1999

GAD advise FSA that they have been reviewing the issue of the level of mathematical reserves established by Equitable in respect of annuity guarantees. GAD explain that there are three actions now needed:

• to tell Equitable in writing that GAD are not happy with the fact that they have zero reserves for annuity guarantees in their 1997 returns;
• to seek a number of items of specific information from Equitable about mathematical reserves and asset shares, together with a ‘copy of the most recent Financial Condition Report produced by the Actuary in accordance with professional guidance note GN2’. GAD explain that this information would ‘help us to form a better understanding of [Equitable’s] current financial condition, and resilience to changing investment conditions’; and
• to provide comments on Counsel’s opinion obtained by Equitable (see 18/12/1998 [entry 3]).

On the last point, GAD comment that Counsel had overlooked that the prudent assumption of the proportions of policyholders who might exercise each option (a guaranteed annuity or cash/current annuity):

… ought to depend on the relative value of these benefits. If the value of the guaranteed annuity is some 20-30% higher than the value of the alternative guaranteed cash, then we believe that almost all policyholders would reasonably be expected to opt for the annuity benefit.

GAD state that Equitable have offered policyholders an additional discretionary cash sum if they chose the cash benefit over the guaranteed annuity. GAD say that this recent experience is not relevant as Equitable:

… cannot sensibly take account in the valuation of the increased proportion therefore taking the cash benefit, since they do not propose to maintain any provision on the balance sheet for this additional cash bonus.

On the subject of the earlier 1993-1996 returns, GAD:

… accept with hindsight that we might have addressed the issue rather earlier by asking some pointed questions about their guaranteed annuities. However, the presentation of their valuation methodology in their returns was somewhat obscure, and required the reader to pick up comments in three quite separate parts of the return and draw certain inferences from them. There was nothing said to indicate that the level or extent of these guaranteed annuities were regarded as significant.

For example, the wording in paragraph 5 refers to no explicit provision being made in current conditions for the “other” guarantees in paragraph 3, without clarifying exactly which guarantees have or have not been included, or saying whether allowance had been made implicitly for guarantees within the methodology adopted or within the other valuation assumptions.

GAD add that ‘the materiality of this issue at end-1996 and earlier would have been much lower’, as market interest rates were then more than 3% higher compared with present levels.

GAD also stress ‘that we have not accepted the reserving basis apparently adopted in the 1997 returns, and indeed have not had any direct communication with the company about these returns’.

GAD dispute that the additional reserve required for annuity guarantees at the end of 1996 would have prevented the declaration of bonuses. GAD state that at no time did Equitable seek to discuss the reserving basis with GAD and HMT.

GAD have ‘some sympathy’ with Counsel’s argument that, had the regulator taken a consistent line on the issue of reserving from 1994, it would have been possible for Equitable to absorb the need to make reserves gradually. However, GAD note that ‘most of the increase in the £1.5bn provision has arisen in 1997 and 1998 …’. GAD observe that they could consider the question of ‘phasing-in’ higher provisions once they had the additional information sought from Equitable.

Legal Adviser B (who transfers to FSA to the position of Chief Counsel, Insurance and Friendly Societies (Chief Counsel A)) sends the Head of Life Insurance a further draft of a letter to Equitable about their Counsel’s opinion.

FSA’s Director of Insurance submits proposed letters of guidance to Appointed Actuaries and Managing Directors and the proposed letter to Equitable about Counsel’s opinion to FSA’s Chairman for him to note. The Director of Insurance says that the letters make clear that HMT’s and FSA’s policy in relation to the level of reserve required for annuity guarantees had not changed. The Director of Insurance explains:

… we would expect the reserve established to be essentially the same whether the contracts involved are written as an annuity with the option to take a cash fund or the other way round. In addition, the focus is on actuarial prudence which requires a reserve at or within a few percentage points of 100% of the value of the GAO rather than the strict letter of the reserving requirements in the Insurance Companies Regulations 1994. Focus on the latter might encourage the argument that the legal requirements should be waived in this instance on the basis that they are excessively burdensome; and this is an argument we have already considered and rejected.

The Director discusses three ‘options’ for dealing with companies which had submitted their 1997 returns on the wrong basis. He says:

We are clear that action to prosecute the companies for supplying improper returns would be a disproportionate response and in any event very unlikely to succeed. We have considered the options available in terms of other intervention action, none of which is attractive, and concluded that the least bad approach is to ask those companies whose 1997 returns were not prepared in accordance with the guidance, and would have shown a materially different financial position if they had been so prepared, to accelerate submission of their 1998 returns. The advantages and disadvantages of the 3 main options are set out below.

The three ‘options’ put forward are:

‘Option 1 – Take no action in relation [to] past returns’

FSA’s Director of Insurance explains:

This would involve allowing the currently submitted 1997 returns to remain on the public record although we could still make clear to companies that this did not mean that FSA was accepting as valid the basis on which they had been prepared. This would appear a weak regulatory stance and would leave us in a very difficult position in respect of arguments that prospective policyholders might be misled by inaccurate 1997 returns.

This said, arguments could be made that any risk of prospective policyholders being potentially misled is short-term (6 months for the vast majority of companies) and is small in size. We consider the risk small as in the vast majority of cases it appears that any inadequacy in the reserving for GAOs would not have had a material impact on the company’s apparent financial strength. In those cases where the impact would have been significant there are other arguments why it is unlikely that prospective policyholders would be misled as to the financial strength of the company:

a) there has been a capital injection or reinsurance arrangements have been put in place since the end of 1997 which means the company is currently in no worse a financial position than its 1997 returns suggested;

b) the company is closed to new business so there are no prospective policyholders; or

c) the company would in any case have been classed as one of the weaker offices so that financial strength would not have been a significant factor influencing the policyholders’ choice of office.

In addition it could be argued that there is only a small likelihood of payouts to those who become policyholders between now and June being significantly reduced as a result of companies having to meet additional liabilities for GAOs which were not apparent in their 1997 returns. This is because companies determine their payouts to policyholders on an asset share basis. This involves ensuring the return largely reflects the investment performance of the policyholder’s premiums. Any additional cost incurred in respect of GAOs is likely to be met out of a company’s free reserves or by an adjustment to the payouts for those existing policyholders with GAOs – thus not affecting the bonuses of new policyholders.

However, it is clear that all the above are complex technical arguments which could not be expected to run well in the media or to be readily accepted by consumer groups.

‘Option 2 – Require correction of “misleading” 1997 returns’

FSA’s Director of Insurance explains:

This would demonstrate the FSA’s willingness to take action where insurance companies fell short of meeting their obligations. However, there are significant doubts about whether the legislation empowers us to require companies to correct their returns where we consider them to have been prepared on an inappropriate basis. Each case would have to be considered on its merits and in many cases we doubt we would have sufficient grounds to intervene. Therefore, it is unlikely that such action would produce a clearer position for the public – certainly in the period before publication of the next returns.

Even if such action could be enforced, we would need to allow companies time to do the necessary work. In practice, companies would be unlikely to be in a position to correct their 1997 returns much before they were superseded by their 1998 returns (at best the end of February assuming the request were issued immediately and instantly accepted by the company). Bearing in mind that the overall financial position in the resubmitted returns might look little different in the majority of cases (see below) and would already be more than a year out of date we believe that the costs of such an approach would be disproportionate to the benefits.

‘Option 3 – Require accelerated 1998 returns from companies who submitted “misleading” 1997 returns’

FSA’s Director of Insurance argues that:

Again this would demonstrate a proactive approach by the FSA and would tackle directly the main concern – i.e. that prospective policyholders might be misled by inaccurate data which had been published by companies in the past.

Under the legislation we could require companies to accelerate preparation of their annual returns by 3 months (so they would be available by the end of March). The difficulty of determining which companies should be asked to provide accelerated returns could be overcome by requiring companies to provide us with information about whether their 1997 returns complied with the line in the guidance and would have appeared materially different had they done so; and, in cases where this applies, whether they have taken steps to strengthen their financial position.

However, other difficulties would remain. The approach brings with it a significantly increased risk of challenge. In particular, on the basis of our discussion with them to date, Equitable Life arguably now have a legitimate expectation that they have until the end of June to settle how they present their 1998 position (subject to their not in the interim declaring a bonus which would threaten their solvency). Therefore requiring Equitable Life to submit an accelerated return would mean a real risk of a successful judicial review. However, leaving them out of any such approach would not be defensible from a consistency perspective. Spreading the focus of regulatory action to a wider group of companies would be helpful to Equitable Life but increases the number of companies with a particular incentive to challenge the guidance and enhances the possibility of a collective industry challenge (something that would clearly have more force than challenge by a single company).

FSA’s Chairman ticks the first two paragraphs. Against the last paragraph, he writes: ‘I’m not clear why the timing point increases the risk of a successful [judicial review], though I can see why it increases the risk of a [judicial review] of some kind’.

FSA’s Director of Insurance recommends to the Chairman that he notes that FSA are proposing to follow ‘Option 3’ – that they ‘propose to ask companies to submit their 1998 returns early where their 1997 returns were not prepared in compliance with the line set out in the guidance and where they presented a materially misleading impression as a result’.

The FSA’s Chairman responds to the Director of Insurance’s recommendations of 07/01/1999 that the Chairman notes:

a) the general industry guidance and the specific letter to Equitable Life that we propose to issue;

b) the draft press notice, which I have discussed in general terms with [a HMT official];

c) that we propose to ask companies to submit their 1998 returns early where their 1997 returns were not prepared in compliance with the line set out in the guidance and where they presented a materially misleading impression as a result.

FSA’s Chairman writes:

I am content with the letters – subject to one point (marked). On the press handling, it seems to me inevitable that this will get into the public domain, given the interest in certain letters, so I would favour a press release which allows us to get in first, rather than allowing a company, or lawyer in support, saying “snoutrage”. A [press release] would also allow us to explain, in a note, the HMT-FSA shift, which will confuse people. If [an HMT official] has some powerful countervailing arguments, I will hear them, but my inclination is to go ahead as [the Director of Insurance] suggests.

FSA write to Equitable in response to their letters of 18 and 31/12/1998 and following their meeting of 22/12/1998. FSA explain that Equitable’s Counsel’s opinion does not cause FSA to change the views set out in HMT’s letter of 07/12/1998. FSA say that, in their view, the company’s discretion not to pay additional bonuses is ‘substantially fettered’ and that ‘prudence would require that the actuary hold a reserve which is within a few percentage points of the reserve required for the guaranteed benefit’.

FSA reject the view that Equitable’s returns since 1993 could be viewed as constituting notice to DTI or HMT of their reserving practice. FSA state:

As we noted in the meeting [see 22/12/1998] the statements in the returns are brief in the extreme and do not disclose the reserving method, the rate of guarantee or the volume of business affected. (In fact, as an aside, we have some concerns about Equitable’s compliance with paragraphs 4(1) [which requires full description of benefits for accumulating with-profits policies] and 6(1) [which sets out the principles and methods to be adopted in the valuation] of Schedule 4 to the Insurance Companies (Accounts and Statements) Regulations 1996 which we hope will be put to rest in the 1998 return.)

FSA go on to state:

The HMT (now FSA) position on reserving is not in any event a change of policy. Our view remains that guaranteed annuities must, as a matter of prudence, be fully reserved. It is a consequence of the changing economic circumstances that the quantum of reserves required has increased significantly over the last year or two. The Equitable has so far presented us with no reasonable argument as to why … reserves should be established at a level significantly less than 100% of the value of the guaranteed annuities …

… To the extent that the Society wishes to argue that a requirement of close to 100% would have a severe impact on the Society which would unduly prejudice policyholders, and that such requirement should not in the short term be enforced (and intervention action should not be taken), clear and convincing arguments need to be put to the FSA …

Any such arrangement which fell short of the normal reserving requirement would need to be disclosed in the Society’s statutory return, so that potential policyholders and their advisors were not materially misled as to the overall financial position of the Society.

Every insurance company is sent by FSA’s Director of Insurance a letter about reserving for annuity guarantees. The Director of Insurance says:

… in view of your ultimate responsibility for ensuring that your company establishes proper reserves, I thought I should alert you to [the Government Actuary’s guidance (see 13/01/1999 below)] and the FSA’s views on the action which companies should take.

FSA’s Director of Insurance writes:

I am concerned that the 1997 returns produced by some companies may not be fully consistent with the line set out in the guidance and as a result may in some instances present a materially misleading impression of companies’ financial positions as at the end of 1997. In such cases I think it important that accurate data should be made available as early as possible.

    Accordingly I should be grateful if you would discuss with your appointed actuary: 

a) whether your company’s 1997 returns were prepared in a way that is consistent with the guidance in the Government Actuary’s letter;

b) if they were not so prepared, whether this had a material effect on the overall financial position presented in the companys returns, taking account, for example, of the relative importance to the company's business of guaranteed annuities and of the amount of any available margins that may exist elsewhere in the valuation basis.

Where there was a material effect on the overall financial position shown in the 1997 returns, and where the company has not subsequently taken commensurate action to strengthen its financial position, it is the FSA’s view that it would be appropriate for such companies to submit their 1998 returns early – and in any case not later than 31 March – so that the FSA and potential policyholders and their advisers can form a proper view of these companies’ financial position.

Every insurance company is sent by the Government Actuary a copy of DAA11, on reserving for  annuity guarantees. The Government Actuary writes:

… 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”.

The Government Actuary explains that, where there is a guaranteed level of annuity, a company should reserve fully for their liabilities to provide annuity benefits to the value guaranteed. In assessing their liabilities, companies must make a ‘prudent assessment’ of the extent to which options are likely to be exercised. He advises:

In general it would not … be prudent to assume that policyholders will choose a benefit form that is of significantly lower nominal value to them, although some limited allowance (of a few percentage points of the reserve) could in some cases be made for a reduction in the liability on the grounds of the additional flexibility or other perceived advantages to policyholders of any alternative benefits.

The Government Actuary acknowledges that, where companies adjust terminal bonuses to bring the value of the annuity guarantee closer to the value of the alternative benefits, there might be an argument that it was not necessary to reserve on the assumption that almost all policyholders would take the guaranteed annuity benefit. However, the Government Actuary points out that, although the benefits formally ‘guaranteed’ under the alternative form of benefit might be lower than those under the annuity guarantee, the company’s discretion in setting the value of terminal bonus applied to the alternative benefit ‘is limited as a result of the existence of the guaranteed annuity’. The Government Actuary considers that close to 100% of policyholders would exercise the annuity guarantee, unless the company set terminal bonuses at a level which ensured that the alternative benefit was at least as valuable as the guaranteed annuity. Accordingly:

… this constraint will need to be reflected in the valuation assumptions made about either the proportion of policyholders opting for the alternative benefit or the value of that alternative benefit. Consequently any reduction in the reserves held by the insurer by more than a few percentage points below the full value of the guaranteed annuity for this reason would require very careful justification by the actuary.

The Government Actuary adds that, although in the past many policyholders had exercised their right to take up to 25% of the benefits of their pension policy in the form of a tax-free lump sum, he ‘would not consider it prudent to use past experience alone in this regard for reducing the proportion of benefits assumed to be taken in the guaranteed annuity form’.

The Government Actuary also states that companies needed to assess the extent to which a resilience reserve was required, and that he expected them to apply the tests and advice set out in the letter of 30/09/1993, as amended by the letter of 24/11/1998. The need to hold substantial mathematical reserves to cover annuity guarantees would not, in his view, be a sound argument for reducing the stringency of the resilience test applied. He states that the level of reserves established for annuity guarantees was likely to be a matter that FSA and GAD would review particularly closely in the 1998 returns. He points out:

It should be remembered that Schedule 4 of the Insurance Companies (Accounts and Statements) Regulations 1996 requires the actuary’s report in the annual returns to include detailed information about the contracts written …

The annual returns should include sufficient information for the FSA and GAD to make an assessment of the extent of the guarantees offered, the reserving basis adopted by the company and hence the scope for guaranteed annuity options to impact on the financial position of the company.

HMT brief the Economic Secretary on the possible responses to the guidance on reserving.  HMT explain that the costs of meeting guarantees (estimated to be £8bn) coupled with the costs of the pensions mis-selling review (estimated to be between £8bn and £11bn) would be borne largely by with-profits policyholders. HMT point out that many, if not most, with- profits policyholders would not have been mis-sold pensions or bought guaranteed annuities, and they might reasonably ask why the return on their savings should be reduced as a result of errors of judgement elsewhere in the business.

HMT refer to the lower investment returns in the 1990s. They also explain that an undistributed amount of profits is held as a float or reserve, so that when profitability is poor, payments to policyholders could be smoothed. However, in the 1980s ‘payments of terminal bonuses … to existing policyholders may have been too generous. The companies were competing by highlighting the size of such bonuses’.

HMT conclude that there was considerable scope for ill will and criticism of companies and their regulation. They say that, in the first instance, FSA should be answerable for their actions. HMT would be answerable to Parliament if it were alleged that the regulatory framework was inadequate, or that the performance of the regulator had been poor or over-zealous.

FSA issue a press release to accompany the guidance letter. They produce in-house briefing notes in anticipation of follow-up questions. In response to the possible query: ‘Have companies in the past failed to set up reserves in line with the guidance now issued?’, FSA state: ‘This is what the current exercise is designed to establish’.

In response to the possible query: ‘Guidance endorses Equitable Life’s approach?’, FSA state:

Guidance does not endorse or criticise any particular company’s approach. Do not wish to comment on individual cases. Accept that guidance allows for the possibility of a company to [reduce] terminal bonus in respect of contracts carrying a guaranteed annuity provided this is in line with the reasonable expectations of policyholders.

Terminal bonus is not normally guaranteed and companies generally make clear to policyholders that the value of any terminal bonus is not guaranteed. Terminal bonus is typically used by insurers to adjust the total benefits received by policyholders to ensure that they reflect a fair return on their investment. Against this background adjusting the level of terminal bonus to take account of the value of the benefit provided by a guaranteed annuity option would not appear to be out of line with normal practice.

A PIA Manager writes to a PIA Director about the press release FSA issued following the letters of 13/01/1999. The Manager comments that this publicises the guidance issued by HMT on 18/12/1998. He expresses concern that FSA ‘has issued guidance which represents the position of one part of FSA, when other bits of FSA have not had an opportunity to consider the matter properly. This is particularly relevant as on this occasion when our position may differ from that of the Insurance Directorate’.

The Manager explains that his instinct from a ‘selling and marketing’ point of view is to establish how the guarantees were promoted and, if appropriate, ‘require firms to honour their promises’. He notes that HMT’s and FSA’s approach is to agree that bonus rates can be reduced to policyholders with guaranteed annuities. The PIA Manager states:

It’s a clear conflict between conduct of business regulation and prudential supervision …

Presumably there is some mechanism within FSA to co-ordinate regulatory activity.

FSA’s Head of Life Insurance informs Line Manager D and GAD that Equitable hoped to provide the information requested on 18/01/1999 in a couple of days. The Head of Life Insurance reports Equitable’s Chief Executive as having said that he expected the Court case to take place in late September, but that an appeal would push it into 2000.

Equitable write to FSA in response to their letter of 18/01/1999. Equitable explain that the

Board had had some preliminary discussions about the bonus for 1998. Their initial view was that it would be appropriate to make a substantial reduction in declared bonuses to reflect current and prospective financial conditions.

Equitable state that they do not have a single document constituting a Financial Condition Report (see 04/01/1999). Equitable explain that:

Currently the main elements of [Financial Condition Report] during the course of a year are covered in the following regular reports, supplemented by occasional individual reports on specific topics:

(i) annual financial projections

(ii) monthly financial reporting including estimates of the statutory solvency position

(iii) a more detailed quarterly review of revenue experience and solvency

(iv) a monthly analysis of the sensitivity to short-term changes in investment conditions produced to assist the Investment Committee in formulating strategy.

Examples of items (i) – (iv) from the 1998 board papers are enclosed for information.

Equitable enclose copies of reports on ‘Projections for 1998-2000’, ‘Revenue – Review of First Six Months’, ‘Solvency Matrix’ and ‘Monthly Business Statistics – Period Ending 30/11/98’. This last report on monthly business statistics included a chart which showed that Equitable’s cover for the required minimum margin, excluding any provision for annuity guarantees, had dropped from around 3.5 in July 1998 to below 1.5 in September 1998.

(Note: Equitable did not send FSA a copy of their most recent quarterly review of revenue experience and solvency, ‘Revenue – Review of First Nine Months’, dated 22 October 1998, which showed Equitable’s cover for the required minimum margin under the current proposed valuation basis, and excluding any provision for annuity guarantees, to be 1.4 as at 30 September 1998.)

Equitable inform FSA that:

… we have entered into a financial reassurance arrangement with effect from 31 December 1998, as you helpfully suggested in your letter of 7 December 1998 …

Equitable explain that the details are as outlined in their note of 31/12/1998. Equitable attach draft terms and say they will check direct with GAD that they have the ‘intended reserving effect’.

FSA’s Director of Insurance provides FSA’s Board with a pre-Board briefing on their regulatory  responsibilities. In advance of the meeting, FSA circulate background papers on inherited estates and on guaranteed annuities. The latter paper notes Equitable’s approach to dealing with the cost of meeting guarantees and outlines the guidance issued by HMT (see 18/12/1998 [entry 1]). The minutes of the meeting record that the Head of Life Insurance:

… focused on key issues facing the regulator including the attribution of surpluses in with-profit funds in inherited estates, the cost implications of pensions mis-selling, the spiralling cost of meeting annuity guarantees, and insurance liabilities, and systems questions associated with the Year 2000.

FSA produce a further update for the Tripartite Standing Committee on the ‘Effect of Current Market Conditions on UK Life Insurers’ (see 22/10/1998). This reflects earlier comments provided by GAD.

FSA state that ‘there are 4 companies giving cause for concern principally as a result of their exposure to guaranteed annuity options …’, one of which is Equitable. On Equitable, FSA report the following:

The company’s difficulties primarily stem from GAOs. It has some pension mis-selling liabilities but these are relatively small and appear to have been reserved for reasonably fully (£72m provision at end March 1998). The company appeared just solvent at the end of October (available assets of £1,150m to cover a solvency margin of under £1000m) on the basis of the reserving standard in the Government Actuary’s recent guidance (the company is disputing the need for such a high reserve). The company is exploring the possibility of reinsurance for its GAO liabilities, and has sought and received an increased future profits implicit item (£1,900m in lieu of £850). However, at the moment it is questionable whether it will be able to declare its usual annual bonus to policyholders (cost - £500m).

FSA’s update goes on to report:

The company has agreed to discuss with FSA in advance any proposed bonus declaration. Clearly it would be commercially damaging if the company had to pass or limit its bonus in February and to publish a low solvency position in April; there is a significant risk that the company’s survival as an independent entity could be threatened in these circumstances.

FSA continue:

Equitable Life has just initiated a court case in an effort to obtain a ruling supporting its practice of limiting the cost of the GAOs by reducing terminal bonus paid to any policyholder exercising the option. Should the case go against the company its financial position would become even more precarious (there would be a potential liability to enhance past settled claims) and it would have to reduce the level of terminal bonus paid to its other policyholders – thus upsetting its status in the market.

Provided the company sets up reserves in accordance with the Government Actuary’s standard, the company would be exposed to further falls in long term interest rates only to the extent that its assets and liabilities were mismatched and the reserves proved insufficiently resilient to market moves. With its present portfolio of assets, the company has indicated that a ½% fall in interest rates would increase its basic GAO liability by about £200m. A fall in equity markets would also be potentially damaging as it would reduce the amount of free assets available to the company and hence its ability to declare future bonuses on all its business. This problem would be more acute if the company declared further guaranteed bonuses in the interim. A fall in either gilt yields or equities could also damage the interests of other with profits policyholders if this led to the complete elimination of terminal bonus on policies with guarantees – the cost of the guarantees would have to be recouped from reductions in those other policyholders’ terminal bonuses.

FSA write to Equitable, thanking them for their letter (with enclosures) of 21/01/1999. FSA ask  for copies of additional documents (relating to bonus recommendations made to the Board within the past 12 months, and to the valuation carried out by the Appointed Actuary at the end of 1997) which FSA ‘would normally expect to see included within the scope of any Financial Condition Report’. FSA also note that they and GAD have arranged to meet Equitable’s Appointed Actuary to discuss the terms of the reinsurance agreement.

Following a telephone conversation between FSA and Equitable earlier the same day, Equitable’s Appointed Actuary writes to FSA in response to their request of 18/01/1999 for information about the Society’s reserves and asset shares as at the end of 1998. The Appointed Actuary provides the following information to FSA:

You will appreciate that some of the figures are provisional at this stage but final figures are unlikely to be significantly different.

The mathematical reserves and total policy values at 31 December 1998 before allowance for GARs and resilience reserves are as follows:

Notes: (i) If new declared bonuses were added at the level indicated in the 21 January 1999 letter, the mathematical reserves would increase by £66m.

(ii) The overall resilience reserve in respect of with profits business at 31 December 1999 is estimated at £920m. If that is apportioned to individual lines of business in a manner consistent with the 1997 Form 57 exercise, the resilience reserve on the above mathematical reserves would be £235m. On this basis Test 3 continues to produce the highest resilience reserve. That would not be the case when reserves for GARs were included, when Test 2 would produce the higher reserves.

(iii) Under our bonus system the total policy values equate to a smoothed asset share. The values shown reflect the overall growth rate of 9% which has applied to pensions business during 1998.

Equitable’s Appointed Actuary says that: ‘The total mathematical reserves for with profits contracts at 31 December 1998 were £18450m. Addition of declared bonuses at the levels indicated in the 21 January 1999 letter would add £365m to those reserves. As noted above, the resilience reserve on the basis indicated was £920m. Total with profits policy values (i.e. smoothed asset shares) amounted to £23140m. That aggregate smoothed asset share was 103% of the value of the actual assets attributable to with profits business’.

FSA’s Chief Counsel A replies to a request from the Director of Insurance for comments on a  response the latter had drafted to an MP who had received a complaint from a constituent about Equitable and PRE. The Chief Counsel notes that the MP had requested a copy of FSA’s guidance on PRE. She comments that, since FSA ‘are now providing the guidance letter on PRE to members of the public, [perhaps] the letter should be made public like the guidance on reserving’. The Chief Counsel adds that, in her view, FSA could continue to examine the issue of policyholders’ reasonable expectations, even though the matter was now before the courts. However, in addition to seeking information from Equitable, FSA should invite comments from Equitable’s policyholders. She also suggests that it would be helpful to see papers relating to Equitable’s Court case.

Chief Counsel A copies her response to the Head of Life Insurance and Line Manager D. Both comment that FSA should await the result of the Court case before taking a view on whether to intervene in respect of policyholders’ reasonable expectations. Line Manager D reminds her colleagues that the guidance on policyholders’ reasonable expectations was already in the public domain, as HMT had issued a press notice (see 18/12/1998 [entry 1]).

GAD inform FSA that they have reviewed the reserving effects of the financial reinsurance  agreement which Equitable had sent to FSA on 21/01/1999.

GAD state:

The treaty is between Equitable and Irish European Reinsurance Company ([IRECO] – which is a Dublin based subsidiary of [a named company]). We have no details of the financial strength of [IRECO] or of the extent, if any, of any support which [the parent company] may be prepared to guarantee to [IRECO].

Under ‘Description of the Treaty’, GAD advise FSA that:

The treaty is a financing arrangement which provides support to Equitable in any year when more than 25% (by value) of the guaranteed business vesting in that year select the guaranteed annuity option – this is called a “Reinsurance Claim Event” and the amount of support provided is called the “Reinsurance Claim”. The support provided is the cost of the guaranteed annuity benefit less the fund available, including final bonus. The support is not paid in cash, but a debtor is created in Equitable’s balance sheet called “amount due from reinsurers”. The treaty limits [IRECO’s] overall exposure at any time to £100m. When a Reinsurance Claim Event has occurred, Equitable is required to pay a “Recovery Amount” to [IRECO] in each preceding year which is offset against this debt until the debt is fully repaid. The Recovery Amount is expressed as 35% of the Reinsurance Claim. In addition, if a Reinsurance Claim Event occurs, Equitable must pay, in cash, a “Risk Amount” of 2% per annum on any outstanding support provided by [IRECO]. These two sums together are called the “Adjustment Premium”. However the Adjustment Premium payable in any year is in some way limited in relation to the emergence of surplus in that year. (Note: the form of this limitation will need to be clarified with the company.)

The cost of this treaty to Equitable is £150K (increasing by [the retail prices index]) for each year that the treaty remains in force – the Equitable can cancel the treaty for the future by giving 3 months notice.

Either party can cancel the treaty, retroactively to the previous 31st December, if certain events occur – such as insolvency, transfer of business, change of control, failure to meet the obligations under the treaty and if the other party loses more than 50% of its paid-up capital.

The treaty can also be cancelled if Equitable changes its practice on GAOs, presumably including if it lost its Court case.

Under the heading ‘The Intention of the Treaty’, GAD advise FSA that:

The intention of the treaty is to enable the Equitable to maintain a reserve, in respect of policies with guaranteed annuity rates, which is equivalent to providing for the additional cost of the guarantees on only 25% of the business rather than the near 100% which we are demanding. We believe that the treaty will not achieve the intended reserving effect for a number of reasons.

A reinsurance liability arises in any year when the percentage of policyholders (measured in terms of the value of the underlying guaranteed benefits) choosing the guarantee exceeds 25%. The reinsurer’s liability is then calculated as the additional cost of the guarantee on any excess over 25%. This would be satisfactory if the additional cost was correctly defined in accordance with the reserving principles which we believe apply (as set out in the [Government Actuary’s] letter). Unfortunately the treaty defines the cost as the difference between the cost of the guaranteed annuity benefit and the total funds available to provide for the benefit including final bonus … We believe that this would result in a requirement to reserve for terminal bonus on the 75% part of the liability which is covered by the reinsurance treaty. This is demonstrated mathematically in the annex. The problem would be resolved if the reinsurance liability were to be expressed as the difference between the cost of the guaranteed annuity benefit and the guaranteed funds available to provide for the benefit … This would increase the reinsurer’s exposure, but this could be offset by requiring the Equitable to pay an additional adjustment premium equal to the reinsurance share of the amount of any final bonus allocated …

GAD continue:

The treaty provides for the treaty to be cancelled retroactively by either party in a number of situations, as described above. On cancellation in these circumstances, the Equitable would be required to immediately repay any outstanding finance and increase its mathematical reserves. This seems to negate the benefit of the arrangement to the Equitable, particularly where the reinsurer has an option to cancel the treaty. These problems might be resolved if:

a) the obligation to repay the outstanding finance was restricted to any surplus funds available after meeting the solvency requirements of the Act (or meeting all liabilities to policyholders in the event of insolvency);

b) the scope of the clause which permits cancellation limited the ability of the reinsurer to terminate the treaty only to events such as insolvency; and

c) the retroactive application was removed.

The treaty limits the total withheld reinsurance claims balance to £100m at any 31 December or otherwise the treaty would have to be restructured. It is difficult to reconcile this with their intention to allow a reinsurance credit in their returns of around £700m. We believe therefore that there should be a commitment for the treaty to be continued, but that the schedule of reinsurance payments to the reinsurer could be revised in the event of this credit of £100m being exceeded.

GAD also provide, as an annex to their advice, a simplified example ‘for the purposes of demonstrating that the reinsurance treaty fails to achieve its intended reserving effect’.

GAD and FSA meet Equitable’s Appointed Actuary and an actuarial consultant working for the Society to discuss the reinsurance treaty. GAD raise the three concerns recorded by Chief Actuary C in his note of 27/01/1999, indicating how these could be resolved. According to FSA’s note of the meeting, their third concern:

… that reaching the £100m limit on the balance of the reinsurance claims should not provide grounds for cancellation of the treaty was explained … [The Appointed Actuary] explained that there was no intention that this should be the case, and it was only intended that the limit should provide a right to review the terms of the treaty. If no agreement could be reached on revising the terms, the treaty would continue unamended. Equitable would look at redrafting the position so that it was clearer.

GAD raise a fourth concern, that:

… there was no provision which would enable Equitable to demand settlement of any claim under the treaty. It was considered that there should be some provision for Equitable to draw down reinsurance claims money if needed in order for the reinsurance debt to be considered to be a realisable asset. Such a provision was likely to need to be subject to Equitable paying a market rate of interest on the money, received from the reinsurer. The timeframe within which payment would be required could be very long (e.g. 30 years, 10 years after the vesting of the last GAO contract, or perhaps be linked to when the outstanding claims reached the £100m limit which would in any case prompt a review of the treaty).

FSA’s note also records that:

The question was also raised of whether Equitable Life was satisfied that the proposed reinsurer (Irish European Reinsurance Company) was sufficiently financially strong to be able to fulfil the potential obligations under the treaty (i.e. to cover a potential £1b+ liability). Equitable Life appeared to be relying on the company’s AAA rating for comfort as to the reinsurer’s financial strength. The Actuary was reminded that it was his responsibility to be satisfied with the security of the reinsurance for which he was [taking] credit in his valuation.

Equitable’s Appointed Actuary asks how the reinsurance arrangements might be presented in the annual returns. FSA record the discussion, as follows:

[Equitable’s Appointed Actuary] was keen not to have to show a £1b+ reserve for GAOs since he thought this would be seized on by the press and interpreted as indicating the real cost of GAOs to the company. This would be damaging when the company had been at pains to make clear that GAOs were unlikely to have a significant financial impact on the company. He would like to show a net reserve figure (after deduction of the reinsurance) in the forms, but would be content to include in Schedule 4 a statement that the reserve had been established at the 25% level because reinsurance provided protection for liabilities in excess of this level. GAD were concerned that this was not consistent with the Directive requirements which required insurers to calculate their gross liabilities and then deduct the liabilities covered by reinsurance. It was also potentially inconsistent with the guidance issued by the [Government Actuary] and endorsed by FSA. It was emphasised that FSA’s main concern was that the reserving basis should be clear from the annual returns. FSA would explore the implications of the presentation Equitable Life were seeking to adopt before expressing a definitive view on the issue. [Comment: having reviewed the structure of the relevant forms, it is clear that any presentation which did not show separately the gross liability and reinsurance cover would be artificial and hence potentially misleading. In view of the significance of the reinsurance treaty to the company’s solvency position it was important that the level of dependence on the reinsurance was clear to readers of the returns.]

Equitable provide Board papers relating to their bonus declarations and valuations for 1997 and 1998. Equitable indicate that they now expected to reduce the future profits implicit item to the originally agreed £850m.

GAD telephone Equitable to discuss the valuation bases underlying the draft valuation result shown in one of Equitable’s Board papers (‘Valuation and Bonus Declaration as at 31 December 1998’, dated 22 January 1999). In his note of their conversation, Scrutinising Actuary E records that ‘[the Appointed Actuary] was, in truth, rather vague as to how he justified the percentages of the total liabilities for which he assumed benefits were being taken in the GAR form’. The Scrutinising Actuary explains that the Appointed Actuary also:

… revealed … that the GAR reserve included an allowance of about £450m in respect to future premiums. Thus, the additional reserve held for existing GAR liabilities was actually in the region of £1bn. Under questioning about the effect of moving to 90% of full GAR reserves, he suggested that perhaps another £150m might be needed — but, perhaps, he would then lower the allowance for future premiums to £300m at this time.

He seemed to be gradually accepting the ultimate need for establishing full provisions, but appeared to be hoping that HMT would look kindly on the idea of phasing-in, which he suggested had received a favourable mention at an earlier meeting.

With regard to the draft treaty, it seemed that no further progress had been made, but he expressed satisfaction that no major problems seemed to arise and he seemed to be hopeful that final agreement could be reached next week.

GAD inform FSA that the papers which Equitable had handed over at the end of their meeting the previous day showed that Equitable:

… are sensibly seeking to balance out the considerations of reducing progressively the amount of additional guaranteed benefits that are added each year, with maintaining a reasonably competitive position, and smoothing the bonus declarations from year to year in line with the perceived expectations of policyholders.

The cost of the declared bonus for 1998 would be some £365 Million (compared with £508M in 1997). This would leave the overall financial position of the company as shown in their draft 1998 returns as showing cover of 250% for the solvency margin (ie similar to 31/12/97) assuming that the reinsurance … is completed (and accepted by FSA as allowing a significant reduction in the reserves for GARs), or 110% if the … reinsurance is not taken into account. In the latter situation, they would though be able to take credit for a larger future profits implicit item which could boost the apparent solvency margin cover to around 200%, though the explicit cover for the guarantee fund would be very thin.

Therefore, the financial position shown in their 1998 returns is likely to appear as reasonably satisfactory following their proposed declaration of bonus, though they would be potentially close to regulatory action under Section 33 [i.e. on failure to maintain the minimum margin] if their proposed reinsurance is not completed satisfactorily. Accordingly I believe it would be difficult to object formally to their proposed course of action, though we would need to continue to monitor their position carefully.

GAD state that the Board papers Equitable had provided at the meeting showed ‘graphically’ the variation in their cover for the required minimum margin. They note that, in the autumn of 1998, Equitable had just covered the margin once, with no significant excess cover, even with the then minimal allowance for guaranteed annuities. GAD understand that Equitable:

… do not have much scope to reduce the margins in their valuation basis in those conditions [where investment returns in 1998 are close to 0%], and they would very likely either have to seek some additional concessions from FSA in their reserving requirements, find some further financial reinsurance or switch their investments from equities to fixed interest. The scope for the two latter options may though be quite limited in practice due to market limitations.

GAD explain how the figures presented by Equitable allowed GAD to compare the policy values attributed to all with-profits policies with the mathematical reserves held. GAD comment: ‘These figures suggest to me that our current reserving standard is not unreasonably harsh, with the possible exception of the resilience reserve requirement on the policies with GARs which will though be dealt with by the proposed financial reinsurance’.

GAD note that Equitable continue to issue annual notices to policyholders showing a high level of projected benefits, ‘thereby generating further expectations’. GAD propose writing to Equitable to say that GAD have no objection to the Society’s current proposed rate of declared bonus, while at the same time voicing concerns about their:

… apparent vulnerability to changing investment conditions. They should also be asked to produce some contingency plans for how they would react if an adverse investment return were to appear over the next 1-2 year period, which reduced their solvency margin cover to close to or even below 100% of the required minimum level.

FSA write to Equitable after the latter had telephoned to ask about FSA’s attitude to Equitable declaring a bonus. FSA say that the paper put to Equitable’s Board on 22 January 1999 (see 29/01/1999) confirms that, without reinsurance, Equitable were in a weak position. FSA point out that they had doubts about a number of aspects of the reinsurance treaty and that, without a robust treaty, FSA would not consider it prudent for Equitable to declare a bonus for 1998. FSA note that, if allowance were made for the proposed reinsurance treaty, Equitable’s financial position would appear to be significantly stronger:

However, even in these circumstances we consider it necessary for the company to consider carefully the scope for declaring a bonus because of the uncertainties surrounding the financial implications of the court case in relation to the company’s payment practice in respect of contracts carrying guaranteed annuity options. In particular it would appear necessary for Equitable Life to consider the prudence of declaring a bonus in the light of the risk of losing the court case and the potential costs that might be incurred as a result. We also consider it necessary for the company to take account of the risk, even after the terms of the reinsurance treaty have been revised as discussed with GAD, of the treaty being cancelled by the insurer …

FSA add that these points are a matter of judgement for Equitable:

But on the basis of the information you have provided to us (and assuming the reinsurance treaty is revised to resolve the concerns expressed by GAD) we are not minded to object to the proposed bonus declaration.

FSA also explain:

You will appreciate that any decision by FSA not to intervene over the bonus declaration should not be taken as an endorsement of what you propose. Nor is it the end of the matter; we remain concerned about the on-going financial health of Equitable Life, because of the relatively low level of explicit free assets and the apparent sensitivity of the free assets to future rates of investment return. On the basis of the 1997 projections for the solvency position at the end of 1998, it appears that a high rate of return (of the order of 16.5%) is necessary for the company to maintain its free asset ratio. In the circumstances I think it would be helpful to discuss this issue again soon, so that we can gain a better understanding of the key factors influencing the company’s longer term solvency position.

FSA conclude by asking Equitable for revenue and solvency projections for 1999 and beyond, as well as contingency plans in respect of any fall in equities.

Equitable write to FSA and note the points made in their letter of 01/02/1999. Equitable explain that discussions were continuing with the reinsurer to amend the treaty so that it met FSA’s concerns. Equitable say that they had considered the position in the ‘unlikely event’ that Equitable lost the Court case and would discuss this and FSA’s comments about the possible cancellation of the reinsurance treaty with the Board.

Equitable say it would take a little time to produce the requested projections because of competing priorities, but they would be provided as soon as possible. They advise that a response to FSA’s letter of 13/01/1999 was well in hand.

Equitable send FSA a copy of the revised reinsurance treaty. Equitable state:

Since we have managed to strengthen the reassurance terms to address the concerns raised on the first draft, and we have considered and satisfied ourselves on the points raised in … your letter of 1 February 1999 [the prudence of Equitable declaring a bonus, in the light of the risk of losing the Court case], there would now seem to be no impediment to our proceeding with our bonus declaration as planned this month.

Equitable respond to FSA’s letter of 13/01/1999. Equitable say that their 1997 returns had not included additional reserves for annuity guarantees at a level consistent with the Government Actuary’s recent guidance (DAA11). If those returns had done, however, ‘the Society would have made full use of the permission to bring £700m of future profits into account, rather than restricting the use to £371m as in the actual returns. There were also some margins in the liability valuation basis which could have been released’.

Equitable estimate that, with these changes, cover for the required minimum margin would have fallen from 2.5 to 2.0 and add: ‘Whether or not such a difference means that there was “a material effect on the overall financial position shown in the 1997 returns” is, of course, a matter of judgement’.

Equitable state that the reinsurance arrangement they have entered into, coupled with use of the future profits implicit item of £850m, would result in a cover for the required minimum margin in the 1998 returns similar to that published at the 1997 year end. Equitable conclude:

I hope you will agree that we have subsequently taken action to strengthen our financial position in the terms described in … your letter of 13 January and thus that there is no necessity for our 1998 returns to be submitted earlier than normal.

FSA write to Equitable in response to their letter of 12/02/1999. FSA explain that they still had one significant concern:

As drafted, the reinsured is not entitled to request a cash payment of outstanding reinsurance claims until after the termination of the last policy covered by the reinsurance; and then only to the extent of 10% of the outstanding reassurance claims. As a result of the partial nature of the right to settlement, and the long period before payment could be required, the value which could be attributed to the reassurance treaty (and hence offset against the Society’s gross liabilities) would be substantially less than the reinsurer’s potential liability. The value would have to be heavily discounted to reflect the long delay (probably more than 30 years) between a claim arising and being settled.

FSA suggest a further meeting between Equitable, FSA and GAD.

Equitable provide a further amended version of the reinsurance treaty with a revised definition for ‘Settlement of claims’.

GAD advise FSA that this did not fully address the points made in the letter of 16/02/1999, ‘as only 10% of the reinsurance amount can be called at any one time’. GAD say that this point would have to be pursued at the meeting (now arranged for 19/02/1999). In reply, FSA say:

I hope though that we only ask for further changes if they are absolutely necessary, especially as we have already made requests which go further than what we had indicated in earlier discussions.

GAD respond to FSA, pointing out that they had indicated to Equitable that they saw difficulty with the discounting that would be required, given the very lengthy settlement period proposed (see 28/01/1999). GAD caution against giving firm agreement to the full effect of the treaty without seeing the final wording. However, GAD explain that they:

… certainly agree that we should endeavour to keep any request for further changes to a minimum. Moreover, we ought to be in a position that FSA can give a “no objection” indication to Equitable following the meeting, as any detailed wording changes at this stage should only effect the value of the offset that may be taken into account rather than the principle of the acceptability of the treaty.

GAD’s Directing Actuary B and FSA’s Head of Life Insurance meet Equitable’s Appointed Actuary – see 22/02/1999.

FSA’s Director of Insurance submits a Weekly Report to Managing Director A. An entry on Equitable records that their bonus declaration was still subject to satisfactory reinsurance arrangements being put in place to offset the liability created by the reserve needed for guaranteed annuities. The report continues:

We and GAD are discussing the reinsurance details. If we can be satisfied that the reinsurance is effective, the Equitable Board is likely to approve a 5% bonus on pensions business – a drop of 1.5%, and at the low end of industry declarations for 1999 but better than at one stage seemed possible.

GAD write to Equitable to record the outcome of the meeting on 19/02/1999. GAD explain that they:

… accept the principle that this agreement will allow a reinsurance offset to be taken in the valuation of liabilities as at 31 December 1998. Our overall objective is therefore to reach a view on the value that may be placed on the reinsurance offset for which credit is taken under the agreement.

GAD note that the meeting had considered four parts of the draft agreement (settlement of claims, risk amount of adjustment premium, fee payable on cash settlements and the termination clause) to see how each might affect the value that could be placed on the reinsurance offset under the ICR 1994. On ‘Settlement of claims’, GAD say:

As presently drafted, we believe that this paragraph would require the reinsurance offset to be treated as a zero yielding “asset” with an average term of about 5 years. Accordingly, it would be available to hypothecate against liabilities of this term valued at a 0% rate of interest.

If, instead, it is intended that it might be hypothecated against liabilities valued at some long-term rate of interest under Regulation 69(9), then we believe that this could be achieved by amending the words of this paragraph in the agreement to read “However, at any 31 December, the Reinsured will be entitled to request a cash payment of up to 100% of the outstanding Reinsurance Claims if such assets are required in order to enable the Reinsured to properly satisfy the requirements of s35A(1)(a) of the Insurance Companies Act 1982”. Although not discussed at our meeting, this would also seem to have the advantage of providing greater protection for policyholders through making a sum of money available from the reinsurer in the event of other assets being insufficient to cover all the liabilities.

… the proposed wording of the reinsurance agreement will have the effect of allowing an appropriate reinsurance offset to be made corresponding to the difference between the gross reserves established and the value of benefits assuming 25% of policyholders take their benefits in the form of a guaranteed annuity. We do of course still need to see the final version of the reinsurance treaty to ensure that the detailed wording is in line with our understanding of the reinsurance agreement.

FSA write to Equitable to confirm FSA’s stance on a bonus declaration, prior to a forthcoming  Board meeting. FSA say:

The FSA’s position following Friday’s meeting is unchanged: subject to the reinsurance treaty having the effect of allowing an appropriate reinsurance offset to be made (i.e. an offset broadly corresponding to the difference between the gross reserves established and the value of the benefits assuming 25% of policyholders exercise the guaranteed annuity option), we are not minded to object to Equitable Lifes proposed bonus declaration. Revision of the provision on the settlement of claims, as discussed on Friday, appears the most important in relation to ensuring the necessary credit can be taken for the reinsurance treaty. Clearly the points in my letter of 1 February remain applicable regarding other factors which we would expect the board to take into consideration in deciding the scope for declaring a bonus.

FSA add that they would write shortly on the issue of the timing of Equitable’s 1998 returns.

FSA write to Equitable in response to their letter of 12/02/1999. FSA state:

As I mentioned on the phone last week, we think that the returns might have given potential policyholders a misleading impression as to Equitable Life’s financial position at the end of 1997. You indicate that there would have been a net decrease in the coverage of the required minimum margin from 2.5 to 2 times after allowing for the use of margins which existed in the valuation basis and taking account of a much larger future profits implicit item. We consider that such a decrease is material and that some account must be taken for the greater reliance on implicit items that would have been necessary (and apparent in the returns) if a further reduction in the solvency margin coverage was to be avoided.

FSA add that they do not consider the actions that Equitable have taken to address the situation sufficient to make early submission of the 1998 returns unnecessary. FSA ask Equitable to agree by 3 March 1999 to submit their returns by 31 March 1999, otherwise ‘we would need to consider taking appropriate regulatory action, in particular whether to require the company to submit its 1998 returns early’.

GAD’s Directing Actuary B informs Chief Actuary C and FSA that Equitable would be making  further amendments to the draft reinsurance treaty. The Directing Actuary says:

You will now have seen the latest version of the text with just 1 amendment to the settlement of claims clause. [Equitable’s Appointed Actuary] phoned again this morning, and I said that I was surprised to see no provision now for any “capital” payment in respect of the settlement of claims clause. He offered to go back to the “payable after all the claims have gone off the books” clause, but I said that this seemed very remote, given also the interest on interest that would accumulate over that period.

Accordingly, we agreed that he would seek to have the payment of 10% per year of “capital” reinstated, in addition to the new “interest amount”.

They are also still discussing the detail of the “termination” clause, and he will contact us again with further details of the revised agreement shortly.

The Directing Actuary also notes that the ratings agency Standard & Poor’s have placed Equitable on ‘credit-watch’ pending further discussions with the Society.

FSA’s Head of Life Insurance advises the Chairman on how to deal with questions about the early submission of returns. The Head of Life Insurance explains that identifying individual companies would breach confidentiality and he suggests that FSA take the following line:

1. Responses to the guidance which we issued in January indicate that life offices are now reserving for guaranteed annuities to a common minimum standard, approved by the Government Actuary. This is an important safeguard for policyholders.

2. Discussions are continuing with a number of offices over whether it is appropriate for them to bring forward publication of their 1998 returns.

3. Cannot comment on the position of individual companies.

FSA ask GAD for their comments on Equitable’s solicitors’ request. FSA state:

I am a bit mystified why we gave this concession in the first place, although I expect you remember the background. I have ordered back copies of files at our end so that I can understand the basis of the original concession.

HMT and FSA hold their first quarterly meeting on insurance regulation issues. The minutes record that:

… regular meetings would help to provide a structured framework for an exchange of views on current and strategic issues relating to insurance and friendly society regulation and related matters. It was important to remember the high public profile of regulation and the need to ensure Ministers were kept well informed in advance of developments.

On guaranteed annuities, FSA’s Head of Life Insurance explains that there might be a problem with the way in which some companies were reserving for such guarantees, that FSA would need to monitor those companies and might request early submission of the 1998 returns. The Head of Life Insurance notes that ‘[complications] may yet arise from some companies who have special circumstances, and the press may pick up on the need for special reporting and misinterpret the reason’.

FSA’s Line Manager D sends the Head of Life Insurance a note headed ‘Summary of Positions of Companies with Significant Exposures to Guaranteed Annuity Options (GAOs)’.

The Line Manager deals with the circumstances of 13 companies. In a covering note she explains that she had sought to list the companies in order of the level of concern to which they gave rise, with the most serious first. The Line Manager’s note begins with Equitable.

Line Manager D explains that Equitable’s ‘financial position has been very severely affected’. She notes that ‘despite having given generous guarantees on a significant proportion of its pensions business’, Equitable had not established any reserve for annuity guarantees at the end of 1997, that they had no estate to meet unexpected costs, and, as a mutual, no ready mechanism to raise capital.

Line Manager D suggests that Equitable would have to establish a reserve of £2.9bn at the end of 1998, and that they would only just be able to cover their solvency margin, with free assets of less than £100m. She notes that Equitable were seeking to finalise a reinsurance agreement, which would reduce their reserving requirement by some £2bn and increase the cover for their solvency margin to ‘a more acceptable’ 2.5. She continues:

We remain concerned about the financial viability of the company in the longer term. It has declared high levels of guaranteed bonuses in the past and its ability to honour these guaranteed bonuses appears heavily dependent on the company continuing to achieve high investment returns. The company’s liabilities for GAOs could also increase significantly if the yields on long gilts [i.e. government bonds with a long period until maturity] fall further.

The Line Manager notes that Equitable had agreed to submit their 1998 returns by 31 March 1999 and to provide financial projections for the next three years. She says this information should enable FSA to make a more accurate assessment of the longer term position. She also notes that, should Equitable lose the test case on their differential terminal bonus policy, they could incur significant compensation costs.

In her covering note, Line Manager D explains that Equitable and five other companies can all be described as ‘at risk’ from annuity guarantees, and that their statutory solvency position could be threatened if economic conditions deteriorated. She notes that, in most cases, a further fall in long term interest rates would have the most detrimental effect.

The Line Manager explains that, of the other seven companies, five are of slightly lesser concern as, despite substantial exposure to annuity guarantees, they have, or are acquiring, well capitalised parent companies. She explains that she sees no immediate threat to the solvency of the remaining two companies.

FSA’s Head of Life Insurance informs Line Manager D that FSA had agreed to approach one of the six companies described as ‘at risk’ from annuity guarantees. (Note: that company was not Equitable.) The Head of Life Insurance asks whether they should also write to one of the five companies that are of slightly lesser concern (see 19/03/1999). Both companies appeared to be operating a differential terminal bonus policy similar to Equitable’s.

The Head of Life Insurance copies his note to GAD.

GAD’s Chief Actuary D writes to FSA’s Line Manager D in response to the Head of Life Insurance’s email of 23/03/1999. Chief Actuary D says:

… there is a serious danger in picking on a few companies, perhaps with worse financial positions than average because they are at the front of our thinking, and putting pressure on them to adopt a more generous line. Meanwhile less threatened companies carry on with the same policy on terminal bonus without question.

In response, the Line Manager points out that FSA had asked Equitable, and one other company, how their differential terminal bonus policies were compatible with PRE. She states that the ‘reason for picking on [the two companies referred to by the Head of Life Insurance] is concern that we are not acting consistently towards these companies and Equitable [and the other company identified by Line Manager D]’.

FSA add that, due to resource implications, they had sought information about differential terminal bonus policies and policyholders’ reasonable expectations only where such a practice had come to their attention, ‘ie we weren’t going to go looking for trouble but thought we needed to be seen to do something where the issue was raised. That said I take your point that there is a case for a more systematic approach’.

In response, GAD’s Directing Actuary B comments that most companies were probably awaiting the outcome of Equitable’s Court case. He suggests another survey, once the case is resolved.