Appendix E

The Government paper on ‘the regulatory regime pursuant to which Equitable Life was regulated during the period 1973 to 2001’.

This appendix contains the paper submitted by the bodies under investigation describing the relevant regulatory regime. It is reproduced here in its original form, with the exception that some minor linguistic editing has been necessary.

Introduction

1 Until 1 December 2001, when the Financial Services and Markets Act 2000 (‘the FSMA’) came into force, life insurance companies such as Equitable Life were subject to two regulatory regimes: prudential regulation and conduct of business regulation.

2 Prudential regulation is concerned essentially with the solvency of insurance companies, and the soundness and prudence of their management. Conduct of business regulation relates primarily to the marketing and sale of a company’s products and the provision of related advice to current and potential policyholders.

3 Conduct of business regulation does not fall within the Parliamentary Ombudsman’s remit and the conduct of business regulation of Equitable Life is accordingly not within the scope of the present investigation.

4 This paper describes the regime for the prudential regulation of life insurance companies pursuant to which Equitable Life was regulated during the period under investigation. Part I describes the background to the regulation of life insurance business in the UK prior to the introduction of the Insurance Companies (Amendment) Act 1973 (‘the 1973 Act’). Part II describes the regulatory regime that was introduced under the 1973 Act, and subsequent events leading up to the Insurance Companies Act 1982 (‘the 1982 Act’). Part III describes the regulatory regime that was put in place pursuant to the 1982 Act. That regulatory regime then remained in place (subject to some changes which are considered in Part IV) until the FSMA came into force on 1 December 2001. Part V deals with the changing identity of the relevant prudential regulator, and its relationship with the Government Actuary’s Department (‘GAD’).

5 The philosophy which has guided the prudential regulation of life insurance companies in the UK from its inception is the doctrine of ‘freedom with publicity’. In summary:

1. From as early as the nineteenth century, it was recognised that, whilst it was desirable for there to be some prudential regulation of life insurance business to safeguard policyholders’ interests, it was also desirable not to restrict commercial freedom. It was also recognised that excessive prudential regulation could have an inhibiting effect on the development of an innovative and competitive life insurance market in the UK.
2. The doctrine of ‘freedom with publicity’ was developed, whereby life insurance companies would make their affairs public through financial information being placed in the public domain. This approach was perceived as providing an appropriate balance between commercial freedom and innovation on the one hand and policyholder protection on the other.
3. Over the course of the twentieth century, the extent of the financial information required to be disclosed by life insurance companies, and the regularity with which that information had to be disclosed, was gradually increased. At the same time, sophisticated actuarial professional practices were developed to try to safeguard policyholders’ interests.
4. The doctrine of ‘freedom with publicity’ was subject to policy consideration prior to the passing of the Insurance Companies (Amendment) Act 1973, and the view taken was that the policy should continue.⁶⁴³ Indeed when contrasted with the prescriptive approach to prudential regulation adopted by some EEC countries at that time (in areas such as premium rates, policy conditions and choice of investments) the view was that this had led to higher charges and poorer service in those countries, whereas the UK’s more liberal approach had ‘paid off handsomely in terms of an enterprising innovating industry with substantial overseas earnings’.⁶⁴⁴
5. Under the 1973 Act, the regulatory regime placed an increasing amount of reliance on the insurance companies’ actuaries through the introduction of the Appointed Actuary system. In addition, a greater role was given to the prudential regulator in scrutinising the financial returns submitted by insurance companies, and, from 1981, in ensuring that appropriate margins of solvency were maintained. But at its heart, the regulatory regime remained one based on insurance companies’ freedom of action rather than on prescriptive rules covering, for example, product design or premium rates.
6. It was not seen as necessary to change the basic policy approach at the time of the passing of the Insurance Companies Act 1982,⁶⁴⁵ nor when the insurance regulations were reviewed in 1994/95⁶⁴⁶.
7. Not only was this approach favoured in the UK,but it came to be substantially accepted by the European Community as striking the right balance between competing policy objectives. Thus the doctrine of ‘freedom with publicity’ also lay behind some of the provisions of the First to Third Life Insurance Directives.⁶⁴⁷
8. Throughout the period under review, the doctrine of ‘freedom with publicity’ accordingly remained a fundamental principle of prudential insurance regulation of insurance companies in the UK.

6 Judged on its own terms, it is fair to say that the policy of ‘freedom with publicity’ was generally successful. It contributed to the development of a highly innovative and competitive life insurance market in the UK. At the same time, during the last quarter of the twentieth century, the UK insurance industry enjoyed a high degree of stability under the policy with few corporate failures.

7 The regulatory approach built on the principle of ‘freedom with publicity’ (and augmented with requirements for limited disclosures to the prudential regulator and professional duties for the Appointed Actuary) was longstanding, endorsed by the domestic and European legislatures and perfectly legitimate for the government to adopt. Moreover, it was a policy decision that had important ramifications for (i) the amount of financial information to which the prudential regulator was to have regard; (ii) the extent of the prudential regulator’s interference in the affairs of the companies it regulated; and (iii) the level of resources that were made available to the prudential regulator.

8 Thus, the amount of financial information to which the prudential regulator was expected to have regard was always carefully circumscribed. Whilst various statutory instruments gradually increased the amount of financial information that life insurance companies were required to disclose to the prudential regulator, at the same time it was perceived that a balance had to be struck, so as to ensure that the regulatory burden imposed on life insurance companies was not so great as to stifle innovation and competition. For example, during the 1990s the DTI’s Insurance Division had an objective: ‘To keep the cost and inconvenience of regulation for insurers as low as is commensurate with effective protection of the consumer’.⁶⁴⁸

9 Likewise, when the concept of ‘policyholders’ reasonable expectations’ (‘PRE’) was first introduced into legislation in 1973, the Government of the day pointed out that the new legislation was not to be operated so as to curtail market competition and innovation.649 Subsequent statutes made clear that intervention by the prudential regulator on the grounds of PRE was a ‘residual’ power, or ‘longstop’ measure that was only to be used if the regulator’s purpose could not be achieved by any of the other powers of intervention;⁶⁵⁰ and one that should be used sparingly by the regulator, and not in such a way so as to restrict a life insurance company’s freedom to dispose of its assets (save in very limited circumstances).⁶⁵¹

10 The doctrine of ‘freedom with publicity’ also had implications for the resources and skills that were made available to the prudential regulator. Given the importance attached by the statutory regime to the role of the Appointed Actuary, it made sense for the prudential regulator to work closely alongside the UK actuarial profession, including outsourcing a scrutiny and advisory role to GAD (from 1984 onwards by way of a series of Service Level Agreements). It also meant that prudential regulation of the UK insurance industry could be resourced on a more streamlined basis.

Part 1 – the background to prudential regulation of life insurance business in the UK prior to 1973

The start of prudential insurance regulation in the UK

11 Substantive legislation to control the prudential regulation of life insurance companies was first introduced in the nineteenth century, following a large number of business failures and mergers that took place in the first half of that century.

12 The 1853 Select Committee on Assurance Associations, chaired by the Rt Hon James Wilson MP, took evidence from a number of leading actuaries and insurance men of the day. John Finlaison, the Actuary and Principal Accountant of the Check Department of the National Debt Office (the nearest there was at that time to a Government Actuary), was an advocate of a free market. As the first President also of the Institute of Actuaries (from 1848 to 1860), Finlaison argued that the right approach was to rely on the professional expertise of actuaries and to protect the public by giving official recognition to the Institute of Actuaries and controlling entry to the profession by examination. As a result no substantive legislation was introduced.

13 However, the collapse of both the Albert Life Assurance Company and the European Assurance Society in 1869 prompted renewed political concern over the lack of any prudential regulation of the activity of life insurance companies. Legislation was introduced into the House by Mr Stephen Cave, as Vice-President of the Board of Trade, and this became the Life Assurance Companies Act 1870 (‘the 1870 Act’). In introducing the Bill, Stephen Cave observed that 285 pure life insurance companies had been formed up to that point, of which only 111 had survived.

14 The 1870 Act required that a separate account should be kept of all receipts in respect of life assurance and annuity contracts of an insurance company and that this fund should be regarded as the absolute security for the life insurance policies. This approach gave particular safeguards in the case of composite insurance companies, which were also carrying on general insurance business, but also entailed, in the case of pure life insurance companies, separation of the life and annuity business transactions from any shareholders’ funds. This was the origin of the long-term business fund, which continues to form part of the legislative structure to the present day. 1872 and to extend the regulatory regime to cover also fire, accident and employers’ liability insurance and bond investment business.

15 The 1870 Act also required regular investigations to be carried out by an actuary into the financial condition of a life insurance company. Existing companies had to be looked at every 10 years and new companies every 5 years, unless more frequent reviews were required under the company’s constitution. A key feature of prudential regulation, which has remained in its essential form up to the present day, was that the annual accounts of the company, together with the abstract of the actuarial valuation when carried out, had to be deposited with the Board of Trade, which then made these available to the public through the Registry of Joint Stock Companies.

16 In 1870 few countries had any statutory regulation of life insurance companies. Sprague (1872) compared the new UK legislation with that recently introduced in Massachusetts and New York, which had the expressed objective of securing the solvency of all life insurance companies. Sprague believed that this could never be absolutely secured; nor was it a desirable objective. In his view it was best to allow insurance companies a good deal of freedom, but require them to make their affairs public by way of regular financial returns.

The early 20th century

17 The 1870 Act concerned only life insurance business, and it was not until 1907 that prudential regulation was extended to any general insurance business with the passage of the Employers’ Liability Insurance Companies Act 1907. Two years later, in 1909, the then President of the Board of Trade, Winston Churchill, introduced a Bill to replace the Life Assurance Companies Acts 1870 to

18 The principles set out in the resulting Assurance Companies Act 1909 were essentially the same as in the 1870 Act. Separate funds were to be maintained for each class of general insurance business, although separation of assets was not necessarily implied. A new certificate was introduced in which the company had to state that, where there was more than one fund, no part of any such fund had been applied directly or indirectly for any purpose other than the class of business to which it related.

19 The actuary’s valuation statement, which now appeared in the Fourth Schedule to the Act, was only slightly modified from the format in which this had previously appeared in the 1870 Act, although separate statements were now required for ordinary branch business, industrial life assurance and sinking fund business. The same split was applied to the tabulation of business in force required under the Fifth Schedule to the Act.

20 The legislation continued to rely on ‘freedom with publicity’ and the Board of Trade was inclined towards non-interventionism. For much of the time this was a successful policy but there were a number of problem companies and a small number of life insurance company insolvencies. The first important failure to occur since the passing of the 1870 Act was the National Standard Life Assurance Company Limited, which was forced to wind up in 1916.

The postwar period and the early influence of Europe

21 The process of developing a single insurance market in Europe started within the Organization for European Economic Cooperation (OEEC), the predecessor of the OECD, in the mid 1950s. At this time an Insurance Subcommittee was established to explore ways in which the European insurance market might be opened up and international trade in insurance encouraged.

22 Reports were commissioned by the Subcommittee from Professor Campagne, which were produced in 1957 and 1961. These reports advocated the adoption of minimum standards for solvency of insurance companies, with Professor Campagne advocating minimum margins of solvency based on 25% of annual premium income for general insurance business and 4% of mathematical reserves⁶⁵² for life insurance business.

23 Following the establishment of the European Economic Community by the Treaty of Rome in 1957, the Conference of EEC Insurance Supervisory Authorities began to address the same problems as those already under consideration by the OEEC. The objective was to move as quickly as possible towards the ideal of a free market in insurance within the EEC. The first stage was to establish the credentials which insurance companies must demonstrate before being allowed to establish branch operations in other EEC countries and write business there.

24 The UK was closely involved in the OEEC/OECD developments, but not in the early EC discussions, which at that time concerned only the original 6 members.⁶⁵³ In the course of the 1960s, UK representatives attended three active OECD Committees on insurance matters.⁶⁵⁴ 

Market turmoil in the 1960s

25 The 1960s saw some significant developments in the insurance market in the UK. On the life insurance side there were some noteworthy new products, in particular the beginnings of unit-linked business and various types of guaranteed income bonds. Pension business was also beginning to grow strongly, subject to a variety of constraints imposed by the Inland Revenue. A number of new insurance companies began to spring up to exploit these opportunities.

26 In general insurance there was an intensification of competition, with a number of new motor insurance companies trying to enter the market. The fraudulent activities associated with the demise of Fire, Auto and Marine raised concerns within Government circles; as did the collapse of Vehicle & General in the late 1960s, which led to a substantial inquiry conducted by the Board of Trade.

27 During the mid to late 1960s the Board of Trade had sought advice from ASTIN, the general insurance section of the International Actuarial Association, and from a leading UK general insurance actuary (Bobby Beard), on how to make material improvements to the information available to the prudential regulator concerning general insurance companies. This led to the general insurance sections of the Insurance Companies (Accounts and Forms) Regulations 1968 and, in particular, to the requirement for general insurance companies to supply information, by each year of origin, relating to the year by year settlement of claims and the amounts estimated to be outstanding.

Part II – the introduction of the 1973 Act

28 At the beginning of the 1970s, the prudential regulation of life insurance business still relied fundamentally, as it had done for 100 years, on the company actuary, whose responsibility it was to value the liabilities and to ensure the adequacy of the assets constituting the long-term business fund to cover the liabilities and to give a good return to the with-profit policyholders. However, under regulations which had been introduced in 1958 and remained in force into the 1970s, a full actuarial valuation was only required every 3 years, with a simple certificate from the actuary in the intervening years to confirm the adequacy of the long-term business fund.

The Appointed Actuary

29 The Insurance Companies (Amendment) Act 1973 introduced for the first time the concept of the ‘Appointed Actuary’. The idea was to upgrade the statutory requirement for an actuary to carry out a valuation of the assets and liabilities every 3 years, and an approximate valuation each year, into a requirement to designate a specific professional person within the company (the Appointed Actuary) who could be relied on by the prudential regulator to monitor the financial position of the company on a continuous basis.

30 The provisions in the 1973 Act, which were consolidated into the Insurance Companies Act 1974, did not specify in any detail the role which the Appointed Actuary was intended to fulfil. However, discussions took place with the UK actuarial profession, which agreed to issue guidance to its members on how to fulfil the responsibilities of the Appointed Actuary to a life insurance company. A Joint Committee (of the Institute of Actuaries and the Faculty of Actuaries) on Financial Standards drew up the first draft of the guidance (entitled ‘Actuaries and Long-term Business’), which was issued in May 1975. This later came to be known as GN1 (Guidance Note 1), being the first of what was to become an extensive series of guidance notes for actuaries involved in different areas of professional activity. Compliance with GN1 was mandatory.

31 When the Appointed Actuary system was introduced, there was no requirement for a life insurance company to hold an explicit solvency margin. It was, however, regarded as the professional responsibility of the Appointed Actuary to monitor the overall financial position of the company and to ensure that the size of the long-term business fund, and the way in which it was invested, were such as to ensure that the future liabilities of the company towards policyholders, including meeting their reasonable expectations (as to which see below), could be met with a high degree of probability. The 1973 Act required the Appointed Actuary to carry out a formal investigation into the financial condition of the company once a year. In addition, the profession made it the Appointed Actuary’s duty to monitor the financial position on a continuous basis. Thus, GN1 stated that the Appointed Actuary was to take all reasonable steps to ensure that he was, at all times, satisfied that if he were to carry out an investigation the position would be satisfactory.

32 A cornerstone of prudential regulation thus became reliance on the Appointed Actuary, who was close to the company and had a professional responsibility to monitor its financial position on a day-to-day basis and to establish prudent mathematical (or technical) reserves. There was no regulation of policy conditions or premium rates, since this was seen to be properly the responsibility of the company, acting on the advice of its Appointed Actuary, and it was considered that regulatory intervention would inhibit competition. Having the Appointed Actuary at the heart of the company (with full right of access to the Board, which was a requirement of GN1) was intended to provide protection for policyholder interests, as well as a strong internal system of financial control and risk management. This structure was reflected both in the legislation and associated regulations and in the extensive mandatory professional guidance to which Appointed Actuaries were subject.

33 Each new Appointed Actuary was invited, following the notification to the prudential regulator of their appointment, to come for a meeting with the Government Actuary. Such meetings were informal in nature, being an opportunity to establish personal contact and to discuss the nature of the Appointed Actuary’s relationship with the Board and other senior executives of the company. The agenda ranged over each of the areas covered by GN1, such as product design, premium setting, investment policy, valuation and data systems, and sought to explore what influence the Appointed Actuary expected to be able to bring to bear in each area and what arrangements had been put in place to ensure that the Appointed Actuary was able to comply with GN1.

34 It is worth noting that this system of regulation has been widely recognised as successful, and many other countries around the world have introduced variants of the Appointed Actuary system. This includes a number of European countries (e.g. the verantwortlicher Aktuar in Germany and Switzerland, and the Appointed Actuary in Belgium, Denmark, Italy and the Republic of Ireland). bonuses in an appropriate way over the duration of Introduction of PRE

35 Another new feature of the 1973 Act was the first mention in statute of the term ‘policyholders’ reasonable expectations’ (‘PRE’), although the term was not specifically defined. The origins of this term, in its application to life insurance regulation, are thought to lie in a paper which Ronald Skerman, then Chief Actuary of Prudential, prepared for discussions in Europe and which was then tabled at a discussion at the Institute of Actuaries in the mid 1960s. His purpose was to articulate the criteria for a solvency test of a life insurance company. He argued that provision should be made within the determination of the company’s liabilities for ensuring that the ‘reasonable expectations of policyholders’ were met. senior DTI official at the time that Ministers had

36 The 1973 Act gave the prudential regulator the power to intervene in the affairs of a company if there were grounds to believe that PRE were not being met. One of the Government’s main policy concerns when considering the 1973 legislation was that the Boards of proprietary life insurance companies might favour the interests of shareholders over and above the interests of policyholders by ‘milking’ the surplus accruing in the long-term business fund for the shareholders’ benefit. The concept of PRE was therefore introduced, at least in part, to enable the interests of policyholders to be protected beyond their strict contractual entitlements.⁶⁵⁵ A further purpose was to support a regulatory requirement for the use of a net premium valuation, which had the effect of preventing a life insurance company from treating the bonus loadings in the premiums as an immediate contribution to surplus and supporting the gradual declaration of reversionary each policy. Thus PRE, in its original intention, was not concerned with the expectations of different cohorts of policyholder interests within a mutual life insurance company.

37 The notes on clauses presented to Parliament when the Bill was introduced show the intentions of Ministers in this regard. These notes explained that the new power of intervention on grounds of PRE would only be exercised ‘where it was obvious that PRE were not going to be fulfilled’, and that this would ‘stop well short of seeking to ensure that with-profit policyholders received value for money under their contracts or a particular level of bonus... regardless of the amount of surplus revealed by the periodic actuarial valuation’⁶⁵⁶. This is consistent with statements made by a accepted that ‘no system we could contemplate would eliminate the occasional failure or give absolute protection’ and that the aim should be to give policyholders ‘a reasonable measure of protection’, his view being that which prevailed when the matter was passed to the Parliamentary Under Secretary of State. These sentiments strongly echoed those of Sprague, advocated 100 years earlier.

38 Consistent with this, Ministers took the decision when the 1973 Act was being drafted that regulation of life insurance companies by the prudential regulator would be based principally on an analysis of companies’ annual regulatory returns, in the case of life insurance companies to be in large part carried out by GAD as actuarial adviser to the prudential regulator, and that any regulatory action taken on PRE grounds would be reactive to what was found in the regulatory returns. In substance, the responsibility for proper treatment of PRE devolved on the Appointed Actuary, This responsibility was reflected in a number of specific provisions relating to PRE being included in GN1.

39 A further indication of what was intended by Ministers in relation to PRE is provided by a speech made by the Minister of State to the Faculty of Actuaries on 16 February 1976, when he said:⁶⁵⁷

What expectations might be reasonable, in any particular case, will have to be determined in the light of the circumstances, but it is certainly our expectation that companies which charge large premiums, with a loading for bonuses, will, in fact, make profits to be shared with their policyholders, and will not take credit for the value of future bonus loadings so that they can hold smaller reserves than would a nonprofit company. On the other hand, we do not envisage any general intervention in the determination of the amount of surplus to be disclosed by companies, or the manner in which it is distributed between policyholders of different generations or different classes. We would hope that this could continue to be left to the directors, acting on the advice of their Actuaries, particularly in view of the strengthening of the Actuary’s role in the legislation and of the description of that role in the joint guide, which is the main subject of this evening’s discussion.

40 Pursuant to the 1973 Act, statutory regulations were passed, identifying the content of the regulatory returns, and also the basis upon which assets were to be valued. There were initially no substantive rules regarding the valuation of liabilities, but such rules were introduced in 1981.

41 Whilst the 1973 Act marked a significant increase in the extent of prudential regulation, the fact that the regulatory regime did not guarantee zero failure was underlined by the collapse of Nation Life in 1974, and by a clutch of other small life insurance companies getting into difficulty in 1974: Lifeguard, Capital Annuities and London Indemnity & General. These events had their origin before the introduction of the 1973 Act, however, and they were in fact a significant factor leading to the development of the Act. They also gave added impetus to the development of professional guidance to Appointed Actuaries on how to fulfil their responsibilities after the Act had been put in place.

Part III – the introduction of the 1982 Act and the regulatory regime imposed

The First Life Directive

42 The Insurance Companies Act 1981 and the subsequent Insurance Companies Regulations 198⁶⁵⁸ (‘ICR81’) were designed to implement the First Life Directive,⁶⁵⁹ which had been adopted by the EC in 1979. The Insurance Companies Act 1981 was then consolidated into the Insurance Companies Act 1982, along with the preexisting regulatory regime introduced under the 1973 Act. To understand the regulatory framework that was put in place by the 1982 Act, it is therefore important to understand the reasons for and the scope of the First Life Directive.

43 As the first recital of that Directive made clear, its aims were to open up the life insurance market to the extent of allowing companies from one EC member state to establish a branch in another member state: ‘freedom of establishment’. Consistent with this, the Directive sought to eliminate certain divergences that existed in national legislation concerning the prudential regulation of life insurance companies, and to coordinate the financial obligations required of life insurance companies. It specified the classes of business for which companies must obtain authorisation and also set out some minimum conditions for the granting (and withdrawal) of authorisation.⁶⁶⁰

44 The Directive required the establishment of technical reserves in respect of the liabilities arising from the whole of a company’s in force business, and for these to be covered by equivalent and matching assets localised in the country where the business was written.⁶⁶¹ The calculation of the technical reserves, and the valuation of assets, including restrictions on the extent to which different assets could be used to match the technical reserves, were to be carried out in accordance with rules laid down in national regulatory legislation. A formal valuation was required to be carried out, and the results of this to be submitted to the prudential regulator, on an annual basis.⁶⁶²

45 The Directive also introduced a requirement for companies to maintain an explicit margin of assets over liabilities, referred to as the solvency margin, to reduce the risk of insolvency and to provide a cushion against adverse business fluctuations.⁶⁶³ The required solvency margin was calculated on a prescribed basis⁶⁶⁴ that was intended, in a very broad-brush way, to reflect the risks to which a company’s capital was exposed; and was subject to an overall minimum called the minimum guarantee fund.⁶⁶⁵

46 The required solvency margin could be represented by explicit items and (to a limited extent and subject to the consent of the prudential regulator) by implicit items. Explicit items included capital, free reserves and surplus  in the company’s balance sheet. Implicit items included hidden reserves such as undisclosed undervaluation of assets⁶⁶⁶, items relating to zillmerising⁶⁶⁷; and, in the case of life insurance companies, the present value of future profits⁶⁶⁸. The mechanism used in the UK to grant consent for, and give effect to, an implicit item in a particular case was the issuance by the prudential regulator of an order under section 57 of the 1974 Act (and subsequently section 68 of the 1982 Act)⁶⁶⁹.

47. The Directive provided prudential regulators with limited powers of intervention in certain circumstances. In particular, prudential regulators were authorised: (i) if a company was unable to establish sufficient localised technical reserves, to prevent the free disposal of assets within a Member State;⁶⁷⁰ (ii) if a company was unable to cover its required solvency margin, to require the submission of a plan for the restoration of a sound financial position;⁶⁷¹ and (iii) if a company’s solvency margin fell below the guarantee fund⁶⁷², to require the submission of a short-term finance scheme and prevent the free disposal of assets.⁶⁷³ The Directive also provided that, in the first and third cases, the prudential regulator might take all measures necessary to safeguard the policyholders’ interests.

48 Furthermore, the Directive allowed prudential regulators to withdraw authorisation (thus requiring a company to close to new business) if: (i) the conditions for admission were no longer fulfilled;⁶⁷⁴ (ii) the company had been unable to take the measures in any restoration plan or finance scheme that it had submitted to the prudential regulator;⁶⁷⁵ or (iii) the company failed seriously in its obligations under the national regulations⁶⁷⁶. Any decision to withdraw authorisation or suspend business had to be supported by precise reasons from the prudential regulator; and provision had to be made to allow the life insurance company to apply to the court to challenge any such decision.⁶⁷⁷ Furthermore, pursuant to Article 21 of the Directive, the prudential regulator was prohibited from preventing the disposal of assets, save in certain exceptional circumstances (such as where regulatory solvency had been breached; or the company was to be closed to new business).

49 From this it can be seen that one of the consequences of the First Life Directive was the introduction of a prudential regulatory regime across Europe that adopted a similar approach to regulation as had previously existed in the UK: with powers of intervention that were narrowly circumscribed, in order to avoid excessive regulatory requirements impeding the development of a single market in insurance within Europe. As set out further below, this approach was subsequently strengthened, at a European level, by the introduction of the Third Life Directive (under which, amongst other things, requirements for prior approval by the prudential regulator of products and premium rates were prohibited).

The Insurance Companies Act 1982

50 The provisions of the First Life Directive were incorporated into UK legislation by the Insurance Companies Act 1981, which was subsequently consolidated into the Insurance Companies Act 1982.

Continuation of the Appointed Actuary scheme

51 As under the previous legislation, the 1982 Act (by section 19) required each life insurance company to appoint an actuary, known as the Appointed Actuary. The appointment of an Appointed Actuary had to be notified to the prudential regulator within 14 days of its having been made. Regulatory approval was not required for the actuary’s appointment; nor did the prudential regulator have power to oppose the appointment of a particular individual or to seek an actuary’s removal;⁶⁷⁸ nor was there any statutory prohibition on the Appointed Actuary holding any other office within the company.⁶⁷⁹ However, section 96(1) of the 1982 Act made it clear that an Appointed Actuary had to hold ‘prescribed qualifications’, which included a requirement that the actuary must have attained the age of 30 and be a Fellow of the Institute of Actuaries or the Faculty of Actuaries; subsequently it became a requirement of the UK actuarial profession that an Appointed Actuary must hold a ‘practising certificate’ from the Faculty and Institute of Actuaries. It also remained established practice for the appointee to be interviewed by the Government Actuary on first appointment.

52 Section 18 of the 1982 Act required the Appointed Actuary to make an annual investigation of the company’s financial condition. The report, which would normally be presented to the Board, had also to be included in abstract in the company’s regulatory returns.⁶⁸⁰ The investigation was to include a valuation of liabilities of the company attributable to its life assurance business; and a determination of any excess over those liabilities of the assets representing the fund or funds maintained by the company in respect of that business.⁶⁸¹

53 Provision was made in the 1982 Act for the basis of valuation of liabilities and assets and the form of the abstract of the Appointed Actuary’s valuation report to be set out in delegated legislation. This was subsequently done in ICR81 and the Insurance Companies (Accounts & Statements) Regulations 1983⁶⁸² (‘ICASR83’). The latter were a modified version of the earlier reporting requirements and included Schedules carried over from the former primary legislation. The abstract of the Appointed Actuary’s valuation report, for example, now appeared in Schedule 4 to these regulations.

54 The determination of liabilities regulations in ICR81 were developed by means of a joint consultative process between DTI, GAD and the UK actuarial profession. As noted above, these were new, no valuation of liabilities regulations having previously been promulgated under the 1973 Act. The Joint Actuarial Working Party (JAWP) was established, with members from GAD and from the profession, chaired by the Government Actuary. DTI had the status of observer, so as to retain its independence of action in drafting the regulations and avoid being irrevocably committed to the recommendations coming from JAWP. The discussions in JAWP made it possible for the leadership of the profession better to understand DTI and GAD’s concerns. They also allowed DTI and

55 GAD to obtain feedback on the potential effect of the regulations, and a degree of ‘buyin’ from the profession to what was being proposed. Section 22 of the 1982 Act required each life insurance company to submit the abstract of the Appointed Actuary’s valuation report to the prudential regulator each year (the regulatory returns), along with the annual report and accounts required under the Companies Acts (the Companies Act accounts). As noted above, the content of the regulatory returns was prescribed by delegated legislation, and these tended to be considerably longer and more detailed than the Companies Act accounts (during the latter half of the 1990s those for Equitable Life ran to some 400 pages for each year).

56 The regulatory returns were the main source of information from which the prudential regulator, acting on advice from GAD, formed a view as to a life insurance company’s current and future regulatory solvency.

Principal regulatory actuarial and accounting provisions

57 Section 32 of the 1982 Act required life insurance companies to hold assets which exceeded their liabilities by at least the margin prescribed by ICR81. That was known as the required margin of solvency and had in principle to be maintained throughout the year, not just at yearend, although it was normally only required to be demonstrated at the yearend. Ensuring continuous solvency was a responsibility of the Appointed Actuary. In accordance with the First Life Directive, in the event that a life insurance company failed to meet the required solvency margin: (i) the prudential regulator could require the company to submit a plan for the restoration of a sound financial position; (ii) the prudential regulator could require the company to modify any such plan; and (iii) the company then had to give effect to that plan.⁶⁸³

58 Pursuant to ICR81 the technical reserves were to be calculated in accordance with generally accepted actuarial methods and assumptions, as prescribed by the regulations, and the required solvency margin, the guarantee fund and minimum guarantee fund were to be calculated on the basis laid down in the First Life Directive.⁶⁸⁴ Regulation 54 of ICR81 provided that the determination of life insurance business liabilities should be made on prudent actuarial principles, and should make proper provision for all liabilities on prudent assumptions with regard to the relevant factors. Initially there was no explicit statutory requirement that such liabilities be assessed having regard to PRE. However, the net premium valuation method was prescribed in regulation 57, using cautious assumptions, and under regulation 59(6) it was not permitted to take into account expected future returns on equities in excess of the current dividend or rental yield. These requirements, taken together with the applicable valuation of assets regulations, meant that implicit provision was appropriately made for future bonuses including future terminal bonuses. More explicit reference to PRE was made in amendments to the determination of liabilities regulations introduced in 1994. Zillmerisation⁶⁸⁵ of the reserves was permitted (but not required) under regulation 58. The ICR81 requirements as to the valuation of life insurance business were amplified after their introduction by another mandatory professional guidance note, GN8 (entitled ‘Additional Guidance for Appointed Actuaries on Valuation of Long-term Business’).

Prudential regulator’s powers of intervention

59 Under section 11 of the 1982 Act, the prudential regulator had the power, either at the request of the company or on any of certain specified grounds, to issue a direction withdrawing a company’s authorisation to conduct new business. The specified grounds were: (i) that it appeared to the prudential regulator that the company had failed to satisfy an obligation to which it was subject by virtue of the Act (for example, failure to maintain the required margin of solvency pursuant to section 32);⁶⁸⁶ (ii) that there were grounds on which the prudential regulator would have been prohibited from issuing authorisation to the company (for example, if share capital was not fully paid up; or the directors, controllers, managers or main agents of the company were not ‘fit and proper’ persons);⁶⁸⁷ or (iii) that the company had ceased to be authorised to effect contracts of insurance in the country where its head office was situated.⁶⁸⁸

60 In accordance with the First Life Directive, before giving a direction to the company under section 11 of the 1982 Act, the prudential regulator had to serve on the company a written notice stating that it was considering giving a direction and the grounds on which this was being considered.⁶⁸⁹ The company could, within one month of that notice being served, make written (or, if the company requested, oral) representations to the prudential regulator. The prudential regulator was then required to take those representations into account before giving a direction.⁶⁹⁰

61 In addition to the power under section 11 of the 1982 Act to withdraw authorisation from a life insurance company, section 37 provided that the prudential regulator could intervene (using a range of powers set out in sections 38 to 45 of the Act) in a limited number of circumstances. In particular, those circumstances included:

1. If the company had failed to satisfy an obligation to which it was subject by virtue of the 1982 Act (for example the failure to maintain the required solvency margin in accordance with section 32);⁶⁹¹
2. If the company had furnished misleading or inaccurate information to the prudential regulator;⁶⁹²
3. If no adequate arrangements were in force or would be made for the reinsurance of insured risks (where the prudential regulator considered that such a class of risks should be reinsured);⁶⁹³
4. If there were grounds on which the prudential regulator would have been prohibited from issuing authorisation to the company: for example if share capital was not fully paid up; or the directors, controllers, managers or main agents of the company were not ‘fit and proper’ persons. (However, before exercising any powers on the grounds of unfitness or impropriety of certain persons, the prudential regulator had to give notice to that person and allow them to make representations which then had to be taken into account);⁶⁹⁴
5. If the company had substantially departed from any business proposal submitted at the time it sought authorisation;⁶⁹⁵ and
6. If the company had ceased to be authorised to effect contracts of insurance in the country where its head office was situated.⁶⁹⁶

62 In addition to these closely circumscribed grounds of intervention, there was a further general ground of intervention pursuant to section 37(2)(a): to protect policyholders or potential policyholders against a risk that a life insurance company might be unable to meet its liabilities, or to fulfil the reasonable expectations of policyholders or potential policyholders.

63 As with the 1973 Act, there was therefore an explicit statutory reference to the concept of PRE, although there was no statutory definition of this concept. The concept of PRE was subsequently the subject of a Faculty and Institute of Actuaries Working Party report, and guidance was provided by the DTI in a Ministerial statement in February 1995 (as to which see further below).

64 The powers of intervention given to the prudential regulator pursuant to sections 38 to 45 of the 1982 Act were also, for the most part, closely circumscribed. They included:

1. a power, under section 38, to require a life insurance company not to make, or to realise, certain investments;
2. a power, under section 41, to limit the aggregate premium income of the company;
3. a power, under section 42, to require the Appointed Actuary to investigate all or a specified part of the company’s business, and to publish an abstract of that investigation;
4. powers, under sections 43 and 44, to accelerate deposit with the prudential regulator of the regulatory returns; and to obtain information or require the production of documents.

65 There was also a power, expressly described in the heading of the section as a ‘residual power’, contained in section 45 of the 1982 Act, which enabled the prudential regulator to take such action as appeared to be appropriate for the purpose of protecting policyholders or potential policyholders of a life insurance company against the risk that the company might be unable to meet its liabilities, or to fulfil the reasonable expectations of policyholders or potential policyholders.

66 Express limits were imposed on that residual power in order to comply with the First Life Directive.⁶⁹⁷Thus, section 45(2) of the 1982 Act provided that the power could not be exercised by the prudential regulator in such a way as to restrict a company’s freedom to dispose of its assets (e.g. by preventing a distribution of assets to policyholders), except where: (i) the prudential regulator had exercised powers under section 11 to withdraw authorisation and close the company to new business; or (ii) the prudential regulator believed that the company had failed to maintain the required solvency margin; or (iii) where the company had submitted accounts which had not been prepared in accordance with valuation regulations or generally accepted accounting practices.

67 Other express limits were also imposed on the section 45 power of intervention by the 1982 Act.Thus section 37(6) made it clear that this power should only be used in the event that policyholder protection could not be appropriately achieved by the exercise of the prudential regulator’s more specific powers as set out above. There was also an implied constraint on the use of this power, as recognised by the Parliamentary Ombudsman in her first report on the ‘Prudential Regulation of Equitable Life’, in that the exercise of intervention powers might bring about consequences which the prudential regulator would otherwise want to avoid, including the possibility of adverse consequences for policyholders.⁶⁹⁸

68 Finally, pursuant to section 54 of the 1982 Act, the prudential regulator could apply to wind up a company if (i) the company was unable to pay its debts as and when they fell due; (ii) the company had failed to satisfy an obligation to which it was subject by virtue of the 1982 Act (e.g. the obligation to maintain the required solvency margin in accordance with section 32); or (iii) the company had failed to keep proper accounts in accordance with its obligations under the Companies Acts. Further rules dealt with the continuation of life insurance business of insurance companies in liquidation, and made provision for the reduction of contracts as an alternative to winding up.⁶⁹⁹

Part IV – subsequent developments in the regulation of life insurance companies under the 1982 Act

The introduction of resilience testing

69 In 1985, the Government Actuary issued guidance to Appointed Actuaries on the interpretation of the requirement under regulation 55 of ICR81 to establish ‘appropriate provision against the effects of possible future changes in the value of the assets on their adequacy to meet the liabilities’. This required life insurance companies to be able to demonstrate that their reserves were sufficient to continue to comply with all the other determination of liabilities regulations after one of a series of shock scenarios affecting the value of the assets. The process of establishing the sufficiency of the reserves in such scenarios came to be known as ‘resilience testing’. The hypothetical scenarios included an immediate fall of 25% in the value of equity investments (and a comparable fall in the value of property) and significant movements in fixed interest yields, either up and down. Monies set aside to ensure the company could cope with the adverse investment scenarios were known as the ‘resilience reserve’, albeit that part of the margins used to satisfy resilience tests could be met by crediting ‘excess’ margins held elsewhere within the overall valuation basis used to calculate the basic policy reserves.

70 The requirement for Appointed Actuaries to conduct such a resilience test was subsequently incorporated into GN8 but without specifying the scenarios to be considered. At the same time, GAD developed and kept under review guidelines as to the changes in equity prices and fixed interest yields that it might be prudent to take into account. The guidelines were published as letters (known as ‘Dear Appointed Actuary’ or ‘DAA’ letters) sent to all Appointed Actuaries, the first such letter relating specifically to the resilience test being issued in July 1992.

71 While not mandatory, such guidance provided the de facto standard for prudent resilience testing. GAD would question Appointed Actuaries on whether the aggregate reserves they had established met this standard. DAA10 from the Government Actuary, issued on 24 November 1998, amended the benchmark scenarios for resilience test 2. It said that, while the revised test was necessarily more complex, it was intended to avoid the unreasonable stringency which might apply if equity markets fell below their current levels.

The introduction of the Second Life Directive, and further consideration of PRE

72 In 1990 the Second Life Directive700 was adopted by the EC, and was implemented in the UK in 1993. This extended the freedom of establishment provided by the First Life Directive to ‘freedom of services’, whereby an insurance company established in one EC member state could sell its products on a cross border basis in other member states. However, such cross-border business remained subject to authorisation by the prudential regulators in those other member states if they so wished.

73 In 1990 DTI issued a consultation document which proposed ways in which the Appointed Actuary system could be strengthened and JAWP was reconvened at this time to review the effectiveness of the existing system and generally to take this process forward. This led in due course to the introduction of the practising certificate regime by the UK actuarial profession and the setting up of various research initiatives within the profession. These included the establishment of professional working parties, on which GAD was represented, 1) to consider the meaning of PRE, 2) to investigate alternatives to the net premium method of valuing liabilities as the statutory minimum valuation basis and 3) to review the impact of guarantees within annuity contracts. The first working party reported in 1993 and the latter two towards the end of the 1990s; all three are mentioned further below.

74 It will be recalled that the concept of PRE had been first introduced in the 1973 Act, and reenacted in the 1982 Act; and although there had been some Ministerial statements about the content of PRE when the 1973 Act was introduced, no statutory definition of what constituted PRE  had been given.

75 It was generally accepted within the UK actuarial profession and the life insurance industry that PRE extended beyond the expectation simply that contractual liabilities or other legal rights would be met. Most with-profits policies contain some element of discretionary annual reversionary bonuses and also terminal bonuses, and it was seen as reasonable that holders of such policies should expect companies to behave fairly and responsibly in exercising their discretion to distribute such discretionary bonuses in a reasonably consistent way. For with-profits business, the profession developed the concept that policyholders were entitled to expect that benefits would, at least broadly, reflect their ‘asset share’ (effectively the proportion of the fund attributed to each policyholder⁷⁰¹).

76 Over time asset share (subject to a smoothing process, that is averaging out the peaks and troughs of stock market movements) came to be regarded by the life insurance industry as providing the starting point for determining what the total benefit payable at maturity should be. If policyholders received something like their asset share, then PRE could generally be said to have been fulfilled. DTI did not fully accept this argument, mainly because it was usually a precursor to life insurance companies arguing that, once PRE according to this definition had been delivered to policyholders, the rest of the surplus could be allocated to shareholders. It was also the case that the policy wording of many with-profits contracts went much wider than this in promising bonuses not only in respect of the surplus emerging on the with-profits business but also a share in the profits emerging from the nonprofit business.

77 Under pressure to give more guidance to the life insurance industry on how PRE should be interpreted, the prudential regulator always took the line that this was a matter for the Courts to decide. However, there were no test cases. Following on from discussions on PRE in JAWP, the UK actuarial profession set up a PRE working party. This sat between 1990 and 1993 and reported in that year. It carried out a series of interviews with Appointed Actuaries and attempted to distil principles.

78  Consistent with the prudential regulator’s view that the interpretation of PRE was a matter for the courts to decide, no formal guidance was issued following the working party’s recommendations. However, some of the principles identified still served to inform Appointed Actuaries as they prepared reports for their Boards. The working party’s report indicated that, for with-profits business, policyholders were entitled to expect that the total benefits paid under the contract would reflect the accumulated value of premiums paid less expenses and the cost of risk benefits in accordance with the actual experience of the company. Thus, asset share would provide the starting point for determining maturity benefits. The degree to which returns were smoothed over time, and the extent to which part of the asset share was retained to finance future expansion, would vary considerably between companies. It was reasonable to expect that a company would change its policy in these areas only gradually; a sudden move from a passive to an active terminal bonus policy could be considered unreasonable.

79 Some case history began to be built up subsequently from agreements that life insurance companies reached with DTI to restructure their long-term business fund, merge ordinary business and industrial business or demutualise. One early case of a company trying to extract shareholder value by attributing a significant part of the ‘inherited estate’ to shareholders (the United Friendly case) involved detailed discussions between DTI and that company as to how section30⁷⁰² of the 1982 Act should apply to it, and led to DTI obtaining legal advice from counsel regarding the balance of interest of shareholders and policyholders in that company’s inherited estate.The prudential regulator’s view of PRE was further developed subsequently from numerous demutualisations which took place during the 1990s, and from other life fund restructurings (for example, the relatively recent Axa case in 2000; and the earlier London Life case, in respect of which a court judgment was given which considered the competing interests affecting policyholders in a transfer of business). 

80 Following on from the United Friendly case, a Ministerial statement on the subject of PRE was made by Jonathan Evans, the Consumer Affairs Minister, on 27 February 1995. This set out the view of DTI of the factors which influenced PRE in respect of the attribution of surpluses in with-profits funds (albeit in the specific context of an inherited estate and with regard to shareholders’ expectations in a proprietary company, rather than PRE between policyholders in mutual companies). These factors were: the fair treatment of policyholders vis-a-vis shareholders; any statements made by the company as to its bonus philosophy and the entitlement of policyholders to a share in profit (for example, in its Articles of Association or in company literature); the history and past practice of the company; and general practice within the life insurance industry.

81 GN1 contained a number of specific provisions relating to PRE. It made it clear that an important aspect of the Appointed Actuary’s role was the duty to advise the Board on the interpretation of PRE. In general terms, it required such advice to have regard to the broad nature of the company and its approach to the treatment of policyholders both individually and (where appropriate) as a group vis-a-vis shareholders. When a significant change of approach was likely to take place, the Appointed Actuary was required take all reasonable steps to ensure that the company appreciated the implications for PRE. It was also incumbent on the Appointed Actuary to take all reasonable steps to ensure that the company’s incoming policyholders should not be misled as to their expectations.

82 With regard to bonus declarations, the Appointed Actuary had to justify any recommendations regarding the allocation of profits and its consequences (if any) for the conduct of the company’s business, by reference, as appropriate, to the Appointed Actuary’s interpretation of the reasonable expectations of the company’s policyholders, having regard to: (a) his appraisal of the relevant experience; (b) his understanding of the company’s financial and business objectives; and (c) his assessment of the company’s continuing ability to meet its statutory solvency requirements. Such expectations were influenced by policy literature and other publicly available information, such as own expense charge illustrations. 

83 The Appointed Actuary was to assume, among the conditions for the fulfilment of these expectations: (i) that, in the recognition and allocation of profits in accordance with the company’s terms of participation and its policy in respect of the nature and timing of allocations of profits, groups of with-profits policies were appropriately and equitably distinguished having regard, inter alia, to the terms of the policies, their duration and their relevant pooled experience; and (ii) that the company conducted its affairs, including its new business and investment strategies, with due regard to its financial resources.

84 The Appointed Actuary also had specific responsibilities under GN1 with respect to terminal bonus. In particular, the Appointed Actuary was required to include in his report to the Board on the statutory valuation comments on bonus prospects, with particular reference to the projected development of outgo on, and asset cover for, unreserved terminal bonus in different investment scenarios.

85 It was a statutory requirement for the Appointed Actuary to list in the regulatory returns the professional guidance notes that had been complied with. Compliance with GN1 was a mandatory professional requirement.

86 Equitable Life had a particular approach to asset shares and equity between policyholders, which was the subject of a paper presented to the Institute of Actuaries for discussion at a sessional meeting in March 1989.703 This extended the concept of asset shares to say that, as a mutual company, Equitable Life could only achieve full equity between policyholders by allocating bonus in such a way as to give each cohort of members their ‘effective asset share’

The introduction of the Third Life Directive

87 In 1992 the Third Life Directive⁷⁰⁴ was adopted by the EC, and was implemented in the UK in 1994.

88 The Third Life Directive further harmonised national legislation in order to provide for the mutual recognition of authorisation and prudential control systems for life insurance companies.⁷⁰⁵ This made it possible to grant a single authorisation valid throughout the EC and apply the principle of prudential regulation by the home member state. The prudential regulator in a member state in which a company authorised in another member state operated was no longer permitted to exercise control over the company’s operations in its state. The Directive thus completed the process of securing full freedom of services, which was the ultimate objective of the single insurance market.

89 The Directive required the calculation of the technical reserves of a life insurance company to be based on actuarial principles, common to all member states, and as recommended by the Groupe Consultatif des Associations d’Actuaires dans les Pays des Communautés Européennes. These principles included limiting the rates of interest that could be used in the valuation, but did not prescribe the valuation method to be used, the choice of which was left open to member states to decide.⁷⁰⁶ The Directive introduced a requirement for ‘admissibility limits’ in relation to assets but prevented member states from requiring companies to invest in particular assets. It amended the asset matching and localisation rules introduced by the First Life Directive so that these applied across all member states.⁷⁰⁷ It also permitted the required solvency margin to be covered (within limits and subject to specified conditions) by subordinated loan capital (and cumulative preference share capital) for the first time⁷⁰⁸. This was not subject to the consent of the prudential regulator under the Directive but such consent was nonetheless made a requirement in the UK, again implemented by means of the issuance by the prudential regulator of an order under section 68 of the 1982 Act.

90 The Directive prohibited the prior approval by the prudential regulator of products or premium rates,⁷⁰⁹ instead relying on the required solvency margin, the rules concerning the technical reserves and the valuation of assets, and other prudential provisions, to afford adequate protection to policyholders. It established minimum requirements for information provided to potential policyholders at the point of sale,⁷¹⁰ and introduced various provisions intended to protect the ‘general good’ of policyholders. Whilst the Third Life Directive permitted member states to impose explicit reserving requirements for terminal bonus, it did not require this⁷¹¹, and it remained the norm throughout the EC instead to adopt the UK approach of using a net premium valuation and prudent interest rate assumptions for valuing the liabilities, which, taken together with appropriate valuation of assets regulations, made implicit provision for future terminal bonuses (to the extent that these existed in other member states)⁷¹².

91 The provisions of the Third Life Directive in part reflected extensive lobbying undertaken by DTI and GAD throughout the EC in the early 1990s, advocating a more flexible approach to prudential regulation of life insurance companies, which placed greater emphasis on a principles based approach rather than the very detailed and prescriptive rules which had been used previously by the prudential regulators in a number of member states and by their companies and their actuaries. This lobbying had also sought to explain and promote the Appointed Actuary system as an effective mechanism for allowing such an approach to prudential regulation of life insurance companies, in response to which a number of other EC countries adopted a variant of that system.

92 The provisions of the Third Life Directive were incorporated into UK legislation by way of amendment of the 1982 Act, and the replacement of ICR81 by the Insurance Companies Regulations 1994⁷¹³ (‘ICR94’). Reporting requirements were also updated with the replacement of ICASR83 with the Insurance Companies (Accounts & Statements) Regulations 1996⁷¹⁴ (‘ICASR96’).

93 The degree of amendment introduced by these new regulations was in practice relatively modest, reflecting the fact that the old regulations already contained many of the provisions now required by the Third Life Directive. However, significantly, regulation 64 of ICR94 for the first time expressly required the Appointed Actuary to take account of PRE,⁷¹⁵ when assessing a life insurance company’s liabilities for the purpose of preparing the regulatory returns; and this was accompanied by new disclosure requirements introduced by paragraph 6(1)(b) of Schedule 4 to ICASR96. Furthermore, a non-exhaustive list of factors to be taken into account in determining the life insurance business liabilities was set out in ICR94, which included: (i) all guaranteed benefits, including guaranteed surrender values; (ii) vested, declared or allotted bonuses to which policyholders were already entitled; (iii) all options available to the policyholder under the terms of the contract; and (iv) expenses including commissions.⁷¹⁶

94 Some other significant changes were also made to both the 1982 Act and the regulations at this time. A list of ‘criteria of sound and prudent management’ was introduced into the 1982 Act, together with a requirement for these to be met as a prerequisite for authorisation⁷¹⁷. Several new powers of intervention for the prudential regulator were introduced including a power to conduct general investigations⁷¹⁸, and the grounds for the exercise of intervention powers was broadened to include a breach of the criteria of sound and prudent management⁷¹⁹. Explicit requirements relating to both the adequacy of assets and the adequacy of premiums for life insurance business were also introduced⁷²⁰. A significant change introduced by ICASR96 was a new requirement for the regulatory returns to include a ‘matching rectangle’⁷²¹, which enabled the prudential regulator and GAD to check more easily compliance of the rates of interest used in the valuation with regulation 69 of ICR94.

95 Successive changes were also made subsequently to ICR94 in particular. These regulations were amended 8 times during the period 1994 to 2000. Amendments made in 2000 included a significant change to regulation 72, the effect of which was that the reserve held for any policy could not be less than the amount which could reasonably be expected to be paid under an option available to the policyholder to secure a cash payment under the policy. For recurrent single premium contracts of the type written by Equitable Life this amount had to be calculated having regard to both the likely current surrender value and the discounted prospective value of benefits (allowing for expected future annual bonuses under the conditions prevailing at the valuation date)722. This amendment established for the first time an explicit reserving standard for contracts of this type, and implicitly (through the resilience test too) required some allowance to be included in the reserve for accrued terminal bonus.

96 Together the 1982 Act, ICR94 and ICASR96 (as successively amended) contained all the statutory provisions relating to the prudential regulation of insurance companies until the coming into force of the FSMA and the introduction of the Interim Prudential Sourcebook by the Financial Services Authority (FSA) on 1 December 2001. These were, however, supported by a number of other documents. These included guidance notes issued by the UK actuarial profession, in particular GN1 and GN8; a series of ‘Prudential Guidance Notes’ (‘PGNs’) issued by the prudential regulator to companies⁷²³; market letters (called ‘Dear Director’ letters) issued by the prudential regulator to companies; and Dear Appointed Actuary letters issued by the Government Actuary to Appointed Actuaries on specific reserving issues, including the resilience test (as to which see above).

Other developments in the 1990s

97 During the first half of the 1990s, GAD had actively promoted the value of encouraging life insurance companies to carry out dynamic financial analysis. This involved the testing of a company’s ability to withstand possible future adverse conditions (in addition to those already required under the regulations and mandatory professional guidance to be considered in the resilience test), making use of cash flow projections on a variety of assumptions. Partly as a result of this encouragement, the UK actuarial profession introduced guidance note GN2 (entitled ‘Financial Condition Reports’) in March 1996.

98 A working party on the net premium method of valuation reported in the spring of 1998. The working party concluded that the net premium method of valuation continued to be an appropriate minimum standard for the valuation of conventional with-profits business for regulatory purposes. This was due to the fact that alternative valuation methods (which had been known about for many years and were widely reported in the actuarial literature) had associated problems, not least from a regulatory perspective, including the capitalisation of future profits. However, the working party recommended that the alternative gross premium method would be more appropriate for nonprofit business, and that a new reserving standard should also be introduced for accumulating with-profit contracts. These recommendations were subsequently accepted by the prudential regulator and implemented through amendment of ICR94⁷²⁴.

99 The annuity guarantees working party was established as current market annuity prices rose during the 1990s, and reported in November 1997. This working party identified a number of possible approaches to reserving for annuity guarantees in relation to with-profits business, which it ‘set out for consideration’. These were: prudential regulator, through GAD, should conduct

1. to allow for the guarantees in the same way as for unit-linked business, by setting aside additional reserves related to prudent estimates of the cost over and above existing, unadjusted with-profits business reserves;
2. to recognise the cost of the guarantees as effectively increasing the guaranteed sum assured on a prudent basis and recalculating net premium reserves on that basis;
3. to review whether, and to what extent, the guarantees could be covered by terminal bonus adjustments. Providing that such adjustments would be used and were sufficient to cover the guarantees in all circumstances, there was an argument for not reserving for such guarantees.

100 None of these approaches was deemed entirely satisfactory. The first was described as the ‘most prudent’ but would have an adverse impact on the reported level of cover for the required solvency margin. The second was arbitrary in its effect. The third (which was that which Equitable Life in fact adopted up to 1997) ‘could be viewed as unsound because no explicit provision was made for an explicit guarantee’. The report concluded that, with low interest rates and improving life expectancy (which compounded the effect of falling interest rates), companies would need to give careful consideration to how to reserve for the guarantees.

101 As part of its research, the working party conducted a survey of life insurance companies’ actual current practices with regard to reserving for annuity guarantees. The responses provided to that survey were confidential. However, these prompted GAD, which had been represented on the working party, to recommend that the its own survey on annuity guarantees in June 1998. It was the response of Equitable Life to this survey which revealed its differential terminal bonus policy to the prudential regulator.

Part V – the changing identity of the prudential regulator, and its relationship with GAD

The relevant prudential regulator

102 Until 4 January 1998, DTI was responsible for the prudential regulation of insurance companies. Immediate responsibility rested with DTI’s Insurance Directorate. This worked closely with GAD as its actuarial adviser.

103 Following the Government’s decision to establish a single financial services regulator, the functions and powers which had formerly been carried out by DTI were transferred to HM Treasury (HMT) by the Transfer of Functions (Insurance) Order 1997⁷²⁵. From 5 January 1998 until 1 January 1999, HMT assumed direct responsibility for the prudential regulation of insurance companies. Staff in the former DTI Insurance Directorate temporarily joined HMT pending transfer to the Financial Services Authority. GAD continued to perform the same advisory role to HMT as it had done with DTI.

104 Responsibility for the prudential regulation of insurance companies was, in most respects, contracted out to FSA from HMT with effect from 1 January 1999 (although some of the regulatory powers under the 1982 Act remained exercisable by HMT). The Contracting Out (Functions in Relation to Insurance) Order 1998⁷²⁶ effected the transfer, backed by a Service Level Agreement between HMT and FSA. GAD continued to provide advice to FSA.

105 On 1 December 2001 the FSMA came into force, at which time FSA became the prudential regulator. The relationship of GAD with the relevant prudential regulator

106 GAD began to provide actuarial advice on insurance matters to the prudential regulator in the 1960s. This included advice on individual companies, on new applications for authorisation to write life insurance business and on policy issues, either of a general nature or relating to the affairs of particular companies. This continued up to the transfer of the GAD actuaries involved in this work to FSA in April 2001.

107 Throughout this period, GAD acted solely as an adviser to the prudential regulator. All powers under the statute were retained by the prudential regulator, with GAD having no authority to instruct a company or its Appointed Actuary to take any actions, but only to provide advice to the prudential regulator to assist it in the fulfilment of its regulatory responsibilities.

108 In 1984 DTI Insurance Division entered into a Service Level Agreement with GAD. This laid down the respective responsibilities of DTI and GAD. It was the responsibility of GAD to monitor the financial position of each life insurance company, including examination of annual regulatory returns, quarterly regulatory returns (where applicable, generally in relation to newly authorised companies) and other information; and to discuss matters with the company, and in particular with the Appointed Actuary, to clear up any uncertainties and, if possible, to resolve any disagreements. GAD would then report to DTI with an assessment of the financial situation of the company and the extent of its compliance with the relevant regulations, including any recommendations for further action.

109 The main output of GAD’s scrutiny of each life insurance company’s regulatory returns was a ‘detailed scrutiny report’ for the prudential regulator. These reports were prepared throughout the year in an order of priority determined shortly after receipt of all the returns as part of an ‘initial scrutiny’ process and agreed with the prudential regulator. For the majority of companies submitting their returns by the end of June (6 months after the valuation date as provided for by the legislation)⁷²⁷ GAD aimed to complete all the initial scrutinies by the end of August. Detailed scrutiny reports were then prepared on a rolling basis, with the aim being to complete reports in all cases classified as urgent (priority 1 or 2) by the end of October. The detailed scrutiny reports were intended to provide the prudential regulator with a means of identifying and considering actions it might take in relation to those companies which were found not to be complying with the regulations, had failed to meet regulatory solvency requirements or were in danger of not meeting them in the near future, or appeared not to be meeting PRE.

110 As part of a programme of strengthening the regulatory process, a much expanded new style of detailed scrutiny report was introduced from 1993. This was accompanied by a revised Service Level Agreement signed in 1995, and an increase in the resources GAD was permitted to apply to this work in the later years.

111 A further revised Service Level Agreement was put in place in 1998 following the transfer of DTI’ s responsibility for prudential regulation of insurance companies to HMT.

112 Satisfying the requirements of the primary legislation, regulations and mandatory professional guidance was unequivocally the responsibility of the Appointed Actuary. In considering whether the Appointed Actuary had met his statutory and professional obligations, GAD had regard to standards generally accepted within the UK actuarial profession and to specific research carried out by the profession. In some key areas of interpretation of the determination of liabilities regulations, GAD developed its own working rules to define what was acceptable. These were issued as guidance to Appointed Actuaries in the form of Dear Appointed Actuary letters and set out details of what GAD considered to be good practice in relation to particular actuarial issues.

113 Following on from the implementation of the 1973 Act, GAD was proactive in establishing, and was represented on, a number of professional working parties. It was also proactive in initiating market surveys, and in speaking at major actuarial events to ensure that the prudential regulatory perspective was presented.

Footnotes

⁶⁴³ As is evident in communications among officials and with departmental lawyers at the time and in statements to Parliament at the time that the Bill was being debated.

⁶⁴⁴ Minute dated 27 February 1973 to Minister.

⁶⁴⁵ As is clear from statements made to Parliament at the time that legislation was passed and contemporaneous briefs on the Insurance Companies Bill.

⁶⁴⁶ Representations were in fact taken from industry on the general policy approach during a consultation in 1994. The conclusion was that there were ‘no compelling reasons for a change’ and that there were ‘many advantages of [the] traditional approach’, conclusions with which ‘[a] very large majority’ of those who responded to the consultation agreed.

⁶⁴⁷ For example, those limiting the circumstances in which regulators could prohibit life insurance companies from disposing of their assets, and provisions which forbade prescriptive rules as to premium rates, policy conditions and choice of investments.

⁶⁴⁸ MINIS 94, Objective 10.

⁶⁴⁹ See paragraph 37.

⁶⁵⁰ See section 37(6), and the heading to section 45 of the 1982 Act.

⁶⁵¹ See section 45(2) of the 1982 Act. This was required to give effect to EEC law, and in particular Article 21 of the First Life Directive, described in Part III.

⁶⁵² Mathematical reserves are based on a mathematical calculation of the basic reserves required to meet all prospective guaranteed liabilities, including additional measures of prudence.

⁶⁵³ France, Germany, Italy, Belgium, Netherlands and Luxembourg.

⁶⁵⁴ The Buol Committee on life insurance technical reserves; the Homewood Committee on general insurance technical reserves; and the de Florinier Committee on solvency margins. The latter made little progress, since it awaited the outcome of the other two committees; Buol reported in 1972.

⁶⁵⁵ DTI minute dated 3 November 1971; instructions dated 29 September 1972 to departmental lawyer; and paragraphs 18 and 19 of instructions to Parliamentary Counsel.

⁶⁵⁶ See the notes on clauses to the Bill.

⁶⁵⁷ 17 Hymans J C S and Donald D W A (1976) Actuaries and long-term insurance business. Transactions of the Faculty of Actuaries, 34, 113-136.

⁶⁵⁸ SI 1981 No 1654.

⁶⁵⁹ Council Directive 79/267/EEC.

⁶⁶⁰ Articles 1 and 6. In particular, the submission of a ‘scheme of operations’ as set out in Article 8.2. Article 17.

⁶⁶² Article 23.

⁶⁶³ Article 18.

⁶⁶⁴ Set out in Article 19. The 4% of mathematical reserves recommended by Professor Campagne was adopted by the Directive, along with 0.3% of capital at risk.

⁶⁶⁵ See Article 20.

⁶⁶⁶ See Article 18(3)(c).

⁶⁶⁷ See Article 18(3)(b).

⁶⁶⁸ See Article 18(3)(a).

⁶⁶⁹ Regulation 10(4) of ICR81.

⁶⁷⁰ See Article 24(1).

⁶⁷¹ See Article 24(2).

⁶⁷² Defined in Article 20 as one-third of the required solvency margin, subject to a minimum of the minimum guarantee fund.

⁶⁷³ See Article 24(3).

⁶⁷⁴ See Article 26(1)(a).

⁶⁷⁵ See Article 26(1)(b).

⁶⁷⁶ See Article 26(1)(c).

⁶⁷⁷ See Article 26(3).

⁶⁷⁸ Contrast the position in relation to the managing director or chief executive where, pursuant to section 60(3) of the 1982 Act, the prudential regulator could object to the appointment of either officer on ‘fit and proper’ grounds, subject to certain procedural requirements.

⁶⁷⁹ Contrast the position of general representatives for foreign applicants, who were expressly prohibited from holding the office of auditor to the proposed life insurance company pursuant to section 10(4) of the 1982 Act.

⁶⁸⁰ Section 18(1)(b).

⁶⁸¹ Section 18(2).

⁶⁸² SI 1983 No 1811.

⁶⁸³ See Section 32(3).

⁶⁸⁴ See Regulations 5 and 9 of ICR81.

⁶⁸⁵ Zillmerisation was a technique that could be used for regular premium policies to spread the initial costs incurred in writing the policyover the duration of the contract in proportion to the premiums due. It operated by means of an increase (subject to specified limits) in the future regular premiums for which credit was taken in the net premium valuation.

⁶⁸⁶ Section 11(2)(a).

⁶⁸⁷ Section 11(2)(b) and section 7.

⁶⁸⁸ Section 11(2)(c).

⁶⁸⁹ Section 12(1) and (2).

⁶⁹⁰ Section 12(6).

⁶⁹¹ Section 37(2)(b).

⁶⁹² Section 37(2)(c).

⁶⁹³ Section 37(2)(d).

⁶⁹⁴ Section 37(2)(e) and section 48.

⁶⁹⁵ Section 37(2)(f).

⁶⁹⁶ Section 37(2)(g).

⁶⁹⁷ In particular, Article 21(2).

⁶⁹⁸ See ‘Prudential Regulation of Equitable Life’, Part II, paragraph 34.

⁶⁹⁹ See sections 56 and 58 of the 1982 Act.

⁷⁰⁰ Council Directive 90/619/EEC.

⁷⁰¹ More precisely, ‘asset share’ represents the actuarially adjusted accumulated value of premiums paid, less deductions for expenses, tax and other charges, plus allocations of business profits or losses, accumulated at the actual rate of investment return achieved.

⁷⁰² Section 30 imposed restrictions on the amount by which the proportion of the total distributed surplus allocated to policyholders could be reduced between successive valuations.

⁷⁰³ Ranson R H and Headdon C P (1989) With profits without mystery. Journal of the Institute of Actuaries, 116, 301-345.

⁷⁰⁴ Council Directive 92/96/EEC.

⁷⁰⁵ See in particular Recital 5 of the Third Life Directive.

⁷⁰⁶ See Article 18, amended Article 17(1)B.

⁷⁰⁷ See Article 18, amended Article 17(3) and Annex 1.

⁷⁰⁸ See Article 25(1).

⁷⁰⁹ See Articles 29 and 39.

⁷¹⁰ See Annex 2.

⁷¹¹ See Article 18, Amended Article 17(1)D.

⁷¹² See paragraph 58.

⁷¹³ SI 1994 No 1516.

⁷¹⁴ SI 1996 No 943.

⁷¹⁵ See Regulation 64(1). Contrast the previous provisions of ICR81, Regulation 54.

⁷¹⁶ See Regulation 64(3). This effectively implemented Article 18, Amended Article 17(1)A(i).

⁷¹⁷ Sections 5(1A), 5(4) and Schedule 2A.

⁷¹⁸ Section 43A.

⁷¹⁹ Section 37(2)(aa).

⁷²⁰ Sections 35A and 35B.

⁷²¹ Form 57.

⁷²² Regulation 72(4).

⁷²³ These included a number of PGNs interpreting ‘sound and prudent management’ in a variety of different contexts.

⁷²⁴ The amendment introduced with respect to accumulating with-profit contracts is as described in paragraph 95.

⁷²⁵ SI 1997 No 2781.

⁷²⁶ SI 1998 No 2842.

⁷²⁷ A minority of companies had accounting year ends other than 31 December and for these there was a corresponding timetable for initial scrutinies and detailed scrutinies.