1993

Equitable, in error, send DTI’s Line Supervisor B a letter addressed to a financial adviser. Equitable ask DTI to destroy the letter. DTI nevertheless retain a copy of a paper attached to the letter, setting out some observations by Equitable on the financial strength of life companies. The paper, dated September 1992, had been prepared as a result of ‘a growing preoccupation amongst intermediaries and financial commentators with the “financial strength” and the solvency ratio of life offices, and the implications for future bonuses’. The Society’s paper discusses free asset ratios, concluding in summary that it ‘depends upon a number of complex variables and is not necessarily a reliable indication of anything’.

Line Supervisor B sends a copy of Equitable’s paper to Line Manager B and to GAD. The Line Supervisor says that she retained the paper because ‘it looked interesting. It’s basically saying that having a low free asset ratio doesn’t necessarily mean that a life office is in trouble’. There is no record of any reaction by GAD.

DTI check with GAD to see if they had received a reply to their letter to Equitable of 29/10/1992. DTI ask GAD for their comments on the point made by the Head of Life Insurance on 29/10/1992, which was:

This paints a worrying picture. Over-distribution by a company with a (deliberately) small coverage of its [required minimum margin] and a (continuing) policy of high equity exposure. I think we should ask GAD for a fuller assessment of the position and of the options available to the company in the event of a significant further downturn in the market.

DTI also ask for GAD’s comments on the point made by Line Manager B, which was:

If the investment yield (dividend + capital) is zero in 92 what would the position of thecompany be at end 92? How long could it continue with present bonuses in the face of azero yield?

I also understand that you would like our comments on this response. I will try to let youhave that as soon as I can. As you know, I have only just taken on responsibility for thiscompany and it may take a little while to become adequately familiar with it.

I also have your note of 14 January quoting comments from [Head of Life Insurance andLine Manager B], which I will also deal with.

GAD’s Scrutinising Actuary C prepares a brief note of the Society’s position. He sets outEquitable’s cover for the required minimum margin from 1987 to 1991, along with the bonuses declared for 1990 and 1991, and notes that:

• 80-85% of policies are single premium with-profits;
• there is a 3.5% guarantee on pensions business;
• investment reserve is a notional terminal bonus reserve; and
• annual premiums in force only £75m at 31 December 1991.

GAD provide DTI with their comments on Equitable’s response of 06/11/1992. GAD say that Equitable’s replies to their questions (about the 1991 returns):

… seem satisfactory. The operation of the bonus system (as described in the responses toQuestions 1 and 3) seems complex, and even more difficult for policyholders tounderstand than that of most companies, but there is nothing inherently unsound aboutit.

In response to the comments by DTI, passed on in the note of 14/01/1993, GAD say that theythink it is useful to draw attention to some ‘unusual features’ of Equitable. GAD explain thatEquitable are the leading non-commission-paying office and a mutual with a reputation for oneof the lowest cost ratios in the UK industry. GAD point out that Equitable have a very highproportion of with-profits business and, even more unusually, that 80%-85% of their with-profitsbusiness is by single or recurrent single premiums, with the annual premiums in forcebeing very modest in relation to the size of the office. GAD state this can be:

… both a strength and a weakness. A strength because it has only to secure the benefitsbought by premiums already paid, and needs less by way of protection for the futurepremiums to be received under the contracts. A weakness because it will have less by wayof “free reserves” and is therefore more vulnerable to changes in asset values.

GAD note that Equitable have always published a bonus reserve valuation, and that the abovefeature of their products makes this more appropriate than the net premium approach. GADadd:

It also means that, although in general a bonus reserve valuation will reveal anapparently weaker position, in terms of [the required minimum margin] cover, than a netpremium valuation, in the case of the Equitable the two results will be similar. This isborne out by the reported results in Schedule 4 and its Appendix.

GAD note from reports of earlier meetings that, in setting bonus rates, Equitable haveconsiderable regard to gilt yields. GAD comment that this is not entirely consistent with thebonus system or the asset mix but conclude that it no doubt explains what in retrospect wasan over distribution in 1990. GAD add:

It seems possible from the [required minimum margin] cover ratios that theoverdistribution followed a period of some underdistribution; but without going backinto previous history in detail I could not be sure.

GAD continue:

As a result the company will have downward pressure on bonuses even in years whenthere are adequate investment returns (income plus capital).We have written to thecompany (copy attached) asking for an estimate of the position at the end of 1992,together with details of their bonus distribution and the rate earned on the fund in 1992.

GAD discuss the options for Equitable in the event of a significant downturn in the market.GAD explain:

Clearly to reduce declared bonuses, perhaps even to zero, is their first line of defence.They have reduced bonuses before and have clearly thought about doing so again. Theycould do this without substantially reducing payouts (which might not be justified bystock market levels) through changes to Terminal Bonus rates. (However they appear notto have the protection against market falls that most companies have in their [terminalbonuses], because these do not represent a high proportion of their total payouts. Againthis stems from the contract design.) As we have seen in earlier discussions, in adverseconditions there is some scope to weaken the valuation basis and the company could usethe Section 68 Order that it has received (it will no doubt continue to apply for such anOrder each year as a precaution).

GAD conclude by saying:

Overall, I suspect that Equitable could survive a short-term fall in market levels, even asubstantial one, as well as most companies. Their portfolio, however, must leave roomfor concern, were there to be a prolonged period of depressed share values. Their recentshift towards fixed interest securities will ease the difficulties, although they would argueat the expense of the expected ultimate benefit to policyholders.

Line Supervisor B passes GAD’s note to Line Manager B with her own note, which says: ‘Below isa helpful update on Equitable’s position. It will be interesting to see what their solvency lookslike at the end of 92’. The Line Supervisor also notes that she had recently read in the press thatEquitable were reducing their bonuses.

There seems little point in asking further questions on the matters relating to the 1991Returns. However we should be interested in your initial estimate of the actual positionat the end of 1992 – in particular, what is the required minimum margin and what assetsare available to cover this? What rate was actually earned on the fund in 1992? We wouldalso like details of your bonus distribution, now or when it is announced (I have notspotted any announcement from The Equitable, but such things are easy to miss).

In your letter of 6 November to [Chief Actuary B], in Appendix C, you gave details of thehypothecation of assets to the net premium reserves. In due course we shall be asking forsimilar information as at 31 December 1992, and in addition will be seeking details of theyield on the various assets thus hypothecated.We shall also be interested in thecorresponding analysis to Appendix D [New Business Analysis] for 1992. I thought it mightbe helpful to you to mention these matters now.

Equitable’s Appointed Actuary responds to GAD’s letter of 03/03/1993. He sets out the Society’s estimated solvency position at the end of 1992, ‘which as one would expect has improved since the end of the previous financial year.We have strengthened the liability valuation by around £100m this year and the 1992 figures are after that strengthening’. The figures provided are:

The Appointed Actuary explains that Equitable had earned 17% on their assets in 1992 and headds:

We have traditionally followed an internal discipline of linking the earnings passed onthrough declared bonuses to the general level of fixed interest rates. This year we havereduced declared rates further to a level equivalent to earnings of 8¾% pa.

Equitable’s Appointed Actuary encloses with his letter a copy of the press release on bonusrates for 1992, issued on 3 March 1993. He explains that, for pension policies, the Society hadawarded an overall rate of return of 10% in respect of benefits bought on or before31December 1991 and 12% for benefits bought in 1992. The Society had reduced thereversionary bonus for pension business from 6.5% to 5%. The Appointed Actuary also enclosesa copy of the Society’s ‘Bonuses’ booklet, ‘which may be of help in providing further detail onour bonus systems’. The Appointed Actuary explains that the information GAD would beseeking later in the year will be readily available from Equitable’s internal analysis.

The letter does not, in my view, call for any further comment, and I do not propose towrite to the company again until we carry out the scrutiny as at 31 December 1992. In themeantime, we regard the 1991 scrutiny as fully completed.

DTI’s Line Supervisor B notes that the estimated solvency position for 1992 ‘looks a lothealthier than last year’s’.

[Equitable] have done their own “mock up” of a specimen disclosure statement, slightlymodifying that in the OFT’s blue report and will send us a copy. The effect of a company’scurrent surrender philosophy could be illustrated by projections using own charges, ownsurrender philosophy and standard rates of return assumptions. They seemed lessconcerned than some that these indications would, by reason of market pressure orotherwise, amount to effective guarantees.

Equitable submit their 1992 regulatory returns to DTI. Accompanying those returns are copiesof the Society’s annual report and accounts for 1992, prepared in accordance with theCompanies Act 1985 and dated 24 March 1993.

Equitable also send DTI a declaration under section 94A of ICA 1982 and pay Insurance Fees of£17,000 in respect of their 1992 returns.

These documents include the following information about Equitable’s business and theirfinancial position as at 31 December 1992.

Companies Act annual report and accounts

In their President’s Statement, Equitable explain that, in common with most other financialinstitutions, Equitable believe they are probably entering a period of low investment returnsand that bonuses, particularly reversionary bonuses, would have to reflect this. Equitable saythe reductions in bonus they are making are in line with the market and that they aremaintaining their competitive position in terms of the real returns provided to policyholders.

Equitable’s President goes on to say:

In The Equitable we pride ourselves on allocating earnings from our investments across allclasses and durations of contract in as fair and consistent a manner as possible. Thefundamental philosophy is that each generation of policies should receive benefitscommensurate with the earnings produced during its lifetime. Beyond the bounds ofnormal commercial prudence, it would be alien to our culture to hold back benefits fromone generation to build reserves for a future generation. As we say in our literature, fornew policyholders future bonuses must depend primarily upon the earnings produced onthe investment of the new premiums. Any deliberate cross subsidies between generationswould not be “equitable”. I believe that we can rightly claim that for as long ascomparative tables of policy results have been published, the Society can demonstratethat it has provided consistently good value across all types and durations of product.

In their Management Report, Equitable explain that they had recently sent with-profitspolicyholders notices of their bonuses and statements together with a letter explainingEquitable’s approach to bonuses for 1992. They state that the 1992 bonus declaration had onceagain demonstrated how the with-profits system smoothed fluctuations in investmentperformance and that Equitable had taken the opportunity of the good investment returns in1992 to recover part of the ‘support’ previously given by the smoothing process, particularly inrespect of 1990 when investment returns were poor and below the returns allocated topolicies.

In their Directors’ Report, Equitable state that, in light of the current investment conditions, inparticular the lower gilt yields, they had reduced reversionary bonuses to a level consistentwith these gilt yields, which was their traditional approach.

The returns

Equitable’s returns are again submitted in two parts covering Schedules 1, 3 and 6 and Schedule4 to the ICAS Regulations 1983.

Schedule 1 (Balance sheet and profit and loss account)

As in previous years, Schedule 1 of Equitable’s returns consists of Forms 9, 10, 13, 14 and 16. Form9 summarises the Society’s financial position at 31 December 1992 as follows:

Equitable do not use in their returns the future profits implicit item that has been agreed withDTI.

Schedule 3 (Long term business: revenue account and additional information)  

As in previous years, Schedule 3 consists of Forms 40 to 51, which have been supplemented byvarious notes providing further information about/explanation for the figures provided.

Form 45 shows that 43% of Equitable’s non-linked assets are invested in equities, 8% in land and40% in fixed and variable interest securities (compared with 51%, 11% and 27%, respectively, in1991).

As in previous years, Equitable disclose in Form 46 that the gross redemption yields on fixedinterest securities issued or guaranteed by any government or public authority are, for certaindurations, higher than for those not issued or guaranteed by any government or publicauthority.

In the notes to this part of the returns, Equitable disclose that a provision has been made forthe contingent liability for tax on unrealised capital gains in respect of non-linked business,which they estimate to be £1.2m.

Equitable state that they have been granted a section 68 Order which permits them to includein aggregate form details of their ‘Personalised Funds’ in Forms 49, 50, 51 and 57, instead of theseparate details for each Personalised Fund required by the ICAS Regulations 1983.

Schedule 6 (Certificates by directors, actuary and auditors)

Three Equitable Directors provide the certification required by Regulation 26(a) of the ICASRegulations 1983. Equitable’s Appointed Actuary provides the certification required byRegulation 26(b) of the ICAS Regulations 1983. As required by Regulation 27 of the ICASRegulations 1983, Equitable’s Auditors provide their opinion that Schedules 1, 3 and 6 of thereturns have been properly prepared.

Schedule 4 (Abstract of valuation report prepared by the Appointed Actuary)

As in previous years, Equitable present two valuations of their long term liabilities (their mainand appendix valuations). The results of the main valuation are carried forward, unadjusted,from Form 58 to Form 14 and on to Form 9.

Schedule 4 – main valuation (text)

Schedule 4 of Equitable’s returns answers the questions set out in paragraphs 1 to 19 ofSchedule 4 to the ICAS Regulations 1983 and includes Forms 55 to 58 and Form 60. Equitablestate that this valuation conforms to Regulation 54 of ICR 1981.

In response to paragraph 3 of Schedule 4, Equitable provide 14 pages of information about theirnon-linked contracts. Most of the information about the contracts remains unchanged fromprevious years.

As in previous years, in paragraph 3(xii) Equitable again disclose that they applied a guaranteedannuity rate to the accumulated cash fund generated by certain types of with-profits pensionpolicies, stating that the guarantees applied to policies issued prior to 1 July 1988.

As in previous years, Equitable provide a description of their principal guarantees of terms.Equitable disclose that recurrent single premium and variable premium deferred annuitypolicies carry guaranteed terms under which future premiums could be paid.

In response to paragraph 4, Equitable provide 35 pages of information about their linkedcontracts. Most of the information about the contracts remains unchanged from the previousyear.

As in previous years, in paragraph 5 Equitable disclose that they have tested the ability of theSociety to hold reserves which satisfy Regulations 54 and 56 to 64 of ICR 1981 in the changedinvestment conditions described in DAA1. Equitable state:

In these conditions the Society would be able to set up reserves which satisfy [Regulations54 and 56 to 64 of ICR 1981] without needing to have recourse to the assets whose currentvalue is shown at line 51 of Form 14 [in Schedule 1] of these Returns. No provision wasmade for any mismatching between the nature (including currency) and term of theassets held and the liabilities valued.

(Note: the entry at line 51 of Form 14 was the excess of the value of admissible assetsrepresenting the long term fund over the amount of those funds and represented thedifference between the market value and book value of those funds.)

Equitable again state that, in determining the provision needed for resilience reserves and taxon unrealised gains, they have taken account of the fact that the long term fund has beenvalued at book value.

In paragraph 5(1)(e), Equitable disclose that a reserve for the prospective liability to tax onunrealised capital gains (losses) is held in respect of policies where benefits are linked to theSociety’s internal funds. Equitable also disclose that the contingent liability for tax onunrealised capital gains in respect of other business is estimated not to exceed £1.2m. Thereturns state that the Society considers that there are sufficient margins in the valuation basisto cover this amount and, accordingly, they hold no specific reserve.

As in previous years, in paragraph 5(1)(f) Equitable state that, in current conditions, they do notconsider it necessary to hold a specific reserve for the guarantee they offer on a unit-linkedannuity.

As in previous years, in paragraph 6(1) Equitable disclose that, for certain non-profit deferredannuities, the valuation rates of interest used were those assumed in the premium basis.Equitable, again, do not elsewhere disclose the rates used in the premium basis.

As in previous years, in paragraph 7(b) Equitable do not explain the method by which they havemade provision in the main valuation for expenses on recurrent single premium business.

As in previous years, at paragraph 7(d) Equitable state:

A further valuation has been undertaken using the net premium valuation method. Thebases employed are in accordance with Regulations 55 to 64 of the Insurance CompaniesRegulations 1981. The resultant aggregate liability is less than the aggregate liability on themethods and bases described in this report. The report on the net premium valuation isgiven in an appendix following Form 60 of this report.

As in previous years, in paragraph 11 Equitable state that they have ‘no business where the rightsof policyholders to participate in profits relates to profits from particular parts of the longterm business fund’.

As in previous years, in response to paragraph 12, Equitable simply state that they distributeprofits in accordance with the principles determined by their Directors and their Articles ofAssociation.

Equitable disclose in paragraph 13 that they had set the reversionary bonus for the main policyclasses at 5.0%, compared with 6.5% in 1991. As in previous years, Equitable disclose that someretirement annuity and individual pension policyholders have been offered loans under a‘loanback’ arrangement.

In response to paragraph 16, Equitable describe their system for determining final bonus.

Schedule 4 – main valuation (forms)

In Form 55, Equitable set out the mathematical reserves held for the various types of non-linkedcontracts, along with information on number of contracts in force, the benefitsguaranteed and the rates of interest and mortality assumptions used in valuing them.

In Form 56, Equitable set out the mathematical reserves held for the various types of linkedcontracts along with information on the number of contracts in force, the value of currentbenefits, the level of benefits guaranteed on death or maturity and the rates of interest andmortality assumptions used in valuing them. Equitable again disclose that they hold reserves fornon-investment options and other guarantees for many of their unit-linked policies.

In Form 58, Equitable set out the valuation result and the composition and distribution of thefund surplus.

Schedule 4 - appendix valuation (text)

Equitable explain that the appendix valuation:

… was undertaken for the purposes of demonstrating that in aggregate the mathematicalreserves determined by the valuation undertaken using the gross premium method, theresults of which are reported on the preceding pages, are not less than an amountcalculated in accordance with Regulations 55 to 64 of the Insurance CompaniesRegulations 1981.

Equitable’s appendix valuation provides the information required by paragraphs 1, 5, 6, 7, 9, 17and 18 of Schedule 4 to ICAS Regulations 1983. They say that the information required for theother paragraphs (apart from paragraph 19 – being a statement of the required minimum marginin the form set out in Form 60 of Schedule 4 which, having had ‘regard to the purpose of thevaluation’, has not been provided) is identical to that given in the main valuation.

As in previous years, in response to paragraph 5(1)(a) Equitable state: ‘In these conditions theSociety would be able to set up reserves which satisfy [Regulations 54 and 56 to 64 of ICR 1981]without needing to have recourse to the assets whose current value is shown at line 51 ofForm 14 [in Schedule 1] of these Returns. No provision was made for any mismatchingbetween the nature (including currency) and term of the assets held and the liabilitiesvalued’.

As in the main valuation, in paragraph 5(1)(f) Equitable state that, in current conditions, they donot consider it necessary to hold a specific reserve for the guarantee they offer on a unit-linkedannuity.

As in previous years, in paragraph 5(1)(g) Equitable disclose the ages that retirement benefitscould be taken on their recurrent single premium with-profits pension business.

Unlike in the main valuation, in paragraph 7(b) Equitable explain the method by which they hadmade provision for future expenses on their recurrent single premium business.

Schedule 4 – appendix valuation (forms)

In the appendix version of Form 55, Equitable set out the mathematical reserves held for thevarious types of non-linked contracts on the appendix valuation basis.

In the appendix version of Form 56, Equitable set out the mathematical reserves held for thevarious types of linked contracts on the appendix valuation basis.

Accompanying the initial scrutiny check are two forms (Form B and Form C1) tabulating key figures disclosed in the 1988 to 1992 returns. GAD also produce a new ‘Form B – Initial Scrutiny Form’. As with the previous version, this includes certain key figures disclosed in the returns.

Equitable’s Chief Executive/Appointed Actuary writes to the Government Actuary following a

The relevant press article quotes the Government Actuary as saying:

The Department of Trade and ourselves are considering sending out a questionnaire to get information on two fronts – what companies say to policyholders when they marketthe contracts, and what their actuaries actually do when deciding on bonus allocationand distribution among their different types of policyholder.

The article also reports:

There are two main areas of concern, says [the Government Actuary]. First, theDepartment of Trade is worried that proprietary companies, those that have outsideshareholders, may be putting the interest of shareholders above those of policyholdersand giving them more than their fair share of company profits …

Second, it will investigate whether marketing pressures may be causing certain groups ofpolicyholders to receive less than they deserve, while other groups may be getting more.

The Government Actuary replies to Equitable’s letter of 05/07/1993. He explains that the

The Government Actuary adds:

In one sense there is nothing new in this, since GAD and the DTI have always taken a closeinterest in policyholders’ reasonable expectations. Indeed, this has been the central issuein many Section 49 Transfers [i.e. transfers of the whole or part of a company’s long termbusiness], in the setting up of sub-funds, in changes to the proportion of surplus going toshareholders and in a number of other areas.We have been signalling for some time thatasset share calculations would be one of the aspects on which we would seek to focusduring the next round of company visits. On top of this, there have been particularpressures on companies because of falling investment returns and some evidence thatproprietary companies are under more than usual pressure to demonstrate value toshareholders. These and other factors pointed to the need to focus on this area and forDTI to be seen to be doing something positive to indicate that it has policyholders’reasonable expectations very much in mind.

The Government Actuary concludes by saying:

It is certainly no part of our remit to weaken confidence in the industry, but we do wantto ensure that policyholders’ reasonable expectations are given their due place in thethinking of all life offices, and not just the best ones. In my view a debate on these issuescan only be a healthy thing.

Lastly, I should reassure you that there is no intention of making any fundamentalchanges to the style of supervision. As I have already mentioned, PRE has always playedan important part in the thinking of DTI and GAD and will continue to do so.We are keento ensure that best practice prevails but have no intention of introducing statutoryregulation on bonus rates.

The Department has an ongoing responsibility to keep itself informed of developmentswithin the life insurance industry, and a particular responsibility to protect policyholders’reasonable expectations. In this context we wish to gain a clearer picture of currentindustry practice in respect of bonus methodology.

We have therefore asked the Government Actuary’s Department to conduct a survey ofleading UK offices which write with-profits business, in order to obtain more detailedinformation about companies’ bonus philosophies, and the actuarial techniques used inassessing bonus payments.

DTI enclose a letter from GAD to Appointed Actuaries, giving more detail on the survey andattaching the questionnaire. In that letter, GAD explain:

As I am sure you are aware, there is a growing debate within the life insurance industryover the most appropriate method for determining the distribution of surpluses arising inthe long-term funds of with-profit offices. Actuaries have introduced some newmethodologies for assessing bonuses including the technique known as “asset shares”,although there is no clearly accepted definition of how these asset shares are calculated,and the art or science of asset shares is still not fully developed in actuarial literature.Moreover, there is no information available in the DTI returns about how appropriaterates of bonus are assessed.

GAD continue:

Accordingly, we have decided to conduct a survey of leading U.K. offices transacting with-profitsbusiness to ascertain how they determine and distribute surplus arising in their long-term funds for policies becoming payable on surrender, death or maturity. Thissurvey is intended to obtain more detailed information about companies bonusphilosophies and the actuarial techniques applied in the assessment of appropriate finalor terminal bonuses to be paid on (non-group) with-profit policies than is availableelsewhere.

The survey is sub-divided into two broad headings, (i) the content of current marketingliterature, combined with information on the principles of distribution in the constitutionof the company and (ii) the company’s actual methodology in respect of thedetermination of appropriate levels of final or terminal bonus payable on with-profitpolicies.

Within the first heading, we are seeking information about references in currentmarketing literature, including those contained in offices’ with-profit guides, to a numberof specific aspects regarding the allocation of surplus to policyholders. For the purpose ofthis section of the survey, we are asking by way of example about references in anyspecific or general marketing literature and product particulars in respect of the currentseries of endowment assurance contracts. However, if there have been recent changes ofsignificance in your marketing literature to references to the allocation of surplusbetween policyholders and shareholders, we would be grateful if you would draw this toour attention by suitable responses to the relevant questions, as we would also ifdifferent principles are applied for other classes of with-profits policies (bothconventional and unitised, if appropriate).

Under the second heading of the survey, we have asked a number of questions about themethods and rationale by which rates of final or terminal bonus are assessed forendowment assurance contracts (though, again, additional information should beprovided if differences of approach apply to other contracts).We have included somespecific questions about the methods of determination and allocation of surplus arisingfrom various potential sources.

GAD also state that they ‘would not wish to rule out the possibility of publication of asummary of the results, though, if we did so, we would ensure that the responses ofindividual participating offices could not be identified’.

Equitable write to GAD enclosing their completed questionnaire for the with-profits survey.Within their responses to part (i) of GAD’s survey (about marketing literature and principles ofdistribution), Equitable say that their Articles of Association give:

… the Society’s Directors absolute discretion as to bonus allocations. Beyond that, there isno statement of bonus philosophy in the Society’s constitution.

… The main statement of the Society’s long-standing philosophy on bonus distribution inmarketing literature is contained in … the With Profits Guide …

The Society explains further that their With-Profits Guides give no specific information on theperiod and magnitude of smoothing or the likely frequency of changes to final bonus rates.However, general comments in the Guide could be expected to lead policyholders to expectrelatively infrequent changes to the latter.

Equitable enclose copies of their Articles of Association, their with-profits Guide (dated May1993), product particulars for endowment assurances (dated March 1993) and for personalpensions (dated October 1992), and the current version of their leaflet on bonuses (dated May1993).

Equitable provide the detailed information sought in part (ii) of GAD’s survey (about actualmethodology for determining final or terminal bonuses). Equitable explain in particular:

• that, for surrenders, ‘the full policy value (including final bonus) is normally adjustedto ensure that the surrender value paid does not exceed the underlying asset share.The level of adjustment required is monitored monthly’;
• that, when determining the annual expense level attributed to with-profits contractsfor recurrent single premium business, ‘allowance is made for an implicit fund chargeof ½% pa. That is, the gross rate of accumulation … is taken to be ½% pa higher forconventional contracts, such as endowment assurances, than for recurrent singlepremium contracts’;
• that, when assessing appropriate final or terminal bonuses, Equitable make noallowance for a charge for the guarantee provided in respect of benefits payable onmaturity or for a contribution to an ‘estate’;
• that Equitable do not discriminate between different contracts in their smoothingprocess;
• that the smoothing of final or terminal bonuses ‘is determined by the relationshipbetween the accumulation rates determined each year and actual investmentearnings. That smoothing is also reflected in the comparison of the aggregate totalpolicy values with actual asset values. In normal circumstances the Directors look toapply a 3 to 5 year averaging cycle but expect to apply that more flexibly in moreunusual circumstances’; and
• that, when valuing their assets for the above comparison, ‘allowance is made for theaccumulated new business strains which will be recouped from future premiumloadings’.

Equitable add: ‘Part of the Society’s stated philosophy is to achieve a reasonable degree ofstability in proceeds with gradual, rather than sudden, changes in proceeds. The approach tosmoothing needs to reflect that philosophy, particularly in volatile investment conditions’.

DTI’s Line Manager B writes again to an Equitable policyholder (see 23/07/1993 [entry 2]). He explains that: ‘The Secretary of State does have extensive powers to intervene in the affairs of insurance companies if, in his opinion, this is necessary to protect the reasonable expectations of policyholders’. However, the Line Manager says that he does not consider on this occasion that it would be appropriate to use these powers, as ‘Equitable appear to have taken the view that equity amongst all policyholders is best served by setting final bonus rates which are very similar (in terms of % per year of policy term) for policies of all terms’.

Line Manager B continues that he ‘would be very surprised if this turned out to be anunreasonable approach’ and that ‘it is very much in line with the approach taken by themarket generally’. Line Manager B suggests that the policyholder may wish to pursue thematter with the Insurance Ombudsman and he provides their details.

The Directing Actuary concludes by saying:

Finally, and very importantly, free asset ratios as published in the DTI returns reflect thereserving basis used by the actuary in determining the company’s liabilities. The ratiosshown in the tables, therefore, do not take account of the varying strengths in thosereserves, and some caution should be expressed when using them to indicate the relativefinancial strengths of companies.

… a significant attraction to policyholders in having access to an interest paying deposittype contract – and I would certainly rather give our members fatter returns rather thanfund managers generally. The ensuing strengthening of the balance sheet would be auseful by product.

The Appointed Actuary asks if DTI would be willing to support an application for a section 68Order.

I leave it to your judgement as to how precisely to define “significant”, but for non-lifecompanies I am thinking of at least a five percentage point deterioration, and for life atleast two or three. Clearly “significance” becomes greater if the company is actually closeto the minimum required margin (or double it for non-life).

The Director says that he is not concerned for this purpose with:

• companies that are already on our lists of companies causing concern;
• subsidiaries in groups where group accounting concessions operate, unless there areparticular problems in a group you want to draw to my attention;
• very small companies which are not of commercial or regulatory significance.

with their comments, to DTI for them to reply.

A DTI official (and former Line Manager with responsibility for Equitable (Line Manager A))writes to the Head of Life Insurance with the results of the exercise to establish whichcompanies had shown a significant deterioration in their 1992 solvency cover compared with1991. (See 24/09/1993.)

The official attaches a list of companies supervised and explains that slightly less than half haveexperienced a reduction in their solvency margin. He suggests that the Director of Insurance’scriteria for identifying companies should be modified to exclude:

1. companies in “intensive care”. These are slightly different from those we report as“causing concern”. Rather they are the companies which we recognise as weak or ashaving special problems, but which we do not actually report to the Minister, mainlybecause they have managed to struggle on over a number of years, mainly on thestrength of “drip fed” capital. Reporting that they are in difficulties would be misleading.We nevertheless regard them as high priority and are in regular touch. Such companiesare [five named companies] and many others. Almost all fall into [the Director ofInsurance’s] third category – small without much commercial significance (although theirregulatory significance is high); and
2. managed pension fund subsidiaries; these cause few problems. The business they doresults in very little financial strain and they can, in fact, survive on very thin margins.

Using this modified criteria and GAD’s note of 16/08/1993, the official highlights 16 companieswhich ‘we should be paying special attention to in the remainder of 1993 and 1994’. This listincludes Equitable, with a note that they are one of eleven companies ‘from [Directing ActuaryA’s] free asset ratio list’, but also one of four from this list which have shown a markedimprovement in terms of solvency.

The official draws attention to Directing Actuary A’s ‘disclaimer about the various reservingbases used by different actuaries making it difficult to compare the strength of one officewith another’.

As the rate of interest would presumably need to be fairly high, perhaps above themarket rate, how would the issue of these deposits benefit the security and, moreimportantly, the reasonable expectations of members generally?

DTI conclude by saying:

Our view is that it would be particularly important that the rights of the [depositors]should be subordinated to those of the with-profits policyholders in respect of theirreasonable expectations to future bonuses, not just their guaranteed benefits, and thatthis was clearly understood by the [depositors].

GAD write to Equitable’s Appointed Actuary. GAD refer to the very useful series of discussionson the effect of market conditions on life insurers which they have held with a number ofAppointed Actuaries towards the end of 1992 (see 15/09/1992). GAD seek a further meetingwith Equitable to take account of any developments over the last year. GAD set out thematters they wish to pursue under four main topics:

Financial position – saying GAD wish to discuss both the current and projected position. GADask for a copy, prior to the meeting, of any relevant report or business plan.

Bonus policy – saying GAD wish to confirm their understanding of how Equitable set theirannual reversionary bonus rates and the investment return required to support current bonusrates; to discuss the likely bonuses for 1993 and their sustainability over the next few years inthe event of low rates of investment return; and to obtain information about the relationshipof current payouts to asset shares and the period over which it is intended to smooth thesepayouts. GAD add that they may wish to clarify some points from Equitable’s response to thewith-profits survey.

Investment policy – saying GAD wish to discuss what rates of return Equitable are assuming fortheir projections and bonus policy.

Resilience reserves – saying GAD wish to discuss the potential effect of the modifications tothe resilience test, as set out in the Government Actuary’s letter of 30/09/1993.

The meeting takes place on 30/11/1993 (see entry below).

Equitable’s Appointed Actuary provides GAD with some background documents ahead of themeeting on 30/11/1993. Those documents are in five categories, being:

1) Standard & Poor’s insurance rating analysis for Equitable dated November 1993

The rating given is ‘AA (Excellent)’, which is explained as: ‘Insurers rated “AA” offer excellentfinancial security. Capacity to meet policyholder obligations is strong under a variety ofeconomic and underwriting conditions’.

The rationale for the rating includes that:

On the basis of its published valuation, ELAS appears to have relatively weak free assetand investment leverage ratios: 2%-5% (since 1990) and above 920%, respectively.However, free assets are understated by the use of a very conservative valuation basis.Adjusted to a more conventional reserving basis, the free asset ratio is much stronger,near 10% in 1992, with investment leverage at a much more moderate level around 480%.[Standard & Poor’s] expects these levels of strength to continue.

It continues:

Because of substantial holdings of equity assets, high profit distribution to policyholders,and mutual status, ELAS’s free asset base appears slightly more susceptible to sharpinvestment or economic fluctuations than some peers. However, [Standard & Poor’s]believes this apparent susceptibility is balanced by ELAS’s existing capital strength, limitedsales of products with significant reserving strain, and the ability to maintain afavourable balance between policyholder reversionary and terminal bonuses.

Under the heading ‘Management and Corporate Strategy’, the report says:

The Society minimizes any cross-subsidy of one group of policies by another. Itscommitment to fairness has led to a high level of distribution and a strict limitation onany retention of today’s policyholder profits for the security of future policyholders. Thisimplies a lower level of published free assets than some competitors, though [Standard &Poor’s] notes the use of a relatively strong valuation basis that significantly understatesthe level of the Society’s free assets compared with other major U.K. offices.

Under the heading ‘Capitalisation’, and in relation to Equitable’s main valuation presented intheir regulatory returns, the analysis says:

… on the basis of the published valuation, which uses a gross premium basis, ELAS had amodest free asset ratio at December 1992 of 5.1% [and a] ratio of availableasset/minimum required margin of 236.5% …

The analysis goes on to say that Equitable’s main valuation basis:

… understates the level of the Society’s free assets, and that underlying financial strengthis considerably stronger than published figures suggest.

The analysis explains that the reason for this view is because:

Using an appropriate alternative net premium valuation for year-end 1992, ELAS wouldhave a much stronger free asset ratio of about 10% [and] ratio of availableassets/minimum margin near 340% …

2) Monthly business statistics for the period ending 31 October 1993 (presented to theEquitable Board on 25 November 1993)

These monthly business statistics comprise of seven reports, being:

•  Revenue Analysis – Global Business
• The Equitable Life Assurance Society Balance Sheet
• “Equitable Management Company” – Global Business Profit & Loss Account
• “Equitable Management Company” – Non UK Business Profit & Loss Account
• Investment of net addition to fund
• UK with profits investment performance
• UK Linked business investment performance.

3) Paper entitled ‘Bonus Declaration at 31 December 1993’ (presented to the Equitable Board on25 November 1993)

The paper says that earnings on the with-profits fund are expected to be high at around 20 to25%. However, it says that, due to the fall in interest rates, some of the return is spurious, and:‘If we took, as a board measure of the intrinsic return on assets for 1993, a weighted mix ofthe overall equity returns and the income yield only on fixed interest, the outcome would bea return of around 17%’. The paper then advises that:

The relatively high level of nominal earnings in 1993, coupled with some relaxation on theregulatory side, as described in the quarterly review of revenue considered last month,means that, virtually irrespective of the bonus decisions taken this year, our publishedposition at 31 December 1993 will be significantly “stronger” than last year. Thepresentational implications of our decisions are therefore much less important than hasbeen the case in recent years. This year we can focus predominantly on fundamentals informulating decisions and that is to be welcomed.

Under the heading ‘Total policy values’, the paper says:

For our main classes of business, total policy values and, hence, final bonuses, aredetermined by rolling forward the value at the end of the previous year, together withsubsequent premiums, at a “total growth rate”. The key decision which the board needsto take regarding bonuses is the level of that total growth rate which then needs breakingup into declared and final bonus rates. The determination of appropriate bonus rates forother products is essentially a technical exercise.

For 1990 and 1991 the total growth rate was 12% p.a. For 1992 a rate of 10% was applied tothe benefits in force at the start of the year and 12% to premiums applied within the yeari.e. for new money. That was in reflection of the relatively high earnings in 1992 and theneed, on the older business, to recover part of the over-distribution in respect of 1990.Policy pay-outs are currently being determined by rolling forward 31 December 1992values, together with subsequent premiums, at 10% p.a.

It continues:

For 1993 we need to decide what is the appropriate rate or rates in the light of theearnings position described … above. An intrinsic return comparable to that earned in1992 would indicate that similar total growth rates are appropriate – i.e. around 12% p.a.we also need to bear in mind that total policy values are still above the value of theunderlying assets. To some extent 1993 might be regarded as the converse of 1990.Allocation of a relatively modest rate of around 12% when “usable” earnings are about17% will restore a position of balance between assets and policy values. If earnings infuture years are at relatively low levels the opportunity for such action may not recur forsome time.

4) Paper entitled ‘Revenue – Review of First 9 Months’ (presented to the Equitable Board on27 October 1993)

The paper sets out the premium and investment income received and the payments made topolicyholders.

Under the heading ‘Earnings and solvency position’, the paper says that the earnings on thewith-profits fund for the first nine months of 1993 is 17.3%. The paper then explains that:

The relatively high earnings level to date has been associated with corresponding falls inincome yields on both fixed interest securities and equities. The board are reminded that,in solvency terms, the effect of high earnings can be offset by the effects of thecorresponding reduction in the income yield on the assets. As income yields fall, thediscount rate which can be used in valuing the liabilities also falls. Purely on technicalgrounds, therefore, the liability valuation can grow as the capital values of the assets rise.

As discussed on previous occasions, the statutory minimum basis for liability reserves islaid down in regulations. These regulations have been supplemented by informalrequirements specified by the Government Actuary. Although those requirements are notmandatory, most offices, including the Society, have chosen to set reserves at a levelwhich meant the informal requirements were satisfied. That is, the requirements have ledto an effective minimum basis somewhat stronger than the bare statutory minimum.That is the basis on which we have discussed “Form 9” presentations. The GovernmentActuary has recently announced a modification to those requirements in the face of ageneral view that the original requirements were unduly stringent in current investmentconditions.

The paper continues:

As mentioned above, these additional requirements are not mandatory and [theAppointed Actuary] may consider it appropriate either to challenge the requirements asinappropriate or set a basis somewhat stronger than that indicated by the requirements.To paint a picture of the range of outcomes the estimated “Form 9” position is shownbelow on 3 different bases – the valuation basis used at 31.12.92, the minimum indicatedby the new requirements, and the traditional “premium basis” valuation used in 1989 andearlier years. The actual 31.12.92 position is also shown for comparison:

(a) excluding accrued declared bonus

(b) including cost of declared bonus

Continued use of the 31.12.92 basis is probably not tenable in view of the reduction inyields this year. If [the Appointed Actuary] considered that use of a basis of similarstrength to that indicated by current guidelines was appropriate, then that represents apoint broadly mid-way between the 31.12.92 and 31.12.89 bases. At this level our published“strength” would be substantially greater than at 31.12.92. The figures indicate that a moveback to our traditional basis is now possible but might result in an unacceptably “weak”published position at this stage. It should, however, be remembered that there is a hiddenmargin in the inadmissible assets. If either we sold the FTSE option before the year end orobtained a dispensation allowing us to bring it into account, some £60-70m would beadded to the DTI value of assets and, consequently, the “free” assets.

5) Paper entitled ‘Cost Management and Control – Report on the First Nine Months’(presented to the Equitable Board on 27 October 1993)

The paper comments on the accounts of the Equitable Management Company.

The Scrutinising Actuary notes that the meeting first discussed the likely bonus at the end of1993 and that the Appointed Actuary had reported a further reduction in the declared rate ofat least 1% leading to a bonus rate of 4% or less. This would need 7.5% to support, which approximated to the return on the gilt portfolio. The Scrutinising Actuary notes that theAppointed Actuary had said that he was expecting this to eliminate the recent excess ofpayouts over asset shares and that future bonuses would depend primarily on the returnsearned on future premiums. The Scrutinising Actuary comments that this indicated possiblefurther reductions and that Equitable ‘appeared to be moving to a lower proportion of thetotal bonus payout being guaranteed (i.e. declared as distinct from terminal)’.

Scrutinising Actuary C records that the meeting then turned to valuation issues and that theAppointed Actuary had indicated that the position at the end of 1993 would be significantlystronger than at the end of 1992, and that the new business strain expected in 1993 was onlyapproximately £25m. GAD’s note continues:

There was a discussion on the resilience test and [the Appointed Actuary] commentedthat as markets were currently moving the new tests were becoming tighter. Pensionsbusiness has a guaranteed annuity rate at about 7% but this was not as onerous as itappeared since, because “old” policies had been given the benefit of more modernfeatures and options, it would be reasonable (in his view) for the allocation of final bonusto be conditional on the waiving of this guarantee. [Chief Actuary C] asked particularlyabout the resilience test in the context of the net premium valuation described in theAppendix to Schedule 4, since it was not explicitly mentioned there; [the AppointedActuary] was sure that resilience had been allowed for, but promised to investigate andconfirm.

Scrutinising Actuary C notes that, in conclusion, the meeting had discussed investment policyand that the Appointed Actuary had explained that Equitable’s investment decisions were ‘aresult of the judgement of the investment team and not driven by resilience concerns’. At themeeting Equitable undertake to provide GAD with some further papers (see 07/04/1994).

DTI’s copies of the papers Equitable provided to GAD prior to the meeting contain annotationsmade by Line Supervisor B at the meeting.

On the Board paper entitled ‘Cost Management and Control – Report on the First NineMonths’, Line Supervisor B notes:

Solvency position will be tightening. Guarantees – don’t reserve for them …We have noguarantees that bite. [Chief Actuary C]: PRE?

On the Board paper headed ‘Revenue – Review of First 9 Months’, Line Supervisor B notes thatthe current GAD minimum basis incorporates the resilience reserve.

On the Board paper headed ‘Bonus Declaration at 31 December 1993’, Line Supervisor B notesthat Equitable are likely to declare a reversionary bonus rate for 1993 of around 4% and that‘GAD said they’d be happy with [this]’.

These calculations include, for the estimated annual profits, that:

Average annual profit = 1207.9/5 = £241.5m

Notes: (a) Surplus was increased by £557.0m as a result of changes in valuation basesduring 1990.

(b) Surplus was reduced by £13.2m as a result of changes in valuation basesduring 1991.

(c) Surplus was reduced by £89.4m as a result of changes in valuation basesduring 1992.

The calculations state that the average period to run for the Society’s in-force contracts is eightyears. The Society’s Appointed Actuary explains:

The periods to run have been reduced to take account of premature withdrawals basedon the Society’s recent experience of such withdrawals. In respect of retirement annuityand personal pension contracts for which a range of retirement ages is available, it hasbeen assumed that retirement benefits are taken at the lowest possible age, orimmediately if that age has already been attained.

The calculations suggest that the maximum future profits permissible is 50% of £241.5mmultiplied by eight years – that being £966m.

DTI ask GAD for their views on Equitable’s application for a section 68 Order.

GAD provide DTI with comments on the application made on 03/12/1993. GAD say that it is Equitable’s regular practice:

… to apply for such an Order shortly before the year end as a precautionary measure. So far as I can see they have never used it, and are most unlikely to do so as at 31 December 1993, but no doubt they feel that it is a useful protection against adverse market movements (for example) right at the end of the year. As usual the amount of the implicit item sought is well below the maximum allowed by the Regulations; on this occasion it is under half that maximum.

We suggest that you issue the Order in the usual way.

assessment of their potential liability to compensation claims from policyholders who had

received inappropriate advice about transfer or opt-out from occupational pension schemes.

DTI seek in particular:

• the best available indication of the total policies sold since 1988;
• the percentages obtained through a direct sales force, independent financial advisersand appointed representatives;
• the percentages of business represented by both transfers and opt-outs fromoccupational schemes; and
• the best provisional estimate of the potential cost of compensation.