Findings of fact

5.1 In Chapters 6, 7 and 8 of Part 1 of my report, supported by the relevant detail in Parts 3 and 4, I set out how the prudential regulation of the Society was undertaken during the period from when the Society’s returns for 1990 were submitted to the prudential regulators until the end of my jurisdiction on 1 December 2001 – with the coming into force of the current regulatory regime.

5.2 As I explained in Section 4, my approach to determining complaints of maladministration leading to injustice is to assess the facts against the overall standard that I have established is relevant to the investigation.

5.3 First, I assess whether an act or omission by the body complained about constitutes a departure from the applicable standard. These are my findings of fact.

5.4 My review of all the evidence, submissions and other material and my application of the overall standard to that evidence have led me to make ten principal findings of fact.

My first finding of fact

5.5 The role of the Appointed Actuary was, at the time relevant to this report, a central component of the system of prudential regulation of insurance companies.

5.6 Given this regulatory role, which was one cornerstone of the system of prudential regulation in the United Kingdom, an Appointed Actuary needed to ensure that he or she had sufficient independence from the executive management of a life insurance company to enable him or her to undertake effectively the responsibilities (to the company, to its policyholders, and to the prudential regulators and GAD) that were conferred on the Appointed Actuary and to enable him or her to do so in line with the intention of Parliament when it had created the role in 1973.

5.7 If an Appointed Actuary was unable to secure or retain the necessary degree of operational independence, this would raise serious questions about the ability of the Appointed Actuary in those circumstances to perform the regulatory functions conferred on him or her.

5.8 My first finding of fact is that, in June 1991, the prudential regulators approved, when they should not have done, the appointment of a new Chief Executive without insisting that he should demit office as the Society’s Appointed Actuary and without applying subsequently a closer degree of scrutiny of the Society’s affairs.

5.9 Furthermore, for the next six years, those regulators failed to consider the use of their powers to seek the removal of that person from his ‘dual role’, despite the assurance that had been given at the time of his appointment that he would hold such a dual role for 18 months only. Yet the dual role existed from 1 July 1991 to 31 July 1997.

5.10 After having considered the representations I had received, I concluded that the way in which the DTI, as prudential regulators, handled the creation and continued existence of the ‘dual role’ fell short of the standard that could reasonably be expected of such regulators.

My second finding of fact

5.11 Each year, the Society, like every other insurance company, was required to submit annual returns to the prudential regulators. Those returns set out a considerable amount of detail about the business of the Society, about its liabilities, about the assets covering those liabilities, and about the solvency position of the Society.

5.12 As I have noted, the submission and scrutiny of those returns were the two prime mechanisms of prudential regulation during the period covered by this report.

5.13 The Society’s returns for the years 1990 to 1993 raised certain issues about the approach that the Society was adopting to its business, which the scrutiny process was designed to highlight in order to enable the prudential regulators, acting with advice and assistance from GAD, to ascertain whether there was any need to raise and pursue those issues.

5.14 My second finding of fact is that, with regard to the scrutiny of the Society’s annual regulatory returns for the year ends for 1990 to 1993, GAD, in providing advice to the prudential regulators, failed to satisfy themselves that the way in which the Society had determined its liabilities and had sought to demonstrate that it had sufficient assets to cover those liabilities accorded with the requirements of the applicable Regulations.

5.15 Accordingly, those regulators were unable to verify the solvency position of the Society as they were under a duty to do. The aspects in respect of which the Society’s returns for these years raised questions which should have been identified, pursued and resolved were:

• the valuation rate of interest used to discount the liabilities, which appeared to be imprudent and/or impermissible (discounting liabilities well below the guaranteed face value of policies); and
• the affordability and sustainability of the bonuses previously declared by the Society, which appeared to raise the expectations of the Society’s policyholders which might not be met.

5.16 On the information before GAD, the Society’s approach to discounting meant that a significant amount of any future surplus would be required simply to fund current guaranteed benefits.

5.17 This occurred in a situation in which GAD knew that the Society had informed its policyholders that, subject to smoothing, the additional returns they would receive by way of future bonus declarations would reflect the future investment performance of the with-profits fund.

5.18 In addition, serious questions arose from the information within the returns about whether the Society could afford the level of bonus it was paying and whether it could continue to pay out at that level. This occurred in a situation in which, as GAD knew, the Society was unique in illustrating to its policyholders the full policy fund value, including terminal bonus.

5.19 From the information before GAD, it was not clear how the Society could fund guaranteed future bonuses (applying the guaranteed investment return) or manage to pay future discretionary bonuses, in line with the reasonable expectations of the Society’s policyholders that such bonuses would continue to be paid.

5.20 Despite those questions, raising issues concerning the prudence of the Society’s approach and whether the Society would be able to fulfil the reasonable expectations of its policyholders, no action was taken by GAD to seek to resolve those questions or to raise them with the prudential regulators.

5.21 After having considered the representations I had received, I concluded that the failures by GAD, as part of the scrutiny process, to raise and seek to resolve questions within the Society’s regulatory returns for each year from 1990 to 1993, related to (i) the valuation rate of interest used to discount the Society’s liabilities and (ii) to the affordability and sustainability of the Society’s bonus declarations, fell short of what could reasonably be expected of GAD.

My third finding of fact

5.22 As is well known, the Society wrote policies containing guaranteed annuity rates. Those policies guaranteed the rate at which the proceeds available at retirement (based on the sum assured plus associated bonuses) would be converted to a pension – and thus the minimum amount of pension available at retirement.

5.23 The Society stopped providing guaranteed annuity rates on new policies from June 1988, although new members of some existing group schemes continued to be provided with policies containing guaranteed annuity rates until the early 1990s.

5.24 The Society’s guaranteed annuity rates continued to apply to the benefits that would be purchased by any future premiums (including in relation to recurrent single premium policies) that might be paid in respect of policies which already enjoyed this guarantee.

5.25 Those guaranteed annuity rates were both more flexible, in that they applied over a wide range of ages without penalty, and potentially more widespread than was the case with similar guarantees provided by other companies. In addition, policyholders could pay future premium payments and still benefit from the same guaranteed annuity rate at the same range of ages.

5.26 No new fund was established by the Society at the time of the changes it made to exclude guaranteed annuity rates and, subsequently, guaranteed investment returns from the policies it wrote. Thus the assets held in respect of the different classes of policy thereby created were held in one fund.

5.27 Nor was there a separate bonus series declared or any differentiation in treatment between the various classes of with-profits policyholders in terms of the level of bonuses declared by the Society, despite the changes in policy terms and the associated guarantees that had occurred.

5.28 In late 1993 and early 1994 and continuously from April 1995 onwards, the Society’s guaranteed annuity rates became generally more favourable than then current annuity rates, due to lowering interest rates and improved mortality. This meant that the cost of providing the guaranteed annuity benefit exceeded the total policy fund, which was only sufficient to provide the lower benefit available at the current annuity rate.

5.29 In order to deal with this situation, the Society introduced what came to be known as the differential terminal bonus policy, by restricting the value of benefit paid to the amount of the total policy fund.

5.30 The Society said that this was done to enable it to continue to reflect the Society’s philosophy of ‘full and fair’ distribution to all its policyholders in its bonus policy and to pay each policyholder just their share of the fund.

5.31 Under the Society’s differential terminal bonus policy, the amount of final bonus payable when a policyholder took benefits would be dependent on the form in which those benefits were taken and so, if the guaranteed annuity benefit was selected, the amount of the final bonus was reduced.

5.32 My third finding of fact is that GAD identified the introduction of a differential terminal bonus policy when scrutinising the Society’s 1993 returns in October 1994, but failed to inform the prudential regulators, as GAD should have done, of that introduction or to raise the matter with the Society.

5.33 This failure by GAD to raise the matter occurred despite there having been full disclosure by the Society within its 1990 returns of the extent and level of the guaranteed annuity rates within its older policies and despite the Society referring to such guarantees when it disclosed the introduction of the differential terminal bonus policy in its 1993 returns. GAD also noted that this policy had the effect of reducing the final bonus payable to policyholders.

5.34 That failure also occurred despite GAD knowing, or having information before them which suggested, both that the Society had told its policyholders that the Society would only change bonus policy gradually and also that the Society’s With-Profits Guides did not (at that time) inform its policyholders of the differential terminal bonus policy.

5.35 After having considered the representations I had received, I concluded that the failures by GAD, when they identified the introduction of the Society’s differential terminal bonus policy as part of their scrutiny of the 1993 returns, (i) to inform the prudential regulators about the policy, (ii) to raise the matter with the Society, or (iii) to seek to identify what the rationale was for the introduction of the policy and how it was being communicated to policyholders, fell short of the standard that could reasonably be expected of GAD.

My fourth finding of fact

5.36 As noted above, the Society submitted annual returns to the prudential regulators. Further issues arose in respect of the Society’s returns for 1994 to 1996.

5.37 My fourth finding of fact is that, in carrying out the scrutiny of the Society’s annual regulatory returns for each year from 1994 to 1996, GAD, in providing advice to the prudential regulators, failed to satisfy themselves that the way in which the Society had determined its liabilities and had sought to demonstrate that it had sufficient assets to cover those liabilities accorded with the requirements of the applicable Regulations. Those regulators were thus unable to verify the solvency position of the Society.

5.38 The matters arising from the Society’s returns which GAD failed to address and resolve to a satisfactory conclusion were:

• the continuation of the two issues which had arisen within the returns for 1990 to 1993 (questions concerning discounting through the use of imprudent and/or impermissible valuation interest rates and the affordability and sustainability of the Society’s bonus declarations);
• what appeared to be arbitrary changes to the assumed retirement age for personal pension policies, contrary to European Directives and the applicable domestic Regulations;
• the absence of explicit reserves for prospective liabilities for capital gains tax and for pensions review mis-selling costs, stating instead that such liabilities were covered by implicit margins in the valuation basis; and
• the absence of reserves in respect of guaranteed annuity rates, which by then GAD should have known were ‘biting’ and should therefore have been provided for.

5.39 GAD failed to identify all of those matters, to pursue them with the Society, or to seek to resolve the issues that they raised.

5.40 After having considered the representations I had received, I concluded that the failure by GAD, as part of the scrutiny process, to question and seek to resolve questions within the Society’s regulatory returns for each year from 1994 to 1996, related to

(i) the valuation rate of interest, (ii) the affordability and sustainability of bonus declarations, (iii) apparently arbitrary changes to the assumed retirement ages, and (iv) the holding of no explicit reserves for the liabilities associated with prospective liabilities for capital gains tax, for pensions mis-selling costs, and for guaranteed annuity rates, fell short of what could reasonably be expected of GAD.

My fifth finding of fact

5.41 Most insurance companies used the valuation method and basis set out in the applicable Regulations to calculate their Mathematical Reserves.

5.42 However, throughout the period covered by this report, insurance companies were entitled to use an approach which differed from the statutory minimum basis, so long as the alternative method that was used produced Mathematical Reserves that were at least as high as that which would have been produced using the statutory minimum basis.

5.43 During the period covered by this report, the Society always used an alternative valuation method within its returns.

5.44 In order to seek to demonstrate compliance with the Regulations, the Society set out information about the amount of its Mathematical Reserves using a basis that its Appointed Actuary considered was compatible with the method set out in the Regulations. This was done in an appendix at the end of Schedule 4 of the Society’s returns.

5.45 My fifth finding of fact is that GAD failed in certain respects to act, when they should have acted, to question the Society’s practice of producing two valuations within the regulatory returns but omitting crucial information from one of those valuations. After 1996, the Society continued to produce two valuations but published the missing information.

5.46 That information was the amount of the resilience reserves required in the Society’s appendix valuation, produced to demonstrate compliance with the Regulations. That omission meant that the Society appeared financially stronger than it was and that its solvency position was capable of being misconstrued.

5.47 While GAD asked the Society for the missing information in all but one year, GAD did not take steps to ensure that a reader of the returns had that information.

5.48 Even though the Society was not in breach of any of the applicable Regulations by presenting its valuations in the way that the Society did, GAD recognised at the time that this position meant that the Society’s returns, which were the main mechanism through which ‘freedom with publicity’ was delivered, might mislead those who read them.

5.49 Although the Society was permitted to produce an alternative valuation from that specified in the applicable Regulations, it was required, by those Regulations, to demonstrate that its chosen alternative valuation was at least as strong as that specified in those Regulations.

5.50 GAD considered that such demonstration was provided through the provision by the Society to GAD – but not through the returns – of the amount of the reserves omitted from the Society’s alternative valuation. However, GAD failed to ask for this information in November 1996 when conducting their scrutiny of the Society’s 1995 returns. GAD were therefore unable to verify whether those returns had complied with the applicable Regulations.

5.51 In addition, from November 1993 onwards GAD had possessed information, in the form of ratings of the Society produced by Standard & Poor’s – an expert ratings agency, which showed that the position was not only capable of being misconstrued but also that it was being misconstrued.

5.52 Standard & Poor’s erroneously concluded that the Society was stronger than it really was. This was as a direct result of the information which GAD knew was missing from the returns. Those ratings were also provided to GAD by the Society and retained on GAD’s files and were used by the prudential regulators as part of briefing for Ministers and in other ways.

5.53 GAD took no action to raise or to seek to resolve these issues.

5.54 After having considered the representations I had received, I concluded that the failures by GAD (i) to ask for the information they needed in respect of the Society’s 1995 returns to enable them to be sure that the Society had produced a valuation that was at least as strong as the minimum required by the applicable Regulations, and (ii) to pursue the information before them that the omitted information had led to the users of the returns misconstruing the financial strength of the

Society, fell short of what it was reasonable to expect from GAD.

My sixth finding of fact

5.55 During 1998, the prudential regulators and GAD became aware that the Society had not made provision for the liabilities arising from guaranteed annuity rates contained within certain of its policies and those regulators required that the Society should do so within its 1998 returns.

5.56 That requirement had led to an immediate increase of £1,600 million in the amount of reserves required to be shown as at 31 December 1998, as well as additional associated resilience reserves. As a result, the Society investigated means whereby those additional liabilities could be offset in order not to disclose a much weaker financial position in those returns.

5.57 Had such offsetting action not been taken, the 1998 regulatory returns would have shown such a weak financial position that the Society’s future as an independent mutual would have been threatened and its continued ability to write new business and declare bonuses would have been in doubt.

5.58 The prudential regulators told the Society in December 1998 that they would take action if they considered that the 1998 bonus declaration made by the Society was imprudent. The Society therefore needed to take urgent action to either raise capital or to reduce its Mathematical Reserves.

5.59 The Society did this through a financial reinsurance arrangement. Within its published returns for 1998, 1999, and 2000, the Society took credit for the arrangement that it had entered into with IRECO.

5.60 The amount of the credit taken for those years was, respectively, £809 million, £1,098 million, and £808 million. The Society’s Mathematical Reserves were reduced by more than those amounts, however, as the resilience reserves it was required to hold were also reduced. The prudential regulators permitted those credits to be taken.

5.61 The Society’s published returns for 1998 showed that it had excess available assets and implicit items of £1,516 million over the required minimum margin, the returns for 1999 showed the excess asset figure as £2,747 million, and those for 2000 showed a figure of £411 million.

5.62 My sixth finding of fact is that the FSA permitted the Society, when they should not have done so, to take credit within its 1998 returns, which were submitted on 30 March 1999 and which were available to the public by 1 May 1999, for a financial reinsurance arrangement which had not been concluded either at the valuation date or at the date that those returns were submitted. This was done without an appropriate reporting concession being given.

5.63 Moreover, even leaving that aside, the FSA permitted the Society within its returns for 1998, 1999, and 2000 to take credit for the financial reinsurance arrangement that did not reflect the economic substance of that arrangement.

5.64 This was despite the fact that GAD had identified the potential problems with the proposed financial reinsurance arrangement and had informed the FSA of those problems, recognising that this arrangement had little or no value for the purposes of the determination of the Society’s solvency position.

5.65 After having considered the representations I had received, I concluded that the failure by the FSA, acting on behalf of the prudential regulators, to

(i) ensure that the financial reinsurance arrangement was not taken into account within the Society’s 1998 returns without an appropriate concession being given, and (ii) ensure that the credit taken by the Society within its returns for 1998, 1999, and 2000 properly reflected the economic substance of that arrangement, fell short of the standard that could reasonably be expected of such regulators.

My seventh finding of fact

5.66 As is well known, the Society sought clarity as to the validity of its differential terminal bonus policy through seeking the view of the Courts. While that litigation was proceeding through the Courts, the Society – and the prudential regulators – undertook scenario planning to consider the likely impact of a range of possible outcomes to that litigation.

5.67 Consideration was given to what those scenarios would mean for the financial position of the Society and for its freedom to maintain the policies it had adopted to manage its affairs, and what other consequences the possible outcomes of the Hyman case could have for the Society and its members.

5.68 Even assuming that the financial reinsurance arrangement which the Society had entered into, and for which it proposed to take a substantial offset within its 1998 regulatory returns, entitled the Society so to do, the continuation of that arrangement was contingent on the Society being able to continue to apply its differential terminal bonus policy. Yet that ability was precisely the issue at stake in the Hyman proceedings.

5.69 Furthermore, if the Society were found not to have been able to apply its differential terminal bonus policy, the question would arise as to how to remedy the position of those policyholders with policies which contained guaranteed annuity rates who had retired since 1 January 1994, but who had not been provided with the option of taking benefits without the reduction in terminal bonus applied under the Society’s differential terminal bonus policy. The question of compensating such policyholders would thus arise if the Society lost the Hyman case.

5.70 My seventh finding of fact is that the FSA failed to pursue the failure by the Society to include contingent liability notes within its regulatory returns for 1998 and 1999 regarding the potential impact of losing the Hyman litigation. This failure to check why the Society had not included any such disclosure in those returns occurred despite the reminders by the prudential regulators that the Society should do so, reminders given prior to the submission of the Society’s 1998 returns.

5.71 No action was taken to seek to ensure that the Society had a sound basis for not publicly disclosing the fact that the outcome of the litigation could have profound effects, including for the operation of its differential terminal bonus policy (and hence its reserving practices) – effects which would have a significant impact on the solvency position of the Society and on the amount of money available to meet the liabilities it had to its policyholders and the future bonus expectations of those policyholders.

5.72 This failure by the FSA to act also occurred in relation to the Society’s 1999 returns in a context in which the FSA knew that the Society had informed its policyholders that no significant costs would be imposed on the Society if it lost the Hyman case.

5.73 After having considered the representations I had received, I concluded that the failure of the FSA, acting on behalf of the prudential regulators, to pursue the issue of the proper disclosure, within the Society’s regulatory returns for 1998 and 1999, of the potential impact on the Society of it losing the Hyman litigation fell short of the standard that could reasonably be expected of such regulators.

My eighth and ninth findings of fact

5.74 Following the decision of the House of Lords in the Hyman case, the Society had been faced with an extremely serious situation. That decision had profound effects.

5.75 The financial reinsurance arrangement that the Society had entered into was, as a result of the ending of the Society’s differential terminal bonus policy, to lapse. Without the credit that had been taken for that arrangement, a serious question arose as to whether the Society could or would continue to meet its required solvency margin.

5.76 The Society was immediately faced with a significant reduction in what the Society regarded as the assets available to meet the costs in respect of those policyholders who chose to take benefits calculated with regard to guaranteed annuity rates. Those costs had to be shared, almost certainly by benefit reductions, across all policyholders – as any ‘ring-fencing’ of policyholders with annuity guarantees had been declared unlawful by the House of Lords.

5.77 This gave rise to inbuilt conflicts between the interests of different classes of policyholders that, in the circumstances facing the Society at the time, could not be resolved using the normal mechanisms available to life insurance companies and which meant that the Society’s situation was inherently unstable.

5.78 In that context, the Society decided to put itself up for sale. The question arose as to what the regulatory response to that decision should be. The FSA decided not to intervene to require the Society to close to new business whilst it sought a buyer.

5.79 I make two findings of fact concerning the decision to permit the Society to remain open to new business following the decision of the House of Lords in the Hyman case.

5.80 My eighth finding of fact is that the FSA failed to record that decision. No contemporaneous record was made of that decision or of the factors and evidence which were taken into account by the FSA when they took it, or what alternative options, if any, the FSA had considered. That decision was highly significant for the interests both of existing and potential policyholders.

5.81 My ninth finding of fact is that, having established from those involved the basis on which the FSA took that decision, the decision to permit the Society to remain open at that time was not grounded in a sound factual or legal basis.

5.82 Relevant considerations – such as the nature of the Society’s business, which meant that it was not just new policyholders who were potentially affected by the decision – were not taken into account. No proper consideration was given to the use of the full range of powers that the prudential regulators possessed.

5.83 After having considered the representations I had received, I concluded that the failure by the FSA, acting on behalf of the prudential regulators, to record their decision to permit the Society to remain open to new business, following its loss of the Hyman litigation fell short of the standard that could reasonably be expected of such regulators.

5.84 I also concluded that the basis on which the decision was taken by the FSA, acting on behalf of the prudential regulators, to permit the Society to remain open to new business was unsound, not taking into account all relevant considerations and not having a proper legal and factual basis and that this fell short of the standard that could reasonably be expected of such regulators.

My tenth finding of fact

5.85 In the period between the Society’s closure to new business on 8 December 2000 and the end of my jurisdiction in relation to relevant events on 1 December 2001, the FSA, acting on behalf of the Treasury as the prudential regulators of insurance companies, were contacted by many hundreds of the Society’s policyholders who were concerned about the position that the Society was in and about their own future options.

5.86 The FSA during this period also issued general information relating to the Society through updates, website material, and factsheets.

5.87 As the Society prepared proposals for a scheme of arrangement under the Companies Act 1985, to compromise the competing claims of the Society’s policyholders, the FSA were also contacted by policyholders about the Society’s proposals and about the attitude of the FSA to those proposals.

5.88 My final finding of fact is that the information provided by the FSA in the post-closure period was misleading and unbalanced, with assurances being provided that the Society was solvent, when that was in considerable doubt and was not the view that was always held within the FSA, who, on behalf of the prudential regulators, had exercised formal intervention powers on the grounds that the Society was likely to be in breach of its regulatory solvency requirements.

5.89 Nor were the assurances given by the FSA that the Society was at that time fulfilling and always had fulfilled all of its other regulatory requirements appropriate, when the FSA knew that this was not the case.

5.90 After having considered the representations I had received, I concluded that the misleading information, about the Society’s solvency position and its record of compliance with other regulatory requirements, that was produced by the FSA, acting on behalf of the prudential regulators, during the period after the Society closed to new business fell short of the standard that could reasonably be expected of such regulators.