Phase 4: 1991 - 1993

Practice regarding exercise of supervisory powers by the DTI in the early 1990s

Draft briefing paper for ministers

441 A ‘snapshot’ of the practical position regarding the exercise of supervisory powers by the DTI prior to the introduction of the changes which took place during this phase is provided by a draft briefing paper prepared by the DTI for new ministers dated 7 April 1992³⁰² .

442 The stated purpose of the paper was to explain to ministers the action which was taken in the name of the Secretary of State under the ICA 1982 on a regular basis, because ministers might be asked to give advance approval in serious or controversial cases and because there were considered to be some gaps and weaknesses in the powers which ministers were to be asked to remedy, including by way of new legislation.

443 The paper explained that the DTI’s fundamental aim was to protect policyholders and identified the two main approaches behind its work as being the monitoring of solvency of insurers and preventing those who were not fit and proper persons from controlling or managing insurance companies.

444 A table annexed to the paper showed how often the different types of main intervention power (encompassing authorisation) had been used in (then) recent years (apparently in relation to all classes of insurance business subject to the ICA 1982). For example, the table showed:

1. that during 1990 the residual power to impose requirements for protection of policyholders under section 45 had been used 28 times on authorisation³⁰³, 9 times on change of control and 10 times when financial difficulties had been encountered by a company. It was explained that in recent years the section 45 power had been used for temporary withdrawal of authorisation to write new business, as exercise of the power under section 11 of the ICA 1982 resulted in a permanent withdrawal of authorisation³⁰⁴;
2. the powers under section 38 to prohibit investments of a particular kind or to require the realisation of investments, the powers to limit premium income under section 41 and those to obtain information under section 44(1) were all said to have been ‘routinely used’, but predominantly on authorisation;
3. the power for the Secretary of State to petition the court for the winding up of an insurance company under section 54 had been used only 9 times since 1979; it was noted that such action was rarely necessary as the company’s directors or creditors normally took action in the event of insolvency;
4. withdrawal of authorisation under section 11 was said to be ‘threatened several times a year’. It was noted that where such action was contemplated in relation to a director who had been found to be unfit, the person usually resigned so the power did not actually need to be used. It was suggested that the one month delay to allow for representations where such action was contemplated was a handicap in a financial crisis; and
5. it was explained that where confidential investigations were undertaken in relation to a company, the powers to secure the production of books and papers under section 447 of the Companies Act 1985 were generally preferred to those under section 44(2) of the ICA 1982 (if the insurance company was subject to the Companies Act 1985) as the powers under the Companies Act were wider.

445 The figures given in the table annexed to the draft briefing paper in respect of the year 1990 are consistent with those shown for that year in a table produced by the Treasury in 1998 as part of its evidence to a House of Commons Treasury Select Committee on Pension Misselling. The table produced by the Treasury in 1998 shows the frequency of exercise of powers of intervention over the years 1985 to 1997 and is reproduced as Appendix B.

446 In relation to the power to prohibit a company from writing new business (under section 11 of the ICA 1982) it was noted that there was no formal power to suspend underwriting, only permanently to prohibit it, although suspension could be achieved with the agreement of the company concerned. It was said that a power to suspend authorisation would be useful to enable reorganisations to take place or to allow swifter protective action (since this required one month’s notice under the statutory procedure).

447 As regards objections to managing directors, chief executives and other ‘controllers’, the briefing paper stated that there was no power to force divestment of shares or to secure changes in the management of a company. It was said that this could only be achieved by threatening to stop the company from writing any more business, but that this was not an effective mechanism in cases where the company had already had its authority to effect new contracts withdrawn³⁰⁵.

448 In describing the use of the powers under the ICA 1982 the draft paper stated:

It is well known in the UK industry that we do not use these powers lightly or in any way capriciously. But it is equally well known that we are fully prepared to use these powers if circumstances warrant. In taking intervention action we have to balance the danger of damage caused by premature action against the risk of acting too late. Experience in the last few years has tended to swing the balance of advantage towards earlier and more decisive action.

449 The draft paper stated that the DTI did not normally disclose to the public the action taken in relation to a particular company as to do so could adversely affect the company and make it more difficult for it to restore a sound financial position, which in turn would be contrary to the interests of policyholders. It was said that this approach sometimes led to unjustified criticism of the DTI for inaction.

Policy Guidance Notes

450 From September 1991 onwards, the DTI began to issue a new series of ‘Policy Guidance Notes’³⁰⁶ to its staff at Executive Officer (EO) level and above. Copies of the Guidance Notes were also issued to the DTI Solicitor’s Branch B1 (referred to as ‘Sols B1’) and to GAD.

451 The series of Policy Guidance Notes was produced as a result of recommendations made in a ‘DTI Insurance Division Business Review and Information Systems Strategy Study’ which had been carried out in 1990 by an actuarial and management consulting firm. The study had suggested that guidelines should be drawn up to help staff in areas of supervision where significant judgmental decisions were required. The guidance was intended to help staff where ‘important and publicly visible decisions’ were required, such as the issue and withdrawal of concessions and requirements and decisions on the admissibility of assets, and to meet a perceived need for greater consistency in decisions made which might affect the operations of individual companies. The stated aim was that:

The Department should operate, and should be seen to operate, a firm but fair regulatory regime in respect of UK authorised insurance companies. The “message” to the industry and to the public should be that the Department is watching very carefully and is likely to err on the side of caution rather than adopt a relaxed attitude, particularly toward companies in difficulties.

452 Individual Policy Guidance Notes (or ‘Guidelines’) were issued on all the main areas of regulation such as authorisation, annual returns, assets and liabilities, failure to maintain solvency margins, intervention powers, concessions (orders under section 68 of the ICA 1982), disclosure and winding up. In general, each of the guidelines followed a common format which included a summary of the relevant legislation and comments on ‘best practice’.

453 A section of the Guidelines³⁰⁷ dealt with the allocation of responsibilities for policy issues between Branches of the DTI and on obtaining advice from GAD, the Solicitor’s Office and ‘industry experts’ in the DTI. Another section contained Guidelines on the Policyholders Protection Act 1975 and the division of responsibility for parts of that Act within the DTI and the circumstances in which information should be provided to the Policyholders Protection Board established under that Act³⁰⁸ .

454 Section 8 of the Policy Guidance Notes contained Guidelines on the Secretary of State’s powers of intervention. It included individual Guidelines which provided a general overview of the intervention powers (Guideline 8.1); general guidance on ‘notice of requirements’ (8.2); guidance on each of the main intervention powers other than the residual power to protect policyholders under section 45 of the ICA 1982³⁰⁹ (8.38.8) and a Guideline entitled ‘Non Statutory Intervention’ (8.10). These Guidelines were said to have been based on advice from the Solicitor’s Branch or prepared by that Branch.

455 Guideline 8.2 explained the legal, procedural and policy requirements in relation to service of ‘notice of requirements’, which constituted the means by which the Secretary of State’s powers of intervention were initiated. Standard draft notices of requirements were included in relation to each of the intervention powers.

456 A Precedents Register was required to be maintained, to include details of unusual requirements which had been imposed, advice received and the background to decisions taken, for reference in subsequent cases. In addition, a record was to be maintained (in a pro forma provided) of the number of occasions on which the powers in sections 3845 of the ICA 1982 had been used, to enable publication of an Insurance Annual Report.

457 Guideline 8.10 on ‘NonStatutory Intervention’ dealt with forms of action which might be taken by the regulator which fell short of the actual exercise of intervention powers under the ICA 1982. The Guideline gave guidance on such action by the DTI as:

1. accepting undertakings from companies (for example, not to write new business) rather than invoking intervention powers;
2. suggesting a course of action to a company to alleviate a regulatory concern;
3. expressing an opinion on the interpretation of legislation (subject to the caveat that only the Courts could decide this);
4. notifying a new company that its business activities constituted unauthorised insurance business and requesting that those activities cease, rather than mounting a statutory investigation;
5. requesting information from a company beyond that required to be provided under the Act; and
6. notifying the appropriate professional body of unprofessional conduct by accountants, lawyers or actuaries.

458 Although described in the Guideline as ‘nonstatutory’ forms of intervention, in the main the examples given might properly be characterised as implicitly authorised under the ICA 1982 (or as being an essential prerequisite to formal action). In some circumstances, certain of these forms of action may have been expressly authorised by the residual power under section 45 of the ICA 1982 to require the company to take action to protect policyholders or potential policyholders.

459 Guideline 10.2, dated July 1992, dealt with disclosure to and liaison with other UK regulators, giving guidance on when and how information or allegations about companies or individuals should be passed on. The principal ‘other regulators’ were identified as being the SIB and the SROs which, along with the Bank of England and the DTI, participated in a ‘College of Regulators’³¹⁰ . Guideline 10.2 included the following points:

1. There was no statutory obligation on the DTI to disclose information to other regulators, but rather there were restrictions under common law³¹¹ and statute³¹² (and there were criminal sanctions for disclosure of information in contravention of the statutory requirements).
2. There were exceptions to the statutory restrictions, but these were ‘extremely complex’ and advice on disclosure should always be sought from lawyers.
3. Liaison with other regulators aided the exercise of such functions as supervision of solvency and ensuring that notified persons (i.e. people who had been proposed for or who had recently filled notifiable positions in insurance companies) were fit and proper and that authorisations were properly granted.
4. The DTI’s objectives were to avoid regulatory failures because an issue or company (or group of companies) fell between regulators and to prevent unfit people moving from one regulated area to another.
5. As ‘best practice’, when staff in the DTI had adverse information about an individual or a company they were to consider whether there were any circumstances which made it likely that the information would be relevant to other regulators.
6. The DTI and the SIB had entered into an agreement in April 1991 relating to the exchange of information on investment business (which was annexed to Guideline 10.2), which required both regular and ad hoc exchanges and provided for information to be exchanged between the SIB, SROs and the DTI in such circumstances as doubts about the integrity or competence of management, doubts about the financial soundness of a company in which the regulators had a mutual interest or cases where the use of formal investigation, disciplinary or intervention powers were being considered. The letter from the SIB dated 19 April 1991 annexed to the Guideline, which set out the agreed framework, stated that in relation to a list of named insurance companies³¹³ the DTI on the one hand and the SIB or the SRO of which the company was a member on the other, would ‘normally’ inform the other and discuss appropriate action (if any) to protect investors if one of the parties became aware of information ‘which appears to it likely to be relevant to the discharge of the supervisory functions of the other’.
7. Regular exchanges of information took place about notified persons through a list which was circulated ‘widely internally’ by the DTI and externally to GAD, the SIB, Lloyd’s, the Stock Exchange and the Bank of England.
8. Where allegations were received about possible improprieties by a person active in the businesses of concern to the regulators, a decision was to be made at or above a specified level (Grade 7) about whether or not that information should be passed on to other regulators.
9. GAD might be the recipients of allegations which they would pass on to the DTI for action.
10. Companies would not normally be aware of the exchanges of information which were taking place.

460 The Policy Guidance Notes did not provide instruction or guidance on the examination of annual returns, which was said to be provided in other ways.

Internal teaching material for DTI staff

461 Further insight into the DTI’s view of the regulator’s powers in the early 1990s is provided in teaching material prepared for DTI staff which was copied to various officials in the DTI in an abbreviated form in 1991³¹⁴.

462 The teaching paper contained a commentary on the individual powers under the ICA 1982 and the grounds for their exercise and included a blend of technical and practical advice on the circumstances in which the powers of intervention could be invoked. The paper highlighted distinctions between the use of the powers for life companies and general business companies. It also provides an indication of the regulator’s interpretation of the legislation and certain aspects of the policy for applying it in the early 1990s.

463 The paper addressed the Secretary of State’s powers of intervention in two categories:

1. first, those which were exercisable on the (more general) grounds under section 37(2) of the ICA 1982³¹⁵, namely the intervention powers relating to investments (section 38); limitation of premium income (section 41); actuarial investigations (section 42); acceleration of annual returns (section 43); supply of information (section 44(1)) and the residual power to take action to protect policyholders (section 45³¹⁶); and
2. secondly, those which entailed imposing a restriction on the free disposal of assets by a company and were only exercisable on the more restricted grounds under section 37(3)³¹⁷, namely intervention in the form of requirements for the maintenance of assets in the UK (section 39) and custody of assets (section 40).

464 In relation to the first group of intervention powers, practical points made in the teaching paper included:

1. a requirement under section 38 regarding the investment (or realisation of investments) in specified assets was included ‘for practically all companies subject to notices of requirement’;
2. the power under section 41 to limit the amount of premium income a company could receive was considered to be ‘imperfect’; it was difficult to monitor because the drafting of the section did not include a definition of the premium income to which it applied, it was not clear whether a limit could be imposed on both gross and net premium income, and a limit on premium income which was designed to control the growth in liabilities could not take account of price movements (such limits normally being applied for a three year period, during which prices could change considerably);
3. section 43, under which the Secretary of State could require a company’s annual returns and other documents to be submitted earlier than their normally due date was ‘not used very often’ and did not feature in the standard notice of requirements; and
4. the power to require an insurance company to provide specified information under section 44(1) was considered to be extremely useful because it was flexible and covered a very wide range of information. The power was used to require quarterly returns and information to be submitted. It was noted that requests for information had to be ‘reasonable’ and justifiable, requiring no more and no less than was needed to monitor the company.

In relation to the residual power under section 45, the paper simply outlined the limitations on its use in a manner which would restrict free disposal of assets (under section 45(2)) and its exclusion in cases where other powers could be relied on (by virtue of section 37(6)).

465 In relation to the grounds, under section 37(2), for exercising the first group of powers the paper included the following points:

1. if reliance was to be placed on the first limb of the ground in section 37(2)(a)³¹⁸, ‘there should actually be a tangible risk that the company may go broke i.e. there needs to be some evidence pointing to financial failure in the foreseeable future’;
2. in relation to the second limb of the ground in section 37(2)(a)³¹⁹ it was simply said that this criterion of risk was ‘even more difficult and intangible’;
3. the ground in section 37(2)(b)(i)³²⁰ was ‘very wide indeed’, covering not only failure to satisfy a requirement of the ICA 1982, but any requirement of the regulations made under the Act or imposed on a company in a notice of requirements;
4. section 37(2)(c)³²¹ was also a very wide and flexible provision, enabling the Secretary of State to intervene where a company had supplied misleading or inaccurate information under the ICA 1982, the regulations made under that Act or pursuant to a notice of requirements;
5. assessment of whether or not any reinsurance programme was adequate or even necessary for the purpose of the ground in section 37(2)(d)³²² could in itself be a difficult question, probably requiring advice from the DTI’s industry experts; and
6. in relation to the ground for intervention based on the involvement of an unfit director or manager under section 37(2)(e)³²³ it was stressed that a preliminary notice under section 46 must be served on the director or manager concerned, allowing that person to make written representations (to the Secretary of State) and/or oral representations (to an officer of the DTI); ‘this is to allow the unfit person an opportunity to convince us that he is not unfit or, alternatively if he fails in doing so or not does not wish to try, the opportunity to resign without the company necessarily knowing what has happened’. It was pointed out that the subsequent notice required to be served on the company under section 46(2) must contain the same details in relation to the grounds for potential intervention as those which had been given in the initial notice served on the director or manager.

466 The paper noted that the second group of intervention powers were used much more rarely than the first group, but this had not always been the case. Until the limitations had been imposed in the late 1970s (through the First NonLife Directive), on the use of forms of intervention which had the effect of restricting the free disposal of assets other than in limited circumstances, maintenance of assets and custody of assets requirements had ‘invariably’ been included in notices of requirements served on newly authorised companies or which had been subject to a change of control.

Proposals for modernisation of insurance legislation outlined by the DTI in 1991

467 A memorandum prepared by an official of I4 Branch of the DTI dated January 1991 to other officials in the DTI and GAD suggests that some of the legislative changes made in later years had their origins almost a decade earlier.

468 In particular, in 1991 it was suggested that there were arguments in favour of taking insurance regulation out of a government department and vesting it in ‘a Commission or whatever, probably encompassing Friendly Society regulation as well’ and that there were various options for ‘sweeping up the landscape’ of financial regulation which might or might not include insurance regulation. The memorandum explained that it was an attempt to summarise the topics that might be included in future legislation given ‘unlimited Parliamentary time and a free policy rein from Ministers’. Points made in that memorandum included:

1. there was uncertainty about whether or not new training programmes and a new Branch 1 structure would turn generalist civil servants into professionally competent enough regulators;
2. when considering the powers the insurance regulator should have, it was necessary first to decide whether the regulator should be a body which was reactive and answerable to Parliament or proactive and answerable to the courts;
3. a radical modernisation of the ICA 1982 would entail ‘tear[ing] up the series of express powers exercisable in defined circumstances with a sweep up residual power of limited use’ and replacing them with a discretionary power, under which continued authorisation would be subject to such conditions as the regulator saw fit to protect the interest of investors;
4. officials had prepared a paper to compare the two approaches, but in the event there had been no prospect of a bill long enough to modernise insurance legislation and the then Minister for Corporate Affairs had ruled out a radical restructuring;
5. the submission eventually sent to the Minister by officials had proposed far more limited changes (including a power to suspend authorisation, placing assets in trust if the minimum solvency margin was breached, forcing divestment of shares and removing voting rights of shareholder controllers)³²⁴, but the Minister had decided against any amendment, his broad approach being that the DTI had adequate leverage against companies and should act robustly;
6. the DTI had given consideration to tightening up requirements for proper management and control systems in insurance companies, but had decided that existing requirements were adequate;
7. the DTI was working with auditors to explore ways of improving the quality of audit and it was suggested that auditors should be placed under an obligation to disclose to the DTI any concerns about their clients, or to require them to report to policyholders as well as to shareholders;
8. it was suggested that the regime for charging fees should be revised so that the DTI could recover all its costs; the Minister wished to see specific fees charged on authorisation and on notification of changes of control.

Other views on the regulatory regime expressed by the Minister in the early 1990s

469 In a letter dated 22 May 1991, the then Minister for Corporate Affairs described the residual power to take action to protect PRE (under section 45 of the ICA 1982) as being:

… designed primarily to protect the position of ‘with profits’ policyholders, a substantial part of whose benefits are payable at the discretion of the company, as a terminal bonus to which they have no contractual right.

470 At a meeting with officials from the DTI and GAD on 24 July 1991 to discuss the submissions they had made to the Minister in relation to various companies which were then causing concern³²⁵, the Minister emphasised the importance of the DTI operating and being seen to operate a firm but fair regulatory regime.

471 In his view, the message to the industry and to the public should be that the DTI was watching very carefully and would be likely to err on the side of caution, rather than adopt a relaxed attitude to companies in difficulties. It was noted that the system for reviewing annual returns was being revised to make it more effective in identifying likely risks and that one of the priorities was major companies. The Minister welcomed this, but expressed concern that the returns could only provide a historic picture of the company, seven months earlier³²⁶ .

472 In a letter from the Principal Private Secretary to the Secretary of State for Trade and Industry to the Permanent Secretary at the DTI dated 9 January 1992 it was said that the Secretary of State and the Minister for Corporate Affairs remained concerned that the regulators were ‘still not concentrating enough on “detective work”, i.e. proper targeted action in that minority of cases where the warning signs are clear’. Citing the Maxwell case as an example, it was said that it was noticeable that no one regulator had accepted responsibility for looking at the whole picture and no one regulator seemed to have reacted quickly or positively enough in another identified area of concern (equity release schemes).

Freedom with publicity

473 In describing the UK regulatory regime, actuaries from GAD and officials from the DTI continued to make reference to the underlying philosophy of ‘freedom with publicity’ or variations on that theme. Speaking in 1990, the then Government Actuary suggested that in some ways the system might better be described as ‘freedom with responsibility’.

474 Within certain constraints, companies were given freedom as to the type of policies they could write, the premiums charged, investments made and the way in which they carried on business. However, information about their business, income and expenditure, assets and solvency had to be provided in their statutory returns to the DTI and was then placed on public record for anyone to refer to.

475 The then Government Actuary explained that ‘[i]n principle, the information which is publicly available should be sufficient to permit another actuary to make an evaluation of the financial state of the company and to estimate the probable level of the future profits which could be attributable to policyholders’. (See further, paragraph 563 in relation to the concept of freedom with publicity or ‘freedom with disclosure’, as explained to the Minister in 1994.)

The regulator’s approach to discounting, financial reinsurance and complex financial arrangements used by some insurance companies

476 Some insight into the general approach the DTI adopted to the regulation of the use by some insurance companies of complex financial techniques is contained in a draft paper prepared for the then Director of the Insurance Directorate at the DTI, for a speech to be given at a meeting of the (American) National Association of Insurance Commissioners in 1992.

477 The draft paper appears to be directed at issues which had been of particular concern in the context of general insurance, but the observations regarding the proper classification and treatment of reinsurance contracts, the need for transparency by insurance companies and for the regulator to understand the reasons behind transactions are of wider significance.

478 The paper sought to acknowledge the commercial reality of insurance business. It referred to the practice of some insurance companies to choose some combination of explicit discounting (where this was permitted) and financial reinsurance (where reserves could be established net of reinsurance), or implicit discounting or simply underreserving, if the other approaches were not available or were thought to be a sign of financial weakness. The paper went on to address the way in which regulators should respond to the use of such financial arrangements.

479 It was suggested that the regulator should allow companies to operate in the ‘real world’, permitting them to set reserves which properly reflected the ‘time value’ of money, but at the same time the regulator should ensure that this freedom was not abused so as to allow companies to present a ‘distorted or overoptimistic picture’.

480 In particular, the regulator should seek to ensure that companies were not encouraged, or forced, into unnecessary and expensive arrangements which left them reliant upon offshore reinsurers whose security could not be properly assessed or which were simply opaque. The paper outlined a concern that too close regulation could be counterproductive, potentially having the effect of driving insurance companies into engaging in more complex (and undesirable) transactions, simply to circumvent the rules.

481 The UK regulator’s approach was illustrated by reference to the line the UK had adopted in negotiations over the preparation of the EC insurance companies accounts directive (Council Directive 91/674/EEC of 31 December 1991, referred to in paragraphs 540 et seq).

482 The draft paper noted that in the course of those negotiations, the UK had faced the almost totally unanimous view that discounting was imprudent and should be prohibited, but the UK had managed to overturn that view so that discounting was eventually permitted, subject to safeguards. The UK had argued that a ban on explicit discounting would have the effect of either forcing companies to rely on implicit discounting or to rely on financial reinsurance which suffered from ‘the disadvantage of expense and obscurity’.

483 It appears that of the alternatives, discounting was considered to be the ‘lesser evil’. The draft paper suggested that within prudent limits and with proper disclosure of the assumptions used, discounting was less risky, easier for the market and the regulator to understand and less expensive for the company. If financial reinsurance was to be used, there should be sufficient information in the company’s accounts to enable the reader to reconstruct the financial position of the company before the reinsurance was taken into account. Otherwise there could be no guarantee that reinsurance was not being used to present an unduly favourable, or even misleading, picture.

484 The draft paper concluded with the view that:

When companies engage in complex, expensive and opaque transactions it is imperative that the regulator should understand why. If he finds it is to circumvent his own regulations he needs to be even more alert. It may be a sign of weakness or wickedness on the part of the company. Or it may be a sign that his own regulations are inconsistent with commercial reality. If it is the latter then extending the scope of the rules may simply result in even more ingenious, expensive and impenetrable devices to get around that too. Regulators must live in the real world too.

The Third Life Directive 92/96/EEC

Introduction

485 The aims of the Third Life Directive of 10 November 1992 were to complete the internal market in life insurance both as regards freedom of establishment and freedom to provide services, to make it easier for assurance undertakings with head offices in the Community to cover commitments (including life assurance and annuities) situated anywhere in the Community and to provide consumers with the widest possible choice of life assurance products.

486 This Directive applied to all the insurance activities covered by the First Life Directive (and is also known as the ‘Framework Directive’). It was repealed (with the successive amendments which had been made to it) by a further Life Directive 2002/83/EC³²⁷ .

487 The preamble to the Third Life Directive states in paragraphs 5 and 10 that:

… the approach adopted consists in bringing about such harmonisation as is essential, necessary and sufficient to achieve the mutual recognition of authorisations and prudential control systems, thereby making it possible to grant a single authorisation valid throughout the Community and apply the principle of supervision by the home Member State …

… the competent authorities of the Member States must have at their disposal such means of supervision as are necessary to ensure the orderly pursuit of business by assurance undertakings throughout the Community whether carried on under the right of establishment or the freedom to provide services … , in particular, they must be able to introduce appropriate safeguards or impose sanctions aimed at preventing irregularities and infringements of the provisions on assurance supervision.

The ‘single passport’

488 The major change made by the Third Life Directive was to introduce a system of authorisation by the state in which the head office of the insurance company was based (the ‘home Member State’), which was to apply throughout the Community ³²⁸ , sometimes known as the ‘single passport’ for insurance companies.

489 Other member states were not to require a company which held such authorisation to be authorised by them in order to do business within their country, subject to a procedure under which the company was required to notify the authorities in its home state if it wished to establish a branch in another member state³²⁹ .

490 Financial supervision became (virtually) the sole responsibility³³⁰ of the home member state, which was required to monitor the ‘financial health of assurance undertakings, including their state of solvency, the establishment of adequate provisions and the covering of those provisions by matching assets’³³¹ .

491 The ‘host state’³³² was required to notify the home state if it had reason to consider that the company’s activities might affect its financial soundness³³³. Article 15 of the First Life Directive, as amended by the Third Life Directive, provided:

1. The financial supervision of an assurance undertaking, including that of the business it carries on either through branches or under the freedom to provide services, shall be the sole responsibility of the home Member State. If the competent authorities of the Member State of the commitment have reason to consider that the activities of an assurance undertaking might affect its financial soundness, they shall inform the competent authorities of the undertaking’s home Member State. The latter authorities shall determine whether the undertaking is complying with the prudential principles laid down in this Directive.
2. That financial supervision shall include verification, with respect to the assurance undertaking’s entire business, of its state of solvency, the establishment of technical provisions, including mathematical provisions, and of the assets covering them, in accordance with the rules laid down or practices followed in the home Member State pursuant to the provisions adopted at Community level.
3. The competent authorities of the home Member State shall require every assurance undertaking to have sound administrative and accounting procedures and adequate internal control mechanisms.

492 The Third Life Directive extensively modified the regimes under the First and Second Directives. It abolished the ‘own initiative’ provisions by introducing the concept of ‘home state’ authorisation (subject to compliance with the notification provisions). It also greatly simplified the Second Life Directive’s provisions concerning transfer of an insurance company’s portfolio of contracts to another member state.

Domestic measures to safeguard the ‘general good’

493 The Third Life Directive allowed host states to continue to implement certain of their domestic measures aimed at safeguarding the ‘general good’, specifically those prohibiting the sale of insurance contracts which conflicted with provisions of the domestic legislation protecting the general good³³⁴ and those requiring companies to comply with the requirements of domestic legislation concerning the form and content of advertising adopted in the interests of the general good³³⁵ .

Authorisation, ‘sound and prudent management’ and ‘qualifying holdings’

494 The conditions for authorisation in the First Life Directive were largely unchanged. However, there was an additional requirement for the company to be run by persons of good repute with appropriate professional qualifications or experience (which had formerly been an optional condition) and prior approval or ‘systematic notification’ of policy conditions, premium scales and technical bases for calculations, was no longer a permissible precondition of authorisation³³⁶ .

495 Authorisation was not to be issued by the home member state before it had been informed of the identities of any shareholders or members who held ‘qualifying holdings’ in an insurance company (broadly, holdings of 10% or more of the capital or voting rights or other holding providing a significant influence over the management of the business). Authorisation was to be refused if ‘taking into account the need to ensure sound and prudent management of an assurance undertaking, [the competent authorities] are not satisfied as to the qualifications of the shareholders and members’³³⁷ .

496 The home member state was to be notified of and to monitor the suitability of anyone wishing to acquire a ‘qualifying holding’ in an insurance company. The competent authorities of that state were given a maximum of three months from the date of such notification to oppose the proposal if, ‘in view of the need to ensure sound and prudent management of the assurance undertaking’, they were not satisfied as to the qualifications of the person proposing to take that holding. Other member states could require the home state totake appropriate measures where the influence exercised by those with qualifying holdings operated to the detriment of the ‘prudent and sound’ management of the company³³⁸ .

Restrictions on free disposal of assets

497 In relation to the restrictions on the free disposal of assets³³⁹, an additional circumstance was prescribed in which this might be permitted. In exceptional circumstances, if the competent authority was concerned that the financial position of an insurance undertaking would further deteriorate, such a restriction might be imposed where the solvency margin had fallen below the minimum required by article 19 of the First Life Directive (in the UK legislation, the margin of solvency under section 32 of the ICA 1982), rather than only once the solvency margin had fallen below the lower level of the ‘guarantee fund’ under article 20 of the First Life Directive (in the UK legislation, the minimum margin under section 33)³⁴⁰.

Harmonisation and protection of consumers

498 Many issues were harmonised in order to make supervision by the ‘home authority’ consistent and with the aim of providing the same level of protection for consumers in every member state. These harmonisation measures included changes to the assets which could be used to provide cover for technical provisions, a requirement of localisation of assets anywhere within the Community (rather than in particular member states) and changes to the rules on valuation of assets and determination of liabilities. Clear and accurate information had to be provided to policyholders on a range of matters specified in Annex II.

Assets to provide cover for margin of solvency – subordinated loans or ‘hybrid capital’

499 Changes were introduced to the assets which could be used to provide cover for the margin of solvency³⁴¹. In particular, the value of subordinated loan capital and cumulative preference share capital could be taken into account, but only up to 50% of the margin, with no more than 25% to consist of subordinated loans with a fixed maturity, or fixed term cumulative preference share capital and subject to a number of conditions regarding the terms of the instruments.

500 For example, under a subordinated loan agreement, the lender’s claims on the insurance company were to rank entirely after all nonsubordinated creditors and the agreement could not provide for early repayment, other than on the winding up of the insurance company.

501 The change under the Directive in relation to the use of such loans to provide cover for the margin of solvency did not result in any amendment to the legislation in the UK to permit this.

502 Instead, arrangements were put in place under which companies could apply to the Secretary of State for an order under section 68 of the ICA 1982 to permit the use of a subordinated loan to provide such cover in an individual case. These arrangements, including the intended effect of an order made under section 68 in these circumstances, were set out in a ‘Prudential Note 1994/1 – Hybrid Capital: Admissibility for Solvency’ issued by the DTI which is referred to in paragraphs 530 et seq.

Technical provisions

503 The Directive provided for some harmonisation of the way in which technical provisions³⁴² were calculated by specifying the basis of the actuarial principles to be used, whilst continuing to allow member states to determine interest rates locally (‘prudently’ and in accordance with prescribed principles). Limitations were imposed on the nature of the assets (and the extent to which investments could be made in particular types of asset) which could provide cover for the technical provisions, in order to ensure diversification and reduce risks (articles 1725). The host state was given power to require notification of the technical bases for calculating scales of premium and technical provisions in order to verify compliance with national provisions concerning actuarial principles, although not as a prior condition to the company carrying on its business³⁴³ .

504 There had been extensive negotiations between member states on harmonisation of the calculation of technical reserves³⁴⁴ based on five actuarial principles proposed by Le Groupe Consultatif des Associations d’Actuaires des Pays des Communautés Européennes. In summary these proposals were that:

1. technical provisions should be calculated on a suitable prudent basis, not on a ‘best estimate’ basis;
2. tthe calculation of reserves should take into account all the benefits guaranteed to be available under the conditions of the policy and the detailed calculation should require the technical reserves to be at least as great as any surrender value guaranteed;
3. the calculation of the technical reserves should take account of the reasonable expectations of policyholders in respect of future bonuses and terminal bonuses (although it should be clear that this did not mean that the company should be able to pay at its present scales indefinitely, but that the method of distribution of bonus would continue to take account of the ‘surplus’ or ‘profit’ on interest, mortality, expenses etc in the same sort of way as the present method, whatever that might be);
4. there should be no discrimination between domestic and nondomestic policyholders; and
5. the methods of calculating technical reserves for liabilities should be consistent with those for valuing the corresponding assets.

505 The provisions of article 18 of the Third Life Directive³⁴⁵ regarding the obligation of the home member state to require insurance companies to establish technical provisions (including mathematical provisions) based on prescribed principles were the result of still further negotiation between member states on these proposals and various compromises. No reference is made in the Directive to the term PRE³⁴⁶.

506 Put briefly, the principles for determining technical life assurance provisions set out in article 17 of the First Life Directive as replaced by article 18 of the Third Life Directive involved requirements for:

1. the technical provisions to be calculated by a sufficiently prudent prospective actuarial valuation, taking account of all future liabilities as determined by the policy conditions, including specified matters such as guaranteed benefits, allotted bonuses, options available to the policyholder and expenses; the method used to be prudent in itself, but also to have regard to the method used to value assets; technical provisions to be calculated separately for each contract (but with approximations permissible if likely to produce approximately the same result) with additional provision for general risk; mathematical provisions at least as great as any surrender value guaranteed at the time; the use of a retrospective method of valuation was permissible if it did not result in lower technical provisions than a prudent prospective method (or if a prospective method was not appropriate for the particular contract);
2. the use of a prudent rate of interest, with the maximum rate to be fixed by the home member state in accordance with specified rules;
3. the statistical elements of the valuation and allowance for expenses used to be chosen prudently, having regard to the state in which the contract had been concluded, the type of policy and the administrative costs and commissions expected to be incurred;
4. in the case of participating contracts³⁴⁷ the method of calculation for technical provisions might take into account, either implicitly or explicitly, future bonuses of all kinds in a manner consistent with other assumptions on future experience and the current method of bonus distribution;
5. allowance for future expenses permitted to be made implicitly e.g. the use of future premiums net of management charges, with a prudent estimate of future expenses; and
6. the method of calculation was not to be subject to discontinuities from year to year arising from arbitrary changes to the method or bases of calculation and was to recognise distribution of profits in an appropriate way over the duration of the contract.

507 The Third Life Directive was implemented in the UK from 1 July 1994 by:

1. the Insurance Companies (Third Insurance Directives) Regulations 1994³⁴⁸ which amended the ICA 1982;
2. the Insurance Companies Regulations 1994³⁴⁹ which replaced ICR 1981; and
3. the Insurance Companies (Accounts and Statements) (Amendment) Regulations 1994³⁵⁰ which amended the ICAS Regulations 1983.

508 The Directive was amended by Directive 95/26/EC and was repealed by Directive 2002/83/EC when the various directives on life assurance were consolidated, simplified and clarified.

Amendments to the ICA 1982 through subordinate legislation in 1991 and 1992

The Companies Act 1989 (Eligibility for Appointment as Company Auditor) (Consequential Amendments) Regulations 1991

509 In 1991, in the light of changes introduced by Part II of the Companies Act 1989 in relation to eligibility for appointment as a company auditor, a consequential amendment was made to section 21 of the ICA 1982 regarding the requirements for insurance companies to be audited in the prescribed manner by a person of the prescribed description.

510 The amendments made by the Companies Act 1989 (Eligibility for Appointment as Company Auditor) (Consequential Amendments) Regulations 1991³⁵¹ enabled regulations made under section 21 of the ICA 1982 to apply the updated provisions of Part II of the Companies Act 1989 relating to eligibility for appointment as a company auditor when specifying the requirements for the audit of accounts of insurance companies (using general Companies Acts provisions, subject to such adaptations or modifications as might appear necessary or expedient).

The Insurance Companies (Amendment) Regulations 1992

511 Amendments were made to the ICA 1982 and the FS Act 1986 in November 1992 by the Insurance Companies (Amendment) Regulations 1992³⁵² to implement various EEC Directives, primarily in relation to nonlife business.

512 The amendments made to the ICA 1982 of more general application were those to section 5 (applications for authorisation) and section 61 (approval of proposed controllers) to enable the Secretary of State to act in certain ways in order to implement a direction of the Council or Commission of the European Communities and a new section 63A, which required any controller of an insurance company which had its head office in the UK to notify the Secretary of State if he or she increased their shareholding so as to become the parent undertaking of the company.

Guidance for Appointed Actuaries – 1992 revisions to GN1 and GN8, guidance from GAD (‘Dear Appointed Actuary’ letters) on resilience testing and survey on ‘asset shares’ and the assessment of terminal bonus

513 Revised versions of GN1 and GN8 were issued during 1992 following a review of the guidance by a working party of the F&IA. The amendments were described as being largely of a ‘tidyingup nature’ as a precursor to the proposed introduction of practising certificates for appointed actuaries in 1992³⁵³, but the revisions made to GN1 in 1992 go beyond that and seem to have been intended to extend the responsibilities of the appointed actuary (or at least to articulate them in greater detail). In addition, the number of references made in the guidance to PRE was increased significantly³⁵⁴ .

GN1

514 Additions and amendments to version 3.0 of GN1 (1 July 1992) included:

1. an introductory comment requiring the appointed actuary to ensure, so far as it was within his or her authority, that the long term business of the company was operated on sound financial lines and with regard to its policyholders’ reasonable expectations (paragraph 1.1). (It was suggested in the second F&IA working party report on PRE³⁵⁵ that this requirement in the guidance signalled a material change in the emphasis placed on PRE);
2. an expansion of the guidance which had appeared in earlier versions of GN1 on the potential for conflict between the appointed actuary’s responsibilities to the company and to the DTI and the actuary’s duty to advise the company of matters which created a material risk that the long term fund might be insufficient to cover the liabilities, or that the company might fail to meet its obligations under the ICA 1982 in relation to its long term business; and in the event that the company persisted in that course of action, or failed to remedy the position or report it to the DTI, the actuary was under a duty to advise the DTI, having so informed the company (paragraph 3.2);
3. the appointed actuary was required to advise the company of ‘his interpretation of its policyholders’ reasonable expectations’. In the event that a significant change was likely to take place, the actuary was required to take all reasonable steps to ensure that the company appreciated the implications for the reasonable expectations of its policyholders; the appointed actuary was also required to take all reasonable steps to ensure that the company’s incoming policyholders should not be misled in their expectations (paragraph 3.3);
4. the former obligation of the appointed actuary to ensure that he or she was ‘at all times’ satisfied as to the sufficiency of the long term fund (and not simply at the time of the statutory investigation) was bolstered with a further obligation: to be satisfied at all times that the company would be able to satisfy ‘any obligation to which it is subject by virtue of the [ICA 1982]’ (paragraph 4.1);
5. the guidance on factors likely to affect the financial position of the company was expanded; the appointed actuary was required to have regard to all aspects likely to affect the company’s financial position including the possible effect of contingent liabilities should they crystallise; items were added to the list of factors considered to be of particular importance to the appointed actuary’s assessment of the financial position of the company, including options contained in contracts in force or being sold (paragraph 4.2);
6. the need to provide for the solvency margin was added to the factors to be considered in relation to the setting of appropriate premium rates for new business (paragraph 5.4);
7. in relation to actuarial investigations, paragraph 6.3 stated that ‘when assessing the liabilities of the longterm business of the company he must also have regard to policyholders’ reasonable expectations’³⁵⁶; the actuary was required to satisfy him or herself as regards the resilience of the financial position of the company in all reasonably foreseeable circumstances which might affect that position; the actuary was also required to ensure that appropriate valuation procedures had been correctly carried out and adequately documented (paragraphs 6.1 and 6.2); and
8. references to the need for the actuary to have regard to the current and likely future taxation position of the company were inserted (paragraphs 4.2(i) and 6.6).

GN8

515 The version of GN8 issued in 1992 (version 3.0) contained few revisions, but included slightly more detailed guidance on Regulations 55 (nature and term of the assets representing the long term fund) and 59 (rates of interest used in valuations) of ICR 1981, although still in general terms. For example, paragraph 3.2.3 stated that the company’s reserves, including any resilience reserves, ‘should be sufficient to absorb the effect of immediate changes in interest rates and asset values, on a suitably prudent basis …’, but did not specify any particular hypothetical changes which should be considered.

Guidance from GAD on resilience testing (DAA letters)

516 Following the issue of revised versions of GN1 and GN8 on 1 July 1992, a further DAA letter was sent by the Government Actuary to appointed actuaries of insurance companies (dated 31 July 1992, DAA4) on the topic of resilience testing.

517 The letter stated that GN8 incorporated ‘the main content’ of Temporary Practice Note No. 2 (TPN2)³⁵⁷ which, in turn, was said to endorse effectively the specific parameters for resilience testing which had been propounded by the Government Actuary in his letter to actuaries dated 13 November 1985 (DAA1, see paragraph 397).

518 DAA4 described the earlier recommendations as being, in normal economic circumstances, to test the resilience of the valuation basis against an immediate fall of 25% in the value of equities and properties and an immediate rise or fall in the yield on fixed interest securities of 3%. It was noted that GN8 did not specifically refer to these parameters, but instead required the appointed actuary to use professional judgment to determine an appropriate range of changes in the financial conditions over which to test the resilience of the valuation basis.

519 It was stated that great care had been taken in the wording of GN8, since the actuary was then soon to be required to certify compliance with that guidance in the statutory returns³⁵⁸ and it was considered inappropriate to include a fixed set of parameters to cover all possible financial conditions.

520 The DAA4 letter stated that it remained the view of the DTI and GAD that, in most financial conditions, the parameters in TPN2 should continue to be the benchmark against which the actuary’s valuation basis would be tested, although higher parameters might be appropriate in certain financial conditions.

521 DAA4 went on to express the view that in ‘more extreme circumstances’ the parameters outlined in TPN2 might be ‘unreasonably strong for offices to have to maintain’, given the reserving standards built into the determination of liabilities regulations.

522 It was said that it would be reasonable for companies whose equity portfolios broadly corresponded to the Financial Times AllShare Index to review the resilience test when the dividend yield on that index exceeded 5.25% and a gradual tapering of the 25% parameter ‘would be envisaged’. Actuaries who were considering introducing such a taper of the 25% parameter or any weakening of the other parameters were advised that they should contact GAD straight away to discuss their proposed basis.

523 Actuaries were also advised that they should consider the possibility of more extreme financial conditions in the future and the extent to which the technical reserves, together with the margin of solvency, would be sufficient to satisfy liabilities in such circumstances. Full details of the assumptions which had been used were to be provided in Schedule 4 to the statutory returns³⁵⁹. Companies and appointed actuaries were invited to discuss and to clarify the contents of DAA4 with officials at the DTI and GAD.

524 On 30 September 1993 a further DAA letter (DAA6) was sent by the Government Actuary to appointed actuaries on the topic of resilience testing, stating that the investment outlook had changed considerably since DAA4 was written and notifying actuaries of new benchmarks which were considered to be appropriate by the DTI and GAD. For withprofit offices it was advised that three different scenarios for resilience testing should be applied:

1. a reduction in fixedinterest yields by 20% combined with a fall in the value of equities of 10%;
2. a reduction in fixedinterest yields by 10% combined with a fall in the value of equities of 25%; and
3. a rise in fixedinterest yields of 3 percentage points combined with a fall in equity values of 25%.

525 In relation to interest rates, reference was made to the requirements of Regulation 59(6)(b) of ICR 1981 and it was said that the overriding limitation in that provision, that the yield assumed should not exceed the yield on British Government 2½ per cent Consolidated Stock on the valuation date (known as the ‘Consols test’), did not apply to the hypothetical yields which arose on the resilience test. However, actuaries were to bear in mind the possible need to fund future reserve strengthening to enable the Consols test to be satisfied at the next valuation if the scenarios were to emerge in practice.

526 The earlier advice was repeated, requiring appointed actuaries to consider the possibility of more extreme financial conditions and the extent to which the solvency margin would be sufficient to meet liabilities in such circumstances and to specify the assumptions used as part of the statutory returns. It was indicated that in the longer term, it was being considered whether further refinement of resilience testing should be applied along the lines adopted in other countries.

527 DAA7 dated 31 March 1994 drew attention to the requirements of paragraph 3.2.3 of GN8 (version 3.0, July 1992) regarding the requirement for the company’s reserves to be sufficient to absorb the effect of immediate changes in interest rates and asset values on a suitably prudent basis without prejudicing the company’s ability to hold reserveswhich satisfied the regulations for valuing liabilities (other than Regulation 55). The requirements of Regulation 59(6)(b) regarding the overriding limitation in the Consols test were set out.

528 DAA7 referred back to the advice in DAA6 to disregard the Consols test when applying the three scenarios (explaining that the Consols test had been devised before the concept of resilience testing was established in 1985). DAA7 noted that the effect of not applying the limitation in the Consols test in the resilience scenarios was that the actuary would need to state that this had been done in the certificate of compliance³⁶⁰ in respect of GN8, because that guidance required the Consols test to be applied. DAA7 proposed a form for the certificate which could be given by actuaries in relation to compliance with GN8 in these circumstances which would be acceptable to the DTI.

GAD survey on the use of ‘asset shares’ and the assessment of terminal bonus

529 Reference had been made to the use by life insurance companies of ‘asset shares’ as a means of assessing bonuses by the 1990s³⁶¹ and the suggested use of asset shares as a means of providing equity for policyholders and meeting PRE. However, it is apparent that ‘asset share’ had no precise meaning and there were no standard means by which assets shares were to be calculated.

530 On 9 July 1993 a letter was sent by a Directing Actuary at GAD to appointed actuaries of companies transacting withprofit business, enclosing a survey requesting information about:

1. the contents of current literature on the allocation of surpluses to policyholders and the information on the principles for distribution of surpluses in the company’s constitution; and
2. the company’s actual methodology in respect of the determination of appropriate levels of final or terminal bonus on withprofit policies.

531 The letter records a growing debate in the life insurance industry over the appropriate method for determining distribution of surpluses in long term funds and GAD’s view that there was no clearly accepted definition of the technique known as ‘asset shares’; that the ‘art or science of asset shares is still not fully developed in actuarial literature’.

532 In relation to item (b) above, the survey raised a number of questions about the actual practices of life companies with withprofit contracts in relation to the calculation of terminal bonuses and the actuarial techniques which were being used. For example, a brief explanation was requested of how appropriate scales of final or terminal bonus were assessed in various circumstances and whether bonus reserve valuations or other methods were used, how frequently scales of final or terminal bonus were reviewed, how asset shares were determined in relation to various specified factors, how expenses were attributed, what allowances were made in the assessment of final or terminal bonus scales for various specified factors such as any charges made for guarantees in respect of benefits payable on maturity and the material considerations which affected the ‘smoothing policy’ applied to final or terminal bonus.

Second and third F&IA joint working party reports on PRE

Second report – 26 October 1992

533 The second F&IA joint working party report on PRE was dated 26 October 1992, a few months after a revised version of GN1 had been issued in which a considerably greater number of references to ‘policyholders’ reasonable expectations’ had been included (version 3.0 of GN1 dated 1 July 1992, referred to in paragraph 514 above).

534 The second report acknowledged the potential difficulties this could cause for the profession in view of the vagueness of the term, but on balance favoured the strengthening of the guidance in this respect. In order to assist appointed actuaries, the report made a number of recommendations on how they should meet their obligations in relation to PRE.

535 It was suggested that uncertainty over the interpretation of PRE could be reduced by greater disclosure to current and future policyholders and their advisers regarding the company’s bonus philosophy and approach to determining discretionary benefits and charges. The recommendations made in the second report included:

1. reporting to the board: all appointed actuaries should report annually to the board of their company regarding their interpretation of PRE and the way this interpretation was being implemented and communicated by the company³⁶²;
2. bonus levels: all appointed actuaries should make available at least internally to the company an analysis of current levels of payouts under withprofits policies, analysed by the source of the profit and stating whether, in his or her opinion, that level would continue³⁶³;
3. company literature: the statements made in the company’s withprofits guide should be submitted to the board for formal approval and the appointed actuary should endeavour to ensure that suitably abbreviated summaries were included in all literature for contracts offering withprofits options;
4. staff training: the appointed actuary should provide input to the training given to the company’s sales staff to ensure that they accurately represented the company’s views on PRE³⁶⁴;
5. discretionary charges and benefits: appointed actuaries should use their best endeavours to ensure that companies adopted a clear and consistent approach towards discretionary charges and benefits and this should be described in plain English for policyholders;
6. assessment of liabilities with regard to PRE: in reporting the results of the valuation³⁶⁵ the appointed actuary should include statements on the extent to which the method used took account of PRE, with particular reference to discontinuance and expense assumptions, the relationship between reserves and asset shares and the maintainability of current reversionary bonus rates; and
7. written reports to the company board on PRE: it was suggested that reporting might be undertaken in two stages: first, a document setting out the company’s agreed approach to PRE and second, inclusion of appropriate references to PRE in the appointed actuary’s report to the board regarding the allocation of profit or surplus. A recommended form for the first of these reports was provided and an outline of the information on PRE to be included in a report to the board on an allocation of surplus was set out in a separate recommendation³⁶⁶.

Third report – June 1993

536 The third F&IA joint working party report, dated June 1993, provided feedback on the results of a questionnaire which had been sent to the appointed actuaries of the largest 25 withprofit companies, following the completion of a questionnaire at a ‘facetoface’ interview with the appointed actuary concerned. The report was the result of a comparison of the responses provided.

537 General points made in the ‘feedback exercise’ included:

1. the recommendations in the second report had been too prescriptive, that actuaries were better left to judge the situation in the particular circumstances of their own company;
2. the structure and modus operandi of individual companies varied such that reliance on the existence of a ‘board’ (e.g. as the recipient of the appointed actuary’s advice) was unsatisfactory, although this seemed to work reasonably well for most mutuals. It was suggested that it would be more helpful to define the ‘seat of power’;
3. there was a fairly widespread (but not universal) view expressed by the actuaries interviewed that their company did not have any problem with PRE which, at the extreme, bordered on complacency. Notwithstanding the dominance given to asset shares in the context of PRE some companies did not calculate them in a very rigorous way and were reluctant to reveal them within the company, other than in general terms (see further footnote 298); and
4. with reducing bonuses, PRE was becoming much more of an issue³⁶⁷ .

538 Responses to the Working Party’s questions relating to the recommendations made in the second report and general followup questions revealed that:

1. most companies were doing something about the recommendation that an annual report should be made to the board on the interpretation of PRE, the most common way being to include a section in the annual actuarial report;
2. by no means did all companies follow the recommendation that the actuary should provide, at least internally, an analysis of current levels of payouts for withprofit policies and the source of profit. Many actuaries did not disclose asset shares and there was seldom a reconciliation between asset shares and payouts; there was considerable variation in the detail in which asset shares were calculated and it was said to be difficult to explain asset shares to the company’s board;
3. very few companies sought formal approval of the board to the withprofits guide and there was a ‘notable absence’ of formal processes for ensuring that an appropriate summary of the guide was included in company literature;
4. the proposal that actuaries should be involved in staff training on PRE was considered to go too far³⁶⁸, taking the appointed actuary into areas outside his or her responsibilities, although many actuaries did explain PRE ‘in general terms’ to their sales and marketing staff;
5. all actuaries agreed with the principle that they should use their best endeavours to ensure that the company adopted a clear and consistent approach towards discretionary charges and benefits (although opinions had differed about the extent to which discretionary charges could be increased). There were also differing opinions as to whether a plain English explanation for policyholders was possible;
6. nearly all appointed actuaries were of the view that no explicit reference to PRE should be made in the statutory valuation report³⁶⁹; however, most actuaries reported internally along the lines of the Working Party’s recommendation in this regard;
7. the general view of actuaries was to oppose reporting to the board on the company’s attitude to PRE in such detail as that suggested in the outline report provided, but nobody had seriously disagreed with the philosophy underlying the recommendation and various simpler approaches had been suggested;
8. in relation to the proposed report to the board by the actuary on the allocation of surplus, all the respondents provided some of the information recommended by the Working Party; projected asset shares over a fiveyear period were rarely given in the annual actuarial report (but might be covered in connection with business plans); many actuaries considered that the implications of such a report for the information to be given to existing and prospective policyholders fell outside the terms of reference of an appointed actuary;
9. fears about guarantees and ‘quasi guarantees’ caused by old policy literature, for example about withprofit bonds, were raised in response to a question regarding special features of significance; concerns were also expressed about cases where current premium rates were known to be inadequate, where an assumed rate of growth until maturity now appeared excessive or was reliant on bonus rates which were unlikely to be paid;
10. adequate communication with policyholders was seen as the main way to deal with PRE. Expectations had been given at the point of sale and subsequent bonus announcements and advertisements extolled the bonus performance. When bonus rates were falling it was desirable that the actuary ensured that the company took the necessary action to circulate details of reduced rates to policyholders and, if appropriate, set out the need for further reductions. In this way, expectations could be modified by current conditions and remain realistic. The frequency of review of terminal bonus rates and market value adjustments affected PRE and the company practice in these areas should be clearly defined; and
11. among the responses to a question concerning ‘other comments’ the point was made that the appointed actuary’s role was advisory rather than executive but that he or she would be concerned to see an adequate system of actuarial protocols in place which would run through the company ‘independent of line management’. Professional guidance on PRE was not seen as desirable.

539 The third joint working party report recommended that no formal professional guidance be given on PRE at that time. However, appointed actuaries should test their own practice against the recommendations made in the second report and the general reactions to those recommendations summarised in the third report.

The Companies Act 1985 (Insurance Companies Accounts) Regulations 1993

540 The Companies Act 1985 (Insurance Companies Accounts) Regulations 1993³⁷⁰ (the CAICA Regulations 1993) were made to amend sections 255 and 255A of the Companies Act 1985 and to substitute a new Schedule 9A to that Act in order to implement a European Directive on the annual accounts and consolidated accounts of insurance companies³⁷¹, in so far as that Directive applied to bodies corporate subject to Part VII of the Companies Act 1985³⁷² .

541 The Directive had been made to coordinate the requirements for the annual accounts of insurance undertakings across member states in order to increase comparability and transparency for creditors, debtors, members, policyholders and their advisers.

542 The Directive stated that it was ‘urgently required’. It recorded the major differences between the practices of various member states regarding the form and contents of insurance undertakings’ accounts and the disclosures made. It also acknowledged the fundamental importance of the values at which assets and liabilities were shown in the balance sheet and of the disclosures made in the accounts in obtaining a proper understanding of the financial situation of the undertaking and to enable comparability of figures³⁷³ .

543 The Directive prescribed a precise layout for the balance sheet and profit and loss account, the items to be included in each and made requirements for the contents of certain notes to the accounts (for example, in relation to the valuation methods which had been used).

544 Under the Directive, member states were permitted either to impose valuation rules or to leave it to the company to choose between alternative rules set out in the Directive. In calculating provisions for life assurance, use was to be made of actuarial methods ‘customarily applied on the market or accepted by the insurancemonitoring authorities’, implemented by any actuary or expert in accordance with conditions laid down by national law ‘and with due regard for the actuarial principles recognised in the framework of present and future coordination of the fundamental rules for the prudential and financial monitoring of direct life assurance business’.

545 To meet the requirements of the Directive, the CAICA Regulations 1993 substituted a new Schedule 9A to the Companies Act 1985 which made new provision for the form and content of the accounts of insurance companies and groups of companies.

546 Part I of the Schedule set out the prescribed formats, the valuation rules to be applied, the rules for determining provisions and the disclosures to be made in the notes to the accounts. Part II of the Schedule adapted the rules in Part VII of the Companies Act 1985 in relation to consolidation of accounts to make them applicable to the special circumstances of insurance groups.

547 The accounts prepared for the purpose of Schedule 9A of the Companies Act 1985 were (and are) required to provide a ‘true and fair’ view of the company’s affairs, in contrast to the annual returns which were prepared for the purposes of the ICA 1982, which were required to be prepared in accordance with the regulations made under that Act, in particular in relation to the valuation of assets and determination of the amount of the liabilities³⁷⁴ .

548 Schedule 9A requires that the company’s balance sheet include in the technical provisions a ‘long term business provision’. The notes³⁷⁵ to that balance sheet item require that the item:

… shall comprise the actuarially estimated value of the company’s liabilities (excluding technical provisions included in Liabilities in item D³⁷⁶), including bonuses already declared and after deducting the actuarial value of future premiums.

The item was also to include unreported claims which had been incurred.

549 The rules for determining provisions specified³⁷⁷ that:

1. The long term business provision shall in principle be computed separately for each long term contract, save that statistical or mathematical methods may be used where they may be expected to give approximately the same results as individual calculations.
2. A summary of the principal assumptions in making the provision under sub-paragraph (1) shall be given in the notes to the accounts.
3. The computation shall be made annually by a Fellow of the Institute or Faculty of Actuaries on the basis of recognised actuarial methods, with due regard to the principles laid down in Council Directive 92/96/EEC³⁷⁸.

550 The guidance issued by the F&IA to the actuary undertaking the required calculations (described in that guidance as the ‘reporting actuary’) and on the wider implications of Schedule 9A is referred to below. It was permissible for the reporting actuary to be the same person as the appointed actuary, but there was no requirement to this effect³⁷⁹.

551 The requirements of the CAICA Regulations 1993 applied to insurance companies’ accounts for financial years commencing on or after 23 December 1994.

552 The Directive (91/674/EEC) remains in force, subject to amendments made by a further Directive in June 2003³⁸⁰. The CAICA Regulations 1993 also continue in force, subject to minor amendments made with effect from January 2005³⁸¹ consequent on the consolidation and repeal of the Life Directives³⁸².

553 In recent years, one of the aims of the FSA has been to try to align the approach in the regulatory returns with the approach in the Companies Act accounts so as to enable reconciliation between the two, thereby increasing the transparency of the figures presented³⁸³.

Footnotes

302 By an official of Branch 1 of the Insurance Division of the DTI, which was responsible for such matters as authorisation.

303 A handwritten note indicated that this comment related to limiting transactions with connected persons.

304 A supplementary memorandum produced by the Treasury several years later, in 1998, to respond to questions from a House of Commons Treasury Select Committee on Pension Misselling, gave further examples of the use of the power as being to prevent a company from paying a dividend and the control of disbursement of assets released from custody. The supplementary memorandum includes the observation that the effect of section 45 was far greater than the formal exercise of the power suggested in that, in practice, companies discussed with the DTI proposed significant changes which might affect policyholders with the result that potentially unacceptable proposals were abandoned or modified, making the actual exercise of the power unnecessary.

305 The involvement of an unfit person in an insurance company as a director, controller, manager or main agent constituted a ground for refusal of authorisation under section 7(3) of the ICA 1982 and for the exercise of certain of the Secretary of State’s powers of intervention under section 37(2)(e) of the ICA 1982 (see paragraphs 313 et seq regarding section 37 of the ICA 1982 and paragraph 76(e) regarding the predecessor provisions of section 12(1)(e) of the ICAA 1973).

306 These replaced an earlier series of Policy Guidance Notes for staff, dating back at least to the time of the ICAA 1973 and were a separate series of documents to the Prudential Guidance Notes issued by the DTI to insurance companies (of which those issued from 1994 onwards are mentioned in paragraphs 715 et seq.). Both the internal and external series of notes were, on occasion, referred to in documents as ‘PGNs’ but in this Part of my report this acronym is used to refer to the Prudential Guidance Notes issued by the DTI externally, to insurance companies.

307 Guidelines 1.1 to 1.6.

308 Guideline 15.1.

309 It appears that an intended Guideline 8.9 on residual intervention powers under section 45 of the ICA 1982 was not issued.

310 Which provided for cooperation in the supervision of financial conglomerates which were subject to regulation by more than one of the members of the College and nominated a ‘lead regulator’ (based on the dominant activity of the group concerned) who would call meetings of other members concerned with that group if the need arose.

311 Particularly in relation to confidentiality.

312 See for example paragraph 605 and the footnote thereto regarding section 47A of the ICA 1982. A less extensive restriction on disclosure of information obtained by the relevant government department in relation to insurance companies had formerly been included in section 111 of the Companies Act 1967.

313 Which included Equitable.

314 With a memorandum from an official of I4 Branch of the DTI’s Insurance Division dated 16 December 1991.

315 Referred to in paragraphs 315 et seq. 316 Section 45 was included in the first category of powers, although the section itself contained limitations on its use in such a way as to impose a restriction on the free disposal of assets.

317 Referred to in paragraph 314.

318 That the exercise of the power was desirable for protecting policyholders or potential policyholders against the risk that the company might be unable to meet its liabilities.

319 That the exercise of the power was desirable, in the case of long term business, to fulfil the reasonable expectations of policyholders or potential policyholders.

320 Relating to the failure of a company to satisfy an obligation to which it was subject by virtue of the ICA 1982 or the former legislation.

321 The ground concerning instances where it appeared to the Secretary of State that the company had furnished him with misleading or inaccurate information under or for the purposes of the ICA 1982 or the former legislation.

322 That the Secretary of State was not satisfied that adequate reinsurance arrangements were in force or would be made.

323 Described as being the ‘most likely’ reason for relying on section 37(2)(e), which was based on a number of specified grounds on which authorisation of a company might be refused if applied for.

324 These proposals had been included in a memorandum from the then Head of the DTI’s Insurance Division to the Minister dated 10 October 1990.

325 Recorded in a memorandum from Principal Private Secretary to the Minister dated 2 August 1991.

326 An issue which GAD was seeking to address through its rolling programme of visits to appointed actuaries (see paragraphs 404 and 405). GAD also stressed the importance of considering the financial position of a company ‘dynamically’ to identify potential future problems (see, for example, paragraph 366). A paper given by a GAD actuary at a meeting in Brussels on 23 April 1993 described the UK supervisors’ role in examining returns to check for compliance with the legislation, the existence of adequate technical provisions and the required margin of solvency at the year end as being only ‘part of the story’. He said that although the supervisors in the UK were not directly concerned with premium rates, they worked with appointed actuaries to examine the impact of factors such as future expenses and assumed levels of sales on the ongoing financial viability of an insurer. Further, the encouragement to companies to use dynamic solvency techniques (paragraphs 825 et seq) was intended to ensure that insurers were themselves looking forward to risks which might emerge in the future and planning how they might react to them.

327 Of 5 November 2002.

328 Article 4, amending Article 7 of the First Life Directive.

329 Article 32, amending article 10 of the First Life Directive.

330 Article 8, amending article 15 of the First Life Directive, which stated that such supervision was to be the ‘sole responsibility’ of the home member state.

331 Preamble, paragraph 7.

332 This expression is not used in the Directive.

333 Article 8, amending article 15 of the First Life Directive.

334 Article 28.

335 Article 41.

336 Article 8.3 of the First Life Directive as replaced by article 5 of the Third Life Directive.

337 Article 7 of the Third Life Directive; the implications of this requirement for the UK legislation are set out below.

338 Article 14.4 of the Third Life Directive. 339 See paragraph 230 in relation to the First Life Directive. 340 Articles 12 and 27 of the Third Life Directive amending articles 24 and 21 of the First Life Directive. 341 Article 25, amending article 18 of the First Life Directive.

342 Article 17 of the First Life Directive as substituted by article 18 of the Third Life Directive referred to obligations of insurance companies to establish sufficient ‘technical provisions’ including ‘mathematical provisions’, rather than ‘technical reserves’ and ‘mathematical reserves’ as in the original drafting of the First Life Directive.

343 Article 29 of the Third Life Directive.

344 As noted in the Penrose Report, Chapter 10, paragraphs 21 et seq.

345 Replacing article 17 of the First Life Directive.

346 Although it was later embodied in Regulation 64 of ICR 1994 on the determination of the amount of the long term liabilities, in relation to the actuarial principles to be used.

347 This term is not defined in the Directive, but appears to be used in the sense of ‘withprofits’ contracts. 348 SI 1994 No. 1696. 349 SI 1994 No. 1516. 350 SI 1994 No. 1515 (subsequently revoked by the Insurance (Accounts and Statements) Regulations 1996 SI No. 943).

351 SI 1991 No. 1997.

352 SI 1992 No. 2890.

353 Notes of the Current Issues in Life Assurance seminar on 6 June 1991: JIA 118, III, 517521 at page 519. It is understood that the practising certificate system was implemented by the F&IA at the end of 1992 and the requirement for appointed actuaries to possess such a certificate was first referred to in the version of GN1 issued in 1994 (v.4.0). The notes of the 1991 Seminar outline the general criteria proposed for practising certificates (see paragraph 704) and indicate that the timetable for their introduction had originally been January 1993, but it was planned to make this a year earlier, with the Continuing Professional Education requirements being added at a later date.

354 The second joint working party report on PRE of 26 October 1992 referred to below, indicates that the revisions to GN1 in respect of PRE were intended to increase the attention to be given to those expectations; however, it was noted that this created a potential problem for the profession ‘in view of the vagueness of the definition of PRE and the limited debate within the profession as to the practical interpretation of PRE’.

355 See paragraphs 533 et seq.

356 The second F&IA joint working party paper noted that this revised wording required the appointed actuary to take PRE into account in valuing long term business liabilities and made recommendations on how this should be dealt with in the actuary’s report.

357 Which had been issued by the F&IA to actuaries in May 1986.

358 From 1 January 1994, by virtue of SI 1993 No. 946 (see paragraph 685).

359 The abstract of the appointed actuary’s valuation report.

360 As required from 1 January 1994, see paragraph 685.

361 In a paper presented in 1989, the appointed actuary of Equitable referred to the use of asset shares in the calculation of final or terminal bonus, referring to the rates needed to lift the guaranteed benefits and declared bonuses to the appropriate asset share as the starting point for the calculation of such bonus rates: ‘WithProfits without Mystery’, R.H. Ranson and C.P. Headdon, JIA 116 (1989) 301345 at paragraph 3.2.15.

362 The Working Party had found that very few appointed actuaries reported formally to their boards on PRE.

363 The Working Party had noted that there were some wellknown examples of withprofit policies for which payouts were very high in comparison to accumulated premiums at the typical rates of return it had been possible to achieve historically, and that confusion could be caused if the reasons for the high payouts and the likelihood that they would not be sustained indefinitely were not explained.

364 It was suggested that the influence of sales staff was likely to be greater than the company’s literature in relation to PRE.

365 It was noted that special factors to be considered in determining the amount of long term liabilities included PRE of discretionary charges and benefits, PRE of terminal bonus and PRE of reversionary bonus rates (and if there was a risk that current bonus levels could not be maintained this should be communicated to policyholders so that their expectations would be modified).

366 Suggesting that the report should cover such matters as the company’s ‘smoothing policy’, target ratio of asset shares to guaranteed benefits, the extent to which a proposed declaration departed from the general principles for distribution of surpluses, an analysis of proposed payouts on maturing policies and future trends in profits and smoothing adjustments, rates of investment return required to support current reversionary bonus rates, projected asset shares over a fiveyear period at alternative levels of future investment return and the implications of these matters for information to be provided to existing and prospective policyholders.

367 One respondent put it that whilst bonus rates were going up the marketing department was pleased to take the lead, but once they were declining it seemed that the actuaries were left to deal with the issue.

368 One actuary suggested that it would be pointless to explain PRE to the salesforce as some would not understand the issues and might misrepresent them to policyholders.

369 It was to become a statutory requirement, not only that due regard should be had to PRE in the determination of liabilities (under regulation 64 of ICR 1994, see paragraph 613) but eventually, that specific reference should be made to the method by which due regard had been given to PRE in the abstract of the actuary’s report (under regulation 25 and paragraph 6(1)(b) of Schedule 4 to the Insurance Companies (Accounts and Statements) Regulations 1996 SI No. 943 (paragraph 788(b)).

370 SI 1993 No. 3246.

371 Council Directive 91/674/EEC of 31 December 1991 (which applied to all insurance companies other than small mutual associations with an annual contribution income of no more than 500,000 ECU for three consecutive years).

372 Separate provision was made for insurance companies which were not subject to those provisions of the Companies Act 1985 in the Insurance Accounts Directive (Miscellaneous Insurance Undertakings) Regulations 1993 SI No. 3245.

373 Preamble to the Directive.

374 See Regulation 4 of the ICAS Regulations 1983 and Regulation 4 of the ICAS Regulations 1996. In relation to the general question of accounting standards for insurance companies, and how provisions should be calculated in order to present a ‘true and fair view’, the Penrose Report and other sources suggest that this was the subject of considerable debate within the actuarial and accounting professions. Chapter 10 of the Penrose Report (paragraph 37 et seq) describes the application of general company accounting requirements to insurance companies and the implications of the requirement that financial statements should present a ‘true and fair view’. The Report notes that insurance companies had largely escaped accounting regulation and that no specific accounting standards had been devised for insurance companies in the United Kingdom (Chapter 10, paragraph 55). In response to the Penrose Report, the Accounting Standards Board issued a new financial reporting standard and the Treasury produced a report in June 2005 on financial reporting for life assurance, which identified the need for further work to be undertaken on various aspects of accounting requirements for life assurance.

375 Note (21) to Section B of Schedule 9A.

376 Technical provisions for linked liabilities, which were provided for separately in note (26).

377 Paragraph 46 of Schedule 9A.

378 i.e. the Third Life Directive (a reference to Directive 2002/83/EC was substituted by the Life Assurance Consolidation Directive (Consequential Amendments) Regulations 2004 SI No. 3379).

379 In the case of Equitable, the roles of chief executive and appointed actuary were combined for the period 19911997 (see footnote 94).

380 Council Directive 2003/51/EC.

381 By virtue of SI 2004 No. 3379, see footnote 378.

382 By Council Directive 2002/83/EC.

383 See the FSA Consultation Paper 202, September 2003, paragraph 4.11.