Submission of the 1996 regulatory returns

Equitable submit their 1996 regulatory returns to DTI. Accompanying these returns are copies of the Society’s annual report and financial highlights and its statutory accounts, prepared in accordance with the Companies Act 1985 and both dated 26 March 1997.

These documents include the following information about Equitable’s business and their financial position as at 31 December 1996.

GAD’s copy of the 1996 regulatory returns and Companies Act reports and accounts includes various annotations. I am satisfied that those annotations were made by Scrutinising Actuary E during the scrutiny programme on or around 07/08/1997, when the Scrutinising Actuary completed the A2 Initial Scrutiny check. However, for ease of reference, mention of these annotations is made here.

Companies Act annual report and financial highlights

In their ‘President’s Statement to members’, Equitable make particular mention of three achievements in 1996, being:

• a record level of new United Kingdom annual premium income of £400m.
• total new premium income had exceeded £2bn for the first time (including single premiums of £1.59bn).
• a fall in the expense ratio to 4.3%.

GAD note these facts.

The President explains that the Society’s approach to bonus distributions was an important aspect of their status as a mutual organisation. He says it had always sought to ensure that each generation of with-profits policyholders received the returns they deserved on their investments with the company. (GAD underline this point.) The distributions had been ‘full and fair’. The President explains that Equitable had not built up surplus assets in order to boost their ‘free assets’ and so their free asset ratio was ‘inevitably, and rightly, lower’ than some of their competitors. (GAD underline this point.) He argues that their low free asset ratio was a reflection of their full distribution policy and not an indication of financial weakness. Equitable’s President demonstrates that their assessment of the financial strength of the Society is supported by an expert third party and reports that the ‘AA (Excellent)’ rating awarded by the international rating agency Standard & Poor’s in 1993 had been confirmed in each subsequent year. The President states that he ‘would like again to put on record your Board’s continued strong commitment to maintaining The Equitable as a mutual society’.

In their ‘Management Report: An appraisal of the Society today’, Equitable explain that, because the Society was self-financing without any shareholder capital, it looked to their members to provide development capital which it expected to repay through its bonus policy. Equitable explain that the prime need for capital was to finance the up-front costs of new business and the occasional major investment in new systems. They explain how existing members provided a loan to cover the acquisition costs of new members and that this was repaid from charges over the lifetime of those policies. Equitable also state that a full distribution policy did not lead to investment considerations that were any different from those applying to life offices generally. They go on to say: ‘Over many years there have not been any particular technical restrictions placed on the investment team’. GAD underline  this sentence.

In their ‘Management Report: Features of 1996’, Equitable set out their investment aim, ‘to provide good returns for our policyholders by prudent investment of their funds’, and discuss the issue of investment risk. They explain:

By implication, with-profits policyholders have indicated a desire for some guarantees and for some protection to their policy values from the short-term volatility of investment markets. The investment risk is controlled by holding a range of assets in several different categories and the guarantees are provided with the help of a suitable proportion being held in U.K. government securities. The assessment of future risk is, however, difficult and it is not possible to define precisely in advance what level of overall risk is implied by a particular investment strategy. Nor can risk be considered solely in absolute terms, since we are in competition with other providers and the “success” of the Society’s investment returns will be largely measured by the results delivered to policyholders compared with those provided by our competitors. Nevertheless, techniques are available which enable a reasonable assessment to be made both of absolute and relative risk, and these are utilised in the management of the Society’s portfolio in pursuit of its investment objectives.

The report goes on to explain that the Society had earned 10.7% on its with-profits assets at market value in 1996, with the result that the average annual return over the last 4 years had been 13% – around 1% per annum higher than would have been obtained on 15-year gilts. The Directors had decided to allocate an overall rate of return of 10% to recurrent single premium pensions business. Equitable say that for many years reversionary bonuses had followed the trend in gilt yields and that the declared rates in 1993 were consistent with the then current gilt yields. As yields had subsequently remained broadly at that level, Equitable had maintained reversionary bonuses at the same level, in 1994, 1995 and 1996.

GAD note the return earned on the Society’s with-profits assets and the rate of return allocated for 1996. GAD also note that Equitable had decided to use an interim rate of return for 1997 of 9%. Next to this GAD write: ‘too high? Unless supported by capital appreciation’.

Companies Act statutory accounts

The Directors’ Report for 1996 includes explanation of the financial results of the Society along with the valuation and bonus declaration made. GAD make various annotations against the Notes on the Accounts.

The returns

The new accounts and statements regulations, ICAS Regulations 1996, came into force during the year. These had altered the format of the information given in the returns and introduced some further disclosure requirements in respect of both the forms and the abstract to the actuary’s valuation report. Some forms were also transferred from Schedule 3 to Schedule 4.

Equitable’s returns are submitted in one part covering Schedules 1, 3, 4 and 6 to these regulations.

Schedule 1 (Balance sheet and profit and loss account)

Schedule 1 of Equitable’s returns consists of Forms 9, 10, 13, 14 and 17. Form 9 summarises the Society’s financial position at 31 December 1996 as follows:

GAD tick some of the figures and circle the future profits figure.

In Form 13, Equitable set out their admissible assets. GAD make various notes on the forms.

In Form 14, Equitable set out their long term business liabilities and margins. GAD note that the excess of the value of admissible assets representing the long term business funds over the amounts of those funds, shown on line 51, is ‘DOWN!’ from the previous year. The figure for 31 December 1996 is £1,420m and the figure for 31 December 1995 is £1,433m.

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

Schedule 3 of Equitable’s returns consists of Forms 40 to 45.

In Form 40, Equitable set out information for the ‘Long term business: Revenue account’. GAD tick some of the figures provided.

In Form 41, Equitable set out information for the ‘Long term business: Analysis of premiums and expenses’. GAD note on this Form the previous year’s figures for ‘Management expenses in connection with acquisition of business’ (which had increased from £82,376,000 to £88,457,000) and ‘Management expenses in connection with maintenance of business’ (which had decreased by £14,000 to £30,208,000).

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 main and 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 of Equitable’s returns provides the information required by paragraphs 1 to 23 of Schedule 4 to ICAS Regulations 1996 and includes Forms 46 to 49, 51 to 58, 60 and 61.

Schedule 4 – main valuation (text)

Equitable state that this valuation is made in conformity with Regulation 64 of ICR 1994.

In response to paragraph 4 of Schedule 4, Equitable provide ten pages of information about their non-linked contracts.

Equitable begin by describing their accumulating with-profits contracts and disclose, in paragraph 4(1)(a)(i), the following as being applicable to all such contracts:

The Society reserves the right to pay less than the full identifiable current benefit attributable to a policy where the contract is terminated by the policyholder at a time other than one at which the policy benefits can be contractually withdrawn. It is the Society’s current practice only to make an adjustment to the full identifiable current benefit in circumstances where the policyholder is exercising a financial option against the Society, for example by requesting a transfer to another provider, and the full policy value exceeds the underlying share of assets. The current method of adjustment is to pay only a proportion of the full final bonus in such circumstances but there is no guarantee that the amount of the adjustment cannot exceed the full amount of final bonus.

GAD underline ‘to pay less than the full identifiable current benefit attributable to a policy’ and have written next to this: ‘Define “full identifiable current benefit”’.

GAD also underline ‘the full policy value exceeds the underlying share of assets’ and ‘there is no guarantee that the amount of the adjustment cannot exceed the full amount of final bonus’. They sideline this part of the paragraph and write ‘Is this reasonable?’.

Equitable go on to disclose in paragraph 4(1)(a)(ii) that, for all accumulating with-profits contracts:

The valuation method is a prospective valuation of the benefits contractually payable and the resultant mathematical reserves may well be less than the full current benefit. That result is not, however, a consequence of taking explicit account of the position described … above in the valuation method.

GAD underline ‘the resultant mathematical reserves may well be less than the full current benefit’ and against this have written:

I presume that “full current benefit” includes the non-guaranteed bonus.

and

In the resilience scenario, it would be hoped that the liability would be no less than the guaranteed benefits!

Equitable explain that they have four main categories of accumulating with-profits contracts. These categories are listed as: ‘Life savings plans’; ‘Life protection plans’; ‘Pension contracts – old series’; and ‘Pension contracts – new series’.

For their Life Savings Plans, Equitable disclose that the full fund is guaranteed to be available on surrender at certain dates, typically the ‘5th and subsequent policy anniversaries’. GAD underline the quoted words, and on the next page of the returns, query whether a full or partial guarantee of fund applies to Equitable’s with-profits bonds.

For ‘Pension contracts – old series’, Equitable disclose that virtually all contracts include a 3.5% guaranteed rate of accumulation (i.e. the guaranteed investment returns). GAD underline this figure. The returns disclose that the full accumulated fund is guaranteed to be available on retirement at ages permitted by the relevant legislation, ‘e.g. between ages 60 and 75 in the case of retirement annuity contracts’. GAD underline ‘between ages 60 and 75’ and write ‘a wide spread!’. Equitable also state: ‘Some older contracts contain minimum guaranteed rates for annuity purchase at retirement’.

For ‘Pension contracts – new series’, Equitable say that the contracts are identical to ‘old series’ contracts, except ‘There are no guaranteed investment returns or bonus rates other than a return of the investment contents paid’.

GAD note that Equitable offer Major Medical Cash Plans. Next to the description, GAD write ‘how do these operate? (an additional benefit funded by cancellation of units) – see [page] 5 of 1995 [Schedule] 4’.

In response to paragraph 5 of Schedule 4, Equitable provide 63 pages of information about their linked contracts. GAD note the business series that are open to new business and mark as new the contracts introduced in 1996.

The description of the general principles and methods adopted in the valuation is now provided in paragraph 6 of Schedule 4 of the returns. The information supplied by Equitable includes that, for accumulating with-profits deferred annuities:

The liability was calculated by discounting the cash fund purchased to date plus declared and attaching bonus cash fund with an allowance for future bonus.

GAD underline this sentence. The information disclosed in the returns continues:

For with profits retirement annuity and personal pensions benefits … the benefits have been valued on the basis that the benefits will be taken at age 60 or, if that age has been attained, at the valuation date.

GAD sideline this and the preceding sentence and write next to it: ‘i.e. can be less than current face value of benefits’.

Equitable then disclose that, for with-profits Managed Pension Policies, the ‘current full value of the guaranteed fund and attaching declared bonus was reserved’. GAD underline the quoted words and place three ticks next to the paragraph.

In paragraph 6(1)(b), Equitable disclose:

The valuation method makes specific allowance for rates of future reversionary bonus additions, the levels of which are consistent with the valuation interest rates employed having regard to the Society’s established practices for the determination of declared bonus rates. The balance of the total policy proceeds, consistent with policyholders’ reasonable expectations, will be met by final bonus additions at the time of claim. Such additions are not explicitly reserved for in advance but are implicitly covered by the excess of admissible assets over mathematical reserves.

GAD sideline the last sentence and underline the words ‘implicitly covered by the excess of admissible assets over mathematical reserves’.

In paragraph 6(1)(e), Equitable set out the rates of future bonus valued for each class of business. GAD add corresponding figures from the previous year or otherwise note where figures are unchanged or new. Equitable then state:

The reserves for future bonus under personal pensions contracts are such that, after allowing for any costs associated with the review of past sales of pensions transfers and opt-outs, future bonuses at the above rates could be supported if the valuation assumptions were met.

GAD underline the words ‘after allowing for any costs associated with the review of past sales of pensions transfers and opt-outs’.

In paragraph 6(1)(f), Equitable state that a reserve for the prospective liability for tax on unrealised capital gains (losses) is held in respect of policies where benefits are linked to the Society’s internal funds. They disclose that the contingent liability for tax on unrealised capital gains in respect of other business is estimated not to exceed £47.7m. Equitable state that they hold no reserve for this, as they consider there were sufficient margins in the valuation basis to cover the discounted value of this liability. GAD underline this figure and add next to it the previous year’s figure of £37.4m. GAD sideline the sentence which says that no reserve was made. GAD have also written:

This is not really acceptable is it?

In paragraph 6(1)(g), relating to investment performance guarantees, Equitable state that, in current conditions, they do not consider it necessary to hold a specific reserve for the guarantee they offer on a unit-linked annuity. GAD underline the words ‘in current conditions’.

In paragraph 6(1)(h), relating to the reserves for all other guarantees not covered by paragraph 6(1)(g), Equitable state:

The premium rate guarantees and options under the Society’s policies are described in paragraph 4. Where the right to effect further policies without medical evidence of health is carried a reserve equal to one year’s extra premium deemed or actually charged was set up. It was considered unnecessary in current conditions to make explicit provision for the other guarantees and options described in paragraph 4.

That is, Equitable state that they do not consider it necessary to hold an explicit reserve for, amongst others, annuity guarantees.

In paragraph 6(1)(i), Equitable disclose that, for certain non-profit deferred annuities, the valuation rates of interest used were those used in the premium bases. Equitable, again, do not elsewhere disclose the rates used in the premium bases.

In paragraph 6(2), Equitable state that, in determining the provision needed for resilience reserves and tax on unrealised gains, they have taken account of the fact that the long term fund has been valued at book value.

In paragraph 7(4), Equitable state that the mortality tables for annuity contracts shown in Forms 51 and 54 have sufficient implicit allowance for future reductions in rates of mortality. Against this, GAD have written ‘Check’.

In paragraph 7(5), Equitable explain that they consider the reserves for future bonus within the valuation to be fully able to withstand any future strains which would arise if there were significant changes in mortality or morbidity experience. They say that, accordingly, the Society does not consider it necessary to establish any additional reserves in this respect.

The information required to be provided in relation to resilience testing and establishment of resilience reserves is changed from previous years. In paragraph 7(6), Equitable set out the resilience scenarios tested (i.e. the scenarios described in DAA6). In paragraph 7(8), Equitable state that no resilience reserve has been provided for. GAD underline this. The Society goes on to disclose, in paragraph 7(8)(a), the changes made to valuation assumptions and methods in the resilience scenarios:

It was assumed that the valuation has been undertaken using the net premium method as described in the appendix following Form 61 of this report with the following changes:

(i) the interest rates are as stated in Form 57;

(ii) for all accumulating with profits business, an annual loading of 0.2‰ increasing by 4% per annum compound of the basic benefit was reserved which is considered to be a prudent allowance for ongoing expenses: for accumulating with profits pensions business, ½% per annum of the benefit value has been deducted for each year up to the date it is assumed that benefits will be taken as a charge for expenses.

(iii) the mortality table used for accumulating with-profits pensions business was adjusted to AM80 ult – 5 years.

GAD underline the words ‘using the net premium method’ and ‘AM80 ult – 5 years’.

In paragraph 7(8)(b), Equitable explain how they had hypothecated assets to liabilities for the resilience test. In paragraph 7(8)(c), they state that, from the application of the most onerous resilience scenario, liabilities changed by £3,278m and assets allocated to match those liabilities changed by £3,273m. GAD question which of the scenarios tested was the most onerous for Equitable.

In paragraph 8(b), Equitable state that ‘For accumulating with profit [pension] business the valuation rates of interest shown in Form 52 are net of a ½% interest rate reduction as a reserve for future expenses’. GAD underline this sentence and note that the rate is unchanged from the previous year.

In paragraph 8(d), Equitable state:

A further valuation has been undertaken using the net premium valuation method. The bases employed are in accordance with Regulations 66 to 75 of the Insurance Companies Regulations 1994. The resultant aggregate liability is less than the aggregate liability on the methods and bases described in this report. The report on the net premium valuation is given in an appendix following Form 61 of this report.

GAD sideline this paragraph.

In paragraph 13, Equitable disclose: ‘The Society has no business where the rights of policyholders to participate in profits relates to profits from particular parts of the long term business fund’.

As now required by paragraph 14 of Schedule 4 to ICAS Regulation 1996, Equitable set out a statement of their aims with regard to bonus distribution and of how they maintain equity between different generations of policyholders. They refer to the Directors’ absolute discretion as to timing and nature of bonus distributions, given to them by the Society’s Articles of Association.

In response to paragraphs 14(1)(d), (e) and (f), Equitable’s returns disclose:

Any literature, including documents the Society is or has been required to issue by any regulatory body authorised under the Financial Services Act 1986, advertisements or other communications with policyholders, dealing with the distribution of bonuses, have stated that the principles underlying the Society’s approach are as follows:–

• that bonuses are primarily influenced by the investment earnings on the invested premiums and that, in particular, future bonus rates will be mainly determined by future investment conditions
• that all with profits policyholders participate in common funds of assets (one for each currency of the policy) and that bonus systems aim to pass the earnings on those assets on to policies of different types and terms in a consistent and fair manner
• that with profits policyholders stand in the position of proprietors and share in any profits or losses which arise from the transacting of non-participating business
• that the bonus systems aim to pass on to each generation of policyholders the value of the assets which their policies have built up; in particular, that there should be no deliberate holding back of returns to build up an “estate” of assets which belongs to no-one
• that changes in bonus rates should reflect the underlying trend of investment returns rather than mirroring short-term fluctuations; that is, changes in rates should be gradual whenever circumstances permit.

In response to paragraph 14(2), Equitable’s returns disclose that:

The Society’s aims in relation to the distribution of profits amongst policyholders flow from the principles described above. In particular:

(a) Policies reaching their contractual termination date should receive, subject to smoothing, the full value of the assets secured by their invested premiums. On early surrender the aim is also generally to pay out a “full value” amount except where the policyholder is exercising a financial option against the office. In such circumstances the aim is to ensure that the continuing policyholders are not disadvantaged and that is achieved by paying a surrender value which approximates to the unsmoothed value of the assets attributable to the surrendering policy where that is below the “full value” amount.

(b) Policies of all types and terms should be treated in a consistent fair manner.

(c) Fluctuations in investment returns should be smoothed over reasonable periods, unless conditions are so exceptional that such an approach would be seriously inequitable, so that bonus rates can progress in an orderly manner.

The returns continue by stating that the principal method by which these aims are achieved is by comparing the current and projected value of assets with total policy values.

In paragraph 15, Equitable disclose that they had set the reversionary bonus for the main policy classes at 4.0%. GAD note that most of the reversionary bonus rates are unchanged from the previous year.

As in previous years, Equitable disclose that they offered loans under a ‘loanback’ arrangement to some retirement annuity, individual and group pension policyholders. GAD note that this description is unchanged from the previous year.

In paragraph 16, Equitable set out final bonus rates. GAD note the comparable rates from the previous year or where the description provided is unchanged or new.

The returns, again, contain the statement, at paragraph 16(viii):

Where benefits are taken in annuity form and the contract guarantees minimum rates for annuity purchase, the amount of final bonus payable is reduced by the amount, if any, necessary such that the annuity secured by applying the appropriate guaranteed annuity rate to the cash fund value of the benefits, after that reduction, is equal to the annuity secured by applying the equivalent annuity rate in force at the time benefits are taken to the cash fund value of the benefits before such reduction.

In paragraph 21, Equitable explain that they risk-adjusted the yields on assets other than land and equity shares by restricting them to 10%, which is that available on the highest yielding risk-free security they hold. Equitable also explain that, where it was considered appropriate, they risk-adjusted yields on land and equity shares.

Schedule 4 – main valuation (forms)

In Form 46, Equitable provide information on changes in their ordinary long term business. GAD circle the figures provided for annual premiums on United Kingdom non-linked pensions business and have written: ‘These omit all renewable premiums!’.

In Form 47, Equitable provide an analysis of their new ordinary long term business. GAD make various annotations to these forms, checking the figures provided.

In Form 48, Equitable provide figures for their expected income from admissible assets not held to match liabilities in respect of linked benefits. This form shows that 52% of Equitable’s non-linked assets are invested in equities, 6% in land and buildings and 38% in fixed and variable interest securities (compared with 50%, 7% and 38% respectively in 1995).

Next to the yield percentage figures on the form GAD have written ‘? Expected’ and annotate the form with the following figures:

GAD circle the figure for other fixed interest securities of 7.32% and have written ‘Query – see Line 24 [of Form 49]’.

In Form 49, Equitable provide an analysis of their fixed interest and variable yield securities. Equitable disclose that the gross redemption yields on fixed interest securities issued or guaranteed by any government or public authority are, for certain durations, higher than for those not issued or guaranteed by any government or public authority. GAD circle the gross redemption yield figure of 5.25% provided for other fixed interest securities with redemption periods of between 10 and 15 years and note that this is very low.

In Form 51, Equitable set out the mathematical reserves held for various types of non-linked contracts (excluding accumulating with-profits), along with information on the number of contracts in force, the benefits valued and rates of interest and mortality assumptions used in valuing them.

In Form 52, Equitable set out the mathematical reserves held for accumulating with-profits contracts, along with information on the number of contracts in force, the benefits guaranteed and the rates of interest and mortality assumptions used in valuing them. Columns 11 and 12 of the Forms detail the current benefit value and discounted value of the Society’s liabilities. GAD note that the difference between these figures (which is almost entirely accounted for by the valuation of Equitable’s UK pensions business) is £638m.

In Form 53, Equitable set out the mathematical reserves held for the various types of property-linked contracts, along with information on the number of contracts in force, the value of current benefits, the level of benefits guaranteed on death and the rates of interest and mortality assumptions used in valuing them. Equitable also disclose that they hold reserves for non-investment options and other guarantees for many of their unit-linked policies.

In Form 54, Equitable set out the mathematical reserves held for the various types of index-linked contracts along with information on the number of contracts in force, the value of current benefits, the level of benefits guaranteed on death or maturity, and the rates of interest and mortality assumptions used in valuing them.

The new Regulations require that matching rectangles (i.e. the notional allocation of assets to each category of non-linked liabilities to show the valuation rates of interest that are supportable) are provided in Form 57. Equitable provide 34 Form 57s, each Form covering a different interest rate and class of business. GAD annotate the first Form (which gives the total values of assets notionally allocated) with corresponding asset figures taken from Form 48. The total value of assets notionally allocated is given as £15,679,987,000. On the Form, GAD have written (the figures being in units of £000s):

GAD have also written ‘N.B. No Resilience Reserve’.

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

Schedule 4 – appendix valuation (text)

Equitable explain that the appendix valuation:

… was undertaken for the purposes of demonstrating that in aggregate the mathematical reserves determined by the valuation undertaken using the gross premium method, the results of which are reported on the preceding pages, are not less than an amount calculated in accordance with Regulations 66 to 75 of the Insurance Companies Regulations 1994.

Equitable’s appendix valuation provides the information required by paragraphs 1, 6 to 8, 10, 11, 20 and 22. The Society states that the information required by the other paragraphs of the ICAS Regulations 1996 is the same as that provided in the main valuation (apart from paragraph 23 – being a statement of the required minimum margin in the form set out in Form 60 of Schedule 4 which, having had ‘regard to the purpose of the valuation’, has not been provided).

In their description of the general principles and methods adopted in the valuation (paragraph 6), for accumulating with-profits deferred annuities Equitable disclose that the liability was calculated ‘by discounting the cash fund purchased to date plus declared and attaching bonus cash fund’. GAD have underlined the words quoted. Equitable then disclose that they have valued benefits assuming retirement ages of 60 for both retirement annuity business and personal pension business.

For with-profits bonds, Equitable disclose that ‘The liability was calculated by discounting the guaranteed fund and attaching bonuses’. GAD underline the words quoted.

In paragraph 6(1)(b), Equitable state that the valuation rates of interest were chosen with due regard to policyholders’ reasonable expectations and their established practices for determining reversionary bonuses. As in the main valuation, Equitable also disclose that:

The balance of the total policy proceeds, consistent with policyholders’ reasonable expectations, will be met by final bonus additions at the time of claim. Such additions are not explicitly reserved for in advance but are implicitly covered by the excess of admissible assets over mathematical reserves.

GAD underline the words ‘are implicitly covered by the excess of admissible assets over mathematical reserves’ and next to it write ‘How well?’.

As in the main valuation, in paragraph 6(1)(f) Equitable disclose that a reserve is held for the prospective liability for tax on unrealised capital gains in respect of policies where benefits are linked to the Society’s internal funds. They also disclose that the contingent liability for tax on unrealised capital gains in respect of non-linked business is estimated not to exceed £47.7m. Equitable state that they hold no reserve for this, as they consider there are sufficient margins in the valuation basis to cover the discounted value of this liability. GAD also underline the figure provided in this appendix valuation, note the previous year’s figure of £37.4m and write ‘Not really acceptable?’.

As in the main valuation, and as in previous years, Equitable state that, in current conditions, they do not consider it necessary to hold a reserve for the guarantee they offer on a unit-linked annuity. Next to this, GAD write ‘Investigate further?’.

In paragraph 6(1)(h), Equitable state:

The premium rate guarantees and options under the Society’s policies are described in paragraph 4.

Where the right to effect further policies without medical evidence of health is carried a reserve equal to one year’s extra premium deemed or actually charged was set up.

It was considered unnecessary in current conditions to make explicit provision for the other guarantees and options described in paragraph 4.

That is, Equitable state that they do not consider it necessary to hold an explicit reserve for, amongst others, annuity guarantees.

In response to paragraph 7(8) of Schedule 4, Equitable disclose that their valuation includes a resilience reserve of £501m. GAD circle and underline this figure and write: ‘Is this a grossed up figure – considering the assets allocated to it. Check [Form] 57!’.

The Society goes on to disclose, in paragraph 7(8)(a), the changes made to valuation assumptions and methods in the resilience scenarios, including that:

… for all accumulating with profits business, an annual loading of 0.2‰ increasing by 4% per annum compound of the basic benefit was reserved which is considered to be a prudent allowance for ongoing expenses: for accumulating with profits pensions business, ½% per annum of the benefit value has been deducted for each year up to the date it is assumed that benefits will be taken as a charge for expenses.

As in the main valuation, Equitable disclose in paragraph 7(8)(c) the changes to their liabilities and assets resulting from the application of the most onerous resilience scenarios. GAD query which of the scenarios produces this result and write ‘presume (c)?’.

As in the main valuation, in paragraph 21 Equitable explain that they risk-adjusted the yields on assets other than land and equity shares by restricting them to 10%, which is that available on the highest yielding risk-free security held by Equitable. Against this figure, GAD write ‘High?’.

Schedule 4 – appendix valuation (forms)

In appendix Form 51, Equitable set out the mathematical reserves held on the appendix valuation basis for various types of non-linked contracts (excluding accumulating with-profits), along with information on the number of contracts in force, the benefits valued, and the rates of interest and mortality assumptions used in valuing them. GAD note changes from the previous year’s returns to some of the interest rates used.

In appendix Form 52, Equitable set out the mathematical reserves held on the appendix valuation basis for accumulating with-profits contracts, along with information on the number of contracts in force, the benefits guaranteed, and the rates of interest and mortality assumptions used in valuing them. GAD make various annotations on these forms, including:

• for some life assurance and general annuity business, GAD note that Equitable have used a valuation interest rate of 2.5% in the appendix valuation compared to ‘Nil used in [the gross premium bonus reserve] valuation’. GAD note that there is a ‘£54m discount’ on the current benefit value of liabilities. GAD also note that the corresponding figure used in the previous year was 4.0%.
• for some pensions business, GAD note that Equitable have used a valuation interest rate of 5.0% in the appendix valuation compared to ‘4.75% [discount] used in [the gross premium bonus reserve valuation]’. Below the figures provided for the rates of interest used, GAD write ‘High?’. GAD note on the form the discounted value of liabilities is
  ‘-£1,246m below face value!’.
• for Equitable’s German life assurance and general annuity business, GAD circle the rates of interest disclosed and write ‘High?’. They also note that the difference between the current benefit value of liabilities and the discounted value is ‘£2.07m’.
• for Equitable’s Guernsey life assurance and general annuity business, GAD circle the rates of interest disclosed and write ‘High?’. They also note that the difference between the current benefit value of liabilities and the discounted value is ‘£1.7m’.
• for Equitable’s Guernsey pensions business, GAD circle the rates of interest disclosed and they note that the difference between the current benefit value of liabilities and the discounted value is ‘£4.2m’.
• for Equitable’s Republic of Ireland life assurance and general annuity business, GAD note that the difference between the current benefit value of liabilities and the discounted value is ‘£1.5m’.
• for Equitable’s Republic of Ireland pensions business, GAD circle the rates of interest disclosed and they note that the difference between the current benefit value of liabilities and the discounted value is ‘£9.7m’.
• for the total of the Society’s accumulating with-profits business, GAD note that the difference between the current benefit value of liabilities and the discounted value is ‘£1,320m’.

In appendix Form 53, Equitable set out the mathematical reserves held on the appendix valuation basis for the various types of property-linked contracts, along with information on the number of contracts in force, the value of current benefits, the level of benefits guaranteed on death, and the rates of interest and mortality assumptions used in valuing them. They also disclose that they hold reserves for non-investment options and other guarantees for many of their unit-linked policies.

In appendix Form 54, Equitable set out the mathematical reserves held on the appendix valuation basis for the various types of index-linked contracts, along with information on the number of contracts in force, the value of current benefits, the level of benefits guaranteed on death or maturity, and the rates of interest and mortality assumptions used in valuing them.

In appendix Form 57, Equitable provide matching rectangles on the appendix valuation basis covering the different classes of their business. As with the main valuation, GAD annotate the first Form (which gives the total values of assets notionally allocated) with corresponding asset value figures taken from Form 48. Equitable state that the total value of assets notionally allocated is £15,174,191,000. On the Form, GAD have written the following (the figures being in units of £000s):

Notes to the returns

In the notes to the returns, disclosed at the end of Schedule 4, Equitable disclose that they have been granted a section 68 Order which permits them to include in aggregate form details of their ‘Personalised Funds’ in Forms 43, 45 and 55.

Equitable also disclose that they have been granted a section 68 Order permitting them to take into account a future profits implicit item with a value not exceeding £600m. The Society states it has included an item of £312,794,000 for the purpose of ‘achieving equality between the total net value of policyholders’ assets included in Form 9 … and … total net asset value shown in the Society’s Companies Act accounts’. As for the previous returns, GAD underline the quoted part of this sentence.

Equitable state that no provision has been made for the contingent liability for tax on unrealised capital gains for non-linked business, which they have estimated as £47.7m. GAD sideline this paragraph and underline the figure of £47.7m.

The notes to the returns also disclose that Equitable had been issued a section 68 Order ‘to the effect that figures in Form 46 exclude recurrent single premiums from the annual premium figures as the Company cannot at present calculate a meaningful figure’. GAD sideline this note.

Schedule 6 (Certificates by directors, actuary and auditors)

Three Equitable Directors provide the certification required by Regulation 28(a) of ICAS Regulations 1996. Equitable’s Appointed Actuary provides the certification required by Regulation 28(b) of ICAS Regulations 1996. Equitable’s Auditors provide their opinion that Schedules 1, 3 and 6 of the returns have been properly prepared.

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

Average annual profit = 2815.5/5 = £563.1m

Note:     In 1994 surplus was increased as a result of changes in valuation interest bases. In 1992, 1993, 1995 and 1996, 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 now eight 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 are 50% of £563.1m multiplied by eight years – that being £2,252.4m.

GAD send DTI some suggested text for inclusion in the loan agreement. This reads:

Liabilities due to policyholders must be calculated so as to fully meet their reasonable expectations, as determined by the appointed actuary to the company, with the appointed actuary also treating the Loan for this purpose as if it did not exist as a liability of the long term fund at that time.

GAD say that this wording ‘… would be very suitable for us. It also helps to reinstate the concept of Para 25 of Prudential Note 1994/1 in the circumstance of a winding up’.

Equitable’s solicitors point out to DTI that the insurance company winding up rules applied and so they did not agree with the suggested amendment. DTI seek advice from GAD and comment:

… do you think they have a point? The (Winding-Up) Rules 1985 refer to policyholders expectations — but presumably the suggested inserted paragraph defines the Appointed Actuary’s responsibilities re PRE prior to the Court making a direction?.

GAD comment to DTI: ‘To the best of our understanding, we are prepared to accept that the revisions made to the Offering Circular do not have any impact on subordination to interests of policyholders’. GAD conclude:

In our opinion therefore, these revisions should not change the provisional agreement of the DTI to provide a Section 68 Order allowing the Society to leave this loan out of account as a liability on its return, subject to the normal limits.

GAD complete the A2 Initial Scrutiny check on the Society’s 1996 regulatory returns.

The form for the A2 check is now more detailed, reflecting the amendments to the returns following the introduction of the ICAS Regulations 1996 and includes the following:

Strength of valuation basis

In response to the question: ‘Are the interest rates in [Form] 57 (including those in line 39) supported by the risk adjusted yields on the matching assets – for with-profits business?’. GAD circle ‘Yes’ and against this write: ‘But? [accumulating with-profits] Line 39’. In response to the question: ‘Do the with-profits rates in line 29 and 39 appear to make provision for PRE?’, GAD circle both ‘Yes’ and ‘No’.

GAD note that they ‘might query’ Equitable’s mortality rates for annuities, and note that Equitable have ‘surprisingly raised their unit growth assumption’. They confirm that Equitable have applied the resilience test in accordance with the Government Actuary’s latest guidance. GAD judge the overall interest basis as ‘adequate’ to ‘weak’ and the valuation basis as ‘adequate’ to ‘weak’.

Solvency position

In response to the question: ‘Taking into account the individual characteristics of the company, is the absolute level of cover for the [required minimum margin] shown in [Form] 9 best described as very healthy (A), healthy (B), adequate (C), of concern (D) or negative/such as to require immediate action by DTI (E)?’. GAD circle ‘C’.

Against this they write: ‘As a major [with-profits] office is unlikely to be insolvent — but may be building higher expectations than can be met’.

GAD describe the trend in the level of cover over recent years as ‘Flat’.

Suitability of assets

GAD answer ‘Yes’ to the question: ‘Does the hypothecation of assets to liabilities in [Form] 57 look reasonable?’.

Operating results

GAD answer that the absolute level of surplus/deficit and its trend over recent years do  not give current cause for concern. They record that the absolute level of sales and its trend over recent years do not give current cause for concern. Next to their answer, GAD write: ‘[Very] high!’.

PRE issues

GAD record that it is not clear whether the answer given by Equitable in paragraph 4(1)(a)(ii) of Schedule 4 of the returns is satisfactory. (In the paragraph referred to, Equitable had written: ‘The valuation method is a prospective valuation of the benefits contractually payable and the resultant mathematical reserves may well be less than the full current benefit’. In the margin of the returns, next to this statement, the scrutinising actuary wrote in pencil: ‘I presume that “full current benefit” includes the non-guaranteed bonus’; and ‘In the resilience scenario, it would be hoped that the liability would be no less than the guaranteed benefits!’.)

Current issues

GAD note that it is not clear if Equitable have set up any identifiable pensions mis-selling reserve, but that GAD understand that Equitable hold £50m in technical reserves. GAD note that Equitable have completed the new style returns ‘adequately’ and against this have written: ‘Review Forms 57’.

Aspects that look worrying

GAD note ‘Substantial unitised [with-profits] – high declared bonuses but reduced reserves could rely too much on application of MVA. [[Company] would be in more comfortable position if held back more as terminal bonus.]’.

Other notes

GAD identify the following:

(1) Review Pension/Annuity mortality assumptions.

(2) Consider raised level for assumed unit growth.

(3) Review [unitised with-profits] reserves in resilience scenario.

[(4) [outstanding] review of Implicit Profit item calculation.]

The last point is noted on the form as ‘Dealt with’.

GAD identify no items to notify to DTI, to be taken up immediately with Equitable. They raise Equitable’s priority rating from 4 to 3. Accompanying the scrutiny check is a Form B Initial Scrutiny Form, which includes certain key figures disclosed in the 1993 to 1996 returns. GAD circle the figure of 8.5% for the growth assumption used for unit-linked business.

GAD’s Scrutinising Actuary E prepares a note for the Government Actuary about Equitable, ahead of the Government Actuary’s meeting with the Society’s new Appointed Actuary. The note says:

As a mutual [Equitable] makes a strong play of not building an excessive estate — and this leads to it declaring high “non-guaranteed” final bonuses on its substantial accumulating with profit contracts … There may be some doubts about the practical ability of the Society to apply an MVA in all the circumstances covered by the resilience test (as assumed in the valuation) – but they insist that their bonus declarations give them the necessary flexibility.

Chief Actuary D adds:

[The individual] has been heir-apparent to the [Appointed Actuary] post for some time. He seems very competent, & having served on a working party he chaired I think he will cope well, & be a bit less “prickly” than [the previous Appointed Actuary]!

GAD’s Scrutinising Actuary E writes to Equitable’s Appointed Actuary in response to his letter of 31/07/1997. The Scrutinising Actuary says:

It seems to me that the calculation of a maximum allowable Future Profits Implicit Item is not an exact science, particularly for a with-profit office that carries a large and variable margin in Line 51 of Form 14.

For a company that has sold a large amount of participating business, it seems obvious that potential insolvency is unlikely – unless such a company were to grant bonuses in relation to capital gains on assets that were later found to evaporate. However, I would obviously feel uncomfortable if it seemed that a major part of future surplus might be needed to maintain solvency – rather than be available to pay bonuses in line with the reasonable expectations of policyholders.

I suspect that part of the margin carried in Line 51 of Form 14 by such a with-profit office may be being retained to cover accumulating but unreserved-for terminal bonus payments, and it seems to me that the best way to interpret the guidance on Future Profits Implicit Items is to accept the judgement of the Appointed Actuary as to the amount of surplus that is distributable each year. Thus, the Form 58, Line 35 figure is the basic amount on which I focus for this purpose.

Clearly, “exceptional items” that affect the disclosed figure must be adjusted for, but these do not include changes in the amount of liabilities due to modifications made in valuation interest rates that reflect similar changes in asset yields — that result in an offsetting variation in asset values. It appears that the “exceptional items” shown in Column B in the Table provided in Section 1 of the Appendix to [Equitable’s] letter of 30 June relate solely to valuation interest rate changes. These items should only be considered to be “exceptional” to the extent that such interest rate changes were not matched by variations in yields on your asset portfolio arising from market movements – although it must be recognised that a switch in asset allocation strategy that modified the portfolio yield would require special consideration.

Scrutinising Actuary E goes on to say:

Although I have in some cases been concerned about the “double counting” of income arising from assets representing the explicit components of the solvency margin, I am not sure in the case of Equitable that such income is necessarily taken credit for in the surplus shown in Form 58 – however.

The Scrutinising Actuary asks Equitable to review their submission in the light of his comments. He concludes: ‘I have no doubt that, however we look at the figures, we will have no difficulty in agreeing to the previously requested figure of £700m’.

GAD’s file contains a page of calculations prepared by Scrutinising Actuary E in respect of the future profits implicit item. These are set out as follows:

The Government Actuary meets Equitable’s Appointed Actuary (at GAD’s offices). His note of the meeting sets out Equitable’s arrangements for actuarial work. The Government Actuary concludes:

Overall, this is a company with a strong actuarial tradition, where the appointed actuary has a strong position in relation to all aspects of the business. Expense levels remain one of the lowest in the industry and new business is still quite buoyant, although now heavily pensions orientated, with quite a lot of AVC business, for example from the NHS and Civil Service pension schemes, for which the Equitable is a preferred FSAVC provider.

Equitable reply to the letter from DTI of 30/09/1997 seeking details of their provision for potential liabilities for mis-sold personal pensions. Equitable explain that, as at 30 September 1997, they had 36,013 potential cases (compared with 34,999 as at 31 December 1996), with an estimated compensation liability of £85m (compared with £50m as at 31 December 1996). Equitable explain that one reason for the increased estimates is that:

… the 31 December 1996 figures treated a block of business, which had been classified as “execution only” under LAUTRO guidelines, as outside the scope of the review. Following subsequent discussions with the PIA those cases have been brought back into the review and subjected to loss assessment.

Equitable note that the cost would be met from the long term fund and therefore, in practice, by the generality of policyholders. Equitable say that, by 30 September 1997, they had made offers of compensation of £11m. They explain that, as their review progresses, Equitable should have a much greater degree of confidence in the provision to be established at 31 December 1997 than was the case at 31 December 1996 and that ‘[accordingly], we are likely to show the provision more explicitly on our 1997 published statements’.

Comments on the letter suggest that, in comparison with other offices, some of Equitable’s estimates of the proportion of cases assumed to require compensation are low, other estimates of the assumed average amount of compensation on some individual cases are high. A further comment is that Equitable’s figures generally appear ‘very “rounded”’.

DTI’s Line Supervisor B seeks the views of the Head of Life Insurance and Line Manager C on the letter of 17/11/1997 from the NHS. She says: ‘To my knowledge there are no outstanding supervisory “points of contention” with Equitable Life (and would we say anything if there were?)’. The Line Supervisor notes some recent issues that have arisen, including:

Personal pensions mis-selling – Equitable appears to be getting on well with this – as at 30/9/97 compensation offers of £11m had been made. Total provision at 30/9/97 is £85m, including non-priority cases.

New Chief Executive from 1/7/97 and separate Appointed Actuary. Previously [Chief Executive] was also the [Appointed Actuary].

Issue of £350m subordinated loan capital August 1997.

Future profits implicit item agreed for 1997 returns of £700m.

Line Supervisor B notes that, at 31 December 1996, Equitable’s cover for the required minimum margin was 2.53. Against this, an official notes that, without the future profits implicit item, it would be 2.07.

The Line Manager advises the Line Supervisor to reply to the NHS, confirming Equitable’s solvency position and indicating that DTI are not aware of any matters that should be brought to the Secretary of State’s attention.

GAD send DTI their annual report on the life insurance industry for the year ending 31 December 1996.

The purpose of the report is described as follows:

The idea of an annual report on the life assurance industry emerged from the work undertaken by the joint GAD and DTI Scrutiny Strategy Working Party. It was seen as a means of providing comparative information to enable more informed comments on relative performance to be made in the detailed scrutiny report written annually on each individual company. However, it was recognised that even more importantly, an annual report also provided the opportunity to give a far wider perspective on the industry as a whole, and act as a useful reference source.

The primary purpose of the report is, therefore, to act as an internal reference document for DTI and GAD senior management, providing a commentary on significant developments within the industry during the year, and an indication of likely future developments. It is also designed to provide detailed comparative information between companies to allow potentially weak companies to be identified. Finally, where relevant, any significant variations between different sectors of the industry can be identified.

The disclaimer says that: ‘The views expressed in this report are not those of any individual, but neither do they represent “official” GAD or DTI thinking. They are meant to contribute to thinking on the past and present developments of the industry’.

On ‘New Business’, the report notes that Equitable are top of the table for pensions sales with a new business index of £512m (£226m more than the second placed company) and are also top for total new business, with an index of £581.2m (the second placed company having a new business index of £573.4m). The report says: ‘Equitable are in a dominant position in the pensions market, as they are known for low charges and generally attract high premiums per case’. On distribution channels, GAD explain that the profile for mutual companies is similar to that of the industry, with 50% of sales made through independent financial advisers and approximately 40% through direct sales.

The report discusses mortality trends and the work of the Continuous Mortality Investigation Bureau (an independent industry body which monitors mortality experience). On mortality experience for people who have taken out life insurance, GAD say the main features demonstrated are:

A rapid improvement in overall mortality …

On mortality experience for pensioners and annuitants, GAD say:

The main point here is to note that the rate of improvement in mortality has been much faster than expected.

On ‘Assets’, GAD provide a breakdown of the average non-linked asset mix, presented as follows:

GAD also produce an estimation of the breakdown of the portfolios that are held by companies to support their with-profit liabilities (including the free estate). They explain: ‘This estimate has been based on the assumptions that fixed interest assets are held to match fixed liabilities and that most miscellaneous assets are held against other miscellaneous liabilities, while real assets are mainly allocated to match with-profit liabilities’. The report includes the following chart:

GAD say:

It is concluded that with-profit liabilities at the end of 1996 were matched by about 75.6% of real assets (10.2% property and 65.4% equities) and by over 24% held in fixed interest securities (14.9% gilts and 9.2% other fixed interest holdings).

This represents a marked reduction of 5.5% in the real asset proportion over the last year. Bearing in mind known market movements, this change would seem to result from deliberate cautious policy changes – and may reflect real tightness in the financial position of certain offices.

On investment performance, GAD say that the average estimated investment return on non-linked assets is 10.4%. The report includes a table setting out the estimated returns achieved by individual companies, which for Equitable shows an estimated return of 10.34%.

GAD’s report includes a chapter on maturity payouts. In the summary, and under the heading ‘Impressions’, GAD say:

While maturity payouts on shorter term policies have fallen sharply over the nineties, and fell generally between 1995 and 1996, the longer term policies have seen a comparatively level performance over the 1990s. However our projections of underlying asset shares, although a very crude indicator of the future, implies further sharp drops are likely. The sharp movements in the early 1990s on 10 year policies were in many ways a reflection of the upswing from the late 1980s (as companies recognised underpayment to policyholders fuelled by favourable investment markets) having to be hastily reversed as lower inflationary expectations brought lower expectations of investment return. At the same time reversionary bonus rates (as opposed to terminal rates) were also under downward pressure for the longer term policies, driven by the same fears of lower investment earnings. The process caused some angst over the speed with which companies could drop reversionary bonus, though the process has been eased by unexpectedly favourable equity markets in the most recent years. Overlaid on this have of course been differing competitive pressures on short term savings vehicles (such as a ten year endowment) and longer term mortgage repayment vehicles (such as a 25 year endowment). Criticism has been made by some of the mutuals over what they perceive as a belated move to more generous payouts from the proprietary companies, which has increased the competitive squeeze on the mutuals.

Companies generally have paid well over simple asset shares (defined below) in recent years, either by their particular experience but more likely by miscellaneous surplus and their estates, with such generosity encouraged by competitive pressures and dividend demands in the proprietary companies. The steady switch from conventional with profit business to unitised with profit options within a unit linked policy may well reduce the competitive pressures on what will become, in time at least, closed conventional series.

GAD provide the following ‘Warnings’ about the information presented in this chapter:

This section of the report looks purely at [ordinary business] conventional with profit policies. Comparisons of Industrial Branch maturity payouts are unfortunately not published in any of the trade magazines, which hinders any useful review. [Ordinary business] unitised with profit business, though very significant, is comparatively young and gives little maturity pay out information with only a handful of companies now capable of showing ten year (pension) results. This class is therefore considered in Section 9 on bonus rates.

The companies considered are the 28 conventional with profit companies that have appeared in the most recent magazine surveys. These are practically all within the “top 66” group that underlies the bulk of this annual report but conversely there are a number (around 10) of “top 66” companies that have not bothered to appear (or avoided appearing) in the magazine surveys. It is these 28 companies that are used for median and leaders and laggards tables in this section.

By concentrating on the major companies who bother to enter surveys one does still capture the bulk of the business in existence, but the considerable number of companies no longer contributing to the surveys must reduce the benefit of our review. (This is indeed a complaint made by the magazines themselves). As noted those not disclosing results are not just the second rank companies outside the top 66 companies but large groups such as [three named companies] and others. While occasional lapses are not suspicious one presumes studied non appearance is because these are often poorly performing offices. (The same effect can potentially be true of the more minor series of policies in the better offices). Such an effect, the self selecting exclusion of poorly performing offices from surveys, means magazine trends of average pay outs must be treated with caution as the later years have higher proportions of those offices who did well. The tables below provide historical data solely for the offices reviewed in 1996, i.e. offices that appeared in the latest surveys, and thus avoid the problem of distorted trends. However the picture is slanted to a band of more successful offices, as some self selection is present by weaker offices being excluded throughout.

On ‘Assets Shares’, GAD’s report explains:

The retrospective roll up of premiums, known as asset shares, is becoming a reasonably common device by which companies gauge the balance of bonus distributions between differing terms of policies. (It is only in some companies that such simple asset shares are looked upon as the sum total of policyholders’ PRE). A graph of asset shares representing the roll up of premiums for the same period as the maturing policies year by year shows a similar picture to a managed fund unit linked policy, i.e. a volatile picture driven by each year’s investment returns. However, the gap between asset shares and the typical smoothed maturity payout can give an indication of the level of miscellaneous surplus and earnings on the estate that companies are distributing to their policyholders. We have therefore created a series of simple asset shares representing the roll up of premiums after the average expense levels identified in section 5, and using investment returns as shown by broadly based indices as the typical with profit asset mix analysed in section 7. The calculations are necessarily crude but do accord with other more theoretical work in actuarial papers of asset shares before the addition of miscellaneous surplus. The main caveats are

• using the average industry acquisition expense for policies of different term overcharges the shorter terms and undercharges the longer terms.
• the asset mix treats all equity investment as in the UK, with none overseas
• the average asset mix could theoretically be a mixture of more conservative mixes for policies close to maturity and more speculative mixes for earlier policies.

GAD set out maturity payouts for 10 and 25 year endowments and 15 year pensions using data from market surveys published in Money Management. They describe the trends in payout levels and particular aspects of certain companies. GAD then set out their ‘Asset Share Comparison’.

Under the heading ‘Theoretical asset share to actual payouts’, GAD say:

On a more speculative basis we can consider the median pay out of the top companies to our calculated progression of simple asset shares, which have no additional miscellaneous surplus added and represent merely a roll up of the contractual premiums less expenses. This comparison is made for a 10 year endowment, a 25 year endowment and a 15 year pension respectively in [the figures below].

GAD present the following figures:

An appendix to the report states that, for 10 year endowment policies, the average maturity payout as a percentage of asset share is 117%. For Equitable, the percentage is 121%.

An appendix to the report states that, for 25 year endowment policies, the average maturity payout as a percentage of asset share is 106%. For Equitable, the percentage is 96%.

An appendix to the report states that, for 15 year pension policies, the average maturity payout as a percentage of asset share is 127%. For Equitable, the percentage is 130%.

GAD say:

Bearing in mind the caveats of sub section 1 and problems arising where terminal bonus declarations are infrequent, there is as expected a noticeable smoothing of maturity payouts. The general effect is of payouts roughly tracking asset shares but at a considerable excess over asset shares in the 1990s. There is a range of possibilities at work here, including the introduction of more accurate methods of setting terminal bonus, competitive pressures in a harsher market and dividend demands in the proprietary companies.

The real interest is whether this apparent situation will continue, as companies recognise the amount of miscellaneous surplus and estate they can distribute; or whether, as at least some companies currently arguing over the attribution of their estates contend, payouts are bound to fall closer to asset shares. [A named company] has separately complained bitterly in public about over paying companies setting unrealistic long term hopes. All of this goes to the heart of PRE arguments and the division of prior surplus not yet distributed.

It is worth noting that if one pushes these simple asset shares on into the years after 1996 then relatively continuous falls in the underlying asset share is revealed year on year, an effect particularly sharp on the longer terms such as the 25 year term. The revealed excesses of current payouts to these crude asset shares described below, and the terminal bonus cover reviewed in section 9 both mean such a future needs a lot of care in management, and may foretell a future reduction in the perhaps over comfortable terminal bonus cushions that were common for offices at the beginning of the 1990s.

Under the heading ‘Excess of actual payouts over asset share’, GAD present the following chart:

GAD explain: ‘With the 10 year contract the excess payment has been present for far longer, though as noted the simple asset shares above are not helped by heavy acquisition costs included in the calculation. None of the top 66 pay under the 1996 base asset share amount of £8,186. With such excesses it is probably no coincidence that the 10 year contract was previously particularly singled out as needing correction by companies in public statements’.

For 25 year endowment policies, GAD present the following chart:

GAD explain: ‘The excess has arisen in the 1990s and implies quite severe earlier under payment to policyholders in the 1980s. If one trusts the crude calculation basis of these simple asset shares, then there has been a significant change in the approach of companies in the last 10 years, possibly for the reasons above with perhaps a more accurate analysis of what is due to policyholders uppermost. By 1996, with a simple asset share of £87,279, the top 66 companies paying below our asset share are [four named companies], Equitable and [another company]. One reasonably common thread between these companies might be a lack of profitable non profit business to boost payouts and relatively modest estates with a similar effect’.

For 15 year pension policies, GAD present the following chart:

GAD explain: ‘The more restricted survey results means the plot of the excess can only be carried back to 1988. The picture does however closely follow that of the ten year endowment. Even with the greater spread of results noted in sub section 2 above for this contract, only [a named company] pays under our simple asset share of £92,486 for 1996’.

In the chapter on ‘Free Assets’, GAD report:

In past years’ annual reports, a broad-brush attempt was made to assess the relative strengths of the valuation bases adopted by the major with-profit offices by comparing the yield on total non-linked assets, adjusting this by stripping out the lowest yielding assets until exactly sufficient assets remain to match the total net non-linked liabilities, and comparing the resulting yield with an average valuation rate of interest used in respect of this business calculated as a weighted average of the actual rates used, the weights being the corresponding net of reinsurance reserves.

This analysis has not been repeated this year, partly because the calculation of the average valuation rate of interest is a very labour intensive exercise, but mainly because there is serious doubt that the level of approximation inherent in the above approach is too great to produce meaningful results. In these circumstances, it seemed that a major manual data extraction exercise from the returns was not the best use of available resources.

GAD continue:

It is hoped that for the 1997 report, a more sophisticated approach might be used based on the information now given in Form 57 of the returns under the new regulations, once a whole year’s experience has been gained in using and summarising the information provided. For this year, however, we have restricted the report to providing just the ratios themselves, with appropriate comments on the relative strength of the valuation basis where this is known from first hand knowledge of the company concerned.

The strength of the valuation basis is, of course, analysed in considerable detail in individual companies’ detailed scrutiny reports. The reader is therefore advised when extracting individual figures from this report to also look at the detailed scrutiny report to put the figure into context.

GAD say that four companies have used implicit items in their 1996 returns, one of which is Equitable. They say that this is unchanged since 1994. GAD say that the free asset ratio for Equitable excluding the implicit item is 3.8%. Under the heading ‘Winners and losers’, GAD provide a table of companies with the highest and lowest free asset ratios. Equitable are listed as being the sixth lowest, with a ratio of 5.5%. (Using free asset ratios that exclude implicit items moves Equitable to joint fourth lowest in the table.) GAD report that:

Both Equitable Life and [the company with the fourth lowest free asset ratio] use the gross premium (bonus reserve) method of valuation, so that the free asset ratios quoted for these companies are not strictly comparable to the others. This method of valuation produces larger reserves because explicit allowance is made for future expenses and bonuses, thereby reducing the free asset ratio. If these ratios were recalculated using the net premium method used by all the other companies, their relative position would improve to some extent.

On the ‘Overall picture’, GAD provide a chart of the percentage change in free asset ratios from 1995 to 1996 and explain:

The most notable feature … is the lack of significant change in free asset ratios compared with 1995. This is in fact not surprising given the economic conditions prevailing during 1996. These were such as to give a typical with-profit office, with a standard spread of investments, a rise in asset values of around 4.75% and a total gross return of around 10.75%. Although this may seem quite a good return, most companies actually require a return of at least this level to sustain their position. Overall, therefore, it was to be expected that free asset ratios would be little changed during the year. Individual companies’ ratios will have changed largely as a result of factors specific to them.

GAD comment on the changes in the free asset ratios of certain companies. They say that Equitable’s free asset ratio had fallen over the year, ‘but this is as much to do with the company’s policy of not maintaining a large amount of free assets as anything else’.

(Note: the bodies under investigation have told me that it should be noted that: ‘the charts selected for this entry all show maturity payouts for regular premium contracts only. By contrast, the bulk of Equitable’s business was recurrent single premium. These charts therefore have very little significance for Equitable. This comment also applies to the corresponding charts provided in the reports prepared by GAD for [other] years’.)

DTI, having received advice from GAD, inform a correspondent from Germany that ‘[being] a member [of Equitable] does not involve any obligations other than the obligation to pay the premium’.

(Note: this statement was to be the subject of criticism in the Penrose Report (Chapter 16, paragraph 215).)

GAD provide DTI with their Scrutiny Report on the Society’s 1996 regulatory returns. (A copy of this scrutiny report is reproduced in full within Part 4 of this report.) The report uses a detailed format similar to that adopted for the 1993, 1994 and 1995 returns (see 15/11/1994 [entry 1], 23/01/1996 [entry 1] and 01/11/1996 [entry 1]). It comprises 15 sections as follows:

(1) Executive summary

GAD say that Equitable are highly regarded, the oldest mutual life assurance society in the world and pay no commission to intermediaries. They achieve outstanding new business growth, based largely on their reputation for low expenses. GAD note:

About 65% of its liabilities relate to unitised with-profits business, for which it endeavours to show competitive annual accumulations of benefits reflecting the total investment returns achieved, but, because guaranteed bonuses include credit for a measure of asset appreciation, future bonus declarations of the Society would seem to be vulnerable to any sustained stock market downturn. It has a modest free estate.

Some questions have been raised about the strength of the reserves established.

(2) Key features

GAD set out some key statistics and observations, including:

• the cover for Equitable’s required minimum margin is 2.53;
• their priority rating is 3;
• new business has more than doubled over the last five years;
• expense ratios are the lowest in the business and persistency experience is good;
• Equitable have achieved a ‘mediocre’ investment return of 10.3% in 1996; and
• ‘The gross premium bonus reserve valuation published does not appear to be any stronger than its permissible net premium valuation’.

(3) Action points

GAD explain that they have asked the Appointed Actuary:

… about the provisions made: (1) for resilience, (2) for possible [capital gains tax], and (3) for pensions mis-selling in the net premium valuation.

He has also been asked to supply data comparing total accumulated assets shares for contracts in force with the total assets available.

(4) Background

GAD reiterate information included in the Background section of their reports on the 1993, 1994 and 1995 returns, namely that Equitable are the oldest mutual life assurance society in the world and that they never pay commission to third parties. GAD explain that: ‘This background is typified by a determination to provide fair bonuses to policyholders, with no deliberate holding back of profits from one generation to another, by unit linked products which often have discretionary surrender values, and by using a gross premium bonus reserve valuation method’. GAD also say that:

The DTI returns also show the results of applying a net premium basis with assumptions close to the minimum permitted by regulations.

GAD note that Equitable obtained a section 68 Order for a future profits implicit item of £600m for the 1996 returns and have used £312.8m. They also note that, in 1995, Equitable purchased a controlling interest in Permanent Insurance and bought out the minority shareholders in June 1997.

GAD explain that Equitable have increased their overseas activity in recent years (in Guernsey, Republic of Ireland and Germany) and that this was producing increasing amounts of new business. GAD state, as in their reports on the 1994 and 1995 returns, that Equitable regard this as ‘missionary work’.

GAD note that the last visit to Equitable was made in November 1996 (see 08/11/1996 [entry 2]), and that in 1997 Equitable took out a £350m subordinated loan.

(5) New business

GAD set out the new products Equitable have developed and the sources of their business. GAD produce tables showing the recent history of new regular premiums and new single premiums and a new business index. GAD comment that Equitable continue to produce exceptionally strong new business figures and that a very large proportion of the business ‘is of the “accumulating with-profit” type, which is newly identified in the 1996 Returns’.

GAD note that, as Equitable are not able to produce meaningful in-force premium figures for renewable single premium business, with the agreement of DTI the annual premiums recorded in Form 46 of the returns ignore this business.

(6) Changes in business in force

GAD provide a table showing ‘Recent history of regular premiums received’. They note:

While the revised Regulations were intended to help give appropriate recognition to renewable single premium business and classify it as regular premium business, the flexible nature of Equitable’s products has made it difficult for them to quote a basic regular premium payment. As a somewhat perverse result, for 1996 the Returns of Equitable actually show lower regular pension premiums and higher single premiums.

GAD produce tables showing: ‘Claims experience’; ‘Persistency experience’; and, ‘Recent history of combined surrender, lapse & paid-up conversion rates’.

GAD note that, although pensions is the major class of Equitable’s business, persistency data was not available, due to the flexible nature of the contracts written.

(7) Expenses

GAD produce a table showing the history of expenses from 1992 to 1996. They comment that Equitable’s expense ratios keep improving and have again reached ‘astonishingly low levels’. GAD note that Equitable claim to have invested £50m in redeveloping all operating systems over recent years, but that no exceptional costs were observed in 1996.

(8) Non-linked assets

GAD produce tables showing Equitable’s: ‘Recent history of asset mix’; ‘Recent history of asset mix attributable to UK with-profits business’; ‘Movement in asset values during the year’; and, ‘Investment performance’.

The latter shows a return of 10.3%. GAD comment:

This return is slightly disappointing for the portfolio held, but includes a write-down in the value of investments in dependants. However, the return claimed in the Society’s accounts for assets matching with-profit liabilities of 10.7% is competitive.

(9) Assets held to match linked liabilities

GAD provide details of internal linked funds, other assets matching property-linked liabilities, mismatching to property-linked liabilities, assets matching index-linked liabilities and PRE. On the latter, GAD comment:

Where a fund invests in an Equitable Unit Trust, the annual management charge is reduced by ½%, and charges are also adjusted where a fund invests in units of another fund to ensure that only one levy is made.

GAD observe no particular problems.

(10) Valuation basis

GAD explain that Equitable:

… produces its published Return on the basis of a gross premium valuation for non linked business, with some allowance for future bonuses, but the results of a net premium valuation are also shown in the Returns – with a negligible liability difference.

The Equitable tries to provide a fair bonus allocation to each generation of policyholders – without holding back an excessive estate. The result is that lower free asset margins exist than might have been expected for such a well thought of institution. It may be noted that the Society has, for the last three years, found it desirable to utilise a future profits implicit item to improve the disclosed free assets position – although at nowhere near the maximum that could be justified under the guidelines.

There is one hidden strength in the valuation – the treatment of recurrent single premium pensions business, under which it is assumed that no more premiums will be received. Although in line with the best practice, this is a strong basis – particularly for property linked contracts. If such business were treated as regular premium, margins in future premiums and charges on the funds built up might allow somewhat lower reserves.

GAD note, as in previous years, that a hidden strength in the valuation is the treatment of recurrent single premium pensions business, under which it is assumed that no more premiums will be received. GAD go on to discuss six particular areas:

Interest – GAD provide a table showing the valuation interest rates used for major classes. They state that ‘Forms 57 show that matching assets are available’.

Mortality – GAD explain that the bases used are reasonably conservative and that ‘[the] Appointed Actuary insists in his report that these tables contain sufficient allowance for future reductions in rates of mortality’.

Expenses – GAD state that the total provisions were more than adequate and that the Actuary’s contention that no additional provisions are needed to cover the continued sale of new business or to cover closure seemed acceptable.

Resilience and special reserves – GAD explain:

A resilience reserve requirement is reported of £501m, but this has not been allowed for in Line 29 of Form 57 and bearing in mind that this must be largely covered by equity assets, it is thought that a grossed up figure of £668m should have been provided for.

This is being queried.

Other factors – GAD explain that the parameters used for establishing sterling reserves for unit-linked products seem rather weak. ‘However, potential expense strains are not thought to be great for this company and the standard annual expense inflation rate assumption they use is only 4%, so no question has been raised on this occasion’.

GAD add:

The failure to set up a specific reserve in relation to the contingent liability of £47.7m for tax on capital gains on non-linked assets is dubious – relying on other margins in the valuation basis. This is being queried.

A pensions mis-selling reserve of £50m was included within the future bonus provision in the bonus reserve valuation, but it is not clear that any such provision was established in the net premium valuation. This is also being queried. [Recent correspondence suggests that the required provision had risen to £85m by 30 September 1997.]

Overall strength — GAD state:

The Society informs its holders of accumulating with profit contracts of the amount of their accumulating final bonus (although clearly stating that it is not guaranteed), but only holds reserves for a discounted sum compared with the current guaranteed value.

It is stated in the return that final bonus additions (the accumulated amount of which are not revealed) are implicitly covered by the amount of excess admissible assets over the mathematical reserves – shown in the 1996 Return as being about £1.4bn (including the [required minimum margin]). However, since the reserves already value current guaranteed benefit values at a combined discount of some £1.3bn, it seems likely that the total current “asset shares” (including final bonuses indicated to members) exceed total current admissible assets. The Actuary is being asked to clarify his view of the situation!

(11) Financial results

GAD provide an overview:

The Bonus Reserve Gross Premium valuation shows available assets covering the [required minimum margin] by a factor of 2.53, and the net premium valuation would show a similar picture.

Without the implicit future profits item of about £312.8m, cover for the [required minimum margin] would be reduced to a factor of 2.07. Further, we are not clear that provisions made against the market value of assets for resilience and prospective capital gains tax are as strong as they should be.

Because of the large proportion of business written on a participating basis and the high level of annual emerging surplus, there are not considered to be any actual potential solvency problems for the Society, but it does seem that, in the event of a marked fall in asset values, the Society might find itself in a position where it had to cut back severely the level of payout to members.

It would seem desirable for the Society to hold back more of its emerging surplus by declaring lower guaranteed bonuses – although it could still attempt to pay out generous final bonuses to members (preferably without raising expectations too much in advance with its declarations of “non-guaranteed final bonuses”).

Against this last point, DTI’s Line Supervisor B notes ‘Policyholders must find this confusing!’.

Under ‘Summary of results for main classes’, GAD produce three tables showing liabilities for non-linked and linked business and a valuation summary. The valuation summary shows, under the main valuation, that Equitable’s cover for the required minimum margin is 2.53 (compared with 2.89 in 1995). There is no figure for cover under the appendix valuation. The table shows that Equitable’s free asset ratio has fallen to 3.84% (from 5.13% in 1995). GAD comment:

The Net Premium Valuation generated a lower non-linked liability of £14,675,209,000 and a lower reserve for declared bonuses of £474,207,000 but was shown to require a resilience reserve of £501m.

Thus, the total Long Term liabilities for … the [net premium valuation] would be £17,705,214,000, ie most of the apparent margin between the [bonus reserve valuation] and [net premium valuation] policy liabilities is needed to cover resilience, and the [bonus reserve valuation] does not produce any material extra margins.

GAD produce a further table showing composition and distribution of surplus. They make no comments on this.

(12) Bonuses

GAD produce tables showing the cost of bonuses declared and the recent history of key bonus rates. They repeat the description of Equitable’s bonus system and quote from Equitable’s own description. Against this, Line Supervisor B writes: ‘Perhaps this confuses [policyholders]?’.

GAD reproduce Equitable’s table of earned investment returns on gross market value and the rate allocated in fixing bonuses, updated to include 1996:

‘* 12% was applied to new benefits secured during the year’

Under ‘PRE’, GAD state that Equitable:

… tries very hard to achieve an equitable distribution to each generation of its policyholders, whilst avoiding short term fluctuations in benefits – with the result that it has not accumulated any material unallocated estate compared with accumulated asset shares (if any – see Section 10.7).

However, it reserves the right to penalise early surrenders, even in relation to guaranteed bonuses added under unitised contracts, and it might be desirable for this possibility to receive greater prominence in the literature distributed. Further, with such a large proportion of unitised business and with the level of guaranteed bonuses declared taking account of some asset appreciation, it would seem to be desirable that policyholders were given some greater warning about the possible implications for future bonuses of a substantial market setback.

Against this, Line Supervisor B notes:

Take up with company? I discussed this briefly with [Scrutinising Actuary E] – concern is that [the company] has no estate – no cushion. Should not perhaps be giving bonuses to new [policyholders]. But the markets are up at present.

(13) Reinsurance

GAD state that Equitable make little use of reinsurance.

(14) Compliance

Under ‘DTI compliance problems’, GAD state:

The Society is not able to produce meaningful in-force premium figures for renewable single premium business, and a Section 68 Order has been given on a temporary basis (up to the end of 1998) [see 30/04/1997] allowing the Society to exclude recurrent single premiums from the annual premiums recorded [in the returns].

Against this, Line Supervisor B has written ‘I wouldn’t call this a compliance problem’.

Under ‘PIA and other compliance problems’, GAD state:

A pensions mis-selling reserve of £50m was included within the future bonus provision in the bonus reserve valuation, although it is not clear that any such provision was established in the net premium valuation and this is being queried.

Recent correspondence suggests the required provision had risen to £85m by 30.9.1997.

(15) Professional requirements

GAD certify that their report conforms with the requirements of the Institute and Faculty of Actuaries as set out in their Memorandum of Professional Conduct and Advice on Professional Conduct and has been prepared in accordance with the Service Level Agreement approved in March 1995.

GAD’s scrutiny report runs to 19 pages. Line Supervisor B copies the report to Line Manager C and to the Head of Life Insurance.

GAD write to Equitable to pursue five issues arising from their scrutiny of the 1996 returns.

(1) GAD point out that Equitable do not state what test they have applied in assessing the required resilience reserve. GAD query if the figure indicated in the report on the net premium valuation (£501m) should be grossed up.

(2) GAD state that they are not convinced that it is acceptable for Equitable to assert that other margins are available to cover the discounted value of the prospective liability for tax on unrealised gains. GAD invite Equitable to comment on this point and to advise what other margins are considered to be available.

(3) GAD note the provision for £50m for pensions mis-selling in the bonus reserve valuation and ask where the corresponding provision is in the net premium valuation.

(4) GAD say:

It is stated in the return that final bonus additions are implicitly covered by the amount of excess admissible assets held over the mathematical reserves – shown in the 1996 Return as being about £1.4bn. (including the [required minimum margin]). However, since your reserves already value current guaranteed benefit values at a combined discount of some £1.3bn, it seems likely that the total current “asset shares” (including the final bonuses indicated to members) exceed total current admissible assets. Is this a correct deduction? Please provide a figure for the accumulated asset shares for all in-force accumulating with-profit contracts at end 1996.

(5) GAD ask Equitable to explain if:

… the policy reserves for any accumulating with profits policies were lower than the basic surrender values available at the valuation date (ie excluding any amounts in respect of final bonus from these values)? If so how much was the total of such differences?