1996

GAD provide DTI with their detailed scrutiny report on the Society’s 1994 regulatory  returns. (A copy of this scrutiny report is reproduced in full within Part 4 of this report.) The report uses the detailed format adopted for the 1993 returns (see 15/11/1994 [entry 1]) and comprises 13 sections as follows:

(1) Summary

Under ‘Key features’, GAD state that Equitable are the seventh largest company, measured in terms of long term business. GAD explain that Equitable are classified as priority 3, unchanged from the previous year. They note that: ‘Rather unusually, especially since the recent disappearance of [another mutual company], the company publishes a gross premium bonus reserve valuation, and a net premium comparison’. GAD also note that Equitable have used a ‘small’ future profits implicit item for the first time; that their pensions business ‘is somewhat unusually structured in that it is almost all on a recurrent single premium basis’; and that ‘reserving bases are weak, by design, to maximise the free asset ratio. Nonetheless, this has fallen in 1994’.

Under ‘Action points’, GAD note that they had derived much useful information the previous year from Equitable’s With-Profits Guide. However, as GAD only have the May 1994 edition, they have requested a later version. (Note: GAD had previously asked Equitable to send this document routinely, and Equitable had agreed to do so: see 28/03 and 07/04/1994). GAD state that they ‘have also raised a number of areas of greater or lesser concern, pre-eminent amongst which are mortality bases for annuitants and interest rates used in the valuation’.

(2) Background

GAD repeat information included in the Background section of their report on the 1993 returns, namely that Equitable are the oldest mutual life assurance society in the world, that they never pay commission to third parties, and that they have a:

… somewhat unusual approach to bonuses, unit linked products (which often have discretionary surrender values) and valuation using a gross premium bonus reserve method. The DTI returns also show the results of applying a net premium basis with assumptions close to the minimum permitted by the regulations.

GAD note that, as well as using a future profits implicit item for the first time in 1994 to the value of £250m, Equitable have obtained a section 68 Order in the sum of £500m for use in the 1995 returns.

GAD explain that Equitable have been active overseas in recent years (in Guernsey, the Republic of Ireland and Germany) and that these branches are producing ever increasing amounts of new business. GAD state:

The impression we have been given is that the Equitable regard this as an exercise in extending the numbers of people who can benefit from the Society as an institution. It is almost like missionary work, rather than a purely commercial move in the interests of UK policyholders, for example. The mutual concept is extended to all policyholders, and indeed is even part of Equitable’s dealing with UK non profit policyholders.

GAD also note that they and DTI visited Equitable in December 1994 (see 09/12/1994 [entry 2]) and that: ‘The Appointed Actuary and Managing Director posts are both held by [the same person], who is due to retire within a few years (though it is dangerous to speculate exactly when!)’.

(3) New business

GAD provide details of the new products Equitable have developed and produce two tables setting out the regular and single premiums which Equitable have received for the various classes of policies sold from 1990 to 1994. GAD produce a third table, showing the year on year increase in new business over the same period.

In a commentary on the figures, GAD state that ‘new business results for Equitable are once again strong’ and ‘[there] will have been a material strain in 1994 associated with the new business, especially in a year of declining market values of assets’. GAD explain that the sales figures are ‘somewhat strange, however, in that a great volume of pension business is regarded as recurrent single premium. This is reported in the year of issue as regular premium, in accordance with the guidance notes, but it does not appear in form 43 [of the returns] as regular premium’.

GAD add:

The annual report on the industry showed Equitable as one of the success stories of 1994. It was ranked only 27th for new life business, but was 1st in pensions and 3rd in the combined table. In terms of growth, it ranked 8th, and was the top mutual office. It held the same place over the period 1989 to 1994 …

(4) Changes in business in force

GAD produce a table showing the recent history of regular premiums. They comment that there has been a continued rise in regular premiums, which is helpful in keeping the expense ratio low. GAD note that this is ‘clearly a virtuous circle’.

Under ‘Claims experience’, GAD produce a table showing the recent history of mortality rates. They comment:

It is not possible from the DTI return to form any view on the mortality experience of annuitants. This was the subject of correspondence with the company in recent times, partly prompted by an enquiry from the BAV on the business being written in Germany. We are returning to this issue again in the light of recently published data.

Under ‘Persistency experience’, GAD produce tables showing lapse rates and surrender and paid up conversion rates.

(5) Expenses

GAD produce a table showing the history of expenses from 1990 to 1994. GAD comment that Equitable again compare very well with the industry as a whole and that their expense ratios have now reached ‘astonishingly low levels’. GAD explain:

Equitable is well known as a non-commission paying office, and prides itself in its low expense ratio. It is a very positive marketing message, and a key attraction of the Society with its customers. It helps explain the positive sales figures in a poor time for most of its competitors, and [is] part of a virtuous circle.

(6) Non-linked assets

GAD produce tables showing Equitable’s mix of assets at the year end, their recent history of allocation of new money (based on Equitable’s own figures), their recent history of yields, and the assets attributable to with-profits business (Note: this was said to be taken from Equitable’s ‘latest available’ With-Profits Guide, although the later guide, dated July 1995, was available at that time). They comment again that the most noteworthy feature of the latter is the shift towards a higher fixed interest component. They calculate from information contained in the returns that the rate of return from investment for 1994 was -5.0%. Against this, GAD note Equitable’s own figure for the return on the with-profits fund of -4.2%.

(7) Unit-linked funds

GAD provide brief details of this class of business.

(8) Valuation and solvency

Under ‘Strengths and/or weaknesses’, GAD first provide an overview:

It is known from the company visit at the end of 1994 that Equitable’s Actuary has decided that the interests of the Society are best served by using a weak valuation basis to show as strong a free asset position as is possible. This means that the valuation basis is selected at the limits of the regulations. This requires us to exercise particular vigilance in ensuring that users of the returns are not misled. Additionally, the Equitable has a full distribution policy. Although one should not, perhaps, be critical of this per se, it does mean that the Society is more vulnerable than many to adverse conditions. The low free asset ratio means that there is comparatively little to spare if the reserves do prove inadequate.

There are, however, a number of hidden strengths in the valuation. Principal amongst these is the treatment of recurrent single premium pensions business. This is assumed to pay no more premiums, and this is an extremely strong basis, though arguably only in line with the best practice. If the business were treated as regular premium, margins in future premiums and charges on the funds built up might allow some lower reserves. It is likely that some credit is being taken implicitly for this in the expense reserves …

GAD go on to discuss four particular areas:

Mortality — GAD explain that they are satisfied with the bases used for Assurances, Annuities — pension, and German business. For Annuities — general, GAD explain that Equitable use a mortality table ‘well in excess of recent industry experience, and although the Appointed Actuary claimed to be able to justify this last year, we are pressing him quite vigorously on this point this year’.

Valuation rates of interest — GAD produce tables showing the interest rates used for major classes and compare those with assets and yields. The scrutiny report is as follows:

The following table summarises the interest rates used, in general terms, for major classes (with liabilities in excess of £50m).

* grossed up at 20% tax for with profit assurances and 25% for non profit assurances.

Comparing this table with the assets and yields as below, gives rise to some doubts as to the sufficiency of higher yielding assets, particularly [once] a yield differential for risk is included.

It is far from clear how this asset yield pattern will allow such a high rate of interest for the with profits business, if the non profit business takes the highest yielding assets to support its valuation rate. We are therefore seeking a thorough matching rectangle in the format under the proposed new Accounts and Statements regulations.

Expenses – GAD state that these are well controlled and falling and that ‘There is little reason to question the low expense allowances in the valuation, therefore. A substantial hidden margin in respect of the pensions recurrent single premium business covers any apparent shortfall’.

Resilience and special reserves – GAD explain:

The Equitable takes advantage of its use of a bonus reserve gross premium valuation to hide its resilience reserve. The difference between the net premium valuation and the gross premium valuation results is its resilience reserve (or at least a substantial part of that difference). They do not disclose how much. This will be asked for yet again. Other reserves seem to be on a reasonable basis.

Under ‘Changes since previous year’, GAD note that Equitable made small amendments to the reserves held for future bonuses under the net premium basis and that interest rate bases were revised to absorb some of the effect of rising interest rates and falling asset values. They note: ‘Pension annuitant mortality was strengthened from a very weak basis to an acceptable one. The old basis would not, given recent publications, have continued to be defensible’.

Under ‘Summary of results for main classes’, GAD provide three tables showing liabilities for linked and non-linked business and a valuation summary. The latter covers the years 1992, 1993 and 1994 and includes figures from both the main and appendix valuations. For 1994, this information is presented as follows:

‡ The amount of resilience reserve is not known for 1994. It is possibly sufficient to make the difference between the [bonus reserve valuation] and [net premium valuation] zero, but we have no way of telling until the answer to our enquiry is received.

GAD’s table shows that, under the bonus reserve valuation, Equitable’s free asset ratio had fallen from 9.4% in 1993 to 3.1% in 1994.

Under ‘Cover for the solvency margin’, GAD comment:

It is not possible at present to calculate the net premium basis cover for the required minimum margin, but the gross premium cover is stated as higher. The cover with the implicit item included amounts to 2.36x, and if the implicit item had not been included it would have been 1.85x. The market reaction to the free assets falling to the level shown in our table (3.12%) as opposed to the free asset ratio often used including the implicit item (4.97%) might have been similar to that when [another mutual life company] revealed a low figure. Note that the section 68 order actually allowed an item up to £500m.

The cover may not be huge, but it is adequate, provided the Appointed Actuary can satisfactorily defend his basis from the questions we have raised.

(Note: the returns stated that the mathematical reserves established using the gross premium valuation method as presented in the main body of Schedule 4 of the returns were at least as high as would be required when using an appropriate valuation method. The returns did not state that the cover for the required minimum margin under the gross premium valuation was higher.)

(9) Financial results

This section is made up of the following table:

Surplus emerging

(10) Bonuses

Under ‘Cost of bonuses declared’, GAD include the following table:

GAD repeat the description of Equitable’s final bonus system used in their report on the 1993 returns (see 15/11/1994 [entry 1]). GAD also repeat Equitable’s own description of their final bonus system and again provide three tables of statistics showing changes in reversionary and final bonus rates. GAD reproduce Equitable’s table of the actual investment returns on gross market value and the rate allocated in fixing bonuses, updated to include 1994:

‘* 12% on new benefits secured during the year

† figures from annual report, not With-Profits Guide’

GAD repeat their comments on Equitable’s distribution policy made in their report on the 1993 returns (see 15/11/1994 [entry 1]), stating again that the reductions in reversionary bonus rates over recent years have influenced policyholders’ reasonable expectations downwards in line with yields.

(11) Reinsurance

GAD state that Equitable make little use of reassurance.

(12) Compliance

GAD state:

Although the Equitable take a highly esoteric line on a number of issues, and are inclined to argue their case rather longer than most, they have a culture which would not permit the continuation of a compliance breach.

There are some small omissions from Schedule 4 relating to a new fund and question 4(2)(c) [of Schedule 4 of the returns]. These are not all mentioned in our letter, and we do not feel they are of sufficient significance for DTI action, especially as elsewhere the actuary does provide the information on derivatives (under 4(2)(a)).

They are reporting business believed by us and DTI to be class IV as class III, but have undertaken to revise this in future. This will have trivially understated the required minimum margin.

Under ‘PIA and other compliance problems’ GAD note that: ‘Although they have had a few issues, we understand, they are not significant’.

(13) Miscellaneous

On mis-selling of pensions, GAD comment:

It looks from the outside as if it is almost impossible for Equitable to conceive that any of their salesmen could have mis-sold anything – or at least they could not publicly acknowledge it! There is no explicit provision, but we understand from Equitable’s reply to [DTI’s] letter [see 19/04/1995] that £50m has been set aside by an “over-estimation” of the liabilities, and this has been accepted under the “true and fair view” accounts sign-off, despite the lack of any sophisticated supporting calculations.

GAD also explain that they have asked Equitable about the Society’s use of derivatives (see 08/12/1995) as this was quite high. (Note: but see Equitable’s reply of 14/12/1995.)

Finally, GAD comment that Equitable were probably the first insurance company to publish their accounts in the new statutory form. GAD note:

Deferred acquisition costs of £219.1m are shown in the accounts. These are not, of course, admissible in the DTI return. It is a matter of debate how meaningful these deferred acquisition costs are in any life assurer, and here less than 60% of acquisition costs are deferred. The total figure represents almost 19% of the “Fund for Future Appropriations” in Equitable Life.

GAD’s scrutiny report runs to 20 pages. DTI’s Line Supervisor B copies the report to the Head of Life Insurance and to Line Manager B.

GAD write to Equitable with questions from their scrutiny of the 1994 returns. GAD:

(1) ask for a copy of the current With-Profits Guide and request that Equitable send a further copy whenever the document is updated;

(2) challenge the mortality tables used by Equitable which GAD consider to be over-optimistic. GAD also ask Equitable to ‘indicate how you feel the future improvement in annuitant mortality is catered for in this choice of basis, and what margins you believe are included for adverse deviations’;

(3) seek additional information, in the form of a matching rectangle, to support the rates of interest used in the alternative net premium valuation contained in the appendix to Schedule 4 of the returns (and enclose a copy of a draft form for the presentation of the results);

(4) ask, in relation to the net premium valuation, ‘what would be the increased reserves on that basis if explicit provision were made for the resilience test referred to [in the returns]’; and

(5) say that they were ‘unable to find a description of the Ethical Fund in accordance with the regulations’.

GAD write to DTI with comments on the papers relating to Equitable’s application of a market value adjustment to policy transfers (see 18/12/1995). GAD point out that Equitable apply a market value adjustment for transfers, but unlike some other companies do not do this for retirements, even when they are not on the originally selected date. GAD note:

This is more generous therefore, but it does mean that transfers, which do suffer an MVA if one is generally applicable, look less generous than retirements. The justification for this is that retirement is not normally selected just for market conditions, but transfer can be.

    If you try to justify Equitable’s stance from rights of transferring policyholders against those of retiring policyholders, it looks unfair and even unreasonably protectionist. However, it would be impossible to allow unfettered unadjusted transfer, and therefore the only way to avoid this comparison being less than happy would be to level down — that is to remove the freedom from MVA (from future policies) on retirements other than on a fixed date. That would diminish the rights of the majority, and is not, I feel, a line which DTI would wish to take.     

DTI note on this that there is no need to write again to Equitable.

Equitable write to GAD in reply to their letter of 23/01/1996 about the 1994 returns.

Equitable:

(1) enclose a copy of their current With-Profits Guide (dated July 1995) and state that GAD will be sent future updates;

(2) provide information about the mortality basis used in the valuation, and explain that Equitable would be strengthening the basis for the 1995 returns;

(3) comment that, were they to follow literally the instructions on the form for presenting information on rates of interest in the net premium valuation, Equitable would have to complete around 30 forms in all. Equitable state that they have put their internal records into the format of the draft forms ‘which involves net and gross business on the same basis (apart from tax) being treated together and some minor classes being amalgamated with larger classes on similar … valuation bases. That results in 10 different forms …’, which they enclose;

(4) explain that, had they published the net premium valuation, Equitable would have needed to show an explicit resilience reserve of £171m in the 1994 returns; and

(5) explain that their ethical funds are invested in the Equitable Ethical Unit Trust, which is described in the returns.

An unsigned analysis carried out by GAD of Equitable’s letter includes on (2): ‘OK for now, general comments only to [Equitable’s Appointed Actuary]’. On (3):

Supplied approximately in the requested format except that, surprise surprise, the resilience reserve is omitted.

OK apart from the missing resilience line. It is probably pushing it a bit to complain and I intend to turn a blind eye.

On (4), that the resilience reserve required is £171m, the comment is: ‘OK’. On (5), the note reads: ‘I did not know there was such a unit trust – hence the confusion. Now OK’.

DTI’s Line Manager B returns his copy of GAD’s scrutiny report on the 1994 returns to the Line  

Supervisor. On this, the Line Manager notes:

I propose to invite myself to see Equitable to discuss

1. Plans for Permanent [Insurance] + development of overseas business
2. Asset/liability management.

GAD write to Equitable with comments on their letter of 21/02/1996. GAD note that Equitable intend to strengthen the mortality basis for 1995 and offer some advice about what mortality tables to use. GAD add: ‘Annuity mortality bases are a matter that GAD keeps under constant review for all offices with a material portfolio, and we shall undoubtedly return to this issue in future years’. GAD raise no objections to Equitable’s amalgamation of information on rates of interest ‘provided that the valuation rate of interest given is the highest for liabilities grouped together’. GAD acknowledge Equitable’s information on the resilience reserve and add:

We do need to know this figure every year, but I appreciate that you do not wish to publish it at present. It would assist me if you could write to me with this figure at about the time you submit the return, as this may avoid correspondence later in the year.

GAD send DTI an update on their scrutiny report for the 1994 returns. GAD revise the valuation table to take account of Equitable’s figure for the resilience reserve under a net premium valuation, as follows:

† Estimated figure.

GAD conclude:

We are now satisfied with the valuation basis. The net premium cover for the required minimum margin is greater than that for the published basis, and a priority of 4 could have been justified.

The scrutiny is now complete.

Equitable write to GAD, in response to their letter of 05/03/1996. Equitable suggest that GAD’s comments on mortality tables appear to imply that:    

… GAD decides what is a professionally satisfactory choice of basis and then sees how close offices come to that. That carries the unfortunate impression that the GAD feel the only people capable of exercising true professional judgment are themselves. 

Equitable conclude:

I would much prefer to see the GAD/DTI taking a far tougher line on whom they allow to become appointed actuaries rather than adopting an increasingly interventionist approach to overcome the deficiencies of some appointees.

GAD copy the letter to DTI’s Line Supervisor B who notes, against the concluding comment: ‘Nice one!’.

GAD reply to Equitable’s letter of 25/03/1996. GAD point out that DTI rely heavily on GAD when satisfying themselves that regulations are being complied with and that GAD’s independent review underpins rather than undermines the Appointed Actuary system. GAD reassure Equitable that: ‘We do not seek to substitute our judgement for that of the Appointed Actuary, but rather, as you suggest, to seek confirmation that relevant factors have been taken into account and that the conclusions are reasonable’. GAD continue that this ‘requires us to decide whether the basis is within the range actuaries generally would consider to be acceptable, and not to set our own basis. However, we have to start from somewhere, and in particular we do use guideline mortality tables to determine whether to make further enquiries’. GAD add:

As you say, it would be unfortunate if GAD were giving the impression of some form of monopoly over professional judgement. We do, however, sometimes express a view to Appointed Actuaries when we feel this might assist their consideration of an issue. My observation was merely intended, in the context of your previous letter, to point out a possible advantage of moving to the latest tables, which you indicated you were considering, and no more than that. I am sorry if you felt any criticism of your professional judgement was implied, and assure you that none was intended.

GAD say:

I feel you may have misunderstood the reference I made to a “material portfolio”. This was not a reference to, say, market share, but to the size of the portfolio in relation to free assets, for example. I was referring to those companies where an improvement in mortality of annuitants might cause a financial strain material for either solvency margins or policyholders’ bonuses …

GAD continue:

This might particularly be the case where the actuary has elected to use a basis that is near to the minimum. Thus “material” should be read perhaps more in the sense used by the accountancy profession. You will appreciate that the mortality experience of your annuity portfolio could be material, because significant improvements above those implicit in the table you use might produce a large financial effect.

GAD also comment on Equitable’s request that GAD should take a tougher line on whom they allow to become Appointed Actuaries:

… the “gatekeeper” to the role is really the profession, through the system of practising certificates. If there is to be a tightening then it would be for the profession to give effect to it. Neither DTI nor GAD has any powers in this respect.

GAD copy the letter to DTI. Line Supervisor B notes that it is a good letter and that the statement that DTI rely heavily on GAD for advice is ‘true!’.

Equitable’s Appointed Actuary writes to GAD in reply to their letter of 03/04/1996. The Appointed Actuary says that: ‘In general I was reassured by your comments’. The Appointed Actuary explains that he shares GAD’s concerns about the need to manage the risk of future improvements in mortality on an annuity portfolio and adds:

That was one of the reasons why we introduced our with profits annuity some years ago. Any unexpected improvement for that class could, of course, be reflected in the bonus rate granted. You may be interested to know that around two thirds of our current immediate annuity new business is with profits.

Equitable’s Appointed Actuary also expresses surprise at GAD’s comment that neither they nor DTI have any powers to secure better quality Appointed Actuaries. He says:

Although I accept that the Act does not require approval of Appointed Actuary appointments, there would appear to be an avenue of influence under the “sound and prudent management” criteria. That is via the requirement that any office “is directed and managed by a sufficient number of persons who are fit and proper persons to hold the positions which they hold”.

Against this, Scrutinising Actuary D writes: ‘This wouldn’t pass review’.

DTI’s Sponsorship Secondee Unit send Equitable notes of a meeting that had been held on 2 May 1996 to discuss insurance industry competitiveness. Under the heading ‘Working with Government & Regulators’, Equitable’s Appointed Actuary is quoted as saying:

DTI valuation regulations have now gone too far …

Regulation has not caused Equitable to change its approach, but it has put up its costs.

Believes that, despite regulations, very little advice is actually given.

DTI’s Director of Insurance writes to Equitable’s Chief Executive and Appointed Actuary to congratulate him on his appointment as a Commander of the British Empire in the Birthday Honours. The Director of Insurance says:

I am sure your many friends and admirers in the industry and elsewhere — among who I would count myself — will regard this as a well deserved recognition of a lifetime’s service to England’s oldest life insurer, and to the high standards for which you have been rightly renowned for so many years. The Equitable’s achievements in recent years show that high ethical and customer standards can be fully compatible with the more conventional measures of commercial success.

Equitable apply to DTI for a section 68 Order for a future profits implicit item of £600m, for possible use in their 1996 returns. Equitable provide financial calculations in support of the application suggesting that they could seek an Order up to the value of £2,212.6m.

Equitable say that they have ‘included in its 1995 annual returns a future profits implicit item of £263,731,000 for the purpose of achieving equality between the total net value of policyholders’ assets included in Form 9 (i.e. lines 21 + 31 – 24) and the corresponding total net asset value shown in the Society’s Companies Act accounts’.

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

Average annual profit = 2458.3/5 = £491.7m

Note: In 1994 surplus was increased as a result of changes in valuation interest bases. In 1991, 1992, 1993 and 1995, surplus was decreased as a result of changes in valuation interest bases. Those changes in surplus are included as exceptional items in column (B) above.

The calculations state that the average period to run for the Society’s in-force contracts is nine years. Equitable explain:

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

The calculations suggest that the maximum future profits permissible is 50% of £491.7m multiplied by nine years – that being £2,212.6m.