2000

The Court of Appeal overturns the High Court’s decision of 09/09/1999 by a split decision, in which the two majority judges give differing reasons for finding in favour of the policyholder. The Court of Appeal finds that Equitable were not entitled under their policies to award differential final bonuses. Equitable are given permission to appeal, and the application of the judgment is suspended in the meantime.

Equitable send FSA a copy of a press release that they have produced, following publication of the Court of Appeal judgment. The press release states that the case had hinged on two key issues; one relating to the nature of the Society’s contracts and the other relating to the way in which Equitable’s Board had exercised their discretion. Equitable set out a table showing the conclusions on these two issues which had been reached by each of the four judges who have given judgment in the case so far:

Equitable say that they ‘took the case to the Courts to establish clarity. This has not yet been achieved’.

FSA advise PIA that the judgment gave no cause for panic. FSA note that the bad publicity was likely to seriously dent Equitable’s sales ‘but that is not a major disaster’. FSA explain that Equitable’s reserving requirement would not be affected by the judgment, so their financial position was largely unaltered.

GAD advise FSA, on the basis of the summary of the judgment they have seen, that most of the advice in the letter of 18/12/1998 would still be relevant for annuity guarantees. GAD note, in particular, that the statement that there could be a reduction in the terminal bonus to reflect the perceived value of the guarantee over the duration of the contract:

… would for example appear to be fully consistent with the comments by [Lord Justice] Waller that the society could reduce the level of final bonus for all GAO policies (but must apply the same amount of bonus irrespective of whether the GAO is selected).

GAD note, however, that the statement that the terminal bonus for policies with a guaranteed annuity might be somewhat lower than the bonus for policies without such a guarantee, and that this terminal bonus could in some cases be applied at current annuity rates:

… would no longer appear to be quite correct (albeit that the advice therein is heavily qualified). In particular, the current practice of a number of insurers whereby the terminal bonus is applied at current annuity rates rather than the GAO would no longer appear to be valid where their contracts are worded and presented similarly to the Equitable’s.

GAD suggest drawing this point to companies’ attention and asking those companies to describe their bonus policy for policies with annuity guarantees.

GAD discuss the possible effect on Equitable if the judgment were to be upheld. GAD note that the number of policyholders choosing a guaranteed option was fairly low, so the cost to Equitable of increasing the benefits to those policyholders so that they received the same terminal bonus should be marginal.

GAD suggest asking Equitable if the reinsurance agreement would remain in place on its present terms and conditions. GAD comment that the recent supplementary advice on reserving (see 22/12/1999 [entry 2]) would now be even more appropriate, as the incentive to take cash rather than a guaranteed option would be much lower as a result of the judgment.

FSA produce in-house briefing notes in anticipation of questions they might receive. In response to the possible query: ‘If the judgement is upheld what will the effect be on Equitable Life?’, FSA’s response is that they:

Would rather not speculate and do not comment on individual companies’ circumstances. However, 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.

In response to the possible query: ‘Doesn’t this show that the FSA failed to act to protect policyholders. Why was it necessary for policyholders to go to court?’, FSA’s response is that:

FSA did not fail to protect the interests of policyholders. The Equitable itself chose to bring this test case, and was commended by the court for doing so. The key issue raised in this case was the interpretation of the detail of contracts issued by the company and the way discretionary powers were exercised by the directors. Once before the court it was right for the FSA to step back and await the outcome, while ensuring adequate reserves were in place.

In response to the possible query: ‘Lord Justice Morritt suggested that Equitable Life’s practice had been “approved” by HM Treasury. Is this true?’, FSA say:

HM Treasury issued guidance at the end of 1998 on the payment practice that it considered companies might legitimately adopt. This indicated that the Treasury accepted that it might be appropriate for insurers to make some charge in relation to the costs of annuity guarantees, and that this might be effected through a reduction in the terminal bonus paid to policyholders, provided this action was consistent with the terms of the contract and policyholders’ reasonable expectations. It did not indicate approval or disapproval of any particular approach. However, we will be considering the need for any revision in this guidance in light of the judgement.

FSA’s Director of Insurance advises, separately, that the basic line is ‘no comment on the substance while the case is still subject to appeal’.

22/01/2000 FSA’s Chairman asks the Director of Insurance if there was any substance to a report in the press ‘that others in the industry think we have been indulgent towards the Equitable?’.

FSA advise PIA and IMRO that they do not consider that the judgment affects the statutory financial position greatly, as Equitable already had to reserve fully for annuity guarantees that bite. However, FSA comment that the judgment was a severe blow for Equitable and was likely to dampen sales and increase uncertainty.

FSA’s Director of Insurance informs FSA’s Executive Committee that the Court of Appeal decision was under consideration.

FSA ask GAD for a list of companies who replied to the 1998 survey (see 20/06/1998) indicating that they took account of whether an annuity guarantee was biting when setting terminal bonuses. GAD reply that one other company took a similar approach, while replies from others were unclear on the point. GAD suggest writing to all with-profits offices to clarify the position.

FSA’s Director of Insurance responds to the Chairman’s query of 22/01/2000. The Director of Insurance says that a number of companies, including Equitable, believe HMT and FSA have taken ‘a very tough line on the reserving standards we expect in respect of GAOs’.

The Director of Insurance reminds the Chairman of the guidance which had been issued on 18/12/1998 on annuity guarantees and policyholders’ reasonable expectations, and notes:

One of the appeal judges refers to this letter (wrongly) as HMT “endorsing” the Equitable’s position. We are reviewing this letter, but at first glance it doesn’t seem too bad even in the light of the Court’s judgement. But this may have been picked up as an indication of our “indulgence”.

FSA prepare a preliminary assessment of the judgment which is marked as not being based on considered legal advice. FSA caution that the judgment is subject to appeal, but set out some of the implications for the industry should it stand. FSA note that, while Equitable would need to revise their bonus policy for the future, the new approach need not lead to additional costs for them. FSA explain that the question of compensation to any policyholders whose policies had matured in the last five years could only be assessed in the light of the House of Lords’ judgment, and that any reputational damage would only become apparent at a later date.

FSA’s Returns Reception and Validation Unit provides Line Supervisor C with a list of seven errors in Equitable’s 1998 returns. The Unit ask if any of the matters should be taken up with Equitable. The Line Supervisor advises that this is not necessary.

FSA’s Chief Counsel A writes to Line Manager D summarising the Court of Appeal judgment.

The Chief Counsel notes that the three judges found for or against the representative policyholder and for or against Equitable for different reasons. The Chief Counsel says: ‘… it is impossible to predict which way the House of Lords will jump’. Chief Counsel A copies her note to other FSA staff and GAD.

Equitable’s Chief Executive writes to policyholders to bring them up to date and to ‘reassure you about a number of misleading comments from third parties reported in the press in recent days’. FSA receive a copy of the letter from an FSA employee who is also an Equitable policyholder. Having explained the findings of the High Court and the Court of Appeal, the Chief Executive says:

Contrary to many of the reports which have appeared in the press, there would be no significant costs imposed on the Society if the Court of Appeal’s decision were upheld in the House of Lords. The speculation regarding financial difficulties and costs to be borne by with-profits policyholders is therefore unfounded. Your Society remains, and will continue to remain, financially secure.

FSA’s Line Manager D writes to PIA concerning a report to FSA’s Executive Committee that Equitable were under investigation for the alleged mis-selling of income drawdown policies. The Line Manager asks for details of the investigation.

Line Manager D notes that Equitable faced a number of current difficulties and ‘as prudential and lead supervisors for the group, I think it is particularly important that [Line Supervisor C] and myself are kept informed of investigations of this type’.

PIA advise that the case is quite old. PIA explain that Enforcement carried out a series of theme visits at the end of 1998 and their understanding is that they ‘did not find too many problems (so discipline case unlikely …)’.

PIA apologise for not keeping FSA informed (adding that: ‘this has rather fallen down the priority chain from our point of view, especially given the time frame’), and undertake to let FSA know of any further developments.

FSA’s Line Manager D writes to PIA to comment that the report they have seen makes the issue look more serious than suggested by PIA in their note of 08/02/2000.

PIA reply ‘of course I may have [misunderstood], or things could have changed, but my general feel is that Enforcement don’t have an appetite for this one’.

PIA provide FSA with a copy of an undated report headed ‘FSA Internal Sensitive Investigation’. PIA note that they had not previously brought this to FSA’s attention ‘as we did not envisage any material prudential concerns for Equitable arising specifically from this investigation’.

PIA’s report refers to potential mis-selling of income drawdown policies, a ‘complex, relatively risky product to a vulnerable market’. The report notes that there had been visits by Enforcement to Equitable and another provider, as the most active firms in the market. The visits had taken place in July. (Note: the report does not specify in which year; other documents suggest the visits had been undertaken in 1998).

PIA’s report states:

Initial reviews of investors’ files revealed serious concerns regarding suitability at Equitable. 7% of files reviewed have been classified by PIA as unsuitable on the basis of the information held in the file and 68% had inadequate evidence to demonstrate suitability. Additional concerns: lack of adequate compliance procedures, high level of execution only transactions and sales of maximum investment plans funded by withdrawals from [pension fund withdrawal] contracts.

PIA’s note provides an ‘Update’:

22 investors interviewed with inconclusive results. Generally investors told of risks but no account taken of risk attitude. Further visit to Equitable on 13-15 December confirmed no specific training on [maximum income plans] and 14 out of 30 execution only cases reviewed considered not [execution only] or insufficiently evidenced.

Interview transcripts will be issued to investors by 11 February. Case conference during February to determine whether any further investigation is appropriate.

Other documents suggest that the further visit on 13–15 December had taken place in 1999 and that the case conference was planned for February 2000.

FSA’s Managing Director A presents his Monthly Report to FSA’s Board. The report notes that Equitable had been granted leave to appeal to the House of Lords and comments:

Equitable does not appear to face any immediate financial risk or any additional threat to its independence. If the appeal judgment was upheld, Equitable would need to revise its bonus policy, but potentially the new approach need not lead to significant additional costs. The reputational damage from the court case will only become apparent at a later date, but interestingly the judgment did not spark a significant surge in calls to the company’s policyholder helpline. For now, the moderate reduction in new business that the company has been experiencing will actually help strengthen its finances.

FSA’s Chief Counsel A asks Line Manager D, in response to her summary of 01/03/2000, if the practice of imposing the costs of GARs only on policyholders with annuity guarantees was in breach of policyholders’ reasonable expectations and contrary to the Court of Appeal judgment. The Line Manager replies that companies had always declared bonuses by class of policies, and if higher expenses attached to a particular class, they would consider it reasonable for the company to declare a lower level of bonus for that class.

Chief Counsel A copies some of her correspondence to GAD. GAD comment that they had little difficulty in concluding that PRE, as defined by three of the four judges who had so far considered the matter, had not been breached by Equitable – except to the extent that a breach of contract was itself a breach of those expectations. GAD say that asset share, and other accepted means of determining terminal bonuses, would require some form of deduction for annuity guarantees. Alternatively, any loss to a company arising from such guarantees would usually be allocated to the class which had caused it. In response (on 3 March 2000), Chief Counsel A observes that the ICA 1982 requires that FSA do their own analysis and that the Court’s view was only one factor to take into consideration ‘(unless the Equitable’s methodology is rejected by the [House of Lords] in a way that leaves us nothing to consider)’. Chief Counsel A notes that Line Manager D would ‘no doubt be setting up a meeting or some other mechanism to allow proper consideration of the issues when she has completed her fact finding’.

FSA write to PIA and IMRO, asking for feedback on any proposed activity and visits concerning Equitable over the last three months. FSA ask whether there were any firm dates for the visits planned by both IMRO and PIA for April/May 2000. FSA refer to their visit in December 1999, the report of which had been circulated. FSA also note that the Pensions Review Team had begun a monitoring visit on 28 February 2000.

IMRO later inform FSA that, due to various factors, they had rescheduled their visit to February 2001.

FSA’s Line Manager D writes to Equitable’s Managing Director (similar letters were sent to Managing Directors of all other life companies writing Trustee Investment Bonds/Plans (i.e. pension contracts written for the trustees of occupational pension schemes)) seeking information about these. FSA’s concern is that some insurers might be wrongly classifying the business.

FSA’s Line Manager D provides Line Supervisor C and GAD with a copy of the note of the meeting held on 08/03/2000. The Line Manager comments that the outcome of the meeting did not look good for Equitable, ‘but it’s not disastrous either – from a solvency perspective anyway’. The Line Manager asks Scrutinising Actuary E whether falls in annuity rates meant that Equitable’s investment performance in relation to income drawdown policies was irrelevant.

GAD write to Equitable to remind them that, at the meeting on 06/12/1999, Equitable had undertaken to check some examples of income drawdown cases to see why cuts had occurred.

GAD ask for Equitable’s views on some possible explanations, and to clarify how they credit investment returns to with-profits business in the drawdown period.

GAD write to Equitable in response to their letter of 20/03/2000. GAD state that it is clear that the cut in drawdown income has been:

… due to the failure of the investment performance of a mixed portfolio to generate adequate returns to match the implied performance of long term gilts over the relevant period. Recognising that some excess performance was really needed as an offset to mortality drag, this is obviously a disappointing outcome.

GAD comment:

I am minded to believe that this has been a rather exceptional period, taking account of the particular pressures that have had such a marked effect on reducing available yields at the long end of the gilt market, and does not totally undermine the concept of income draw down as a way of preserving capital and deferring the purchase of an annuity.

GAD write to FSA in the light of Equitable’s letter of 20/03/2000 and their response. GAD comment that there are risks involved in income drawdown policies and that they hope ‘that all participants are made fully aware of them at the outset’. GAD suggest that only pensioners with a large fund, or with other sources of income, ‘should reasonably be invited to go down this route’.

Equitable write to FSA in response to their letter of 02/03/2000. Equitable provide their completed questionnaire, updating their potential exposure to compensation claims for pension mis-selling. This shows that they held a reserve of almost £132m within their 1999 returns.

Equitable say that they have not made any explicit allowance for the review of Free Standing AVCs, ‘because the extent of the review process is still unclear. Based on the details contained in the consultation paper … we believe the level of redress will be very low relative to the provisions for the pension review’.

30/03/2000 Equitable apply to FSA for a section 68 Order to raise the limit on the admissibility of shareholdings in one particular company. Equitable say they wish the concession to take effect from 31 December 1999.

FSA’s Line Supervisor C submits a report to the Insurance Supervisory Committee recommending that HMT do not agree the requested section 68 Order (see 30/03/2000). The Line Supervisor explains that the application is retrospective and that, in line with previous decisions, such concessions could not be granted. The Committee agree this recommendation.

FSA inform Equitable of this decision. FSA invite Equitable to resubmit the application for use in the future.

Equitable write to FSA in response to their letter of 10/04/2000. Equitable explain that they do not wish to resubmit their application for a section 68 Order for use in the 2000 returns, as market movements could make it out of date by the year end. Equitable say:

If no retrospection is to be allowed then it would seem that the concession is only ever going to operate in a somewhat arbitrary and approximate manner. Although the impact on our 1999 Returns will be relatively modest and the point is, therefore, somewhat academic, there does seem to be a point of principle involved. It would be helpful if you could confirm whether there is any scope within the procedures to deal with such a situation – for example, by applying in advance for an “in principle” concession on all stocks that are close to the normal admissibility limit and then confirming the exact increased limit requested when the year end data is known.

Equitable seek FSA’s further comments.

FSA’s Line Manager D advises the Head of Insurance of possible disciplinary action against Equitable in relation to their sales of income drawdown policies. The Line Manager explains that Enforcement had found that a significant proportion of Equitable’s sales had probably been inappropriate, in that investors had not been made aware of the risks they were taking on. The Line Manager says that Equitable’s compliance monitoring of sales appears to be ‘ineffective/incompetent’. The Line Manager notes: ‘unless Equitable present a credible challenge to the findings … [Enforcement] would expect the [Enforcement] Committee … to support a call for a fine and remedial action (including compensation to investors)’.

Line Manager D explains that Equitable had been asked to comment on Enforcement’s report by 23 June 2000 and that:

… given Equitable’s relatively precarious financial position we will need to keep close to this so we can assess the financial implications for the firm ahead of any [Enforcement] decision. The potential for further reputational damage is also a concern.

I feel fairly well plugged into [Enforcement] on this issue and currently do not see problems in ensuring co-operation with them as things move forward.

Equitable apply to FSA for a section 68 Order for a future profits implicit item of £1.1bn, for possible use in their 2000 returns. Equitable provide financial calculations in support of the application, suggesting that they could seek an Order up to the value of £3,304m.

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

Average annual profit = 4130.6/5 = £826.1m

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 item permissible is 50% of £826.1m multiplied by eight years – that being £3,304.4m.

Equitable explain that they have included a future profits implicit item of £925m in their 1999 returns.

FSA copy the letter to GAD.