The Society’s response to GAD’s Reserving for Annuity Guarantees survey

Equitable state that the mathematical reserves for these products, at the most recent valuation date (31 December 1997), total £6,539m but that this figure includes no reserves for the annuity guarantee. Against this an unidentified official writes: ‘?’. Equitable further state that ‘No explicit provision is made for annuity guarantees’ and ‘No explicit provision [for annuity guarantees] is made in setting the resilience reserve’. Equitable confirm that they make no general allowance for the guarantees when establishing maturity values and take no significant account of the guarantees when determining investment policy and matching guidelines.

In response to the question: ‘On with profits contracts is your approach to setting terminal bonus rates for a cohort of policies influenced by whether or not an annuity guarantee is biting?’, Equitable reply ‘Yes’ and explain:

For any policy for which the annuity guarantee is biting, the amount of terminal bonus is reduced to pay for the cost of the guarantee. For all but a few small policies the “cost” of the annuity guarantee is covered by this adjustment.

GAD’s Scrutinising Actuary E sidelines this statement.

Equitable also confirm that policyholders are not advised of any available options to receive a guaranteed annuity when they reach retirement. Against this an unidentified official writes: ‘?’. Equitable further confirm that, if a policyholder selects an annuity different from the one on which a guarantee is offered, the amount of annuity is not determined on the same basis as would have applied. Equitable state that annuity guarantees raise no other issues for them as a company. They add as a final comment:

The cost of annuity guarantees has more than adequately been covered by the terminal bonus cushion to date for all but a few small policies, as described … above. As the business to which annuity guarantees apply ages, the increasing terminal bonus cushion will make it increasingly unlikely that guarantees will actually bite.

Scrutinising Actuary E sidelines this response and writes: ‘Is this acceptable?’.

GAD’s Chief Actuary C (who has resumed responsibility for Equitable) annotates his copy of Equitable’s completed questionnaire with a number of calculations.

GAD’s Chief Actuary D sends HMT a paper headed ‘Guaranteed annuity options – matching and ancillary considerations’.

The Chief Actuary explains that a guaranteed annuity rate effectively combines an annuitant mortality table and a rate of interest. But:

With the passage of time, the mortality table has become imprudent, in that it assumes too high a rate of mortality. This did not initially cause any problems, as the interest rate was modest, and the overall rate was below current rates. More recently, with significant falls in long gilt yields, this counter-balance has disappeared, or at least fallen to very modest levels.

Companies now face a significant problem with regard to these options.

The Chief Actuary suggests that insurance companies have in effect written derivatives for their policyholders’ benefit and that one solution to the current problems is for companies to buy an equivalent option from the investment markets. This has a number of complications, but he states:

Whatever is the technical position, it must be remembered:

• these GAOs exist in large numbers, and threaten solvency in many cases and policyholders’ actual, if not necessarily reasonable, expectations in more
• derivatives are a natural way to protect the interests of policyholders
• there is a risk of these becoming the regulator’s problem!

Chief Actuary D discusses policyholders’ reasonable expectations. He explains that there are two views in the industry:

Terminal bonus is determined as the amount necessary to raise policy proceeds to asset share (plus or minus a bit). If a GAO applies, then the policy proceeds can be measured as the cost of an annuity of that amount (on a realistic not a prudent basis). Therefore terminal bonus can be restricted to keep the cost of GAO down. This cannot justify a lower reserve, however, as the terminal bonus is not itself reserved for.

Alternatively, the terminal bonus has been described, and therefore a policyholders’ reasonable expectation created, based upon the open market option, and to the extent that a GAO applies to the full sum, the full pain must be borne.

There is probably no solution to this issue on an industry basis, as it probably is a function of policy wordings, marketing material, with profits guides and similar items.

Under ‘Investment Policy’, the Chief Actuary says:

The presence of guarantees of all kinds serves to restrict investment freedom. This is surely one of those things which fall within policyholders’ reasonable expectations. Where there are GAOs on some policies and not on others, to what extent is it in accordance with PRE to:

• buy derivatives, and charge the cost generally to the estate which may need to be built up again from current or future policyholders
• buy derivatives, but charge the cost to assets shares of the GAO policies
• buy derivatives, but charge the cost to asset shares of all policies
• invest more heavily in fixed interest securities, earmarked to those policies with GAOs, which therefore have probably lower asset share growth
• invest more heavily in fixed interest securities leaving the probably lower returns to impact asset share growth generally
• treat emerging losses as a charge to the estate, which may need to be built up again from current or future policyholders
• treat emerging losses as a hit on asset shares on GAO policies
• treat emerging losses as a hit on asset shares on all policies
• There is no easy answer, and again it may be necessary to look carefully at each case.

The Chief Actuary also discusses the required minimum margin of solvency. He explains: ‘The required minimum margin will rise naturally as reserves are held, but to the extent derivatives remove the need for mathematical reserves in a resilience test or mismatching test, there will be a reduced additional requirement’. He suggests that any contract with a guaranteed annuity option requires a full 4% margin on all associated mathematical reserves.

Chief Actuary D concludes by suggesting that the matters discussed could be explained at a forthcoming conference on valuation developments and linked to a Dear Director or Dear Appointed Actuary letter.

GAD complete the A2 Initial Scrutiny check on the Society’s 1997 regulatory returns.

The form for the A2 check follows the same, more detailed, format adopted for the 1996 returns and includes the following:

Strength of valuation basis

GAD note that the interest rates used are ‘just about’ supported by the risk-adjusted yields on the matching assets. On Equitable’s annuity mortality rates, GAD say that they ‘thought about querying in 1996 Return, but did not’. They note that other management expenses, at £7.3m, are material. GAD confirm that Equitable have applied the resilience test in accordance with the Government Actuary’s latest guidance. They judge the overall interest basis as ‘adequate’ and the valuation basis as ‘adequate’ to ‘weak’. However, GAD state that ‘Enormous Growing Liability for terminal bonus on [unitised with-profits] business is not reserved for, so that FORM 9 margin overstates strength!’.

Solvency position

GAD note that the absolute cover for the required minimum margin is ‘adequate’ and refer to their comments about Equitable’s growing liability for terminal bonus and to the fact that Equitable had raised £350m from the subordinated loan.

Operating results

GAD circle both yes and no to whether Equitable’s absolute level of sales or the trend over recent years give cause for concern and comment ‘[very] high and negligible estate’.

PRE issues

GAD do not answer the question as to whether the answer given by Equitable in paragraph 4(1)(a)(ii) of Schedule 4 of the returns is satisfactory.

Current issues

GAD note that Equitable have not set up any identifiable pensions mis-selling reserve and comment that ‘In [company] response, £75m stated to be included (FORM 52)’. GAD state that Equitable are known to have material exposure to annuity guarantees and note: ‘Adjusts terminal bonuses – so no value to policyholders! No additional reserves considered necessary’.

Aspects that look worrying

GAD query whether Equitable’s position on annuity guarantees is satisfactory.

Other notes

GAD initially note that Equitable appear to have failed to disclose provision for pensions mis-selling as promised in their letter of 04/02/1998 – but then appear to be satisfied that provision has been made in the returns. GAD also identify the following:

(2) Review annuitant mortality assumptions

(3) Issue of £350m Subordinated Loan appears to be sole reason for increase in available assets over year.

GAD identify no items to notify to HMT, to be taken up immediately with Equitable. They lower Equitable’s priority rating from 3 to 4.

Accompanying the Initial Scrutiny check is a Form B Initial Scrutiny Form, which includes certain key figures disclosed in the 1994 to 1997 returns.

(Note: there was no formal detailed scrutiny, given the events that unfold from July 1998 onwards, following the annuity guarantees survey, until comment on them is combined with the scrutiny of the 1998 returns: see 20/05/1999.)

GAD write to HMT about monitoring ‘the behaviour of companies towards policyholders who have … a guarantee which is valuable at maturity’. GAD set out the circumstances under which a company would be obliged to tell a policyholder about a guarantee and suggest that this would depend on whether, under the terms of the FS Act 1986, the company was offering advice or not. GAD explain that, if the company were offering advice, it would be obliged to offer best advice, and the PIA are the relevant authority to monitor that. GAD add that the powers under ICA 1982 are not applicable to advice ‘unless the general obligations are relied upon’.

GAD advise that HMT have a duty to ensure that policyholders’ reasonable expectations are met. GAD say that HMT appear to have a number of options, but recommend the following ‘best course of action’:

• circulate all companies referring to the issue of annuity options and guarantees and identifying the avoiding of these obligations as unacceptable behaviour;
• all companies should be asked to report on the procedures in place to ensure guaranteed rates are applied in maturity option quotations, and that the existence of options is made known (is this going a step too far?);
• any policyholder or [independent financial adviser] complaint should be the trigger for a visit to review the procedures;
• any subsequent failures should result in a Section 43A investigation, to include a sample review of files;
• identification of a substantial problem would necessitate action, including a review of cases and “fit and proper” action.

GAD conclude:

A more proactive course, reviewing companies routinely, would seem to be too intensive in resources to be practical. It is also arguably a significant overreaction to few if any recorded incidents. It is open therefore to criticism as a misuse of powers.

HMT’s Head of Life Insurance thanks GAD for their note of 01/09/1998. The Head of Life Insurance says: ‘This is something which had begun to worry me, but I had not got beyond the unfocused feeling that we would need to do something. Your note helpfully clarifies the issues’. He suggests a meeting of HMT and GAD officials to discuss these issues.

HMT’s Head of Life Insurance writes to FSA’s Managing Director of Financial Supervision (Managing Director A). He notes that there had been a good deal of recent press interest in guaranteed annuities. The Head of Life Insurance explains the action HMT and GAD had taken on annuity guarantees. He explains that: ‘When it became clear that a number of companies had issued policies with these guarantees’ GAD, on their behalf, had written in June 1998 to all life companies seeking detailed information about their annuity guarantees and how they reserved for them. He says that the results were now being analysed by GAD and that they were ‘also considering the implications for the fulfilment of policyholders’ reasonable expectations’. HMT copy the note to FSA’s Director of Investment Business:

… since his division [conduct of business] will no doubt have an interest in some aspects of [these] issues (eg the extent to which companies are informing policyholders of the existence of a guarantee at the time when they come to make choices about annuities on retirement). This is an example of an issue on which we will need to work closely together to ensure a seamless regulatory approach.

In the same note, GAD raise the issue of the reduction of terminal bonuses for policies which included annuity guarantees. GAD explain:

It should be recognised that guaranteed annuity rates based on a(55) ult and 7% interest rates (as offered by Equitable in a substantial number of cases) would, based on current life expectations, require the availability of investment yields in the regions of 9%. Such investment returns are not currently available, so that it would normally be presumed that the inclusion of such a minimum guaranteed annuity rate in a contract would give additional value.

However, Equitable apparently considers it acceptable to reduce the terminal bonuses payable in such cases to nullify any additional value – and thus is suffering negligible strains and does not see any need to establish any special reserves.

GAD say:

We suggest that it is desirable for HMT to explore this subject further. We suggest that you write to the Society indicating that you have noted the manner in which they are dealing with maturing pension contracts that contain guaranteed annuity rates, and request that they supply copies of relevant marketing literature or other evidence that gives support to their approach of reducing terminal bonuses in such cases — since you wish to be satisfied that the reasonable expectations of policyholders are being met.

HMT ask Equitable to ‘supply copies of relevant marketing literature or other evidence that gives support to this approach of reducing terminal bonus in such cases [where the annuity guarantee is biting] as we will wish to be satisfied that policyholders’ reasonable expectations are being met’.

Equitable write to HMT in reply to their letter of 21/09/1998. Equitable explain that a key underlying factor is that they guarantee ‘full value’ benefits whenever retirement occurs within a wide permitted age range. Because of the wide ranging nature of the guarantee:

… it was always clear to us that the guarantee could become a valuable one in a period of sustained low interest rates. In a mutual with profits fund the key question is, of course, how the potential costs of guarantees should be reflected in bonus rates.

Against this HMT’s Line Supervisor C writes: ‘Is it?’.

Equitable set out a number of reasons why they did not think that it would be practical or fair to try to set bonus rates so that the same final bonus would be paid, irrespective of whether or not benefits were taken in cash (the open market option) or in guaranteed annuity form. Equitable explain that they had decided that the fairer course:

… was to introduce a system of different final bonus entitlements depending on whether the benefits were taken as an open market option cash fund or by utilising the guaranteed annuity option, so as to produce, as far as possible, benefits of equivalent value under the two approaches.

Equitable add:

Until recently the likelihood of the guaranteed annuity option producing a higher level of income was small but recent declines in interest rates now make it more likely that the guaranteed annuity option will produce a higher level of income, if a client requires a form of annuity allowed for under the option. We have yet to decide whether to absorb the costs of that within the with profits fund generally or to introduce a small differential between the bonuses allotted to contracts carrying a guaranteed annuity option and those that do not. The Appointed Actuary will, of course, also be taking the position into account in setting his reserving basis at the end of the year.

Against the penultimate sentence of this paragraph, Line Supervisor C writes: ‘Is this what they said in the questionnaire[?] Seems different’. On another copy of the letter, GAD’s Chief Actuary C writes against the last sentence: ‘Why did he not do this at the end of 1997?’.

Equitable say that they have always described their approach to bonuses ‘in the most general terms in marketing literature’. They add:

… the comments we have made about bonuses have focused on principles such as fair treatment between different classes of business, that bonuses are primarily determined by the level of investment returns over a contract’s lifetime, and that our aim is to pass on the smoothed earnings achieved on the contributions made during a policy’s term.

Equitable explain that they reinforce these messages when they write to policyholders explaining bonus decisions and that they ‘make it very clear that final bonus is allotted only at the point of retirement, that the amount can vary and that any amount shown is not guaranteed’. They add:

The approach of having a different final bonus entitlement where a guaranteed annuity option is exercised was first introduced at the end of 1993 and has been disclosed in the returns prepared for the DTI each year since then.

Equitable continue:

In practice, the prevailing level of current annuity rates during 1994 and early 1995 meant that the final bonus entitlement was the same whether or not a guaranteed annuity option was taken. At the end of 1995, when conditions were such that the approach could give a different final bonus entitlement on some cases, a note was added to annual statements to indicate that that was the case. An example of the 1995 statement is also enclosed. The same approach was adopted for the 1996 statements and, with the exception of some policies for which the note was omitted in error, for the 1997 statements. Thus all clients with policies containing guaranteed annuity rates have had at least two annual statements explaining that a different final bonus entitlement could apply, as well as having had the more general material describing our bonus philosophy as set out in the preceding page of this letter.

Equitable copy their letter to HMT, in view of the meeting arranged for 02/10/1998 (see below [entry 1]).

The explanatory note to the policy document states:

The principle benefit secured by the Policy is pension provision by application of the premiums to secure an annuity or further annuities which participate in the profits of the Society and which together form the basic pension on retirement. The annuity available may be increased if the annuity rates available when the pension payments begin exceed those guaranteed in the policy. The pension may begin at any time chosen between the ages of 60 and 70 with the option of extending the period to an age not later than age 75 and it is not necessary that the date chosen should coincide with the actual retirement date. The date must be notified to the Society in the month preceding the pension being required. In the event of death before the pension has commenced, the Society will pay the full value of the Fund built up under the Policy to the date of death.

HMT (Head of Life Insurance, a new Line Manager with responsibility for Equitable (Line

Manager D) and Line Supervisor B) and GAD (Directing Actuary B and Chief Actuary C) meet Equitable’s Chief Executive, Appointed Actuary and Investment Manager to discuss the Society’s approach to deciding the benefits which policyholders with annuity guarantees would receive, and the solvency implications of reserving for those guarantees. HMT prepare a note of the meeting.

Equitable’s Chief Executive reaffirms that the Society’s approach to deciding policyholder benefits had been set out in recent correspondence with HMT and that he believed that its approach ‘aimed to give all clients a fair return from the Equitable’. He acknowledges that Equitable had received a bad press recently, but says that this was due to the media not having a full grasp of the facts. The Chief Executive says that he had received 25 letters of complaint and a few hundred enquiries about the issue. The note records: ‘Ahead of the recent press coverage there had been no complaints from policyholders whose policies with GAO options had recently matured’.

HMT’s note says:

With respect to the specific charge of clawing back terminal bonuses to pay for GAOs the Equitable’s response is that the company wants all policyholders in the mutual to be treated equally. On maturity policyholders receive either GAO benefits or cash of an equal benefit. In the current environment of plunging annuity rates it would be disproportionate to give, what are now, high annuity rates to one set of policyholders based on the same cash amount received by another set of policyholders without the GAO.

There was, according to the company, considerable variation as to how the effected contracts were expressed at inception. Firstly for the earlier policies sold (pre 1980s) the concept of a terminal bonus did not exist, later when terminal bonuses were first introduced this bonus was a much smaller proportion of total benefits than what they would be for a policy sold today. Furthermore, the provision of a terminal bonus has always been at the discretion of the Directors and they have the powers within the Equitable’s constitution to vary terminal bonuses for different cohorts of policyholders.

GAD’s Chief Actuary C says that ‘when the GAO was offered to policyholders the literature could be interpreted to suggest that the policyholder was expecting to receive the higher of the two figures (unadjusted cash fund converted using current annuity rates or GAO)’. In response, Equitable’s Chief Executive claims that Equitable had not departed from any promises given, and that Counsel had recently advised that they were acting fully within their rights. The Chief Executive adds:

If the policy document states that a policyholder is entitled to additional benefits then the policyholder receives them. Currently a policyholder receives the greater of the guaranteed fund x guaranteed annuity rate or assets share x guaranteed annuity rate (the asset share being adjusted by the cost of providing the GAO). Subsequent to the submission of the GAD questionnaire annuity rates had fallen further in the market. This had meant that there were now policies where guaranteed fund x guaranteed annuity rate were biting, so these policyholders were getting a larger share of Equitable’s assets than an equivalent policyholder with no GAO taking the cash benefit.

Only this year has guaranteed fund x guaranteed annuity rate bitten, they have not yet decided how to divide up funds with respect to this; [Chief Actuary C] said it could be interpreted as an additional bonus.

Equitable’s Chief Executive explains that he would be concerned about policyholders’ reasonable expectations if treating one set of policyholders more favourably affected the expectations of the remainder of Equitable’s policyholders.

HMT’s note records:

The company agreed that many of their policies allowed the payment of additional premiums, but this was not seen as a risk because of the treatment taken with respect to asset shares. However, switches of policies into the Equitable were currently a risk but the company was looking to impose endorsements on any switches in to stop these policyholders gaining disproportionate benefits.

Under the heading ‘Solvency/Reserving’, HMT’s note records Equitable’s Chief Executive as explaining that:

… no provision had been made for GAOs as at 31 December 1997 since it had only been recently that the guarantees were biting on the guaranteed fund. The Equitable does not as a matter of course reserve for GAOs that exist on policies; the recent practice has only been to reserve once the guarantees bite.

In response, GAD’s view is that:

Whilst no reserve needs to be held on that part of the bonus that is discretionary (effectively the terminal bonus) … guarantees should be provided for in the valuation basis (they should be reserved for whether or not they are biting).

Equitable’s Appointed Actuary argues that ‘two thirds of policyholders take the cash benefit, so it would not be appropriate to reserve fully for all the guarantees if only a small proportion of policyholders chose the guarantee’. Chief Actuary C makes the point that ‘as the guarantees became more valuable it would seem logical to assume that a higher proportion of policyholders are going to take the GAO’.

Equitable say that the need to reserve for the annuity guarantees ‘could have severe consequences for the company and that they may have to switch from equities to gilts to maintain solvency’. They continue: ‘However in the current economic environment such a strategy would in itself harm the company as it would have to sell stocks which have fallen by c20% and buy gilts at inflated levels’. Equitable’s Investment Manager adds that: ‘a flight to quality in current volatile markets was reducing gilt yields. Furthermore the abolition of [advance corporation tax] had exacerbated this. Further falls in the discount rate are going to hit Equitable and the life insurance industry heavily’.

Equitable agree to provide a revised assessment of the reserves required for the annuity guarantees and to undertake a reassessment of their solvency. Options for identifying ‘extra resources’ are discussed, including the possibility of reducing declared bonuses. HMT and GAD agree to consider the status of Equitable’s future profits concession, following this assessment.

HMT draw up initial working arrangements for the Insurance Directorate Supervisory Committee. The proposed terms of reference for the Committee are to:

• take decisions on the exercise of HMT’s powers under the ICA 1982 and subordinate legislation (including decisions not to exercise powers in circumstances where they might be expected to be exercised);
• keep the use of all powers/discretion under review; and
• act as a forum for discussing/advising on casework raising novel or contentious issues, and supervisory policy generally.

GAD write to HMT suggesting that there is a need to offer guidance to companies on policyholders’ reasonable expectations in the context of annuity guarantees. GAD explain that, as a first step, they could say that policyholders with such guarantees could reasonably expect to pay some premium or charge towards the cost. GAD add:

The level of the charge deemed to be payable by participating policyholders for the annuity options and guarantees (applicable normally under the terms of the contract to at least the guaranteed initial benefit and attaching declared bonuses) would we understand generally be assessed by reference to their perceived value over the duration of the contract. The selected treatment by each office would though depend on the wording of their contracts and how these are presented to policyholders.

This could therefore result in some reduction of the final bonus that would otherwise be payable if there were no such options or guarantees in the policy.

As a consequence of the above, we would expect that for most companies the present guaranteed cash benefits (including declared bonuses) would be converted, as a contractual minimum, to annuity on the guaranteed terms. However, the appropriate final (or terminal) bonus may be somewhat lower than for contracts without such options or guarantees, and could be converted at current annuity rates.

GAD also comment further on the points in Chief Actuary D’s note of 01/09/1998. They cite six companies who seek to avoid letting policyholders know of the existence of annuity guarantees. GAD add:

Equitable Life also fall in this category, although we know that they do apply the guaranteed funds at the guaranteed rate where this would exceed the annuity derived from applying the “open market option” funds, including discretionary bonus, at current annuity rates.

HMT provide briefing for the Economic Secretary, who has expressed concern about Equitable and their exposure to annuity guarantees. HMT say that it was common practice in the 1970s and 1980s to include guaranteed annuity rates in pension contracts. HMT also say that:

The guarantee was set at a relatively low level and at the time the contracts were written the guarantee appeared unlikely to have any value. However, the recent dramatic falls in the yields on long term gilts on which annuity rates are based, along with increasing longevity of policyholders, means that the guaranteed rates are currently above, or comparable with, the annuity rates available in the market.

Under the heading ‘Equitable Life’s position’, HMT say:

Equitable Life is a very long-established mutual insurer with a high reputation for efficient and economical service, along with good investment returns to policyholders. It is one of the companies that has sold a large number of pension contracts which contain guaranteed annuity options which are set at a level above that currently available in the market.

HMT continue:

Meeting the cost of the guarantees is putting a significant strain on the company’s resources and, as a mutual, it does not have the option of obtaining a capital injection from shareholders to relieve this strain. We have discussed the situation with the company and it has been agreed that it will submit to HMT updated information regarding its liabilities for GAOs and its resulting financial position in order that we can monitor this and take any action that becomes necessary to protect policyholders’ interests. It is feasible that the company could have to consider some form of demutualisation, for instance through merger with another company, depending on how serious the financial situation proves to be.

HMT note that: ‘Equitable Life has recently been heavily criticised in the press for the approach it is taking to fulfilling the guarantee contained in its pension contracts – adjusting the levels of terminal bonus paid to policyholders to take account of the cost of the guarantee’. HMT report:

We have discussed the situation with the company, and our initial view, on the evidence we have seen to date, is that the company’s approach appears to be consistent with the terms of the contracts sold, and that the company is endeavouring to fulfil the reasonable expectations of all its policyholders. In particular, the company is fully aware that any increase in the level of bonuses for policyholders with annuity guarantees would very likely lead to reduced bonuses for other policyholders. We are continuing to explore the position with the company.

HMT say that they propose to provide guidance to the industry shortly ‘to the effect that making some charge for the options is acceptable provided this does not conflict with the overriding requirement to meet policyholders reasonable expectations’.

HMT produce an update paper on the effect of current market conditions on UK life insurers. They refer to an undated paper submitted to a previous meeting of the Tripartite Standing Committee (a Committee of senior officials from HMT, FSA and the Bank of England). That paper says:

Most UK life insurers are reasonably well-placed to maintain an adequate financial position in current market conditions and allowing for further volatility in equity markets (although a fall on the scale of 1974 would create more serious problems).

There are 8 fairly well-known offices that we are monitoring particularly carefully.

One of the companies listed is Equitable. HMT go on to say: ‘The two offices causing most concern at present are [a named other insurance company] and Equitable Life. These are likely to need some form of additional capital support if present conditions continue. We are in discussions with them about their view of their exposure, and options for remedial action’.

In their analysis, HMT explain that there are a number of factors which help to protect life insurance companies against adverse investment conditions. These are listed:

(a) Our regulations require liabilities to be evaluated at relatively conservative long-term interest rates.

(b) Allowance is also made in this evaluation for the effects of a 25% fall in equity values, and a 20% reduction in current gilt yields (the so-called “resilience test”, the parameters for which are set from time to time in guidance from GAD).

(c) For with-profit contracts, the bonuses (both declared bonus at year-end and final bonus payable on claims) may be reduced (though normally with some degree of smoothing).

(d) Surrender values for most non-linked contracts are discretionary and could be reduced significantly, particularly in adverse investment conditions.

(e) With unit-linked or index-linked contracts, all of the investment risk is normally borne by policyholders (or by investment banks in the case of some guaranteed bond products).

(f) In extreme conditions, some modification of the solvency rules could be considered, though there are EU constraints to be observed.

HMT note: ‘As part of the regulatory framework there is an appointed actuary for each life insurer who is responsible for monitoring the ongoing financial condition of that company. The actuary is required to advise the board of directors on appropriate action to be taken if an unsatisfactory situation is developing, and if this is unsuccessful, the actuary is required to inform the regulators accordingly’.

HMT recognise that:

Companies most at risk are likely to be those with a combination of:

(i)Weak free asset ratios at end-97 (and few implicit margins),

(ii)Significant exposure to annuity guarantees (which become more onerous with falling gilt yields),

(iii)Pension mis-selling costs not yet fully recognised including the effect of any [Investor Compensation Scheme] levy, and

(iv)Dependence on high investment returns to sustain bonus rates (some reduction in bonuses may now of course be expected but this is normally subject to smoothing).

HMT say that the eight companies identified are those companies which HMT believe, based on current information, to be vulnerable on account of these factors. HMT conclude:

There are various strategies that can be followed by offices to improve their financial condition and to protect the interests of investors. These include:

1. Re-balancing the investments by switching from equities to gilts or corporate  bonds with good credit ratings.
2. Reduction in overhead costs by trimming or even eliminating the sales  distribution network.
3. Merger or take-over by other stronger company.
4. Reduction in bonus rates and in discretionary surrender values.

An annex to the undated paper gives details for each office. On Equitable, HMT say that the Society:

… is a very long-established mutual insurer with a high reputation for efficient and economical service to policyholders, along with good investment returns for policyholders through discretionary bonus additions. In addition to a sizeable UK operation, they have also opened a branch in Germany a few years ago. They have always operated on the basis that “capital” should not be built up unnecessarily but should instead be returned to departing policyholders.

HMT continue:

As a result, they are not well placed to weather difficult investment conditions. They are also impacted by a substantial exposure to annuity guarantees on a large number of their policies.

HMT’s update paper explains that recent improvements in equity markets and an increase in the yields on bonds are likely to result in ‘fairly slight’ improvements to the financial positions of most companies. The update states that:

[Another named insurance company] and Equitable Life have each been asked to produce some more detailed figures to show their solvency position as at 30 September 1997. We expect these by the end of this month, and will study them with the help of GAD. We will then be able to consider with these companies what further action if needed.

An annex to the update provides the following figures:

The notes to the figures are:

1) Free Reserves shown above exclude any item for future profits (which is allowable within limits as part of “own funds”).

2) Costs of Annuity Guarantees estimated by GAD from recent survey. (The range for Equitable reflects some present uncertainty about the nature of their guarantees).

3) Additional possible cost for pension mis-selling is broad estimate based on industry averages (with no allowance for [the Investor Compensation Scheme]).

4) No allowance has been made for margins in the liabilities that may be released.

5) Effect of current investment conditions compared with 31/12/97 is assumed to be neutral or offset by margins as in Note 4 above.

6) No allowance has been made for discretionary bonuses that may be payable at year end, or for profits earned during the year.

 

Equitable provide GAD with the information requested at the meeting on 02/10/1998. Equitable explain that, in the first nine months of 1998, only 3% of retirement annuities had been used to secure a conventional non-profit annuity. Equitable explain:

All retirement cases are checked to determine whether, if a conventional non-profit annuity is required, the guaranteed annuity rate will produce a higher level of income. Currently that is so in around 30% of cases and clients are advised accordingly, even if their intention is known to be to take some other form of annuity. Interestingly, to date no such clients have actually chosen to take advantage of the guaranteed annuity rate – all have preferred a more modern form of annuity.

Equitable estimate that, in a worst case scenario (i.e. where 100% of annuities which produce a higher income are taken in their guaranteed form), the cost to Equitable would be an additional £170m. But given their analysis of experience so far in 1998, they consider the more likely commercial cost would not exceed £50m. They explain that more generally they believe the figure of £7-10bn, quoted as the likely cost to the industry, to be totally unrealistic. Equitable say:

Such figures appear to have been computed as simply 20-30% (being the typical margin between guaranteed and current rates) of the liability figure of £35bn quoted in the working party’s report. In practice, I believe that offices will generally fall into one of three main categories:

(a) those that reduce the bonus rates for the class so that the open market option cash fund to which the guaranteed annuity rate is applied is lower than would otherwise be the case;

(b) those that operate bonus systems similar to the Society;

(c) those for whom the form of the guarantee is so restrictive that in practice only a small minority of clients will exercise it.

Each of those approaches will significantly reduce the true cost, i.e. the value of additional benefits beyond those the policy would otherwise provide, which will fall to be met by shareholders or other policyholders.

Equitable set out some reserving issues, saying that:

… the additional reserve held in respect of guaranteed annuity rates should bear some relationship to a suitably prudent assessment of the commercial cost of those rates being exercised. To require a much higher level of reserving, e.g. one where the additional reserves were an order of magnitude greater than the expected commercial cost, would seem inappropriate for the following reasons:

i) The level of reserving will be interpreted by commentators as being broadly equivalent to the commercial cost. It would be particularly ironic for the Society if, having attracted criticism for an approach which minimises the impact on policyholders not having or not exercising guaranteed annuity options, those policyholders were then to read comments to the effect that annuity guarantees were going to “cost” the office, say, £500m.        

ii) The purpose of reserving is to protect the interests of policyholders. It would be difficult to reconcile that purpose with an excessively prudent level of reserving in this area which, for example, pushed an office towards an extremely conservative investment strategy, thereby damaging the future prospects of those same policyholders. This point is particularly relevant in current financial conditions both because constraints on investment strategy would be more likely to arise than in other conditions, and because the current state of markets make it a particularly disadvantageous time at which to switch from equities into fixed interest securities.

Equitable conclude by saying that: ‘A prudent approach to assessing the value of the option would be to assume that all eligible benefits would be taken in guaranteed annuity form where that would produce a higher income than the full open market option cash fund could secure on current rates. As indicated above, that would lead to a reserve of £170m in current conditions which would be at least 3-4 times the expected true commercial cost and, probably, a substantially higher multiple than that’.

GAD send HMT their annual report on the life insurance industry for the year ending 31 December 1997. The report follows a similar format to that used for the previous year. The report’s purpose and disclaimers are unchanged. (See December 1997.)

The executive summary says, under the heading ‘Provision for Annuity Guarantees’, that:

The increasing longevity of annuitants, and the sharp fall in long term bond yields that has recently been experienced, has brought to light a new major problem for a number of offices in relation to guaranteed annuity rates that had been incorporated in pensions contracts - largely sold in the 1970s and 1980s. These guarantees are now proving to be very onerous, and large increases in provisions are needed.

Some general data is given in Appendix 4, showing total reserves held at the end of 1997 for annuity guarantees was nearly £3.8bn (when long gilts yielded about 6.4%). With yields now below 5%, this problem requires, and is being given, careful scrutiny on a case-by-case basis by HMT and GAD. A need for further increased provisions is likely to result.

On new business, the report notes that Equitable remain the largest writer of new pensions business (with a new business index of £613.7m). For total new business, Equitable move from first to second place (with a total new business index of £743.4m).

On mortality, the report repeats the material in the 1996 annual report, noting that the rate of improvement had been much faster than expected.

On ‘Non-linked assets’, GAD report:

Prospective long term yields have fallen substantially over the year, so that valuation interest rates should have been cut and liabilities substantially increased. Rises in terminal bonuses but falls in reversionary bonuses are a natural consequence of market movements. Strong asset performance should have been enough to sustain most Free Asset Ratios, but the recognition of lower prospective yields may be increasing valuation strains – especially in relation to guaranteed annuity rates.

GAD again produce an estimation of the breakdown of the portfolios that are held by companies to support their with-profit liabilities (including the free estate). The report includes the following chart:

On investment performance, GAD say that the average estimated investment return on non-linked assets was 18.48%. The report includes a table setting out the estimated returns achieved by individual companies, which for Equitable shows an estimated return of 19.55%.

GAD again report their comparison of maturity payouts against their own calculations of the theoretical asset shares. In the background section to this part of the report, GAD note that Equitable have the largest in-force unitised with-profits pension liabilities. GAD explain:

For unitised with profit business (UWP), recent bonus additions have increasingly relied on capital gains rather than investment income, and this is beginning to cause reserving problems. UWP is a comparatively young product with, in theory, flexible bonuses. The product uses market value adjustments (MVAs) to protect companies against fluctuations in stock markets, except at defined moments or periods when no MVA is applicable – such as maturity. However, competition has meant a range of minimum bonus guarantees on earlier products, and annual bonus rates have been sustained at a level that is today high in comparison to the potentially reduced future investment returns. Terminal bonus cushions on UWP business have not therefore developed to any extent and the business would need considerable support in statutory reserving terms from the rest of the with profit fund, unless market value adjusters can be reflected in the valuation. Proposed amendments to HMT regulations tighten up standards in this area, with the effect of increasing reserves for certain offices.

Thus, as offices project their future bonus policy, they may start to see greater problems in sustaining high, but volatile, equity investment in a total environment of more modest assumptions of future investment returns – unless they can rapidly reduce the expectations of policyholders in relation to guaranteed levels of benefits.

On ‘Underlying trends, comparisons of Asset Shares’, GAD provide a similar explanation to that provided in the previous annual report, that being:

… a retrospective roll up of premiums, known as asset shares, is becoming a common device by which companies gauge the balance of bonus distributions between differing generations of policies. (In many companies such simple asset shares are looked upon as a floor to policyholders’ PRE.) … 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.

GAD repeat the main caveats set out in their previous annual report. GAD’s report presents the following results of their analysis:

The appendix to GAD’s report shows that they calculate that Equitable’s maturity payout of £9,926 for this type of business is 126% of the theoretical asset share.

The appendix to GAD’s report shows that they calculate that Equitable’s maturity payout of £86,355 for this type of business is 102% of the theoretical asset share.

The appendix to GAD’s report shows that they calculate that Equitable’s maturity payout of £109,211 for this type of business is 122% of the theoretical asset share.

GAD then report:

Bearing in mind the caveats that opened this Part of the Annual Report, 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 these basic 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 situation can continue, as companies recognise limits to the amount of miscellaneous surplus and estate that 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 insurance 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 accumulated surplus.

GAD’s report considers ‘Possible future actual payouts’. It states:

The precise excess actual payouts over our crude basic asset share is of less interest than the general trend of actual payouts into the future. The investment return on a typical with profit fund has been in the region of 17% per annum over the last 25 years. This compares to inflation over the same period of 6% per annum and thus has delivered a real return of 11% per annum. The likelihood of lower future inflation and a slowing of what has been an astounding real rate of return (i.e. the 11% p.a.) mean that a different future is likely. Our crude asset shares can be pushed forward on assumptions of investment returns and expenses to plot a possible picture of the likely path of real payouts. This is given in figure 12.10 below.

This forecast accords with more precise and calibrated work elsewhere. Namely, while the shortest terms have a forecast of a relatively gentle decline in future payouts, the reverse is true for longer term contracts. These could see a comparatively steep fall in underlying asset share values in the next few years – as modest investment years replace the good investment years of the past.

It is quite possible that such trends, if borne out in practice, will pose other problems in relation to the longer term policies – not just falling payouts disappointing policyholders. The past accumulation of guaranteed bonuses, and future compound bonuses on top, mean that on quite plausible future investment scenarios these guaranteed endowment maturity values or guaranteed pension values will exceed accumulated asset shares.

While this conforms to the concept of with profit business – smoothed returns underpinned by guarantees the industry will need to be careful in negotiating such a scenario. Put bluntly, the industry is likely to face a future where its terminal bonus cushions are far thinner, and the management of real guarantees becomes more important.

(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’.)

GAD provide HMT with comments on Equitable’s letter of 30/10/1998. GAD disagree with Equitable’s analysis on the grounds that it ‘does not take account of the key point that the existence of a guaranteed annuity rate increases the level of cash that needs to be paid in substitution for that annuity (as otherwise policyholders would not agree to take the cash sum in place of the guaranteed annuity)’.

GAD advise that:

… appropriate mathematical reserves need to be established for the full value of these guaranteed benefits and the associated obligations to policyholders in accordance with Part IX of ICR94, including in particular Regulation 64. It is not acceptable in this context to regard these guarantees as covered by a “first charge” against a final bonus for which no provision is made. This has clearly not yet been recognised by Equitable Life (and they have not even attempted as we requested at the meeting to quantify the reserves on this basis).

I believe that you should write to them along the above lines … and invite them back to a further meeting in the very near future to explain how they propose to establish the appropriate level of mathematical reserves. If they are unable to meet this obligation, then intervention under either Section 37 or Section 11 may be warranted.

The issue over the adequacy of their mathematical reserves is quite separate from that of whether their interpretation of how the guaranteed annuity rates should be applied is consistent with policyholder reasonable expectations. Even if the Equitable’s interpretation of PRE is accepted, then, as explained above, we believe that substantial additional mathematical reserves are needed for the guaranteed annuities …

While we accept as a general reserving standard at present that no provision is needed for discretionary final bonus, this cannot apply to the extent that the company is obliged to pay a final bonus, in order to “buy out” the guaranteed annuities.

GAD state that £170m ‘commercial cost’ would be quite inappropriate as an estimate of the additional mathematical reserve that is needed. GAD continue:

Where companies have identified the existence of annuity guarantees on a block of contracts, then we believe that appropriate mathematical reserves do need to be established on a satisfactory basis in accordance with Part IX of ICR94, including regulation 64. It is not acceptable to regard these guarantees as a “first charge” against a final bonus for which no provision has been made. Indeed we believe that this principle is generally accepted by the actuarial profession and is being followed by all other companies.

Consequently, we believe that the mathematical reserves do have to reflect the full value of the guarantees that have been given.

GAD conclude:

I believe that we need to write to them urgently making the above points and inviting them to a meeting in the next few days to explain how they propose to fund the mathematical reserves that are required.

On the same day, HMT’s Head of Life Insurance advises FSA’s Managing Director and Head of Financial Supervision (Managing Director A) of HMT’s intention to provide guidance to companies on meeting the cost of guaranteed annuity options. The Head of Life Insurance refers to Equitable’s ‘controversial policy of paying the guaranteed annuity rate only on the guaranteed sum built up in the fund (ie not on the discretionary terminal bonus)’. He says that their preliminary view is that Equitable are entitled to do this, but that their principal concern is over Equitable’s ability to reserve adequately for the guarantees. The Head of Life Insurance concludes: ‘The information received to date is unconvincing, and raises serious questions about the company’s solvency’.

(Note: after the House of Lords judgment this note was leaked to The Guardian newspaper (see 19/12/2000 [entry 13]). Commenting on the last point in the note, FSA’s then Line Manager wrote: ‘We were subsequently satisfied that [the Society] was solvent and it remains solvent today’.)

HMT’s Director of Insurance writes to the Head of Life Insurance Division having seen GAD’s  ‘very helpful’ note of 03/11/1998. The Director of Insurance says:

We agreed that we should seek an urgent meeting with Equitable probably in advance of replying to [Equitable’s Appointed Actuary] raising the points [GAD’s Directing Actuary B] has highlighted. The purpose of the meeting would be to make it clear to the Equitable that we need to satisfy ourselves:

a) that the Equitable is taking a proper view of the liabilities which arise under the policies in question. This [seems] to me to cover not only the actuarial issues to which [Directing Actuary B] draws attention but also the question of whether the Equitable’s interpretation of the legal rights arising under these policies is one which the courts would support. As you know I think we may need to require the Equitable to provide to us (to the extent they have not already) samples of policy documents, promotion literature etc etc in accordance with criteria specified by us. I have no reason to believe that the Equitable have “cherry picked” the documents they have provided so far but equally I would not wish it to be possible for anyone to suggest that they had. Our legal advisers will no doubt be able to express a view on the security of the Equitable’s legal position, but it may be appropriate for us, if there is any doubt, to seek Counsel’s opinion too.

b) To take a view on whether the approach being taken by the Equitable, even if secure as a matter of contract law, is consistent with its obligation to “conduct its business with due regard to the interests of policyholders” as required by [paragraph 7] of Schedule 2a to the Insurance Companies Act and more generally whether it accords with PRE.

Equitable write to HMT in reply to their letter of 05/11/1998. Equitable apologise that they appear to have misinterpreted what was requested at the meeting on 02/10/1998. Equitable explain that, as at 31 December 1997:

… the basic additional reserve on the basis indicated in your letter, before any allowance for cash commutation or any entitlement to pay future premiums, would have been around £675m. The corresponding increase in reserves on the same basis, including the standard resilience tests, would have been at a similar level.

Equitable estimate that, as at 31 December 1998, assuming valuation interest rates of 5%, 5.5% and 6%, additional basic reserves would be £1,375m, £1,160m or £955m, respectively. A manuscript note on the HMT and GAD copy of the letter suggests that ‘Reserves if assume 5% interest rate and 20% needed for resilience’ would be £1,650m.

GAD’s Scrutinising Actuary E produces a note of the ‘fundamental questions’ to be raised with  Equitable at the meeting now arranged for 13/11/1998. GAD’s questions include:

1. When did the Board decide that different final bonus entitlements would apply if a policyholder elected to utilise the guaranteed annuity option? Was it in 1995, when it appears that a Note (2) was first incorporated in the Bonus Statement?
2. Has the company made the possible variation of final bonuses sufficiently clear to policyholders? The 1998 [With-Profits] Guide makes a passing reference only (at the bottom of Page 5); Note (2) in the Bonus Statement is very much “small print”. Unless further evidence can be provided, it might be felt that previous policyholder expectations have not been adequately modified.
3. Was the tweaking of bonus policy, in relation to the introduction of a differential final bonus, in itself an action contrary to policyholders’ reasonable expectations – that had previously been built on notices and statements referring to the build-up of a policy fund?
4. The letter of 30th October from [Equitable’s Appointed Actuary] implies that policyholders who do not elect to take guaranteed annuity benefits are not given credit for the higher “Policy Annuity Value” forgone. How can this be justified in relation to the terms on which the contract was issued?

The Scrutinising Actuary lists the documents that Equitable should be asked to provide, those being:

(1) copies of Board papers relating to the decision that alternative (lower) final bonuses should be added where policyholders elect to take advantage of the guaranteed annuity rate;

(2) copies of any communications with policyholders issued prior to the 1995 Bonus Statement that might have indicated that a two-tier bonus allocation could apply;

(3) any documents that lend support to the adoption of the two-tier final bonus structure, as a modification of policyholders’ previous expectations – that would almost certainly have previously been built on the accumulation of a simple “policy fund”, that would ultimately be converted into an annuity.

Scrutinising Actuary E concludes: ‘Even if the two-tier final bonus practice of the company were found to be acceptable, it would seem clear from the policy document already supplied that each policyholder is entitled to a “Policy Annuity Value” that is based on the guaranteed annuity available, whether or not they elect to take such [a] guaranteed annuity. The company should be asked to confirm that such a minimum value is paid, notwithstanding the impression given in the letter from [Equitable’s Appointed Actuary] of 30th October, or alternatively, should justify its current payment policy’.

HMT (Director of Insurance, Head of Life Insurance, Line Manager D, Line Supervisor C and Legal Adviser B) and GAD (Directing Actuary B and Scrutinising Actuary E) meet Equitable’s Chief Executive and their Appointed Actuary. The note prepared by HMT records that the meeting noted that the reduction of terminal bonuses where guaranteed annuity options were biting had become a high profile industry issue; that further information from Equitable was required so that the regulators would be able to assess policyholders’ reasonable expectations; that Equitable had instructed their solicitors to advise and that Leading Counsel had endorsed their approach; and that Equitable’s Chief Executive agreed to provide any Board papers concerning discussion of the policy of reducing terminal bonus.

HMT’s note records: ‘[Equitable’s Chief Executive] confirmed that it was in 1995 in a climate of reducing interest rates that the policy was first applied, there had been plans to introduce the policy earlier in 1993 but subsequent higher interest rates had taken this policy revision off the agenda’. (Note: it has been put to me by one of the Society’s attendees that HMT’s record of what was said at the meeting is incorrect. It is suggested that, while the level of interest rates between early-1994 and mid-1995 meant that the differential terminal bonus policy had no practical effect, it is clear that the policy had been introduced in 1993, with effect from 1 January 1994.)

HMT’s note records:

The company agreed that there had been a case (reported in the media) whereby a policyholder had obtained an extra settlement from the company, this was effectively giving him a biting GAO on top of unadjusted terminal bonus. The company argued that this policyholder received this amount as redress for administrative failings and delays encountered in settling the policy. The case was not routine and junior members of the company had given the policyholder misleading information. In additional age was a factor in deciding to give compensation, the policyholder was 73 and wanted to retire. However, the Equitable did not elaborate on why they decided to give compensation in this manner rather than giving an ad hoc payment to cover this.

Equitable’s Chief Executive states that he is ‘satisfied that the Board had acted correctly in using their discretion to reduce or remove terminal bonuses from policies with biting GAOs’ and that ‘terminal bonuses were not guaranteed and the literature has always stated that’. He also adds that some policyholders had written to the Society in support of its stance. HMT state that ‘to properly understand the PRE implications of this we would want to get a feel of what impression had been given to policyholders over the years’.

There is continuing disagreement on the reserving issue. Equitable’s Chief Executive argues that 100% reserving would have ‘severe commercial implications from low solvency cover which would have to be reported’. HMT and GAD argue ‘that it was a statutory requirement to reserve on this basis and unless Equitable could put up a compelling argument to the contrary we would expect the company to reserve on this basis’.

Equitable’s Appointed Actuary says he is convinced that the Society remained solvent, and that he was considering a section 68 Order application with respect to the resilience calculations, in order to assume that only 50% of policyholders took the GAR option.

Equitable agree to provide a copy of Counsel’s opinion which endorses their differential terminal bonus policy, and they defend their argument about asset shares.

HMT and GAD say that, in order to properly understand the policyholders’ reasonable expectation implications, they want to see a selection of the documents sent to policyholders ‘to get a feel of what impression had been given to policyholders over the years’. They agree to select some policy numbers at random from a list of policies that had matured over the last three years.

GAD’s Scrutinising Actuary E writes to Chief Actuary C setting out points discussed that day.

This includes the view that ‘provided alternative Accumulation Values [the value applicable to premiums paid for retirement annuity policies set out in Table A of the policy document] are permissible, then the current practice of the Society [to apply a lower Accumulation Value where a policyholder takes the GAR option] would seem to be legally acceptable’. Scrutinising Actuary E notes that:

We have observed that the possibility of reducing terminal bonuses if policyholders elected to take a guaranteed annuity rate was first mentioned in Schedule 4 of the returns as at the end of 1993 – so the Society clearly became aware of the potential strains fairly early. However, it does not appear to have communicated its intentions to policyholders at that time. It seems that the first Bonus Notice to give any indication that the final bonus might be reduced to take account of the existence of guaranteed annuity rates was that issued in January 1996 covering the end 1995 declaration (in Note (2)). The With-Profits Guide that was issued in July 1995 certainly made no mention of it. [The 1998 With-Profits Guide now includes a reference to special rules applying in some circumstances, such as where particular benefit guarantees apply.]

It is accepted that the Directors have absolute discretion over the amounts of any bonuses to be declared and have the power to modify their methods of allocation from time to time.

It is also recognised that they are reluctant to grant bonuses to particular policyholders that effectively give those policyholders benefits of value materially in excess of accumulated “asset shares” – to the detriment of the expectations of other policyholders. However, it is still an open question as to whether the different Accumulation Values are consistent with policyholder expectations.

The Scrutinising Actuary copies his note to HMT.

The Assistant Private Secretary to the Economic Secretary informs Line Manager D that the Minister is unhappy with the proposed guidance sent to her on 26/10/1998. The Assistant Private Secretary explains:

The Minister has commented that surely if people bought a contract, it is a guarantee and they should not now expect to pay for the guarantee themselves. The Minister is minded to think that the shareholder should bear some/all? of the costs themselves.

The Minister has asked about Orphan Assets asking if some appropriate use could be made where they exist. The Minister would welcome a fuller justification and consideration of other issues before she is prepared to agree a way forward.

Equitable write to GAD following the meeting on 13/11/1998 and HMT’s letter of 16/11/1998.

Equitable state that there appears to be some misunderstanding about the precise nature of the policy benefits in question which had not been resolved at the meeting. Equitable seek to clarify the position by setting out some examples of how benefits are calculated when a differential terminal bonus is applied. They suggest that these make clear ‘why the vast majority of clients select the cash fund form of benefit’.

Equitable state that they still feel that their approach to reserving for annuity guarantees under Regulation 64 as previously explained is valid. They add that it is also ‘the approach which GAD have tacitly accepted since 1993’ and that the consequences for Equitable of adopting GAD’s approach (of reserving on the basis that 100% of benefits are taken in guaranteed annuity form) are ‘potentially extremely serious’. Equitable state that they ‘cannot see why prudency with “appropriate margins” necessitates assuming that 100% of benefits will be taken in the most onerous form when that flies in the face of the logic of the situation and the practical experience’.

Equitable provide information about their estimated solvency cover as at 30 October 1998, as follows:

The estimated “Form 9” position (excluding linked business) at 30 October 1998, before taking account of implicit items or making any allowance for additional reserves for guaranteed annuity rates was as follows:

	£m	£m
Value of assets		24076
Reserves – Form 58	21205
– resilience	781
		21986
Available assets		2090
Required minimum margin		926
Surplus assets		1164

Equitable say: ‘The Society has a section 68 order allowing implicit items of up to £850m to be brought into account. Financial conditions have changed so as to improve the solvency position since 30 October so it is clear from the above figures that there is no question of basic solvency being currently in question. The figures also, of course, include resilience reserves in accordance with the normal GAD guidelines, which I should not necessarily consider appropriate, if very substantial additional reserves were also required for guaranteed annuity rates’.

Equitable then disclose the reserves required when accounting for annuity guarantees. This is presented as:

 

Proportion of benefits assumed taken on guaranteed annuity rate terms

Reserves	0%	25%	50%	100%
	£m	£m	£m	£m
Form 58	21205	21548	21892	22579
Resilience	781	644	720	1201
Total	21986	22192	22612	23780

Equitable then disclose: ‘There are some margins in the basis, particularly on assurance mortality, which could be released. I would not, however, anticipate those releasing more than £100m of reserves. Since the bulk of the Society’s business is investment in nature it is the regulatory restrictions on yields which primarily govern the strength of the basis. By virtue of the fact that a substantial resilience reserve is required on top of “full face value” reserves, it follows that there are no significant margins in the interest assumptions released’.

On a copy of the letter, an official has written:

24,076

23,780

£300m

+£100m

850m

Equitable describe the options available to them in the event that reserving at ‘the onerous end of the spectrum’ was required. These include:

1. Passing the bonus declaration, either for all business or for the classes incorporating guaranteed annuity rates.
2. Raising capital either through further subordinated debt (limited scope at present) or financial reassurance.
3. Trying to obtain some sort of protection based on derivatives. [An option explored by GAD, see 13/08/1998.]
4. Publishing a Form 9 where the required minimum margin is only just covered.
5. Making a sizeable switch from equities to fixed interest or cash.

Equitable go on to explain:

Of the above (ii) is now probably rather difficult to put in place by 31 December and there must be doubts as to how effective (iii) could be. Approaches (i) – (iv) carry very significant PR risks – possibly of a scale which would threaten the continued independence of the Office. Approach (v) will damage the future prospects of policyholders for a number of years.

Equitable conclude by saying that unless they and GAD could come to an agreement on the interpretation of Regulation 64 they would need to consider what steps to take in terms of consulting with the profession.

GAD provide HMT with a ‘2nd Update’ on the ‘Effect of Current Market Conditions on UK Life Insurers’ for them to provide to the Tripartite Standing Committee. This follows the assessment on 22/10/1998. GAD say that they had identified eight companies that should be ‘called in’ to discuss their current financial position and state that:

With the possible exceptions of Equitable and [another named company], I would expect each of these to be covering their margin of solvency at present, but without much cushion for further adverse movements in market conditions.

GAD’s second update says that:

Figures for Equitable Life at 30 October indicate that the company was just solvent assuming that 100% of policyholders exercise their GAOs (the company is disputing the need to assume such a high take up rate). While this is reassuring it should be realised that publication of such a low solvency position is likely to severely undermine the company’s reputation in the market and could threaten its survival as an independent entity. Equitable’s annual returns are due to be published next July. Discussions are on-going on the appropriate reserving basis to be used and the acceptability of the company’s approach to charging policyholders for the cost of the GAOs.

GAD provide HMT with comments on the enclosures in Equitable’s letter of 23/11/1998. In relation to Counsel’s opinion, GAD say:

The legal opinions do not wholeheartedly support the actions taken thus far by the Society.

Counsel advise that the Board of the Society might have sufficient discretion under their articles to apply different bonus rates to different classes of policyholder and, within any class, to different policyholders depending on the policyholders’ choice of benefits subject to any limitations in the contract or statements made to policyholders. We do not disagree with this advice.

GAD agree with Counsel that Equitable’s documentation to date has ‘not adequately described the bonus methodology that the Society are now adopting’. GAD note that the ‘question remains as to whether past vesting policyholders have been treated fairly’, and that Counsel advises that ‘the Society ought to be able to defend its position in Court’. GAD say:

We do not feel sufficiently competent to offer an opinion on this legal question. The presentation adopted by the Society in its bonus notices, of the benefits available at maturity, does not appear to have been in strict accordance with the policy conditions, but it is difficult to see how this might have created a breach of contract. It remains possible that policyholders could successfully argue that they were not led to expect a differential terminal bonus rate dependent upon the benefit they chose at vesting.

GAD provide HMT with comments on Equitable’s letter of 24/11/1998. Under the heading ‘Reserving Issues’, GAD describe Equitable’s arguments on Regulation 64 as unconvincing, asserting that Regulation 64(3)(c) on ‘taking account of options (e.g. in this case to take cash or a different form of annuity) needs to be read in conjunction with Regulation 72 which requires a provision on a prudent basis to cover any increase in liabilities caused by policyholders exercising options’. GAD continue:

There is nothing in the regulations that specifically allows a reduction in liabilities because of the existence of policyholder options (see for example Regulation 74 which considers the effect of voluntary discontinuance) and indeed, in our view, it would not be prudent to make such an assumption.

GAD set out why they are unconvinced by Equitable’s arguments on reserving less than fully for their annuity guarantees. In relation to resilience reserves, GAD write:

I would have some sympathy though over the additional provision of £1.2 Bn apparently required by our standard resilience test (and which would not normally be included as a provision in the Companies Act accounts). Nevertheless, we believe that a “fair value” of the guaranteed annuity, assessed on derivative-base methods, would include a significant part of this £1.2 Bn provision. Moreover, they would of course have to find all this amount if the investment scenario postulated in the resilience test were to materialise.

Accordingly, I do not think that we could openly encourage them to reduce this “resilience” provision, albeit that the “advice” in [the Government Actuary’s] letter is not a regulatory requirement. They would also of course have a PR problem in explaining why they chose a different “resilience test” scenario if they decided to pursue such an avenue. It should also be recognised that in the resilience scenarios which assume a fall in the yield on gilts the guaranteed annuity benefit is more likely to be selected by clients.

On Equitable’s ‘Form 9 Position’, GAD advise that:

According to the figures presented in his letter, Equitable would have a surplus of assets over liabilities of some £300M (before any declaration of bonus) if they reserve in full for 100% of the benefits in guaranteed annuity form (or equivalent) including an amount of £1.2 Bn in respect of the standard resilience test. With an implicit item for future profits of around £850M (which may need to be adjusted slightly), they would just have sufficient cover for their required margin of solvency as at 30 October 1998.

GAD continue:

While we recognise that this may not suit them commercially, we believe that this would place them on a consistent basis with other offices. It also indicates that they are very reliant on future surplus, largely arising from significant potential returns on equity investment, in order to fund their future bonuses, including the discretionary final bonuses. They have not provided any figures (admittedly, we had not specifically requested these at present) to suggest that this would be an unfair conclusion. (For example, it would be instructive for us to see a figure for their aggregate asset shares which could be compared with assets, including any inadmissible assets. A copy of any financial condition report by the appointed actuary, under GN2, would also be helpful.)

Commenting on the options, as identified by Equitable, GAD state that:

It seems likely that they will need to consider [in the short term] some suitable combination of these for this current year-end. In particular it is difficult to see how they could justify declaring any bonus at this year end.

In the medium term, though, I believe that they will need to look for some ongoing form of capital support if they are to remain viable under difficult investment and trading conditions.

HMT’s Legal Adviser B sends Line Manager D a draft advice note. She explains that her note was not complete legal advice, because ‘we are not yet at the stage where that is possible’.

The Legal Adviser casts some doubt on whether a failure by Equitable to reserve 100% for annuity guarantees would provide grounds for regulatory action. She suggests that Regulation 64 is very wide and sets out an objective standard. Legal Adviser B states that it is not for HMT to decide whether liabilities have been properly provided for, but for a court. She agrees that GAD’s and HMT’s approach on reserving is within Regulation 64, but says that it is less clear whether Equitable’s view is in breach. If Equitable are not in breach, it is not clear on what basis HMT might take action against them.

Legal Adviser B argues that it is for HMT to show a breach, and only where Equitable could be shown to be ‘significantly out of sync’ with accepted practice, or were clearly acting unreasonably, would the onus fall on Equitable to demonstrate compliance. On Equitable’s Counsel’s opinion, she says:

… I find it hard to take issue with what he says. He thinks that on balance a Court would accept that Equitable’s practices were valid in terms of contract and trust law. However, I understand it to be your view that considerations of PRE may go beyond determining what is a legally acceptable construction of the contract or exercise of a discretion under or in conjunction with the contract. If so, then [Equitable’s Counsel’s] opinions (even if you accept them) are not an end to the matter. You will still wish to make your own examination of the documents, events and policyholders’ representations to come to your own view on PRE.

HMT and GAD meet Equitable to discuss reserving for annuity guarantees. HMT prepare a note of the meeting. HMT begin the meeting by confirming their position that Equitable ‘would need to reserve for all guaranteed benefits under the contracts’. Equitable’s Appointed Actuary argues that Equitable’s reserving methodology is:

… not new and that GAD should have been aware from the returns that the company was writing GAO business. The reserving basis had been, until now, tacitly accepted.

In response, GAD ‘rejected this argument and countered that whilst they were aware that the Equitable had written GAO business it was not possible to tell the construction of the contracts or the reserving basis from the return’.

HMT’s note records:

GAD further commented on the reduction in the resilience reserve given in the solvency illustrations recently supplied to [GAD’s Directing Actuary B]. They expressed the view that the holding of substantial mathematical reserves to cover guaranteed annuity options did not appear to be a sound argument for reducing the stringency of the resilience test applied. Although the resilience tests specified by the Government Actuary were not legally binding, companies had to be satisfied of the actuarial prudence of the test used. It was explained at the meeting that the Government Actuary could be expected to wish to discuss with [Equitable’s Appointed Actuary] the basis for any relaxation of the resilience tests applied by the company.

Equitable’s Chief Executive states that ‘the reserving basis required was excessively prudent and bore no resemblance to commercial reality and policyholders would be damaged by this (through a change to a more conservative investment policy, passing bonuses or through there being a run on the office)’. The note of the meeting goes on to record:

[Equitable’s Chief Executive] asked whether there was any scope for HMT to give any concession on this issue and what would be the consequences of the company not following this requirement. [HMT’s Head of Life Insurance Division] responded that he could not see any scope for issuing a concession in these circumstances. Furthermore, the requirements derived from EC Directives and there was limited scope to give concessions in these circumstances. [He] said that we would take appropriate measures to ensure compliance. [The Chief Executive] asked whether there was any scope for appeal, [the Head of Life Insurance] said that any scope for appeal would be limited to judicial review, [the Chief Executive] said that he might well have to take up this option.

GAD comment that:

… if the company had not been mistaken in its interpretation of the regulations it would not have been in the past so generous in its bonus declarations. Questions were also raised about the prudence of trying to operate a company without an estate. [Scrutinising Actuary E] stated that from his interpretation of last year’s bonus declaration that a fair proportion of reversionary bonus was paid out of asset value gains. [Equitable’s Appointed Actuary] argued that since 1986 reversionary bonus rates have been managed down although he did admit that it was possible that there had been times when the value of accumulated policyholders’ asset shares had been greater than Equitable’s assets. Nevertheless he argued that he did not believe that it was in the interests of policyholders for the Equitable to build up a large estate.

Equitable’s Appointed Actuary confirms that he has considered reinsurance ‘as [an] option for protecting the balance sheet’, but he ‘was reluctant to broadcast the Equitable’s position to potential reinsurers at this time and he had hoped that the regulatory position might change at this meeting’. He points out that a reinsurance agreement is unlikely to be in place by the end of the year. HMT ‘thought it would be possible to give a concession so that the effect was post dated to cover the 1998 year end position’.

Equitable’s Appointed Actuary continues that he ‘was concerned from a professional point of view that he was being forced to adopt a reserving approach that was “wildly prudent” and he thought he would need to consult professionally regarding this’. GAD say that they do not think that there is a professional issue to consider and that there is ‘a distinction between the legal position as required by Regulation 64 and the resilience reserve where there was more scope for professional judgement and interpretation’.

There is further discussion of the implications for policyholders’ reasonable expectations of the differential bonus policy. HMT and GAD tell Equitable that they still have some way to go before coming to a conclusion. They say that they believe policyholders’ reasonable expectations would be met in the future if Equitable’s Counsel’s advice about the wording of annual statements were followed; the issue is whether expectations had been met in the case of policies that have matured: ‘… since the way in which the contracts and the company’s bonus policy had been described did not appear to be fully in line with the approach adopted by the company’. HMT request further documentation in order to consider this point.

HMT’s Legal Adviser B sends Line Manager D her advice. She says that: ‘The following is not intended to be final or complete legal advice. We are not yet at a stage where that is possible. We await, for example, one more submission from Equitable. But I hope it assists to clarify the issues and to set out my views at this stage’. The Legal Adviser states:

“Liabilities” are defined in [Regulation] 58 to mean amounts calculated in accordance with Part IX of the Regulations in respect of the items shown at C and D under the heading “Liabilities” set out in [paragraph] 9 of [Schedule] 9A to the Companies Act 1985. Broadly, [Regulation] 64 says that long term liabilities must be determined on actuarial principles, making proper provision for all liabilities on prudent assumptions that shall include appropriate margins for adverse deviation of relevant factors. Pursuant to [Regulation] 64(2), the determination must take account of all prospective liabilities as determined by the policy conditions for each existing contract. Factors to consider are guaranteed benefits, bonuses to which policy holders are contractually entitled, options available, PRE and the nature and term of the assets representing the liabilities and the value placed upon them. I note that there is provision in [Regulation] 66 to avoid future valuation strain and in [Regulation] 72 to cover any increase in liabilities caused by policy holders exercising options under their contracts.

The advice continues:

[Regulation] 64 is very wide. It also sets out an objective standard. In other words, it is not for HMT to take the final decision as to whether liabilities have been properly determined, but for a Court. Generally speaking, however, there seems to be room for more than one reasonable actuarial view as to “proper provision” and “prudent assumptions”. Having said that, it seems to me that any entity which adopts the GAD/HMT view on reserving would be within [Regulation] 64. What is not so clear is whether Equitable Life’s view (or any position between that of Equitable and HMT) is in breach of [Regulation] 64. If Equitable is not in breach, I am not clear on what basis HMT might take action against it. (As to what action might be taken, see below.)

The Legal Adviser notes that ‘Equitable seems to agree that the prospective liabilities here are those under the policies themselves and not those under any other available options, and there seems to be no dispute about the amount of the liabilities, but Equitable argues that [Regulation] 64(2) does not necessarily require provision to back 100% of that amount’. The advice continues:

On first glance, the Equitable position is appealing in purely legal terms. [Regulation] 64(2) requires that a determination of the amount of long term liabilities “shall take account of all prospective liabilities” under the policies. It does not say in terms that the amount must equal 100% of the value of such liabilities. The overarching general requirement in [Regulation] 64(1) requires the making of “proper provision for all liabilities on prudent assumptions” which also suggests that provision need not necessarily equal 100% of the liabilities – it might be more or less.

However, reading [Regulation] 64 together with the rest of Part IX and with [Article] 17 of the First Council Directive 79/267 (as substituted by Directive 92/96) which Part IX is intended to implement, it can also be reasonably argued that Part IX contemplates 100% provision unless there is a respectable actuarial position that the provision might be lower. The tenor of Part IX is cautious and the intent is clearly that determinations should be relatively stringent. [Article] 17 of the First Directive offers some small support for this view stating, for example, that prudent valuation must not be a “best estimate”, but must include appropriate margins.

The Legal Adviser says that, for this reason, a court ‘would accept that Equitable’s position is untenable (even though supported by its actuary)’. However, she adds that, although she is not convinced that a court would accept that Regulation 64 required that prospective liabilities be 100% reserved, the court is likely to accept that ‘100% (or thereabouts) is required in this case, if Equitable continues to maintain its position at the low end’. She discusses what action might be taken if Equitable do not accept HMT’s and GAD’s position:

It appears that Equitable is or will be in breach of the 1994 Regulations, the Insurance Companies (Accounts and Statements) Regulations 1996 and Sections 17 or 18 of [ICA 1982]. You say you do not think it will be in breach of Sections 32 or 33 [of ICA 1982] (solvency and minimum margins). Equitable might be pursued for the breaches, but you are minded to proceed rather by way of intervention under Section 45 [of ICA 1982] to require full determination of the amount of liabilities on the grounds that the criteria of sound and prudent management are not being met ([paragraph] 6 of [Schedule] 2A to [ICA 1982]). (Action under section 45 assumes the purpose of intervention cannot be appropriately achieved under sections 38 to 44.) Assuming [that there is a] breach, such intervention is unlikely to be successfully challenged in the Courts as long as its terms are not Wednesbury unreasonable.

The advice continues: ‘As an aside, the issue of breach raises the question of burden of proof. Is it for HMT to show breach of the 1994 Regulations or for Equitable to show compliance? I think that it is for HMT to show breach. Only where Equitable could be shown to be significantly out of [step] with accepted practice or clearly acting unreasonably would the onus fall on it as a matter of fact to demonstrate compliance’.

Legal Adviser B says that she understands it to be HMT’s view that ‘considerations of PRE may go beyond determining what is a legally acceptable construction of the contract or exercise of a discretion under or in conjunction with the contract’. She notes that HMT would wish to examine ‘documents, events and policy holders’ representations’ in order to come to their own view on what policyholders’ reasonable expectations might be. Legal Adviser B records that she had discussed with Line Manager D certain aspects of Counsel’s opinion, which may indicate further grounds for Equitable having to increase their reserves. The advice states:

It is conceivable that the Unfair Terms in Consumer Contracts Regulations 1994 might also apply. However, the term(s) in question (to the extent they may be viewed as terms of the contract, rather than of a trust) arguably do not themselves cause “a significant imbalance in the parties’ rights and obligations … to the detriment of the consumer”. It is the exercise of the discretion which does or might have that effect. One would have to argue that it was the open-ended nature of the discretion which was unfair. I find it difficult to say whether this line of argument might be successful, but nevertheless am left with the feeling that the more profitable lines of examination are those discussed by Counsel and PRE.

As we indicated at the meeting we consider that Part IX of the Insurance Companies Regulations 1994 (ICR 1994) requires a life office to calculate its liabilities (and hence to reserve) on the basis of all the benefits offered under the contract. Regulation 64 of the Regulations requires long-term liabilities to be determined “on actuarial principles”, and to “make proper provision for all liabilities on prudent assumptions”. Regulation 64(2) makes clear that the determination must “take account of all prospective liabilities as determined by the policy conditions”.

HMT set out their view that:

In the majority of cases, Equitable Life’s pension contracts appear to have been written so that the principal benefit provided is an annuity, and there is an option to take benefits in cash form. In the case of such a contract, the effect of Part IX of the ICR 1994 is in our view to require full reserving for the liabilities to provide the annuity benefits to the value already guaranteed under the contract (i.e. to assume that 100% of policyholders take their benefits in annuity form), plus any additional liabilities arising from the cash option. While we accept that the precise wording of Regulation 64(1) which refers to “proper provision for all liabilities on prudent assumptions” may suggest some flexibility in appropriate cases, we are not persuaded that any credit can be properly taken for any reduction in reserving requirements that would result from assuming policyholders would exercise their option to take their benefits in the form of cash. The guaranteed annuity appears to be effectively the benchmark for minimum liabilities, whatever “option” is chosen by the policyholder.

HMT explain that:

To the extent that regulation 64 of the ICR 1994 could be disapplied under section 68 of the Insurance Companies Act 1982, HMT would not be inclined to make such an order. This is because, as indicated above, we consider that “prudence” requires that, even if other options are available and actually selected by the policyholder, reserves should be established at or very close to 100% of the value of the guaranteed benefit.

HMT argue that, for policies written to provide a cash benefit and which include an option to convert this benefit to an annuity at a guaranteed rate, Equitable should reserve for the terminal bonus up to the level required for the guaranteed annuity, since that level of terminal bonus could no longer be considered discretionary.

In relation to resilience reserves, the letter says:

HMT commented that there might be room for debate regarding the level of resilience reserves Equitable Life is required to maintain. The resilience tests specified by the Government Actuary are not legally binding in themselves. Companies could adopt an alternative test provided that they were satisfied of the actuarial prudence of the test used. This said the holding of substantial mathematical reserves to cover guaranteed annuity options did not appear to be a sound argument for reducing the stringency of the resilience test applied. It was explained at the meeting that the Government Actuary could be expected to wish to discuss with [Equitable’s Appointed Actuary] the basis for, and prudence of, any relaxation of the resilience tests applied by the company, particularly if the basis adopted was not universally accepted by the market.

In relation to reinsurance, the letter says:

Reinsurance was suggested as a possible means of overcoming the difficulties that Equitable Life would face in reserving on the assumption that 100% of policyholders took their benefits in the form of a guaranteed annuity. You pointed out that it would be difficult to put in place such an arrangement before the end of the month. We acknowledged this but indicated that we would be willing to consider the possibility of treating any such reinsurance arrangement as having been effective from the year end provided that at least the broad terms of the agreement were in place by that date and a firm intention to enter into the agreement could be shown.

(Note: an earlier draft of this letter included a note in relation to the section on reinsurance that ‘this paragraph still requires revision by GAD to take account of the technical difficulties of reinsurance identified since the meeting’. It does not seem that anything about technical difficulties was added. However, the following drafting was removed from the final version of the letter: ‘Reinsurance of the guaranteed annuities would enable the company to reserve purely for its liabilities under the cash option within the contracts’.)

HMT repeat the points about policyholders’ reasonable expectations set out in the note of the meeting and refer to the request for additional documentation from Equitable so that HMT could consider the issue further.

HMT conclude: ‘We also indicated that we expected an appropriate statement on contingent liabilities to appear in your regulatory returns, related to the risk [of] successful challenge to the Equitable Life’s bonus practice with regard to guaranteed annuities’.

GAD send HMT a note about reserving for annuity guarantees. GAD suggest that:

… it could be reasonable to assume that less than 100% of policyholders elected to take the guaranteed annuity provided that the reserve held in respect of those policyholders who are assumed to take an alternative annuity benefit is based on a realistic value of that alternative.

GAD suggest a mathematical formula that might be applied to Equitable and say they would not object to Equitable being allowed to phase in this formula over a reasonably short period of time. However, GAD recommend that HMT:

… obtain some commitment from the Society to reduce declared reversionary bonus for the effected contracts until such time as full provision has been made. We should also require the Society to fully disclose in the HMT Returns the basis that it has adopted.

GAD refute Equitable’s claim that their reserving basis had been tacitly accepted by the prudential regulators. GAD state:

There was a suggestion at the last meeting with the Society that they had disclosed their current reserving basis in their Returns and we had not challenged that basis and hence they were entitled to assume that their existing reserving basis was adequate. We dismiss this argument as being without substance. Schedule 4 of the 1997 Returns discloses the existence of the guarantees as “Some older contracts contain minimum guaranteed rates for annuity purchase at retirement”. This brief statement gives no indication of the significant exposure to guarantees that actually exists. The Actuary then goes on to say that “It was considered unnecessary in current conditions to make explicit provision for other guarantees and options described in paragraph 4.” The other guarantees referred to in this statement include the annuity guarantees. There is no further explanation offered as to how the Actuary reached this conclusion. As the Actuary signed a certificate which confirmed that the liabilities had been determined in accordance with the regulations we had no reason to challenge that Actuary’s basis. However we have subsequently been challenging his basis following receipt of the Society’s response (dated 29th July 1998) to GAD’s questionnaire on guaranteed annuities which disclosed the Society’s significant exposure to such guarantees.

(Note: the note of 03/12/1998 did not only specify the Society’s 1997 returns.)

GAD raise the possibility that there might be grounds for seeking to censure Equitable’s Appointed Actuary in that he had signed the 1997 returns which had, by doing so, confirmed that the liabilities had been determined in accordance with the regulations. GAD note that the approach adopted by Equitable was, broadly, one of the approaches set out in the November 1997 report of the Annuity Guarantees Working Party. The Working Party had gone on to comment that the approach ‘could be viewed as being unsound because no explicit provision is made for an explicit guarantee’. However, GAD also note that the Working Party had not recommended an approach to reserving ‘because of the variation between products and the approaches of different companies to managing the guarantees’ and that they had commented that ‘there is no industry consensus on reserving for guarantees’.

GAD conclude by saying that it might be appropriate for the Government Actuary to discuss the matter with the Society’s Appointed Actuary, if HMT felt that they wished to take issue with the Society’s reserving stance.

HMT send the Economic Secretary a further draft of a letter to companies on determining how the costs of annuity guarantees should be met. The briefing provided says:

A particular difficulty arises for mutual insurers (such as Equitable Life) that do not have any “orphan assets” or “estate” from which the residual costs of guaranteed annuity options can be met. In this situation, the ultimate residual cost of the guarantees must either be met by the policyholders who benefit from the guarantee or be spread across all with-profit policyholders who share in the overall profits and losses of the relevant business. Unfortunately Equitable Life has given these guarantees on a substantial portfolio of its policies (approximately 25% of its with profits business by liability value) and the level of the guarantee is comparatively high. Consequently, the residual cost of the guarantees is relatively large and will necessarily impact on the total amount of bonuses that can be paid to policyholders.

HMT’s Head of Life Insurance sends Line Manager D a note of a telephone call with Equitable’s Chief Executive. The Chief Executive had told him that Equitable still disagreed with HMT and GAD on what constituted a prudent reserve for annuity guarantees and that they had received ‘favourable’ legal advice on the question of reserving and were also seeking Counsel’s opinion on the issue.

The Head of Life Insurance records that ‘[The Society’s Chief Executive] made clear that if we could not reach agreement, the Equitable were prepared to challenge any use of our powers through Judicial Review’. His note goes on to record that:

Meanwhile, they were pursuing the possibility of financial reinsurance. They had approached two reinsurers, both of whom thought that they might be able to help. The Equitable were also considering possible asset reallocation; but they did not see much scope for this before the year end; the markets were not favourable to any major reallocation.

The Head of Life Insurance outlined the approach to reserving that GAD had set out in their note of 08/12/1998. The Chief Executive’s reaction was that this approach did not provide much flexibility.

HMT and Equitable had agreed that there would be another meeting between HMT, GAD and Equitable within the next week or so. Equitable’s own record of the call concurs with this account.

HMT’s Legal Adviser B advises the Head of Life Insurance in response to questions that he had raised at a meeting the previous day. The questions were whether:

(a) a breach of section 17(1) and (2) of the ICA 82 and the Insurance Companies (Accounts and Statements) Regulations 1996 ([especially Regulation] 4) would give rise to a mens rea offence or one of strict liability (where intent need not be proved); and

(b) if [HMT] were of the view that the accounts were in breach of the Regulations, the company allegedly in breach might be required to reissue the accounts in a manner which brought them into compliance.

The advice provided is as follows:

The relevant offence provision appears, by a process of elimination, to be subsection 71(3)(a) of the ICA 82:

“any insurance company which makes default in complying with, or with a requirement imposed under, any provision of this Part of this Act, being a default for which no penalty is provided by the foregoing provisions of this section … shall be guilty of an offence and liable, on summary conviction, in England and Wales and Scotland to a fine not exceeding level 5 on the standard scale …”

None of the defences in subsections (5) - (7) of section 71 apply.

The words “makes default” do not seem to me to suggest intent as do words used in other provisions of section 71 such as “knows to be false” or “intentionally obstructs”. I take the phrase to mean “fails to do what ought to be done”. This imports the idea of a wrongful act, but need not mean a wilful or intentional act. Indeed the phrase “wilful default” is often used in offence provisions and might have been used here if that was what was meant. Clearly though, if we approach a decision as to whether to prosecute, this is a matter on which Counsel should be instructed.

The advice continues:

As to whether a company might be required to “reissue” or amend accounts when it has breached [Regulation] 64 of the Insurance Companies Regulations 1994, I can find no provision in the Act or any Regulations which contains such a power. There is a provision in section 22(5) ICA 82 allowing the Treasury to “communicate with the company with a view to the correction of any such inaccuracies and the supply of deficiencies”, but this imposes no obligation on the company and in any event it is very doubtful that it would apply to a breach of [Regulation] 64. Such breach would not be an “inaccuracy” or a deficiency in the sense of a failure to “complete” the account.

I think a Court would expect that the [Insurance Division] would prosecute a clear breach of the Accounts and Statements Regulations or, if we considered [Regulation] 64 to be met, to amend it if we thought that appropriate in policy terms (or to act under section 45 if we considered [Regulation] 64 insufficient in any particular case). In any event, a decision to intervene to direct that past published accounts should be corrected and republished would have to be supported by good grounds under section 45(1). We will need to discuss any such grounds nearer the time.

GAD’s Chief Actuary C annotates his copy of the advice:

The breach is s18(4).

This leads to a breach of [sound and prudent management] Sch 2A – Para 8(a).

S37(2)(aa) gives grounds to exercise powers.

S42(1) could be exercised or s45(1)(b).

(Note: all these references are to ICA 1982.)

GAD’s Chief Actuary C writes to HMT’s Legal Adviser B (copied to HMT’s Director of Insurance, Head of Life Insurance, Line Manager D, Line Supervisor C and GAD’s Scrutinising Actuary E) in response to her note of 11/12/1998. The Chief Actuary says that GAD are:

… surprised that you believe that there is no power in the Act or any Regulations which would enable HMT to require a company to “reissue” or amend accounts when it has breached reg 64 of the Insurance Companies Regulations 1994. In our opinion there are grounds to require reproduction of the abstract of the actuary’s report and resubmission of the returns produced by the company.

The Chief Actuary continues:

There is a failure to undertake the actuarial investigation required by s18(1)(a) of the Act in accordance with s18(4), as the liabilities have not been determined in accordance with the applicable valuation regulations (i.e. Part IX of the Insurance Companies Regulations 1994). Furthermore, the form of the abstract of the actuary’s report, required to be made under s18(1)(b), has not been produced in the form prescribed under s18(5) as it does not meet the requirements of [Regulation] 4(a) of the Accounts and Statements Regulations.

Both of the above counts result in breaches of Paragraph 8(a) of the Criteria of Sound and Prudent Management (Schedule 2A to the Act). S37(2)(aa) of the Act seems to give the grounds to exercise the power under s42(1) of the Act in respect of the first breach. The [Secretary of State] would thereby have the power to require a company to produce an abstract in accordance with s42(3) of the Act. The second breach would also seem to give the grounds to exercise the power under s45(1)(b) of the Act, which could be used to require a company to resubmit the returns in accordance with the Accounts and Statements Regulations (i.e. to include the correct abstract of the actuary’s report) in order to ensure that the criteria of sound and prudent management are fulfilled.

HMT (Director of Insurance and Line Manager D) meet FSA (Chairman and Managing Director  A) to brief them about Equitable prior to FSA assuming responsibility for prudential regulation. HMT supply a note in advance of the meeting. This appears to be an unsigned and undated note headed ‘Financial position at end October 1998’.

In the note, HMT set out the Society’s financial position at the end of October 1998, as follows:

i.e. the company is just solvent if it reserves fully for its guaranteed annuity options.

HMT continue:

However, it should be noted that the free assets figure makes no allowance for the declaration of bonuses. The cost of annual bonuses, assuming they are maintained at their current level, is £500m, so the company would appear to have insufficient assets to declare a bonus in 1999.

Also it should be noted that £850m of the assets available to cover the [required minimum margin] are implicit items (allowance for future profits). Only 5/6th of the [required minimum margin] can be covered by implicit items. The company is therefore close to breaching this requirement when GAOs are fully reserved for. A relatively small fall in equities or gilt yields could wipe out the company’s explicit free assets.

HMT explain the arguments surrounding the level of reserving required. HMT set out a ‘Strategy for Regulatory action’. This was to form the basis of a further meeting with Equitable before Christmas which would be used to:

• Clarify that HMT [are] not minded to take action against the company for its failure to reserve fully for GAOs in its 1997 returns. (This would be consistent with [the] approach taken with other companies);
• Formally put the company on notice that the reserving approach that the company is proposing (assuming this remains to reserve for 25-35% of the GAOs) is not acceptable in HMT’s view;
• Indicate that in the context of settling its year end position it is for Equitable to decide the reserving approach that it intends to adopt in its 1998 returns since it is for the company to comply with the Regulations. But make the company aware that if in FSA’s view the returns submitted at the end of June are not compliant, FSA will take action;
• Seek an undertaking from the company that it will not declare any further bonuses without prior discussion with HMT. If necessary use the lever/threat of intervention action on the grounds of sound and prudent management to obtain agreement from the company.          

HMT state that intervention action would be likely to take the form of closing the company to new business. HMT say:

• If we are unable to obtain agreement from the company not to declare further bonuses without prior discussion with HMT we will need to take intervention action immediately.
• If agreement is obtained intervention action would only become necessary when the company indicated its intention to declare a bonus which would have the effect of making the company breach its [required minimum margin] if the GAOs were fully reserved for. (The company usually declares bonuses in February.)
• If agreement is obtained and no bonus is declared the need for intervention action/prosecution would probably not arise until July when the annual returns were submitted and it was clear from those returns that the GAOs had not been adequately reserved for.

HMT warn that Equitable could be expected to seek judicial review of any intervention action on reserving for annuity guarantees.

HMT’s note concludes, under the heading ‘Other regulatory action to be taken’:

In December/January we would analyse the policyholder documentation issued by the Equitable in order to reach a view on whether the company’s approach of reducing terminal bonus to meet the cost of GAOs was consistent with PRE in the case of policies maturing before this year end.

In January we would seek to issue a Dear Director letter to all life companies setting out our interpretation of the reserving requirements for GAOs (ie that full reserving was required) and that adequate disclosure was required in the returns of the reserving basis used for GAOs.

According to Line Manager D’s note of the meeting, FSA’s Managing Director queries the amount of future profits that could be taken into account to cover the required minimum margin, and asks why no action had been taken on Equitable’s 1997 returns when they showed no reserving for annuity guarantees. On the latter point, the note records: ‘It was explained that the approach taken by the company had not been clear from the return. [FSA’s Managing Director A] considered it defensible for HMT to have changed its view as the picture filled out and the significance of GAOs changed’.

HMT’s note records:

[FSA’s Chairman] was concerned that if Equitable were forced to pass a bonus this would amount to commercial suicide. No advisor would subsequently recommend the company’s products. It was agreed that it would be commercially very damaging for the company to pass its bonus. At this stage it was not clear whether this would be necessary (for instance there might be some margins in the reserving basis which could be released and the financial position might improve ahead of the date for setting future bonuses). From HMT’s perspective it was vital that the company was not permitted to make itself insolvent (assuming 100% reserving for GAOs) by declaring further bonuses.

The financial position of other companies was discussed and it is noted that:

Other companies had seen their financial position severely affected by GAOs but were expected to pull through.

HMT’s note records the following discussion:

Equitable had stated its willingness to take the reserving issue to judicial review. However, it was not certain that it would do so in practice. [FSA’s Chairman] noted that the fiduciary duties of Equitable’s directors might point in the direction of seeking a buyer for the business rather than challenging the HMT position and risking intervention action such as being closed to new business. It was clear that Equitable wished to avoid being taken over and it was agreed that a takeover would not be a good result for the company or HMT.

FSA’s Chairman asks if Equitable had any significant exposure to pension mis-selling. HMT explain that: ‘It was thought the company’s liabilities were small and that the reserves established … were reasonably generous in comparison with those of other companies’.

The Chairman also asks about the potential impact of a policyholder challenge to the differential terminal bonus policy. HMT state that Equitable’s financial position would not be made worse, assuming they had reserved on a 100% basis. The only additional costs to the Society would arise from topping up payments to policyholders who have already retired.

At the end of the meeting, the note records: ‘It was concluded that [the] situation was not a happy one but in the circumstances HMT appeared to be taking the only sensible approach’.

Every insurance company is sent by HMT’s Director of Insurance a guidance letter, ‘Guaranteed  Annuity Option Costs and Policyholders’ Reasonable Expectations’. This reflects the draft that had been approved by the Economic Secretary (09/12/1998).

HMT advise that policyholders entitled to some form of annuity guarantee or option on guaranteed annuity terms could reasonably be expected to pay some premium or charge towards the cost of the guarantee or option. HMT explain that:

Generally we consider that it would be appropriate for the level of the charge deemed to be payable by participating policyholders for their guarantee (or annuity option) to reflect the perceived value of that guarantee (or option) over the duration of the contract. This could be achieved in some cases through some reduction in the terminal bonus that would be payable if there were no such guarantee (or option) attached to the policy. However the selected treatment by each office would need to depend on the wording of the contract involved and how it had been presented to policyholders.

HMT further advise that they would expect:

… that for most companies the present guaranteed cash benefits (including declared bonuses) would be converted, as a contractual minimum, to the annuity on guaranteed terms. However as indicated above, it would appear possible, depending on the particular circumstances relating to the contract, that any terminal bonus added at maturity may be somewhat lower than for contracts without such options or guarantees, and that this terminal bonus could in some cases be applied at current annuity rates.

HMT add that ‘the appropriateness of any adjustments to bonus allocations for participating policyholders would need to be assessed by each office in the context of the reasonable expectations of policyholders. This assessment will be influenced by their policy documents and any representation made through marketing literature, bonus statements or elsewhere’.

GAD write to HMT in response to their note of the meeting with FSA on 15/12/1998. GAD dispute that no action had been taken on the 1997 returns, pointing out that the current discussions on annuity guarantees followed directly from questions that GAD had raised on the reserving bases in the returns. GAD note:

It should be remembered by HMT that GAD invited [Equitable’s Appointed Actuary] to a meeting on 28th May this year (following consideration of their 1996 returns), at which we discussed the reserving bases appropriate to accumulating with-profits business, attempted to clarify certain PRE aspects of the bonus notices being issued by Equitable and urged great restraint in the granting of guaranteed bonuses.

GAD say that they disagreed with the statement by the FSA Chairman that it would be commercial suicide if Equitable were to award no guaranteed bonuses that year. GAD say:

As a non-commission paying office, Equitable does not rely on [independent financial advisers] to recommend its products. GAD does not believe that it would necessarily amount to commercial suicide if no additional guaranteed bonuses were granted this year in relation to contracts containing GAOs, provided the reasons were properly explained to policyholders – indeed we consider that such a step is probably necessary for the prudent management of the Society. It should be recognised that this would not prevent the company from indicating further growth in the value of the cash option alternative available under these contracts. [From figures so far provided to us, it is hoped that the financial position of Equitable will not be so tight at the end of 1998 as to inhibit the granting of some additional guaranteed bonuses on other contracts – i.e. naturally including those currently being marketed. Admittedly, this is not yet certain.]

Equitable send HMT a copy of Leading Counsel’s opinion in support of Equitable’s stance on  reserving for annuity guarantees. Equitable express the hope that the forthcoming meeting (arranged for 22/12/1998) would lead to a mutually satisfactory outcome. Equitable tell HMT that:

On the advice of Leading Counsel the Society has decided to take one or more test cases to the High Court in order to confirm that the Society’s Directors have acted entirely properly and within their powers in adopting the system of final bonus additions which applies to policies containing GAOs. Although not directly pertinent to our current discussions, I hope that you will regard this action as a demonstration of the Society’s confidence in its position and its determination to maintain it for the future.

Equitable’s Counsel explains that, over the last five years, ‘only a tiny proportion of policyholders have elected to take an annuity based on GARs’. Counsel says that this low take-up will have been ‘substantially influenced’ by Equitable’s differential terminal bonus policy. Counsel says:

This approach has been notified to the Treasury (and previously to the DTI) in the returns made by the Society pursuant to its obligations under Schedule 4 of the Accounts and Statements Regulations for all years from 1993 through to 1997 consistently. To quote from the 1993 to 1995 versions of the return: “It was considered unnecessary in current conditions to make explicit provision for the other guarantees described in paragraph 3”, and paragraph 3 stated in relation to Relevant Policies that “the premium provide a cash fund at the pension date, to which (for policies issued prior to 1 July 1988) a guaranteed annuity rate is applicable.” The 1996 and 1997 returns adopted the same wording as regards the absence of provision (save that in that case the cross-reference was to paragraph 4), and the cross-reference was to the following statement: “older contracts contain minimum guaranteed rates for annuity purchase at retirement.”

Further, we understand that the Treasury has been well aware of the existence of such policies throughout the relevant period, and that the GARs referred to were higher than CARs, in the light of experience from 1994 onwards. We note that the Society’s returns made under Schedule 4 of the Accounts and Statements Regulations for the years 1993 to 1997 quoted verbatim the text of the resolutions of the Society’s Board which declared differential final bonuses which adjust such final bonuses for the fact that GARs exceeded CARs: see paragraph 16(vi) of the 1993 to 1995 versions of the return, and paragraph 16(viii) of the 1996 and 1997 returns.

Counsel for the Society continues:

The ICR came into force on 1 July 1994. Thus the obligations imposed on the Society by the ICR have been applicable at all material times – that is at all times when GARs have exceeded CARs. This notwithstanding we are instructed that the Treasury did not seek to take the point now being taken against the Society in respect of the valuation dates falling in 1994, 1995, 1996 or 1997. And yet circumstances giving rise to the alleged necessity to make a reserve will have existed in each of those years (and at the 31 December 1995, 1996 and 1997 valuation dates in particular), if indeed it is necessary on a proper understanding of the ICR to make a reserve at all.

In each of those years, the Society has in good faith declared annual bonuses and allotted and paid final bonuses on the assumption that there was no need to make any such reserve. It is obvious that had the Treasury raised with the Society in any of the years 1994 to 1997 the point of interpretation of the ICR which it now seeks to take, the Society would not have been able to declare and allot bonuses to Relevant Policies at any such level, if at any level at all. Further, the Society’s investment strategy over the relevant period would have been different had the Treasury required that the Society make such a reserve. None of this can be undone today. The Society’s reliance on the Treasury’s previous interpretation of the ICR infects 1998 also, in that the bonus declarations for the year ending 31 December 1997 were made in February 1998, some ten months prior to the 31 December 1998 valuation date in respect of which the present issue arises; and the Society’s investment strategy for 1998 is also history.

Equitable’s Counsel argues that:

Had the Treasury sought to take a consistent line on this issue from 1994 onwards, it would have been possible for the Society to absorb any need to make reserves progressively, as the downward trend of annuity rates over the 1994 to 1998 period would have dictated a steady increase in reserves. The consequence of the Treasury seeking to impose its interpretation of the ICR on the Society at the end of 1998 for the first time is to require the Society to make a one-off reserve of approximately £1.5 billion, which is massive by any standards, and which threatens the statutory solvency of the institution.

The opinion states that ‘it is impossible for the Treasury validly to conclude in the face of these matters that a 100% reserve is necessary in respect of the value of GARs under Relevant Policies’.

HMT and GAD meet Equitable. HMT prepare a note of the meeting.

Equitable undertake to articulate the problems they would face if they published a low solvency cover, and to apply for a section 68 Order for a larger future profits implicit item. HMT and GAD promise to send a response to Equitable’s Counsel’s opinion as quickly as possible and to consider any case Equitable put forward for the phasing in of reserves. HMT stress:

… that it was for the Equitable to reserve how it saw fit. However, HMT would take regulatory action if the Annual Returns disclosed that the reserves were inappropriate or if the company’s actions imperilled solvency margin cover. The bonus declaration was of particular importance here and if HMT felt that bonus levels declared were imprudent it would take action.

Equitable’s Appointed Actuary states that he ‘did not agree that the reserve should be 100% and that the regulatory regime did not require reserving for terminal bonus, this was something that HMT was suddenly applying’. HMT repeat their position that ‘terminal bonus was effectively guaranteed up to the value of the guaranteed annuity’.

GAD reject the contention in Counsel’s opinion that they had tacitly accepted Equitable’s reserving practice, saying that ‘the information disclosed in the return was limited and gave them no reason to question the validity of the reserving basis’.

The note records that ‘[the Appointed Actuary] believed that HMT’s approach would disadvantage policyholders’ and that ‘[if] the Equitable had to reserve for the full amount of the guarantees this would seriously constrain investment strategy and low solvency would threaten the company’s future’. Equitable’s Chief Executive agrees to write further ‘on the consequences of taking this reserving hit as [HMT] had some difficulty in accepting all of his arguments’.

The note goes on to record that there was ‘no agreement between HMT and the company on the fundamentals of the argument’, with Equitable arguing that the approach taken by HMT was not in the interest of policyholders – and with HMT’s Head of Life Insurance saying that HMT ‘did not want policyholders or potential [policyholders] to be misled or disadvantaged by the company mis-reporting its financial position in the annual returns’. The Head of Life Insurance stresses that ‘whilst he expected the company to accept the principle of reserving outlined by HMT we were sympathetic to aiding the company in softening the blow in getting to this position, as we understood there was the potential for policyholders to be adversely affected by a sudden hit of this magnitude’.

HMT’s note of the discussion records that:

[Equitable’s Appointed Actuary] said that there were margins in the reserving that could be released giving the company approximately c£200m further free assets. The company could apply for a larger implicit item (up to £1.9bn) HMT stated that if a Section 68 Order request was received from the company we were likely to treat this application sympathetically. The company agreed to apply for this larger implicit item before the year end and it could then decide at a later date whether to use some or all of the amount allowed under the concession. [Equitable’s Chief Executive] felt that it would take a period of 4-5 years to manage the problem down, if the HMT reserve were required.

Manuscript notes made by HMT’s Head of Life Insurance and GAD’s Chief Actuary C at the meeting reflect the above concerns and points.

GAD advise HMT on Equitable’s section 68 Order application. GAD say:

I am happy to confirm that we are comfortable that the figures used in relation to the original submission of 26 June remain appropriate and would support the amount now requested.

[This conclusion is supported by the presumption that had higher reserves been established at the end of 1997, as we now think appropriate, these would have been supported by increased transfers from investment reserve (as carried in line 51 of Form 14) and would not have affected the level of emerging surplus shown in form 58 in that year.]

Equitable press HMT for their views on their Counsel’s opinion, following the meeting on  22/12/1998. Equitable explain that Equitable have received an offer in respect of a financial reinsurance arrangement. They enclose a copy of a fax from Irish European Reinsurance Company (IRECO), which confirms that a meeting is to take place on 7 January 1999 where they hope that the remaining issues could be resolved to enable a contract to be drawn up. Equitable also enclose a copy of an internal note, which sets out that:

The reassurance would cover the retirement annuity portfolio with the following costs:–

1. an annual non-refundable premium of £50,000; and
2. in the event of a claim, 2% of the claim amount.

A claim would occur under the reassurance treaty if in any year the guaranteed funds to which guaranteed annuity rates applied (i.e. for those policies for which the option was effected) exceed 25% of the total guaranteed funds for all retirements in that year.

It is proposed that any claim would be repaid by the Society to the reassurer over a period of about 3 years. That repayment would be taken out of investment returns in excess of those required for the statutory valuation.

(Note: this note was altered before it was sent to HMT. On the original, the final sentence above continued ‘… which means that no reserves would need to be set up for this liability’. The sentence ‘As you are aware, we have also been talking to [another reinsurance company] but we have had no offer as yet’ was also removed from the copy sent to the regulators.)

HMT’s Legal Adviser B sends the Head of Life Insurance a first draft of a letter to Equitable  about the opinion. She states that the opinion does not cause HMT to change their views, as set out in their letter of 07/12/1998. The Legal Adviser adds:

… we are firmly of the view that returns made by the Society since 1993 could not be viewed as constituting notice to DTI or HMT of the Society’s reserving practice. As we noted in the meeting, the statements in the accounts are brief in the extreme and do not disclose the reserving method or the rate of guarantee. Nor does the text of resolutions of the Society’s Board reveal that GARs actually exceeded CARs. The problem (which in any event was not significant before 1995) was not revealed until HMT began to consider the responses to the relevant questionnaire in 1998. We raised the matter with the Society and others very soon after that. DTI/HMT was not aware from 1994 that the GARs referred to were higher than CARs.

The HMT position on reserving is not in any event a change of policy, but a view that in the changing economic circumstances guaranteed annuities must, as a matter of prudence, be fully reserved.