1998

Equitable write to GAD in reply to the five points in their letter of 16/12/1997:

(1) Equitable state which of the resilience scenarios tested was the most onerous and used for the resilience reserve. They undertake to specify this in future. They confirm that the figure used is the grossed up amount.

(2) Equitable reiterate that there are substantial margins in the expense reserves and point to the parts of their returns which show these. They say:

The prospective liability to tax on unrealised gains will essentially relate to earnings to be distributed as final bonus on [basic life and general annuity] business. As such the potential tax liability might reasonably be argued to be a charge on the Investment Reserve and, accordingly, not need to be provided for within the mathematical reserves in any event.

Equitable ask for GAD’s comments on this view.

(3) Equitable state that the provision of £50m was similarly held within the mathematical reserve for personal pension business.

(4) Equitable explain that they do not understand GAD’s question. Equitable say:

A comparison of the totals of columns 11 and 12 on form 52 shows that the discounted value of accumulating with profits benefits is £638m less than the full “face value”, not £1.3bn less as you state. I am also not clear as to the meaning you attach to the highlighted words “current guaranteed”. The face value of benefits is the current value of guaranteed benefits if a contractual event (eg death) occurred at the valuation date. In most cases there is no contractual right to receive the current accumulated benefit at the valuation date.

Against this paragraph, GAD note that current benefits are discounted by £638m ‘for [gross premium valuation], but £1,320m in [net premium valuation]’.

Equitable acknowledge, however, that GAD are:

… correct in deducing that at 31.12.96 the total face value of policies including accrued final bonus was in excess of the value of the assets attributable to with profits business. Those assets will include items like the accumulated new business strains and so are higher than a pure share of the Form 9 admissible assets.

Equitable continue:

Regarding your final sentence, I am not clear whether you are asking about unsmoothed or smoothed asset shares. Because of the flexibility of our contracts we do not calculate unsmoothed asset shares for every policy. However, given the way we operate the business the totality of unsmoothed asset shares will be close to the value of the assets attributable to with profits business. If, however, you are asking about smoothed asset shares, then our bonus systems mean that the policy value, including final bonus, is effectively a smoothed asset share. Thus the total of such asset shares will be the total face value of policies including accrued final bonus, as discussed above.

Equitable then state that the total figure for accumulating with-profits contracts at 31 December 1996 was £14.7bn.

(5) Equitable explain that their accumulating with-profits policies do not include guaranteed surrender values as such, but that:

… there are ranges of dates between which benefits may be taken at full value (eg on retirement). The valuation method takes account of such options which explains why the discounted value of benefits is 95% of the face value, when the typical outstanding period to selected pension date would lead one to expect a much more substantial degree of discounting.

They add:

You may be interested to know that, in the light of the reduction in yields in 1997 and the loss of tax credits on UK dividends, I expect that the reserves at 31 December 1997 for accumulating with profits business will, including resilience reserves, need to be greater than the face value of benefits.

GAD sideline this paragraph.

GAD write to Equitable in reply to the five points in their letter of 13/01/1998:

(1) GAD thank Equitable for confirming that the resilience reserve required of £501m is the grossed up value. GAD say:

It would be easier to follow what has been done if Forms 57 of your Returns included the resilience reserve as a liability in Line 29 – presumably giving a total initial liability of £15,675,191,000 and a corresponding value for initial matching assets.

GAD point out that Equitable’s figure in the body of their returns for the fall in value of assets and liabilities does not correspond with the figure in the net premium valuation.

(2) GAD state:

We accept that there are margins that will emerge from expense reserves in future years, but are still not convinced that it is appropriate to use these to cover the discounted value of the prospective liability for tax on unrealised gains on assets shown at market value in Form 9.

GAD continue:

With regard to your more general point, in the Statement of Solvency as set out in Form 9 total liabilities are set against the total market value of admissible assets. This automatically includes any amount that is considered to be an “investment reserve”, irrespective of the use to which it might be put. We believe that liabilities must also allow for any tax payable on chargeable gains, though it is naturally possible to reduce this tax liability in resilience scenarios.

GAD ask Equitable to reconsider this matter for their next returns.

(3) GAD note that the pensions mis-selling provision of £50m was included within the mathematical reserves for personal pensions business in the net premium valuation. They state: ‘We consider that the existence of such reserves should be disclosed in the valuation report, and it would clearly be helpful if it were also disclosed where such reserve is held. Please review for the next Return’.

(4) GAD explain that the figure for the discounting of reserves of £1.3bn is taken from the figures supplied in the net premium valuation. GAD say that this ‘is the valuation basis that we consider to be most informative. [Indeed, I am unclear as to why the Society persists with providing the gross premium bonus reserve alternative.]’

GAD continue:

It is my understanding that bonus notices from Equitable relating to accumulating with-profits business include details of accumulated non-guaranteed final bonuses. I do not think that it is possible to derive from your Returns the amount to which such final bonus expectations have accumulated at the valuation date, and my emphasis on the level of accumulated “current guaranteed” benefits was merely intended to highlight this missing information. I naturally accept your point that even the amount of the current face value of guaranteed benefits is not immediately payable at the valuation date.

I am grateful for the clear answers given in your second and third paragraphs, confirming my deductions about the overall financial position of the Society. The total figure for the face value of all accumulating with-profit policies including accrued final bonus of £14.7bn is £3.8bn above the net premium reserve carried for this business, and this margin clearly well exceeds the amount of available free assets shown in Form 9. I am happy to confirm that this does not necessarily cause me any concern, but the lack of any unutilised free estate does bring to prominence the importance of not building up policyholder expectations too far – with the implication that it might then be considered necessary to hold reserves for anticipated final bonus additions. I am sure that you are acutely aware of this.

Line Supervisor B underlines and sidelines the comment about the lack of an unutilised free estate and policyholders’ expectations. On her copy of GAD’s scrutiny report on the 1996 returns, the Line Supervisor records concern that Equitable have no estate and queries if they should be giving bonuses to new policyholders (see 16/12/1997). She further records that the above is GAD’s response.

(5) GAD state that they assume Equitable’s answer relates to the reserves held in the bonus reserve valuation, whereas their question related to the net premium valuation. GAD repeat their request that Equitable confirm:

… that available surrender values at the valuation date under accumulating with profit policies, excluding any amount which may be attributed to final bonuses, did not exceed the discounted reserves held in the net premium valuation.

GAD send copies of Equitable’s letter of 13/01/1998 and this reply to HMT. GAD explain that they will provide their final thoughts on the scrutiny after they have considered Equitable’s next reply.

Equitable write to GAD in reply to the five points in their letter of 16/01/1998:

(1) Equitable give an explanation for the discrepancy in the figures. They query if GAD’s suggestions for completing the returns are consistent with the ICAS Regulations 1996.

(2) Equitable note GAD’s comments and undertake to consider the matter for the 1997 returns.

(3) Equitable explain that their approach in the 1996 returns reflected the difficulty of quantifying the amount of the possible liability. Equitable say they now have more data and that they ‘will be showing an explicit reserve in the 1997 returns’.

(4) Equitable explain that:

The bonus reserve valuation published is the one the Appointed Actuary considers appropriate to the requirements of regulation 64(1). The fact that it is based on a bonus reserve method is partly due to historical precedent (it was the method developed by William Morgan to carry out the first ever actuarial valuation of a life office) but, more importantly, because successive actuaries have felt it better suited to the nature of our business. The net premium valuation is published purely to demonstrate compliance with regulation 67(4).

Equitable suggest that the figures given by GAD in their letter of 16/01/1998:

… somewhat misrepresent the position because you are comparing the excess of total policy values (including final bonus) over the net premium reserves with the Form 9 “free assets” which are based on the bonus reserve valuation. Also, as noted in my previous letter the admissible assets are, in commercial terms, a conservative view of the assets properly attributed to the with profits policyholders.

Equitable explain that they ‘take great care on our bonus statements to emphasise that the final bonus element of the current policy value is not guaranteed in any way’ and that ‘In the years we have been using this form of presentation we have, as you say, been acutely aware of the need not to build-up inappropriate expectations’. Equitable continue and say that they ‘do, however, feel very strongly that giving full policy values (as well as the current value of guaranteed benefits) is very useful for policyholders in planning their affairs’.

Equitable suggest that some declared bonuses are being kept imprudently high by some offices, particularly on with-profits bonds ‘partly due to a failure of [those] offices to communicate the developing terminal bonus position adequately to their clients’. They continue by saying that ‘[an] annual presentation of the overall position, such as that used by the Society, avoids such pressures and allows a more disciplined approach to reversionary bonuses. I think it would do a grave dis-service both to policyholder communications and the sound management of offices if quoting current policy values including terminal/final bonuses effectively became outlawed for the reasons implied by your penultimate sentence’.

(5) Equitable state:

I apologise for misunderstanding your question but the approach described in … my response applied equally to the net premium valuation. (The degree of discounting is slightly higher due to the higher interest rates.)

GAD’s insurance sections hold a regular monthly meeting. Amongst other matters, they discuss annuity guarantees. GAD’s minute records the following:

[A Directing Actuary] explained that this subject had become relevant due to the current low interest rate environment for both short and long term stocks, and with the additional factor that mortality rates were lower than when guarantees were given.

[A GAD Scrutinising Actuary and member of the Annuity Guarantees Working Party] outlined the response by the Institute Working Party on this matter, although the [Working Party] had not met since the Brighton conference in November 1997. The three aims of the working party were to:

1. Identify what the risk was.
2. Find methodologies for reserving for that risk.
3. Survey the industry to determine what actuaries were thinking on their reserving basis.

The findings demonstrated that a problem existed, with roughly 50% of companies recognising they had a problem and of those, a further 50% reserving properly, leaving 75% of companies not reserving adequately.

It was agreed that a GAD circular letter should be sent to companies to provide information on this subject, with the [Working Party] questionnaire being used as a template.

GAD write to Equitable in reply to the five points in their letter of 04/02/1998:

(1) GAD state:

We and, I confidently believe, most actuaries have accepted that long term liabilities to be incorporated into Forms 57 include any required resilience reserve – and such reserve is normally included with other liabilities that do not require a discount rate to be applied.

(2) & (3) GAD note Equitable’s comments.

(4) GAD say that they:

… note your reasons for sustaining the bonus reserve valuation for conventional with-profit business, but I would point out that the overall result compared with the net premium valuation (that we monitor) would now appear to be little different. I calculate that, including the required resilience reserve, the liability that would have been shown in Line 23 of Form 9 using your alternative net premium valuation as at 31.12.1996 was £17,567,234k, i.e. less than £5m lower than the reserves produced using the bonus reserve valuation figures.

GAD reassure Equitable that no consideration was being given to outlawing the type of bonus notice they currently issue, but that it would be a matter for concern if any holders of accumulating with-profits contracts were ever to feel that they had been misled. GAD add:

It is clearly in the best interests of the whole industry for all participants to be wary of either granting over-generous guaranteed bonuses or of building up any false expectations in relation to final bonuses. The manner in which Equitable operates as a mutual – giving the best possible returns to each generation of policyholders, with the consequent lack of any substantial unutilised free estate, does mean that you do not have much of a cushion to enable you to protect holders of such contracts from the natural effects of future falls in the market value of assets. We remain confident that your company is fully aware of this.

(5) GAD note Equitable’s comments, but add:

I am not clear that you have directly answered my question “can you confirm that available surrender values at the valuation date under your accumulating with-profit policies, excluding any amount which may be attributed to final bonuses, did not exceed the discounted reserves held in the net premium valuation?”

GAD copy this letter to HMT. GAD say that there are no compliance points in relation to the 1996 returns for HMT to follow up, although Equitable have agreed to some presentational changes for the 1997 returns (see 04/02/1998, point 3). GAD continue:      

I also confirm that, even though our correspondence is not yet concluded about their accumulating with-profit business, we are basically satisfied with the prudence of their reserving bases as adopted for the 1996 returns.

The position revealed is very tight, since Equitable operates on the basis that, as a mutual, it should endeavour to give full value to each generation of policyholders. It therefore does not accumulate any meaningful free estate. Hence our desire to ensure that it does not build up any false expectations for its policyholders, because it would be hard for it to establish reserves for any greater liabilities than those it currently recognises.

GAD conclude that HMT may now regard the scrutiny of the 1996 returns as complete.

Equitable write to GAD in reply to their letter of 27/02/1998. In response to the outstanding points from the correspondence:

(1) Equitable explain that they are happy to adopt whatever approach GAD require, but observe that there seems to be ‘some general confusion’ on the point, with one other company interpreting the requirement in the same way as the Society. They suggest that HMT clarify the guidance notes on this point at the next update.

(4) Equitable note GAD’s comments with interest. Equitable add:

The relationship between the bonus reserve valuation result and the net premium result is not surprising where the view taken about the appropriate level of the bonus reserve valuation is similar to the regulatory requirements (including resilience testing).

The point may become clearer in the 1997 returns. As mentioned previously, I shall be showing essentially “full value” bonus reserve liabilities (ie no discounting of the accumulating with profits “current benefits”) since I consider that to be appropriate to current conditions. The net premium reserves will be lower. Conditions at 31 December 1997 were, however, such that an explicit resilience reserve will be needed in addition to the bonus reserve liabilities in order to satisfy the GAD guidelines. The net premium valuation will naturally require a larger resilience reserve, the difference between the two resilience reserves being equal to the difference between the two sets of mathematical reserves.

(5) Equitable explain that they now understand GAD’s question to relate to any surrender. Equitable say that they could not ‘state categorically that the non-contractual surrenders we were actually paying on 31 December 1996 were, in all cases, lower than the mathematical reserves held’. They add that they are not clear as to the relevance of the point as:

The surrender values being paid were only “available” because we were prepared to pay them on the low incidence of early non-contractual terminations being experienced. If we had been experiencing a significant volume of surrenders we should have exercised our right to reduce further the values paid – possibly to below the level of the mathematical reserves in all cases – in order to protect the fund.

GAD write to Equitable’s Appointed Actuary in reply to their letter of 12/03/1998. GAD state that the new guidance note would make the approach to showing the resilience reserve clear. GAD note Equitable’s comments on questions 4 and 5 and add:

The whole area of the appropriate bonus methodology to be used for accumulating with-profits business, the expectations built up for policyholders and the establishment of proper reserves has become more difficult as a greater proportion of investment returns is being derived from asset appreciation — which could prove to be ephemeral.

GAD describe Equitable’s Appointed Actuary as Actuary to a leading office in the field which has been writing this type of business for longer than anyone else. GAD invite him to visit to discuss these topics. The meeting is set for 28/05/1998. On HMT’s copy of this letter, Line Supervisor B notes that GAD would let HMT know the outcome. The Line Supervisor notes further: ‘28/5 — discuss how he runs his bonus policy’.

An HMT official writes to the Head of Life Insurance about the service level agreement in place between HMT and GAD. The official says:

This is the first time I have read this document and there are many parts of it that appear to me to be surprising and open to question. In places it reads much more like a set of rules designed to ensure that Insurance Directorate does not default on its obligations to GAD rather than the other way round. There is no provision for termination of the agreement, few standards are set out, and there is no time limit. In fact, if this agreement was submitted by a company requiring authorisation as a services agreement eg for third party administration, we would probably require it to be re-written!

Given the sensitivities involved it may be difficult to do this but there is one part that is difficult to accept. This is A16. This allows GAD to write to the company without any reference to us unless they consider it appropriate for us to do so. In my view GAD should never write to a company without prior reference to us and express agreement on our part that they should do so; and they should copy such letters to us as soon as they have been sent.

Basically I think this agreement is out of date and will be outmoded when we enter the FSA. There seems little to be gained by revising it at this stage. But what is the purpose of renewing it if it will be replaced by an FSA/GAD agreement. And is it really appropriate for us to renew it without reference to the FSA given that we are now getting into the mode of becoming more integrated with the FSA?

GAD (Scrutinising Actuary E and Chief Actuary D) meet Equitable’s Appointed Actuary. GAD do not make a formal record of the meeting. However, the Scrutinising Actuary’s notes of the meeting show that they discuss Equitable’s bonus declaration strategy, individual savings accounts and Permanent Insurance. With respect to the first of these topics, Scrutinising Actuary E notes:

Non [guaranteed] element could be negative.

Particular problems with Bonds rather than pensions [business].

Has company done specific market research on policyholder understandings? Analysed telephone queries.

Further discussion to take place on reserves. – Equitable.

[Regulation] 69, max interest rate. – Permanent [Insurance]?

Discussed PRE surrender test.

Equitable’s Appointed Actuary prepares his own note of the meeting. He records:

The meeting was fairly unstructured and went through somewhat of a ragbag of not particularly well thought through concerns that [GAD] have. However, their main points seem to be:

1. Declared bonus rates are still too high.
2. That offices have been incautious in distributing recent high capital returns and have not made sufficient allowance for the fact that such returns may reflect a “one off” adjustment to a lower yield basis or could be reversed to a significant degree by a change in sentiment.
3. That the way benefits have been presented to policyholders restricts the ability of offices to make significant changes to terminal bonuses without severely damaging policyholders’ perceptions of them.

The Appointed Actuary notes that, although GAD had general concerns about the industry, GAD:

… appeared to have some specific concern that we were more exposed to the above risks than most other offices. That was partly due to our “full distribution” approach and also to some anecdotal evidence that policyholders believed their full fund value to be guaranteed.

The Appointed Actuary records that he strongly refuted the suggestion that Equitable were more exposed, citing Equitable’s disciplined approach to declaring reduced bonuses; their realistic views on investment prospects ‘that had led to a deliberately cautious approach to setting bonuses over the last couple of years’; and the information provided to policyholders. He also notes that GAD:

… asked about the current relationship of total policy values to underlying assets and I said that I thought currently assets were around 105% of policy values.

He concludes:

It is difficult to judge exactly what [GAD] were hoping to gain from the meeting but they stated at the end that they were considerably more reassured about our approach than they had been at the start.

The Appointed Actuary notes that, at the end of the meeting, there was some general conversation about other issues, including the proposals from the Working Party on the statutory valuation basis and reserving for annuity guarantees.

GAD write to Equitable following the meeting on 28/05/1998. GAD say:

I think that there is little more to be said or done at this stage in relation to the reserving bases that are appropriate for accumulating with-profits business, but it is clear that we are agreed that great restraint should be exercised in relation to the setting of guaranteed bonus levels at a time when a large part of investment returns is being derived from capital gains.

GAD note the openness of Equitable’s current bonus structure and the clarity of the notes included in their bonus notices. GAD explain that they still remain wary that some of Equitable’s policyholders may not appreciate that levels of non-guaranteed final bonus might actually be reduced from one declaration to the next. They note that the only research Equitable had done into policyholders’ understanding of the notices was an analysis of telephone enquiries received, and question whether the analysis remained relevant.

GAD write to HMT enclosing a copy of their letter to Equitable. GAD confirm that their discussions:

… did not conclude that any particular strengthening of their reserves was needed in relation to accumulating with-profits business, although I remain somewhat concerned that not all holders of such contracts (with this and other offices) appreciate what could happen at future bonus declarations if we saw a sudden downturn in the market value of assets. The whole industry is relying on a soft landing, so that reductions can be achieved gradually and without trauma.

GAD inform HMT that they intend to conduct a survey of companies about annuity guarantees. GAD say:

You may like to see the attached questionnaire that we propose to send to life offices requesting further information about some of their pension contracts. We are aware from a recent similar survey by the actuarial profession that there is a potential issue for a number of companies which have provided guarantees of the basis on which they will convert lump sums under various pension contracts to an annuity income stream.

Most of these guarantees were given on bases (for mortality and interest rates) which looked relatively conservative at the time they were given. However, with increasing life expectancies, and significant reductions in yields on gilts in recent years, a number of these offices may now be significantly exposed to additional liabilities in respect of these guarantees.

Unfortunately, most of the company returns do not provide sufficient information at present about this particular exposure. Our questionnaire is therefore designed to elucidate further information on these guarantees from each office. This can then be analysed here so that we can identify those companies where further discussion may be needed as part of the ongoing supervisory process.

I hope that there are no perceived difficulties over our collecting this general information. We shall certainly inform you of our findings, and of course highlight for you any companies where there may be a particularly significant problem.

Every insurance company is sent by a GAD Directing Actuary, who also has responsibility for Equitable, (Directing Actuary B) a letter, headed ‘Reserving for Annuity Guarantees’. The Directing Actuary says:

We are aware that a number of companies have included various forms of annuity guarantees on some of their pension products. Detailed information on the nature and extent of these guarantees is not though specified as having to be provided for all contracts in the returns.

Directing Actuary B explains that, given trends in recent years in mortality and market  interest rates, a number of the guarantees may be of increasing significance to the financial management of life insurers. Consequently, GAD are seeking further information about the nature of the annuity guarantees written, methods of reserving for them, and other related issues. The Directing Actuary encloses a questionnaire and asks for it to be completed and returned by 31/07/1998.