Submission of the 1998 regulatory returns

The returns include the following information about Equitable’s business and their financial position as at 31 December 1998.

Equitable’s returns are submitted in one part covering Schedules 1, 3, 4 and 6 to the ICAS Regulations 1996.

GAD’s copy of the 1998 returns includes various annotations. I am satisfied that some of these were made by Scrutinising Actuary E during the scrutiny programme on or around 09/04/1999, when the Scrutinising Actuary completed his Initial Scrutiny note (which was countersigned by Chief Actuary C). However, for ease of reference mention of these annotations is made here.

Schedule 1 (Balance sheet and profit and loss account)

Schedule 1 of Equitable’s returns consists of Forms 9, 10, 13, 14, 15 and 17. Form 9 summarises the Society’s financial position at 31 December 1998 as follows:

In Form 13, Equitable set out their admissible assets.

In Form 14, Equitable set out their long term business liabilities and margins.

(Note: on 07/12/1998, HMT had asked Equitable to include a note on contingent liabilities in the returns relating to the risk of a successful challenge to their bonus practices. I am advised that this note would have been expected to have been made in Form 14 as required by Regulation 13 of the ICAS Regulations 1996. I have been unable to find such a note in Form 14 or anywhere else in Equitable’s 1998 returns.)

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

As in previous years, Schedule 3 consists of Forms 40 to 45.

In Form 40, Equitable provide a revenue account. GAD circle the figures provided for interest payable before deduction of tax (being £30,655,000 for 1998 and £15,777,000 for the 1997 returns).

Schedule 4 (Abstract of valuation report prepared by the Appointed Actuary)

As in previous years, Equitable present two valuations of their long term liabilities (their main and appendix valuations). The results of the main valuation are carried forward, unadjusted, from Form 58 to Form 14 and on to Form 9.

Schedule 4 – main valuation (text)

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

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

In response to paragraph 4, Equitable provide 11 pages of information about their non-linked contracts. Most of the description provided is identical to that supplied in the previous returns.

GAD underline the statement that ‘Pension contracts – old series’ contain a guaranteed interest rate of 3.5% and that ‘some older contracts’ contain guaranteed annuity rates.

Equitable provide a fuller description than in previous years of the guarantees which existed on some deferred annuity policies, disclosing:

For UK retirement annuities the option to purchase an annuity on minimum guaranteed rates at retirement can be exercised at any age between 60 and 75. The form of the annuity is restricted to a single life, level non-profit annuity with no guaranteed period paid quarterly in advance. The minimum guaranteed rates are based on a(55) ultimate mortality and 7% interest except for some older contracts which are based on 4% interest.

GAD note that this description is new and they underline ‘a(55) ultimate mortality and 7%’.

In response to paragraph 5, Equitable provide 71 pages of information about their linked contracts.

In paragraph 6, Equitable set out the general principles and methods adopted in the valuation.

As in previous years, Equitable state:

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

As in previous years, Equitable disclose:

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

As in the 1997 returns, Equitable state that they have made an explicit provision for their liability for tax on unrealised capital gains (in relation to business other than that linked to their internal funds), which they now estimate as not exceeding £97.9m. The provision made is £100m, which they say is shown in the Appointed Actuary’s certificate in Schedule 6 of the returns.

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

In paragraph 6(1)(h), Equitable disclose that they had set up reserves for the annuity guarantees on their ‘Pension contracts – old series’ business. They explain the assumptions used in establishing these reserves relating to assumed take-up rate of the annuity at a guaranteed rate and cash commutations. Equitable’s returns state:

The combined effect of the allowances made is to assume that of those policies which survive to retirement date (mortality in deferment based on AM80 ult -5 years) the following proportions of benefits are taken in guaranteed annuity form:

UK retirement annuities	70.0%
UK individual pensions (1st series)	82.5%
UK transfer plans (1st series)	82.5%
UK group pensions (1st series)	82.5%

 

GAD question the figures used for these adjustments.

Equitable also disclose the interest rate basis used to value the guaranteed annuities, stating that:

Annuity benefits have been valued at an average interest rate based on 5% for annuities taken out during 1999 with lower rates of interest assumed for future years to take account of 69(9)(a) of the Insurance Companies Regulations.

As in previous years, Equitable disclose that, for certain non-profit deferred annuities, the valuation rates of interest used were those assumed in the premium basis. Equitable, again, do not elsewhere disclose the rates used in the premium basis.

As in previous years, in paragraph 6(2), Equitable state that, in determining the provision needed for resilience reserves, they have taken account of the fact that the long term fund has been valued at book value.

As in their 1996 and 1997 returns, Equitable explain in paragraph 7(5) that they consider the reserves for future bonus within the valuation to be fully able to withstand any future strains which would arise if there were significant changes in mortality or morbidity experience. They say that, accordingly, the Society did not consider it necessary to establish any additional reserves in this respect.

In paragraph 7(6), Equitable disclose that they have tested the need for resilience reserves against the three scenarios contained in DAA6, as amended by DAA10. They state that the most onerous scenario tested is scenario b (a 10% reduction in fixed interest yields, a 25% fall in equity values, a 20% fall in property values and a 10% increase in index-linked yields).

Equitable disclose that a resilience reserve of £600m had been provided for.

In paragraph 7(8)(a), Equitable disclose the changes made to valuation assumptions and methods in the resilience scenarios. They explain that, in the resilience scenarios, they had used the appendix (net premium) valuation method rather than the main (gross premium) valuation method, but with some changes to the valuation described in the returns. As in their 1996 and 1997 returns, Equitable disclose that the changes include:

… for all accumulating with profits business, an annual loading of 0.25‰ increasing by 4% per annum compound of the basic benefit was reserved which is considered to be a prudent allowance for ongoing expenses: for accumulating with profits pensions business, ½% per annum of the benefit value has been deducted for each year up to the date it is assumed that benefits will be taken as a charge for expenses.

Equitable also disclose, in paragraph 8(a)(iv), that, in the resilience scenario, they had reduced the reserve for their potential liability to tax on capital gains to £20m.

In paragraph 8(b), Equitable state that: ‘For accumulating with profit business the valuation rates of interest shown in Form 52 are net of a 0.25% interest rate reduction as a reserve for future expenses’.

In paragraph 8(d), Equitable state:

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

In paragraph 9, Equitable provide information on the valuation of their linked contracts. GAD make various annotations on this section.

Paragraph 12(2) of Schedule 4 to the ICAS Regulations 1996 required that:

For each treaty of reinsurance where the company is the cedant and under which business is in force at the valuation date—

1. the name of the reinsurer;
2. whether the reinsurer is authorised to carry on insurance business in the United Kingdom;
3. whether the company and the reinsurer are connected;
4. an indication of the nature and extent of the cover given under the treaty;
5. the premiums payable by the company under the treaty during the report period;
6. the amount deposited at the valuation date in respect of the treaty under any deposit back arrangements;
7. the extent to which provision has been made for any liability of the company to refund any amounts of reinsurance commission in the event of lapses or surrender of the contract; and
8. whether the treaty is closed to new business.

In their returns, at paragraph 12(2)(viii), Equitable in response state:

1. The reinsurer is Irish European Reinsurance Company Ltd.
2. The reinsurer is not authorised to carry out insurance business in the United Kingdom.
3. The Society and the reinsurer are not connected.
4. The reinsurer provides surplus cover for the costs arising from the exercise of guaranteed annuity rates in respect of Retirement Annuity policies, Individual Pension Plans and Transfer Plans issued before 1 July 1988. If, in any calendar year, the proportion of terminations due to retirements exercising the guaranteed annuity option exceeds 25% of the total retirements in that calendar year, as measured by the guaranteed funds for those policies, the reinsurer’s gross liability is the value of the guaranteed annuity in excess of the guaranteed policy funds for that proportion of retirements effecting the guaranteed annuity option which is in excess of 25%.
5. The premium payable since the last investigation was £150,000.
6. There is no deposit back arrangement.
7. Not applicable.
8. The treaty is closed to new business.

GAD mark this section as ‘NEW’.

In response to the information required by paragraph 12(3) of Schedule 4, Equitable state:

There were no financing arrangements in force at 31 December 1998.

In the event of a claim under the treaty described … above, the reinsurance would become a financing arrangement. There were no undischarged obligations under this treaty at 31 December 1998.

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

In paragraph 14, Equitable set out a statement of their aims with regard to bonus distribution and how they maintained equity between different generations of policyholders. The information provided is the same as for 1996 and 1997 ­– with the exception that, in relation to surrender values, Equitable have added the statement:

There are, however, no guarantees whatsoever as to the way in which surrender values will be determined.

GAD mark this sentence as new.

In paragraph 15, Equitable disclose that they had set reversionary bonuses for the main policy classes at 1.5% (previously 3%). As in previous years, Equitable disclose that they offered loans under a ‘loanback’ arrangement to some retirement annuity, individual and group pension policyholders.

In paragraph 16, Equitable set out final bonus rates. The returns again contain a description of Equitable’s differential terminal bonus policy:

If the contract guarantees minimum rates for annuity purchase the aggregate final bonus otherwise applicable is reduced when benefits are taken by the amount, if any, necessary such that the annuity secured by applying the appropriate guaranteed annuity rate after such reduction, is equal to the annuity which would be secured by applying the Society’s annuity rate for an equivalent annuity in force at the time benefits are taken to the cash fund value of the benefits before that reduction, subject to a minimum value for the final bonus after such reduction of zero.

If the contract guarantees minimum rates for annuity purchase and a reduction has been made under the immediately preceding paragraph, then where benefits are not taken in a form to which those minimum rates apply an additional amount of final bonus will be made available to the policyholder at the time benefits are taken equal to the reduction if any made under the immediately preceding paragraph. Such additional amount of non guaranteed final bonus will not constitute a “related bonus” or bonus allotted under the contract.

In paragraph 21, Equitable explain that they used risk-adjusted yields on assets other than land and equity shares by restricting them to 6%, which is that available on the highest yielding risk-free security held by Equitable. Equitable also explain that, where they considered this appropriate, they risk-adjusted yields on land and equity shares.

Schedule 4 – main valuation (forms)

In Form 46, Equitable provide information on changes to their ordinary long term business.

In Form 47, Equitable provide an analysis of their new ordinary long term business.

Form 48 shows that 51% of Equitable’s non-linked assets are invested in equities, 6% in property and 36% in fixed and variable interest securities (compared with 53%, 6% and 38% respectively in 1997). GAD circle the figure of 6.04% as the yield on ‘All other assets’ producing income.

As in previous years, in Form 49 Equitable disclose that the gross redemption yields on fixed interest securities issued or guaranteed by any government or public body are, for certain durations, higher than for those not issued or guaranteed by any government or public body.

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

In Form 52, Equitable set out the mathematical reserves held for accumulating with-profits policies, along with information on the number of contracts in force, the benefits guaranteed and the rates of interest and mortality assumptions used in valuing them. The Form 52 for ‘Pension business’ discloses that the gross total reserve for ‘Options and guarantees other than investment performance guarantees’ (i.e. the reserve for annuity guarantees) is £1,593m. The Form also shows that this reserve has been reduced by reinsurance of £809m to a net total reserve of £784m. GAD circle these figures and note that they refer to annuity guarantees.

The Form 52 summarising the totals for all of Equitable’s accumulating with-profits business discloses that the valuation has assumed a discounted value of current benefits of £15,739,015,000 (against the current benefit value of £15,740,152,000). This is a discount of just over £1m (and relates only to the Society’s School Fees Trust Plan).

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

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

In Form 57, Equitable provide matching rectangles illustrating the notional allocation of assets to each category of liabilities, showing the valuation rates of interest supported, and the ability of the matching assets to cover the reserves in the resilience scenarios.

In Form 58, Equitable set out the valuation result and composition and distribution of fund surplus. Against the figure of £16,532,642,000 (which had been discounted from the current benefit value by £1m) for ‘Mathematical reserves for accumulating with profit policies’, GAD add the corresponding figure from the appendix valuation of £16,115,623,000 (which had been discounted from the current benefit value by £795m).

Schedule 4 – appendix valuation (text)

Equitable explain that the appendix valuation:

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

Equitable’s appendix valuation provides the information required by paragraphs 1, 6 to 8, 10, 11, 20, 21 and 22. The Society states that the information required by the other paragraphs in Schedule 4 is the same as that provided in the main valuation (apart from paragraph 23 – being a statement of the required minimum margin in the form set out in Form 60 of Schedule 4 which, having had ‘regard to the purpose of the valuation’, has not been provided).

In paragraph 6, Equitable set out the general principles and methods used in the appendix valuation.

Equitable disclose that they assume a retirement age for personal pension policies of 60.

In paragraph 6(1)(b), Equitable again state that the valuation rates of interest were chosen with due regard for policyholders’ reasonable expectations and the Society’s established practices for determining reversionary bonuses.

As in the main valuation, Equitable state in paragraph 6(1)(g) that they do not consider it necessary, in current conditions, to hold a reserve for the guarantee they offer on a unit-linked annuity.

In paragraph 6(1)(h), like in the main valuation, Equitable disclose that they had set up reserves for the annuity guarantees on their ‘Pension contracts – old series’ business. They explain the assumptions used in establishing these reserves relating to assumed take-up rate of the annuity at a guaranteed rate and cash commutations.

In paragraph 7, Equitable state that a resilience reserve provision of £1,236m had been made. GAD annotate this part of the returns with the corresponding figure from the main valuation and note that the difference between the two figures is £636m. GAD also write:

Identical with [unclear] in liabilities shown by Net [premium valuation].

As in their main valuation and the previous returns, Equitable disclose in paragraph 7(8)(a) the changes made to the valuation assumptions and methods in the resilience scenarios, including that:

… for all accumulating with profits business, an annual loading of 0.25‰ increasing by 4% per annum compound of the basic benefit was reserved which is considered to be a prudent allowance for ongoing expenses: for accumulating with profits pension business, ½% per annum of the benefit value has been deducted for each year up to the date it is assumed that benefits will be taken as a charge for expenses.

As in the main valuation, Equitable explain that they risk-adjusted the yields on assets other than land and equity shares by restricting them to 6%, which is that available on the highest yielding risk-free security held by them. Equitable also explain that, where they considered this appropriate, they risk-adjusted yields on land and equity shares.

Schedule 4 – appendix valuation (forms)

In the appendix version of Form 51, Equitable set out the mathematical reserves held on the appendix valuation basis for various types of non-linked contracts (excluding accumulating with profit) along with information on the rates of interest and mortality assumptions used in valuing them. GAD annotate the Forms with some of the rates used in the previous returns.

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

The form covering ‘Pension business’ discloses that the gross total reserve for ‘Options and guarantees other than investment performance guarantees’ (i.e. the reserve for annuity guarantees) is £1,556m. The Form also shows that this reserve has been reduced by reinsurance of £793m to a net total reserve of £763m. GAD circle these figures and note that they refer to annuity guarantees. GAD also mark some of the policies as ‘NEW’.

This Form also discloses that the valuation of this pensions business had assumed a discounted liability of current benefits of £12,939,338,000 (against the current benefit value of £13,614,745,000). Next to this GAD write: ‘£675m below face value’.

The Form 52 summarising the totals for all of Equitable’s accumulating with-profits business discloses that the valuation had assumed a discounted liability of current benefits of £14,945,576,000 (against the current benefit value of £15,740,152,000). This is a discount of just under £795m.

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

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

As in the main valuation, Equitable provide appendix versions of Form 57 giving the notional allocation of assets to each category of liabilities on the appendix valuation basis, showing the valuation rates of interest and the ability of the matching assets to cover the reserves in the resilience scenarios. On the Form relating to life assurance and annuity business, GAD circle and note with question marks some of the risk-adjusted yields used. GAD also circle some of the risk-adjusted yields used in respect of certain pensions business.

Supplementary notes to the returns

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

Equitable disclose that they have been granted a section 68 Order which permits them to take into account a future profits implicit item. The Society states that it has included an item of £850m and that this is within the maximum amount permitted by the Order.

Equitable disclose that they have been granted a section 68 Order enabling them to disregard amounts owing under the subordinated loan up to an amount not exceeding 50% of the required solvency margin.

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

Schedule 6 (Certificates by directors, actuary and auditors)

Three Equitable Directors provide the certification required by Regulation 28(A) of the ICAS Regulations 1996. Equitable include in their Directors’ certificate the statement that the required margin of solvency had been maintained throughout 1998.

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

Equitable apply to FSA for a section 68 Order for a future profits implicit item of £1bn, for  possible use in their 1999 returns. Equitable provide financial calculations in support of the application, suggesting they could seek an Order up to the value of £2.96bn.

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

Average annual profit = 3700.0/5 = £740.0m

GAD tick these figures.

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

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

The calculations suggest that the maximum future profits permissible is 50% of £740m multiplied by eight years – that being £2,960m.

Equitable explain that they have used a future profits implicit item in their 1998 returns to the sum of £850m.

GAD reply to FSA’s note of 05/03/1999 about Equitable’s subordinated loan. GAD had  discussed the matter with an accountant at Equitable and are satisfied that there is no good reason why FSA should object to the change, as it is:

… largely a change in accounting procedure, and does not have any implications that suggest that the subordination principle is being breached in relation to the original Loan Agreement. The revised position is adequately covered by the existing Section 68 Order.

GAD offer no comments on the circumstances under which the concession was originally agreed.

FSA write to Equitable’s solicitors to confirm that their proposal would not require any change to the section 68 Order dated 19/08/1997.

Equitable advise FSA of changes to the requisite details for their branch in Germany, following  the marketing of a new product.

(Note: Equitable’s Appointed Actuary on this day sent IRECO a letter of understanding, not intended to be legally binding. The letter said that ‘both parties agree that should the withheld fund exceed £100,000,000 sterling and no solution can be found’ under the terms of the agreement, then the treaty would be cancelled. GAD had previously expressed concerns to Equitable that the treaty could be cancelled and received assurances that this was not the case — see 28/01/1999. Equitable did not disclose the letter of understanding to FSA or GAD, and it did not come to light until 24/09/2001. In June 2004, FSA concluded that the Appointed Actuary had been wrong not to disclose the letter to FSA. They made an order (under section 56 of the Financial Services and Markets Act 2000) prohibiting him from holding a significant management role within a regulated company until May 2010.)

GAD complete the A2 Initial Scrutiny check on the Society’s 1998 regulatory returns.

The form for the A2 check follows the format adopted for the 1996 and 1997 returns and includes the following:

Strength of valuation basis

GAD circle both yes and no when answering the question as to whether the interest rates used for with-profits business appeared to make provision for policyholders’ reasonable expectations and comment that it would be necessary to ‘review implications of discount rates shown for [unitised with-profits] business’. They note that other management expenses, at £8.5m, are material. GAD confirm that Equitable have applied the resilience test in accordance with the Government Actuary’s latest published guidance. GAD say that they judge the overall interest basis to be ‘adequate’ but refer to their comments about reviewing the implications of the discount rate used. GAD also judge the valuation basis to be ‘adequate’, but comment: ‘But, gross [guaranteed] annuity reserves have been established assuming that would not be taken in all cases – allowances appear to be greater than suggested in [the Government Actuary’s] guidance. N.B. Higher gross reserves would have been offset by higher reassurance credit’.

Solvency position

GAD note that the absolute cover for the required minimum margin was ‘adequate’ and comment:

(1) We still need to be satisfied that [the reinsurance] treaty with [IRECO] works in the way intended — REQUEST COPY OF TREATY as finally agreed.

(2) Loss of the Court case on treatment of [Guaranteed] Annuities would put position in doubt — would need to cut all bonuses.

GAD describe the trend in the level of cover for the required minimum margin over recent years as ‘flat’ and add ‘(Increasing use of [Implicit Future Profits] Item has raised line 44 margin [excess of available assets and implicit items over the required minimum margin])’.

Operating results

GAD note that the level of surplus/deficit emerging and its trend over recent years were not a current cause for concern ‘but fall shown for 1998’. GAD note that the level and trend of capital injection into Equitable were not current causes for concern ‘but remember £350m Subordinated Loan issued in 1997’. GAD note that the amount of reinsurance was material and that there was ‘a material exposure to non-UK authorised reinsurers without deposit back’.

PRE issues

GAD circle both yes and no to the question as to whether the answer given by Equitable in paragraph 4(1)(a)(ii) of Schedule 4 to the returns was satisfactory. GAD comment: ‘Reserve is normally less than asset share, but [surrender values] only limited to asset share [and] normally achieved by reducing terminal bonus i.e. Society would normally pay out more than reserve carried’.

Current issues

GAD note that Equitable had a material exposure to annuity guarantees and that this was the ‘[reason] for early submission of their Return’.

Aspects that look worrying

GAD identify the following:

(1) Consider 6(1)(h) [assumptions on the take-up rate of guaranteed annuity options] response.

(2) Need to examine [the reinsurance] treaty.

(3) Possible loss of court case – implications for the Society?

GAD identify items 1 and 2 from ‘Aspects that look worrying’ to be notified to HMT, to be taken up immediately with Equitable. GAD raise Equitable’s priority rating from 4 to 2.

Accompanying the scrutiny check is a new ‘Initial Scrutiny Summary Form’, which includes certain key figures disclosed in the 1994 to 1998 returns.

GAD send FSA a one and a half page report on their initial scrutiny of the 1998 returns. GAD note that the cover for the required minimum margin is 2.5, although without the future profits implicit item it would have been 1.6.

GAD explain that Equitable reached this position after including additional gross reserves for annuity guarantees of £1,593m, reduced by reinsurance of £809m to a net provision of £784m. GAD observe that Equitable’s gross reserve was lower than GAD would have hoped. This was because Equitable had made greater allowances for non-take-up of GARs than might have been expected in the light of the Government Actuary’s guidance (DAA11 – see 13/01/1999). GAD comment that they assumed that Equitable were reluctant to disclose any higher figures for their gross liability or the extent of their resultant reliance on reinsurance. GAD note that the solvency implications for Equitable were ‘negligible’, but that GAD needed to consider further the implications for other companies if they accepted Equitable’s arguments.

GAD point out that they had not yet seen a copy of the finalised reinsurance treaty and suggest that FSA should urgently request a copy, ‘so that we can assess any questions that may need to be raised about the value being placed on the reinsured liability’.

GAD note that Equitable had made an application for an increased future profits implicit item of £1bn, and explain that they had set a target to complete the combined scrutiny of the 1997 and 1998 returns by the end of June 1999.

A trustee of a company pension scheme telephones FSA to express concern about the solvency of Equitable. FSA’s Line Manager D advises:

Explained take intervention action if policyholders at risk. [An Independent Financial Adviser whom the trustee] had spoken to had a vested interest in casting doubt on [the] financial position of Equitable Life. Recommended talking to Equitable Life about the position and not to take any rushed decisions to transfer the occupational pension scheme elsewhere.

Equitable write to FSA explaining that they were awaiting the final reinsurance treaty but have asked that this be progressed as a matter of urgency. Equitable enclose a copy of the term sheet on which the treaty would be based.

Equitable also provide, in strict confidence, a copy of a detailed report for the Board, prepared by the Appointed Actuary, on measures available to Equitable to improve their statutory solvency position. The Appointed Actuary identifies six measures which he says it would seem sensible for Equitable to pursue: increasing the subordinated loan (he says it had always been Equitable’s intention to use the maximum permitted level of 50% of the required minimum margin); use of reinsurance; shifting the equity portfolio from lower to higher-yielding stocks; limiting the extent of exposure to development property situations; exploring the merits of a new bonus class for GAR policies while actively encouraging policyholders to give up their GARs; and introducing new policies with no entitlement to declared bonuses. The Appointed Actuary also proposes to apply for the maximum possible future profits implicit item in future and to bring into account in the returns approximately 5/6 of the minimum margin.

FSA pass a copy of Equitable’s letter of 20/04/1999 to GAD. FSA ask:

Am I being pedantic here but if the reinsurance treaty has not yet been finalised can The Equitable take credit for it in their 98 returns?

GAD write to FSA in response to their query of 21/04/1999. GAD say:

We understand that the FSA have agreed in principle that, where there is a letter of intent in place at the valuation date, credit may be taken for the existence of a reinsurance agreement. Indeed we believe that this position was clearly signalled to Equitable in earlier discussions.

GAD compare the draft term sheet provided on 20/04/1999 with that provided on 25/02/1999. GAD observe that Equitable are now entitled to request interest on the outstanding reinsurance claims amount or request that 10% of this amount is settled in cash. They also note that the annual ‘Deposit Premium’ payable by Equitable has increased from £150,000 to £400,000. GAD explain that they are content with the way payments of additional premiums in the event of a claim have now been subordinated to policyholders’ rights. GAD say that other aspects of the treaty remain broadly unchanged.

GAD also comment on the report to Equitable’s Board sent at the same time. GAD note that such measures as maintaining the future profits implicit item at the maximum level, increasing subordinated debt, making further use of reinsurance ‘look to be fairly plausible – but may only have marginal impact, bearing in mind the existence now of the overarching [reinsurance] treaty …’. GAD further state that applying policy conditions to limit the impact of existing annuity guarantees would have a strong adverse impact on the image of the Society, while inducing policyholders to give up their GARs may be in conflict with statements made in product and marketing literature. GAD acknowledge, however, that ‘in principle, a reasonable charge could be made to asset shares to reflect the cost of GAOs’.

A PIA official writes to PIA’s Head of Policy about some correspondence from MPs on behalf of policyholders with Equitable and another company, who are concerned about not receiving a terminal bonus if GARs were honoured. The PIA official explains that as most, if not all, complaints were about policies sold before the FS Act 1986 came into force, there is little action PIA could take. The official adds:

… we are aware that there is a possible conflict between the position taken by the Insurance Directorate in terms of prudential supervision and the conduct of business regulation.

The official attaches PIA’s note of 18/01/1999.

Equitable send FSA copies of their statutory annual report and accounts and their annual  report and financial highlights for 1998, prepared in accordance with the Companies Act 1985 and dated 24 March 1999.

In their President’s Statement, Equitable say that the year had been unusual, given the unfavourable publicity about their differential terminal bonus policy. They give some background to the issue and report their decision to fund a representative action in the High Court to confirm that their approach was lawful, was within the terms of the guaranteed annuity rate policy document and was within the Board’s powers under the Articles of Association. Equitable explain that they adhered to the philosophy of distributing profits fairly to members and without deliberate cross subsidy between different contract types or durations of saving. They therefore strived to ensure that all their members received benefits that represented a fair and highly competitive return on the contributions they had made.

In their Management Report, Equitable reiterate that they operated a full distribution policy to avoid the unfairness created by the retention of profits earned by one generation of policyholders for the benefit of successors. Equitable state that, despite having such a full distribution policy, investment strategy was driven by investment, rather than technical, considerations. They report that the return for the with-profits fund in 1998 of 13.3% and the average return of 14.5% over the last four years were significantly in excess of inflation, which averaged less than 3% pa. They explain that, in a reflection of the general trend towards lower average returns in a low inflation environment, the Directors had decided to allocate an overall rate of return of 10% for recurrent single premium pensions business. Equitable state that, in the face of falls in yields during 1998 and the likelihood of a sustained period of future low returns, they had reduced the element of return which was given in guaranteed form (i.e. reversionary bonuses) to 5% for an illustrative contract. Equitable report that, as in 1997, the ‘expense rebate’ would be extended to all in-force pension policyholders, regardless of the amount contributed.

Equitable’s President writes to the Economic Secretary to the Treasury, after meeting her at a dinner on 21 April 1999.

The President elaborates on concerns he expressed at the dinner about the impact on Equitable of the Government Actuary’s guidance on reserving for annuity guarantees (DAA11 — see 13/01/1999). The Society’s President explains that Equitable had been including in their accounts a prudent provision of £200m; but the guidance required an additional reserve of no less than £1.6bn in their regulatory returns. He comments that the Economic Secretary had suggested that, if he wrote to her, she would ‘ensure the matter was considered in the right quarter of Government’. The President warns that such a requirement would result in excessive constraints on investment policy and thus lower benefits to policyholders.

Equitable’s President acknowledges that FSA and GAD have sought to be as helpful as they can but believes they have limited room for manoeuvre. He suggests that Equitable and others in the industry are being subjected to ‘extremely onerous reserving requirements which bear little resemblance to commercial reality’. He suggests that it might need the intervention of the Economic Secretary to secure ‘a more commercial and satisfactory outcome’.

The President attaches a paper of the same date, prepared by the Society’s Appointed Actuary on the cost of reserving for annuity guarantees. The paper reiterates the Appointed Actuary’s view that the Government Actuary’s guidance is excessively prudent in that the guidance assumed a take-up of annuity guarantees at around 80%. He points out that, for many policyholders, the extra value of exercising a guarantee was outweighed by the attractions of a more modern type of annuity which could only be achieved by taking the cash form. He explains that Equitable’s experience to date was that less than 5% of benefits had been taken in guaranteed form.

The Appointed Actuary acknowledges the argument that policyholders only take the cash form of the benefit if there were a discretionary bonus added to it and that companies must therefore reserve for this in advance. However, he states that the existence of an element of discretionary bonus is already ‘implicit in the regulatory system’ and allowed for in the required minimum margin and resilience reserve. The Society’s Appointed Actuary suggests that the assumption implicit in the guidance:

… that there will be no discretionary bonuses available at any time in the future at which the relevant policies mature seems excessively prudent, particularly in view of the margins of prudence already provided in the statutory reserves.

GAD’s Directing Actuary B suggests to Chief Actuary C that they need to point out to the Economic Secretary that £1.6bn is ‘indeed a reflection of the potential economic value of these GAOs (assessed on a prudent regulatory basis) and is not an unreasonable financial imposition on Equitable’.

The Directing Actuary acknowledges that companies could hold less than the ‘fair share of the fund’ in recognition of the discretionary nature of the final bonus, ‘for which no provision is normally required’. However:

… where the company provides a GAO, then this removes much of this discretion for the insurer and it is necessary for the provision in the balance sheet to be increased accordingly.

GAD provide FSA with their scrutiny report on the Society’s 1998 regulatory returns. (A copy of this scrutiny report is reproduced in full within Part 4 of this report.) The report uses a detailed format similar to that adopted for the 1993, 1994, 1995 and 1996 returns (see 15/11/1994 [entry 1], 23/01/1996 [entry 1], 01/11/1996 [entry 1] and 16/12/1997), but incorporating revisions agreed in 1998 to reflect changes deriving from the Insurance Companies (Accounts and Statements) Regulations 1996. GAD explain that it combines comment on activity in both 1997 and 1998.

In the heading to the report, GAD state that Equitable have a priority rating of 2.

The body of the report comprises 15 sections as follows:

(1) Key features

GAD set out some key statistics for both 1997 and 1998, including:

• Equitable had available assets of £2.1bn in 1997 and £2.5bn in 1998;
• they had used an implicit item of £371m in 1997 and £850m in 1998; and
• they had a subordinated loan of £346m in both 1997 and 1998.

GAD set out Equitable’s required minimum margin. GAD note that the last visit to Equitable had been in November 1996.

(2) Action points

GAD explain that they have raised no points with Equitable as a result of their scrutiny. GAD note however:

• that FSA and GAD needed to consider the final terms of the reinsurance treaty; and
• that FSA needed to decide whether to challenge the assumptions Equitable had used in setting reserves for their annuity guarantees (see section 10 below).

(3) Executive summary

GAD state that Equitable try ‘to provide fair benefits to each generation of its policyholders, on maturity or surrender – without holding back any excessive estate’, but that, as a result, they have lower free asset margins than might be expected ‘for such a well thought of institution’. GAD note that Equitable have used a future profits implicit item for the last five years, and took out a subordinated loan in 1997.

GAD explain that the solvency position has been ‘complicated on this occasion’ by the need to carry reserves for annuity guarantees. They state that Equitable’s cover for their required minimum margin is 2.51, that this was unchanged since the end of 1997 and that, without the implicit item of £850m, the cover falls to 1.66.

GAD note that, although new business fell between 1997 and 1998, total gross premiums received rose from £3.45bn to £3.7bn. They state that Equitable’s expense ratios remain the lowest in the industry. GAD note that Equitable’s asset performance is ‘a little disappointing’.

(4) Background

GAD reiterate information included in the Background section of their reports on the 1993, 1994, 1995 and 1996 returns, namely that Equitable are the oldest mutual life assurance society in the world and that they never pay commission to third parties. GAD explain:

This background is typified by a determination to provide fair bonuses to policyholders, with no deliberate holding back of profits from one generation to another, by unit linked products which often have discretionary surrender values, and by using a gross premium bonus reserve valuation method. (However, the returns also show the results of a net premium valuation on a minimum basis – and the free asset position shown is identical.)

GAD repeat that Equitable gained a controlling interest in Permanent Insurance in June 1997.

GAD explain that Equitable have increased their overseas activity in recent years (in the Republic of Ireland, Germany and Guernsey) and that these branches are producing increasing amounts of new business; however, Equitable have expressed dissatisfaction with the cost effectiveness of the German branch. GAD note that, from August 1998, Equitable have provided insurance in Greece. GAD state, as in their reports on the 1994, 1995 and 1996 returns, that Equitable regard overseas activity as ‘missionary work’. GAD note that Equitable have provided systems support to other companies.

GAD provide details of Equitable’s subordinated loan.

GAD emphasise that Equitable have been:

… heavily criticised in the press, of late, for the approach that it is taking of reducing terminal bonuses to meet the costs of guaranteed annuity options attaching to some of its pension contracts. A test case to be brought before the Courts in July 1999 will try to obtain legal clearance for the practice.

GAD provide details of the four section 68 Orders in force at the end of 1997, being:

• to allow Equitable to use a future profits implicit item not exceeding £700m (see 14/10/1997);
• to allow Equitable to exclude recurrent single premiums from the ‘annual premium’ figures in the returns (see 13/06/1997);
• to allow Equitable to aggregate the details of their total personalised funds (see 31/01/1997); and
• to allow Equitable to make use of the subordinated loan (see 20/08/1997).

GAD explain that, for the 1998 valuation, Equitable had also been granted an Order allowing them to take into account a future profits implicit item of up to £1,900m.

GAD note that, following the retirement of Equitable’s Appointed Actuary and Chief Executive on 31 July 1997, the roles had been filled by two different people. GAD state that the last visit to Equitable had been made in November 1996 (see 08/11/1996 [entry 2]).

Business developments during the year

(5) New business

GAD set out the new products Equitable have developed and the sources of their business. GAD explain that Equitable target ‘high net worth individuals’. They provide tables showing recent history of new regular premiums and new single premiums and a new business index. GAD note that, as Equitable are not able to produce meaningful in-force premium figures for renewable single premium business, the annual premiums recorded in the returns ignore this business and that this has been sanctioned by a section 68 Order.

GAD comment that Equitable ‘may have underperformed the industry average in 1998 in terms of increases in new business. This could, though, be put down to the Society’s starting position – having achieved excellent growth in 1997’. GAD note, however, that in 1997 Equitable were reported to be the largest writer of pensions business in the UK.

(6) Changes in business in force

GAD produce a table showing ‘Recent history of regular premiums received’. GAD reiterate that, while revised regulations in 1996:

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

GAD note the rise in gross premiums received.

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

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

GAD explain: ‘These are excellent results, reflecting the fact that business is largely bought rather than sold!’.

(7) Expenses

GAD produce a table showing the history of expenses from 1994 to 1998. They comment that Equitable’s reported expense ratios have again reached ‘astonishingly low levels’ and are the lowest in the industry. GAD state that Equitable’s low expense ratio is a positive marketing image, which helps to explain the strong sales figures and is thus ‘part of a virtuous circle’.

GAD note, as an exceptional item, that Equitable claim to have invested some £70m in redeveloping all their operating systems over recent years.

Situation at year end

(8) Non-linked assets

GAD produce tables showing Equitable’s: ‘Recent history of asset mix’; ‘Recent history of asset mix attributable to UK with-profits business (%)’ (taken from Equitable’s 1998 With-Profits Guide); ‘Movement in asset values over the last year’; and ‘Investment performance in 1998’.

The latter shows a return of 13.8%. GAD comment:

This return slightly underperforms what might have been hoped for in 1998 – but is probably in line with returns generally achieved. The correspondingly calculated 1997 figure of around 19.1% was somewhat higher than the average return achieved by with-profit offices in that year, of 18.5%. [However, it may be noted that in the Society’s accounts the return claimed for assets matching with-profit liabilities is lower than the figures generated by us: it was only 17.2% in 1997, and was just 13.3% in 1998.]

(9) Assets held to match linked liabilities

GAD provide details of internal linked funds, other assets matching property-linked liabilities, mismatching to property-linked liabilities, assets matching index-linked liabilities and policyholders’ reasonable expectations (issues on linked funds). On the latter, GAD comment:

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

GAD observe no particular problems.

(10) Valuation basis

Overall strength – GAD explain that Equitable produce their published returns:

… on the basis of a gross premium valuation for non linked business, with some modest allowance for future bonuses, but the resilience reserve included is determined such that the total liability is identical with the results of a net premium valuation – that is shown as an Appendix to the Returns, and is largely the basis on which the strength of the reserves is monitored by GAD.

GAD consider the bases used to be generally acceptable, subject to concerns about the Society’s reserves for annuity guarantees. GAD note that Equitable inform holders of ‘accumulating with profit contracts of the amount of their accumulating final bonus (although clearly stating that it is not guaranteed), but only holds reserves for a discounted sum compared with the current guaranteed value’.

GAD state:

It is known, having been acknowledged by the Society, that total current “asset shares” (indicated to members as their policy value) exceed total current admissible assets.

GAD note that Equitable have taken out a reinsurance contract in an attempt to mitigate the strain of carrying reserves to meet annuity guarantees.

Interest – GAD produce a table showing the interest rates used in the net premium valuation for major classes. GAD raise no concerns.

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

Expenses – GAD state that the total provisions seem to be more than adequate, and note the Appointed Actuary’s statement that no additional provisions are needed to cover the continued sale of new business or to cover closure.

Resilience – GAD explain:

A resilience reserve requirement under the net premium valuation method is reported as £1,236m in 1998 (£1,022m in 1997). Whereas, for the gross premium bonus reserve (GPBR) valuation a resilience reserve is shown of £600m (£325m). The modified resilience reserve figures shown in the published GPBR valuation are designed to ensure that the amount of free assets disclosed is the same as would be shown by the Net Premium Valuation!

It may be noted that the most adverse scenario at the end of 1998 involved a reduction of 10% in fixed interest yields combined with a 25% fall in equity values, whereas at end 1997 it had been the combination of a 3% rise in fixed interest yields with a 25% fall in equity values.

Other factors – GAD note that Equitable have included a reserve of £70m for pensions mis-selling. GAD state that Equitable had established a capital gains tax reserve of £75m at the end of 1997, increased to £100m at the end of 1998, reducing to £20m in the most onerous resilience scenario. (Note: these are both points GAD had queried following their scrutiny of the 1996 returns – see 16/12/1997.)

Options and guarantees – GAD explain that as a result of current economic conditions, annuity guarantees are proving extremely onerous, although Equitable attempt to restrict the ultimate value to policyholders by use of a differential terminal bonus policy. GAD state that this approach is being tested in the Courts, and that loss of the case (by Equitable) ‘would result in a need for the Society to reduce its level of terminal bonus additions to a wider group of policyholders – maybe all!’.

GAD state that, notwithstanding Equitable’s approach, the Government Actuary has determined:

… that there is a need in the statutory valuation to recognise the accumulated option liability attaching to the minimum level of benefits already guaranteed – without taking credit for any possible future emerging surplus offset.

GAD note that, accordingly, in the net premium valuation Equitable have set up a reserve of £1,556m, with £793m ceded to the reinsurer. In the bonus reserve valuation, Equitable have set up a reserve of £1,593m, with £809m ceded to the reinsurer.

GAD state that Equitable’s assumptions about the take-up of annuity guarantees ‘somewhat stretched the concessions offered by the [Government Actuary]’ in the guidance letter of 13/01/1999. GAD produce a table which shows that Equitable have assumed take-up rates of between 70% and 82.5% and refer to three assumptions disclosed in the returns, namely:

(1) that allowance of a few percentage points has been made for the additional flexibility and other perceived advantages of alternative forms of benefit available and for the bonus system that the Society operates in relation to these contracts;

(2) that a modest allowance has also been made for the availability of cash commutation options, and

(3) where it would be advantageous for higher rate tax-payers to commute for cash and buy a purchased life annuity, then a further allowance of a few percentage points has been made.

GAD explain that it is necessary to consider whether Equitable’s assumptions should be challenged.

GAD note that Equitable have not supplied any information about how the reinsurance offset has been determined, and in particular what allowance has been made for the premiums payable.

(11) Financial results

GAD provide an overview. GAD note that Equitable’s cover for their required minimum margin is 2.51, unchanged since the end of 1997. GAD continue:

Without the implicit future profits item of £850m, cover for the [required minimum margin] would be reduced to a factor of 1.66. Further, we are still not entirely clear that provisions made to cover the currently guaranteed level of annuity liabilities are as strong as they should be.

A large proportion of business is written on a participating basis, so that, provided the currently high level of annual emerging surplus continues, the Society should be able to work its way out of its current solvency margin problems. However, it does seem highly desirable for the Society to mitigate the risks posed by a possible downturn in asset values, by holding back more emerging surplus by declaring lower guaranteed bonuses – although it can still pay out appropriate final benefits to its members with declarations of “non-guaranteed final bonuses”.

To be fair, the Society appears to be proceeding down this path – although mindful of the need to sustain a competitive position in the marketplace.

Under ‘Summary of results for main classes’ GAD produce three tables, showing liabilities for non-linked and linked business and a valuation summary, for the years 1994 to 1998. The valuation summary shows, under the bonus reserve valuation, that Equitable’s cover for the required minimum margin in 1997 and 1998 is 2.51 (compared with 2.53 in 1996). There is no figure for cover under the net premium valuation.

The table shows, in summary form, that Equitable’s free asset ratio fell to 3.80% in 1997 (from 3.84% in 1996) and then rose to 5.37% in 1998. (Note: however, the detailed data contained within the table indicated that GAD’s figure for 1998 was incorrect and that Equitable’s free asset ratio had in fact fallen further, to 2.36%.)

In a note to the valuation summary, GAD state:

Although the Net Premium Valuation showed a lower non-linked liability of [£21.5bn] and a lower reserve for declared bonuses of [£340.5m] it was shown to require a resilience reserve £636m higher than the GPBR valuation. Thus, as intended, the total of Long Term liabilities … for the NPV is identical with the result shown above.

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

(12) Bonuses

GAD produce tables showing the cost of bonuses declared and the recent history of key bonus rates. GAD explain that Equitable’s:

… method of annual bonus declarations for unitised type contracts is unusual. As well as a declared guaranteed annual bonus, based on a proportion of accrued income and capital appreciation, a further annual bonus is quoted, which is not guaranteed (in that it may be withdrawn and/or reduced in future), but which makes up the total quoted accrued policy value at the valuation date. This non-guaranteed final bonus is declared in a similar way to reversionary bonuses, as a percentage of benefit, and the amount payable at maturity is the sum of these total annual “declarations”, subject to the proviso that the final non-guaranteed bonus can be withdrawn.

GAD reproduce Equitable’s table from their 1998 With-Profits Guide, showing gross investment returns at market value and the rate allocated in fixing bonuses, updated to include 1997 and 1998:

GAD produce tables showing final bonuses for traditional life contracts and deferred annuities, according to duration of the contract.

Under ‘PRE (issues on with-profit business)’, GAD state that Equitable:

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

(Note: this same point had been made in the scrutiny report on the 1996 returns — see 16/12/1997.)

Under ‘Recent history of maturity payouts’, GAD produce a table of Equitable’s payouts from 1994 to 1998, set against the industry average, and a chart showing payouts as a percentage of asset share. GAD comment:

It is clear that, while Equitable strives to be fair to all its policyholders, and pays much more generous surrender values than most other offices, its maturity payouts fall well short of the best in the market, particularly for conventional life contracts.

Nevertheless, the chart … shows that policyholders seem to be receiving quite fair returns — no doubt helped by the low expense charges levied by the Society.

(13) Reassurance and financing

GAD state that Equitable make little use of traditional reinsurance ‘other than for very large sums assured (retention being £400,000 for UK life risks and DM250,000 for German risks), and for supplementary disability and accident risks’.

GAD repeat details of the reinsurance treaty entered into in order to cover costs arising from the exercise of annuity guarantees and note that this allows Equitable to reduce the reserves they hold for these policies.

(14) Compliance

Under ‘HMT compliance problems’, GAD state ‘None observed’.

Under ‘PIA and other compliance problems’, GAD note that a reserve of £70m has been included for pension mis-selling.

(15) Professional requirements

GAD certify that their report conforms to the requirements of the Institute and Faculty of Actuaries, as set out in their Memorandum of Professional Conduct and Advice on Professional Conduct. GAD also certify that the report has been prepared in accordance with the Service Level Agreement between HMT and GAD, signed in November 1998, as that agreement had been continued between FSA and GAD, following an exchange of letters in December 1998.

GAD’s scrutiny report runs to 23 pages.

GAD’s Directing Actuary B suggests to Scrutinising Actuary E that they should ask Equitable to  consider other possible scenarios, in addition to those considered in the Board paper sent to them on 04/05/1999 – such as gilt yields at 5% and a 10% fall in equities. The Directing Actuary says that they should also ask the Appointed Actuary to confirm that he had allowed for the expected cost of bonuses as at 31 December 1999, and that the estimated reserves on that date had been calculated on the same basis as the previous year, apart from changes to the valuation rate of interest. The Directing Actuary expresses surprise that, in the ‘central scenario’, which assumed a modest rise in gilt yields to 5% and broadly unchanged equity values, Equitable’s mathematical reserves increased by only £1.2bn over 1999, despite a projected cash flow of over £2bn.

FSA write to HMT seeking to address the Economic Secretary’s concern about whether it was reasonable to require Equitable to hold such a large reserve for annuity guarantees. The note reproduces undated comments made by GAD. FSA state:

Insurance legislation requires insurers to establish reserves for “all guaranteed benefits” on the basis of “prudent” assumptions. It also specifically provides that insurers must reserve for any additional costs of policy options. These requirements form part of the UK’s implementation of the EC Third Life Insurance Directive.

FSA explain that £1.6bn:

… is a provision for the additional liabilities the company would face in applying the annuity rates that it has guaranteed to policyholders to the cash benefits arising under its pension contracts (to the extent that these cash benefits are guaranteed).

FSA say that Equitable’s provision is the largest in absolute terms, reflecting their position as the leading United Kingdom provider of individual pensions. FSA explain that the cost of annuity guarantees and the reserving requirement had become significant because of ‘the recent falls in long term interest rates’. FSA go on to explain: ‘Where Equitable Life has guaranteed rates in the region of £110 pa per £1000 cash available, the best current market rate for an equivalent annuity is now only of the order of £80 pa per £1000 of cash pension fund’.

FSA say: ‘The reserving standards applied in Treasury returns are almost invariably more onerous than general accounting standards …’.

FSA state that it should be noted that the Government Actuary’s guidance had been ‘widely endorsed within the actuarial profession’, whilst there were a few actuaries (including Equitable’s Appointed Actuary) who thought it unduly onerous and a ‘significant number’ who thought that the standard was not strong enough. FSA conclude that they are ‘content that the reserving standard … strikes an appropriate balance’.

FSA have no comments on the draft of a reply to Equitable’s President, prepared by HMT.

FSA’s Line Manager D sends the Head of Life Insurance an extract from GAD’s scrutiny report on Equitable’s 1998 returns. Referring to section 10, ‘Options and Guarantees’, the Line Manager states:

I think we will have to challenge the GAO reserving assumptions. Making allowance for cash commutation is contrary to specific guidance given by the [Government Actuary] and a reserving level of 70% seems unacceptably low. Please can we discuss handling.

GAD write to Equitable, having cleared their letter with FSA. GAD explain that, although they had discussed various aspects of Equitable’s reserving methodology earlier in the year, a number of points remained about the Society’s approach in the 1998 returns. GAD note that Equitable had assumed a reduced take up rate (ranging from 70% to 82.5%) for annuity guarantees in each class of business. GAD ask Equitable to ‘clarify exactly how these reduced proportions have been justified, since we find the description given in the returns to be rather imprecise’.

GAD ask Equitable to provide details of ‘how the reinsurance offset was calculated in relation to these guaranteed benefits, including an explanation of how allowance was made for the premiums that would become payable if this reinsurance was called on’.

GAD also seek some additional information in the light of the paper to Equitable’s Board, provided on 04/05/1999, taking up the points made by Directing Actuary B (see 21/05/1999 [entry 1]).

FSA prepare a paper discussing possible outcomes of the Court case and their implications for

Equitable and FSA. FSA identify four scenarios:

• Equitable win totally;
• Equitable win in part (in that it is now acceptable to reduce the terminal bonus, but had not been so in the past);
• Equitable win (in total or in part) on contractual grounds, but FSA would have to take a view on the outcome’s acceptability from the perspective of policyholders’ reasonable expectations; or
• Equitable lose (in that reducing the terminal bonus where an annuity guarantee was exercised was unacceptable).

On the third scenario, FSA note that they would expect to conclude that Equitable’s current practice is consistent with PRE, but they would be more doubtful about past practice because ‘bonus notices [were] of dubious clarity’.

On the fourth scenario, FSA explain that they would need to determine Equitable’s solvency position and serve a notice under section 32 of ICA 1982 if Equitable were in breach of their required minimum margin. FSA state that they would need to consider closing the company to new business or suspending their authorisation if there was a significant risk that Equitable could not meet their liabilities to policyholders or their reasonable expectations. FSA caution that there could be potential for allegations that FSA should have prevented Equitable writing new business earlier.

FSA also consider the implications for Equitable of the fourth scenario, under which Equitable’s reinsurance treaty would be invalidated. FSA note that, without reinsurance in place, Equitable was likely to only just be able to cover their required minimum margin - even after taking full account of future profits implicit items. FSA note that coverage might be ‘slightly more comfortable if the current level of gross reserving for GAOs was accepted, allowance was made for the improvement in the Society’s position since the year end … and some of the solvency boosting measures currently being considered had been put in place’. FSA also consider other implications for Equitable, such as having to: reduce substantially terminal bonus payments; consider switching assets from equities to gilts; and pay compensation to policyholders who had taken benefits in guaranteed annuity form and had suffered from reduced terminal bonus payouts as a result.

GAD comment on FSA’s paper. GAD explain that it needed to be read alongside the paper presented to Equitable’s Board at the end of April 1999 (see 04/05/1999 [entry 2]). GAD note that they await a reply to their letter to Equitable of 27/05/1999. They emphasise that, unless Equitable’s practices are given full clearance by the Court, they would need to modify or replace the reinsurance arrangement.

HMT send FSA a revised draft of a reply by the Economic Secretary to Equitable’s President’s  letter of 30/04/1999. The draft explains that HMT’s more onerous reserving standards reflect the fact that the regulations required a prudent valuation, which included an appropriate margin for adverse deviation of the relevant factors.

The draft acknowledges the concern that the guidance assumed that nearly all benefits would be taken in the guaranteed annuity form, but suggests that this was an example of the ‘prudential principle’. HMT’s draft continues:

If, by exercising the option of taking an annuity with a guaranteed rate of return, the policyholder will obtain a return that is in excess of that which may be available elsewhere, then the rational policyholder will exercise that option. It is reasonably foreseeable that the guaranteed annuity rate will exceed the rate which will be available more generally in the annuity market. Past experience and projected experience are less relevant when circumstances may reasonably be foreseen to be going to be different.

FSA’s Line Manager D comments that:

… why Equitable have to reserve effectively on the assumption that all GAOs are exercised is somewhat complicated and I don’t think the current draft would stand up (Equitable could argue that the annuity benefit is not more valuable to the policyholder in most cases – I won’t bore you with the details of why).

The Line Manager suggests some alternative wording, being that:

If the guaranteed benefits under the annuity option are higher than those available in cash form it must be prudent to reserve for the higher value benefit. Low take up of an option in the past does not necessarily mean it is reasonable to reserve on the assumption that take up will remain low in future. This is especially true when past practice is likely to have been influenced substantially by factors that may change (eg the payment of additional bonuses to those not exercising the option when those payments have not been reserved for and therefore cannot be guaranteed to continue).

The Economic Secretary to the Treasury writes to Equitable’s President in reply to his letter of  30/04/1999. The Economic Secretary explains by way of background that:

… companies have to err on the side of underestimating the value of their assets’ future income and overestimating their liabilities. In this way it is ensured companies have some spare capacity to withstand adverse economic circumstances. The determination of how conservative the assumptions should be has been derived from past experience and is embodied in guidance to appointed actuaries.

The Economic Secretary’s letter includes the wording suggested by FSA (see 09/06/1999 [entry 2]) in response to the President’s concern that the reserving requirement was excessively prudent.

FSA’s Line Manager D informs officials at FSA and GAD that Equitable, subject to legal advice, have agreed to provide the Court papers. She says that the hearing was due to begin on 05/07/1999 and was expected to last two or three days, but that there might be significant delays before a judgment was published.

The Line Manager attaches a revised scenarios paper prepared by FSA. This now describes three scenarios:

l Equitable win totally;

l Equitable win in part (in that it is now acceptable to reduce the terminal bonus, but had not been so in the past); or

l Equitable lose (in that reducing the terminal bonus where a GAR option was exercised was unacceptable).

FSA’s discussion of the implications of each outcome reflects the points made in the note of 09/06/1999. FSA also deal with consideration of policyholders’ reasonable expectations issues under the second scenario.

FSA, GAD and PIA meet The Consumers’ Association. Prior to the meeting, FSA prepare a briefing note.

FSA state that life insurance companies were required to meet their contractual obligations and PRE. FSA state that they were unaware of any company failing to meet their contractual obligations. Whether or not a reduction in terminal bonuses was consistent with policyholders’ reasonable expectations ‘will depend on what policyholders were told at the time they took out the contract and subsequently’. FSA explain that annuity guarantees were an additional benefit for which it was reasonable to make some charge if costs were incurred in providing it.

FSA state that they were not aware of insurance companies deliberately concealing from policyholders their right to take a guaranteed annuity. Complaint mechanisms existed for those who suffered loss as a result of poor or incomplete advice from companies.

FSA note that they had used the GAD survey to identify companies with the most significant exposure to annuity guarantees and that the situation had been discussed in detail with any company that appeared to face a solvency threat. FSA are content that companies are reserving fully for their annuity guarantees liabilities. They note that a number have controlled their liabilities through measures such as reinsurance.

FSA prepare a note of the meeting. FSA observe that there appeared to be much more common ground between FSA and The Consumers’ Association than FSA had expected. FSA state that they were able to alleviate the Association’s concerns that insurers were not honouring their guarantees. The Association had acknowledged the difficulty of being fair to all policyholders in meeting the costs of annuity guarantees and the appropriateness of the costs being met from the with-profits fund.

FSA write to the Personal Investment Authority Ombudsman confirming arrangements for a meeting on 23/06/1999 to discuss the complaints the Ombudsman had received concerning Equitable’s differential terminal bonus policy. FSA say that they wished to discuss the Personal Investment Authority Ombudsman’s jurisdiction over complaints and how those complaints would be handled.

FSA advise PIA that advice about GAR options given to, or withheld from, policyholders by companies after 29 April 1988 – when the FS Act 1986 came into force – would be subject to the conduct of business rules, even if the policy had been sold before that date. Failure by a company to tell policyholders on maturity about their rights to GARs would undoubtedly breach PIA principles.

Equitable’s solicitors provide FSA with a pack of materials relating to the Court case.

GAD write to FSA, following a query they had received from a mutual company about how they should present a subordinated loan in their returns. GAD conclude that two different approaches to drafting section 68 Orders appear to have been used, and that those have generally resulted in two different presentations in the returns. The first presentation was a much more explicit one, while the second could lead to a distorted asset/liability picture in circumstances where a company was in financial difficulty. GAD state that Equitable used a slight variation on the first presentation.

GAD also prepare a summary. GAD note that Equitable had discussed the adoption of a two-tier terminal bonus structure by reference to a Board resolution in February 1998. GAD say:

This initially gave me some concern that it had not been formally introduced at the time that GARs first began to bite, in 1993. However, I have now found a copy of 1993 board minutes that clearly explain that for recurring [single premium] pension GAR contracts, “the amount of final bonus payable is reduced by the amount, if any, necessary such that the annuity secured by applying the appropriate guaranteed annuity rate to the cash fund value of the benefits, after that reduction, is equal to the annuity secured by applying the equivalent annuity rate in force at the time benefits are taken to the cash fund value of the benefits before such reduction”. This would seem to adequately demonstrate that the Board were cognizant and had taken action on this matter at the earliest moment that it became relevant.

GAD note that Equitable have argued that if they lost the case they would seek to spread the cost of providing benefits at a higher level amongst policyholders with an annuity guarantee and ensure that payouts to policyholders without such guarantees were not affected. Against this, an official has written ‘good grief’. GAD comment that it is unlikely that the Court would ignore consideration of policyholders’ reasonable expectations or ask FSA to consider this aspect. (Note: comments on their note (Why?) suggest others did not agree with this assessment.)

GAD suggest that they and FSA should clarify why Equitable were asking the Court to consider their practice up to 31 March 1999, as their subsequent practice was also likely to be questionable. GAD suggest that they should also clarify the extent of the Personal Investment Authority Ombudsman’s jurisdiction.

FSA and GAD meet the Personal Investment Authority Ombudsman. According to a note made by FSA, the meeting was held at the Personal Investment Authority Ombudsman’s request to discuss jurisdiction over complaints. The Ombudsman explained that Equitable have accepted that the Ombudsman had jurisdiction prior to 1988 but that they could not arbitrate on matters concerning Equitable’s Board policy. While for the most part, complaints about reduced terminal bonus were for the courts to decide, they might still consider complaints of misleading bonus notices. The Personal Investment Authority Ombudsman said that they ‘would only look at PRE in terms of misrepresentation – eg if Board deliberately did not change bonus notices even after the Board had decided to adopt a differential [terminal bonus] policy’.

FSA’s Chief Counsel A comments that the note had not been cleared with her and was not entirely accurate.

GAD send FSA some thoughts on what position FSA should take if the High Court referred the  issue of policyholders’ reasonable expectations (in relation to Equitable’s differential terminal bonus policy) to FSA. GAD say:

… taking account both of the relative ambiguity of the material presented to policyholders and also the Equitable’s long-stated position on the financial management of the society (with no estate being maintained), their position that GAR policyholders should receive benefits equivalent in value to asset share (except where the guaranteed fund applied at the GAR provides larger benefits) is tenable on both counts. While they could have reached an alternative position that gave some higher benefits to these policyholders, I would doubt that we could insist on this if we apply the above test.

GAD note:

Equitable do appear to have … informed policyholders of their change of practice on the application of GAR’s, in annual bonus notices, and each policyholder does have the right to cancel the contract and switch to another provider.

Against this FSA have written: ‘No – this is [very] much debatable’.

GAD also discuss the extent to which illustrations of final bonuses give rise to an expectation of how the GAR would be applied. GAD doubt that a reasonable policyholder would interpret the illustration as being binding in all circumstances. GAD suggest that a more plausible approach would be to regard the final bonus as variable ‘in line with underlying investment conditions but not otherwise’ or variable ‘subject only to smoothing over some reasonable period of time’.

FSA ask PIA if they had yet come to a view on whether they could consider information given to holders of policies bought before 1988.

FSA also ask if PIA had jurisdiction in relation to annual bonus notices issued to policyholders, for both pre- and post-1988 policies. FSA explain that they have: ‘for sometime been unhappy with the format of Equitable Life’s bonus notices because we think that the way terminal bonus is indicated is potentially mis-leading. A figure is quoted for terminal bonus and this is then added to the guaranteed benefits under the policy to give a total benefits number. You have to read the notes over the page to appreciate that terminal bonus is not guaranteed’.

FSA say that the annuity guarantee issue has again focused their attention on the issue ‘because it is arguable that the format of the notice would have encouraged policyholders to think that their guarantee would apply to the full fund including terminal bonus’. FSA ask if PIA had any powers to require Equitable to change their bonus notices.

In response, PIA comment that bonus notices were not advertisements but were still communications which could be potentially misleading. PIA consider that it would be easy to argue that notices were issued in the course of relevant business, although this only applied to those issued after 18 July 1994, when Equitable had become a PIA member. PIA also consider that any explanation by Equitable of options available on maturity would be caught by PIA’s rules.

PIA conclude that it would be worth looking at the current bonus notices and ask FSA for a copy.

Equitable write to GAD in reply to their letter of 27/05/1999.

Equitable provide details of the reductions in the assumed take-up rate for the annuity guarantee in each class of business and the reasons for those reductions. Equitable explain that the adjustments combined to produce the overall proportions set out in GAD’s letter of 27/05/1999.

Equitable state:

The reinsurance offset has been calculated assuming that any guaranteed benefits taken in guaranteed annuity form above 25% are covered by the reinsurer to be paid back from future surpluses. The value of the deposit premium of £400,000 pa has been calculated assuming it increases in line with [the retail prices index] and has been deducted from the reinsurance offset. The risk premium of 2% of any outstanding claim amount should the reinsurance be called on is payable out of future surpluses and therefore, as discussed on previous occasions, has not been included in the reserves for guarantees.

Equitable provide the additional information requested in the light of the paper to their Board (see 27/05/1999). Equitable explain that, under the alternative scenario suggested by GAD (see 21/05/1999 [entry 1]), cover for the required minimum margin would be 1.4. Equitable confirm that their projections assume a declared bonus at 0.5% below that for 1998 and that there has been no change in the valuation bases. They explain that the projected cash flow is for non-linked and linked business, while the figures for projected solvency related only to non-linked business.

GAD pass a copy of the letter to FSA.

An undated note written by FSA’s Line Supervisor C queries whether Equitable had yet replied to GAD’s letter of 27/05/1999. The Line Supervisor writes:

• What is present bonus notice practice, can we see an example.
• What do they think of how old bonuses were reported, don’t they think they are vulnerable & that it misrepresents PRE. 
  • Did [Chief Counsel A] sort out position of various Ombudsmen ([insurance] v PIA)
  • Need to make clear we are thinking of PRE.
  • Ask Equitable to flesh out scenarios.
  • Have they considered things envisaged in our scenarios.

FSA’s Line Manager D writes to the Head of Life Insurance, outlining her own thoughts on the  implications for FSA, should they have to express a view on whether Equitable’s differential terminal bonus policy was consistent with PRE. The Line Manager explains that FSA’s own legal advice (from Chief Counsel A) was that they should assess if it was ‘reasonable’ to consider that Equitable’s approach was consistent with PRE, rather than whether it was the best possible approach in the context of PRE.

The Line Manager explains that ‘[further] analysis of the policy documentation provided by Equitable could be undertaken ahead of the court case, but it was not considered practical to reach a formal preliminary view on PRE until the court judgment had been digested’. However, Line Manager D indicates her intention to do more work on the PRE issue ahead of the Court case, so that FSA might arrive at a preliminary view relatively quickly after the judgment was given. She adds that, at FSA’s meeting with Equitable the following week, they should remind Equitable that PRE remained a live issue.

Line Manager D also explains that she had asked PIA if they had the power to change bonus notices. The Line Manager comments that these notices were currently the main factor supporting the argument that Equitable’s approach was not consistent with PRE. The Line Manager says:

Even in the context of non-GAO policies the notices appear liable to lead policyholders to have potentially unrealistically high expectations of their total payouts because of the prominence given to the total accumulated benefits figure which includes undeclared terminal bonus. The format of bonus notices is something we have raised with Equitable previously (before the GAO issue arose) but we never made any progress in obtaining changes.

GAD comment to FSA that the note by Line Manager D of 25/06/1999 is a useful summary of the current position and a sensible way forward. GAD send FSA a copy of their thoughts of 24/06/1999 and add that they feel the PIA and/or the Personal Investment Authority Ombudsman might have a greater role to play if there were any suggestions of mis-selling by the sales force.

FSA’s Line Manager D explains to Chief Counsel A that she has not commented on GAD’s thoughts of 24/06/1999, as she did not know where to start or what to make of them. The Line Manager says that she would have expected an actuary to ‘argue from a point of principle what constituted PRE rather than look at what might be a convenient result for FSA’.

FSA and GAD meet Equitable to discuss the implications of the pending Court case. FSA prepare a note of the meeting. FSA note that the policyholder would be arguing his case from a PRE perspective. Equitable maintain that the core of the case would be the scope of the Director’s discretion in relation to bonuses. FSA record that:

The Equitable have thought through various outcomes and their implications, these were different to those envisaged by [FSA], but broadly covered the same alternatives. Referring to the document sent under cover of their letter dated 21 June 1999 their lawyers believed that outcomes 1 and 2 were very likely (complete success or success but with some adverse comment in the judgement). Scenario 6 was deemed “inconceivable” (Equitable approach deemed invalid and final bonus rates on cash and annuity benefits must be equalised at the cash level) because it was thought that a Judge could not totally discount the scope for directors to exercise discretion over bonus levels.

FSA’s note continues:

The financial implications of scenario 6 had been covered in [the Appointed Actuary’s] April Board paper [see 20/04/1999], consistently running down all policyholders’ bonus levels was not seen as a credible option. [The Appointed Actuary’s] initial view if business dried up was that whilst it would be a serious commercial problem it would probably strengthen the solvency of the office. He confirmed that none of the mechanisms discussed in the April board paper for strengthening Equitable’s financial position had been put in place, they were being retained as contingency plans.

In relation to the IRECO reinsurance treaty, Equitable’s Chief Executive tells FSA that, if the court ruling fell between scenarios 1 to 4, the reinsurance would remain in place, as they would not be forced to change their bonus policy. FSA note Equitable as saying:

As a contingency against losing the case the company had been in discussion with reinsurers about increasing the scope of reinsurance cover. [A named reinsurance company] had been prepared to offer a form of surplus relief reinsurance and even offered to take over the company’s existing reinsurance with [IRECO]. However at the eleventh hour [the company’s] Head Office backed off from the proposal claiming “capacity problems”.

Following this the company had decided to wait until the outcome of the Court case before talking to other reinsurers, they did not want to tout around the reinsurance market at such a sensitive time. [Equitable’s Chief Executive] believed that there was room to extend the scope of the existing reinsurance contract if Equitable were to lose the case and that premium rates would be practical and consistent with the existing treaty. GAD made the point that any extension in the scope of these treaties could have implications for the size of the company’s future profits implicit item.

FSA stress that:

… even if The Equitable gained a total or partial victory at the Court this would not necessarily be the end of the matter as far as we were concerned; we would need to investigate PRE aspects of the company’s policy. [FSA’s Head of Life Insurance] added that we had some concern about what policyholders had been actually been told in bonus notices and we had not yet reached a view on this. [Equitable’s Appointed Actuary] said that the Court might assume that we have already examined PRE. [Chief Counsel A] did not think that the Court would make such a statement but if it did we would strongly refute it.

Following discussion of the fact that the Personal Investment Authority Ombudsman had relinquished jurisdiction over complaints relating to the Court case, the Society confirms to FSA that ‘[it] had in one or two cases paid unadjusted terminal bonus on biting GAO policies but this had been compensation solely in respect of bad administrative errors the company had made when handling these cases’.

Equitable confirm to FSA that they had adopted a new approach to bonus payments that had been recommended by their lawyers. Under this approach, Equitable ‘award an additional cash sum to policyholders that do not exercise a GAO as opposed to operating the other way around’. Equitable agree to send FSA their latest bonus notice and accompanying literature.

FSA record that:

[Equitable] confirmed that despite the bad publicity business was holding up well, in the first quarter single premium business was up 8% and annual premium business was down 8%, CAT marked ISAs were also selling well. There had also been no increase in lapse rates. [Equitable’s Chief Executive] regarded his sales force as an important asset and a crucial indicator of the health of the company, turnover of sales staff was still very low. He was concerned for presentational reasons at the lower S&P rating, although he argued that A+ was still a very creditable rating. The lower credit rating was less of an issue for a non  [independent Financial Adviser] provider such as The Equitable and was considered unlikely to have a direct impact on company financially.

FSA also record:

[Equitable’s Chief Executive] confirmed that the company would continue to offer “good value” to policyholders by paying out as much as possible in bonuses. The company would not be building up any hidden estates, e.g. by reducing surrender values. The lack of an estate was a useful deterrent against predators who wanted to demutalise the Society, but this was a secondary outcome from the main historical objective of the Society, which was to pay out fair shares. [He] confirmed that a number of suitors had approached the company but he had told them that the company was committed to mutuality.

(Note: in an interview with the FSA’s Baird Inquiry, Chief Counsel A said that, following a meeting with Equitable (which the Baird Report believed to have been the meeting referred to in this entry), she had provided oral advice to FSA and GAD, which had been that: ‘… it is probably true to say that if the Court takes a Chancery approach to this matter, that will favour the Equitable’s position but, make no mistake, this is very high risk for the Equitable. You can never predict judicial outcomes. At the High Court level, they are more likely to get a judge who would take a Chancery approach, but we can’t be certain about that. Courts are more and more inclined now to take a wider policy approach to these matters. There is no relevant case law. If Equitable get the wrong panel or the wrong judge, they could find themselves on the receiving end of a change in judicial approach. The Court … might not like what the Equitable has done and might be influenced for that reason. Don’t jump to conclusions on this’.)

The proceedings in the High Court begin.

Equitable’s solicitors send FSA copies of the opposing skeleton arguments and supporting affidavits, and a witness report prepared for the Court by an independent actuarial expert.

The actuarial expert sets out the background to Equitable’s practice on annuity guarantees and their differential terminal bonus policy. He explains the concept of policyholders’ reasonable expectations drawing on ICA 1982, the terms of the Minister’s statement to Parliament in February 1995, HMT’s letter of 18/12/1998, GN1, the first report of the F&IA joint working party on policyholders’ reasonable expectations and a statement by the F&IA in March 1999. In summary, the actuarial expert notes:

Generally HM Treasury regards it as appropriate for GAR policyholders to meet the perceived value of that guarantee, in some cases through some reduction in final bonus, subject to the wording of the contract and how it has been presented to policyholders.

The actuarial expert says that Equitable’s Appointed Actuary’s interpretation of the Society’s policyholders’ reasonable expectations is that they would each receive their smoothed asset share and that Equitable would make a full and fair distribution. He considers this interpretation to be fair and reasonable. He notes that, as Equitable have no estate, if policyholders with annuity guarantees were to receive more than their fair share this could only be at the expense of other policyholders and their reasonable expectations.

The actuarial expert considers Equitable’s documentation (policy documents, Article 65 (see 01/10/1998), With-Profits Guides, bonus notices, annual statements, illustrations and statements and reports contained in Equitable’s annual accounts). He concludes that ‘the PRE to which they give rise is that policyholders will receive a fair return as represented by smoothed asset shares’.

The actuarial expert charts Equitable’s bonus payments from 1989 to 1998. He concludes that Equitable’s approach to the smoothing of investment returns had been satisfactory and that there had been no abrupt change in practice and no inconsistency with PRE.

The actuarial expert concludes that he could see no basis for criticising Equitable’s approach to policyholders’ reasonable expectations or the determination of final bonuses for GAR policyholders. The expert notes the statement by Equitable’s Appointed Actuary that if GAR policyholders did expect that they should receive the same final bonus, irrespective of the form in which they took their benefits, he would nevertheless recommend to the Directors that they did not change their current practice. The expert considers this to be a fair and reasonable approach for the Appointed Actuary and the Directors to take. FSA produce a further scenarios paper. This discusses, in slightly more detail, the three scenarios identified in the paper circulated by Line Manager D on 14/06/1999.

Line Manager D sends a copy of the paper to Managing Director A. She sets out Equitable’s differential terminal bonus policy and the background to the proceedings. The Line Manager explains:

… unless the judgement definitely settles the matter, we will need to undertake a significant exercise to determine whether we should intervene to ensure that Equitable Life’s approach is consistent with PRE pursuant to our powers under the Insurance Companies Act 1982.

In reaching a view on PRE we consider that we will need to address the following series of questions:

a) What is/was Equitable’s payment practice?

b) In objective terms, what would policyholders as a class have expected?

c) Is there a difference between the company’s practice and policyholders’ expectations?

d) Were policyholders’ expectations reasonable in all the circumstances?

e) If policyholders’ expectations were reasonable, is intervention action by FSA warranted to ensure that policyholders’ interests are met?

The Line Manager adds:

[PIA] are considering the presentation of Equitable Life’s bonus notices. It appears to us that the notices may be misleading to policyholders because of the emphasis they place on the projected total fund value which includes terminal bonus although it is not guaranteed.

Line Manager D attaches to her note a list of suggested responses to possible press enquiries. In answer to the question: ‘What would be the implications for Equitable if they lose?’, she writes: ‘Would not expect the judgement to have a significant impact on the level of reserves the company needs to hold to cover its liabilities to policyholders’.

GAD write to Equitable in response to their letter of 25/06/1999. GAD explain that they  intend to defer consideration of Equitable’s justifications for the proportions of policyholders assumed to take benefits in guaranteed annuity form until after the Court case. GAD caution that they still have some difficulty in accepting that reductions of between 17.5% and 30% are consistent with the ‘few percentage points’ referred to by the Government Actuary in DAA11 (see 13/01/1999 [entry 2]).

In response to Equitable’s projections of their financial position, GAD note that no material changes are assumed in the valuation bases used in the resilience scenario, other than taking due account of changed investment yields. GAD recognise that the figures quoted in the Society’s Board paper (see 04/05/1999) relate only to non-linked business. GAD note the indication of the potential outcome in the suggested scenario.

Equitable write to GAD in reply to their letter of 15/07/1999. Equitable say that the Government Actuary’s letter of 13/01/1999 contains several references to relaxing the assumption of a 100% take-up of annuity guarantees and that:

The letter does not imply that the combined effect of all relevant factors should be “a few percentage points” but that each factor should be considered individually.

Equitable also point out that the letter refers to the allowance being ‘a few percentage points of the reserve’ rather than of the assumed take-up rate. Equitable conclude:

Looked at in that way, even for the retirement annuities, where I have assumed the lowest take-up rate of 70%, the effective reduction in the overall reserve is less than 10%. That would seem to put a rather different light on the reserving assumptions.

FSA meet PIA for a Supervisory Co-operation Meeting. The aim of the meeting is to discuss ways in which they could more effectively supervise firms for which they have joint responsibility. Equitable were selected to be used as an example to see in which areas information could be shared and how it should be communicated. FSA highlight what they feel are the differences between FSA and PIA’s visits to companies, those being:

• [FSA’s] visits usually took the form of a half-day meeting spent in the boardroom with top management, as opposed to the 50-80 man-hour visits carried out by PIA on the “shop floor”.
• [FSA] had the advantage of a more objective third party contact at the firm in the [appointed] actuary. PIA’s contact, the compliance officer, was often from an ex-sales background and the fact that his salary was paid by the firm automatically made him less objective.
• Within [FSA], there was a greater emphasis on the Policyholders’ Reasonable Expectation aspect of the process.

The note of the meeting records that ‘[generally], it was agreed that Equitable Life was easier than many other companies to regulate because the company worked to high standards, had good quality personnel and staff turnover was low’. It is noted that PIA Investigations were soon to visit Equitable, as part of a themed visit programme on income drawdown products.

FSA and PIA decide that, in five areas, it would be possible to share information about Equitable, including:

1. PIA felt that they would benefit from information on the issue of solvency – because this impacts on risk … and affects how much new business the company can afford to sell and how much pressure is put on salesmen.
2. [FSA] felt they would benefit from more “nuts-and-bolts” type information on products and their selling gained by PIA.

GAD write to Equitable and a number of other companies. GAD explain that they intend to introduce changes to the ‘valuation of liability’ regulations in ICR 1994, but that, before making recommendations to HMT, they were writing informally to a range of companies seeking further information.

GAD add that they are considering changes to the regulations to introduce a new method for assessing an appropriate yield on equities when determining the valuation rate of interest and corresponding changes to the resilience test. GAD attach a draft letter which is to be sent to all Appointed Actuaries which explains this in more detail. (Note: The attached letter was not held on file. It has been suggested to me that this was a draft version of DAA12 which was later issued on 30/09/1999.)

GAD seek to arrange a meeting with Equitable to discuss the proposals and invite written comments in advance of this.

Equitable write to GAD in reply to their letter of 17/08/1999. Equitable comment on the changes to the liability regulations. Equitable acknowledge that a non-contractual surrender value (for example, a transfer or early surrender) is the surrender value a policyholder would reasonably expect. However, Equitable point out that they make clear that they do not guarantee a non-contractual surrender value and that, on occasion, they have ‘found it appropriate to apply an adjustment so as to protect the interests of the remaining with-profits policyholders’. Equitable express concern that the proposed Regulation 72 might require companies to hold reserves for non-guaranteed payments on accumulating with-profits business at or above the level held for guaranteed payments.

Equitable also comment on proposed changes to the resilience test. They express concern that the new test 2, contrary to the advice from GAD, might be more, rather than less, severe and that this also would require companies to hold increased reserves.

GAD write to Equitable in reply to their letter of 27/08/1999.

GAD point out that the surrender value a policyholder might reasonably expect depends on ‘the representations made to policyholders by the Society, either at the inception of the contract or through subsequent bonus notices or illustrations’. GAD accept that, accordingly, in the circumstances Equitable describe the reserves required by Regulation 72 could be lower than a policyholder’s asset share.

GAD dispute that the new resilience test 2 is more rather than less severe.

c31/08/1999 FSA’s files contain an undated ‘Initial Risk Assessment’ of Equitable as part of a new approach to company assessment. (Note: according to the Baird report, the assessment is prepared by FSA as part of a pilot for the introduction of risk assessment for all companies. It is based on already available information.)

FSA’s overall assessment is that Equitable are a high financial risk because of the level of benefits guaranteed to policyholders, the low free asset position and the difficulty in raising external finance. FSA note that Equitable are vulnerable to a sustained fall in equity prices. FSA assess organisational, strategic and management risks as low. Environmental risks are also low, with the exceptions of regulatory risks (as the effect of stakeholder pensions on the company’s business is uncertain) and reputational risk (as a result of the current dispute over how the costs of annuity guarantees are met).

FSA discuss Equitable’s management. FSA comment that Equitable have a ‘tendency to arrogant superiority’, which could blind them to the financial risks of guaranteeing high benefit levels. However, FSA note that Equitable are open with them and that ‘there are no particular concerns about the level of co-operation that has been shown in the past’. FSA state that Equitable generally have a good record of compliance with both the prudential and conduct of business regulators.

FSA discuss Equitable’s solvency position. FSA note that Equitable’s relatively low free asset position, together with their mutual status and policy of declaring high reversionary bonuses, means that they are ‘highly vulnerable’ to a change in economic circumstances. FSA state that Equitable have taken heed of their concerns about the level of bonuses and taken steps to reduce these this year; further reductions would be needed in future years. FSA note that Equitable use future profits implicit items and have already issued close to the maximum admissible subordinated debt. They state that Equitable have set a reserve of £1.5bn in respect of annuity guarantees, half of which is covered by the reinsurance arrangement, but say that it is arguable that this should have been higher.

FSA conclude that Equitable have a strong reputation in the insurance market, which could be tarnished by the outcome of the Court case. Against this, an official has written ‘already tarnished’.

GAD’s Pensions Policy Section write to Equitable to explain that they have been contacted by holders of Equitable’s income drawdown policies who had seen the maximum income they could withdraw cut considerably at the first three year review. GAD say it appears that the policyholders have been told that this is due to the actions of GAD (who prepare tables against which maximum and minimum amounts of withdrawal are determined). GAD ask Equitable to not give such a misleading impression, pointing out that the basis of the tables had not changed, and that the cuts had occurred because falls in gilt yields had not been matched by investment returns in the funds.

(Note: Equitable’s sales of income drawdown policies were being investigated by PIA at the time. The matter was discussed briefly at the meeting on 06/12/1999 and then became the subject of further correspondence from 08/02/2000.)

Judgment is given in the High Court. The ruling is that Equitable are entitled to operate their differential terminal bonus policy. The representative policyholder is given leave to appeal.

GAD send FSA some thoughts on the judgment, particularly in relation to PRE. GAD interpret the judgment as saying that policyholders who selected an annuity at a guaranteed rate in 1994, or shortly after, may have had a reasonable expectation that they would receive a final bonus based only on accumulated investment returns and to which the guaranteed annuity rate would apply. GAD suggest that FSA might need to consider whether to intervene in respect of those policyholders whose expectations had not been met. GAD query if FSA would be expected to express any views to the Court of Appeal.

FSA’s Chief Counsel A provides a summary of the judgment in the High Court by the Vice-Chancellor. The Chief Counsel describes as very significant the recognition that policyholders might have a reasonable expectation of benefits over and above contractually guaranteed benefits.

Chief Counsel A notes that, on the issue of breach of contract, the Vice-Chancellor had found against the representative policyholder, in that the effect of Equitable’s policy and practice was to allocate final bonuses to GAR policyholders on a conditional basis. She also notes that FSA have some evidence that ‘on maturity and when options were being discussed with policyholders, the Equitable did not tell policyholders in terms that terminal bonus was conditional’. She states that this was a matter for PIA.

Chief Counsel A notes that, on the exercise of discretion, the Vice-Chancellor had found that GAR policyholders had a reasonable expectation that they would receive full terminal bonus with a GAR annuity, but that a reasonable expectation did not become a contractual right. Policyholders’ reasonable expectations were one of several factors to be taken into account by Equitable’s Directors. The Vice-Chancellor had not accepted that, in making their decision, Directors had failed to take their previous practice into account.

In assessing the implications of the judgment for FSA, Chief Counsel A states:

… based on the evidence we have examined so far, we would be likely to come to the same conclusion [that policyholders had a reasonable expectation that they would receive full terminal bonus with a GAR annuity] … The next step then, would be for us to consider whether, under section 45 of the Insurance Companies Act 1982, action should be taken to ensure that the criteria of sound and prudent management are fulfilled. These criteria, in Schedule 2A to the Act, include:

a) carrying on the business of the society with integrity (para 1); and

b) conducting business with due regard to the interests of policyholders and potential policyholders (para 7).

The [Vice-Chancellor] concluded that the directors of the Equitable had properly had regard to PRE; the question for us goes beyond that and is whether sufficient or due regard was had to PRE.

As we have already discussed, if we were to take the view that due regard was not had to PRE, there is real awkwardness in taking action against the Equitable for all sorts of reasons (which I won’t go into here) including the need to rely on grounds which are primarily directed at good management, soundness and prudence, rather than conduct of business as such.

Chief Counsel A adds that there was ‘also a PIA “ring” to this case’, although she could not comment on the extent to which PIA could or should get involved.

(Note: in April 2001, Chief Counsel A was questioned by the FSA’s Baird Inquiry on the point quoted above that ‘there is real awkwardness in taking action against the Equitable for all sorts of reasons (which I won’t go into here)’. The transcript of that interview records that Chief Counsel A had explained that:

In … my summary of the Scott judgment, I say that if, assuming the Scott judgment not to have been appealed, that we were to have done our investigation and taken the view that due regard was not had to PRE – obviously, Scott himself took that view … that PRE had been breached – that in that context it had not been properly considered, there would be a real awkwardness in taking action against the Equitable, for all sorts of reasons which I won’t go into here, and I didn’t go into in this note because it had been copied around to all and sundry around FSA and it didn’t seem to be either the time or place to get into that sort of analysis, including the need to rely on grounds which were primarily directed at good management, soundness and prudence, and I said that there was a PIA “ring” to the case, and part of the reason for that was that Scott found that there had been [a] breach of PRE, not with respect to the contract itself, but rather with respect to point of sale documentation and post-point of sale documentation. As soon as you get into that area, obviously someone concerned with prudential regulation starts thinking, “This is starting to feel a bit like conduct of business, getting a bit uncomfortable from the point of view of applying criteria of sound and prudent management”.

I think that there was still good argument to be made there, that what the Equitable had, was doing, was a sort of globally applied management policy; the arguments were there to be made. But, for me, there was an area of discomfort beginning to creep in. In addition, when the starting point is that the contractual relationship was perfectly fine, legally speaking, but rather PRE was to be derived from the bonus notices and so on, then you are also getting into a situation which is starting to look more like misrepresentation. You start getting into an analysis which is along the lines of, “Well, they didn’t have any PRE when they signed up to the contract, but instead that PRE began to build up post-contract. Well, it couldn’t have affected their decision, or might not necessarily have reflected their decision at point of sale, but that perception increased returns developed as time went on”.

How do we as a Regulator respond to that? It starts to look as though the analysis is one of misrepresentation and reliance, and then you start asking yourself about loss, then you start asking about what intervention would be appropriate in that sort of situation, particularly taking into account the interests of other groups of policyholders.)

Chief Counsel A notes that Line Manager D has decided to defer reaching a decision on whether to take action pending the appeal. The Chief Counsel suggests, however, that FSA check if PIA were adopting the same position.

GAD’s Directing Actuary B informs FSA that his understanding of the judgment in relation to policyholders’ reasonable expectations differs slightly from those of the Director of Insurance and Chief Counsel A. The Chief Counsel advises the Directing Actuary that, in her view, ‘the Court clearly found that PRE had not been fulfilled for holders of GAR options (but the Court also held that that was OK)’.

FSA write to PIA. FSA say that they are keen to look at the issues arising from the judgment from the perspective of all the FSA constituent bodies, and that any possible action should be considered in the same way. However, no action should be decided or initiated until the Court of Appeal’s decision is known.

FSA pass to GAD details of the changes to Equitable’s Republic of Ireland branch. They suggest that the changes are uncontroversial but seek GAD’s views. FSA add:

… more importantly we still have the implicit item concession outstanding [see 06/07/1999]. We probably need to make a decision on this as it looks unlikely that the Court decision will be appealed during 1999.

FSA ask GAD when they expected to complete their scrutiny of the Society’s 1998 returns. In

response, GAD explain that their detailed scrutiny report had been submitted to FSA on 20/05/1999. GAD say that no questions of the ‘conventional kind’ had been raised with Equitable but that GAD had left two points outstanding. The first is further consideration of the final terms of the reinsurance treaty. GAD ask if Equitable have yet sent the final wording. The second is the assumptions made by Equitable when reserving for annuity guarantees. GAD refer to the exchange of correspondence from 27/05/1999 and say that GAD need to consider Equitable’s last letter of 19/07/1999.

FSA write to Equitable to arrange a company visit, pointing out that it is nearly three years  since the previous one (see 08/11/1996 [entry 2]). FSA note that much of the contact in the last year had been on the issue of guaranteed annuities and that now would be an opportune  moment to discuss Equitable’s overall position and future plans. FSA set down six matters they would expect to cover:

1. Overview of corporate management structure of Equitable Group.

2. General market outlook and business strategy.

3. Marketing approach including product development and distribution.

4. Role of the Appointed Actuary.

5. Systems and Controls.

6. Investment Policy and Asset Management.

PIA write to FSA, having reviewed a selection of Equitable’s bonus notices that FSA had provided to them. PIA tell FSA that they had concluded that the Society’s notices were not poorly presented or inaccurate. As a result, PIA did not intend to pursue Equitable for a breach of the requirement that anything said, written, sent, given or shown to a policyholder or potential policyholder should be clear, fair and not misleading.

PIA add that they have not previously pursued a company in relation to this requirement as PIA’s scope:

… covers the activities of dealing, arranging deals in, managing and advising on certain types of investments. The ongoing servicing of policies does not seem to fit comfortably within these activities. And we would therefore have to have serious concerns about a document issued in the course of servicing a policy to attempt to breach the firm concerned.

FSA note: ‘A surprisingly unqualified endorsement for the bonus notices’.

GAD write to FSA about Equitable’s application for a section 68 Order (see 30/03/1999 [entry 3]). GAD confirm that ‘the calculations provided are in line with the guidance and that the figure of £2,960m appears to be a fair estimate of 50% of “Estimated Future Profits”’. GAD say that the amount sought (£1,000m) was about a third of the maximum amount that could have been claimed (£2,960m), and substantially less than the amount approved in 1998 (£1,900m). GAD advise FSA that they ‘have no real doubts that such a sum can be reasonably accepted by the FSA’.

However, GAD suggest that FSA should ask the Society’s Appointed Actuary to certify:

… that the amount applied for does not exceed the present value of future profits that may be expected to arise in the future on the long term business in force on 31 December 1998, in excess of sums that may be required to meet claims recovery premiums payable under the [reinsurance] treaty ….

GAD advise FSA to take the opportunity, when doing this, to ask for a copy of the reinsurance treaty as finally signed.

In the same note, under the heading ‘Returns as at 31 December 1998’, GAD comment on the reserving assumptions made by Equitable in respect of GARs, following their letter of 19/07/1999:

We are not inclined to take this matter any further at this time, even though we remain somewhat uncomfortable that [Equitable’s] assumptions are not fully in line with expectations based on our interpretation of the [Government Actuary’s] letter on this subject, since, with the reinsurance now in place, a stronger interpretation would raise the Society’s gross liability but not its net liability. (It would of course raise to a modest degree the [required minimum margin] of the Society.) The topic could be discussed again at the proposed FSA visit.

GAD conclude that they ‘now consider [their] scrutiny of these Returns to be closed’.

On the same day, GAD advise FSA that they have no objections to Equitable’s changes to the requisite details of their Republic of Ireland branch.

The Scrutinising Actuary notes the conclusion in the judgment that GAR policyholders had a reasonable expectation that they would receive full terminal bonus with a GAR annuity. The Scrutinising Actuary points out, however, that this conclusion only referred to the period ‘up to 1994 and perhaps for a while thereafter’ and that the practice followed by Equitable, up to 1994, had been consistent with this. He cites subsequent comments in the judgment which suggested that there was no basis for policyholders taking benefits in fund form to have a similar expectation, or for policyholders to expect Equitable to apply the same rate of bonus to all policyholders.

Scrutinising Actuary E cites a further comment in the judgment that there was no basis for concluding that Equitable had failed to take into account policyholders’ reasonable expectations when exercising their discretion regarding final bonus.

Subject to some doubts about what was done ‘for a while’ after 1994, Scrutinising Actuary E concludes that: ‘On the basis of this judgement, it would seem to me that sufficient or due regard was and continues to be given to PRE’.

FSA and PIA hold their fourth bilateral meeting. FSA’s Line Manager D explains the implications of the court judgment for both FSA and PIA. The minutes of the meeting record that:

Although the judgement was in favour of the Equitable, the [FSA] view is that although Equitable had regard to PRE they did not meet it so there is the possibility of intervention. In terms of Conduct of Business issues there may for example be misleading bonus notices supplied to investors or firms may have churned investors into new contracts without guarantees.

Equitable confirm to FSA that they are happy to include GAD’s suggested wording  (24/09/1999) in their application for a section 68 Order.

On the same day, Equitable seek a section 68 Order to allow them to raise the limit on the admissibility of share holdings in the returns from 2.5% to 5% for the stocks of four companies.

c20/10/1999 In an undated note, FSA write to GAD suggesting some proposed wording in response to Equitable’s request of 14/10/1999 regarding limits on the admissibility of share holdings. FSA also request that GAD should review the final version of the reinsurance treaty recently received from Equitable.

FSA write to Equitable in response to their letter of 14/10/1999. FSA explain that they have  put together a formula to consider requests for section 68 Orders to raise the limit on the admissibility of share holdings. FSA ask Equitable to apply the formula to each of the companies concerned. (Note: In an earlier draft response, FSA had suggested that Equitable should make their application in mid-November when GAD would be in a better position to assess it.)

FSA advise GAD of a meeting held that day with PIA to discuss the annuity guarantees issue and Equitable.

FSA explain that PIA are likely to conclude that they do not have the power to act in relation to any misleading bonus notices, as these were not marketing literature. As regards the sales process, PIA needed to establish if there was a material number of policies in their remit to justify an investigation. To this end, FSA would write to Equitable to ask about the number of policies sold after April 1988, when the FS Act 1986 came into force, and the number of top ups sold after June 1988, when Equitable had stopped selling the basic contract written to provide an annuity at a guaranteed rate.

FSA explain that PIA needed to consider the position of other companies. To this end, FSA ask GAD to provide information on companies’ exposure to annuity guarantees, drawn from the responses to the survey in 1998 (see 20/06/1998).

GAD advise FSA that the revised certificate for the section 68 Order was exactly in the form required.

GAD confirm that the reinsurance agreement:

… is totally in accord with the Draft Term Sheet that was examined in detail in April. [It is my understanding that the construction of the reinsurance agreement as set out in the draft term sheet was considered to be acceptable at that time.]

FSA ask Equitable how many policies with GARs the Society had sold after 29/04/1988 when the then current conduct of business regime under the FS Act 1986 came into force. FSA also ask how many GAR policies had been ‘topped up’ after April 1988 and if top ups were still being made in 1994 and more recently.

November 1999 GAD send FSA their annual report on the life insurance industry for the year ending 31 December 1998. The report follows a similar format to that used for previous years.

In the Executive summary, GAD note:

Once again, the low level of income yields available and the modest growth seen in dividends makes it likely that the strong investment performance of 1998 will only really enhance the free assets of those companies that entered the year already in a healthy position. Further, it is important to recognise that for companies paying terminal bonuses, a proportion of their reported free assets are in fact needed to cover their obligation to provide these bonuses (in respect of which there is no requirement under the regulations to establish explicit reserves) and that apparently increased free assets are in fact largely needed to cover increased hidden obligations to provide these bonuses.

In the section on ‘Free Assets’ and under the heading ‘Economic Background & Impact on Life Offices’, GAD’s report states:

A standard UK life office would be expected to have secured a rise in capital value of assets of about 10.5% over 1998, an income return of about 4.5% and a total gross investment return in the region of 15.0%.

Nevertheless:

Since prospective yields have again fallen substantially over the year, valuation interest rates will need to have been reduced further - raising the amount of the disclosed liabilities for all conventional contracts. This in turn will have had an upward impact on required minimum margins. It also remains clear that recent bonuses declared under at least some accumulating with-profit contracts, and those bonuses that seem likely to be declared in the future, are being supported partly by capital gains. To be prudent, most bonus enhancement should be paid in terminal form, and reversionary bonus rates reduced.

Once again, the low level of income yields available and the modest growth seen in dividends makes it likely that the strong investment performance of 1998 will only really enhance the free assets of those companies that entered the year already in a healthy position. Further, it is important to recognise that for companies paying terminal bonuses, a proportion of their reported free assets are in fact needed to cover their obligation to provide these bonuses (in respect of which there is no requirement under the regulations to establish explicit reserves) and that apparently increased free assets are in fact largely needed to cover increased hidden obligations to provide these bonuses.

In commenting on the free asset ratios of individual companies, GAD say that Equitable ‘purports to carry out a bonus reserve valuation but, in practice, this gives effectively the same answer as a net premium valuation’.

On maturity payouts for a 10 year endowment policy, GAD report that Equitable and another company show the largest falls in payouts over the five years to 1998. For a 25 year endowment policy, GAD report that Equitable remain ‘among the poorer performers’. In relation to surrender values, however, GAD note that Equitable and four other companies ‘all show to advantage’.

Unlike in previous annual reports, GAD’s annual report to FSA does not include a comparison

of maturity payouts against their own calculations of theoretical asset shares. However, GAD’s report still provides a review of maturity payouts across the industry. An appendix to the report shows that, for an endowment policy with contributions of £50 per month for 10 years, Equitable’s maturity payout value is shown as £9,681, against a with-profits industry median

of £9,825. For an endowment policy based on contributions of £50 per month for 25 years, Equitable’s maturity payout value is shown as £84,418, against a with-profits industry median

of £104,049. For a pension policy based on contributions of £200 per month for 15 years, Equitable’s maturity payout value is shown as £98,303, against a with-profits industry median

of £103,790.

I have seen that GAD still undertake their own analysis comparing maturity payouts to their estimates for the theoretical asset shares. Continuing their previous work, they prepare the following charts:

Unlike in previous years, GAD do not appear to have undertaken an analysis of maturity payouts to theoretical asset shares for individual companies.

(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’.)

FSA provide a note to the Insurance Supervisory Committee, recommending that HMT should approve Equitable’s application for a section 68 Order for a future profits implicit item of £1bn, for possible use in their 1999 returns.

By way of background, FSA explain that:

The company whilst solvent is not highly capitalised, this is mainly because the company has a policy of distributing a high level of the company’s profits to policyholders. This has meant that the company has not built up an estate.

FSA refer to Equitable’s high profile due to their potential exposure to annuity guarantees and to the court case. FSA explain that Regulation 24 of ICR 1994 specifies the basis of calculation for an implicit item and that:

We have routinely given Section 68 Orders to companies for future profit implicit items provided that we have been satisfied that the basis of calculation provided for in Regulation 24 has been correctly carried out …

Under their analysis of the application, FSA explain:

Whilst there is still some debate at the margins between the company and GAD relating to the precise reserve for the GAOs, we are generally satisfied that the company is adequately reserved for this exposure. The reserve for the GAO exposure has been largely offset through reinsurance.

FSA note that Equitable face the threat of the appeal. However:

… any Court decision on this issue should not effect the financial position of the Equitable as shown in the HMT Annual Return since our Regulations require the company to reserve fully for all GAO policies in any case.

FSA state that Equitable’s detailed calculations show that Equitable could have qualified for a future profits implicit item of almost twice that applied for. FSA note that GAD have reviewed the calculations and ‘are content that the concession should be granted’.

Equitable write to FSA in response to their letter of 29/10/1999. Equitable explain that they would in due course provide details of policies sold between 29 April and 30 June 1988. Equitable seek clarification of what FSA mean by ‘topping up’.

Equitable refer also to the proposed company visit, now arranged for 06/12/1999, and the forthcoming Court of Appeal hearing. Equitable explain that, at the company visit, they think it would be helpful for FSA to meet the general managers responsible for marketing and investment, in addition to the Appointed Actuary and the Chief Executive. Equitable caution that the Court of Appeal judgment might be delivered on 6 December 1999 and thus that they might have to postpone the visit. Equitable undertake to send copies of the skeleton arguments for the hearing as they become available.

GAD write to FSA in response to their request for information on companies’ exposure to annuity guarantees. The information is drawn in the main from companies’ responses to the survey commissioned by GAD in 1998 (see 20/06/1998).

GAD state that the information suggests seven companies which PIA might further investigate. Equitable are one of these.

GAD explain that the seven companies sell predominantly through a direct sales force, sold products with annuity guarantees after 1988, and are those who, in response to GAD’s annuity guarantee survey, had answered ‘No’ to either or both of the following questions:

• ‘On with profits [contracts] with an annuity guarantee, do you make a general allowance for the guarantee when establishing maturity values.’
• ‘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.’

FSA write to Equitable to seek the following information prior to the visit on 06/12/1999:

(1) Equitable’s latest Financial Condition Report.

(2) Structure charts for the Equitable Group and senior management.

(3) Details of the Board’s sub-committees.

(4) Copies of Equitable’s latest business plan and papers on future strategy.

(5) Details of their investment policy and terms of reference for the Investment Manager.

(6) The latest report from the Investment Manager on fund performance, especially the main fund.

(7) Equitable’s internal audit programme for 1998 and 1999, along with details of any additional special studies conducted in 1999.

(8) Internal audit’s most recent report to the Board/senior management.

FSA request the information by 26 November 1999.

The letter incorporates changes suggested by GAD, who were sent on the previous day a draft on which to comment.

FSA prepare an ‘Overall Assessment’ of Equitable, in the light of information received in response to their note of 21/10/1999 and in preparation for the college meeting on 26/11/1999. FSA assess Equitable as medium to high risk, predominantly due to their exposure to annuity guarantees. FSA say that PIA have assessed the parts of Equitable that they supervise as average risk and that PIA’s Pensions Review Team have identified no particular concerns on Equitable’s handling of the pensions review. FSA note that IMRO have significant concerns and had recently fined Equitable Unit Trusts Managers Limited £80,000 for breaches of IMRO rules in 1998 and had identified further significant compliance issues at a visit in June 1999. Both FSA and IMRO express concern over Equitable’s ‘slight institutional arrogance about being a mutual’.

FSA summarise Equitable’s present financial position, drawing on the initial risk assessment (see c31/08/1999). FSA observe that Equitable have ‘gone too far in distributing surplus to policyholders to the extent that the company is dangerously under capitalised and exposed to a market downturn’. FSA note that Equitable have taken heed of their concerns about the level of reversionary bonuses and have made some effort to reduce them this year. FSA note that Equitable’s reserving basis overall is ‘acceptable (but not particularly strong)’. FSA also note that, while Equitable were not alone in ‘being caught out’ by the annuity guarantees issue, they did not wake up to the issue quickly enough and their unclear communication to policyholders had left them open to criticism.

FSA’s Legal Adviser A passes Chief Counsel A a copy of an unsigned and undated paper, prepared by FSA, discussing the degree to which companies can assume, for reserving purposes, that policyholders choose to take part of their policy proceeds as a cash sum rather than as an annuity at a guaranteed rate.

FSA cite the Government Actuary’s guidance (DAA11 – see 13/01/1999) that assumptions regarding the number of policyholders choosing to take benefits in a form other than an annuity at the guaranteed rate could lead, at most, to a reduction of ‘a few percentage points’ in the reserve. FSA explain that when the guidance was formulated:

… our thinking internally was that up to a 5% reduction in the reserves could be considered to constitute “a few percentage points”. A 5% reduction in reserves generally equates to an assumption that 20% of policyholders take the maximum tax free cash …

However, FSA note that a number of companies have interpreted the guidance as permitting an assumption of 10% of policy proceeds being taken in non-guaranteed annuity rate form. Some companies have gone further, ‘Equitable Life assuming 20% of the proceeds are taken in other forms …’.

FSA note that no action has been taken to criticise the standard of reserving adopted by Equitable (or any other company), and that FSA need to settle their approach before the year end. FSA discuss the possibility of setting a minimum reserving requirement of 90% or 80%. It is noted that the former approach might give the impression that FSA were singling out Equitable for criticism. The latter approach would ‘avoid conflict with Equitable’ but move FSA ‘an unacceptably long way from the reserving level the guidance was originally intended to indicate’.

FSA favour retaining their original interpretation of the guidance, but articulating to companies that there are two alternatives:

• to assume up to 5% of policy proceeds are taken in non-guaranteed annuity rate form; or
• to assume up to 20% of policyholders choose to take the maximum tax free cash permitted under the policy.

Chief Counsel A passes the note to Line Manager D. The Chief Counsel says:

I thought we had required Equitable to reserve at 95%. Or was the difference covered by the reinsurance?

The Line Manager responds that Equitable are as bound by the guidance as everybody else. But that the Society’s interpretation of a few percentage points had ‘proved to be 20%’. The Line Manager says that FSA knew Equitable ‘would go for as high a figure as they thought they could get away with’. The Line Manager says that, as part of the scrutiny of their annual returns, FSA had asked Equitable ‘how they got to an assumption of 20% of the proceeds being taken in non-GAO form’, but, as yet, FSA had not expressed a view on the Society’s arguments as to why this allowance was prudent (see 27/05/1999, 25/06/1999 [entry 1] and 15/07/1999 [entry 1]).

Chief Counsel A comments in turn:

Your paper gives the impression I think that you have implicitly accepted the returns (or decided to do nothing about them).

Equitable write to FSA to provide information in response to each of the eight points set out in FSA’s letter of 15/11/1999.

Under point (1), Equitable provide copies of their letter of 21/01/1999 and the report to their Board sent on 04/05/1999, together with a copy of the latest report to their Board on revenue and solvency matters.

Under point (6), Equitable enclose the latest report to their Investment Committee on the investment performance of the main fund, and updated schedules showing the with-profits fund and linked fund performance to 31 October 1999.

Under point (7), Equitable explain that they have operated a unit called the ‘Systems and Controls Review Group’ which has performed an internal audit role and made regular reports to the Audit Committee. They enclose copies of the Group’s terms of reference, a summary of all its reviews, and copies of reports put to the Audit Committee in October 1998 and October 1999.

FSA and IMRO attend the college meeting (see 21/10/1999 [entry 2]) to discuss Equitable; PIA and their Pensions Review Team send their apologies. FSA prepare a note of the meeting. They summarise IMRO’s actions towards Equitable Unit Trusts Managers Limited. FSA note that IMRO view Equitable Unit Trusts Managers Limited’s­ regulatory history as poor and deem them to be a continuing high risk and thus on a ten month visit cycle. FSA reiterate their observations from the Overall Assessment (see 17/11/1999) and note that FSA intend to fill in some of the gaps in their knowledge at the company visit on 06/12/1999.

The meeting agrees that those responsible for supervising Equitable should remain in touch.

PIA suggest that there are some confusing indicators in the documents, both regarding the ‘Control Awareness’ of the organisation and the extent to which the Society’s Systems and Controls Review Group have tested rather than documented existing control processes.

PIA discuss a range of positive and negative factors indicated by the documents. They conclude:

Overall, like you, I read a few more negatives than positives. I formed the opinion that Equitable realise that maintaining strong effective controls is important to them. They seem to have heard some of the buzzwords about best practice. However, they have certainly not articulated in the documents we have seen that they are approaching this topic in a robust and action oriented manner.

PIA suggest that it would be helpful to explore the role of Equitable’s auditors.

FSA and GAD visit Equitable as a part of the regulators’ rolling programme of company visits. The visit had been arranged on 20/09/1999.

FSA prepare a note of the meeting. This shows that Equitable give an overview of their corporate management structure and explain the role of the Board and the executive management team. Equitable’s Chief Executive reiterates that ‘he was keen to run the company on a collegiate consultative basis (the suggestion had been made that his predecessor had been somewhat autocratic)’.

Equitable discuss the general market outlook and their business strategy. They explain that, when deciding their strategy, ‘the Society did not use return on equity type analysis – it concentrated on assessing how it could meet the needs of clients and potential clients’.

Equitable discuss their investment policy and asset management. They explain that some income drawdown policyholders were upset at cuts in the amounts they could take from their pensions. Equitable suggest that this might be due to the cap imposed by the Inland Revenue. Equitable agree to look at some examples to see if this is the case.

GAD express concern that Equitable’s future projections ‘did not fully take into account the scenario of a long-term stock market depression – which could have severe implications for the society’.

Equitable provide more information about the work of their Systems and Controls Review Group. They also confirm that the reinsurance treaty now covers group business as well as individual business and that this would reduce the gross annuity guarantees reserve of £1.56bn to a net exposure of £560m. FSA warn Equitable that they and the Government Actuary would be writing to companies before the end of the year, outlining more clearly the expected approach to reserving, and that this could mean that Equitable would need to increase their gross reserves.

Finally, Equitable explain that they recognise that declared bonus rates would have to reduce further if the current investment return persisted. However:

… the Society proposed to pause for breath before cutting bonuses further, in order to see if yields would improve. Terminal bonuses were likely to be pushed up, however, if reversionary bonuses remained at 5% since the company would be allocating less than it had earned for the last 4 years.

Following the meeting, FSA and GAD are shown Equitable’s paperless administration systems.

GAD send FSA a draft of a letter from the Government Actuary to Appointed Actuaries  clarifying the guidance on reserving for annuity guarantees.

FSA’s Line Manager D advises the Head of Life Insurance that the guidance ‘looks OK’. The Line Manager suggests that there should be an accompanying letter from FSA to Chief Executives clarifying that FSA would not ask companies to resubmit 1998 returns if they had not been prepared in accordance with the revised guidance.

FSA’s Line Manager D provides Managing Director A with drafts of the letters FSA are preparing to send to all life insurance companies. The Line Manager asks for comments and adds that this:

… latest guidance has been shown to the actuarial profession and accepted by them, so should not be particularly controversial. Those companies that reserved at levels below those now being specified are also not expected to raise … objections (very few reserved significantly below the specified level).

The Head of Life Insurance explains that he now favours a shorter letter to Chief Executives, which does no more than draw their attention to the Government Actuary’s guidance. The Head of Life Insurance explains:

This achieves our objective of clarification, and avoids raising questions of possible future intervention which may not otherwise arise, and some of which I think would need to be brokered more widely within FSA if we wanted to trail them in this letter. This simpler approach also deals with [Directing Actuary B’s] concerns over the role of the profession.

In response, Chief Counsel A comments:

You should be aware that failure to mention possible intervention by way of publication now will make it harder, and perhaps impossible, to publish as proposed next year. Companies would, not unreasonably I think, raise an argument of legitimate expectation based on our past behaviour.

Every Appointed Actuary is sent by the Government Actuary a copy of DAA13. The Government Actuary states that, having reviewed the majority of companies’ 1998 returns, it appeared that some aspects of the guidance in DAA11 (see 13/01/1999 [entry 2]) had been interpreted in a variety of ways. He offers further clarification on the reserving standards that would normally be expected, as ‘it is clearly important there should be consistency in the approach taken’.

The Government Actuary reiterates his view that it would not generally be prudent to assume that policyholders would choose a benefit form that was of significantly lower value than the guaranteed annuity. In DAA11, the Government Actuary had indicated that he would expect any allowance for policyholders making such choices to be limited to ‘a few percentage points’ of the reserve. He now clarifies that he was referring to:

… the total aggregate allowance that might prudently be made for all other benefit forms (whether cash or other forms of annuity) and that in my view an allowance in excess of 5% would not be considered to represent “a few percentage points”.

He acknowledges that there might be a stronger case for an allowance for policyholders taking a proportion of their benefits in a tax free cash sum. However, he says he does not consider it prudent to assume that more than 20% of policyholders would exercise this option. This would equate to a 5% reduction in the reserve, which is itself the maximum that GAD were likely to accept as prudent.

The Government Actuary states that ‘for the avoidance of any doubt’, GAD would expect full disclosure of the proportions of policyholders assumed to take any guaranteed annuity, along with underlying mortality and interest rate assumptions. They would also expect to see prudent allowance made for future mortality improvement.

On the same day, FSA’s Head of Life Insurance sends a copy of GAD’s letter to Equitable’s Managing Director (and to Managing Directors of all other life companies). The letter is in the simpler form favoured by the Head of Life Insurance. FSA ask any company foreseeing difficulties in complying with the guidance to let FSA know of any such difficulties.