1992

GAD write to Equitable’s Chief Executive to announce that they intend to visit in the near future. GAD explain that this is part of the DTI’s and GAD’s rolling programme of visits to insurance companies authorised to write long term business, that it is the intention to visit all offices within three years, and that no significance should be attached to the order in which the visits take place.

GAD say:

We would like to discuss the following main areas:

1. Board of Directors
2. Management Structure
3. Future Plans and Strategy
4. The role of the Appointed Actuary
5. Decision Taking
6. Corporate Structure
7. Administration
8. Distribution Systems
9. Investment Policy
10. Bonus Policy

Equitable’s Chief Executive and Appointed Actuary writes to GAD to confirm the visit for 05/03/1992. The Chief Executive adds: ‘Have you asked [Directing Actuary A] whether he wants to attend? At one time he did express an interest in so doing but this is essentially a domestic matter for yourselves’.

(The meeting is postponed (see 02/03/1992). It takes place on 19/05/1992 and the Directing Actuary does attend.)

GAD write to DTI with a ‘Post Scrutiny Report’ on the Society’s 1990 regulatory returns, in the light of Equitable’s letter of 22/11/1991. GAD explain that:

• they have no additional comments on the figures that Equitable have provided for debts due from other companies;
• the long term business returns for premiums and expenses, revenue and claims were split for tax reasons and ‘will not affect the distribution of surplus to with-profits policyholders. This is reasonable’;
• they are satisfied with Equitable’s ‘assertion’ that sufficient provision has been made in the valuation of liabilities for future expenses;
• that, as the last two years’ returns have shown that most of Equitable’s business is now recurrent single premiums and regular premium business is dwindling, ‘the need for a general reserve to augment the mathematical reserve is not necessary’;
• they are seeking more information on with-profits bonds, enclose a copy of their letter to the Society (see 31/01/1992 [entry 2]) and undertake to comment on the valuation basis of the bonds when Equitable have replied;
• they are satisfied with the information Equitable have given about the mismatching reserve and the cost of the change in the valuation basis; and
• they will be in touch again when they hear further about the position as at 31 December 1991.

GAD write to Equitable’s Appointed Actuary, to ask about the Society’s with-profits bonds:

I note that the current practice on surrender is to pay the full value of the guaranteed fund and bonuses standing to the credit of the policy … Although you do not guarantee to pay this amount I am surprised that the reserves held are lower than the current surrender values. I would be glad if you would please comment on this.

GAD continue:

I wonder what your surrender experience is like on these Bonds and also whether you have any limit in mind on the amounts of single premiums which your Society will undertake on these contracts?

Equitable’s Appointed Actuary replies to GAD’s letter of 31/01/1992. The Appointed Actuary explains that the guarantee of ‘full value’ payment on the with-profits bond applies only at certain specific dates set out in the policy document and that the valuation basis takes account of those dates. However, although Equitable’s current practice is to pay out ‘full value’ on early surrender:

… we do not guarantee this. I do not see that the reserving basis for the bonds needs to take any particular account of this practice.

For 1990 business it was convenient to value this class on similar bases to other business which obviously led to some release of premiums into surplus.We could, of course, easily have done something different since this class is trivial in relation to the whole. For 1991 we shall be valuing new business of this type so as to avoid such releases.

The Appointed Actuary explains that the Society is currently experiencing a very low rate of surrender on this business and that:

We incur no initial strains on this business and, since we have told our policyholders that future bonuses will be at a level which can be supported by future investment conditions, there should be no commercial reason to put limits on the volume of business transacted. If our surrender experience deteriorates or if financial conditions worsened significantly, we should certainly impose surrender penalties.

Equitable’s Appointed Actuary says that the Society will not view this class of business as a source of surplus. He adds that the 1990 valuation basis ‘needs to be considered over the total business and not class by class’.

The GAD actuary who had commented previously on this type of business (see 29/08/1991 and 12/09/1991) passes Equitable’s letter to Scrutinising Actuary B with a note:

We cannot insist that he uses reserves [equal to or greater than surrender values] where latter are not [guaranteed].Would be a different matter if all business were like this.

DTI’s Director of Insurance writes to GAD’s Directing Actuary A about life companies’ bonus rates. The Director of Insurance says that he and Directing Actuary A had ‘discussed briefly whether it would be possible to compile a simple table showing the changes between 1991 and 1992 in the major life companies’ bonus rates (reversionary and terminal), as a cross indicator of current and prospective pressures on life funds’.

The Director of Insurance says that DTI do not routinely receive the with-profits guides of all the insurance companies they regulate. He asks GAD to put together a table showing the main bonus rates for with-profits policies. The Director says: ‘I foreswear judgement on what precisely we will do with this information until I have seen what it reveals. But I would not rule out using this comparative data as an input into the questioning of life companies’ future plans on our visit programme’.

DTI’s Line Manager A writes to the Director of Insurance, having seen a copy of his minute (see 25/02/1992 about companies’ bonus rates. The Line Manager provides the Director with a copy of the most recent Money Management survey on endowment policies. He says that DTI have contacted the magazine and were told that the bonus rates for 1992 would appear in their May 1992 edition.

On 7 April 1992 the Director of Insurance informs Line Manager A that he would like to see the article when it is available. An undated subsequent note records this as being ‘done’.

Equitable’s Appointed Actuary writes to GAD about the forthcoming 1991 returns and, in particular, to advise them of the Society’s likely solvency position, as requested by GAD in their letter of 19/11/1991. The Appointed Actuary says that the ‘Form 9 position as at 31 December 1991 was as follows’:

The Appointed Actuary states:

During 1991 the Society continued to attract relatively large volumes of new annual premium and single premium business (including additional recurrent single premiums). The total amount of such premiums in 1991 was about £1400m. Taking account of this fact I decided to strengthen the valuation bases for recurrent single premium policies in order to ensure that there was no immediate release of surplus in respect of 1991 premiums. In effect we put the valuation of 1991 new business back on to the premium basis which has been our traditional approach. That strengthening of the valuation bases increased reserves by about £150m. The general basis is also fairly strong because new business expenses are effectively written off as incurred. They will be recouped as the business matures but there is no accepted method of “zillmerising” recurrent single premium business, which is about 80% of our business in force.

As in previous years I will be publishing a net premium valuation as an appendix to my valuation report to demonstrate compliance with the Valuation of Liabilities Regulations. The total net premium reserves shown will be £6,459m which, if they were to be shown in line 11 of Form 14, would require an additional mismatching reserve of £450m.

He continues:

I am monitoring on a regular basis the Society’s expenses and the effect of new business on the Society’s financial position, and continue to be satisfied that no undue strain is being caused. New business will, of course, provide little or no contribution in the shortterm to the Society’s solvency margin. I believe that the underlying strength of the Society’s business is being masked in [the returns] by our success in attracting business.

Equitable point out that they are not using the future profits implicit item of £300m approved in December 1991. They say that an implicit item up to £650m could have been justified and continue:

If we were to compare the excess of available assets and future profits implicit item (for which credit could have been but was not taken) over the required solvency margin at the 1990 and 1991 year-ends, there was an increase from £580m as at 31 December 1990 to £701m as at 31 December 1991. Although a somewhat artificial measure in some respects, I believe it helps to demonstrate the underlying soundness of the Society’s financial position.

I regard my prime professional role as ensuring that prudent provision has been made for meeting future liabilities, that the various statutory and non-statutory requirements have been satisfied and that a demonstration of solvency can be achieved. I do not regard it as a priority to show the best possible position in Form 9 [i.e. the statement of solvency] even though there is the real possibility of attracting adverse comments from so called “financial experts”. This is, of course, comment to which we are well used.

The Appointed Actuary continues:

Having said that, however, we monitor regularly the Society’s ongoing financial position and possible positions in the future. In particular, the investment policy and its appropriateness taking account of the financial constraints of the business are reviewed. We have decided, for example, that in view of some uncertainty that equities will “perform” over the next year or so to invest the greater proportion of new monies into fixed interest investments during 1992. That will increase investment income and reduce the dependence upon capital appreciation for bonus declaration purposes at the year-end.

Equitable invite GAD’s comments on their letter before Equitable finalise their 1991 returns.

Chief Actuary B passes Directing Actuary A a copy of Equitable’s letter of 12/05/1992. The Chief Actuary sets out background comments in preparation for the forthcoming meeting with Equitable, along with their solvency position using Equitable’s bonus reserve valuation and the alternative position using net premium reserves.

Chief Actuary B attaches a note of the interest rates used in the 1989 and 1990 valuation bases. He notes that ‘the margins were very thin in 1990, with an average interest rate used of 7.12%’. He says that GAD do not know the basis used in 1991 but they could seek this information during the meeting with Equitable, now arranged for 19/05/1992. He notes that the strengthening of the valuation basis in 1991 increased reserves by £150m whereas the weakening in 1990 reduced reserves by £557m.

In relation to initial expenses of new business, Chief Actuary B says:

A comment made in [the Appointed Actuary’s] letter is that 80% of the business is single premium business. He states that initial expenses will be recouped as the business matures as there is no accepted method of “zillmerising” single premium business. The business is mainly with profits pensions. I thought that a reasonable valuation rate of interest would allow the company to recover initial expenses right away – the main danger being a release of the bonus loading.We should query this.

Regarding the level of new business, the Chief Actuary notes:

Comment is made about the effect of the new business on the Company’s financial position, and [the Appointed Actuary] states that new business provides little or no contribution to the solvency margin. Could it be that the level of new business is reducing the solvency margin too much?

He also notes:

At the end of 1990 the company had over £100m of single premiumWith Profits Bonds in force. These were valued on an acceptable basis, although the reserves held were less than current surrender values (not guaranteed). This led to some release of premiums into surplus. I do not know how much of this class of business was written in 1991.We should ask about the effect of this on surplus.

Chief Actuary B adds that he had expected to see an increase in the excess assets in 1991 with the increase in market values and was surprised to see a fall. He suggests they discuss this with Equitable. He also raises the continuing position of one person holding the dual positions of Chief Executive and Appointed Actuary: ‘This was queried by DTI and the company hoped to appoint a new Appointed Actuary in 12-18 months after 1 July 1991. I wonder what is happening on that issue?’.

Scrutinising Actuary B, in an attachment to the note, records some further comments aboutEquitable:

1. Strength of Equitable: It provides a good service at a reasonable cost. Expenses are thelowest in the industry. It does not pay commission. Adverse publicity about commissionand its associated problems have made Equitable very attractive to a lot of investors.
2. Weakness: Free asset ratio is low and when 1991 results are published a lot of [Independent Financial Advisers] will question the strength of Equitable.We will be asked to comment about it by the National Health Service and the Treasury because Equitable underwrites both [Additional Voluntary Contribution] schemes.
3. Equitable has used up investment reserves quickly in paying very good bonuses.
4. [Equitable’s Appointed Actuary] says that single premium business will release profitswhen it matures but with-profits business will probably be surrendered early rather thanreach maturity when the interest rates will rise.
5. Recurrent single premium business is exposed to cancellation as soon as there isadverse publicity about the strength of Equitable.
6. [The Appointed Actuary’s] position as Chief Executive and Actuary may createproblems because there is nobody to blow the whistle when things go wrong.

Behind this note are two pages from ‘With ProfitsWithout Mystery’, the paper that two ofEquitable’s actuaries presented to a meeting of the Institute of Actuaries on 20/03/1989 and tothe Faculty of Actuaries on 19/02/1990. The paper had included, as an appendix, historical datasetting out the market value of Equitable’s fund and their investment reserve, for 1972 to 1987.GAD’s copy of this appendix is annotated with figures for 1988 to 1991.

GAD copy their note to DTI’s Line Supervisor B. The Line Supervisor adds her own comments inmanuscript. She notes that the alternative position showing net premium reserves is ‘to meetthe requirements in the [Regulations]’. She highlights that the total reserve in the net premiumvaluation, including the resilience reserve, is £6,909m, which compares with Equitable’spublished reserve of £6,991m. Line Supervisor B adds:

[Chief Actuary B] thinks they have been paying too much in bonuses …

[The Regulations] require a net premium reserve valuation. But [the Appointed Actuary]can use the bonus reserve method providing it can be demonstrated that [the] publishedbasis gives as big reserves as [the] net basis.

… considerable reduction in Excess Assets between 1989 and 1991. 1990 Returns showedrapid expansion – total new premium income increased 30% to £836m. New regularpremiums, at £258m, were up 10% on previous year and single premiums increased 42% to£578m (due partly to success of Society’s with profits bond).

Society has experienced falls in the market value of equities and other assets, and theactuary has decided to weaken valuation basis of [with-profits] business. Reduction incover for [required minimum margin] is due to fall in value of assets, growth in newbusiness, and maintenance of unchanged bonus rates on [with-profits] policies.

GAD meeting with Equitable on 14.11.90 noted that they were considering not paying anyreversionary bonuses for 1990. In the event a bonus was declared for 1990 at same rate asfor 1989.

DTI’s note also highlights some other recent issues, including: that Equitable have set upbranches in the Republic of Ireland and Germany (note: GAD’s scrutiny report on the 1993returns recorded that a new branch was not established in Germany until 1993 – see 15/11/1994);that they do not appear to be using the future profits implicit item of £300m, agreed inDecember 1991, in their 1991 returns; and that:

[One individual] is [Managing Director]/Chief Executive and Appointed Actuary as fromJuly 91 …We were not happy with one person holding both positions, and regarded this asa temporary situation – see attached correspondence. Perhaps we could ask about thisat the meeting.

The role of the Appointed Actuary

Both DTI and GAD express concern that the Managing Director is also the Appointed Actuary,as this could lead to a conflict of interest, as ‘[where] the jobs were separate, and theAppointed Actuary thought that management was not doing its job, he could come direct toDTI’. However:

[The Appointed Actuary and Chief Executive] did not perceive any conflicts of interest butsaid that if a conflict arose he would drop one of the jobs. His view was that the[Appointed Actuary] should be a generalist rather than a backroom “number cruncher”.He felt that the position of [Appointed Actuary] was weakening in some companies, and that the calibre of the newer entrants was lower because their job was so specialised andfragmented.

[The Appointed Actuary and Chief Executive] was due to retire in 3 to 4 years time, bywhich time the [Managing Director] and [Appointed Actuary] roles would be separatedagain. He was considering whether any of the present actuaries was qualified to take onthe [Appointed Actuary] role but the appointment of a new [Appointed Actuary] was atleast a year off. He agreed with [Directing Actuary A] that the [Appointed Actuary] shouldbe part of the senior management team. The problem was that there was at presentnobody within the company to take over this role. The Equitable usually found the[Appointed Actuary] from its in-house actuarial team, but was prepared to recruitsomeone from outside if necessary.

[The Appointed Actuary and Chief Executive] had been an executive director for sometime, and had been a member of the investment committee, which was a “sub-set” of theBoard, for about 14 years.

Equitable’s investment strategy

After an outline is given of Equitable’s process of devising their investment strategy, GAD ask ifEquitable found their investment policies were constrained by the valuation regulations. TheAppointed Actuary responds that ‘the liability regulations were only an irritant, i.e. aconstraint, in the sense that they had to comply with them, but their main problem wasfunding the amount of surplus they needed at the right time’.

Equitable’s bonus policy

Equitable’s Appointed Actuary says that 80-85% of their business was single premium withprofitspolicies which included a guaranteed interest rate of 3.5%. DTI ask if Equitable reservedfor future terminal bonuses. The Appointed Actuary responds that:

… the company knew at all times the terminal bonus for each policy on the books. Therewas a notional terminal bonus reserve earmarked which was called the investmentreserve. All the with-profits pension customers had annual statements which showed thenotional accrued terminal bonus figure, but they were told that this bonus was notguaranteed.

[The Appointed Actuary] explained that all the assets belonged to the current generationof members, and that they did not want to build up reserves for future generations.

The note records that:

[Chief Actuary B] noted that if the value of equities had fallen, the company would needto cover their solvency margin. [The Appointed Actuary] said they would first look aftertheir members’ interests, and check that there would be enough surplus. They would thendo the solvency tests.

[Directing Actuary A] asked what the mechanism was for determining bonuses. [TheAppointed Actuary] explained that he presented a paper to the Board in April. InSeptember/October a further paper was presented about bonuses, and the actual bonusdeclaration from the Board issued in the following February. In 1992 the bonus wasexpected to be about 9½-10%.

It was necessary to look at what was being notionally earned on fixed interest in respectof the Fund. In 1990 the rate that could be earned on deposits (gilts) was 12%. The bonuswas 11%, which comprised 3½% guaranteed bonus, and 7½% declared bonus, totalling 11%.This included a 1% terminal bonus. In 1991 the notional rate earned was 14% and thebonus was 12%, which included a 2% terminal bonus.

The note records that:

[The Appointed Actuary explained that at] the end of 1990 the valuation of the liabilitieswas weakened but in 1991 the liabilities had been valued more strongly, but were still wellwithin the DTI regulations. [Directing Actuary A] noted that he liked Equitable’sphilosophy for its policyholders, but felt that its solvency strength was arguable.

[Directing Actuary A] asked if there was a built-in mechanism for reducing reversionarybonuses if the need arose. [Equitable’s Appointed Actuary] said they looked at thefollowing options available: (i) non-declaration of bonuses; (ii) implicit items; (iii) to stopwriting new business.

On ‘Future Plans’, Equitable say that they prepared a plan of their future objectives every threeyears. They agree to provide a copy of the current version to the regulators once it wasfinalised; it was only in draft at that time. DTI’s note records that: ‘The plan emphasised fourimportant concepts that the Equitable stood for: (i) It was a mutual company; (ii) It operatedat the top end of the market; (iii) It only sold direct, and (iv) It was innovative, and aimed forgrowth’.

Under ‘Distribution Systems’, DTI record that ‘Out of the first premium, 10% went to thesalesman, 20% to the branch, 5% to admin, and 5% to marketing’.

At the conclusion of the meeting, Directing Actuary A ‘noted that he would be concernedabout Equitable’s performance if there were dramatic falls in the market. Also there was theproblem of who would take over when [the Appointed Actuary and Chief Executive] retired’.

(Note: the meeting note contained no reference to ‘zillmerising’ or any explicit reference tothe reason for the fall in excess assets in 1991—see 14/05/1992.)

Equitable’s Appointed Actuary sends GAD information about the Society’s management structure, management company accounts and corporate objectives, as provided at the meeting on 19/05/1992. He explains that the ‘actuarial management’ area is under the control of a very experienced, practical senior actuary who has four actuaries reporting to him, and expresses the wish that this will give GAD a feel of how the actuarial management is now being spread.

The Appointed Actuary writes: ‘With hindsight, it might have been better to have some junior colleagues present at our meeting, but nothing we discussed would have been unfamiliar to them. I do try to run a very open area’.

He explains that the Society has developed a new form of internal ‘management company accounts’, saying that these are:

… an attempt to pull together into one document the various financial implications of what we do and which previously would have appeared, either directly or indirectly, in various papers to the board on a variety of topics.

The Appointed Actuary continues:

The various loadings on which the “management expenses fund” is based are well documented internally and have effectively been in the current form for many years …

The accounts will be produced for me on a monthly basis, before the end of the followingmonth, and submitted to the board on a formal basis each quarter.

The documentation enclosed with the letter includes information about the Society’smanagement structure, a profit and loss account for the period ended 30 April 1992, thebalance sheet as at 30 April 1992 and notes on the account.

Equitable’s Appointed Actuary provides GAD with a copy of a Board paper entitled ‘Revenue –Report on First 3 Months’, dated 22 April 1992. On the market value of the fund, the paper says:

The estimated market value of the fund at 31 March 1992 was £7,748m. That compareswith a figure of £7,368m at 31 December 1991.

The increase in the market value of the fund over the first 3 months of 1992 represents anannualised rate of return of around 6.9%. That reflects the improvement in capital valuesduring January and February followed by a decline during March. If at 31 March 1992market values had been at the levels to which they increased following the GeneralElection, the assets would have been around £125m higher. In that event, the increase inthe market value of the fund since 31 December 1991 would have represented anannualised rate of return of about 14%.

The excess of market value of assets over liabilities at 31 December 1991 was £375m. By 31March 1992 that was estimated to have grown very slightly to £377m before allowing forany accrued declared bonus cost.

He encloses a copy of the draft corporate objective, saying that, once finalised, it would thenbe sent to the regulators. The Appointed Actuary also encloses a copy of their current‘statement of intent’.

The Society’s Appointed Actuary concludes by saying that:

I enjoyed the meeting and hope that you and your colleagues got out of it what theywere looking for. As you know, I am normally prepared to be very open about all of ouractivities and no doubt you will come back to me if anything needs further explanationor expansion.

That reduction in reserves has been facilitated primarily by retaining the same valuationbases for general annuity and pensions recurrent single premium business as was used at31 December 1990. The strengthened basis which I described in my letter of 12 May 1992has been retained for recurrent single premium life business including with-profits bonds.

The Appointed Actuary summarises the position at 31 December 1991, taking into account thereduced mathematical reserves, as follows:

The Appointed Actuary explains that the appendix to the returns would show net premiumreserves of £6,453m. If these reserves were shown in the body of the returns, an additionalmismatching reserve of £390m would be required. He states that the reduction of themismatching reserve, compared with that shown in their letter of 12/05/1992:

… arises because we have looked again at the minimum reserves we should need toestablish in the revised conditions of the mismatching test. From that review weconcluded that, in our previous calculations, we had applied the regulations in an undulystringent manner so as to produce reserves above those indicated by the minimum basis.

Equitable’s Appointed Actuary concludes:

Having taken the view previously that it was not a priority to show the best possible[solvency position], I have on reflection come to the conclusion that there is nothing tobe gained from presenting such an apparently weak … position as set out in my letter of12 May 1992. The revised presentation will show a position of broadly comparable“strength” to last year. The mathematical reserves to be shown in our annual returncontinue to represent prudent provision for meeting future liabilities and satisfy thevarious statutory and non-statutory requirements governing the valuation of liabilities.