March 2001

FSA’s Director of GCD forwards FSA’s note of the meeting with Equitable on 20/02/2001 [14:00] to Managing Director A and comments in manuscript as follows:

1.In case you were not aware of this note, which I have only seen today.

2.I do not know the context of the discussions on s68 orders, but we will need a very clear record of the basis for making such orders in the current circumstances.

3.The sidelined passages seem to me to reflect a dangerous degree of robustness about OFT and about the need to sell a compromise to all policyholders, to persuade the court it is right to bind dissentients.

The sidelined passages referred to by the Director of GCD are:

On the OFT investigation [Equitable’s Appointed Actuary] had rejected the OFT’s arguments about the need to identify the circumstances under which the MVA would be used and how it would be applied. He thought that Equitable’s contracts contained clauses that were “industry standard” and were necessary for any actuary operating a WP fund. He thought that the OFT had raised generic industry issues that the industry (not just the Equitable) had to respond to. Furthermore it would not be realistic to consider amending existing contracts and since the Company was no longer writing new business, there were no new contracts to amend.’; and:

[The Appointed Actuary] said that the test for a s425 scheme would be different from that of a Schedule 2C because in a 2C the [Independent Actuary] needs to argue that no policyholder would lose out. By definition, this test was not relevant in a compromise.

FSA’s Managing Director A informs the Director of Insurance (copied to others) that the FTSE 100 Index had fallen that morning and now stands at 5.5% below the end-2000 level. The Managing Director notes, ‘on the positive side’, that the Halifax money would arrive that day, which would boost Equitable’s solvency position. The Managing Director says that he thinks that FSA should ‘increase contact’ with Equitable and review their position on two key issues:

a) the MVA. We’ve always understood that the MVA would have to be increased in the face of a sharp fall in equity prices. Do we know how near we are to that? Shouldn’t we?

b) solvency. Obviously it’s helpful (from the solvency point of view) for 2000 bonuses to be “final” only but just how confident are we that [we] can identify pretty promptly the point at which [Equitable] would fall below our solvency standards?

[10:24] The Head of Life Insurance replies, saying that he had spoken to Equitable that morning. The Head of Life Insurance reports that the Society’s Appointed Actuary: ‘is acutely aware that the solvency margin is thinly covered. The Halifax £500m. removes immediate concern, but he would regard a fall in FTSE100 below 5,900 as a trigger for review of the MVA. If it were to be increased (and he recognised the political sensitivity of that) his actuarial gut feel would suggest a rise to 20%, but realism would suggest 15% (any smaller increase would incur more PR downside than the financial benefit would justify). But at present, he can justify no increase to the MVA because he can use the cash from the December/January asset sales to pay surrenders; if he had to sell more assets, the case for an increased MVA would be very strong’.

[10:27] Managing Director A thanks the Head of Life Insurance for the quick action, commenting that ‘[the Appointed Actuary’s] reaction shows how little room there is’ and ‘[regarding] the fall below 5,900” in the FTSE I would just point out that, as I write this, the figure is 5882!!!’.

[11:24] The Director of GCD replies, saying:

1.You need to know that there is some £200m of solvency dependent on a view of the interpretation of regulation 72 of the Insurance Companies Regulations.

2.… GAD’s view was that provisions for options need to be made on [the] basis that all will be exercised at 50. Our legal analysis (though this is not beyond doubt) is that the regulation allows provisions to be made on the basis of assumptions about when people will exercise.

3.Given the importance of the issue, we will need some more due diligence before offering a final view, for example, about generally accepted actuarial practice, and views taken previously. But in any event you should know that this sum is dependent on which provisioning route is used.

[11:58] The Head of Life Insurance adds that GAD now accepted FSA’s provisional interpretation and that Equitable had not yet taken credit for this interpretation in their solvency calculation.

FSA’s Director of GCD responds to Legal Adviser A’s advice on Regulation 72 (see 27/02/2001 [14:32]), saying he agreed that the interpretation of the Regulation was not free from doubt. Given the significance of the matter, the Director says that he wants to check past advice, check professional guidance, establish what other companies do, ask GAD for analysis, and seek confirmation from Counsel.

[17:26] Chief Counsel B writes to the Director to explain why he believed Regulation 72(3) would have the effect of requiring policies to be valued on the basis that policyholders would exercise the option to retire at 50 where this was provided for in the contract.

GAD send FSA and PIA their review of the Merged Agreement between Equitable and Clerical Medical (sent to FSA on 26/02/2001). GAD note that they have ‘only identified one issue where we recommend clarification to be obtained from the company – this relates to the provision of “Fixed Price Services”’. (Note: these were described in the agreement as ‘ongoing support and company care in respect of customers’. The issues which GAD suggest should be raised in relation to these were the exact nature of the services to be provided, and whether the charges for these services (which are specified in the agreement) were reasonable).

After describing the detailed arrangements, GAD welcome the inclusion of a provision that:

On termination of the administration agreement (for whatever reason), Clerical Medical shall return to Equitable all “Retained Business data” and all books, records, registers, computer data, documentation and information held by it in relation to the provision of the administrative services, together with copies of all such information held in hard copy … to the extent to which such data, books, records, registers, computer data, data, documentation and information are not required for it to discharge its obligations under the asset management agreement.

FSA’s Legal Adviser A advises Line Manager E on Regulation 72, following a discussion on the issue the previous day. The Legal Adviser says that he was not aware that any legal advice had been given on this issue prior to it arising in relation to Equitable but, having had a chance to look into the background of the Insurance Companies (Amendment) Regulations 2000 which had introduced Regulations 72(3) to 72(5) into ICR 1994, he was now able to provide such advice.

Legal Adviser A explains the aim of the Regulation as being ‘designed to ensure consistency of reserving for unitised with profit policies where there was an option to surrender’.

After giving a hypothetical example of how a market value adjuster might operate in practice, the Legal Adviser continues by listing three points that arose in the particular context under consideration. These being:

First, if the Amendment Regulation 2000 had not been passed, then there would not be any question of reserving having to be made on the basis of retirement at 50. The Consultation Document (so far as is relevant) talked of the general need to establish a sound and consistent standard which is not currently achieved to a consistent degree by the existing regulations. It did not foreshadow any considerable change.

Secondly, it was pointed out by [an official] who drafted the regulations that the reference to assumptions in 72(3) opened up a gap between regulation 72(2) and 72(3). This was accepted.

Thirdly, and more pertinently, I quote from [GAD’s Chief Actuary D] “There must be a reference to the assumptions adopted for the valuation, else it makes no actuarial sense. Otherwise it would not be acceptable to assume some people die before they get to the option date, for example.” If (in the context for which the regulations were designed) it is permissible to make mortality assumptions with respect to the amount of people who can take up the surrender options, I do not see why the regulations should not be interpreted as permitting assumptions as to the date at which people will take retirement.

Legal Adviser A concludes by stating that he: ‘cannot find anything which leads me to assume that the intended interpretation was contrary to that I have suggested’ and that the professional guidance notes: ‘do not directly deal with the issue. In so far as they are largely concerned with prudency of assumptions in relation to regulation 72 they, if anything more favour the “Equitable interpretation”. I note, at least the Equitable has purported (in part) to rely on them’.

On FSA’s files, a copy is held of information dated 5 March 2001 produced by Equitable for their policyholders. The purpose of the information sheet was to give more information about both the deal with Halifax and the possibility of a GAR compromise scheme. The sheet says that:

When considering the deal, the Board had many factors to take into account. They received advice from the Society’s bankers, lawyers, accountants and actuarial advisers and from the Society’s actuaries and others.

An important benchmark against which to judge a deal is the option of closing the fund and continuing as an independent entity. This is not a simple comparison as the business risks for the closed fund would have been particularly acute. Likely ranges of values were considered for the components of the business. The advantage and disadvantages of the closed fund route in comparison to the Halifax deal were compared for each component.

The results of the analysis were annexed to the sheet. In relation to a possible compromise, the sheet explained:

The consultation document is intended to show how the current value of the GAR liabilities are estimated and to consider the issues which arise regarding how the cost of a GAR compromise scheme could be distributed to the GAR members. Both GAR and non GAR members will need to agree [to] the scheme for it to be adopted. At this stage there is no specific proposal. The Society is collecting feedback from a wide range of clients and other interested parties. The results of this consultation will be used to inform the design of a proposal which will then be the subject of further consultation.

FSA hold an Equitable Life Lawyers Group meeting. The Group discuss aspects of the sale process, noting that the transfer to Halifax would be done by reinsurance rather than through a Schedule 2C transfer. It is agreed that the Head of Life Insurance and Line Manager E should be contacted to ensure that they had discussed such reassurance arrangements with Halifax’s supervisors.

Chief Counsel A and the Director of GCD note that there were a number of points arising from the Treasury Select Committee hearing and that the Director would prepare a note on whether the Companies Act 1985 required disclosure of contingent liabilities.

The Group discuss the appointment of Equitable’s new Managing Director and the fact that FSA had not received notification of this. The Group note that, according to reports in the press, the previous Chief Executive was to head up a services company at Halifax. The Director of GCD says that he would take up with the Director of Insurance the issue of whether FSA should make a complaint concerning the previous Appointed Actuary to the Institute of Actuaries.

The Group consider a revised list of legal issues. On market value adjusters, the minutes of the meeting state that:

… the decline in the FTSE may result in the raising of MVAs. [The Director of GCD] stated it was important that the Equitable made a public statement setting out the criteria for exercising the MVA. Such a statement would constitute a contractual term. [Legal Adviser A] is to pursue this with [FSA] to encourage Equitable [to] take action.

With respect to the compromise scheme, it is said that:

… winding-up could be dropped from the list of legal issues and that counterfactuals, compromise and follow up work on accommodation, could be amalgamated as one issue.

It was noted that policyholder approval was still required on the compromise and as such counterfactuals were still required. [The Director of GCD] noted that the compromise would inevitably be detrimental to a minority of policyholders. [Chief Counsel A] advised the group that better argument/explanation was still awaited from the Equitable on this issue.

Finally, it was noted that:

[FSA’s Insolvency Practitioner] was still in the process of preparing his note on insolvency. The group agreed that he should be invited to the next meeting of the group so that he could provide a review of his findings.

GAD’s Directing Actuary B responds to Legal Adviser A’s advice on Regulation 72 (see 27/02/2001 [14:32]), saying he feels that the arguments were ‘a little tenuous’.

The Directing Actuary explains that his reasoning for this was that such an interpretation would involve the regulators saying:

… that the date on which the option is exercised (ie age retirement) is one of the relevant assumptions. This makes the whole regulation rather circular, and I am not sure that the difference in wording between paragraphs (2) and (3) is really that great.

The Directing Actuary continues:

We also then need to be satisfied that our guidance on reserving for guaranteed annuity options is consistent with this interpretation, and that the regulation still achieves the intended outcome on reserving for accumulated with-profits business.

[17:44] The Director of GCD asks Legal Adviser A to ensure that the Directing Actuary’s points were brought out in instructions to Counsel.

FSA’s Director of GCD writes to Chief Counsel A, following a meeting held that afternoon with Managing Director A. This had been called to consider, among other issues, whether FSA should ask for the Equitable Board papers referred to in an article that had appeared in a national newspaper. The Director says that he had indicated that FSA’s powers were very wide and allowed them to call for the relevant Equitable Board papers. The Director of GCD says: ‘Before doing so, however, colleagues would like to be clear as to the exact use which we would make of them. I have been asked to commission work from you or [Legal Adviser A] on the regulatory functions for which we might use such information’.

The Director of GCD notes that FSA were to meet Equitable’s new Chairman the following day and that the agenda would include: ‘its financial situation; the need to ensure that the proposed compromise works for all policyholders, if we are to avoid finding that we are unable to recommend the court to buy out on a compulsory basis those who do not accept; the OFT concern about the ability to impose an MVA, which needs to be resolved by a public statement as to the criteria on which MVAs would be set, certainly before any increase in the MVA is contemplated’.

The Director of GCD says that he had also mentioned in the meeting that afternoon that he thought that FSA might want to complain to the Institute of Actuaries about Equitable’s former Appointed Actuary and that the Director of Insurance had said that there had been ‘some movement on this front’.

FSA and GAD meet Equitable, at the request of FSA, to get an update on some ‘key issues’ facing the Society. FSA’s note of the meeting records the issues discussed under the following headings:

Solvency

Equitable’s new Chief Executive reports that the £500m from the Halifax sale had given a boost to solvency greater than its value ‘because the Society was now invested heavier in gilts and the £500m gave a disproportionate benefit when the effect of this worked through the resilience testing’. Equitable disclose that the money was at that time still invested in cash but that they intended to invest 61% of the £500m in equities. FSA’s note records:

For the year end financial position as demonstrated in the statutory return (due 30 June 2001) solvency cover was likely to be tight with only £300m free assets after [required minimum margin] coverage. In making this assessment the Society was taking into account the benefit from the “artificial bond” concession that had yet to be formally applied for or given (which itself would be worth £300m). It was also taking into account the debt from the sale of the Permanent [Insurance] to Liverpool Victoria which was not completed until 2001 …

As at the end of January (before the £500m injection) the Society believed that it had £700m of free assets after coverage of the [required minimum margin]. Solvency was boosted by the sale of £1.8bn of equities and the reduction in the resilience test. It was thought that current solvency cover was of a similar magnitude despite the £500m injection, this was because the FTSE at c5900 was a lot lower than it was at the end of January. [Equitable’s Chief Executive] disclosed that prior to the end of February with weak equity markets solvency cover was thin.

The Regulation 72 issue is discussed and Equitable say that they were taking account of the higher reserving standard suggested by GAD, which had a reserving impact of approximately £200m. FSA note that they had not yet decided on the correct approach and say that they would write to Equitable, confirming their position as soon as possible.

Equitable’s Chief Executive agrees to provide GAD with information on the sensitivities of their financial position, and:

It was confirmed that the main monitoring triggers were the FTSE and long term interest rates, although knee jerk reacting to these triggers could be damaging and policyholders interests would not benefit if equities were sold at the bottom of the market. It was thought that the Society should now be able to withstand a market slump down to FTSE 5000 before solvency margin cover was jeopardised.

Equitable’s equity backing ratio is discussed and they state that, prior to closure, the ratio had been 72%, reducing to 68% at the end of 2000 and to 61% currently. Equitable confirm that, in their ratio, equities included investments in property. The Chief Executive says that he was keen to keep the ratio at 61% until the result of the compromise was known, arguing that this was in the interests of policyholders. Furthermore:

He also felt that even in the unlikely event of technical statutory solvency not being maintained he would still not wish, in the interim, to indulge in a fire sale of equities. [The Head of Life Insurance] said that both FSA and the Society have continued to state that the Society is solvent whatever definition of solvency is used. There would be a major confidence issue if this statement needed to be qualified.

Equitable’s Chief Executive says that the Society’s auditors wished to include a paragraph in the Companies Act report and accounts referring to ‘fundamental uncertainty post the House of Lords judgement’ and that the Appointed Actuary’s certificate would also need to cover the issue of GAR uncertainty.

Policyholder Compromise

Equitable explain that the purpose of the roadshows was to gain an understanding of policyholder concerns, to lay the ground for the compromise scheme, and to ‘[take] the sting out of the annual general meeting’. FSA note that:

… the Society needed to convince policyholders as to why it needed a scheme. Issues to be addressed also included what the transfer of value should be from non-GAR to GAR … whether transfer could be done using an age related (or other scale) and what the cut off date for this should be. [Equitable’s Chief Executive] thought that logically it should apply prior to the House of Lords ruling.

Equitable say that their solicitors were currently working on the structure of policyholder classes for the scheme. FSA stress that they would need to be closely involved in this work, and would want to see the proposals, together with the underpinning information.

Market value adjuster

FSA record: ‘It was confirmed that the rationale for the size of the MVA was not to make either surrender losses or profits. The size was determined by the level of the FTSE, the extent to which up front charges/expenses were spread over the duration of the policy and the need to maintain solvency and investment freedom. It was confirmed that for the MVA to be currently neutral it would need to be pegged nearer to 15% as the Society was making surrender losses with the FTSE being so low. However, because the level of surrenders were now modest there was no imperative to increase the MVA which would be very damaging in PR terms’.

The Chief Executive undertakes to give FSA ‘forewarning of any proposed change to the level of the MVA’.

The OFT

FSA inform Equitable of their understanding of the OFT’s thinking on Equitable’s application of the market value adjuster. This was that the contract term gave too much discretion to the company and this was unfair. However, they had accepted that, in practice, the term had not operated unfairly. Equitable’s Chief Executive argues that Equitable’s With Profit Guides had set out the basis for the market value adjuster and says that he thought the OFT had looked at the terms of the contract in isolation. Equitable say that they had written to the OFT on 28 February 2001, offering to make the position clearer in their annual statements. FSA note that: ‘The Equitable was now awaiting a response from the OFT but [the Chief Executive] argued that if the OFT continued to argue that the contract was “unfair” he would need to get both the regulator and the [Association of British Insurers] involved because the issues raised were generic and did not just apply to the Equitable’.

Bonuses

Equitable confirm that, as had been reported in the press, no guaranteed bonus would be allocated for 2000, except for policies that included a guaranteed interest rate but that a non-guaranteed terminal bonus would be allocated. Equitable say that the 2000 bonus would be reviewed after the result of the compromise vote, ‘when guaranteed bonus might be reinstated’. FSA record that: ‘An 8% rate of bonus would be the implied rate used for 2000 (although most policyholders would only get 5 months of this 1 Aug – 31 December = 3.3%). This was much better than the market because of the smoothing reserve. The previous year the Society had declared 4% less than what it had earned’.

Board Papers

Equitable disclose that a full set of Board papers had gone missing and that it appeared that a courier might have been responsible. Equitable say that, having threatened legal action, the newspaper had returned the papers, after they had used them, and stated that they had destroyed all copies. FSA note: ‘[The Chief Executive] was relieved that the broadsheets had not obtained copies of the papers as they could have caused a lot more damage. The statements referred to in the article referring to risk control statements were according to [the Chief Executive] fairly innocuous and were connected to the standard type of issues for Boards of Directors to address under Turnbull. [FSA’s Head of Life Insurance] reserved the right to ask for copies of these papers’.

Action Points

Under ‘Action Points’, it was noted that Equitable were to: provide GAD with information on solvency sensitivities; send FSA their January 2001 solvency statement; apply for a section 68 Order to permit the use of an artificial bond; and liaise with their auditors and FSA on the valuation at the year end of Permanent Insurance. The action point recorded for FSA is that they would confirm their position on the Regulation 72 issue.

It is agreed that FSA and Equitable would meet weekly or fortnightly to keep each other informed on developments.

FSA meet Equitable’s new Chairman, at FSA’s request, to discuss the outstanding issues facing Equitable and the way forward. FSA’s note of the meeting records the issues discussed under the following headings:

New Board

Progress on putting together a new Board is discussed and the Society’s Chairman reports that a promising start had been made.

Compromise Proposal

The Chairman sets out what he believes are the stages for a compromise. These stages were:

… first, the company itself must be satisfied that any proposal was both clear and understandable to policyholders; the advantages and disadvantages would have to be set out clearly, and any recommendation would have to be made separately. The next three stages would require the Independent Actuary, the regulator and finally the Court to be satisfied that the proposals were fair.

He says that the annual general meeting on 23 May 2001 would be too soon to announce the scheme and his plan was to report briefly on the events of 2000 and to set out in general terms Equitable’s current position, including the need for an accommodation between GAR and non-GAR policyholders.

Market value adjuster

FSA record that there was ‘agreement on the public relations importance’ of the level of the market value adjuster. FSA say that they would want to be consulted on any proposal to change the level from 10%. FSA also explain ‘the importance of the OFT investigation into the MVA; we believed that a satisfactory outcome was achievable, if the Equitable were prepared to indicate in some suitably public way the criteria which they used in exercising their discretion to apply and adjust the MVA’.

House of Lords’ judgment

The Society’s Chairman informs FSA that, as a result of ‘pressure from a policyholder action group’, they had sought Counsel’s opinion on whether the House of Lords’ judgment might be challenged. The Chairman says that:

It would then be a difficult judgment for the society as to whether or not to spend more money pursuing such a challenge. The financial consequences both for the society and individual policyholders were so great that it would be difficult not to pursue even a small chance. [Equitable’s Chairman] believed that the House of Lords would be willing to look at the issue “quite quickly”. But he would probably want a second legal opinion before making a decision.

The Chairman notes that in, any further case, both GAR and non-GAR policyholders would have to be separately represented.

Mis-selling

FSA’s note records:

[The Chairman] said that he saw three primary sources of claims: from mis-selling, against the auditors, and against the previous board. He was inclined to take the view that if there was a prima facie case for a claim, the Equitable would not wish to stand in the way of the claimant pursuing redress. [FSA’s Director of Insurance] urged caution about being too ready to offer redress which might set difficult precedents; the costs would in general have to be met by other policyholders, and there is a need to balance out the interests of all policyholders. The FSA was undertaking some internal work on the principles which might properly be applied to assessing claims for redress, and we were also in discussion with the Financial Services Ombudsman. It would be regrettable if this work was pre-empted by early isolated cases of compensation.

Public Relations

FSA suggest that the Chairman opens a dialogue with The Consumers’ Association and that he should brief the FSA Consumer Panel. Equitable’s Chairman says that he would be ‘very happy to do this’.

Equitable provide FSA with updated information from 1 March 2001 on the value of payments made on surrenders, transfers and switches and calls to Equitable’s helpline.

[10:54] Line Manager E circulates a summary of this information, which he has prepared.

FSA’s Director of GCD replies to Legal Adviser A’s note on Regulation 72 of 01/03/2001 [15:16]. The Director of GCD says: ‘This fortifies me in the view we should take advice from [Counsel]. Also makes me [uncomfortable] with use of MVA in reserving – I had seen it as a step to be taken if assets were inadequate, rather than a means to allow reserving requirements [to] be reduced to match available assets!’.

[11:13] GAD’s Directing Actuary B says: ‘There is, I agree, some circularity in that the actuary of the insurer has to determine the appropriate MVA to assume for reserving purposes, taking account of the available assets, but having regard of course to policyholder reasonable expectations. The relevant assumed MVA does though have to be published in the FSA returns’.

FSA’s Legal Adviser A advises the Director of GCD that there were two areas in which FSA might use the information contained in the Equitable Board papers which they were considering requesting. The Legal Adviser says:

First, it might give rise to the exercise of powers under section 45 to require the Society to take action for the purposes of ensuring that the criteria of sound and prudent management are fulfilled. The information might, for example, reveal lack of fitness and properness on the part of the directors or deficiencies in systems of control or records. It is difficult to be more specific but sight of the board papers might give a greater insight into the internal workings of the company which has the potential to reveal a failure to fulfil any of the criteria of sound and prudent management as set out in Schedule 2A which [it] might be necessary to redress by the use of section 45.

The second area, which is perhaps more likely given the tone of the article, relates to possible future regulatory action in respect of individuals. It may be the case that information obtained shows a lack of fitness and properness on the part of persons who may be notified to us as notifiable persons in respect of another company at some time in the future.

The Director of GCD informs Legal Adviser A that Managing Director A was now doubtful about his first point (in his advice of 06/03/2001 [12:03]), given that all the Society’s existing directors were resigning. The Director also says, on the second point, that he thought FSA would need to get HMT to exercise these powers, as the power to require individuals to produce information under section 44 (2)(a) of ICA 1982 had not been delegated to FSA.

On 8 March 2001, Legal Adviser A says that he took the point on the first argument but adds that there could be systemic problems with Equitable’s Board.

On 12 March 2001, the Director of GCD says that, if Legal Adviser A could put a convincing argument on systemic concerns, ‘all to the good’.

GAD prepare a review of the reinsurance agreement between Equitable and Halifax in respect of non-profit business (other than immediate annuities). GAD make several suggestions to FSA, including:

• ‘The effect of the reassurance is that the profits from the business will emerge in Halifax Life. Indeed, Halifax Life are paying commission of £300m. to Equitable in respect of this Agreement. However, profits from the non-profits and unit linked business would formerly have been a source of miscellaneous surplus, which would have benefited the with profits policyholders in the form of an enhancement to the return credited to their smoothed asset shares. Now that these profits have been capitalised, this will no longer be so. We suggest the company are asked what enhancements the with profits policyholders formerly enjoyed on this account, and whether the scale of the enhancements projected to be foregone in the future is similar.’
• that FSA should ask Equitable to clarify how they intended to meet any charges for future expenses as there appeared to be no margins left from which they could meet any such charges.
• that FSA should ask Equitable about the statement in the agreement that ‘Halifax Life shall not be required to indemnify Equitable in respect of any guaranteed investment options in respect of Covered [i.e. reassured] Policies’. GAD say that it was not clear what those options were, how significant they were, or how any costs would be met.
• that FSA should clarify with Equitable what impact the reassurance had on the reasonable expectations of unit-linked policyholders in relation to the deduction of charges.
• that FSA should ask Equitable for further information on the tax consequences of the reassurance on policyholders, as it appeared to be adverse.

Equitable send FSA a summary of their estimated solvency position as at 31 January 2001. The position is set out as follows:

Solvency position at 31 January 2001

An FSA official writes to Managing Director A’s office, following the meeting with Halifax the previous day. The meeting was attended by Clerical Medical who had given a presentation on the key aspects of the transaction, integration issues and future corporate governance – and who answered questions.

After setting out some staffing changes, the official writes that: ‘Contrary to original expectations, it had been decided to close Equitable’s international operations in Dublin, Dubai, Germany and Guernsey. The existing business will remain with the closed fund’.

FSA’s Director of GCD sends Legal Adviser A a note, dated 8 March 2001, concerning his draft instructions to Counsel on the issue of Regulation 72. In his note, the Director suggests that FSA should consider the position they wanted to take on this issue ‘in the new world’ (i.e. under the regulatory regime which was to come into force with FSMA 2000). The Director suggests: ‘Since no one has, I think, suggested that the more restrictive view is the right approach from a policy viewpoint, surely we should ensure that the less restrictive view is given clear effect in the new rules’; adding that: ‘This would also, it seems to me, help to make clear that this is not a case of convenient special treatment for a particular company’.

[16:58] Line Manager E thanks the Director of GCD for his comments and says: ‘Our discussions have really been on two levels – what is the effect of the regulations, and what is the effect we are seeking to achieve in policy terms. I am now fairly clear, and that is consistent with my understanding of the position we reached when discussing the point with GAD, that the correct result is that the actuary should make reasonable assumptions about variables when valuing for the purposes of regulation 72(3)’.

Halifax send FSA a copy of a report which they had commissioned, described as a ‘high level Compliance Risk Assessment’ in relation to Equitable. (As promised at the meeting on 08/03/2001.)

In relation to PIA activity, the report outlines the following conclusions:

• Significant recent regulatory activity – themed visits from PIA in key areas. May indicate the “risk” considered by the PIA to be posed by ELAS.
• Compliance failures have been identified in most of the key areas of regulatory risk. In particular, failures in [pension fund withdrawal] and [free-standing AVC] sales process and subsequent tone of response to PIA’s report, may indicate material lack of understanding of regulatory risks and standards.
• The approach of “delegating” compliance to the business does not appear to have been successful in establishing robust systems and controls.
• The regulatory relationship appears to have been flawed. Substantive discussion and disagreement followed most regulatory reports.
• The failures identified, particularly in relation to the repeat breaches identified in [PIA’s visit conducted in June 2000] may indicate that a strong compliance culture is not embedded throughout ELAS.
• A substantial amount of remedial work required to address past issues and significant forward planning to ensure compliance in the future.

In relation to IMRO issues, it is noted that:

Conclusion which may be drawn from the documents covering the supervision of [Equitable Unit Trust Managers Limited]:

• there is a concern that Senior Management appear to have failed to either recognise or acknowledge the seriousness of front office issues and risks faced as a regulated entity;
• in the light of the history it appears that Senior Management have not developed the role of Compliance to address the issues and mitigates regulatory risk;
• compliance initiatives from Senior Management appear weak;
• at its worst, the front office attitude appears to be resistant to complying with existing procedures and to acknowledging the importance of regulatory compliance.

Information from the “compliance” documents give the following perceptions

Management appear:

• to place over reliance on people doing what they are asked to do without placing sufficient checks on performance;
• to assume that procedures will be followed and yet, when they are not, have underplayed the need for and benefit of checks and compliance monitoring; and
• to have put insufficient preventative and detective controls in place over the fund managers/front office.

In the conclusions on IMRO issues, it is noted that the information available was ‘generally historic’ and that the report did not assess the impact of recent compliance initiatives – in particular, Equitable’s new Central Compliance Department.

Equitable send FSA technical information about the terms and conditions applying to investment in the Clerical Medical fund available to existing Equitable group pension policies, where benefits are purchased on a money purchase basis. This information concludes:

In the normal course of events it will be possible for an individual member to switch investments between the Equitable’s funds and between Equitable and Clerical Medical funds. There is no guarantee that a switch between Equitable and Clerical funds will be allowed in future.

There is no guarantee whatsoever of the terms for switching between Equitable and Clerical Medical funds. The terms for these may change at any time or the availability to switch into Clerical Medical funds may be withdrawn at any time. The terms and availability of switching between Equitable funds at any time will not affect the terms or availability of switches between any Clerical Medical funds.

There is currently no charge for switching between any Equitable or Clerical Medical funds but the Equitable reserves the right to apply an administration charge in the future.

Equitable send FSA a copy of a letter that is ‘about to be issued’ to policyholders by Halifax Equitable. The letter concerns the transfer of personal information which Equitable held about policyholders.

Amongst other matters, the letter informed policyholders that, while ‘Halifax has not acquired existing Equitable Life with-profits policies [it] will be administering those policies for Equitable Life in accordance with its instructions’.

Line Manager E records that he had notified PIA that FSA had received the letter.

FSA reply to Equitable’s letter of 08/03/2001, which included the report on their estimated solvency position at 31 January 2001. FSA point out that Equitable continued to rely on a future profits implicit item of £1bn. FSA ask, ‘In view of the changed circumstances at the Equitable, and in particular its closure to new business last December and the subsequent Halifax transaction’, that Equitable should provide an actuarial certificate to confirm that the item was still sustainable prospectively from 31 December 2000.

FSA continue:

It should also be supported by a note of the key assumptions, particularly on future investment returns, persistency rates and GAR take-up rates, that are made for the purposes of the certificate. The calculation should of course take into account the effect of any potential payments to be made under the reinsurance treaty.

(Note: it appears that the letter, although dated 12 March 2001, was actually sent on 13 March 2001 after FSA had sought comments on it from GAD.)

GAD’s Scrutinising Actuary F had noted that Equitable:

… should of course take account of the effect of any potential payments under the [IRECO] reinsurance treaty. The GAO take-up rate is itself another key assumption. (We need to be satisfied that there is no double counting as between the future profits implicit item and any obligations under the reinsurance treaty.)

The following day, Chief Actuary C comments that the letter ‘should also make it clear that we expect the actuary to take account of the changes that have taken place after the end of 2000’.

The relevant GAD file contains an undated note by Scrutinising Actuary F that was not sent to FSA, as FSA had already issued the letter. The Scrutinising Actuary’s note reads:

For the record, the Society’s application of 27.06.2000 (for a future profits implicit item of £1.1bn.) showed estimated future profits of £3.3bn. on the retrospective approach (based on projecting past year’s profits into future years). However, the Actuary only certified that the profits expected to emerge prospectively were no less than the £1.1bn. applied for (after taking into account the impact of the GAR treaty), so we do not know what margin there was in that calculation.

It would be worth asking for the results of the prospective calculation, as well as the assumptions used, and what the impact of the existence of the GAR treaty is on the calculations.

The Halifax deal is unlikely to have any more than a second order effect on the above – the £500m. injection per se does not alter the profit stream from the existing business, but persistency sounds as though it is now reverting to more normal levels, and the changes to the asset mix as between equities/gilts are having a beneficial effect on the valuation interest rates (which may feed through to the assumptions the Actuary makes when assessing the amount of future profits).

FSA inform GAD that GAD might be contacted by a trustee of FSA’s pension scheme, which contained ‘inherited’ elements provided by Equitable. FSA say that they were happy for GAD to talk with him, but that he ‘should not be told anything that [FSA] would not normally tell a person in the same position elsewhere’. FSA continue: ‘We are only allowing him access to files that contain papers that are in the public domain’.

[16:37] A trustee of the FSA Pension Plan approaches GAD. The trustee explains that FSA had inherited people paying into Equitable AVCs from various organisations – including the Civil Service, the Bank of England, the Securities and Investments Board ‘and most of the [self-regulatory organisations]’. The Trustee says that, while they have now combined those schemes, the trustees were having problems establishing what charges should be applied. The trustee’s particular concern was a 2% administration charge that had been referred to in the Civil Service scheme booklet, but was not referred to in the annual returns for 1999, 1998 or 1997. The trustee asks GAD for comments.

FSA’s Head of Life Insurance records that Equitable’s Chief Executive had notified FSA that Equitable were seriously considering raising the market value adjuster to 15%, following recent falls in the FTSE 100 Index. The Chief Executive had said that he was going to discuss the issue with the Society’s Chairman and would revert to FSA before a decision was taken, although he added that Equitable might need to announce the increase that night. The Head of Life Insurance’s note continues:

[Equitable’s Chief Executive] recognises the PR implications. But the issue is not solvency, but fair value between leavers and stayers. In strictly financial terms, [he] is clear that an MVA of 15% is now justified. With surrenders at their current low level, it might be possible to justify not raising the MVA (and accept that the fund is subsidising the leavers). But this is a moot point, and will not be suitable if surrenders run higher, as policyholders seek to “select against” the fund by getting out with a fund value above their asset share. If a rise is announced, requests for surrender/transfer in the pipeline will be dealt with at 10%, with new requests attracting the higher rate.

The Head of Life Insurance continues that:

this must be a decision for the Equitable. If [the Chief Executive] rings back to say they want to raise the MVA, I propose to note that, but agree a public line which stresses that this is a question of fair value between policyholders, and not prompted by solvency considerations. We can expect press and consumer queries.

[10:30] FSA meet to discuss the issue. FSA’s note (prepared on 14 March 2001) records:

Action:

• [FSA’s Head of Life Insurance] to contact [Equitable’s Chief Executive/Chairman] to relay FSA’s perception of possible risks (as below) in increasing MVA [Done]. Equitable would need to undertake additional work to minimise expected negative media/policyholder reaction.
• FSA to continue monitoring levels of withdrawals from fund and in addition, to establish the amount of withdrawal that represents over-valuation of individual policies (and consequently detriment to overall fund value) in current circumstances. [[Action]: [The Head of Life Insurance].]

The note then records the key supporting points, as follows:

1. [FSA’s Managing Director A] requested additional information on analysis undertaken by Equitable before concluding that 15% was an appropriate level for the MVA. This was necessary to enable FSA to take a view on whether the company was exercising its discretion in a reasonable way. [Subsequently received note from Equitable setting out main factors that would trigger a closer review of the level.]
2. [FSA’s Chairman] noted that there had been no evidence to date of surrender rate increasing following falls in FTSE. The existence of such evidence would provide stronger grounds for increasing the MVA. Otherwise, risk remains that an increase in the MVA would itself precipitate a run on the fund.
3. [The Director of Insurance] noted that any increase in the MVA might damage prospect of reaching a compromise between GAR/non-GAR policyholders and equally may damage [Equitable’s Chairman’s] reputation at a critical point in the negotiations.
4. In considering, Equitable’s basis for increasing the MVA, [FSA’s Chairman] asked whether other companies were also considering increasing their MVA as a result of recent stock market movements. [FSA] believed that in principle, this would be the case but were not aware of any specific examples. Equally, any action taken by other companies was unlikely to be as transparent as action taken by Equitable [as] other companies did not publish detailed information re announced (but not guaranteed) terminal bonuses.
5. Given the subjective nature of the decision regarding the appropriate level of the MVA, it seemed unlikely that FSA would be able to invoke any statutory powers if Equitable concluded that increasing the MVA was necessary to ensure fairness of treatment between different policyholders.

FSA’s Director of GCD writes to Chief Counsel A about the meeting held that morning. According to the Director of GCD:

On a preliminary analysis, we had no reason to believe that the Equitable were not paying due regard to the interests of policyholders. As a result, it seemed unlikely that we would be able to intervene, one way or the other.

It was noted that the Equitable had not yet made a public statement as to how they would exercise their powers to impose MVAs. This would mean that any early decision would potentially not carry the OFT with it.

I indicated that we needed to consider not only the downside of an increase to the MVA, but also the risks of damage to policyholders from allowing withdrawals to be made at an overvalue, to the detriment of those who remained. It was reported that the level of withdrawals was currently around £1–2mn per day, and, even if the MVA was some 5% out, the reduction in value was not significant.

In contrast, it was also thought relevant to take into account the damaging effect which an FSA mandated increase in the MVA could have on the stability of the company, and the prospects for an accommodation. In any event, the company seemed more likely to increase the MVA than to keep it as now.

Equitable send FSA a copy of Equitable’s note ‘Application of financial adjuster by Equitable Life’ (see 19/12/2000 [16:08]), along with an update as at 13 March 2001. The update states:

Policy values have continued to grow although the interim rate of return from 1 August 2000 was reduced from 9% p.a. to 8% p.a. on 5 March 2001. Final bonus therefore fell on that date as did total policy values.

Volumes of individual surrenders have fallen from 5–7 times normal volumes to less than 2 times normal volumes.

Requests for Group Scheme bulk surrender terms have continued and a few schemes have gone.

[An actuarial consultancy] have written to the President indicating that they feel the 10% financial adjustment is too low considering the current level of markets and they may feel that the best advice is to surrender in order to protect the current position of schemes. They feel that those who stay in the fund are not sufficiently protected.

At 9 March 2001 the appropriate Type 1 and Type 2 theoretical adjusters would be:

On 13 March the FTSE-100 closed at 5720, a level at which a 10% adjuster is clearly unsustainable.

Levels of surrenders will be closely monitored as will the views of benefit consultants.

[17:47] The note and update are forwarded to senior FSA officials.

[18:36] Managing Director A asks whether there was any way that Equitable:

… can distinguish in their rules between different kinds of with-profits policy. This could have 2 possible uses:

1. a PR benefit, because it would help to get away from a “there has been a rise from 10% to 15%” or whatever (because actually there would be a variety of rates dependent upon eg length of time policy held). Comment this might not help greatly on the first rise but it could be [particularly] useful if there had to be more.
2. more questionably to load the increase into those policies (like the Group Policies) that were most likely to be pulled quickly.

The Managing Director concludes that ‘a)’ obviously is possible – because they had a system like it before closing to new business – and asks whether FSA were aware of where the Society’s Chairman stood.

[19:05] The Director of Insurance reports that FSA had not heard from Equitable’s Chief Executive or Chairman and suggests that FSA could assume nothing was going to happen immediately. In response to the Managing Director’s suggestion, the Director of Insurance says that Equitable had always dealt differently with group schemes than individual policyholders.

FSA’s Head of Life Insurance informs the Director of Insurance of two other ‘less urgent’ issues which arose from his conversation with Equitable on 13/03/2001:

1) On the compromise scheme: ‘We agreed that FSA should receive all papers for [the steering group] … and that in the light of these we might attend some meetings on an ad hoc basis as observers, (depending on the agenda, state of play etc.). But I agreed with [the Chief Executive] that we would not want full membership, because we needed to preserve our distance from decisions taken by Equitable, and be free to form our own view. This arrangement is also easier to handle in PR terms (for both FSA and Equitable)’.

2) The Head of Life Insurance had informed Equitable’s Chief Executive that FSA would be requesting further information in relation to his appointment as Managing Director of Equitable.

[10:23] Managing Director A comments that he was sure these responses ‘have to be right’. He also warns, in relation to discussion about the market value adjuster, that the FTSE 100 Index had fallen, as of that morning, a further 1% to 5660.

The OFT send FSA copies of correspondence between them and a bank who had complained, on behalf of their staff who were policyholders, about Equitable’s use of the market value adjuster. The OFT’s response to the bank explains:

We have no plans at this time to proceed against the Society in respect of its increase in the financial adjuster imposed on 8th December. This is not least because our powers under the Regulations are to prevent the continued use of unfair terms and do not extend to, for example, requiring the Society to compensate customers for penalty charges applied since December. Our concern lies with the clause in the Equitable’s Terms and Conditions which gives it “absolute discretion” in relation to the basis for calculation of the sum paid to policyholders on early withdrawal from the fund. The term is unfair because it has the potential to cause a significant imbalance in the parties’ rights and obligations arising under the contract, to the detriment of the consumer. Lack of transparency in consumer contracts is a well established concern among regulators, watchdogs and consumer associations alike.

The OFT continue, saying that they were:

… discussing with the Equitable ways in which the term can be made less opaque and restricted in the discretion granted to the Society. Our main aim is to develop wording which reflects considerations of fairness and equity, including meeting the legitimate expectations of contributors to the fund and reflecting the legitimate interests of both those who decide to leave the fund early (whether in ‘draw down’ or not) and those who remain until the contracted departures date(s).

FSA’s Legal Adviser A replies to Line Supervisor C’s request for advice of 28/02/2001 about Equitable writing new business (see 26/02/2001 [entry 1], 28/02/2001 [entry 3] and 05/03/2001 [14:54]). The Legal Adviser advises that: ‘Given the general sympathy for the policyholders concerned and [Scrutinising Actuary F’s] advice that the company has reserved for this and the fund will not be disadvantaged financially by allowing the switch, it does not seem unreasonable to allow this in the limited circumstances set out in the letter as referred to by [Scrutinising Actuary F]’.

Legal Adviser A concludes ‘that policyholders should be made aware of any implications of exercising the options’.

FSA’s Director of GCD sends Managing Director A a draft of a public statement of the kind that Equitable might consider issuing. It is intended to illustrate what he had in mind because: ‘I have been saying for some time that I thought that the Equitable would considerably strengthen its position from the viewpoint of the unfair contract terms legislation by a clear statement as to its approach to imposing market value adjusters’. The Director of GCD acknowledges that it was not for FSA to draft public statements on behalf of Equitable or to micro-manage their affairs.

The Director of GCD goes on to say: ‘But I thought it nevertheless desirable to make clear that what would be needed to ensure that the powers do not amount to an absolute discretion is achievable without needing to attempt an actuarial certainty which could never cover all situations’.

[16:25] The Managing Director says that the statement was helpful and makes some suggestions as to how it could be improved.

FSA’s Head of Life Insurance queries with the Director of GCD whether he was saying, in his note of 05/03/2001 [18:31] that, if a single policyholder were to be disadvantaged by its terms, the FSA might not be able to recommend the compromise scheme.

[17:00] The Director of GCD replies: ‘the court will need to decide whether it is fair that the compromise should bind dissentients. If we are to advise that it should do so we will need a basis for assessing whether it is fair to them. [The] more the conclusion is that the [proposal] is fair to each, the easier to conclude that it is fair to all’.

FSA’s Head of Life Insurance asks all insurance company supervisors to organise ‘a quick straw poll of their main life offices to establish the extent of the use of market value adjusters’. The Head of Life Insurance says that they should: ‘explain this as FSA wishing to establish how life offices are responding to the current stock market falls. (An additional, but confidential, reason is that if Equitable Life raise their MVA, we would like to know whether this is part of a more general pattern, or a problem specific to the Equitable.)’ He sets out ‘four key questions’ to ask and says that it would be helpful to include five companies on the survey who had been described in a recent press article as being particularly weak.

The four key questions are:

a) Is the company currently imposing an MVA?

b) If so, at what level? (any details about how it is calculated would be helpful but not essential).

c) How long has it been in place, and are there any plans to adjust it up or down?

d) If there is no MVA in place at the moment, are there any plans to introduce one, and what would be the criteria for doing so?

FSA inform Equitable that they have no objection to them ‘honouring the options under the level temporary assurance’ (see 26/02/2001 [entry 1]), provided:

… that this was responding to a client request and that policyholders are made clear about the implications of exercising the option.

We are generally sympathetic to this approach being extended in similar circumstances but could you please give us advance notice of which contracts you intend to take this approach with. We would want to ensure that there were no material costs to the Society from allowing non compulsory options.

FSA write to Equitable to confirm a point that had been discussed on the telephone the previous day about the proposed compromise scheme. FSA say that it had been agreed that Equitable would provide all the papers on the scheme that were going to Equitable’s steering group and that someone from FSA might attend meetings of the group as an observer.

FSA note that a round-up meeting with Equitable was planned for the following day and that this would be an opportunity to discuss the proposals further. FSA also suggest the following agenda items for that meeting: feedback on the roadshows; impact of the falling stock market on solvency, asset mix and the market value adjuster; discussions with the OFT; and restructuring/control arrangements within Equitable.

FSA’s Managing Director A reports to the FSA Board on the ongoing supervision of Equitable. His report, dated 7 March 2001, provides an update on various aspects of the position.

The Managing Director’s report includes the following statements:

There have been a number of developments on Equitable Life over the last month. Most notably, the sale of the operating business to the Halifax Group plc was announced on 5 February and completed on 1 March. The transaction includes the sale of the infrastructure of the Society (including its administration and marketing staff and IT systems) and the Equitable’s fund management subsidiary to Halifax. The Equitable’s non-profit and unit-linked businesses will be reinsured into Halifax Life (personal lines) and Clerical Medical (group business). Halifax will provide services back to the with-profits fund, which will remain within Equitable Life. Certain regulatory consents were given before completion and both companies have undertaken to co-operate to address any regulatory concerns that might arise on closer examination of the detailed documentation relating to the transaction.

Solvency

Equitable Life is currently preparing its accounts and statutory returns for the 2000 year end. At this stage, the financial information available is provisional and subject to audit. The free assets of the Society (i.e. those above our conservative statutory minimum requirements) should be of the order of £300 million (compared with total funds of over £30 billion). The figures take into account the more rigorous reserving standards that have been introduced by the Insurance Companies (Amendment) Regulations 2000, but they also rely on certain accounting concessions that have been requested but not yet granted. If those concessions cannot be given, the position will be very tight. We continue to receive monthly reports. Looking forward, there will have been the immediate improvement following the payment of the initial £500 million from Halifax on 1 March 2001; against that, equity prices have fallen since year end. Overall, the fund is reasonably stable, and after an initial rise in December, the rate of surrenders has fallen with the news of the Halifax deal.

Market Value Adjuster

Policyholders had been complaining to the Office of Fair Trading that the adjustments made to the policy values on surrender (which was increased from an average of 5% to 10% after the closure announcement) were contrary to the unfair contract terms legislation. As a matter of policy, we share the concerns that adjustments should not be excessive and serve materially to disadvantage one group of policyholders over another. However, for prudential reasons, it is important that any life office has sufficient flexibility to protect its insurance funds. OFT accepted that a 10% penalty was not unfair but were concerned about the ‘absolute discretion’ reserved to the Society to determine surrender values. We have worked closely with both the OFT and Equitable on this and assisted them [to] reach agreement about a way forward. OFT will not seek to challenge the relevant powers, and in return, Equitable will seek to improve the information about MVAs available to policyholders, including the reasons why they may be applied. The biggest short-term concern is that continuing falls in equity prices may lead Equitable to want to raise the MVA …

Policyholder Compromise

At the time of the Halifax announcement, Equitable also announced that it would be looking to put forward proposals for a compromise between policyholders under section 425 of the Companies Act 1985. Any proposal would require the support of a majority of policyholders voting, and be subject to court approval. In substance, Equitable is looking to buy out the guarantees in policies in return for an uplift of around 20 per cent in policy values. This would be funded from the additional reserves set aside to cover the cost of the guarantees. Equitable are already making arrangements for the new President to tour the country to meet policyholders to get support. The field force are also being lined up to explain and canvas the level of support for the proposals. If agreement is achieved, it will attract a payment of up to £500 million more from the Halifax, for goodwill, and improve the financial position by releasing statutory reserves held to cover the guarantees (these reserves are over and above the likely cost of a compromise along the lines set out above).

Equitable will be writing to policyholders soon about bonus rates. They have announced that in present circumstances, the entire annual bonus to be declared in March will be allocated to final bonuses, and none to guaranteed bonuses, because guaranteed bonuses add to the reserving requirement, and thus constrain investment freedom. They have held out the prospect of a guaranteed bonus if a compromise agreement on GARs is achieved, and will review the position later in the year.

In addition, the Managing Director’s report deals with changes in Equitable’s senior management, PIA review work on advice provided both prior to and after closure to new business, relations with policyholder action groups, and the Treasury Select Committee inquiry.

The Insolvency Practitioner provides the Director of Insurance, the Head of Life Insurance and another official with a 12-page analysis of the consequences and conduct of a liquidation of Equitable. The Insolvency Practitioner’s report’s summary reads:

There are no material benefits in liquidation to policyholders as a whole, or to any particular group of policyholders. Only one minor advantage to non-GAO policyholders arises: the prevention of GAO policyholders topping up their contracts.

Significant disadvantages arise: the termination of the reinsurance cover for high GAO take-up; a hiatus in any ongoing benefit payments being made whilst the liquidator and [Policyholders Protection Board] assess the position; and a short-term investment strategy being adopted.

A liquidator would seek a transfer or sale of the with-profits fund, but this would be difficult or impossible to achieve. During this period, compensation payments on policies maturing would be met by the [Policyholders Protection Board], but compensation in respect of terminal bonuses is excluded. This adds pressure for an early move to a “cash liquidation” – where the court makes a stop order and the liquidator ceases to carry on the business. Any transfer of business funded by the [Policyholders Protection Board] would also exclude “rights” to terminal bonuses: to the detriment of both GAO and non-GAO policyholders.

On a cash liquidation, substantial costs arise when all funds must be paid into the ISA and the Halifax administration and fund management contract is terminated with penalties. These costs could be of the order of £500m. These consequences are so severe that a liquidator is likely to explore the support for a [company voluntary arrangement] as an alternative distribution mechanism.

The compensation paid by the [Policyholders Protection Board] would now include PRE (as the compensation is by reference to the valuation of claims in a liquidation which includes PRE at the court’s discretion). It would also include the value of GAOs.

The Insolvency Practitioner says that he was now working on the wider problems with the Insurance Companies (Winding Up) Rules and on what the appropriate test of insolvency might be for an insurance company.

[18:27] Line Manager E sends the Insolvency Practitioner his thoughts on the issue. These include:

As a general matter, I thought that a liquidation could have tax implications for policyholders. For example, termination of some policies could as I understood lead to a chargeable event. Also am not clear what would happen to contributions made to pension funds. Presumably they would have to be transferred to another provider in some form or other, even if only on the basis of a new contract being entered into and the historic funds being added into the new pension. (Such matters may be quite important and at least as persuasive to a court and policyholder groups as any other issues).

[With reference] to GAR options. As a matter of fact, I understand (and this is consistent with my reading of the policy) is that GAR entitlement is actually set out in the policy, and the option under the contract is actually not to take the GAR. I mention this because it seems to me that it could be material in assessing the basis on which a policy would be valued on liquidation.

[With] reference to the [Policyholders Protection Board]. So far as I am aware, the new arrangements under part XV of [FSMA 2000] will not (so far) be materially different from those under the [Policyholders Protection Act 1975] and it might be worth recording this in the note for the benefit of other readers who may be less familiar with the schemes.

… some of the comments that arise later about the prohibitions under the agreements between Equitable and the Halifax Group [are questionable]. For example, would Clerical Medical, Halifax Life and the service company really insist on withdrawing altogether from their agreements at a time of insolvency, which would simply leave the Equitable policyholders in complete chaos, rather than coming to an arrangement with the liquidator, [Policyholders Protection Board] or the court to provide the necessary support and administration? …

… there are a number of reasons why we would expect the value of the reinsurance to be lost, but if take up of the GAR had already reached the 60% level, any claims that had already been made, then any amounts due in respect of those policies would presumably still flow through. As I understand it, GAR effective take up would automatically become 100% in insolvency, since that is the only way of establishing a value of the right, but at least the GAR would apply to lower levels of fund than would have been anticipated.

[With reference to the subordinated loan, if that] is subordinated to the rights of other creditors, I assume that it would continue to be subordinated in liquidation. That seems quite fundamental to allowing credit to be taken for it in solvency calculations. We (and Equitable) sought Counsel’s opinion on the interpretation of Article 4. I am not sure if you have seen the papers, but while we (and Equitable) were unable to obtain a definitive view of what Article 4 does mean, we managed to rule out certain interpretations, including the one that is most obvious from words (and which appears to be the one you are alluding to).

… what would happen if the contract provided for a further contract to be issued. For example, if a pension plan provided for an annuity to be paid at retirement, does the policyholder get his annuity including a GAR or does the liquidator/[Policyholders Protection Board] have to give him a cheque and send him out to the open market? As to the last sentence, that possibility is precluded in Equitable’s case by the terms of the Halifax agreement, as you mention later.

[On a future sale] I see the logic of what you say in sub-paragraph (a) – it is fairly clear that as things stand the Equitable’s with-profits fund is not something that anyone is prepared to take on so if the situation were to get worse, there seems little prospect of a company coming forward to take it over. In reality, this is precisely the point when the [Policyholders Protection Board’s] powers to provide assistance are important since it enables a subsidised transfer of reduced policies to take place. No doubt the costs of ongoing (or not) relationship with Halifax group will be a consideration when assessing who might be the most likely transferee. Even if the transfer were not made to a company in the Halifax group, there are a number of presentational reasons why Halifax might not be difficult about making sensible arrangements. The parties might agree that Halifax should continue to provide services for some time, and Halifax would certainly not wish to be seen to be frustrating arrangements that would be beneficial to policyholders if they can be concluded in a satisfactory way because of the significant reputational damage to the group. There must be questions about whether the Halifax could in any event enforce the contract, or at least some of the penalty clauses, if the company had become insolvent and the court had sanctioned a transfer to a third party …

[On a compromise scheme] I would not rule out at this point even if Equitable’s own attempts had been successful. For the time being, some policyholders will think if they hold out there is the prospect of getting a better deal. Once an insolvency has happened and the liabilities have crystallised, people may be keen to find some way of ensuring that their funds can be released quickly and in an orderly way. Interestingly, while it is those closest to retirement who I see as most likely to frustrate the Equitable scheme, they seem to be the most likely to want to sort things out quickly if an insolvency happened.

Line Manager E also made other, more technical, points.

FSA and GAD meet Equitable to discuss the proposed compromise scheme and other matters. FSA’s note of the meeting records discussion under the following headings:

S425 Compromise Arrangements

Equitable’s Chief Executive explains that Equitable were examining the compromise proposals under four areas: actuarial, legal, public relations and implementation. FSA repeat the need for them to be kept closely informed on developments. It is agreed that, while FSA ‘would not wish to be formally associated with this accommodation’, FSA would nominate someone to attend meetings of Equitable’s steering group as an observer. The Chief Executive says that he was concerned about possible strain on the Society’s human resources, given the likely work involved if, as he had been advised, it could be ‘as difficult as a formal Schedule 2C transfer of business’. Equitable report that the debate on the numbers of policyholder voting classes was continuing. They also say that the offer to GAR policyholders might be differentiated according to the ‘perceived “value” of the option’ and was now unlikely to be a straightforward percentage increase.

Roadshows/PR

Equitable’s Chief Executive says that the roadshows had gone well and he thought ‘there was 98-99% agreement from those that he spoke to that some form of accommodation should go through’.

Market Value Adjuster

Equitable’s Chief Executive says the announcement to increase the market value adjuster had ‘gone down as well as could be expected’ and that: ‘He would not have been happy to let existing policyholders subsidise those that were leaving’. FSA also record:

It was confirmed that when calculating an MVA the same principles applied to Group Schemes as individuals. However, when evaluating the Group MVA closer attention is spent on gauging the precise level of markets at the time of surrender and this is one of the reasons that a Group MVA can be different to an individual MVA.

The Society had also deterred groups from selecting against the Society on the odd occasion a group provider has sought to surrender non GAR contracts and maintain the GAR contracts. The Society had quoted on these occasions fairly stiff surrender penalties on the non GARs.

On a copy of the note of the meeting, the Director of Insurance highlights the second paragraph and underlines ‘on the non GARs’. On 23 March 2001, the Director asks Chief Counsel A whether she saw a problem with this.

The OFT

The note records that:

Both FSA and the Society had forewarned the OFT about the increases in the MVA but all sides appreciated that this did not really change the rationale and arguments behind this issue. The Equitable had formally responded to the OFT at the end of February and were awaiting OFT’s response.

Equitable’s Chief Executive says that he thought the matter with the OFT was largely closed. FSA say that they thought the OFT wanted Equitable to attempt to explain the basis for applying the market value adjuster in their literature.

Solvency/Asset Mix

FSA’s note records:

The [equity backing ratio] was still being maintained at 61% and this was the plan until the compromise plan was voted on. Solvency margin coverage was still relatively safe and could withstand another 10% fall in the markets.

[FSA’s Head of Life Insurance] said that we were still considering the Regulation 72 reserving issue with our legal team (retirement age assumption on certain contracts) and we would get back to the Society on this. [The Chief Executive] confirmed that the Society was currently using the more conservative reserving method so there could be a c£100m release from reserves if we accepted their interpretation. [An Equitable actuary] confirmed that the actuarial team were still checking the basis for applying for the synthetic bond Section 68 Order which was needed for the 31/12/2000 Annual Returns. [Line Manager E] had already communicated FSA’s views on the Permanent [Insurance] valuation and the Society needed to sort out any presentational issues with its auditors. [The Head of Life Insurance] stressed the need to take care with the presentation of the year end position.

It was confirmed that the auditors … will put in a fundamental uncertainty clause in the 2000 accounts and returns. The Directors’ statement will elaborate on this issue explaining what the uncertainties are in the balance sheet. It was also confirmed that after 2000 sign off the Society would seek to appoint new auditors as part of its attempt to make a clean break from the past.

Appointments

Equitable report that they were close to appointing a new Appointed Actuary and that the Appointed Actuary would be from an accounting or actuarial firm, but would be ‘expected to dedicate his time full time to the Society’. Equitable say that they had not yet finalised the appointment of the eight new Board members.

Control Arrangements

FSA’s note records: ‘It does appear that the haste at which the Halifax deal was put together had left a few holes in the arrangements between the two parties. There was no written material available on what the formal control responsibilities were between the Halifax and the Equitable in certain areas. This was an area that the Equitable’s audit committee was currently examining and the Halifax were also aware of shortcomings in this area’.

FSA’s Line Manager E attends a meeting of Equitable’s steering group on the compromise scheme. The terms of reference of the group were to ‘oversee the implementation of the section 425 scheme at a general management level’. He circulates his notes of the meeting to FSA and GAD, saying that there ‘is not much new to report’.

Line Manager E says that it had been noted during the discussion that there was a very heavy workload being placed on some parts of Equitable and that they were trying to buy in resources to cope. The Line Manager says: ‘There was already a risk to delivering to their existing timetables for the pensions review work and the GAR rectification scheme. They have also been constrained in the progress they have been able to make on the pension fund withdrawal review. I thought it would be helpful to mention this so that PIA colleagues are aware of the problems, and also that Equitable are aware of them and trying to resolve them. It is, I think, also helpful to remind ourselves that corporately we attach importance to the delivery of the compromise and would ask PIA colleagues to take that into account (and talk to me) before taking further action’.

FSA’s Line Manager E reports on a discussion that he had had with Equitable about section 68 Orders, following the meeting of Equitable’s Compromise Scheme Steering Goup. The Line Manager says that he had informed Equitable that:

I was concerned that if we were to get things done in time, we would now need to move quickly. This is in part because the Easter recess is not far away, and also because there is still allegedly a significant possibility of a general election being called. We will not get approval from ministers in that period, particularly on something that will be seen as vaguely contentious. [Equitable] took the point on board and will chase up work at their end.

The Line Manager records that Equitable had:

… updated me on the valuation of Permanent [Insurance]. They have established for Companies Act Accounts, the correct valuation is the sale price, but they have reached the view that it could not be treated as a debt. They will therefore require a concession that will enable them to count the consideration over and above the admissibility limits that normally apply. (Presentationally, I think that one is not too difficult – the contracted sale price is clearly a more useful valuation and I think we can argue that the payment was reasonably secure in this case.) I understand that this is simply a matter of specifying the valuation that should be applied for Form 9, but I would welcome advice on that.

Line Manager E continues:

For consistency, we probably need additionally to have a [section] 68 order that deals with the presentation of the year end returns. It might be that that would pick up on Permanent [Insurance] (if my understanding above is correct), and also the admissibility of [a company’s] shares at the year end, a section 68 order for which has been granted since the start of the new year. It might also be helpful if the [synthetic] bond presentation in the 2000 returns could be dealt with in the same order, so that the general acceptability of their valuation basis and the presentation of the end 2000 returns are dealt with separately. That way Press Office have only to explain once that the 2000 returns have been presented in a way that shows a “proper” valuation that is meaningful, rather than one that is technically correct but misleading. Discussions with [the Head of Insurance Policy] and [Legal Adviser A] persuade me that there are precedents.

[18:51] FSA’s Head of Life Insurance responds that he agreed with the overall approach. He says that FSA needed to press on with their view on the interpretation of Regulation 72.

Further to his note of 21/03/2001 [17:00], Line Manager E adds that he had also discussed with Equitable the issue of Regulation 72 and their retirement age assumptions. Equitable had told him that they still believed that retirement at age 55 would be a very prudent assumption and, if FSA conceded this issue, Equitable’s solvency position would improve by around £100m.

[11:56] GAD reply to FSA saying that they supported FSA granting Equitable a concession on the valuation of Permanent Insurance along the lines suggested.

GAD also say that they were ‘surprised’ that Equitable were: ‘now saying that moving the personal pensions retirement age from 50 to 55 would only release £100m – in earlier discussions (based on figures from the [Equitable’s Auditor’s] Reports) we had believed that the change would reduce liabilities by £200m – £250m. Or to put it the other way, reserving at 50 has not caused so large a strain as we had anticipated’.

Equitable apply to FSA for a section 68 Order in respect of the calculation of the rates of interest on fixed interest assets. Equitable ask for the Order to be granted with effect from 31 December 2000, as originally requested.

Line Manager E advises Line Supervisor C that FSA would have to tell Equitable ‘again!’ that any Order would have effect from the day it were made but ‘you can tell them that we will consider the possibility that we might order them to report as if the order have been in place. But they need to be clear that it will be tough getting HMT to sign up to this, and presentationally this (as opposed to Permanent + [the Order in relation to admissibility limits for shares in an individual company]) will be [very] difficult’.

FSA reply to Equitable’s application for a section 68 Order (see 23/03/2001 [16:51]), stating that they could not recommend to HMT that they should issue such an Order with retrospective effect, which ‘we believe to be outside their powers’. However, FSA explain how Equitable could submit an application which would be acceptable. FSA say:

… that it is possible for the Treasury to make an order under section 68 that would require the Society to prepare its annual returns on a particular basis, even though that information would relate to a period that has already ended but has not yet been reported upon.

… the application that we believe we would be able to consider would be for an order in respect of:

a) the future calculation of rates of interest on defined segments of fixed interest assets; and

b) the formation to be included in the 2000 year end returns.

However, in order to draft the order we need you to define clearly the different segments of the fixed interest assets. The order would require that this segmentation, and the method of determining the yield, is applied thereafter. Any application would need to explain fully why the Society considers that it should report a valuation other than one determined in accordance with the 1994 Regulations.

FSA continue that their understanding is that:

… the Society would like to obtain a concession that would enable it to show the value of the Permanent Insurance Company Ltd in its 2000 annual returns on the basis of the agreed sale price rather than on a look through basis. I understand from [an Equitable actuary] that the agreed sale price will be the figure shown in the Companies Act accounts for the period ending 31 December [2000]. If you wished to pursue that, we would need you to make an application for that concession as soon as possible. Again the application would need to set out the reasons why you consider that the Society should report a valuation other than as required by the 1994 regulations. You should also specify in an application the statutory provisions that you wish to see disapplied, or the modifications to such provisions that you would wish to see applied.

FSA conclude that:

… if you would like to proceed on the basis outlined above, I would be grateful if you could provide confirmation as soon as possible. I should make it clear that once such an application has been made, I will need to seek the approval of the FSA’s Insurance Supervisory Committee before making recommendations to the Treasury as to whether it should grant such concessions.

FSA and GAD hold a conference with Counsel on Equitable’s approach to assumptions on the retirement ages of policyholders. The advice of Counsel was that:

1. the contracts had to be valued on an individual basis;
2. Regulations 65(3) or (4) did not permit any reduction in provisions as these were concerned with circumstances in which an increase, or at least no reduction, was required;
3. Regulation 66 was concerned with situations where there was a valuation strain in respect of groups of contracts and was not concerned with the value of individual contracts;
4. Regulation 72(3) did permit assumptions to be made as to the age at which the individual would take the benefits.

Counsel further advised that there was scope for amendments to (i) clarify regulation 72(3) so that it is clear that assumptions as to the retirement age can be made and (ii) put in a requirement for reserving so that there was a smooth curve leading to the position where regulation 72(2) took effect. There was also a scope for the issue of helpful guidance on regulation 72(3).

GAD provide advice to PIA on the rectification scheme (see 20/03/2001 [17:28]). This includes the following:

GAD need to be satisfied that the rectification Scheme is fair between policyholders who retire(d) before, during and after the period January 1994 – July 2000, and that the New Bonus Resolution is consistent with the terms offered to policyholders who have taken retirement benefits since bonus rates were revised to take account of the House of Lords judgment. To enable us to reach a view on these matters, it would help if some additional information could be obtained from the Society, as follows …

• What approach was used to determine the new bonus rates under the New Bonus Resolution? Details of the method and basis used would be helpful.
• What criteria were used to determine whether the new rates of bonus were “fair”?
• How are the rates of bonus under the New Bonus Resolution expressed? Do they form an “end-piece” adjustment to the previous year-by-year roll up rates, or have the roll up rates themselves been restated?
• Examples of the application of the New Bonus Resolution to policies maturing over the period, say in each of 1994, 1997 and 2000.
• What proportion of smoothed asset shares do policyholders receive under the New Bonus Resolution for retirements over the period 1994 – 2000, if they exercise/do not exercise the GAR option?
• What proportion of smoothed asset shares have policyholders received on retirement since the House of Lords judgment in July 2000, if they exercise/do not exercise the GAR option?
• The Rectification Scheme booklet states (on [page 2]) that retirement benefits since 20 July 2000 have been calculated in line with the judgment. It also says (on [page 2]) that revised final bonus rates were set in October 2000, and that these took account of the judgment. Could the Society clarify which changes, in July and in October, are being referred to here?

FSA’s Line Manager E asks Managing Director A and FSA’s Chairman whether they were content with a response prepared to claims for compensation from Equitable policyholders. Part of the suggested responses states:

In your letter you say that you expect the FSA to compensate you for the losses you consider you have suffered. The FSA considers that it has throughout, acted reasonably and in good faith in performing its regulatory functions in relation to the Equitable. I note too that it is still very early days and, for the vast majority of policyholders, any conclusions about any amount they might have lost over the period of their policy would be premature.

On 28 March 2001 [15:39], the Director of GCD suggests to the Managing Director that, given the recent Bank of Credit and Commerce International case, the wording should be:

You suggest that the FSA should compensate you for losses incurred through your investment with the Equitable. We understand why you make this suggestion. But the reality is that regulation cannot provide a guarantee of the performance of every investment product. Our position is that we fully discharged our responsibilities in supervision of the Equitable. So I am sorry to say that there can be no question of us offering to pay compensation.

The final version of the response reads:

In your letter you say that you expect the FSA to compensate you for the losses you consider you have suffered. The FSA considers that throughout, it has discharged its responsibilities in performing its regulatory functions in relation to the Equitable and that there is no basis on which we could or should offer compensation. I note too that, for the vast majority of policyholders, any conclusions about any amount they might have lost over the period of their policy would be premature.

FSA write to Equitable about the interpretation of Regulation 72, in order to conclude their scrutiny of the company’s 1999 returns. FSA state:

Our discussions sought to establish the basis on which the Society should determine the statutory reserves needed to cover the potential cost of policyholders choosing to exercise the option to take early retirement. The latest correspondence on the subject was [Equitable’s] letter of 21 December 2000 and [GAD’s] reply of 9 January 2001.

I have now had the opportunity to review the relevant provisions with our actuarial and legal advisers. We have concluded that a correct interpretation of Regulation 72(3) is that it requires the appointed actuary to make prudent assumptions (as set out in broad terms in Regulation 72(1)) about additional liabilities that might arise if the option is exercised. We have reached the view that it is appropriate therefore for the Appointed Actuary to make prudent assumptions about the variable factors underlying the calculation, and this would include making assumptions about the age at which the option is exercised. I believe this is consistent with the Society’s interpretation of the relevant provisions.

FSA’s Director of Insurance informs Managing Director A that he had received a telephone call from Equitable’s Chairman, following a meeting between Managing Director A and the Society’s Chairman that afternoon. (Note: I have not seen a record of that meeting.) The Director of Insurance says that they were to announce that their auditors were not being put forward for reappointment and that the Chairman was sorry to see them go, but was ‘firm that they will continue to be involved behind the scenes’. The Director of Insurance also gave updates on the compromise roadshow, possible claims against Directors, auditors and regulators, and the Treasury Select Committee inquiry.

[17:52] The Head of Life Insurance adds that Equitable’s Chief Executive had telephoned to say that the Board had agreed yesterday that a new company should be proposed as the new auditors at the annual general meeting (the current auditors having indicated that they did not wish to be considered for reappointment) and that they had also approved the appointment of a new Appointed Actuary (a consultant from an actuarial firm), with immediate effect.

A GAD actuary sends Scrutinising Actuary F correspondence that he has had with the trustees of an Equitable AVC scheme of a government agency that was due to be privatised. In reply, the Scrutinising Actuary states:

The email from Equitable at the foot of this memo states that the absence of a 3.5% guaranteed rate of roll-up on the new policies will make no practical significant difference, since it just affects the apportionment of the declared bonus. However, the declared bonus for 2000 was nil, so those with a 3.5% guarantee received a 3.5% uplift to their guaranteed benefits, whilst policyholders without the 3.5% guarantee would have been credited with nil. On the other hand, final bonus (which applies to the whole fund) was declared at the rate of 9% for the last 5 months of the year, and so policyholders’ total funds would have increased by 5/12 of 9%, i.e. 3.75%, regardless of whether the guaranteed benefits were increased by 3.5%. The difference thus becomes one of the extent to which benefits are increased in guaranteed or non-guaranteed form; non-guaranteed benefits are exposed to the possibility that they can subsequently be taken away (via the MVA).

GAD (Scrutinising Actuary F) write to FSA (Line Manager E and the Head of Life Insurance), setting out ‘some aspects of the way in which Equitable is currently managing its affairs which, despite our numerous discussions with the Society, I feel I do not fully understand’. GAD write:

1. The 15% MVA only appears to be being applied to non-contractual surrenders, and is designed to scale back surrender/transfer values to a “fair” amount, taking into account primarily current investment conditions (the “type 1” adjustment) but also other factors such as unrecouped acquisition expenses (types 2 & 3 adjusters). Currently the type 1 adjuster is almost 15% in its own right. However, I understand that the MVA is not applied at all on contractual terminations, and so in these cases the policyholder is receiving about 15% too much (relative to current market levels). I would have thought there was a case for applying the MVA on contractual terminations also, provided it was only used to cut back the final (terminal) bonus and leave the guaranteed benefits intact. (On a non-contractual exit, it is OK for the MVA to eliminate not only the whole of the non-guaranteed bonus, but to erode some of the guaranteed benefits as well.) As things stand, those who leave the fund on contractual exit seem to be getting an unfairly good deal (at the expense of other policyholders).
2. If, on a contractual termination, the policyholder exercises the GAR option as well, the situation is exacerbated by the policyholder receiving not only an underlying “fund” 15% above its true value, but also a GAR on top worth perhaps a further 25%.
3. Following on from the above, presumably the current “interim” bonus rate of 8% p.a., which is all being added in “final” (non-guaranteed) form, would not be clawed back on contractual terminations either. Given the recent gyrations in the stock market, to allow funds to roll up at a rate of 8% p.a. seems very brave – the premise seems to be “it will be all right in the end”!

In essence, these questions are all about the extent to which the Society feels able to cut back final (non-guaranteed) bonus to reflect market conditions on contractual exits. (I raised some similar issues in my note to [PIA] on the Rectification Scheme earlier in the week.)

If my understanding is correct, then I presume that the Society may be taking the view that they do not want to “rock the boat” too much by cutting back benefits on contractual terminations at a time when they are desperately keen to achieve a GAR/non-GAR compromise deal. However, they could not go on paying excessive amounts on contractual terminations indefinitely.

GAD say that they wanted to raise these issues with Equitable at the meeting on 04/04/2001.