmeasures to protect the Society’s statutorysolvency position. One issue that the paperdiscussed, but could offer no solution to, was howthe Society might use policy conditions to restrictthe growth in its guaranteed annuity rate business.The paper concluded with a list of measures which,it was said, it seemed sensible to pursue.

115 Commenting on those measures on 27 April 1999,GAD said that they seemed ‘fairly plausible’, butcould ultimately reduce the Society’s investmentreturns. GAD said that they were also content withthe level to which any future repayment premiumsunder the reinsurance treaty had been subordinatedto policyholders’ rights.

116 Meanwhile, on 30 April 1999 Equitable had writtento the then Economic Secretary of the Treasury,complaining about the level to which the Societywas being required by the FSA and GAD to reservefor guaranteed annuity rates. She replied on 14 June1999, defending the position which had been takenby the prudential regulators, saying that:

… companies have to err on the side ofunderestimating the value of their assets’  future income and overestimating theirliabilities. In this way it is ensured companieshave some spare capacity to withstandadverse economic circumstances. Thedetermination of how conservative theassumptions should be has been derived frompast experience and is embodied in guidanceto appointed actuaries.

May 1999

117 On 4 May 1999, Equitable provided a further paperon the Society’s projected solvency position. Thatpaper showed three different scenarios, each basedon different assumptions as to developments in theinvestment markets.

118 All three scenarios showed the Society remainingsolvent and the position steadily improving.Equitable had attempted to project the impact oflosing the court case, although it was said that thishad been difficult to do, as there were a number ofvarying components. In the Society’s view, however,the key solvency consideration, if an unfavourableoutcome occurred, was the replacement ormodification of the reinsurance arrangement, whichwas being actively pursued.

119 On 20 May 1999, GAD provided the FSA with adetailed scrutiny report on the Society’s 1997 and1998 regulatory returns; this gave Equitable apriority rating of 2 (raised from 3 in respect of their1996 returns). A detailed description of that reportis contained within the chronology entry for thatdate within Part 3 of this report.

120 GAD highlighted a number of problem areas, butconcluded that, because of the way that theSociety operated, ‘provided the currently high levelof annual emerging surplus continues, the Societyshould be able to work its way out of its currentsolvency margin problems’. The Society, in GAD’sview, needed to hold back more emerging surplusby declaring lower guaranteed bonuses; and to givepolicyholders greater warning about the possibleimplications for bonuses of a substantial marketsetback.

121 The following day, GAD suggested to the FSA that  the Society should be asked to consider furtherpossible scenarios – and to confirm the basis ofsome of those calculations.

June 1999

 122 In the meantime, both the FSA and Equitable hadbeen considering the possible outcome scenarios inrespect of the Society’s court case and the resultingimplications of those scenarios. On 21 June 1999, theSociety informed the FSA that its lawyers hadidentified six possible scenarios, which were:

1) Complete success.

2) Success but with some adverse comment in[the] judgement.

3) Directors have discretion but have incorrectlyexecuted it on technical grounds (for example,the wording of the formal statement ofbonuses is inadequate in some way).

4) Directors have discretion but have not givensufficient weight to or considered the right PRE.

5) Ruling that ELAS approach invalid and thatfinal bonus rates on cash and annuity benefitsmust be equal but that Board still havediscretion to set rates at a level they deemappropriate. Even if the Society appeals, thejudgement stands until that appeal is heard.

6) Ruling that ELAS approach invalid and thatfinal bonus rates on cash and annuity benefitsmust be equal due to PRE it must be at thecash levels. Appeal certain but judgement willstand until that appeal is heard.  

Equitable said that they considered all of themexcept for scenarios 1 and 2 to be highly unlikely.Nevertheless, Equitable confirmed that they hadbeen discussing with IRECO possible amendments tothe reinsurance agreement, and had been discussingother possible arrangements with other reinsurers.The next day, the FSA and GAD reviewed the courtpapers which had been provided by the Society.

123 On 24 June 1999, the FSA asked the conduct ofbusiness regulators if they had any jurisdiction overthe bonus notices issued to policyholders, andwhether those regulators could require Equitable tochange those notices. The FSA sent the conduct ofbusiness regulators copies of the 1996 and 1997notices, which the FSA said were possiblymisleading, and said that they would forward the1998 notice to those regulators the following week.

124 On 25 June 1999, prompted by concerns expressedby GAD on the likely consequences if the courtreferred the issue of policyholders’ reasonableexpectations to the prudential regulators, the FSAprepared a paper on the action that they mightneed to take if the court did not give a clear viewon how policyholders’ reasonable expectationsmight be viewed.

125 The FSA noted that they saw no point in reaching aview ahead of the court judgment, but also saidthat they would do some more work on the issue,so as to be ready to give a view shortly afterwards.

126 The FSA added that the Society’s bonus notices,which seemed to give policyholders unrealisticallyhigh expectations of the pay-outs they couldexpect, were currently the main evidence insupport of the argument that the Society’sapproach had not been consistent with thereasonable expectations of its policyholders.

127 The FSA stated that:

Even in the context of non-GAO policies thenotices appear liable to lead policyholders tohave potentially unrealistically highexpectations of their total payouts because ofthe prominence given to the totalaccumulated benefits figure which includesundeclared terminal bonus. The format ofbonus notices is something we have raised withEquitable previously (before the GAO issuearose) but we never made any progress inobtaining changes.

128 On 29 June 1999, Equitable met GAD and the FSA todiscuss further information that the Society hadprovided and also developments in relation to thecourt case. Equitable said that their lawyersconsidered it very likely that the Society would winthe court action but with some adverse comment.Equitable also said that those lawyers consideredthe worst case scenario (wherein bonus rates forboth the cash fund option and annuities had to beequalised at the highest cash level) to be  ‘inconceivable’^[17].

129 The FSA pointed out that, even if Equitable won,the FSA would still need to consider whether theSociety’s bonus policy had been consistent withpolicyholders’ reasonable expectations; the FSAalso said that they had concerns about theinformation contained within the Society’s bonusnotices, but that the FSA had not yet reached aview as to whether that information had beenmisleading.

130 The Society insisted that its practice of paying outas much as possible in bonuses and in not buildingup any hidden estate offered the best value topolicyholders, as well as being a useful deterrentagainst predators. Equitable said that they had beenapproached by a number of suitors, but thatEquitable had always replied that the Society wascommitted to mutuality.

131 The impact of each presumed potential court rulingon the reinsurance treaty was also discussed at thatmeeting. Equitable’s Chief Executive told the FSAand GAD that he believed that the reinsurancetreaty would remain in place if the court ruling fellwithin scenarios 1 to 4. He also informed the FSAand GAD that:

As a contingency against losing the case thecompany had been in discussion withreinsurers about increasing the scope ofreinsurance cover. [A named reinsurancecompany] had been prepared to offer a formof surplus relief reinsurance and even offeredto take over the company’s existingreinsurance with [IRECO]. However at theeleventh hour [the company’s] Head Officebacked off from the proposal claiming  “capacity problems”.

Following this the company had decided towait until the outcome of the Court casebefore talking to other reinsurers, they did notwant to tout around the reinsurance market atsuch a sensitive time. [Equitable’s ChiefExecutive] believed that there was room toextend the scope of the existing reinsurancecontract if Equitable were to lose the case andthat premium rates would be practical andconsistent with the existing treaty…

 July and August 1999

132 The High Court hearing began on 5 July 1999, andon the same day the FSA Managing Director withresponsibility for Equitable was sent a note (whichwas also copied to the conduct of businessregulators) about that legal action and about theimplications both for Equitable and the FSA, interms of any follow-up action which might berequired.

133 The FSA’s note set out the implications of threepossible outcomes: Equitable winning, winning inpart, and losing the case. In the last scenario, theFSA noted that the reinsurance arrangement wouldthen be invalid, although the Society hadestablished that there would then be scope forreplacing it; should that not be possible, the FSAnoted that Equitable would only just cover therequired minimum solvency margin after taking fullaccount of the future profits implicit item availableto the Society. The FSA also noted that Equitablewould need to consider drastic measures, whichmight precipitate a take-over bid or a reduction innew business.

134 The note continued by stating that the FSA wouldthen need to determine the Society’s solvencyposition and, if the required minimum margin werebreached, to exercise intervention powers torequire the production of a plan for the restorationof a sound financial position.

135 Even if the solvency margin were not breached, thenote said that the FSA would require steps to betaken to strengthen the position in the short tomedium term. It was noted that there would also bethe question, if there were a significant risk thatEquitable would be unable to meet their liabilitiesto policyholders, as to whether to close thecompany to new business or to suspend theirauthorisation.

September and October 1999

 136 On 9 September 1999, the High Court ruled thatEquitable had been entitled to operate theirdifferential terminal bonus policy. However, theclaimant was given leave to appeal. GAD told theFSA that they could see nothing in the judgmentwhich was inconsistent with the guidance that hadbeen issued by the prudential regulators on thatsubject, although GAD suggested that the FSAmight need to consider intervening in respect ofthose policyholders whose expectations might nothave been met.

137 The FSA’s legal advisers also pointed out variousissues arising for the FSA, which related topolicyholders’ reasonable expectations. However,those advisers noted that the FSA had decided todefer a decision on taking such action until theappeal had been concluded.

138 On 15 September 1999, the FSA’s prudentialregulation division suggested to the FSA’s conductof business division that both divisions neededtogether to consider the matter from theperspective of all the FSA constituent bodies, butshould not decide on any action until the Court ofAppeal’s decision was known.

139 If the High Court judgment were overturned, theFSA noted that it would be possible thatintervention action would be warranted under the1982 Act, and that they wanted to avoid any actionwhich might constrain or prejudice such action. TheFSA noted that they should consider the matterfurther in the light of analysis that they had agreedshould be undertaken while the appeal was stillpending.

140 On 20 September 1999, the FSA contactedEquitable to arrange a company visit. The FSA saidthat they were:

… very conscious that although we have had aconsiderable amount of contact over the pastyear, this has necessarily been heavily focussedon the guaranteed annuities issue. I think thatwhile this issue is somewhat in abeyance, andgiven that it is nearly 3 years since we lastvisited you, now would be an opportunemoment for a visit to discuss the Society’soverall position and future plans.

The FSA expected that the visit would last a day,would involve both the FSA and GAD, and wouldcover the following areas:

1. Overview of corporate management structureof Equitable Group.

2. General market outlook and business strategy.

3. Marketing approach including productdevelopment and distribution.

4. Role of the Appointed Actuary.

5. Systems and Controls.

6. Investment Policy and Asset Management.

141 On 23 September 1999, the FSA’s conduct ofbusiness division responsible for regulating PersonalInvestment Authority member firms (such as theSociety) wrote to their prudential regulationcolleagues within the FSA about the Society’s bonusnotices which had been referred to them.

142 The conduct of business regulators said that theydid not consider the Society’s bonus notice to bepoorly presented or inaccurate and that they didnot therefore intend to take any regulatory action.The conduct of business regulators went on to saythat, historically, they had not regarded post-salesliterature as being within their remit and would, therefore, have had to have serious concerns abouta document before taking action against a company.

143 On 24 September 1999, GAD advised the FSA thatthe Society’s application of 30 March 1999 for afuture profits implicit item of £1,000 million wasacceptable. GAD confirmed that the calculationswhich had been provided by the Society’sAppointed Actuary were ‘in line with the guidanceand that the [figure for the maximum amount offuture profits that could be claimed] of £2,960mappears to be a fair estimate of 50% of “EstimatedFuture Profits”’.

144 GAD also noted that the sum applied for was aboutone third of the sum for which the Society couldhave applied, and was substantially less than it hadbeen allowed in the previous year. However, GADsaid that Equitable should first be asked to confirmcertain details and should be asked to provide acopy of the reinsurance agreement as that had beenfinally signed (which Equitable subsequentlyprovided and GAD confirmed as acceptable^[18]).

145 The FSA subsequently^[19] recommended to itsInsurance Supervisory Committee that theapplication should be granted. The FSA informedthe Committee that, while there remained somedebate at the margins between Equitable and GADabout the appropriate reserves for guaranteedannuity rates, the FSA were generally satisfied thatEquitable had adequately reserved for theirexposure to those rates, as that had ‘been largelyoffset’ through reinsurance. The Committeeapproved the application and the Treasury issuedthe Order on 9 November 1999.

146 In the meantime, on 14 October 1999 Equitable sentthe FSA a copy of the final signed version of thereinsurance treaty. On 22 October 1999, GADadvised the FSA that the treaty:

… is totally in accord with the Draft Term Sheetthat was examined in detail in April. (It is myunderstanding that the construction of thereinsurance agreement as set out in the draftterm sheet was considered to be acceptable atthat time).

November and December 1999

147 On 17 November 1999, the FSA prepared a riskassessment of Equitable, as part of piloting a newapproach to company assessment. That assessmentsuggested that Equitable should be viewed as a highfinancial risk for a number of reasons.

148 The assessment noted that, while Equitable had notbeen alone in being caught out by the guaranteedannuity rate issue, the FSA’s view was that the Societyhad not woken up to that issue quickly enough, andcommunication to policyholders of the Society’schange in policy in relation to bonuses was decidedlyunclear and had left Equitable open to criticism.

149 The assessment observed that Equitable had ‘gonetoo far in distributing surplus to policyholders tothe extent that the company is dangerously undercapitalised and exposed to a market downturn’.However, it was noted that Equitable had takenheed of concerns about the level of reversionarybonuses and had made some effort to reduce them.It was also noted that the Society’s reserving basiswas ‘acceptable (but not particularly strong)’. Theoverall assessment prepared as part of the FSA’s coordinatedsupervisory programme confirmedEquitable as medium to high risk.

150 On 6 December 1999, the FSA and GAD carried outa company visit to Equitable. The areas discussedincluded: the Society’s corporate structure; itsbusiness plan; and its intentions with regard tobonuses.

151 On 20 December 1999, the FSA informed Equitablethat the FSA had introduced a system of ‘enhancedlead supervision’. The FSA explained that, underthose arrangements, a lead supervisor would benominated for each company (which, in its case,would be the prudential line supervisor for theSociety) and that that lead supervisor would beresponsible for maintaining an overall assessment ofthe Society and for producing a co-ordinatedsupervisory plan, with the aim of avoiding anyregulatory ‘overlap and underlap’.

January 2000

152 On 21 January 2000, the Court of Appeal gavejudgment against Equitable by a majority of two toone. One of the majority judges, however, went onto say, at the end of his judgment and in anobservation which did not form part of hisreasoned decision, that it would be legitimate, in hisview, for the Society effectively to ‘ring-fence’  funds relating to different types of policyholder,which could result in those policyholders withguaranteed annuity rates not doing much better incash terms.

153 The Society was granted leave to appeal to theHouse of Lords and was permitted by the Court inthe interim to continue its differential terminalbonus policy pending the appeal, so long asEquitable gave an assurance that, if the Court ofAppeal’s decision were to be upheld, the Societywould pay additional sums in respect of any policymaturing after the Court of Appeal’s judgment byway of rectification.

154 On the same day, GAD told the FSA that thejudgment meant that most of the advice inthe guidance note issued by the Treasury on18 December 1998 remained valid. GAD suggestedthat the extra costs to Equitable might be fairlymarginal, but that the Society should be asked toconfirm that the judgment did not affect itsreinsurance agreement.

155 The FSA told their conduct of business colleaguesthat the judgment gave no cause for panic. The FSA,while noting that the adverse publicity was likely todent the Society’s sales, told those colleagues thatthe Society’s reserving requirement would not beaffected by the judgment – and so Equitable’sfinancial position for regulatory purposes would belargely unaltered.

156 On 28 January 2000, the FSA prepared a notesetting out the implications for the insuranceindustry if the House of Lords were to uphold theCourt of Appeal’s judgment. The FSA said that,although the Society would need to revise its bonuspolicy for future years, the new approach need notlead to any significant additional costs for it.

157 On 31 January 2000, an FSA legal adviser circulated asummary of the judgment, commenting that eachof the four judges who had at that stage consideredthe case (the High Court judge and the three Courtof Appeal judges) had arrived at their respectiveconclusions for different reasons.

158 The FSA legal adviser said that, in that context, itwas not possible to predict what the decision of theHouse of Lords would be, and any attempt to do so,or to determine the implications of the Court ofAppeal’s decision, would therefore be of littlebenefit. Over the subsequent months, discussionscontinued internally about the wider implicationsmore generally of the judgment for policyholders’ reasonable expectations.

February to May 2000

159 On 1 February 2000, Equitable had written topolicyholders, assuring them that there would beno significant costs for the Society if the House ofLords were to uphold the Court of Appeal’s decision.

160 On 22 March 2000, Equitable published theirCompanies Act report and accounts for 1999^[20] anddeclared a bonus of 5%. In that report and accounts,the Society explained that any additional costsresulting from the guaranteed annuity rate issuewould fall generally on the with-profits fund.Equitable reported that:

We have projected that the cost of theseadditional benefits is unlikely to exceed  £50 million in total over the coming years, andthe experience in 1998 and 1999 was well withinour expectations. However, for accountingpurposes we have established a provision of  £200 million in our balance sheet, to providean allowance for more extreme future changesin financial conditions and mortalityexperience which could lead to morepolicyholders taking benefits in the guaranteedannuity form.

Equitable also set out the background to theHyman litigation and the progress up to that date,saying that the Society expected the House ofLords’ hearing to be in June 2000 and that thejudgment would follow shortly thereafter.

161 On 30 March 2000, Equitable applied for a section68 Order to raise the limit on the amount ofshareholdings in a particular company that could betaken into account within the Society’s 1999 returns.On 10 April 2000, the FSA’s Insurance SupervisoryCommittee confirmed that such an Order could notbe granted retrospectively. The FSA informed theSociety of their decision, and the reason for it.

June and July 2000

162 On 27 June 2000, Equitable applied for a section68 Order for a future profits implicit item of  £1,100 million, for use in their 2000 returns. On30 June 2000, Equitable submitted their regulatoryreturns for 1999. A detailed description of thosereturns is contained in the chronology entry forthat date within Part 3 of this report.

163 On 7 July 2000, GAD recommended to the FSA thatthe Society’s application for a future profits implicititem should be granted on the grounds that therewas a significant margin between the sum appliedfor and the maximum for which Equitable couldhave applied (£3,300 million). GAD also noted thatthe Society’s Appointed Actuary had confirmedthat he had taken account of the reinsuranceagreement in determining the value of futureprofits.

164 In the meantime, on 4 July 2000 the FSA’s relevantManaging Director told his senior colleagues thatone of the Society’s directors had approached himto say that there were ‘straws in the wind’ that theHouse of Lords would find against Equitable – andthat the Society was considering ‘what level ofsacrifice’ might be needed at the top of theorganisation if that proved right.

165 On 18 July 2000, the FSA and GAD met withEquitable to discuss contingency planning for theHouse of Lords’ judgment, which was due to bedelivered two days later. The Society expressed theview that it was unlikely that the House of Lordswould find against it, but nevertheless the meetingdiscussed the possibility that Equitable might beprevented from altering the rate of bonus for thosewith policies containing guaranteed annuity ratesand who chose to take benefits to which thoserates were applied.

166 Whilst this had previously been identified as apossible (but not a probable) outcome, it was notedthat this outcome was beginning to appear morelikely, in the light of the arguments which had beenput forward for the first time before the House ofLords. It was stated that the cost of that outcome(referred to as the third option) would be in theregion of £1,000 to £1,500 million, and would have aprofound effect on the Society’s regulatorysolvency position.

167 Equitable informed the FSA and GAD at themeeting that the Society had not attempted torenegotiate the reinsurance agreement to takeaccount of such a ruling and that such renegotiationwas unlikely to be viable.

168 In the event of such a ruling, the Society said that itwould immediately announce an intention to seek apartner. The Appointed Actuary said that he ‘didnot think that the company would be insolvent ifthe company suffered this judgement, but he wascurrently conducting some scenario modelling’.

169 Equitable’s Chief Executive said that he was keen toavoid precipitous regulatory action should thejudgment go against the Society, mainly becausethat was likely to have a detrimental effect on thevalue of the business. The FSA’s Head of LifeInsurance:

… reassured the Society that we would not rushto take remedial action in these circumstancesand understood the importance ofmaintaining the value of the society.Wewould, however, need to be convinced that asuitable buyer for the Society was likely to befound quickly.

Equitable envisaged that substantive sales negotiationscould begin in August 2000, with the view tocompleting a sale by the end of that year. Equitablesaid that, if the House of Lords simply upheld theCourt of Appeal’s decision, the Society expected toreduce the bonuses payable to guaranteed annuityrate policyholders as a class; they did not considerthat this would contravene any such judgment.

170 On 19 July 2000, the FSA prepared a note, which waseffectively an update of earlier scenario planning,setting out the possible outcomes of the appeal,and the regulatory action that was likely to beappropriate in each case. The note recognised thethird option as a possibility, but it was said that thiswas much less likely than the other two potentialoutcomes. The FSA noted that, should that thirdoption become a reality, Equitable would only justbe able to meet their required minimum margin andwould therefore seek a partner. The FSA’s noteconcluded that it was expected that there would beno shortage of potential partners.

171 On 20 July 2000, the House of Lords gave itsdecision, holding, in terms of both the guaranteedannuity rate policy contracts and the Society’sArticles of Association, that Equitable could notapply different rates of bonus depending onwhether or not the policyholder took benefitsbased on guaranteed annuity rates, and that theSociety could not pay lower bonuses to guaranteedannuity rate policyholders as a class.

172 Equitable immediately announced that they wereseeking a buyer, and told the FSA that the Societyplanned an immediate cut of 5% in the value of allwith-profits policies at non-contractual terminationand that no bonus would be allotted for the firstseven months of 2000. The Society said that itexpected bonus levels to be restored once a salehad been completed.

Events leading to closure

July 2000

173 On 21 July 2000, Treasury officials informed the FSAthat it was likely that those officials would be askedby their Ministers for briefing on the situationregarding Equitable. The Treasury said that thedecision of the House of Lords had promptedthoughts on the wider implications for the futuredevelopment of the life insurance sector and theeffectiveness of the regulatory system. The Treasuryset out a number of key questions to be consideredby the FSA, as part of preparing their input to suchbriefing. Those questions included whether the FSAnow considered that they ought to have done moreto prevent the situation from arising.

174 On 24 July 2000, the FSA told GAD that, in theirview, the House of Lords’ judgment had noimplications for the life insurance industry as awhole, because companies had generally beenrequired to reserve fully for the liabilities associatedwith those policies containing guaranteed annuityrates, with the same level of reserve being neededwhether or not a differential terminal bonus policywas being applied.

175 The FSA said that the impact would be different onEquitable because the Hyman judgment had led toa reduction in the Society’s assets, rather than anincrease in its liabilities, because the reinsuranceagreement had fallen away as a result of thatjudgment.

176 GAD replied, confirming the FSA’s analysis. GAD saidthat:

Equitable was unique in the form ofreassurance that it entered into, with itscancellation clause. In retrospect the Actuaryis shown to have acted imprudently in takingcredit for the reassurance. No doubt he wasrelying upon the Board’s view, based upon legaladvice, that they were unlikely to have tochange their bonus policy.

177 In an internal minute, the FSA commented that,while a sale could not be regarded as an absolutecertainty, ‘it must be close to 99.9%’. The FSA alsocirculated an action plan, under which the FSAwould:

•  obtain confirmation as to the Society’sregulatory solvency position and reviewprojections of future solvency;
• review the reserving guidance which had beenissued by the Treasury in 1998;
• ask other companies what implications they sawfor themselves; and
• arrange discussions with the Society about thebidding process.

178 On 26 July 2000, the Society announced thechanges to its bonus rates, but added that, throughthe sale, Equitable would be looking to secure fundsto make good the lost growth. On the same day, theSociety’s Appointed Actuary also wrote to the FSA,setting out the company’s solvency position. TheAppointed Actuary said that:

On a continuing basis the position would beunacceptably weak. However, as you said lastweek, we have effectively implemented a planto strengthen the position by taking the courseof action which we have. Meanwhile I believe itis reasonable to regard the Society ascontinuing to meet its required minimummargin.

179 Also on 26 July 2000, the FSA replied to theTreasury’s questions. On the matter of whether theguidance that the prudential regulators had issuedon meeting the cost of the liabilities associatedwith guaranteed annuity rates had been right, theFSA said that it would have been difficult for anyguidance to be consistent with the full range ofCourt judgments which had been made. If the FSAhad been wrong, then, it was said, so too had theactuarial profession – since the Faculty and Instituteof Actuaries had gone on record as saying that theactuarial profession had fully supported theguidance.

180 The FSA said that they were not convinced thateither the Treasury or the FSA could or should havepushed the Society to alter its differential terminalbonus policy; and that the Society’s policy ‘was notclearly unlawful’, as had been demonstrated by thefirst judgment and by the fact that the Court ofAppeal had found against Equitable only by amajority.

181 The FSA told the Treasury that:

The FSA did ensure that Equitable set upadequate reserves to cover their GAOexposure. As a result Equitable decided toenter into the reinsurance treaty in order toavoid having to take alternative courses ofaction that they considered to be against theirpolicyholders’ interests.

The FSA also informed the Treasury that:Equitable had been told that if the courtupheld their practice, we would neverthelessconsider whether PRE had been breached andwhether intervention was appropriate. Obviously FSA’s consideration of this issue wassuspended whilst the matter was before thecourts.

August and September 2000

182 On 11 August 2000, the FSA and GAD met Equitableto discuss the regulatory aspects of the saleprocess. On 24 August 2000, the prudential andconduct of business divisions within the FSA met todiscuss the implications of the Hyman judgment.The FSA’s prudential division said that it was hopedthat a buyer would be identified by December2000, and that the process could be completed byJune 2001.

183 The FSA’s note of that meeting said that:

It was clarified that the judgment generally didnot have solvency implications as the level ofreserving had not been affected (it was justthat some companies would experience higherreal costs). Equitable Life had only experienceda weakening in its financial position becausethe reinsurance it held for [guaranteed annuityrates] had been terminated (because it wasconditional on the company continuing to paydifferential terminal bonuses).

184 On 1 September 2000, the Society submittedan update of its estimated solvency position(showing the position as at 31 July 2000), whichshowed that Equitable had available assets of  £2,500 million to cover the required minimummargin of £1,200 million.

185 On the same day, the FSA recommended to theirInsurance Supervisory Committee that they shouldgrant the Society’s application for a future profitsimplicit item of £1,100 million. The FSA said that,although Equitable had been weakened as a resultof the Hyman judgment, the Society was stillsolvent. The FSA noted that Equitable was seekingonly a third of the sum to which they were entitled,and that the relevant calculation had been checkedby GAD.

186 As a result, on 11 September 2000 the FSA’s Head ofLife Insurance and Chairman of their InsuranceSupervisory Committee told members of thatCommittee, by e-mail, that the Society’s section 68application involved a ‘fairly standard request’ for aconcession for a future profits implicit item.

187 The FSA recommendation made clear that theSociety’s request was well within normalparameters, and no difficulty was envisaged inagreeing to the recommendation. The Head of LifeInsurance added, however, that the implicit itemwas an important aspect of Equitable’s overallfinancial position and that, given the Society’s highprofile at that time, he imagined that somemembers might wish to discuss the paper.

188 One member of the FSA Insurance SupervisoryCommittee responded that:

… the amount of the implicit item actuallyshown in Form 9 for the December 2000 returncannot exceed the amount that could besupported by a new application submittedwith that return and bringing in the financialperformance of the company in 2000.Weexpect a sharp fall in surplus in 2000 becauseof the [House of Lords’] judgment and this willneed to be brought in to the figures … Inpractice, the company may not actually beable to use the figure that we agree now.

189 The FSA’s Committee approved the application on11 September 2000 without meeting and, on13 September 2000, the Treasury issued a section68 Order. At their quarterly meeting with the FSAthe following week, the Treasury pointed out thatEquitable were still advertising for new business.The FSA responded to this point by stating that theSociety’s recent difficulties ‘have not affected itssolvency position, only its freedom to invest’.

190 On 21 September 2000, the FSA’s relevant ManagingDirector told the FSA Board that the House of Lordshad gone much further than the previous courtrulings in that case, in that the House of Lords hadheld that Equitable could not ‘ring-fence’  guaranteed annuity rate business from other withprofitsbusiness, for the purposes of settingterminal bonus.

191 The extra costs of the guaranteed annuity ratestherefore had to be spread amongst allpolicyholders in the with-profits fund. This, he said,had potentially serious implications for thereasonable expectations of the other with-profitspolicyholders of the Society.

192 On the same day, GAD informed the FSA that theyhad no questions to raise about the Society’sregulatory solvency at that time, although GADpointed out that, without the future profits implicititem, Equitable would have excess assets of ‘just  £300m’.

October 2000

193 On 9 October 2000, the Society informed the FSAthat, as at 31 August 2000, Equitable had availableassets estimated to be £3,360 million to cover therequired minimum margin of £1,195 million. Equitablesaid that this significant improvement from the July2000 position had been due to the markets havingstrengthened in the interim.

194 Meanwhile, since Equitable had announced in July2000 that they were seeking a buyer, a number ofpotential bidders had expressed interest and hadbeen assessing the Society’s financial position. Anumber of those had since withdrawn.

195 In a report to the FSA Board on 19 October 2000,the relevant FSA Managing Director said that,  despite the difficulties in assessing the level ofliability arising from the Hyman judgment,Equitable had received three serious expressions ofinterest – all of which would be sufficient to enablethe repayment of the bonuses which had beenwithheld for the first seven months of that year,with an additional payment for goodwill. However,he also said that the FSA would need to see thedetailed bids and their structure to determinewhether the with-profits fund would, as a result, bestrong enough to secure the desired restoration ofinvestment freedom going forward.

196 On 30 October 2000, Equitable provided solvencyfigures which showed that, as at the end ofSeptember 2000, the Society had available assetsestimated to be £2,345 million to cover the requiredminimum margin of £1,205 million.

197 On 31 October 2000, a potential bidder forEquitable (whom in this report I call bidder A) toldthe FSA that they believed that the shortfall in theSociety’s funds was greater than Equitablethemselves had estimated.

198 Bidder A expressed concern that the wording of theSociety’s policies allowed guaranteed annuity ratepolicyholders to increase their contributions to thefund, to which the guarantee would attach, therebyincreasing the fund’s liabilities to the detriment ofother policyholders. Bidder A said that they wereinvestigating whether and, if so, how that liabilitymight be capped, but explained that they weremore pessimistic on the issue than were theSociety’s Directors.

199 On the same day at a meeting of FSA’s Firms andMarkets Committee, the FSA’s Chairman expressedconcern over press reports that there had beenlittle interest in purchasing the Society. The minutes of that meeting record that, although only threepotential bidders were left, the FSA still thoughtthat it was likely that ‘a good sale’ could beachieved.

November 2000

200 Meanwhile, GAD had been considering potentialmeans through which Equitable might cap theliabilities, arising from guaranteed annuity ratepolicyholders making ‘topping up’ payments,without preventing the Society from writing newbusiness. The closure of the Society to newbusiness would, GAD said, almost certainly end anychance of a sale and there was a need to cap thoseliabilities.

201 It does not appear that, at this time, GAD’sconsideration of those matters had taken intoaccount the fact that the Society’s guaranteedannuity rate policyholders had a contractual right tomake such ‘top-up’ payments even after any closureto new business.

202 On 3 November 2000, the FSA and GAD metEquitable to discuss the Society’s current financialposition. GAD noted that the Society did notappear to believe that the ‘top-up’ issue was aserious concern for potential bidders. GAD alsorecorded that the aggregate value of the recent cutin bonus rates had amounted to £1,500 million,which, it was expected, would be sufficient to coverthe cost of paying guaranteed annuity rates on fullasset shares.

203 GAD concluded, therefore, that:

With the recent cut in bonus rates … newpolicyholders should not have to meet any [of]the cost of GARs, as indeed is likely to be theirexpectation. However, they will be joining avery weak fund.

GAD also noted that, if no sale were to take place,the Society would almost certainly have to stopwriting new business, and would probably have torearrange the Society’s investments to a moredefensive position, to protect against possibleliquidation in the event of a substantial fall in equityvalues.

204 Also on 3 November 2000, in the light of furthercomplaints from policyholders about theappropriateness of the Society’s advertising, theFSA prepared a draft response to those complaints,which they circulated to their conduct of businesscolleagues.

205 The draft, which was agreed by the FSA’s Head ofLife Insurance, stated:

As regulator, the FSA does of course monitorthe financial position of insurance companiescarefully. However, we understand thatEquitable continues to be solvent forCompanies Act purposes and indeed continuesto maintain the required margin of solvencyover its liabilities as required under theInsurance Companies Act 1982. As theEquitable continues to be a going concern,complying with the relevant regulatoryrequirements, we do not share your view thatit should be prevented from marketing itsproducts, which could be damaging to thebusiness. Nor do we believe that at a timewhen the statutory requirements continue tobe met, and when there is a realistic chance ofa successful sale of the business, that thenewspaper advertisement inviting potentialcustomers to request additional informationfrom the company is misleading.

206 On 6 November 2000, another potential bidder,bidder C, met with the FSA and GAD and expressedsignificant concerns about the risks that they wouldbe taking on if they were to acquire the Society,citing: the reinsurance arrangement; what appearedto be a zillmer adjustment applied to the Society’sreserves in the resilience scenarios; and thepossibility that, given the Society’s precariousregulatory solvency position, Equitable might ‘gothrough a period of statutory insolvency’, beforemaking a recovery.

207 On 10 November 2000, bidder C informed the FSA’sChairman that, although they had been veryinterested in acquiring Equitable, they:

… had reached the view that the Equitable’sfinancial position was considerably worse thanthey had first thought. The hole wassignificantly larger than they had expected…  [and their] main motive in telling [us] this wasto alert [us] to the fact that the Equitable’sposition might be rather more doubtful thanwe had been led to believe.

208 In an internal note dated 14 November 2000, theFSA set out how each of the possible outcomes ofthe sales process might be handled.While notingthe serious concerns raised by potential biddersabout the Society’s exposure to certain liabilities,the FSA concluded that, at this stage, ‘there do notseem to be any grounds for considering action onthe basis of insolvency since Equitable is able tomeet its contractual obligations’.

209 On the following day, bidder C told the FSA thatthey considered it would not be worth takingEquitable ‘at any price’, as some currentpolicyholders were clearly expecting a restorationof bonuses forgone and perhaps even ade-mutualisation bonus, expectations which itwould be impossible to meet.

210 On 16 November 2000, GAD commented that, if nobuyer were found, the Society would be in a verydifficult position. GAD told the FSA that:

… from a regulatory perspective, we know that[Equitable’s] financial position remains veryclose to the edge of not covering their marginof solvency, there are a number ofuncertainties (eg in the viability of theirfinancial reinsurance, and resilience to changesin financial markets – they are unable atpresent to satisfy one of the recommendedresilience tests which they argue is quite strongand they point to a known anomaly inRegulation 69), and we would then also knowthat it would be difficult to arrange a “rescue”  by another insurer in the event of technicalinsolvency arising.

211 GAD advised the FSA that the prudential regulatorswould have to require the Society to commission anindependent investigation into its viability, in orderto help to demonstrate to all concerned whetherEquitable should be allowed to continue writingnew business.

212 Over the next two weeks, Equitable and GADcontinued to debate the determination ofappropriate reserving levels. The FSA also continuedto explore with the potential bidders various issuesincluding:

•  the possibility of capping the Society’s liabilities;
• whether the acceptance of payments intonon-guaranteed annuity rate policies (whichmight then have to be used to subsidiseguaranteed annuity rate policy payments) mightbe viewed as mis-selling (as to which theconduct of business regulators provided advicethat this would not be so viewed, if anappropriate warning had been given);
• whether the bidders’ proposals would fulfil thereasonable expectations of the Society’spolicyholders; and
• whether the Society’s existing future profitsimplicit items could be transferred to any buyer.

213 On 22 November 2000, Equitable’s AppointedActuary reported that, as at the end of October2000, the Society’s available assets were estimatedto be £2,295 million to cover the required minimummargin of £1,215 million.

214 On 24 November 2000, GAD submitted to the FSAtheir detailed scrutiny report on the Society’s 1999regulatory returns. A detailed description of thecontent of GAD’s report is contained within thechronology entry for that date within Part 3 of thisreport.

215 Although GAD said that the Society’s solvencyposition appeared reasonable, with available assetsof £3,860 million to cover a required minimummargin of £1,110 million, GAD noted that this figureincluded a future profits implicit item of  £925 million, disregarded liability to repay asubordinated loan of £346 million, and benefitedfrom a reduction in the liabilities of almost  £1,100 million resulting from the reinsurancearrangement.

216 Without those factors, GAD noted that theSociety’s available assets would reduce to  £1,510 million. The report went on to cite a list offurther weaknesses in Equitable’s position, andadded that the question of whether the Societyshould continue to sell non-guaranteed annuityrate policies in a common fund with guaranteedannuity rate policies could be considered an‘environment risk’.

217 On 29 November 2000, the FSA informed theManaging Director with responsibility for Equitableand their Chairman that two potential bidders(bidders A and B) remained interested in a possiblesale. It was said that the Society’s preferred bidder,bidder A, was to submit a recommendation to theirBoard on 7 December 2000 on whether or not tomake a formal bid.

December 2000

218 On 1 December 2000, the FSA and GAD metEquitable. The discussion at that meeting concludedthat there now seemed to be only one realisticbidder remaining, bidder A, and that it was doubtfulthat the sum that that bidder was likely to offerwould be sufficient to allow Equitable to proceedwith the sale. Should that be the case, it was notedthat it was probable that the Society would close tonew business and seek to sell its sales force andinfrastructure.

219 The FSA noted at that meeting that there remaineddisagreement between GAD and Equitable onreserving requirements and on the use of a quasizillmeradjustment^[21] in their returns. The FSA alsonoted that the Society ‘did not appear to beunduly concerned about [with-profits]policyholders who joined the Society after theHouse of Lords judgement’.

220 The FSA recorded that the Society had explained tothe FSA that ‘they had not considered whetherpost 20 July [with-profits] policyholders could beexcessively disadvantaged in a closed fund. This isbecause after this date the preferential treatmentof GAR policyholders was known’. It was also notedthat Equitable had confirmed to the FSA that theirsales force had been adequately informed aboutthe Society’s circumstances and that Equitable’sBoard had taken legal advice on that matter.

221 On the same day, the FSA met with the tworemaining prospective bidders (bidders A and B)and it became apparent during those meetings thatboth bidders might be about to pull out of thesales process.

222 Bidder B pulled out on 4 December 2000, afterEquitable felt unable to agree to allow them aperiod of exclusive negotiation. On the same day,bidder A told the FSA that they were becomingincreasingly concerned that acquisition of Equitablewould be uneconomical. Bidder A said that theycould not predict what their Board’s decision on7 December 2000 would be.

223 On 5 December 2000, the relevant FSA ManagingDirector was informed that GAD had madeadjustments to the Society’s free asset estimates toinclude various assumptions in the reserving basis  ‘to bring them into line with what [GAD] wouldnormally expect’.

224 It was said by GAD that, if all their assumptionswere correct and if all the adjustments were made,this would leave the Society with free assets of only  £70 million – although this was an arithmetical error,with the correct amount being £20 million – abovethe required minimum margin of solvency. GAD’sestimate of the Society’s available free assets wasthus approximately £1,010 million lower than theSociety’s own estimate.

225 In reply, the FSA then said that, if no bid wereforthcoming, the prudential regulators would havegrounds for closing Equitable to new business,either for failing to meet the required minimummargin or because of the risk that policyholders’  reasonable expectations would not be met.However, it was said that the FSA would prefer theSociety’s directors to take that decision on avoluntary basis.

226 On 5 and 6 December 2000, urgent meetings wereheld, including internal FSA meetings, meetings ofthe FSA Chairman’s Committee, and meetingsbetween the FSA, GAD and Equitable, to discuss theimplications of a scenario in which the lastremaining bidder withdrew.

227 On 6 December 2000, an urgent meeting of theTripartite Standing Committee was also called todiscuss whether the closure of Equitable wouldhave any systemic consequences for financialstability. The Committee noted that closure to newbusiness would be the only option if the salesprocess fell through.

228 The Committee agreed that the Society’s positionhad been different to that of other insurancecompanies due to a unique combination of factors,which meant that the Hyman judgment had had aparticularly significant effect on Equitable. At thatmeeting, the Treasury listed those factors as being:

•  It was a mutual, so (in the absence of a buyer)had limited access to capital.
• It did not have an estate of surplus assets.
• The terms of its guarantees were unusuallygenerous and flexible.It was noted that Equitable could not refuse top-uppayments from with-profits policyholders with suchguarantees, even though those payments wouldpotentially harm non-guaranteed annuity rate withprofitspolicyholders. The FSA said that that waswhy, given the Society’s lack of substantial surplus,Equitable could no longer prudently write newbusiness.

229 Treasury officials also briefed the then EconomicSecretary at this time, informing her that a sale wasunlikely to take place; those officials said that thiswas mainly because it had been impossible to capthe Society’s guaranteed annuity rate liabilities.

230 The Treasury officials also said that, while it mightbe argued that the prudential regulators shouldhave stopped Equitable writing new businesssooner, there had, until a few days previously, beenevery sign that a sale could be achieved. It was saidthat those regulators had been just as surprised asthe markets that no buyer could be found.

231 On 7 December 2000, prospective bidder Awithdrew and on 8 December 2000, as is noted inChapter 1 of this report, the Society closed to newbusiness with immediate effect.

232 In the next Chapter of this report, I will summarisethe way in which the prudential regulation of theSociety was undertaken during the post-closureperiod – ending with 1 December 2001, when myjurisdiction over the relevant events ended.

Footnotes

1 It appears that GAD did not inform the Treasury at this time that they were aware that such a problem existed.

2 This empowered the prudential regulators to appoint one or more competent persons to make an investigation into, and report tothose regulators on, (a) whether the criteria of sound and prudent management were fulfilled with respect to an insurance company, or(b) whether those criteria would be so fulfilled if a person notified to the prudential regulators as intending to become a controller ofsuch a company were to become such a controller.

3 That is, action under section 37(2)(aa) of Insurance Companies Act 1982.

4 See paragraphs 914 to 918 of Part 2 of this report.

5 Equitable’s former Appointed Actuary in post at that time has told me that there was no change to the Society’s reserving practice overthis period. He said: ‘The Society’s approach was that reserving could reflect actual and expected policyholder behaviour, in terms ofthe proportion of policy benefits that could reasonably be expected to be taken in guaranteed annuity form. Up to and including theend of 1997, financial conditions were such that that proportion was effectively nil because, as stated in the survey response,conditions were such that the DTBP could be expected to result in GAR benefits of no higher value than the “cash based” alternativein all but a trivial proportion of cases. The sharp fall in interest rates in 1998 had changed that position so that, by the time of themeetings, the GAR was “biting” in the sense that, even with a zero final bonus, the GAR benefits were more valuable than thealternative. In those changed conditions, it was now reasonable to expect some level of take-up of guaranteed benefits. The Societyhad accepted that that change of conditions meant further reserves were needed at the end of 1998 – the debate was around thelevel of those further reserves (the Society suggested that assuming a take-up rate of GAR benefits of 25-35% would be appropriate)’.

6 Equitable’s former Appointed Actuary has told me that: ‘Cases were not routinely checked at the time of the survey response becauseby then interest rates had not fallen to a level which was likely to lead to more valuable benefits in GAR form. Checking of allretirements was introduced a little later in 1998 following further falls in interest rates and, once introduced, applied to 100% of cases.’

7 Equitable made no reference here to the role of the differential terminal bonus policy, which was designed to ensure that there was, infact, no difference in the benefits produced if a policyholder elected to take a guaranteed annuity. Equitable’s Counsel subsequentlyrecorded in the factual background of his Opinion on the reserving implications of annuity guarantees that the differential terminalbonus policy had ‘substantially influenced’ the low take-up of an annuity at the guaranteed rate specified in the policy.

8 See paragraphs 854 to 872 of Part 2 of this report.

9 Some time later, on 3 August 2001, the FSA ‘look again’ at the requirements of the applicable Regulations and came to the view that itwas not clear that reserving on the basis of a 100% take up rate was required by those Regulations and concluded that a lower level ofreserving would be permissible, if that was prudent.

10 No such note had been added to the 1993 or 1994 statements. Furthermore, it appears that not all the 1997 statements contained such anote due to clerical errors.

11 See the entry for 18 December 1998 within Part 3 of this report.

12 However, the Society had not suggested that it was only in its 1997 returns that this approach had been stated.

13 Under the Treasury’s lowest estimate for the cost of meeting the annuity guarantees, they calculated that Equitable had £700 million tocover the required minimum margin of £845 million. Under the Treasury’s highest estimate for the cost of those guarantees, theTreasury calculated that Equitable would have been insolvent for regulatory purposes by £750 million. However, the Treasury noted thatthose figures did not account for certain measures which might have been taken. Such measures included any future profits that mighthave been permissible if an appropriate concession were granted or any margins within the valuation basis which might have beenavailable to be released. (For the full notes accompanying the Treasury’s figures, see the entry for 22 October 1998 in Part 3 of thisreport.)

14 In December 2000, after the decision of the House of Lords in the Hyman case, this note was leaked to a national newspaper.Commenting on the last point in the note, the FSA’s Line Manager E wrote: ‘We were subsequently satisfied that [Equitable] wassolvent and it remains solvent today’.

15 When the Treasury and GAD met Equitable on 22 December 1998, the Society had been warned that regulatory action was a possibility.

16The public bodies told me that the FSA had taken the same action in respect of several other life assurance companies which had notreserved appropriately for guaranteed annuity rate policies.

17 At interview with the FSA’s Baird Inquiry, Chief Counsel A said that she had provided oral advice to the regulators and GAD on the likelyoutcome of Hyman following a meeting with Equitable. The Baird Report stated that it was believed that this advice was provided afterthis meeting. In response to the view put forward by Equitable at the meeting (that the outcome of the case was likely to be positivefor them), Chief Counsel A cautioned that: ‘You can never predict judicial outcomes … If Equitable get the wrong panel or the wrongjudge, they could find themselves on the receiving end of a change in judicial approach. The Court … might not like what theEquitable has done and might be influenced for that reason. Don’t jump to conclusions on this.’ (See the entry for 29 June 1999 withinPart 3 of this report.)

18 See the entries for 14 and 22 October 1999 within Part 3 of this report.

19 See the entry for 3 November 1999 within Part 3 of this report.

20 See the entry for 30 June 2000 within Part 3 of this report.

21 See the glossary for an explanation of this term.